Entry and Exit Economics of Strategy Chapter 9 Besanko, Dranove, Shanley and Schaefer, 3rd Edition Chapter 9 Entry and Exit Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc.

Forms of Entry Entry could take place in different forms An entrant may be a brand new firm (Example: Dreamworks SKG) An entrant may also be an established firm that is diversifying into a new product/market (Example: Microsoft entering gaming systems market) The form of entry is important when we analyze entry costs and strategic response to entry by the incumbents

Forms of Exit Exit could also take different forms A firm may simply fold up (Example: PanAm) A firm may discontinue a particular product or product group or leave a particular market (Peugeot leaves the U.S. market)

Evidence on Entry and Exit Study by Dunne, Roberts and Samuelson (DRS) of entry and exit in different industries in the U.S. found that Entry and exit were pervasive and the rates of entry and exit varied from industry to industry Entrants and exiters were smaller than the others Most entrants do not last longer than 10 years and those that do grow precipitously

DRS Findings on Entry and Exit Over a five year horizon, a typical industry experienced 30 to 40 percent turnover Conditions in an industry that encouraged entry also fostered exit Only 5 to 10 percent of entrants were diversifying firms

DRS Findings on Entry and Exit Unlike new entrants, diversifying firms built plants on the same scale as incumbents Diversified incumbents rarely close a plant permanently (2 to 3 percent of all exits) Plants closed by diversified exiters were approximately twice the size of other exiters’ plants

Implication of DRS Findings for Strategy As part of planning for the future, managers should account for the unknown future competitors Diversifying firms pose a greater threat to the incumbents since they tend to build bigger plants than other entrants

Implication of DRS Findings for Strategy Managers of new firms need to find capital for growth since survival and growth go hand in hand Managers should be aware of the entry and exit conditions of the industry and how these conditions change over time due to technological changes, regulation and other factors

Cost Benefit Analysis for Entry A potential entrant compares the sunk cost of entry with the present value of the post-entry profit stream Sunk costs of entry range from investment in specialized assets to government licenses Post-entry profits will depend on demand and cost conditions as well as the nature of post-entry competition

Barriers to Entry Barriers to entry are factors that allow the incumbents to earn economic profit while it is unprofitable for the new firms to enter the industry Barriers to entry can be classified into Structural barriers to entry and Strategic barriers to entry

Barriers to Exit Barriers to exit are factors that make the firm continue producing under such conditions which would not have encouraged the firm to enter Examples of such barriers are specialized assets labor agreements, commitment to suppliers and governmental regulations

Structural Barriers to Entry Structural barriers to entry exist when The incumbent has cost advantages or marketing advantages over the entrants Incumbents are protected by favorable government policy and regulations

Strategic Barriers to Entry Strategic entry barriers are barriers created and maintained by the incumbents Incumbents can erect strategic barriers by expanding capacity and/or resorting to limit pricing and predatory pricing

Typology of Entry Conditions Markets can be characterized by whether the existing barriers to entry are structural or strategic Three entry conditions according to Joe Bain are Blockaded entry Accommodated entry Deterred entry

Blockaded Entry Entry is considered to be blockaded when the incumbent does not need to take any action to deter entry Existing structural barriers are effective in deterring entry

Accommodated Entry When the condition accommodated entry, the incumbents should not bother to deter entry This condition is typical of markets with growing demand or rapid technological change Structural barriers may be low and strategic barriers may be ineffective in deterring entry or simply not cost effective

Deterred Entry Entry is not blockaded Entry deterring strategies are effective in discouraging potential rivals and are cost effective Deterred entry is the only condition under which the incumbents should engage in predatory acts

Types of Structural Barriers The three main types of structural barriers to entry are Control of essential resources by the incumbent Economies of scale and scope Marketing advantage of incumbency

Control of Essential Resources Nature may limit the sources of certain inputs and the incumbents may be in control of these limited sources Patents can prevent rivals from imitating a firms products Special know how that is hard for the rivals to replicate may be zealously guarded by the incumbents

Economies of Scale and Scope If economies of scale are significant, incumbent may face a high threshold of market share to be profitable Incumbent’s strategic reaction to entry may further lower price and cut into entrant’s profits If entrant succeeds, intense price competition may ensue

Economies of Scale and Scope Economies of scope in production may exists when multiple products that share inputs and production technology are produced in the same plant Economies of scope in marketing are due to the bulky up front expenditure an entrant has to incur to achieve comparable brand awareness as the incumbent’s brand

Hit and Run Entry Economies of scale and scope deter entry only if the entrant cannot recoup the up front entry costs If up front costs are nor sunk costs, entrant can come in on a large scale and exit if incumbents retaliate - hit and run strategy However, economies of scale and scope may often require up front sunk costs

Marketing Advantage of Incumbency Incumbent can exploit the brand umbrella (different products sold under the same brand name) to introduce new products more easily than new entrants can The brand umbrella can make it easy for the incumbent to negotiate the vertical channel (Example: It is easier to get shelf space with an established brand)

Marketing Advantage of Incumbency Exploitation of the brand name and reputation is not risk-free If the new product is unsatisfactory, customer dissatisfaction may harm the image of the rest of the brands

Entry Deterring Strategies Some examples of entry deterring strategies are limit pricing, predatory pricing and capacity expansion For these strategies to work Incumbent must earn higher profits as a monopolist than as a duopolist and The strategy should change the entrants’ expectations regarding post-entry competition

Contestable Markets and Entry Deterrence In a perfectly contestable market, a monopolist sets the price at competitive levels If there is a possibility of a hit and run entry (zero sunk cost) the market is contestable If the market is contestable, it is not worth the monopolist’s while to adopt entry deterring strategies

Limit Pricing An incumbent using the limit pricing strategy will set the price sufficiently low to discourage entrants The entrant observes the low price and concludes that the post entry price will be low as well and decides not to enter

Is Limit Pricing Rational? When multiple periods are considered, the incumbent has to set the price low in each period to deter entry in the next period Thus, the incumbent never gets to raise the price and does not reap the benefits of entry deterrence

Is Limit Pricing Rational? Even in a two period setting, limit pricing equilibrium is not subgame perfect Potential entrants can rationally anticipate that the post-entry price will not be less than the Cournot equilibrium price

Predatory Pricing A firm using the predatory pricing strategy sets the price below short run marginal cost with the expectation of recouping the losses when the rival exits Limit pricing is directed at potential entrants while predatory pricing is directed at entrants who have already entered

Is Predatory Pricing Rational? If all the entrants can perfectly foresee the future course of incumbent’s pricing, predatory pricing will not deter entry In experimental settings with complete information, predation did not occur Chain store paradox: Many firms commonly perceived to engage in predatory pricing

Situations When Limit Pricing Works Limit pricing will work if the incumbent has a cost advantage over the entrant With a cost advantage, the incumbent can set the price slightly below entrant’s minimum average cost, ensuring that entrant can not make profits

Situations When Limit Pricing Works Limit pricing will work if the entering firm in uncertain regarding the market demand or some determinant of post-entry pricing such as incumbent’s marginal cost If entrant can predict post-entry price, its decision to enter or not will be independent of the incumbent’s strategy

Limit Pricing and Uncertainty about Cost In a model developed by Milgrom and Roberts, entrant is assumed be uncertain regarding incumbent’s marginal cost Incumbent can be either a high cost producer or a low cost producer If the incumbent is a low cost producer, it can pick a low price to signal its low cost and deter entry

Limit Pricing and Uncertainty about Cost The price picked by the low cost incumbent will be too low to be rational had the incumbent been a high cost producer Hence the low price becomes a credible signal of low marginal cost If the incumbent is a high cost producer, it cannot deter entry

Limit Pricing and Dual Uncertainty In Garth Saloner's model, the entrant is uncertain about the incumbent’s cost as well as the level of demand Incumbent prices below the monopoly price regardless of cost which signals that either the demand is low or the incumbent is a low cost producer In either case entry is deterred

Situations When Predatory Pricing Will Work With uncertainty, predatory pricing can deter entry If the incumbent does not slash prices, other challengers may consider him ‘easy’ rather than ‘tough’ An incumbent can be ‘tough’ either due to low costs or due to an irrational desire for market share To deter entry, incumbent has to establish a reputation for toughness

Excess Capacity and Entry Deterrence By holding excess capacity, the incumbent can credibly threaten to lower the price if entry occurs Since an incumbent with excess capacity can expand output at a low cost, entry deterrence will occur even when the entrant is completely informed about the incumbent’s intentions

Excess Capacity is Not Always Strategic When capacity addition has to be lumpy, firms may often have excess capacity in anticipation of future growth A temporary down turn in demand may leave the firms in an industry with excess capacity with no strategic overtones

Situations When Excess Capacity Works to Deter Entry Incumbent has a sustainable cost advantage Market demand growth is slow Incumbent cannot back-off from the investment in excess capacity Entrant is not the type trying to establish a reputation for toughness

Entrant’s Strategy: “Judo Economics” If the entrant can convince the incumbent that it does not pose a long term threat, incumbent may be reluctant to adopt costly entry deterring strategies (using the opponent’s strength to one’s advantage) Netscape’s open source strategy may be Judo move against Microsoft whose strength is in standardized rather than customized software

War of Attrition In a price war, larger players may have better staying power (larger cash reserves, better access to credit) Larger players also incur a greater cost (especially if they do not have a cost advantage)

Winning the War of Attrition The more a firm believes it can outlast its rivals, the more willing it will be to begin and continue with a price war A firm that faces exit barriers is well positioned to engage in a price war A firm can also try to convince its rivals that it can outlast them (For example, by claiming that they are making money even during the price war

Evidence on the Use of Entry Deterring Strategies Reported Use of Entry Deterring Strategies Aggressive price reductions to move down the learning curve Intensive advertising to create brand loyalty Acquiring patents Enhancing reputation for predation using announcements and other means Limit pricing Holding excess capacity