In the theories of
competition
Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, indivi ...
in
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
, strategic entry deterrence is when an existing firm within a
market
Market is a term used to describe concepts such as:
*Market (economics), system in which parties engage in transactions according to supply and demand
*Market economy
*Marketplace, a physical marketplace or public market
Geography
*Märket, an ...
acts in a manner to discourage the entry of new potential firms to the market. These actions create greater
barriers to entry
In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have ...
for firms seeking entrance to the market and ensure that incumbent firms retain a large portion of
market share
Market share is the percentage of the total revenue or sales in a market that a company's business makes up. For example, if there are 50,000 units sold per year in a given industry, a company whose sales were 5,000 of those units would have a ...
or
market power
In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market powe ...
. Deterring strategies, might include an
excess capacity,
limit pricing,
predatory pricing
Predatory pricing is a Pricing strategies, pricing strategy, using the method of undercutting on a larger scale, where a Article 102 of the Treaty on the Functioning of the European Union#Dominance, dominant firm in an industry will deliberately ...
, predatory acquisition (
hostile takeovers
In business, a takeover is the purchase of one company (the ''target'') by another (the ''acquirer'' or ''bidder''). In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to t ...
) and
switching costs Switching costs or switching barriers are terms used in microeconomics, strategic management, and marketing. They may be defined as the disadvantages or expenses consumers feel they experience, along with the economic and psychological costs of swit ...
.
Although in the
short run In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints an ...
, entry deterring strategies might lead to a firm operating inefficiently, in the
long run In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints an ...
the firm will have a stronger holder over market conditions.
Preemptive deterrence
An incumbent who is trying to strategically deter entry can do so by attempting to reduce the entrant's payoff if it were to enter the market. The expected payoffs are obviously dependent on the number of customers the entrant expects to have – therefore one way of deterring entry is for the incumbent to "tie up" consumers.
The strategic creation of
brand loyalty
In marketing, brand loyalty describes a consumer's positive feelings towards a brand, and their dedication to purchasing the brand's products and/or services repeatedly, regardless of deficiencies, a competitor's actions, or changes in the envir ...
can be a
barrier to entry
In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have ...
– consumers will be less likely to buy the new entrant's product, as they have no experience of it. Entrants may be forced into expensive price cuts simply to get people to try their product, which will obviously be a deterrent to entry.
Similarly, if the incumbent has a large
advertising
Advertising is the practice and techniques employed to bring attention to a product or service. Advertising aims to put a product or service in the spotlight in hopes of drawing it attention from consumers. It is typically used to promote a ...
budget, any new entrant will potentially have to match this in order to raise awareness of their product and a foothold in the market – a large
sunk cost
In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with '' prospective costs'', which are future costs that may be ...
that will prevent some firms entering.
Before its patent on aspartame expired, Monsanto engaged in preemptive deterrence when it signed contracts with its biggest customers, Coke and Pepsi. Because Monsanto locked in the consumers of Coke and Pepsi through its contracts, it made entry into the soda market less desirable because potential entrants would have less consumers and, in turn, less profit. Furthermore, if another firm decided to enter the market and obtain contracts with other soda brands, it would be less likely to attract as many customers as Monsanto because customers are loyal to Coke and Pepsi due to their popularity.
[Cabral L.M.B. (2008) Barriers to Entry. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London.]
Another example is when Xerox created hundreds of patents that were never used (sleeping patents) in order to make it more difficult for an entrant to challenge its monopoly on plain-paper photocopying. By creating so many patents, Xerox made it harder for potential entrants to create patents relating to plain-paper photocopying - increasing entry costs - and less firms were likely to enter the photocopying market.
In both of these examples of strategic deterrence, prior action was taken by incumbents in order to reduce the probability of a subsequent entry by another firm into the market.
Common entry deterrence strategies
Excess capacity
Strategic excess capacity may be established to either reduce the viability of entry for potential firms. Excess capacity take place when an incumbent firm threatens to entrants of the possibility to increase their production output and establish an excess of supply, and then reduce the price to a level where the competing cannot contend.
Excess capacity typically occurs in markets with firms that have a
natural monopoly
A natural monopoly is a monopoly in an industry in which high infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming adv ...
. Economist Dr. William W. Sharkey established five key aspects that lead to an monopolized industry;
# The product or service is essential;
# The location for production supersedes alternatives;
# The outputs are not storable;
# The product is produced at an economies of scale; and
# The product is can only be produced by a single supplier.
Limit pricing
In a particular market an existing firm may be producing a
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
level of output, and thereby making
supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these
profits. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
level, a strategy known as
limit pricing. Not only will this reduce the
profits being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the
market
Market is a term used to describe concepts such as:
*Market (economics), system in which parties engage in transactions according to supply and demand
*Market economy
*Marketplace, a physical marketplace or public market
Geography
*Märket, an ...
. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger
factory
A factory, manufacturing plant or a production plant is an industrial facility, often a complex consisting of several buildings filled with machinery, where workers manufacture items or operate machines which process each item into another. T ...
to produce the extra capacity, for it to be a credible deterrent.
However, limit pricing does not always need to be enacted. Many industries use limit pricing as a signaling technique. Signaling is possible here because entrants do not ever have all the information on profit margins of existing companies or the true matrix outcome. When considering entering the market, an entrant must build an outcome matrix and rely on observable factors from the incumbent companies. This gives existing firms the ability to use observable variables to confuse entrants as a strategic barrier to entry. For example, a firm may change its price, leading the incumbent to infer the marginal cost of a product (incorrectly). This could lead a firm with a high-cost structure to charge a low price in order to deter competition or a firm with a low-cost structure to charge a high price to confuse entrants and hopefully deter them.
Predatory pricing
In a legal sense, a firm is often defined as engaging in
predatory pricing
Predatory pricing is a Pricing strategies, pricing strategy, using the method of undercutting on a larger scale, where a Article 102 of the Treaty on the Functioning of the European Union#Dominance, dominant firm in an industry will deliberately ...
if its price is below its short-run
marginal cost
In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it r ...
, often referred to as the Areeda-Turner Law, which forms the basis of US
antitrust
Competition law is the field of law that promotes or seeks to maintain market competition by regulating anti-competitive conduct by companies. Competition law is implemented through public and private enforcement. It is also known as antitrust l ...
cases. The rationale for this action is to drive the rival out of the market, and then raise prices once
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter. According to Luís M. B. Cabral, as long as a potential entrant believes that an incumbent will take action to limit its profits, strategies like predatory pricing can be successful, even if the entrant misreads the situation and the incumbent does not act aggressively towards other entrants.
In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm's best response in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is "weak" and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its "hard" reputation. One such example occurred when
British Airways
British Airways (BA) is the flag carrier airline of the United Kingdom. It is headquartered in London
London is the capital and List of urban areas in the United Kingdom, largest city of England and the United Kingdom, with a populati ...
engaged in a competition war with
Virgin Atlantic
Virgin Atlantic, a trading name of Virgin Atlantic Airways Limited and Virgin Atlantic International Limited, is a British airline with its head office in Crawley, England. The airline was established in 1984 as British Atlantic Airways, and w ...
throughout the 1980s over its
transatlantic
Transatlantic, Trans-Atlantic or TransAtlantic may refer to:
Film
* Transatlantic Pictures, a film production company from 1948 to 1950
* Transatlantic Enterprises, an American production company in the late 1970s
* ''Transatlantic'' (1931 film), ...
route. This led to Virgin Atlantic chairman,
Richard Branson
Sir Richard Charles Nicholas Branson (born 18 July 1950) is a British billionaire, entrepreneur, and business magnate. In the 1970s he founded the Virgin Group, which today controls more than 400 companies in various fields.
Branson expressed ...
, to say that competing with British Airways was "like getting into a bleeding competition with a
blood bank
A blood bank is a center where blood gathered as a result of blood donation is stored and preserved for later use in blood transfusion. The term "blood bank" typically refers to a department of a hospital usually within a Clinical Pathology laborat ...
."
Predatory acquisition
Incumbent firms can eliminate the possibility of competition from entering firms by acquiring enough shares from the target firm in order to gain a desired level of control. Predatory acquisitions occur when one firm seeks to purchase a share of a smaller target firm anonymous to the
management
Management (or managing) is the administration of an organization, whether it is a business, a nonprofit organization, or a government body. It is the art and science of managing resources of the business.
Management includes the activities o ...
of the target firm. Predatory acquisitions commonly arise to form a new
majority
A majority, also called a simple majority or absolute majority to distinguish it from #Related terms, related terms, is more than half of the total.Dictionary definitions of ''majority'' aMerriam-Webster
switching costs Switching costs or switching barriers are terms used in microeconomics, strategic management, and marketing. They may be defined as the disadvantages or expenses consumers feel they experience, along with the economic and psychological costs of swit ...
represents the expense a consumer faces in the light of changing to the product or service to a competing firms. Switching costs are not strictly monetary. To forestall customers from defecting, a company might employ a number strategies that increases a customers perceived and fiscal costs when switching. The costs associated with switching commonly fall under three categories; procedural, financial, and relational.
Procedural switching costs credited to the time and effort spent in completing the change. A firm might financially deter their customers from leaving by enforcing an
exit fee. Relational switching costs refer to the inconveniences that are evoked in learning to use the new product or service.
See also
*
Limit price
A limit price (or limit pricing) is a price, or pricing strategy, where products are sold by a supplier at a price low enough to make it unprofitable for other players to enter the market.
It is used by monopolists to discourage entry into a mark ...
*
Perfect competition
In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In Economic model, theoret ...
References
{{DEFAULTSORT:Strategic Entry Deterrence
Anti-competitive practices