Consider the following entry deterrence model. An entrant makes an initial decis

Question

Consider the following entry deterrence model. An entrant makes an initial decision either to enter or not into some industry. The incumbent observes this decision and subsequently decides either to compete aggressively with the entrant, or to accommodate the entrant and not compete aggressively. Suppose that aggressive competition pays both firms a profit of1. Non aggressive competition pays each firm a profit of 2. If the entrant stays out then the entrant earns zero profit elsewhere and the incumbent earns a monopoly profit of 3. In this framework, entry deterrence can be thought of as an initial threat from the incumbent to compete aggressively should entry arise.

Now suppose that we repeat this sequential game once. After the first period, the entrant decides to either be in the industry or not. Then the incumbent decides how to react if the entrant enters or stays in. Now there can be a reward for aggressive competition because if the entrant exits between periods, the incumbent earns a monopoly profit in the final period. Can we have an equilibrium outcome where firm 1 competes aggressively in the initial period in reaction to entry, and threatens to continue competing aggressively if the entrant stays in? Explain.

Explanation / Answer

Aggressive competition played by both firm gives payoff (1,1)

Cooperation gives payoff (2,2)

When entrant stays out and incumbent earns profit, payoff is (3,0)

Fierce competition gives both firms equal payoff of (1,1). Incumbent firm can deter entry by taking policy of limit pricing, signalling, cost leadership or predatory pricing. These policies make the competition less by making it difficult for the entrant to sustain in the market. If the incumbent firm has high cost structure, then entry deterrence policies would result in (3,0) as entrant will be compelled to leave the market.

However, this may not be the case always. If the entrants enter with a greater potential and makes the competition irrelevant by innovation, product differentiation, then the incumbent may lose its monopoly power. When the monopoly power does not exist, incumbent has no other options than to take non aggressive competition.

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