neatly 1997, a consortium of electronics firms led by Toshiba, Sony, Mat- ‘sushita, and Philips introduced a new digital video format called DVD. This for- mat offered video resolution and sound quality that was superior to conventional videocassettes. By spring 1997, several major studios, including Warner, MGM, and Columbia, released a few movies in DVD format. The DVD hardware con- sortium expected “early adopters"—individuals willing to pay a premium price for new technology—to purchase DVD players at high prices, despite the shortage of movies to play on them. This would encourage the release of more movies and generate additional hardware sales. The consortium hoped to have a large installed base of DVD players in consumers’ homes by Christmas 1997. Studios would then rush to release their movies on DVD, and consumers would replace their video ‘tape players with DVD players, just as they had replaced their record players with CD players a decade earlier. Sales of DVD players exceeded expectations through the summer of 1997, but the Christmas season was a disappointment. In the fall of 1997, electronics retailer Circuit City made a surprise announcement. They were spearheading the release ofa digital video format called DIVX that was partially incompatible with DVD. Circuit City hoped to make DIVX the format of choice. Consumers, wary of pre~ vious format wars, such as that between VHS and Beta videotape, stayed on the ‘Sidelines that Christmas season, as did several major studios, such as Paramount and Fox. Circuit City did not adequately follow through with the DIVX introduction. finally released DIVX hardware and software in two test markets in early sum- ‘er 1998. They offered only a few brands of DIVX players (initially, the only Player was made by Zenith, which had entered into bankruptcy at that time), and sold only a few hundred DIVX movie titles. Circuit City was unable to persuade Most other electronics retailers to sell DIVX hardware and software. Video rental Outlets refused to carry DIVX software. Meanwhile, by the time of the nationwide rollout in late summer 1998, the DVD market was taking off. There wereaggressively discounting soltware, and video rental stores such as Blockbuster er anarkets. In the last two decade, the Eccentric (owned by Oprah Winfrey) Hallywood Video were heavily promoting DVD rentals. It was a good Chrigh d the Chieago restaurant marketRenault and Peugeot exited the U.S, auto- for DVD—aales of DVD hardware in the Christmas season of 1998 topped salae! ile market, Intel stopped making }RAM chips, and Harv, phies fell vi in all of 1997. Tt was a bad Christmas for DIVX—hy the week before Chri to Microsoft in the graphics softwre market Circuit City had begun promoting DVD alongside its promotions of DIVX, aq ‘The best systematic analysis of ery and exit rates across industries 4s by was repositioning DIVX as a DVD product feature rather than an alternative fi thy Dunne, Mare Roberts, and_arry Samuelson (henceforth DRS). They iat, Circuit City's entry strategy had failed, ed entry and exit in U.S, maufacturing firms berween 1963 and 1982. : ough dated, their findings are vaable because they emphasize the impor- of entry and exit in many indutries, and offer insights about patterns of and decline, sales by a new firm in a marke, and exit oceurs when a firm ceases to produce market. ‘The experience of the DVD consortium demonstrates that incr firms—frms that are already operating—should take entry into account Ww making their strategic decisions. Hntrants—firms that are new to a marke threaten incumbents in two ways. First, rhey ake marker shave mony frome ince firms, im effect reducing an incumbent's share of the “prafit pie,” Second, : 4 . . — price rivalry among incumbents is limited, entry of additional firms often svtens DRS examined data from the U.S. Casus of Manufacturing for the years 1963, omapwtition, ‘This occurs because entrants often reduce prices or even give 1967, 1972, 1977, ane 1982. The cenas identifies all manufacturing ttrms in the their product to establish a foothold in the market. In this way, entry reduces t al maufactnring facilities. Kael firm reports the Fthe* i jygned a primary size of the “profit pie.” Exit has the opposite effet on competitors: Survivi ucts itm I is assigned a primary ian mt igit S.I.C. code to indicate its pricipal industry. Each firm also reports the walue of goods shipped from each manfacturing facility. By matching firms actos srent years of the census, DRS cold identify entering and exiting firms, and sure postentry growth and preexidecline. Overall, DRS studied more th 1,000 firms in each census year. ‘To summarize the main findingwof DRS, imagine aa industry in the year 0; This hypothetical industry has|00 firms, with combined annual sales of 100 million. Thus, the average incursent has annual sales of $1 million, If pat- ms of éntry and exit im this industryire representative ofall U.S. industries in ious decades, then the following wl be truc: e, Roberts, and Samuclon’s Evidence on Entry and Exit increase their share, and competition diminishes, Entry into the long-distance communications market illustrates both of effects. After the deregulation of the market, AT&'T faced entry by several fi notably MCEand Sprint. Initially, AT&T also faced a regulatory floor on the pr it could charge. Entrants to the marker offered lower prices than did AT&T, that by the mid-1990s, AT&T's market share had slipped to less. than 65 per In the past few years, AT&T has been freed from many regulatory restraints, has lowered its price t hale the erosion of its market share. In this chapter we demonstrate the importance of entry and exit in most kets, We then deserihe structural factors (.e., factors beyond the control of firms in the markei) that affect entry and exit decisions, We also address stea that incumbents may employ to reduce the threat of entry and/or encourage: by rivals, Entry and exit will be pervasive. By ve year 2005, between 30 and 40 new firms will have entered. ‘They will have ombined annual sales of $12 ts $20 million (adjusted for inflation). Ac the samutime, 30 to 40 firras that were operating. in 2000 will have left the market, ‘The year 2000 sales would also have been $12 _to'§20 million. In other words, in jst five years, the industry will experience a eeooe 30 to 40 percent turnover in firmsand all the entering and exiting firms will account for 12 to 20 percent of vole, Of the 30 to 40 new entrants, sout half will be diversified firms operating nother product markets, and halivill be new firms, Of the 30 to 40 exiters, 40 percent will be diversified. Entrants and cxiters tend to be soualleshem establiched firms, A typical entrant will SOME FACTS ABOUT ENTRY AND Exrr Pery is pervasive in many industries and may take many forms, An entrant oy ‘anew firm, that isy ane that did not exist before it entered a market. An entrant be a firm diversifving its product liney that is, che firm already exists but had previously been in that market, An entrant may also be a firm diversifying ‘ graphically, thar is, the firm sells the same product in other geographic m: "be only one-third the size of a typhl incumbent, and will have annual sales of Phe distinction between new and. diversifying firms is often important, $ “*otind $350,000. An important eeption is entry by diversifying firms that when we assess the casts of entry, aid When ive consider strategic responses build new physical plants (as opposd vo switching an existing plant to making Regent new entrants in various markets include Dreamworks SKG (a mouon PS (2 hew product), Though diversifyig firms building new physical plants may ture studio founded by Stephen Spielberg, Jeffrey Katzenberg, and David Gel Tepresent only 5 to 10 percent oall entrants ftwo tw four firms over five British Midlinds (which provides airline secvice to the British Isles and several YEN), they tend to be three time the size of other entrants-—roughly the ropean destinations), and Amayon.com (which sells books over the internet) “Same size as the average incumbent s cent diversifying entrants include the National Basketball Association (whlé Tn the year 2000, firms that wl leave the industry by the year 2005 ~will opened! a chain of restaurants), Microsoft (which introduced the Microsoft Explot pnly be about one third the size othe average firm, Diversified firms rarely web browser), and Sony (which introduced the Playstation video game system)- ‘Slose 9 plant permanently (such eleings account for only about 2 to 3 percent ich2usn AIS OCGuF LUE TWICE that are closed are roughly twice the size of those of the typical nondiversificd exiter Most entrants donot strvive 10 years, jut those that do grow precipitowsly. OF the 30 to 40 firms chae enter the marker between 2000 and 2005, coughly 60 percent will exit by 2010. The survivors will nearly double their size by 2010, 4. Entey and exit ravis vary by Industry, Not surprisingly, entry and exit are more common in some industries than in others. Some industries in which entrants are numerous-and command substantial market shares include apparel, lum= ber, furniture, printing, and fabricated metals. Industries with high exit rates include apparel, lumber, furniture, printing, and leather. Industries with little entry include food processing, tobacco, paper, chemicals, and primary metals, Industries with little exit include tobacco, paper, chemicals, petroleum and coal, and primary metals, Clearly, entry and exit are highly related: Condi- tions that encourage entry in industry foster exit ‘The DRS findings have four important implications far strategy: © When planning for the future, the manager must account for an unknown comperitor—the entrant, Fully one-third of a eypieal incumbent firm’s competition five years hence is not a competitor today. + Not many diversilying competitors will build new plants, but the size of their plants can make them a threat ta ineumbents. * Managers should expect most new ventures to fail quickly. However, survival and growth usually #o hand in hand, 30 managers of new firms will have wo find the capital te support expansion * Managers should know the entry and exit conditions of their industry. Enery-and exit are powerful forces in some industries, but relatively unimportant in others. (ee o t YXAMPLE 10.1 McDonalp’s IN POLAND: A (FILET OF) FISH STORY When Poland's first McDenald’s opened in Warsaw in June 1992, the local pop ulation’s appetite for hamburgers had already been whetted. Shortly after the fall of communism in Poland, thousinds of entrepreneurs opened small restaurants, amang them a number of burgec stands Gacluding ane called Matdonald). Me~ Donalds was already engaged in a massive global expansion, with plans to open 450 international locations in 1992 alone. It was confident that Poland would be profitable market to enter, McDonald's calculated that it could sell hamburgers in Poland that were identical to those found under the golden arches throughout the world, ata price | comparable to that charged by independent hamburger sellers. These low prices; combined with the pawer of the McDonald’s brand name, and the attractiveness of its relatively huge restaurants, assured early success. McDonald’s preferred to buy from Jocal sellers co avoid transportation costs: But when it first entered the Polish marker, it found few Polish vendors the: necessary abilities and technology. Thus, it purchased 7 percent of its supplies from vendors outside Poland, such as french fries imported from Russia. In some gases McDonald’s could not find a low cost vendor and kept certain items off the menu. For example, McDonald's did not offer its popular fish filet because it could not find a low cost vendor of processed ead. The absence of fish filet was particularly ironic. The Polish fishing industry “yas'a major supplier of cod to European. fish processors, including the Danish _ processor that supplied fish filets to McDonald's in western Europe. While it was prohibitively expensive for McDonald's in Poland to purchase Polish cod processed in Denmark, costs would be much lower if the fish was processed in Poland, So McDonald's country manager Tim Fenton suggested that the Danish “firm open a processing plant in Poland. The firm entered into-a joint venture with a Polish firm and the two invested 2.5 million in the plant, Further invest- ents were made in training more than 80 workers in the special techniques needed ro make McDonald's fish filets. The plant opened on February 28, 1995. ~The next day, McDonald’s Poland began serving Fish Macs. MeDonald’s expansion across Poland (there were 40 by the end of 1995) cre- "ated many other entry opportunities for local vendors, A beef processing plant “opened in 1993. A potato. pracessing company opened in 1994, and farmers " began growing the longer potatoes necessary for MeDonald’s french tries. In the ‘came year, 1 bakery invested in the equipment necessary to supply all the huns McDonald's needed. By the end of 1995, McDonald's obtained 70 percent of its plies from Polish suppliers. The investments by these suppliers clearly illus- trate Adam Smith’s dictum that “the division of labor is limited by the extent of othe amatker.” McDonald's entry expanded the market for locally grown food "products. Local sellers responded by entering and specializing. In this way, entry begat entry. Enrry AND Exit Drcisions: Basic CONCEPTS A profit-maximizing, risk-neutral firm should enter a market if the sunk costs of Entry are less chan the net presestt value of expected postentry profits,! There ate Many patential sunk costs to enter-a market ranging from rhe costs of speciatived capital equipment, to government licenses. Later in this chapter we claborate on these and other entry ensts. Postentry profits will vary according tw demand and cost conditions, as well as the nature of postentry competition, Postentry competition represents the conduct and performance of firms in the market after entry has ocourred, The potential en- {ant may use many different types of information about incumbents, ineluding Mstorical pricing practices, cots, ariel capacity, to assess what postemtry comper- fon may be like. If the potential entrant expects postentry competition to be ———— is ee ae te ig risk-neweval if is indiffcrenr hetween a sure thing and a.gum- in equal expected payoff. Individuals are usually risk-averse, as evidenced by pur ‘thases of auts and health insurance. Shareholders may not want their managers co avoid Tisk, however, since they can cheaply shinimize risk by holding diversified portfolios of debit “hd equity instruments, eee eepeer sii ona eso SEE NEL ENS SARC A Ae Ban argued Chat an incumbent frm should anaiyée the entry CONaions: in its to stay out, Even when the potential entrant believes that postentey competit et and choose an entry-dererring strategy based on these conditions. If entry will be relatively mild, it may not enter if there are significant barriers to entry. lockaded or accommodated, the firm need do nothing more te deter entry, If ig deterred, the firm should engage in a predatory act. ‘To assess entry condi s, the firm must understand the magnitude of structural entry: barriers, ard zor the likely consequences of strategic entry barriers, We discuss the farmer Barriers to Entry Bain’s Typology of Extry Conditions Barriers to entry are those fetors that allow incumbent fims to earn positive nomic profits, while making it unprofitable for newcomers to enter the industry Barriers to entry may he serucreral or strategic. Seractural entry barriers result whe the incurnbent has natural cost or marketing advantages, or benefits from fa able regulations. Strategic entry barriers.result- when the incumbent agpress deters entty, Bntry-dererving steutegies may include capacity expansion, Tinie “Eeonomies of scale and seape ing, and predatory pricing, all of which we discuss later in this chapter. 4 eee “J BT Hi ceils wed on ching, Jed Beth tepuad Heck ms may be chai Boa sone acvanmg?s.of new ized according to whether entry barriers are structural or strategie, and w! incuba can prait from using enury-detersing strategies. Bain deseribed entry conditions al Enwy Barviers are three main types of stiictaral entey barriers: Control of essential resourc beney iscuss ¢ach in turn. Hof essential resources An incumbent is protected from entry if it con- a resource necessary for production. DeBeers in diamonds, Alcoa in alu- , and Ocean Spray in cranberries all maintained monopolies or cartels by trolling essential inputs. Does shis imply thar firms should acquire key: inputs fn) manopoly status? There are several risks to this approach, some of which sed in Chapter 3, in the context of make-or-buy decisions, First, just Blockaded entry Fnery is blockaded if the incumbent needs to do nothiny deter entry. For example, there may be structucal barriers tw entry, perhaps b cause production in an industry requires large fixed investments or the ente may expect postentry protits to be low, perhaps because it sells an undifferenti scusse product and expects price competitian to be fierce. Entry by mass merchandise the firm thinks that it has tied up existing supplies, new input sources may into small towns that already have a Wal-Mart store, for instanee, may be bl », For diamonds, aluminum, and cranberries, nature limits mew input aded both beeause of the eests of constructing a new store and the expectatior ces, which helps explain why these monopolies cauld endure. Second, owners resources may hold out for high prices before selling to the would-be t. Accommodated entry Entry is accommodated if structural entry barriers here is also a regulatory risk associated with attaining monopoly status low, and cither (a) emry-deterring strategies will be ineffective, or (b) the gh acquisition. Antitrust laws in many nations forbid incuunbents with domi- the incumbent of trying to deter entry exceeds the benefits it could gain fro ant market shares from preventing competitors from obtaining key inputs, Under ommodated entry is typical in markets with growing has become known as the “essential facilities” doctrine, the U.S, Supreme in 1912 ordered the Terminal Railroad Association to permnit competing slroads to use a bridge ‘Terminal owned. As mentioned in Chapter 5, the bridge ided the only access into St. Louis from the cast, and the Court feared that (a) the incumbent fminal might use its controf of the bridge to exclude rival railroads.’ In 1985, ' Supreme Court used similar reasoning to force the Aspen Skiing Company, the entry deterring strategy is mare than offset by the additional profits that Bich controlled three of the principle skiing mountains in Aspen, Colorado, to incumbent will enjoy in the {ess comperitive environment. Frank Fisher calls Moen He accay life ticker access to a fourth facility controlled by another entry-deterting strategies predurory aets.* We describe several predatory acts | pany. in this chapter. fietee price competition. keeping the entrant out, A demand or rapid technological improvements. Entry is then so attractive incumbent(s} should not waste resources trying to prevent it Deterred enery Entry is deterred, if not blockaded, keep the entrait out by employing an entry-deterring strategy, and (b) the ¢ ibents can legally erect entry barriers by ubtaining a patent to a novel Monobvious product or production process. Patent las vary by country, and ie countries, such as China and Bravil, they are nonexistent or extremely An individual or firm that develops a marketable new praduct or proce: to New Competition: Their Character and Canseqaences in Maaufictuving Industries, CAmODNE *Y ppltes for a patent in its home country. In Europe and Japan, the patent MA; Harvard University Press, 1956, and C, C, Von Weizsicker in Barriers to Ener A IS Bo to the first persct to apply for the patent. In the United States the first retical Trearmeyt, Berlin: Springer-Verlag, 1980. "Bain, Joe, vp. ‘Fisher, Fy Andustria? Orwmisation, Ezonontis, aad the Lana, Cambridge, MA‘ Press, 1991, his definition is a synthesis of the ilefinirions af enery barriees of Joe Bain inperson to invent the idea gets the patent. As might be expected, firms seeking U.S, patents often go to considerable expense to document precedence of diseovery, Once the patent is approved (ic usually wakes one to two years, and the invention’is. protected from imitation during the waiting period), anyone who wishes to use the process or make the product must obtain permission from the patent holder, Patent lives are currently 20 years in most developed nations. Parents ai effective entry barriers beesuse they ean often be “ine vented aroun stuse a government patent office can sometimes not dis— tinguish between a new product and at imitation of a protected product, As a result, some innovations, such a6 Rollerblades and the personal computer, seem to have had no patent provection wharsaever: Conversely, incumbents may file parent infringement lawsuits against catrants Whose products are seemingly different from the incumbent's. Some observers claim that Intel used this strategy to protect its microprocessors from entry by Advanced Micro Device: Incumbents may not need patents to progect specialized know-how, Coes Cola has zealously guarded its cola syrup formala for a century, and no.one by learned how to duplicate the sound of a Steinway piano or the beauty of Water: 5 ford il. Firms may turn to the legally and ethically questionable practice of Feonomies of scale and scope When economies ut scale are significant, estale- industria! espionage to steal such information, ‘shed firms operating at ot beyond the minimum efficient seale ( will have a substantial cost advantage over smaller entrants, ‘The average cost curve in Figure 10.1 ihlustraes the problem facing a porential envant in an industry where che MES is 1,000 units, and total industry sales are 10,000 units: An incumbent with a ‘obtained approval to market their drugs for sale without preseription in the hope ¢ consumers would purchase the drugs based on brand name (much the way ¢ many consumers purchase branded aspirin). Drug makers can reap enormous returns on their résearch investments for those handful of drugs, like Tagamet and Zantac, that treat common diseases yet nave few substitutes, Those returns fall rapidly when patents expire, Drug mak- ers thus becane extremely concerned when the Food and Drag Administration DA) required lengthy testing for new drugs before marketing. These tests re luced the effective patent lives of new drugs (Le., the time between FDA approval and the expiration of the patent) to as little as chree years. In 1984, Congress en- acted the Pater Term Restoration Act, which gives new drugs a minimum effec- tive patent life of seven years, The act also simplified the testing requirements for erie manufacturers, thus intensifying postentry competition. ; oa ; b$obeeoeotoetee seam market share of 10 percent or higher is reaching rhe MES, and has average cost of (ACyyes. If the emrant only achieves a market share of, say, 2 percent, it will have 4 XAMPLE 10-2 much higher average cost of AC; The market price would have to be at least as high as 4C for entry to he profitable. __. The entrant might try to overcome the incumbent’s cost advantage by spend tng to boost its marker share, Per example, it could advertise heavily or form ae sales force, While this strategy may allow the entrant to, 3 : reater i | ‘ For esample in de late 960s, Eh Lilly introdueed Kefin, the first of new Fors yoo Geek nace of drugs called cephalosporins (a “magic bullee” antibiovic), Lilly introduced the ‘ i first “second generation” cephalosporin, Reflex, in 1971. Though belonging i the same chemical class and having similar biological properties, Keflex and K “Figure 10.1 Economies OF SCALE MAY BE A Barkie TO EXTRy PATENT PROTECTION IN THE PHARMACEUTICAL INDUSTRY selling prescription drugs in the United States every year between |! Aleve Sai 1985, ‘The drugs would have sold even better if Lilly’s patents had provided protection. Differences in chemical structure enabled several competitors:t0 troduce new cephalosporins by the late 1970s. A few, sueh as Merck's also became top sellers, a Patents proved to be more enduring in the market for H2 antagonists ( ulcer medications). Tagamet, the first effective medication, was introduced Smith, Kline, and French (later SmithKline) in 1978, By 1980, it was the to The incumbent fi dy selling prescription drug in the United States. In 1984, Glaxo’s anti-uleer d PP Ficene sq ott bl Producing ae safe Zontac was introduced, and a year later replaced Tagamet as the bestsel BEES AC. tf tig porcreial eaten can Gay Se Get boners cena ene Lhe eee as Pope to produce a volume of output. equal to 200) line and Glaxo encouraged other companies to develop H2 antagonists. But Be came ren ee tac and Tagamet sales held firm until their patents expired in the mi 2 lirker price must be at least this high for the late-1990s. Faced with competition from generic drugs, StithKtine and ital entrant to realize profits from sath,its market share by reducing its price, this will cut into the entrants profits.” The entrant thus faces a dilemma: To overcome its cost dis advantage, it must increase its market share, Bur iFits share increases, price competition may intensify. Fierce price competition frequently results from large-seale entry into capital. intensive industries. Sometimes, this represents the results of intensified rivalry re- sulting from an increase in the number of firms competing in a market, Sometimes, this represents blatant efforts by incumbents to drive entrants out of business by pricing below marginal costs. This strategy, known as predatory pricing, is described. below, The US. gunpowder industry in the nineteenth century offers an example of intense postemtry rivalry. [n 1889, eight firms, including, the industry leader DuPont, formed a “gunpowder pool” to fix prige and output. In the early 1890s, three new firms entered the industry. Their growth challenged the continued success of the pool. DuPont's respoiise to one entrant was 10 “put the Chattanooga Powder Com pany out of business by selling at lower priees,”* In this way, the gunpowder pool survived until antitrust enforcers broke it up. In the 1980s, entry into the airline business by Laker Airlines and People’s Express le 10 price wars that eventually drove them from the market. The introduction of off-brand cigarettes by the Liggett Group in the early L98s eventually ler! to hefty price reductions that eroded: the profts of the entire tobacco industry. The off-price brands survived, perheey - canst price-cost margins in the cigarette industry had heen extremely high, a Incurnbents may also derive 2 cost adsantage from economies of scope. The ready-to-eat breakfast cereal industry providesa good example.” For several decades, De ea Bi ae me Barrrers ‘TO ENTRY IN THE AUSTRALIAN AIRLINE INDUSTRY In 1992, a second attempt was made to start Australia’s third airline, under the name Compass Il. Compass’ first startup effort, described in Chapter 9, came two years earlier, when there was consilerable public support for a eut price doe estic carrier. To leverage this public goodwill, the decision was made to use same Compass I. To counter negative sentiment created whem many "yaKation ers” were left stranded with worthless tickets when the original Compass went bankrupt, Compass I would honor the tickets issued by the original come airlines far a $20 fee, The new sirline was forced ro iste 100,000 of these $79 tickets, At the same time, Qantas and Ansett (the ovo incumbent airlines) both uPLE 10.3 "Such a pricing response is likely in this example, because when the entrant steals busi- ness from the incunsbents, their marginal costs decrease. a *Pligstein, N., The Transformation of Corporate Control, Cambridge, MA: Harvard Unk verity Press, 1990. "Por a detailed diseussion see Schmalensee, R., “Entry deterrence in the ready-to-eat breakfast cereal industry,” Beil Fournal of Economics 9 (2), 1978: pp. 305-27. cial strains on an already under capitalized airline. ares a future discount airline may offer, This commitment had the el the industry has be General Foods, ures on advertising that are ne pital requirements for entry are substantial, ma “ed, Adams, VW, (ed), New York: Macmillan, 1986. ‘The biggest problem facing Compass II was the leasing of terminal space, Both Ansett and Qantas had been granted long leases on land at all Australia’s ajoF airports, and both airlines had invested considerable money in building erminal facilities. The government forced Qantas to lease terminal space to jompass LI airlines, Compass II har! to negotiate with Qantas for airport gates id boarding areas in their terminal, Not surprisingly, the boarding gates allo- ed to the new airline were all at Jeast a half mile from the terminal entrance the farthest gates from the terminal hub. Compass II encountered many other obstacles. Qanuis was responsible for ige handling for Compass fights. The CEO of Compass II claimed that as was committing “corporate sabomge” hy delaying baggage handling. for mpass flights, revulting in majar delays for che new startup airline. Compass IL ke the terminal space to offer flight lounges for business travelers. This busi- jpantities of business travel te support airline competition, if Compass TT could r business class facilities. Another critical factor i attracting business travelers flight frequency, Compass II could not compete with the incumbent airline Lof whom were offering hourly fights between major Australian airports ‘Compass TI fell into bankruptey less than 12 months ater its incorporation, faster than its predecessor. Incensed with the fhilure of its efforts to create a ore competitive airline industry, the Australian government considered build third “common use” terminal at all major Australian airports, for any airline ig to lease terminal gates. ‘The previous chairman of Compass announced apt to start a third discount airline, “Aussie Airlines.” Hlowever, the two jor airlines, Qantas and Ansett, both publicly com service was critical, because several large companies offered to transfer large rnitred to marching any air- 4 fleet of sear apy investors from backing another startup airline. At the same time, the lian government will not build any new “common use” terminal space there are new airlines to lease these facilities, and potential investors see ter= nal Space a8 4. Inajor requirement for any startup airline. It seems that the pub- desire fora third corrier will not be satisfied any! Ne $001 en dominated by a few firms, including Kellogs, General Mills, and Quaker Outs, and there has been virtually no new entry sin War T, cope in production stem trom the flexibility in materials f that arises from haying multiple production lines within the Of scope in marketing are due to substantial up-front expen= dled for a new entrant to establish a minimum ac- le level of brand awareness, Ik has been estimated that far entry to be while; a newcomer would need to introduce 6 to 12 successful brands.” king ony a risky proposition. plant. Economies ‘The Breakfast Cereal Industry,” in The Seructeire of Lamericuns IneecteyAn incumbent launching a new cereal would not face the same up-front costs ag anew entrant, The incumbent has already established brand name awareness and may be able to use existing facilities to manufacture its new cereal. ‘This explains why new products are profitahle for incuinbents but unprofitable for new entrants, Indeed, despite the near tacal absence of entry by outsiders, incumbents increased the number of cereals offered for sale from 88 in 1980 ta over 200 in 1995, Success: fal newcomers have chosen niche markets, such as granola-hased cereals, in which they may try co offset their cost disadvantage by charging premium prices. Economies of scale and soope create barsers to entry beeause they force poten- tial entrants to enter on a large scale or with many products to achieve unit cost pare icy with incumbent firms. Strictly speaking, though, entering ata large seale oF seope is disadvantageous only to the extent thar the entrant cannot recover its up-front entry costs if it subsequently decides t exit (Le., only if the up-front entry costs are. sank costs). An entrant whose up-frone entry costs were not sunk could come in ata large seale, undercut incumbent firms’ prices, and exit the market and recover its entry costs if the incumbent firms retaliate, This strategy, known as hit-and-run entry, would leave incumbents vulnerable to entry even if economies of scale were so significant in comparison to market demand that the market eottld sapport only one firm. For this reason, as Daniel Spulber has pointed out, sunk costs, not economies” of seale or scope per se, represent the underlying struetueal barrier to entry." Still, in most markets entrants can only achieve scale and scope economies in production or marketing by making significant nonrecoverable up-front costs. Marketing advantages of incumbeney Chapter 2 discussed umbrella branding, whereby a firm sells different products under the same brand name. This is'a spe- cial case of economies of seope, but an extremely important one in many consumer product markets. An incumbent can exploit the umbrella effect to offset uncer tainty about the quality’ of @ new product that it is introducing, Consumers who are satisfied with the incumbent's old! products are inelined to believe that its new product will also be satisfactory. ‘The brand umbrella makes the incumbent's sunk: cost of introducing « new product less than that of a new entrant because the en trant must spend additional amounts of money on advertising and product promo- tion to develop credibility in the eyes of consumers, retailers, and distribucors. A brand umbrella will not protect an incumbent if its new preduct turns out 0 be unsatisfactory. Would-be repeat purchasers will turn to other sellers’ products, and word-of-mouth and poor reviews in consumer magazines may deter first-time purchasers. The incumbent may suffer even more if consumers’ dissatisfaction with the new product leads them to doubt the quality of the rest of the incum= bent's procluct line, or if managers of competing firms view the failure as a si that the incumbent may be a Jess formidable competitor than they had thought Thus, although the brand umbrella can give incumbents an advantage over ene trants, the exploitation of brand name credibility or reputation is not risk free. The umbrella effect may also help the ineumbent negotiate the verti chain, If an incumbent's other products have sold well in the past, distributors and retailers are more likely to devote searce warehousing and shelf space t0 iS new products, For example, Coke and Pepsi have launched new praduets with the confidence that retailers will allocate searce shelf space to them, At the same ‘Spulber, D. ., Regulation and Mavkets, Cambridge, MA: MIT Press, 1989; time, supplicrs may be more willing to sell on credit or extend favorable prices to successful incumbents, Physician management companies, such as PhyCor, have obtained purchasing discounts for physicians partly because suppliers trust these organizations to make good on their accounts payable. ————s SSsSSSSSSSSSsSS e+e XAMPLE 10.4 ENTRY BARRIERS AND PROFITABILITY IN THE JAPANESE BREWING INDUSTRY ‘The Japanese brewing industry has enjoyed several decades of financial prosper- ity, The Japanese market for beer is enormous, with per capita consumption ap- -proaching 16 gallons per year. Four firms—Kirin, Asahi, Sapporo, and ‘Suntory—account for almost 100 percent of the market. The market leader, ‘Kirin, has a nearly 45 percent marker share, and its annual sales rival those of An heiser-Busch, the leading U.S. brewery. The industry after tay return on assets fanges from 3 to4 percent, which is good in Japan where inflation is low, More- ‘over, these firms have been profitable for decades, Normally, a profitable industry attracts entrants seeking to share the pie Even so, Suntory is the only brewery to gain significant market share in Japan in the fast 15 years, and its market share is only about § percent. Profitable incum- ‘bents combined with minimal entry usually indicate the presenee of entry ba: ers.In the United States, profitable breweries are protected by strong brand identities. Would-be competitors must invest tens of millions of dollars or more 4 achieve the brand recognition and strength of image enjoyed by Budweiser “and Miller. This deters serious competition from neweomers. Japanese brewers also enjoy brand identity, and brands like Kiria’s Tchibanshibors, and Asahi’s Super Dry have Joyal followings. But Japanese brewers also enjoy two entry bar- fiers not shared by U.S. firms. Entry has historically been restricted by the Japanese government, and the dominance of “Ma and Pa” retail stores eompli- tates access to distribution channels. __. Breweries in Japan must have a license from the Mini istry of Finance (MOF), | Before 1994, the MOF would not issue a license to any brewery producing fewer than 2 million liters annually. Although this is a relatively small percentage of the “total market of 7 billion liters, it represents an imposing hurdle to a startup firm without an established beand name, It is not clear whether the MOF maintained thishurdle to protect the big four breweries, or to reduce the number of firms it heeded to tax and regulate. «As part of an overall liberalization of marketplace re- “sitictions, the MOF has reduced the license threshold ta 60,000 liters. In the wake of this change, existing small brewers formed a Small Brewers Association, _ and many new microbreweries opened. ____The four incumbents responded by offering their own “gourmet” brews such '@ Kirin’s Heartland and Sapporo's Edelpils, They have also expanded into malt liquors. This has earned them the continued loyalty of restanrant and bar own- 3, who are responsible for 50 percent of all retail beer sales in Japan, By com-pinmg clever marketing strategies (¢.g., Heartland has a distinctive botde RE 10.2 not widely available in retail stores; Edilpils is positioned as a Germanestyle with the cost advantages of well-established distribution changals, the m Average Total breweries have maintained their strangtehold on che beer tacket, ada i Changes in Japanese retailing practices may eventually chreaten the ma THAT Lyouer Exrry AND Eat May Dirrrr, ost ‘Marginal Case breweries. After restaurants and bars, the second largest category of beer vera Average ‘Lota Cost are “Ma and Pa” liquor stores, These stores have had litte purchasing pow. PT eset the tadsiey vb long as she | have not aggressively sought to stock low-cost beers. In recent year market price exceeds Pescrgy, the tmininyam Peary \ “Average Variable Cost Japanese consumers have begun to. turn. w discount liquor stoves offering savings A ofaverage total casts, Finns will exit che, Pextt of 25 percent or more on the same beers sold at family run stores. These idustry only if price falls below Py, the ae caunt stores (and, to a lesser extent, the supermarkets that are slowly repla imum level of average variable costs, 6 acighborbood groceries) are willing to sell imported hers. Imports cost thirds as much as domestic beers. Entry by imports, facilitated by the grow new retail channels, could eventually force the big four breweries to lower to match the competition, lose market share, or both, woes of the rest af the frm, Relationship-specific productive assets will hare a j resale value, and are thus a second exit barricr.!’ Government restrictions are sna third exit barrier. For exangple, some states forbid hospitals vo close with- Jatacy approval, Barriers to Exit Exit is che opposite of enery. To exit a marker, a firm staps production and eit NTRY-DETERRING STRATEGIES eoeee redeploys or sells off its assets. A change in ownership that does not entail ping production js pot considered an exit, A risk-neutral, profit-maximizing | rawhat conditions does it pay for incumbent firms te raise che harriers to will exit if the value of its ascets in their best alemnative use exce: into their market? At the most general level, entry-dewrring strategies will value from remaining in che market. However, exit barriers ean limit the in sd only if evo conditions are met: - tives for the firm 10 step producing even when the prevailing conditions ate that the firm, fiad it known with certainty thar these conditions would pi would not have entered in the first place igure 10,2 illustrates the effect of exit barriets, The price Poy is the , peice—the price at which the firm is indifferent becween entering the indus Reneed for the first conditian is obvious. “The second condition is necessary I staying out. The prive Pag. is the price below which the firm would either ligul ‘the entrant will ignore any strategy that does not change its expectations its. assets or redeploy them to another market, Exit barriers drive a wedge bet St postentry competition, rendering the stritegy useless Pegand Boge Teseems as i€a firm would always carn higher profits if it iso monopolise than Exit harriers commonly arise when firns have obligations that they must “has to share the marker, because jt can charge higher prices, If a monopolist whether o not they cease operations, Examples of such obligations includ Labo SaBnot raise price above competitive levels, the market js said to be perfecely ei agreements ani] coummirments to guirchase raw materials, [fa firm has to pay 0 4,4 concept developed by William Baurnol, John Pananr, and. Robert ven if it stupa production, the effective marginal cost of remuail ig.” The key requirement for contestability is hit-and-run entry, sed When a monopolist raises prive in a contestable market, 2 hit-and-run en- apidly enters the marker, undercuts the price, reaps short-term profits, and Me market just as rapidly if the incumbent retaliates. The hit-and-run encrant eS as long as it can set a price high enaugh, and for a Jong enough time, to. —— tts sunk entry costs, If its sunk entry costs are zero, then hit-and-run enury "In many industries there is an intermediate optien shart oF full exit: the-fi 'ys be profitable. In that ease, the market price can never be higher than “mothball” jes production facilities and restart them when demand or cose conditions) sae Cost, even if only one firm is currently producing. IF the incumbent raised prove. Also, when there is demand ancertain ice that triggers entry will gen average cost, there would be immediate entry, and price would fall inerense, and the price that triggers exie will generally decrease. ‘This is beewuse HFMD® y defer entry of exit decisions w see how the uncertainty is resolved. See Diaity AR RUS. Pindycks Javesenvent Under Uncectainty, Prineston, NJ; Princeton University © 1904, for a lucid develapment of the theory af entry, exit, «nid methballing unset UF Wi. J. Panzar, and R. Willig, Contestable Murkets and the Theory of dadusertal uncertainty. New York: Harcourt Brace Jovanovich, 1982. = igher profits « Phe strategy changes emrants! ex a monopolist than it does ag a duvpolist. tations about the nature of postentry suppliers r operation is low, and exit Js less attractive. Obligations to input suppliers | tore signiticam exit barrier for diversified firms contemplating exit from a marker, since the suppliers to @ faltering division ate assured payment out ol‘The incumbent fas to charge # price that yields zero profits, even when itis an ape eS a miget deter entry Dy Amit pricing, consider a market parent monepolist. 7 will last for wo years. Demand in each year is given by P= 100 ~ Q, where P Comestability theory shows how the threat of entry can keep monopolis, ates price and Q denotes quantity. The production technology has nonrecove from raising: prices. However, finding contestable markets has proven diff je fixed costs of S800 per year, and constant marginal costs of $10, In the first When the theary was first developed, ir was felt that i¢ might apply to the ai year, there is a single firm with the technological know-how to compete in this industry. Entry into the industry is fairly easy, especially by established carriers gy ket We call this firm N, Another firm that we eall E has developed the tech- : gy to enter the market in year 2. Table 10.1 summarizes usetul pricing and tering new routes. A carrier cat redeploy aircraft almost overnight, and can se gates and ground personnel almost as quickly (provided the airports involved. fit information about this market. This information can be confirmed by solv af the appropriate profit-maximizing prices and quantities: . hot at capacity.) New carriers can enter almost as fast, by leasing aircraft and gat 0 Fven so, Severin Borenstein showed thar airline markets are not perfectly eo, Ifthere were ne danger of entry, N would select the manopoly priee of $55 in testable,” If they were, then fares should be independent of market concentra gaming two-year total profits of $2,450. (For simplicity, we ignore the However, Borenstein found that monopoly routes have higher fares chan duopoly: of discounting second-year profit.) Firm N is less fortunate, because firm roures of comparable lengths. He also found that fares on monopoly routes aren enter in year 2. To determine if it should enter, KE must anticipate the na- duced when another carrier is already operating at one or both ends of the ro of postentry competition, Suppose that when F, observes N charging $55 in “This makes sense. If fares on the monopoly route were high enough, such a carrie st year, it concludes that N will not be am aggressive competitor. Specificall could quickly redeploy its aircraft there, Borenstein concluded that the threat « ects the Cournot equilibrium ta prevail in the second year, with both fai potential competition causes the monopolist carrier to moderate its prices, but the market equally," Based on this expectation, E calculates that it will to competitive levels. profits of $100 if it enters. If N shares F's belief that competition will be Te would he surprising if airline markets were: perfectly contestable, The | jot, then conditional on entry, firm N would also expeet to earn $100 in the and-run entrant ust be able to capture business before the incumbent cam te: ond year. This would give it a combined two-year profit of $1,325, which is far spond. But with computerized reservation systems linked to computerized, tariff y its two-year Monopoly profit of $2,450, Entry would be casey to firm N. clearinghouses, such as the Airline Tariff Publishers, an incumbent airline can ad in N may wonder ifit can deter entry. It could reason as follows just its fares instantancously in fesponse to new entry, Faced with the prospect duopoly pricing, che potential entrant may feel that the market is not large enc to support nwo firms, and swill not enter, Incumbents in most markets can probs adjust prices rapidly when threatened by entry, so that the applications of the ¢ : testability theory are probably limited." logic, suppose that firm N seleets a first-year price of $30. E may Assuming that the incumbent monopolist’s market is not perfectly os price and reason as follows: “ - . testable, it may expect to reap additional profits if it can keep out entrants, Vi now discuss three way's in which it might do so. Afl set a low first-year price, perhaps E will expect the postentry price also tw be low, WE expects the postentry price to be sufficiency low, then it will nat enter, and Pean _ earn monopoly profits in the second year. ‘HFfirm N charges a price of $30 when ; iS a monopolist, then surely its price fi fice of competition will be even lower, Suppose we enter and, eae ioe _femains at $30, so that toral market demand is 70. Hf we ean achieve a 50 percent market share, we will sel] 35 units, and realize profits of (0-10) x 354 — gn0 _~ $100. the price is below $30), we will fare even worse. We should nov enter. Bt aes esi, then N should seta linit price of $30. By doing so, Eee Os }) — 800 = $600 im the first year and full monopoly prof #°25 in the second year, for total profits of $1,825, This exceeds the profits * Limit pricing * Predatory pricing = Capacity expansion Limit Pricing Limit pricing refers to the practice whereby an_ineumbent firm «3 n_discou entry by charging « low price befire entry eaurs.!” The entrant, observing the Id price set by the incumbent, infers that the postennry price would be as low or evs 10.1 lower, and that entry into the market would therefore be unprofitable, AND PROvrTS UNDER DikbexiNT Conmerrrtive Coxprrions Stonetnre tional Profit per Fires 355 SI S40 SLO Borenstein, S- “Hubs and [igh Faves; Dominance-and Market Power in the U Ailing Industry,” RIND Journal of Frinommics, 20, 1989: pp. 344-365 3 Vor a further discussion and eritique of contestability, see Tirole, J. Thr Theory dustrial Organisation, Cambridge, MA: MIT Press, 1989. Bain, J. S..'A Note on Pricing in Monopoly and Oligopoly,” mericast Hamma uicw, 39, March 1949: pp, 8-464 Recall from Chapter 7 that in a Cournot equilibrium, ther each fren makes a 's Output, and the guesses prove ta be correct, 3Fioure 10.3 LIMIV PRICING: EXTENSIVE FORM GAME, ‘The limic pricing equilibrium is shown by the dashed! line. The inewsbent selects P,, and the potential entrant stays aut, This is not a subgame perfect Nash equilibrium, because if the potential entrant goes in, the incumbent will select the accommodating pr The subgasne perfeet Nash equilibrium is islspicted by the heavy line. The incumbent knows that it cannoc credibly prevent entry, so it sets Fl, in the first period, uave Earned Nad tt set the monopoly price of S95 tn the first period and J£E selects “Out,” then N selects P,, in year two. IFE selects “In,” then competition then shared the market in the second year. played out in year two. We suppose that N’ ean control the nature of year-two mpetition. In particular, N’ can maintain the price at P; = 30, oF it ean “acqui- 2” and permit Cournot competition, in which case the price will be P, = 40. ‘o-yeor payofis are reported at the end nodle for each branch of the game tree “The limit pricing outcome is shown by the slashed line in Figure 10,3. Under earns tata! profits of $1,825, and firm F earns $0. This is not not, we must analyze the The Flawed Logic of Limit Pricing The previous argument is appealing, bur fawed. The first flaw is the arcificialay, a two-year model. Ina more realistic setting of more than Gwo years, firm’N mi; have to limit price every year to constantly deter entry. It would never get to price to reap the monopoly profits that it forsook when it initially set the price. Limit pricing would be attractive only if the incumbent does not need onrcome, firm 3 game perfect equilibrium, however, To see why: 4 sme using the “fold-hack” methoxl.*! First consider the branch of the game tree lower its price too much to deter entry. This could occur if N enjoys a substang hich E ignores the limit price and chooses to enter, According to the limit- cost advantage over E.and sets its price equal to or just below E’s minimum avers ig argument, E stays out because it expeees that afier ewtry bax oeverred, N will age cost. By virtue af N's cost advantage, it could reap large profits indefini fect P, But examination of the game tree shows that it is not rarfonal for N to se- Edwin Blackstone ses this argument in his analysis of Xerox's prieing of pl Py, Gonditional an entry having already occurred, Ni should select 2. N would paper copiers inthe L96is, which we deseeibse in Example 16,5,'° n total profits of S700, which exceeds the profits of $500 it cams Hit selects Ph A second flaw is thar the limit pricing argument relies on an equilibrium th P's expectation of N's postentry behavior is awed is not subgame perfect.” In particular, Es expectations about N’s postentry pri E should anticipare that if it enters, N will select 2. E should calculate ics are irrational, To see where the logie of limit pricing breaks down, we depi fits from entry to be $L00, which exceeds the profits of 0 that it carns iF it stays limit pricing game in game tree form in Figure 10.3. The payofis to N and E Thus, E will choose to enter, even if N has selected P, in the first stage of the culeulared by using the demand and cost data from the previous examiple, e, Continuing to work backward, N should anticipate that it cannot prevent igure 10.3 shows that in year one, the incumbent's strategic choices. even if it selects Py It should calculate that il it does select 2, it will eal Pj, where P., refers to the monapely price of $55, and P; refers to the: fits of $700. By selecting P,, in the first stage and Pin the second stage, N price of $30, The entrant obsetves N’s selection, and then chooses fron (In, Out] Id have earned $1,325, Our analysis of the game tree is now complete, N will select Py, in the first tige. E will select “In.” Seconl-year competition will be Cournot. This subgame Nash equilibrium is shown by the heavy solid line in Figure 10.3, "This analysis suggests that incumbent firms should not limit price. Potential is will recognize that any price reductions belore entry are artificial, and do amit the incumbent to maintain low prices subsequent to entry, Once entry it would make no sense for the incumbent to continue + suppress price, lost profit opportunities from having previously set the limit price are sunk. that the entrantis already in the market, the incumbent shauld acquiesce andl ximize future profits. INCUMBENT. © Pin the second period. Neto introduced the 914 plain paper copier, the first mass-marketed et to take advantage of she innovative copying technology called xerogra- \ competing technology being developed at the time, electrofax, had several tages, It required a paper coating that added $.01 to the cost of each d the quality of its reproductions was inferior. When. eleetrofax finally “Blackstone, Ei, “Limit Pricing in the Copying Machine Industry,” Quarter! eanorrits and Basiness, 12, 1972: pp, 37-05. 4 See the Economics Primer for a discussion of the concept of a subgame perfect Kibriue,K ae i pee nt's payotls from e Bos ible poster piclag seeogtioe nat comme fo @ induce customers to use clectrofa instead of Xerox. xan intry price. If the incumbent is best off selecting a high postem esos advantage per copy, Xetox machines had higher manufacturing ¢ Eirant wil know this, and will not be deterred fronv entering. however. This translated into a higher rewil price, which somewhot offser Ifthe entrant is uncertain about the postentry price, however, then the incu lower effective cost per copy, Hess . 's pricing strategy could affect the entrant's expectations, Two types of uncer= Xerox usually leased copiers, carting aa, BS ae conde ity may confound Se fares ‘The first Cs uogereinty about the umber of copies made per month. Xerox sought a fee schedule that we bent’s objectives. The analysis of predatory priving discussed in the next sec ihe entry, E vin Blackstone carefully eximined, Xetoxs prices andie illustrates how this type of uncertainty can promote behaviors that seer inra- well ag the prices and costs of the rival eluctrafax process to determine if X; fila world at ee The sed a seertany ghost the incumbents id, in fact, limit price, or the level of market demand, which we now discuss. a Blackstone estmaied that Xerox's monopoly price was about $10 pag ‘na paper that explored the rationality of limit pricing, Paul Milgrom and which was well above the average cost of electrofax copies. If Xerox set this, ohn Roberts argued that an entrant is likely to know less about the incumbent's electrofax manutacturers might be tempted to enter the market. Blackstone oss chan the incumbent itself docs.” Ifso, by engaging in limit pricing the in- ported that for small customers, who made approximately ae copies: bent may influence che entran’s estimate of its costs, andl chos shape its expec month, Xerox charged close to the monopoly price. But for medium and | tions of postentry profitability, To illustrate this argument, suppose thar the customers, who made over 2,000 copies per month, Nerox charged only. nt believes that the incumbent's marginal cost és either $3 ar $10, It expects 8.05 per page, , ney hav postentry competition will be Cournat. If ic knew for certain that the inewm- Blackstone argued that these prices were consistent with a limirpricing ’s marginal cost is $10, then, as before, the entrant will expect profits of $100 egy, The 914 had a high manufacturing cost, so that for a small user, the el ‘s the second year and would want to enter, If it knew for certain that the incum- fax actually had a smaller effective cost per page. Xerox felt that it sag 's marginal cost is $5, however, then the entrant wauld expect profits of — $56 forestall entry into the small customer segment, and did nor artificially redi would not enter. price, As a result, about 25 electrofax firms entered this end of the mar If the incumbent did nor think strategically, ic would ser its first-year price a 1968, Xerox had a significant cost advantage among medium and large u fing to its marginal cost and the demand curve. If its marginal cost was §10, however. It could afford to reduce prices to medium and large customers and its first-year priee would be $55, IF ts marginal cost was $3, then its first year. cover average costs. Xerox hoped that this would limit entry. The strat ge would be $52.50. 1F the enteant knew that the incumbent was not thinking peared to succeed; by 1968, only 10 electrofax firms compered in the, ‘eally, then it could observe the incumbent's first-year price and immedi- and large customer segments, j infer its marginal cost. For example, if the incumbent set s first-year price of Xerox continued to prosper in the plain paper copicr market until the entrant could infer that the incumbent's warginal cost was SL, amd ernment forced it to share its technology (even belore its, mee ee ore that entry would be profitable. If the incumbent thinks stiategically, 1970s. Many companies, including IBM and Litton, then entere ; then if it has marginal costs of $10, it may reason as follows: eo oe aad copiers fell from 100 percent a me y ee ‘ jee reductions: su Tshould try to-eonvince the en ‘0 persent, and prices Fell by 30; peteenty The) passe duay Want to compete against me if it thinks T have such k Ishould seta price of Xerox was making substantial profits even when it was limit pricing, pete age ave sich Zow costs. [should seta pri ant that my sarginal cost #8 $3, because it will nae $52.50, which is what the entrant would expect from a low-cost incumbent. ‘Then, the | Ghtrant would not knovy iFit was facing a low-cost or high ost incumbent, and anight not to enter, Resening Limit Pricing—When Might It Make Sense? ] th their analysis, Milgrom and Roberts recognized chat hecause a high-cost in ‘This critique of the logic of limit pricing seems to suggest that no rational ene could Lower its price to disguise ies costs, a low-cost incumbent would try woud cen laces, Yet ‘anecdotal examples, and a few systematic analyses “sure thar the entrant would recognize its cost ac ntage. Todo se a low Hackstone’s analysis of Xerox} indicate that limit pricing does occur. ONe} Ancumbent would lower its price by a sufficiently large amount below $52.50, as Blackstone’s analysis « pee ionally. If this is correct (and We’ the potential entranc is convinced that aly a low-eust producer would price ble explanation se seb oem Lani aan firms thae limit price: Don’t do it : ‘In effect, a low price becomes acredible signad chat the incumbent's ent is ee i often eh he ipsa pricing iegatonal: but chat the analysis aaa Ene a low-cost incumbent would price below $52.50. Ironically, though, fils ta captire Enporrautelémendy af te srategie innoraceton v ¢ low-cost incumbe nt charges a price that a rational high-cost incumbent entrant could infer the incumbent's true marginal costs frem SP year price. The high-cost incumbent's limit price would not deter entry. Game theorists have identified key conditions under whieh limit pe id not charge, the be profitable, In general, entering firms must be weertai about some cba tic of the incumbent firm or the level of market demand, Reexamination Of & tensive form game shows why uncertainty is important. The incumbent WHEE entrant to believe thar postentry prices will be low: Ifthe entrant is not about what determines postentey pricing, the entrant can calculate FMilgrom, P, and:J, Roberts, “Limit Pricing and Entry Under tacomplete Informa- Econometrica, 30, 1982: pp. 43460.Lisp glaci 3 “asicede eset Bape Shs" At ae ame mcd nt value to slashing prices in market 10. ‘The potential entrant in the tenth well as the incumbent's cost. ‘These two types of uncertainty support an ket ean figure this out coo, and so enters. In this way, the prablem completely: rium in which (a) the ineumbent prices below its single-year monopoly prig “unravels, so that the incumbent realizes that it has nothing to gain from predatory gardless of its cost, and (b) the lower the incumbent's cast, the lower the price th pricing in January in the first market! The striking conclusion is this In a world in it sets, The low price signals to the entrant that the incumbent's costs may be lo sich all entrants could accurately predict the future course of pricing, predacory and/or market demand may be low. Either signal may deter entry. icing would not deter entry, and therefore would be irrational Generalizing from Saloner’s model, we conclude that the entrant must be un ‘To est this conclusion, R. Mark Isaac and Vernon Smith conducted an exper- certain about postentry competition for limit pricing to be effective. Experi ment in which students played a predation “gam 7 They found thar student sub- ‘ompeted in many markets and are well-informed about incur ‘jects behaved in accordance with this theory. In their experiment, a student played “the role of an incumbent for several periods, setting prices in competition with dif. ‘ferent students in each period. Students had camplete information about payo| aac and Smith found that “incumbent” students did not slash prices. This result that predation is seemingly irrational is associated with a puzale in james known as the chais-store paradox:* The paradox is that, despite the con- that predatory pricing to deter entry is irrational, many firms are com- ly perceived as slashing prices to deter entry. The gunpowder pool cited it entrants who have ue bent’s costs and the level of market demand are unlikely to be fooled by limit pr ing. The limit-pricing incumbent sacrifices short-term profits without 4 lengeterm competition. Predatory Pricing Predatory pricing refers to the practice of setting a price in order to drive oth ‘ a firms out of business. The difference between predatory pricing and limit pric er is one example. Standard Oil, whose pricing policies in the 19th century are is diot tone wilng ie divested at Stu bed in Example 10.7, is another. The paradox is resolved by considering the whereas predatory pricing is aimed at firms that have already entered. All d ole of uncertainty. : Predatory pricing in the chain-store paradox is irrational because potential en- can perfectly predict ineumbent behavior in every market and are certain predatory pricing in the “last” market is irrational, no matter what has hap- pened up to that point. If entrants lack such certainty, then price cutting by an in- eumbent may affect their expectations of the incumbent's future pricing strategy For example, suppose that the entrant stands to make profits of 7, if the incum- bentis an “easy” competitor and incur losses of , if the incumbent is a “cough ompetitor,” where =, > 0 > 7). In other words, a tough incumbent's single- eriod profit maximizing price is so low that the entrant would lose money. This ght occur if the tough incumbent has substantially lower variable costs than ‘the entrant. Suppose also that the entrant believes that the probability that incumbent is tough is p, and the probability that the incumbent is easy is FES equals the sunk costs of entry, then the expected profitability of eniry is 0)7, + pa, — S. helow cost (e.g, average variable cost or short-run marginal cost) with the expe lasses ir incurs after entrants or competi 4 1 tation that it will recover whatew have been driven from the marker, and it can exercise market powe ‘The Chain-Store Paradox j Ie seems intuitive that an incumbent that prices below cost in ene market may able ta deter entry in other markets in the future, ‘The intuitive argument, ever, is not always valid, To see why, immagine that an incumbent firm oper 12 markets, and faces entry in each. [n January, it faces entry in market 1; in . it faces entry in market 2; and so on, Should the incumbent slash pric as can answer this question by working backward from December, to i e ere ‘dless of the course of action how earlier pricing decisions affect later entry, Regar ‘ before Dane nben the incumbent will find it optimal not to engage in predaton Clearly, the potential entrant would like to know omething about p. Suppose pricing in marker 12. The reason is that there is no further entry to deter. The [iit tis certain thor the incumbent is easy, thatis, p = (0 Then it will enter as long inant in the twelfth market knows this, and counting on the rationality of the ine’ © S; that is, as long as the profits from postentry eompetition when the incum- bent, will enter regardless of previous price cuts. But knowing that it cannot t Cooperates exceed the sunk cost of entry. However, if the potenti entrant be- entry in the pvelith market, the incumbent has no reasen to slash prices a 3 ee the incumbent is tough (ie., » is close to 1), it will forecase that it is vember in the eleventh market either, The potential entrant in the elevent iy poe Generate sufficient profits to offset the costs of entry, and will stay out. Ket ean anticipate thar the incumbent will not stash prices against it, and 30 Obviously, the incumbent wants the entrant to believe that pis high. The in- Fee could influence the entrant's perceptions by setting a low price in its es= ished markets. Following the logic of the Milgrom-Roberts and Saloner isloner, G. “Dynamic Equilibrium Limit Pricing in an aera Bate a mimeo, Graduate Sehoo! of Business, Stanford University. See also A ned ewe] ig i Fi Miron, “Equilibrium Limi Pricing: The Effects of Stochasti Demand,” Hronomeri feck San vs pe : 3 ), 320-345. 1983: 981-996. pp. ; ‘See Marti, $. Industrial Baomonia, New Vor: Namal, 1968, for a good 164 Be copatliemcasmerurns cette the various legal tests for predatory pricing that have been proposed rane eas eae Res “In Search of Predatory Pricing," Jorrmal af Political Beon—