(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 537
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512 PART 3 • Market Structure and Competitive Strategy
TABLE 13.16(b)
ENTRY DETERRENCE
Potential Entrant
High price (accommodation)
Incumbent
Low price (warfare)
Enter
Stay out
50, 20
150, 0
70, ؊10
130, 0
Can an incumbent monopolist deter entry without making the costly move
of installing additional production capacity? Earlier we saw that a reputation
for irrationality can bestow a strategic advantage. Suppose the incumbent firm
has such a reputation. Suppose also that by means of vicious price-cutting, this
firm has eventually driven out every entrant in the past, even though it incurred
losses in doing so. Its threat might then be credible: The incumbent’s irrationality suggests to the potential competitor that it might be better off staying away.
Of course, if the game described above were to be indefinitely repeated, then
the incumbent might have a rational incentive to engage in warfare whenever
entry actually occurs. Why? Because short-term losses from warfare might be
outweighed by longer-term gains from preventing entry. Understanding this,
the potential competitor might find the incumbent’s threat of warfare credible
and decide to stay out. Now the incumbent relies on its reputation for being
rational—and far-sighted—to provide the credibility needed to deter entry. The
success of this strategy depends on the time horizon and the relative gains and
losses associated with accommodation and warfare.
We have seen that the attractiveness of entry depends largely on the way
incumbents can be expected to react. In general, once entry has occurred, incumbents cannot be expected to maintain output at their pre-entry levels. Eventually,
they may back off and reduce output, raising price to a new joint profitmaximizing level. Because potential entrants know this, incumbent firms must
create a credible threat of warfare to deter entry. A reputation for irrationality
can help. Indeed, this seems to be the basis for much of the entry-preventing
behavior that goes on in actual markets. The potential entrant must consider
that rational industry discipline can break down after entry occurs. By fostering
an image of irrationality and belligerence, an incumbent firm might convince
potential entrants that the risk of warfare is too high.13
Strategic Trade Policy and International Competition
We have seen how a preemptive investment can give a firm an advantage by
creating a credible threat to potential competitors. In some situations, a preemptive investment—subsidized or otherwise encouraged by the government—can
13
There is an analogy here to nuclear deterrence. Consider the use of a nuclear threat to deter the
former Soviet Union from invading Western Europe during the Cold War. If it invaded, would the
United States actually react with nuclear weapons, knowing that the Soviets would then respond
in kind? Because it is not rational for the United States to react this way, a nuclear threat might
not seem credible. But this assumes that everyone is rational; there is a reason to fear an irrational
response by the United States. Even if an irrational response is viewed as very improbable, it can be
a deterrent, given the costliness of an error. The United States can thus gain by promoting the idea
that it might act irrationally, or that events might get out of control once an invasion occurs. This
is the “rationality of irrationality.” See Thomas Schelling, The Strategy of Conflict (Harvard Univ.
Press, 1980).
