Question

Can the threat of a price war deter entry by potential competitors?What actions might a firm take to make threat credible?

Answer 1

Both the incumbent and the potential entrant know that a price war will leave both worse off so normally, such a threat is not credible. Thus, the incumbent must make his or her threat of a price war believable by signaling to the potential entrant that a price war will result if entry occurs. One strategic move is to increase capacity, signaling a lower future price. Even though this decreases current profit because of the additional fixed costs associated with the increased capacity, it can increase future profits by discouraging entry. Another possibility is to develop a reputation for starting price wars. Although the price wars will reduce profits, they may prevent future entry and hence increase future profits.