Sane Methods of Entry Deterrence

While threatening to set low prices won’t deter rivals from entering your market if they believe you to be rational, game theory provides other ways of keeping out the competition. Because you can so easily change prices, threats to maintain low prices lack credibility. Thus, to convince the competition that it would lose money if it entered your market, you need to employ a more permanent mechanism than price setting.

You could, for example, contractually agree to charge your customers low prices for a long period. Since your customers could sue if you violated such an agreement, your rivals would believe a threat to keep low prices if these prices were guaranteed by contract. Of course, if the potential competition decided not to enter, you would still be stuck with these low, contractually mandated prices.

An ideal mechanism to deter entry would be to contractually promise lower prices to customers only if the competition enters your market. Such a contingent contract would deter rivals from entering, but if they didn’t enter, you could continue to enjoy high prices. Unfortunately, such an agreement would almost certainly be declared illegal under antitrust laws. The paramount objective of antitrust law is to promote competition, so if a plan’s clear and obvious purpose were to restrict competition, then it would probably be found illegal. (Of course, no sane person should rely on a game theory book for legal advice.)

Increasing factory production could also credibly deter entry. If you build an extra factory, you will have a lot of new products to sell so you will have to lower prices regardless of whether your competition increases. Building extra production capacity credibly signals to the potential competition that you will maintain low prices. Once you have built the extra capacity, your interests would actually be served by charging less.