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1 Industrial Organization Entry deterrence Univ. Prof. dr. Maarten Janssen University of Vienna Summer semester Week 5

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2 Definition of entry deterrence Incumbent’s choice of business strategy such that it can only be rationalized in face of threat of entry Two different mechanisms often contemplated: Building up capacity Studied in both Cournot and Stackelberg context Choice of prices to signal (low) cost structure Context of game with asymmetric information Cournot and Stackelberg applications to entry deterrence

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3 Capacity Expansion and Entry Deterrence Central point: For predation to be successful—and therefore rational—the incumbent must somehow convince the entrant that the market environment after the entrant comes in will not be a profitable one. How this credibility? One possibility: install capacity Installed capacity is a commitment to a minimum level of output

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4 Stackelberg with Fixed Entry Cost: Follower Q1Q1 Q2Q2 Follower’s Profits are High Follower’s Profits are Low With Entry Cost: follower’s profits in the market can be too low to recover entry cost Reaction Curve with Entry cost

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5 Follower’s decision with entry cost f Stackelberg Follower’s Profit (with α=β=1) Stackelberg Follower’s Reaction Curve: If π F ≥0, i.e., if (1-q L ) 2/ 4 ≥ f or q L ≤ 1 - 2√fq F = (1-q L )/2 Otherwise q F = 0

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6 Stackelberg with Entry Cost: Leader Q1Q1 r1r1 r2r2 Q2Q2 Q1SQ1S Stackelberg Equilibrium Optimal output

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7 Stackelberg with Low Entry Cost: Leader Q1Q1 r1r1 r2r2 Q2Q2 Q1SQ1S Stackelberg Equilibrium Entry deterrence is not optimal (accommodated entry)

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8 Stackelberg with High Entry Cost: Leader Q1Q1 r1r1 r2r2 Q2Q2 Q1SQ1S Stackelberg Equilibrium Monopoly Output is enough for entry deterrence

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9 When do the different cases occur? Leader’s profit of entry accommodation is 1/8 (as p = ¼ and its output is ½); follower’s profit is 1/16 – f. Leader’s profit of entry deterrence is 2√f(1-2√f) (as p = 2√f and [total] output is 1- 2√f); choosing minimal output level to deter Entry deterrence profitable if 2√f(1-2√f) > 1/8, i.e., iff √f > ¼(1- ½√2) 0 < √f < ¼(1- ½√2) is too costly ¼(1- ½√2) < √f < ¼ entry deterrence in proper sense (distort output decisions compared to monopoly decision) √f > ¼ monopoly output to deter entry

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10 Is entry deterrence in Stackelberg context always bad? Welfare (TS) if entry takes place is ½ - 1/32 – f Total output is ¾; price is ¼ Welfare (TS) if entry is deterred is ½ - 2f Total output is 1-2√f; price is 2√f Thus, TS is higher under entry deterrence if f < 1/32 Entry deterrence is individually optimal for incumbent and takes place if (1- ½√2) 2 /16 < f < 1/32 Thus, entry deterrence is sometimes optimal from a TS point of view (entry can be excessive)

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11 Entry Deterrence under Cournot Central point: For predation to be successful—and therefore rational—the incumbent must somehow convince the entrant that the market environment after the entrant comes in will not be a profitable one. How this credibility? One possibility: install capacity Installed capacity is a commitment to a minimum level of output

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12 Entry Deterrence: how to make the threat credible? An example: P = Q = (q 1 + q 2 ) marginal cost of production €60 for both cost of each unit of capacity is €30 firms also have fixed costs of f incumbent chooses capacity K 1 in stage 1 entrant chooses capacity and output in stage 2 at moment firms compete in quantities.

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13 Core idea By moving your cost to an earlier moment, you effectively lower marginal costs when you compete -More aggressive competitor -Higher profits

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14 The Example (cont.) q2q2 q1q R2R2 30 R1R1 By installing capacity of K 1, marginal cost up to K 1 is 30, not 60. So, best response function up to K 1 is shifted out. By installing capacity of K 1, marginal cost up to K 1 is 30, not 60. So, best response function up to K 1 is shifted out. K1K1 kink in best response function. NOTE: The incumbent will never let installed capacity stay idle: it can credibly commit to produce at least K 1 in the production stage 90 45

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15 Some of the relevant math Standard profit function for firm 1 is π = P(Q)q 1 – c(q 1 ) = (120-Q)q q 1 = (60-Q)q 1 Standard reaction function q 1 = 30 – ½ q 2 Installing capacity changes consideration for any q 1 up to K 1 to π = P(Q)q 1 – c(q 1 ) = (120-Q)q q 1 – 30K 1 = (90-Q)q 1 – 30K 1 New reaction function q 1 = 45 – ½ q 2 for q 1 ≤ K 1 K 1 does not effect the marginal consideration

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16 The Example (cont.) q2q2 q1q R2R2 30 R1R1 Installing capacity below the Cournot output level is ineffective. Installing capacity below the Cournot output level is ineffective

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17 The Example (cont.) q2q2 q1q R2R2 30 R1R1 Can the incumbent let installed capacity rationally stay idle? Can the incumbent let installed capacity rationally stay idle? 90 45

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18 So, in equilibrium firm 1 will produce up to capacity. How much capacity to install? q2q2 q1q R2R2 30 R1R1 K1K If f = 0 π = P(Q)K 1 – c(K 1 ) = (120-K 1 -[30- ½K 1 ])K K 1 = (30-½K 1 )K 1 Effectively, firm 1 is a Stackelberg leader and rationally installs the monopoly output

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19 Thus, similar reasoning as Stackelberg If there is a fixed cost of production (entry), then it may be rational to install more capacity than the monopoly output in order to deter entry If there is an entry cost of 200 in this example, then installing 32 units of capacity is enough to deter entry At K 1 = 32, optimal reaction (if positive) is 14, total output would be 46, per unit profit 14 and operating profits are = 196

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20 The Example (cont.) q2q2 q1q R2R2 30 R1R1 15 S R’ Effectively this commits the incumbent to q 1 = 32. The entrant’s best response to q 1 = 32 is q 2 = 14. So, operating profit does not cover the entrant’s $200 overhead.

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21 Conclusion Entry deterrence can take the form of installing a large capacity (that is fully used in equilibrium) Analyzed in context of Stackelberg or Cournot model Effectively, yields same type of considerations and results Without fixed cost, Cournot reduces to Stackelberg if one party can move its capacity choice to an earlier moment With fixed cost, it can lead to entry deterrence behavior like in Stackelberg with fixed cost of entry

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