Economics of Strategy Fifth Edition Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc. Chapter 11.

Economics of StrategyFifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 11

Entry and Exit

Besanko, Dranove, Shanley, and Schaefer

Entry

Entrants are firms that produce and sell in new markets

Entry threaten incumbents in two ways. The market share of the incumbents is

reduced Price competition is intensified

Forms of Entry

Entry could take place in different forms An entrant may be a brand new firm An entrant may also be an established firm

that is diversifying into a new product/market

The form of entry is important for analyzing the costs of entry and the strategic response by incumbents

Forms of Exit

A firm may simply fold up (PanAm) A firm may discontinue a particular

product or product group (Sega leaves the video game hardware market

A firm may leave a particular geographic market segment (Peugeot leaves the U. S. market)

Evidence on Entry and Exit

Dunne, Roberts and Samuelson (DRS) studied entry and exit in U. S. industries. They find that: Entry and exit are pervasive in the U.S. Entrants (exiters) are smaller than incumbents

(survivors.) Most entrants fail quickly and the ones that don’t

grow precipitously The rates of entry and exit vary from industry to

industry.

DRS Findings on Entry and Exit

Over a five year horizon, a typical industry experienced 30 to 40 percent turnover

About half the entrants were diversified firms and the rest were greenfield entrants (new firms).

About 40% of the exiters were diversified firms that continued to operate in other markets.

Conditions in an industry that encouraged entry also fostered exit

DRS Findings on Entry and Exit

Unlike new entrants, diversifying firms built plants on the same scale as incumbents.

The size of the exiters is about one third of the average firms’.

Within 10 years of entry 60% of the entrants leave the industry. The survivors double in size over the same horizon.

Cost Benefit Analysis for Entry

A potential entrant compares the sunk cost of entry with the present value of the post-entry profit stream

Sunk costs of entry range from investment in specialized assets to obtaining government licenses

Post-entry profits will depend on demand and cost conditions as well as post-entry competition

Barriers to Entry

Barriers to entry are factors that allow the incumbents to earn economic profit

while making it unprofitable for the new firms to enter

the industry.

Barriers to entry can be classified into structural barriers (natural advantages) and strategic barriers (incumbents’ actions to deter

entry).

Structural Barriers to Entry

Structural barriers to entry exist when: incumbents have cost advantages incumbent have marketing advantages incumbents are protected by favorable

government policy and regulations

Strategic Barriers to Entry

Incumbents can erect strategic barriers by expanding capacity resorting to limit pricing and resorting to predatory pricing

Types of Structural Barriers

The three main types of structural barriers to entry are:

control of essential resources by the incumbent

economies of scale and scope marketing advantage of incumbency

Entry Deterring Strategies

Some examples of entry deterring strategies are limit pricing, predatory pricing and capacity expansion.

For these strategies to work Incumbent must earn higher profits as a

monopolist than as a duopolist and The strategy should change the entrants’

expectations regarding post-entry competition

Contestable Markets & Entry Deterrence

If there is a possibility of a hit and run entry (zero sunk cost) the market is contestable.

In a perfectly contestable market, a monopolist sets the price at competitive levels

If the market is contestable, it is not worth the monopolist’s while to adopt entry deterring strategies

Limit Pricing: Extensive Form Game

Predatory Pricing

Predatory pricing involves setting the price below short run marginal cost with the expectation of recouping the losses via monopoly profits once the rival exits

Predatory pricing is directed at entrants who have already entered while limit pricing is directed at potential entrants.

Is Predatory Pricing Rational?

If all the entrants can perfectly foresee the future course of incumbent’s pricing, predatory pricing will not work.

The chain store paradox: Many firms are commonly perceived to engage in predatory pricing even when it is irrational to expect predatory pricing to deter entry.

Is Predatory Pricing Rational?

Simple economic models indicate that predatory pricing is irrational

Either the firms’ pricing strategies are irrational or the models are incomplete.

Game theoretic models that include uncertainty and information asymmetry show that predation can be a rational strategy.

Situations Where Limit Pricing & Predation are Rational

Incumbent wants the entrant to lower its expectations for post entry price

Entrant lacks information about incumbents costs.

Incumbent’s pricing strategy can alter entrant’s expectation when there is asymmetric information.

Excess Capacity

For U. S. manufacturers average capacity use is about 80%.

When capacity addition has to be lumpy, firms may often have excess capacity in anticipation of future growth

A temporary down turn in demand may leave the firms in an industry with excess capacity with no strategic overtones

Excess Capacity and Entry Deterrence

By holding excess capacity, the incumbent can credibly threaten to lower the price if entry occurs.

An incumbent with excess capacity can expand output at a low cost.

Entry deterrence will occur even when the entrant as informed as the incumbent.

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Excess CapacityDuPont Titanium Dioxide Ti-Pure®

3

0

E E

MonopolyCapacity

NE

Excess Capacity

NE

Rival

DuPont

E=EnterNE=Do not enter

4

0

1

-1

2

1

DuPontRival

http://www.dupont.com/tipure/

Excess Capacity and Entry Deterrence

Excess capacity works to deter entry when incumbent has a sustainable cost

advantage, market demand growth is slow, incumbent cannot back-off from the

investment in excess capacity and entrant is not the type trying to establish a

reputation for toughness.

Entry Deterring Strategies

Aggressive price reductions to move down the learning curve

Intensive advertising to create brand loyalty

Acquiring patentsEnhancing reputation for predation Limit pricingHolding excess capacity

Page 25

ET and the Chocolate Wars

In the movie “E.T.” a trail of Reese's Pieces, one of Hershey's chocolate brands, is used to lure the little alien into the house. As a result of the publicity created by this scene, sales of Reese's Pieces trebled, allowing Hershey to catch up with rival Mars.

Page 26

ET and the Chocolate Wars (Continued)

Universal Studio's original plan was to use a trail of Mars’ M&Ms.

However, Mars turned down the offer, presumably because it thought $1m was a very high price to pay.

The producers of “E.T” then turned to Hershey, who accepted the deal.

Page 27

ET and the Chocolate Wars (Analysis)

Suppose that the publicity generated by having M&Ms included

in the movie would increase Mars' profits by $800,000.

Hershey's increase in market share cost Mars a loss of $500,000.

the benefit for Hershey's from having its brand featured in the movie is given by b.

Hershey knows the exact value of b. Mars knows that b=1200 or b=700 with equal probability.

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The Mars ProblemA: Decision-theory Approach

[-200]bu

y

not buy

M

[0]

Page 29

The Mars ProblemB: Naïve Game-theory Approach

[-200, 0]bu

y

not buy

M

[-500, -50]

[0, 0]not buy

buyH

0

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The Mars ProblemC: Game-theory Approach

[-500, 200]

[0, 0]

[-500, -300]

[0, 0]

[-200, 0]buy

not buy

b = 1200(50%)

not buy

buy

not buy

buy

M

N

H

Hb = 700

(50%)

-500

0-250

See also: Joël Glenn Brenner, The Emperors of Chocolate. New York: Random House, 1999 http://www.JoelGlennBrenner.com/http://luiscabral.org/iio/ch04/ET/

Page 31

Dominant and Dominated Strategies

Dominant strategy: payoff is greater than any other strategy regardless of rival’s choice.

Rule 1: if there is one, choose it and that’s the end of it.

Dominated strategy: payoff is lower than some other strategy regardless of rival’s choice.

Rule 2: do not choose dominated strategies.

Check whether there are dominant and/or dominated strategies in the example above. What can we say based on this?