222 • Chapter 6 • Entry and Exit

other firm has chosen. In a static world in which both firms make simultaneous entry decisions, there are two equally plausible Nash equilibria: Big D enters and Giant E stays out, and vice versa. These equilibria are highlighted in Figure 6.4. Economic theory has little to say about which firm will actually enter, and this issue might be determined by idiosyncratic factors not captured by the model.

In both equilibria, the firm that enters earns $6 million and the firm that stays out earns $0, so the firm that stays out will surely feel that it should have done something differently, even if it knows that it would be futile to enter now and lose $4 million. For example, it might have lobbied the local Blueville government for legislation giving it exclusive local rights to mix cement, transferring some of the profits to the legislators who have the power to erect entry barriers. This is known as rent-seeking behavior—costly activities intended to increase the chances of landing available profits. (The term rent refers to excess returns above and beyond opportunity costs and is often used interchangeably with economic profit.)

By leaving the static model and adding a time dimension, we can explore other, less sinister ways for our cement firms to assure themselves of a better shot at the monopoly profits. Remember that Blueville is growing and was not always the bustling metropolis it is today. Rather than entering today, when Blueville is so big that the monopolist’s net lifetime profits are $6 million, one of the firms could have entered earlier, when Blueville was much smaller. The discounted lifetime profits would be something less than $6 million, but this would still preempt entry by the other firm, and it is better to earn somewhat less than $6 million than earn nothing at all.

We can again use the concept of the Nash equilibrium to study the timing of entry. Consider the situation if Big D enters the Blueville market today and makes $6 million in net lifetime profits, while Giant E stays out and earns $0. Once we leave the static world, this is not a Nash equilibrium because Giant E could do better by entering the market before Big D. Giant E’s net lifetime profits would be somewhat less than $6 million because it would have entered when Blueville was a smaller community, while Big D would earn $0. Provided that Giant E is earning any positive profits, this is still not a Nash equilibrium because Big D could do better than earn $0 by entering earlier still. By this logic, the only Nash equilibrium is when either Big D or Giant E enters when the market is very small, so that its net lifetime profits are $0, and the other firm never enters and also earns $0. In this way, early entry dissipates all the monopoly rents.

This example illustrates a broader point. By engaging in rent-seeking behavior, firms that would appear to be in an enviable competitive position, even firms with established monopolies, may have dissipated some or all of the available profits. This may take the form of preemptive entry, lobbying the government, or spending money to develop supplier or customer relationships. And if several firms are competing for the monopoly rents, the “winner” must have some unique assets or abilities—what we have dubbed “asymmetries” in this chapter—if it hopes to end up earning positive profits.

CHAPTER SUMMARY

Entry and exit are pervasive. In a typical industry, one-third of the firms are less than five years old, and one-third of the firms will exit within the next five years.

A firm will enter a market if it expects postentry profits to exceed the sunk costs of entry. Factors that reduce the likelihood of entry are called entry barriers.

Questions • 223

A firm will exit a market if it expects future losses to exceed the sunk costs of exit.

Entry barriers result from asymmetries between incumbent firms and entrants.

Exogenous market forces can create structural entry barriers. Low demand, high capital requirements, and limited access to resources are all examples of structural entry barriers. Exit barriers arise when firms must meet obligations whether or not they produce.

An incumbent firm can use predatory acts to deter entry or hasten exit by competitors. Limit pricing, predatory pricing, and capacity expansion change entrants’ forecasts of the profitability of postentry competition.

Limit pricing and predatory pricing can succeed only if the entrant is uncertain about the nature of postentry competition.

Firms may hold excess capacity to credibly signal their intent to lower prices in the event of entry.

Firms can engage in predatory practices to promote exit by rivals. Once a firm realizes that it cannot survive a price war, it exits, permitting the survivors to raise price and increase share. A firm may try to convince its rivals that it is more likely to survive a price war to hasten the rival’s exit.

Managers report that they frequently engage in entry-deterring strategies, especially to protect new products.

Firms competing to enter new markets may engage in rent-seeking behaviors, such as preemptive entry, that dissipate some or all of the available profits.

QUESTIONS

1.Researchers have found that industries with high entry rates tended to also have high exit rates. Can you explain this finding? What does this imply for the pricing strategies of incumbent firms?

2.Dunne, Roberts, and Samuelson examined manufacturing industries in the 1960s to 1980s. Do you think that technological changes since that time will have affected entry and exit patterns? What industries are most likely to have been affected?

3.“All else equal, an incumbent would prefer blockaded entry to deterrable entry.” Comment.

4.Under what conditions do economies of scale serve as an entry barrier? Do the same conditions apply to learning curves?

5.Under what conditions can a firm prosper by gaining control of essential resources?

6.Industries with high barriers to entry often have high barriers to exit. Explain.

7.How a firm behaves toward existing competitors is a major determinant of whether it will face entry by new competitors. Explain.

8.Why is uncertainty a key to the success of entry deterrence?

9.An incumbent firm is considering expanding its capacity. It can do so in one of two ways. It can purchase fungible, general-purpose equipment and machinery that can be resold at close to its original value. Or it can invest in highly specialized machinery which, once it is put in place, has virtually no salvage value.

224 • Chapter 6 • Entry and Exit

Assuming that each choice results in the same production costs once installed, under which choice is the incumbent likely to encounter a greater likelihood of entry and why?

10. In most models of entry deterrence, the incumbent engages in predatory practices that harm a potential entrant. Can these models be reversed, so that the entrant engages in predatory practices? Why do you think incumbents are more likely to set predatory pricing than are entrants?

11. Suppose that a hospital monopolizes the local market for heart surgery, charging $10,000 per procedure. The hospital does 1,000 heart surgeries annually, and the cost of heart surgery is $5,000 per procedure. The hospital is a duopolist in the market for cataract surgery. The hospital and its competitor both perform 2,000 cataract procedures annually, charge $2,000 per procedure, and have costs of $1,000 per procedure. The hospital plans to go to insurers and offer a bundled price. It will discount the price of heart surgery below $10,000 and hold the price of cataracts at $2,000, provided that it is given exclusivity in the cataract market. What price for heart surgery must the hospital charge to insure that its competitor cannot profitably compete in the cataract market? (Assume that the hospital would match its rival’s price in the cataract market if the rival were to respond to this bundling arrangement by cutting its cataract price.)

12. “Judo economics suggests that economies of scale are useless at best.” Do you agree or disagree?

13. Recall the discussion of monopolistic competition in Chapter 5. Suppose that an entrepreneur considered opening a video store along Straight Street in Linesville. Where should the entrepreneur position the store? Does your answer depend on whether further entry is expected?

14. Consider a firm selling two products, A and B, that substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war?

ENDNOTES

1Dunne, T., M. J. Roberts, and L. Samuelson, “Patterns of Firm Entry and Exit in U.S. Manufacturing Industries,” RAND Journal of Economics, Winter 1988, pp. 495–515.

2Disney, R., J. Haskel, and Y. Heden, 2003, “Entry, Exit and Establishment Survival in UK Manufacturing,” Journal of Industrial Economics, 51(1), pp. 91–112.

3The theory of real options described in Chapter 7 discusses many of the issues affecting the timing of entry and exit decisions.

4This definition is a synthesis of the definitions of entry barriers of Joe Bain in Barriers to New Competition: Their Character and Consequences in Manufacturing Industries, Cambridge, MA, Harvard University Press, 1956, and C. C. Von Weizsäcker in Barriers to Entry: A Theoretical Treatment, Berlin, Springer-Verlag, 1980.

5Bain, Barriers to New Competition.

6Fisher, F., Industrial Organization, Economics, and the Law, Cambridge, MA, MIT Press, 1991.

7Much of the information for this example was taken from Michaels, D., “From Tiny Dubai, an Airline with Global Ambition Takes Off,” The Wall Street Journal, January 11, 2005, p. 1.

Endnotes • 225

8Fligstein, N., The Transformation of Corporate Control, Cambridge, MA, Harvard University Press, 1990.

9For a detailed discussion see Schmalensee, R., “Entry Deterrence in the Ready-to-Eat Breakfast Cereal Industry,” Bell Journal of Economics, 9(2), 1978, pp. 305–327.

10Scherer, F. M., “The Breakfast Cereal Industry,” in Adams, W. (ed.), The Structure of American Industry, 7th ed., New York, Macmillan, 1986.

11Bain, J. S., “A Note on Pricing in Monopoly and Oligopoly,” American Economic Review, 39, March 1949, pp. 448–464.

12Salvo, A., “Inferring Conduct under the Threat of Entry: The Case of the Brazilian Cement Industry,” London School of Economics, 2005, Mimeo.

13See Chapter 1 for a discussion of the use of the fold-back method to determine subgame perfect equilibria.

14See Martin, S., Industrial Economics, New York, Macmillan, 1988, for a good review of the various legal tests for predatory pricing that have been proposed.

15This term was coined by the game theorist Reinhard Selten in his article, “The Chain Store Paradox,” Theory and Decision, 9, 1978, pp. 127–159.

16Isaac, R., and V. Smith, “In Search of Predatory Pricing,” Journal of Political Economy, 93, 1985, pp. 320–345.

17Jung, Y. J., J. Kagel, and D. Levin, “On the Existence of Predatory Pricing: An Experimental Study of Reputation and Entry Deterrence in the Chain-store Game,” Rand Journal of Economics, 25(1), 1994, pp. 72–93.

18Based on Lieberman, Marvin B., “Strategies for Capacity Expansion,” Sloan Management Review, Summer 1987, pp. 19–25.

19Antitrust Modernization Commission, Report and Recommendation 99 (April 2007), available in full text at http://govinfo.library.unt.edu/amc.

20Gelman, J., and S. Salop, “Judo Economics: Capacity Limitation and Coupon Competition,” Bell Journal of Economics, 14, 1983, pp. 315–325.

21Smiley, R., “Empirical Evidence on Strategic Entry Deterrence,” International Journal of Industrial Organization, 6, 1988, pp. 167–180.

22Baumol, W., J. Panzar, and R. Willig, Contestable Markets and the Theory of Industrial Structure, New York, Harcourt Brace Jovanovich, 1982.

23Borenstein, S., “Hubs and High Fares: Dominance and Market Power in the U.S. Airline Industry,” RAND Journal of Economics, 20, 1989, pp. 344–365.