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Strategic Management Journal
Strat. Mgmt. J.
,
26
: 1229–1248 (2005)Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.502
INCUMBENT PRICING RESPONSES TO ENTRY
DANIEL SIMON*
Department of Applied Economics and Management, Cornell University, Ithaca,New York, U.S.A.
 Empirical research on incumbent pricing responses to new entry has yielded mixed results. Somestudies find that incumbents cut prices post entry, while others find that incumbents accommodateentry by leaving prices unchanged (or even raising prices). To better understand these findings,this study explores the conditions under which incumbents are more likely to cut prices when faced with entry. I argue that incumbents vary in their incentives to cut prices; incumbents withgreater incentives are more likely to respond aggressively to entry. Using data on magazinesubscription prices, I find that, on average, incumbent magazines do not reduce prices followingentry.But,the results suggestthatnewer incumbentscut prices more thanolder incumbents,whileincumbents that compete in fewer and in more competitive markets cut prices less following entry.These results help to explain inconsistent empirical results in the literature, and support a moregeneral explanation of when firms respond aggressively to entry: incumbents respond to entrymore aggressively when their incentives to do so are greater.
Copyright
2005 John Wiley &Sons, Ltd.
INTRODUCTION
The entry of new firms has important effects onincumbent firms and consumers. New entrantsincrease competition, reducing market share andprofits of incumbent firms. New entrants also intro-duce new products and processes, forcing incum-bents to become more efficient and innovative(Geroski, 1995). As a result, incumbents havestrong incentives to deter entry, while consumerswelcome new entrants.When facing new entry, incumbent firms mustdecide how to respond. They may reduce pricesbefore or after entry, either to deter potentialentrants or simply to maximize current profits in
Keywords: entry; incumbent response; pricing; maga-zines; competitive dynamics
*Correspondence to: Daniel Simon, Department of Applied Eco-nomics and Management, Cornell University, Ithaca, NY 14853,U.S.A. E-mail: dhs29@cornell.edu
the face of increased competition. Alternatively,incumbents may accommodate entry, leaving pri-ces unchanged (or raising prices). This studyexamines incumbents’ pricing responses to newentry in the consumer magazine industry.Theories of entry deterrence and incumbentresponse to entry have evolved, with a large num-ber of studies generating a variety of predictions.Early limit pricing studies predicted that incum-bents would reduce prices before entry, but leavethem unchanged after entry. More recent game-theoretic studies suggest that incumbents mayreduce prices post entry as a way to drive outentrants and deter future entrants.These evolving theoretical predictions haveprompted many empirical studies of incumbentresponses to entry. The results of these stud-ies are very inconsistent: some find that entryhas a negative effect on incumbent prices; oth-ers find that entry has no effect on incumbent
Copyright
2005 John Wiley & Sons, Ltd.
Received 24 September 2002Final revision received 4 June 2005
 
1230
D. Simon
pricing. Even within the same industry, incumbentresponses to entry may vary (Frank and Salkever,1997; Yamawacki, 2002). These inconsistent find-ings may indicate that incumbents only respondaggressively to entry under certain conditions.This study argues that incumbents’ heterogeneousresponses reflect varying incentives to respondto entry; incumbents with stronger incentives aremore likely to respond.To consider the inconsistent findings regardingincumbent pricing responses to entry, I examinewhether incumbent and market characteristics mayinfluence the incumbents’ pricing response. Thatis, this study seeks to better understand the hetero-geneity in incumbent responses to entry by exam-ining the conditions under which incumbent firmshave a greater incentive to cut prices in responseto entry.Consistent with prior empirical work, this studyfinds substantial heterogeneity in incumbents’ pric-ing responses. The results indicate that incumbentand market characteristics influence the incum-bent’s incentive to respond to entry; newer incum-bents cut prices more than older incumbents,while incumbents that compete in fewer and inmore competitive markets cut prices less followingentry. These results suggest that some of the incon-sistent findings may reflect variation in incumbentand market characteristics.While this study focuses on pricing responsesto entry, it should be pointed out that incum-bents are not restricted to reducing prices as away to respond to the threat of entry. As dis-cussed below, firms can use various non-priceweapons to deter entry (Geroski, 1995). This studyexamines pricing behavior because theory offersmore testable predictions regarding heterogeneouspricing responses by incumbents, and because theinconsistent empirical results regarding incumbentpricing responses pose a mystery to researchers.Moreover, prices are observable and measurable,while many non-price responses are unobserved ordifficult to measure.
LITERATURE REVIEW
A great deal of research has examined entry andincumbent responses to entry. But as Geroski(1995) notes, empirical research on entry is muchless conclusive than theoretical research. Theoret-ical models suggest that firms can use price as anentry deterrent before or after entry has occurred.Limit pricing models emphasize deterring entrybefore it occurs. Predation models focus on cut-ting prices after entry as a way to drive out entrantsand deter future entry. But empirical research hasprovided little support for any theory of price asan entry deterrent. It appears that in an effort tobe parsimonious and tractable, theoretical modelshave omitted important contingency factors thatinfluence the incumbent’s incentive to respond toentry.Early theoretical research, notably by Bain(1956), Modigliani (1958), and Sylos-Labini(1962), emphasizes limit pricing: an incumbentfirm setting its pre-entry price low enough tomake entry appear unprofitable. Implicit in thelimit pricing models is the belief that potentialentrants use current industry profits as an indicatorof future profits (Masson and Shaanan, 1982).Such a strategy makes sense for incumbents if the foregone pre-entry profits are less then theadditional profits earned by deterring entry andsubsequently raising prices back to monopolylevels (Geroski, 1995).Empirical evidence provides little support forlimit pricing strategies. A survey of U.S. firmsby Smiley (1988), and a survey of U.K. firmsby Singh, Utton, and Waterson (1997) both findthat firms report rarely using prices to deterentry. Dynamic limit pricing models, which sug-gest that incumbents use their prices to regulateentry behavior continuously, also find little supportempirically.Game-theoretic models emphasize that underconditions of complete information limit pricingis not a credible deterrent. Limit pricing modelstraditionally assume that potential entrants believethat incumbents will not change their price or out-put after entry. But game-theoretic models demon-strate that under conditions of complete informa-tion, regardless of its pre-entry behavior, maintain-ing the limit price after entry is not profit maxi-mizing; once entry has occurred, the incumbenthas an incentive to raise the price from the limitprice to the post-entry equilibrium level. In otherwords, with complete information, pre-entry pricesor profits do not predict post-entry profitability(Milgrom and Roberts, 1982a). Rational poten-tial entrants will not be affected by low pre-entryprices, and thus incumbents only squander prof-its by limit pricing (Milgrom and Roberts, 1982a).These game-theoretic models emphasize the need
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 1229–1248 (2005)
 
 Incumbent Pricing Responses to Entry
1231
for incumbents to credibly commit to low post-entry prices in order to deter entry.Game-theoretic research has considered a vari-ety of strategies and conditions that might providecredible deterrents to entry. Spence (1977) andDixit (1980) develop a model in which an incum-bent invests in excess capacity as a way to deterentry. The excess capacity allows the incumbent tocommit to increased post-entry output and a lowerpost-entry price. This commitment to price reduc-tion makes entry less attractive.But empirical research provides little supportfor the use of excess capacity as an entry deter-rent. Masson and Shaanan (1986) and Lieberman(1987a) find no evidence that incumbents investin excess capacity to deter entry, although Lieber-man (1987b) does find that in more concentratedindustries firms build capacity after entry. In a sur-vey of U.S. firms, Smiley (1988) finds that almostnone of the respondents used excess capacity todeter entry. Singh
et al
. (1997) received similarresponses from U.K. firms.Another game-theoretic approach uses asymmet-ric information to make low prices a crediblethreat. Milgrom and Roberts (1982a) develop asignaling model in which the entrant is uncer-tain about the incumbent’s costs. In this model,the incumbent tries to signal that it has low costsby setting a low price pre-entry, as a way todeter entry. Kreps and Wilson (1982) and Mil-grom and Roberts (1982b) show that when theentrant is uncertain about the incumbent’s pay-offs the incumbent may have an incentive to cutprices after entry as a way to build a reputation forfighting entry. A tough reputation may deter futureentrants by reducing the expected profitability of entry.Few studies have explicitly tested theories of predatory pricing, largely because it is difficultto identify predatory pricing. But several papershave examined incumbent pricing responses toentry, yielding inconsistent results. Some find thatincumbents cut prices post entry while others findno response, or even a positive response.In the airline industry, Joskow, Werden, andJohnson (1994) find that incumbents cut prices fol-lowing entry, while Windle and Dresner (1995)report that entry by low-cost carriers induces pricecuts from incumbents. Looking at retail grocerystores, Marion (1998) finds that prices are neg-atively affected by entry by warehouse stores. Inthe retail tire industry, Bresnahan and Reiss (1991)find that prices fall with entry. On the other hand,Thomas (1999) finds that incumbents in the ready-to-eat breakfast cereal industry do not cut pricesafter entry (Thomas, 1999). Finally, two studiesfind that incumbent pricing responses vary withinthe same industry. Frank and Salkever (1997) findthat brand-name prescription drug prices increaseafter generic entry, but generic prices fall withgeneric entry. Yamawacki (2002) finds that somecar manufacturers cut prices in response to entrywhile others do not. Table 1 summarizes the empir-ical studies of incumbent pricing responses toentry.While empirical results are mixed, little is knownabout why some incumbents reduce price postentry and others do not. The literature offers little
Table 1. Summary of empirical studies of incumbent pricing responses to entryAuthors Industry Key resultJoskow, Werden, andJohnson (1994)Airlines Incumbents cut prices post entryWindle and Dresner(1995)Airlines Incumbents cut prices following entry by low-costcarriersMarion (1998) Grocery stores Incumbent supermarkets reduce prices following entryby warehouse storesThomas (1999) RTE breakfastcerealIncumbents accommodate on priceFrank and Salkever(1997)Pharmaceuticals Incumbent producers of prescription drugs raise pricesafter generic entry, while generic incumbents reduceprice after generic entryBresnahan and Reiss(1991)Local retailmarketsIncumbent tire retailers reduce prices following entry inlocal retail marketsYamawacki (2002) AutomobilesegmentsFirm-specific and group-specific factors determine whichincumbent auto manufacturers respond to entry
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 1229–1248 (2005)
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