Entry Deterrence and Predation
Chapter 9: Entry Deterrence and
Predation
1
Introduction
• A firm that can restrict output to raise market price has
market power
• Microsoft (95% of operating systems) and Campbell’s
(70% of tinned soup market) are giants in their industries
• Have maintained their dominant position for many years
– Why can’t existing rivals compete away the position of such firms?
– Why aren’t new rivals lured by the profits?
• Answer: firms with monopoly power may
– eliminate existing rivals
– prevent entry of new firms
• These actions are predatory conduct if they are profitable
only if rivals, in fact, exit
– e.g., R&D to reduce costs is not predatory
Chapter 9: Entry Deterrence and
Predation
2
Evolution of market structure
• Evolution of markets depends on many factors
– one is relationship between firm size and growth
• Gibrat’s Law
– begin with equal sized firms
– each grows in each period by a rate drawn from a random
distribution
– this distribution has constant mean and variance over time
– result is that firm size distribution approaches a log-normal
distribution
• Very mechanistic
– no strategy for growth
• Including strategic decision making affects distribution but not
conclusion that firm sizes are unequal
– What about the facts in the market place?
Chapter 9: Entry Deterrence and
Predation
3
Monopoly power and market entry
• Several stylized facts about entry
– entry is common
– entry is generally small-scale
• so small-scale entry is relatively easy
– survival rate is low: >60% exit within 5 years
– entry is highly correlated with exit
• not consistent with entry being caused by excess profits
• “revolving door”
• reflects repeated attempts to penetrate markets dominated by large firms
• Not always easy to prove that this reflects predatory
conduct
• But we need to understand predation it if we are to find it
Chapter 9: Entry Deterrence and
Predation
4
Predatory conduct and limit pricing
• Predatory actions come in two broad forms
– Limit pricing: prices so low that entry is deterred
– Predatory pricing: prices so low that existing firms are driven
out
• Outcome of either action is the same—the monopolist
retains control of the market
• Legal action focuses on predatory pricing because this
case has an identifiable victim
– a firm that was in the market but that has left
• Consider first a model of limit pricing
– Stackelberg leader chooses output first
– entrant believes that the leader is committed to this output choice
– entrant has decreasing costs over some initial level of output
Chapter 9: Entry Deterrence and
Predation
5
A limit pricing model
Then the entrant’s
the is
residual demand R1These
,
are the cost curves
$/unit
residual With
demand
entrant
for
potential entrant
Bythe
committing
to output
R1 =the
D(P)
- Q1 can operate profitably.
Entry is not deterred by the d
Q the incumbent deters
incumbent choosing Q1.
d
entry. Market price P
Then the entrant’s
is the limit price
e
e
R1
At price
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is The
is MR
entrant’s residual
The
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e
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Assume
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Re = D(P) - Qd
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incumbent
commits
D(P) = Market Demand
to output Q1
Re
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Pe
MRe
qe
Quantity
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Qd
Q1
Chapter 9: Entry Deterrence and
Predation
6
Limit pricing
• Committing to output Qd may be aimed either at
eliminating an existing rival or driving out a potential
entrant.
• Either way, several questions arise:
– Is limit pricing more profitable than other strategies?
– Is the output commitment credible?
– If output is costly to adjust then commitment is possible
• why should this property hold?
– could be claimed to be ad hoc to support the theory
• even if it holds, is monopoly at output Qd better than Cournot?
– may not be if the entrant’s costs are low enough
• Credibility may relate output to capacity
Chapter 9: Entry Deterrence and
Predation
7
Capacity expansion and entry deterrence
• For predation to be successful and rational
– the incumbent must convince the entrant that the market after
the entrant comes in will not be profitable one
• How can the incumbent credibly make this threat?
• One possible mechanism
– install capacity in advance of production
• installed capacity is a commitment to a minimum level of output
• the lead firm can manipulate entrants through capacity choice
• the lead firm may be able to deter entry through its capacity choice
– but is this credible?
– capacity must be costly to install and should be irreversible
Chapter 9: Entry Deterrence and
Predation
8
The Dixit model
• Consider a two-stage game
– incumbent in period 1 installs capacity
•
•
•
•
capacity K1 costs r.K1 to install
in second period incumbent can produce up to K1 at unit cost w
capacity can be expanded in period 2 at additional cost r per unit
capacity cannot be reduced in period 2
– potential entrant in period 2 observes incumbent’s capacity
choice
• to enter and produce incumbent needs capacity K2 which costs r.K2
• unit cost of production is w
• note: entrant will never install unused capacity
– if entry takes place firms play a Cournot game in the second
period
• Market demand: P = A – B(q1 + q2)
Chapter 9: Entry Deterrence and
Predation
9
The Dixit model 2
• Costs for the incumbent are:
– C1 = F1 + w.q1 + r.K1 for q1 < K1; marginal cost w
– C1 = F1 + (w + r)q1 for q1 > K1; marginal cost w + r
• Costs for the entrant are:
– C2 = F2 + (w + r)q2 ; marginal cost w + r
• Standard Cournot analysis gives the best response
functions:
– q*1 = (A – w)/2B – q2/2
when q1 < K1
– q*1 = (A – w – r)/2B – q2/2 when q1 > K1
– q*2 = (A – w – r)/2B – q1/2 provided that q*2 > 0
• for the entrant to enter it must expect to cover the sunk costs F2
• this implies a lower limit on the output that the entrant must make
Chapter 9: Entry Deterrence and
Predation
10
The Dixit model 3
• The incumbent’s best
response function has a
break in it at K1
• The entrant’s best
response function has a
break where sunk costs
are not covered
• Equilibrium depends
upon these two breaks
q2
L’
N’
R’
Chapter 9: Entry Deterrence and
Predation
R
N
K1
L
q1
11
The Dixit model 4
q2
• Consider the possibilities
• Suppose that firm 2 enters
• Equilibrium must lie
between T and V
• Where depends upon
location of the break in R’R
• Firm 1’s output is greater
than T1 and smaller than V1
• So capacity choice lies
between T1 and V1
L’
N’
R’
T2
T
V
V2
R
N
T1
Chapter 9: Entry Deterrence and
Predation
V1 L
q1
12
The Dixit model 5
q2
• Now suppose that firm 2
does not enter
• Must be that it cannot break
even at output less than T2
• Then firm 1 would want to
choose capacity M1
L’
N’
– this is the monopoly output
with MC = w + r
• M1 is actually the Stackelberg
output level for firm 1
– firm 1 as market leader will
never choose output and
capacity less than M1
R’
T2
M2
V2
T
S
V
R
N
T1
Chapter 9: Entry Deterrence and
Predation
M1
V1 L
q1
13
The Dixit model 6
• Suppose that the break in the
entrant’s best response
function lies at BL in R’T
• Incumbent chooses capacity
M1 and entry is deterred
• Suppose that the break in the
entrant’s best response
function lies at BS in TS
T2
M
• Incumbent chooses capacity 2
V2
M1 and entry is deterred
q2
L’
N’
R’ BL
TB
S S
V
BL
N
T1
M1
V1 L
• Suppose that the break in the entrant’s
best response function lies at BL in VR
• Incumbent chooses capacity M1 and entry is accommodated
Chapter 9: Entry Deterrence and
Predation
R
q1
14
The Dixit model 7
• Now suppose that the break
in the entrant’s best response
function lies at B* in SV
• Incumbent can choose to
install capacity M! and share
the market
• Or install capacity B! and
maintain monopoly in the T
2
M2
market
V2
• Choice depends upon relative
profitability
q2
L’
N’
R’
T
S
B*V
N
T1
M1 B1 V1 L
R
q1
– If B* is “close to” S then use capacity to deter entry
– If B* is “close to” V then accommodate entry as Stackelberg leader
Chapter 9: Entry Deterrence and
Predation
15
Capacity expansion and entry deterrence 2
• An example:
–
–
–
–
–
–
P = 120 - Q = 120 - (q1 + q2)
marginal cost of production $60 for incumbent and entrant
cost of each unit of capacity is $30
firms also have fixed costs of F
incumbent chooses capacity K1 in stage 1
NOTE: incumbent will always produce at least K1 in
production stage—otherwise it throws away revenue that could
help cover the cost of installed capacity
– entrant chooses capacity and output in stage 2
– firms compete in quantities in stage 2.
Chapter 9: Entry Deterrence and
Predation
16
Entry deterrence
• Entry may not occur
– entrant’s costs are too high
• blockaded entry
• not predatory
• Entry may be accommodated
– entrant’s costs are low
• incumbent takes advantage of its being first in the market
• but does not deter
• Entry may be strategically deterred
– strategic deterrence profitable for the incumbent
– installs excess capacity as an entry-deterring strategy
– uses a credible commitment
Chapter 9: Entry Deterrence and
Predation
17
Preemption and the persistence of monopoly
• A distinct but related issue is an incumbent
investing early to prevent new entry
– market may be a natural monopoly at current size
– but expected to grow and attract entry
• Now we have an issue of timing
• It may be in the interests of an incumbent to
preempt by
– building new plants prior to a rival’s entry
– adding new products prior to a rival’s entry
• Related to another issue
– entrant may race to innovate to preempt entry
• A simple model:
Chapter 9: Entry Deterrence and
Predation
18
Preemption and the persistence of monopoly 2
• A market with an incumbent
– current profit pM
– market is expected to double in the next period and stay at the
new size in perpetuity
– to meet the new demand requires additional capacity at cost of F
– the new capacity can be added:
• In first period or in second period
• By incumbent or by new entrant
• With no threat of entry
– incumbent installs new capacity at beginning of second period
– profit is 2pM minus cost of capacity
• With threat of entry may need to install capacity early
Chapter 9: Entry Deterrence and
Predation
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Preemption and the persistence of monopoly 3
• Consider the entrant choosing in period 1
– suppose that competition is Cournot if entry occurs
– entry in period 1 gives the entrant pe1 = pC + 2pC/(1 – R) - F
• R is the discount factor = 1/(1+r) where r is the discount rate
– entry in period 2 gives the entrant pe2 = 2pC/(1 – R) – RF in
present value terms
– suppose pe1 < pe2 which implies (1 + r)pC < rF
– entrant will enter in the second period
Chapter 9: Entry Deterrence and
Predation
20
Preemption and the persistence of monopoly 4
• What about the incumbent?
– do nothing in period 1
• entry takes place in period 2
• earns 2pC/(1 – R)
– install additional capacity in period 1
• entry deterred
• earns 2pM/(1 – R) – F
– install capacity early provided that 2(pM - pC)/(1 – R)
>F
• provided that present value of additional profit from protecting
monopoly is greater than the fixed cost
• Incumbent wants to maintain monopoly; entrant
only shares in non-cooperative profits
Chapter 9: Entry Deterrence and
Predation
21
Market preemption
• Why does the incumbent have a stronger
incentive to invest “early”?
–
–
–
–
the incumbent is protecting a valuable monopoly
the entrant is seeking a share of the market
so the incumbent’s incentive is stronger
willing to incur initial losses to maintain market
control
Chapter 9: Entry Deterrence and
Predation
22
Evidence on predatory expansion
• Some anecdotal evidence
• Alcoa
– evidence that consistently expanded capacity in advance of
demand
• Safeway in Edmonton
– evidence that it aggressively expanded store locations in
response to potential entry
• DuPont in titanium oxide
– rapidly expanded capacity in response to to changes in rivals’
costs
– market share grew from 34% to 46%
Chapter 9: Entry Deterrence and
Predation
23
Introduction
• Charges of predatory conduct are not new
– Microsoft is only one of the latest
– goes back to the days of Standard Oil
– more recent examples of predatory pricing
• Wal-Mart
• AT&T
• American Airlines
• But they face problems of credibility
– price low to eliminate rivals
– then raise price
– so why don’t rivals reappear?
Chapter 9: Entry Deterrence and
Predation
24
Predatory pricing: myth or reality?
• Theoretical and empirical doubts
– predation is generally not subgame perfect without
uncertainty regarding the incumbent
• return to this below
– McGee’s argument that predation is dominated by
another strategy
• merger is more profitable than predation
• so predation should not happen
– take an example
•
•
•
•
•
two period market
inverse demand P = A – B(qL + qF)
qF is output of leader and qF is output of follower
leader is a Stackelberg quantity leader
both leader and follower have constant marginal costs of c
Chapter 9: Entry Deterrence and
Predation
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An example of predation
• At the Stackelberg equilibrium
– leader makes (A – c)2/8B
– follower makes (A – c)2/16B
– if the leader were a monopolist it would make (A – c)2/4B
• Suppose that the leader predates in period 1
– sets output (A – c)/B to drive price to marginal cost
– follower does not enter
– leader reverts to monopoly output in period 2 but the follower
does not enter
– aggregate profit is (A – c)2/4B
Chapter 9: Entry Deterrence and
Predation
26
An example of predation 2
• Suppose instead that the leader offers to merge
with the follower in period 1
– monopoly in both periods
– aggregate profit (A – c)2/2B
– so the leader can make a merger offer that the
follower will accept
• Merger is more profitable than predation but:
– merger may not be allowed by the authorities
• monopoly power
– what if there are additional potential entrants?
• may enter purely in the hope of being bought out
• Main point remains: threat of predation has to
be credible if it is to work
Chapter 9: Entry Deterrence and
Predation
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Predation and imperfect information
• Suppose that the entrant faces financial
constraints
– must borrow to finance entry
• Entrant also faces uncertainty pre-entry
– faces some probability of “low” returns
• private information that can be concealed from bank
• incentive to misrepresent
• bank must then enforce removal of funding if low returns are
reported
• Incumbent then has incentive to take actions
that increase probability of failure
Chapter 9: Entry Deterrence and
Predation
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Asymmetric information and limit pricing
• The preemption “games” are ways of resolving
the Chain-store paradox
– indicate that it is rational for incumbents to make
investments that are not profitable unless they deter
entry
• An alternative approach: information structure
– suppose that an entrant does not have perfect
information about the incumbent’s costs
• if the incumbent is low cost do not enter
• if the incumbent is high-cost enter
– does a high-cost incumbent have an incentive to
pretend to be low-cost - to prevent entry?
• for example by pricing as a low-cost firm
Chapter 9: Entry Deterrence and
Predation
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•
•
•
•
A (simple) example
Incumbent has a monopoly in period 1
Threat of entry in period 2
Market closes at the end of period 2
Entrant observes incumbent’s actions in period
1
• These actions determine whether or not to
enter in period 2
• Incumbent is expected to be high-cost or lowcost
– no direct information on costs
– entrant knows that there is a probability p that the
incumbent is low-cost
• Need to specify pay-offs in different situations
Chapter 9: Entry Deterrence and
Predation
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The Example 2
• Incumbent profits in period 1 (in $million)
– low-cost firm acting as low-cost monopolist: $100m
– high-cost firm acting as high-cost monopolist: $60m
– high-cost adopting low-cost monopoly price: $40m
• Incumbent profits in period 2
– if no entry, profits according to true type
– if entry occurs:
• low-cost incumbent: $50m
• high-cost incumbent: $20m
• Entrant’s profits in period 2
– competing against a low-cost incumbent: -$20,
– competing against a high-cost incumbent: $20m
Chapter 9: Entry Deterrence and
Predation
31
The Example 3
High Price
E3
Enter
Incumbent: 60 + 20 =
80 Entrant: 20
Stay Out
Incumbent: 60 + 60 = 120
Entrant: 0
Enter
Incumbent: 40 + 20 = 60
Entrant: 20
High-Cost
Nature
I1
Low Price
E4
Stay Out
Low-Cost
I2
Enter
Low Price
E5
Stay Out
Incumbent: 40 + 60 = 100
Entrant: 0
Incumbent: 100 + 50 = 150
Entrant: -20
Incumbent: 100 + 100 = 200
Entrant: 0
Chapter 9: Entry Deterrence and
Predation
32
With uncertainty and
With no uncertainty
The ifexample
a4
low price the entrant
the entrant enters
the
does not
incumbent is high-cost
Incumbent:
60 +know
20 = 80if
Enter
Entrant:
20 at E4 or E5
he is
High Price
E3
Stay Out
Incumbent: 60 + 60 = 120
Entrant: 0
High-Cost
Nature
I1
Low Price
Enter
E4
Stay Out
Low-Cost
I2
Enter
Low Price
E5
Stay Out
Incumbent: 40 + 20 = 60
Entrant: 20
Incumbent: 40 + 60 = 100
Entrant: 0
Incumbent: 100 + 50 = 150
Entrant: -20
Incumbent: 100 + 100 = 200
Entrant: 0
Chapter 9: Entry Deterrence and
Predation
33
The example 3
• Consider a high-cost incumbent
– high price in period 1 - entry happens, profits are 80
– low price in period 1 - if no entry profits are 100
– low price in period 1 - if entry profits are 60
• A high-cost incumbent has an incentive to
pretend to be low-cost
• The entrant knows this
• So a low-price of itself will not deter entry
– it is not a true signal of the incumbent’s type
• Only the probability that low-price means lowcost deters entry
Chapter 9: Entry Deterrence and
Predation
34
The example 4
• Consider the profits of the entrant given that the
incumbent sets a low-price in period 1
– if the incumbent is high-cost - profit is 20 with
probability 1 - p
– if the incumbent is low-cost - profit is -20 with
probability p
– so expected profit is 20(1 - p) - 20p = 20 - 40p
• Will the entrant not enter when it sees a low price?
• Only if p > 1/2
• Only if there is a “sufficiently high” probability
that the incumbent is low cost.
• Provided that pretence is expected to work a highcost incumbent has an incentive to set a limit price
Chapter 9: Entry Deterrence and
Predation
35
Limit pricing and uncertainty
• Monopoly power can persist even if the
incumbent is high-cost
• Entry only takes place if entrants believe that
the incumbent is high-cost
– so entry is more likely when incumbents are
expected to be weak
– entry then consistent with exit: efficient entrants
drive out inefficient incumbents
Chapter 9: Entry Deterrence and
Predation
36
Limit pricing and uncertainty 2
• Note: the model shows how a high-cost firm
can deter entry.
• However, to do this it must set a low price.
– This is how it “fools” the would-be entrant.
• The threat of entry forces the incumbent to
price below the monopoly price it would
otherwise set
• This lower limit price therefore mitigates the
resource misallocation effects of monopoly.
Chapter 9: Entry Deterrence and
Predation
37
Predation and Financial Constraints
• Two period model. Microhard and Newvel both start
in the market.
• Fixed cost are F and monopoly and duopoly profits πM
and πD
• Microhard may try to drive Newvel out in the first
period by driving pricing down so each firm looses
- ε = (πP – F )
• If Newvel is credit constrained, it cannot borrow the
necessary fixed cost for period 2 if it loses money in
period 1
• Microhard will predate if
• πM – F – ε > 2(πD – F) or πM – ε > 2πD – F
• Uncertainty and asymmetric information can generate
credit constraints
Chapter 9: Entry Deterrence and
Predation
38
Long-term contracts as entry barriers
• Can an incumbent preclude entry by signing customers to
log-term contracts that can only be broken with penalty?
– Chicago School Answer: No. Buyer cannot be forced to sign a
contract that is against its own best interest
– Post Chicago School Answer: Yes. Incumbent can write a contract
that makes it in the customer’s interest to keep out a lower cost
alternate supplier
• Essence of the Post-Chicago argument
– A new entrant will earn a lot of surplus
– The long-term contract can be written so as to limit entry by
making sure that much of any surplus generated by entry goes to
the customer
Chapter 9: Entry Deterrence and
Predation
39
An example
• The Setup: One seller (the incumbent), one buyer
and one potential entrant—and two periods
– Buyer is willing to pay $100 for a commodity
– Incumbent has cost of $50
– Potential entrant with cost c randomly distributed
between 0 and $100
– Contract between buyer and seller written in first period
but covers 2nd period
– Entrant decides whether or not to enter in 2nd period
– Bertrand competition post-entry
Chapter 9: Entry Deterrence and
Predation
40
The example 2
• Competition and entry without a Long-term Contract
– No entry: the incumbent sets a price of $100
– Entry will occur only if entrant’s cost is c < $50
– Competition between the entrant and the incumbent will mean the
entrant cannot price above $50.
– No pressure for it to price below $50 even if c is very low
– In this scenario, the buyer’s expected price is:
– P = ½ x $100 + ½ x $50 = $75  Expected Surplus = $25
– Buyer must be offered this surplus in any other contract
Chapter 9: Entry Deterrence and
Predation
41
The example 3
• Competition and entry with a long-term contract
– Can the incumbent offer the buyer a contract that makes entry less
probable?
• Yes.
– Consider the following contract (written in 1st period):
• In 2nd period, incumbent sells to buyer at P = $75.
• Buyer buys from incumbent unless the buyer pays a $50 breach of contract
fee
– Entrant must now charge no more than $25
• price plus breach of contract fee must be no more than $75
• so entry occurs only if c < $25, i.e. ¼ of the time.
– Buyer:
• ¾ of the time, it stays with the contract and pays $75.
• ¼ of the time it breaks the contract, pays entrant $25 and pays incumbent $50
breach-of-contract fee for a total of $75.
• Buyer’s expected surplus is $25 with contract as it was without the contract.
Chapter 9: Entry Deterrence and
Predation
42
The example 4
• Incumbent’s Incentive to Offer the contract:
– Without the contract, incumbent wins the 2nd period
competition ½ the time.
• It will sell at P = $100 and incur cost of $50 for an expected profit of
$25.
– With the contract it will:
• Win the 2nd period competition ¾ of the time. It will sell at P = $75,
incur a cost of $50 for an expected profit of 0.75 x $25 = $18.75
• Lose the 2nd period competition ¼ of the time. It will then incur no
cost but receive a $50 breach of contract payment. Its expected
profit will be 0.25 x $50 = $12.50.
– Overall, incumbent’s expected profit with the contract is
$31.25 > $25. The incumbent prefers the contract.
Chapter 9: Entry Deterrence and
Predation
43
Contracts and efficiency
• Incumbent’s profit is greater with the contract
– $31.25 as against $25
• Buyer’s expected surplus is the same with and
without the contract
• So the contract will be offered and signed
• But it is inefficient
– net gain to incumbent and buyer of $6.25
– this is less than the entrant’s reduction in surplus
• Why?
Chapter 9: Entry Deterrence and
Predation
44
Contracts and efficiency 2
• Without the contract
–
–
–
–
entrant stays out half the time
when it enters it prices at $50
expected cost is $25 (uniformly distributed on [$0, $50]
expected surplus is therefore (50 – 25)x1/2 = $12.50
• With the contract
–
–
–
–
entrant stays out three quarters of the time
when it enters it prices at $25
expected cost is $12.50
expected surplus is (25 – 12.5)x1/4 = $3.13
Chapter 9: Entry Deterrence and
Predation
45
Naked Exclusion
• If there are initial economies of scale, the
incumbent can contract with enough of the market
to prevent the potential entrant from entering.
• Customers will agree to the contract because if the
potential entrant does not enter, they will be
charged monopoly price, so they are better off with
the long-term contract
• If customers could coordinate to not take the long
term contract, the entrant would enter and they
would be better off, but often they cannot
coordinate.
• Two Nash Equilibria: all consumers sign or none
Chapter 9: Entry Deterrence and
Predation
46
Predatory Conduct and Public Policy
• The evidentiary requirements for prosecuting
predatory pricing cases are high
– Pricing below cost
– The predator had a reasonable expectation of recouping
the losses
• Very hard to distinguish predation from other procompetitive behavior
– Hard to measure marginal cost
– Learning curves, network effects, and other externalities
Chapter 9: Entry Deterrence and
Predation
47
Empirical Application: Entry Deterrence
In The Pharmaceutical Industry
• It is difficult to test in a statistical sense for systematic
entry deterrence. We need to identify markets:
– where entry was likely; and
– where the incumbent could do something to limit entry
– where deterrent actions can be identified
• Incumbent may not take any action if entry is not likely
or if there is little it can do to stop entry.
• Incumbent may take action if entry is fairly likely in an
effort to limit the number coming in
• Efforts by incumbent to build brand loyalty may seem
like entry deterrence but it may instead result in
incumbent not needing to price aggressively when rival
enters, which makes entry easier
Chapter 9: Entry Deterrence and
Predation
48
Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 2
• Ellison and Ellison (2006) try to overcome these issues
in a recent study of the pharmaceutical industry
• They look at the advertising behavior of companies in
the case of 64 drugs about to lose their patents
• Their first step is to identify those markets where entry
following patent expiration was likely
Chapter 9: Entry Deterrence and
Predation
49
Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 3
• For this purpose, they estimate the equation:
Entryi =constant + β1Revi + β2Hospi + β3Chronici + εi
– Entryi is a 1,0 dummy variable equal to 1 if there was entry
within three years after patent expiration in market i
– Revi is the average revenue earned by the incumbent in market i
for the three years before expiration
– Hospi is the fraction of drug revenues paid by hospitals
– Chronic is 1 if the drug treats a chronic/acute condition and 0
otherwise
• Because they estimate a Probit equation, the results give the
probability of entry as a function of market features
• They identify three market types where the probability of entry is: 1)
low; 2) medium; and 3) high
Chapter 9: Entry Deterrence and
Predation
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Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 4
• What is predatory or entry-deterring behavior here? Ellison
and Ellison focus on advertising.
• They note that when one firm advertises a prescription drug,
the benefits of that advertising spill over to rivals
• The decision-makers with respect to pharmaceuticals are
doctors. They will have a keen sense of the chemical identity
of generic competitors.
• If an advertisement trumpets the ability of a a particular
hydrochloride to alleviate depression, doctors understand
that near identical hydrochlorides will have the same effect
• In this environment, an incumbent wishing to deter entry
may advertise LESS
Chapter 9: Entry Deterrence and
Predation
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Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 5
• Ellison & Ellison (2006) estimate the following equation:
Advertisingit
– 1 = [1Low + 2Medium + 3High]Time + i
Advertisingi
• The dependent variable measures advertising for each
firm i in each of the 12 months just prior to the patent
expiration relative to the average level of advertising in
each of the 24 months before that
• The dependent variable measures advertising for each
firm i in each of the 12 months just prior to the patent
expiration relative to the average level of advertising in
each of the 24 months before that
Chapter 9: Entry Deterrence and
Predation
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Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 6
• On the right-hand-side, the coefficient on the time to patent
expiration variable depends on what probability of entry
category for that market
• Ellison and Ellison argue any entry-deterring efforts will
only occur in the middle group
– No need to deter entry when probability is Low
– Impossible to deter entry when probability is High
• So, given our understanding of entry deterrence, advertising
should be low in Medium profanity markets
• That is, 2 should be negative
Chapter 9: Entry Deterrence and
Predation
53
Empirical Application: Entry Deterrence
In The Pharmaceutical Industry 7
• Ellison & Ellison (2006) estimates are shown below
Advertising Intensity Time Trend By Category of
Entry Probability, 64 Pharmaceutical Markets
Coefficient
1
2
3
Estimated
Value
Standard
Error
-0.007
0.013
-0.032
0.009
0.009
0.007
• 2 is significantly negative. Firms facing a medium
probability of entry after patent expiration do reduce their
advertising in the months prior to that date
• Some mild support for entry deterring behavior
Chapter 9: Entry Deterrence and
Predation
54