1. Limit pricing. This refers to the practice where an incumbent tries to discourage
entry by charging a lowprice before any newfirm enters.However, it has
been shown using game theory that this strategy should only work if
the potential entrant does not know the cost structure of the incumbent.
Otherwise the firm will enter anyway, believing that any price reduction by
the incumbent is only temporary; this is because it is rational for the incumbent
to raise price after entry, since this would maximize its profit. On the other
hand, if the potential entrant does not know the incumbent’s cost structure,
a low price may fool it into believing that the incumbent has low costs and can
profitably maintain the low price3. In this case it would not be profitable
to enter. The behaviour of incumbent and potential entrant may change over
time as the latter may gain more accurate knowledge of the incumbent’s cost
structure and therefore may be more inclined to enter. Airlines, in particular
Continental, have practised limit pricing to discourage competitors on particular
routes. Note that the monopoly is limited in this case to that route.
2. Predatory pricing. This refers to the practice where an incumbent tries to
encourage exit, meaning drive firms out of the industry, by charging a low
price after any new firms enter. Again it has been shown that this strategy
should only work if the new entrant does not know the cost structure of the
302 STRATEGY ANALYSIS
incumbent. The reasoning is basically the same as with limit pricing, and has
been illustrated by what is known as ‘the chain-store paradox’.4 In the United
States and some other countries predatory pricing is prohibited by law.
3. Excess capacity. Most firms typically operate at about 80 per cent of full
capacity. Firms may have extra capacity for a number of reasons, either deliberate
or accidental, but excess capacity can serve as a credible threat to
potential entrants. This is because it is easy for incumbents to expand output
with little extra cost, thus forcing down the market price and post-entry
profits; if these profits are less than the sunk costs of entry, the entrant will
be deterred from entering the market. This would apply even if the potential
entrant had full knowledge of the incumbent’s cost structure.
4. Heavy advertising. This forces the potential entrant to respond by itself
spending more on advertising, which has the effect of increasing its fixed
costs, thus increasing the minimum efficient scale in the industry. It also
adds to the marketing advantages of the incumbent, as discussed earlier.
These practices will not be possible if the market is contestable. The concept
of contestable markets was developed by Baumol, Panzar and Willig5 and is
examined in more detail in the next chapter. The following conditions are
necessary for a market to be contestable:
1 There are an unlimited number of potential firms that can produce a homogeneous
product, with identical technology.
2 Consumers respond quickly to price changes.
3 Incumbent firms cannot respond quickly to entry by reducing price.
4 Entry into the market does not involve any sunk costs.
Under such conditions a monopolist cannot raise price above the level of a
perfectly competitive market. The result would be that a firm could enter on a
hit-and-run basis, by undercutting the incumbent, and exiting quickly if the
incumbent retaliates. Railway operating companies and airlines are generally
quoted as examples of industries where such conditions may apply, since firms
are supposed to be able to sell the necessary rolling stock or aircraft on
secondary markets with no loss.
Unfortunately for the theory there appears to be little empirical evidence
supporting it, at least in terms of the airline industry,6 where it was supposed
to apply. This appears to be because it takes longer for firms to enter or leave
the industry than it takes to adjust prices. Empirical evidence suggests that
entry and exit barriers are often high, causing considerable differences in
profitability, both between firms in the same industry and between different
industries. Although entry is frequent, both by new firms and by existing firms
in other markets, exit is also frequent, and entry does not appear to be that
responsive to differences in profitability, or to affect profitability significantly.
7 The most that can be claimed regarding contestability is that somemarkets are partially contestable, in that monopolists may reduce prices somewhat
under the threat of potential competition.
This completes the discussion of entry barriers for the moment. Further
aspects of this topic will be covered in the next chapter, particularly those
relating to game theory and making credible threats, for example threats to
enter a market or reduce price.