Federal Trade Commission

The Effect of Exit on Entry Deterrence Strategies Federal Trade Commission

The ability of incumbent firms to maintain their market power by deterring entry has been a topic of considerable interest for some time. With the advent of game theory, economists have recognized that entry deterrence strategies must be credible. Imposing this credibility requirement on an incumbent?s strategy in a price or quantity setting game with the entrant has had a profound effect on the analysis of several types of entry deterrence strategies, such as limit pricing (e.g., Milgrom and Roberts 1982) or capacity expansion (e.g., Dixit 1980). Typically, however, these analyses have not considered the credibility of the incumbent?s decision to remain in the market or to exit. They have assumed parameter values such that exit is never optimal (the no exit threat is always credible) or that the incumbent can commit not to exit the market. In industries with large fixed, but not sunk, costs, however, exit can be the profit maximizing strategy when faced with an entrant who may be much more efficient or have a far superior product. American Airlines, for example, decided to abandon its San Jose hub and many routes within California shortly after Southwest Airlines entered the San Jose market (San Jose Mercury News 1993; Washington Post 1993). In fact, as the above quote indicates, the credibility of the no exit threat could become increasingly important as rapidly advancing technology provides opportunities for entrants to topple dominant firms in many industries. Thus, it is more important than ever to analyze the effect of the exit option on the ability of incumbents to deter entry.