Entry and Exit

1. Entry and Exit

2. Introduction • Incumbent firms formulate strategy taking into account the possibility of entry by new firms • Entry has two effects • reduced market share • intensified market competition • Can take two forms • entry by a new firm • entry by an existing firm diversifying into a new market • Exit is the reverse process • Acquisition is not entry: merely change of identity

3. Some Stylized Facts • Entry and exit is pervasive • over a five year period in most industries • 30-40% new firms enter • 30-40% of existing firms exit • entrants are generally small if they are new • most entrants do not survive 10 years • if they survive they grow rapidly: 60% fail, the remainder at least double in size • patterns vary across industries

4. Strategic Implications • Firms should • plan for entry by unknown firms • realize that diversifying entrants can threaten incumbents • expect most new ventures to fail quickly • but survivors will grow quickly • in planning entry focus on how to manage rapid growth • know the industry

5. Strategic implications (cont.) • Entrants should consider • costs of entry and exit: are there sunk costs? • likely reaction of incumbents: aggressive or passive • what has been the history of the market? • barriers to entry of various types

6. Barriers to Entry • Barriers can take two forms • Structural • incumbents have natural cost advantages • cost • location • regulatory environment • Strategic • through deliberate actions of incumbents

7. A Taxonomy • Entry conditions can be classified into three types • blockaded entry • structural conditions preclude entry without strategic actions • accommodated entry • structural barriers are low and there are no effective strategic barriers to entry • deterred entry • incumbents use specific strategies to deter entry

8. Structural Entry Barriers • control of strategic resources • patents • if not deliberately anti-competitive • economies of scale and scope • cost advantage of incumbency • ability to sustain a price war • leave no “holes” in the market • requires that some part of entry costs is sunk

9. Structural entry barriers (cont.) • marketing advantages of incumbency • exploit reputation and brand name • risky if a new product does not meet expectations • access to distribution based on reputation

10. Barriers to Exit • Exit if cannot make an acceptable return on assets • but consider only recoverable assets Do not enter unless expected price is at least PENTRY An illustration of the entry/exit decisions $ Do not exit if price is greater than PEXIT • Exit barriers exist • when there are fixed costs • when there are relationship-specific assets MC ATC AVC PENTRY PEXIT Quantity

11. Strategic Entry Deterrence • An incumbent will adopt entry deterring strategies • if monopoly is preferred to accommodated entry • if the strategies affect expectations of potential entrants about post-entry competition • First condition is obvious • unless the market is perfectly contestable • Second condition requires that strategies are credible

12. Entry deterrence • There are several potential strategies that have been suggested • limit pricing • predatory pricing • capacity expansion

13. Limit pricing • Charge a low price before entry • entrant is put off by the low price • An illustration suppose demand is P = 100 - Q marginal cost is $10 per unit fixed costs are $800 per annum incumbent has monopoly in year one; faces potential entry in year 2 market closes at the end of year 2

14. The Example An incumbent monopolist produces Q = 45 units; price = $55 $ = $1,225 Profit p.a. = (55 - 10)x45 - 800 Monopoly profit per period ignoring fixed costs 100 Suppose an entrant in period 2 with the same costs Demand Assume that the incumbent and entrant are Cournot (quantity) competitors 55 MC 10 MR 45 100 Quantity

15. The Example Each firm produces 30 units in period 2; price = $40 $ Profit to each firm = (40 - 10)x30 - 800 100 = $100 Demand Given this expectation entry will occur The incumbent’s profit in period 2 is sharply down 40 MC 10 MR 60 100 Quantity

16. The example (cont.) • Can the incumbent deter entry? • use the reasoning • price low in period 1 • the entrant will then expect an even lower price in period 2 • entry will not happen • I can then charge the monopoly price in period 2 • suppose the incumbent charges $30 in period 1 • the incumbent then expects a price no higher than $30 in period 2 • suppose that the price is actually $30

17. The example (cont.) • aggregate demand is 70 units • suppose that this is split equally • the entrant expects profits of (30 - 10)x35 - 800 = -$100 • with a lower price losses are even greater • so the potential entrant should not enter • the incumbent then has profits Limit pricing would appear to be successful in increasing profits Monopoly profit in the second period Profit in the first period (30 - 10)x70 - 800 = $1,825 + $1,225

18. The Example (cont.) • But this outcome is wrong: the logic is flawed • why only two years? • if more periods then the limit price might have to be sustained over a very long time • for this to be acceptable the incumbent needs a strong cost advantage over potential entrants • the supposed equilibrium is not credible • technically, it is not subgame perfect • the entrant’s supposed expectations regarding the incumbent’s post-entry actions are unreasonable • consider the full game in extensive form

19. The Entry Game Incumbent sets the limit price Entrant decides whether to enter Incumbent chooses its pricing strategy Out pI = $1,825; pE = 0 PL PL pI = $500; pE = -$100 Entrant In Incumbent Incumbent pI = $700; pE = $100 PC Incumbent sets the monopoly price Out pI = $2,450; pE = 0 Entrant PL pI = $1,125; pE = -$100 PM In Incumbent pI = $1,325; pE = $100 PC

20. The Entry Game If the Incumbent sets the limit price the Entrant will enter If the Entrant enters the Incumbent will choose Cournot The Incumbent will set the monopoly price Out pI = $1,825; pE = 0 PL PL pI = $500; pE = -$100 Entrant In In If the Incumbent sets the monopoly price the Entrant will enter Incumbent If the Entrant enters the Incumbent will choose Cournot Incumbent pI = $700; pE = $100 pI = $700; pE = $100 PC PC Limit pricing is not a credible strategy Out pI = $2,450; pE = 0 Entrant PL pI = $1,125; pE = -$100 PM PM In In Incumbent pI = $1,325; pE = $100 pI = $1,325; pE = $100 PC PC

21. Limit Pricing Rescued • Can limit pricing be rational? • what if the entrant is uncertain of the incumbent’s costs • high-cost incumbent - enter • low-cost incumbent - stay out • then the low-cost incumbent can signal a price that induces the entrant to stay out • but a high-cost incumbent might send the same signal • for this to work the price signal by a low-cost incumbent must be impossible for a high-cost incumbent • or there is additional uncertainty e.g. about demand

22. Predatory Pricing • Pricing intended to eliminate rivals • more aggressive than limit pricing • charge low price to drive out rivals • then subsequently raise price • Has similar credibility problems • chain store paradox • incumbent will not fight in a “last” market • so will not fight in all previous markets

23. Predatory pricing (cont.) • Paradox can be resolved if there is uncertainty about the incumbent’s “type” • if “easy” then entry is profitable • if “tough” then entry is unprofitable • incumbent wants to develop a tough reputation • Wal-Mart • American Airlines • develop routines that make managers tough • reward on market share not profits

24. Excess Capacity • Firms carry excess capacity • capacity use generally around 80% • economic reasons • to cope with unexpected fluctuations in demand • as a result of competition from new firms • strategic reasons • to deter entry • convince potential entrants of toughness of incumbents • potential entrants know that incumbents can expand output at low cost

25. Entry at limited scale • Potential entrants may be able to enter at low scale • deterrence is costly • incumbent may be inclined to ignore a small entrant • so entrant needs credible mechanism to convince incumbents of small-scale entry • “puppy-dog ploy” • modern manufacturing techniques may help • micro-breweries

26. War of attrition • Firms have been accused of charging low prices to eliminate competition • Standard Oil • Toyota • Wal-Mart • but price wars are costly and uncertain • firm with “deep pockets” will win • but at the expense of considerable profits • create exit barriers to influence rivals