An incumbent monopolist wants to scare off entrants by threatening a price war. But once a rival has entered, fighting hurts the incumbent too, so the threat rings hollow. The fix is counterintuitive: spend money in a way that makes fighting your best option.
Entry deterrence in business
This is subgame perfection and commitment applied to industrial strategy. A bare threat to fight entry is not credible, so it does not deter. But a sunk investment, like building excess capacity, can change the incumbent’s own payoffs so that fighting becomes profitable, and the threat becomes real.
A threat is credible only if carrying it out is the threatener's...
Commitment can help a player by...
Predict, then play
Walk the entry game as the incumbent. First without commitment: if the entrant enters, will you really fight? Solve it backward.
Why did that happen?
Take a guess, then reveal the reason
Once the entrant is in, the incumbent compares two futures: fight and earn 20, or accommodate and earn 50. It accommodates, so the entrant safely enters. Announcing “I will fight” changes nothing, because the entrant looks ahead and sees the incumbent would not. Deterrence requires changing the post-entry incentives before the fact. Extra capacity can lower the marginal cost of producing aggressively, making fighting more attractive than accommodating. Its strategic effect comes from that changed marginal incentive, not from the investment merely being sunk.
The real strategy
Deterrence requires a credible threat, and subgame perfection says a threat is credible only if the incumbent would prefer to carry it out after entry. Dixit (1980) showed how pre-entry capacity can change this: extra capacity may lower the marginal cost of producing a lot, which can make aggressive post-entry output more attractive. Calling the expenditure sunk is not enough. The investment deters only if it changes the incumbent’s later best response.
Without commitment, post-entry payoffs are Accommodate Fight , so the incumbent accommodates and entry occurs; the incumbent earns instead of its monopoly . Now suppose capacity changes production costs enough to raise the fight payoff above the accommodate payoff. Then fighting is the credible best response, the entrant foresees a loss from entering, and stays out. The capacity expenditure itself must still be subtracted when deciding whether deterrence is profitable overall.
Work it out
From empty threat to credible deterrence
Solve the tree without commitment. At the incumbent’s node, Accommodate pays and Fight pays , so it accommodates. The entrant, foreseeing from entering versus from staying out, enters. The incumbent is stuck at , and its threat to fight was never credible.
Now sink an investment in capacity that makes producing aggressively cheap, so that after entry, fighting yields, say, while accommodating still yields . Now the incumbent’s best response to entry is to fight, and the entrant, foreseeing a loss of , stays out. The incumbent keeps its monopoly. The investment worked not by being used (fighting never happens on the equilibrium path) but by making the threat credible, exactly the value of commitment.
Key idea
A bare threat to fight entry is not credible and does not deter. Pre-entry capacity can deter only when it changes later production incentives enough to make fighting the incumbent’s best response. Sunkness alone does not create commitment.
Check yourself
Sources
- Dixit, A. (1980). The role of investment in entry-deterrence. Economic Journal, 90(357), 95-106.
- Selten, R. (1975). Reexamination of the perfectness concept for equilibrium points in extensive games. International Journal of Game Theory, 4(1), 25-55.