5 Entry How does entry or potential competition

5. Entry • How does entry or potential competition affect market power of established firms? • How can dominant firms try to limit opportunities for competition: deter entry, increase costs, reduce revenue, close mkts, etc? • So far only actual competition between firms already on market • Look at potential competition: competitive pressure by firms not yet on market that can enter if conditions are attractive enough • Basic micro: entry determined by structure of market: entry costs, demand, MC, number of firms on market, … • Entry barriers: structural characteristics of market that protects incumbent by making entry unprofitable HKKK TMP 38 E 050 1 © Markku Stenborg 2005

• • – High sunk costs: capacity, marketing costs, technology, 5. Entry know-how, scale or scope economies, … – Patent, license, . . . Concentrate here on entry deterrence: strategies incumbent can use to keep potential rivals out or influence their costs and/or revenues Suppose an incumbent monopolist i on market already, charges p > ac An entrant e considers whether to enter or not Decision rule: – enter if EV = t t te > f, sunk cost of entry – otherwise stay out • For small enough f and large enough V, entry yields positive NPV • If monopolist keeps p>ac, firms enter mkt until EV = f HKKK TMP 38 E 050 2 © Markku Stenborg 2005

• Monopoly, but no mkt power! (in LR) 5. Entry • Contestable market: threat of entry or potential competition enough to curb monopoly power, to keep price close to LRAC • Game-theoretic structure of contestable market: – 1) Firms choose prices – 2) Given prices, firms choose quantities [0, q. M] – Flavor of model: output/capacity more flexible and easier to change than price – Not realistic? • Not all mkts are contestable – Threat of hit-and-run entry not credible • General lesson: mere threat of entry important to curb market power • Could dominant incumbent try to prevent entry and remove threat? HKKK TMP 38 E 050 3 © Markku Stenborg 2005

5. 2 Limit Pricing • • • Motta Ch 7 Limit price p. L: price low enough to make entry unprofitable p. L depends on sunk entry costs f Limit quantity qi. L: corresponding output by incumbent firm(s) Idea: incumbent discourages entry by lowering price High (low) price now signal of (low) high profits in future Potential entrant supposed to conclude from low prices that entry is not attractive and stay out Incumbent raises price once threat of entry disappears and earns high profits Problem 1: Potential entrant can alter her decision and enter if price does not stay low Problem 2: Does limit pricing satisfy backward induction? HKKK TMP 38 E 050 4 © Markku Stenborg 2005

• Stylized 2 -stage entry game: 5. Entry st – 1 stage: e chooses to enter or stay out – 2 nd stage: i fights or accommodates – e enters if net profits from post-entry game are positive • Use backward induction to analyze entry decision – Two alternartives • i accommodates, eg. Stackelberg duopoly: • i fights, eg. price war: i. F , e F i. A, e. A, so that e wants to enter – Fighting deters entry if e. F < f – But i. F < i. A – Assume f < – No incentive for i to fight as post-entry fighting leaves less profit than accommodation – Fighting entry never rational to i – e always enters, as threat of fighting is not credible HKKK TMP 38 E 050 5 © Markku Stenborg 2005

• Only credible equilibrium: deterrence is not possible 5. entry Entry • “Chain-Store Paradox: ” Even a strong monopolist unable to keep entrants out • More general 3 -stage game: – 1 st stage: i takes aggressive or passive stance • Aggressive: eg. “irrationally” fights entry to gain reputation for toughness – 2 nd stage: e chooses to enter or stay out – 3 rd stage: i fights or accommodates, and profits are realized – e enters if profits from post-entry game expected to be positive – e does not know whether i is irrational aggresive or rational profit-maximizing firm – e can use info, including i’s previous actions, to try to predict i’s future behavior HKKK TMP 38 E 050 6 © Markku Stenborg 2005

• Now entry deterrence can credible 5. be Entry • Need Bayesian game theory to analyze, as there is incomplete info: e does not know i’s objectives, hence cannot plug in i’s RF in her decision problem • Basic idea: – 2 types of i: Tough (T) or Soft (S) • S maximizes present value of profits • T likes to fight, eg. gets some non-monetary utility from aggressive behavior – e has prior probability assesment 0 < P(i. T) < 1 – e updates probability assesment by Bayes rule, using all relevant info including i’s past behavior, P(i. T|info) • Early fighting increases P() for later entry decisions • Milk reputation: P(i. T|accomodation) = 0 HKKK TMP 38 E 050 7 © Markku Stenborg 2005

• e enters if expected profits exceed sunk costs: 5. Entry P(i. T|info) e. F + (1–P(i. T|info)) e. A > f • Early fighting now rational: gain reputation for toughness to deter future entry • Not maximizing profits yields higher profits than profit maximizing! – Incomplete info and possibility of “irrational” tough type yield positive externality to i – Similar results with other incomplete info HKKK TMP 38 E 050 8 © Markku Stenborg 2005

5. 3 Capacity • Can excess or large capacity deter entry? – i builds excess capacity to use it for price war if e enters? • Excess capacity intended to signal price war after entry • Has i incentives to lower price and increase output after entry? No – i builds “too much” capacity to lower MC? • Commit to high output • Not necessarily free pre-entry capacity as i might have incentives to produce at full capacity HKKK TMP 38 E 050 9 © Markku Stenborg 2005

• 2 -stage game 5. Entry – 1 st stage: i invests in capacity k – 2 nd stage: knowing k, e chooses to enter or stay out – Cournot competition: qi, qe – e enters if net profits from post-entry game positive – e wants to install capacity ke = qe* = equilibrium output, so we can ignore e’s capacity choice – Cost of capacity r and cost of labor w – Unit cost of production r+w • Note that firms are symmetric, other than – i on mkt already with sunk capacity k – e must also consider entry costs f – MCi = w for qi ≤ k – e has marginal costs r+w for entire production HKKK TMP 38 E 050 10 © Markku Stenborg 2005

• Can i credibly threaten to entry by installing enough 5. fight Entry capacity to produce limit output? • Backward induction: Marginal costs at 2 nd stage quantity subgame • In equilibrium each produces at MR=MC, given (correct) expectations of rival’s production • MCe = w+r • MCi: – qi < k: MCi = w as cost of capital is sunk – qi > k: MCi = w+r – MC jumps up at k Example • Demand p=68–(qi+qe), cost of capital r=38, w=2, f=4 • Can i deter e from entering? HKKK TMP 38 E 050 11 © Markku Stenborg 2005

– – – – – Limit output = 24 (plug in numbers from homework) 5. Entry e’s RF is qe(qi) = (68 – qi – (w+r))/2 If qi = 24, qe* = 2 MRi (24) = 18 40 = MC(25) > MRi(24) > MC(24) = 2 Hence i wants to produce at full capacity Anticipating qi = 24, e will not enter Incumbent can deter entry We do not yet know whether entry deterrence is profitable Reaction functions in 2 nd stage quantity sugbame • To find Nash equilibrium we need to find 2 nd stage RF's for both firms • e's RF qe*(qi) is implicitely defined by MRe = MCe = w+r • i's RF qi*(qe) is bit harder: HKKK TMP 38 E 050 12 © Markku Stenborg 2005

1) Suppose k = , no capacity constraint on 2 nd stage 5. Entry – Then 2 nd stage MCi = w – RF now defined by MRi(qi, qe) = w – Denote RFi( , qe) by qi (qe) 2) Suppose other extreme: k = 0 – 2 nd stage MCi = w+r – Now RF defined by MRi(qi, qe) = w+r – Denote RFi(0, qe) by qi 0(qe) 3) For all other cases 0 < k < , MCi vertical at k – MRi depends on qe – For small (large) qe, i's MRi and profit maximizing output is relatively high (low) – i's RF defined by intersection of MRi and MCi – If qe is low enough, i will want to increase capacity HKKK TMP 38 E 050 13 © Markku Stenborg 2005

• Summary: 5. Entry – If MRi(k, qe) < w, then qi = qi (qi) – If MRi(k, qe) > w+r, then qi = qi 0(qi) – If w < MRi(k, qe) < w+r, then qi = k • Translate MC picture into RF picture – Kink in RF at k – Different values of k shift the kink in i's RF Nash equilibrium in quantity subgame • Outputs of two firms are equal at one-stage Cournot equilibrium outcome with MCi=w+r; denote with C • Another one-stage equil outcome with MCi=w; denote with D • i's RF is presented by linking these two one-stage RFs with kink at k • Nash equilibrium = intersection of RFs: both firms are producing profit maximizing quantities and neither has incentive to deviate HKKK TMP 38 E 050 14 © Markku Stenborg 2005

1) • • • 2) • • Capacity expansion: qi. C 5. > k. Entry Kink in RF left of C Kink is also above qi 0(qe) i will want to increase output beyond k as MRi exceeds w+r and i is not on its RF at (k, qe(k)) Excess capacity: k > qi. D Kink in RF right of D i will not want to use all its capacity To right of D, both qi 0(qe) and qi (qi) lie below RFe qe(k, qi) Kink will also be below qe(k, qi) Producing at capacity means MR < MC Threat of producing at capacity is not credible as e knows that i will not want to produce qi = k Thus e will want to expand her production above candidate equilibrium outcome (k, qe’) HKKK TMP 38 E 050 15 © Markku Stenborg 2005

3) Full capacity utilization: 5. qi. C Entry > k > q i. D • Equilibrium on RF of e where qi = k and qe = qe*(k) • To right of C and left of D, qi (qi) is above and qi 0(qe) and below RFe • Kink will cross RFe at k • i will want to produce at capacity and not to expand capacity, as MRi < w+r • In both 2) and 3), Nash equilibrium quantity subgame is asymmetric and favors i Optimal 1 st stage capacity decision 3 cases: 1) Blocked entry: e's profits are negative at C • Profits of e are negative even in best post-entry equilibrium • Limit output less than monopoly profit maximizing level • i need not worry about entry HKKK TMP 38 E 050 16 © Markku Stenborg 2005

2) • • • 3) • • • Stackelberg: e's profits are positive at D 5. Entry Profits of e are positive even in worst post-entry equilibrium i can credibly commit only to qi. D < q. L, and e enters Two subcases: – i can commit to Stackelberg outcome q. S by strategic overinvestment if q. S lies between C and D – If cost advantage of sunk capital is small, excess capacity at Stackelberg outcome get close to Stackelberg outcome and qi = k Strategic entry deterrence or accommodation Profits of e are positive at C and negative at D i can deter entry since q. L lies between C and D Two sub-cases: – Always profitable for i to strategically deter entry as q. L < q M HKKK TMP 38 E 050 17 © Markku Stenborg 2005

• • S or strategically – Accomodate entry by 5. installing k = q Entry. L deter entry by installing k = q i can choose to commit to either by choosing k Optimal choice depends on relative profits: – Benefits of entry deterrence: monopoly – Costs of entry deterrence: expand capital and output beyond monopoly level – If entry on small scale, accomodation likely to be optimal – If q. S > q. L, always deter entry Entry deterrence is possible because capacity is sunk investment, commitment Incumbent strategically invests in capacity beyond monopoly profit maximizing level to commit to output level guaranteed to drive potential entrant's profits to zero HKKK TMP 38 E 050 18 © Markku Stenborg 2005

• Two requirements for profitable strategic entry deterrence: 5. Entry – Incumbent able to reduce MC by sunk investments – Economies of scale • Other ways to limit entry: – Tie customers with long-term contracts – Discounting schemes • May look aggressive competition but can be tool to reduce entry – Advertisement and brand loyalty – Customer switching costs – Manipulation of installed base of customers – Homework: How would these show up in RF picture? HKKK TMP 38 E 050 19 © Markku Stenborg 2005

Final Exam 23. 05. 2005 • 2+2 questions – One applied, one technical – Two straight forward explanations – 1+1 answers Requirements • Lecture Notes • US Merger Guidelines • Airtours, Volvo/Scania, UPM/Haindl, Deutsche Post cases – Economics behind • Market definition • Competitive assesment HKKK TMP 38 E 050 20 © Markku Stenborg 2005