1. Business Economics (A) Researcher training course 9-10th week
RIETI シンポジウム
2005/6/23
Business Economics (A) Researcher training course 9-10th week
Yuji Honjo
Faculty of Commerce
Chuo University
Yuji Honjo

2. Contents Theme Keyword Discussions Entry and exit
Barriers to entry, Limit pricing, Predatory pricing
Discussions
Do you think economies of scale are considered barriers to entry?
Do economies of scale protect incumbents from hit-and-run entry unless the associated fixed costs are sunk?

3. Some facts about entry and exit
Entry forms
New firm
A firm did not exist before it entered a market.
Diversified firm
A firm already exists but had not previously been in that market.
A firm sells the same product in other geographic markets.
e.g.) Amazon.com (which sells books over the Internet), Microsoft (which introduced the Microsoft X-Box gaming system)

4. (Continued) Exit forms Withdrawal of a product from a market
A firm shuts down completely.
A firm continues to operate in other markets.
e.g.) Renault and Peugeot (which exited the U.S. automobile market), Sega (which exited the video game hardware market)

5. Dunne et al.’s (1988) findings
U.S. manufacturing firms between 1963 and 1982
Entry and exit will be pervasive.
30 and 40 new entrants during 5 years per 100 firms
Entrants and exiters tend to be smaller than established firms.
A typical entrant will be only one-third the size of typical incumbent.
Diversifying entrants tend to be three times the size of other entrants.
Most entrants do not survive 10 years, but those that do grow precipitously.
Roughly 60% will exit during 10 years.
Entry and exit rates vary by industry.

6. (Continued) Implications for strategy
The manager must account for an unknown competitor (entrant).
Not many diversifying competitors will build new plants, but the size of their plants can make them a threat to incumbents.
e.g.) Microsoft X-box -> Sony playstation
Managers should expect most new ventures to fail quickly.
Managers should know the entry and exit conditions of their industry.

7. Entry and exit decisions: basic concepts
A profit-maximizing, risk-neutral firm should enter a market
Net present value of expected post-entry profits > Sunk costs of entry
Post-entry profits <= demand and cost conditions, and the nature of post-entry competition

8. (Continued) Barriers to entry Definition by Bain (1956)
Factors that allow incumbent firms to earn positive economic profits, while making it unprofitable for new comers to enter the industry.
Structural or strategic entry barriers
The incumbent has natural cost or marketing advantages. => Structural entry barriers
The incumbent aggressively deters entry. => Strategic entry barriers

9. Bain’s typology of entry conditions
Three entry conditions
Blockaded entry
Structural entry barriers are so high that the incumbent need do nothing to deter entry.
<= Fixed investments, Product differentiation
Accommodated entry
Structural entry barriers are low.
<= Growing demand, Rapid technological improvements
Deterred entry
The incumbent can keep the entrant out by employing an entry-deterring strategy, and employing the entry-deterring strategy boosts the incumbent’s profits.

10. Structural entry barriers
Three main types of structural entry barriers
Control of essential resources
Economies of scale and scope
Marketing advantages of incumbency

11. (Continued) Control of essential resources
e.g.) DeBeers in diamonds, Alcoa in aluminum, and Ocean Spray in cranberries
Incumbents can legally erect entry barriers. => Patent
cf.) A government patent office sometimes cannot distinguish between a new product and an imitation of a protected product. => Invented around

12. (Continued) Economies of scale and scope
Cost advantage => Minimum efficient scale (MES)
The entrant cannot recover its up-front entry costs if it subsequently decides to exit. => Only if the up-front entry costs are sunk costs.
Marketing advantages of incumbency
Brand umbrella

13. Barriers to exit
(See Figure 9.2.)

14. Entry-deterring strategies
Two conditions for entry-deterring strategies
The incumbent earns higher profits as a monopolist than it does as a duopolist.
The strategy changes entrants’ expectations about the nature of post-entry competition.

15. (Continued) Three ways for entry-deterring Limit pricing
Predatory pricing
Capacity expansion
<= Assuming that the incumbent monopolist’s market is not perfectly contestable.

16. Cf. Contestability theory
Baumol et al. (1982)
A monopolist cannot raise price above long-run average cost. => The market is perfectly contestable.
Cf.) hit-and-run entry
The theory was applied to the airline industry.
=> See Borenstein (1989).

17. Limit pricing Limit pricing
An incumbent firm discourages entry by charging a low price before entry occurs.
Example
Demand function P = 100 – Q
Cost function MC = 10, F = 800
Case: Monopoly MR = MC
⇒ P = 55, Q = 45
⇒ Profit = (55 – 10)*45 – 800 = 1225

18. Limit pricing Case: Cournot duopoly (reaction functions)
⇒ P = 40, Q1 = Q2 = 30 (Q = 60)
⇒ Profit = (40 – 10)*30 – 800 = 100
Market Structure
Price
Annual Profit per Firm
Monopoly
$55
$1225
Cournot duopoly
$40
$100

19. (Continued) Two-periods game Is limit pricing rational?
Incumbent => P = 30 (Q = 70)
Incumbent’s profit (1st period)
(30 – 10)*70 – 800 = 600
Entrant’s profit (if entry occurs)
(30 – 10)*35 – 800 = – 100
Is limit pricing rational?
(See Figure 9.3.)

20. Predatory pricing Predatory pricing
A firm sets a low price to drive rivals out of business.
Difference between limit pricing and predatory pricing
Limit pricing => Rivals that have not yet entered the market.
Predatory pricing => Rivals that have already entered.
Chain-store paradox
An incumbent can slash prices to drive out rivals. => Irrational

21. Are limit pricing and predatory pricing irrational strategies?
Rescuing limit pricing and predation: the importance of uncertainty and reputation
Are limit pricing and predatory pricing irrational strategies?
The explanation is that the analysis far fails to capture important elements of their strategies.
=> Uncertainty
Cf.) Milgrom and Roberts (1982)
Reputation for toughness

22. Limit pricing Limit pricing
An incumbent firm discourages entry by charging a low price before entry occurs.
(See Table 9.1.)

23. (Continued)
Is limit pricing rational?
(See Figure 9.3.)

24. Predatory pricing Predatory pricing
A firm sets a low price to drive rivals out of business.
Difference between limit pricing and predatory pricing
Limit pricing => Rivals that have not yet entered the market.
Predatory pricing => Rivals that have already entered.
Chain-store paradox
An incumbent can slash prices to drive out rivals. => Irrational

25. Are limit pricing and predatory pricing irrational strategies?
Rescuing limit pricing and predation: the importance of uncertainty and reputation
Are limit pricing and predatory pricing irrational strategies?
The explanation is that the analysis far fails to capture important elements of their strategies.
=> Uncertainty
Cf.) Milgrom and Roberts (1982)
=> Reputation for toughness

26. Excess capacity Excess capacity
Firms hold more capacity than they use.
=> By holding excess capacity, an incumbent affects how potential entrants view post-entry competition, and thereby blockade entry.
Cf. Credible commitment
Excess capacity deters entry even when the entrants possesses complete information about the incumbent’s strategic intentions.

27. (Continued) Conditions for entry deterrence (Lieberman, 1987)
The incumbent should have a sustainable cost advantage.
Market demand growth is slow.
The investment in excess capacity must be sunk prior to entry.
The potential entrant should not itself be attempting to establish a reputation for toughness.

28. Judo economics and puppy-dog ploy
Judo economics proposed by Gelman and Salop (1983)
Smaller firms and potential entrants can use the incumbent’s size to their own advantage.
Cf. Puppy-dog ploy
Case: On-line book retail market (Amazon vs. Barnes & Noble)

29. Exit-promoting strategies
Wars of attrition
Evidence on entry-deterring behavior
Survey data on entry deterrence by Smiley (1988)