Can the Threat of Entry Reduce Competition

This paper is the rst to provide a general context whereby potential entry can 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 existing incumbents, we demonstrate that, when competitive choices are strategic complements, a more e¢ cient entrant may be unable to acquire those rights from a less e¢ cient incumbent due to the accommodating behavior of e¢ cient incumbents. Similarly, such accommodating behavior may deter e¢ cient investment by an incumbent or mergers that would generate social welfare improvements. These results have implications as to how economists view potential entry and its bene ts. This Version: December 2008 J.E. L. Classi cation: L13 Keywords: Entry, Dynamic Price Competition, Markov Perfect Equilibrium We are grateful to Yongmin Chen and Stephen King for comments on an earlier draft of this paper. The latest version of this paper is available at www.mbs. edu/jgans y Department of Economics, University of Colorado at Boulder. z Melbourne Business School, University of Melbourne. 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 that entry. Second, originating with Seltons chain store paradox, potential entry will not induce a prior change in incumbent behavior as it either does not commit them to maintaining that behavior in the post-entry environment or their own forecasted behavior in that environment is su¢ cient to deter entry in of itself. Resolving the theoretical tension between the two predictions has relied on considerations of the actions incumbents can take to commit themselves to tough post-entry competition or the possibility that pre-entry behavior might signal relevant information regarding forecasted behavior post-entry. Regardless, together, all of these theories predict that potential entry will not lead to less competition in a market.1 The existing models all have in common one feature: 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. While, in some situations, this may be a choice aimed at eliminating incumbent competitors, in others, there may be market constraints on de novo entry. For instance, in a market with high sunk entry costs, a natural oligopoly might arise with a ceiling on the number of suppliers (Gilbert and Newbery, 1992). In this case, entry may only be credible if it is by acquisition. Here we consider this by examining a situation where an environment where a rm may only participate in the market if it owns one of a strictly limited number of access rights. These rights could be in the form of complementary assets that are uneconomic to replicate but critical for competition. Or, alternatively, these rights could arise as a result of government licensing arrangements. Examples of this include the need for broadcasting licenses for television and radio or the rights to spectrum 1See Davis, Murphy and Topel (2004) for a recent treatment and Wilson (1992) for a review.