Profit-increasing asymmetric entry

Abstract

Despite conventional wisdom that firm profits decrease with competitive entry, the empirical literature finds a number of situations where the entry of an equivalent-quality competitor into a market led to higher profits for the incumbents. Our paper uses a standard linear Hotelling (1929) market to study how location choices affect the possibility that profits increase for the incumbents with competitive entry by a new rival. We show that profits of all incumbents can increase after competitive entry even if the new competitor is located such that it competes directly with only one of the incumbents. This asymmetric entry demonstrates two separate mechanisms that can lead to profit increases: first, profits can increase because a rival's pricing incentives have changed, causing the rival firm to increase its price. Second, entry can change a firm's own pricing incentives, which in turn cause the competitor to increase its price anticipating a higher-priced equilibrium. Either of these effects on their own can be sufficient for profits to increase. Of course, increased prices do not imply increased profits. Rather, profits only increase in scenarios where the higher prices offset the lost sales. As such, we note that profits for a monopolist are always higher than profits for firms facing any level of competition. Further, we show that average industry profits must eventually go to zero. Thus, the relationship between profits and the number of firms in the market for industries with profit-increasing entry follows a down–up–down shape. We discuss the implications this has on interpreting results from the empirical entry literature.