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Entry barriers and entry deterrence: Sequential games

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

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Entry barriers and entry deterrence: Sequential games

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  1. Entry barriers and entry deterrence: Sequential games

  2. 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

  3. 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.

  4. Porter’s 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 firm’s 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

  5. 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?

  6. 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

  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)

  8. 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

  9. 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)

  10. 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

  11. 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

  12. 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

  13. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£50m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m (4) A decision tree for a game between Boeing and Airbus New market Enters same new market

  14. 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?

  15. 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 Boeing’s payoff if the threat is carried out and its payoff if it isn’t

  16. 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

  17. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£50m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m (4) Analysing the game tree: what will Boeing actually do at B1 and B2?

  18. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£50m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m (4) Boeing’s decisions

  19. 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?

  20. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£50m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m (4) Analysing the game tree: what will Airbus do at A?

  21. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£50m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m (4) Analysing the game tree: what will Airbus do at A?

  22. 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

  23. 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 Boeing’s threat to build the new plane credible?

  24. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£(50+12)m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m + £12m = £2m (4) Analysing the new game tree: what will happen?

  25. Airbus +£10m Boeing +£10m (1) no plane Boeing decides B1 new plane Airbus +£1m Boeing +£(50+12)m (2) no plane Airbus decides A Airbus +£50m Boeing +£1m (3) new plane no plane B2 new plane Boeing decides Airbus –£10m Boeing –£10m + £12m = £2m (4) Analysing the new game tree

  26. The game theoretic prediction • Government intervention changes the outcome of the strategic game by making Boeing’s 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 EU’s decision?

  27. E M • 1 4 • -11 Concede M1 Enter Fight E Stay Out M2 • 08 Do nothing 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.

  28. E M • 1 4 • -11 Concede M1 Enter Fight E Stay Out M2 • 08 Do nothing 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 incumbent’s threat to fight credible? What outcome do you predict in this game?

  29. E M • 1 4 • -11 Concede M1 Enter Fight E Stay Out M2 • 08 Do nothing 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

  30. 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

  31. E M • 1 4-c • -11+d Concede M1 Enter Fight E Stay Out M2 • 08-c Do nothing 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?

  32. 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)

  33. 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) • 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)?

  34. Implication • Firms can make tangible and costly investments (commitments) that make psychological entry barriers credible – but costs (c) can’t 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

  35. 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)

  36. 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……….

  37. Union –£100m Employer –£150m Employer fight E1 Concede Union +300m Employer -£500m (but union is uncertain about employer’s payoff) strike UNION U Union +£50m Employer +£200m Don’t strike E2 Employer introduces labour reforms The same kind of analysis might be applicable to a situation of industrial conflict – see e.g. Washington Post cases - what’s your prediction?

  38. Union –£100m Employer –£150m Employer fight E1 Concede Union +300m Employer -£500m (but union is uncertain about employer’s payoff) strike UNION U Union +£50m Employer +£200m Don’t strike? E2 Employer introduces labour reforms The same kind of analysis might be applicable to a situation of industrial conflict – see e.g. Washington Post cases - what’s your prediction?

  39. USA –£100m Small country –£150m Small country decides fight S1 Give in USA +300m Small Country +£50m Invade The USA U USA +£50m Small Country +£200m Don’t invade S2 Small country does nothing This game theoretic model could also be used to analysed some international relations scenarios: Is the USA’s threat to invade credible – this depends on what will the small country does if the USA invades – what will it do?

  40. USA –£100m Small country –£150m Small country decides fight B1 Give in USA +300m Small Country +£50m Invade USA A USA +£50m Small Country +£200m Don’t invade B2 Small country does nothing Since the small country will give in if the USA invades - the USA will invade – its threat is credible

  41. A very diffierent example: Robbing a bank: Is Bert’s 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

  42. Robbing a bank: Is Bert’s 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

  43. 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.

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