1. 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.

2. 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

3. 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)

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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)

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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)

43. 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

44. 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