Competitive Strategy 421commitment. If the incumbent can bind itself to a low-price policy (now and
in the future), the new firm will be convinced that entry is a losing proposi-
tion. This might be accomplished by making long-term price agreements with
customers or by staking the firm’s reputation on its low prices. In most cases,
however, pricing practices can be undone relatively rapidly and costlessly. The
operative question is, If the entrant were to enter, would the incumbent con-
tinue to limit price, or would it revert to a high price that best serves its self-
interest? If the incumbent is expected to revert, limit pricing loses its credibility
and its deterrence effect. Reversion can be depicted by adding a final pricing
decision in Figure 10.2b’s game tree. Clearly, cutting price in advance does no
good if the incumbent is expected to undo the price cut after entry.
How might the incumbent convince a new firm that it will cut prices after
entry? One way is to invest in additional capacity that makes it inexpensive—
indeed, profitable—to increase output should a new firm enter.^7 Putting this
capacity in place means incurring immediate fixed costs but allows the incum-
bent to expand output at a low marginal cost. For example, suppose capacity
expansion costs $4 million directly so that all incumbent payoffs are reduced
by 4. At the same time, the added capacity reduces the cost of expanding out-
put (following a price cut) by $3 million. The incumbent’s payoff is 6 4 $2
million if it sets a high price after entry; its payoff is 4 4 3 $3 million if
it cuts price after entry. Now the firm’s profit incentive is to cut price. Knowing
this, the new firm will rationally forgo entry. The incumbent’s net payoff is
12 4 $8 million, some $2 million better than the original equilibrium.
Strategies to block entry make up one category of entry barriers noted in
Chapter 8. A strategic entry barrieris defined as any move by a current firm
designed to exclude new firms by lowering the profitability of entry. Credible
limit pricing and maintenance of excess capacity are two such strategies.^8 High
levels of advertising, saturating the product space by proliferating the number
of brands, or making product improvements that require high levels of R&D
are others. Many of these strategies are not profitable in themselves.For example,
spending on advertising may increase the firm’s own costs faster than it
increases revenues. However, if such a move raises the cost of entry, it may be
profitable overall by excluding new firms (and thus reducing competition). In(^7) Analysis and discussion of capacity strategies appear in A. Dixit, “Recent Developments in
Oligopoly Theory,” American Economic Review(1982): 12–17, and in M. B. Lieberman, “Strategies
for Capacity Expansion,” Sloan Management Review(1987): 19–27.
(^8) Setting a low price can also serve as a signal to the entrant that the incumbent has low costs. This
signal is important when the entrant is uncertain of the incumbent’s true costs. Against a high-cost
incumbent, entry is likely to be profitable since prices will remain high. But against a low-cost rival
(ready and able to lower price), entry would be disastrous. By charging a low price prior to entry,
the incumbent can send a credible message that its costs are, indeed, low. To work as a credible sig-
nal, the price must be low enough to distinguish a low-cost incumbent from a high-cost one. That
is, the high-cost incumbent must have no incentive to imitate this low price. For a thorough dis-
cussion, see P. Milgrom and J. Roberts, “Sequential Equilibria,” Econometrica(1982): 443–459.
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