Entry and Exit

Entry and Exit

Introduction

Incumbent firms formulate strategy taking into account the possibility of entry by new firms

Entry has two effects reduced market share intensified market competition

Can take two forms entry by a new firm entry by an existing firm diversifying into a new market

Exit is the reverse process Acquisition is not entry: merely change of identity

Some Stylized Facts

Entry and exit is pervasive over a five year period in most industries

30-40% new firms enter 30-40% of existing firms exit

entrants are generally small if they are new most entrants do not survive 10 years if they survive they grow rapidly: 60% fail, the

remainder at least double in size patterns vary across industries

Strategic Implications

Firms should plan for entry by unknown firms realize that diversifying entrants can threaten

incumbents expect most new ventures to fail quickly

but survivors will grow quickly in planning entry focus on how to manage rapid

growth know the industry

Strategic implications (cont.)

Entrants should consider costs of entry and exit: are there sunk costs? likely reaction of incumbents: aggressive or

passive what has been the history of the market?

barriers to entry of various types

Barriers to Entry

Barriers can take two formsStructural

incumbents have natural cost advantages cost location regulatory environment

Strategic through deliberate actions of incumbents

A Taxonomy

Entry conditions can be classified into three types blockaded entry

structural conditions preclude entry without strategic actions

accommodated entry structural barriers are low and there are no effective

strategic barriers to entry deterred entry

incumbents use specific strategies to deter entry

Structural Entry Barriers

control of strategic resources patents if not deliberately anti-competitive

economies of scale and scope cost advantage of incumbency ability to sustain a price war leave no “holes” in the market requires that some part of entry costs is sunk

Structural entry barriers (cont.)

marketing advantages of incumbency exploit reputation and brand name

risky if a new product does not meet expectations access to distribution based on reputation

Barriers to Exit

Exit if cannot make an acceptable return on assets but consider only recoverable assets

$

Quantity

ATC

AVC

MC

PENTRY

An illustration of theentry/exit decisions

An illustration of theentry/exit decisions

Do not enter unlessexpected price is at

least PENTRY

Do not enter unlessexpected price is at

least PENTRYDo not exit if priceis greater than PEXIT

Do not exit if priceis greater than PEXIT

PEXIT

Exit barriers exist when there are

fixed costs when there are

relationship-specific assets

Strategic Entry Deterrence

An incumbent will adopt entry deterring strategies if monopoly is preferred to accommodated entry if the strategies affect expectations of potential

entrants about post-entry competition

First condition is obvious unless the market is perfectly contestable

Second condition requires that strategies are credible

Entry deterrence

There are several potential strategies that have been suggested limit pricing predatory pricing capacity expansion

Limit pricing

Charge a low price before entry entrant is put off by the low price

An illustration

suppose demand is P = 100 - Q

marginal cost is $10 per unit

fixed costs are $800 per annum

incumbent has monopoly in year one; faces potential entry in year 2

market closes at the end of year 2

The Example

$

Quantity

Demand100

100

10MC

An incumbent monopolist produces Q = 45 units;

MR45

price = $55

55

Profit p.a. = (55 - 10)x45 - 800 = $1,225Monopoly profit per

period ignoringfixed costs

Monopoly profit perperiod ignoring

fixed costs

Suppose an entrant in period 2 with the same costs

Assume that the incumbent and entrant are Cournot (quantity) competitors

The Example

$

Quantity

Demand100

100

10MC

Each firm produces 30 units in period 2;

MR

price = $40Profit to each firm = (40 - 10)x30 - 800

= $100

Given this expectation entry will occur

60

40

The incumbent’s profit in period 2 is sharply down

The example (cont.)

Can the incumbent deter entry? use the reasoning

price low in period 1 the entrant will then expect an even lower price in period 2 entry will not happen I can then charge the monopoly price in period 2

suppose the incumbent charges $30 in period 1 the incumbent then expects a price no higher than

$30 in period 2 suppose that the price is actually $30

The example (cont.)

aggregate demand is 70 units suppose that this is split equally the entrant expects profits of (30 - 10)x35 - 800 = -

$100 with a lower price losses are even greater so the potential entrant should not enter the incumbent then has profits

(30 - 10)x70 - 800

Profit in thefirst period

Profit in thefirst period

+ $1,225

Monopolyprofit in the

second period

Monopolyprofit in the

second period

= $1,825

Limit pricing would appearto be successful inincreasing profits

The Example (cont.)

But this outcome is wrong: the logic is flawed why only two years?

if more periods then the limit price might have to be sustained over a very long time

for this to be acceptable the incumbent needs a strong cost advantage over potential entrants

the supposed equilibrium is not credible technically, it is not subgame perfect the entrant’s supposed expectations regarding the

incumbent’s post-entry actions are unreasonable

consider the full game in extensive form

The Entry Game

Incumbent

PL

Incumbent sets thelimit price

Incumbent sets thelimit price

PM

Incumbent sets themonopoly price

Incumbent sets themonopoly price

Out

EntrantIn

I = $1,825; E = 0

EntrantOut

I = $2,450; E = 0

Incumbent

PL I = $500; E = -$100

PC

I = $700; E = $100

InIncumbent

PL I = $1,125; E = -$100

PC

I = $1,325; E = $100

Entrant decideswhether to enter

Entrant decideswhether to enter

Incumbent choosesits pricing strategy

Incumbent choosesits pricing strategy

The Entry Game

Incumbent

PL

PM

Out

EntrantIn

I = $1,825; E = 0

EntrantOut

I = $2,450; E = 0

Incumbent

PL I = $500; E = -$100

PC

I = $700; E = $100

InIncumbent

PL I = $1,125; E = -$100

PC

I = $1,325; E = $100

If the Entrant enters theIncumbent will choose

Cournot


Cournot

PC

I = $700; E = $100

If the Incumbent sets thelimit price the Entrant

will enter

If the Incumbent sets thelimit price the Entrant

will enter

In


Cournot


Cournot

PC

I = $1,325; E = $100

If the Incumbent sets themonopoly price theEntrant will enter

If the Incumbent sets themonopoly price theEntrant will enter

In

The Incumbentwill set the

monopoly price

The Incumbentwill set the

monopoly price

PM

Limit pricing is nota credible strategy

Limit Pricing Rescued

Can limit pricing be rational? what if the entrant is uncertain of the incumbent’s

costs high-cost incumbent - enter low-cost incumbent - stay out

then the low-cost incumbent can signal a price that induces the entrant to stay out

but a high-cost incumbent might send the same signal

for this to work the price signal by a low-cost incumbent must be impossible for a high-cost incumbent

or there is additional uncertainty e.g. about demand

Predatory Pricing

Pricing intended to eliminate rivals more aggressive than limit pricing charge low price to drive out rivals then subsequently raise price

Has similar credibility problems chain store paradox

incumbent will not fight in a “last” market so will not fight in all previous markets

Predatory pricing (cont.)

Paradox can be resolved if there is uncertainty about the incumbent’s “type” if “easy” then entry is profitable if “tough” then entry is unprofitable

incumbent wants to develop a tough reputation Wal-Mart American Airlines

develop routines that make managers tough reward on market share not profits

Excess Capacity

Firms carry excess capacity capacity use generally around 80% economic reasons

to cope with unexpected fluctuations in demand as a result of competition from new firms

strategic reasons to deter entry

• convince potential entrants of toughness of incumbents• potential entrants know that incumbents can expand

output at low cost

Entry at limited scale

Potential entrants may be able to enter at low scale deterrence is costly incumbent may be inclined to ignore a small

entrant so entrant needs credible mechanism to

convince incumbents of small-scale entry “puppy-dog ploy”

modern manufacturing techniques may help micro-breweries

War of attrition

Firms have been accused of charging low prices to eliminate competition Standard Oil Toyota Wal-Mart

but price wars are costly and uncertain firm with “deep pockets” will win but at the expense of considerable profits

create exit barriers to influence rivals

Documents

Entry and Exit