Entry barriers and entry

deterrence: Sequential games

Suggested reading
Allen et al. 2009. Managerial Economics. Norton.
Chapters 6 (pp170) 11
Kreps, D. M. 2004. Microeconomics for Managers.
Norton. Chapters 20-23
Frank, R. H. 2008. Microeconomics and behaviour.
McGraw Hill. Chapters 12-13
Wall,S., Minocha, S. and Rees, B. 2010. International
Business, Pearson. Chapter 7
Rasmusen, E. 2007. Games and Information, Blackwell.
Chapters 1-2, 4-5
Carmichael, F. 2004. A Guide to Game Theory, Pearson.
Chapters 1-4, 7-8

Entry barriers and entry deterrence

Objectives are for you to be able to:
Explain what is meant by the idea of a
credible threat e.g. the threat to fight the
entry of a new firm into an industry.
Use game theory to show how an incumbent
monopolist (or oligopolistic cartel) might be
able to deter entry even though fighting
entry is costly.
Porters Five Forces again
A firm is more profitable:
The less intense the rivalry among existing
firms (monopoly or if oligopoly -collusion vs.
competition)
The less the danger of potential entrants and
the higher barriers to entry
The fewer substitutes for the firms products (the more firms that
sell complements)
The weaker the bargaining power of customers (e.g. in sports)
The weaker the bargaining power of suppliers
Implications of the analysis so far
i.e. in relation to oligopoly collusion
Oligopoly collusion (restrained rivalry) can
be sustained in some circumstances
but new entrants to the sector also have to be
kept out HOW?
Entry barriers and entry deterrence
If firms in an industry are profitable, there are
likely to be potential entrants
Successful entry will lower profits for
existing/incumbent firms
Therefore existing firms will want to impede (deter)
entry
Question: what kinds of entry barrier exist? Hint:
some are tangible or semi tangible and some
are based on beliefs (psychological)
See e.g. Kreps chapter 20 or Frank chapter 12 pp.
413-7
Types of entry barriers (1)
Tangible and semi tangible
Put entrants at a disadvantage in the competition that
takes place after entry e.g.:
Cost
economies of scale: large firms more able to withstand cost cutting
(price war)
economies of scope : large diversified firms have cost advantages
knowledge based advantages (technology gives cost
advantages)
access to resources e.g. financial or access to natural
resources or distribution channels
customer loyalty goodwill and reputation (brands, niche
markets), lock-in (e.g. due to compatibility)
legal factors e.g. certification, subsidies, trade barriers and
patents
Strategic entry barriers e.g. output and pricing decisions
(product development, bundling products, loss leaders, limit
pricing)


Types of entry barriers (2)
Psychological barriers (beliefs)
Reputation for aggressive response to entry
fighting is a credible threat even if costly for
the incumbent (e.g. price war)
Key is credibility
Analysing the idea of credibility in relation to
entry barriers and entry deterrence

Sequential moves mean that players
move in turns so one player moves first
and the other follows e.g.:
Firm A erects an entry barrier
Pre-emptive investment strategies tangible
entry barrier
threatens to fight a price war if there is entry -
Psychological entry barrier
Firm B decides whether to enter or not
See Kreps chapters 21 and 23, Allen chapter 11
and Frank chapter 13 (especially pp.463-467)

Credible threats
A key idea in the analysis of sequential
move games is that of credibility
the credibility of a threat or promise depends
on whether the action would actually be
carried out if it was tested; the potential gain
needs to outweigh any cost
A threat to enter a market whatever the cost
A threat to fight entry (e.g. by fighting a price
war) - a psychological entry barrier
In either case can pre-emptive action be taken by
those threatened (to neutralise the threat) or those
doing the threatening (to make the threat credible)
e.g. by introducing a new product or expand a
product line = a tangible entry barrier





Example 1: pre-emptive investment
decisions and credible threats in the
aircraft industry
The aircraft companies Boeing and Airbus are
involved in a strategic game, in this example
Airbus moves first
Airbus has to decide whether to invest in new plane
or not i.e. a new product line/market
Boeing is also deciding whether to invest in a new
plane but because of lags its production process it
has to make its decision after Airbus has made its
decision

The firms payoffs
The firms payoffs reflect the following:
Despite high development costs there is a market for
the new plane which could be supplied profitably
But the market for aircraft is limited and there is only
room for one company to supply a new plane
profitably
If both companies supply a new plane they would be in direct
competition with each other and both would make lower
profits due to undercutting
And large economies of scale means that high levels of output are
needed to make profits
SO THE MARKET IS NOT COMPETITIVE

A decision tree for a game
between Boeing and Airbus
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +50m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

New
market
Enters same
new market
Boeing threat
Boeing threatens to also enter the new
market - by supplying the new plane - if
Airbus supplies the new plane
By making this threat Boeing hopes to
deter Airbus from supplying the new plane
so it can make the new plane itself
Is this a credible threat?
would this threat deter Airbus from building
the new plane?
can Airbus take pre-emptive action?

Game theoretic analysis: Is Boeing
threat credible?

Boeing threat is only credible if Boeing
would actually carry it out if Airbus built
the new plane
We need to think about what Boeing would
actually do if Airbus built the new plane or did
not.
Whether the threat is credible or not depends on
Boeings payoff if the threat is carried out and its
payoff if it isnt


Game theoretic analysis: Is Boeing
threat credible?

We need to work backwards from the last
decision points of the game (B
1
and B
2
) to
the decision point at the start of the game
(A)
This is called backward induction


Analysing the game tree:
what will Boeing actually do at B
1
and B
2
?
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +50m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

Boeings decisions
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +50m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

Boeing will supply the new plane if Airbus
does not
Boeing will not supply the plane if Airbus
does
therefore the threat to do so is not credible
So what will Airbus do?
Boeing choices
Analysing the game tree:
what will Airbus do at A?
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +50m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

Analysing the game tree:
what will Airbus do at A?
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +50m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

The game theoretic prediction
Backward induction implies that Airbus will
supply the new plane and Boeing will not
Boeing threat to also supply the new plane if
Airbus supplies the plane is not a credible
threat and therefore it does not deter Airbus
Airbus will make higher profits
it has a first mover advantage and take the
pre-emptive investment choice
Exercise
The aircraft industry is considered to be strategically
important by both the USA and the EU and therefore
worth protecting by subsidising or using tariffs (see Allen
Chapter 16)
There are ongoing disputes between the USA and the
EU regarding unfair subsidisation of Boeing and Airbus
in developing aircraft
Construct a game tree and use backward induction to
predict the outcome of the game if Boeing receives a
subsidy of the equivalent of 12m from the US
government if and only if it builds the plane
In the new version of the game is Boeings threat to build the
new plane credible?
Analysing the new game tree: what will happen?
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +(50+12)m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m + 12m = 2m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

Analysing the new game tree
Airbus +10m
Boeing +10m
(1)
Airbus +1m
Boeing +(50+12)m
(2)
Airbus +50m
Boeing +1m
(3)
Airbus 10m
Boeing 10m + 12m = 2m
(4)
Boeing
decides
B
2

Airbus
decides
A
Boeing
decides
B
1

The game theoretic prediction
Government intervention changes the outcome
of the strategic game by making Boeings threat
credible
Implication: government intervention can change the
outcome of transnational strategic games played by
oligopolists
But what about the long-term?
What do you think the EU will do?
And what will be the outcome of the EUs decision?



Example 2: Entry deterrence and
reputation
E M
1 4


-1 1









E
M
1

M
2

Enter
Concede
Stay Out
Do nothing
Fight
0 8









E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel effectively a
monopoly) making monopoly profits
Entrant
decides
whether to
enter or not.
Monopolist
only has to
decide
whether to
fight or
concede if
entrant
enters.
Example 2: Entry deterrence and
reputation
E M
1 4


-1 1









E
M
1

M
2

Enter
Concede
Stay Out
Do nothing
Fight
0 8









E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel effectively a
monopoly) making monopoly profits
Is the
incumbents
threat to
fight
credible?
What outcome
do you predict
in this game?
Entry deterrence and reputation
E M
1 4



-1 1









E
M
1

M
2

Enter
Concede
Stay Out
Do nothing
Fight
0 8









Threat to fight is not credible there will be entry
followed by concession, unless the monopolist (or cartel) can
make the threat to fight credible by pre-committing to fight
Making the threat to fight credible
Firms can take costly pre-emptive actions to
make a psychological barrier credible e.g.:
Excess capacity for increasing output (lowers prices)
Holding patents or products as backup if there is entry
Choosing high fixed cost (economies of large scale)
technologies so needs to protect market share
Investing in ability to retaliate in other markets
i.e. some makes some unrecoverable sunk cost that makes
fighting optimal
There is a commitment cost (c) but a reward (d) if there is entry
and the monopolist fights

Making the threat to fight credible
E M
1 4-c



-1 1+d









E
M
1

M
2

Enter
Concede
Stay Out
Do nothing
Fight
0 8-c









The monopolist (or
cartel) invests in
some unrecoverable
sunk cost that
makes fighting
optimal:
Commitment cost = c
Generates reward if
fights entry =d.
Under what conditions will entry be fought?

Making the threat to fight credible
The threat to fight is credible only if:
(payoff from fighting) 1 + d > 4 c (payoff from concession)
or -c < 1+ d - 4 (divide through by -1)
or c > -1 - d + 4
or c > 3-d (1)
But the commitment will only be made if payoff in game
without commitment (4) is greater than 8-c:
8 c > 4
or -c > -4
or c < 4 (2)
Combining (1) and (2): The cartel will invest in the
commitment and entry will be deterred if:
4 > c > 3 d (3)

Making the threat to fight credible
The threat to fight is credible if:
1 + d > 4 c or c > 3-d (1)
The commitment will only be made if:
8 c > 4 (2)
Combining (1) and (2)implies:
4 > c > 3 d (3)
Example:
If d = 2 and c = 3 both conditions are satisfied
(1) 1+d = 3, 4-c = 1 so 1=d >4-c
and (2) 8-c = 5 > 4
Which must mean that 4 > c (= 3) > 3-d (= 1)
1. Think of two other values for d and c that would
satisfy the conditions
2. Can you provide any interpretation of what these
conditions mean (in terms of the cost and rewards
of commitment - the relative payoffs)?

Implication
Firms can make tangible and costly investments
(commitments) that make psychological entry
barriers credible but costs (c) cant be too high
and gains (d) need to be sufficiently large so
that:
Payoff from deterring entry with the investment cost
(8-c) is greater than the payoff without incurring the
commitment (4)
Increase in payoff from fighting with commitment (d)
needs to large enough so that fighting is optimal
Uncertainty and reputation
The costly commitment to fight might not even
need to be made if there is;
Uncertainty e.g. about whether the commitment has
been made or not e.g. if the probability of fighting is
high enough
And/or the scenario is repeated (indefinitely or
infinitely) and the cartel has or can gain a reputation
for fighting entry its worth a costly fight initially in
order to create a reputation for fighting
Previous aggressive behaviour reputation: E.g. Procter &
Gamble deterred Union Carbide from entry into the disposable
diaper industry by making it look like it was up for a fight with a
series of price cutting strategies (see e.g. Kreps chapter 23 page
586)


Implications
Analysis of repeated prisoners dilemma
suggests that oligopolists may be able to
sustain collusion in order to extract
monopoly profits
and sequential game theory shows that
they may be able to protect their collusive
agreements through psychological entry
barriers e.g. threatening to fight entry - as
long as this is credible
But the creation of entry barriers and entry
deterring strategies are often illegal.


The same kind of analysis might be applicable to a
situation of industrial conflict see e.g. Washington Post
cases - whats your prediction?
Union 100m
Employer 150m
Union +300m
Employer -500m
(but union is uncertain
about employers
payoff)
Union +50m
Employer +200m
Employer introduces
labour reforms
E
2

UNION
U

Employer

E
1

The same kind of analysis might be applicable to a
situation of industrial conflict see e.g. Washington Post
cases - whats your prediction?
Union 100m
Employer 150m
Union +300m
Employer -500m
(but union is uncertain
about employers
payoff)
Union +50m
Employer +200m
Employer introduces
labour reforms
E
2

UNION
U

Employer

E
1

This game theoretic model could also be used to analysed some
international relations scenarios: Is the USAs threat to invade credible
this depends on what will the small country does if the USA invades
what will it do?
USA 100m
Small country 150m
USA +300m
Small Country +50m
USA +50m
Small Country +200m
Small country
does nothing
S
2

The
USA
U
Small
country
decides

S
1

Since the small country will give in if the USA
invades - the USA will invade its threat is
credible
USA 100m
Small country
150m
USA +300m
Small Country
+50m
USA +50m
Small Country +200m
Small country
does nothing
B
2

USA
A
Small
country
decides

B
1

A very diffierent example: Robbing a
bank: Is Berts threat to blow himself
and Angela up credible?
A
B
1

B
2



B A
-, -


-100, 100


1000, -10








Demands
money
NS
Not Detonate and
take the money
B
S
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death

Robbing a bank: Is Berts threat to blow
himself and Angela up credible?
A
B
1

B
2



B A
-, -


-100, 100


1000, -10

Demands
money
NS
Not
Detonate
B
S
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death
Test your understanding
Entry barriers and entry deterrence
1.Explain what is meant by the idea of a
credible threat e.g. the threat to fight the
entry of a new firm into an industry.
2.Use game theory to show how an
incumbent monopolist (or oligopolistic cartel)
might be able to deter entry even though
fighting entry is costly.