Entry and Exit Revised: October 22, 2001 One of the key areas of strategic decision-making relates to entry and exit in competitive markets. In class we used the example of Boeing and McDonnell Douglas deciding to enter the wide-body aircraft market to show how firms must decide whether to enter the market based on predictions of how their rivals will act and how these actions will impact industry profitability. As in other situations of strategic behavior we have studied this semester, firms confronting entry and exit decisions must attempt to see this "game" through their rivals' eyes and reason backwards to decide on an optimal strategy. However, these decisions can be murky-and very risky-and mistakes are not uncommon despite well-intended strategic decisions. Commitment Commitment is an extremely important factor in competitive behavior. If an industry like wide-body aircraft, where frequently there is only enough room for one profitable firm and several firms consider entering, the firm that makes a credible, irrevocable commitment to entering the industry may increase its equilibrium profits by convincing rivals to stay out. Thus, we can say that commitment creates value in strategic behavior. We showed this formally in class, but intuitively we can understand why with the following example. When Spanish conquistador Hernan Cortés arrived in the "New World" of Latin America in the 16th century, his insidious goal was challenging. With only a small army backing him, he intended to conquer and colonize a large population of unknown, potentially hostile indigenous people. Upon his arrival in Mexico, he made the seemingly insensible move of burning his entire flotilla of ships (except for one), ensuring that the local people observed this act. Why did Cortés burn his ships? After all, he was essentially destroying his escape strategy in case he was not victorious in his efforts. He was also destroying assets that could prove valuable from a military point of view. Was Cortés insane or what? Cortés probably was crazy to some extent. (If you are ever in Mexico City go see Diego Rivera's murals in the Mexican government headquarters where he unflatteringly portrays Cortés as a hideous-looking, shriveled-up pasty-white demon.) Nevertheless, Cortés's ship-burning was not crazy: it was most probably a calculated, rational move. He was demonstrating his unwavering commitment to colonizing the New World. By burning his ships in plain view, he was saying in a matter of words "we are here to stay; and we will either conquer you or die trying to do it." This commitment was credible because he Firms and MarketsLecture NotesEntry and Exit Page 2 was destroying his ability to undertake any other course of action besides staying and fighting. To understand why commitment can be so powerful in competitive behavior, think further of a chain store like Duane Reade. Why does Duane Reade build pharmacies just two blocks away from each other in Manhattan? Perhaps they estimate that the market has enough capacity to generate sufficient demand for two Duane Reades per quarter mile. But suppose that Duane Reade knows that it will not capture enough demand to make these two stores very profitable. Why on earth would they intentionally build excess capacity? One important reason is demonstrating a credible commitment. By building stores everywhere, Duane Reade is signaling-in an observable and irrevocable way-that it intends to dominate the market. This signals to competitors, and especially mom-and-pop operations, that it is a force to be reckoned with. By building up its presence, it is committing to weather the market and remain standing. If other firms correctly perceive this commitment they may decide to exit the market (or not enter). Thus, in the long run, Duane Reade's commitment will create extra value via its competitive impacts. Note that commitments must be credible in order to work. If Duane Reade decided to signal its commitment by staging a press conference and saying "we intend to be #1", this would not have much competitive cache. After all, we know that talk is cheap. Any firm can make a public statement of its intentions, but only by acting on these commitments in an observable and credible way can firms ensure their commitment has an enduring effect. Preemption The Duane Reade example also highlights a related strategic dimension of entry and exit, that of preemption. (We explored preemption briefly in last week's lecture notes with our example of the extensive cereal aisle.) Firms can create barriers to entry by increasing their product line in the hopes that they will capture demand that otherwise could be appropriated by a potential entrant. We can say more formally that a preemption strategy by a firm is one that makes entry by one more firm unprofitable. This is different from a straight monopoly strategy because, like we saw with Duane Reade, it may intentionally sacrifice profitability in exchange for controlling the market. Predation If you can keep'em out, drive'em out. Perhaps a more devious (and usually illegal) strategy to prevent entry by competitors is that of predation. Predatory pricing has a long and infamous history in the United States, ranging from Standard Oil to railroad companies to AT&T's longstanding clench of the telephony market. Predation occurs when a firm prices its products below cost-thus pricing so low that it forces other firms out of the market or prevents their entry. You may wonder why a firm would ever wishEntry and Exit Page 3 to price below cost and lose money. In a static world, this would make no sense-but in a competitive landscape, predatory pricing can be an effective deterrent. Much economic inquiry occurred on predation. At one extreme there is the so-called Chicago school. According to the Chicago school, predatory strategies cannot be profitable; if a firm prices low, then this must be considered a competitive, not anti-competitive, strategy. There are however several explanations of why below cost might be a successful predatory strategy: •= Asymmetric information. If firms know more about their costs than do the public and rival firms, they are able to exploit this fact by pricing low to convince rivals they are very efficient and not worth competing against. •= Reputation-building. We have talked about how it can be rational to establish a