A Report on the Actuarial, Marketing, and Legal Analyses of the CLASS Program. V. Competitor Responses to Entry: What Does the Literature Say?

10/14/2011

CLASS insurance will represent a major new entrant into the LTCI market. It is therefore important to anticipate how incumbent sellers will respond. There is a large theoretical literature and substantially smaller empirical literature on incumbent responses to entry. Thomas (1999) reviews the literature and provides some evidence from the breakfast cereal industry.35 Simon (2005) also reviews the literature and adds evidence from magazine subscriptions.36 We review both of these papers below.

a. Thomas

Thomas notes that early research focused on the use of price to deter entry. Incumbents could set a “limit price” below the short term profit maximizing level in order to make the market less attractive to entrants. Game theorists were skeptical of the limit pricing strategy because it assumes that the entrant is myopic and believes that the pre-entry price will prevail after entry. In fact, once entry occurs, the incumbent might accommodate the newcomer by, for example, tacitly colluding on price. Or incumbents might be better served by slashing prices after entry occurs, a strategy known as predatory pricing. This might drive out the entrant and deter future entry. But the strategy is costly in the short run and there is no guarantee that future entrants will be deterred.

Thomas identifies other entry deterring strategies, including product proliferation in differentiated goods markets to limit opportunities for entrants to fill product niches; increases in capacity, perhaps as a way to credibly threaten price reductions after entry; and advertising to build consumer loyalty to branded products.

The costs of advertising can dictate the structure of a market.37 He observes that in many consumer products markets, there appear to be a small number of firms with recognizable brands, as well as several fringe “off-brand” competitors. The firms that advertise heavily attract customers who prefer to sample branded products while the fringe firms split the remainder of the market. The substantial sunk costs of creating a brand dictate the market structure. Entrants face the choice of duplicating the sunk advertising costs and splitting the branded market, or avoiding advertising costs and sharing the unbranded market. If sunk advertising costs are large relative to the market size, the number of branded firms will be limited, and entrants will be restricted to the unbranded segment.

Thomas also mentions the idea of “judo economics.” Small entrants may not attract the interest of incumbents. It may even be in the interest of entrants to try to commit to remaining small.

Thomas finds few empirical studies of entry deterrence. Entrants report in surveys that they rarely perceive responses by incumbents. There is some observational evidence that incumbents do occasionally add capacity or advertise more heavily after entry. Thomas’ own empirical research focuses on breakfast cereals. He divides the data into different category segments (e.g., bran cereals.) He finds that incumbent firms in a segment tend to increase prices after entry into their segment by other incumbents, but reduce prices after entry by newcomers. Conversely, incumbents seem to increase advertising after entry by newcomers, but they do increase advertising when an established firm enters their segment.

b. Simon

Simon’s discussion of the theoretical literature on entry deterrence largely covers the same ground as Thomas. Simon does make the critical observation that responses to entry may depend on the characteristics of the incumbent. This is the main theme of his empirical work. He posits that an incumbent’s age, corporate scope, and market structure all predict the incumbent’s response. Established firms are protected by reputations and their customers are less price sensitive. Thus, established firms are less likely to cut prices than younger incumbents. Firms that operate in multiple markets can extend a “reputation for toughness” across product lines and therefore benefit more from price cutting. Finally, firms in relatively unconcentrated markets may be reluctant to take the lead in price cutting.

Simon extends Thomas’ review of the prior empirical literature. He finds fairly consistent evidence that incumbents reduce prices in the face of entry. Airlines cut prices in response to entry, especially entry by low cost carriers. Supermarkets cut prices in response to entry by warehouse clubs; tire retailers cut price in response to entry; some auto makers cut prices. Drug companies, in contrast, often do not cut prices in response to entry, preferring instead to increase prices and target a price insensitive niche. Overall, Simon’s research does suggest a pattern of price cutting by incumbents. It is particularly noteworthy that we see price cutting in airlines and supermarkets, as airlines traditionally have low returns on investment and supermarkets traditionally have low returns on sales. Even so, incumbents are willing to sacrifice short term profits to combat entry.

Simon’s studies responses to entry in magazines. He finds that older incumbents cut prices by 1-4 percent after entry while newer incumbents cut prices by 12 percent. Multimarket contact increases price cutting by 0.7 percent per “market”; The effect is present for new entrants but not for diversifying entrants. Finally, concentration does not, by itself, seem to matter.

Taken as a whole, the literature suggests that incumbents often cut prices after entry and may increase advertising after entry by new firms. However, incumbents in the LTCI market have several characteristics that might temper price cutting in response to CLASS entry. First, they are old and have long established reputations. Second, they are not very diversified and do not face the threat of entry in their core market of life insurance. Incumbent LTCI firms may increase advertising after CLASS entry. There is already some mention of encouraging sales agents to make negative comments about CLASS insurance.

Despite the theory and evidence of price cutting, it is not clear that LTCI sellers would also reduce prices to combat CLASS entry, for five reasons.

  1. The market is already fairly competitive; there may not be much room for further price reductions.

  2. State underwriting requirements require prices be set to cover expected future costs.

  3. Price cutting is not likely to drive HHS from the market.

  4. There is no further deterrence effect from price cutting, since other entry barriers remain high.

  5. CLTCI is likely to expand enrollment rather than draw business away from established sellers.

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