Strategic entry deterrence

Strategic excess capacity may be established to either reduce the viability of entry for potential firms.[5] Excess capacity take place when an incumbent firm threatens to entrants of the possibility to increase their production output and establish an excess of supply, and then reduce the price to a level where the competing cannot contend.[6]

Excess capacity typically occurs in markets with firms that have a natural monopolyy. Economist Dr. William W. Sharkey established five key aspects that lead to an monopolized industry;[6]

1. The product or service is essential;
2. The location for production supersedes alternatives;
3. The outputs are not storable;
4. The product is produced at an economies of scale; and
5. The product is can only be produced by a single supplier.

In a particular market an existing firm may be producing a monopoly level of output, and thereby making supernormal profits. This creates an incentive for new firms to enter the market and attempt to capture some of these profits. One way the incumbent can deter entry is to produce a higher quantity at a lower price than the monopoly level, a strategy known as limit pricing. Not only will this reduce the profits being made, making it less attractive for entrants, but it will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market. Limit pricing will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market. It also requires commitment, for example the building of a larger factory to produce the extra capacity, for it to be a credible deterrent.

However, limit pricing does not always need to be enacted. Many industries use limit pricing as a signaling technique. Signaling is possible here because entrants do not ever have all the information on profit margins of existing companies or the true matrix outcome. When considering entering the market, an entrant must build an outcome matrix and rely on observable factors from the incumbent companies. This gives existing firms the ability to use observable variables to confuse entrants as a strategic barrier to entry. For example, a firm may change its price, leading the incumbent to infer the marginal cost of a product (incorrectly). This could lead a firm with a high-cost structure to charge a low price in order to deter competition or a firm with a low-cost structure to charge a high price to confuse entrants and hopefully deter them. [7]

In a legal sense, a firm is often defined as engaging in predatory pricing if its price is below its short-run marginal cost, often referred to as the Areeda-Turner Law, which forms the basis of US antitrust cases. The rationale for this action is to drive the rival out of the market, and then raise prices once monopoly position is reclaimed. This advertises to other potential entrants that they will encounter the same aggressive response if they enter. According to Luís M. B. Cabral, as long as a potential entrant believes that an incumbent will take action to limit its profits, strategies like predatory pricing can be successful, even if the entrant misreads the situation and the incumbent does not act aggressively towards other entrants.[1]

In the short run, it would be profit maximizing to acquiesce and share the market with the new entrant. However, this may not be the firm's best response in the long run. Once the incumbent acquiesces to an entrant, it signals to other potential entrants that it is "weak" and encourages other entrants. Thus the payoff to fighting the first entrant is also to discourage future entrants by establishing its "hard" reputation. One such example occurred when British Airways engaged in a competition war with Virgin Atlantic throughout the 1980s over its transatlantic route.[8] This led to Virgin Atlantic chairman, Richard Branson, to say that competing with British Airways was "like getting into a bleeding competition with a blood bank."[9]

Incumbent firms can eliminate the possibility of competition from entering firms by acquiring enough shares from the target firm in order to gain a desired level of control.[10] Predatory acquisitions occur when one firm seeks to purchase a share of a smaller target firm anonymous to the management of the target firm.[11] Predatory acquisitions commonly arise to form a new majority, and establish a greater voting power in order to effect a change.

A switching costs represents the expense a consumer faces in the light of changing to the product or service to a competing firms.[12] Switching costs are not strictly monetary. To forestall customers from defecting, a company might employ a number strategies that increases a customers perceived and fiscal costs when switching. The costs associated with switching commonly fall under three categories; procedural, financial, and relational.[13] Procedural switching costs credited to the time and effort spent in completing the change. A firm might financially deter their customers from leaving by enforcing an exit fee. Relational switching costs refer to the inconveniences that are evoked in learning to use the new product or service.