Competitive Strategy - Entry and Exit

Entry and Exit

  • Entry and exit are common in markets.
  • Dunne, Roberts, and Samuelson (1988) found in a study of 250,000 manufacturing firms (through 1982) that:
    • In an average industry of 100 firms with annual sales of 100 million, about 30-40 new firms will enter within five years, with annual sales of 12-20 million. During the same period, 30-40 firms will exit.
    • Half of the new firms will be brand new, and half will be diversifying.
    • Entrants will be about 1/3 the size of incumbents.
    • More than half of the entering firms will be gone within ten years. The survivors will be twice as large as when they entered.
    • There's considerable variability across industries.

Basic Entry Strategy

  • The best entry strategy is to find an unoccupied product space, referred to as a "Blue Ocean" strategy.
  • Entering a contested space leads to intense competition.
  • Entering an uncontested space creates new demand.
  • It may be possible to achieve both high differentiation and low cost.
  • Examples: Netflix and Cirque du Soleil.

Blue Ocean Strategy - Cirque du Soleil

  • Achieved increased demand through:
    • Innovative music, lighting, storylines, and artistry, rivaling Broadway shows in sophistication and allowing for high ticket prices.
    • More comfortable seating.
    • Creation of multiple unique productions to increase repeat demand.
  • Cost reduction strategies:
    • Eliminated animal acts and associated costs (care, training, transportation, and housing).
    • Shows feature one stage instead of three rings, reducing the number of performers.
    • Anonymized performers to prevent bargaining leverage.
  • Competition with traditional circuses became largely irrelevant.

Basic Entry Strategy with Incumbents

  • True Blue Ocean strategies are rare, so firms should consider the usual determinants of rivalry.
  • When facing competition with incumbents, use a dynamic framework for studying entry.
  • Think forward, reason backward.
  • Analyze how product positioning, differentiation, and capacity choice affect profits after entry and rivalry.
  • Consider incumbents' willingness and ability to retaliate against entrants.

Entry with Differentiated Products

  • Consider a firm entering a differentiated market with an incumbent at one end of a Hotelling line. The entrant must pay a fixed cost F to locate at the other end and compete.
  • When two firms are at opposite ends of the line with a travel cost of c, both firms charge c in equilibrium and sell to half the customers.
  • The entrant's profit will be \frac{c}{2} - F.
  • Entry is profitable if F < \frac{c}{2}.

Profitable Entry on the Opposite End of a Hotelling Line

  • If products are highly differentiated, the entrant can sustain a higher entry cost.

Entry Prospects

  • The most favorable situation is in the lower-right corner (unspecified in the transcript but implied to be high differentiation and low cost).
  • With a good cost position, an entrant may survive even with low product differentiation.

Barriers to Entry

  • Joseph Bain categorized barriers to entry as structural or strategic.
    • Blockaded entry: Structural barriers are so high that incumbents don't need to take action to prevent entry. This can be due to control of natural resources or lack of demand.
    • Accommodated entry: Structural barriers are low, and incumbents cannot deter entry effectively. Common in fast-growing, technologically improving industries.
    • Deterred entry: Incumbents can keep entrants out through strategic maneuvers that increase the incumbent’s profit. This may involve acts of predation.

Asymmetry Between Incumbent and Entrant

  • In theory, there is no required asymmetry between incumbent and entrant.
  • Incumbents often have large sunk-cost investments, giving them a fixed-cost advantage.
  • Examples:
    • FedEx and UPS have invested heavily in hub facilities, planes, and trucks.
    • Airlines have large customer bases loyal through rewards programs.

Structural Entry Barriers

  • Control of scarce resources:
    • DeBeers controlled most diamond mining, though new finds impact profits, requiring them to buy out competitors.
    • Courts may require firms to allow access to their resources.
  • Economies of scale and scope:
    • Entrants unable to quickly gain market share will struggle to spread fixed costs.
    • Large cereal companies like Kellogg and General Mills can handle multiple production lines in one facility.
    • Entrants may need to establish multiple brands to survive, creating a disadvantage against incumbents.
    • The breakfast cereal industry has seen little entry in recent decades.

Entry Deterrence

  • Predatory pricing
  • Limit pricing
  • Capacity expansion
  • Spatial preemption

Predatory Pricing

  • Firms set low prices to drive competitors out.
  • Examples: The "gunpowder pool" and Standard Oil.
  • Consider a monopolist facing entry in multiple markets sequentially.

The Chain-Store Game

  • A chain store competes against rivals in multiple cities.
  • Entry decisions occur sequentially in different cities.
  • There is a finite number of periods, and competition is the same in all periods.

The Chain-Store Game: One Period of the Game

  • Entrant's options: Enter or Don't Enter.
  • Incumbent's options: Retaliate or Accommodate.
  • Payoff matrix:
    • If the Entrant Enters and Incumbent Retaliates:
      • Entrant: -1
      • Incumbent: 0
    • If the Entrant Doesn't Enter:
      • Entrant: 0
      • Incumbent: 5
    • If the Entrant Enters and the Incumbent Accommodates
      • Entrant: 1
      • Incumbent: 2

The Chain-Store Game - Just One Period Played

  • Like the Boulton-Watt game vs Trevithick, the incumbent’s best response to entry is to accommodate.
  • The subgame perfect equilibrium is for the incumbent to accommodate. The entrant thus best responds by entering.

The Chain-Store Game - Multiple Periods

  • Suppose the incumbent faces N > 1 potential entrants, in sequence. Payoffs are the same as in the one-period game.
  • The incumbent might use predatory behavior.
  • If entrants believe the incumbent will retaliate, they may not enter.
  • The incumbent might retaliate early to deter later entrants.
  • With perfect information, this won't work, but it may with imperfect information.

The Chain-Store Game - A Reputation for Toughness

  • Suppose the incumbent has private information about their toughness.
  • There might be some chance the incumbent is "crazy," motivated by factors other than profit.
  • By retaliating early, the incumbent can develop a reputation for toughness, deterring subsequent entrants.
  • Wal-Mart, American Airlines, and others have had reputations for toughness due to fierce price competition.

Limit Pricing

  • An incumbent charges a low price before any entry to discourage it.
  • The simplest form is when the incumbent has a lower marginal cost than the entrant and charges a price just under the entrant’s marginal cost. This results in Bertrand duopoly with asymmetric marginal costs.
  • The incumbent serves all demand and earns positive profits but cannot charge the monopoly price.
  • Strategic limit pricing involves the incumbent setting a price to influence the entrant’s beliefs about the incumbent’s future behavior.

Strategic Limit Pricing

  • A two-period game: In period 1, an incumbent monopolist operates alone. In period 2, another firm may enter and compete (Cournot-style) or stay out.
  • The monopolist prices low in period 1, sacrificing some profit to signal low prices if entry occurs.
  • If deterring entry makes the strategy profitable overall, it seems beneficial.
  • However, there may be a problem with this strategy.

Strategic Limit Pricing - Subgame Perfect Equilibrium

  • Is the limit price outcome consistent with a subgame perfect equilibrium? No.
  • Once entry occurs, the incumbent loses the incentive to maintain a low price.
  • The entrant will expect accommodation and enter.

Strategic Limit Pricing - Asymmetric Information

  • With asymmetric information, things can change.
  • Suppose the incumbent knows more about its costs than entrants.
  • A low-cost "tough" incumbent would cut prices when facing entry, while a high-cost "weak" incumbent would not.
  • The entrant might stay out if it anticipates facing a "tough" incumbent.
  • What can the incumbent do?

Strategic Limit Pricing - Signaling

  • The low-cost incumbent wants to signal its low costs.
  • It must take an action unprofitable for a high-cost incumbent.
  • Merely setting the monopoly price consistent with low costs is insufficient; it may need to price even lower.
  • The high-cost incumbent would not do this, even to deter entry.

Spatial Preemption

  • Firms often sell multiple products (e.g., cereal makers).

  • By strategically positioning products, they can preempt entry.

  • Consider one firm positioning two products.

  • Let the transport cost be t per unit distance, and entry cost F > 0.

  • How far apart must the products be to make entry unprofitable?

  • The entrant would ideally locate halfway between the incumbent’s two products. If this yields profit greater than F, entry is profitable.

Spatial Preemption - Determining the Ideal Distance

  • When two identical firms are located at opposite ends of a line, and the travel cost from point 0 to point 1 is t, their profit margin is t in equilibrium
  • If the entrant locates halfway between products a distance d apart, equilibrium margins will equal the travel cost from the entrant to either firm = \frac{dt}{2}
  • The entrant will sell to a mass of customers = \frac{d}{2}. So its profit will be (\frac{d}{2})^2t - F
  • This is negative if d < 2\sqrt{\frac{F}{t}}.
  • The necessary distance is increasing in the fixed cost F, but at a decreasing rate.

Capacity Expansion

  • If an incumbent has a sustainable cost advantage, maintaining excess capacity may be strategically advantageous.
  • Entrants expect a price war they will lose.
  • If demand grows rapidly, it will eventually outstrip capacity, preventing the strategy.
  • If the capacity is threatened but not sunk, the incumbent may not expand capacity upon entry.

Judo Economics

  • Using the incumbent’s size to the entrant’s advantage.
  • Enter in a way that, if the incumbent tries to drive you out, it hurts itself significantly.
  • If done correctly, such entry will be accommodated.
  • Commit to remaining small (e.g., by building small capacity). Then, a price war to claim your market share hurts the incumbent's larger share.
    American Airlines defeated Braniff in 1991 with its "Value Advantage" pricing, right after Braniff announced its intention to serve limited routes.