entry and exit
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Entry and Exit. 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 - PowerPoint PPT PresentationTRANSCRIPT
Entry and Exit
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
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
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
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
Barriers to Entry
Barriers can take two formsStructural
incumbents have natural cost advantages cost location regulatory environment
Strategic through deliberate actions of incumbents
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
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
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
Barriers to Exit
Exit if cannot make an acceptable return on assets but consider only recoverable assets
$
Quantity
ATC
AVC
MC
PENTRY
An illustration of theentry/exit decisions
An illustration of theentry/exit decisions
Do not enter unlessexpected price is at
least PENTRY
Do not enter unlessexpected price is at
least PENTRYDo not exit if priceis greater than PEXIT
Do not exit if priceis greater than PEXIT
PEXIT
Exit barriers exist when there are
fixed costs when there are
relationship-specific assets
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
Entry deterrence
There are several potential strategies that have been suggested limit pricing predatory pricing capacity expansion
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
The Example
$
Quantity
Demand100
100
10MC
An incumbent monopolist produces Q = 45 units;
MR45
price = $55
55
Profit p.a. = (55 - 10)x45 - 800 = $1,225Monopoly profit per
period ignoringfixed costs
Monopoly profit perperiod ignoring
fixed costs
Suppose an entrant in period 2 with the same costs
Assume that the incumbent and entrant are Cournot (quantity) competitors
The Example
$
Quantity
Demand100
100
10MC
Each firm produces 30 units in period 2;
MR
price = $40Profit to each firm = (40 - 10)x30 - 800
= $100
Given this expectation entry will occur
60
40
The incumbent’s profit in period 2 is sharply down
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
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
(30 - 10)x70 - 800
Profit in thefirst period
Profit in thefirst period
+ $1,225
Monopolyprofit in the
second period
Monopolyprofit in the
second period
= $1,825
Limit pricing would appearto be successful inincreasing profits
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
The Entry Game
Incumbent
PL
Incumbent sets thelimit price
Incumbent sets thelimit price
PM
Incumbent sets themonopoly price
Incumbent sets themonopoly price
Out
EntrantIn
I = $1,825; E = 0
EntrantOut
I = $2,450; E = 0
Incumbent
PL I = $500; E = -$100
PC
I = $700; E = $100
InIncumbent
PL I = $1,125; E = -$100
PC
I = $1,325; E = $100
Entrant decideswhether to enter
Entrant decideswhether to enter
Incumbent choosesits pricing strategy
Incumbent choosesits pricing strategy
The Entry Game
Incumbent
PL
PM
Out
EntrantIn
I = $1,825; E = 0
EntrantOut
I = $2,450; E = 0
Incumbent
PL I = $500; E = -$100
PC
I = $700; E = $100
InIncumbent
PL I = $1,125; E = -$100
PC
I = $1,325; E = $100
If the Entrant enters theIncumbent will choose
Cournot
If the Entrant enters theIncumbent will choose
Cournot
PC
I = $700; E = $100
If the Incumbent sets thelimit price the Entrant
will enter
If the Incumbent sets thelimit price the Entrant
will enter
In
If the Entrant enters theIncumbent will choose
Cournot
If the Entrant enters theIncumbent will choose
Cournot
PC
I = $1,325; E = $100
If the Incumbent sets themonopoly price theEntrant will enter
If the Incumbent sets themonopoly price theEntrant will enter
In
The Incumbentwill set the
monopoly price
The Incumbentwill set the
monopoly price
PM
Limit pricing is nota credible strategy
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
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
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
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
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
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