How to enter a new market

4-1 - How to enter a new market

This weeks lecture covers:

1. Process of planning entry
2. Choice of markets - Market attractiveness
3. Choice of markets - Structural Entry Barriers
4. Choice of markets - Strategic Entry Barriers
5. Entry Strategies - Commitment
6. Entry Strategies - Judo Economics
7. Entry Deterrence - Structural Entry Barriers
8. Entry Deterrence - Limit Pricing
9. Entry Deterrence - Pre-emption

4-2. Choice of markets - Market attractiveness

1. Process of planning entry
2. Market attractiveness defined by Porter's Five Forces

1. Process of planning entry

1. Evaluate attractiveness of new market entry
2. Choose a market based on its attractiveness and entry barrier
3. Choose an entry type
4. Choose an entry strategy

Porter

1. More Competition = Less Attractive
2. Less Supplier = Less Attractive
3. Less Buyers = Less Attractive
4. More Entry Barriers = More Attractive
5. More Substitutes = Less Attractive

4-3 Choice of markets - Structural Entry Barriers

1. What are Entry Barriers
2. Structural Entry Barriers
3. Strategic Entry Barriers

2. Structural Entry Barrier

Control of essential resources - Control of resoures - DeBeers / diamonds - Control the Supplier capacity - Minnetonka / liquid soap - Patents: Sony and Philips / CD - Control the Distribution channel: Coca Cola / fast food chains - Control the location: Supermarkets - Control of Timing: Airlines / Arrival slots at airports - Rationing by government: Taxi cabs license; mobile phone spectrum

Economies of scale and scope - Minimum efficient scale: Semiconductor production or industries with large fixed costs - Cost advantages of incumbents thru experience of economies of scope: Airframe production - Doubling of production means 20% reduction in price - Reuse some parts i.e. economies of scope.

Marketing advantages of incumbents - Brand loyalty: Frequent flyer programmes - Switching costs: 1-year mobile phone contracts

4-4 Choice of markets - Strategic Entry Barriers

1. What are Strategic Entry Barriers

Considers deterring if 1. incumbent still earns profit 2. changes entrant's expectations

Potential Actions - Block Entry - Accommodate Entry

Decide by comparing the NPV of each option.

4-5 Entry Strategies - Commitment / Value Chain Reconfiguration

1. Commitment
2. Value Chain Reconfiguration
3. Judo Economics
4. Niche Markets

Types of commitment 1. High sunk cost investments - Production capacity - R&D - Advertising 2. Exit from other strategic market segments and focus on entry

Value Chain Reconfiguration - Innovators enter the market with inferior products. - Incumbents ignore the threat. - Over time the products improve and take large chunks of the market

Example: Bloomberg - basic financial data to small investment analysts and brokers - gradually improve data offerings and analysis

4-6 Entry Strategies - Judo Economics / Niche Market

1. Judo economics
2. Niche strategies

These strategies work when incumbents cannot retaliate because the cost of retaliation is much larger than the cost of accommodation

Consider an entrant with low price pL against an incumbent with high price pH. Entrant goes after a market xE out of a total market of x.

Incumbent does not retaliate if: pH xE < (pH - pL) x where left side represents cost of accommodation right side represents cost of retaliation

An example of judo economics working is Amazon vs. Barnes & Noble.

4-7 Entry Deterrence - Structural Entry Barriers - Commitment

Situation is that potential entrants are expected: 1. patent runs out 2. technology advances

Incumbent can either: 1. Block entry - costs money => lower profits 2. Accommodate entry - costs margins => lower profits

Raising Entry Barriers

Control of essential resources - Get exclusive access to essential resources - Control the supply route so it dries up

Economies of scale / scope - Lower costs through scale - Leverage experience advantage - Increase technological lead

Develop marketing advantages - Build brand loyalty - Raise switching costs for consumers - get people to buy complementary products - GO launcher and similar

Commitment - Commit to an aggresive behaviour after entry. - To eliminate moves that are profitable to the entrant

4-8 Entry Deterrence - Limit Pricing & Predatory Pricing

Both refer to aggresive pricing. Limit Pricing is before entry. Predatory is after entry has happened

Limit Pricing - Keep price low in spite of monopoly position - Signal to the potential entry - "low demand" (market may appear unattractive) - "low cost incumbent" (dangerous competitor) - Works only in presence of incomplete information

Example: Ferries and Eurotunnel

Predatory Pricing - Charging low prices (even below marginal costs) in the current competition - to induce exit - Works only in presence of incomplete information

Example: UK newspaper industry - Times vs Independent

4-9 Entry Deterrence - Pre-emption

Invest so that you can produce cheaply. - Over-investing - Pursue horizontal product differentiation - Choose locations of outlets more densely than optimal

Example - Coffeeshops at LSE

The Power of Complements

The Power of Complements

In this week's lecture:

• Examples and definition of complementary products
• The economic definition for complementary products
• Cross-price elasticity of complementary products
• How substitute goods can also be surprising complements
• Interesting strategies in markets with complementary products
• Supporting the supplier of a complementary product
• Produce the complements - Advantages and disadvantages
• Strategies for firms that produce the complements
• Cross subsidize complementary products
• Bundle complementary products
• Increase Lock-In
• How complementarity can help achieve cooperation among firms who might otherwise compete
• Competitors as Complementors
• How Strategic Partnerships foster coordination between firms
• Shared decision making
• Organisation Integration
• Economic Integration

Complementary Products

Examples of complementary products:

• Computers and Software
• Skis & Skiing Sticks
• Smartphones & Apps

 

Economic Definition

The utility increase when the products are used together.

• Two products A and B
• These are complements if B increases users' utility from A, and vice versa
• U(A+B) > U(A) + U(B)

Cross-Price Elasticity

• Two products A and B
• These are complements if the demand for B increases when the price of A drops, and vice versa
• This phenomenon is referred to as negative cross price elasticity
• Cross price elasticity is how the price of one product depend on the price of another products

Surprising Complements

• Substitute good can also have complementary effects
• A price cut of the substitute good decreases market share but increases the size of the market, resulting in a positive net effect
• Example: Cloth shops in the same mall
• Shop A's price cut makes the whole mall more attractive
• Shop B's sales increase due to the additional customers

Supporting the Supplier

• Enable the supplier in ways that increase sales of complement e.g.:
• Better quality of complement
• Higher sales of complement
• Example: Apple
• Gave laptops to students writing software for Mac OS
• More compatible software titles made Apple's laptops more attractive
• Example: Game console manufacturer 3DO
• Problem
• Console manufacturers sold consoles for high prices to make profits
• This attracted a limited number of customers only
• Neither optimal for console manufacturers not for game publishers
• Solution
• Publishers paid a fee of 3 dollars to 3DO for every game copy sold
• 3DO could sell consoles much cheaper and attract more customers
• This way, publishers could sell more copies and increase profits

Producing Complements

• It may make sense to produce the complement yourself
• Example
• Sony produces game console and video games
• Hewlett Packard manufactures printers and printing ink
• Contra
• Market for complements may simply be unattractive
• Complement may require competencies the firm lacks (production, R&D, management, ...)
• Prospective customers might be put off by a firm's dominant position
• Pro
• Better tailoring of complement to own product
• Quality control for complement
• Internalization of the positive effects (externalities) of the complement on own product
• Cross-Subsidies
• Bundling
• Increasing Lock-in

Cross Subsidies

• Idea
• Product A is sold at small margins (even loss) to increase sales of Product B (high margins)
• Advantage
• Increase profits through intelligent pricing
• Risks
• Consumers do not buy product B at all
• Consumers buy product B from another manufacturer
• Examples: 
• Razors and razor blades
• Printers and printer cartridges
• Mobile phones & operator contracts

Bundling

• Idea
• Firm sells product A and complement B combined as a package
• Advantage
• Little or no competition in market for A
• Decreased competition in market for B
• Risks
• Potential buyers of "A only" or "B only" are lost
• Bundling becomes standard and advantages of unbundling are overlooked
• e.g. How to differentiate and how to set prices
• Examples
• Game console and games 
• e.g. Wii bundle with console, game, steering wheel
• Operating system and web browser
• Flight and baggage handling

Increasing Lock-In

• Idea
• Users have switching costs when switching from A to a substitute
• The more complements (B, C, ...) to A they buy, the higher the switching cost
• Advantage
• Higher switching costs imply a higher value of the customer to the firm
• You can charge customers higher prices
• Examples
• Microsoft Office and MS Windows
• Games and video consoles

Competitors as Competitors

• In certain situations, firms may be
• Competitors in one part of the market
• Complementors in another part of the market
• In such a constellation, they may not compete that harshly
• Example: Music Players & Music Content
• Sony and Apple
• Competitors
• Both sell portable music players
• Complementors
• Sony Music provides music content for Apple's iPod / iPhone
• Apple's iTunes store is important sales platform for Sony's music content
• Example: Mobile Phone Calls
• Vodafone and T-Mobile
• Competitors
• Both sell mobile phone contracts
• Complementors
• Their networks are interlinked
• Customers join Vodafone because they know that they can also call T-Mobile customers , and vice versa.
• Parts of Vodafone's / T-Mobile's revenues come from these cross-network calls

Strategic Partnerships

• Drivers of Strategic Partnerships
• Producers of complementary goods depend on each other
• Helping each other and coordinating each other's behaviour maximizes the positive effects of complementarity
• In many cases, integration into one single company not feasible or not desired by involved firms
• Forming a strategic partnership is a powerful way of institutionalizing coordination and formalising interests
• Definition of Strategic Partnerships
• Relationships between firms
• Typical characteristics
• Shared decision making
• Organizational linkages & coordination mechanisms(organisational integration)
• Joint equity ownership (economic integration)
• Organisational Integration
• Teams across firms
• Established reporting and decision routines across firms
• Heavy exchange of information
• Economic Integration
• Direct cross ownership of equity
• Firm A holds X% of Firm B's assets and vice versa
• Setting up a new legal entity (joint venture)
• Benefits
• Alignment of interests
• Retention of control and exclusivity
• Feasibility of inter-organisational coordination
• Complementarity and Strategic Partnerships
• If firms produce complementary products, already high incentives to work together cooperatively
• Less need for economic integration to align interests

Cooperation

Why do companies cooperate?

• Sometimes competition is not in the companies' best interests
• i.e in a Prisoner's Dilemma
• Sometimes companies need each other

What are the mechanisms to achieve cooperation between individual profit maximizers?

• Repeated games
• Commitment

Sequential Games, Backward Induction and Credible Threats

1-6 Sequential Games I - Game Setting

Sequential games where firms make decisions one after another are represented as game trees.

Game trees are built up as follows:

1. First decision starts the game
2. Every decision point represents a node
3. From there, the decisions of subsequent players branch out accordingly

A revised working definition of strategy: strategy is a player's plan of actions in a game, given any possible circumstances.

Sequential games can be applied to the problem of price setting.

1-7 Sequential Games II - Backward Induction

Backward Induction is:

• Simplification of a sequential game
• Eliminate actions at the final node and work one's way backwards
• Eliminate actions that would not maximize an individual's profit at that point
• A rational player always tries to maximize their own profits
• You can rely on a rational rival never choosing these actions

Backward induction allows us to find the best strategy for the first mover.

1-8 Sequential Games III - Credible Threats

Motivating question: How to distinguish between a credible threat and cheap talk?

Apply backward induction to determine if a threat is credible.
A public commitment (e.g. Lufthansa committing to a penalty) can also change the payoffs in such a way as to make a threat credible.

Commitment strategies is one way to change your payoffs to make your threat credible.

Simultaneous Games, Dominant and Dominated Strategies, Nash Equilibrium, Prisoner's Dilemma

1-2 Simultaneous Games I - Game Setting

A working definition of a strategy is a player's plan of actions in a game.
Simultaneous games as represented in a matrix structure.
The elements of a simultaneous games matrix are:

• Players e.g. Sensodyne, Colgate
• Actions e.g. Advertise, Don't Advertise
• Rules e.g. Simultaneous decisions
• Payoffs e.g.80% of market if advertise

1-3 Simultaneous Games II - Eliminating Dominated Strategies

A dominant strategy is a strategy that always does better than any other strategy regardless of what the other firm does.

• A rational player always chooses the dominant strategy. 
• We can anticipate that our rival will also choose the dominant strategy

A dominated strategy is a strategy that never does better than another one.

• A rational player would never opt for this strategy. 
• More importantly, you can rely on a rational rival never playing a dominated strategy

To solve this game, eliminate dominated strategies iteratively to eventually find the optimal strategy for each player.

1-4 Simultaneous Games III - Nash Equilibrium

A Nash Equilibirum is a combination of strategies such that any player that deviates from that equilibrium will have a worse payoff.
A good question to ask is: Does any player have an incentive to change their strategy?

Questions:

1. Is a Nash Equilibrium the same as a dominant strategy?
2. Can a Nash Equilibrium contain dominated strategies?
3. Will every Nash Equilibrium contain dominant strategies?
4. Will every game will have a Nash Equilibrium?
5. Can a game have more than one Nash Equilibrium?

1-5 Simultaneous Games IV - Prisoner's Dilemma

The Prisoner's Dilemma is a special form of Nash Equilibrium such that:

• there exists a combination of strategies with higher joint payoffs 
• but it is unlikely to be chosen because each player chooses a dominant strategy 
• and players gravitate to the lower-paying Nash Equilibrium