Response to Competitive Entry: A Rationale for Delayed Defensive Reaction
Empirical studies examining responses to new product entries come to the puzzling conclusion that, in general, an incumbent reacts to a new entrant after a significant delay. Even easy-to-implement price cuts are observed after significant lag following entry. These findings seem to contradict the existing literature that either implicitly assumes or strongly advocates immediate defensive responses to limit competitive encroachment. When a competing firm enters the market, consumers may be uncertain about the entering firm's product quality. The incumbent firm (through rigorous tests) may fully know the entrant's quality. Suppose the incumbent aggressively lowers price. This may cause the consumers to wonder if indeed the entrant's quality is high. In other words, an incumbent's reaction may cause the consumers to make inferences about the entrant's quality. Such strategic implications of the incumbent's reactions have to be carefully analyzed before determining the optimal response by the incumbent. In this paper, we propose a conceptual framework for understanding differences in the magnitude and timing of incumbents' responses to competitive entries. We consider a model in which a monopolist incumbent firm faces competitive entry. The incumbent firm knows the true quality of the entrant with certainty. Although consumers are aware of the incumbent's product quality through their prior experience, they are initially uncertain of the entrant's product quality. In such a situation, a high-quality entrant has the incentive to signal her true quality through her strategic price choice. However, the uncertainty about the entrant's quality is favorable to the incumbent in the sense that consumers believe with a high probability that the entrant's quality is low. As a result, the strategic incentives facing the incumbent and the entrant oppose each other. While the entrant wants to signal her high quality, the incumbent wants to prevent her from doing so. We demonstrate that one way the incumbent can prevent the quality signaling is to select a higher than his optimal competitive (duopoly) price. In other words, the incumbent can prevent or “jam” the entrant's quality signaling by choosing a price higher than his optimal competitive price when consumers are fully informed about the entrant's true quality. Though the signal-jamming price is lower than the monopoly price, the price is substantially higher than the competitive price. This marginal reduction in the incumbent's price from the pre-entry monopolistic price represents a muted or lack of response by the incumbent to the competitive entry. However, once the entrant's quality gets revealed in subsequent periods through consumer usage and word of mouth, the entrant has no incentive to engage in quality signaling and the incumbent has no incentive to jam it. Therefore, the market reverts to the complete-information competitive prices, and the incumbent lowers his price considerably. This temporal pattern of muted price reduction in the first period followed by a sharp price reduction in the second period corresponds to a delayed defensive reaction in our model. Although the empirical studies suggest that the delayed reaction may arise due to factors such as managerial inertia or indecision, we demonstrate that such a behavior is indeed an optimal strategy for a profit-maximizing firm. Thus, our model reconciles empirical results with the equilibrium outcome of a strategic analytical framework. Furthermore, in an experimental setting, we test the predictive power of our framework and establish that consumers indeed form conjectures about the entrant's quality based on the incumbent's reactions. In the first experimental study, we find strong support for the notion that the incumbent's price reaction may indicate entrant's quality. In a follow-up study, we observe that whenever the incumbent lowers prices, respondents judge the quality of the entrant to be higher as compared to the case when prices are the same or increased. The managerial implication of this paper is that well-established incumbent firms should be cautious in the implementation of their defensive responses to product introductions of uncertain quality by competitors. Of particular concern are situations where the reactions are easily observable by consumers. A strong reaction may suggest that the incumbent takes the competitive threat seriously, leading consumers to believe in the quality of the competitor's product.
Volume (Year): 17 (1998)
Issue (Month): 4 ()
|Contact details of provider:|| Postal: 7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA|
Web page: http://www.informs.org/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Milgrom, Paul & Roberts, John, 1982.
"Limit Pricing and Entry under Incomplete Information: An Equilibrium Analysis,"
Econometric Society, vol. 50(2), pages 443-459, March.
- Paul Milgrom & John Roberts, 1998. "Limit Pricing and Entry Under Incomplete Information: An Equilibrium Analysis," Levine's Working Paper Archive 245, David K. Levine.
- Schmalensee, Richard, 1978. "A Model of Advertising and Product Quality," Journal of Political Economy, University of Chicago Press, vol. 86(3), pages 485-503, June.
- Wujin Chu & Woosik Chu, 1994. "Signaling Quality by Selling Through a Reputable Retailer: An Example of Renting the Reputation of Another Agent," Marketing Science, INFORMS, vol. 13(2), pages 177-189.
- Iwata, Gyoichi, 1974. "Measurement of Conjectural Variations in Oligopoly," Econometrica, Econometric Society, vol. 42(5), pages 947-966, September.
- Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
- Paul R. Milgrom & John Roberts, 1984. "Price and Advertising Signals of Product Quality," Cowles Foundation Discussion Papers 709, Cowles Foundation for Research in Economics, Yale University.
- Kenneth L. Judd & Michael H. Riordan, 1994. "Price and Quality in a New Product Monopoly," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 773-789.
- Fudenberg, Drew & Tirole, Jean, 1984. "The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look," American Economic Review, American Economic Association, vol. 74(2), pages 361-366, May.
- Bulow, Jeremy I & Geanakoplos, John D & Klemperer, Paul D, 1985. "Multimarket Oligopoly: Strategic Substitutes and Complements," Journal of Political Economy, University of Chicago Press, vol. 93(3), pages 488-511, June.
- In-Koo Cho & David M. Kreps, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 102(2), pages 179-221.
- In-Koo Cho & David M. Kreps, 1997. "Signaling Games and Stable Equilibria," Levine's Working Paper Archive 896, David K. Levine.
- Preyas S. Desai & Kannan Srinivasan, 1995. "Demand Signalling Under Unobservable Effort in Franchising: Linear and Nonlinear Price Contracts," Management Science, INFORMS, vol. 41(10), pages 1608-1623, October.
- K. Ravi Kumar & D. Sudharshan, 1988. "Defensive Marketing Strategies: An Equilibrium Analysis Based on Decoupled Response Function Models," Management Science, INFORMS, vol. 34(7), pages 805-815, July.
- Ming-Jer Chen & Ken G. Smith & Curtis M. Grimm, 1992. "Action Characteristics as Predictors of Competitive Responses," Management Science, INFORMS, vol. 38(3), pages 439-455, March.
- Chen, M.J. & Smith, K.G. & Grimm, C.M., 1991. "Action Charasteristics As Predictors of Competitive Responses," Papers fb-_91-12, Columbia - Graduate School of Business.
- William T. Robinson, 1988. "Marketing Mix Reactions to Entry," Marketing Science, INFORMS, vol. 7(4), pages 368-385.
- Subramanian Balachander & Kannan Srinivasan, 1994. "Selection of Product Line Qualities and Prices to Signal Competitive Advantage," Management Science, INFORMS, vol. 40(7), pages 824-841, July.
- Moulin, Herve, 1979. "Dominance Solvable Voting Schemes," Econometrica, Econometric Society, vol. 47(6), pages 1137-1151, November.
- Drew Fudenberg & Jean Tirole, 1986. "A "Signal-Jamming" Theory of Predation," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 366-376, Autumn.
- Kannan Srinivasan, 1991. "Multiple Market Entry, Cost Signalling and Entry Deterrence," Management Science, INFORMS, vol. 37(12), pages 1539-1555, December.
- K. Sridhar Moorthy, 1988. "Product and Price Competition in a Duopoly," Marketing Science, INFORMS, vol. 7(2), pages 141-168.
- Bagwell, Kyle & Riordan, Michael H, 1991. "High and Declining Prices Signal Product Quality," American Economic Review, American Economic Association, vol. 81(1), pages 224-239, March.
- Kyle Bagwell & Michael Riordan, 1988. "High and Declining Prices Signal Product Quality," Discussion Papers 808, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Nelson, Philip, 1974. "Advertising as Information," Journal of Political Economy, University of Chicago Press, vol. 82(4), pages 729-754, July/Aug..
- Birger Wernerfelt, 1988. "Umbrella Branding as a Signal of New Product Quality: An Example of Signalling by Posting a Bond," RAND Journal of Economics, The RAND Corporation, vol. 19(3), pages 458-466, Autumn.
- Subramanian Balachander & Kannan Srinivasan, 1998. "Modifying Customer Expectations of Price Decreases for a Durable Product," Management Science, INFORMS, vol. 44(6), pages 776-786, June.
- Paul Klemperer, 1987. "The Competitiveness of Markets with Switching Costs," RAND Journal of Economics, The RAND Corporation, vol. 18(1), pages 138-150, Spring.
- Asher Wolinsky, 1983. "Prices as Signals of Product Quality," Review of Economic Studies, Oxford University Press, vol. 50(4), pages 647-658.
- Sridhar Moorthy & Kannan Srinivasan, 1995. "Signaling Quality with a Money-Back Guarantee: The Role of Transaction Costs," Marketing Science, INFORMS, vol. 14(4), pages 442-466. Full references (including those not matched with items on IDEAS)