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ECON 696: Managerial Economics and Strategy
Lecture Notes 9: Entry and Exit
The previous few chapters have looked at how firms deal with each other, both
strategically and tactically, while they're operating.
This chapter discusses the conditions under which firms enter and leave markets.
The textbook first covers the market characteristics most important in entry and exit
decisions and most important in determining the likely profitability of new entrants.
The textbook then turns its attention to strategies incumbent firms (firms already in the
market) may use in attempting to prevent the entry of new firms, some of which appear
sensible only under some very specific assumptions.
The most important things a potential entrant should consider before entering a market
are the barriers to entry that may be in place, the cost of overcoming these barriers, and
the potential for profits in the industry once they have entered. In fact, the competitive
environment may be quite different once the entrant has started operating in a market.
Barriers to Entry
Barriers to entry are factors that keep potential entrants from entering an industry in
which incumbent firms are making positive economic profits. That is, the firms already
in an industry are earning an unusually large return on their investment but some barriers
keep new firms from coming in.
Barriers to entry may be structural or strategic. Structural barriers exist in an industry
independent of any behavior taken by an incumbent firm toward an entrant, or even a
potential entrant. Strategic barriers exist because incumbent firms can be reasonably
expected to respond aggressively to any attempts at entry.
The level of these barriers is described by Bain's Typology:
1. Blockaded entry describes a situation where there are sufficient structural barriers in
place so that incumbent firms need take no action in order to prevent entry. Something
about the market just makes it impossible for new firms to enter profitably.
2. Accommodated entry describes a situation where the structural barriers are so low and
the cost of any sort of strategic reaction is so high that incumbent firms can do nothing
but accept and accommodate new entrants. Aggressive reactions simply make no sense.
3. Deterred entry describes a situation where barriers to entry are sufficiently high that
incumbents, through some aggressive or predatory acts, can keep a potential entrant out
and will enjoy greater profits, even considering the cost of the predatory acts, by doing
so.
The book discusses three classes of structural barriers to entry:
1. Control of essential resources means that a firm owns something critical to producing
and selling in a market. This might be a natural resource, a transit route, a patent or a
trade secret. By excluding other firms from use of that resource, and incumbent firm can
prevent any new firm from entering profitably.
2. Economies of scale and scope means that there are sufficient advantages to being large
that no small entrant can possibly hope to compete profitably. As mentioned among the
empirical observations at the beginning of the chapter, most entrants tend to be smaller
than established firms.
3. Marketing advantages of incumbency describes situations in which consumers rely on
existing reputations when making purchase decisions, secure in the knowledge that a firm
with an established reputation and a valuable brand name would not risk these by selling
a poor quality product. An entrant will either have to spend a lot of money advertising to
establish such a valuable brand name or will have to work in other costly ways to
establish a reputation for quality.
Barriers to Exit
In exiting an industry, a firm reduces its losses by reducing its variable costs to zero. It
will still suffer losses equal to its fixed or sunk costs.
Barriers to exit are, to some extent, these sunk costs. If these are small or zero, firms can
easily exit an industry. If they are high, a firm can suffer large losses even if it shuts
down.
To understand why firms would choose to erect barriers to exit, consider first a firm's
decision about whether or not to shut down in the short run.
A firm will choose to enter a market if it expects to make a profit. This means that it
must expect that, after entry, the price will be above minimum average cost.
A firm will choose to exit a market in the short run if it is not covering its variable costs.
That is, for a firm to exit in the short run, the market price needs to be below the
minimum average variable cost.
This is summarized in Figure 9.2 from the text (p. 310):
So, firms will enter a market only if they expect that the price, post-entry, will be above
Pentry and will leave a market in the short run only if the price is driven down to a level
below Pexit.
The position of the average variable cost (AVC) curve depends on the inputs over which
the firm has control in the short run.
The lower Pexit is, the lower the incumbents must be prepared to drive the price if they are
going to either force an entrant out of business or deter its entry in the first place. If a
firm can commit to purchasing a certain quantity of inputs, or if it has some inputs which
cannot be resold for some reason, it can reduce its variable costs and shift the AVC curve
down. This makes is more difficult for incumbents to drive an entrant out of business.
Note that this is a situation where flexibility is sacrificed in order to gain a strategic
advantage. This is another form of strategic commitment.
Entry-Deterring Strategies
The text discusses three ways in which incumbent firms, who may be monopolists, can
deter entry.
An important preliminary point is that these techniques will not work if the market is
perfectly contestable, meaning that entrants can come in on very short notice any time the
price rises even slightly, make a profit, and then quickly exit after prices have fallen. If a
market is perfectly contestable, prices will remain at competitive levels even if there is
only one firm serving the market. While the theory of perfectly competitive markets is
theoretically appealing, there seem to be very few good examples in reality.
1. Limit pricing
Limit pricing describes the practice of a monopolist keeping prices sufficiently low to
deter entry. This has the effect of reducing profits now, but by preserving the monopoly,
positive profits can be maintained in the long run.
Limit pricing is supposed to be some sort of implied threat to any potential entrant that
the incumbent, by keeping prices low even as a monopolist, will increase the quantity
produced and lower prices severely and drive any entrant out of business. The problem is
that once the entrant is in, the incumbent firm really has no reasonable incentive to follow
through with the threat. If the incumbent follows through with the threat, it will suffer
losses. While it may drive the new firm out of business, there will likely be a new
potential entrant waiting as soon as it increases prices. If, instead, the incumbent firm
accommodates the new entrant, they may be able to share the market and split Cournot
duopoly profits, a far preferable outcome. So, no incumbent would ever really carry
through with the threat to drive the entrant out of business. Doing so would be irrational,
so the threat isn't really credible.
One situation in which limit pricing might be effective is when there is uncertainty about
the incumbent firm's costs. An incumbent firm might charge a price lower than the
normal profit maximizing price in hopes of making potential firms believe that it has
lower costs (and can thus compete more aggressively) than it really does.
To illustrate this idea, consider a monopolist who has marginal costs of MChigh. Potential
entrants don't know this, however, so she sets her price at Plow instead of the ordinary
profit maximizing price of Phigh. Seeing the lower price, potential entrants may be fooled
into believing that she actually has marginal costs given by MClow against which they
cannot hope to compete. The new firms stay out of the market and the monopoly is
preserved, though at the cost of lower annual profits.
This is rather like bluffing in poker. A player with a weaker hand bets and attempts to act
as if her hand is stronger than it really is in hopes of getting other players to withdraw
from the game and leave her with the pot. If the cost of staying in (or in an entrant's case,
the cost of getting into) the game is sufficiently high and there is enough at risk, bluffing
can be a very effective strategy.
2. Predatory pricing
Predatory pricing is pricing designed to drive firms that have already entered a market out
of business. This differs from limit pricing in that limit pricing is designed to keep new
firms from ever entering. The two are related in that limit pricing may be seen as
carrying with it the threat of predatory pricing should a new firm enter.
If you are a monopolist, predatory pricing is illegal. If you're not a monopolist, it's
probably just good healthy competition.
The analysis of predatory pricing presented in the book is basically confusing and
worthless. The bit about a model with twelve periods (January to December) is a waste
of ink. Firms don't typically exist in worlds with final periods (there's no final December
in the real world) so working backward from the end of the game doesn't have much of a
practical application here.
The way to think of predatory pricing is that there is an infinite supply of potential
entrants waiting to try their hand either at one monopolist's market or at another
monopolist's market. They know that, after they enter, each monopolist might either
accommodate them (and split a Cournot duopoly) or fight them, slash prices, and try to
drive them out of business and preserve their monopoly.
Each of these potential entrants is constantly sizing up all the monopolists out there,
trying to determine which are most likely to accommodate their entry and, thus, are the
easiest targets.
Each monopolist knows that, in any one period, it would be better off accommodating an
entrant than fighting, once that entrant is in. However, all the potential entrants also pay
attention to how all the monopolists have responded in the past. They know which have
fought entrants.
Fighting is always more costly in any one period than accommodating is. Over a longer
period of time, however, fighting a lot can lead to a reputation as a monopolist who
aggressively defends her market. This can deter potential future entrants and result in
some benefit.
At some level, it's sort of disturbing how similar this might be to an elementary school
playground.
3. Excess capacity
There are a variety of reasons for holding excess productive capacity. One of them is to
be able to increase production quickly and at relatively low cost in order to drive prices
down and scare off a potential or actual entrant.
Excess capacity is a critical tool either for the conduct of limit pricing or predatory
pricing.
Having excess capacity makes expanding output sufficiently inexpensive that some sort
of action in the face of entry is credible.
Fighting a War of Attrition Against an Entrant
If a new firm enters a market and the incumbent firm or firms decide(s) to fight it, they
all face the prospect of zero or negative profits until the incumbent relents and
accommodates or the entrant leaves.
Predicting outcomes here is difficult. Even if a firm has deep pockets, it would hopefully
be smart enough to recognize a battle that is not worth winning. A winning incumbent
might find itself unable to fight off another entrant. A surviving entrant might find itself
in worse shape than if it had never entered.
Given good financial markets, if a firm has some advantage, we would expect that it
would be able to find investors willing to ride out a war of attrition, secure in the
knowledge that the firm's advantage will result in very healthy profits afterward.
Summary
When analyzing the potential for entry and exit in a market, one of the most important
characteristics to look at is the degree to which there are barriers to entry. Entry may be
blockaded if the barriers are severe or accommodated if they are small or non-existent.
Entry may be deterred if barriers are of a level such that entry could be possible in the
absence of preventative action by incumbents.
Incumbent firms may practice limit pricing in an attempt to keep firms from entering or
predatory pricing to get those who have entered to leave. In any case, a firm might
choose to keep some excess capital available so that it may increase production relatively
quickly and fend off an entrant.
If an entrant does begin selling in a market, a monopolist who chooses to fight may be
successful in scaring it off and enhancing its reputation as a tough firm, but it also faces
the prospect of a war of attrition that could leave it much worse off than if it had been
accommodating.