Potential competition in the presence of sunk entry costs: an experiment

Abstract

This paper studies the effect of sunk entry-costs on potential competition in a multi-market framework, where potential entrants have different home market profits. Although sunk-entry-costs are supposed to increase entry barriers, the experimental results suggest that firms view entry costs differently depending on their home market profits. It is found that subjects are reluctant to enter, and compete in another market if they are already earning monopoly rents. Subjects instead, collude tacitly and earn monopoly rents in home markets, thereby weakening the effect of potential competition. In contrast, subjects who earn small secure returns in their home markets aggressively enter the contestable market whenever there are scopes for earning net profits. The threat of entry and the effects of potential competition are strong in the latter situation, forcing the monopoly incumbents to lower prices to limit-pricing levels.

Keywords:

• potential competition
• contestable markets
• sunk cost
• limit-pricing
• hit-and-run entry
• collusion
• experiment

Acknowledgements

I thank members of my dissertation committee at the University of Arizona for providing guidance and support. Financial support from the Economic Science Laboratory at the University of Arizona is gratefully acknowledged. The current version of the paper has benefited a lot from excellent suggestions and comments from two anonymous referees. All remaining errors are mine.

Notes

1. The upper and lower adjacent value defined by Tukey (1977) is as follows. Let x _[p] be the pth percentile. Define U as x _[75] – 3/2(x _[75] – x _[25]). The upper adjacent value is defined as the x_i such that x_i ≤ U and x_{i −1} > U. Define L as x _[25] – 3/2(x _[75] –x _[25]). The lower adjacent value is defined as the x_i such that x_i ≥ L and x_{i −1} < L.