Strategic entry deterrence
In business, strategic entry deterrence refers to any action taken by an existing business in a particular market that discourages potential entrants from entering into competition in that market. Such actions, or barriers to entry, can include hostile takeovers, product differentiation through heavy spending on new product development, capacity expansion to achieve lower unit costs, and predatory pricing.[1] Although many barriers to entry are created by incumbents, timing can also act as a barrier to entry, as potential entrants are less likely to enter into a market if it will take a significant amount of time for them to catch up to an incumbent, while they incur costs and lose profit in the process.[2] Barriers to entry are sometimes deemed anti-competitive and can be subject to various competition laws.
Limit price
In a particular market an existing firm may be producing a monopoly level of output, and thereby making supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these profits. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly level, a strategy known as limit pricing. Not only will this reduce the profits being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory to produce the extra capacity, for it to be a credible deterrent.
Signaling
The incumbent firm has an advantage of being the "first mover" and can therefore act in a way that it knows will influence the entrant's decision. If we assume imperfect knowledge (i.e. the incumbent firm's costs are only known privately) the entrant can only make assumptions about the incumbent's cost structure through its price and output levels. Therefore, the incumbent can use these as a signal to any potential entrant.
One way of using this advantage to deter entry is to charge a price less than the monopoly level. If an entrant is considering entry in a number of similar markets, a low cost incumbent can signal its efficiency to a potential entrant through lowering prices – thereby discouraging what the entrant believes would be unprofitable entry. Signaling needs to be credible to be effective – a low cost firm must be able to show that it can withstand lower profits for an extended period of time, which it would not be able to if it had higher costs.
Preemptive deterrence
An incumbent who is trying to strategically deter entry can do so by attempting to reduce the entrant's payoff if it were to enter the market. The expected payoffs are obviously dependent on the number of customers the entrant expects to have – therefore one way of deterring entry is for the incumbent to "tie up" consumers.
The strategic creation of brand loyalty can be a barrier to entry – consumers will be less likely to buy the new entrant's product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.
Similarly, if the incumbent has a large advertising budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large sunk cost that will prevent some firms entering.
Monsanto engaged in preemptive deterrence when it signed contracts with Coke and Pepsi. Because Monsanto locked in the consumers of Coke and Pepsi through its contracts, it made entry into the soda market less desirable because potential entrants would have less consumers and, in turn, less profit. Furthermore, if another firm decided to enter the market and obtain contracts with other soda brands, it would be less likely to attract as many customers as Monsanto because customers are loyal to Coke and Pepsi due to their popularity.[2]
Predatory pricing
In a legal sense, a firm is often defined as engaging in predatory pricing if its price is below its short-run marginal cost, often referred to as the Areeda-Turner Law, which forms the basis of US antitrust cases. The rationale for this action is to drive the rival out of the market, and then raise prices once monopoly position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter. According to Luís M. B. Cabral, as long as a potential entrant believes that an incumbent will take action to limit its profits, strategies like predatory pricing can be successful, even if the entrant misreads the situation and the incumbent does not act aggressively towards other entrants.[2]
In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm's best response in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is "weak" and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its "hard" reputation. One such example occurred when British Airways engaged in a competition war with Virgin Atlantic throughout the 1980s over its transatlantic route.[3] This led to Virgin Atlantic chairman, Richard Branson, to say that competing with British Airways was "like getting into a bleeding competition with a blood bank."[4]
Doomsday device
The threat to fight any potential entrant is credible if its reputation is built up, or it can set up conditions that make it optimal to fight if a rival enters.
If there are relatively low barriers to exit within a market, an incumbent competing against a more efficient rival may find it optimal to exit the market rather than fight. Hence, one way to make a fighting threat credible is for the incumbent to artificially raise the cost of exit, for example by having high sunk costs.
Examples of this are railroad companies. The high sunk cost of laying a network of railway lines makes it likely that a rail operator will be willing to fight a more costly price war than a rival with lower sunk costs, for example an airline that can switch its aircraft to another route relatively easily. At the extreme, if the incumbents sunk costs are very high, any entry by a rival will end in a mutually destructive outcome.
See also
References
- Tutor2u Barriers to Entry - Strategic Deterrence Retrieved on 28 July 2007
- Cabral L.M.B. (2008) Barriers to Entry. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London.
- Old Red Lion Virgin Atlantic Airways - The Dirty Tricks Episode Retrieved on 16 July 2007
- Think Exist Richard Branson Quotes Retrieved on 1 August 2007