3

Game Theory & IO Entry

Two-period entry & competition games.

3.1
3.1.1

Non-credible threats
Competing in Quantities

Revisit Stackelberg . . .
S The leader rm says that it will produce a particular quantity, q1 . If the follower rm believes this, then it may enter (depending on the xed costs of entry) S and produce its best-response quantity, q2 . S If the leader rm can now change its choice, it would do so: q1 is not its best response S to q2 . If the follower rm believed this in the rst place, then (if it entered) it would produce the best-response quantity of the Cournot game, as would the leader.

3.1.2

Threatening a Price war

We saw in Section 2.2 that a threat by an incumbent rm to ght after a potential rival entered the market was not credible (in a nite horizon game of complete & perfect information).

3.2
3.2.1

Credible behaviour
Sunk costs

Based on: Spence (1977), Bell Journal; Dixit (1980), EJ. Period 1: Firm I (incumbent) chooses capacity k at a cost of r per unit this pushes its reaction curve out from BRI to BRI as long as qI < k; for qI > k its reaction curve is still BRI ; at qI = k its reaction curve is vertical. Having observed k, rm E (potential entrant) decides whether or not it will enter the market in period 2 entry will entail a xed cost F . Period 2: Firm I produces up to k with unit cost w, beyond k with unit cost r + w. If rm E does not enter, it incurs no costs. If rm E enters, the two rms engage in quantity competition, but rm E incurs the xed cost F and has a unit cost of r + w. Find SPE by working backward from the end. 11

Stage 2: Quantity competition Firm Es best response function is bE (qI | r, w). Firm Is best response function is bI (qE | r, w; k). Firm E will enter the market if its expected post-entry prot covers the xed cost. Stage 1: Capacity choice Entry could be blockaded, entry could be inevitable, or entry deterrence could be possible but not inevitable. Entry is blockaded Entry is strategically accommodated (Stackelberg) qE T
BRI r rr r rr b r C rr S d r r rr N rb r rZ b rr BRE BRI rr r E

qE T
BRI r rr r rr b Z r C rb rr rr r bN r r rr BRE BRI rr r r E d

qI Entry might not be deterred . . . but if it is, output and welfare increase

qI

qE T
BRI r rr rr b rr C rr S d r rr rr N b b r Z r rr BRE BRI rr r E

qE T
BRI r rr rr b rr C rr S b rr b r b Z rN r r rr BRE BRI rr r r E d

qI 12

qI

3.2.2

Imperfect information

Example: Milgrom & Roberts (1982), JET. Two periods, production costs of rm I (incumbent) initially uncertain: either they are low (L) in both periods or they are high (H) in both periods; anyone outside the market initially believes that rm I has low costs with probability and high costs with probability 1 . Period 1: Firm I is alone in the market, and knows its own production costs. It charges a price p1 , making a prot limited by either M L or M H , depending on its costs it could make less by charging a price dierent from its static monopoly price. Having observed rm Is rst-period price, rm E (potential entrant) decides whether or not to enter the market in period 2 it can base its decision on the observed price. Period 2: Firm I remains in the market. If rm E does not enter, it makes 0 and rm I makes a prot of either M L or M H , depending on its costs. If rm E enters, rm I makes either DL or DH , depending on its costs, and rm E H L makes either DE < 0 or DE > 0, depending on which type of rm I it is facing. Assume that an incumbent with low costs benets more from deterring entry than one with high costs: M L DL > M H DH and also that
L H DE + (1 )DE < 0

i.e. is large enough to deter entry unless rm E learns that rm I has high costs. Firm I would like to discourage entry either by keeping rm E unsure, or by convincing rm E that it is low-cost. Firm I has an incentive to charge a low price in period 1 to do this . . . But rm E knows about this, and might not be fooled . . . A low-cost incumbent suers an eective loss of M L M L (p1 ), but makes a gain of (M L DL ) when entry is deterred. So, rm I is willing to charge any p1 satisfying M L M L (p1 ) (M L DL ) if this means that rm E either learns nothing, or learns that rm I has low costs. A high-cost incumbent suers an eective loss of M H M H (p1 ), but makes a gain of (M H DH ) when entry is deterred. So, rm I is willing to charge any p1 satisfying M H M H (p1 ) (M H DH ) if this mimics the behaviour of a low-cost rm I implying that rm E learns nothing. However, rm I is unwilling to charge p1 satisfying M H M H (p1 ) > (M H DH ) to mimic the behaviour of a low-cost rm I and deter entry it is better o if rm E learns that rm I has high costs and then enters. 13

Gain/Loss (M D )
L L

T L M

. M L (p1 ) M H M H (p1 ) . . . . .

(M H DH )

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. .. .. . . .. .. .. .. . . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. . . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ... ... . . .. ... .. ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... .... .... ...... .... ... .... ..... .... ... .... ....... ... .... ....... .... .... ..... .... .... .... . ..... .... ..... .... ........ .... ..... ..... ..... ...... ...... ..... ..... ...... ...... ...... ...... .......... .......... ............ ................. ............ ................. ................. ................. .... ....

p Two equilibria stand out:

pL m

pH m

p1

[P] Firm I charges the same rst-period price pL independent of its costs. m Firm E learns nothing and so stays out, leading to a total prot for a high-cost rm I of M H (pL ) + M H . m Firm I cannot gain from increasing rst-period price if it has high costs since this induces entry, leading to a total prot for rm I of at most M H + DH < M H (pL ) + M H . m Note: This implies that, if has high costs, rm I is, in principle, prepared to lower rst-period price as far as p if this manages to deter entry. In equilibria like [P]: Inecient entry Welfare eect ambiguous

[S] Firm I charges a rst-period price p if it has low costs, and pH if it has high costs. m Firm E learns the costs of rm I and enters if and only if they are high. That is, rm E is convinced that rm I has low costs if it observes a rst-period price p. So rm I makes a total prot of M H + DH if has high costs, and a total prot of M L () + M L if it has low costs. p Firm I cannot gain from decreasing rst-period price to p if it has high costs rm E H H H H stays out but rm I makes M () + M = M + D . p Firm I cannot gain from increasing rst-period price above p if it has low costs this is a credible choice for a high-cost rm I (see the note above), so rm E enters and rm I makes at most M L + DL < M L () + M L . p Note: This implies that, if it has low costs, rm I is, in principle, prepared to lower rst-period price as far as p in order to convince rm E. In equilibria like [S]: Ecient entry Welfare enhancing 14