The impact of buyers' expectations on entry deterrence

Economics Letters North-Holland

375

26 (1988) 375-380

THE IMPACT OF BUYERS’ EXPECTATIONS David

BESANKO

Indiana

University, Bloomington,

Shabtai

ON ENTRY DETERRENCE

*

IN 47405, USA

DONNENFELD

Tel-Aviv

University, Ramat-Aviv,

Received

30 December

Tel-Aviv 69978, Israel

1986

A model of entry deterrence is presented in which consumers are perfectly informed about an incumbent monopolist’s quality but are imperfectly informed about the qualities of potential entrants. To deter entry, the monopolist chooses price and quality than he would in the absence of an entry threat.

product a higher

1. Introduction Entry deterrence has been usually examined in the context of a game between an incumbent firm and potential entrants, and the focus has been on limit pricing [Bain (1956) and Milgrom and Roberts (1982)]; investment capacity [Spence (1977) and Dixit (1980)]; brand proliferation [Schmalensee (1978)]; and raising rivals’ costs [Williamson (1968) and Salop and Scheffman (1983)] as strategies employed by the incumbent to impede or discourage entry of potential rivals, A common presumption in most of the papers cited above is that some sort of asymmetry exists between the original (established) firm and its (potential) rivals. Empirical evidence suggests that established firms enjoy advantages over new entrants, even when entrants offer their products at lower prices than those charged by the incumbent firm. [See Bond and Lean (1977) and Whitten (1979) for empirical analyses of first-mover advantages in the prescription drug and cigarette industries, respectively.] While unit promotional cost disadvantages may provide a partial explanation for these first-mover advantages, * an important explanation is undoubtedly due to the fact that buyers have better information about the quality of an established firm’s product than they do about the products of new entrants. As Greer (1984, p. 178) points out: ‘Even though an imitation brand and persuasion as the advertising consumers have with the pioneering

may advertise vigorously to win converts, such information contains may not readily substitute for the experience brand.’

The purpose of this paper is to present a model of entry deterrence in which buyers’ expectations about product quality play an important role in the established firm’s choice of an entry-deterring * The first author’s work has been supported by National Science Foundation thank Joseph Greenberg and David Wildasin for their helpful comments. ’ Buzzell and Farris (1977) found that pioneering brands enjoy promotional over later entrants.

0165-1765/88/$3.50

0 1988, Elsevier Science Publishers

B.V. (North-Holland)

Grant

SES-8408335.

cost advantages

The authors

would like to

equal to 1.45 percent

of sales

D. Besanko, S. Donnenfeld /

376

The impact of bu_yers’expectations

strategy. The basic model involves an industry that produces differentiated products and that is currently dominated by a monopoly. Consumers are assumed to be perfectly informed with regard to the quality of the product produced by the monopoly but are imperfectly informed about qualities which will be offered by new entrants. In this setting, we find that an optimal entry-deterring strategy involves the monopolist charging a higher price and producing a higher quality than would a monopolist that is not threatened with entry. In the recent literature on entry deterrence, our paper is most closely related to Schmalensee’s (1982) study of the advantages of pioneering brands. Schmalensee presents a model in which brands enter a market sequentially and early entrants enjoy an advantage over later entrants. Their advantage stems from the fact that the industry’s product is an experience good and thus consumers possess better information about the pioneering brands than they do about brands that enter later. The organization of the remainder of the paper is as follows: in section 2 we present the model. In section 2.1 we present the simple monopoly case. In section 2.2 we investigate the behavior of the established firm, when faced with entry. Section 3 concludes with a brief summary.

2. The model The economy consists of three classes of agents: a group of identical buyers, an established firm (or group of firms), and a large number of potential entrants. In the analysis that follows we will focus on buyers as consumers whose utility from consuming one unit of the good of quality q is given by u(q,

1-P)

=q+h(l-P),

where p is the price of the good and Z-p is the remaining income spent on a composite always have the option of not commodity. 2 We assume that h’ > 0 and h” < 0. Consumers purchasing the good. Let U, be the utility level obtained if a consumer does not purchase the good. Let p(q) denote the equation of the reservation-indifference curve in (q, p) space. p(q) is defined implicitly by

u(q,

I-P(q))

= u,.

For later reference, let q* be such that p(q *) = 0, i.e., the buyer’s reservation price for a good of quality q* is zero. ’ Since we focus on the strategic behavior of the incumbent, we assume, in the spirit of much of the entry deterrence literature, that the established firm has an information advantage over its potential

Although the strict interpretation is of buyers as consumers, the model is also applicable to other situations. For instance, the buyers could be competitive firms which consider purchasing an essential input from either a reliable domestic source (i.e., the established firm), or from foreign suppliers who may be less reliable in delivery of the input. In the analysis that follows, we will assume that the lowest quality ?j produced by a potential entrant is less than 4 * This assumption ensures that firms which are expected to produce goods of the lowest technologically feasible qualities are not viable. In the absence of such an assumption, entry of the lowest quality firms would not be forestalled and a different market structure than the one considered here would emerge.

377

D. Besanko, S. Donnenfeld / The impactof buyers’expectations

quality q is known because buyers have developed a long-term relationship rivals. 4 The incumbent’s with the established firm, and the good is an experience good. An entrant (indexed by i) who comes into the market produces a quality q, E [q, co] that cannot be observed ex ante by the consumer. 5 The unit cost of producing a product with quality q is given by

C(q) = c4. The parameter c is common be common knowledge.

to both the established

firms and potential

entrants

and is assumed

to

2.1. Unconstrained monopoly To provide a benchmark for the analysis that follows, we consider the case where the monopoly position of the established firm is not threatened by potential entry. The monopolist’s problem is to choose a single quality q E [q, 001 and a price p to maxr P?4

s-t.

=p - cq,


P

(1)

Constraint (1) reflects the fact that buyers have the option not to purchase the price-quality pair offered by the monopolist if this pair does not yield at least their reservation level of utility U,. Let (p M, qM) be the solution to the above problem. The first-order condition of this problem can be written as 1 c=

h’(l-p,)

‘P’(4M).

The analysis which follows presumes that it is in the interest of the established firm to engage in entry deterrence, since otherwise large-scale entry will lead to a dissipation of monopoly profits. 2.2. Strategic entry deterrence The profitability of the industry attracts potential entry. The entrants sell products that are observationally indistinguishable from the product sold by the established monopolist. Because the quality of the products produced by new entrants cannot be identified prior to consumption, to decide whether to purchase from the established firm (whose quality is known) or from a potential entrant, the buyer compares the monopolist’s price-quality combination ( p, q) with the price-qual4 Comanor and Frech (1984, p. 374) argue that in order to explain predatory conduct or strategic entry deterrence, one must assume underlying asymmetry between the incumbent firm and its rivals. ‘This asymmetry.. may simply be that one firm is in the position to make a commitment before its rivals can do so. After that the commitment is datum and the rivals’ action is constrained by it.’ ’ We assume that product quality of an entrant is exogenous. Quality could, however, be treated as a choice variable for the entrant. Under this interpretation, the product quality 4 brought to market by an entrant would be the quality that the entrant would optimally produce in a steady state equilibrium of the type described by Shapiro (1983). That is, we would implicitly assume that if entrants successfully enter the established firm’s market, a steady-state competitive equilibrium of the type described by Shapiro would occur in the long run. The only difference is that instead of the entry price being the marginal cost of producing the lowest possible quality, firms will enter at the price currently charged by the established firm. Under this interpretation, an unraveling of the type described by Akerlof (1970) would not occur.

378

D. Besanko, S. Donnenfeld / The mpact of buyers’ expectations

ity combination ( p, qA) where qA is the average quality expected from the distribution of qualities offered by entrants. Entrants are modeled as a price-taking competitive fringe and thus are assumed to sell at the same price p as the incumbent. The actual equilibrium that will emerge hinges on the expectations buyers form with regard to the distribution of qualities offered by potential entrants. If the current price is pO, consumers will know that a potential entrant i will enter the market if and only if pO 2 cq,. Thus, consumers will know that the range of qualities offered by entrants will be [ 4, e( p. 1c)] where G( pO ) c) is defined by the equality of pO = cq( pO 1c). We assume that the distribution function of qualities offered by entrants is uniform. Thus the average quality of potential entrants is given by

When

faced with potential

maxr

=p - cq,

entry,

the monopolist’s

maximization

problem

is (3)

P.4

s.t.


(4)

4~&(PIC).

(5)

P

Constraint (5) in the above maximization problem indicates the established firm chooses a pricequality combination such that no consumer would purchase from an entrant. (Violation of this constraint would induce entry and drive the incumbent’s profits to zero.) Let ( pr, qr) be the solution to the problem in (3)-(5). Clearly if qM 2 qA( p M 1c), the optimal solution to the problem in (3)-(5) is the unconstrained monopoly solution. In the remainder of this paper, we will focus on the case where the pure monopoly price-quality pair induces entry (i.e., qM < qA( pM 1c)). In this case we can prove Proposition 1. In the entry deterrence equilibrium, the established higher quality at a higher price than in the simple monopoly case. Proof.

The Lagrangian

for the problem

in (3)-(5)

firm

is induced to offer goods of

is

L=p(q)-cq+p[q-q*(P(q)lc>l. This expression reflects the fact that constraint to q and letting qT denote the optimal quality, aL G=P’(qT)-c+!J

PkO,

I”[qT-qA(P(qT)

[

1-~(P(q,)l+P’(q,)

I41=o.

(4) holds as an equality. yields

I

Differentiating

with respect

=o> (7)

Note that

p’(e) = [h’(I-p,)] GA -=_

1

ap

2c’

-‘>

(8) (9)

D. Besanko, S. Donnenfeld

where or -p(qT).

[l - ch’(Z-p,)]

319

/ The impact of buyers’ expectations

With (8) and (9) (6) can be rewritten as

= -Ph’(Z-PT) 2

1

ic

_

y_

2c 1 .

Now, by weak duality, the sufficient condition for (qT, p) to be the saddlepoint for the Lagrangian is that (6) and (7) hold and a2L/aq2 -C 0. The latter condition implies that p”(qT)[l - ~/2c] < 0, or equivalently, [l - ~/2c] > 0. For (10) to hold then, it is necessary that 1 h’(Z-Pr)

Cc=

1 h’(Z-p,)

which implies that pM
’ and thus qM -C qT.

Q.E.D.

At first glance, it may seem surprising that the threat of potential competition leads to a higher price and quality than would prevail in the absence of such a threat. The desirability of this strategy stems from the fact that by committing itself and hence its price-taking rivals to a high price, the established firm makes the adverse selection problem more acute for buyers who contemplate purchasing from one of the new entrants. At the same time, the established firm raises its quality in order to ensure that buyers still purchase from it. It is clear that the threat of potential entry lowers the profits of the established firm. Moreover, entry deterrence becomes more costly the less significant is the adverse selection problem facing consumers. This latter point can be seen by noting that the maximum profit 7i of the monopolist as a function of the lowest possible quality q- is decreasing in q, i.e., using the Envelope Theorem, d7i _=_=dq-

aL a4-

since aqA/aq > 0. This suggests that an established monopolist threatened opposed to minimum quality standards whose effect would be to raise q.

with entry would be

_

3. Summary Analyses of entry deterrence have usually focused on the strategic interaction between the incumbent and entrants. In these analyses the buyer’s role was either neglected or at most was assigned a passive role. In this paper we highlighted the role of buyers’ expectations in the context of a market with quality-differentiated products, where the incumbent engages in entry deterrence. Buyers have been assumed to be perfectly informed about the product sold by the incumbent, and imperfectly informed about the characteristics of the product to be offered by new entrants. By endogenizing the formation of buyers’ expectations, we have shown how the incumbent’s behavior affects and is affected by these expectations. Conventional wisdom usually associates a strategy of entry deterrence with sub-monopoly prices by the incumbent firm. The message of our analysis is that an established firm may be able to deter entry by raising its price relative to the unconstrained monopoly price. References Akerlof, George A., 1970, The market Economics 84, Aug., 488-500.

for lemons:

Qualitative

uncertainty

and the market

mechanism,

Quarterly

Journal

of

380

D. Besanko, S. Donnenfeld

Bain,

J.S.,

Bond,

1956,

Ronald

Staff BuzzelI,

Barriers

to the U.S. Federal

Robert

D. and

Comanor,

+ structure William

Avinash

Salop,

University

promotion,

Press,

Cambridge,

and product

MA).

differentiation

in two prescription

drug markets,

1977,

Marketing

costs

(Indiana

University

Press,

III, 1984,

Strategic

behavior

in consumer

goods

Bloomington,

industries,

in:

Hans

B. Thorelli,

ed.,

IN).

and antitrust

analysis,

American

Economic

Review

Papers

74, May, 372-376.

F., 1984,

P. and

Econometrica

Sales,

Commission.

W. Far&,

= performance

K., 1980,

Douglas

Milgrom.

Paul

(Harvard

1977, Trade

S. and H.E. Frech,

and Proceedings Dixit,

F. Lean,

Report

Strategy

Greer,

to new competition

S. and David

/ The impact of buyers’ expectations

J.

The role of investment

in entry deterrence,

Industrial

and public

Roberts,

50, March,

organization

1982,

Limit

pricing

and

policy, entry

Economic second

under

Journal

90, 95-106.

ed. (Macmillan,

incomplete

New York).

information:

An

equilibrium

analysis,

and Proceedings

73, May,

443-459.

Steven and David Scheffman,

1983,

Raising

rivals’ costs, American

Economic

Review

Papers

2677271. Schmalensee,

Richard,

Autumn,

1978,

Entry

Richard,

1982,

Product

1983,

Consumer

1977,

Entry,

capacity,

Paolo,

1962,

Oligopoly

deterrence

in the ready-to-eat

breakfast

cereal

industry,

Bell Journal

of Economics

9,

3055327.

Schmalensee,

differentiation

advantages

of pioneering

brands,

American

Economic

Review

72, June,

349-365. Shapiro,

Carl,

information,

product

quality

and seller

reputation,

Quarterly

Journal

of Economics,

Nov.,

659-679. Spence,

A.M.,

Sylos-Labini, Whitten,

Ira T., 1979,

Federal Williamsen. 85-116.

Trade Oliver,

Brand

investment

and oligopolistic

and technical

performance

progress

in the cigarette

pricing,

(Harvard

industry

Bell Journal

University

of Economics

Press, Cambridge,

and the advantages

of early entry,

8, Autumn,

534-544.

MA). Staff

Report

to the U.S.

Commission. 1968,

Wage

rates as a barrier

to entry:

The Pennington

case,

Quarterly

Journal

of Economics

82, Feb.,