Entrants threaten incumbents, that is, the firms that were already in the market, in two ways.

First, they
take market share away from incumbents. Second, entry often intensifies competition, leading to lower
prices. Moving beyond these models, note that entrants often reduce prices to establish a foothold in
the market. In some cases, the mere threat of entry can limit the incumbent firm’s ability to raise prices.
In such cases we say that the market is contestable.

Entry is pervasive in many industries and may take many forms. An entrant may be a new firm, that is,
one that did not exist before it entered a market. An entrant may also be a firm that is active in a product
or geographic market but has chosen to diversify into others. The distinction between new and
diversifying firms is often important, as it may affect the costs of entry and the appropriate strategic
response.

If past patterns of entry and exit still hold, here is what that industry can expect in the next 5 to 10 years:
1. Entry and exit will be pervasive. By 2017, between 30 and 40 new firms will enter, with combined
annual sales of $12 to $20 million. At the same time, a similar number of firms will exit.

2. Entrants and exiters tend to be smaller than established firms. A typical greenfield entrant will be only
one-third the size of a typical incumbent. Entrants diversifying from another industry tend to be about
the same size as the average incumbent. In 2012, firms that will leave the industry by 2017 are only
about one-third the size of the average firm.

3. Most entrants do not survive 10 years, but those that do grow precipitously. Of the 30 to 40 firms that
enter the market between 2012 and 2017, roughly 60 percent will exit by 2022. The survivors will nearly
double their size by 2022.

4. Entry and exit rates vary by industry. Many industries have high entry rates including apparel, lumber,
and fabricated metals. Industries with high exit rates included apparel, lumber, and leather. Industries
with little entry included tobacco, paper, and primary metals. Industries with little exit included tobacco,
paper, and coal. Entry and exit are highly related: Conditions that encourage entry also foster exit.

These facts have three important implications for strategy:

1. When planning for the future, the manager must account for entry. While the exact identity of an
entrant is hard to predict, the incumbent should expect the entrant to be either a small greenfield
enterprise or a large diversifying firm. 2. Managers should expect most new ventures to fail quickly.
However, survival and growth usually go hand in hand, so managers of new firms will have to find the
capital to support expansion. 3. Managers should know the entry and exit conditions of their industry.
Entry and exit are powerful forces in some industries but relatively unimportant in others.

It helps to think of entry as an investment. The entrant must sink some capital that cannot be fully
recovered upon exit—it is this element of risk that makes the entry decision difficult. The entrant hopes
that postentry profits (i.e., the excess of revenues over ongoing operating expenses) exceed the sunk
entry costs. 3 There are many potential sunk costs to enter a market, ranging from the costs of
specialized capital equipment to government licenses. Many sunk entry costs are associated with the
fixed costs that give rise to economies of scale, which we discussed in Chapter 2, such as the cost of
building a factory or performing R&D. But the factors that give rise to entry costs and economies of scale
are not identical. Recall that fixed costs are sunk costs only if the fixed costs are not recoverable. And
some sources of scale economies are not fixed costs, such as inventory management.
The potential entrant may use many different types of information about incumbents, including
historical pricing practices, costs, and capacity, to assess what postentry competition may be like. The
sum total of this analysis of sunk costs and postentry competition determines whether there are barriers
to entry.

Barriers to Entry

Because the potential for profits is a siren call to investors, a profitable industry invites entry. Barriers to
entry allow incumbent firms to earn positive economic profits while making it unprofitable for
newcomers to enter the industry. Barriers to entry may be structural or strategic. Structural entry
barriers exist when the incumbent has natural cost or marketing advantages, or when the incumbent
benefits from favorable regulations. Strategic entry barriers result when the incumbent takes aggressive
actions to deter entry. Whether structural or strategic, these entry barriers either raise sunk entry costs
or reduce postentry profitability.

Blockaded Entry: Entry is blockaded if structural barriers are so high that the incumbent need do nothing
to deter entry. For example, production may require large mixed investments relative to the size of the
market (high sunk entry costs), or the entrant may sell an undifferentiated product for which it cannot
raise price above marginal cost (low postentry profitability).

Accommodated Entry: Entry is accommodated if structural entry barriers are low, and either (a) entry-
deterring strategies will be ineffective or (b) the cost to the incumbent of trying to deter entry exceeds
the bene! ts it could gain from keeping the entrant out. Accommodated entry is typical in markets with
growing demand or rapid technological improvements. Entry is so attractive in such markets that the
incumbent(s) should not waste resources trying to prevent it.

Deterred Entry: Entry is deterred (a) if the incumbent can keep the entrant out by employing an entry-
deterring strategy and (b) if employing the entry-deterring strategy boosts the incumbent’s profits. Frank
Fisher calls such entry-deterring strategies predatory acts. Predatory acts may either raise entry costs or
reduce postentry profits. We describe several predatory acts later in this chapter.

Bain argued that an incumbent firm’s approach to potential entry should depend on market conditions.
If entry is blockaded or accommodated, the firm should not make any effort to deter entry. If blockaded,
the effort is superfluous; if accommodated, the effort is wasted. If entry is deterred, the firm should
consider engaging in a predatory act.

What is the strategic distinction between entrants and incumbents? As we will see, most of the
predatory strategies available to incumbents are also available to entrants.

For example, in a strategy known as predatory pricing, the incumbent firm slashes prices in an effort to
drive out a new entrant. It is possible that the new entrant could slash prices in an effort to drive out the
incumbent. Incumbents and entrants will naturally differ in financial resources and productive
capabilities, but the incumbent does not necessarily have the advantage. There must be other
asymmetries that usually work in favor of the incumbent. Incumbents usually have incurred sunk entry
costs while entrants have not.
Asymmetries also arise from relationships with customers and suppliers that can take years to build. An
upstart carrier could establish the same relationships, but this would take time, during which it could
suffer significant losses.

As we discuss entry barriers, bear in mind that entrants may enjoy many of the attributes that we
normally associate with the incumbent firm. Diversifying entrants are particularly likely to have sunk
investments in facilities, tools and training, and have established relationships in the vertical chain of
production. If so, entrants can turn these attributes to their own advantage, turning entry-deterring
strategies into “incumbent-removing” strategies.

Structural Entry Barriers

The three main types of structural entry barriers are:

• Control of essential resources

• Economies of scale and scope

• Marketing advantages of incumbency

Control of Essential Resources

An incumbent is protected from entry if it controls a resource or channel in the vertical chain and can use
that resource more effectively than newcomers. Some firms attempt to purchase the resources and
channels in the vertical chain, preventing potential entrants from acquiring raw materials and/or getting
final goods to market. Firms that attempt to secure their incumbency by tying up the vertical chain face
several risks. First, substitutes can emerge. Second, new channels can open. Third, the price to acquire
other firms in the vertical chain can be excessive. Finally, firms that attempt to tie up channels via
acquisition may face antitrust challenges.

Incumbents can legally erect entry barriers by obtaining patents to novel and nonobvious products or
production processes. Entrants can try to “invent around” existing patents. Conversely, incumbents may
file patent-infringement lawsuits against entrants whose products are seemingly different from the
incumbent’s. Firms often stockpile patents so that they can countersue in patent infringement cases.
Incumbents may not require patents to protect specialized know-how. Rivals may turn to the legally and
ethically questionable practice of industrial espionage to steal such information.

Economies of Scale and Scope

When economies of scale are significant, established firms operating at or beyond the minimum efficient
scale (MES) will have a substantial cost advantage over smaller entrants.

This analysis presumes that there is some asymmetry giving the incumbent the advantage in market
share. We can easily imagine this advantage to be the incumbent’s brand reputation, built up through
years of operation. The entrant might try to overcome the incumbent’s cost advantage by spending to
boost its market share. For example, it could advertise heavily or recruit a large sales force. Although this
strategy may allow the entrant to achieve a market share greater than 2 percent and average production
costs below ACE. it involves two important costs. The first is the direct cost of advertising and creating
the sales force, costs that the incumbent may have already incurred. Second, the entrant must also be
concerned that if it ramps up production, the incumbent may not cut back its own output, as many of
the incumbent’s costs associated with procuring inputs and paying for labor are sunk. Recall from
Chapter 5 that when overall industry output increases, prices and individual firm profits fall. The entrant
thus faces a dilemma: to overcome its cost disadvantage, it must increase its market share. But if its
share increases, prices will fall.

Fierce price competition frequently results from large-scale entry into capital intensive industries where
capital costs are largely sunk.

Incumbents may also derive a cost advantage from economies of scope. dozens of new cereals

Diversified incumbents may also enjoy scope economies. These economies make it relatively inexpensive
for an incumbent to devote part of an existing production line to a new formulation.

Incumbents have established brand names that give them marketing economies. Entrants would have to
build brand awareness from scratch, and it has been estimated that for entry to be worthwhile, a
newcomer would need to introduce 6 to 12 successful brands. Even when incumbents enjoy advantages,
the principle that profits attract entrants remains in effect. Even so, most of the successful newcomers
have chosen niche markets, such as granola-based cereals, in which they may try to offset their cost
disadvantage by charging premium prices.

Marketing Advantages of Incumbency

Umbrella branding, whereby a firm sells different products under the same brand name. This is a special
case of economies of scope but an extremely important one in many consumer product markets. The
umbrella effect may also help the incumbent negotiate the vertical chain. A brand umbrella may increase
the expected profits of an incumbent’s new product launch, but it might also increase the risk. If the new
product fails, consumers may become disenchanted with the entire brand and competitors may view the
incumbent as less formidable. Thus, although the brand umbrella can give incumbents an advantage
over entrants, the exploitation of brand name credibility or reputation is not risk free.

Barriers to Exit

Because Pexit < Pentry, firms may remain in a market even though price is below long-run average cost.
For this reason, high exit barriers are viewed negatively in an analysis of industry rivalry. Exit barriers
often stem from sunk costs, such as when firms have obligations that they must meet whether or not
they cease operations. Examples of such obligations include labor agreements and commitments to
purchase raw materials. Because these costs are effectively sunk, the marginal cost of remaining in
operation is low and the firm can recover its incremental costs even if operating revenues fall short of
expectations. Hence, the firm is better off remaining in the market. If the firm were revisiting the
decision to enter, it would have to cover both sunk entry costs and incremental operating costs, and with
the benefit of hindsight it might have chosen to stay out.

Exiting firms can often avoid debt obligations by declaring bankruptcy. Diversified firms contemplating
exiting a single market do not enjoy this “luxury,” however, because suppliers to a faltering division are
assured payment out of the resources of the rest of the firm.

Governments can also pose barriers to exit.

In general, entry-deterring strategies are worth considering if two conditions are met:

1. The incumbent earns higher profits as a monopolist than it does as a duopolist.

2. The strategy changes entrants’ expectations about the nature of postentry competition.

An incumbent may expect to reap additional profits if it can keep out entrants. We now discuss three
ways in which it might do so: 1. Limit pricing 2. Predatory pricing 3. Strategic bundling

Limit Pricing

Limit pricing refers to the practice whereby an incumbent firm charges a low price to discourage new
firms from entering.11 The intuitive idea behind limit pricing is straightforward. The entrant sees the low
price and, being a good student of oligopoly theory, assumes that the price will be even lower after
entry. If the incumbent sets the limit price low enough, the entrant will conclude that there is no way
that postentry profits will cover the sunk costs of entry; it therefore stays out. At the same time, the
incumbent believes that it is better to be a monopolist at the limit price than to share the market at a
duopoly price.

Is Strategic Limit Pricing Rational?

The preceding arguments hew close to the intuitive explanation of limit pricing: the entrant sees the low
incumbent price and reasons that it cannot prosper by entering. A closer look reveals some potential
problems with this intuition. For one thing, the analysis assumes that the market lasts only two periods,
after which the incumbent and entrant effectively disappear. In the real world, the potential entrant may
hang around indefinitely, forcing the incumbent to set the limit price indefinitely. Depending on costs
and demand, the incumbent might be better off as a Cournot duopolist than as a perpetual monopoly
limit-pricer.

We may also question the assumption that by setting a limit price, the incumbent is able to influence the
entrant’s expectations about the nature of postentry competition.
N will select Pm in the first stage. E will select “In.” Second-year competition will be Cournot.

Predatory Pricing

Predatory pricing occurs when a large incumbent sets a low price to drive smaller rivals from the market.
The purpose of predatory pricing is twofold: to drive out current rivals and to make future rivals think
twice about entry. The second purpose is reminiscent of the goal of limit pricing. Predatory pricing
causes rivals to rethink the potential for postentry profits, while the predatory incumbent expects that
whatever losses it incurs while driving competitors from the market can be made up later through future
monopoly profits.

The striking conclusion: in a world with a finite time horizon in which entrants can accurately predict the
future course of pricing, we should not observe predatory pricing. Just like limit pricing, predation seems
to be an irrational strategy.

The apparent failure of the intuition supporting predatory pricing strategies has given rise to a puzzle in
economics known as the chain-store paradox. The paradox is that many firms appear to engage in
predatory pricing, despite the theoretical conclusion that the strategy is irrational.

Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation

Game theorists have shown that predatory actions may be profitable if entrants are uncertain about
market conditions. This argument presumes that the entrant knows with certainty why the incumbent
has set a low pre-entry price. But suppose that the entrant is uncertain about the reasons behind the
incumbent’s pricing strategy. For example, if market demand is low, or the incumbent has low costs,
then it might be sensible for the incumbent to set a low price without regard to strategic considerations.
Incumbents can exploit this uncertainty by slashing prices, thereby establishing a reputation for
toughness.

The chain-store paradox not only sheds light on the role of uncertainty; it also reminds us of the
importance of asymmetry. In our analysis, it is reputation, not incumbency per se, that matters. An
entrant might come into the market and slash prices. An incumbent that is uncertain about the entrant’s
costs or motives may elect to exit, rather than try to ride out the price war.

Wars of Attrition

Price wars harm all firms in the market regardless of who starts them, and are quintessential examples of
wars of attrition. In a war of attrition, two or more parties expend resources battling with each other.
Eventually, the survivor claims its reward, while the loser gets nothing and regrets ever participating in
the war. If the war lasts long enough, even the winner may be worse off than when the war began
because the resources it expended to win the war may exceed its ultimate reward.

Asymmetries can profoundly influence the outcome of a price war. Suppose that two firms are engaged
in a price war and one of the firms has made sunk commitments to workers and other input suppliers.
The other firm may as well give up. A firm that has made sunk commitments has low incremental costs
of remaining in the market. Any rival who persists in fighting the price war should expect a long battle
that is probably not worth fighting.

Predation and Capacity Expansion

Predatory pricing will not deter entry if the predator lacks the capacity to meet the increase in customer
demand. Disappointed customers will simply turn to the entrant. Excess capacity makes the threat of
predation credible. The conditions under which an incumbent firm can successfully deter entry by
holding excess capacity:

• The incumbent should have a sustainable cost advantage. This gives it an advantage in the event of
entry and a subsequent price war.

• Market demand growth is slow. Otherwise, demand will quickly outstrip capacity.

• The investment in excess capacity must be sunk prior to entry. Otherwise, the entrant might force the
incumbent to back off in the event of a price war.

• The potential entrant should not itself be attempting to establish a reputation for toughness.

Strategic Bundling

Bundling occurs when a combination of goods or services are sold at a price that is less than what it
would cost to buy the same items separately. In some cases, bundling can be used strategically to deter
entry. An incumbent may consider strategic bundling if it is a monopoly in one market but is threatened
in a second market. Strategic bundling works by giving consumers little choice but to buy the entire
bundle from the incumbent rather than buy the monopolized good from the incumbent and the second
good from competing firms.
“Judo Economics”

We have argued that an incumbent firm can use its size and reputation to put smaller rivals at a
disadvantage. Sometimes, however, smaller firms and potential entrants can use the incumbent’s size to
their own advantage. This is known as “judo economics.”20 We have already given one theoretical
rationale for judo economics—the revenue destruction effect. When an incumbent slashes prices to
drive an entrant from the market, it stands to lose more revenue than its smaller rivals. Incumbents may
also be hamstrung by their own sunk costs.

EVIDENCE ON ENTRY-DETERRING BEHAVIOR

There may be little evidence on entry deterrence from sources other than antitrust cases for several
reasons. First, firms are naturally reluctant to report that they deter entry because this may be sensitive,
competitive information and might also violate antitrust statutes. Second, many entry-deterring
strategies involve pricing below the short-term monopoly price. To assess whether a firm was engaging
in such a practice, the researcher would need to know the firm’s marginal costs, its demand curve, the
degree of industry competition, and the availability of substitutes. Outside of antitrust cases, such
information is difficult for researchers to obtain. Finally, to measure the success of an entry-deterring
strategy, a researcher would need to determine what the rate of entry would have been without the
predatory act. This, too, is a difficult question to answer.

Product managers report that they rely much more extensively on strategies that increase entry costs
than on strategies that affect the entrant’s perception about postentry competition.

CONTESTABLE MARKETS

Throughout this chapter we have argued that entry poses two problems for incumbents: entrants steal
market share and they drive down prices.

The key requirement for contestability is “hit-and-run entry.” When a monopolist raises price in a
contestable market, a hit-and-run entrant rapidly enters the market, undercuts the price, reaps short-
term profits, and exits the market just as rapidly if the incumbent retaliates. The hit-and-run entrant
prospers if it can set a high enough price for a long enough time to recover its sunk entry costs. If sunk
entry costs are zero, then hit-and-run entry is profitable whenever the incumbent’s price exceeds the
entrant’s average variable costs. If the incumbent raised price above the entrant’s average cost, there
would be immediate entry and price would fall. As a result, the incumbent monopolist has to charge a
price no higher than the entrant’s average cost, a result that approximates what one would expect to see
in a competitive market.

Potential competition causes the monopolist carrier to moderate its prices but not to competitive levels.
For example, it might have lobbied the local Blueville government for legislation giving it exclusive local
rights to mix cement, transferring some of the profits to the legislators who have the power to erect
entry barriers. This is known as rent-seeking behavior—costly activities intended to increase the chances
of landing available profits.