ECON 330 Lecture 23 Thursday, December 13

NEXT THURSDAY, DECEMBER 20th: COURSE EVALUATIONS

Today’s Lecture: Strategic Entry Deterrence

The free entry model we studied is unrealistic. All firms make the entry decision at the same time. In reality in all markets there are incumbent firm(s) and potential entrant(s). The incumbents try to stop new firms entering profitable markets.

Entry deterrence (A little story) EasyJet is one of the European success stories of 1990s. It started low-cost, low air-fare service between different European cities. London – Glasgow 1995 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.

KLM’s goal was to make EasyJet exit the market (London-Amsterdam route). In early 1998, British Airways (BA) started its own discount fare airline, Go. It’s motives were. Take advantage of a business opportunity (growing demand for low- fare flights). Eliminate the competition from small, low-fare airlines. EasyJet bought Go in 2002!

Now some theory Entry decision is a strategic decision. The potential entrant must think about the incumbent’s possible response/retaliation in the post entry stage. An incumbent may charge a low price to induce the exit.

A simple model of Entry Deterrence The market is currently monopolized by an incumbent (I). A potential entrant (E) is considering entry into the market. TIMING of EVENTS The incumbent chooses its capacity (quantity) qI first. This choice is irreversible. After observing the incumbent’s quantity choice, the entrant decides whether to enter.

TIMING of EVENTS, cont. To enter, the entrant must pay a fixed entry cost, F=225. If the entrant enters, it will choose its quantity qE. If the entrant does not enter, the incumbent remains a monopolist.

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

Solve the model: Start at Stage 2. Given qI, suppose E enters. It will choose qE to maximize 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 maximizes profit with qE*=(80 – qI)/2. Inverse demand P = 100 – Q Q  qE + qI so P = 100 – qE – qI

The entrant’s profit The Incumbent produces qI The Entrant produces qE*= (80 – qI)/2. The Entrant’s profit is πE = (100 – qE – qI)qE – 20qE. πE = (100 – qE – qI – 20)qE. πE = (100 – [(80 – qI)/2] – qI– 20)[(80 – qI)/2]. πE simplifies to πE* = (80 – qI)2/4

The entrant’s maximum profit is πE. = (80 – qI)2/4 Observation πE The entrant’s maximum profit is πE* = (80 – qI)2/4 Observation πE* decreases as qI increases.

Now we go to stage 1, E’s entry decision E will enter if πE* = (80 – qI)2/4 ≥ F What is the minimum qI the Incumbent must produce to deter entry? We solve this inequality for qI: qI ≥ 80 – 2F1/2 Remember F = 225 To deter entry, the Incumbent must produce at least 50 units. In that case its profit will be 1500.

Should the Incumbent produce 50 units and deter entry Should the Incumbent produce 50 units and deter entry? Is this a good outcome (profit = 1500) for the Incumbent? Let’s compare these profits to some benchmark profit.

For example, to the Incumbent’s monopoly profit P = 100 – Q. MC = 20. The monopoly price is 60, the monopoly quantity is 40, the monopoly profit is 1600. If I chooses the monopoly quantity of 40, the entrant will enter. Producing an output level of 50 units will deter entry, and brings a profit of 1500.

So… Can we say that entry deterrence is a good strategy?

What if the Incumbent accommodates entry? Then they are in the Leader-follower competition in the style of Stackelberg. 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 Find the profit maximizing qI: dπI/dqI = 40 – qI= 0  qI* = 40; and qE* = 20. I’s profit is 800.

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

The effect of the entry cost F Now suppose that the entry cost is 625. To deter entry I must produce qI ≥ 80 – 2F1/2 = 30. Even if I chooses the monopoly quantity 40, the entrant will not enter. We call this case the blockaded entry. The threat of entry is irrelevant.

The effect of the entry cost F Now suppose that the entry cost is 25. To deter entry I must produce qI ≥ 80 – 2F1/2 = 70. I’s profit under deterred entry is 700. This is lower than its profit if entry is accommodated. The incumbent will choose 40 and entry is accommodated. We call this case entry accommodation.

Concluding remarks-Entry Deterrence As the entry cost increases, deterring entry becomes less costly for the incumbent, so it becomes more likely that entry will be deterred. As the entry cost becomes very big, the entrant will not enter, even when the incumbent doesn’t increase output to deter entry. To deter entry, the incumbent’s quantity choice must be “not reversible”. Otherwise, the incumbent will want to adjust its quantity after E enters.

This is what happens if qI is reversible I chooses q = 50 and believes that this will make E stay out. E enters. E is now about to choose its q. If E believes that I will not change q = 50, E will choose q = 15. But if I believes that E will choose q = 15, I will want to revise qI from 50 to 32.5. The best response to q = 15 is q = 32.5. But this destroys the entry deterrence strategy.

If the Incumbent’s quantity choice is reversible at a later stage, then the competition will be as in the Cournot model. Entry deterrence is impossible. So some argue that it’s better to think that the Incumbent chooses capacity, rather than quantity. Only irreversible choices are credible. We say that irreversible choices have commitment value.

Now it is your turn

Two coffee-shop companies compete in a big city neighborhood Two coffee-shop companies compete in a big city neighborhood. Starbox (Firm S) and Timmy’s (Firm T). Each firm has to choose how many coffee-shops to operate in the neighborhood. Firm T is the incumbent and has one coffee-shop. Firm S is the potential entrant, and it does not have any shops at the moment. Period 1: Firm T decides whether to open another shop. Period 2: Firm S decides whether enter the local market and open its first coffee-shop.

After firm S’s decision, firms compete in the style of Bertrand and profits are realized. (This is the differentiated product version, see below.) The Bertrand equilibrium profit of a firm depends on its own number of stores and on the number of stores of the competitor. The profit functions are: Firm T: πT = nT(6 − 2nT − nS) Firm S: πS = nS(3.5 − 2nS − nT) nT is the number of stores of firm T; nS is the number of stores of firm S.

End of lecture