Entry deterrence as a sequential game Week 4

Question 1

What is Classic Entry Deterrence?

Answer 1

This concept is part of game theory in economics. It describes a situation where an established company (the “monopolist”) is enjoying high profits in a market and a new company (the “entrant”) considers entering the market. The monopolist wants to stop the new entrant to protect its profits.

Question 2

What is an entrant?

Answer 2

The potential new competitor who is thinking about entering the market. They are a “first mover” in their attempt to challenge the existing monopolist.

Question 3

What is a monopolist’s role in classic entry deterrence?

Answer 3

The company already in the market, earning monopoly profits. This could be a single company or a group of companies (oligopoly) acting together.

Question 4

The problem with classic entry deterrence

Answer 4

The entrant threatens to enter the market, meaning it will start competing.
The monopolist threatens to respond by starting a price war (drastically lowering prices to make the market unprofitable for both).
Why does this matter? Price wars are expensive for both companies—neither the monopolist nor the entrant wants this to happen. However, the entrant might back off if they believe the monopolist will really follow through on its threat.

Question 5

Will the entrant enter the market, why and what is the payoff for the entrant and the monopolist

Answer 5

The entrant will enter as the monopolist’s threat to fight is not credible. Hence, the entrant will enter and the monopolist will concede (accept defeat) and the expected payoff of the entrant will be £1 million and the expected payoff of the monopolist will be £4 million

Question 6

How can a monopolist make the threat to fight entry credible?

Answer 6

By making a costly pre-commitment to fight, which involves sunk (unrecoverable) costs such as:

Building excess capacity to lower prices if needed.
Holding patents or backup products.
Choosing high fixed-cost technologies to protect market share.
Establishing a costly reputation for
fighting entry.

Key Point: The pre-commitment is costly (cost = c), but fighting entry offers a reward (reward = d).

Question 7

Will the entrant enter the market in general?

Answer 7

The entrant will enter the market if by doing so it can make positive profits, otherwise it will stay out, in which case the monopolist doesn’t have to do anything

Question 8

What needs to be true for the threat to be credible and the commitment made in entry deterrence?

Answer 8

The monopolist’s decision to fight depends on two conditions:

Condition 1: Fight if
1+d>4−c
This means the monopolist will fight if the payoff from fighting (1 + d) is greater than conceding (4 - c).
d: The reward for fighting.
c: The sunk cost.

Condition 2: The threat must be credible
Even if fighting is profitable, the entrant won’t be deterred unless they believe the monopolist will follow through with the threat.

If the entrant does not enter: The monopolist gets 8−c (a high payoff minus the sunk cost of committing).
If the entrant enters and the monopolist concedes: The monopolist gets 4
For the entrant to stay out of the market, the monopolist’s payoff from “no entry” (8−c) must be higher than their payoff from conceding (4):

Question 9

What are the implications of making psychological entry barriers credible?

Answer 9

Tangible and costly commitments must meet these conditions:

Payoff from fighting with costly commitment > Payoff from conceding with costly commitment (gains from commitment need to be large enough).
Payoff if no entry with costly commitment > Payoff from conceding with no commitment.
Sunk costs (c) must not be too high.

Question 10

Real life example of sunk costs as a commitment to fighting

Answer 10

• Lower (predatory) prices by Procter and Gamble to deter Union Carbide from entry into one of its local markets in New England and a subsequent national rollout in consumer expendable more generally

Question 11

Why do risky choices for market entrants depend on uncertainty about the monopolist’s commitment?

Answer 11

Entrants face incomplete and asymmetric information, unsure if the monopolist has made a strong commitment to fight.
Monopolists can be:
Fighters (strong): Always fight entry aggressively.
Conceders (weak): Prefer to share the market.
If the risk of facing a fighter is high enough, entrants may be deterred from entering.
Key Point: Creating uncertainty about commitment can prevent market entry.

Question 12

What are the payoffs for the entrant depending on their decision?

Answer 12

If the monopolist concedes: Payoff = 5 (profitable).
If the monopolist fights: Payoff = -1 (loss due to price war).
If no entry: Payoff = 0 (no gains or losses).
Decision: The entrant enters if they believe the monopolist will concede and stays out if they believe the monopolist will fight.

Question 13

What are the payoffs for a weak monopolist?

Answer 13

If it fights: Payoff = -1 (loss due to high costs).
If it concedes: Payoff = 5 (smaller but positive profit).
If no entry: Payoff = 10 (highest profit by maintaining monopoly).
Decision: A weak monopolist concedes if the entrant enters and does nothing if there’s no entry.

Question 14

What are the payoffs for a strong monopolist?

Answer 14

f it fights: Payoff = 4 (willing to incur costs to deter entry).
If it concedes: Payoff = 3 (less profitable than fighting).
If no entry: Payoff = 8 (monopoly profits with sunk costs).
Decision: A strong monopolist fights if the entrant enters and does nothing if there’s no entry.

Question 15

How does incomplete/asymmetric information affect one-shot entry deterrence?

Answer 15

The potential entrant (E) doesn’t know if the monopolist is strong or weak.
They only know the probability (Ps) that the monopolist is strong.
The entrant’s decision depends on their payoffs and the probability Ps.

Question 16

what will the monopolist likely do at Ms1 and Mw1?

Answer 16

At Ms1 the Ps (strong monopolist) will likely fight as it would have already adquired sunk costs. At Mw1 the 1-Ps (weak monopolist) will likely concede.

Question 17

How can entry be deterred even if the incumbent firm is weak?

Answer 17

Entry may still be deterred if the probability of the monopolist being strong (Ps) is high because:

There are enough strong incumbents in the market to keep Ps high.
The monopolist has taken costly actions that signal it is prepared to fight, building a reputation for being a fighter, even if it isn’t truly strong.

Question 18

How can a monopoly/cartel gain a reputation for fighting entry over time?

Answer 18

By fighting entry in previous rounds, which serves as signaling through past behavior. Other players infer future behavior based on these actions.

Question 19

Why might a monopolist fight early entrants even if it is costly? especially in the beginning

Answer 19

o create a reputation for fighting, which deters future entry by raising the perceived probability (Ps) of the monopolist being strong.

Question 20

What is an example of reputation deterring future entry?

Answer 20

US tobacco companies fought lawsuits rather than settling small claims to deter larger lawsuits, creating a reputation for fighting and raising Ps.

Question 21

What is signalling?

Answer 21

Signaling is when a monopolist takes actions (like fighting early entrants) to send a message to potential competitors that they are strong. This raises the competitors’ belief (Ps) that the monopolist will fight, deterring entry. The signal is effective if it is more convincing or less costly for a strong monopolist than a weak one.

Question 22

How does the entrant update their belief about the monopolist’s strength (Ps) through signalling?

Answer 22

Question 23

Why must weak monopolists sometimes send signals?

Answer 23

To make the signal credible:

If weak monopolists never send signals, entrants will believe any signal is always from a strong monopolist (Ps = 1).
If weak monopolists always send signals, the signal loses meaning, and Ps does not change.