An Opportunity to Teach!

Last week, I had the wonderful opportunity to tutor economics, specially the topic of entry deterrence in industrial organizations, to some fellow students! I am quite proud of my understanding in this topic, and being the overachiever that I am, I compiled all of my notes and research into this post. If you're ever bored, or if you ever wonder how firms drive other firms out of the market and when firms make the decision to enter, here's the place to read! Enjoy!

Entry deterrence is a series of strategic moves that discourages potential entrants from entering the market through the incumbent’s strategic moves to minimize competition. Existing models explain the optimal quantities and prices required for the incumbent (firm 1) to set in order to deter potential entrants’ ability to succeed in the market. Through a series of strategies in the competition (assuming there will be such competition), firm 1 will be able to make the decision of production and investment where the entrant(s) will not sustain a positive profit. This post will examine the taxonomy of entry deterrence strategies through investigation of prominent models that delineate entry deterrence and cases of incumbent behavior through first move advantage. There will also be a practical case study of entry deterrence in the mobile industry, where symptoms of entry deterrence strategies will be discussed and analyzed.

Models describe entry deterrence as a game, an instance where firms (players) strategize to seize the most market power in order to maximize their own profits. Entry deterrence, in accordance to a dynamic game theory, centers around enter or stay out for the entrant and deter or accommodate for the incumbent.

Animal taxonomy of entry deterrence strategies

In a basic, general model, one may assume that there is currently only one firm in the market, imperfect knowledge within the market, and that market is a contestable market. That firm shall be referred to as the incumbent, the possessor of market power. Then, a second firm wishes to enter the market, which shall be referred to as the entrant. In this case, there are three stages of strategic planning that both the incumbent and entrant must make. In stage (i), the incumbent needs to decide on the amount of capacity, technology, utility, advertisement, etc., to invest in preparation for the second firm’s potential entry. In stage (ii), the entrant decides whether to enter or stay out of the market. This outcome of this stage depends greatly upon the action of the incumbent because the incumbent has a first move advantage, in which it is able to freely manipulate levels of investment to address the entrant. Here, the incumbent’s profit depends on its own strategy, the entrant’s planned strategy, and its own investment while the entrant’s profit depends only on its own strategy and the incumbent’s planned strategy; in short, the entrant is at a disadvantage at the inception of the game. Finally, at stage (iii), competition occurs if the entrant infiltrates the market. If not, the incumbent retains its position and earns the monopoly profit.

Although the entrant’s final decision is greatly impacted by the amount of investment the incumbent prepares beforehand, one cannot presume that entrant always fails to enter the market due to domination of the market by the incumbent (otherwise, entry anywhere would never happen), nor can one presume that the incumbent can always deter. Instead, backward induction describes the series of analyses the two players have to consider before the conclusion of this game. Backward induction begins analyzing the result of the game and progresses reversely to the beginning. Stage (iii) depends on stage (i)—how much the incumbent invests. Because the amount of investment determines whether the incumbent can deter the entrant from the market, the strategies of both the incumbent and the entrant depend on that level of investment, such that there is a unique SPNE where the incumbent and the entrant make their best possible decisions that maximize each other’s payoff. This is the level of quantity or price—in essence, strategies for different competitions—that both players materialize in order to reach optimal profits.

The result of stage (iii), if a competition is to occur, has been defined at the equilibrium point that maximizes both players’ payoffs. In stage (ii), the entrant decides whether to enter the market; thus, the entrant needs to ensure that the profit in the market will be greater than the fixed cost of entrance. Otherwise, the entrant will have no choice but to stay out. Here, the incumbent faces two realities: Deterrence is profitable, or accommodation is better off instead. Both realities influence how much investment will be prepared since the entrant’s market profit is largely determined by the incumbent’s investment. If the incumbent decides that deterrence is the better option, the firm needs to guarantee enough investment to undermine the entrant’s profit below the fixed cost of entrance; this way, the entrant would be forced to exit. The incumbent’s strategy with respect to its investment directly affects the entrant’s profit, and the magnitude of this strategic entry deterrence determines the behavior of the incumbent’s strategy. If the incumbent is “tough,” the firm will overinvest before the entrant infiltrates. By overinvesting, the incumbent will be depicted as extremely confident in terms of dictating its operations to maximize market power, pulling a “top dog” strategy that will discourage another firm’s entry. If the incumbent is “soft,” the firm will underinvest (a “lean and hungry” strategy), acting seemingly as if the market is not as strong as it appears, demoralizing another firm’s entry. In stage (i), the incumbent determines its strategic entry deterrence. Whether the firm decides to compete in strategic substitutes, where an inverse relationship occurs between the two firms’ competition, or strategic complements, where a positive relationship occurs, it applies either top dog or lean and hungry strategies to being tough and soft, respectively.

This theory provides a very simplified view into entry deterrence. On a practical scale, this theory captures a holistic view of the game—a specific game involving differentiating a price competition with a quantity competition, a specific set of strategies for each, and a more complicated selection of investments. More or less, the above model appears as more of an outline to an entry deterrence game addressed for a general competition undefined as either a quantity competition or a price competition. Taking a look at a specific model of quantity competition, the Dixit model of entry deterrence describes investment of capacity more deeply in relations to each firm’s individual cost.

Dixit model of entry deterrence – quantity competition

Similar to the previous model, the Dixit model has two players: the incumbent and the entrant. This is a two-stage game. In stage (i), the incumbent sets the choice of capacity. In stage (ii), the entrant makes an entry decision based on the incumbent’s level of capacity; if the entrant decides to enter, a certain fixed cost will be incurred. As such, the entrant will only enter if there is a positive profit. The strategic decision both firms make is their output levels.

When the firms select their quantity outputs, they do so by producing where the marginal revenue equals the marginal cost given each individual’s expectation of how much its rival will produce in response. At the very beginning of the game, the incumbent has already incurred a sunk cost due to investing in capacity; now, that firm’s marginal cost depends on its level of output. If the output level is more than capacity, it has to supplement additional marginal cost due to acquiring additional capacity. As the incumbent maximizes quantity output level, the entrant responds according to the impact of incumbent’s capacity until both players reach the Nash equilibrium where both firms have their best responses to one another. A higher capacity allows the incumbent to produce more quantity per every unit of quantity the entrant produces. Assuming that quantities competed are strategic substitutes, when the incumbent’s marginal cost decreases the firm has an incentive to produce more efficiently, which lowers the production and, in turn, the profit of the entrant. The new equilibrium involves a higher output for the incumbent and a lower output for the entrant. Now, the goal for the incumbent is to be efficient and produce output at a level that causes the entrant’s output level to be so low that its profit is lower than the fixed cost of entry. Thus, in the Dixit model, in theory, the incumbent should always overinvest in capacity in stage (i) to deter the entrant.

This theory provides a more detailed investigation into a more specific type of competition. In practicality, the idea of the increasing capacity to deter entry may already manifests itself in industries such as diamonds. De Beers, essentially a monopolist in the diamond industry, may be deterring potential entrants through its highly invested machineries and equipment along with an army of diamond cutters. Most recently, De Beers launched a £122m ship off the coast of Namibia to mine diamonds under the seabed, the only miner to do so.[1] Any entrants will immediately incur a huge cost of entry in efforts to match De Beers’ capacity in order to be competitively viable. Of course, this theory may also be inapplicable to most industries where there are usually multiple firms. With multiple firms, each firm receives a portion of the monopoly profit. Thus, entry deterrence becomes difficult as it becomes more difficult to find an appropriate level of investment for capacity while avoiding huge increases in marginal cost and staying competitively viable with other existing firms in the market. In reality, when entries are announced, incumbents do expand capacity, but expansion would seldom reach the level of entry deterrence, leading to accommodation instead.[2]

A case typical of this model being applied practically is titanium dioxide producer DuPont in the 1970s investing in capacity when a series of pollution controls were set in place.[3] In an oligopoly, DuPont initially shared the industry with six competitors, but stricter pollution controls increased prices of raw materials and forced closure by competitors. With other suppliers of titanium dioxide were struggling, DuPont invested aggressively in capacity and was able to become much more efficient than its remaining competitors. DuPont saw its demand growing steadily and was able to fulfill it, all the while discouraging competitors from expanding and producing.

Price competition

There are theories that describe price competition of entry deterrence. Predatory pricing, setting price so low to deter entrants, is an illegal strategy under antitrust laws since it causes markets to be vulnerable to monopolies. The goal for the incumbent is to force entrants out of the market by seemingly indicating the market price as extremely low. Being illegal, such strategy is not used formally in practical settings. However, a real example of this phenomenon involves Amazon in mid-2014, where “Amazon can currently purchase a book for $13… and then sell it for $9…With customers hungry for a discount, Amazon will continue to sell books at a discount until it has captured nearly all of the market share”.[4]

Another strategy, limit pricing, involves the incumbent marking a price lower than the monopoly price while producing a high level of outputs. While this decreases profit for the incumbent, this will make the market appear less attractive to the entrant. In addition, assuming that there is imperfect information, the incumbent is able to signal its low costs and efficiency to the entrant, tricking the entrant into thinking an unprofitable entry. However, the incumbent may very well be bluffing due to imperfect information, and this strategy could very well be risky if the entrant decides to enter anyway.

Brand proliferation, while not directly manipulating prices, can deter entry by physically squeezing potential entrants out of the market. This phenomenon refers to when the incumbent fulfills nearly all features of the market, so that the entrant has no place left for anything unique in the market. For example, the toothpaste industry sees its few existing firms’ products covering all sorts of benefits ranging whitening to breath refreshing to enamel builder. New entrants will probably have a difficult time producing a differentiated product that can successfully compete. This effect is also strong in the cereal industry, where a single firm (say, General Mills) has a huge selection of different brands of different flavors and themes. Brand proliferation as a strategy implicitly assumes that market exit is sufficiently expensive, or else the incumbent can always pull back products. If the incumbent can withdraw its product at a low cost while facing an entrant, brand proliferation may cause negative effects instead. Needless to say, this theory applies to many industries practically.

Entry deterrence also becomes strategized in second degree price discrimination, in which there is an unverifiable sorting of consumers to differentiate prices directly. In this case, firms create bundles of goods in order to let consumers choose for themselves and price discriminate from that. In terms of entry deterrence, the incumbent acts as a monopolist in two markets, and one of the markets is threatened by a potential entrant. By bundling goods from both markets, the incumbent may reduce the demand for the entrant, discourage its production, and cause its entry to be unprofitable. By leveraging its monopolistic market power in one market to the other, the incumbent can deter the entrant away. Such is case with Microsoft in Europe, in which the company leveraged its (near) monopolistic market power in the PC operating systems market to the work group server market. After bundling, Microsoft’s share in the latter market rose about 40% under ten years. Microsoft was eventually fined by the European Commission and forced to unbundle.[5]

Case Study

In reality, most markets are not monopolistic. Even in industries with huge brand names, monopolistically competitive or oligopoly structure exists. Such as the case in the mobile app market. iPhones and Android have the highest market share in the mobile industry, but what is more scintillating is Apple and Google’s monopolistic power over mobile stores, namely the App Store and Google Play (formerly Android Market). When both companies established these two digital stores, they leveraged their first move advantages and gathered app developers across the world to flood their systems. According to Statista, the percent of app developers that are yet to be on Google Play and App Store are 20% and 48% respectively (as expected, Apple has more restrictions on app developers than Google) while for Kindle Store and Windows Store, the numbers are high up at 74% and 72%, respectively.[6]

Like computers, there are many more mobile phone manufacturers than operating systems. Already, there is a huge barrier of entry for a new operating system/app store to infiltrate the market. In relations to entry deterrence strategies, the existing app stores discussed above have invested in a huge amount of capacity ranging from contracting with phone manufacturers to enticing emerging app developers to optimizing store function. In terms of the number of apps, one can compare the App Store and Google Play and deducing potential entry deterrence strategies in play. When the App Store was launched in July 2008, it started with around eight hundred apps. Google Play, or Android Market, launched in October 2008. Interestingly, beginning in September 2008, the number of apps in the Apple App Store grew extremely rapidly, at a rate of two hundred and seventy-five apps per day.[7] By January 2010, there were 140,000 apps in the App Store. However, Google Play app growth did not accelerate at first. By October 2010, Google Play barely reached over 100,000 apps while App Store had 400,000 apps in November 2010.[8] The huge expansion of the App Store in late 2008 may be a sign of investment to combat Google Play. For the developers, access to iPhone users, who are usually better off economically, was very attractive, and Apple was not too keen on making money off of apps. Developers keep 70% of the profit without needing to pay to list their products. On Apple’s part, the company has guaranteed top quality design on both the mobile hardware and software.[9] Google Play did not reach a huge expansion until October 2012, where growth appears to be exponential.[10] It has now overtaken App Store’s total number of apps. However, Google Play has less developer restrictions than App Store and has been criticized for low-quality apps (Apple ensures topnotch quality).

In conclusion, Incumbents often have an incentive to engage in strategic entry deterrence to protect both market power and economic profits. Because entry depends on the entrant’s expectations of its post-entry profitability, incumbent firms may be able to engage in entry deterrence by making strategic investments—prior to entry—that make it profit maximizing for the incumbent to respond aggressively post-entry by committing to produce the limit output. The incumbent decides how much to invest in capacity in anticipation of the entrant’s strategy. Post-entry the costs of capacity are sunk and up to its capacity the marginal costs of the incumbent firm are less than the marginal costs of the entrant. This cost advantage makes it credible for the incumbent firm to produce to capacity—provided its marginal revenue is not less than its marginal costs exclusive of capacity costs. Entry deterrence strategies are played practically in the real world, but antitrust laws often prevention huge market power of one firm.

[1] Yeomans, Jon. "De Beers £122m Diamond-hunting Ship." The Telegraph. Telegraph Media Group, 15 June 2017. Web. <http://www.telegraph.co.uk/business/2017/06/15/de-beers-launches-122m-diamond-hunting-ship-coast-namibia/>.

[2] Church, Jeffrey R., and Roger Ware. Industrial Organization: A Strategic Approach. Boston: McGraw Hill, 2004. Print.

[3] See previous footnote.

[4] Sandholm, Drew. "Amazon's 'Predatory Pricing' Questioned." CNBC. CNBC, 30 June 2014. Web. <http://www.cnbc.com/2014/06/30/amazons-predatory-pricing-questioned.html>.

[5] "Microsoft v Commission Case Summary." European Commission Legal Services (2007): n. pag. Web. < http://ec.europa.eu/dgs/legal_service/arrets/04t201_en.pdf>

[6] "App Developers: Number of Apps in App Stores 2015 | Statistic." Statista. N.p., November 2015. Web. <https://www.statista.com/statistics/515053/developers-number-of-apps-across-app-stores/>.

[7] Costello, Sam. "Charting The Explosive Growth of the App Store." Lifewire. N.p., n.d. Web. <https://www.lifewire.com/how-many-apps-in-app-store-2000252>.

[8] "Number of Google Play Store Apps 2017 | Statistic." Statista. N.p., 2017. Web. <https://www.statista.com/statistics/266210/number-of-available-applications-in-the-google-play-store/>.

[9] Ranger, Steve. "IOS versus Android. Apple App Store versus Google Play: Here Comes the next Battle in the App Wars." ZDNet. ZDNet, 16 Jan. 2015. Web. <http://www.zdnet.com/article/ios-versus-android-apple-app-store-versus-google-play-here-comes-the-next-battle-in-the-app-wars/>.

[10] See footnote #8.