9. Entry Barriers, Entry Deterrence and Limit Pricing Flashcards
Entry definition
Entry: entry of a new firm producing a good that is a perfect substitute for the goods already produced in that industry.
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Note:
The degree of substitutability depends on consumers’ preferences. It is important how consumers perceive the features of a product.
New entry does not necessarily imply the creation of a new firm (e.g. entry in industry A of a firm belonging to industry B (diversification)).
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The entry decision depends on expected profits, that are a function of:
- Production costs.
- Demand conditions post entry.
Indeed the entry has an impact on the market quantity and price. Thus, new entrants have to forecast the reaction of incumbents.
Entry graph
Green: market demand (at industry level).
Blue: demand for the entrant if incumbents are producing q1.
Red demand for the entrant if incumbents are producing q2.
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Example:
If MD is P = 400 – (qi + qe)
and qi = 100
then PD is P = 300 - qe
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The new entrant will face a Potential Demand given by:
PD=Marketdemand - q(incumbent)
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With q(incumbent) equaling the quantity that incumbents choose to produce after the new entry.
Entry barriers
Obstacles preventing new firms from entering a market and compete against the incumbents.
The entry barriers are obstacles preventing new firms from:
Entry barriers taxonomy
The entry barriers are additional costs sustained by new entrants with respect to costs sustained by incumbents. Analyzing the entry barriers taxonomy:
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1. Institutional/legal barriers
- Administrative authorizations needed to conduct business
Institutional monopoly through the grant of patent
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2. Structural barriers:
- Economies of scale (real or pecuniary), scope and learning. Economies of scale create a cost advantage and a price decrease
- Customer loyalty (e.g. structural switching costs, brand loyalty)
- Access to key resources (e.g. distribution channels)
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3. Strategic barriers
Ex ante: capacity investment, artificially induced switching costs, long-term binding contracts, product proliferation, vaporware
Ex post: predatory pricing, vaporware
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Extra:
If there is more than one typology of entry barriers in the same industry, the maximum difference between the price and the average cost without incurring in new entries is given by the height of the highest entry barrier.
There are different definitions of entry barrier: Bain’s, stigler’s, weizsacker’s
Bain’s definition (1956):
Anything that allows incumbents to rise prices above competitive levels without inducing entry.
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Extra: some rents are granted to incumbents, even though the conditions for competition are guaranteed. Non-efficient firms do not enter the market and there are no social surplus losses.
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Stigler’s definition (1968):
Entry barriers are given by the cost that a firm entering new markets has to bear, but that the incumbents do not have to bear.
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Extra: Therefore, there is an asymmetry and in particular an advantage for incumbents if compared with new potential entrants.
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Extra: Weizsacker’s definition: it adds to the Stigler’s definition a ‘distortion in resource allocation’, so that there are inefficiencies and loss of social surplus if compared with the perfect competition. This inefficiency is related to very little protection of incumbents, for example, if new entrants can copy the incumbents, they do not have an incentive to spend on innovation, or to very high protection of incumbents, which implies too much protection
Sylos Labini postulate
New potential entrants behave as if they were able to forecast that the incumbents will keep their production at the same level as before the new entry.
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Thus, the new entrant will assess whether entering or not considering:
- The potential demand diagram
- Its own cost function
Sylos Labini postulate: How do incumbents react?
How do incumbents react?
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Which are new entrants conjectures?
How much will incumbents produce after the new entry?
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- Potential entrants forecast that incumbents will not vary their production after the new entry.
- Incumbents do not vary their production after the new entry.
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-> The potential demand for the new entrant is given by the difference between the market demand and the quantity already offered by incumbents.
Bain, Sylos Labini & Modigliani model
Hypotheses of B-SL-M model:
- Perfect information
- Sylos Labini postulate (no production changes after entry)
- 2-steps competition. In t=1 the incumbent is the monopolist and it decides both price and quantity. In t=2 a new potential entrant decides whether to enter the market.
- Constant MC and AC
- Incumbent’s absolute cost advantage: the incumbent’s (constant) AC is strictly lower than the new entrant’s AC
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NOTE:
Absolute cost advantages: incumbents’ costs are always lower than new potential entrants’ costs.
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Many factors may underlie new entrants’ cost disadvantage:
- Product differentiation (higher differentiation may be needed to compensate for brand loyalty or switching costs)
- Institutional barriers (e.g. payment of the royalties related with a certain patent)
- Less advantageous contracts due to lack of prior relationships with suppliers
Bain, Sylos Labini & Modigliani model
The entry decision is taken considering the potential demand and the cost function.
The potential entrant will enter the market if it can obtain positive profits, so if:
p-ACi>ACe-ACi
(p- ACi = unitary profit for the incumbent)
( ACe-ACi = incumbent’s cost advantage)
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If the entrant’s potential demand has a part that is above the average cost curve, positive profits can be made and the new firm may enter the market.
(SEE GRAPH)
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If p>ACe , there is a part of De allowing to the new entrant positive profits.
–> The new entrant enters the market.
There is no entry if the new entrant cannot make positive profits.(graph)
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The higher the difference between ACe and ACi , the greater the possible difference between P and AC without incurring new entries.
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–>With a high difference between ACe and ACi , the incumbent can charge higher prices without attracting new potential entrants.
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—> P-ACi is a proxy for the height of entry barriers.
Limit pricing
Limit price: price where
p-ACi=ACe-ACi
(p- ACi = unitary profit for the incumbent)
( ACe-ACi = incumbent’s cost advantage)
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Highest price that can be charged without incurring new entries:
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- For higher prices the entrant may enter the market.
- For lower prices the entrant cannot enter the market, but the incumbent is making suboptimal profits.
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p-ACi=ACe-ACi -> p=ACe
Bain, Sylos Labini & Modigliani with ES
Economies of scale –> decreasing average cost before the Minimum Efficient Scale.
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In the B-SL-M model with ES, the stronger the economies of scale, the higher is the price limit (i.e. the optimal price enabling new entry deterrence).
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Hypotheses:
A) Complete information
B) Sylos Labini postulate (no production changes after the entry)
C) 2-steps competition
- In t=1 the incumbent is the monopolist and it decides both price and quantity.
- In t=2 a new potential entrant decides whether to enter the market.
D) The two firms face the same u-shaped AC curve: no absolute cost advantages*** (new)
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Essentially, the line of reasoning is the same:
- SL postulate: the new entrant knows that the incumbent will keep production unchanged.
- The potential new entrant’s decision depends on potential demand (i.e. the difference between the market demand and the incumbent’s production).
- Considering the average cost curve of the new entrant, the incumbent sets the quantity so that potential demand will not allow any profits for the new entrant.
- As a result, the potential new entrant refrains from entering.
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(graph) Where AC and the Residual Demand are tangent, the profit for the new entrant is null
AC is higher than the residual demand De -> the price is lower than the AC –> the entrant would incur losses.
qL is the minimum quantity allowing new entry deterrence
PL is the Price Limit allowing new entry deterrence
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As in the model with an absolute cost advantage, the Price Limit is the highest price the incumbent can set to prevent new firms’ entry in the market.
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Charging a price higher than PL -> entry becomes feasible. If the price is higher than the price limit, there is a part of the potential demand that is above the average cost
-> positive profits for the new entrant (graph)
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Charging a price lower than PL -> extra profits reduction for the incumbent.
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Limitation and critique:
The Sylos-Labini postulate implies irrational conjectures of the potential entrant regarding the leader’s behavior:
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After the entry, the incumbent might not find it convenient anymore to produce the quantity at the price limit.
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Ex-post, an accommodating strategy by the incumbent may be the most rational outcome, as a price war would harm both players
Dixit model
Dixit model (1982): removal of the SL postulate
- First step: the new entrant decides whether to enter the new market or not.
- Second step: the incumbent decides whether to engage in a price war or adopt an accommodating strategy.
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- If the potential entrant does not enter, the incumbent will make monopolistic profits.
- If the potential entrant decides to enter:
- Price war -> low profits for both players equal to π^W
- Acquiescence -> Cournot duopoly profits equal to π^C
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1. As long as π^C is greater than π^W , the incumbent will choose an accommodating strategy in the event of new entry, and the new entrant knows it.
2. Since the new entrant is aware of point 1 and it acts first, it just selects the best alternative between no entry and entry -> accommodating strategy.
3. No entry is preferable to entry -> accommodating strategy if and only if the payoffs associated with the former are. Thus, in this version of the model, if 0 is greater than π^C (i.e. Cournot profits are negative).
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The threat to engage in a price war is not credible.
The monopolist does not have a rational interest to implement the threat.
The incumbent will produce the quantity maximizing monopoly profits π^M rather than the one corresponding to the price limit.
Entry is prevented only if π^C <0
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Can the incumbent alter the payoffs in such a way as to make its threat credible?
References
Cabral (I edition) 12, 13, 14, 15.1, 15.2
Cabral (II edition) 10.1, 10.2, 12.1, 12.3
