Entry and exit

1. Entry and exit September 16, 2008

2. Some facts • Think of an industry with 100 firms doing a combined $100 million revenue in 2008 • In the next 5 years, 30 to 40 new firms will enter • Combined annual sales of $12 to $20 million • Half will be diversified firms entering the market • Half will be brand new (greenfield) firms • In the next 5 years, between 30 and 40 incumbent firms will exit • About 40% will be diversified firms that will continue to operate in other markets Entry and exit

3. Some facts • Think of an industry with 100 firms doing a combined $100 million revenue in 2008 • The typical greenfield entrant will be only 1/3 the size of the typical incumbent • Diversifying entrants are about the same size as incumbents • Firms that will leave the market in the next 5 years will be only about 1/3 the size of the average firm Entry and exit

4. Some facts • Think of an industry with 100 firms doing a combined $100 million revenue in 2008 • Of the 30 – 40 firms entering in the next five years, 60% will exit by 2018 • The survivors will double their size by 2018 • Some industries have more entry or exit than others • But, industries with more entry tend to have more exit Entry and exit

5. Question of the day • What protects an incumbent against entry, • and what can it do to promote exit by its rivals? Entry and exit

6. More about costs • Today we must think about average costs • A firm would like to operate in a market if • revenue ≥ cost • revenue per unit ≥ cost per unit price ≥ average cost Entry and exit

7. More about costs • Marginal costs are incremental costs • Apply to only the last or next unit produced • Used for determining the amount to produce • Average costs are not incremental • Apply to all units produced • Used for determining whether a firm wants to participate in an industry or market Entry and exit

8. Prices, costs, entry, and exit • If price > average cost, economic profit is positive, and firms earn higher profit than they would in the next best alternative use of their resources • Firms would like to enter • If price < average cost, economic profit is negative, and firms could earn higher profit in the next best alternative use of their resources • Firms would like to exit Entry and exit

9. Incumbents vs. entrants • What is the difference between an incumbent firm in an industry and an entrant in that industry? • Incumbents are already in the market • Entrants are not yet in the market • Is that it? Entry and exit

10. Incumbents vs. entrants • We often think about incumbents trying to drive entrants out of the market • Why don’t we think about entrants driving incumbents out of the market? • What is different about the two firms? Entry and exit

11. Incumbents vs. entrants • There is an asymmetry between incumbents and entrants • Incumbents have already taken actions to establish their operations and position in the market • Capacity • Advertising • Reputation • Etc. • The costs entailed for these expenses are • Sunk for the incumbent • Incremental for the entrant Entry and exit

12. Barriers to entry • Structural barriers • Control of a resource • Control of a patent • Economies of scale and scope • Economies of scale – scaling up the size of the operation reduces average cost • Economies of scope – participation in other markets may allow firms to produce at lower cost in this market • Marketing advantages • Umbrella branding Entry and exit

13. Entry-deterring strategies • An incumbent would like to raise barriers to entry if • The incumbent earns higher profit as a monopolist than it does as a duopolist • The strategy changes expectations about the nature of post-entry competition • Three types • Limit pricing • Predatory pricing • Capacity expansion Entry and exit

14. Entry-deterring strategies • Limit pricing • Discouraging entry by reducing prices before entry occurs • Predatory pricing • Discouraging entry by threatening to reduce prices after entry occurs Entry and exit

15. Contestable limit pricing • Suppose that the incumbent has sunk costs and a cost advantage over the entrant • The entrant must incur a fixed cost that the incumbent has already paid • The cost advantage means that there are prices at which the incumbent earns positive economic profit but the entrant earns negative economic profit Entry and exit

16. Contestable limit pricing • Suppose that the incumbent has sunk costs and a cost advantage over the entrant • The entrant must incur a fixed cost that the incumbent has already paid • The cost advantage means that there are prices at which the incumbent earns positive economic profit but the entrant earns negative economic profit • Strategy: • Set price just below the entrant’s average cost • Entrant does not find entry profitable, so stays out Entry and exit

17. Strategic limit pricing • The incumbent has sunk costs but no cost advantage • Limit pricing strategy: • The incumbent sets a price low enough that the entrant will not find it profitable to pay the fixed cost and enter • The entrant believes that if the incumbent sets a low price now, it will continue to do so after the entrant enters Entry and exit

18. Strategic limit pricing • The incumbent has sunk costs but no cost advantage • Limit pricing strategy: • The incumbent sets a price low enough that the entrant will not find it profitable to pay the fixed cost and enter • The entrant believes that if the incumbent sets a low price now, it will continue to do so after the entrant enters • Will this work? Entry and exit

19. Game-theoretic analysis Example from book Two years Monopoly price = $55 Cournot price = $40 Limit price = $30 Fixed cost = $800/year Sunk in year 1 for incumbent Entrant pays only if it enters Incumbent p = $55 p = $30 Entrant Out Out In In Incumbent $30 $30 $40 $40 Entry and exit

20. Game-theoretic analysis Example from book Two years Monopoly price = $55 Cournot price = $40 Limit price = $30 Fixed cost = $800/year Sunk in year 1 for incumbent Entrant pays only if it enters Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

21. Game-theoretic analysis The limit pricing strategy we talked about says: Incumbent sets p = $30 in first period Entrant believes incumbent will set p = $30 at end if entrant enters Entrant stays out Is this an equilibrium? Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

22. Game-theoretic analysis Remember that we find the equilibrium through backward induction Incumbent sets p = $40if entrant enters, regardless of the incumbent’s initial price Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

23. Game-theoretic analysis Remember that we find the equilibrium through backward induction Incumbent sets p = $40if entrant enters, regardless of the incumbent’s initial price Entrant enters regardless of of the incumbent’s initial price Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

24. Game-theoretic analysis Remember that we find the equilibrium through backward induction Incumbent sets p = $40if entrant enters, regardless of the incumbent’s initial price Entrant enters regardless of of the incumbent’s initial price Incumbent does not set the limit price of $30 Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

25. Game-theoretic analysis Remember that we find the equilibrium through backward induction Incumbent sets p = $40if entrant enters, regardless of the incumbent’s initial price Entrant enters regardless of of the incumbent’s initial price Incumbent does not set the limit price of $30 Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

26. Game-theoretic analysis The only subgame perfect equilibrium has no limit pricing The threat of future low prices after entry is not credible The proposed rationale for limit pricing was that it would change the entrant’s beliefs It didn’t work Incumbent p = $55 p = $30 Entrant Out Out In In 1825 0 2450 0 Incumbent $30 $30 $40 $40 700 100 1125 –100 1325 100 500 –100 Entry and exit

27. Entry-deterring strategies • Limit pricing • Discouraging entry by reducing prices before the entry occurs • Predatory pricing • Discouraging entry by threatening to reduce prices after entry occurs Entry and exit

28. Predatory pricing Entrant first decides whether to enter or stay out If entrant enters, incumbent decides whether to have a price war or just follow the standard duopoly strategy Entrant has to pay a fixed cost that is already sunk for the incumbent Entrant In Out Incumbent 0 400 Duopoly Price war 50 100 –20 30 Entry and exit

29. Predatory pricing Solve this game using backward induction Incumbent plays “duopoly” if the entrant enters Entrant enters Incumbent’s threat of a price war is not credible and does not deter entry Entrant In Out Incumbent 0 400 Duopoly Price war 50 100 –20 30 Entry and exit

30. Rescuing limit and predatory pricing • We found that neither limit pricing nor predatory pricing survived game-theoretic analysis • So how can a firm deter entry? Entry and exit

31. Rescuing limit and predatory pricing • We found that neither limit pricing nor predatory pricing survived game-theoretic analysis • So how can a firm deter entry? • Change the game Entry and exit

32. Rescuing limit and predatory pricing • Game theorists have found circumstances under which entry can be deterred • Rescuing limit pricing • If the entrant does not know the incumbent’s costs, the incumbent can set low prices in the beginning to make the entrant believe the incumbent’s costs are low, in which case future low prices are credible • (This uses advanced game theory, and you would want to take a course in game theory to understand the model) • Building excess capacity might make low costs more believable, and allow for limit pricing Entry and exit

33. Rescuing limit and predatory pricing • Game theorists have found circumstances under which entry can be deterred • Rescuing predatory pricing • If the incumbent operates in several separate markets and faces a (different) potential entrant in each one, and • there is some chance that the incumbent is irrational and would fight a price war anyway, then • the incumbent can deter further entry by fighting a price war against the first entrant, thereby suggesting that the incumbent is the irrational type • This can be achieved by rewarding managers based on market share instead of profit, for example Entry and exit

34. Exit • One firm can drive another one out of the market through predatory pricing • This time the game is changed, because after the rival firm leaves the remaining firm is a monopoly • Examples • Price war (war of attrition) • Dumping Entry and exit

35. Exit • With predatory pricing strategies, both firms are worse off while prices are low • Before undertaking such a strategy, the firm must consider two factors: • Which firm will last the longest? • Are monopoly profits high enough to make up for the losses incurred during the price war? Entry and exit

36. Exit • With predatory pricing strategies, both firms are worse off while prices are low • Before undertaking such a strategy, the firm must consider two factors: • Which firm will last the longest? • Are monopoly profits high enough to make up for the losses incurred during the price war? • The second issue arises in limit and predatory pricing • Is the low profit during the low-pricing period recovered during the monopoly period? • Both issues arise in labor negotiations Entry and exit

37. Lessons • Entry barriers are caused by asymmetries between incumbent firms and entrants • Strategies for deterring exit are tricky • Threatening low prices tends to be non-credible • Must change the game or do something to make the threats credible • Uncertainty on the part of the entrant is helpful • Strategies for promoting exit are more straightforward • Firm must analyze whether the benefits of being a monopoly are worth the costs of driving away the competition Entry and exit

38. Entry and exit September 16, 2008