Business Economics (A) Researcher training course 9-10th week RIETI シンポジウム 2005/6/23 Business Economics (A) Researcher training course 9-10th week Yuji Honjo Faculty of Commerce Chuo University Yuji Honjo

Contents Theme Keyword Discussions Entry and exit 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?

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)

(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)

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.

(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 -> Sony playstation Managers should expect most new ventures to fail quickly. Managers should know the entry and exit conditions of their industry.

Entry and exit decisions: basic concepts A profit-maximizing, risk-neutral firm should enter a market Net present value of expected post-entry profits > Sunk costs of entry Post-entry profits <= demand and cost conditions, and the nature of post-entry competition

(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. => Structural entry barriers The incumbent aggressively deters entry. => Strategic entry barriers

Bain’s typology of entry conditions Three entry conditions Blockaded entry Structural entry barriers are so high that the incumbent need do nothing to deter entry. <= Fixed investments, Product differentiation Accommodated entry Structural entry barriers are low. <= 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 incumbent’s profits.

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

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

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

Barriers to exit (See Figure 9.2.)

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.

(Continued) Three ways for entry-deterring Limit pricing Predatory pricing Capacity expansion <= Assuming that the incumbent monopolist’s market is not perfectly contestable.

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

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

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

(Continued) Two-periods game Is limit pricing rational? Incumbent => P = 30 (Q = 70) Incumbent’s profit (1st period) (30 – 10)*70 – 800 = 600 Entrant’s profit (if entry occurs) (30 – 10)*35 – 800 = – 100 Is limit pricing rational? (See Figure 9.3.)

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 => Rivals that have not yet entered the market. Predatory pricing => Rivals that have already entered. Chain-store paradox An incumbent can slash prices to drive out rivals. => Irrational

Are limit pricing and predatory pricing irrational strategies? 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. => Uncertainty Cf.) Milgrom and Roberts (1982) Reputation for toughness

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

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

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 => Rivals that have not yet entered the market. Predatory pricing => Rivals that have already entered. Chain-store paradox An incumbent can slash prices to drive out rivals. => Irrational

Are limit pricing and predatory pricing irrational strategies? 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. => Uncertainty Cf.) Milgrom and Roberts (1982) => Reputation for toughness

Excess capacity Excess capacity Firms hold more capacity than they use. => 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 incumbent’s strategic intentions.

(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.

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

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