5.2.1.1. The weakness of traditional models analyzing barriers to entry

These models are derived from the postulate of Sylos-Labini, which can be summarized as follows: if the barriers to entry are not strong enough, an established firm may be led to set a “limit price”. The firm then decides to apply a selling price which is higher than the marginal cost of production, but lower than the marginal cost of potential entrants.

At first sight, this presentation may seem attractive, but at a closer look it remains unsatisfactory in order to understand the problem. Criticism has focused on the credibility of threats and on the real commitments of the firm. “Modern” theories regarding strategic barriers have complemented the former analysis by arguing, not only “the theme of retaliation threats, but fundamentally, the credibility of such threats”. By this means, the concept of credible threats or engagement was introduced [GAF 90a].

Current research devoted to strategic entry barriers is mostly grounded in game theory. This theory focuses on the representation of strategies of the actors involved. In game theory models, potential entrants engage in a “complex game of strategic relations” with the established firms [JAC 85]. Game theory makes it possible to model the decisions and actions of each firm, that is to say, the actions of potential entrants as well as those of established firms. It also measures the equilibrium (or equilibria) and the conditions for achieving balance. The aim of game theory is to determine which will be the optimal strategy for each player. From this viewpoint, the definitions of “perfect equilibrium” or “equilibrium for each subset” can be reached.

5.2.1.2. Formalization of the basic model

Within the theoretical framework of entry barriers, established firms are conceived either as mere enterprises or as a “perfect” cartel, which is almost a monopoly. From this perspective, the model has the following two players: the established firm and the firm seeking to penetrate the market. For the sake of the argument, we will assume that the firm (or the leading group comprising n firms) uses a fixed irreversible expenditure policy, which has a dissuasive effect on potential entrants. These expenses, as stated by Jacquemin [JAC 85], may correspond to investment in publicity, R&D costs or any other capital outflow, such as the capital cost for entrants, for example, which tends to increase. In the model we will discuss below, the strategic variable available to players refers to R&D expenditure.

In the words of [JAC 85], it is a “model of strategic rivalry based on the assumption of an initial asymmetry. In situations where it is advantageous to take the initiative (where there is struggle for who strikes first) and where information is perfect, the established firms are favored by an asymmetry before entry: they are supposed to take the initiative and are capable of making prior and irrevocable commitments which actually match reliable threats.”

Moreover, the model reveals how an established firm in the market may profit from a time advantage, corresponding to the fact that it has accumulated a sufficient amount of “capital” (in the broadest sense) before the entry of other firms and what will automatically discourage their entry [TIR 85]. This analysis can be found in several authors’ work. For example:

“The strategic advantage that Bain implicitly considers is the one held by established firms, that is to say, the first ones who have made a commitment. This is the same type of advantage to which Stigler refers, namely, an advantage associated with time. It appears that there can be no other strategic advantage than the one implying that the firms involved will not have access to the same cost function. In accordance with Stigler’s intuition, the asymmetry is essentially temporal. We can confirm the preeminent role of sunk costs (fixed but also variable costs), which are associated with either physical assets or due to intangible assets, such as for example, customer loyalty” [GAF 90].

Let us assume the case of two firms in a context of certainty, with a finite horizon. One is already established in the market, while the other is trying to access the same market. Two situations may arise:

• – only “innocent” behavior is allowed, that is to say, the established firm does not seek to affect the expectations of potential competitors. In this case, the firm remains passive and we confront a two-stage sequential noncooperative game. The first step concerns the decision of the potential entrant to stay out of the market (or not). If he stays outside the market, the established firm may benefit from monopoly profit. If the entry effectively takes place, the next step will be for the firm to choose either economic war (with a corresponding profit for each firm) or market share (with a duopoly profit for both players). At this point, we can assume that the duopoly is a profitable option (less profitable than monopoly), but always bearing in mind that a price war could be devastating for both firms. The determination of the optimal strategies for each player, the determination of “equilibrium”, is obtained through inductive reasoning¹, going back from step number 2 to step number 1.

The pair of “entry war” strategies for the established firm and “staying out of the market” for potential entrants represents a Nash equilibrium situation in which none of the players is willing to change their strategy given the strategy chosen by the other participant. But it is evident that war is neither a reliable threat, nor would it be the optimal response for the established firm in case of entry. Bearing this in mind and given the context, the entrant is naturally not discouraged. As it has been pointed out by [RAI 88], this answer is contradictory to the very idea of Nash’s equilibrium and “it is the existence of a potential commitment that makes it possible to solve the difficulty”. In fact, this result is linked to the introduction of a new concept, that of perfect equilibrium, which can be defined as the equilibrium which “excludes possible actions corresponding to unreliable threats, given the strategies of the others. These threats are the actions of the players whose implementation would not be carried out if these players had the opportunity to execute them, because such a performance would clearly go against their own interests” [JAC 85];

• – only “strategic” behavior is possible, that is to say, when a reliable threat strategy can be deployed and is thus realized by a commitment of the firm installed, to prepare the war, in expenses that will constitute costs. These costs may be related to the installation of production capacity or to advertising expenses. In this case, the sunk cost is linked to R&D expenses which will then become the strategic means to deter entry.

The model contains two aspects: the threat itself and the credibility of the threat. The potential entrant must be convinced that the established firm will respect the threat in case of entry. In other words, the threat has to be credible, it must be accompanied by an “irrevocable” and “irreversible” commitment from the established firm towards R&D [RAI 88]. It also implies that the established firm has an interest to execute the threat. The firm must be assured of “its profitability in the sense that the expenses incurred into thanks to this policy will be more than compensated for by the resulting additional revenue” [JAC 85]. These expenses will not affect the profit of the established firm if the war actually effectively takes place, but otherwise its gains will be reduced by the value of the R&D engagement. A fundamental point regarding this model concerns the irreversibility of the commitment made by the established firm, which is actually known before the potential entrant makes its decision.

The different stages of the game are the same as in the model we described earlier: already knowing the decision of the established firm, the potential entrant decides whether to enter the market or not. In addition, the established firm chooses its pricing policy having to opt between market share and war. After making a decision, each player takes into account the potential reaction of the other player. We should perhaps mention a third step, which already began when the established firm had to decide whether to remain passive or to engage.

In this sequential game, the player’s strategies for any subset constitute a Nash equilibrium where each player adopts the best possible response to the strategies of other players, so as to safeguard his interests. In a case where the entry takes place, it is credible for the established firm to choose to fight in case where the loss due to the sharing is higher than in a war scenario. Knowing this before entering, the entrant will probably choose to stay out if the established firm is seriously committed. “Do not enter” is the optimal strategy for the entrant.

The established firm is capable of sustaining this reasoning by placing itself in the place of the potential entrant. It must then decide whether the optimal strategy will be to remain passive or, conversely, to engage in R&D expenses. It will adopt strategic behavior only if, on blocking the entry, the monopoly gains are greater than the ones the firm would obtain in case of passivity (sharing duopoly). The threat of the established firm will be considered reliable only under the condition that the difference between the monopoly profit and the duopoly profit exceeds the cost of strategic engagement (R&D expenditure), and that the latter is higher than the difference between the profit of duopoly and the gain in case of war. “The entrance will be prevented. The existence of a barrier to entry directly results from the strategy of the established firm” [RAI 88].

5.3.2.1. Cooperative behavior between established firms

See the case where two established firms explicitly cooperate (joint venture and consortium) and engage in a policy for joint research expenses, in order to bar the entry of potential competitors:

“The context is described as cooperative if the players can group themselves in coalitions where their strategy is decided in common in order to improve the gains for all the coalition players. Players are in a position to abdicate their decision-making power in the hands of a collective authority which emanates from a coalition to which they belong. They can enter into firm commitments and be forced to maintain them: these commitments can either take the form of threats or promises they intend to keep” [MOU 81].

This situation produces similar results to those of the initial engagement model (see section 5.2.1.2) where the two established firms implemented a coalition.

5.3.2.2. Noncooperative behavior between established firms

Two scenarios are possible:

• – strictly noncooperative behavior between the two firms. This case illustrates a commitment of established firm 1 while firm 2 remains passive;
• – noncooperative collusive behavior between the two firms. A priori, this paradoxical expression refers to the possibility for a firm to be in collusion with another firm in the absence of an explicit agreement between the two units. Both established firms decide to commit themselves separately to the new entrant.

Due to the fact that it is difficult to formalize the problem of entry and the phenomena of strategic alliances only through the use of game theory, other analysis grids are suggested in the following two sections.

5.4.1.1. Product lifecycle, technology and industrial cycle

Several authors [MAG 77, FOS 86] have described the four phases of the technological lifecycle. Not only does each phase correspond to one of the uses of technology, but it also envisions the product from the point of view of its lifecycle. Throughout this cycle, the nature and uses of technology change profoundly.

The pre-introductory phase corresponds to fundamental research. This phase is the one of invention, the one that involves complex technology. At this stage, the product does not exist as such: the action takes place before the beginning of the lifecycle of the product itself. The second phase, that of introduction, is the one of applied research and innovation development. This phase, which involves the introduction of new technology to an existing market, is the one of “sophisticated” technology. It is precisely at this stage of the technology cycle that the product lifecycle begins. The third phase is the one of standardized technology. The implemented technology only has a few improvements and the intensity in R&D decreases. At this point, we move on to large-scale industrial development and the race to differentiate the product properly begins, and this is what corresponds to the second phase in the product lifecycle. The fourth phase is that of commonplace technology, with investment in R&D being practically marginal. This is the final step in the product’s cycle.

The technological cycle is generally represented by “S” curves [FOS 86]. Management consulting firm A.D. Little has suggested the following nomenclature, thereby making a distinction between:

• – basic technologies: these have often been at the origin of the sector, but are widely distributed and are currently available without any competitive advantage. While it is true that the firm (the same as its competitors) masters these technologies, it is at this phase that the company must decide whether to abandon these technologies and launch new ones;
• – key technologies: those which constitute the competitive foundation of the sector, whose proficiency is absolutely essential for success in the chosen activity or brand. These are exploited both by the company and its competitors, and have significant impact, because their mastery results from the opportunities to differentiate themselves within the sector;
• – emerging technologies: these are often at their initial stages of development and application, only used in a marginal way in the corresponding sector, but with high potential and candidates to becoming key technologies in the future;
• – embryonic technologies: these technologies are often at a research phase and have no concrete application, but may be of interest at a later stage of development. Investments at this stage are high.

Other consulting firms in strategic management have worked over and adapted the concept of technological lifecycle. For example, this is the case of Gartner, a consulting group who confirmed that there is a relation between the succession of the four phases and the hype cycle [GAL 16]. Gartner’s curves characterize the typical progression of emerging technology, from initial enthusiasm towards a period of disillusionment and understanding of the pertinence and the role of technology in a market (Box 5.1). Each phase is characterized by distinct indicators related to the market, investment and the adoption of technology.

In his most recent report, Gartner [GAR 16] highlighted three key technological features that will be imposed on firms facing a digital transformation of their activities:

“Transparently immersive experiences: Technology will continue to become more human-centric to the point where it will introduce transparency between people, businesses and things […].

The perceptual smart machine age: Smart machine technologies will be the most disruptive class of technologies over the next 10 years due to radical computational power, near-endless amounts of data, and unprecedented advances in deep neural networks that will allow organizations with smart machine technologies to harness data in order to adapt to new situations and solve problems that no one has encountered previously.

The platform revolution: Emerging technologies are revolutionizing the concepts of how platforms are defined and used. The shift from technical infrastructure to ecosystem-enabling platforms is laying the foundations for entirely new business models that are forming the bridge between humans and technology. Within these dynamic ecosystems, organizations must proactively understand and redefine their strategy to create platform-based business models, and to exploit internal and external algorithms in order to generate value.

[These] three overarching technology trends that profoundly create new experiences with unrivaled intelligence and offer platforms that allow organizations to connect with new business ecosystems”.

An interesting development of product lifecycle and technology lies in the combination that can be achieved, thanks to the concept of industrial cycle [NPV 83]. At the beginning, the notion of lifecycle used to be applied to so-called “mature” industries, for which different strategies could be adopted in order to improve their competitiveness or competitive advantage. But in fact, the process should have been denominated substitution, because it referred to the introduction of a new generation of products, to the extension of lifecycles through the introduction of “minor” innovations, to other technological changes or to the perpetuation of the maturity stage, by means of increasing internationalization. A parallel between the lifecycle and the diffusion of innovation has been carried out by several authors.

In general, the richness of the product cycle (associated with technological factors and industrial aspects) lies in the intervention of a number of factors (market structure: monopolistic, oligopolistic or competitive, costs and production and shifts in demand) that will surely have an impact on business strategies.

5.4.1.2. Costs and entry conditions during the different phases of the technological lifecycle

Lifecycle analysis can be enhanced by associating it with the conditions and the costs of entering an industry. The presentation of [PER 88] leads to a specific analysis in terms of phases, but focusing on the different strategies adopted by the various actors, be it the firms or the public authorities. It is also a means of “breaking the determinism” of the product’s lifecycle [JAC 85] or the technological lifecycle.

According to [PER 88], we may consider a four-phase technological lifecycle for which there are four matching elements that determine the real cost of entry for each firm: fixed investment (I); the scientific and technical knowledge required to assimilate innovation (S); the cost of acquiring an experiment (E) and the costs of the disadvantages associated with the elements concerning the setting-up (X), for example, the general infrastructure or the economic and institutional environment of the company.

Phase 1 corresponds to the introductory phase, where the focus is placed on the product itself. It must perform correctly and it is successfully led to the market. In this case, the S threshold will be high whereas E could be low.

Phase 2 constitutes a period of rapid growth in the marketplace. Once the product is defined and it is market-tested with clear growth prospects, the focus will shift towards the production process. Successive improvement measures are implemented both on the product and on the production process, with the aim of increasing production and productivity. As the technological aspects are gradually solved and their solution becomes an integrated part of the product and the production equipment, the S level for imitators drops. But the E threshold in terms of required skills will rapidly increase due to the fact that experience is accumulating within the company. In the measure that the optimum plant size increases, the cost of I becomes higher than that in the previous phase.

In phase 3, we have reliable knowledge concerning the size and the growth rate of the market. Also, we have clearly identified additional incremental innovations in order to increase productivity. At present, the emphasis is placed on managing the growth of the company and conquering new market segments. The actual capital costs and the firms’ skills in terms of management required to stay in the race can be sensibly high. The S component of entry costs is now relatively low, but the ever-increasing E and I components are now at their highest level. The advantages to localization become less important. What is more, in phase 1, the price that a firm would set to sell technology tends to infinity in the measure that the firm has an interest in maintaining a monopoly on technical information (S); but in phase 3, it can still remain relatively high, which can be explained, thanks to the amount of accumulated experience (E) within the firm.

Phase 4 is the maturity stage, when the product and its production process are standardized. Additional investments aimed at improving technology lead to decreasing returns. From the moment the inputs are fixed, the advantage in terms of cost-of-production goes back to the firm (or country). This should lead established firms to relocate some of their facilities even at the end of phase 3 (see Chapter 8). But, this could also lead them to focus on other innovations and to suggest alternative technology that makes the technology acquired during previous phases obsolete. Another option is for firms to sell technology in the form of licenses and know-how contracts.

As we can appreciate, entry conditions may differ according to the phase of the cycle under consideration. For instance, in phase 1, an innovator can penetrate a market. However, entry during this phase does not guarantee “survival” in the race. An entry during the maturity phase appears relatively safer, as long as a new product is not substituted for the old one in the market.

On the basis of these factors, it is possible to consider that the strategies of firms differ according to the stage of the lifecycle studied.

5.5.2.1. Innovation as a race with a fixed line of arrival

Preemption could be described as the situation when a firm excessively accelerates its R&D and innovation programs [JAC 87]. According to [FUD 83a], we can identify two types of preemption. Simple preemption refers to the case in which a leading firm cannot be surpassed from the moment it has a certain lead. Competitors then abandon the race on the spot. There is also ε-preemption, which corresponds to the situation in which a firm remains at the head of the race, regardless of the advantage it has over its competitors.

In particular, [FUD 83a] introduced a technological race model of patents with delayed information in which the finish line is fixed. A firm wins the race if it is the first to accumulate a certain amount of knowledge provided a priori. It is a game measured in discrete time. The intensity of the R&D efforts can be measured in three values (0, 1 and 2). In other words, both firms have the following choice: either to make zero effort, to learn at a rate of “one unit” or to learn at a rate of two “units”.

There is a delay in obtaining information about the competitor’s R&D behavior. It is only at period t that firms can be fully informed about the R&D activities carried out by their rivals during the previous period (t – 1). Such is the dynamic that a firm could even surpass the leader because it could accomplish real advances in its technological knowledge without having to reveal its results to the more experienced firm. The inability to monitor a firm’s R&D program may cause the leader to be unable to react on the spur of the moment. As a result, he will probably be overtaken.

In the model we are considering, in order to introduce innovation, a firm must have accumulated a certain number of experience “units”. The firm’s accumulated knowledge is the result of the distance that has been traveled by the company. The experience that remains to be acquired will be the distance still to be traveled. Two cases can be distinguished so as to measure whether the distance to be traveled in order to catch up with the leader has to be considered long or short.

If a firm is kept behind the leader by two “units”, we are in front of a preemption phenomenon. The firm which has this delay abandons its R&D activity, what will allow the leader to invest at the lowest rate. If both firms possess the same level of experience, they will engage in intense rivalry provided that the number of challenges before the goal is relatively low. If the distance between the leader and another company is equivalent to one unit, both firms will adopt a mixed strategy. In the latter case, there is no complete preemption.

5.5.2.2. Innovation as a stage (treasure) hunt

Fudenberg et al. [FUD 83a] conceived an innovation process which can be split into two stages. The model is based on the chance for a latecomer firm to catch up with the leader of the race. A preliminary innovation must be made before the invention can be patented, “to follow the metaphor of the treasure hunt, before efficiently searching for the treasure, we must find the temple in which it is buried” [GUE 85].

In this model [FUD 83a] shows that ε-preemption no longer appears systematically. Let us imagine that two firms (1 and 2) are identical. Firm 1 is supposed to enter the race for the patent before its competitor does. The first stage is characterized by a discovery made by firm 1, what becomes immediately known to the rival firm. Nevertheless, the innovation remains private property of the innovative firm and is kept secret. In this model, firm 2 is yet able to make up for its initial delay, despite a lower level of experience than firm 1. In fact, firm 2 can take the lead during the second stage of the race. At this point, the hypothesis is made that the probability of producing an innovation is constant, because the chance rates have become constant and equal for both firms.

Being the first firm to have entered the race, firm 1 will persevere unless its rival achieves the preliminary innovation before a specified date: w1. The latecomer, firm 2 (who entered the race at t = t2) may adopt one of the following three responses (depending on the value of the parameters): either it quits from the start or it continues its R&D activity until w1, or it persists, unless the leader achieves the preliminary innovation before w₁ + t₂.

In this model, the latecomer can begin to accumulate experience during the second stage and catch up with his rival. This modest success will encourage him to give up less easily. In the words of Fudenberg et al. [FUD 83a], the laggard can resort to “leapfrogging” before his rival.

5.5.3.1. The introduction of cooperation in the technological race

Grossman and Shapiro [GRO 87] developed a two-stage patent race model based on the patent race reported in [LEE 80], where technology has a stochastic character. In order to win the race, a firm must complete two R&D phases of equal difficulty. The two stages should respectively be considered as research and development phases. As such, each firm is fully informed about the progress of its rival and immediately knows if it can take the lead or if it must remain in its current position. Progressively, participants can adjust their tactics as the race progresses.

This model is interesting in that it intends to decipher what encourages firms to adopt cooperative responses at certain stages of the technological race. Grossman and Shapiro identified three alternatives that may alter rivalry dynamics in R&D. First, the leader shares his (intermediate) results with the rival, by means of a license agreement in exchange for the payment of a fee. Second, the government grants intermediate patents to a firm before it reaches all the development stages of an innovation that are necessary to introduce a marketable product. As a result, participation in the race for the latecomer during this initial phase is excluded. The third case corresponds to a situation in which firms enter a research joint venture during the first stage before competing in the development phase.

In the context of a patent race divided into several stages, every time a firm has completed an initial phase of research that its rivals have not yet achieved, the firm should feel motivated to make these results available to other firms in exchange of royalties. In this way, the firm may acquire potential gains for the information exchange, that is to say, it can profit from communicating intermediate results.

The question of potential gains obtained from an information exchange necessarily requires a comparison of the overall industry profits, with and without a license. The license itself is an attractive operation for both firms because it offers the follower the possibility of moving closer to the finish line without incurring into any additional expenses on intermediate results. This way, the follower can endure the race in situations where the only alternative would be for him to withdraw. Nonetheless, from the point of view of a duopolistic race to the patent, the license has the disadvantage of intensifying rivalry between firms. Without a license, the rivalry period could be altogether avoided, if the leader finished the research program before the follower made progress.

Grossman and Shapiro [GRO 87] found that having recourse to a license may lead to potential gains in several situations. For example, in the event that the follower quits without a license, the fact of using one could increase industry profits when the discount rate is high or, in case of a positive rate, when the elasticity of the R&D cost function is strong enough. In the case where the follower remains active, the license is likely to be more profitable for the firms if the rivalry it gives rise to in the final stage of the race is not too intense. Finally, a high discount rate is conducive to a license, even if the follower remains in the race, because the license reduces the expected time for the discovery.

The second means contemplated in [GRO 87] concerns so-called “intermediate” patents, and more specifically, a government policy which grants a patent to the intermediate stage of the innovation process. Results have shown that at the beginning of the race, rivalry is likely to be more intense if intermediate patents are granted. Thus, patents appear to be beneficial for all firms ex post.

The last scenario considered in this model is the one of research joint venture. This tends to increase profits for all participants in the race for two reasons: first, because it eliminates rivalry at the initial stage of the research program. Second, because the firm’s access to intermediate results at the moment technological advancements have been made in one of the laboratories avoids duplication efforts in R&D.

We should retain two results extracted from the [GRO 87] model. On the one hand, the leader invests more than the follower, but if the follower succeeds the intermediate phase and recovers his delay, both firms will intensify R&D efforts. On the other hand, the various forms of cooperation (sharing intermediate results by means of licenses, granting of patents in the framework of a technological policy or engagement in a joint venture during the first phase of the race) are all conducive to increased profits for the entire industry.

5.5.3.2. Extension of the model by Fudenberg et al.: firm cooperation and noncooperation

In line with the model of the dynamic patent race suggested in the literature [FUD 83a, HAL 92], we have considered the possibility for firms who compete for a single patent to cooperate at certain stages of the race for specific purposes. In fact, firms may or may not decide on a temporary information exchange agreement, but this possibility is actually challenged at each stage of the technological race. In other words, at every stage of the patent race, firms can either keep the result of their R&D efforts as a secret, or, on the contrary, they can disclose a part or the whole of the progress of their knowledge.

When a firm decides to embark on an R&D program, its cooperation strategy is to provide its rival with a unitary amount of knowledge. In this case, the active company always benefits its temporary “partner” with a positive external effect.

In Fudenberg’s model, firms have the choice of offering their competitor the benefit of the whole or half of its investment. Under the agreement itself, it benefits from positive externalities when its rival invests in R&D (but this will only be perceived during the following period). In a situation where there is no agreement, firms increase their stock of knowledge only through their own effort in the race. Actually, they do not exchange any kind of information but results must remain secret:

“Finally, when they are both active in R&D, the agreement option versus the non-agreement option enables competitors to increase their knowledge stock faster and, consequently shorten the time lapse for obtaining a patent, achieving this at a lower accumulation cost. In particular, if the both firms decide to ‘cooperate’ on equal terms and invest each at the maximum pace, their experience will increase by three units, two thanks to their own effort, and an additional unit by the effort of their ‘partner’ for the cost of only two units” [HAL 92].

Contrary to this, the agreement will prove to be a particularly unfavorable strategy for a company who invests while its “partner” is not engaged in a R&D effort. In a situation of maximal externality, the latter will advance the same amount as its rival does, but without providing any effort or cost.