Entry

How is the market structure determined in an industry?

(number of firms, market shares, etc.)

• Entry until profit equals zero

- But what with all the positive profits we observe?

• Regulations
- But what with deregulations over the last decades?

• Technology
- Economies of scale → natural monopoly

• Vertical product differentiation

- natural oligopoly

• The established (incumbent) firms’ strategic advantage

Three strategies when confronted with an entry threat

• Blockading entry: ”business as usual”

• Deterring entry: Established firms act in such a way that

entry is sufficiently unattractive

• Accommodating entry

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 1

 Technology vs. strategic advantages

What kind of fixed costs?

• Irreversible/Sunk costs: Strategic advantage

• Reversible fixed costs: Economies of scale

Contestability theory
Main thesis: economies of scale give only a limited
advantage for the established firm

Suppose costs are:

C(q) = cq + f, if q > 0,
0, otherwise

(reversible fixed costs)

D(p)

pc AC

qc

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 2

The incumbent firm sets price pc and quantity qc.

This situation is sustainable in equilibrium because

- any p < pc by another firm yields a loss
- any p > pc by the incumbent firm entails entry

What game is played here?

• Prices before quantities?

• Short-term commitment of capacity; ”hit-and-run entry”.

- Short-term commitment means a small strategic
advantage.
- If another firm enters, then the incumbent wants to
leave as soon as possible.
- In order to prevent such entry, the incumbent may
want to set q > qm.
- As the commitment period shrinks to zero, q → qc.
[Tirole, pp. 340-341]

The strategic advantage of being incumbent

• a simple model
• a general analysis of business strategies

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 3

How to treat an entry threat? A simple model

Two-stage game: Sequential moves.

Stage 1: Incumbent (firm 1) chooses capacity.

Stage 2: Potential entrant (firm 2) chooses capacity;

zero capacity = no entry.

Profit functions (gross of any entry costs):

π1(K1, K2) = K1(1 - K1 - K2)

π2(K1, K2) = K2(1 - K1 - K2)

Ki = capacity choice of firm i.

∂2πi/∂K1∂K2 < 0.

Case (i): No entry costs (Stackelberg 1934)

Accommodated entry

Stage 2: ∂π2/∂K2 = 1 - K1 - 2K2 = 0

→ K2 = R2(K1) = (1 - K1)/2

Stage 1: π1 = K1[1 - K1 - K2] = K1[1 - K1 - (1 - K1)/2]

= K1(1 - K1)/2.

→ K1s = 1/2;
K 2s = R2(1/2) = 1/4.

π1 = 1/8; π2 = 1/16.

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 4

Comparison: Simultaneous moves - Cournot.

K1 = R1(K2) = (1 - K2)/2
K2 = R2(K1) = (1 - K1)/2
→ K1 = K2 = 1/3; π1 = π2 = 1/9.

Case (ii): Entry costs

f = entry costs.

Entry cost not relevant for firm 1 - sunk cost.

Profit function of firm 2 net of entry costs:

π2(K1, K2) = K2(1 - K1 - K2) - f, if K2 > 0;

= 0, if K2 = 0.

Blockaded entry: K2 = 0.

Stage 1: max π1(K1, 0) = K1(1 - K1).

→ K1m = 1/2.

But when is K2 = 0 the best response to K1 = 1/2?

Stage 2: K2 = R2(1/2) = 1/4, or

0.

Profit is:
π2 = π2(1/2, 1/4) = 1/16 - f, or
0.
→ Entry is blockaded if: f ≥ 1/16 ≈ 0.063.

Deterred entry:

Which stage-1 quantity makes firm 2 indifferent between entry and no

entry? K1b
If K1 ≥ K1b , then firm 2 chooses no entry.

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 5

Stage 2: max K2(1 - K1b - K2) – f
K2

→ K2 = (1 - K1b )/2.

→ π max
2
= [(1 - K1b )/2]{1 - K1b - [(1 - K1b )/2]} - f

2
π max = 0 → K1b = 1 − 2 f 

f ≥ 1/16 →
K1b ≤ K1m , and firm 1 prefers K1m to K1b ; blockaded entry.

f < 1/16 →
By setting K1 = K1b , firm 1 deters entry and earns:
π1( K1b , 0) = K1b [1 - K1b ]
= ( 1 − 2 f )[1 - ( 1 − 2 f )]
= 2 f −4f

Alternatively, firm 1 can accommodate entry and earn 1/8 (Stackelberg).

→ Entry deterrence better than entry accommodation when:

π1( K1b , 0) > 1/8
1 1 1 1 1
2 f − 4 f > 1/8 ⇔ f − f + <0 ⇔ f − f + < ⇔
2 32 2 16 32
2
⎛ 1⎞ 1
⎜ f − ⎟ <
⎝ 4⎠ 32

We are interested in the case f < 1/16, that is, f - 1/4 < 0. Taking squares, we are
interested in the absolute value of f - 1/4, that is 1/4 - f :

2
1 1 1⎛ 1 ⎞ 1⎛ 1 ⎞ 1 ⎛3 ⎞
− f < ⇔ f > ⎜1 − ⎟ ⇔ f > ⎜1 − ⎟ = ⎜ − 2 ⎟ ≈ 0.0054
4 4 2 4⎝ 2⎠ 16 ⎝ 2⎠ 16 ⎝ 2 ⎠

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 6

→ What the incumbent chooses to do in face of an entry threat
depends on the entry costs:

(i) Low entry costs imply accommodated entry:

f ∈ [0, 1 ⎛⎜ 3 − 2 ⎞⎟ ]
16 ⎝ 2 ⎠
K1 = 1/2, K2 = 1/4.

(ii) Medium-sized entry costs imply deterred entry:

f ∈ ( 1 ⎛⎜ 3 − 2 ⎞⎟ , 1 )
16 ⎝ 2 ⎠ 16
K1 = 1 − 2 f , K2 = 0.

(iii) High entry costs imply blockaded entry:

f ≥ 1/16
K1 = 1/2, K2 = 0.

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 7

How to treat an entry threat? A more general model

Two firms:
firm 1 – the incumbent
firm 2 – the potential entrant

Stage 1:
Firm 1 chooses K1.
Firm 2 decides whether or not to enter.

Stage 2:
either:
(i) firm 1 is a monopolist,
or:
(ii) both firms are in the market and choose their
stage-2 variables x1 and x2 simultaneously.

Stage-2 equilibrium:
{x1(K1), x2(K1)}

Comparative statics

How is stage-2 equilibrium affected by the incumbent’s

stage-1 move K1?

Can we apply comparative statics to an equilibrium?

- uniqueness
- stability

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 8

Stability: dynamic reasoning in a static model

If the stage-2 game changes, then also the stage-2

equilibrium changes. But will the model stabilize at the
new equilibrium?

R (x 2 )
1


⎫
⎬ R2 ( x1 )
⎭

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 9

Stability condition:

”R1 crosses R2 from above”

or: R1 steeper than R2, as we see them.

−
1
( )
R1 ' x2*
> − R2 '( )
x1
*

⇔ R1’(x2*) R2’(x1*) < 1

∂ 2π 1 ∂x1∂x2 ∂ 2π 2 ∂x1∂x2
⇔ 2 1 <1
∂ π ∂ x1 ∂ π ∂ x2
2 2 2 2

∂ 2π 1 ∂ 2π 2 ∂ 2π 1 ∂ 2π 2
⇔ − >0
2
∂x1 ∂x2 2
∂x ∂x
1 2 ∂x ∂x
1 2

Firms’ stage-2 profits:

π1(K1, x1*(K1), x2*(K1)) and
π2(K1, x1*(K1), x2*(K1))

What does firm 1 do at stage 1?

• If π2(K1, x1*(K1), x2*(K1)) ≤ 0, then firm 1 has made a

choice of K1 at stage 1 that deters entry.

• If π2(K1, x1*(K1), x2*(K1)) > 0, then firm 1 has made a

choice of K1 at stage 1 that accommodates entry.

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 10

Entry deterrence
In order to deter entry, firm 1 must set K1 such that π2 = 0.
What is the effect on π2 of a change in K1?

dπ 2 ∂π 2 ∂π 2 dx1* ∂π 2 dx2*
= + +
dK1 ∂K1 ∂x1 dK1 ∂x2 dK1
N
=0

dπ 2 ∂π 2 ∂π 2 dx1*
= +
dK1 ∂K1 ∂x1 dK1
N   

direct strategic
effect effect

Stage-1 choices with a direct effect:

- location
- advertising
- not capacity

Firm 1 wants π2 so low that π2 = 0.

• If dπ2/dK1 < 0, then π2 = 0 is obtained by increasing K1,

that is, by being big. The strategy is to look aggressive
by being big: the top dog strategy

• If dπ2/dK1 > 0, then π2 = 0 is obtained by reducing K1,

that is, by being small. The strategy is to look aggressive
by being small: the lean-and-hungry-look strategy

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 11

Entry accommodation

The optimum choice for firm 1 at stage 1 is such that firm

2’s profit after entry is positive:

π2(K1, x1*(K1), x2*(K1)) > 0

Since entry is inevitable, firm 1 seeks to maximize own

profit, given entry by firm 2.

dπ 1 ∂π 1 ∂π 1 dx1* ∂π 1 dx2*
= + +
dK1 ∂K1 ∂x1 dK1 ∂x2 dK1
N
=0

dπ 1 ∂π 1 ∂π 1 dx2*
= +
dK1 ∂K1 ∂x2 dK1
N   

direct strategic
effect effect

Suppose ∂π1/∂K1 = 0: no direct effect

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 12

The strategic effect

Assume firms’ stage-2 actions are symmetric: one firm’s

effect on the other firm’s profit is qualitatively the same for
the two firms.

⎛ ∂π 1 ⎞ ⎛ ∂π 2 ⎞
sign⎜⎜ ⎟⎟ = sign⎜⎜ ⎟⎟
⎝ ∂x2 ⎠ ⎝ ∂x1 ⎠

From the chain rule:

dx2* dx2* dx1*
( )
*
* dx1
= = R2 ' x1
dK1 dx1 dK1 dK1

⇒
⎛ ∂π 1 dx2* ⎞ ⎛ ∂π 2 dx1* ⎞
sign ⎜⎜ ⎟⎟ = sign⎜⎜ ⎟⎟ ⋅ sign (R2 ')
N
⎝∂
x2 dK1 ⎠

⎝ ∂x1 dK1 ⎠
 
slope
strategic effect, strategic effect,best -
entry accommodation entry deterrence response
curve

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 13

(i) Stage-2 variables are strategic substitutes: R2’ < 0.

Example: quantity competition at stage 2.

⎛ ∂π 1 dx2* ⎞ ⎛ ∂π 2 dx1* ⎞
sign⎜⎜ ⎟⎟ = − sign⎜⎜ ⎟⎟
⎝ ∂x2 dK1 ⎠ ⎝ ∂x1 dK1 ⎠

If an increase in K1 reduces π2, then it increases π1.

If an increase in K1 increases π2, then it reduces π1.

With strategic substitutes, entry accommodation and entry

deterrence are the same thing.

It is good for firm 1 to be aggressive at stage 1, also when it

accommodates entry.

The strategy is, either:

to look aggressive by being big:

the top dog strategy,

or
to look aggressive by being small:
the lean-and-hungry-look strategy

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 14

(ii) Stage-2 variables are strategic complements: R2’ > 0.

Example: price competition at stage 2.

⎛ ∂π 1 dx2* ⎞ ⎛ ∂π 2 dx1* ⎞
sign⎜⎜ ⎟⎟ = sign⎜⎜ ⎟⎟
⎝ ∂x2 dK1 ⎠ ⎝ ∂x1 dK1 ⎠

If an increase in K1 reduces π2, then it also reduces π1.

If an increase in K1 increases π2, then it also increases π1.

An entry-accommodating incumbent firm now wants to be

non-aggressive!

If firm 1 becomes aggressive when K1 is large, then it now

wants to keep K1 down in order to look non-aggressive:
the puppy dog strategy.

If firm 1 becomes aggressive when K1 is small, then it now

wants to have a high K1 in order to look non-aggressive:
the fat cat strategy.

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 15

Business strategies

I. Entry deterrence

Incumbent looks aggressive when investment is

big small

Top Dog Lean and Hungry Look

II. Entry accommodation

Incumbent looks aggressive when

investment is

big small

strategic Puppy Dog Fat Cat

complements

strategic Top Dog Lean and

substitutes Hungry Look

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 16

Applications:

i) Two-stage model:
1) capacities
2) prices

Prices strategic complements.

Large capacity makes a firm aggressive.

→ Puppy dog strategy: Install a rather small capacity

in order to soften the ensuing price competition

ii) Location model:

1) location
2) prices

Again: prices are strategic complements

Interpret K1 as closeness to the centre.

→ Puppy dog strategy: Locate far away from the centre

in order to soften the ensuing price competition

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 17

iii) Puppy-dog entry

Stage 1: Entrant decides capacity and price

Stage 2: Incumbent decides price

Incumbent’s options:
• monopoly on residual market: π = A + C
• undercut and get the whole market: π = B + C
D(p) – Q
D(p)

pM

A
p2

c2
C B
cM

N
xM Q
Entrant’s optimum decision: Choose p and Q such that A > B.
[Gelman and Salop, ”Judo Economics: Capacity Limitation and Coupon Competition”,
Bell Journal of Economics 14 (1983), 315-325]

A Norwegian example: Viking Cement, 1983.

[Sørgard, ”A Consumer as an Entrant in the Norwegian Cement Market”, Journal of

Industrial Economics, 41 (1993), 191-204]

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 18

iv) Persuasive advertising

Stage 1: Incumbent invests in loyalty-inducing advertising

Stage 2: Price competition (if entry)

Entry deterrence: look aggressive

High investments → Many loyal firm-1 customers in stage

2 → High price by firm 1

⇒ Lean and Hungry Look: In order to deter entry, the

incumbent firm keeps its advertising low in order to keep
post-entry prices, and therefore firm 2’s post-entry profit,
low.

Entry accommodation: look non-aggressive

Firm 1 wants to have many loyal customers, so that its

incentives to set a low price in stage 2 are weak.

⇒ Fat Cat strategy

Example: the Norwegian ice-cream market 1992

NM (Norske Meierier) vs GB.

High level of advertising by NM. Not because NM wanted
to keep GB out, but because it wanted to keep GB’s prices
high (Fat Cat).

Tore Nilssen – Strategic Competition – Lecture 6 – Slide 19