Entry Deterrence: Credibility Applied

In game theory, entry deterrence discourages competitors from entering a market by creating credible threats or signals that make entry risky.

Consider Walmart, a retail giant, and a local grocery chain.

First, the local grocery chain decides whether to enter a market. If it doesn't, the game is over. The local grocery chain earns a profit of zero, and Walmart earns 2 million dollars profit.

If it enters the market, Walmart will decide whether to respond by starting a price war.

If Walmart fights a price war, the local grocery chain will lose 0.5 million dollars, and Walmart will earn 0.8 million dollars.

If Walmart doesn't fight, the local grocery chain will earn 0.5 million dollars, while Walmart will make 1 million dollars. If the local grocery chain does enter the market, both parties know that Walmart will earn more money by not fighting the market entry.

Realizing that Walmart's threat to start a price war is not credible, the local grocery chain enters.

However, Walmart can invest in excess capacity to make the threat more convincing. With this signal, the local grocery chain may believe the threat is real and choose not to enter.

Walmart retains its monopoly, earning 1.2 million dollars, a smaller profit because of its new investment but still higher than that in a price war.