Entry Deterrence Spring 2003 1 Why Entry is

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Entry Deterrence Spring 2003 1

Entry Deterrence Spring 2003 1

Why Entry is Bad (A Reminder) u More firms means a smaller share of

Why Entry is Bad (A Reminder) u More firms means a smaller share of the pie even if prices are unaffected. u More firms means it is harder to sustain tacit collusion. Hence prices could fall as well. Entry Deterrence Spring 2003 2

For Some Firms Entry not an Issue u Legally protected monopoly u Patents, copyrights,

For Some Firms Entry not an Issue u Legally protected monopoly u Patents, copyrights, other IP u Exclusivity Various telecom in “old” Europe u Post office in America u Spectrum, bandwidth limits u u Economies of scale create “natural” monopoly u Land-line telecom u Cable TV u Electricity transmission u Network externalities Convergence and Swiss-army-knife networks u e. Bay u Windows Entry Deterrence Spring 2003 3

The Problem fight Incumbent Entrant -1, 2 enter acquiesce 5, 6 stay out 0,

The Problem fight Incumbent Entrant -1, 2 enter acquiesce 5, 6 stay out 0, 10 Entry Deterrence Spring 2003 4

The Problem More Generally fight Incumbent Ef, If enter Entrant stay out Ea >

The Problem More Generally fight Incumbent Ef, If enter Entrant stay out Ea > Es > Ef Is > Ia > If Entry Deterrence acquiesce Ea, Ia Es, Is Spring 2003 5

Remember: Game Theory as the Ghost of Christmas Future u Need to take steps

Remember: Game Theory as the Ghost of Christmas Future u Need to take steps today that u make fighting credible; or u make entry unattractive; i. e. , Es > Ea; or u develop a reputation for being crazy; or u develop a reputation for fighting; or u signal toughness. Entry Deterrence Spring 2003 6

Make Fighting Credible u Install “doomsday devices” u For example u advertise heavily that

Make Fighting Credible u Install “doomsday devices” u For example u advertise heavily that you will beat any competitors price. u build excess capacity to make Bertrand competition credible. Entry Deterrence Spring 2003 7

Excess Capacity as Doomsday Device u Consider a monopoly incumbent deciding how much capacity

Excess Capacity as Doomsday Device u Consider a monopoly incumbent deciding how much capacity to build. u Naïve approach is to build capacity equal to demand at the monopoly price. u Why naïve? u Because typically at monopoly output, there is sufficient demand to attract entry. u Moreover, because incumbent has limited capacity, it is constrained to cooperate (avoid the Bertrand trap). Entry Deterrence Spring 2003 8

Excess Capacity as Doomsday Device u Suppose prior to entry, however, incumbent builds enough

Excess Capacity as Doomsday Device u Suppose prior to entry, however, incumbent builds enough capacity to serve all demand at any price above marginal cost. u Now if entrant enters, the firms risk being in the Bertrand trap, because incumbent has capacity to serve the entire market at a price equal to marginal cost. u Entrant is deterred from entering (as long as it believes Bertrand competition will ensue). Entry Deterrence Spring 2003 9

A Caveat on Capacity as a Doomsday Device u Just because incumbent alone has

A Caveat on Capacity as a Doomsday Device u Just because incumbent alone has this capacity doesn’t guarantee Bertrand trap if entry – need to have reason to think incumbent will “pull the trigger. ” u Incumbent enjoys sufficient cost advantage that excess capacity makes credible predation against entrant. u Sometimes the added capacity creates economies of scale (Du. Pont in titanium dioxide) – especially valuable if demand is expected to grow. u Excess capacity makes credible that incumbent can seek to maintain/establish reputation for toughness (see slides later on). Entry Deterrence Spring 2003 10

Make Entry Unattractive u. Ways to make entry unattractive ulock up customers ulock up

Make Entry Unattractive u. Ways to make entry unattractive ulock up customers ulock up suppliers Entry Deterrence Spring 2003 11

Locking up customers I u Frequent buyer (loyalty) programs u Frequent-flier programs to block

Locking up customers I u Frequent buyer (loyalty) programs u Frequent-flier programs to block hub entry. u But not all loyalty programs are for entry deterrence purposes: u Some are to raise consumer switching costs to lessen risk of Bertrand competition u u Entry Deterrence With Hertz #1 Club Gold, there's no need to stop at any counters at over 40 of the world's busiest airports. And at over 1, 000 other locations around the world, simply go to the specially designated Gold counter, show your driver's license and pick up your keys. The annual membership fee is only $50. (From Hertz’s web cite; emphasis added. ) Some are forms of second-degree price discrimination (volume discounts). Spring 2003 12

Locking up customers II u Use contracts to lock-in customers u Apollo & Sabre’s

Locking up customers II u Use contracts to lock-in customers u Apollo & Sabre’s use of long-term contracts with travel agents. u IBM’s service contracts to limit entry into punchcard market. u Microsoft’s contract with OEMs concerning operating systems. u A danger with such contracts is that they frequently run afoul of antitrust authorities. Entry Deterrence Spring 2003 13

Locking up customers III u Building brand loyalty u Amazon. com u Claritin u

Locking up customers III u Building brand loyalty u Amazon. com u Claritin u Loratadine (though – almost – won’t find this term on Schering-Plough’s web site for Claritin). u Went off patent last December, which means generic production possible. u In anticipation of entry, S-P sought and gained approval to make Claritin an OTC medication. u It also launched a huge ad campaign for Claritin. Entry Deterrence Spring 2003 14

Schering-Plough u Why did S-P do what they did? u Much easier to enter

Schering-Plough u Why did S-P do what they did? u Much easier to enter when competition is for prescriptions Doctors less brand conscious u Health plan formularies create incentives for doctors to prescribe generics u u Much harder to compete against a brand imagine to end consumers u What else has S-P done? u Sued two would-be manufacturers of generic loratadine claiming patent infringement on metabolites of loratadine. u Introduced Clarinex (desloratadine). Entry Deterrence Spring 2003 15

Schering-Plough u Why did S-P do what they did? u What else has S-P

Schering-Plough u Why did S-P do what they did? u What else has S-P done? Entry Deterrence Spring 2003 16

Make Entry Unattractive u Locking up suppliers u control key inputs u sign suppliers

Make Entry Unattractive u Locking up suppliers u control key inputs u sign suppliers to long-term contracts u Alcoa Entry Deterrence Spring 2003 17

Develop a Reputation for Being Crazy u If entrant thinks you might carry out

Develop a Reputation for Being Crazy u If entrant thinks you might carry out an incredible threat, then may think twice about entering against you. u Developing a reputation for being crazy requires doing apparently irrational things. Entry Deterrence Spring 2003 18

Game Theory in Film From the Maltese Falcon: Spade smiled at the Levantine and

Game Theory in Film From the Maltese Falcon: Spade smiled at the Levantine and answered him evenly: “You want the bird. I’ve got it … If you kill me how are you going to get the bird? If I know that you can’t afford to kill me till you have it, how are you going to scare me into giving it to you? ” Entry Deterrence Spring 2003 19

Game Theory in Film (continued) “I see what you mean. ” Gutman chuckled. “That

Game Theory in Film (continued) “I see what you mean. ” Gutman chuckled. “That is an attitude, sir, that calls for the most delicate judgement on both sides, because as you know, sir, men are likely to forget in the heat of the action where their best interest lies and let their emotions carry them away. ”

WORD FOR WORD/MOB PSYCHOLOGY Analyze This: Vincent Gigante, Not Crazy After All Those Years

WORD FOR WORD/MOB PSYCHOLOGY Analyze This: Vincent Gigante, Not Crazy After All Those Years By ANDY NEWMAN (New York Times, April 13, 2003) n enduring urban mystery was solved last week when Vincent (The Chin) Gigante, the Mafia leader who spent decades slobbering, muttering and wandering Manhattan in his bedclothes, admitted in a Brooklyn federal court that he had deceived the teams of psychiatrists who had evaluated his mental competency from 1990 to 1997 and found him to be suffering from various forms of dementia. Entry Deterrence Spring 2003 21

Develop a Reputation for Fighting Incumbent Entrant fight enter acquiesce The one-shot game -1,

Develop a Reputation for Fighting Incumbent Entrant fight enter acquiesce The one-shot game -1, 2 5, 6 stay out 0, 10 Entry Deterrence Spring 2003 22

Develop a Reputation for Fighting u Suppose you fight all entrants. u Suppose fought

Develop a Reputation for Fighting u Suppose you fight all entrants. u Suppose fought entrant exits. u Present discounted value of fighting is u Present discounted value of acquiescing is Entry Deterrence Spring 2003 23

Develop a Reputation for Fighting u So it is worth developing a reputation for

Develop a Reputation for Fighting u So it is worth developing a reputation for fighting if d ³ ½; that is, if the interest rate does not exceed 100%. u More generally, it is worth developing a reputation for fighting if u So more likely to develop reputation the closer Ia is to If or the greater the distance between Is and If. Entry Deterrence Spring 2003 24

A Digression on Reputation u. Reputation sustained by future play very important in business:

A Digression on Reputation u. Reputation sustained by future play very important in business: uquality assurance upersonal integrity utacit collusion on price Entry Deterrence Spring 2003 25

Signaling Toughness u. The beer & quiche model u An incumbent monopolist can be

Signaling Toughness u. The beer & quiche model u An incumbent monopolist can be either tough or a wimp (not tough). u An incumbent monopolist receives 4 if the entrant stays out and 2 if the entrant enters. u An entrant earns 2 if it enters against a wimp incumbent, loses 1 if it enters against a tough incumbent, & gets 0 if it stays out. Entry Deterrence Spring 2003 26

Beer & Quiche u Prior to the entrant’s decision to enter or stay out,

Beer & Quiche u Prior to the entrant’s decision to enter or stay out, the incumbent gets to choose its “breakfast. ” Specifically, the incumbent can have beer for breakfast or quiche for breakfast. Breakfasts are consumed in public. u A beer breakfast is less desirable than a quiche breakfast. u But costs differ according to type: a beer breakfast costs a tough incumbent 1, but a wimp incumbent 3. Entry Deterrence Spring 2003 27

Beer & Quiche enter 1, -1 Incumbent 3, 0 out tough Entrant out 4,

Beer & Quiche enter 1, -1 Incumbent 3, 0 out tough Entrant out 4, 0 [½] Entrant Nature enter -1, 2 2, -1 quiche beer wimp enter [½] 2, 2 quiche beer 1, 0 out enter Incumbent out 4, 0

Beer & Quiche u Equilibrium: Tough incumbent drinks beer; wimp incumbent eats quiche; entrant

Beer & Quiche u Equilibrium: Tough incumbent drinks beer; wimp incumbent eats quiche; entrant stays out against beer drinkers; and entrant enters against quiche eaters. u What are beer & quiche? Entry Deterrence Spring 2003 29

Beer & Quiche Entry Deterrence Spring 2003 30

Beer & Quiche Entry Deterrence Spring 2003 30

Conclusions u u Entry Deterrence Entry is undesirable Generally, can’t wait for the entrant

Conclusions u u Entry Deterrence Entry is undesirable Generally, can’t wait for the entrant to arrive – must take action in advance (e. g. , Schering-Plough). Remember the Ghost of Christmas Future. Spring 2003 31

Conclusions (continued …) u Strategies for deterring entry fall into five broad categories: u

Conclusions (continued …) u Strategies for deterring entry fall into five broad categories: u Making fighting credible (sometimes necessary to carry out other strategies). u Make entry unattractive Lock up consumers u Lock up suppliers u u Develop a reputation for being crazy u Develop a reputation for fighting u Signal toughness Entry Deterrence Spring 2003 32

Some of the Companies and Industries Mentioned u u u u u Alcoa Amazon.

Some of the Companies and Industries Mentioned u u u u u Alcoa Amazon. com American Airlines (Sabre) Du. Pont e. Bay Hertz IBM Microsoft Schering-Plough UAL (Apollo) Entry Deterrence u Telecom u Electricity transmission u Pharmaceuticals u Titanium dioxide u Airline Spring 2003 33