Exit and Entry
-
Upload
srikanth-gera -
Category
Documents
-
view
231 -
download
0
Transcript of Exit and Entry
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 1/92
ENTRY AND EXIT ENTRY AND EXIT
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 2/92
2
Entry Entry
Entry is pervasive in many industries and
may take many forms
1. An entrant may be a new firm, that is, one
did not exist before it entered a market.2. An entrant may be a firm diversifying its
product line; that is, the firm already exists
but had not previously been in that market.
3. An entrant may be a firm diversifyinggeographically, that is, the firm sells the same
product in other geographic markets.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 3/92
3
Entry Entry
The distinction between new anddiversifying firms is important, such as
when we assess the costs of entry and
when we consider strategic responses to it.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 4/92
4
Exit Exit
Exit is the reverse of entry
the withdrawal of a product from a
market, either by a firm that shuts down
completely, or by a firm that continues to
operate in other markets.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 5/92
5
The Study by Dunne, Roberts and The Study by Dunne, Roberts and
Samuelson Samuelson
The DRS findings have four important implicationsfor strategy:
1. When planning for the future, the manager mustaccount for an unknown competitor-the entrant.Fully one-third of a typical incumbent firm¶scompetition five years hence are not competitorstoday.
2. Not many diversifying competitors will build newplants, but the size of their plants can make them athreat to incumbents.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 6/92
6
The Study by Dunne, Roberts and The Study by Dunne, Roberts and Samuelson Samuelson
3. Managers should expect most venturesto fail quickly. However, survival and
growth usually go hand in hand, so
managers of new firms will have to find
the capital to support expansion.
4. Managers should know the entry and
exit conditions of their industry.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 7/92
7
H yundai¶s entry into the steel H yundai¶s entry into the steel
industryindustry
In December 1997, Hyundai announced that it
would enter the steel business.
It would have a production capacity of 6million tons per year.
The government had opposed the plan.
The dominant firm, POSCO, was once owned
by the government.
The government still owns a major portion of
the shares of POSCO.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 8/92
8
H yundai¶s entry into the steel H yundai¶s entry into the steel
industryindustry
POSCO had a production capacity of 26
million tons.
No other company has a mill
approaching 6 million tons, the minimum
efficient scale.
POSCO priced below the competition,
and did not have enough capacity to meet
industry demand.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 9/92
9
H yundai¶s entry into the steel H yundai¶s entry into the steel
industryindustry
Without POSCO, its customers wouldhave to turn to imports.
Hyundai felt that demand for steel would
continue to grow. Without a new plant,
Korea would have to import steel.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 10/92
10
H yundai¶s entry into the steel H yundai¶s entry into the steel
industryindustry
Hyundai had many good reasons to enterthe steel market:
With demand forecast to grow, themarket was ripe to enter.
Hyundai felt it could be more efficient
than POSCO.Hyundai consumes so much steel itself that it can achieve minimum efficientscale without selling to the market.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 11/92
11
H yundai¶s entry into the steel H yundai¶s entry into the steel
industryindustry
The Korean government discouraged
Hyundai from building the plant,
claiming that demand was likely to
slacken.
The Korean government¶s forecast
turned out to be correct after all.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 12/92
12
Entry and Exit Decisions Entry and Exit Decisions
A profit-maximizing, risk-neutral firm
should enter a market if the sunk costs of
entry are less than the net present value of expected post-entry profits.
There are many potential sunk costs to
enter a market, ranging from the costs of
specialized capital equipment to
government licenses.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 13/92
13
Entry and Exit Decisions Entry and Exit Decisions
Post-entry profits will vary according to
demand and cost conditions, as well as
the nature of post-entry competition.
The potential entrant may use many
different types of information about
incumbents, including historical pricingpractices, costs, and capacity, to assess
what post-entry competition may be like.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 14/92
14
Entry and Exit Decisions Entry and Exit Decisions
If the potential entrant expects post-entry
competition to be fierce, then it is morelikely to stay out. Even when the potential
entrant believes that post-entry
competition will be relatively mild, it may
not enter if there are significant barriers
to entry.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 15/92
15
Barriers to Entry Barriers to Entry
Barriers to entry are those factors thatallow incumbents to earn positiveeconomic profits, while making itunprofitable for newcomers to enter theindustry.
Barriers to entry may be structural orstrategic.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 16/92
16
Barriers to Entry Barriers to Entry
Structural entry barriers result when theincumbent has natural cost or marketingadvantages, or benefits from favorableregulations.
Strategic entry barriers result when theincumbent aggressively deters entry.
Entry-deterring strategies may includelimit pricing, predatory pricing, andcapacity expansion.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 17/92
17
Bain¶s Typology of Entry Conditions Bain¶s Typology of Entry Conditions
1.B
lockaded Entry: Entry is blockaded if structural barriers are so high that the
incumbent need do nothing to deter
entry.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 18/92
18
Bain¶s Typology of Entry Conditions Bain¶s Typology of Entry Conditions
2. Accommodated Entry: Entry is
accommodated if structural entry barriers
are low, and either (a) entry-deterringstrategies 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. Accommodatedentry is typical in markets with growing
demand or rapid technological improvements.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 19/92
19
Bain¶s Typology of Entry Conditions Bain¶s Typology of Entry Conditions
3. Deterred Entry: Entry is deterred if (a)
the incumbent can keep the entrant out
by employing an entry-deterring
strategy, and (b) employing the entry-
deterring strategy boosts theincumbent¶s profits.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 20/92
20
Entry Conditions Entry Conditions
Bain argued that an incumbent firm
should analyze the entry conditions in its
market and choose an entry-deterring
strategy based on these conditions.If entry is blockaded or accommodated,
the firm need do nothing more to deter
entry.If entry is deterred, the firm should
engaged in a predatory act.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 21/92
21
Entry Conditions Entry Conditions
To assess entry conditions, the firm mustunderstand the magnitude of structural
entry barriers and consider the likely
consequences of strategic entry barriers.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 22/92
22
Structural Entry Barriers 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
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 23/92
23
Control of Essential ResourcesControl of Essential Resources
An incumbent is protected from entry if it controls a resource necessary forproduction.
DeBeers in diamonds, Alcoa inaluminum, and Ocean Spray incranberries all maintained monopoliesor cartels by controlling essential inputs.
This suggests that firms should acquirekey inputs to gain monopoly status.
However, there are several risks to thisapproach.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 24/92
24
Control of Essential ResourcesControl of Essential ResourcesJust When the firm thinks that it has tied upexisting supplies, new input sources mayemerge.
Owners of scarce resources may hold out forhigh prices before selling to the would-bemonopolies.
There is a regulatory risk associated with
attaining monopoly status throughacquisition. Antitrust laws in many countriesforbid incumbents with dominant marketshare from preventing competitors fromobtaining key inputs.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 25/92
25
Control of Essential ResourcesControl of Essential Resources
Incumbents can legally erect entry
barriers by obtaining a patent to a novel
and nonobvious product or productionprocess.
In Europe and Japan, the patent rights
go to the first person to apply for the
patent. In the United States the first
person to invent the idea gets the patent.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 26/92
26
Control of Essential ResourcesControl of Essential Resources
Patents are not always effective entry
barriers because they can often be³invent around.´
Incumbents may not need patents to
protect specialized know-how. Coca-Colahas zealously guarded its cola syrup
formula for a century.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 27/92
27
Economies of Scale and Scope Economies of Scale and Scope
When economies of scale are
significant, established firmsoperating at or beyond the
minimum efficient scale (MES)
will have a substantial costadvantage over smaller entrants.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 28/92
28
Economies of Scale and Scope Economies of Scale and ScopeThe entrant might try to overcome the
incumbent¶s cost advantage by spending to
boost its market share. For example, it couldadvertise heavily or form a large sales force.
However, it involves two important costs.
1. The direct cost of advertising and creating the
sale force.
2. The indirect cost associated with a strategic
reaction by the incumbent.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 29/92
29
Economies of Scale and Scope Economies of Scale and Scope
If the incumbent responds to a decline in its
market share by reducing its price, this willcut into the entrant¶s profits.
The entrant faces a dilemma: To overcome its
cost disadvantage, it must increase its market
share. But if its share increases, pricecompetition may intensify.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 30/92
30
Economies of Scale and Scope Economies of Scale and Scope
Fierce price competition frequently
results from large-scale entry into
capital-intensive industries.
Incumbents may also derive a cost
advantage from economies of scope. The
ready-to-eat breakfast cereal industryprovides a good example.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 31/92
31
Economies of Scale and Scope Economies of Scale and Scope
Economies of scale and scope create barriers to
entry because they force potential entrants to
enter on a large scale or with many products toachieve unit cost parity with incumbent firms.
Entering at a large scale or scope is
disadvantageous only to the extent that the
entrant cannot recover its up-front entry costsif it subsequently decides to exit (i.e., only if the
up-front entry costs are sunk costs).
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 32/92
32
Economies of Scale and Scope Economies of Scale and Scope
An entrant whose up-front entry costswere not sunk could come in at a largescale, undercut incumbent firms¶ prices,
and exit the market and recover its entrycosts if the incumbent firms retaliate.This strategy is known as hit-and-runentry.
Sunk costs, not economies of scale orscope per se, represent the underlyingstructural barrier to entry.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 33/92
33
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustry
For several decades, the industry has
been dominated by a few firms, includingKellogg, General Mills, General Foods,and Quaker Oats, and there has beenvirtually no new entry since World WarII.
There are significant economies of scopein producing and marketing cereal.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 34/92
34
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustry
Economies of scope in production stemfrom the flexibility in materials handlingand scheduling that arises from havingmultiple production lines within the same
plant.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 35/92
35
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustry
Economies of scope in marketing are dueto substantial up-front expenditures onadvertising that are needed for a newentrant to establish a minimum
acceptable level of brand awareness.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 36/92
36
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustry
If has been estimated that for entry to be
worthwhile, a newcomer would need tointroduce 6 to 12 successful brands.Thus,
capital requirements for entry are
substantial, making entry a risky
proposition.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 37/92
37
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustryAn incumbent launching a new cerealwould not face the same up-front costs as
a new entrant. The incumbent hasalready established brand nameawareness and may be able to usefacilities to manufacture its new cereal.
This explains why new products areprofitable for incumbents butunprofitable for new entrants.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 38/92
38
The readyThe ready--toto--eat breakfast cereal eat breakfast cereal
industryindustry
Despite the near total absence of entry by
outsiders, incumbents increased the number of
cereals offered for sale from 88 in 1980 to over200 in 1995.
High profit margins eventually invited limited
entry by private-label manufacturers.
Most of the successful newcomers have chosen
niche markets in which they may try to offset
their cost disadvantage by charging premium
prices.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 39/92
39
M arketing Advantages of M arketing Advantages of
Incumbency Incumbency
Umbrella branding (a firm sells differentproducts under the same brand name) is
a special case of economies of scope, butit is an extremely important one in manyconsumer product markets.
An incumbent can exploit the umbrella
effect to offset uncertainty about thequality of a new product that it isintroducing.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 40/92
40
M arketing Advantages of M arketing Advantages of
Incumbency Incumbency
The brand umbrella makes the
incumbent¶s sunk cost of introducing a
new product less than that of a newentrant, because the entrant must spend
additional amounts of money on
advertising and product promotion todevelop credibility in the eyes of
consumers, retailers, and distributors.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 41/92
41
M arketing Advantages of M arketing Advantages of
Incumbency Incumbency
Although the brand umbrella can giveincumbents an advantage over entrants,
the exploitation of brand namecredibility or reputation is not risk free.
The incumbent may suffer more thannewcomers if consumers¶ dissatisfaction
with the new product leads them todoubt the quality of the rest of theincumbent¶s product line.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 42/92
42
M arketing Advantages of M arketing Advantages of
Incumbency IncumbencyThe umbrella effect may also help theincumbent negotiate the vertical chain. If
an incumbent¶s other products have soldwell in the past, distributors and retailersare more likely to devote scarcewarehousing and shelf space to its newproducts. Suppliers and distributors may
be more willing to make relationship-specific investments.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 43/92
43
Barriers to Exit Barriers to Exit
To exit a market, a firm stops productionand either redeploys or sells off its assets.
A risk-neutral, profit-maximizing firm will
exit if the value of its assets in their bestalternative use exceeds the present valuefrom remaining in the market.
Exit barriers commonly arise when firmshave obligations that they must meetwhether or not they cease operations.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 44/92
44
Barriers to Exit Barriers to Exit
Examples of such obligations include:
1. Labor agreements and commitments topurchase raw materials.
2. The low resale value of the relationship-specific productive assets.
3. Government restrictions.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 45/92
45
Entry Entry--Deterring Strategies Deterring Strategies
Entry-deterring strategies areworthwhile only if the following two
conditions are met:1. The incumbent earns higher profits as
a monopolist than it does as aduopolist.
2. The strategy changes entrants¶expectations about the nature of post-entry competition.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 46/92
46
ContestabilityContestability
If a monopolist cannot raise price above long-run average cost, the market is said to beperfectly contestable.
The key requirement for contestability is hit-
and-run entry.When a monopolist raises price in a contestablemarket, a hit-and-run entrant rapidly entersthe market, undercuts the price, reaps short-
term profits, and exits the market just asrapidly if the incumbent retaliates.
The hit-and-run entrant prospers as long as itcan set a price high enough, and for a longenough time, to recover its sunk entry costs.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 47/92
47
ContestabilityContestability
If the sunk entry costs are zero, then hit-and-run entry will always be profitable.I
n that case, the market price can neverbe higher than average cost, even if onlyone firm is currently producing. If theincumbent raised price above averagecost, there would be immediately entry,
and price would fall. The incumbent hasto charge a price that yields zero profit,even when it is an apparent monopolist.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 48/92
48
ContestabilityContestability
Contestability theory shows how the
mere threat of entry can keep
monopolists from raising prices.
However, finding contestable markets
has proven difficult.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 49/92
49
Entry Entry--Deterring Strategies Deterring Strategies
Assuming that the incumbentmonopolist¶s market is not perfectlycontestable, it may expect to reapadditional profits if it can keep outentrants. We discuss three ways inwhich it might do so:
1. Limit pricing2. Predatory pricing
3. Capacity expansion
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 50/92
50
Limit Pricing Limit Pricing
Limit pricing refers to the practicewhereby an incumbent firmdiscourages entry by charging a low
price before entry occurs.The entrant, observing the low priceset by the incumbent, infers that thepost-entry price would be as low oreven lower, and that entry into themarket would be unprofitable.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 51/92
51
Limit Pricing Limit Pricing
The logic of limit pricing is highlyappealing. Yet economists have identifieda number of problems with the limitpricing strategy.
As the incumbent might have to limitprice every year to constantly deter entry.
It would never get to raise price to reapthe monopoly profits that it forsook whenit initially set the limit price.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 52/92
52
Limit Pricing Limit Pricing
Limit pricing fails because potential
entrants recognize that any pricereductions before entry are artificial,
and do not commit the incumbent to
maintain low prices subsequent to
entry.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 53/92
53
Limit Pricing Limit Pricing
Once entry occurs, it would make nosense for the incumbent to continue tosuppress price. The lost profit
opportunities from having previously setthe limit price are sunk. Now that theentrant is already in the market, theincumbent will acquiesce and maximize
future profits.
Many firms do occasionally limit price(i.e., Xerox).
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 54/92
54
Predatory Pricing Predatory Pricing
Predatory pricing refers to the practice
of setting a low price in order to drive
other firms out of business.The predatory firm expects that
whatever losses it incurs while driving
competitors from the market can bemade up later through the exercise of
market power.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 55/92
55
Predatory Pricing Predatory Pricing
The difference between predatory pricing
and limit pricing is that limit pricing isdirected at firms that have not yet
entered the market, whereas predatory
pricing is aimed at firms that have
already entered.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 56/92
56
The ChainThe Chain--Store Paradox Store Paradox
The idea that an incumbent can slash
prices to drive out rivals and deter entryis highly intuitive.
Yet it is possible to construct an example
in which the intuition fails.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 57/92
57
The ChainThe Chain--Store Paradox Store Paradox
Regardless of the course of action before thelast entrant, the incumbent will find it optimalnot to engage in predatory pricing in the lastmarket. The reason is that there is no further
entry to deter.
The last entrant knows this, and counting onthe rationality of the incumbent, will enterregardless of previous price cuts. Knowing
that it cannot deter entry in the last market,the incumbent has no reason to slash prices inthe previous market.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 58/92
58
The ChainThe Chain--Store Paradox Store Paradox
In a world in which all entrants could
accurately predict the future course of pricing, predatory pricing would not
deter entry, and therefore would be
irrational.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 59/92
59
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
Game theorists have identified keyconditions under which predatoryactions may be profitable.
Entering firms must be uncertain aboutsome characteristic of the incumbentfirm or the level of market demand.
The incumbent wants the entrant tobelieve that post-entry prices will be low.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 60/92
60
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
If the entrant is certain about whatdetermines post-entry pricing, the
entrant can analyze all possible post-entry pricing scenarios and correctlyforecast the post-entry price.
If the incumbent is best off selecting a
high post-entry price, the entrant willknow this, and will not be deterred fromentering.
Th I t f U t i t dTh I t f U t i t d
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 61/92
61
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
If the entrant is uncertain about thepost-entry price, then the incumbent¶spricing strategy could affect the
entrant¶s expectations.An entrant is likely to know less aboutthe incumbent¶s costs than theincumbent itself does. If so, by engaging
in limit pricing the incumbent mayinfluence the entrant¶s estimate of itscost, and thus shape its expectations of post-entry profitability.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 62/92
62
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation ReputationGarth Saloner has pointed out that for limitpricing to deter entry, the entrant must beunable to perfectly infer the incumbent¶s cost
from its limit price.Saloner showed that this could occur if theentrant was uncertain about the level of demand as well as the incumbent¶s cost.
The low price signals to the entrant that theincumbent¶s costs may be low and/or market
demand may be low. Either signal may deterentry.
Th I f U i dTh I f U i d
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 63/92
63
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
Similar arguments explain why firms wouldwant to set predatory prices, despite theconclusions of the chain-store paradox.
Predatory pricing in the chain-store paradoxappears to be irrational because potentialentrants can perfectly predict incumbentbehavior in every market and are certain thatpredatory pricing in the ³last´ market is
irrational, no matter what has happened up tothat point.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 64/92
64
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation ReputationWith a little bit of uncertainty, predation canmake sense. In any event, if a firm believes thatthe incumbent is easy (not slash prices), then it
may follow the logic of the chain-store paradoxand decide to enter. If the incumbent does notslash price in the first market, then otherpotential entrants may also think that it is easy.This is reinforced each time the incumbent
accommodates entry.If the incumbent wants to deter entry, it mustestablish and maintain a reputation fortoughness.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 65/92
65
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
Some well-known firms, including Wal-Martand American Airlines, enjoy a reputation fortoughness earned after fierce price competition
led to the demise of rivals.Some firms announce a mission to achievedominant market shares, such as Black andDecker. These announcements may effectively
signal to rivals that these firms will dowhatever is necessary, even sustain price wars,to secure their share of the market.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 66/92
66
The Importance of Uncertainty and The Importance of Uncertainty and
Reputation Reputation
Firms may promote toughness by rewarding
workers for aggressiveness in the market. A
firm might want to reward managers based onmarker share rather than profits. This will
encourage them to price aggressively, thereby
enhancing the firm¶s reputation for toughness,
and could ultimately lead to higher profits thanif managers were focusing on the bottom line.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 67/92
67
Coffee WarsCoffee Wars
In 1970, General Foods¶ Maxwell Housewas the best selling brand of coffee east
of the Mississippi. Procter andGamble¶s Golger¶s brand was the bestseller to the west.
In 1971, P&G started selling Folger¶s in
parts of the Midwest and east.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 68/92
68
Coffee WarsCoffee Wars
To promote Folger¶s, P&G used a combinationof television advertising, retailer¶s promotions,coupons, in-pack gifts, and free samples in the
mail. General Foods responded with mailedand in-pack coupons, promotional incentivesfor retailers to sell Maxwell House, and heavyprice discounts.
It appears that General Foods was signaling toP&G that it intended to fight aggressively todefend its dominant position in eastern markets.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 69/92
69
Excess Capacity Excess Capacity
Many firms carry excess capacity. The
capacity use is typically about 80 percent.
Firms hold more capacity than they use for
several reasons.
1. In some industries, it is economical to add
capacity only in large increments. If firms
build capacity ahead of demand, then such
industries may be characterized by periods
in which firms carry excess capacity.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 70/92
70
Excess Capacity Excess Capacity
2. Excess capacity results from market forces.
Downturns in the general economic business
cycle, or a decline in demand for a single firmcan create excess capacity. Firms may be
profitable when operating at capacity, but
other firms may then enter seeking a share of
those profits, creating excess capacity.3. Firms may hold excess capacity for strategic
purposes.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 71/92
71
Excess Capacity Excess Capacity
By holding excess capacity, an incumbentmay affect how potential entrants view
post-entry competition, and therebyblockade entry.
Excess capacity may deter entry evenwhen the entrant possesses complete
information about the incumbent¶sstrategic intentions.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 72/92
72
Excess Capacity Excess Capacity
The reason is that when an incumbentbuilds excess capacity, it can expand
output at a relatively low cost.Facing competition, the incumbent mayfind it desirable to expand its outputconsiderably, regardless of the impact on
the entrant¶s profits. This will have theeffect of reducing the entrant¶s post-entryprofits.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 73/92
73
Excess Capacity Excess Capacity
If the post-entry profits are less than the sunk
costs of entry, the entrant will stay out. Theincumbent may even decide not to utilize all of
its capacity, with the idle capacity serving as a
credible commitment that the incumbent will
expand output should entry occur.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 74/92
74
Excess Capacity Excess Capacity
An incumbent firm can successfullydeter entry by holding excess capacityunder the following conditions:
1. The incumbent should have asustainable cost advantage. This gives itan advantage in the event of entry and asubsequent price war.
2. Market demand growth is slow.Otherwise, demand will quicklyoutstrip capacity.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 75/92
75
Excess Capacity Excess Capacity
3. The investment in excess capacity must
be sunk prior to entry. Otherwise, theentrant might force the incumbent toback off in the event of a price war.
4. The potential entrant should not be
attempting to establish a reputation fortoughness.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 76/92
76
DuPont¶s Use of Excess Capacity to Control the DuPont¶s Use of Excess Capacity to Control the
M arket for Titanium Dioxide M arket for Titanium Dioxide
Titanium dioxide is a whitener used inpaints, papers, and plastics.
DuPont expected that the industrywould need 537,000 tons of additionalcapacity.
I
n 1972, DuPont elected to ³preempt´the market by adding 500,000 tons of capacity.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 77/92
77
DuPont¶s Use of Excess Capacity to Control DuPont¶s Use of Excess Capacity to Control
the M arket for Titanium Dioxidethe M arket for Titanium Dioxide
DuPont felt that it could expand fasterthan its competitors because (a) its
competitors had to spend money oncleanup that DuPont did not; and (b) ithad lower costs of using its raw materials,due to scale and learning economies.
DuPont believes that its costs were about22 percent lower than its competitors, sothat they would be reluctant to competehead to head.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 78/92
78
DuPont¶s Use of Excess Capacity to Control the DuPont¶s Use of Excess Capacity to Control the
M arket for Titanium Dioxide
M arket for Titanium Dioxide
There is a lag between planning to addcapacity and having capacity in place.
DuPont tried to forestall additionalentry. It let its competitors know themagnitude of its planned expansion of existing facilities, and falsely announced
that it had begun constructing a new130,000-ton facility.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 79/92
79
DuPont¶s Use of Excess Capacity to Control the DuPont¶s Use of Excess Capacity to Control the
M arket for Titanium Dioxide
M arket for Titanium Dioxide
DuPont also used limit pricing by setting prices just under the average total costs of production
in the new plants. DuPont¶s competitors,holding out for higher prices, refused to match.
This two-tiered pricing structure persistedbecause DuPont lacked capacity to handle thewhole market. When demand slackened in
early 1975, DuPont¶s competitors lostsubstantial sales and were forced to meetDuPont¶s price.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 80/92
80
DuPont¶s Use of Excess Capacity to Control the DuPont¶s Use of Excess Capacity to Control the
M arket for Titanium Dioxide
M arket for Titanium Dioxide
When demand remained soft through1975, DuPont reexamined its preemptionstrategy. When demand did not recoverin 1976, DuPont scaled back its capacityexpansion.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 81/92
81
J udo Economics J udo Economics
We have provided examples in which an
incumbent firm has used its size and
reputation to put smaller rivals at adisadvantage.
However, smaller firms and potential
entrants can use the incumbent¶s size totheir own advantage. This is known as
³judo economics.´
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 82/92
82
J udo Economics J udo Economics
When an incumbent slashes prices to drive an
entrant from the market, it sacrifices its own
short-run profits.T
he larger is the incumbent,the greater the loss.
If an entrant can convince the incumbent that
it does not pose a significant long-term threat
to the incumbent¶s profitability, the incumbentmight think twice about incurring large losses
to drive the entrant from the market.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 83/92
83
J udo Economics J udo Economics
An example is provided by Amazon¶s
entry into the on-line book retail market.
Many observers wondered whyBarnes &
Noble did not immediately respond with
their own web site, potentially drivingAmazon from the market.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 84/92
84
J udo Economics
J udo Economics
Because of its dominant presence in the bricks-
and-mortar market, Barnes & Noble had much
to lose by entering the on-line segment.This would quickly legitimize online sales, and
probably trigger an online price war, thereby
cannibalizingBarnes & Noble¶s bricks-and-
mortar sales. As it turned out, Amazonsucceeded beyond the expectations of most
market analysts.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 85/92
85
Wars of AttritionWars of Attrition
An aggressive firm supposedly starts aprice war to eliminate competition and
ultimately reap monopoly profits. Thispresumes that the rival would exit beforethe aggressor abandoned its strategy.
A price war harms all firms in the
market regardless of who started it.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 86/92
86
Wars of AttritionWars of Attrition
A larger firm is said to have deep pockets
from which it can finance the price warand have the ability to sustain lossesbetter than its smaller rivals.
However, a large firm may also suffer
greater losses during the price war.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 87/92
87
Wars of AttritionWars of Attrition
Price wars are examples of wars of attrition.
Firms may try to convince their rivalsthat they are better positioned to survive
the price war. Firms may claim that theyare actually making money during theprice war, or that they care more aboutwinning the war than about making
money. Either message may cause a rivalto rethink its ability to outlast itsopposition, and encourage it to exit themarket early.
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 88/92
88
Survey Data on Entry Deterrence Survey Data on Entry Deterrence
Robert Smiley asked major consumerproduct makers if they pursued avariety of entry-deterring strategies.Smiley surveyed product managers atnearly 300 firms. He asked themwhether they used several strategiesincluding:
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 89/92
89
Survey Data on Entry Deterrence Survey Data on Entry Deterrence
1. Aggressive price reductions to move down thelearning curve, giving the firm a cost
advantage2. Intensive advertising to create brand loyalty
3. Acquiring patents for all variants of a product
4. Enhancing firm¶s reputation for predation
through announcements or some other vehicle5. Limit pricing
6. Holding excess capacity
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 90/92
90
Survey Data on Entry Deterrence Survey Data on Entry Deterrence
The first three strategies create highentry costs. The last three change theentrant¶s expectations of post-entrycompetition.
Reported Use of Entry Reported Use of Entry--Deterring Deterring
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 91/92
91
Strategies Strategies
LearningCurve
Advertising R&DPatents
Reputation LimitPricing
ExcessCapacity
New
Products
Frequently 26% 62% 56% 27% 8% 22%
Occasionally 29% 16% 15% 27% 19% 20%
Seldom 45% 22% 29% 47% 73% 48%
Existing
Products
Frequently 52% 31% 27% 21% 21%
Occasionally 26% 16% 22% 21% 17%
Seldom 21% 54% 52% 58% 62%
8/3/2019 Exit and Entry
http://slidepdf.com/reader/full/exit-and-entry 92/92
Reported Use of Entry Reported Use of Entry--Deterring Deterring
Strategies StrategiesNote that managers were asked aboutexploiting the learning curve for new productsonly.
More than half of all product managerssurveyed report frequent use of at least oneentry-deterring strategies.
Product managers report that they rely much
more extensively on strategies that increaseentry costs, rather than on strategies thataffect the entrant¶s perception about post-entry competition