Outline

Entry Deterrence and Predatory • • Contestable Markets (Again) Strategies I • Strategic Entry deterrence (and accommodation) Industrial Organization • Capacity expansion in the titanium dioxide K. Graddy industry

Defining Barriers to Entry (BTE) Learning • Bain defined a BTE as anything which allows incumbent firms to earn supernormal profits without the threat of entry. He asserted that there • Learning occurs when the cost of producing are four elements of structure which give a given level of output falls with the rise to barriers to entry: exppgpyperience of doing so period by period – Economies of scale • Learning occurs when costs depend on – Absolute cost advantages cumulative output • Scarce resources • Legal barriers • Patents • learning

– Product Differentiation Learning • Location • Switching costs • Complementary goods Average – Capital Raising Requirements Costs • Von Weizsacker defined a BTE as a cost of AC1 producing that must be borne by a firm which seeks to enter an industry but is not borne by firms AC The Learning Curve 2 already in the industry – BTE imply a distortion in the allocation of resources AC3 from the social point of view – theory suggests sunk costs (both exogenous and endogenous!) and imperfect or asymmetric Q* 2Q* 3Q* information are the main barriers to entry under von Q* Current Cumulative Weizsacker’s definition Output Output

1 • Results: With increasing returns to scale the Ultra Free Entry: Contestable following conclusions are predicted Markets (Baumol 1982) – There is a unique operating firm in the industry – This firm makes zero profits • Assumptions – Average-cost pricing prevails – Homogeneous goods • In the absence of competition, potential entry is – Firms set prices very effective in disciplining incumbent firms -- – No sunk costs this theory presents a strong argument against – Free entry and exit or nationalization of utilities – Entrant may enter and undercut rival before • Criticism: Generally believed that prices adjust incumbent is able to respond more rapidly than decisions about quantity or entry

Schelling’s definition of Strategy

• A strategic move is one that influences the strategic entry deterrence refers to any action taken by an existing other person’s choice, in a manner favorable business in a particular market that to one’s self,,y by affecting the other p erson’s discourages potential entrants from expectations of how one’s self will behave. entering into competition in that market. • Schelling (1960)

Strategic Entry Deterrence Predatory Pricing

• A firm fights entry now to limit entry and make • When a firm lowers its price in order to drive higher profits later rivals out of business and/or scare off potential – Stage 1: Potential entrant decides whether to enter (IN) entrants, and then raises its price when its rivals or not enter (OUT) exihit the mark et. – Stage 2: Incumbent decides whether to fight or acquiesce. • The Problem with Predatory Pricing: • Two Nash equilibria, (IN, ACQUIESCE) and – The inability to commit (OUT, FIGHT) – The strategies do not belong a subgame perfect Nash • Entrant would like to establish (OUT, FIGHT), equilibrium but not credible, so no predation occurs • (SPNE Strategies that are best responses in all subgames)

2 Incumbent P.E. acquiesce 2 Nash Equilibria 1 1

Incumbent • 1) In, Acquiesce – Need to check two things in fight -1 -1 •If the ppg,potential entrant goes in, it is optimal for the Potential incumbent to acquiesce acquiesce • If the incumbent acquiesces, it is optimal for the Entrant 2 0 potential entrant to go in out

fight 2 0

2 Nash Equilibria

• 2) Out, Fight • This equilibrium is not subgame perfect – Again, need to check two things • What we really mean, is that it is not a • If the potential entrant stays out, it is optimal for the incumbent to fight (it actually doesn ’t matter , as he gets 2 either way) credible threat for the incumbent to say that • If the incumbent fights, it is optimal for the potential entrant to he will fight, because if the incumbent stay out – But, we are uncomfortable with this equilibrium. If “by enters, it also makes sense for the accident” the potential entrant enters, the incumbent incumbent to acquiesce. will acquisce

Incumbent P.E. acquiesce 1 1 The Entry Problem Entrant’s Incumbent’s Incumbent Payoff Payoff d d in fight Incumbent -1 -1   Potential Potential c c Entrant Entrant

out   20 m

3 Situations in which Predation Strategic Pre-commitment May Occur • Owners appoint managers with managerial rather • When an incumbent chooses to invest in a than objectives sunk cost (K) in order to deter entry. • Self-crippling devices: locking customers in LT contracts at low prices • Repeated interaction – With incomplete information about incumbent’s payoffs – With imperfect financial markets • Strategic precommitment – Example: building excess capacity

Strategic Precommitment Strategic Precommitment Entrant’s Incumbent’s • Assume investment in K is sunk Payoff Payoff (k) – Stage 1: Incumbent chooses K d d (k) – Stage 2: Entrant decides whether to enter entrant – Stage 3: Post -entry output/price game delivers payoffs 0(k)m (K) Incumbent entrant  (0)d d (0) • Entry is deterred if d(K)<0 and m(K)> d(0) • Entry is accommodated if  (K)<0 and  (K)< d m  m(0) d(0) • Entry is blockaded if d(0)<0

Examples of K q2 RF1

• Capacity which reduces marginal costs of RF1(K)

incumbent and and shifts out RF1 • Experience • Customer good-will

• Advertising RF2 • Research and development (which reduces mc)

q1

4 • Direct effect: If by changing K, firm 1 has a direct How K effects firm 2 effect on firm 2’s profits • Examples of direct effects: – If firm 1 accumulates a greater clientele, has a negative • Incumbent chooses a level of K, so as just to deter entry direct effect (so that firm 2’s profits would be just zero if it entered): • Strategic effect: K changes firm 1’s ex post  (Kx , *( K ), x *( K )) 0 21 2 behaviour, thus affecting firm 2’s profits How does  vary in K? 2 – Accumulation of greater clientele leads to less First note that aggressive pricing– makes firm 1 soft since firm 2 maximized profits in the 2nd period – High prices from firm one increase firm 2’s profits, overall strategic affect is positive  2 (Kx ,12 *( K ), x *( K )) 0, so – The sign of the strategic effect is related to investment x 2 making firm 1 tough or soft and to the slope of the dx* reaction functions 2221 dK K x1 dK Direct Strategic effect effect

• Suppose K is advertising: – If advertising makes firms price less Animal taxonomy aggressively, firm one is “soft”, which results in a positive strategic effect • Firms might * – Over-invest in capacity to deter entry (top dog: be big  21p to look tough) (Example 1) p dK 1 – UdUnder-iidiidinvest in advertising to deter entry (l (ldean and  0 >0 • Suppose K is capacity expansion hungry: small to look tough) – Over-invest in advertising to accommodate entry and – If capacity expansion makes firms produce create soft price competition after entry (fat cat: big to more, firm one is “tough” and we have a look soft) (Example 2) negative strategic effect – Under-invest in capacity to accommodate entry (small *  21x to look soft) (puppy dog)

x1 dK  0 >0

Example 1 q2 RF1

• Suppose firm 1 chooses an investment K RF1(K) that lowers its second-period marginal cost. In the second pp,geriod, a higher K shifts firm 1’s reaction curve to the right. Investment raises firm one’s optimal quantity, which RF hurts firm 2. Negative strategic effect. 2 (Spence and Dixit case)

q1

5 Example 2 • The actual strategy a firm uses if it wishes to accommodate or deter entry depends upon • Suppose K is firm 1’s pre-entry clientele. whether investment makes the incumbent tough or The direct effect reduces firms 2’s potential soft AND which way the reaction curves slope market. Strateggppic effect has the opposite • In quantity competition, reaction curves slope impact on firm 2’s profit if firm1 cannot downwards price discriminate. The fact that firm 1 has • In price competition, reaction curves slope a captive audience induces it to raise its upwards overall price, thus inducing entry. • For complete taxonomy, see (Fudenberg and Tirole, AER, 1984) • positive strategic effect

x2 p2

Table 1 -- Fudenberg and Tirole AER 1984

Investment Makes Incumbent: R1

Slope of Reaction Curves Tough Soft R2

Upward Case IV Case I A: Puppy Dog A: Fat Cat R2 D: Top Dog D: Lean and Hungry R1

Downward Case III Case II D: Top Dog D: Lean and Hungry A: Top Dog A: Lean and Hungry x p Strategic substitutes 1 Strategic complements 1 (quantities, R&D spending) (prices)

Case I: Goodwill Case II: R&D

• Investment is in Goodwill or Advertising • Investment is in capital (K) • Competition takes place on prices * • Competition takes place in R&D spending  21p – So reaction curves slope upwards – So reaction curves slope downwards  RD& * – Investment Makes Incumbent Soft pdK1 – Investment makes incumbent soft 21 RD& dK  0 >0 1 <0 <0 • Overinvest to Accommodate Entry (fat cat) • Underinvest to Deter Entry (Lean and Hungry) • Underinvest to Deter Entry (lean and hungry) • Underinvest to Accommodate Entry (Lean and Hungry)

6 Case III: Capacity Titanium dioxide industry

• Investment is in capital (K) • Dupont in 1972 had two options • Competition takes place in quantities – A “maintain” strategy that would involve – So reaction curves slope downwards investing $192 M in new capacity between  x * – Investment makes incumbent tough 21 1972 an d 1985 t o i ncrease mark et sh are t o 45% x1 dK – A “growth” strategy that would involve <0 >0 investment $394 million over the same period • Overinvest to Deter Entry (Top dog) to achieve a 1985 target share of 64%. This • Overinvest to Accommodate Entry (Top Dog) strategy would require approximately 500,000 tons of new capacity

• Titanium dioxide: White chemical agent used in History and Market Structure paint, paper, plastics, synthetic fibers. No suitable alternative; expensive to import • National lead began production in the US in 1918. • Two technologies Du Pont entered through acquisition in 1931. By – Batch process sulfate: produces large amounts of ecologically hazardous waste 1955 American Cyanimide and Glidden(acquired by SCM) ha d jo ine d t he ir rank s – Continuous process chloride: uses either ilmenite (low - grade) or rutile (high-grade) feedstock • Market shares: DuPont: 36%, National Lead: • Economies of scale: a doubling of plant size cut 24%, American Cyanamide: 15%, SCM: 10% costs for the sulfate process by 7.5% and for the • 4-firm concentration ratio: 85% chloride process by 14.3%

• Position in 1972: – New pollution control legislation sharply increased waste disposal costs which was quickly Investment Considerations making the batch sulfate process not economically viable • Capital constraints: DuPont was not capital – Sudden shortage of rutile sharply increased ore constrained, though in order to finance investment prices from cash flow, might prefer to expand in phases – AhAs the on ly prod ucer usi ng il ilimenite chl hlidoride rather than all at once technology for most of its output, these two • For a plant with an annual capacity of 150,000 shocks combined with DuPont’s greater average tons, there is a lag of at least four years between scale per per plant resulted in Du Pont’s costs the decision to construct and the date on which the being 21-23% lower than its competitors’ costs plant can be started – Sales growth projected at 3% per annum. • Existing plants can be expanded rather quickly Demand is pro-cyclical. Prices generally stable. and easily. Assume a total of 100,000 tons of capacity can be added in this manner

7 Epilogue Initial Strategy • Initially Dupont decided to expand existing plants, but announced it would begin work on a new plant in 1975. • Blow everyone else out of the market by capacity pre-emption. • Kerr-McGee announced in 1974 that it would build a 50,000 ton plant; Dupont then responded • Specifically, they forecast that demand would that it had begg,,un construction of a 130,000 tons, increase by 377,000 tons. and located near the proposed Kerr-McGee plant; • Apart from National Lead, all competitors would announcement was false. have closed their sulfate units, eliminating • Economic downturn in 1974, shortage of 160,000 tons of existing capacity. Create room for corporate capital induced Du Pont to delay other 537,000 tons of new capacity, of which DuPont projects, but commitments induced it to go ahead intended to add 94% with first 130,000 tons plant, which went on-line in 1979. • Exercise was not profitable for DuPont

Titanium Dioxide Capacity (000 tons)

Rival Firms • In Ghamewat’s words:”preemption is a 500 hazardous process in which miscalculations DuPont can depppress profitability for the entire industry – for years to come” (1984) 250 • But…

Year 72 74 76 78

• As of 2000, a market share between 55% and 60% had been maintained since the late Conclusion 1970s. • By 1985, 5 of the firms competing with •BTE Dupont in the domestic market had exited • Entry Deterrence – Three by acquisition, – Contestable Markets – One by cessation of operations – Strategic Deterrence and Accommodation – One by shutting down US plants • Example of Titanium Dioxide industry

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