Entry barriers and entry deterrence: Sequential games

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Entry barriers and entry deterrence Sequential
games
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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

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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.

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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

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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?

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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

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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)

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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

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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)

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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

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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

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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

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A decision tree for a game between Boeing and
Airbus
New market
Enters same new market
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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?

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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

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Game theoretic analysis Is Boeing threat
credible?

• We need to work backwards from the last decision
  points of the game (B1 and B2) to the decision
  point at the start of the game (A)
• This is called backward induction

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Analysing the game tree what will Boeing
actually do at B1 and B2?
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Boeings decisions
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Boeing choices

• 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?

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Analysing the game tree what will Airbus do at
A?
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Analysing the game tree what will Airbus do at
A?
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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

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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?

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Analysing the new game tree what will happen?
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Analysing the new game tree
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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?

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Example 2 Entry deterrence and reputation
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.
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Example 2 Entry deterrence and reputation
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?
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Entry deterrence and reputation
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
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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

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Making the threat to fight credible
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?
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Making the threat to fight credible

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

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Making the threat to fight credible

• The threat to fight is credible if
• 1 d gt 4 c or c gt 3-d (1)
• The commitment will only be made if
• 8 c gt 4 (2)
• Combining (1) and (2)implies
• 4 gt c gt 3 d (3)
• Example
• If d 2 and c 3 both conditions are satisfied
• (1) 1d 3, 4-c 1 so 1d gt4-c
• and (2) 8-c 5 gt 4
• Which must mean that 4 gt c ( 3) gt 3-d ( 1)
• Think of two other values for d and c that would
  satisfy the conditions
• Can you provide any interpretation of what these
  conditions mean (in terms of the cost and
  rewards of commitment - the relative payoffs)?

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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

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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)

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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.

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The same kind of analysis might be applicable to
a situation of industrial conflict see e.g.
Washington Post cases - whats your prediction?
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The same kind of analysis might be applicable to
a situation of industrial conflict see e.g.
Washington Post cases - whats your prediction?
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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?
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Since the small country will give in if the USA
invades - the USA will invade its threat is
credible
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A very diffierent example Robbing a bank Is
Berts threat to blow himself and Angela up
credible?

• B A
• -?, -?
• -100, 100
• 1000, -10

Detonate
B1
NS
Not Detonate
B
A
Demands money
S
B2
Not Detonate and take the money
B Bert the bank robber A Angela the bank
cashier S surrender NS not surrender -?
implies infinite pain and suffering and/or death
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Robbing a bank Is Berts threat to blow himself
and Angela up credible?

• B A
• -?, -?
• -100, 100
• 1000, -10

Detonate
B1
NS
Not Detonate
B
A
Demands money
S
B2
Not Detonate
B Bert the bank robber A Angela the bank
cashier S surrender NS not surrender -?
implies infinite pain and suffering and/or death
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Test your understanding

• Entry barriers and entry deterrence
• 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.