IO5

• No barriers to entry and exit other than entry costs
• Firms enter as long as profit can be repead.

What is the equilibrium number of firms in a market characterized by free entry?

• Assume an industry with symmetic firms, entry cost e>0.
• Two stage game
• Stage 2: firms compete (in q or p)
  • If n active firms, profit is   (n), with
• Stage 1: entry decision
  • Each potential entrant must decide whether to enter the market (at a set-up cost of e)
  • Free entry equilibrium number of firms is:
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• When e increases, ne decreases

Is entry socially desirable?

• Let n* denote the socially optimal number of firms - the number of firms that maximises social welfare W(n), given first will compete Cournot.
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• Result ne>n*
• Cournot competiton tends to result in excessive entry, relative to the socially optimal number of firms.

• Prices so low that entry is deterred. 
• Two assumptions:
  • the entrant believes that the leader is committed to its output choice
  • the entrant has decreasing average costs over some initial level of output.
• Incumbent commits to Qd so the entrants residual demand is Re=D(P) - Qd.
• Incumbent prices at P=AC, pe
• At pe entry is unprofiable

• Limit pricing can only work if the incumbent firm can commit to producing the limit output even if entry occurs.
• Three ways
  • Capacity expansion
  • imperfect information
  • long term contracts