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Bachelor Thesis Organization & Strategy Bachelor Thesis Organization & Strategy It’s crowded enough in here already! Title: Incumbent strategies for deterring entry into an industry Topic: Industries, firms, competitive dynamics, and competitive advantage Name: Elmar Seghers ANR: 816632 Email: [email protected] of [email protected] Supervisor: Astrid Kramer Academic year: 2009-2010 Words: 7976 Preface My name is Elmar Seghers and I am a Strategic Management pre-master student of the Tilburg University. This bachelor thesis will give information on, how an incumbent firm can influence the height of entry barriers to prevent entrants from entering an industry. This bachelor thesis is written as a part of the pre-master programme of Strategic Management. I would like to thank Astrid Kramer for her support and useful feedback during the writing of this bachelor thesis. I would also like to thank all the member of the feedback group, Ad van Ballegooien, Debby van Deursen, Jan Klein Poelhuis and Tjeerd van Loosbroek, for giving me feedback on concept versions. This bachelor thesis is written for people with some economical of business background. Breda, 11-06-2010 Elmar Seghers 2 Table of contents Page number Summary 4 Chapter 1 Introduction 5 1.1 Problem indication 5 1.2 Problem statement 6 1.3 Research questions 6 1.4 Research design and data collection 7 1.5 Overview of rest of the chapters 7 Chapter 2 Entry Barriers 8 2.1 What are entry barriers? 8 2.2 Types of entry barriers 9 2.2.1 Cost advantage 9 2.2.2 Product differentiation 11 2.2.3 Capital requirements 12 2.2.4 Customer switching costs 13 2.2.5 Access to distribution channels 14 2.2.6 Government policy 15 Chapter 3 Entrants 17 3.1 Why enter? 17 3.2 Types of entrants 18 3.2.1 ‘Novo’ entrants vs. established entrants 18 3.2.2 Early vs. late entrants 18 3.3 Entry decision 19 3.3.1 Competitive environment 19 3.4 Conclusion 20 Chapter 4 Incumbent’s entry deterrence strategies 21 4.1 Limit pricing 21 4.2 Excess capacity 22 4.3 Investments in advertising 23 4.4 Investments in patents and R&D 24 4.5 Spatial pre-emption & building switching costs 24 Chapter 5 Conclusion, discussion & recommendations 26 Conclusion 26 Discussion & recommendations 27 References 28 3 Summary Entry barriers are advantages of an incumbent firm over an entrant. Many different entry barriers have been defined throughout the literature. Because some of the barriers are derived from another, they can be narrowed down to six of them. Namely; cost advantage barrier, product differentiation barrier, capital requirement barrier, customer switching costs barrier, access to distribution channels barrier and government policy barrier. Besides these entry barriers there are more variables influencing the entry decision of the entrant. The ability of potential entrants to overcome barriers depends on the position they occupied before entry. The distinction that can be made is between ‘novo’ entrants and established companies. ‘Novo’ entrants seem to be more sensible to entry barriers. The stage of the product-life-cycle also influences the entry conditions. Entrants make their entry decision based on the competitive environment as proposed by Gruca & Sudharshan (1995). The competitive environment consists of four factors, namely; cost conditions, demand conditions, history and legal climate. Besides the competitive environment, the incumbent’s choice of entry deterrence strategy has effect on the entry decision of the entrant. Several entry deterrence strategies have been distinguished from the literature, namely; limit pricing, excess capacity, investments in advertising, investments in patents and R&D, spatial pre-emption and building switching costs. A condition for these strategies to have effect is that the entrant bases its decisions on basis of incomplete information. Even though, these entry deterrence strategies can raise the entry barriers, there has not been convincing evidence that they will deter entry with certainty. 4 Chapter 1 Introduction 1.1 Problem indication Michael Porter (1980) named ‘the threat of entry’ as one of the five competitive forces in his competitive forces model. The ‘five competitive forces model’ is a tool to analyse the attractiveness of an industry. The higher the threat of entry, the less attractive the industry is to operate in. This means that Porter (1980) sees new entrants as a threat to the position of incumbents in an industry. An incumbent is a company established in an industry. The entry of new firms, also called entrants, can lead to erosion of high profits and market share among incumbent firms (Thomas, 1997). Porter (1980) also states that the type of industry influences the entry barriers, but also the incumbents can influence the entry barriers by taking strategic actions. Entry barriers are barriers that influence the entry decision of an entrant. Harrigan (1981) states that the height of the entry barriers is not only determined by the industry structure but also by deterrent activities of existing firms such as making investments in physical plants, R&D, advertising and other assets. Geroski (1995) states, that the entry of new firms has important effects on incumbent firms and consumers. New entrants increase competition, reducing market share and profits of incumbent firms. New entrants introduce innovative products and processes. This leads to better and cheaper products for the consumer. The incumbents have to compete with this by becoming more efficient and innovative. Simon (2005) concludes that incumbents have strong incentives to deter entry, while consumers welcome new entrants. McCann and Vroom (2010) state that entrants add capacity to an industry and attempt to gain market share, often at the expense of existing firms. For example; when an entrant enters an industry and the demand from consumers stays at the same level. Then the entrants will take away market share from the incumbents. This is a reason why entry is typically seen as a threat to the profitability of incumbents. Entry is expected to occur when incumbent firms achieve above-normal returns (McCann and Vroom, 2010). With new entrants the intensity of rivalry will increase. As a result of this, profitability will get to a lower point where new entry is not profitable anymore. 5 Shankar, Carpenter, and Krishnamurthi (1998) state that entrants can even achieve market-leader positions on the strength of their successful innovations. By copying the incumbent’s product and adding small innovations a late entrant can produce a better product then the incumbent. The entrant will have lower R&D costs because they just had to make some modifications in stead of developing a completely new product. Also they do not have to introduce a new product to the consumers. The incumbent did this already. The entrant only has to point out their innovations, which lead to less advertising costs. These are al advantages for the late entrant. As a result of this, Han Kim and Kim (2001) say that it is more important than ever for incumbents to seek out effectual means of protecting their market positions against the competitive threats of entrants. Therefore, it is better to prevent new entrants from entering the industry. The studies from Porter (1980), Harrigan (1981), Geroski, (1995) Shankar, Carpenter, and Krishnamurthi (1998) and Han Kim and Kim (2001) all indicate that entrants form a real threat for an incumbent in an industry. New entrants take away market share and profit and intensify the competition. Therefore it is useful for incumbents to have a clear view of the possible strategic actions they could take to prevent new players to enter their market. A lot of research has been done about this topic but the information is scattered and inconsistent. Therefore the goal of this bachelor thesis is to get to understand what influences the entry decision of the entrants and which strategic actions an incumbent can take to prevent new entrants from entering their industry. 1.2 Problem statement The problem statement is: How can an incumbent firm influence the height of entry barriers to prevent entrants from entering an industry? 1.3 Research questions - Which entry barriers can be distinguished? - What influences the entry decision of the entrant? - What can incumbents do to deter entry when being under the threat of entrants? 6 1.4 Research design and data collection To answer the research questions and the problem statement, a descriptive research will be conducted. According to Sekaran (2003), a literature survey is the documentation of a comprehensive review of the published and unpublished work from secondary sources of data in the areas of specific interest to the researcher. Literature databases like web of science, AB inform, Jstore and the library of the Tilburg University will be used as a source of information for this bachelor thesis. Keywords that are used to find articles from Journals are; ‘entrants’, ’incumbent’, ‘entry barriers’, ‘strategy’, ‘entry’, ‘retaliation’, ‘response’, ‘excess capacity’, ‘limit pricing’ and combinations of these. Forward and backward citations from found papers will be used to find new useful papers. The website ‘web of science’ provides a Journal Impact Factor which indicates the quality of the journals in which the papers are published. The higher the impact factor, the higher is the quality of the journal. The weighted average journal impact factor of the literature is 3.033 and varies from 6.125 (Academy of Management Review) to 1.075 (International Journal of Industrial Organization). 1.5 Overview of rest of the chapters In Chapter 2 will be explained what entry barriers are, which can be distinguished and how they form a barrier for entrants. Chapter 3 will focus on the entry decision of the entrants. First, the motivation for entering a market will be discussed, followed by a distinction between different types of entrants.
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