Chapter 6: Entry & Exit

What are different forms of entry for a firm?

• Entry Could Take place in different forms

• An entrant may be a brand new firm

(Example: Dreamworks SKG)
• An entrant may also be an established firm that is diversifying into a new
product/market (Example: Microsoft entering gaming systems market)

Why is the form of entry important?

• The form of entry is important when we analyze entry costs and strategic response to
entry by the incumbents

What are different forms of exit for a firm?

• Exit could also take different forms

• A firm may simply fold up (Example: PanAm, Sabena)
• A firm may discontinue a particular product or product group (Consumer imaging
by AGFA, Virgin cola by Virgin) or leave a particular market (Peugeot leaves the U.S.
market)

What are certain implications that can arise for firm strategies that are trying to diversify?
• As part of planning for the future, managers should account for the unknown future
competitors
• Diversifying firms pose a greater threat to the incumbents since they tend to build
bigger plants than other entrants

What are the important implications that managers should be aware of in entry & exiting of
a market?
• Managers of new firms need to find capital for growth since survival and growth go
hand in hand
• Managers should be aware of the entry and exit conditions of the industry and how
these conditions change over time due to technological changes, regulation and
other factors

What are the cost benefit analysis for entering a market?

Do you think the sunk costs are low or high?

● A potential entrant compares the sunk cost of entry with the present value of
the post-entry profit stream
● Sunk costs of entry range from investment in specialized assets to
government licenses
● Post-entry profits will depend on demand and cost conditions as well as the
nature of post-entry competition
 WHAT ARE SUNK COSTS?

A sunk cost, sometimes called a retrospective cost, refers to an investment already

incurred that can't be recovered. Examples of sunk costs in business include
marketing, research, new software installation or equipment, salaries and benefits, or
facilities expenses.

What are the existing barriers to entry ?

Structural or Strategic

What are the types of entry conditions that exist?

Three types of entry conditions:

• Accommodated entry (no or unadequate barrier)
• Deterred entry (mostly because of strategic barrier)
• Blockaded entry (mostly because of structural barrier)
Blockaded Entry Entry is blockaded if structural barriers are so high that the incumbent need do nothing to
deter entry. For example, production may require large fixed investments relative to the size of the market (high
sunk entry costs), or the entrant may sell an undifferentiated product for which it cannot raise price above
marginal cost (low postentry profitability).

Accommodated Entry Entry is accommodated if structural entry barriers are low, and either (a) entry-deterring
strategies will be ineffective or (b) the cost to
the incumbent of trying to deter entry exceeds the benefits it could gain from keeping the entrant out.
Accommodated entry is typical in markets with grow- ing demand or rapid technological improvements. Entry
is so attractive in such markets that the incumbent(s) should not waste resources trying to prevent it.

Deterred Entry Entry is deterred (a) if the incumbent can keep the entrant out by employing an entry-deterring
strategy and (b) if employing the entry-deterring strategy boosts the incumbent’s profits. Frank Fisher calls such
entry-deterring strategies predatory acts.6 Predatory acts may either raise entry costs or reduce postentry profits.
We describe several predatory acts later in this chapter.

What are barriers to entry?

• Barriers to entry are factors that allow the incumbents to earn economic profit
while it is unprofitable for the new firms to enter the industry
• Barriers result in deterred or blockaded entry
• Barriers to entry can be classified into :
• Structural barriers to entry and
• Strategic barriers to entry

INCUMBENT MEANING = THOSE THAT ARE ALREADY WELL ESTABLISHED IN

THE MARKET AND HAVE MAJORITY OF SHARES IN IT

What are the different types of structural barriers to entry?

The three main types of structural barriers to entry are:

1. Control of essential resources by the incumbent:

An incumbent is protected from entry if it controls a resource or channel in the verti- cal chain and can
use that resource more effectively than newcomers.

Some firms attempt to purchase the resources and channels in the vertical chain, preventing potential
entrants from acquiring raw materials and/or getting final goods to market.

Firms that attempt to secure their incumbency by tying up the vertical chain face several risks. First,
substitutes can emerge. Second, new channels can open. Third, the price to acquire other firms in the
vertical chain can be excessive.

Incumbents can legally erect entry barriers by obtaining patents to novel and nonobvious products or
production processes. An individual or firm that develops a marketable new product or process usually
applies for a patent in its home country.

Entrants can try to “invent around” existing patents. This strategy can succeed because a government
patent office sometimes cannot fully distinguish between a new product and an imitation of a protected
product and also because courts may be reluc- tant to limit competition.

As a result, some innovations, such as rollerblades and the personal computer, seem to have had no
patent protection whatsoever.
Incumbents may not require patents to protect specialized know-how.

2. Economies of scale and scope

When economies of scale are significant, established firms operating at or beyond the minimum
efficient scale (MES) will have a substantial cost advantage over smaller entrants.
This analysis presumes that there is some asymmetry giving the incumbent the advantage in market
share. We can easily imagine this advantage to be the incumbent’s brand reputation, built up through
years of operation. The entrant might try to over- come the incumbent’s cost advantage by spending to
boost its market share. For example, it could advertise heavily or recruit a large sales force.

The first is the direct cost of advertising and creating the sales force, costs that the incumbent may have
already incurred. Second, the entrant must also be concerned that if it ramps up production, the
incumbent may not cut back its own output, as many of the incum- bent’s costs associated with
procuring inputs and paying for labor are sunk. Recall from Chapter 5 that when overall industry output
increases, prices and individual firm profits fall. The entrant thus faces a dilemma: to overcome its cost
disadvantage, it must increase its market share. But if its share increases, prices will fall.

Fierce price competition frequently results from large-scale entry into capital- intensive industries
where capital costs are largely sunk
Incumbents may also derive a cost advantage from economies of scope.

Diversified incumbents may also enjoy scope economies. For example, there are significant economies
of scope in producing cereal, stemming from the flexibility in materials handling and scheduling that
arises from having multiple production lines within the same plant. These economies make it relatively
inexpensive for an incumbent to devote part of an existing production line to a new formulation. A
newcomer might have to build an entire new production line, putting much more capital at risk.

Incumbents have established brand names that give them marketing economies (such as Kellogg’s
Bite-Size Mini-Wheats, a spinoff of Original Frosted Mini- Wheats). Entrants would have to build
brand awareness from scratch, and it has been estimated that for entry to be worthwhile, a newcomer
 would need to intro- duce 6 to 12 successful brands.10 Even when incumbents enjoy advantages, the
principle that profits attract entrants remains in effect.

SHORTER:
• If economies of scale are significant, incumbent may face a high threshold of
market share to be profitable
• Incumbent’s strategic reaction to entry may further lower price and cut into
entrant’s profits
• If entrant succeeds, intense price competition may ensue

3. Marketing advantage of incumbency

umbrella branding, whereby a firm 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 product markets. An incumbent can
exploit the umbrella effect to offset uncertainty about the quality of a new product that it is intro- ducing. The
brand umbrella makes the incumbent’s sunk cost of introducing a new product less than that of a new entrant
because the entrant must spend additional amounts of money on advertising and product promotion to develop
credibility in the eyes of consumers, retailers, and distributors.
The umbrella effect may also help the incumbent negotiate the vertical chain. If an incumbent’s other products
have sold well in the past, distributors and retailers are more likely to devote scarce warehousing and shelf space
to its new products.

A brand umbrella may increase the expected profits of an incumbent’s new product launch, but it might also
increase the risk. If the new product fails, consumers may become disenchanted with the entire brand and
competitors may view the incum- bent as less formidable. Thus, although the brand umbrella can give
incumbents an advantage over entrants, the exploitation of brand name credibility or reputation is not risk free.

SHORTER:
• Incumbent can exploit the brand umbrella (different products sold under the same
brand name) to introduce new products more easily than new entrants can
• The brand umbrella can make it easy for the incumbent to negotiate the vertical
channel (Example: It is easier to get shelf space with an established brand)
• Exploitation of the brand name and reputation is not risk-free: if the new product is
unsatisfactory, customer dissatisfaction may harm the image of the rest of the
brands

THESE ARE USUALLY USED FOR LACK OF BARRIERS - WHAT IS MISSING:

What are the deterring (discourage) strategic barriers to entry?-WHAT CAN BE CONSIDERED
MISSING
• Some examples of entry deterring strategies are
• limit pricing:
• An incumbent using the limit pricing strategy will set the price sufficiently low to
discourage entrants
• The entrant observes the low price and concludes that the post entry price will be
low as well and decides not to enter

• predatory pricing:
• A firm using the predatory pricing strategy sets the price below short run marginal
cost with the expectation of recouping the losses when the rival exits
• Limit pricing is directed at potential entrants while predatory pricing is directed at
entrants who have already entered
• capacity expansion
• By holding excess capacity, the incumbent can credibly threaten to lower the price
if entry occurs
• Since an incumbent with excess capacity can expand output at a low cost, entry
deterrence will occur even when the entrant is completely informed about the
incumbent’s intentions
• For these strategies to work
• Incumbent must earn higher profits as a monopolist than as a
duopolist; and
• The strategy should change the entrants’ expectations regarding post-entry
competition

lack of capacity expansion: means that sometimes others believe that the market is
does not have enough of this thing

Is Predatory pricing considered rational?

• If all the entrants can perfectly foresee the future course of incumbent’s pricing,
predatory pricing will not deter entry
• In experimental settings with complete information, predation did not occur
• Chain store paradox: Many firms commonly perceived to engage in predatory
pricing (cf. backward induction or the failure of intuition; p. 211)

Under what situations does limit pricing work?

Limit pricing will work if the incumbent has a cost advantage over the entrant
• With a cost advantage, the incumbent can set the price slightly below entrant’s
minimum average cost, ensuring that entrant can not make profits
• Limit pricing will work if the entering firm is uncertain regarding the market
demand or some determinant of post-entry pricing such as incumbent’s marginal
cost
• If entrant can predict post-entry price, its decision to enter or not will be
independent of the incumbent’s strategy

Under what situations does predatory pricing work?

• With uncertainty, predatory pricing can deter entry
• If the incumbent does not slash prices, other challengers may consider him
‘easy’ rather than ‘tough’
• An incumbent can be ‘tough’ either due to low costs or due to an irrational desire
for market share
• To deter entry, incumbent has to establish a reputation for toughness

Under what situations does excess capacity pricing work?

• Incumbent has a sustainable cost advantage
• Market demand growth is slow
• Incumbent cannot back-off from the investment in excess capacity
• Entrant is not the type trying to establish a reputation for toughness

Under what exceptions to excess capacity pricing work?

What are exceptions as to why there might not be entry deterring strategies?
1. Contestable Markets and Entry Deterrence
• In a perfectly contestable market, a monopolist sets the price at competitive levels
• If there is a possibility of a hit and run entry (zero sunk cost) the market is
contestable
• If the market is contestable, it is not worth the monopolist’s while to adopt
entry deterring strategies

What are exceptions as to why there might not be entry deterring strategies?

Exceptions:
2. Entrant’s Strategy: “Judo Economics”
● If the entrant can convince the incumbent that it does not pose a long-
term threat, incumbent may be reluctant to adopt costly entry deterring
strategies (using the opponent’s strength to one’s advantage)
● Netscape’s open source strategy may be Judo move against Microsoft, whose
strength is in standardized rather than customized software.

Why excess capacity is not always considered strategic?

• When capacity addition has to be lumpy, firms may often have excess capacity in
anticipation of future growth
• A temporary down turn in demand may leave the firms in an industry with excess
capacity with no strategic overtones
What are considered evidence on the use of entry deterring strategies?
Reported Use of Entry Deterring Strategies
● Aggressive price reductions to move down the learning curve;
● Intensive advertising to create brand loyalty;
● Acquiring patents;
● Enhancing reputation for predation using announcements and other means;
● Limit pricing;
● Holding excess capacity.

Why is there a need to control essential resources?

• Nature may limit the sources of certain inputs and the incumbents may be in
control of these limited sources
• Patents can prevent rivals from imitating a firms products
• Special know how that is hard for the rivals to replicate may be zealously guarded
by the incumbents

What is a hit and run type of entry?

HIT AND RUN STRATEGY —> CONSIDERED TO HAVE LITTLE, TO ALMOST NO SUNK COSTS
• Economies of scale and scope deter entry only if the entrant cannot recoup the
up-front entry costs
• If up-front costs are not sunk costs, entrant can come in on a large scale and exit if
incumbents retaliate = hit and run strategy
• However, economies of scale and scope may often require up-front sunk costs

What are the barriers to exit?

• Barriers to exit are factors that make the firm continue producing under such
conditions which would not have encouraged the firm to enter
• Examples of such barriers are specialized assets labor agreements, commitment to
suppliers and governmental regulations