10.7

• Strategic Entry Deterrence refers to actions taken by incumbent firms to prevent new competitors from entering the market. This topic explores how firms use strategies to maintain their market dominance and discourage potential entrants.
• Sequential Game: A game where players take turns making decisions. In strategic entry deterrence, the incumbent makes the first move, and the potential entrant observes this before deciding whether to enter the market.
• Backward Induction: A method used to solve sequential games. By analyzing the final move first and working backward to the first decision, firms can predict outcomes and plan strategies accordingly.
• Payoffs: The profits or losses that firms expect from each potential outcome. For incumbents, they must weigh the cost of fighting off an entrant versus the cost of allowing them to enter and compete peacefully.
• Key Strategy: Pre-commitment

  Incumbents often invest in spare capacity (additional production capability) or other costly strategies to signal to potential entrants that they are ready to fight a price war if necessary. This can discourage entry because the entrant expects heavy competition and lower profits.
• Pre-commitment is represented in the decision tree where the incumbent spends 3 units to invest in spare capacity. If the entrant enters, both firms make losses. However, if the entrant stays out, the incumbent profits by 2.
• Using backward induction, we can predict the strategic moves of the firms:

  1. The incumbent first considers its decision: fight or accept.Fighting results in a loss, so the rational decision for the incumbent is to accept entry.

  • If it fights, the expected payoff is -1.
  • If it accepts, the payoff is 1.

  1. The entrant observes this and chooses between entering or staying out.Since 1 is better than 0, the entrant chooses to enter.

  • If it enters, it gets a profit of 1.
  • If it stays out, it gets 0.

  Thus, the equilibrium (rational outcome) is Accept, Enter, where both firms peacefully share the market.
• Strategic Takeaways:

  • Credible Threats: If an incumbent can make a credible threat to fight (i.e., invest in capacity to withstand a price war), it can deter entry effectively. However, if the threat is not credible, potential entrants may enter regardless.
  • Entry Deterrence: Incumbents aim to discourage entry by making the potential entrant believe that entry will lead to a fight and losses. However, deterrence is only effective if the threat of a price war is credible.
• Real-World Application: Southwest Airlines Case Study (Case 10.4)

  The case of Southwest Airlines shows how incumbent airlines react to the threat of entry by lowering prices. When Southwest threatens to enter a new route, incumbents preemptively cut fares by 17-24%, effectively deterring entry. However, on routes where Southwest’s entry is almost guaranteed, incumbents do not bother cutting prices, as the market dynamics will change anyway.