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• Barriers to entry exist when incumbents are able to exercise market power, but entrants anticipate nonpositive profits
• Incumbents often have an incentive to engage in strategic entry deterrence to protect both market power and economic profits
• In the Dixit model, incumbents deter entry by overinvesting in capacity, as the costs of capacity are sunk and up to its capacity the MC of the incumbent firm is less than the MC of the entrant, making it credible for the incumbent firm to produce to capacity
• Whether strategic entry deterrence in the Dixit model is profitable depends on the relative importance of capital costs and the extent of economies of scale
• Section 2 of the Sherman Act prohibits monopolization in the United States, with the offense having two elements: (1) possession of a monopoly and (2) exclusionary or predatory conduct
• Perfectly contestable market


  Defined by absolutely free entry and absolutely costless exit
• Contestable markets are imperfectly competitive markets in which firms face real and potential competition, and the threat of entry from new rivals may be sufficient to keep the industry operating at a competitive price and output
• Sunk costs of entry create barriers to entry by exposing the entrant to the risk of nonrecovery, raising the cost of capital for entrants and creating a cost disadvantage vis-à-vis incumbents
• Structural barriers to entry

  • Economies of scale
  • Product differentiation
  • Cost advantages
• Profit entry deterrence depends on both barriers to entry and the credible threat of aggressive behavior by the incumbent post-entry
• The welfare implications of barriers to entry are case specific, as structural barriers to entry or strategic entry deterrence by incumbents may increase or decrease welfare
• Two-stage game


  Strategic behavior can be fully studied using the framework of two-stage competition
• Strategic moves


  Set the framework for subsequent competition, with the key feature being commitment
• Tactical moves


  Correspond to the second stage of the two-stage game, such as prices and quantities, made conditioned on the strategic environment created in the first stage
• Strategic substitutes


  When the reaction function in the second stage slopes downward
• Strategic complements


  When the reaction function in the second stage slopes upward
• Strategic investment


  In the first stage, makes the firm tough if it makes it more aggressive in the second stage, or soft if it increases the profits of rival firms
• Taxonomy of equilibria


  • Top dog
  • Fat cat
  • Puppy dog
  • Lean-and-hungry look
• Top dog strategy


  The commitment makes the firm tough or aggressive, and strategic variables are strategic substitutes
• Fat-cat effect


  The commitment makes the firm soft, and strategic variables are strategic complements
• If the goal is to deter entry, the only possible equilibria are top dog by overinvesting or lean-and-hungry look by underinvesting
• The welfare effects of strategic investment are ambiguous, as even if consumers are made better off, rival firms may be made worse off, and in some cases, consumers will be made worse off
• If advertising is persuasive but not informative, in both monopoly and oligopoly equilibrium, the level of advertising will be excessive from a welfare point of view
• Other things being equal, an increase in total industry output will be welfare improving, so if advertising causes consumers to purchase more, it can be welfare increasing
• When advertising is an exogenous sunk cost, any increase in the sunk advertising investment required to enter the industry will increase the equilibrium level of concentration
• When advertising is an endogenous sunk cost, advertising outlays can increase indefinitely as market size increases, but there is a lower bound to concentration below which the market never goes
• Predatory advertising


  Attracts away the customers of rival firms
• Cooperative advertising


  Increases demand for all firms in the industry
• The use of advertising as an instrument to deter entry depends critically on whether advertising tends to be predatory or cooperative
• Advertising


  Investment required to enter the industry
• Advertising increases


  Equilibrium level of concentration increases
• Market size increases


  Concentration approaches zero in the limit
• Endogenous sunk costs


  Fixed costs that firms can choose to invest in, which affect the price-cost margin of a firm
• Advertising is an endogenous sunk cost

  Advertising outlays can increase indefinitely as market size increases, but there is a lower bound to concentration below which the market never goes
• Cooperative advertising


  • Manufacturer helps a retailer pay for cereals
• Advertising as an instrument to deter entry

  Depends on whether advertising tends more to create goodwill or whether advertising tends to be more to making it softer in its pricing response entry
• Goodwill


  Intangible asset associated with the purchase of one company by another
• Direct strategic costs of advertising

  Arise when strategic advertising directly lowers the profits of rival firms, by attracting away their customers
• Indirect strategic effects of advertising

  • Inducing the rival to change its price or output in response to the advertising investment. Ex. Mix & Match of Mcdo and Jabee
• Advertising can lead to lower prices in equilibrium, compared to the case where advertising is prohibited