Entry barriers and entry deterrence Sequential games Suggested

Entry barriers and entry deterrence: Sequential games

Suggested reading • Allen et al. 2009. Managerial Economics. Norton. Chapters 6 (pp 170) 11 • Kreps, D. M. 2004. Microeconomics for Managers. Norton. Chapters 20 -23 • Frank, R. H. 2008. Microeconomics and behaviour. Mc. Graw Hill. Chapters 12 -13 • Wall, S. , Minocha, S. and Rees, B. 2010. International Business, Pearson. Chapter 7 • Rasmusen, E. 2007. Games and Information, Blackwell. Chapters 1 -2, 4 -5 • Carmichael, F. 2004. A Guide to Game Theory, Pearson. Chapters 1 -4, 7 -8

Entry barriers and entry deterrence • Objectives are for you to be able to: – – Explain what is meant by the idea of a credible threat e. g. the threat to fight the entry of a new firm into an industry. Use game theory to show an incumbent monopolist (or oligopolistic cartel) might be able to deter entry even though fighting entry is costly.

Porter’s Five Forces again… • A firm is more profitable: – The less intense the rivalry among existing firms (monopoly or if oligopoly -collusion vs. competition) – The less the danger of potential entrants and the higher barriers to entry – The fewer substitutes for the firm’s products (the more firms that sell complements) – The weaker the bargaining power of customers (e. g. in sports) – The weaker the bargaining power of suppliers

Implications of the analysis so far i. e. in relation to oligopoly collusion • Oligopoly collusion (restrained rivalry) can be sustained in some circumstances – but new entrants to the sector also have to be kept out – HOW?

Entry barriers and entry deterrence • If firms in an industry are profitable, there are likely to be potential entrants – Successful entry will lower profits for existing/incumbent firms – Therefore existing firms will want to impede (deter) entry • Question: what kinds of entry barrier exist? Hint: some are ‘tangible or semi tangible’ and some are based on beliefs (psychological) – See e. g. Kreps chapter 20 or Frank chapter 12 pp. 413 -7

Types of entry barriers (1) • Tangible and semi tangible – Put entrants at a disadvantage in the competition that takes place after entry e. g. : • Cost – economies of scale: large firms more able to withstand cost cutting (price war) – economies of scope : large diversified firms have cost advantages • knowledge based advantages (technology gives cost advantages) • access to resources e. g. financial or access to natural resources or distribution channels • customer loyalty – goodwill and reputation (brands, niche markets), lock-in (e. g. due to compatibility) • legal factors e. g. certification, subsidies, trade barriers and patents • Strategic entry barriers e. g. output and pricing decisions (product development, bundling products, loss leaders, limit pricing)

Types of entry barriers (2) • Psychological barriers (beliefs) – Reputation for aggressive response to entry – fighting is a credible threat even if costly for the incumbent (e. g. price war) • Key is credibility

Analysing the idea of credibility in relation to entry barriers and entry deterrence • Sequential moves mean that players move in turns – so one player moves first and the other follows e. g. : – Firm A erects an entry barrier • • – Pre-emptive investment strategies – tangible entry barrier threatens to fight a price war if there is entry Psychological entry barrier Firm B decides whether to enter or not • See Kreps chapters 21 and 23, Allen chapter 11 and Frank chapter 13 (especially pp. 463 -467)

Credible threats • A key idea in the analysis of sequential move games is that of credibility • the credibility of a threat or promise depends on whether the action would actually be carried out if it was tested; the potential gain needs to outweigh any cost • • A threat to enter a market whatever the cost A threat to fight entry (e. g. by fighting a price war) - a psychological entry barrier • In either case can pre-emptive action be taken by those threatened (to neutralise threat) or those doing the threatening (to make threat credible) • e. g. by introducing a new product or expand a product line = a tangible entry barrier

Example 1: pre-emptive investment decisions and credible threats in the aircraft industry • The aircraft companies Boeing and Airbus are involved in a strategic game, in this example Airbus moves first – Airbus has to decide whether to invest in new plane or not i. e. a new product line/market – Boeing is also deciding whether to invest in a new plane but because of lags its production process it has to make its decision after Airbus has made its decision

The firms’ payoffs • The firms’ payoffs reflect the following: – Despite high development costs there is a market for the new plane which could be supplied profitably – But the market for aircraft is limited and there is only room for one company to supply a new plane profitably • If both companies supply a new plane they would be in direct competition with each other and both would make lower profits due to undercutting – And large economies of scale means that high levels of output are needed to make profits » SO THE MARKET IS NOT COMPETITIVE

A decision tree for a game between Boeing and Airbus no B 1 new p plan e no pl an e Boeing decides e lan Airbus decides A ne New market w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 10 m (1) Boeing +£ 10 m Airbus +£ 1 m (2) Boeing +£ 50 m Airbus +£ 50 m (3) Boeing +£ 1 m Enters same new market Airbus –£ 10 m (4) Boeing –£ 10 m

Boeing’ threat • Boeing threatens to also enter the new market - by supplying the new plane - if Airbus supplies the new plane • By making this threat Boeing hopes to deter Airbus from supplying the new plane so it can make the new plane itself • Is this a credible threat? – would this threat deter Airbus from building the new plane? – can Airbus take pre-emptive action?

Game theoretic analysis: Is Boeing’ threat credible? • Boeing’ threat is only credible if Boeing would actually carry it out if Airbus built the new plane – We need to think about what Boeing would actually do if Airbus built the new plane or did not. • Whether the threat is credible or not depends on Boeing’s payoff if the threat is carried out and its payoff if it isn’t

Game theoretic analysis: Is Boeing’ threat credible? • We need to work backwards from the last decision points of the game (B 1 and B 2) to the decision point at the start of the game (A) • This is called backward induction

Analysing the game tree: what will Boeing actually do at B 1 and B 2? no B 1 new p plan e no pl an e Boeing decides e lan Airbus decides A ne w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 10 m (1) Boeing +£ 10 m Airbus +£ 1 m (2) Boeing +£ 50 m Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m

Boeing’s decisions Boeing decides p new plan e no pl an e B 1 no Airbus +£ 10 m (1) Boeing +£ 10 m e lan Airbus decides A ne w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 1 m (2) Boeing +£ 50 m Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m

Boeing’ choices • Boeing will supply the new plane if Airbus does not • Boeing will not supply the plane if Airbus does – therefore threat to do so is not credible – So what will Airbus do?

Analysing the game tree: what will Airbus do at A? Boeing decides p new plan e no pl an e B 1 no Airbus +£ 10 m (1) Boeing +£ 10 m e lan Airbus decides A ne w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 1 m (2) Boeing +£ 50 m Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m

Analysing the game tree: what will Airbus do at A? Boeing decides p new plan e no pl an e B 1 no Airbus +£ 10 m (1) Boeing +£ 10 m e lan Airbus decides A ne w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 1 m (2) Boeing +£ 50 m Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m

The game theoretic prediction • Backward induction implies that Airbus will supply the new plane and Boeing will not – Boeing’ threat to also supply the new plane if Airbus supplies the plane is not a credible threat and therefore it does not deter Airbus • Airbus will make higher profits – it has a first mover advantage and take the pre-emptive investment choice

Exercise • The aircraft industry is considered to be strategically important by both the USA and the EU and therefore worth protecting by subsidising or using tariffs (see Allen Chapter 16) • There are ongoing disputes between the USA and the EU regarding ‘unfair’ subsidisation of Boeing and Airbus in developing aircraft • Construct a game tree and use backward induction to predict the outcome of the game if Boeing receives a subsidy of the equivalent of £ 12 m from the US government if and only if it builds the plane – In the new version of the game is Boeing’s threat to build the new plane credible?

Analysing the new game tree: what will happen? Boeing decides p new plan e no pl an e B 1 no Airbus +£ 10 m (1) Boeing +£ 10 m e lan Airbus decides A ne w pla ne no B 2 Boeing decides ne pla new pla ne Airbus +£ 1 m (2) Boeing +£(50+12)m Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m + £ 12 m = £ 2 m

Analysing the new game tree Boeing decides p new plan e Airbus +£ 1 m (2) Boeing +£(50+12)m no pl an e B 1 no Airbus decides A ne w pla ne no B 2 Boeing decides Airbus +£ 10 m (1) Boeing +£ 10 m e lan ne pla new pla ne Airbus +£ 50 m (3) Boeing +£ 1 m Airbus –£ 10 m (4) Boeing –£ 10 m + £ 12 m = £ 2 m

The game theoretic prediction • Government intervention changes the outcome of the strategic game by making Boeing’s threat credible • Implication: government intervention can change the outcome of transnational strategic games played by oligopolists • But what about the long-term? – What do you think the EU will do? • And what will be the outcome of the EU’s decision?

Example 2: Entry deterrence and reputation E = Potential market entrant - first mover M = Incumbent monopolist (or oligopoly cartel – effectively a monopoly) making monopoly profits Entrant decides E M whether to 1 4 Concede enter or not. M 1 Monopolist Enter only has to Fight -1 1 decide E whether to fight or M 2 Stay Out 0 8 Do nothing concede if entrant enters.

Example 2: Entry deterrence and reputation E = Potential market entrant - first mover M = Incumbent monopolist (or oligopoly cartel – effectively a monopoly) making monopoly profits Concede Enter M 1 Fight E 1 M 4 -1 1 0 8 E Stay Out M 2 Do nothing Is the incumbent’s threat to fight credible? What outcome do you predict in this game?

Entry deterrence and reputation Threat to fight is not credible – there will be entry followed by concession, unless the monopolist (or cartel) can make threat to fight credible by pre-committing to fight Concede Enter M 1 4 -1 1 0 8 M 1 Fight E Stay Out E M 2 Do nothing

Making the threat to fight credible • Firms can take costly pre-emptive actions to make a psychological barrier credible e. g. : – Excess capacity for increasing output (lowers prices) – Holding patents or products as backup if there is entry – Choosing high fixed cost (economies of large scale) technologies – so needs to protect market share – Investing in ability to retaliate in other markets • i. e. some makes some unrecoverable ‘sunk’ cost that makes fighting optimal – There is a commitment cost (c) but a reward (d) and the monopolist fights if there is entry

Making the threat to fight credible E Concede Enter -1 1+d 0 8 -c M 1 Fight E Stay Out 1 M 4 -c M 2 Do nothing The monopolist (or cartel) invests in some unrecoverable ‘sunk’ cost that makes fighting optimal: Commitment cost = c Generates reward if fights entry =d. Under what conditions will entry be fought?

Making the threat to fight credible • The threat to fight is credible only if: (payoff from fighting) 1 + d > 4 – c (payoff from concession) or -c < 1+ d - 4 (divide through by -1) or c > -1 - d + 4 or c > 3 -d (1) • But the commitment will only be made if payoff in game without commitment (4) is greater than 8 -c: 8–c>4 or -c > -4 or c < 4 (2) • Combining (1) and (2): The cartel will invest in the commitment and entry will be deterred if: 4 > c > 3 –d (3)

Making the threat to fight credible • • • The threat to fight is credible if: 1 + d > 4 – c or c > 3 -d (1) The commitment will only be made if: 8–c>4 (2) Combining (1) and (2)implies: 4 > c > 3 –d (3) Example: If d = 2 and c = 3 both conditions are satisfied (1) 1+d = 3, 4 -c = 1 so 1=d >4 -c and (2) 8 -c = 5 > 4 Which must mean that 4 > c (= 3) > 3 -d (= 1) 1. Think of two other values for d and c that would satisfy the conditions 2. Can you provide any interpretation of what these conditions mean (in terms of the cost and rewards of commitment - the relative payoffs)?

Implication • Firms can make tangible and costly investments (commitments) that make psychological entry barriers credible – but costs (c) can’t be too high and gains (d) need to be sufficiently large so that: – Payoff from deterring entry with the investment cost (8 -c) is greater than the payoff without incurring the commitment (4) – Increase in payoff from fighting with commitment (d) needs to large enough so that fighting is optimal

Uncertainty and reputation • The costly commitment to fight might not even need to be made if there is; – Uncertainty e. g. about whether the commitment has been made or not e. g. if the probability of fighting is high enough – And/or the scenario is repeated (indefinitely or infinitely) and the cartel has or can gain a reputation for fighting entry – its worth a costly fight initially in order to create a reputation for fighting • Previous aggressive behaviour – reputation: E. g. Procter & Gamble deterred Union Carbide from entry into the disposable diaper industry by making it look like it was up for a fight with a series of price cutting strategies (see e. g. Kreps chapter 23 – page 586)

Implications • Analysis of repeated prisoners’ dilemma suggests that oligopolists may be able to sustain collusion in order to extract monopoly profits • and sequential game theory shows that they may be able to protect their collusive agreements through psychological entry barriers e. g. threatening to fight entry - as long as this is credible – But the creation of entry barriers and entry deterring strategies are often illegal……….

The same kind of analysis might be applicable to a situation of industrial conflict – see e. g. Washington Post cases - what’s your prediction? Employer ht fig E 1 Con ke ced e st ri UNION U Do n ’t Union –£ 100 m Employer –£ 150 m st rik e E 2 Employer introduces labour reforms Union +300 m Employer -£ 500 m (but union is uncertain about employer’s payoff) Union +£ 50 m Employer +£ 200 m

The same kind of analysis might be applicable to a situation of industrial conflict – see e. g. Washington Post cases - what’s your prediction? Employer ht fig E 1 Con ke ced e st ri UNION Union –£ 100 m Employer –£ 150 m U Don ’t st rik e? E 2 Employer introduces labour reforms Union +300 m Employer -£ 500 m (but union is uncertain about employer’s payoff) Union +£ 50 m Employer +£ 200 m

This game theoretic model could also be used to analysed some international relations scenarios: Is the USA’s threat to invade credible – this depends on what will the small country does if the USA invades – what will it do? Small country ht g i decides f Giv e in ad e S 1 USA +300 m In v The USA U USA –£ 100 m Small country –£ 150 m Do n Small Country +£ 50 m ’t in v ad e S 2 Small country does nothing USA +£ 50 m Small Country +£ 200 m

Since the small country will give in if the USA invades - the USA will invade – its threat is credible Small country ght decides fi USA Give in In va de B 1 USA –£ 100 m Small country – £ 150 m A Do n’t USA +300 m Small Country +£ 50 m inv ad e B 2 Small country does nothing USA +£ 50 m Small Country +£ 200 m

A very diffierent example: Robbing a bank: Is Bert’s threat to blow himself and Angela up credible? NS A B Demands money te a n o t e D B - , Not D -100, 100 B 1 etona S A - B 2 te 1000, -10 Not Detonate and take the money B = Bert the bank robber A = Angela the bank cashier; S =surrender; NS = not surrender - implies infinite pain and suffering and/or death

Robbing a bank: Is Bert’s threat to blow himself and Angela up credible? NS A B Demands money te a n o t e D B - , Not D -100, 100 B 1 etona S A - B 2 Not Detonate te 1000, -10 B = Bert the bank robber A = Angela the bank cashier; S =surrender; NS = not surrender - implies infinite pain and suffering and/or death

Test your understanding Entry barriers and entry deterrence 1. Explain what is meant by the idea of a credible threat e. g. the threat to fight the entry of a new firm into an industry. 2. Use game theory to show an incumbent monopolist (or oligopolistic cartel) might be able to deter entry even though fighting entry is costly.