eee eee eee ee ee n early 1997, a consortium of electronics firms led by Toshiba, Sony, Mat- shshica, and Philips introduced a new digital video formar called DVD. "This forimat eficred video resolution and sound quality that was superior to conventional video cassettes. By spring 1997, several major studios, including Warner, MGA, and Co lumbia, released a few movies in DVD format. The DVD hardware consortimn expected “early adopters"—individuals willing to pay a premium price for new tech- nology—to purchase DVD players at high prices, despite the shortage of inovies to play on them. This would encourage the release of more movies and yenerate adii- tional 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 videotape players with DVD players, just as they had replaced their record players with CD players a decade earlier. Sales of DVD players exceeded expectations throngh the summer of 1997, but the Christmas season was 2 disappointment. In the fall of 1997, electronics retailer Circuit City made a surprise announcement. It was speatheaing the release of a digi tal video format called DIVX that was partially incompatible with DVD. Citenit City hoped to make DIVX the format of choice. Consumers, wary of previous format wars, such as the one between VHS and Beta videotape, stayed on the ‘Christmas scason, as did several major studios, including Paramount a Cireuit City did not adequately follow through with the DIVX introduction. Ie finally released DIVX hardware and software in two test markets in early summer 1998. It offered only a few brands of DIVX players and sold only a handful of exelu- siye DIVX movie titles. Circuit City was unable to persuade most other electronics retailers to sell DIVX hardware and software. Video rental outlets refused to catty DIVX software. Meanwhile, by the time of the nationwide DIVX rollout in late stun, ‘ner 1998, the DVD market was taking off. All te major stulios were on hoard, ons line DVD retailers aggressively discounted software, and video vental stores hewvily promoted DVD rentals. It was a good Christmas for VD ~sales of DVI) hati season of 1998 topped sales in all of 1997. It was a bad208 = Chapter 9 * Ent ores and Exit {DVD alongside its promotions of Dyyy } feature rather thyn an alternative forma’ ent ns for DIVN—Cirenit City promoted repositioned DIVX as a DVD pels f cuit City’s entry strategy had failed — ' This chapter is haut entry and exit, Entry is the beginning of production and sales by a new firm ina market, and exit occurs when a firm ceases t0 produce jy market. The experience of the DVD consortium demonstrates that incartent ng firms that are already operating shold take entry into account when taking gj, strategic decisions. Enerants—firms that are new toa market—threaten incumbents iq two ways. Fitst, they take market share aivay from incunabent firms, n effect reducing ay incumbent's share of the “profit pie.” Second, entry often intensifies competition, Tig isa natural consequence of oligopoly theory (more firms mean lower prices) and be. cause entrants often reduce prices to establish a foothold in the market. In this way, entry reduces the size of the profit pie. Exit has the opposite effect on competitors Surviving Entry by mail-order ph is increase their share, and competition diminishes. tmacies into the retail pharmacy market illustrates both of these effects. Beginning in the carly 990s, mail-order pharmacies such ag Express Scripts and Value Rx offered low prices on many prescription drugs and soon captured about 10 percent of the market. Traditional pharmacies suffered from both lower sales and lower prices. To combat this threat, several retail phar- macies launched a costly but unsuccessful antitrust challenge against the pharma- ceutical companies that offered discounted wholesale prices to the mail-order pharmacies. ' In this chapter we demonstrate the importance of entry and exit. We then de- scribe structural factors (i.e, factors beyond the control of the firms in the market) that affect entry and exit decisions. We also address strategies that incumbents may employ to reduce the threat of entry and/or encourage exit by rivals. \ Some Facts Anour Entry ANb Exrr’ ntry is pervasive in many industries and may take many forms, At new firm, that is, one that did inot exist before it entered a market, a firin diversifying its product line; that is, the firm already exists but had not previ- ously been in that market, An entrant may also be a firih diversifying geograp hical that is, thg firm sells the same product in other geographic markets, he distinction between new and diversifying firms is often important, such as.when we assess she costs of entry and when we consider strategic responses to it. Recent new entrants 4 various markets include Dreamworks SKG:(a motion picture studio founded he Stephen Spielberg, Jeffrey Katzenberg, and David Geffin), British Midhinde (whi o provides airline service to the British Isles and several European destinations) a ‘Amazon.com (hich sells books over the Internet). Recent diversifying we ane clude ESPN (which opened a chain of restaurants), Microsoft (which introde, mts in- Microsoft X-Box gaming system), and Corona Beer (which entered new geoecs the markets in Australia and Europe). Seographic Fait is the reverse of entry—the withdrawal of product from a market, ¢ a firm that shuts down completely, or by a fim that gontinues to opersee se b markets. In the last two decades, the Eccentric Restaurant (owned by Cy, in other firey) exited the Chicago restaurant marke, Renault and Peugeot exitay 79 Win- tomobile market, and Sega exited the video game hardware marker, 3, n entrant may be & An enteant may be = aus € oajane Facts Al wl Exit #299 The best systematic analysis of entry and exit rates across industries is by ‘Viemoth Dunne, Mare Roberts, and Larry Samuelson (henceforth DRS)!""They examined entey and exit 1 over 250,000 US, manafictuting firass between 1963 and 1982. "Though dated, tho findings ave valuable because they emphasize the importance of entry and exit in many industries, and offer insights about patterns of growth and decline ‘To sunmarize the main findings of DRS, imagine an industry in 2003. pothetical mdustey has 100 firms, with combined anmnal sales of S100 tems of entry and exit in this industry are representative of all U: previous decades, then the following will be true: 3 hy- lion. If pat- industries in 1. Entry und exit will be pervasive. By 2008, letween 30 and 40 new Gums will have entered. They will have combined annual sales of $12 to $20 million (adjusted for inflation). At the same time, 30 to 40 firms that were operating in 2003 will have left the market. Their year-2003 sales would also have been $12 to $20 mil- Jion. Of the 30 to 40 new entrants, about half will be diversified firms operating in other product marke’s, and half will be new firms. Of the 30 to 40 exicers, 40 percent will be diversified. Enerarts and exiters tend t0 be smaller than established firms, A typical enteant will be only one-third the size of a typical incumbent. An important exception is entry by diversifying firms that build new physical plants (as opposed co switching an existing plant to making a new product). Diversifying entrants tend to be three times the size of other eiitrants—roughly the same size as the average incumbent. In 2003, firms thae will leave the industry by 2008 will be only about one-third the size of the average firm, Few exiters will be diversified firms, Most entrants do not survive 10 years, but those that do grow precipitously. Of the 30 to 40 firms that enter the market between 2003 and 2008, roughly 60 percent will exit by 2013, The survivors will nearly double their size by 2013. Entry aad exit rates vary by industry. Not surprisingly, entry and exit are more com- mon in some industries than in others. Some industries in which entrants are nu- merous and command substantial market shares include apparel, lumber, furniture, and fabricated metals, Industries with high exit rates include apparel, lumber, furniture, and leather, Industries with litle entry include food processing, tobacco, paper, chemicals, and primary metals. Industries with lite exit include tobacco, paper, chémicals, petroleum and coal, and primary metals. Clearly, entry and exit are highly related: Conditions that encourage entry in industry foster exit. ‘The DRS tindings have four important implications for strategy: When planning for the future, the manager must account for an unknown com~ petitor—the entrant. Fully one-third of a typical incumbent firm's competition five years hence are not competitors today. : i Not many diversifying competitors will build new plants, but the size of their plants can make them a threat to incumbents. Managers should expect most new ventures to fail quickly. However, survival and growth usually go hand in hand, so managers of new firms will have to find the capital co support expansion, Managers should know the entry and exit conditions of their industry. Entry and exit are powerful forces in some industries, but relatively unimportant in others. es t "Dunne. T., M. J. Roberts, and L. Samuelson, “Patterns of Firm Entry ang fanufacturing Industries,” RAND Journal of Economics, Winter 1988, pp. 495-51roo « Chapter © * Baty and Fxit Hyunvat’s ENTRY INTO THE In December 1997, Hyundai announced that it would enter the steel business, Its plan was to build a fully integrated blast furnace-type steel ill in Korea by 2005. ‘The mill would have @ production capacity of 6 million tons per year. Hyundai's steel mill business plan has been one of the nation’s hottest economic issues. Hyundai's announcement was a surprise to many Koreans because the government had opposed the plan. Hyundai, Korea's largest firm, started as a construction business and expanded into engi- neering, automobile, shipbuilding, and other heavy equipment manufacturing. Although most of the Korean conglomerates overlap in many industries, Hyundai has'a greater focus on heavy industrial sectors. Samsung, the next largest Korean conglomerate, is regarded as more of a consumer products company. Hyundai has long been eager to partici- pate in the steel industry. The dominant firm, POSCO, was once owned hy the government. ‘The government still owns a major portion of the shares of POSCO and appoints its CEO. POSCO has two big steel mills with combined production capacity of about 26 million tons. No ether company in Korea has a mill ap- proaching even 6 million tons, which is gener- ally; regarded to be the minimum efficient scale. (It should be noted that some of the new production technologies have narrowed the cost disadvantage of sinaller mills.) Given its cost advantage, POSCO catt easily outcompete” its rivals, and has been one of the most prof- itable companies in Korea, ‘While POSCO priced below the competi- tion, it did not have enough capacity to meet industry demand. Experts in the Korean steel STEEL INDUSTRY Iusiness noted that POSCO's supply was criti eal; without POSCO, its customers would have to turn to imports. Hyundai felt that de- vad for steel would continue t0 cow, far foutstripping POSCO's production capabil. ties, Without a new plant, Korea would have to import steel. Tiyundai had many good reasons to enter the steel market. With demand forecast to throw, the market was ripe for entry. Uiyundsi, Brvvrate company, felt it could be more eff. soit than POSCO, which is thought to hare huch redundancy and bureaucracy. Moreover, Hyundai consumes so much steel itself that it we achieve minimum efficient scale without Seling to the market. Thus, Hyundai stood to Jower its steel costs through backward integra- tion. By assuring capacity, Hyundai might also be better able to plan its other operations Guch as car or ship, production) more flexibly and easily. Finally, Hyundai's growth orienta- tion might have led it to conclude that the steel mill would be the most cost-effective way to pull far ahead of Samsung in the bartle to be Korea's top firm, he Korean government discouraged Hyundai from building the plant, claiming that demand was likely to slacken. Hyundai sus- pected that POS: had been influencing the government's opinion, Not only would a new plant threaten BOSCO's profits, but Hyundai would no longer need to purchase steel from POSCO. In the end, the government failed to dissuade Hyundai from building the plant. As it turned out, the worldwide economic downtum of the early 2000s sharply reduced steel de- mand. ‘The Korean government's for turned out to be correct afterall! seasal 7 oty an Est Decisions: Mase Concepts «301 ‘ould = ie de. NRY AND E: SIONS: Basic Concupps Ws far ; ; pabili. A protitmivinicing,risk-newtral fr shoul ent fae ae leas than the wet present value of expected pustenng eee te ak ost oF entry tenia aml cont mera mathe, tangng fo tc ene NY a sauinmanc co gyveroment Wiens. Laterin this chapter eee ee eal ree Postentry profs will vary according to demand an! cost cond ae the nature of pstenty competition. Pstentry competition renee ee ell as rae performance of firms in the market after entry has ocennel ate ee cee an ven may use many different types of information sbout incumbents eta et hat it pricing pructices, casts, and capacity, to assess what postentry computer ety hout like Ifthe potential entrant expects postentry competion to he ene, ieee expects incumbent firms to slash prices, then i the potential entrant believes that postentry may noc enter if there are si s more likely to stay out. Even when competition will be relatively sila, it ificant barriers to entry. —_ Barriers to Entry ~~ \ Barriers to entry are those fattors that allow incumbent firms to earn positive eco i nomic profits, while making it unprofitable for newcomers to enter the indvsa: Barriers to entry may be serterural or steategic. Structural entry barriers result whea the incumbent has aaqural cost or marketing advantages, or benefits from favorable regulations. Strategic entry barriers result when the incumbent aggressively deters enury. Eniry-deterring strategies may include limie pricing, predatory pricing, and e pacity expansion, all of which we discuss later in this chapter ‘ ~ Bain’s Typology of Entry Conditions In his seminal work on entry, Joe Bain argued that markets may be characterized ac- cording to whether entry barriers are structural or strategic, and whether incumbents can profit from using entry-deterring strategies.' Bain described three entry condi- to tio sit im Blockaded Entry Entcy is blockaded if structural barriers are so high that the in- le- combent yeed do nothing w ' ast fixed investments, or the enti Ginnot raise price above marginal cast 74 firm or individual is risk-neutral if itis indifferent between a suce thing and a gamble with an equal expected payoff. Individuals are usually risk-averse, as evidenced by purchases of auto and health insurance, Shareholders may not want their managers to avoid risk, however, since they can cheaply’ minimize risk by holding diversified portfolios of debt and equity instruments *This detinition is a synthesis of the definitions of entry barriers of Joe Bain in Burziers 10 New Competition: Their Character and Consequences in Manufacturing Industries, Cambridge, MA, Harvard University Press, 1956, and C. C. Von Weizsicker in Barriers to Entry: A Uheoretical 7 Verlag, 1980. ' Treatment, Berlin, Springer ‘Bain, op. cit.302 « Chapter 9 + Entry and Es ic Batiy t modated if structural entry batt Accommodated Entry Rntry is accommodated if str IIS ate loy, and either (a) entry-deterring strategies will be ineffective, a (b) C Ost 0 the in! cannent of ayn 10 deter entry exceeds the benefits it could gain from keeping eh entrant out{ Accommodated entry is typical in markets with growing demand or rapig technological improvements JEntey 1 rcutnbent(s) should Ren so attractive that the not waste resources trying to prevent it. | Deterred Entry ny is deterred, i€not blockaded, if (a) the incumbent ean keep the entrant out by employing an entry-deterring strategy, and (b) employing the entry-deterting strategy boosts the incumbent's profits. Prank [Fisher calls “such, entry-deterring strategies predatory acts We describe several predatory sets later in this chapter. Bain argued that an incumbent firm should analyze the entry conditions in jxg market and choose an entry-deterring strategy based on these conditions. If entry blockaded or accommodated, the firm need do nothi ig more to deter entry. Ifentry is deterred, the firm should engage in a predatory act. T'o assess entry conditions, the firm must understand the magnitude of structural entry barriers and consider the likely , consequences of strategic entry barriers. We discuss the former below, and the latter in the next section. Structural Entry Barriers ‘There are three main types of structural entry barriers: 1. Control of essential resources 2. Economies of scale and scope 3. Marketing advantages of incumbency We discuss each in turn. i 7 Control of Essential Resources (An incumbent is protected from entry if it cot- trols a resource necessary for production) DeBeers in diamonds, Alcoa in aluminum, and Ocean Spray in cranberries all maintained monopolies or cartels by controlling essential inputs. This suggests that firms should acquit: key inputs to gain mondpoly Stauin However, there ae seers Salsa shis appenacly eos or oe, in Chapter 3, in the context of make-or-buy decisions. First, just when the fem thinks that it has tied up existing supplies, new input sources may emerge, A recent diamond find in northwestern Canada has loosened DeBeers’ grip on the worldwide diamond market. But nature seems to have limited the available supply of aluminum and cranberries, helping these monopolies to endure. Second, owners of scarce re- sources may hold out for high prices before selling to the would-be monopolist. De. Beers tried to buy out much of the Canadian diamonds, but the high price cu in the cartel’s profits. ‘© ‘There is also a regulatory ssk associated with attaining monopoly status through acquisition. Anvisust ws in many nations forbid incumbents with dominane moe shares from preventing competitors from obsaining key inputs. Under whae has het come known as the esensal facies doctrine, the,U.S. Supreme Court in 19 ordered the Terininal Railroad Association to permit competing taioads tg yo 4 ea SFisher, F., Industrial Organization, Economics, and the Law, Cambridge, Ma, Mir 1991. Press, bridge tha the east, an clude rival r Aspens Shitn Aspen, Co tralled by a Incur honabsiou! vidual oF th patene in it son to appl wets the pal erable expe usually tak; the wait obtain pert developed Patent vented aro) guish beow séme inno) patent pro lawsuits a nt's. Sor sors from ecisions i Teun has zealou how to du may warn | steal such, Econom lished tire substantia illustrates 1,000 uni share of | entrant o erage cos wo be pro The to boost force. W than 2 p Um. Maxie Concepts #308 tide that Terminal owned. The hthdge pov “ah east aun dhe Comtt feared that Teresa enc eee aly access ‘luda/rieal railroads? In 1983, the Supremeia ee, Aon Silitie Geurpany whlch gseniemer hee oper Cal cred anaes conan Tncatubents can fegally erect entry harreas > Matrers by «dsining nonobrious praduct of prodiction process, Pavers Let Counties, such as Chit and Brag they vidual or fin dat develops a marketable new to St, Loni fra its control of the Inidge to ex ne used similar reasoning. to Force the fof the principal skiing: mountains in lata, too meld tn ity siv lay Hit chet acess toy Tony a patent to a novel and say by country, austin sone nonexistent or extremely weak, Au adh product or provess asually applies for a the patent rights go to the first pet [ited States the fist person to invent the ea | firms secking U.S. patents often yo to consis erable expense to document precedence of discovery Ones he naan ea iisually takes ane to two years, and the inv Ie patent in its home country. In Europe aid Japa son to apply for the patent. In the United Su ets the patent, As might be expected he pact approved (it bain eto from the patent holder. Patent lives are currently 20 years in most Patents are not always effective entry barriets because they ean often be “in vented around,” in part because a government patent office sometimes cannot distin- wish between a new product and an imitation of a protected product, As a result, some innovations, such as areas and the personal computer, seem ww have had no- patent protection whatsoevef, Conversely, incumbents may file parent-infringement lawsuits against entrants whose products are seemingly different fom the incum- hent’s, Sonne observers claim that Intel used this strategy to protect its microproces- sors from entry by Advanced Micro Devices. It took a pair of U.S. Supreme Court decisions in the late 1990s to loosen Intel’s grip on this market, Incumbents may not need patents to protect specialized know-how. Coca-Cola has zealously guarded its cola syrup formula for a century, and no one has learned how to duplicate the sound of a Steinway piano or the beauty of Daum crystal. Firms may turn to the legally and ethically questionable practice of industrial espionage to steal such information, Economies of Scale and Scope When economies of scale are significant, estab- lished firms operating at or beyond the minimum efficient scale (MIES) will have a substantial cost advantage over smaller entrants. The average cost curve in Figure 9.1 ough illustrates the problem facing'a potential entrant in an industry where the MES is ioe 1,000 units, and total industry sales are 10,000 units. An incumbent with a market rhe. share of 10 percent or higher reaches the MES, and has average cost of Cues Ifthe 1917 entrant only achieves a market share of, say, 2 percent, it wil have a snuch higher av- Sea erage cost of ACp. The market price would have to be at least as high as 1G. for entry o be profitable. ‘The entrant might try to overcome the incumbent's cost advantage by spending to boost its market share. For example, it could advertise heavily or form a large sales force, While this strategy may allow the entrant to achieve a marker share greater than ? percent and average production costs below IC in Figure 9.1, it involves wwo “United Seates v. Terminal R. R. clgn., 224 US. 383 (1912), “Aspen Stung Co. Aspen Higblands Skiing Corp. 172 U.S. SHS (1985),FIGURE 9,1 Econoars of The incumbent firm producing at minimum efficient scale of 1,000 units per year has average costs Ifthe potential enteane can only hope to produce a AChE | - volune of ouput equal co 200 units per year, average costs will equal AC, Market price must be at least th profits fiom entry, 200 units 1,000 units ‘May Bea Barrier 10 ENTRY _4 Average cost igh for the potential entrant to realize Q important costs. The first is the direct cost of advertising and creating the sales force, The second is the inditect cost associated with a strategic reaction by the incumbent. For example, if the incumbent responds to a decline in its market share by reducing its price, this will cut into the entrant's profits." The entrant thus faces a dilemma: To overcome its cost disadvantage, it must increase its market share. But if its share in- creases, price competition may intensify. ce tition frequently_results from. large-scale entry wcusive industies.'The U.S. gunpowder industry in the nineteenth cencury offers an example of intense postentry rivalry. In 1889, eight firms, including the industry leader DuPont, formed a “gunpowder pool” to fix price and output. In the early 1890s, three new firms entered the industry. Their growth challenged the continued success of the pool. DuPont's response to one entran. was to “put the Chattanooga Powder Company out of business by selling at lower prices.”* In this way, the gun- powder poo! survived until antitrust enforcers broke it up. More recently, rapid entry by fiber-optic telecom providers intensified price competition, saddling mnarket leader WorldCom with over $20 billion in debt and driving them into banky prey. Incumbents may also derive a cost adyantage from econ: o ready-to-eat breakfast cereal industry provides a good example.” For several decades the industry has been dominated by a few firms, including Kellogg, General ML General Fouds, and Quaker Oats, and there has been virtually no new entry singe World War Il. There are significant economies of scope in producing and marian cereal. Economies of scope in production stem from the flexibility in materiale Ieee dling and scheduling. tat arises froi iple_production lines within th same plant. Economies of scope in marketing are due t front expendi, 1to_capital- iomiies of scope. The "Such a pricing response is likely in this example, from the incumbents, their marginal costs decrease. *Fligstein, N., The Transformation of Corporate Control, Cambrid Press, 1990. ee "Hlge, MA, Harvard University 10for a detailed discussion see Schmalensee, R. “Entry Deterrence j Breakfast Cereal Industry,” Bell Journal of Eeonomics, 9 (2), 1978, pp, en the Ready-to-Eat because when the entrant steals business Patent ple, is Keflin cephal Lilly cephal longir simila had su separs Lilly’ amon| in the and 1 bette \ tectio abled cepha as Me P marke tions) was i (ater top-s State: was it met runni by Si comp Zant: paten Faces cures of able ley newcor ments | AnGas PATENT PROTECTION IN-11 Patent protection is exitical to snecess or fy ple, in the late 19605, Eli Lilly introduced Keflin, the first of a new class of drugs called cephalosporins (a “magic bullet” antibiotic) Lilly introduced the first “second-generation” cephalosporin, Keflex, in 1971. ‘Though be- Jonging to the same chemical class and having similar biological properties, Keflex and Kellie had sufficiently different structures to warrant separate patents. ‘These drugs quickly became Lilly's top-ewo sellers—one oF both ranked among the top-10-selling prescription dn in the United States every year between 1940 and 1985. The drugs would have sold even better if Lilly's patents had provided full pro- \ fection. Differences in chemical structure en- ijubled several competitors; to introduce new cephalosporins by the late{1970s. A few, such as Merck's Mefoxin, also became top sellers. Patents proved to be more enduring in the market for H2 antagonists (anti-ulcer medica- tions). Tagamet, the first effective medication, was introduced by Smith, Kline, and French (later SmithKline) in 1978. By 1980, it was the top-selling prescription drug in the United States. In 1984, Glaxo’s anti-ulcer drug Zantac was introduced, and a year later replaced Taga- met as the best-selling drug, with Tagamet running second. The substantial profits earned by SmithKline and Glaxo encouraged other companies to develop H2 antagonists. Bu Zantac and Tagamet sales held firm until their patents expired in the mid- to late-1990s. Faced with competition from generic drugs, tures on advertising that are needed for a able level of brand awareness! Tt has been estimated newcomer would need to intraduce 6 to 12 success ments for entry are substantial, making entry a risky prot cereal would not face the same up- ablished brand name awareness and nay incumbent launching a new new entrant, ‘The incumbent has already est MScheres. F. Mu American Industry, THh ed, New York, “The Breakfast Cereal Industry, facinillan, 1986. Entey and ; Y anil Ksit Decisions: Hasie Concepts * 305 & PHaRMAcey incl Glaxo obtained htained approval to rugs for sale without prescription ne (ich the way that ‘ay consuniers pds bended pi ie on thei esearch imestnent fo tee Ma ful of drugs that treat common diseases and yet have few substitutes. Glaxo became one of the 50 largest companies in the world, almost ex- lusively froin Zantac profits. In recent years, patented drugs like Prilasee (for ulcers), Tipi tor (for high cholesterol), and Norvasc (for hy- pertension) have generated billions of dollars jn annual profits. Those profits can disappear rapidly when patents expire. Glaxo’s patents on Zantac expired in 1997, and sales of Zantac immediately fell by half. As a resule, the con pany posted a 4 percent drop in overall sales, despite an 11 percent increase in sales of prod- ucts other than Zantac. Because patent protection is so crucial to their snccess, drug makers are extremely con- cerned about the lengthy testing process that comes after a drug is patented bat before it is approved for sale by the Food and Drug Ad- ministration (FDA) and other regulatory bod- ies. In recent years, the FDA has worked closely with industry to sueamline the testing and approval process. It used to take 10 years ‘or more to move a drug through all the phases of FDA testing. Today, many drug makers are able to obtain approval for promising new drugs within five to seven years, without ap- pearing to compromise patients’ safety. new entrant to establish a minimum accept- | that for entry to be worthwhile, a ful brands. Thus, capital require- position. front costs a5 a ‘Adams, W. (ed.), The Structure ofo + Fouy Exit re its new cereal. This explains why jy manufactt Je for new entrants, Indeed, ofitab ents but unprofi br Her outsdens, anetmvents increased he si Haare ever 20018 1998, High profit margin : ate label manafacturets Mal-O-Meal and sisting facilities €0 he able to use © neural products ate profitable for in gpite the near total absence of af cereals offered for sale from 88 i eventyally invited limited entry by priv Ralston Pu en so, most of the successful Neve ete such as granola-based cereals, in which they 0 ‘antag by cei ee eeate batiers to eny cause they foce pen any products t0 achieve whit cost pa tial entrants to enter on a large scale or vith ntany Pe ‘a large scale ea jty with incumbent finns, Strictly speaking, though, ent “1B ata large scale oF scope je dicadvantageous only to the extent that the entrant cannot recover its up-frone entry costs if it subsequently decides to exit (Le, only ifthe — ny cost ae Sonk costs). An entrant whose up-front entry costs were not sunk cous vote in ata ne reins’ prices, and exit the market and recover is large scale, undercut incumbent fi entry cost ifthe incumbent firms rts is strategy. known 2s bitcandarua eur, send leave incumbents vulnerable to entry even if economies of scale were so signif icant arion to market demand that che aarket could support only one fim, For this reason, as Daniel Spulber has pointed out, sunk costs, not eco scale ‘he underlying structural barrier to entry." Still in most or scope per se, represent a y quatkels Gaivante com achieve scale and scope economies iri production or marketing only by snaking significant nonrecoverable up-front cos Me fal newcomers have chosen niche may, yy try to offset thei cost disad. Marketing Advantages of Incumbency Chapter 2 discussed umbrella branding, whereby a fit sells different products under the same brand name. This is a special case of economies of scope, but an extremely important'one in many consumer prod- uct markets. An incumbent can exploit the umbrella efféct to offset uncertainty about the quality of a nev product that itis introducing. The brand umbrella wakes the i cumbent’s sunk cost of introducing a new product less than that of a new entrant be cause the entrant must spend additional amounts of money on advertising and product proniotion to develop credibility in the eyes of consumeis, retailers, and distributors. ‘A brand umbrella will not protect an incumbent if its new product turns out to be unsatisfactory. The incumbent may suffer even more than newcomers if consumers’ dissatisfaction with the new product leads them to doubt the quality of the rest of the incumbent's product line, or if managers of competing firms view the failure as a sig- al that the incumbent nay be a less formidable competitor than they had thought. hus, although the brand urnbrella can give incumbents an advantage over entrants, the exploitation of brand name credibility or reputation is not risk free. 7 “The umbrella effect may also help the incumbent negotiate the vertical chain, If an incumbeat’s other products have sold well in the past, more likely to devote scarce warehousin, a te ributors and retailers are ‘ and shelf space to its new products, For ex tiple, Coke and Pepsi have launched nev products with the confidence th retailers will allocate scarce shelf space to them. At the same time, suppliers and distributors 0 mak elaoshipspecif invents ino sel un eve to ents. For many years, Sears purchased specialized crs ns: For any chy equipinent for Emerson to make Sears Craftsman tools, This relationship soured in the late 19906, and in 2002, Sears accused Emerson of breaking an exclusivity ag using the equipment to make tools for Home Depot. as lina "Spulber, D. Fo Regulation and Markets, Cambridge, MA, MIT Press, 1989. Ew Batt Tn Sept Australi foray ¢ Bransor In 1984 ternati¢ lami wonder magic Virgin Europ the Au kind t hegem Austra Pr pass I irline tic ma cumb Corny sustai the s petite MO 2001€ AMPLE 9.3 Banwiers 10 ENTRY INTHE AUSTRALIAN AIRLINE MARKET In September 2000, Virgin Blue, a discount carrier, began operations ‘in the competitive Australian domestic market, ‘TI the first foray of Virgin Companies CEO. Richard Branson into the Australian domestic marker. Tn 1984, Branson successfully entered the in- ternational air travel market with Virgin At- antic Airlines, But many industry analysts wondered whether he could work the same magic with Virgin Blue. For one thing, his Virgin Fxpress aiclines, 2 discount carrier in Enrope, tad not fared well. More importantly, the Australian domestic market had not been kind to airlines that tried to challenge the hegemony of the two de.ninant airlines in ‘Australia—Qantas and Ansett. Prior to Virgin Blue, budget airline Com- S pass IT (a reincarnation of a previously failed nirline, Compass) tested thé Australian domes- tic marker where it faced enormous barriers to entry. Compass TI did not have access to the same airport infrastructure as the incumbent Sirlines. Tt lacked access to such facilities as business-class lounges, which were critical in Turing business travelers away from its come petitors. Furthermore, as a smaller airline, Compass IT could not provide the frequency of flights demanded by business travelers. Addi- tionally, Compass II's boarding gates were usually the farthest gates from terminal hubs. “Most important, the upstart did not effec- tively differentiate itself from its competitors. Ik aimed to provide the same level of service ‘and competed along the same routes as Qantas and Ansett, Tt wasn’t long before the wo ine cummbent airlines started a price war with Compass II. In the end, Compass II could not sustain its low-price structure while offering the same services as its deep-pocketed comn- petitors. Compass IT was bankrupt less than a TorConnell, Dominic, "Virgin Blue Flies High in 2001 Entry and Bait Decisions: Basie Concepts * 307 year after its inception, Would Virgin. Blue face the same 7 Virgin Blue differentiated itself from Compass aislines by not aiming to be a low- priced equivalent of Qantas or Ansett. At the start, Virgin Blue chose not to compete with Qantas and Ansett on major trunk routes like Sydney-Melbourne. Instead, Virgin set up op- rations in a smaller Australian city, Brisbane From there, it began flying less-traveled routes like Brisbane-Sydlney and Brisbane-Melbourne. Te only added the Sydney-Melbourne ran and other well-traveled routes to its network once it had wet its feet on the less-traveled routes. ‘A differentiated route steucture might hold off competition for a while. Bu if Qantas or Ansett wished, they could easily introduce con peting flights along the same routes. Hete is where Virgin Blue's low-cost-structure helped prevent the price wars that had plagued Com= pass and Compass TI. Virgin Blue followed 2 Jow-cost business model similar to pioneer dis count airlines Southwest in the United States Blue's business due to lower operating costs. Like Southw Virgin Blue operated only one model of air- plane—the Bocing 737, resulting in simpler Jad less expensive maintenance. It ordered newer models of the aircraft, Tike the Boeing 737-100, which were more fuel-efficient than earlier versions of the aircraft. ‘The aicline did ot make seat assignments, as airliners were configured in a single-class layout. ‘Tickets did not include meals, but food was made available to passengers in-flight if they decided to pur cchase it. In Sydney, Virgin Blue’s terminal was affectionately dubbed “the tin shed” by staff for its Spartan appearance and amenities.” Australia,” Sunday Business, January 14,308 + Chapter 9 + Enty and Brit Southwest, developed Nonetheless, Virgin, like that drew back a reputation for friendly sevvice customers. Unlike previous upstarts in Australia, Vit~ gin could deaw on an additional competitive advantage: the resources of its,mother corpo- ration, the Virgin Companies. For example, aircraft were transferred to Australia from its European operation, Virgin Express, during non-peak months in Europe. Virgin Blue also benefited from the international reputation of 3 Virgin Atlantic. At the sie, Virgin Blue CEO Brett Godfrey noted “Vi gin’s brand-awareness figures for Austral [were] only slightly smaller than those in the UK." Australia was a big English-speaking marker that had Been exposed 10 he Vig name." In its frst yea ter than Compass ait Toad factors and 1, Virgin Blue fated 11uch be, lines. It reported 75 per, J gained 9 percent of the DA cent cd 9 B ea etan domestic market! It as also cong a yiesthe New Zealand domeng 1, th et which was recently abandoned by Qu any bres liters at Miliary Qantas Neve Zealand. Only tine Pell whether Virgin Blue can maintain ig cnr growth, or whether Qantas oF Anse fe war to try t0 drive Virgin » vill risk a costly p' Blue from the rarket. Nonetheless, through 1 stnall pe lion tite a start name. J a developed business approach Virgin Be ‘ined Tas changed the competitive landscape inainar. SVN ket previously diought ro be a secure duopoly. needed all ibe the AI DOR eo Hoa ea ssreee res G. ENTRY BARRIERS AND PROFITABILITY IN VHE JAPANESE. BREWING INDUSTRY MPLE. 9.4 ‘The Tapanese brewing industry has enjoyed seve~al decades of financial ‘prosperity. ‘The Japeiese market for beer, is enormous, with “per-capita consuitiption approaching 16 gallons “per yeat. Four firns—Kirin, "Asahi, ‘Sapporo, End Suintory—dominate the market. The lead tes; Asahi and Kirin, each have nearly 40 per- ceitt market share, and their anoual sales rival those of Anheuser-Busch, the leading, U.S. brewery. ‘The industry after-tax fet on as- "gets ranges from 3 to 4’percent, which is good in’ Japan where inflation’ is low. Moreover, these firms have been profitable for decades. ‘Normally, a profitable industry attracts en- trants seeking to share the pie. Even so, Suntory, is the only brewery to gain significant market sshare iv Japan in the last 20 years, and its mar- et share is only shout 10 percent. (Che Gfth largest seller, Orion, lras a market share below 1 PAD POOH a EOS DES HORE ing th Heard is ued lo percent) Profitable incumbents combined with! 3" minimal entry usually indicate the presence of "681 entry barriers. In the United States, profitable eee breweries are prote-ted by strong brand ideni- Ue 2" ties. Would-be competitors must invest tens af ‘Sir millions of dollas of more to achieve the brand yo recognition and strength of image enj ge enjoyed mark Budveiser and Miller. This deters seriows i ‘ petition from newcomers. Japanese brewers also snay Taey beard identity, and brands ike Kins Ate loyal folowing a fSahi’s Super Dry have ste Cig as ae fo Japanese brewers also liane grlgy mo entry baurets not shared by US. ‘ts theyepenee, £8; stricaly een restricted ty _ 2% “Maran Pat ecareent and the dominance of distribution channe's s CoPlicates access to Breweries in Japan im a from the ‘Men Bane have a license {5°77 (MOP), Before To ex chang exit. Dest a ever, are si vail The | firmofitable identi- tens of : brand yed by | s com- ers also Kirin’s y have rs also y US. xed by ance of Sess to license Before oO dose OY A) eit Ge Metter alder. 1994, the MOK Would not issue a license to any brewery producing fewer than liters annually. Althongh this is a relatively small percentage of the total market of 7 bi «, lion liters, it represents an imposing hurdle to a startup finn without an established brand name. It is not clear whether the MOF nai tained this hurdle to protect'the big four brew- eries, or to reduce the number of firms it needed to tax and regulate, As part of an ove all liberalization of marketplace restrictions, the MOF has reduced the license threshold to 60,000 liters. In the wake of this change, exist- ing small brewers formed a Small Brewers As- sociation, and many microbreweries opened. ‘The four incumbents responded by offer ing their own “gourmet” brews such as Kirin's Heartland. This has earned them the con ued loyalty of restaurant and bar owners, who are responsible for 50 percent of all retail beer sales in Japan. By combining clever marketing strategies (e.g., Heartland has a distinctive bot- ‘tle and is not widely available in retail stores) (ywith the cost advantages of well-established distribution channels, the! major brew have maintained their stranglehold on the beer market. Changes in Japanese retailing practices may eventually threaten the major breweries. After restaurants and bars, the second largest category of beer retailers are Ma-anil-Pa liquor stores. These stores have had little pu chasing power and have, not aggressively sought to stock low-cost beers. In recent years, (9) Avenir. error bomen Japanese consy tun to discount liquor stores offering suvings of 25 percent or nce ‘on the same, Veet sold at family-run stores. Av the same tin a Japanese government continues to liberalize laws permitting the development of more dis- count stores. ‘These discount stores (and, to a lesser extent, the supermarkets that are slowly replacing neighborhood groceties) are willing to sell imported hers. Ihuports cost. two= thirds as much as domestic beers. To meet the challenge, the Japanese breweries introduced new low-malt Happoshu beers, Benefiting from lower taxes, Happoshu bcers sell for 30 percent less than regular beer, and have quickly, captured 40 percent of the overall beer market. Acthe same time, the Japanese breweries have diversified into hard liquor and other aleoholic beverages, in order to better serve discount stores looking for full-service suppliers. These strategies have helped forestall foreign ery, though aggressive pricing of Happoshu beers has depressed profits. This undoubtedly has contributed to deterring entry. i Tronically, though protected from entry in their home country, the Lig Japanese brew- eries ate aggressively expanding overseas. Asahi began producing beer in China in 1994, and now has 6 plants. Te also has a joint venture with Chinese brewer Tsingtao to produce and sell beer in third-world nations. At the same time, Kirin and Suntory have either acquired or entered into joint ventures with foreign dis- tillers and now sell hard liquor worldwide, Barriers to Exit To exit a marker, a firm stops production and either redeplays or sells off its assets. A change in ownership that dog not entail stopping production is not considered an exit. A risk-neutral, profit-maximizing firm will exit if the value of its assets in their best alternative use exceeds the present value from remaining in the market. How- ever, exit barriers can keep a firm in the market even when the prevailing conditions are such that the finn, had it known with certainty that these conditions would pre- vail, would not have entered in the first place. Figure 9.2 illustrates why this is so. “The price Poyay is the entry price—the price at which the firm is indifferent between entering the industry and staying out. The price Pag is the price below which the firm would either liquidate its assets or redeploy them to another market, Exit bari- ers drive a wedge between Pry, and Peyuy- Because Pou S Paguy firms may remain in a j310 Chapter 0¢ Fntry and Bxit Brunt 9.2 : a Tir Preers aye Iypvce EXERY AND Exit, MLWy DIR Average tural cost c Averaie varia Fane wll entre industry slong the var ice exceed Pyseyny the nina evel of average De Coat ens Fung eat the indy only fice Pent falls below Pps the minis level of average oe vatiable costs Pexiey 3 3 market even though price is below long-run average cost. I high ex, patriers are viewed negatively in an analysis of industry rival 2. whether or not they cease operations. Examples of such ees include be agreements and commitments to purchase raw materials. If #°firm has to pay off iets even if ie WOT production, the effective marginal cost of remaining in opera. ind exit i less attractive, Obligations to input suppliers are a more signif. cant exit barrier for diversified firms contemplating exit from a single marker, since the suppliers to a faltering division are aggyred payment out of the resources of the rest of the fir Reladonship-pecite jrodatuive ase will have a low resale value, and are thus a second exit barrier.” Government restrictions ace often a third exit harrier. For example, some states forbid hospitals to close without regulatory approval i @@ + @@ ENTRY-DETERRING STRATEGIES" Under what condi ns does it pay for incumbent firins to raise the barriers to entry into their market? At the most general level, entry-deterring strategies are worth- while only if wvo conditions are met: 1. ‘The incumbent earns higher profits as a mono 2. ‘The strategy changes entrants’ competition. polist than it does as a dhuopolist. expectations about the nature of postentry ‘The need for the first condition is obvious. The second conditi cause the entrant wll ignore any strategy that does not change its expectations chyrg postentry competition, rendering the strategy useless. . . It seems as if a firm is always better off as a monop well above average costs, But this may not always be thé case. [fa Honopolist cannot raise price above long-run average cost, the market is said to be perfectly contestable, colcept developed by Willian Rausuol, John Panzar, and Robert Willig te tec requirement for contestability is hit-and-run entry, discussed earlier. When a mo- roti ies price in a contetable market, hitand-nn entrane rapidly enter ne, fon is necessary be- + because it can set prices "Asset specific is discussed in Chapter 3. "aninol, W, J. Pansat, ane R. Willig, Contetable Markets and the Theory Struaure, New York, Harcourt Brace Jovanovich, 1982. of Industrial case, the n currently pr immediate yields zero | Contes from raisin, the theory Entry into routes. A ground per ity). To te Borenstein comparabl otherwise, monopoly both ends fares wil petition c: levels. Assun may expec ways in w 1. Limit 2. Pred 3. Capa Limit P Limit pric charging the ineut entry int Po i that will denotes able fixe there is call this the mar "he line Indy "Bi; 39, Mary Deters re rapidiy if 0 c incumbent seta price high enough, ee, reaps short te etaliates. ‘The hit-and ul for a long es n profi run et anu exits the market just as KC prospers as long as it ean, +10 tecover ity sunk entry costs. IF le. In that rts sunk ent'y cunts are Zer case, the market price can currently producing. If the irumediate entry, and price would fall yields zero profits, even when itis an a Contestability theory shgws how cre threat of entry can keep monopolists from raising prices, However, finding eontestable markets has proven abt Wl the theory was first leveloped, it was felt that it might apply ni Entry into the industry is fairly easy, HG especially by routes. A catrier can redeploy aireraft alinost uve erage cost, there would be ‘The incumbent has to chatge a price that PParent monopolist. the mn hen to the airline industry. established caniers entering new pay off might, and can secure gates and {0 Opera BP ground personnel almost as quickly (provided the airports involved are nel aaa re signi ig). To text contestability theory, Severin Borenstein examined alive wine Since the [J orenstein found that monopoly routes have higher fares than deonaly roster of he rest of FP comparable lengths, He conchided that airline markets are not pefocly conventables .and arg JJ otherwise, fares would be independent of concenteation, Ile alee faaed thor face Lier. Foy ff} monopoly routes are reduced when another attier is already operating at one or s d monopolists in these situations fear that high fares will isivite competition. Borenstein concluded that the threat of potential com- petdon causes the monopolist carrier to moderate its prices, but not to competitive levels. both ends of dhe route. Apparently, Assuming that the incumbent monopolist’s market is not perfectly contestable, it may expect ro reap additional profits ifit can keep out entrants. We now discuss three ° ENUY HB ways in which it might do so: worth- 1. Limit pricing _| 5 Predatory pricing ~~ ost. 3. Capacity expansion tentry , Limit Pricing oe Limit pricing refers to the practice whereby an incumbent finn discourages entry by charging a low price before entry occurs.” ‘The entrant, observing the low price set by prices fp the incumbent, infers that the postentry price would be as low or even lower, and that annor fp &BtY into the market would therefore be unprofitable. — ables 3 To illustrate how a firm might deter entry by limit pricing, consider a market ne kev fp at will last for two years. Demand in each year is given by P = 100 ~ Q, where P 1m. fp denotes price and Q denotes quantity. The production technology has nonrecover- Sthe fp able fixed costs of $800 per year, and constant marginal costs of $10. In the first year, there is a single firm with the Jechnological know-how to compete in this market. We call this firm N. Another firm that we call E has developed the technology to enter the market in year 2. Table 9.1 summarizes useful pricing and profit information rial “Borenstein, $., “Hubs and High Fares: Dominance and Market Power in the U.S. Air- line Industry,” RAND Journal of Economics, 20, 1989, pp. 344-365, Bain, J. S., “A Note on Pricing in Monopoly and Oligopoly," Arserican Economic Review, 39, March 1919, pp. 448-464. OOVaniy 91 Prick axp Prorits UNDER DIEERENT IONDILIONS ‘ Anminal Profit per Firm Marter Srmame Powe taal Tipe we $1238 Monopoly $100. ice to rea The secon APPrOPTIge dhe ine about this market. hy ofit-maximizing prices and quantities. a ‘t there Reena ae of entry, N would select the monopoly Price of $55 jx each year, eaing two-year total profits of $2,450. (For simplicvy, we i fect of discounting second-year profit.) Unfortunately for firm N, firm E might ente, the incumt in year 2. To determine if it should enter, E must anticipate the nature of postenty of $55, anc : competition. Suppose that when E observes N charging $55 in the first year, it con, then coo cludes that N will not be an aggressive competitor. Specifically, it expects th, lecs"In,* Cournot equilibrium to prevail in the second year, with both firms sharing the mar. nature of ket equally." Based on this expectation, E calculates that i will earn profits of $100;¢, can acqu it enters. If N shares E's belief that competition will be Cournot, then conditional oj 4. me entry, firm N would also expect to earn $100 in the second year. This would give ita e combined two-year profit of $1,325, which is far below its Ovo-year monopoly prof Outcome, of $2,450. behavior Firm N may wonder if it can deter entry. It could reason as follows: Sai I we set a low first-year price, perhaps E will expect the postentry price also wo be low. If" consider E expects the postentry price to be sufficiently low, then it will not enter, and we can earn to enter. monopoly profits in the second year. after entr. oe . is not ra : Following this logic, suppose that firm N selects a first-Vear price of $30. E may see aa } should s : his price and reason as follows: aa If firm N charges a price of $30 when it is a monopolist, then surely its price in the face of competition will be even lower. Suppose we enter and, optimistically, the price remains at FIGURE $30, so that total market demand is 70. If we can achieve a 50 percent market share, we LIMIT will sell 35 onits and realize profits of (30 ~ 10) 35} ~ 800 = ~$100. Ifthe price i below $30, we will fare even worse. We should not enter. If both firms follow this logic, then N should set a limit will earn ((30 ~ 10) X 70} ~ 800 = $600 in the first year and full monopoly prefiee of $1,225 in the second year, for toal profits of $1,825. This exceeds the profs it would have earned had it set the monopoly price of $55 in the first period the market in the second year. y : : Z Is Limit Pricing Rational? price of $30. By doing so, it and then shared ‘The lim ‘The logic of limit pricing is highly appealing. Yet economists have identified a ruum~_ dashed ber of problems with the limit pricing strategy. One problem isthe artificiality of potent two-year model, In a more realistic sting of more than two years mn N tuighe DE have to limit price every yer to constanly deter entry. Te would never gen vg ng th ' select d _ ——— period. depict. "Rec fom Chap that ina Coun eqilibrinm, ich Bom makes a ess ong ghee ‘s ve mit the: ” other's output, and the guesses prove to be correct. insice to teap the senopoly profits that i forsook whey dead ana tally se he ln pis The secon:! problem is revealed ' of the options available tr rng andl entrant firms, SX To see where the logic of limit pricing breaks dom we depict the ict the line prici the demans! and cost data from the p an a ml Wate calcula by using the incumbent's strategic choices are (P__ py ee ee ors an Prion thc pee eests Pe tele te mma eke then cogs fiom (a, Out). IE sees “Ouan tee Rega sles, ad lects “In,” then competition is played outin yrs 2 eters ses {eg ey thea competion i played out in yar 2. Wesapyoe ei SD cae N Hain the price a Py = 30, or it Petition, in which ease the price will be P. = Ts ach branch of the g The lim mb 23 Under by the dashed line in Figure 93, Unuler this putcome, finn N earns total profits of $1,825 and fin E eane $0, Tomeee a reese {a Milt pricing owtcome is not rational (nthe pula of gone theary leveloped in the Prinier, the outcome is nota “subgame peifet Noch soallocie’) 9 see why nor, we smist analyze the game using the Lol backs a ae consider the branch of the game tee in which E ignores sisi ia chooses to enter, According to the limit-pricing argument, I says ont acanse ie expoes thar after entry bas occurred, N will select Py. Buc examination ofthe game tree shows that it is not rational for N to select P, Conditional on entry having alreah iN wry having already occurred, should select 2. N would earn total profits of $700, which exceeds the profits of $500 it cams iit selectsP, Thus, E's expectation of N's postenuy behavior flawed. 5 9.3 shows that in year ty FIGURE Li PricinG: ExTeNsive For Game INCUMBENT ‘The limit pricing equilibrium is shown by the dashed line. The incumbent selects P, and the potential entrant stays out. This is not a subgame perfect Nash equilibrium, because if the potential entrant goes in, the incumbent will select the accommodating price P, in the second period. The subgame perfect Nash equlibrium is depicted by the heavy line. The incumbent ot ay So nae a credibly prevententy 9 S17 13s ig fash Naan sets P,, in the first perio See dhe Economics Primer for a discussion of the use of the “fold-back” method to de- termine subgame perfect equilibria,314 + Chapter 9 + Entry and Exit J will select PF should calculate its progh pied ee tet Pn ct Oe oe stig fr tage nF Sot eet Pa they — : O ee compe tion will be Cournot. This outcome is shoy,, Ca by the heavy solid line in Figure 9-3. i PLE According to this analysis, limit p that any price reductions before entry ar¢ ¢ bent to maintain low prices subsequent to entry DAE should an 4 fiom entry to be $100 ential entrants recogni Is because potenti et Sata and do not commit the iney, ‘Linrr Pricr Once entry occurs, it would maj) In. 1960, Xero ‘ce. fit opportuy;, copier, the firs 1 yess price. The lost profit opportun, 5 eee enna ela bi secare ane Now that the entrant is gj,» advantage of rejesce and maximize future profits, oxy called 3 |-world behavigg, O8Y being de ‘Though eminently logical, this argument flies in the face of real. Ad behz ior, Ss il i 9.5, which disco had several d it price, crated in Example 9-5, ad : Many is do occasional init pie, sisted in Exaile 9.5 00 alc) Ce chat ties from having previously set the li ready in the market, the incumbent will acquiese limit pricing by Xerox. ‘To understand why real i i Fe copy, anil:thy cepts of the model, tis helpful to fist dacass another enty-deterting strategy for) COPY, Nd 1 which economic models and real-world behavior sometimes diverge | oa . 7 | less per elect Predatory Pricing : fuse electrof | Xerox an ef Predatory pricing refers to the practice of setting a low price in order to drive other) eee firs out of business. The predatory firm expects that whatever losses it incurs while) CoS howe diving Competitors from the market can be made up'iater trough the exercise of] TEE price market power.” The difference between predatory pricing and limit pricing is that, Tern PU limit pricing is directed at firms that have not yet entered the market, whereas preda- Xerox | tory pricing is aimed at firms that have already entered, sliding fee The Chain-Store Paradox | orem ‘The idea that an incumbent can slash prices to drive out rivals and deter entry is highly intuitive. Yet i is possible to construct an example in which the int ‘The example is somewhat arti predation. ‘stone caret ion fails. costs, as we 1, but it helps us to hone our understanding about] electrofax fact, imc Ibnagine that a rational incumbent firm operates in 12 markets, and faces entry in Blacks ‘ach. By rational, we mean that the incumbent can correctly anticipate how its rivals _ oly price \ ill respond to its actions. In January, it faces entry in market 1; in February, it faces| Well above entry in market 2; and so on. Should the incumbent slash prices in Janusrea | fXerox s We can answer this question by working backward from December. to see how, ™ight.be | earlier pricing decisions affect Inter entry. Regardless of the course of aro tefne S0Re Tepé December, the incumbent wil find it optimal not to engage in y pricing i mde, ADP market 12. The reason is that there is no further entry to denen oe | twelfib market knows this and counting on the rationality of the incumbent | regardless of previous price cuts. Backing up to November: the fone Sil emer cummbent knows that it cannot deter entry in December in thes predatory: pricing in forward-looking in- | ie has no re: elfth market. ‘Thus, | tential entr: f prices again | completely + for a good review of | predatory p world in w | predatory p "See Martin, S., Industrial Economics, New York, } Tacmillan, the vatious legal tests for predatory pricing that have bee » 1988, ” proposed.Lan Pricine By XEROX In 1960, Nerox introduced the 914 plain paper copier, the first mass-marketed product to take advantage of the innovative copying technol. ogy called xerography. A competing technol- ogy being developed:at the 1 had several disadvantages. Ut required a paper coating that added $.01 to the cost of each copy, and the quality of its reproductions was ferior. When electrofax finally reached the market, copying centets had to’ charge $.005 less per electrofax page to induce customers to use electrofax instead of Xerox. This gave. Xerox an effective $.015 advantage per copy. Xerox, machines had higher manufacturing. costs, however. This translated into a higher retail price, which somewhat offset the lower effective cost per copy. Xerox usually leased copiers, charging.a sliding fee per copy depending on the number of copies made per month; Xerox sought a fee schedule that would deter entry. Edwin Black- ‘stone carefully examined, Xerox's prices and costs, as well as the prices and costs of the rival electrofax process to determine if Xerox did, in fact, limit price.’ Blackstone estimated that Xet oly, price was about $.10, per page, which, was "well above the average cost of electrofax copies. IfXerox set this price, electrofax manufacturers might be tempted to enter the market ,Black- stone reported that for small: customers, who made_ approximately ,1,000 ‘copies. per. month, ey electrofar, rox’s monop; + i 1 ' Strategies © 315 Xerox charged close:to the monopoly price. ? But. for medium and: large: customers, who? ‘made’ over ,2,000 copies per month, Xerox? charged only about $.05 per page S Blackstone: argued that these prices were consistent with’ a limit pricing strategy. The 914 had a high manufacturing cost, so that for small user,. the electrofax actually had a smaller effective cost per page. Xerox felt that it Gould not forestall entry into the stall cus- tomer segment;'and did not artifically reduce "its price. As a result, about 25 electrofax firins entered this end of the market by 1968. Xerox had a significant, cost advantage among smedium and large users, however. Tt could af- ford to reduce prices to medium and large «tomers, and. still, cover -average:costs. Xerox «sshoped.that this would limit entry. The strategy. . appeared to succeed; by 1968, only 10 electro- \ fax firms competed in,the medium and Jarge . Customer segments, {Xerox continued.to prosper in the plain ‘ipaper copier market, until the government forced it to share its technology (even before its patents expired) inthe early 1970s. Many companies,, including TBM. and Litton, then entered the market.,By 1978, Xerox's market" share’ of new copiers fell from 100 percent to about 40,percent, and prices fell by 30 percent. The price réductions: suggest that Xerox was + making substantial profits ‘even when it was * Time pricing. 0%, i has no reason to slash prices in November in ¢ he eleventh market either. The po- téntial entrant in the eleventh market can anticipate that the incumbent will not slash prices against it, and so enters wi completely unravels, so that te incumbent realizes that i ‘January in the first market! The striking conclusion is this: In a predatory pricing world in which all entrants could accurately pri predatory pricing would not deter entry, and ther: Blackstone, E. “Limit Pricing in the Copying Mat nomics and Business, 12 1972, pp. 57-65. hout fear of retaliation. In this way, the problem has nothing to gain from ‘edict the future course of pricing, efore would be irrational. chine Industry” Quarterly Review of Er-316 * Chapter 9 + Enuy and Exit without empirical support. Rs Mark Isaac af astonishing, and no re Sn Thich students played a pred, ‘ udu ‘an experiment in W icl dal se They coment suet " chraved in accordance with this theory.) a Cer cape Meetle of an incumbent for several periods, sq) their ceperiment, a student playe inert for sere bets el i " orf different students in each period. had com Ehret pea a Herne sanich found that “incumbent” studeng plete information about payofls. . did not slash prices - _ ae ciated with a punicial atte in not sls ies on x aeemingy rational is asocated with a pune) coding tos economies known as the chain-store parad ‘e"The paradox is that, despite the concly4._ its first-year p come ae ilng to deter entry is itraonal, many firms ae Coron pr) would be $52. ; eat weder pool cited earlier is\ong, cally, then icc ceived as slashing prices to deter entry. ‘The gunpo i then example. eee th wtovan-pasing cies in She Scenery itis Hele Si marginal cost. banklopcy, another, The paradoxis resolved by considering the roe of nceriny, could infer th would be prof Predation: The Importance Rescuing Limit Pricing and P | ginal costs ‘of $ of Uncertainty and Reputation | Tshould ey “The economic models presented above suggest that limit pricing and predatory pric.) to compet ing are irrational strategies, Yet anecdotal examples, and a few systematic analyses) which is w (uch as Blackstone's analysis of Xerox in Example 9-5), indicate that firms do pursue) would not them. One possible explanation is that firms set pricestirrationally. If this is correct) not to ent: {and we doubt that it often is), then this analysis should warn firms that limit prices) ye Don’t do it! Another explanation is that firms are rational, but that the analysis thy) cmnbent eo i far fails to capture important elements of their strategies. be ue eats th Game theorists have identified key conditions under which predatory actions may) incumbent wi be profitable. In general, entering firins must be wncertaig about some characteristic of) she potential the incumbent fen or the level of market demand. Reessmination of the Limit pricing) tp effect, a lo game shows why uncertainty is important. The incumbent wants the entrant to be- Garth S: lieve that postentry prices will be low. If the entrant is certain about what determines] rust be unal postentry pricing, the entrant ean analyze all possible postentry pricing scenarios and| showed that Correctly forecast the postentry price. Ifthe incumbent is best off selecting a high pos-| well as the ir tentry price, the entrant will know this, and will not be deterred from entering. |in which (a) if the entrant is uncertain about the postentry price, however, then the inrcum- its cost, and bent’s pricing strategy could affect the entrant's expectations. In a paper that ex-|low price si plored the rationality of limit pricing, Paul Milgrom and John Roberts argued that an demand a entrant is likely to know less about the incumbent's costs than the incumbent itself Simil oes” If so, by engaging in limit pricing the incumbent may influence the entrants [the conelus estimate of its costs, and thus shape its expectations of postentry profitability. “T it ldox app i fererate this argument, suppose that the entrant belictes that the ineumbec’s seat, behavior in ginal costis ether $5 or $10. Itexpects that postentry competition will be Courner Lirelde : ples mpetition will be Cournot, iFfational, ni fit knew for certain that the incunbent’s marginal cost is $10, then, a8 before che certainty, cntrant will expect profits of $100 in the second year and would wart oye lthe ines Pes abate fda reat po Ton gee eg ee ean a eae would expect profits of $56 and would not enter. » then the entrant ror sh Pr as ‘simply disti ‘ \nopolist. In %4saac, R. M. and V. Smith, “In Search of Predatory Pricing,” 1 . 93, 1985, pp. 320-345. 8 Journal of Polit Economy, the leaie °! This term was coined by the game theorist Reinhard Selten in hi a ida theri Store Paradox,” Theory and Decision, 9, 1978, pp. 127-159. “The Chain iif th ae Milgrom, P. and J. Robers, “Limit Pricing and Entry Under tncoy eet Econometrica, 50, 1982, pp- 443-460. mplete Information? |g S atticle, Salonaac ang Station eotys Th s,s «come Eotry-Detersing Strategies © 317 Ifthe incumbent did not think strateyicall i gical, it would set its first-year price ac cording to its marginal cost and the demnan ene: Ie margied een Ge its first-year price would be $55. If its marginal cast was $5. papa pick would be $52.50. If the entrant knew that the inewmbent was noe think marginal cost. For example, ifthe incumbent seta first-year price of 855, the entrant could infer that the incumbent's marginal cost was $10, and therefore that ent ‘would be profitable, Ifthe incumbent thinks strategically, however, then ifit has mnoc, sginal costs of $10, it may reason as follows: : a first-year price is one als into, tainty, should wy to convince the entrant that my marginal cost is $5, because it will not wane PM shih t okatthecraan eguenm Gan oeentoete Tee FOIE would creo ile war hdl Lagoon orhgirces tenses catnip doe ee oc a ; , done In their analysis, Milgrom and Roberts recognized that because a high-cost i cumbent could lower its price to disguise its costs, a low-cost incumbent would try t0 rake sure that the entrant would recognits its cat advantage, To do 40, ieee incumbent would lower its price by a sufficiently large amount below $52.50, so that the potential entrant is convinced that only a low-cost producer would price that low. In effect, a low price becomes a credible signal that the incumbent's cost is low. Garth Saloner has pointed out that for limit pricing to deter entry, the entrant nfust be unable to perfectly infer the incumbent's cost from its limit price.” Saloner showed that chis could oceur if the entrant was uncertain about the level of demand as ‘well as the incumbent's cost. These two types of uncertainty support an equilibrium in which (a) the incumbent pr!zes below its single-year monopoly price regardless of its cost, and (b) the lower the incumbent's cost, the lower the price that it sets. The low price signals to the entrant that the incumbent's costs may be low and/or market demand may be low. Either signal may deter entry. ‘Similar arguments explain why firms would want to set predatory prices, despite the conclusions of the chain-store paradox. Predatory pricing in the chain-store pa dox appears to be irrational because potential entrants ean perfectly predict incumbent behavior in every market and are certain that predatory pricing in the “last” matket is. irtational, no matter what has happened up to that point. But with a lite bit of | certainty, predation can make sense. Suppose that the entrant is uncertain about how ‘the incumbent would set prices in the very last period. An “easy” incumbent would | not slash prices, buta “tough” incumbent would. The incumbent might be tough be cause it has very low costs, and actually finds it optimal to slash prices. Or ie might simply dislike competition, even to the poinc of sacrificing profits to remain a mo nopolist. In any event, ifa firm believes that the ineumbent is easy, then it may follow the logic of the chain-store paradox and decide to enter. If the incumbent does not slash price in the first market (ie, in January), then other potential entrants may also think that itis easy. This is reinforced each time the incumbent accommodates entiy: Ifthe incumbent wants to deter entry, it must establish and maintain a reputation for roughness, beginning in January, In an experiment, Yun Joo Jung, John Kagel, and ns may of, stain, Environment niversty. See also Mathews, S. and L. Mi Stochastic Demand,” Econometrica, 51, 1983, *Saloner, G., “Dynamic Equilibeium Limit Pricing in an Unee mimeo, Graduate School of Business, Stanford U man, “Equilibrium Limit Pricing: The Effects of pp. 981-996.318 + Chapter 0 « Fntey and Est hen students playing 4 pre + enty and st redid ‘ash prices to deter entry. 7 cubes coe yal-Mart and American Airlines, enjoy | SS tae price competition led to the demnise oft : te egroweh ‘of strategies to increase market, shag, i ea nchieee dominant market shares, such as. Black any Tee be oa rket. Along these lines, firms may promot ee : 7 ¢ xa i" their share of the marh Jeeness in the market. Chaim Fershanan GS ennet Jud oa Wa i ie reaeghe want to reward managers ‘based on market share rather thay x " profits.”° “This will encoura fe them to price i firm's repatation for veoh. er ould ultimately lead to higher profits thang the best sellin managers were focusing on the bottom i sissippi. Proc “The chain-stoie paradox not only sheds light on the importance of uncertainy fea nea : rahe chain-stove ParrSonmibene” and ventrant” are arbitrary. Its feputation gj 1971 Ot incumbency per se, chat matters. An entrant might come into the market andy the Mio trices. If thse entrant bas reputation for toughness, the incumbent may elect toexiy C7, rather than try to ride out the price war. Be iroilacdonsi jase, Now cess Capacity atc ane gers in Cle Many firms carry excess capacity. To measute capacity stlization, every year the US, orclevision Census of Manufacturers asks plant managers to state the levels of current and de oupons,in- sired production. The resulting ratio, called capacity we, is typically about 80 percent) ail, Gener Firms hold more capacity than they use for several reasons. In some industries, itis and in-pack ‘economical to add capacity only in large increments. If firms build capacity ahead of centives for demand, then such industries may be characterized by periods in which firms carry, Even so, Fe excess capacity. Downturus in the general economic business cycle, or a decline in) Cleveland m psu about Dan Levin fo t incumbent's tendencies, ‘Some well-known firms, reputation for toughness carne vals, Aggressiveness is also a 18 demand for a single firm can also create excess capacity. Firms in imperfectly compe! By 197 itive industries may be profitable when operating at capacity. Other firms may then. Maxwell He center seeking a share of those profits, creating excess capacity. In these examples, ex Folger’s “d cess capacity results from market forces. IF Gaaagal Firms may also hold excess capacity for strategic purposes. By holding excess ca-| throughout pacity, an incumbent may affect how potential entrants view postentry competition,“ Foods adop nd thereby blockade entry. Unlike predatory pricing and limit pricing, excess capac, “defend no ity may deter entry even when the entrant possesses complete information about the, limit Folge incumbent's strategic intentions. ‘The reason is that when an incumbent builds excess)‘ This strate capacity, it can expand output at a relatively low cost. Facing competition, the incuni.| _ ing, alton bent may find it desirable to expand its output considerably, regardless of the impact) Maxwell 1 on the entrant's profits. This will have the effect, intended or not, of substantiall 4 | fee below a ducing the entrants postentry profits, If postentry profits ae less than the aunke Seve, these instn of entry, the entrant will stay out. The monopolist incumbent may even decide notte, the Federal | of this cas | sold below ® Jung, ¥. Ju.J- Kagel, and D. Levin, “On the Existence of Pre . | (from 1973 mental Study of Reputation and Entry Deterrence in the Gan eitony Pricing An Experts Eeonontics, 25(1), 1994, pp. 72-93. Fe Game,” Rand Journal of) ershuman, C. and K. Judd, “Equilibrium Incentives ix us - Review, 77, 1984, pp. 927-940. ives in Oligopoly," American Economit NThis ex : Corp., reprint ‘ J. and P. Nels Foods) Case,” Foresman, 19% 2 Hike a Re Genainty, n, not slash O exit, al of mic Correr Wars" In 1970, General Foods! Maxwell House was the best selling brand of cotfee east of the Mis- Sisippi. Procter and Gamble’s (P&G's) Fol set brand was the best seller to the west. In 1971, P&G started selling Foler’s in parts of the Midwest and East where it had not sold before, P&G first introduced Folger’s in Cleveland in 1971. P&G followed this with in- troductions in Pennsylvania in 1973, and Syra- 1974, before expanding o promote Fol- of television advertising, retailer's promotions, coupons, in-pack gifts, and free samples in the mail, General Foods responded with mailed and in-pack coupons as well as promotional in- centives for retailers to sell Maxwell House. __ Even so, Folger’s claimed 15 percent of the Cleveland market in is first year. By 1972, executives in General Foods’ Maxwell House division were concerned about Folger’s “disturbingly successful” entry into Cleveland and feared similar successes throughout the East. At that point, General * Foods adopted what came, to be known as its “defend now” strategy, Which attempted to limit Folger’s share in the' Fast to 10 percent. This strategy involved heavy price discount- ing, although General Foods instructed its Maxwell House executives! not to sell the cof- fee below average variable costs. Regardless of these instructions, evidence presented during the Federal Trade Commission’s investigation of this case suggest that Maxwell House was sold below average variable cost in Cleveland (from 1973 to 1974), Pittsburgh (from 1973 to This example draws on the Federal Trade Con Conp,, reprinted in Antitrust and,Trade Régulation Report, May 3, 1984, pp. 888-905; and Hilke, 3 J.and P. Nelson, “Strategic Behavior and Attempted Monopolization: The Coffee (General Foods) Case,” in Kwoka, J-and L. J. White (eds.), The Antitrust Revolution, Glenview, IL, Scott Foresman, 1989, pp. 208-246. 2Hfilke and Nelson, op. cit. pp. 235-236. 3Re General Foods Corp., 901 1975), and Syracuse (from 1974 Maxwell House also introduced a so-called fighting brand (Horizon) explicitly to disrupt Folger’s launch in Philadelphia and Syracuse. “The evidence suggests that Lorizon was also priced below its average variable cost. Te certainly appears that General Foods was signaling to P&G that it intended to fight aggressively to defend its domiinant position in eastern markets. Internal General Foods’ doc- uments seem to confirm this. They spoke of a desire to “delay Folger expansion,” to “force them to carefully consider the financial wis- dom of farther eastern expansion,” and to en- gage in “eye-for-eye” retaliation.” In 1976, the staff of the Federal ‘Trade Commission charged General Foods with at- tempted monopolizatior unfair competition, and price discrimination in the ground-coffee market. In 1984, the full Commission exoner- ated General Foods. The commission rea soned that the relevant coffee market was the United States as a whole (as opposed to i vidual, geographically based markets) and that within this broader market General Foods did not possess the market power to raise prices above competitive levels should other éom- petitors exit. As a result, the Commission con- cluded, “Maxwell House did come dangerously close to gaining monopoly power as a result of any of its challenged conduct in any of the alleged markets. As a result, its ac~ tions were output-enhancing and procompeti- tive—the kind of conduct the antitrust laws seek to promote.”” not nission’s opinion in General Foods320 * Chapter 9+ Entry and Exit rs the idle capacity serving #5 4 eredible commitreny «| utilize al its capacity, with i Abescell cape it should entry occur ‘inn i el jer which a tag can successfully deter entry by holding excess oe are when stainable cost advantage. This gives it an +The ncumbent should havea sustainable come ste 1 | advantage in the event of entry and a sul ; i \d will quickly outstrip or patents + Market demand growth is slow. Otherwise, demand will quickly outstrip ot capacity. : Otherwice 4, | Hered Be + Theis i capacity must be sunk prior to entry. Otherwise, the | credibly c aan pe incumbent to backoff inthe event of price war vn i is fog Petail mar * ‘The potential entrant should not itself be attempting t establish a reputation, reanai a for toughness, \\ cause of it {much to | - 1’ jes, and “Judo Economics” and the “Puppy-Dog Ploy’ ales: a In this chapter, we have provided examples in which an incumbent firm has used jy_pectation size and reputation to put smaller rivals at a disadvantage. Sometimes, howeye;) Barnes & sinaller firms and potential entrants can use the incumbent's size to their own advan) selling rc tage. This is known as “judo economics.”** Consider that when an incumbent slashes Nets prices to drive an entrant from the market, it sacrifices its own short-run profits. The. its new | larger is the incumbent, the greater the loss. If an entrant can convince the incum.| other ex bent that it does not pose a significant long-term threat to the incumbent's profitabil. customi: ity, the incumbent might think twice about incurring large losses to drive the entrant, would b from the market. This example of judo economics is closely related to the “puppy., plorer. dog ploy” described in Chapter 8. | why wo An example is provided by Braniff Airlinés. Restaurateur and doll company owner, tomizat Jeffrey Chodorow and real estate developer Arthur Cohen purchased a struggling) Hal Vat Braniff in 1988. Braniff went bankrupt the next year. In settling the Braniff assets, Ye" by Chodorow and Cohen bought the rights to the Braniff trademark for $313,000, took “¢*S ©! over bankrupt Enierald Airlines, and combined the wo into a new Braniff. Braniffpub- 1940 st licly announced in the spring of 1991 that it intended to limit its flights from Dallas to ™€"S Los Angeles, New York, Florida, and the Caribbean. Braniff started flying scheduled trips in June 1991. Ie had some immediaté setbacks, including flying a banned Boeing > 4.4-7 727 into Los Angeles International Airport (the plane violated local-noise- pollution of dinances) Bue Branifts fate was sealed even before i : re its frst scheduled figh amore that many believe was prompted by Braniffs reentry into is rani a allis, American Airlines imzoduced “value pricing” on May 27, 1991, tgaering he Price war that drove Braniff rom the market for good two months ater, ? eee eee Irie had stayed trae to its word, Banff would have eamied cy 3 cmp many passengers as American, So why did Amer oe Ord ce prices ™ Based on Lieberman, Marvin B., “Strategi ' merci sent Review, Summer 1987, pp. 19-25." ™*Bit® for Capacity Expansion,” Sloan Manag’: PY PE Gelman, J. and S, Slop, “Judo Economics: Capaci year tion,” Bell Journal of Eznomic, 14, 1983, pp, 315-395 7 mitation and Coupon Compet- en : ab lov 2 ‘| mere 1 has ‘ ‘aA - , _ , Strategies + 324 oF patents deter future entrants, the puppy-dog ma sponse. Even if American was unconcerned sons Rar, lieved BranifP’s promise to stay small, In general, th credibly commit not to grow. | : ‘A more successful example is provided by Amazon’ ction pest ae ee h to lose by entering the on-line segment. This would quickly legitimize on-line Noble's bricks-and-mortar sales. As it turned out, ‘Armaan ded ceynd the ee pectations of most market analysts, legitimizing the scewr wiioee ap tele Row Barnes & Noble. Despite its late start, Bornes & Noble has also done well on Tine, selling roughly half as many books on-line as Amazon. : Netscape’s announcement-in January 1998 that it id make th that it would make the source code of its new browser, Communicator 5.0, freely available on the Intemes, ons yet i other example of judo economics. This move enabled sophisticated programmers to customize the Communicator browser to their own idiosyncratic needs. Many firms would be expected to prefer such a customized product to Microsoft's Internet Px- plorer. Given that Microsoft seemed on the verge of dominating the browser market, why would Microsoft not limit the impact of Netscape’s move by permitting cus- tomization of its own Internet Explorer browser? As explained by Carl Shapiro and Hal Varian, Microsoft would be unlikely to do this because its success had been dri ven by uniformity—all users of Internet Explorer have identical sofiware Gust as users of Microsoft operating systems have identical sofiware).”® Though Netscape judo strategy was successful for a while, ‘Microsoft eventually used its clout with PC. makers and retailers to establish Internet Explorer as the dominant web browser. ect with an aggressive re- mre entry, it might not have be- here are few ways that a firm can pinediately ExrT-PROMOTING STRATEGIES Firms occasionally contend thie their rivals are slashing prices to drive them from the market. The complaining firm also argues that consumers should object to low prices, because eventually the’price slasher will have monopoly power, raise prices, ind more than recoup its losses. Oil refiners alvanced these arguments when they at- tempted to break up the Standard Oil Trust 100 years ago. Ia 1993, three drugstores in Conway, Arkansas, made 4 similar claim about the local Wal-Mart store. ‘They fart under state antitrust statutes and won 2 $300,000 award, plus a coure Srder forcing Wal-Mart to increase its drug prices. Complaints about unfsily low prices are common during trade disputes. In 1991, the U.S. Department of Com merce ruled that Toyota and Mazda were dumping minivans into the U.S. market— by pricing below cost—although the International Trade Commission (IT) ruled a year later that American automakers were not harmed by such practices and wers No YeWtled ro compensation (begging the question of why Toyota and Mazda would sell low cost in the fist place). In a seeming replay ofthis dispute in 2000, the Com: merce Departnent ruled that Japanese manufacturers were dumping seamless h Shapiro, C. and H. Varian, “A Judo Blow Aga Jinst Microsoft,” Wall Street Journal, Keb- muary 2, 1998, section I, p. 22. \ 4i cent. Two years later, the ty ort tariffs as high as 150 percent. TW0 9 the rr Lee US manufacturers opening the door to end renee The European Commission has leveled ‘dumping charges against Czg he tari J Europe i “y nations of dumping steel. The inte sree Thniland has accused 14 nations of du sel ake an aa alsa Taxation (GATT 8 feqvently repay ated to deal with complex dumping issues. p22 + Chapter 8 * Entry and stainless steel and se found no evidence of harm against Wars of Attrition y Jiminate competition and uj, ‘An aggressive firm supposedly starts a price war to elisa e mately reap monopoly profits. This presumes that the rival would exit before the ag freseor abandoned its strategy. It is not obvious why th DuPont ould happen. A price wy = MARKET Rorine al firm in the market regardless of who started it. 1h a6 one might em. Panta Gs dames incumbent can sustain fosees better than its smaller rivals (© Peesiee 7M expansion | Fee caaaaen to lines of credit), then it should be able to outlast them: In this ease, the 1970s. the large firm is said to have “deep pockets” from which it can finance the price war) seq in pai Gas the other hand, a large firm may also suffer greates losses during the price wai; umber of especialy if ie had higher sales before the war began, and did not have a cost advat) MP wbich i tage over smaller rivals. In this cise, the large firm may seek to stop the price wart ond learni t stem its losses. (This is another variant of judo economics.) virmally e Price wars are examples of wars of atrition. In a war of attrition, two or more par! “The Jone. ties expend resources battling with each other. Eventually, the survivor claims its re- on the “cl : ward, while the loser gets nothing and regrets ever participating in the war. Ifthe wat the 1940s. lasts fong enough, even the winner may be worse off chan when the war began, be; process cause the resources it expended to win the war may exceed its ultimate reward. Besides, cost rutile price wars, many other types of interactions are wars of attrition. The U.S./Soviet nu-) a decides Hear arms buildup between 1945 and the late 1980s is a classic example, Both coun-) process, 2 tries spent huge sums to increase their nuclear arsenals, each hoping that the other| those bui country would be the first to make concessions. Eventually, the Soviet Union fell) costs for apart, and Russia acknowledged that it could not afford to carry on the buildup. American Virtually all firms are worse off during a prolonged price war. If the price war, Jowenou drives some firms from the market, however, the survivors can raise prices above the. ‘tl for t pre-price war levels Ifa firm were certain that it would lose a price war, it would pre-| 19705, P fer to exit the market as soon as the price war began. By.exiting immediately, it would, e sulfa avoid the costly battle that it expected to lose anyway’ If no firms exit in the early, "= COS trages of price war, the war may last so long that all firms, including the survivors,| menite lowe In tha’eoel. This may fuer: oeomved in the pen rors among "warthone cult jo ; : ' : club stores during the early to mid-1990s.” Afcer exit by several rivals, Sam's Club uly. Md § tnately emerged with the largest share of this market. But it suffered auch snajo! Potts losses during the price war that it might never recover them, such major) mand. fe “The more that a frm believes it ean outlast its sivas, the more willing ie will be| eed toenter and sustain a price war. Firms may even try to convince their rivet gree) Rested are better positioned to survive the ptice war. For example, ims mey cra Cat ey |. tons Of are actually making money during the price war, or that they cai ‘ay claim that they elected 7 , = Fe tore about win- ning the war than about making money. Either message may cause a ri mut win. 500,000 use a rival to rethink | share o F | iteould Warehouse clubs are less luxurious versions of mass twerchandisers cause (% Wal-Mart. They offer ates al soins on cy Purchases, They are ony a5 Target and on cle shoppers must pay a nominal fe to become members. led clubs becauyz ™OSt © "Costs o! We Bi Aa |nore par ns its re- f the war egan, be; I. Besides oviet nu th coun- he other | nion fell p. price war above the ould pre it would the early | survivors, use cub” Club ulti- ch major it will be that they that they pout wil o rethink € XAMPL DuPoNt's Use OF Excess Car, MARKET FOR TYTANIUM D1oxIDE Pankaj Ghemawat analyzed DuPont's capacity expansion in the titanium dioxide industry in the 1970s.” Titanium diodide is a whitener used in paints, paper, and plastics. ‘There are a number of ways of making titanium dioxide, all of which involve substantial economies of scale Jand learning economies. Until the mid-1960s, virtually every firm used the “sulfate process.” “The lone exception was DuPont, which relied on the “chloride process” that it developed in the 1940s, DuPont’s chief raw material in th process was ilmenite. ‘The discovery of low- cost rutile ore—a substitute for ilmenite—gave a decided cost advantage to the cliloride process, and all new chloride units, including those built by DuPont, used rutile. Margitial costs for existing sulfate producers (mainly American Cyanamid and Glidden) were still Jow enough, however, that it was not economi- ‘cal for them to switch processes. In the early 1970s, pollution control legislation rendered the sulfate process unworkable and increaseil the costs of using rutile ore. “The cost of using ilmenite was unaffected. DuPont recognized that its competitors would soon lose 160,000, tons of sulfate’ process capacity. DuPont also forecast that de- mand for titanium dioxide! would grow by 377,000 tons in 13 years. Thus, DuPont ex- pected that the industry would need $37,000 tons of additional capacity. In 1972, DuPont elected to “preempt” the market by adding 500,000 tons'of capacity. It targeted a matket share of 65 percent by 1985. DuPont felt that i could expand faster than its competitors be- cause (a) its competitors had to spend money ‘on cleanup that DuPont, using ilmenite in most of its plants, did not; and (b) it had lower costs of using ilmenite, due to scale and learn- & "Ghemawat, P, “Capacity Expansion in the Titanium Dioside Industry,” Journal of In- dustrial Economics, 33 2), 1984, pp. 145-163. ry TO CONTROL TY ics. Overall, DuPont believed that its costs were about 22 percent lower than its competitors, so that they would he reluctant © compete head to head a Of course, there is a lag between planining to add capacity and having capacity in place. Daring this lag, DiPoiné was volnerabil to ex- pansion by competitors. In 1974, Kerr-MeGee responded to a shortage of titanium dioxide by starting constriction of a 50,000-ton plant. DuPont tried 'td forestall additional entry. Te let its coitipeiiors kivow the magnitude of its planned exjunsioiloF dxisting facilities, and falsely aniiodinced that it had begun construct- ing a new 130,000:ton’ facility. DuPont also appears to have limit priced-setting prices just under the averige total ‘costs of production in the new plants. DuPont's competitors, holding out for higher prices, refused to match. While market forces had historically forced all sellers to charge the sanié price, this two-tiered pric , ing structure persisted beciuise DuPont lacked capacity to handle’thé' whole market. When demand ‘slickenéd ‘inearly “1975, DuPont's competitors, lost substantial sales and were forced to ineet DuPont's price. When, demarid ,remained soft through 1975, DuPont; reexamined, its preemy strategy. It recognized that the costs of adding ‘apacity would be’ substantial, since it could never hope to ramp up production a * pally planned: Te 4lso realized that competitors were moving down’ the Iéamning curve and would be at’ [és of ‘a cost disadvantage. DuPont was prepareid to expand capacity as originally planned—on a faster timetable—but only if demand recovered: When demand did not recover in 1976, DuPont scaled back its capacity expansion. I"824° Chayer 9 + Futry and bait ‘exit the market early. (An ang, saul ta outlast is oppeniton, and encourage i eo ext he AEA An a xy in the aris race is Ronald Reagan's pronouncen survive amd win a miclear war.) example fk ee air ae oe oer supe gees Hovluction levels maybe niferent suo renin 818 ing a price war thany Ag2sine production altogether. ‘This finn has les to lose during 2 p fir that can adjust its input costs. MIDENC: EE ON ENTRY-DETERRING BEHAVIOR THMNnUel theorists have devoted considerable atention to entry dese cee, there id eataie evidence repatding whether firms pursue entry-deterring strateg and, if they do, whether these sik a ae cele Mow of ou Crdevce re loathed est €38¢s, where discovery requirements often provide researchers with dletailed cost, matker au strategic falornnon (Pankaj Ghemawat used such‘ face to analyze many ofthe entry-detering strategies DuPont used in the market for titanium dioxide in Example 97 ‘Thete may be little evide titeust cases for several reasons. F lever entry, because this may be sen trust statutes. Second, short-term monopoly price. practice, the researcher would ne, the degree of industry comp teases, sich measure the success of an entry deterrence from sources other than an. 2 Gnen are natal reluctant vo report that they nsitive, competitive information and might also vi- hy entry-deterring strategies involve pricing below To assess whether a firm was engaging in such a ed to know the firm's marginal costs, its demand petition, and the availability of substitutes. Out formation is difficult for researchers to obtain. Finally, to Table 9.2 ly, 0% goad enti pgouve for frequen olate the rely much cutry-deterring strategy, a researcher would need to deer, ee thac 3 lilevte gece ate of entry would hae been without the predatory ee This, too, isa difficult question to answer Survey Data on KE Despit try Deterrence Satay concerns about the wi ——— miley asked major consumer product maker terting strategies." Smiley surveyed proc thei whether they used several sta 1. Aggressive price reduct advantage that later entran 2. Intensive advertising 3. Acquiring ngness of fins to.srovide frank responses, Robert hey pursued a variety of entry-de- t managers at nearly 300 firms, He seed tegies discussed inthis chapter, including: # Eouy and ex ns to move down the learning curve, nts could only match by investing inl to create hand loyalty Patents for all varionts of a product ancing firm's reputation for predation though giving the firm a cost learning themselves announcements or some o Limit pricing 6. Holding excess capacity ‘The first three strategies create hi entry costs, ‘The last three change the entra expectations of poster competition i ‘Smiley, R., “Empirical Evidence on Strateg Indratrial Organization, 6, 1988, pp. 167180. ry Deterrence,” International,Sounnary © 325, Limit Bao New Prosucts Pricing Capuing Frequently Occasional Seldom Existing Proxtucts Frequently Occasionally Seld Table 9.2 reveals the percentage o ucts and existing products. Note that managers were kel slant oglolig the hove ing curve for new products only. More than balf ofall prniucs emoeecs sencped casional use of one or more entry-deterring strategies, Product managers rejort hat they rely rnuch snore extensively on strategies that inerease entry cost, rahe ato strategies that affect the entrant's perception about postentry competition, SUMMARY Ina typical industry, one-third of the firms are less than five will exic within the nest five yeas. $ Enury and exit are perv years ol, and one-third of A Ginn will enter a matket if it expects postentry profits to exceed the sunk costs of enty Factors that reduce the likelihood of entry are called entry bariers A firm will exit a market if it expects Future losses to exceed the sunk costs of ext Seructural entry barriets reste from exogenous market forces. Low demand, high capital Tequiresnens, and limited access to resources are all examples of structural entry barriers Ext barriers arise when firms must meet obligations whether they produce or not, [An incumbent firm can use predatory acts to deter entry or hasten exit by competivos Limit pricing, predatory pricing, and capacity expansion change entrants! forecasts ofthe profitability of postentry competition, Limit pricing and predatory pricing can suceee! only ifthe entrant i uncertain about he ‘nature of postentry competition. ; Finns may hold excess capacity to credibly sigal thee itent co Tower prices inthe eves of entry. to promote exit by rivals. Once a firms realizes that it cannot survive a price war, it exits, permit 1-6 Tee A A vive a price crete Seca em may try to convince is als likely to survive a p war to hasten the rival's exit ? to hasten the Fira ary deterring strategies, especially. (0 J in en Managers repore that they frequently engege 19 protect new products. *326 © Chapter 9 + Fatey and Exit QUESTIONS 1, Dunne, Roberts, and Saniuelson found that industries with high entry rates tended t0 aly) have high exit rates, Can you explain this finding? What does this imply for pricing strat, gies of incumbent firms? | 2. Dunne, Roberts, and Samuelson examined manufacturing industries in the 1960s to 1980, | Do you think that entry and exit rates have changed in the past two decades? Do you thing that entry and exit rates are systematically different for service and retail industries? 3. “AIL else equal, an incumbent would prefer blockaded entry to deterable entry? Comment. 4. Explain why economies of scale do not protect incumbents from hit-and run-entry unles ‘th the associated fixed costs are sunk. Does the learning curve limit contestibility? eve 5. How a firm behaves toward existing competitors is a major determinant of whether it will of face entry by new competitors. Explain. ‘ so) 6. Why is uncertainty a key to the success of entry detetvence? i 7. An incumbent firm is considering expanding its capacity. It can do so in one of two Ways He + Tecan purchase fungible, general-purpose equipment and machinery that can be resold zt : close to its original value. Or it can invest in highly specialized machinery which, once itis th put in place, has virtually no salvage value. Assuming that each choice results in the same production costs once installed, under which choice ig the incumbent likely to encountera kK greater likelihood of entry and why? A 8. In most models of entry deterrence, the incumbent engages in predatory practices. that i. hharm a potential entrant. Can these models be reversed, so that the entrant engages in predatory practices? If so, then what are the practical differences between incumbent and si entrants? 9. Recall the discussion of monopolistic competition in Chapter 6. Suppose that an entrepre- neur considered opening a video store along Straight Street in Linesville. Where sheuld the entrepreneur positon the store? Does your answer depend on whether further entry is fi expected? : 10. Consider a firm selling tyo products, A and B, that substitute for each other. Suppose that an entrant introduces a product th: will affect (a) whether a price wa identical to product A. What factors do you think \ tiated, and (b) who wins the price war?Web asennis 14 F Sostubal Wary e Internal Baetor Evaluation (EE) mattiy steyie man ‘He Mangement wl For auditing ar gvubuating major steengths and weaknesses inf veuknesses in finetional twas of a business, ‘wt c E mati also provides a bisi P basis for ideutityin The Internal Factor valu, ‘wal evaiating rel tmyermal Factor Evaluation wists or show HT nag tating relationships among those areas, ‘watts is sed in strategy formulation ‘The IEE Matis toy L ornttation tool that ean be wttized vo vate how a compan ssttorning in rey ie ‘sears to identified intemal strengths aul Weaknesse ofa company. The IFE matix method conceptually relates to the 1 ates to the Balan oat in some aspects How to create the IPE matrix? The IFE matris can be created using the following five steps Key internat facto Conduct internal audit and identity both strengths and weaknesses in all your b anid weaknesses in all your business areas. It is suggested you identity 10 1020 internal factors, Lut the more you ean provide fur the IEE matuis, he number of factors has no effect on the range of (otal weighted scores ( h e zhis always sum to 1,0, but it helps to diminish estimate eirors resulting from subjective ratings. First, list strengths and then weaknesses. It is wise to be as specitiv and objective as possible, You can for example use percentages; ratios, and comparative numbers. Weights... Having identified strengths and weaknesses, the core of the IFE matrix, assign a weight that ranges from 0.00 to 1 00 to each fuctor, The weight assigned to a given factor indicates the “relative importance of the factor. Zero means not important One indicates very important, If you than 10 factors in your IFE matrix, i can be easier to assign weights using the 0 ess of whether a Key factor is an infernal strength or fest importance in your organizational perfoumance should be ssign weight to individual fae work with mo to 100 scale instead of 0.00 fo 1.00, Regard weakness, factors with the great tors, make sure the sum of assigned the highest weights! Alier you as rals 1,00 (or 100 if using the 0 to 100 se factor to being & factor indicates the relative importance of the f re industry based. (ll weights equ sale weights). ‘The weight assigned to a given ! successful in the firm's industry. Weights al Rating... ‘Your raving scale can be per your preference, Pracitione’s atures whether the factor represents major = 3), or a mayor actor 1 1 to 4. Rating cap Assign a! to X rating to each f ie 2), a minor strength (rating gale fron i weakness (riliNg = usually use rating on the weakness (rating = 1), 4 miner