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25E52000 Market Entry Strategies
for Entrepreneurial Business
Lecture 4
Market Entry
Based on Chapter 6 in Besanko et al. (2013).
Economics of Strategy. Sixth Edition. Wiley.
Learning Objectives
—  Identify barriers to entry
—  Analyse incumbent’s response strategies to
market entry
—  Principal concepts
Structural and strategic barriers to entry
¡  Limit pricing
¡  Predatory pricing
¡  Tit-for-tat pricing
¡ 
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Market Structures
Entry
—  Entrants are firms that produce and sell in new markets
¡ 
¡ 
Brand new firms
Established firms diversifying into a new market
—  Entry threatens incumbents in two ways
¡ 
¡ 
The market share of the incumbents is reduced
Price competition is intensified
—  A potential entrant compares the sunk cost of entry with
post-entry profits
¡ 
¡ 
Sunk costs of entry range from investment in specialised assets to obtaining
government licenses
Post-entry profits will depend on demand and cost conditions as well as
post-entry competition
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Asymmetry between Incumbents and Entrants
—  Incumbents have incurred sunk costs,
entrants haven’t
—  Established relationships with customers
and suppliers are not easy to replicate
—  Learning curve effects
—  Switching costs for the customers
Barriers to Entry
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Barriers to Entry
—  Barriers to entry are factors that
¡  allow
the incumbents to earn economic profit while
¡  making it unprofitable for the new firms to enter the
industry
—  Characteristics of markets for assessing
entry barriers
¡  Structural
barriers (natural advantages)
¡  Strategic barriers (incumbents’ actions to deter entry)
¡  Feasibility of entry deterring strategies
Structural Barriers to Entry
—  Control of key resources
¡ 
Physical resources
÷ 
÷ 
¡ 
natural resources (e.g. minerals, oil)
infrastructure (e.g. railways, phone lines)
Intangible resources
÷ 
÷ 
÷ 
Patents
Mobile phone ecosystems
Special know-how that is hard for the rivals to replicate
—  Economies of scale and scope
¡ 
¡ 
Market has significant economies of scales that the incumbent has already exploited
Potential entrant may face cost disadvantages that deter entry
—  High set-up (sunk) costs
¡ 
¡ 
¡ 
Manufacturing sector
R&D intensive industries
Any business that requires large investments in marketing and advertising
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Strategic Barriers to Entry
—  Limit pricing
¡ 
¡ 
Incumbent sets a low price to signal to entrants that post-entry profits are
impossible
Incumbent exploits scale economies and superior knowledge of the market
—  Predatory pricing
¡ 
After entry has occurred, the rival tries to force the entrant out of the market
by means of low prices
—  Capacity expansion
¡ 
¡ 
By holding excess capacity, the incumbent can rapidly increase its output
Credible threat of post-entry predatory pricing
—  Vertical integration
¡ 
Example: breweries owning pubs
—  Exclusive contracts
¡ 
Example: a retail chain selling only one brand of milk
Blockaded Entry
—  Entry is considered blockaded when the incumbent
does not need to take any action to deter entry
—  Existing structural barriers are effective in
deterring entry
High sunk entry costs relative to market size
¡  Low post-entry profitability
¡ 
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Accommodated Entry
—  Incumbents should not bother to deter entry if
the market is highly contestable
—  Structural barriers may be low
¡ 
Low sunk costs for entrants
—  Strategic barriers may be ineffective or not cost
effective
—  Typical of markets with
¡  growing
demand
¡  rapid technological change
Deterred Entry
—  Entry is deterred
if the incumbent can keep the entrant out by employing an
entry-deterring strategy
¡  if employing the entry-deterring strategy boosts the
incumbent’s profits
¡ 
—  Deterred entry is the only condition under which
the incumbents should engage in predatory acts
—  Predatory acts aim to
raise entry costs
¡  reduce post-entry profits
¡ 
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Is Limit/Predatory Pricing Rational?
Monopoly vs. Duopoly
—  Consider a market with
¡  One incumbent (monopoly)
¡  Entry by one firm that transforms the market into a
duopoly
—  For entry deterring strategies to work
¡  Incumbent must earn higher profits as a monopolist than
as a duopolist
¡  The strategy should change the entrants’ expectations
regarding post-entry competition
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Limit Pricing
—  Incumbent sets the price sufficiently low to discourage
entrants
¡ 
¡ 
¡ 
It has excess capacity and can set prices below entrant’s marginal
cost
It can meet the market demand at the low prices
It believes that it is better to be a monopolist at the limit price than to
share the market at a duopoly price
—  Entrant concludes that post-entry profits won’t cover sunk
costs of entry
¡ 
¡ 
It assumes the incumbent will lower the price further as a
consequence of entry
But is this a rational conclusion?
Limit Pricing Example
—  Jane is the incumbent in the local
craft beer market in a small town
¡ 
¡ 
¡ 
¡ 
Demand for craft beer: P = 100 – Q
Total costs: €800 + €10Q
Monopoly price: €55
Monopoly profit: €1225
—  Assume a market that lasts two years
—  Jane would earn €2,450 as monopolist
—  Paul considers entry in Year 2
¡ 
¡ 
¡ 
Scenario
If Paul enters, both expect equal
market shares
Cournot duopoly price: €40
Duopoly profit per firm: €100
Jane’s profit
Paul’s profit
Year 1
Year 2
Total
Year 2
Jane does not limit price; Paul enters
€1,225
€100
€1,335
€100
Jane sets P=€30 in Year 1, Paul enters;
Jane keeps P=€30 in Year 2
€600
-€100
€500
-€100
Jane sets P=€30 in Year 1, Paul does not
enter; Jane raises P=€55 in Year 2
€600
€1,225
€1,825
-
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Is Limit Pricing Rational for Jane?
Pm = monopoly price €55
Incumbent (Jane)
Pl = limit price €30
Pm
Pl
Pc = Cournot price €40
Year 1 profits for Jane
Entrant (Paul)
Monopoly = €1225
Out
Out
In
In
Pl
πI = 1125
πE = -100
Year 2 profits (Jane & Paul)
πI = 2450
πE = 0
Incumbent
Pc
Pl
πI = 1325
πE = 100
πI = 500
πE = -100
Limit price = €600
πI = 1825
πE = 0
Pc
Limit price = -€100
Cournot = €100
πI = 700
πE = 100
Is Limit Pricing Rational?
—  When multiple periods are considered
¡  The incumbent has to set the price low in each period
¡  To deter entry in the following period
¡  So in fact if Jane chose to limit price P=€30, that would be her price
indefinitely!
—  The incumbent may be better off being a Cournot duopolist
¡  Than limit pricing forever as a monopolist
—  Rational incumbents and entrants look for a Nash
equilibrium outcome
¡ 
¡ 
Both strive for the best outcome (e.g., profit maximisation)
Given the other’s strategy (e.g., price or capacity decision)
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Predatory Pricing
—  Predatory pricing is directed at entrants who have
already entered
¡  setting
the price below short run marginal cost
¡  with the expectation of recouping the losses via monopoly
profits once the rival exits
—  Predatory pricing will not work assuming
¡  a
finite time horizon
¡  entrants being able to foresee the future course of the
incumbent’s pricing
—  Models that include uncertainty and information
asymmetry show that predation can be a rational
Limit Pricing & Predation Can Be Rational
—  Entrant is uncertain about
¡ 
¡ 
¡ 
Market demand
Incumbent’s costs
Incumbent’s motivations
—  Information asymmetry
¡ 
¡ 
Incumbent does not have a cost advantage and/or market demand ‘meets
expectations’ for feasible business – but the entrant does not know it
The incumbent can use a low price to persuade the entrant that they do have
a cost advantage (or market demand is low)
—  Reputation
¡ 
¡ 
Predatory pricing can deter entry when the incumbent seeks a reputation for
toughness
If the incumbent does not slash prices, other challengers may consider them
‘easy’ rather than ‘tough’
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Entrant’s Strategy: ’Judo Economics’
—  Smaller entrants use the larger incumbent’s size to
their own advantage
—  Revenue destruction effect
¡  Incumbent
stands to lose more revenue if it slashes prices
compared to the entrant
¡  Incurring large losses may not appear worthwhile to the
incumbent
—  Entrant discourages the incumbent from entry
deterrence strategies by appearing to be a nonthreat in the long term
Tit-for-Tat Pricing
HOW FIRMS CAN SET PRICES ABOVE
COMPETITIVE LEVELS WITHOUT FORMAL
COLLUSION?
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Example of Price Increase
—  Paul and Jane charge pubs €40 per cask
The market is worth €120,000 in profits per year
¡  Currently split evenly between Jane and Paul (€60,000 each)
¡ 
—  Paul’s partner is pressuring him to boost profits and raise
price to €60
—  If Jane keeps her price at €40
She will capture 100% of the market
¡  And earn an annual profit of €120,000
¡ 
—  If Jane follows Paul and raises her price to €60
Total profits increase to €160,000
¡  Jane (as Paul) earns a profit of €80,000
¡ 
Example of Price Increase
—  Suppose prices can change every week
—  Paul raises his price, Jane doesn’t follow
¡ 
¡ 
¡ 
¡ 
¡ 
Paul loses one week’s profit at the current price of €40 (€1150)
Jane gains a one-off profit of 100% market share for that week (€2300)
Paul drops his price back to €40 after a week
Jane’s profits return to ‘normal’
In annual terms:
÷ 
÷ 
Jane’s profits: €61,150
Paul’s profits: €58,850
—  What if Jane followed the price increase?
¡ 
¡ 
¡ 
¡ 
Instead of the current annual profit of €60,000 each
Both would earn €80,000/pa
This is more for Jane than the current profit + one week’s profit bump
Paul has an incentive to keep his price at €60
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Prisoner’s Dilemma
Tit-for-Tat
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Tit-for-Tat Pricing
—  When two firms compete over several periods, a
tit-for-tat strategy may make cooperative pricing
possible
—  Since each firm knows that its rival will match any
price cut, neither has an incentive to engage in
price cutting
—  Similarly, there might be an incentive for
cooperative price increases
The Superiority of Tit-for-Tat
—  Tit-for-tat is easy to communicate:
¡  ‘Lowest price guaranteed’
—  Successful implementation of tit-for-tat
¡  Be nice: never be first to defect
¡  Be forgiving: cooperate if cooperation is offered
¡  Be retaliatory: defect if others defect against you
¡  Be clear: make it easy to infer that you follow this
strategy
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