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BITS, PILANI K. K.

BIRLA GOA CAMPUS

The Determinants of Industry


Concentration & Barriers to
Entry

ASWINI KUMAR MISHRA

BITS, PILANI K. K. BIRLA GOA CAMPUS

There
are
many
concentration:

systematic

determinants

of

seller

These factors include economies of scale, entry and exit


barriers, regulation, the scope for discretionary sunk cost
expenditure on items such as advertising and research.

Fundamentally, entry(and exit) conditions play a key role in


determining industry concentration.

BITS, PILANI K. K. BIRLA GOA CAMPUS

Perfectly competitive markets have many producers because


the cost of entry and exit is zero. In contrast, barriers to entry
insulate a sole firm in a monopoly market from competition.

Economists have defined the concept of a barrier to entry in


several different ways:

Bain (1959) defines it as a market condition that raises the


cost of entering the market to such an extent that incumbent
firms earn long-run economic profits.

Stigler (1968) argues that a barrier to entry exists only if the


cost of entry is higher for new entrants than it was for
established firms.

Classification of barriers to entry


There is no unique, agreed system for classifying the
many factors that may impede entry.

Broadly speaking, however, entry barriers may be


subdivided into those that stem from the structure of the
industry itself (structural barriers to entry), providing
shelter for the incumbent firms, and

Those that are created by the incumbent firms


deliberately, in order to keep out potential entrants or at
least retard the rate of entry (strategic barriers to entry)
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Structural barriers to entry


Barriers that are caused by basic economic conditions
are called natural/structural barriers to entry.

These barriers might derive from basic demand and


cost conditions, because demand conditions are
determined by consumers and cost conditions are
technologically determined.
Under this heading, we consider the three types of entry
barriers originally discussed by Bain: 1) economies of
scale, 2) absolute cost advantage and 3) product
differentiation.
6

Structural barriers to entry


1. Economies of scale: Economies of scale exist when
the long-run average cost (AC) curve has a negative
slope.

The minimum level of


production needed to take
advantage of all economies of
scale is a useful concept in
industrial economics and
is given a special name,
minimum efficient scale (MES).
There are economies of scale until output reaches q.
Beyond q, AC has a positive slope, indicating
diseconomies of scale. The smallest output for which AC
is at its minimum, q, is called minimum efficient scale
(MES).

Structural barriers to entry


1. Economies of scale: Economies of scale can act as an
entry barrier is when average costs associated with a
production level below the MES are substantially
greater than average costs at the MES.
Figure 2: MES as a barrier to entry

In both industry A and industry B, the penalty for producing at 50 per cent of the
MES is C1 C2. This penalty is much greater in industry B than in industry A, due to
the difference in slope between the two LRAC functions.
8

Structural barriers to entry


1. Economies of scale: One way to see how demand and
cost conditions affect entry barriers and concentration is
to review the theory of a natural monopoly.

A natural monopoly occurs when there are substantial


scale economies relative to the size of the market
(represented by market demand), making it productively
inefficient to have more than one firm produce total
market output.
In other words, in this case, demand and cost
conditions make it productively efficient and most
profitable for a single firm to serve the entire market.
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Structural barriers to entry


1. Economies of scale: In the following figure, AC is
long-run average cost and D represents market
demand. In this example, MES equals 4 (million units),
which corresponds to an average cost of $10.
Figure 2: MES as a barrier to entry
Baumol et al. (1982) define the
cost-minimizing industry structure
as the number of firms in an industry that are
needed to produce industry output (x) at
minimum cost, which is: x/MES=n*.

When this occurs, the industry is productively efficient.


To demonstrate, when x=20, five symmetric firms minimize
the total cost of producing at MES=4. Thus, the cost-10
minimizing industry structure is five firms.

Structural barriers to entry


1. Economies of scale: The concept of a cost-minimizing
industry structure provides a simple way of showing
how scale economies in relation to the size of the
market affect industry concentration.
That is, when x is small and the cost minimizing number
of firms is 1, then the industry is a natural monopoly. If x is
very large, then the industry is naturally competitive.
At intermediate values of x, we have the natural
oligopoly. Thus, when scale economies increase (decrease),
causing MES to shift right (left), the cost minimizing
number of firms decreases (increases) and concentration
rises (falls). When demand increases (decreases), the cost
minimizing number of firms increases (decreases) and
concentration falls (rises).
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Structural barriers to entry


2.

Absolute Cost Advantage: An incumbent has an


absolute cost advantage over an entrant if the LRAC
function of the entrant lies above that of the incumbent,
and the entrant therefore faces a higher average cost at
every level of output.

Figure 2: Absolute cost advantage as a barrier to


entry
13

Structural barriers to entry


2. Absolute Cost Advantage: There are several reasons
why an entrant may operate on a higher LRAC function.
First, an incumbent may have access to a superior
production process, hold patents, etc.
Second, incumbent firms may have exclusive ownership
of factor inputs. They may control the best raw materials,
or have recruited the most qualified or experienced labour
or management personnel. Consequently entrants are
forced to rely on more expensive, less efficient or lowerquality alternatives.

Third, incumbents may have access to cheaper sources


of finance, if they are viewed by capital markets as less
risky than new firms.
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Structural barriers to entry


2. Absolute Cost Advantage: Finally, the presence of
vertically integrated incumbents.
In industries such as biotechnology, brewing, iron,
mobile telephones, steel or chemicals may force an entrant
to operate at more than one stage of production if it wishes
to overcome the incumbents absolute cost advantage.
It is worth noting that an absolute cost differential need
not always work in favour of the incumbent. It is possible
that an incumbent has overpaid for its assets, in which
case the entrant may be favoured. This might be true in
industries reliant on rapidly changing technologies, such as
computer hardware or software, whose costs fall rapidly
over time.
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Structural barriers to entry


3. Natural product differentiation: A structural entry
barrier exists if customers are loyal to the established
brands and reputations of incumbents.
A successful entrant will need to prize customers away
from their existing suppliers, or at least stir customers out
of their inertia.

This might be achieved either by selling the same


product at a lower price, or launching advertising,
marketing or other promotional campaigns.

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Threats to Structural barriers to


entry
Bain (1956) argues structural entry barriers arising from
economies of scale, absolute cost advantage and product
differentiation are generally stable in the long run.

However, this does not imply these barriers should be


regarded as permanent. The same comment also applies to
legal and geographic entry barriers.

Market structures can and do change eventually, and


the importance of any specific entry barrier can
increase or decrease over time.
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Threats to Structural barriers to


entry
For example, new technology may re-shape the LRAC
functions of both incumbents and entrants, transforming
the nature of an economies of scale entry barrier.

New deposits of a raw material may be discovered,


reducing the absolute cost advantage enjoyed by an
incumbent.

One highly original or innovative marketing campaign


might be sufficient to completely wipe out long
established
brand
loyalties,
or
other
product
differentiation advantages of incumbents.
20

Legal and Geographic barriers to


entry
Legal Barriers: Legal barriers to entry are some of the
most effective of all entry barriers, as they are erected by
government and enforced by law. Examples of legal
barriers include:
Registration, certification and licensing of businesses and
products.

Monopoly rights. Monopoly rights may be granted by


legislation. Government may allow certain firms
exclusive rights to produce certain goods and services
for a limited or unlimited period.
21

Legal and Geographic barriers to


entry
Geographic Barriers: Geographic barriers are the
restrictions faced by foreign firms attempting to trade in
the domestic market.

Such barriers affect the extent and type of entry (either


through acquisitions and joint ventures) pursued by foreign
firms. Examples of geographic entry barriers include:

Tariffs, quotas, subsidies to domestic producers. All


such measures place foreign producers at a
disadvantage.
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Strategic Barriers to Entry


Structural barriers stem from underlying product or
technological characteristics, and cannot be changed easily
by incumbent firms.

There is however a second class of entry barrier over


which incumbents do exercise some control.

Incumbents can create or raise barriers of this second


kind through their own actions. Relevant actions might
include changes in price or production levels, or in some
cases merely the threat that such changes will be
implemented if entry takes place.
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Strategic Barriers to Entry


We discuss four major entry-deterring strategies.

The first two are pricing strategies: limit pricing and


predatory pricing. The third is strategic product
differentiation.

The fourth, creating and signalling commitment, involves


an incumbent demonstrating its willingness to fight a price
war in the event that entry takes place, by deliberately
incurring sunk cost investment expenditure.
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Strategic Barriers to Entry


1. Limit Pricing: Suppose a market is currently serviced
by a single producer, but entry barriers are not
insurmountable (impossible).
The incumbent therefore faces a threat of potential
entry.

According to the theory of limit pricing, the incumbent


might attempt to prevent entry by charging a price, known
as the limit price, which is the highest the incumbent
believes it can charge without inviting entry.

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Strategic Barriers to Entry


1. Limit Pricing: The limit price is below the monopoly
price, but above the incumbents average cost.

Therefore the incumbent earns an abnormal profit, but


this abnormal profit is less than the monopoly profit.

In order to pursue a limit pricing strategy, the incumbent


must enjoy some form of cost advantage over the potential
entrants. In the limit pricing models developed henceforth,
this is assumed to take the form of either an absolute cost
advantage or an economies of scale entry barrier.
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Strategic Barriers to Entry


1. Limit Pricing: A critical assumption underlying models
of limit pricing concerns the nature of the reaction the
entrants expect from the incumbent, if the entrants
proceed with their entry decision.
A key assumption of these models, is that entrants
assume the incumbent would maintain its output at the
pre-entry level in the event that entry takes place.
Limit pricing theory begins with the logical assumption
that rational firms should maximize long-run, not short-run
profits.

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Strategic Barriers to Entry


1. Limit Pricing to deter entry:
(a) Absolute Cost/Sunk Cost Advantage

Inverse demand curve of incumbent monopolist: P = 100 qM & MCM=$40.This implies qM=30,
PM=$70, Profit M= ($70 $40) x $30 =$ 900.
Residual demand curve of potential entrant: P = (100 qM) qPE=70-qPE & MCPE=$50.This
implies qPE=10, PPE=$60, Profit PE= ($60 $50) x 10 = $100( Given the assumption that the
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monopolist will maintain its output forever).

Strategic Barriers to Entry


1. Limit Pricing to deter entry:
(a) Absolute Cost/Sunk Cost Advantage

However, once the new entrant starts charging a price of 60, the incumbent monopolist can no
longer continue to charge a price of 70. It has to match the price of the new entrant.
Now, monopolist matches the potential entrants price(i.e., PM=$60).
New profit: Profit M= ($60 $40) x $30 = $600. The arrival of new entrant has resulted in a 33%
decline in monopolists profit(from $900 to $600).
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Strategic Barriers to Entry


1. Limit Pricing: To deter entry, the monopolist must
lower its price sufficiently to ensure that the potential
entrants residual demand curve lies everywhere below
the potential entrants average cost curve.

Since the incumbent monopolist does not want


competition from the new entrant, it threatens to charge the
limit price.
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Strategic Barriers to Entry


1. Limit Pricing:

Note that the incumbent has a cost advantage


over the new entrant; the average cost of the former is $40, while
that of the latter is $50. If, therefore, the incumbent charges a limit
price that is just less than $50 per unit, the entrant (who will have to
match this price) will necessarily make a loss.

However, since this price is above 40, the incumbent


monopolist will continue to make a profit.
33

Strategic Barriers to Entry


1. Limit Pricing to deter entry:
(b) With Economies of Scale and No Absolute Cost
Advantage for the Incumbent Firm
What if the incumbent monopolist does not have a cost
advantage over the new entrant?

If MC (= AC) does not change with output, incumbent will


not make any profit with limit pricing. As in our previous
example, if P = 100 (qM+ qPE) & MCM= MCM =$40.The limit
price would therefore equal $40 and profits fall to zero as
soon as the incumbent adopts the limit pricing policy.

35

Strategic Barriers to Entry


1. Limit Pricing to deter entry:
(b) With Economies of Scale and No Absolute Cost
Advantage for the Incumbent Firm

With the industry demand curve:P=100-1.25Q and the residual demand curve faced by the

potential entrant will depend on the price charged by the incumbent.


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Strategic Barriers to Entry


1. Limit Pricing to deter entry: With Economies of Scale
and No Absolute Cost Advantage for the Incumbent
Firm

Inverse demand curve of incumbent monopolist: P = 100


1.25 qM & LRAC is minimum at LRAC=$20 and the corresponding
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qM=34, PM=$57.5, Profit M= ($57.5 $20) x $34 =$ 1275.

Strategic Barriers to Entry


1. Limit Pricing to deter entry: With Economies of Scale
and No Absolute Cost Advantage for the Incumbent
Firm

For the above mentioned Residual demand curve: P =57.5-1.25qPE, the


profitable range of output is between Q1 &Q2 because the demand curve
is above the LRAC for those outputs.
41

Strategic Barriers to Entry


1. Limit Pricing to deter entry: With Economies of Scale
and No Absolute Cost Advantage for the Incumbent
Firm
What is the limit price in this case?

Assuming that the monopolist will maintain the same


output after entry, the monopolist must lower its price
sufficiently to ensure the potential entrants residual
demand curve lies everywhere below the LRAC.
42

Strategic Barriers to Entry


1. Limit Pricing to deter entry: With Economies of Scale
and No Absolute Cost Advantage for the Incumbent
Firm

For PM=$40, the residual demand curve of potential entrant is : P PE = 40 1.25 qPE
& here, the residual demand curve is just tangent to the LRAC at output level
qPE=10. Any price less than $40, even by an infinitesimal amount, will shift the
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potential entrants residual demand curve to the left and deter entry.

Strategic Barriers to Entry


1. Limit Pricing to deter entry: With Economies of Scale and No
Absolute Cost Advantage for the Incumbent Firm

Thus, in general, monopolist must set its output at a level such that the residual
demand curve of the new entrant is DPE. All points on this demand curve lie below the
average cost curve (AC), i.e., the new entrant cannot charge any price at which it can
make a profit. However, since the incumbent monopolist has a positive output level, it
enjoys economies of scale, such that its average cost is now reduced, and it can
therefore earn a profit.
44

Strategic Barriers to Entry-Will a dominant firm


always choose to keep entrants out?
1. Limit Pricing to deter entry: Will a dominant firm
always choose to keep entrants out?

A dominant firm will pursue the strategy that yields the


largest profit. If it will reap a greater profit by letting a rival
into the market than by keeping it out, it will prefer to let
the rival in. Based on market size and sunk costs, there are
three possibilities :
If the market is large and sunk entry costs are small, a
dominant firm will have to produce far more than a
monopolist, and charge a price only slightly above the
entrants MC, to preclude entry.
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Strategic Barriers to Entry


1. Limit Pricing to deter entry: Will a dominant firm
always choose to keep entrants out?

In large markets with easy entry, a dominant firm will


make a greater profit by charging a higher price and
sharing the market with a competitive fringe than it will by
setting a low price and keeping the fringe out.
On the other hand, if the market is very small and sunk
entry costs are small, a dominant firm can keep an entrant
out is to set a price that yields zero economic profit.

46

Strategic Barriers to Entry


1. Limit Pricing to deter entry: Will a dominant firm
always choose to keep entrants out?

However, if the market is very small and entry costs are


very high, it will not be profitable for an entrant to come in
even if the existing firm charges the monopoly price.

This is the case of blockaded entry.

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Strategic
Barriers
-Blockaded Entry

to

Entry

P
D

Pm
ACe

MCdf
0

Qm

Strategic Barriers to Entry-Criticisms


1. Limit Pricing: The theory is being criticized on the
following grounds:

Why should the entrant believe the incumbent would not


alter its pricing and output policies if entry takes place?

If an industry is growing, it may be difficult to persuade a


potential entrant that there is no market available if entry
takes place.

49

Strategic Barriers to Entry-Criticisms


1. Limit Pricing: The theory is being criticized on the
following grounds:
Market structure is ignored. Applied to the case of
oligopoly, the theory assumes all incumbent firms would
implement a limit pricing strategy. For this strategy to
succeed, a high level of coordination or collusion would be
required.
Limit pricing implies perfect information regarding the
market demand function, the incumbents own costs, the
entrants costs, and so on. These would be impossible to
estimate with any degree of precision.

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Strategic Barriers to Entry


2. Predatory Pricing(also undercutting): It is a pricing
strategy where a product or service is set at a very low
price, intending to drive competitors out of the market.

Here, the incumbent adopts the role of predator,


sacrificing present profit and perhaps sustaining losses in
the short run, in order to protect its market power and
maintain its ability to earn abnormal profit in the long run.

Strictly
strategy.

speaking,

predatory

pricing

is

post-entry

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Strategic Barriers to Entry


2. Predatory Pricing: There are two questions to keep in
mind:

First, what kind of market structure is required for


predatory pricing to be profitable at all, so that it is a
strategy that a dominant firm would consider?.

Second, in which circumstances is predatory pricing the


most profitable strategy for maintaining dominance, so that
it would be strategy actually chosen by a dominant firm?
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Strategic Barriers to Entry-Predatory


Pricing and the Role of Market Structure
2. Predatory Pricing: Kind of market structure Required:

One prerequisite for the use of predatory pricing as a


strategy toward rivals is that the predatory firm has the
market power in some markets like Wal-Mart, Reliance
Fresh, etc. that operate in many local geographic markets.

In one market where its actions are constrained by a


fringe of small competitors, it sets price below cost. By so
doing, it loses money in that market. But the dominant firm
is sustained by its operations in other markets as in these
markets it sets price above marginal cost.
53

Strategic Barriers to Entry-Predatory


Pricing and the Role of Market Structure
2. Predatory Pricing: While adopting this strategy, there
is no way to avoid the time element:

The losses come now, the profits come later.

Predatory pricing is an investment in market power, and


like all investments, it is inherently dynamic.

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Strategic Barriers to Entry-Predatory


Pricing-When will it be Profitable?
2. Predatory Pricing: Two simple assumptions
required to make predation profitable.

are

Before the predatory campaign, P=LRAC (i.e., the status


quo is long-run competitive equilibrium).The producer can
produce in other markets to supply the target market with
very low transportation costs.

The target firm is a price taker. It maximizes its profit,


given the price sets by the producer. Thus, for it, the supply
curve is its SRMC curve, above the shutdown point (=Min. pt.
on the SRAVC curve).
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Strategic Barriers to Entry-Predatory


Pricing-When will it be Profitable?
2.

Predatory Pricing: Stage 1-Losses (for both predator and victim?)

During the first stage of predation, the predator lowers price below LRAC and sets
ppred as the price. As a result of which, the victim reduces output from qc to qpred. Total
losses for the victim is given by the area ALMJ and this is for a single period, the firm
will lose this much, per period, as long as it continues to operate.
56

Strategic Barriers to Entry-Predatory


Pricing-When will it be Profitable?
2.

Predatory Pricing: Stage 2-Profit (The dominant firm as a monopolist in


the local market?)

The monopolist profit is given by the area BNRS and the deadweight welfare losses is
given by the area SRF.

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Strategic
Barriers
to
Entry:
Predatory Pricing-Criticisms
2. Predatory Pricing: The (anti-interventionist) Chicago
school is rather sceptical about the reality of predatory
pricing.
First, the predators gain in profit in the long run must
exceed the loss resulting from price-cutting in the short
run. It may be difficult for a predator to be certain this
condition will be met.
Second, for a predatory pricing strategy to succeed in
deterring entry, the predator has to convince the entrant it is
prepared to maintain the reduced price and sustain losses for
as long as the entrant remains in business.

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Strategic Barriers to Entry


2. Predatory Pricing: The (anti-interventionist) Chicago
school is rather sceptical about the reality of predatory
pricing.
Third, as suggested above, for a predatory pricing
strategy to be worthwhile, the predator has to be sure that
having forced its rival out of business and raised its price,
the entry threat will not return, either in the form of the
same rival, or some other firm.
Finally, if an incumbent and an entrant have identical cost
functions, a predatory pricing strategy could just as easily be
used by the entrant against the incumbent as the other way
round.
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Strategic Barriers to Entry


3. Strategic Product Differentiation: For many product
types, a certain amount of product differentiation is
quite natural, in view of basic product characteristics
and consumer tastes.
Recall
that
natural
product
differentiation
interpreted as a structural barriers to entry.

was

In some imperfectly competitive markets, however,


incumbents may employ advertising or other types of
marketing campaign in order to create or strengthen brand
loyalties beyond what is natural, in order to raise the start-up
costs faced by entrants.
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Strategic Barriers to Entry


3. Strategic Product Differentiation: Many firms
wishing to establish a new brand incur significant sunk
costs in the form of advertising and other promotional
expenditure.
Spurious product differentiation or brand proliferation (
for example, in detergents and processed foods) refers to
efforts by an incumbent firm to crowd the market with
similar brands, denying an entrant the opportunity to
establish a distinctive identity for its own brand.
In July 2003, ITC forayed into the Biscuits market with the
Sunfeast range of Glucose, Marie and Cream Biscuits(pls.
visit http://sunfeastworld.com/)

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Strategic Barriers to Entry


3. Strategic Product Differentiation: Many firms
wishing to establish a new brand incur significant sunk
costs in the form of advertising and other promotional
expenditure.
As many as 12 varieties of biscuits can be found under
Sunfeast brand name. Compared to this, Britannia also has
had
many
varieties
of
biscuits
(pls.
visit
http://www.britannia.co.in/overview.htm)
Existing brand loyalties, and therefore entry barriers, are
strengthened in cases where consumers incur significant
switching costs: costs associated with switching to another
supplier.
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Strategic Barriers to Entry


3. Strategic Product Differentiation: Many firms
wishing to establish a new brand incur significant sunk
costs in the form of advertising and other promotional
expenditure.

Customers with high switching costs are committed to


remaining with their existing suppliers, and cannot easily
be lured elsewhere.

Examples of products which may have high switching costs


include bank accounts, computer software, and supermarkets
and other stores that offer loyalty cards.
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Strategic Barriers to Entry


4. Creating and Signalling Commitment: An incumbent
firm attempts to deter entry by deliberately increasing
its sunk cost expenditure(like creating additional
productive capacity) before entry takes place.

The incumbent creates and signals a commitment to


fight entry by engaging the entrant in a price war, in the
event that entry subsequently occurs.

Incumbent can be passive or committed one.

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Strategic Barriers to Entry


4. Creating and Signalling Commitment: Passive Vs.
Committed Incumbent

A passive incumbent does not pre-commit to fighting the


entrant, in the event that entry subsequently takes place.

In other words, a passive incumbent waits to see if entry


occurs, before investing in the additional productive capacity
or the aggressive marketing campaign that will be required
in order to fight a price war.
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Strategic Barriers to Entry


4. Creating and Signalling Commitment: Passive Vs.
Committed Incumbent

A committed incumbent does pre-commit, by incurring


the sunk cost expenditure that will be required in order to
fight in advance, before it knows whether or not entry will
actually take place.

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References
Bain,

J.S. (1956) Barriers to New Competition. Cambridge, MA:


Harvard University Press.
Comanor, W.S. (1967a) Market structure, product differentiation and
industrial research, Quarterly Journal of Economics, 18, 63957.

Comanor, W.S. (1967b) Vertical mergers, market power and the


antitrust laws, American Economic Review, Papers and Proceedings, 57,
25465.
Martin, Stephen(1988) Industrial Economics. Macmillan, USA.

Lypczynski, John et al. (2005) Industrial Organisation-Competition,


Strategy, Policy. Pearson Education Limited.
Stigler, G.J. (1968) The Organisation of Industry. Holmwood, IL: Irwin.

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