User:Nickg23/Strategic Entry Deterrence

In business, strategic entry deterrence refers to any action taken by an existing business in a particular market which aims to discourages any potential entrants from gaining entry to specific markets. These constraints, or barriers to entry, can include hostile takeovers, product differentiation through heavy spending on new product development, expanding capacity to achieve lower unit costs, and predatory pricing. Although many barriers to entry are created by incumbents, timing can also act as a barrier to entry, as potential entrants are less likely to enter into a market if it will take a significant amount of time for them to catch up to an incumbent, while they incur costs and lose profit in the process. Barriers to entry are sometimes deemed anti-competitive and can be subject to various competition laws.

Structural barriers to entry

When structural barriers to entry are ineffective at deterring entry, incumbent firms may choose to engage in strategies such as predatory pricing, limit pricing and capacity expansion. In order for these strategies to be effective in deterring entry, incumbent firms must be earning a higher profit as a monopolist that it does as a duopolist, and the strategy should alter the entrants' outlook on the prosperity of the market post-entry. The two most common structural barriers are;

1. Accommodated entry: Where structural barriers to entry are low, and entry deterring strategies are ineffective or the significant sunk cost incurred by the incumbent exceeds the potential benefits of keeping the new entrant out of the market.
2. Blockaded entry: When the incumbent firm does not need to protect itself from potential entrants. The initial upfront costs of capital are large enough to deter entry.

Signalling

The incumbent firm has an advantage of being the "first mover" and can therefore act in a way that it knows will influence the entrant's decision. If we assume imperfect knowledge (i.e. the incumbent firm's costs are only known privately) the entrant can only make assumptions about the incumbent's cost structure through its price and output levels. Therefore, the incumbent can use these as a signal to any potential entrant.

One way of using this advantage to deter entry is to charge a price less than the monopoly level. If an entrant is considering entry in a number of similar markets, a low cost incumbent can signal its efficiency to a potential entrant through lowering prices – thereby discouraging what the entrant believes would be unprofitable entry. Signalling needs to be credible to be effective – a low cost firm must be able to show that it can withstand lower profits for an extended period of time, which it would not be able to if it had higher costs.

Preemptive deterrence

An incumbent who is trying to strategically deter entry can do so by attempting to reduce the entrant's payoff if it were to enter the market. The expected payoffs are obviously dependent on the number of customers the entrant expects to have – therefore one way of deterring entry is for the incumbent to "tie up" consumers.

The strategic creation of brand loyalty can be a barrier to entry – consumers will be less likely to buy the new entrant's product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.

Similarly, if the incumbent has a large advertising budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large sunk cost that will prevent some firms entering.

Monsanto engaged in preemptive deterrence when it signed contracts with Coke and Pepsi. Because Monsanto locked in the consumers of Coke and Pepsi through its contracts, it made entry into the soda market less desirable because potential entrants would have less consumers and, in turn, less profit. Furthermore, if another firm decided to enter the market and obtain contracts with other soda brands, it would be less likely to attract as many customers as Monsanto because customers are loyal to Coke and Pepsi due to their popularity.

Limit pricing

File:Limit pricing3.jpg

In the left-hand diagram, the incumbent firm incurs lower costs than the entrant. Hence, if they both are charging the same price, the incumbent firm makes a profit equal to the size of the blue line. In this scenario, even the new entrants make a profit due to the price being above their long-run average cost curve (LRAC).  However, if the existing firm is able to take advantage of it's significant cost advantage and charges a price equal to the point on the entrants LRAC, then these potential entrants would have no incentive to join the market. Overall, the incumbent firms sacrifice short-run profits to ensure profits equal to the size of the orange arrow in the right-hand diagram.

In a particular markets, an incumbent firms may be producing a monopoly level of output, and thereby experiencing supernormal profits. These attractive profit margins create an incentive for new firms to enter the market and attempt to capture some of these profits. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly level, a strategy known as limit pricing. Not only will this reduce the profits being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory to produce the extra capacity, for it to be a credible deterrent.

If the limit price is set low enough by the incumbent, then the potential entrant will conclude that they will be unable to recover the sufficient upfront sunk costs of entry, and therefore decides to stay out. However, in doing this, the incumbent firm is forced to forgo a portion of their supernormal profits.

Capacity Expansion

Firms which are able to store greater stocks of excess capacity can benefit for multiple reasons. Firstly, when firms anticipate future growth within the industry they often purchase in larger increments. Secondly, "during an economic recession within the industry the firms with excess capacity benefit. This excess capacity is considered a sunk cost for the incumbent firm".

By utilising this excess capacity, the incumbent firms can legitimately lower the price if the entrant was considering entry. As opposed to predatory pricing and limit pricing, excess capacity may seek to deter entry even if the potential entrant has access to perfect information. If the incumbent firm is successfully able to build excess capacity, they have the increased advantage in expanding output at a lower cost.

Long Term Contracts

Another strategy to deter potential entrants into a particular industry is for upstream and downstream firms to engage in long term contracts between one another. This is a common strategy used by both downstream and upstream firms to defer entry away from the supplier market. The aim is for these upstream and downstream firms to act as the monopolist incumbent over prospective entrants.

Judo Economics

Judo economics is a competitive strategy used within the market which emphasises skill and performance as opposed to a firms size or market share. The theory was developed by Steven Salop and Judith Gelman to enable a firm to use a larger firms size to its advantage. In this model, the potential entrant must determine how aggressively they wish to enter the market which is already held by the incumbent. These economists believed that once the entrants attempts to capture a large share of the market, the incumbent will retaliate and most likely win. In rare cases, the entrants can persuade the incumbent to accomodate their entry by making a commitment to only target a small section of the market.

Doomsday device

The threat to fight any potential entrant is credible if its reputation is built up, or it can set up conditions that make it optimal to fight if a rival enters.

If there are relatively low barriers to exit within a market, an incumbent competing against a more efficient rival may find it optimal to exit the market rather than fight. Hence, one way to make a fighting threat credible is for the incumbent to artificially raise the cost of exit, for example by having high sunk costs.

Examples of this are railroad companies. The high sunk cost of laying a network of railway lines makes it likely that a rail operator will be willing to fight a more costly price war than a rival with lower sunk costs, for example an airline that can switch its aircraft to another route relatively easily. At the extreme, if the incumbents sunk costs are very high, any entry by a rival will end in a mutually destructive outcome.

See also

• Limit price
• Perfect competition
• Barriers to entry