Entrance Deterrence and Accommodation Games Appendix 13 A

Entrance Deterrence and Accommodation Games Appendix 13 A • Credible threats are believable tactics one firm can employ to try to assure cooperation. This include ü Excess capacity ü Non-redeployable assets • Also are possible customer sorting rules to achieve higher profits. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Slide 1

Entry and Deterrence • Firms announce to the public their plans for expansion and their opening of new stores or new factories • These announcements tell their own stockholders what management is doing, but they also serve as a notice to rivals that they are committed to this industry. • Announcements can serve as an entry deterrence to rival firms. Slide 2

An Entry Game • Suppose a potential entrant is deciding whether to enter an industry in competition with an incumbent firm. • If the entrant decides to enter the industry, the incumbent has two paths of action: • Accommodate the entry; • Or it can Fight the entry. • By modeling the situation using game theory, we find that accommodating an entrant leads to profits while fighting an entrant leads to losses. Slide 3

• Payoffs are {PE, Incumbent Firm} • PE is the potential entrant • PE can decide to enter or not enter • If not enter, it gets zero. • If it enters, it will get 25. • Entry occurs. • PE sees if it enters, the incumbent firm will decide to accommodate. Entry Game Fights {-$20, -$20} Entry I Accommodates {$25, $25} PE No entry {$0, $50} Slide 4

How to Deter Entry? • The question is how to change the game to your own advantage? In the Entry Game, if the incumbent firm can deter entry, it would earn $50 profit, instead of only $25. • To deter entry, the incumbent firm can threaten to “commit” to fight the entry and price low. • This takes away one of the incumbent’s options, the ability to accommodate entry. • By committing to fight entry, the incumbent can benefit, even though the incumbent would be worse off if entry did occur, and the incumbent had to fight. • The best threat is one you do not have to use. Slide 5

Credible Threats • A credible threat is a conditional strategy that is perceived as a possible penalty in a noncooperative game. » One method is to build huge Excess Capacity » With excess capacity, costs decline as output increases » Irreversible investments in excess capacity means that the incumbent will fight to the death » Potential entrants will not want to fight. Excess capacity acts as an entry deterrent. Slide 6

Excess Capacity as a Credible Threat • Building excess capacity deters entry. Potential entrants fear that the price will be driven down to zero if they entered. • The building of extra capacity is an action in a sequential game to forestall entry. This is called a precommitment game. • Customers may be inclined to buy from the newest firm or from incumbent firms. Slide 7

Precommitments Using Non-Redeployable Assets • Some assets can be readily changed into other uses. Space in a strip-mall selling shoes can be easily changed to selling sports equipment. • But other assets are not easily changed or “redeployed”. » Hospital Expansion is not easily redeployed » Other hospitals must consider whether to expand when the rival hospital in town just did. Slide 8

Customer Sorting Rules Ø Incumbent firms tend to have an advantage. If a new entrant comes into the market, will they buy from the new firm or the incumbent (established) firm? Ø Several possibilities suggest themselves about the consumers: 1. Brand loyalty to incumbents ─ that favors incumbents and first-movers. The new firms have to attract new customer through lower prices or different service or styling. 2. Efficient rationing – customers prefer low prices. This is favorable at times to low-cost entrants. If the entrant has higher costs, they are unlikely to successfully enter. Slide 9

More Sorting Rules 3. Inverse intensity rationing – the most price sensitive customers buy up all of the capacity of the low priced producers. Ø It is much easier to accommodate an entrant with this type of customer. Let the entrant sell to these low cost customers, and the incumbent service a different segment of customers. 4. Random rationing – customers buy from incumbents or entrants randomly, so long as the price is the same. Ø This is the most threatening to the incumbent firms, as established customers defect to the entrant if the entrant lowers its price. This means there is no Brand Loyalty. Slide 10

Perfectly Contestable Markets • The theory of contestable markets holds that, with no barriers to entry, even a monopolist must be aware that charging higher prices will encourage entry. • Hence, a contestable market will tend to have zero economic profits and competitive prices, even if there are only a few firms. • Potential entry (rather than number of firms) matters most to the profitability of markets. Slide 11

Brinksmanship and Wars of Attrition • Brinksmanship is a strategy taken that threatens, unless the other party concedes » Unions threaten strikes, unless they attain the contract they want. » If they get what they want, the strategy works. But the results can sometimes be disastrous for a union, if the firm or government doesn’t budge • Wars of Attrition occur in sequential games if firms drop out as time goes on » New product introductions lead to multiple firms competing. As some lose money on their venture, they pull out. » A slippery slope is the tendency for wars of attrition to generate mutual losses that worsen over time. » If each party ‘hangs tough, ’ then losses mount for all firms. Slide 12

If there is new firm that enters What to do? • Should we defend every geographic market, every product segment or category? » If we fight every entry, we tend to fight with price. » Lowering price to maintain market share lowers margins and tends to lower profitability. • If entry occurs, can the entrant be accommodated without long term loss of profitability? » Accommodation is like diplomacy rather than war, there may be room in the market for several firms to coexist. Slide 13

Pricing Wisdom • Set a pricing policy that is consistent with plans: » If a premium product, a price advantage can be maintained » If a discount product, need a pricing edge • When contemplating price discounting: » Require a discount be tied to the elimination of some service or feature. » Require a longer-term purchase agreement in return for a negotiated discount. » Or consider non-price incentives rather than price cuts. » Or consider expanding your product array to upscale and down scale versions. • These are represent features of diplomacy rather than war. Slide 14