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its vast video tape holdings. Blockbuster chose instead to take a wait-and-see attitude toward DVD rental. This may have been the best decision at the time, as it was difficult to forecast the extent of DVD growth and the success of the Netflix business model. Once Blockbuster realized that DVD rental was going to be a huge success, it was too late to copy Netflix. Netflix had a large installed base of customers, its own vast inventories and purchasing clout, and had developed a personalized video rating system that assured customer loyalty (about which we say more in Chapter 10). Netflix used its customer relationships to establish a beachhead in video streaming, which is gradually replacing video-by-mail. The rest is history. Blockbuster filed for bankruptcy in 2011, and Netflix rentals have led to a sharp decline in home video purchasing, threatening the profitability of the biggest Hollywood movie studios.

EVIDENCE ON ENTRY-DETERRING BEHAVIOR

Although theorists have devoted considerable attention to entry deterrence, there is little systematic evidence regarding whether firms pursue entry-deterring strategies and, if they do, whether those strategies are successful. Most of our evidence comes from antitrust cases, where discovery requirements often provide researchers with detailed cost, market, and strategic information.

There may be little evidence on entry deterrence from sources other than antitrust cases for several reasons. First, firms are naturally reluctant to report that they deter entry because this may be sensitive, competitive information and might also violate antitrust statutes. Second, many entry-deterring strategies involve pricing below the short-term monopoly price. To assess whether a firm was engaging in such a practice, the researcher would need to know the firm’s marginal costs, its demand curve, the degree of industry competition, and the availability of substitutes. Outside of antitrust cases, such information is difficult for researchers to obtain. Finally, to measure the success of an entry-deterring strategy, a researcher would need to determine what the rate of entry would have been without the predatory act. This, too, is a difficult question to answer.

Despite concerns about the willingness of firms to provide frank responses, Robert Smiley asked major consumer product makers if they pursued a variety of entrydeterring strategies.21 Smiley surveyed product managers at nearly 300 firms. He asked them whether they used several strategies discussed in this chapter, including:

1.Aggressive price reductions to move down the learning curve, giving the firm a cost advantage that later entrants could only match by investing in learning themselves

2.Intensive advertising to create brand loyalty

3.Acquisition of patents for all variants of a product

4.Enhancement of firm’s reputation for predation through announcements or some other vehicle

5.Limit pricing

6.Holding of excess capacity

The first three strategies create high entry costs; the last three change the entrant’s expectations of postentry competition.

Table 6.2 reveals the percentage of product managers who report that their firms frequently, occasionally, or seldom use each of the preceding strategies for new products and existing products. Note that managers were asked about exploiting the learning curve for new products only. More than half of all product managers

Contestable Markets • 219

TABLE 6.2

Reported Use of Entry-Deterring Strategies

surveyed report frequent use of at least one entry-deterring strategy, and virtually all report occasional use of one or more entry-deterring strategies. Product managers report that they rely much more extensively on strategies that increase entry costs than on strategies that affect the entrant’s perception about postentry competition.

CONTESTABLE MARKETS

Throughout this chapter we have argued that entry poses two problems for incumbents: entrants steal market share and they drive down prices. The theory of contestable markets, developed by William Baumol, John Panzar, and Robert Willig, states that the mere threat of entry can force the incumbent to lower prices.22 The key requirement for contestability is “hit-and-run entry.” When a monopolist raises price in a contestable market, a hit-and-run entrant rapidly enters the market, undercuts the price, reaps short-term profits, and exits the market just as rapidly if the incumbent retaliates. The hit-and-run entrant prospers if it can set a high enough price for a long enough time to recover its sunk entry costs. If sunk entry costs are zero, then hit-and-run entry is profitable whenever the incumbent’s price exceeds the entrant’s average variable costs. If the incumbent raised price above the entrant’s average cost, there would be immediate entry and price would fall. As a result, the incumbent monopolist has to charge a price no higher than the entrant’s average cost, a result that approximates what one would expect to see in a competitive market.

It has proven difficult to find examples of contestable markets, perhaps because the sunk costs of entry into most markets are not trivial. The airline industry has been held up as a possible example. Entry is fairly easy, especially by established carriers entering new routes. A carrier can redeploy aircraft almost overnight, and can secure gates and ground personnel almost as quickly (provided the airports involved are not at capacity). To test contestability theory, Severin Borenstein examined airline pricing.23 Borenstein found that monopoly routes have higher fares than duopoly routes of comparable lengths, a result consistent with standard oligopoly theory and proof that airline markets are not perfectly contestable; otherwise, fares would be independent of market concentration. But he also found that fares on monopoly routes are lower when another carrier is already operating at one or both ends of the route and therefore had relatively low entry costs. Borenstein concluded that the threat of potential competition causes the monopolist carrier to moderate its prices but not to competitive levels.

220 • Chapter 6 • Entry and Exit

AN ENTRY DETERRENCE CHECKLIST

Table 6.3 lists the variety of entry-deterring tactics that incumbents may consider, when they are most effective, and relevant economic concepts.

TABLE 6.3

Entry-Deterrence Checklist