ENTRY DETERRENCE AND REPUTATION EFFECTS : AN EMPIRICAL STUDY

Abstract

Proactive actions to deter the entry of new competitors are as important as strategic decisions to increase market share and growth. Entry deterrence is a complex problem largely because of a combination of signal perceptions and interpretations by incumbents and potential entrants. An incumbent may use various strategies like reputation building, limit pricing and carrying of excess capacity to deter entry. SeIten (1978) has presented one of the most widely cited pioneering works in the area of reputation and entry deterrence. Employing backward induction reasoning, he shows that, when faced with a finite queue of potential entrants, a monopolist incumbent's optimal strategy should be to accommodate (.and not react aggressively) to each and every entrant. Hence, Selten argues that there is no role for reputation building. Selten 's result is counterintuitive since it contradicts the widely held belief that reputation does matter. Various studies have extended Selten's work. The significance of reputation building and the possibility of rapacious response have been studied under various assumptions such as complete information, asymmetrical information, presence of uncertainty, and correlation between entrants, among others. However, little work has been done to empirically validate the theories in the area of entry deterrence. Selten's and other similar studies are used as a basis here, to determine if incumbent(s) react aggressively to entry and attempt to build reputation(s). The specific empirical issue being studied is : do reputation effects exist in real life competitive interaction situations? This study test three broad questions. The first question tests Selten's counter-intuitive result. The second question tests whether reputation building is an effective strategy for multimarket incumbents. The third question tests the impact of reputation building in a particular (geographic) market on the future behaviour of the potential entrants and the incumbents in that market . Out results of data analysis support both Selten as well as the conflicting school of thought. As per Selten, we find that entry is indeed met with accommodation most of the time. However, aggression, though infrequent, does occur. Rapacious response by a monopolist incumbent does not deter future entry in its markets. Reputation effects do not work at the level of geographic markets either, that is they do not deter entrants to particular markets. We find that, market characteristics, specifically the balance between demand and market capacity, rather than reputation building considerations, determine whether entry will be met with accommodation or aggression. Interestingly, we find that aggression is more likely in oligopolistic markets and is less likely in growing markets. We also find that geographic markets that have witnessed aggressive response are more likely to witness further aggressive responses. We speculate that consistently aggressive responses may be attributed to the characteristics of the specific market--balance between market demand and market capacity. We identify two broad avenues for further research on the tries of entry deterrence and reputation building. First, the study could be replicated in other countries and industries. Secondly, primary data could be used to further test the conclusions reached by this study.