Business Economics (A) Researcher training course 9-10th week

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Business Economics (A)Researcher training course
9-10th week

• Yuji Honjo
• Faculty of Commerce
• Chuo University

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Contents

• Theme
• Entry and exit
• Keyword
• Barriers to entry, Limit pricing, Predatory
  pricing
• Discussions
• Do you think economies of scale are considered
  barriers to entry?
• Do economies of scale protect incumbents from
  hit-and-run entry unless the associated fixed
  costs are sunk?

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Some facts about entry and exit

• Entry forms
• New firm
• A firm did not exist before it entered a market.
• Diversified firm
• A firm already exists but had not previously been
  in that market.
• A firm sells the same product in other geographic
  markets.
• e.g.) Amazon.com (which sells books over the
  Internet), Microsoft (which introduced the
  Microsoft X-Box gaming system)

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(Continued)

• Exit forms
• Withdrawal of a product from a market
• A firm shuts down completely.
• A firm continues to operate in other markets.
• e.g.) Renault and Peugeot (which exited the U.S.
  automobile market), Sega (which exited the video
  game hardware market)

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Dunne et al.s (1988) findings

• U.S. manufacturing firms between 1963 and 1982
• Entry and exit will be pervasive.
• 30 and 40 new entrants during 5 years per 100
  firms
• Entrants and exiters tend to be smaller than
  established firms.
• A typical entrant will be only one-third the size
  of typical incumbent.
• Diversifying entrants tend to be three times the
  size of other entrants.
• Most entrants do not survive 10 years, but those
  that do grow precipitously.
• Roughly 60 will exit during 10 years.
• Entry and exit rates vary by industry.

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(Continued)

• Implications for strategy
• The manager must account for an unknown
  competitor (entrant).
• Not many diversifying competitors will build new
  plants, but the size of their plants can make
  them a threat to incumbents.
• e.g.) Microsoft X-box -gt Sony playstation
• Managers should expect most new ventures to fail
  quickly.
• Managers should know the entry and exit
  conditions of their industry.

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Entry and exit decisions basic concepts

• A profit-maximizing, risk-neutral firm should
  enter a market
• Net present value of expected post-entry profits
  gt Sunk costs of entry
• Post-entry profits lt demand and cost conditions,
  and the nature of post-entry competition

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(Continued)

• Barriers to entry
• Definition by Bain (1956)
• Factors that allow incumbent firms to earn
  positive economic profits, while making it
  unprofitable for new comers to enter the
  industry.
• Structural or strategic entry barriers
• The incumbent has natural cost or marketing
  advantages. gt Structural entry barriers
• The incumbent aggressively deters entry. gt
  Strategic entry barriers

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Bains typology of entry conditions

• Three entry conditions
• Blockaded entry
• Structural entry barriers are so high that the
  incumbent need do nothing to deter entry.
• lt Fixed investments, Product differentiation
• Accommodated entry
• Structural entry barriers are low.
• lt Growing demand, Rapid technological
  improvements
• Deterred entry
• The incumbent can keep the entrant out by
  employing an entry-deterring strategy, and
  employing the entry-deterring strategy boosts the
  incumbents profits.

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Structural entry barriers

• Three main types of structural entry barriers
• Control of essential resources
• Economies of scale and scope
• Marketing advantages of incumbency

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(Continued)

• Control of essential resources
• e.g.) DeBeers in diamonds, Alcoa in aluminum, and
  Ocean Spray in cranberries
• Incumbents can legally erect entry barriers. gt
  Patent
• cf.) A government patent office sometimes cannot
  distinguish between a new product and an
  imitation of a protected product. gt Invented
  around

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(Continued)

• Economies of scale and scope
• Cost advantage gt Minimum efficient scale (MES)
• The entrant cannot recover its up-front entry
  costs if it subsequently decides to exit. gt Only
  if the up-front entry costs are sunk costs.
• Marketing advantages of incumbency
• Brand umbrella

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Barriers to exit

• (See Figure 9.2.)

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Entry-deterring strategies

• Two conditions for entry-deterring strategies
• The incumbent earns higher profits as a
  monopolist than it does as a duopolist.
• The strategy changes entrants expectations about
  the nature of post-entry competition.

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(Continued)

• Three ways for entry-deterring
• Limit pricing
• Predatory pricing
• Capacity expansion
• lt Assuming that the incumbent monopolists
  market is not perfectly contestable.

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Cf. Contestability theory

• Baumol et al. (1982)
• A monopolist cannot raise price above long-run
  average cost. gt The market is perfectly
  contestable.
• Cf.) hit-and-run entry
• The theory was applied to the airline industry.
• gt See Borenstein (1989).

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Limit pricing

• Limit pricing
• An incumbent firm discourages entry by charging a
  low price before entry occurs.
• Example
• Demand function P 100 Q
• Cost function MC 10, F 800
• Case Monopoly MR MC
• ? P 55, Q 45
• ? Profit (55 10)45 800 1225

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Limit pricing

• Case Cournot duopoly (reaction functions)
• ? P 40, Q1 Q2 30 (Q 60)
• ? Profit (40 10)30 800 100

Market Structure Price Annual Profit per Firm
Monopoly 55 1225
Cournot duopoly 40 100
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(Continued)

• Two-periods game
• Incumbent gt P 30 (Q 70)
• Incumbents profit (1st period)
• (30 10)70 800 600
• Entrants profit (if entry occurs)
• (30 10)35 800 100
• Is limit pricing rational?
• (See Figure 9.3.)

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Predatory pricing

• Predatory pricing
• A firm sets a low price to drive rivals out of
  business.
• Difference between limit pricing and predatory
  pricing
• Limit pricing gt Rivals that have not yet entered
  the market.
• Predatory pricing gt Rivals that have already
  entered.
• Chain-store paradox
• An incumbent can slash prices to drive out
  rivals. gt Irrational

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Rescuing limit pricing and predation the
importance of uncertainty and reputation

• Are limit pricing and predatory pricing
  irrational strategies?
• The explanation is that the analysis far fails to
  capture important elements of their strategies.
• gt Uncertainty
• Cf.) Milgrom and Roberts (1982)
• Reputation for toughness

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Limit pricing

• Limit pricing
• An incumbent firm discourages entry by charging a
  low price before entry occurs.
• (See Table 9.1.)

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(Continued)

• Is limit pricing rational?
• (See Figure 9.3.)

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Predatory pricing

• Predatory pricing
• A firm sets a low price to drive rivals out of
  business.
• Difference between limit pricing and predatory
  pricing
• Limit pricing gt Rivals that have not yet entered
  the market.
• Predatory pricing gt Rivals that have already
  entered.
• Chain-store paradox
• An incumbent can slash prices to drive out
  rivals. gt Irrational

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Rescuing limit pricing and predation the
importance of uncertainty and reputation

• Are limit pricing and predatory pricing
  irrational strategies?
• The explanation is that the analysis far fails to
  capture important elements of their strategies.
• gt Uncertainty
• Cf.) Milgrom and Roberts (1982)
• gt Reputation for toughness

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Excess capacity

• Excess capacity
• Firms hold more capacity than they use.
• gt By holding excess capacity, an incumbent
  affects how potential entrants view post-entry
  competition, and thereby blockade entry.
• Cf. Credible commitment
• Excess capacity deters entry even when the
  entrants possesses complete information about the
  incumbents strategic intentions.

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(Continued)

• Conditions for entry deterrence (Lieberman, 1987)
• The incumbent should have a sustainable cost
  advantage.
• Market demand growth is slow.
• The investment in excess capacity must be sunk
  prior to entry.
• The potential entrant should not itself be
  attempting to establish a reputation for
  toughness.

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Judo economics and puppy-dog ploy

• Judo economics proposed by Gelman and Salop
  (1983)
• Smaller firms and potential entrants can use the
  incumbents size to their own advantage.
• Cf. Puppy-dog ploy
• Case On-line book retail market (Amazon vs.
  Barnes Noble)

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Exit-promoting strategies

• Wars of attrition
• Evidence on entry-deterring behavior
• Survey data on entry deterrence by Smiley (1988)