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Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 11 Entry and Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 11 Entry and Exit Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc.

Entry Entrants are firms that produce and sell in new markets Entry threaten incumbents Entry Entrants are firms that produce and sell in new markets Entry threaten incumbents in two ways. The market share of the incumbents is reduced Price competition is intensified

Forms of Entry could take place in different forms An entrant may be a Forms of Entry could take place in different forms An entrant may be a brand new firm An entrant may also be an established firm that is diversifying into a new product/market The form of entry is important for analyzing the costs of entry and the strategic response by incumbents

Forms of Exit A firm may simply fold up (Pan. Am) A firm may Forms of Exit A firm may simply fold up (Pan. Am) A firm may discontinue a particular product or product group (Sega leaves the video game hardware market A firm may leave a particular geographic market segment (Peugeot leaves the U. S. market)

Evidence on Entry and Exit Dunne, Roberts and Samuelson (DRS) studied entry and exit Evidence on Entry and Exit Dunne, Roberts and Samuelson (DRS) studied entry and exit in U. S. industries. They find that: Entry and exit are pervasive in the U. S. Entrants (exiters) are smaller than incumbents (survivors. ) Most entrants fail quickly and the ones that don’t grow precipitously The rates of entry and exit vary from industry to industry.

DRS Findings on Entry and Exit Over a five year horizon, a typical industry DRS Findings on Entry and Exit Over a five year horizon, a typical industry experienced 30 to 40 percent turnover About half the entrants were diversified firms and the rest were greenfield entrants (new firms). About 40% of the exiters were diversified firms that continued to operate in other markets. Conditions in an industry that encouraged entry also fostered exit

DRS Findings on Entry and Exit Unlike new entrants, diversifying firms built plants on DRS Findings on Entry and Exit Unlike new entrants, diversifying firms built plants on the same scale as incumbents. The size of the exiters is about one third of the average firms’. Within 10 years of entry 60% of the entrants leave the industry. The survivors double in size over the same horizon.

Cost Benefit Analysis for Entry A potential entrant compares the sunk cost of entry Cost Benefit Analysis for Entry A potential entrant compares the sunk cost of entry with the present value of the post-entry profit stream Sunk costs of entry range from investment in specialized assets to obtaining government licenses Post-entry profits will depend on demand cost conditions as well as post-entry competition

Barriers to Entry Barriers to entry are factors that allow the incumbents to earn Barriers to Entry Barriers to entry are factors that allow the incumbents to earn economic profit while making it unprofitable for the new firms to enter the industry. Barriers to entry can be classified into structural barriers (natural advantages) and strategic barriers (incumbents’ actions to deter entry).

Structural Barriers to Entry Structural barriers to entry exist when: incumbents have cost advantages Structural Barriers to Entry Structural barriers to entry exist when: incumbents have cost advantages incumbent have marketing advantages incumbents are protected by favorable government policy and regulations

Strategic Barriers to Entry Incumbents can erect strategic barriers by expanding capacity resorting to Strategic Barriers to Entry Incumbents can erect strategic barriers by expanding capacity resorting to limit pricing and resorting to predatory pricing

Types of Structural Barriers The three main types of structural barriers to entry are: Types of Structural Barriers The three main types of structural barriers to entry are: control of essential resources by the incumbent economies of scale and scope marketing advantage of incumbency

Entry Deterring Strategies Some examples of entry deterring strategies are limit pricing, predatory pricing Entry Deterring Strategies Some examples of entry deterring strategies are limit pricing, predatory pricing and capacity expansion. For these strategies to work Incumbent must earn higher profits as a monopolist than as a duopolist and The strategy should change the entrants’ expectations regarding post-entry competition

Contestable Markets & Entry Deterrence If there is a possibility of a hit and Contestable Markets & Entry Deterrence If there is a possibility of a hit and run entry (zero sunk cost) the market is contestable. In a perfectly contestable market, a monopolist sets the price at competitive levels If the market is contestable, it is not worth the monopolist’s while to adopt entry deterring strategies

Limit Pricing: Extensive Form Game Limit Pricing: Extensive Form Game

Predatory Pricing Predatory pricing involves setting the price below short run marginal cost with Predatory Pricing Predatory pricing involves setting the price below short run marginal cost with the expectation of recouping the losses via monopoly profits once the rival exits Predatory pricing is directed at entrants who have already entered while limit pricing is directed at potential entrants.

Is Predatory Pricing Rational? If all the entrants can perfectly foresee the future course Is Predatory Pricing Rational? If all the entrants can perfectly foresee the future course of incumbent’s pricing, predatory pricing will not work. The chain store paradox: Many firms are commonly perceived to engage in predatory pricing even when it is irrational to expect predatory pricing to deter entry.

Is Predatory Pricing Rational? Simple economic models indicate that predatory pricing is irrational Either Is Predatory Pricing Rational? Simple economic models indicate that predatory pricing is irrational Either the firms’ pricing strategies are irrational or the models are incomplete. Game theoretic models that include uncertainty and information asymmetry show that predation can be a rational strategy.

Situations Where Limit Pricing & Predation are Rational Incumbent wants the entrant to lower Situations Where Limit Pricing & Predation are Rational Incumbent wants the entrant to lower its expectations for post entry price Entrant lacks information about incumbents costs. Incumbent’s pricing strategy can alter entrant’s expectation when there is asymmetric information.

Excess Capacity For U. S. manufacturers average capacity use is about 80%. When capacity Excess Capacity For U. S. manufacturers average capacity use is about 80%. When capacity addition has to be lumpy, firms may often have excess capacity in anticipation of future growth A temporary down turn in demand may leave the firms in an industry with excess capacity with no strategic overtones

Excess Capacity and Entry Deterrence By holding excess capacity, the incumbent can credibly threaten Excess Capacity and Entry Deterrence By holding excess capacity, the incumbent can credibly threaten to lower the price if entry occurs. An incumbent with excess capacity can expand output at a low cost. Entry deterrence will occur even when the entrant as informed as the incumbent.

Excess Capacity Du. Pont Titanium Dioxide Ti-Pure® Du. Pont Monopoly Capacity Excess Capacity Rival Excess Capacity Du. Pont Titanium Dioxide Ti-Pure® Du. Pont Monopoly Capacity Excess Capacity Rival E Du. Pont 2 Rival 1 NE E NE 4 1 3 0 -1 E=Enter NE=Do not enter 0 http: //www. dupont. com/tipure/ Page 22

Excess Capacity and Entry Deterrence Excess capacity works to deter entry when incumbent has Excess Capacity and Entry Deterrence Excess capacity works to deter entry when incumbent has a sustainable cost advantage, market demand growth is slow, incumbent cannot back-off from the investment in excess capacity and entrant is not the type trying to establish a reputation for toughness.

Entry Deterring Strategies Aggressive price reductions to move down the learning curve Intensive advertising Entry Deterring Strategies Aggressive price reductions to move down the learning curve Intensive advertising to create brand loyalty Acquiring patents Enhancing reputation for predation Limit pricing Holding excess capacity

ET and the Chocolate Wars In the movie “E. T. ” a trail of ET and the Chocolate Wars In the movie “E. T. ” a trail of Reese's Pieces, one of Hershey's chocolate brands, is used to lure the little alien into the house. As a result of the publicity created by this scene, sales of Reese's Pieces trebled, allowing Hershey to catch up with rival Mars. Page 25

ET and the Chocolate Wars (Continued) § Universal Studio's original plan was to use ET and the Chocolate Wars (Continued) § Universal Studio's original plan was to use a trail of Mars’ M&Ms. § However, Mars turned down the offer, presumably because it thought $1 m was a very high price to pay. § The producers of “E. T” then turned to Hershey, who accepted the deal. Page 26

ET and the Chocolate Wars (Analysis) § Suppose that § the publicity generated by ET and the Chocolate Wars (Analysis) § Suppose that § the publicity generated by having M&Ms included in the movie would increase Mars' profits by $800, 000. § Hershey's increase in market share cost Mars a loss of $500, 000. § the benefit for Hershey's from having its brand featured in the movie is given by b. § Hershey knows the exact value of b. Mars knows that b=1200 or b=700 with equal probability. Page 27

The Mars Problem A: Decision-theory Approach bu y [-200] M not buy [0] Page The Mars Problem A: Decision-theory Approach bu y [-200] M not buy [0] Page 28

The Mars Problem B: Naïve Game-theory Approach bu y [-200, 0] M not buy The Mars Problem B: Naïve Game-theory Approach bu y [-200, 0] M not buy 0 H bu y not buy [-500, -50] [0, 0] Page 29

The Mars Problem C: Game-theory Approach [-200, 0] buy -500 M b = 1200 The Mars Problem C: Game-theory Approach [-200, 0] buy -500 M b = 1200 (50%) not buy [-500, 200] H not buy [0, 0] N -250 b = 700 (50%) buy 0 [-500, -300] H not buy See also: Joël Glenn Brenner, The Emperors of Chocolate. New York: Random House, 1999 http: //www. Joel. Glenn. Brenner. com/ http: //luiscabral. org/iio/ch 04/ET/ [0, 0] Page 30

Dominant and Dominated Strategies § Dominant strategy: payoff is greater than any other strategy Dominant and Dominated Strategies § Dominant strategy: payoff is greater than any other strategy regardless of rival’s choice. § Rule 1: if there is one, choose it and that’s the end of it. § Dominated strategy: payoff is lower than some other strategy regardless of rival’s choice. § Rule 2: do not choose dominated strategies. à Check whethere are dominant and/or dominated strategies in the example above. What can we say based on this? Page 31