ENTRY AND EXIT

Entry
Entry is pervasive in many industries and may take many forms An entrant may be a new firm, that is, one did not exist before it entered a market. An entrant may be a firm diversifying its product line; that is, the firm already exists but had not previously been in that market. An entrant may be a firm diversifying geographically, that is, the firm sells the same product in other geographic markets.
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Entry
The distinction between new and diversifying firms is important, such as when we assess the costs of entry and when we consider strategic responses to it.

Exit
Exit is the reverse of entry the withdrawal of a product from a market, either by a firm that shuts down completely, or by a firm that continues to operate in other markets.

The Study by Dunne, Roberts and Samuelson

The DRS findings have four important implications for strategy: When planning for the future, the manager must account for an unknown competitor-the entrant. Fully one-third of a typical incumbent firms competition five years hence are not competitors today. Not many diversifying competitors will build new plants, but the size of their plants can make them a threat to incumbents.

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The Study by Dunne, Roberts and Samuelson

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Managers should expect most 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. Managers should know the entry and exit conditions of their industry.
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Hyundais entry into the steel industry

In December 1997, Hyundai announced that it would enter the steel business. It would have a production capacity of 6 million tons per year. The government had opposed the plan. The dominant firm, POSCO, was once owned by the government. The government still owns a major portion of the shares of POSCO.
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Hyundais entry into the steel industry

POSCO had a production capacity of 26 million tons. No other company has a mill approaching 6 million tons, the minimum efficient scale. POSCO priced below the competition, and did not have enough capacity to meet industry demand.
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Hyundais entry into the steel industry

Without POSCO, its customers would have to turn to imports. Hyundai felt that demand for steel would continue to grow. Without a new plant, Korea would have to import steel.

Hyundais entry into the steel industry

Hyundai had many good reasons to enter the steel market: With demand forecast to grow, the market was ripe to enter. Hyundai felt it could be more efficient than POSCO. Hyundai consumes so much steel itself that it can achieve minimum efficient scale without selling to the market.
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Hyundais entry into the steel industry

The Korean government discouraged Hyundai from building the plant, claiming that demand was likely to slacken. The Korean governments forecast turned out to be correct after all.

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Entry and Exit Decisions

A profit-maximizing, risk-neutral firm should enter a market if the sunk costs of entry are less than the net present value of expected post-entry profits. There are many potential sunk costs to enter a market, ranging from the costs of specialized capital equipment to government licenses.
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Entry and Exit Decisions

Post-entry profits will vary according to demand and cost conditions, as well as the nature of post-entry competition. The potential entrant may use many different types of information about incumbents, including historical pricing practices, costs, and capacity, to assess what post-entry competition may be like.
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Entry and Exit Decisions

If the potential entrant expects post-entry competition to be fierce, then it is more likely to stay out. Even when the potential entrant believes that post-entry competition will be relatively mild, it may not enter if there are significant barriers to entry.
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Barriers to Entry
Barriers to entry are those factors that allow incumbents to earn positive economic profits, while making it unprofitable for newcomers to enter the industry. Barriers to entry may be structural or strategic.

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Barriers to Entry
Structural entry barriers result when the incumbent has natural cost or marketing advantages, or benefits from favorable regulations. Strategic entry barriers result when the incumbent aggressively deters entry. Entry-deterring strategies may include limit pricing, predatory pricing, and capacity expansion.
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Bains Typology of Entry Conditions

1.

Blockaded Entry: Entry is blockaded if structural barriers are so high that the incumbent need do nothing to deter entry.

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Bains Typology of Entry Conditions

2.

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 benefits it could gain from keeping the entrant out. Accommodated entry is typical in markets with growing demand or rapid technological improvements.
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Bains Typology of Entry Conditions

Deterred Entry: Entry is deterred if (a) the incumbent can keep the entrant out by employing an entry-deterring strategy, and (b) employing the entrydeterring strategy boosts the incumbents profits.

3.

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Entry Conditions
Bain argued that an incumbent firm should analyze the entry conditions in its market and choose an entry-deterring strategy based on these conditions. If entry is blockaded or accommodated, the firm need do nothing more to deter entry. If entry is deterred, the firm should engaged in a predatory act.
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Entry Conditions

To assess entry conditions, the firm must understand the magnitude of structural entry barriers and consider the likely consequences of strategic entry barriers.

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Structural Entry Barriers

There are three main types of structural entry barriers: Control of essential resources Economies of scale and scope Marketing advantages of incumbency

1. 2. 3.

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Control of Essential Resources

An incumbent is protected from entry if it controls a resource necessary for production. DeBeers in diamonds, Alcoa in aluminum, and Ocean Spray in cranberries all maintained monopolies or cartels by controlling essential inputs. This suggests that firms should acquire key inputs to gain monopoly status. However, there are several risks to this approach.
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Control of Essential Resources

Just When the firm thinks that it has tied up existing supplies, new input sources may emerge. Owners of scarce resources may hold out for high prices before selling to the would-be monopolies. There is a regulatory risk associated with attaining monopoly status through acquisition. Antitrust laws in many countries forbid incumbents with dominant market share from preventing competitors from obtaining key inputs.
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Control of Essential Resources

Incumbents can legally erect entry barriers by obtaining a patent to a novel and nonobvious product or production process. In Europe and Japan, the patent rights go to the first person to apply for the patent. In the United States the first person to invent the idea gets the patent.
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Control of Essential Resources

Patents are not always effective entry barriers because they can often be invent around. Incumbents may not need patents to protect specialized know-how. Coca-Cola has zealously guarded its cola syrup formula for a century.
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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.
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Economies of Scale and Scope

The entrant might try to overcome the incumbents cost advantage by spending to boost its market share. For example, it could advertise heavily or form a large sales force. However, it involves two important costs. The direct cost of advertising and creating the sale force. The indirect cost associated with a strategic reaction by the incumbent.
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Economies of Scale and Scope

If the incumbent responds to a decline in its market share by reducing its price, this will cut into the entrants profits. The entrant faces a dilemma: To overcome its cost disadvantage, it must increase its market share. But if its share increases, price competition may intensify.

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Economies of Scale and Scope

Fierce price competition frequently results from large-scale entry into capital-intensive industries. Incumbents may also derive a cost advantage from economies of scope. The ready-to-eat breakfast cereal industry provides a good example.
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Economies of Scale and Scope

Economies of scale and scope create barriers to entry because they force potential entrants to enter on a large scale or with many products to achieve unit cost parity with incumbent firms. Entering at a large scale or scope is disadvantageous only to the extent that the entrant cannot recover its up-front entry costs if it subsequently decides to exit (i.e., only if the up-front entry costs are sunk costs).
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Economies of Scale and Scope

An entrant whose up-front entry costs were not sunk could come in at a large scale, undercut incumbent firms prices, and exit the market and recover its entry costs if the incumbent firms retaliate. This strategy is known as hit-and-run entry. Sunk costs, not economies of scale or scope per se, represent the underlying structural barrier to entry.
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The ready-to-eat breakfast cereal ready-toindustry

For several decades, the industry has been dominated by a few firms, including Kellogg, General Mills, General Foods, and Quaker Oats, and there has been virtually no new entry since World War II. There are significant economies of scope in producing and marketing cereal.
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The ready-to-eat breakfast cereal ready-toindustry

Economies of scope in production stem from the flexibility in materials handling and scheduling that arises from having multiple production lines within the same plant.

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The ready-to-eat breakfast cereal ready-toindustry

Economies of scope in marketing are due to substantial up-front expenditures on advertising that are needed for a new entrant to establish a minimum acceptable level of brand awareness.

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The ready-to-eat breakfast cereal ready-toindustry

If has been estimated that for entry to be worthwhile, a newcomer would need to introduce 6 to 12 successful brands. Thus, capital requirements for entry are substantial, making entry a risky proposition.

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The ready-to-eat breakfast cereal ready-toindustry

An incumbent launching a new cereal would not face the same up-front costs as a new entrant. The incumbent has already established brand name awareness and may be able to use facilities to manufacture its new cereal. This explains why new products are profitable for incumbents but unprofitable for new entrants.
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The ready-to-eat breakfast cereal ready-toindustry

Despite the near total absence of entry by outsiders, incumbents increased the number of cereals offered for sale from 88 in 1980 to over 200 in 1995. High profit margins eventually invited limited entry by private-label manufacturers. Most of the successful newcomers have chosen niche markets in which they may try to offset their cost disadvantage by charging premium prices.
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Marketing Advantages of Incumbency

Umbrella branding (a firm sells different products under the same brand name) is a special case of economies of scope, but it is an extremely important one in many consumer product markets. An incumbent can exploit the umbrella effect to offset uncertainty about the quality of a new product that it is introducing.
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Marketing Advantages of Incumbency

The brand umbrella makes the incumbents sunk cost of introducing a new product less than that of a new entrant, because the entrant must spend additional amounts of money on advertising and product promotion to develop credibility in the eyes of consumers, retailers, and distributors.
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Marketing Advantages of Incumbency

Although the brand umbrella can give incumbents an advantage over entrants, the exploitation of brand name credibility or reputation is not risk free. The incumbent may suffer more than newcomers if consumers dissatisfaction with the new product leads them to doubt the quality of the rest of the incumbents product line.
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Marketing Advantages of Incumbency

The umbrella effect may also help the incumbent negotiate the vertical chain. If an incumbents other products have sold well in the past, distributors and retailers are more likely to devote scarce warehousing and shelf space to its new products. Suppliers and distributors may be more willing to make relationshipspecific investments.
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Barriers to Exit
To exit a market, a firm stops production and either redeploys or sells off its assets. A risk-neutral, profit-maximizing firm will exit if the value of its assets in their best alternative use exceeds the present value from remaining in the market. Exit barriers commonly arise when firms have obligations that they must meet whether or not they cease operations.

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Barriers to Exit
Examples of such obligations include: Labor agreements and commitments to purchase raw materials. The low resale value of the relationshipspecific productive assets. Government restrictions.

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EntryEntry-Deterring Strategies
Entry-deterring strategies are worthwhile only if the following two conditions are met: The incumbent earns higher profits as a monopolist than it does as a duopolist. The strategy changes entrants expectations about the nature of postentry competition.
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Contestability
If a monopolist cannot raise price above longrun average cost, the market is said to be perfectly contestable. The key requirement for contestability is hitand-run entry. When a monopolist raises price in a contestable market, a hit-and-run entrant rapidly enters the market, undercuts the price, reaps shortterm profits, and exits the market just as rapidly if the incumbent retaliates. The hit-and-run entrant prospers as long as it can set a price high enough, and for a long enough time, to recover its sunk entry costs.
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Contestability
If the sunk entry costs are zero, then hitand-run entry will always be profitable. In that case, the market price can never be higher than average cost, even if only one firm is currently producing. If the incumbent raised price above average cost, there would be immediately entry, and price would fall. The incumbent has to charge a price that yields zero profit, even when it is an apparent monopolist.
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Contestability
Contestability theory shows how the mere threat of entry can keep monopolists from raising prices. However, finding contestable markets has proven difficult.

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EntryEntry-Deterring Strategies
Assuming that the incumbent monopolists market is not perfectly contestable, it may expect to reap additional profits if it can keep out entrants. We discuss three ways in which it might do so: Limit pricing Predatory pricing Capacity expansion
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1. 2. 3.

Limit Pricing
Limit pricing refers to the practice whereby an incumbent firm discourages entry by charging a low price before entry occurs. The entrant, observing the low price set by the incumbent, infers that the post-entry price would be as low or even lower, and that entry into the market would be unprofitable.
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Limit Pricing
The logic of limit pricing is highly appealing. Yet economists have identified a number of problems with the limit pricing strategy. As the incumbent might have to limit price every year to constantly deter entry. It would never get to raise price to reap the monopoly profits that it forsook when it initially set the limit price.
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Limit Pricing
Limit pricing fails because potential entrants recognize that any price reductions before entry are artificial, and do not commit the incumbent to maintain low prices subsequent to entry.

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Limit Pricing
Once entry occurs, it would make no sense for the incumbent to continue to suppress price. The lost profit opportunities from having previously set the limit price are sunk. Now that the entrant is already in the market, the incumbent will acquiesce and maximize future profits. Many firms do occasionally limit price (i.e., Xerox).
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Predatory Pricing
Predatory pricing refers to the practice of setting a low price in order to drive other firms out of business. The predatory firm expects that whatever losses it incurs while driving competitors from the market can be made up later through the exercise of market power.
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Predatory Pricing
The difference between predatory pricing and limit pricing is that limit pricing is directed at firms that have not yet entered the market, whereas predatory pricing is aimed at firms that have already entered.

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The Chain-Store Paradox ChainThe idea that an incumbent can slash prices to drive out rivals and deter entry is highly intuitive. Yet it is possible to construct an example in which the intuition fails.

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The Chain-Store Paradox ChainRegardless of the course of action before the last entrant, the incumbent will find it optimal not to engage in predatory pricing in the last market. The reason is that there is no further entry to deter. The last entrant knows this, and counting on the rationality of the incumbent, will enter regardless of previous price cuts. Knowing that it cannot deter entry in the last market, the incumbent has no reason to slash prices in the previous market.
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The Chain-Store Paradox ChainIn a world in which all entrants could accurately predict the future course of pricing, predatory pricing would not deter entry, and therefore would be irrational.

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The Importance of Uncertainty and Reputation

Game theorists have identified key conditions under which predatory actions may be profitable. Entering firms must be uncertain about some characteristic of the incumbent firm or the level of market demand. The incumbent wants the entrant to believe that post-entry prices will be low.

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The Importance of Uncertainty and Reputation

If the entrant is certain about what determines post-entry pricing, the entrant can analyze all possible postentry pricing scenarios and correctly forecast the post-entry price. If the incumbent is best off selecting a high post-entry price, the entrant will know this, and will not be deterred from entering.
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The Importance of Uncertainty and Reputation

If the entrant is uncertain about the post-entry price, then the incumbents pricing strategy could affect the entrants expectations. An entrant is likely to know less about the incumbents costs than the incumbent itself does. If so, by engaging in limit pricing the incumbent may influence the entrants estimate of its cost, and thus shape its expectations of post-entry profitability.
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The Importance of Uncertainty and Reputation

Garth Saloner has pointed out that for limit pricing to deter entry, the entrant must be unable to perfectly infer the incumbents cost from its limit price. Saloner showed that this could occur if the entrant was uncertain about the level of demand as well as the incumbents cost. The low price signals to the entrant that the incumbents costs may be low and/or market demand may be low. Either signal may deter entry.
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The Importance of Uncertainty and Reputation

Similar arguments explain why firms would want to set predatory prices, despite the conclusions of the chain-store paradox. Predatory pricing in the chain-store paradox appears to be irrational because potential entrants can perfectly predict incumbent behavior in every market and are certain that predatory pricing in the last market is irrational, no matter what has happened up to that point.

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The Importance of Uncertainty and Reputation

With a little bit of uncertainty, predation can make sense. In any event, if a firm believes that the incumbent is easy (not slash prices), then it may follow the logic of the chain-store paradox and decide to enter. If the incumbent does not slash price in the first market, then other potential entrants may also think that it is easy. This is reinforced each time the incumbent accommodates entry. If the incumbent wants to deter entry, it must establish and maintain a reputation for toughness.
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The Importance of Uncertainty and Reputation

Some well-known firms, including Wal-Mart and American Airlines, enjoy a reputation for toughness earned after fierce price competition led to the demise of rivals. Some firms announce a mission to achieve dominant market shares, such as Black and Decker. These announcements may effectively signal to rivals that these firms will do whatever is necessary, even sustain price wars, to secure their share of the market.
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The Importance of Uncertainty and Reputation

Firms may promote toughness by rewarding workers for aggressiveness in the market. A firm might want to reward managers based on marker share rather than profits. This will encourage them to price aggressively, thereby enhancing the firms reputation for toughness, and could ultimately lead to higher profits than if managers were focusing on the bottom line.

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Coffee Wars
In 1970, General Foods Maxwell House was the best selling brand of coffee east of the Mississippi. Procter and Gambles Golgers brand was the best seller to the west. In 1971, P&G started selling Folgers in parts of the Midwest and east.

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Coffee Wars
To promote Folgers, P&G used a combination of television advertising, retailers promotions, coupons, in-pack gifts, and free samples in the mail. General Foods responded with mailed and in-pack coupons, promotional incentives for retailers to sell Maxwell House, and heavy price discounts. It appears that General Foods was signaling to P&G that it intended to fight aggressively to defend its dominant position in eastern markets.

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Excess Capacity
Many firms carry excess capacity. The capacity use is typically about 80 percent. Firms hold more capacity than they use for several reasons. In some industries, it is economical to add capacity only in large increments. If firms build capacity ahead of demand, then such industries may be characterized by periods in which firms carry excess capacity.
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Excess Capacity
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Excess capacity results from market forces. Downturns in the general economic business cycle, or a decline in demand for a single firm can create excess capacity. Firms may be profitable when operating at capacity, but other firms may then enter seeking a share of those profits, creating excess capacity. Firms may hold excess capacity for strategic purposes.
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Excess Capacity
By holding excess capacity, an incumbent may affect how potential entrants view post-entry competition, and thereby blockade entry. Excess capacity may deter entry even when the entrant possesses complete information about the incumbents strategic intentions.
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Excess Capacity
The reason is that when an incumbent builds excess capacity, it can expand output at a relatively low cost. Facing competition, the incumbent may find it desirable to expand its output considerably, regardless of the impact on the entrants profits. This will have the effect of reducing the entrants post-entry profits.
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Excess Capacity
If the post-entry profits are less than the sunk costs of entry, the entrant will stay out. The incumbent may even decide not to utilize all of its capacity, with the idle capacity serving as a credible commitment that the incumbent will expand output should entry occur.

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Excess Capacity
An incumbent firm can successfully deter entry by holding excess capacity under the following conditions: 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.
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Excess Capacity
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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 be attempting to establish a reputation for toughness.

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DuPonts Use of Excess Capacity to Control the Market for Titanium Dioxide

Titanium dioxide is a whitener used in paints, papers, and plastics. DuPont expected that the industry would need 537,000 tons of additional capacity. In 1972, DuPont elected to preempt the market by adding 500,000 tons of capacity.
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DuPonts Use of Excess Capacity to Control the Market for Titanium Dioxide DuPont felt that it could expand faster than its competitors because (a) its competitors had to spend money on cleanup that DuPont did not; and (b) it had lower costs of using its raw materials, due to scale and learning economies. DuPont believes that its costs were about 22 percent lower than its competitors, so that they would be reluctant to compete head to head.
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DuPonts Use of Excess Capacity to Control the Market for Titanium Dioxide

There is a lag between planning to add capacity and having capacity in place. DuPont tried to forestall additional entry. It let its competitors know the magnitude of its planned expansion of existing facilities, and falsely announced that it had begun constructing a new 130,000-ton facility.
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DuPonts Use of Excess Capacity to Control the Market for Titanium Dioxide DuPont also used limit pricing by setting prices just under the average total costs of production in the new plants. DuPonts competitors, holding out for higher prices, refused to match. This two-tiered pricing structure persisted because DuPont lacked capacity to handle the whole market. When demand slackened in early 1975, DuPonts competitors lost substantial sales and were forced to meet DuPonts price.
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DuPonts Use of Excess Capacity to Control the Market for Titanium Dioxide

When demand remained soft through 1975, DuPont reexamined its preemption strategy. When demand did not recover in 1976, DuPont scaled back its capacity expansion.

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Judo Economics
We have provided examples in which an incumbent firm has used its size and reputation to put smaller rivals at a disadvantage. However, smaller firms and potential entrants can use the incumbents size to their own advantage. This is known as judo economics.
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Judo Economics
When an incumbent slashes prices to drive an entrant from the market, it sacrifices its own short-run profits. The larger is the incumbent, the greater the loss. If an entrant can convince the incumbent that it does not pose a significant long-term threat to the incumbents profitability, the incumbent might think twice about incurring large losses to drive the entrant from the market.
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Judo Economics
An example is provided by Amazons entry into the on-line book retail market. Many observers wondered why Barnes & Noble did not immediately respond with their own web site, potentially driving Amazon from the market.

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Judo Economics
Because of its dominant presence in the bricksand-mortar market, Barnes & Noble had much to lose by entering the on-line segment. This would quickly legitimize online sales, and probably trigger an online price war, thereby cannibalizing Barnes & Nobles bricks-andmortar sales. As it turned out, Amazon succeeded beyond the expectations of most market analysts.
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Wars of Attrition
An aggressive firm supposedly starts a price war to eliminate competition and ultimately reap monopoly profits. This presumes that the rival would exit before the aggressor abandoned its strategy. A price war harms all firms in the market regardless of who started it.

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Wars of Attrition
A larger firm is said to have deep pockets from which it can finance the price war and have the ability to sustain losses better than its smaller rivals. However, a large firm may also suffer greater losses during the price war.

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Wars of Attrition
Price wars are examples of wars of attrition. Firms may try to convince their rivals that they are better positioned to survive the price war. Firms may claim that they are actually making money during the price war, or that they care more about winning the war than about making money. Either message may cause a rival to rethink its ability to outlast its opposition, and encourage it to exit the market early.
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Survey Data on Entry Deterrence

Robert Smiley asked major consumer product makers if they pursued a variety of entry-deterring strategies. Smiley surveyed product managers at nearly 300 firms. He asked them whether they used several strategies including:

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Survey Data on Entry Deterrence

1.

2. 3. 4.

5. 6.

Aggressive price reductions to move down the learning curve, giving the firm a cost advantage Intensive advertising to create brand loyalty Acquiring patents for all variants of a product Enhancing firms reputation for predation through announcements or some other vehicle Limit pricing Holding excess capacity
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Survey Data on Entry Deterrence

The first three strategies create high entry costs. The last three change the entrants expectations of post-entry competition.

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Reported Use of Entry-Deterring EntryStrategies

Learning Advertising Curve New Products Frequently 26% 62% 16% 22% 52% R&D Patents 56% 15% 29% 31% Reputation Limit Pricing 8% 19% 73% 21% Excess Capacity 22% 20% 48% 21% 27% 27% 47% 27%

Occasionally 29% Seldom Existing Products Frequently 45%

Occasionally Seldom

26% 21%

16% 54%

22% 52%

21% 58%

17% 62%

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Reported Use of Entry-Deterring EntryStrategies

Note that managers were asked about exploiting the learning curve for new products only. More than half of all product managers surveyed report frequent use of at least one entry-deterring strategies. Product managers report that they rely much more extensively on strategies that increase entry costs, rather than on strategies that affect the entrants perception about postentry competition.
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