Exit Deterrence

• Date: 01 September 2014
• DOI: http://doi.org/10.1111/jems.12063
• Author: Martin C. Byford,Joshua S. Gans
• Published date: 01 September 2014

Exit Deterrence

MARTIN C. BYFORD

School of Economics, Finance and Marketing

RMIT University

Building 80 Level 11, 445 Swanston Street, Melbourne, VIC 3000 Australia

martin.byford@rmit.edu.au

JOSHUA S. GANS

Rotman School of Management

University of Toronto

Toronto,Canada

Joshua.Gans@rotman.utoronto.ca

This paper is the first to provide a general context whereby potential entry can lead incumbent

firms to permanently reduce the intensity of competition in a market. All previous results found

that potential entry would lead to lower prices and greater competition. Examining markets where

entry occurs by the acquisition of access rights from an existing incumbent, we demonstrate that,

where competitive choices are strategic complements, a more efficient entrant may be unable

to acquire those rights from a less efficient incumbent due to the unilateral accommodating

behavior of the efficient incumbent. Similarly, such accommodating behavior may deter efficient

investment by an incumbent. These results have implications as to how economists view potential

entry and its benefits.

1. Introduction

Economic models of the impact of potential entry on competition give rise to two distinct

predictions. First, theories of contestable markets and limit pricing predict that credible

entry threats will induce incumbents to price lower so as to deter entry. Second, orig-

inating with Selten’s chain store paradox, potential entry will not induce a change in

incumbent behavior prior to entry as it either does not commit the incumbent to main-

taining such behavior in the postentry environment or, alternatively, the incumbent’s

own forecasted behavior in the postentry environment is sufficient to deter entry in and

of itself. Resolving the theoretical tension between the two predictions has relied on ex-

amination of the actions incumbents can take to commit themselves to tough postentry

competition or the possibility that pre-entry behavior might signal relevant information

regarding anticipated postentry behavior. Nonetheless, all of these theories predict that

potential entry will not lead to less competition in a market.1

The existing models all have one feature in common: that entry, if it occurs, will be

de novo; that is, the entrant adds to the pool of competitors in a market. In contrast, there

are many situations where entry arises by acquisition of an incumbent. Although, in some

situations, eliminating an incumbent competitor may be the aim of the entrant firm, in

others, there may be market constraints on de novo entry. In a market with high sunk

Weare grateful to Yongmin Chen, Stephen King, and two anonymous referees for comments on earlier drafts

of this paper, and to VivienneGroves for research assistance.

1. See Davis et al. (2004) for a recent treatment and Wilson (1992) for a review.

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 3, Fall 2014, 650–668

Exit Deterrence 651

entry costs, for instance, a natural oligopoly might arise with a ceiling on the number of

suppliers (Gilbert and Newbery, 1992). In this case, entry may only be credibleif it is by

acquisition.

Consider a market in which firms require a certain asset in order to gain access

to, and operate within, the market. We call this asset an access right. Access rights are

characterized by being (a) necessary for a firm to participate in a market; (b) potentially

transferable; and (c) rival in that they cannot be utilized by more than one firm at any

point in time. The owner of an access right may sell, but can never share, its access to

a market. Transferability means that either the asset itself can be traded between firms

or, alternatively, it can be traded as a pool of assets through a merger, acquisition, or

management buyout.2

Access rights can come in the form of government licensing arrangements—

including broadcasting licenses for television and radio, and spectrum used by wireless

carriers—as well as complementary assets that are uneconomic to replicate but critical

for competition. For example, sea and air ports require significant amounts of land that

exhibit very specific physical and location characteristics. Similarly, an asset such as

“eyeballs” is necessary to compete in the market for internet advertising; this is particu-

larly true for targeted advertising connected to web searches, social media, and internet

portals.3

The focus of this paper is on markets with restricted access: that is, markets with a

strictly limited number of access rights. Entry into a restricted access market may only

take place via acquisition of an incumbent’s access right, forcing the incumbent to exit.

Simple intuition would suggest that if an entrant emerges who is capable of utilizing

the access right more efficiently than an incumbent, there would be gains from trade

from an exchange that transfers the access right from the less efficient incumbent to the

more efficient entrant. Hence, it would normally be presumed that the emergence of a

potential entrant would (a) not result in any change in pre-entry behavior of incumbents,

and (b) eventually result in entry.

This simple intuition, however, neglects the role that rival incumbents might play

in influencing the terms of trade in the acquisition market for the access right. Using an

infinite horizon, dynamic model of competition, we show that there is exists a noncollu-

sive subgame perfect equilibrium (SPE) in which the threat of entry can reduce competition.

In our model, an inefficient incumbent competes with an efficient incumbent in a re-

stricted access market. With the emergence of a potential entrant, the inefficient firm has

an incentive to sell its rights. Nonetheless, we demonstrate that, where the actions of

firms are strategic complements and firms are sufficiently patient, there exists an equi-

librium in which the efficient incumbent unilaterally relaxes competition, directing a

stream of profits to the inefficient incumbent, sufficient to eliminate the gains from trade

in the acquisition market. The efficient incumbent takes this action anticipating that the

inefficient incumbent will respond by remaining in the market. In turn, the inefficient

2. The rivalry assumption may seem questionable in a world in which regulators frequently require firms

to grant their rivals access to privately owned infrastructure. However, such regulated access usually only

arises when that infrastructure is a bottleneck. Here, however, we assume that is not the case and there are

two providers of that infrastructure. Thus, even if a new entrant should take ownership of the access rights

of one incumbent, that is not normally a case where an antitrust regulation would require the new entrant to

also open up their infrastructure while leaving the other incumbent unregulated. This is even more likely to

be the case as the new entrant here is actually new and so the acquisition, while it may be a merger,is a merger

between firms that, ex ante, operated in different markets.

3. Moreover, the term access right could apply to situations in which firms need to access a constrained

distribution system (Dana and Spier, 2007) or wherelimitations on physical capital restricts access.