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Exit Deterrence
∗
Martin C. Byford
†
Joshua S. Gans
‡
Abstract
This paper is the first to provide a general context whereby potential entrycan lead incumbent firms to permanently reduce the intensity of competitionin a market. All previous results found that potential entry would lead to lowerprices and greater competition. Examining markets where entry occurs by theacquisition of access rights from an existing incumbent, we demonstrate that,where competitive choices are strategic complements, a more efficient entrantmay be unable to acquire those rights from a less efficient incumbent due to theaccommodating behavior of the efficient incumbent. Similarly, such accommo-dating behavior may deter efficient investment by an incumbent. These resultshave implications as to how economists view potential entry and its benefits.
This Version: June 2009
J.E.L. Classification 
: L13
Keywords
: Entry, Dynamic Price Competition, Markov Perfect Equilibrium
∗
We are grateful to Yongmin Chen, Stephen King, Mark Armstrong (the editor)and two anonymous referees for comments on an earlier draft of this paper. The latestversion of this paper is available at www.mbs.edu/jgans
†
Department of Economics, University of Colorado at Boulder.
‡
Melbourne Business School, University of Melbourne.
 
Economic models of the impact of potential entry on competition give rise to twodistinct predictions. First, theories of contestable markets and limit pricing predictthat credible entry threats will induce incumbents to price lower so as to deter thatentry. Second, originating with Selten’s chain store paradox, potential entry willnot induce a prior change in incumbent behavior as it either does not commit themto maintaining that behavior in the post-entry environment or their own forecastedbehavior in that environment is sufficient to deter entry in of itself. Resolving thetheoretical tension between the two predictions has relied on examination of theactions incumbents can take to commit themselves to tough post-entry competitionor the possibility that pre-entry behavior might signal relevant information regardinganticipated post-entry behavior. Regardless, together, all of these theories predictthat potential entry will not lead to less competition in a market.
1
The existing models all have in common one feature: that entry, if it occurs, will bede novo; that is, the entrant adds to the pool of competitors in a market. In contrast,there are many situations where entry arises by acquisition of an incumbent. While,in some situations, this may be a choice aimed at eliminating incumbent competitors,in others, there may be market constraints on de novo entry. For instance, in amarket with high sunk entry costs, a natural oligopoly might arise with a ceiling onthe number of suppliers (Gilbert and Newbery, 1992). In this case, entry may onlybe credible if it is by acquisition.Consider a market in which there exists an asset that is required in order for afirm to gain access to the market. We term this asset as
access right 
which has char-acterized by being (a) necessary for a firm to participate in a market; (b) potentiallytransferable and (c) rival in that it cannot be utilised by more than one firm at anypoint in time. The owner of such an asset may sell, but can never share, its access to amarket. Transferability means that either the asset itself can be traded between firms
1
See Davis, Murphy and Topel (2004) for a recent treatment and Wilson (1992) for a review.
1
 
or, alternatively, it can be traded as a pool of assets through a merger, acquisition ormanagement buyout.
2
Access rights can come in the form of government licensing arrangements — in-cluding broadcasting licenses for television and radio, and spectrum used by wirelesscarriers — as well as complementary assets that are uneconomic to replicate but criti-cal for competition. For example, sea and air ports require significant amounts of landthat satisfy the very specific requirements. Likewise, an asset such as “eyeballs” isnecessary to compete in the the market for internet advertising; particularly targetedadvertising connected to web searches and internet portals.
3
The focus of this paper is on
markets with restricted access
: that is, where there isa strictly limited number of access rights. Entry into a restricted access market mayonly take place via acquisition of an incumbent’s access right: forcing the incumbentto exit. Simple intuition would suggest that, if an entrant emerges who is capable of utilizing the access right more efficiently than an incumbent, there would exist gainsfrom trade in an exchange in which the access right is transferred to the entrant.Hence, it would normally be presumed that the emergence of a potential entrantwould (a) not result in any change in pre-entry behaviour of incumbents, and (b)eventually result in entry.However, this simple intuition neglects the role that rival incumbents might playin influencing the terms of trade in the acquisition market for the access rights.Using an infinite horizon, dynamic model of competition, we show that, in a Markovperfect equilibrium,
the threat of entry may result in reduced competition 
. In themodel, an inefficient firm competes with an efficient firm in a restricted access market.
2
The rivalry assumption may seem questionable in a world in which regulators frequently requirefirms to grant their rivals access to privately owned infrastructure. However, this issue can be resolvedby distinguishing between the market for infrastructure services, and the downstream market forwhich the infrastructure is a necessary input.
3
Moreover, the term access right could apply to situations in which firms need to access a con-strained distribution system (Dana and Spier, 2007) or where limitations on physical capital restrictsaccess.
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