1. Entry barriers and entry deterrence: Sequential games

2. Suggested reading
Allen et al Managerial Economics. Norton. Chapters 6 (pp170) 11
Kreps, D. M Microeconomics for Managers. Norton. Chapters 20-23
Frank, R. H Microeconomics and behaviour. McGraw Hill. Chapters 12-13
Wall,S., Minocha, S. and Rees, B International Business, Pearson. Chapter 7
Rasmusen, E Games and Information, Blackwell. Chapters 1-2, 4-5
Carmichael, F A Guide to Game Theory, Pearson. Chapters 1-4, 7-8

3. Entry barriers and entry deterrence
Objectives are for you to be able to:
Explain what is meant by the idea of a credible threat e.g. the threat to fight the entry of a new firm into an industry.
Use game theory to show how an incumbent monopolist (or oligopolistic cartel) might be able to deter entry even though fighting entry is costly.

4. Porter’s Five Forces again…
A firm is more profitable:
The less intense the rivalry among existing firms (monopoly or if oligopoly -collusion vs. competition) 
The less the danger of potential entrants and the higher barriers to entry
The fewer substitutes for the firm’s products (the more firms that sell complements)
The weaker the bargaining power of customers (e.g. in sports)
The weaker the bargaining power of suppliers
Tangible and psychological is how Kreps divides entry barriers (from Porter), there are other possibilities e.g. cost based, legal and strategic.
Tangible barriers are anything that would put an entrant at a disadvantage in the resulting competition if it enters the industry (define post-entry situation) – they include less tangible barriers such as knowledge (sometimes called an intangible asset). Some tangible barriers can be strategic -----strategies that make entrant’s (an maybe also oligopolists’) profits low by making entrant’s costs high (e.g. locking up resources or distribution channels) or keeping prices low (limit pricing)
Kreps defines another category of barrier – mobility barriers which relate to niche markets within an industry e.g. Apple Mac computers. These include product differentiation or market segmentation e.g. protected by patents or copyrights

5. Implications of the analysis so far i. e
Implications of the analysis so far i.e. in relation to oligopoly collusion
Oligopoly collusion (restrained rivalry) can be sustained in some circumstances
but new entrants to the sector also have to be kept out – HOW?
If infinite repetition P = 1 but usually use discounting to model
If P high enough the (shadow of the) future is significant
New entrants (e.g. new owners) are likely to be bad for collusion – supernormal profits have to be divided even more, new entrants may not understand the rules of the collusive arrangement, they may not want to collude etc
Also need compliance with collusive agreement to be observable so cheating/transgressions punished e.g. OPEC
Small numbers in the industry as a whole are helpful – easier to observe cheating and fewer outsiders to deal with
Possibility of collusion implies a need for regulation if there are expected net welfare losses – some oligopolies may have a tendency/predisposition to collude while others may not (Kreps cites Boeing and Airbus as an oligopoly where there is no tendency to collude)
Finite repetition may be sufficient if there is some uncertainty about payoffs or intended strategies – where there is scope for players to gain a ‘reputation’ for cooperative behaviour

6. Entry barriers and entry deterrence
If firms in an industry are profitable, there are likely to be potential entrants
Successful entry will lower profits for existing/incumbent firms
Therefore existing firms will want to impede (deter) entry
Question: what kinds of entry barrier exist? Hint: some are ‘tangible or semi tangible’ and some are based on beliefs (psychological)
See e.g. Kreps chapter 20 or Frank chapter 12 pp
Tangible and psychological is how Kreps divides entry barriers (from Porter), there are other possibilities e.g. cost based, legal and strategic.
Tangible barriers are anything that would put an entrant at a disadvantage in the resulting competition if it enters the industry (define post-entry situation) – they include less tangible barriers such as knowledge (sometimes called an intangible asset). Some tangible barriers can be strategic -----strategies that make entrant’s (an maybe also oligopolists’) profits low by making entrant’s costs high (e.g. locking up resources or distribution channels) or keeping prices low (limit pricing)
Kreps defines another category of barrier – mobility barriers which relate to niche markets within an industry e.g. Apple Mac computers. These include product differentiation or market segmentation e.g. protected by patents or copyrights

7. Types of entry barriers (1)
Tangible and semi tangible
Put entrants at a disadvantage in the competition that takes place after entry e.g.:
Cost
economies of scale: large firms more able to withstand cost cutting (price war)
economies of scope : large diversified firms have cost advantages
knowledge based advantages (technology gives cost advantages)
access to resources e.g. financial or access to natural resources or distribution channels
customer loyalty – goodwill and reputation (brands, niche markets), lock-in (e.g. due to compatibility)
legal factors e.g. certification, subsidies, trade barriers and patents
Strategic entry barriers e.g. output and pricing decisions (product development, bundling products, loss leaders, limit pricing)
Tangible and psychological is how Kreps divides entry barriers (from Porter), there are other possibilities e.g. cost based, legal and strategic.
Tangible barriers are anything that would put an entrant at a disadvantage in the resulting competition if it enters the industry (define post-entry situation) – they include less tangible barriers such as knowledge (sometimes called an intangible asset). Some tangible barriers can be strategic -----strategies that make entrant’s (an maybe also oligopolists’) profits low by making entrant’s costs high (e.g. locking up resources or distribution channels) or keeping prices low (limit pricing)
Kreps defines another category of barrier – mobility barriers which relate to niche markets within an industry e.g. Apple Mac computers. These include product differentiation or market segmentation e.g. protected by patents or copyrights

8. Types of entry barriers (2)
Psychological barriers (beliefs)
Reputation for aggressive response to entry – fighting is a credible threat even if costly for the incumbent (e.g. price war)
Key is credibility
Tangible and psychological is how Kreps divides entry barriers (from Porter), there are other possibilities e.g. cost based, legal and strategic.
Tangible barriers are anything that would put an entrant at a disadvantage in the resulting competition if it enters the industry (define post-entry situation) – they include less tangible barriers such as knowledge (sometimes called an intangible asset). Some tangible barriers can be strategic -----strategies that make entrant’s (an maybe also oligopolists’) profits low by making entrant’s costs high (e.g. locking up resources or distribution channels) or keeping prices low (limit pricing)
Kreps defines another category of barrier – mobility barriers which relate to niche markets within an industry e.g. Apple Mac computers. These include product differentiation or market segmentation e.g. protected by patents or copyrights

9. Analysing the idea of credibility in relation to entry barriers and entry deterrence
Sequential moves mean that players move in turns – so one player moves first and the other follows e.g.:
Firm A erects an entry barrier
Pre-emptive investment strategies – tangible entry barrier
threatens to fight a price war if there is entry - Psychological entry barrier
Firm B decides whether to enter or not
See Kreps chapters 21 and 23, Allen chapter 11 and Frank chapter 13 (especially pp )
But it is easier to see whether a threat is credible or not if moves are sequential
One firm moves first
To analyse this type of scenario game theory uses decision trees or game trees

10. Credible threats
A key idea in the analysis of sequential move games is that of credibility
the credibility of a threat or promise depends on whether the action would actually be carried out if it was tested; the potential gain needs to outweigh any cost
A threat to enter a market whatever the cost
A threat to fight entry (e.g. by fighting a price war) - a psychological entry barrier
In either case can pre-emptive action be taken by those threatened (to neutralise the threat) or those doing the threatening (to make the threat credible)
e.g. by introducing a new product or expand a product line = a tangible entry barrier

11. Example 1: pre-emptive investment decisions and credible threats in the aircraft industry
The aircraft companies Boeing and Airbus are involved in a strategic game, in this example Airbus moves first
Airbus has to decide whether to invest in new plane or not i.e. a new product line/market
Boeing is also deciding whether to invest in a new plane but because of lags its production process it has to make its decision after Airbus has made its decision

12. The firms’ payoffs The firms’ payoffs reflect the following:
Despite high development costs there is a market for the new plane which could be supplied profitably
But the market for aircraft is limited and there is only room for one company to supply a new plane profitably
If both companies supply a new plane they would be in direct competition with each other and both would make lower profits due to undercutting
And large economies of scale means that high levels of output are needed to make profits
SO THE MARKET IS NOT COMPETITIVE

13. A decision tree for a game between Boeing and Airbus
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£50m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
New market
Enters same new market
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m
(4)

14. Boeing’ threat
Boeing threatens to also enter the new market - by supplying the new plane - if Airbus supplies the new plane
By making this threat Boeing hopes to deter Airbus from supplying the new plane so it can make the new plane itself
Is this a credible threat?
would this threat deter Airbus from building the new plane?
can Airbus take pre-emptive action?

15. Game theoretic analysis: Is Boeing’ threat credible?
Boeing’ threat is only credible if Boeing would actually carry it out if Airbus built the new plane
We need to think about what Boeing would actually do if Airbus built the new plane or did not.
Whether the threat is credible or not depends on Boeing’s payoff if the threat is carried out and its payoff if it isn’t

16. Game theoretic analysis: Is Boeing’ threat credible?
We need to work backwards from the last decision points of the game (B1 and B2) to the decision point at the start of the game (A)
This is called backward induction

17. Analysing the game tree: what will Boeing actually do at B1 and B2?
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£50m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m
(4)

18. Boeing’s decisions Boeing decides Airbus decides Boeing decides (1) B1
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£50m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m
(4)

19. Boeing’ choices Boeing will supply the new plane if Airbus does not
Boeing will not supply the plane if Airbus does
therefore the threat to do so is not credible
So what will Airbus do?

20. Analysing the game tree:
what will Airbus do at A?
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£50m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m
(4)

21. Analysing the game tree:
what will Airbus do at A?
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£50m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m
(4)

22. The game theoretic prediction
Backward induction implies that Airbus will supply the new plane and Boeing will not
Boeing’ threat to also supply the new plane if Airbus supplies the plane is not a credible threat and therefore it does not deter Airbus
Airbus will make higher profits
it has a first mover advantage and take the pre-emptive investment choice

23. Exercise
The aircraft industry is considered to be strategically important by both the USA and the EU and therefore worth protecting by subsidising or using tariffs (see Allen Chapter 16)
There are ongoing disputes between the USA and the EU regarding ‘unfair’ subsidisation of Boeing and Airbus in developing aircraft
Construct a game tree and use backward induction to predict the outcome of the game if Boeing receives a subsidy of the equivalent of £12m from the US government if and only if it builds the plane
In the new version of the game is Boeing’s threat to build the new plane credible?

24. Analysing the new game tree: what will happen?
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£(50+12)m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m + £12m = £2m
(4)

25. Analysing the new game tree
Airbus +£10m
Boeing +£10m
(1)
Boeing
decides B1
no plane
no plane
new plane
Airbus +£1m
Boeing +£(50+12)m
(2)
Airbus
decides A
new plane
Airbus +£50m
Boeing +£1m
(3)
no plane
Boeing
decides B2
new plane
Airbus –£10m
Boeing –£10m + £12m = £2m
(4)

26. The game theoretic prediction
Government intervention changes the outcome of the strategic game by making Boeing’s threat credible
Implication: government intervention can change the outcome of transnational strategic games played by oligopolists
But what about the long-term?
What do you think the EU will do?
And what will be the outcome of the EU’s decision?

27. Example 2: Entry deterrence and reputation
E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel – effectively a monopoly) making monopoly profits
Entrant decides whether to enter or not.
Monopolist only has to decide whether to fight or concede if entrant enters.
E M E M1 M2
Enter
Concede
Stay Out
Do nothing
Fight
The entrant will enter the market if by doing so it can make positive profits, otherwise it will stay out, in which case the monopolist doesn’t have to do anything. If the entrant enters the market the monopolist will no longer be in a monopoly position and consequently its profits will be lower. However, it can try to deter entry by threatening to fight should entry occur e.g. by engaging in some kind of aggressive and costly market action. The alternative is to concede a share of the market.

28. Example 2: Entry deterrence and reputation
E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel – effectively a monopoly) making monopoly profits
E M E M1 M2
Enter
Concede
Stay Out
Do nothing
Fight
Is the incumbent’s threat to fight credible?
What outcome do you predict in this game?
The entrant will enter the market if by doing so it can make positive profits, otherwise it will stay out, in which case the monopolist doesn’t have to do anything. If the entrant enters the market the monopolist will no longer be in a monopoly position and consequently its profits will be lower. However, it can try to deter entry by threatening to fight should entry occur e.g. by engaging in some kind of aggressive and costly market action. The alternative is to concede a share of the market.

29. Entry deterrence and reputation
Threat to fight is not credible – there will be entry followed by concession, unless the monopolist (or cartel) can make the threat to fight credible by pre-committing to fight
E M E M1 M2
Enter
Concede
Stay Out
Do nothing
Fight
A simple threat (or promise) is insufficient. Cartel need to redesign the situation so that it is in their interests to fight – needs to make payoff from fighting higher than payoff from conceding. - Kreps calls this tying your hands so that you must fight – Dixit calls it investing in a sunk cost that makes fighting optimal

30. Making the threat to fight credible
Firms can take costly pre-emptive actions to make a psychological barrier credible e.g.:
Excess capacity for increasing output (lowers prices)
Holding patents or products as backup if there is entry
Choosing high fixed cost (economies of large scale) technologies – so needs to protect market share
Investing in ability to retaliate in other markets
i.e. some makes some unrecoverable ‘sunk’ cost that makes fighting optimal
There is a commitment cost (c) but a reward (d) if there is entry and the monopolist fights

31. Making the threat to fight credible
The monopolist (or cartel) invests in some unrecoverable ‘sunk’ cost that makes fighting optimal:
Commitment cost = c
Generates reward if fights entry =d.
E M c d E M1 M2
Enter
Concede
Stay Out
Do nothing
Fight c
In effect makes concession so unattractive that fighting is optimal – commitment to post entry action that is costly for both sides
e.g. sub-optimal technology that has very high costs – so needs to keep output i.e. market share high – too expensive to concede market share
Also strategies that make entrant’s (an maybe also oligopolists’) profits low by making entrant’s costs high (e.g. locking up resources or distribution channels) or keeping prices low (limit pricing)
Under what conditions will entry be fought?

32. Making the threat to fight credible
The threat to fight is credible only if:
(payoff from fighting) 1 + d > 4 – c (payoff from concession)
or c < 1+ d - 4 (divide through by -1)
or c > -1 - d + 4
or c > 3-d (1)
But the commitment will only be made if payoff in game without commitment (4) is greater than 8-c:
8 – c > 4
or -c > -4
or c < (2)
Combining (1) and (2): The cartel will invest in the commitment and entry will be deterred if:
4 > c > 3 –d (3)
-3 + d > -c or c > 3 – d
-c > 4-8 or c < 4
e.g. if c = 3 and d = 1
If invest then if fight get 2 but if concede get 1 and if no entry get 5. If don’t invest get 4
For examples of these kinds of commitments see e.g. Kreps ch. 23 e.g. the case of Kodak and Polaroid
And if there is uncertainty about M’s payoffs and number of repetitions of the game, the cartel may not even need to make the commitment – if incumbent can acquire a a reputation for fighting e.g. Procter and Gamble have a reputation for aggressively fighting entrants (see Kreps ch. 23)

33. Making the threat to fight credible
The threat to fight is credible if:
1 + d > 4 – c or c > 3-d (1)
The commitment will only be made if:
8 – c > (2)
Combining (1) and (2)implies:
4 > c > 3 –d (3)
Example:
If d = 2 and c = 3 both conditions are satisfied
(1) 1+d = 3, 4-c = 1 so 1=d >4-c
and (2) 8-c = 5 > 4
Which must mean that 4 > c (= 3) > 3-d (= 1)
Think of two other values for d and c that would satisfy the conditions
Can you provide any interpretation of what these conditions mean (in terms of the cost and rewards of commitment - the relative payoffs)?
-3 + d > -c or c > 3 – d
-c > 4-8 or c < 4
e.g. if c = 3 and d = 1
If invest then if fight get 2 but if concede get 1 and if no entry get 5. If don’t invest get 4
For examples of these kinds of commitments see e.g. Kreps ch. 23 e.g. the case of Kodak and Polaroid
And if there is uncertainty about M’s payoffs and number of repetitions of the game, the cartel may not even need to make the commitment – if incumbent can acquire a a reputation for fighting e.g. Procter and Gamble have a reputation for aggressively fighting entrants (see Kreps ch. 23)

34. Implication
Firms can make tangible and costly investments (commitments) that make psychological entry barriers credible – but costs (c) can’t be too high and gains (d) need to be sufficiently large so that:
Payoff from deterring entry with the investment cost (8-c) is greater than the payoff without incurring the commitment (4)
Increase in payoff from fighting with commitment (d) needs to large enough so that fighting is optimal

35. Uncertainty and reputation
The costly commitment to fight might not even need to be made if there is;
Uncertainty e.g. about whether the commitment has been made or not e.g. if the probability of fighting is high enough
And/or the scenario is repeated (indefinitely or infinitely) and the cartel has or can gain a reputation for fighting entry – its worth a costly fight initially in order to create a reputation for fighting
Previous aggressive behaviour – reputation: E.g. Procter & Gamble deterred Union Carbide from entry into the disposable diaper industry by making it look like it was up for a fight with a series of price cutting strategies (see e.g. Kreps chapter 23 – page 586)
It may be necessary and optimal to sacrifice short term payoffs from concession to acquire a reputation for fighting in order to deter entry in the future – especially if the future is significant (long) - especially if repetition is either infinite or indefinite.
Union Carbide attempted to enter just one of P&Gs local markets (disposable nappies) in the US. P&G fought of entry aggressively via price reductions, coupons, discounts etc. UC gave up. Note though that these kinds of actions may be illegal.
A psychological barrier to entry even if no other commitment has been made

36. Implications
Analysis of repeated prisoners’ dilemma suggests that oligopolists may be able to sustain collusion in order to extract monopoly profits
and sequential game theory shows that they may be able to protect their collusive agreements through psychological entry barriers e.g. threatening to fight entry - as long as this is credible
But the creation of entry barriers and entry deterring strategies are often illegal……….

37. Employer UNION Employer introduces labour reforms
The same kind of analysis might be applicable to a situation of industrial conflict – see e.g. Washington Post cases - what’s your prediction?
Employer E1
Union –£100m
Employer –£150m
fight
strike
Concede
Union +300m
Employer -£500m
(but union is uncertain about employer’s payoff)
UNION U
Don’t strike
Union +£50m
Employer +£200m
Employer introduces
labour reforms E2

38. Employer UNION Employer introduces labour reforms
The same kind of analysis might be applicable to a situation of industrial conflict – see e.g. Washington Post cases - what’s your prediction?
Employer E1
Union –£100m
Employer –£150m
fight
strike
Concede
Union +300m
Employer -£500m
(but union is uncertain about employer’s payoff)
UNION U
Don’t strike?
Union +£50m
Employer +£200m
Employer introduces
labour reforms E2

39. Small country decides The USA Small country does nothing
This game theoretic model could also be used to analysed some international relations scenarios: Is the USA’s threat to invade credible – this depends on what will the small country does if the USA invades – what will it do?
Small country decides S1
USA –£100m
Small country –£150m
fight
Invade
Give in
USA +300m
Small Country +£50m
The
USA U
Don’t invade
USA +£50m
Small Country +£200m
Small country
does nothing S2

40. Since the small country will give in if the USA invades - the USA will invade – its threat is credible
Small country decides B1
USA –£100m
Small country –£150m
fight
Invade
Give in
USA +300m
Small Country
+£50m
USA A
Don’t invade
USA +£50m
Small Country +£200m
Small country
does nothing B2

41. A very diffierent example: Robbing a bank: Is Bert’s threat to blow himself and Angela up credible?
-, -
-100, 100
1000, -10
Detonate B1 NS
Not Detonate B A
Demands
money S B2
Other, less trivial examples: Threat to prosecute trespassers; worker demands a rise and threatens to resign but this is not credible if few alternative job options; if a union demands a rise and threatens a strike but this is not credible if there are minimal strike funds; the US demands disarmaments but the threat to invade may not be credible if the UN is divided
In this kind example the first mover, Bert, makes the threat. In other examples, entry deterrence, the second mover tries to prevent an action by the first mover by making a threat
Not Detonate and take the money
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death

42. Robbing a bank: Is Bert’s threat to blow himself and Angela up credible?
-, -
-100, 100
1000, -10
Detonate B1 NS
Not Detonate B A
Demands
money S B2
Other, less trivial examples: Threat to prosecute trespassers; worker demands a rise and threatens to resign but this is not credible if few alternative job options; if a union demands a rise and threatens a strike but this is not credible if there are minimal strike funds; the US demands disarmaments but the threat to invade may not be credible if the UN is divided
In this kind example the first mover, Bert, makes the threat. In other examples, entry deterrence, the second mover tries to prevent an action by the first mover by making a threat
Not Detonate
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death

43. Test your understanding
Entry barriers and entry deterrence
Explain what is meant by the idea of a credible threat e.g. the threat to fight the entry of a new firm into an industry.
Use game theory to show how an incumbent monopolist (or oligopolistic cartel) might be able to deter entry even though fighting entry is costly.