8. Structural barriers to entry and sequential games PDF

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8.3 Sequential games 1

8. Structural barriers to entry and sequential games Industry concentration is not a given fact. It varies across markets because of: 

Market size and the degree of scale economies



Entry barriers: incumbents’ advantages (first mover’s advantages) related to – –

Structural characteristics of the industry (“innocent”, exogenous advantage), which are not an outcome of the behaviour of incumbents. Strategic behaviour of incumbents  Moves in a sequential game  Rational and feasible in the presence of information asymmetries

Now we will focus on the structural causes of the market barriers:

Determinants of concentration: 8.2 Demand-and supply-side structure (free entry equilibrium 8.3 Structural barriers to entry 8.4 Sequential games

8.1 Demand-and Equilibrium)

Supply-Side

Structure

(Free

Entry

Let’s focus on demand-side. The role of the size of the market is intuitive: if the market is large, the big number of customers demand our product. So, there could be a bigger room for suppliers, a larger number of competitors. However, the relation between these increases is not proportional. Let’s consider the free entry model:

28. Structural barriers to entry and sequential games How many firms can fit in a market that is S large?

The entry process will stop, in the Cournot oligopoly when there will be no barriers to entry. The number of firms that fit into a market which has a S size. We can find this number putting the profit function equal to zero.

√

^n=( a− c ) ⋅ S −1 F 1. S analysis The larger S, the larger the number of firms, but not proportionally. There is a square root: if S quadruplicates, the number of firms duplicates. If S increases, there are two counteracting effects:  

Direct effect: the larger the market, the greater the number of firms that find room in the market and enter. Negative feedback: at the same time, the greater the nr of firms, the tougher and fiercer the competition, the lower the margin (when N → ∞ , P → MC ), the lower the attractiveness So, the entry process stops before than expected, because, even if the size is larger, the margins are smaller and fewer firms can self-sustain in the market. This is the reason why there is less than the proportional effect of the market size in the final number of firms.

S ↑↑

n↑

Competition↑

Margin↓

Example a=100, c=1, F=100, S ranges from 1 to 100

Attractiveness↓

8.3 Sequential games 3 All other things being equal, ^n rises and the concentration ratio concentrated (though more and more slowly.

^ C1

falls. The industry gets less

2. F analysis Fixed costs are a way of representing economies of scale. The larger the fixed costs, that in the long run are only setup costs, given a constant marginal cost c, the larger is the Minimum Efficient Scale. So, average costs function, when F increases, is less steep, it decreases to reach the MES but slowly. Thus, the range of output where there are economies of scale is larger: the MES that I have to reach to have the minimum possible level of AC is larger.



Given c, if I have an increase in fixed costs, it means that I have scale economies that are more significant.



All other things being equal, the greater the degree of scale economies (F), the smaller the number of active firms. In particular, we can see that the number of firms increases less rapidly if we have scale economies, because there are firms do not reach the MES and so they have costs that are too high to stay in the market without losing. In general, we will have few large firms in the market.

3. Conclusions



Demand-side: the larger the market the lower the industry concentration (higher number of firms) –

Larger countries tend to host more competitive markets whatever the firms’ conduct.

48. Structural barriers to entry and sequential games This is the reason why governments sponsor free trade agreements, such as common markets (e.g. European Union), free trade areas (e.g. Trans-Pacific Partnership), frameworks of free trade (e.g. the World Trade-Organisation) –



The effect saturates as markets get larger though1

Scale economies: the more significant the increasing the scale economies, the higher the concentration of industry. So, industries with larger fixed costs tend to be less competitive whatever the firm’s conduct.

8.2 Structural Barriers to Entry There are limits given by the economies of scale, due to the size of the market. So, even though we do not have barriers we will observe a limited number of firms in the market; the entry process is not infinite. At the same time, we may have additional factors that discourage data entry. So far, we assumed symmetry thus that all firms are equal: same costs, demand is equally divided between the firms and more particularly no differences between first movers (incumbents) and latecomers. However, many markets exhibit barriers to entry such that 2 incumbents hold advantages relatively to entrants. The market will be more concentrated because new entrants do not manage to enter due to the high costs, or once entered will face competition in disadvantage. Let’s focus on structural barriers: – –

These are advantages enjoyed by incumbents (first movers), but that are not a consequence of their actions. In fact, they are a sort of lucky circumstances or natural advantage. Barriers do not depend on the incumbent’s strategies  Incumbents exploit own advantages, but they “just” maximize own profit without considering the effect on potential entrants;  Barriers are structural, not strategic. This means that incumbent does no act strategically to deter potential entrants.

There are four fundamental types of structural barriers, both supply and demand-side:

1. Absolute cost advantages

1 The effect saturates as markets gets larger though: l’effetto si satura man mano che I mercati si ingrandiscono 2 Such that: tale per cui

8.3 Sequential games 5 1.1 Incumbents have lower costs, because they control natural resources, for instance the access to mines, oil reserves, water for hydropower dams, etc.), so entrants have to exploit less efficient sites. 1.2 Efficient location (ex. close to a freight airport or port) is another absolute cost advantage for incumbents, while entrants have to locate in less profitable sites.

2. Entry regulation The advantage given by policies, by the state through exclusionary rights (licenses, concessions, etc). In this case, entrants should bargain3 with incumbents to replace them, but of course, the latter will resist selling their licences, their zoned land.

3. Scale economies Fatally entrants are smaller than a firm that historically is located there. They make a Greenfield investment from scratch4 and have higher average costs. If there are scale economies, larger firms have lower average costs due to an earlier entry.

4. Product differentiation Incumbents may have an advantage from reputation, image, customers’ loyalty (ex. brand or traditional “national champions” that have built over the years; so, positive expectations toward incumbents are hard or slow to replicate by entrants. However, workforce skills are a source of an advantage as well (ex. location in a design or handcraft cluster). In this case, skilled personnel can be recruited by entrants yet a premium.

The traditional view of entry barriers as structural traits suffers from a few limitations: 

More than a matter of luck : structural advantages of incumbents may be “given” such as a legacy of history5 or natural gift, but generally they are intentionally obtained and maintained



Strategy: rational firms know that their profit depends on other players’ behaviour. They naturally strategize, not only toward actual competitors but also potential entrants.

In order to understand the strategic barriers to entry we should know: –

How strategy is formed in sequential games

–

What information asymmetries are.

3 bɑː.ɡɪn 4 From scratch: da zero 5 Legacy of history: eredità della storia

68. Structural barriers to entry and sequential games

8.3 Sequential games In the sequential games, agents choose actions in different periods, or, realistically, it is easy and quick to observe other’s actions. The model is the game tree that explicits player’s decisions at different times (actions) and final payoffs:  Decision node: name of the player who is entitled to make decisions in that period & actions available to the player in the node  Payoffs defined for each player in the final node  Subgame: any (non-final) decision node along with all the nodes following it.

Story – There are 2 firms – I (the incumbent) is currently monopolizing the market – E (the entrant) is thinking over market entry, i.e. it has to decide whether or not to enter the market – Based on E’s decision, I will have to decide whether or not to “retaliate”6, i.e. to launch a war price that brings the price to an unprofitable level – Both firms know their and other’s actions and payoffs. 1. Game 3 (Sequential game): The entrant and the incumbent

6 Retaliate: rivelarsi, rivendicare

8.3 Sequential games 7

The game equilibrium is called subgame perfect equilibrium (SPE) and it is an extension of the NE concept; generally, there is more than one NE in a subgame but only a few are plausible. The method through which finding the SPE, if it exists, is the backword induction and consists of: 



Finding the sequence of the optimal decision in every period, given “subsequent” optimal decisions 1. Start from the end and find the Ne of the final subgames 2. Then go back to last nodes before the final ones and find the Ne of every node, given optimal decisions in final ones 3. And so on SPE is the sequence of best choices obtained in this way

88. Structural barriers to entry and sequential games

2. Commitment As it contemplates entry, E knows that once it chooses e, I will find it more profitable not to choose pw. And E does enter. What if I signs an enforceable and non-renegotiable contract that obliges it to launch a price war if E enters, despite the prospective loss (because for example the contract gives I a sanction greater than the loss), the price war is now a credible threat and E does not enter. Let’s suppose a sanction equal to 40: __ SC

I SC

t=1

t=2

πE = -10 πI=20-40= -20

If I signs the contract E finds more profitable not to enter (0 > -10). If I does not sign the contract E enters (10> 0, 10> -10) and I finds profitable to not launch the price war. Between the two results (SC -0,50; Not SC 10,20), for I it is better to sign the contract. So, the commitment is a choice that makes the best yet hard strategy credible (other players do not have to doubt that one will follow through on it, and give up) and it makes other learn something they were uncertain about, and functions as a signal, because we should inform possible entrance in our domain that the reaction will be tough. Commitment must: – make the best strategy “compulsory”, not taking it would be more costly – be irreversible. In conclusion, a firm may commit strategically to an otherwise unfavourable course of action, signal other players that it will keep to it, and win the game.7

3. Conclusion 3.1 Entrants Have to assess the new market and so analyse structural drivers of concentration and profitability: – Market size – Economies of scale – Structural barriers to entry 3.2 Incumbents and entrants

7 In conclusione, un’azienda può impegnarsi strategicamente in un corso d’azione altrimenti sfavorevole, segnalare ad altri giocatori che si atterrà ad esso e vincere la partita.

8.3 Sequential games 9 Seek actions that may work at a self-imposed commitment to make moves that are costly yet profitable8.

8 Cercano azioni che possano funzionare con un impegno autoimposto per compiere mosse costose ma redditizie....