FormalPara Definition

Potential competition for incumbent firms in an industry alters market outcomes before or without actual entry. The economic concept of potential competition is narrower than the mere possibility of entry by new firms. If there is no pre-entry effect, there is no potential competition, and only post-entry or actual competition occurs, if any at all.

Competition is consequential interaction among firms. Possible new firms in an industry may provide competition for incumbent firms before or without their actual entry. Alternately, possible new firms may have no pre-entry effect. Only the former case is potential competition.

Potential competition has been an analytical tool for industrial organization economics. This approach offers an explanation for the differential performance of firms and industries through analysis of market structure. Formally, incumbent firms exploit structural features of industries to earn above-normal profits. In particular, incumbents strategically deter entry of new firms, and entry deterrence has been the focal preentry effect studied with analysis of potential competition. Note that the immediate details of potential competition are in service of the larger agenda of understanding patterns of firm performance.

Incumbent Commitment and Potential Competition

The modern theory of industrial organization economics identifies credible commitment by incumbent firms as the mechanism linking possible new firms and pre-entry effect (Tirole 1988: ch. 8; Gilbert 1989). If an incumbent firm can undertake pre-entry action with irreversible post-entry impact, then potential competitors may reduce their scale of entry or be deterred from entry altogether.

Spence (1977) examines capacity expansion as a commitment mechanism. By increasing durable preentry capacity, incumbent firms lower future cost and price. If the future price is sufficiently low, entry is discouraged. The irreversible nature of incumbent action is central to any effect of potential competition. If the incumbent firm can resell the excess capacity and fully recover that investment after entry, then it is no longer credible that the incumbent will maintain this higher level of capacity and lower prices should entry occur.

Fudenberg and Tirole (2000) examine the customer base of a product with network externalities (as occurs with computer operating systems). The incumbent firm sets a low current price, expanding its current and future customer base.

Empirical Evidence for Potential Competition

The most prominent evidence for the existence and nature of potential competition is provided by the US airline, pharmaceutical and computer software industries. Peteraf (1995) examines domestic US city-pairs, with airlines serving one of these cities but not the city-pair itself. Potential entry by a traditional airline into a city-pair unexpectedly increases prices, while that by a newer low-cost firm lowers prices. Goolsbee and Syverson (2008) confirm the latter finding, examining potential entry by low-cost Southwest Airlines into city-pair markets. They find large impacts of both potential and actual competition from Southwest, with over half the impact of actual competition realized before entry. They identify building customer loyalty through lower prices as the method of incumbent commitment.

Grabowski and Vernon (1992) examine the impending entry of US generic drugs before patents on incumbent drugs expire. They find, unexpectedly, that potential competition increases incumbent prices, as the incumbent segments the market into price-sensitive and price-insensitive components. The former will be conceded to entrants with patent expiry. Ellison and Ellison (2011) also find that prices rise with potential competition. They further find that incumbent prices continue rising in markets where actual entry is limited, though they fall in markets with significant actual entry. Again, demand-side mechanisms drive pre-entry actions by market incumbents.

Hall et al. (2003) estimate that potential entry forces Microsoft to price operating system software (Windows) and productivity software (Office) at 40 % of the pure monopoly price with no entry. The commitment mechanism is again on the demand side, with consumer switching costs and network externalities. The lower price limits the customer base for potential competitors, successfully deterring their entry.

This evidence validates the basic concept of potential competition and the underlying mechanism of commitment. However, these empirical effects are often in a different direction from those predicted by canonical models, in particular because consumer demand is more complicated in practice than in the original theory.

Practical Limits for the Concept of Potential Competition

Analytical models highlight one mechanism at the expense of others. Models of potential competition focus on rivalrous interactions among homogenous firms/customers with static technology/market definition. The concept of potential competition sits uneasily in modern strategic management, where analyses focus instead on heterogeneous firms and dynamic competition.

The decades that have seen formalization of the theory and demonstration of empirical effect for potential competition have also seen increases in differences among firms and increases in the pace of innovation. These immediate gains for the concept are thus offset in part by a changed environment that reduces the range of economic activity explained by it.

For example, the US airline industry shows steady decline in inflation-adjusted average fares, emergence and success of two distinct business models (hub/spoke network and point-to-point), large financial losses for most firms, and significant process technology innovations based on outsourcing, labour relations and information technology (Borenstein and Rose 2013). Even though this industry provides perhaps the strongest evidence for potential competition, strategic entry deterrence of potential competition explains an arguably very small part of the actual evolution of this industry and the performance of firms therein.

See Also