ECON 330 Lecture 21 Monday, December 9

Announcements Study questions PART I for the final exam are posted –the Assignments section Final exam Fall 2012 (w/o solutions) is also posted –the Announcements section

Today’s menu Entry and Social welfare (Oligopoly markets, Cournot) Strategic entry deterrence

Last lecture: Entry costs and market structure All potential entrants use the same technology with the cost function: TC(q) = F + cq. The market demand is Q(p) = S(a−P). S is the market size parameter. Stage 1: Firms decide whether to enter or stay out. Those who decide to enter pay the fixed entry cost F. Stage 2: Firms that have entered compete in the style of Cournot. In stage 2 all firms have constant AC=MC=c.

The equilibrium number of firms N* Result: N* = (a–c) – 1. Example: Market demand is Q(P) = 100 – P, Entry cost is F = 225; the marginal cost is c = 20. Translation into S and a: S = 1, a = 100 Use the formula: (100 – 20) – 1 = 80/15 – 1 = 4.33, so, N* = 4!

Is N. = 4 optimal. Does it maximize the social welfare Is N* = 4 optimal? Does it maximize the social welfare? SW(N) = CS(N) + PS(N) – NxF? Social welfare: consumers’ surplus + producers’ surplus – sum of entry costs

Short answer: NO! N = 4 is too many!

Example, contunied: free entry and social welfare N* = 4 (free entry equilibrium) The potential entrant compares F = 225 to PS per firm The socially optimal N is 2! We (social optimizers) compare F to change in PS + CS total + =

Entry and social welfare With Cournot oligopoly competition in the post entry stage, free entry leads to excessive entry. Why? Because of the “business stealing effect”.

What is this business stealing effect?

Business stealing effect explained Let QN+1 – QN be the change in total industry output following the entry of firm #(N+1). Let qN+1 be the output of Firm #(N+1). We say that there is a “business stealing effect” if QN+1 – QN < qN+1.

Is there are business stealing effect? QN+1 – QN < qN+1? Let N = 1 (monopoly) Compare: QN (total) is 40 QN+1 (total) is 53.3 QN+1 – QN = 13.3 qN+1 = 26.7. Yes, there is business stealing effect. After firm #2 enters, the first firm reduces its q by 13.3 units from 40 to 26.7.

Business stealing effect QN+1 – QN < qN+1 leads to excessive entry Social benefits from entry = (P – MC)(QN+1 – QN)

the gray shaded trapezoid

Business stealing effect: QN+1 – QN < qN+1. Social benefits from entry = (P – MC)(QN+1 – QN) Private benefits (profits) from entry = (P – MC)qN+1

the dashed lined rectangle

Business stealing effect: QN+1 – QN < qN+1. Social benefits from entry = (P – MC)(QN+1 – QN) Private benefits from entry = (P – MC)qN+1 So, whenever P > MC, and there is a business stealing effect, private benefits social benefits of entry of entry, so there will be too many firms in the free entry equilibrium (oligopoly market). >

Now it is your turn…

In class exercise The inverse market demand is p(Q) = 21 − Q. The cost function is TC(q) = F + q. F is the entry cost: F = 6. Entering firms compete in the style of Cournot. Use the table to determine the equilibrium number of firms, and the number of firms that maximizes social welfare. Consumers’ Surplus PS per firm Total PS

The Nash equilibrium of the Cournot competition with N = 1, 2, … 8 firms. Profits are post entry profits (P-c)xq Consumers’ Surplus PS per firm Total PS

Now: Strategic Entry Deterrence A “simple” model

We assumed that all firms make the entry decision at the same time We assumed that all firms make the entry decision at the same time. This is not a good assumption. In almost all markets, at any point in time, there are firms who already entered earlier (the incumbents) and potential entrants who are comparing the costs and benefits of entry. It is reasonable that the incumbents will try to make entry less attractive for the new firms.

Entry deterrence (EU Airlines industry) EasyJet (1990s) started low- cost, low air-fare service between different European cities. Soon after it entered London-Amsterdam segment, KLM (held 40% of market share) responded by matching EasyJet’s low fares. It seemed that KLM was pricing below cost. It also implied serious losses for EasyJet. KLM’s intention is to make EasyJet exit the London- Amsterdam route.

The incumbents will try to make entry less attractive for the new firms because entrants take market share away, reducing the incumbent’s share of total profits, and their entry intensifies competition, reducing total profits.

Now some theory

A simple model of entry deterrence The market is currently monopolized by an incumbent (I). A potential entrant (E) is deciding whether to enter. The timing of events Stage 1: The incumbent chooses its quantity qI. Stage 2: E makes the entry decision. If E chooses to enter, it pays the fixed entry cost F, and chooses its quantity qE. If E stays out, the incumbent remains a monopolist, sells qI units.

Cost and demand information The inverse demand is p(Q) = 100 – Q. Both firms have a constant average and marginal cost of 20.

Solve the model: Start at Stage 2. The incumbent has chosen qI in stage 1. So now, suppose E pays F and enters. Then… E chooses qE to maximize πE = pxqE – 20qE, πE = (100 – qE – qI)qE –20qE. dπE/dqE = 100 – 2qE – qI –20 = 0 qE*=(80 – qI)/2 Given the incumbent’s quantity qI the entrant achieves the maximum profit with qE*=(80 – qI)/2. p(Q) = 100 – Q, Q = qI +qE

Is that maximum profit high enough for E Is that maximum profit high enough for E? (enough to pay off the entry cost F?)

Compute the entrant’s (maximum) profit The Incumbent produces qI (decided in stage 1) The Entrant enters and produces qE*= (80 – qI)/2. (this is stage 2) The Entrant’s profit is πE = (100 – qE – qI)qE – 20qE. πE = (100 – [(80 – qI)/2] – qI– 20)[(80 – qI)/2]. πE simplifies to πE* = (80 – qI)2/4

After observing qI … E will enter only if πE* = (80 – qI)2/4 ≥ F We solve this inequality for qI: qI ≥ 80 – 2F1/2 Remember F = 225 To deter entry, the Incumbent must produce 50 units or more. Assuming that qI = 50 deters entry, the Incumbent’s profit with entry deterrence will be 1500. Q = 50, P = 50, profit = (50–20)x50

Is entry deterrence profitable for the Incumbent?

Is entry deterrence (qI = 50) “bad” for social welfare Is entry deterrence (qI = 50) “bad” for social welfare? Compare the free entry equilibrium with the entry deterrence equilibrium.

Another option for the Incumbent: Entry accommodation The Incumbent still has an advantage: It chooses q in stage 1 before E chooses qE. This is the Stackelberg Leader-Follower model. I chooses qI to maximize πI = (100 – qE* – qI – 20)qI Remember: qE*= (80 – qI)/2. Substitute this into πI and simplify: πI =(80 – qI)qI/2 dπI/dqI = 40 – qI= 0  qI* = 40; and qE* = 20.  P = 40 I’s profit is 800. (40-20)x40

Summary Incumbent’s Option 1 Choose qI = 50 and deter entry. Profit 1500 Incumbent’s Option 2 Accommodate entry, choose qI = 40. Profit 800 It’s better for I to choose 50, and deter entry.

Is entry deterrence (qI = 50) “bad” for social welfare Is entry deterrence (qI = 50) “bad” for social welfare? Compare the free entry equilibrium with the entry deterrence equilibrium.

The effect of the entry cost F Suppose that the entry cost is much higher: F = 625. Then to deter entry I must produce qI ≥ 80–2F1/2 = 30. Even if I chooses the monopoly quantity 40, the entrant will not enter. This case is known as blockaded entry. The threat of entry is irrelevant.

Suppose that the entry cost is very low F = 25 Suppose that the entry cost is very low F = 25. To deter entry qI ≥ 80–2F1/2 = 70. When qI = 70, P = 30, so profits are (30 – 20)x70 = 700. This is lower than I’s profit if entry is accommodated. The incumbent will choose 40 and entry is accommodated. We call this case entry accommodation.

Concluding remarks on Entry Deterrence As the entry cost F increases, deterring entry becomes less costly for the incumbent, so in equilibrium entry will be deterred. To deter entry, the incumbent’s quantity choice should not be reversible. Otherwise, the incumbent can adjust its quantity after the Entrant chooses to enter, since the Incumbent’s quantity choice in stage 1 is not a best response when the Entrant is in.

If the Incumbent’s quantity choice is reversible at stage 2, then the competition will be as in the Cournot model, and entry deterrence is impossible, unless the Incumbent has a much lower MC than the Entrant. So some argue that it’s better to think that the Incumbent is choosing capacity, instead of quantity. Only irreversible choices are credible. Irreversible choices can deter entry because they have commitment value.

End of Lecture