Prices, Capacity, and the Entry Decision: A Conditional Logit Analysis

Abstract

An understanding of what potential entrants consider in reaching an entry decision is important in assessing the validity of some rather fundamental hypotheses concerning the behavior of firms faced with an entry threat. The reason is that such hypotheses are based on implicit assumptions concerning what influences the decisions of potential entrants. If, for example, established firms deter entry by adjusting their prices, as suggested by the limit-pricing hypothesis, then it must be true that prices in fact influence potential entrants.1 Similarly, if firms build capacity to deter entry, as suggested recently by Spence [8], then it must be true that observed capacity in fact influences the entry decision. Hence, an examination of whether these considerations are important to potential entrants can be interpreted as a test of a necessary (though not sufficient) condition for the existence of these types of behavior on the part of established firms. Despite the significance of this question as a foundation upon which a number of important hypotheses concerning firm behavior rest, few studies have attempted to estimate the relationship between the relevant market characteristics and the behavior of identifiable potential entrants. The reasons for this are not hard to isolate. Price data of the type required is not generally available for most industries, leaving untested the frequently debated relationship between pre-entry market price and the entry decision. Also, in the interindustry context in which empirical resesarch is usually conducted, it is virtually impossible to account systematically for the differing levels of knowledge and experience among potential entrants, and such differences may significantly influence the relative attractiveness of markets for entry. Thus any attempt to estimate the relationship between market characteristics and the entry decisions of individual potential entrants in the interindustry context will founder on the inability to account for the influence of knowledge and experience on the attractiveness of the potential entrant's choices. This paper circumvents these problems by examining the relationship between market