Strategic entry deterrence
Encyclopedia
In business, strategic entry deterrence refers to any action taken by an existing business in a particular market
that discourages potential entrants from entering into competition in that market. Such actions, or barriers to entry
, can include hostile takeovers
, product differentiation
through heavy spending on new product development, capacity expansion to achieve lower unit cost
s, and predatory pricing
. These actions are sometimes deemed anti-competitive
and could be subject to various competition law
s.
level of output, and thereby making supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these profits
. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly
level, a strategy known as limit pricing
. Not only will this reduce the profits
being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market
. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory
to produce the extra capacity, for it to be a credible deterrent.
to any potential entrant.
One way of using this advantage to deter entry is to charge a price less than the monopoly
level. If an entrant is considering entry in a number of similar markets, a low cost incumbent can signal its efficiency to a potential entrant through lowering prices – thereby discouraging what the entrant believes would be unprofitable entry. Signalling needs to be credible to be effective – a low cost firm must be able to show that it can withstand lower profits for an extended period of time, which it would not be able to if it had higher costs.
The strategic creation of brand loyalty
can be a barrier to entry – consumers will be less likely to buy the new entrant’s product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.
Similarly, if the incumbent has a large advertising
budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large sunk cost
that will prevent some firms entering.
if its price is below its short-run marginal cost
, often referred to as the Areeda-Turner Law and which forms the basis of US antitrust
cases. The rationale for this action is to drive the rival out of the market, and then raise prices once monopoly
position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter.
In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm’s best response
in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is “weak” and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its “hard” reputation. One such example occurred when British Airways
’ engaged in a competition war with Virgin Atlantic
throughout the 1980’s over its transatlantic
route. This led Richard Branson
, chairman of Virgin Atlantic
, to say that competing with British Airways was “like getting into a bleeding competition with a blood bank
.”
If there are relatively low barriers to exit
within a market
, an incumbent faced with competing against a more efficient rival may find it optimal to exit the market rather than fight. Hence, one way to make a fighting threat credible is for the incumbent to artificially raise the cost of exit, for example by having high sunk costs.
Examples of this are railroad companies. The high sunk cost
of laying a network of railway lines makes it likely that a rail operator will be willing to fight a more costly price war
than a rival with lower sunk costs, for example an airline
that can switch its aircraft
to another route relatively easily. At the extreme, if the incumbents sunk costs are very high, any entry by a rival will end in a mutually destructive outcome.
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
that discourages potential entrants from entering into competition in that market. Such actions, or barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...
, can include hostile takeovers
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
, product differentiation
Product differentiation
In economics and marketing, product differentiation is the process of distinguishing a product or offering from others, to make it more attractive to a particular target market. This involves differentiating it from competitors' products as well as a firm's own product offerings...
through heavy spending on new product development, capacity expansion to achieve lower unit cost
Unit cost
The unit cost of a product is the cost per standard unit supplied, which may be a single sample or a container of a given number. When purchasing more than a single unit, the total cost will increase with the number of units, but it is common for the unit cost to decrease as quantity is increased...
s, and predatory pricing
Predatory pricing
In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices...
. These actions are sometimes deemed anti-competitive
Competition (economics)
Competition in economics is a term that encompasses the notion of individuals and firms striving for a greater share of a market to sell or buy goods and services...
and could be subject to various competition law
Competition law
Competition law, known in the United States as antitrust law, is law that promotes or maintains market competition by regulating anti-competitive conduct by companies....
s.
Limit price
In a particular market an existing firm may be producing a monopolyMonopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
level of output, and thereby making supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these profits
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
level, a strategy known as limit pricing
Limit price
A limit price is the price set by a monopolist to discourage entry into a market, and is illegal in many countries. The limit price is the price that a potential entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average...
. Not only will this reduce the profits
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory
Factory
A factory or manufacturing plant is an industrial building where laborers manufacture goods or supervise machines processing one product into another. Most modern factories have large warehouses or warehouse-like facilities that contain heavy equipment used for assembly line production...
to produce the extra capacity, for it to be a credible deterrent.
Signalling
The incumbent firm has an advantage of being the “first mover” and can therefore act in a way that it knows will influence the entrant’s decision. If we assume imperfect knowledge (i.e. the incumbent firm’s costs are only known privately) the entrant can only make assumptions about the incumbent’s cost structure through its price and output levels. Therefore, the incumbent can use these as a signalSignalling (economics)
In economics, more precisely in contract theory, signalling is the idea that one party credibly conveys some information about itself to another party...
to any potential entrant.
One way of using this advantage to deter entry is to charge a price less than the monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
level. If an entrant is considering entry in a number of similar markets, a low cost incumbent can signal its efficiency to a potential entrant through lowering prices – thereby discouraging what the entrant believes would be unprofitable entry. Signalling needs to be credible to be effective – a low cost firm must be able to show that it can withstand lower profits for an extended period of time, which it would not be able to if it had higher costs.
Pre-emptive deterrence
An incumbent who is trying to strategically deter entry can do so by attempting to reduce the entrant’s payoff if it were to enter the market. The expected payoffs are obviously dependent on the amount of customers the entrant expects to have – therefore one way of deterring entry is for the incumbent to “tie up” consumers.The strategic creation of brand loyalty
Brand loyalty
The American Marketing Association defines brand loyalty as:# The situation in which a consumer generally buys the same manufacturer-originated product or service repeatedly over time rather than buying from multiple suppliers within the category .# The degree to which a consumer consistently...
can be a barrier to entry – consumers will be less likely to buy the new entrant’s product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.
Similarly, if the incumbent has a large advertising
Advertising
Advertising is a form of communication used to persuade an audience to take some action with respect to products, ideas, or services. Most commonly, the desired result is to drive consumer behavior with respect to a commercial offering, although political and ideological advertising is also common...
budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large sunk cost
Sunk cost
In economics and business decision-making, sunk costs are retrospective costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken...
that will prevent some firms entering.
Predatory pricing
In a legal sense, a firm is often defined as engaging in predatory pricingPredatory pricing
In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices...
if its price is below its short-run marginal cost
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...
, often referred to as the Areeda-Turner Law and which forms the basis of US antitrust
Antitrust
The United States antitrust law is a body of laws that prohibits anti-competitive behavior and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace. These competition laws make illegal certain practices deemed to hurt businesses or consumers or both,...
cases. The rationale for this action is to drive the rival out of the market, and then raise prices once monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter.
In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm’s best response
Best response
In game theory, the best response is the strategy which produces the most favorable outcome for a player, taking other players' strategies as given...
in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is “weak” and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its “hard” reputation. One such example occurred when British Airways
British Airways
British Airways is the flag carrier airline of the United Kingdom, based in Waterside, near its main hub at London Heathrow Airport. British Airways is the largest airline in the UK based on fleet size, international flights and international destinations...
’ engaged in a competition war with Virgin Atlantic
Virgin Atlantic Airways
Virgin Atlantic Airways Limited is a British airline owned by Sir Richard Branson's Virgin Group and Singapore Airlines...
throughout the 1980’s over its transatlantic
Transatlantic flight
Transatlantic flight is the flight of an aircraft across the Atlantic Ocean. A transatlantic flight may proceed east-to-west, originating in Europe or Africa and terminating in North America or South America, or it may go in the reverse direction, west-to-east...
route. This led Richard Branson
Richard Branson
Sir Richard Charles Nicholas Branson is an English business magnate, best known for his Virgin Group of more than 400 companies....
, chairman of Virgin Atlantic
Virgin Atlantic Airways
Virgin Atlantic Airways Limited is a British airline owned by Sir Richard Branson's Virgin Group and Singapore Airlines...
, to say that competing with British Airways was “like getting into a bleeding competition with a blood bank
Blood bank
A blood bank is a cache or bank of blood or blood components, gathered as a result of blood donation, stored and preserved for later use in blood transfusion. The term "blood bank" typically refers to a division of a hospital laboratory where the storage of blood product occurs and where proper...
.”
Doomsday device
The threat to fight any potential entrant is credible if its reputation is built up, or it can set up conditions that make it optimal to fight if a rival enters.If there are relatively low barriers to exit
Barriers to exit
In economics, barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it doing so....
within a market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
, an incumbent faced with competing against a more efficient rival may find it optimal to exit the market rather than fight. Hence, one way to make a fighting threat credible is for the incumbent to artificially raise the cost of exit, for example by having high sunk costs.
Examples of this are railroad companies. The high sunk cost
Sunk cost
In economics and business decision-making, sunk costs are retrospective costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken...
of laying a network of railway lines makes it likely that a rail operator will be willing to fight a more costly price war
Price war
Price war is a term used in economic sector to indicate a state of intense competitive rivalry accompanied by a multi-lateral series of price reduction. One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new round of...
than a rival with lower sunk costs, for example an airline
Airline
An airline provides air transport services for traveling passengers and freight. Airlines lease or own their aircraft with which to supply these services and may form partnerships or alliances with other airlines for mutual benefit...
that can switch its aircraft
Aircraft
An aircraft is a vehicle that is able to fly by gaining support from the air, or, in general, the atmosphere of a planet. An aircraft counters the force of gravity by using either static lift or by using the dynamic lift of an airfoil, or in a few cases the downward thrust from jet engines.Although...
to another route relatively easily. At the extreme, if the incumbents sunk costs are very high, any entry by a rival will end in a mutually destructive outcome.