In contrast to this case consider now a monopolist who actively pursues a strategy of entry deterrence. This means that an already-operating supplier adopts a strategy that will deter new entrants. What follows is a non-technical description of how a monopolist might strategically erect a barrier to entry.
Devil’s Glen is the sole ski resort accessible to the residents of local Angel’s Valley. The resort is profitable, but the owners fear that an adjoining hill, owned by a potential competitor, may be developed. Such a development would reduce Devil’s Glen’s profits radically. In the face of this threat, can Devil’s Glen develop a strategy to protect its profit, or at least a large part of its profit?
One such strategy is for Devil’s Glen to pre-commit itself to a specific course of action that is additionally costly to itself. In particular, it could invest in a new ski lift that would generate excess capacity, or that it might not even use. Such a strategy would indeed be costly, but it would undoubtedly send a signal to its potential competitor that Devil’s Glen could bring on this spare capacity, reduce lineup times, and thereby make it very difficult for a new resort operator to make a profit.
A key component of this strategy is that the incumbent invests ahead of time - and inflicts a cost on itself. The incumbent does not simply say “I will build another lift if you enter the business.” Such a policy does not carry the same degree of credibility as actually incurring the cost of construction ahead of time.
This capacity commitment is an example of strategic entry deterrence. Of course, there is no guarantee that such a move will always work; it might be just too costly to pre-empt entry by putting spare capacity in place. An alternative strategy might be to permit entry and share the market.
Spare capacity is not the only pre-commitment available to incumbents. Anything with the character of a sunk cost may work. Advertising to build brand loyalty is a further example. So is product proliferation. Suppose one cereal manufacturer has a strong grip on the market. A potential competitor is contemplating entry. So the incumbent decides to introduce a new line of cereals in order to prevent the entry. The incumbent thereby commits himself to an additional cost in the form of product development. And this development cost is sunk. The incumbent reduces his profit today in order to prevent entry, and maintain his profit tomorrow.
The threats associated with the incumbent’s behaviour become more credible since the incumbent incurs costs up front. To be completely credible the potential competitor must be convinced that the incumbent will actually follow through with the implication of building the additional capacity. Hence in the case of the ski hill owner who has added capacity, the potential competitor would have to be convinced that the incumbent would actually use that additional capacity if the competitor were to enter.
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