1. HKKK TMP 38E050 © Markku Stenborg 2005 1 5. Entry How does entry or potential competition affect market power of established firms? How can dominant firms try to limit opportunities for competition: deter entry, increase costs, reduce revenue, close mkts, etc? So far only actual competition between firms already on market Look at potential competition: competitive pressure by firms not yet on market that can enter if conditions are attractive enough Basic micro: entry determined by structure of market: entry costs, demand, MC, number of firms on market, … Entry barriers: structural characteristics of market that protects incumbent by making entry unprofitable

2. HKKK TMP 38E050 © Markku Stenborg 2005 2 5. Entry –High sunk costs: capacity, marketing costs, technology, know-how, scale or scope economies, … –Patent, license,... Concentrate here on entry deterrence: strategies incumbent can use to keep potential rivals out or influence their costs and/or revenues Suppose an incumbent monopolist i on market already, charges p > ac An entrant e considers whether to enter or not Decision rule: –enter if EV =  t  t  t e > f, sunk cost of entry –otherwise stay out For small enough f and large enough V, entry yields positive NPV If monopolist keeps p>ac, firms enter mkt until EV = f

3. HKKK TMP 38E050 © Markku Stenborg 2005 3 5. Entry Monopoly, but no mkt power! (in LR) Contestable market: threat of entry or potential competition enough to curb monopoly power, to keep price close to LRAC Game-theoretic structure of contestable market: –1) Firms choose prices –2) Given prices, firms choose quantities [0, q M ] –Flavor of model: output/capacity more flexible and easier to change than price –Not realistic? Not all mkts are contestable –Threat of hit-and-run entry not credible General lesson: mere threat of entry important to curb market power Could dominant incumbent try to prevent entry and remove threat?

4. HKKK TMP 38E050 © Markku Stenborg 2005 4 5.2 Limit Pricing Motta Ch 7 Limit price p L : price low enough to make entry unprofitable p L depends on sunk entry costs f Limit quantity q i L : corresponding output by incumbent firm(s) Idea: incumbent discourages entry by lowering price High (low) price now signal of (low) high profits in future Potential entrant supposed to conclude from low prices that entry is not attractive and stay out Incumbent raises price once threat of entry disappears and earns high profits Problem 1: Potential entrant can alter her decision and enter if price does not stay low Problem 2: Does limit pricing satisfy backward induction?

5. HKKK TMP 38E050 © Markku Stenborg 2005 5 5. Entry Stylized 2-stage entry game: –1 st stage: e chooses to enter or stay out –2 nd stage: i fights or accommodates –e enters if net profits from post-entry game are positive Use backward induction to analyze entry decision –Two alternartives i accommodates, eg. Stackelberg duopoly:  i A,  e A i fights, eg. price war:  i F,  e F –Assume f <  e A, so that e wants to enter –Fighting deters entry if  e F < f –But  i F <  i A –No incentive for i to fight as post-entry fighting leaves less profit than accommodation –Fighting entry never rational to i –e always enters, as threat of fighting is not credible

6. HKKK TMP 38E050 © Markku Stenborg 2005 6 5. Entry Only credible equilibrium: entry deterrence is not possible “Chain-Store Paradox:” Even a strong monopolist unable to keep entrants out More general 3-stage game: –1 st stage: i takes aggressive or passive stance Aggressive: eg. “irrationally” fights entry to gain reputation for toughness –2 nd stage: e chooses to enter or stay out –3 rd stage: i fights or accommodates, and profits are realized –e enters if profits from post-entry game expected to be positive –e does not know whether i is irrational aggresive or rational profit-maximizing firm –e can use info, including i’s previous actions, to try to predict i’s future behavior

7. HKKK TMP 38E050 © Markku Stenborg 2005 7 5. Entry Now entry deterrence can be credible Need Bayesian game theory to analyze, as there is incomplete info: e does not know i’s objectives, hence cannot plug in i’s RF in her decision problem Basic idea: –2 types of i: Tough (T) or Soft (S) S maximizes present value of profits T likes to fight, eg. gets some non-monetary utility from aggressive behavior –e has prior probability assesment 0 < P(i T ) < 1 –e updates probability assesment by Bayes rule, using all relevant info including i’s past behavior, P(i T |info) Early fighting increases P() for later entry decisions Milk reputation: P(i T |accomodation) = 0

8. HKKK TMP 38E050 © Markku Stenborg 2005 8 5. Entry e enters if expected profits exceed sunk costs: P(i T |info)  e F + (1–P(i T |info))  e A > f Early fighting now rational: gain reputation for toughness to deter future entry Not maximizing profits yields higher profits than profit maximizing! –Incomplete info and possibility of “irrational” tough type yield positive externality to i –Similar results with other incomplete info

9. HKKK TMP 38E050 © Markku Stenborg 2005 9 5.3 Capacity Can excess or large capacity deter entry? –i builds excess capacity to use it for price war if e enters? Excess capacity intended to signal price war after entry Has i incentives to lower price and increase output after entry? No –i builds “too much” capacity to lower MC? Commit to high output Not necessarily free pre-entry capacity as i might have incentives to produce at full capacity

10. HKKK TMP 38E050 © Markku Stenborg 2005 10 5. Entry 2-stage game –1 st stage: i invests in capacity k –2 nd stage: knowing k, e chooses to enter or stay out –Cournot competition: q i, q e –e enters if net profits from post-entry game positive –e wants to install capacity k e = q e * = equilibrium output, so we can ignore e’s capacity choice –Cost of capacity r and cost of labor w –Unit cost of production r+w Note that firms are symmetric, other than –i on mkt already with sunk capacity k –e must also consider entry costs f –MC i = w for q i ≤ k –e has marginal costs r+w for entire production

11. HKKK TMP 38E050 © Markku Stenborg 2005 11 5. Entry Can i credibly threaten to fight entry by installing enough capacity to produce limit output? Backward induction: Marginal costs at 2 nd stage quantity subgame In equilibrium each produces at MR=MC, given (correct) expectations of rival’s production MC e = w+r MC i : –q i < k: MC i = w as cost of capital is sunk –q i > k: MC i = w+r –MC jumps up at k Example Demand p=68–(q i +q e ), cost of capital r=38, w=2, f=4 Can i deter e from entering?

12. HKKK TMP 38E050 © Markku Stenborg 2005 12 5. Entry –Limit output = 24 (plug in numbers from homework) –e’s RF is q e (q i ) = (68 – q i – (w+r))/2 –If q i = 24, q e * = 2 –MR i (24) = 18 –40 = MC(25) > MR i (24) > MC(24) = 2 –Hence i wants to produce at full capacity –Anticipating q i = 24, e will not enter –Incumbent can deter entry –We do not yet know whether entry deterrence is profitable Reaction functions in 2 nd stage quantity sugbame To find Nash equilibrium we need to find 2 nd stage RF's for both firms e's RF q e * (q i ) is implicitely defined by MR e = MC e = w+r i's RF q i * (q e ) is bit harder:

13. HKKK TMP 38E050 © Markku Stenborg 2005 13 5. Entry 1)Suppose k = , no capacity constraint on 2 nd stage –Then 2 nd stage MC i = w –RF now defined by MR i (q i,q e ) = w –Denote RF i ( ,q e ) by q i  (q e ) 2) Suppose other extreme: k = 0 –2 nd stage MC i = w+r –Now RF defined by MR i (q i,q e ) = w+r –Denote RF i (0,q e ) by q i 0 (q e ) 3) For all other cases 0 < k < , MC i vertical at k –MR i depends on q e –For small (large) q e, i's MR i and profit maximizing output is relatively high (low) –i's RF defined by intersection of MR i and MC i –If q e is low enough, i will want to increase capacity

14. HKKK TMP 38E050 © Markku Stenborg 2005 14 5. Entry Summary: –If MR i (k,q e ) < w, then q i = q i  (q i ) –If MR i (k,q e ) > w+r, then q i = q i 0 (q i ) –If w < MR i (k,q e ) < w+r, then q i = k Translate MC picture into RF picture –Kink in RF at k –Different values of k shift the kink in i's RF Nash equilibrium in quantity subgame Outputs of two firms are equal at one-stage Cournot equilibrium outcome with MC i =w+r; denote with C Another one-stage equil outcome with MC i =w; denote with D i's RF is presented by linking these two one-stage RFs with kink at k Nash equilibrium = intersection of RFs: both firms are pro- ducing profit maximizing quantities and neither has incentive to deviate

15. HKKK TMP 38E050 © Markku Stenborg 2005 15 5. Entry 1) Capacity expansion: q i C > k Kink in RF left of C Kink is also above q i 0 (q e ) i will want to increase output beyond k as MR i exceeds w+r and i is not on its RF at (k, q e (k)) 2) Excess capacity: k > q i D Kink in RF right of D i will not want to use all its capacity To right of D, both q i 0 (q e ) and q i  (q i ) lie below RF e q e (k,q i ) Kink will also be below q e (k,q i ) Producing at capacity means MR < MC Threat of producing at capacity is not credible as e knows that i will not want to produce q i = k Thus e will want to expand her production above candidate equilibrium outcome (k, q e ’)

16. HKKK TMP 38E050 © Markku Stenborg 2005 16 5. Entry 3) Full capacity utilization: q i C > k > q i D Equilibrium on RF of e where q i = k and q e = q e * (k) To right of C and left of D, q i  (q i ) is above and q i 0 (q e ) and below RF e Kink will cross RF e at k i will want to produce at capacity and not to expand capacity, as MR i < w+r In both 2) and 3), Nash equilibrium quantity subgame is asymmetric and favors i Optimal 1 st stage capacity decision 3 cases: 1) Blocked entry: e's profits are negative at C Profits of e are negative even in best post-entry equilibrium Limit output less than monopoly profit maximizing level i need not worry about entry

17. HKKK TMP 38E050 © Markku Stenborg 2005 17 5. Entry 2) Stackelberg: e's profits are positive at D Profits of e are positive even in worst post-entry equilibrium i can credibly commit only to q i D < q L, and e enters Two subcases: –i can commit to Stackelberg outcome q S by strategic overinvestment if q S lies between C and D –If cost advantage of sunk capital is small, excess capacity at Stackelberg outcome  get close to Stackelberg outcome and q i = k 3) Strategic entry deterrence or accommodation Profits of e are positive at C and negative at D i can deter entry since q L lies between C and D Two sub-cases: –Always profitable for i to strategically deter entry as q L < q M

18. HKKK TMP 38E050 © Markku Stenborg 2005 18 5. Entry –Accomodate entry by installing k = q S or strategically deter entry by installing k = q L i can choose to commit to either by choosing k Optimal choice depends on relative profits: –Benefits of entry deterrence: monopoly –Costs of entry deterrence: expand capital and output beyond monopoly level –If entry on small scale, accomodation likely to be optimal –If q S > q L, always deter entry Entry deterrence is possible because capacity is sunk investment, commitment Incumbent strategically invests in capacity beyond monopoly profit maximizing level to commit to output level guaranteed to drive potential entrant's profits to zero

19. HKKK TMP 38E050 © Markku Stenborg 2005 19 5. Entry Two requirements for profitable strategic entry deterrence: –Incumbent able to reduce MC by sunk investments –Economies of scale Other ways to limit entry: –Tie customers with long-term contracts –Discounting schemes May look aggressive competition but can be tool to reduce entry –Advertisement and brand loyalty –Customer switching costs –Manipulation of installed base of customers –Homework: How would these show up in RF picture?

20. HKKK TMP 38E050 © Markku Stenborg 2005 20 Final Exam 23.05.2005 2+2 questions –One applied, one technical –Two straight forward explanations –1+1 answers Requirements Lecture Notes US Merger Guidelines Airtours, Volvo/Scania, UPM/Haindl, Deutsche Post cases –Economics behind Market definition Competitive assesment