Strategic entry deterrence

Last updated

In the theories of competition in economics, strategic entry deterrence is when an existing firm within a market acts in a manner to discourage the entry of new potential firms to the market. These actions create greater barriers to entry for firms seeking entrance to the market and ensure that incumbent firms retain a large portion of market share or market power. Deterring strategies, might include an excess capacity, limit pricing, predatory pricing, predatory acquisition (hostile takeovers) and switching costs. [1] [2] [3] Although in the short run, entry deterring strategies might lead to a firm operating inefficiently, in the long run the firm will have a stronger holder over market conditions.

Contents

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.

Before its patent on aspartame expired, Monsanto engaged in preemptive deterrence when it signed contracts with its biggest customers, 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. [1]

Another example is when Xerox created hundreds of patents that were never used (sleeping patents) in order to make it more difficult for an entrant to challenge its monopoly on plain-paper photocopying. By creating so many patents, Xerox made it harder for potential entrants to create patents relating to plain-paper photocopying - increasing entry costs - and less firms were likely to enter the photocopying market. [4]

In both of these examples of strategic deterrence, prior action was taken by incumbents in order to reduce the probability of a subsequent entry by another firm into the market.

Common entry deterrence strategies

Excess capacity

Strategic excess capacity may be established to either reduce the viability of entry for potential firms. [5] Excess capacity take place when an incumbent firm threatens to entrants of the possibility to increase their production output and establish an excess of supply, and then reduce the price to a level where the competing cannot contend. [6]

Excess capacity typically occurs in markets with firms that have a natural monopoly. Economist Dr. William W. Sharkey established five key aspects that lead to a monopolized industry; [6]

  1. The product or service is essential;
  2. The location for production supersedes alternatives;
  3. The outputs are not storable;
  4. The product is produced at an economies of scale; and
  5. The product is can only be produced by a single supplier.

Limit pricing

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.

However, limit pricing does not always need to be enacted. Many industries use limit pricing as a signaling technique. Signaling is possible here because entrants do not ever have all the information on profit margins of existing companies or the true matrix outcome. When considering entering the market, an entrant must build an outcome matrix and rely on observable factors from the incumbent companies. This gives existing firms the ability to use observable variables to confuse entrants as a strategic barrier to entry. For example, a firm may change its price, leading the incumbent to infer the marginal cost of a product (incorrectly). This could lead a firm with a high-cost structure to charge a low price in order to deter competition or a firm with a low-cost structure to charge a high price to confuse entrants and hopefully deter them. [7]

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. [1]

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. [8] 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." [9]

Predatory acquisition

Incumbent firms can eliminate the possibility of competition from entering firms by acquiring enough shares from the target firm in order to gain a desired level of control. [10] Predatory acquisitions occur when one firm seeks to purchase a share of a smaller target firm anonymous to the management of the target firm. [11] Predatory acquisitions commonly arise to form a new majority, and establish a greater voting power in order to effect a change.

Switching costs

Switching costs represent the expenses a consumer faces in the light of changing to the product or service to a competing firms. [12] Switching costs are not strictly monetary. To forestall customers from defecting, a company might employ a number strategies that increases a customer's perceived and fiscal costs when switching. The costs associated with switching commonly fall under three categories; procedural, financial, and relational. [13] Procedural switching costs credited to the time and effort spent in completing the change. A firm might financially deter their customers from leaving by enforcing an exit fee. Relational switching costs refer to the inconveniences that are evoked in learning to use the new product or service.

See also

Related Research Articles

A monopoly, as described by Irving Fisher, is a market with the "absence of competition", creating a situation where a specific person or enterprise is the only supplier of a particular thing. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly and duopoly which consists of a few sellers dominating a market. Monopolies are thus characterised by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process by which a company gains the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant market power, that is, the power to charge overly high prices, which is associated with a decrease in social surplus. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A small business may still have the power to raise prices in a small industry.

<span class="mw-page-title-main">Monopolistic competition</span> Imperfect competition of differentiated products that are not perfect substitutes

Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a company takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other companies. If this happens in the presence of a coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the company maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereals, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition. Further work on monopolistic competition was undertaken by Dixit and Stiglitz who created the Dixit-Stiglitz model which has proved applicable used in the sub fields of international trade theory, macroeconomics and economic geography.

In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition causes market inefficiencies, resulting in market failure. Imperfect competition usually describes behaviour of suppliers in a market, such that the level of competition between sellers is below the level of competition in perfectly competitive market conditions.

<span class="mw-page-title-main">Porter's five forces analysis</span> Framework to analyse level of competition within an industry

Porter's Five Forces Framework is a method of analysing the operating environment of a competition of a business. It draws from industrial organization (IO) economics to derive five forces that determine the competitive intensity and, therefore, the attractiveness of an industry in terms of its profitability. An "unattractive" industry is one in which the effect of these five forces reduces overall profitability. The most unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit levels. The five-forces perspective is associated with its originator, Michael E. Porter of Harvard University. This framework was first published in Harvard Business Review in 1979.

Penetration pricing is a pricing strategy where the price of a product is initially set low to rapidly reach a wide fraction of the market and initiate word of mouth. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with marketing objectives of enlarging market share and exploiting economies of scale or experience.

Anti-competitive practices are business or government practices that prevent or reduce competition in a market. Antitrust laws ensure businesses do not engage in competitive practices that harm other, usually smaller, businesses or consumers. These laws are formed to promote healthy competition within a free market by limiting the abuse of monopoly power. Competition allows companies to compete in order for products and services to improve; promote innovation; and provide more choices for consumers. In order to obtain greater profits, some large enterprises take advantage of market power to hinder survival of new entrants. Anti-competitive behavior can undermine the efficiency and fairness of the market, leaving consumers with little choice to obtain a reasonable quality of service.

In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have not had to incur. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies and oligopolies, or give companies market power. Barriers of entry also have an importance in industries. First of all it is important to identify that some exist naturally, such as brand loyalty. Governments can also create barriers to entry to meet consumer protection laws, protecting the public. In other cases it can also be due to inherent scarcity of public resources needed to enter a market.

Monopoly profit is an inflated level of profit due to the monopolistic practices of an enterprise.

In economics and commerce, the Bertrand paradox — named after its creator, Joseph Bertrand — describes a situation in which two players (firms) reach a state of Nash equilibrium where both firms charge a price equal to marginal cost ("MC"). The paradox is that in models such as Cournot competition, an increase in the number of firms is associated with a convergence of prices to marginal costs. In these alternative models of oligopoly, a small number of firms earn positive profits by charging prices above cost. Suppose two firms, A and B, sell a homogeneous commodity, each with the same cost of production and distribution, so that customers choose the product solely on the basis of price. It follows that demand is infinitely price-elastic. Neither A nor B will set a higher price than the other because doing so would yield the entire market to their rival. If they set the same price, the companies will share both the market and profits.

Predatory pricing is a commercial pricing strategy which involves the use of large scale undercutting to eliminate competition. This is where an industry dominant firm with sizable market power will deliberately reduce the prices of a product or service to loss-making levels to attract all consumers and create a monopoly. For a period of time, the prices are set unrealistically low to ensure competitors are unable to effectively compete with the dominant firm without making substantial loss. The aim is to force existing or potential competitors within the industry to abandon the market so that the dominant firm may establish a stronger market position and create further barriers to entry. Once competition has been driven from the market, consumers are forced into a monopolistic market where the dominant firm can safely increase prices to recoup its losses.

A limit price is a price, or pricing strategy, where products are sold by a supplier at a price low enough to make it unprofitable for other players to enter the market.

In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, held that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibrium because of the existence of potential short-term entrants.

In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market power occurs if a firm does not face a perfectly elastic demand curve and can set its price (P) above marginal cost (MC) without losing revenue. This indicates that the magnitude of market power is associated with the gap between P and MC at a firm's profit maximising level of output. The size of the gap, which encapsulates the firm's level of market dominance, is determined by the residual demand curve's form. A steeper reverse demand indicates higher earnings and more dominance in the market. Such propensities contradict perfectly competitive markets, where market participants have no market power, P = MC and firms earn zero economic profit. Market participants in perfectly competitive markets are consequently referred to as 'price takers', whereas market participants that exhibit market power are referred to as 'price makers' or 'price setters'.

<span class="mw-page-title-main">Market structure</span> Differentiation of firms by goods and operations

Market structure, in economics, depicts how firms are differentiated and categorised based on the types of goods they sell (homogeneous/heterogeneous) and how their operations are affected by external factors and elements. Market structure makes it easier to understand the characteristics of diverse markets.

In marketing strategy, first-mover advantage (FMA) is the competitive advantage gained by the initial ("first-moving") significant occupant of a market segment. First-mover advantage enables a company or firm to establish strong brand recognition, customer loyalty, and early purchase of resources before other competitors enter the market segment.

<span class="mw-page-title-main">Pricing strategies</span> Approach to selling a product or service

A business can use a variety of pricing strategies when selling a product or service. To determine the most effective pricing strategy for a company, senior executives need to first identify the company's pricing position, pricing segment, pricing capability and their competitive pricing reaction strategy. Pricing strategies and tactics vary from company to company, and also differ across countries, cultures, industries and over time, with the maturing of industries and markets and changes in wider economic conditions.

Supracompetitive pricing is pricing above what can be sustained in a competitive market. This may be indicative of a business that has a unique legal or competitive advantage or of anti-competitive behavior that has driven competition from the market.

The six forces model is an analysis model used to give a holistic assessment of any given industry and identify the structural underlining drivers of profitability and competition. The model is an extension of the Porter's five forces model proposed by Michael Porter in his 1979 article published in the Harvard Business Review "How Competitive Forces Shape Strategy". The sixth force was proposed in the mid-1990s. The model provides a framework of six key forces that should be considered when defining corporate strategy to determine the overall attractiveness of an industry.

In economics, barriers to exit are obstacles in the path of a firm that wants to leave a given market or industrial sector. These obstacles often have associated costs, prohibiting the firm from leaving the market. If the barriers of exit are significant, a firm may be forced to continue competing in a market. This forced stay in the market occurs when the costs of leaving a market are higher than costs incurred by continuing in the market. Sometimes, when firms operate at low profit or at loss, they still choose to compete with others. Major factors of this decision making is high barriers to exit.

<span class="mw-page-title-main">Profit (economics)</span> Concept in economics

In economics, profit is the difference between revenue that an economic entity has received from its outputs and total costs of its inputs, also known as surplus value. It is equal to total revenue minus total cost, including both explicit and implicit costs.

References

  1. 1 2 3 Cabral L.M.B. (2008) Barriers to Entry. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London.
  2. ↑ Bagwell, Luarie Simon (1991). "Share repurchase and takeover deterrence". The RAND Journal of Economics. 22 (1): 72–88. doi:10.2307/2601008. JSTOR   2601008.
  3. ↑ Klemperer, Paul (1987). "Entry deterrence in markets with consumer switching costs". The Economic Journal. 97: 99–117. doi:10.2307/3038233. JSTOR   3038233.
  4. ↑ "U-M Weblogin". weblogin.umich.edu. doi:10.1057/978-1-349-95121-5_2712-1 . Retrieved 2020-12-09.
  5. ↑ Lieberman, Marvin (1987). "Excess Capacity as a Barrier to Entry: An Empirical Appraisal". The Journal of Industrial Economics. 35 (4): 607–627. doi:10.2307/2098590. JSTOR   2098590.
  6. 1 2 Fusillo, Mark (2003). "Excess Capacity and Entry Deterrence: The Case of Ocean Liner Shipping Markets" . Maritime Economics and Logistics. 5 (2): 100–115. doi:10.1057/palgrave.mel.9100074. S2CID   154952650.
  7. ↑ Salop, Steven (May 1979). "Strategic Entry Detterence". The American Economic Review. 69 (2): 335–338. JSTOR   1801669 . Retrieved 7 December 2020.
  8. ↑ "Virgin Atlantic Airways - The Dirty Tricks Episode". Old Red Lion. Retrieved 16 July 2007.
  9. ↑ "Richard Branson Quotes". Think Exist. Retrieved 1 August 2007.
  10. ↑ Chen, James; James, Margeret (14 June 2020). "Hostile Takeover". Investopedia.
  11. ↑ Palmer, Donald; Barber, Brad; Xueguang, Zhou; Yasemin, Soysal (1995). "The Friendly and Predatory Acquisition of Large U.S. Corporations in the 1960s: The Other Contested Terrain" . American Sociological Review. 60 (4): 469–499. doi:10.2307/2096288. JSTOR   2096288.
  12. ↑ Jones, Michael; Reynolds, Kristy; Mothersbaugh, David; Beatty, Sharon (2007). "The Positive and Negative Effects of Switching Costs on Relational Outcomes" . Journal of Service Research. 9 (4): 335–355. doi:10.1177/1094670507299382. S2CID   167831200.
  13. ↑ Blut, Markus; Evanschitzky, Heiner; Backhaus, Christof; Rudd, John; Marck, Michael (2016). "Securing business-to-business relationships: The impact of switching costs" (PDF). Industrial Marketing Management. 52: 82–90. doi:10.1016/j.indmarman.2015.05.010.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.