18.21 : Entry Deterrence: Credibility Applied

In game theory, entry deterrence is a strategy that established firms use to discourage new competitors from entering a market. This is achieved through a firm making credible threats or taking actions that make market entry appear unprofitable or risky for the potential entrant. A credible threat is one that the established firm can convincingly commit to, ensuring that it influences the entrant's decision-making.

Consider a large shipping company operating in a port city with a smaller logistics firm that is considering entering the market. This scenario can be viewed as a two-stage game. In the first stage, the smaller firm decides whether to enter the market. If it chooses not to enter, the existing shipping company retains its monopoly and continues to earn high profits with no competition. If the smaller firm enters the market, the game moves to the second stage, where the shipping company must decide between making aggressive price cuts or maintaining its current pricing strategy.

If the shipping company opts for aggressive pricing, this action reduces profits for both firms. While the shipping company would face reduced profit margins, The limited resources of the smaller firm means it would struggle to compete over time. Alternatively, if the shipping company allows the smaller firm to enter without retaliation, both firms earn some profit, though the existing shipping company's profits would be lower than it would earn in a monopoly scenario. The smaller firm, however, might not take the threat of aggressive pricing seriously if it believes the larger company would prefer to avoid the lost profits associated with a price war.

Knowing this, the shipping company might invest in additional infrastructure, such as building new warehouses or acquiring more vehicles, solely to make the threat of lowering prices and flooding the market a credible threat. This investment signals its readiness to handle increased competition, demonstrating a willingness to engage in a price war if necessary. This strategic signaling can convince the smaller firm that entering the market would be unprofitable, deterring entry. While the upfront investment reduces the shipping company's short-term profits, it helps retain its monopoly in the long term.

This scenario illustrates key principles of game theory, such as the importance of credibility and strategic signaling in shaping competitive outcomes. It also highlights how firms use commitment mechanisms to influence rivals' decisions, ensuring favorable outcomes in competitive markets.