How does game theory analyze strategic entry deterrence?

Game theory analyzes strategic entry deterrence by examining the strategic interactions between existing firms and potential entrants in a market. Strategic entry deterrence refers to the actions taken by incumbent firms to discourage or prevent new firms from entering the market.

In game theory, this situation is typically modeled as a sequential game, where the incumbent firm moves first and the potential entrant moves second. The game is analyzed using the concept of a subgame perfect Nash equilibrium, which represents the optimal strategy for each player given the strategies chosen by the other players.

The incumbent firm has several strategies to deter entry, including limit pricing, predatory pricing, and strategic capacity expansion. Limit pricing involves setting a low price to make it unprofitable for potential entrants to enter the market. Predatory pricing involves temporarily lowering prices to drive potential entrants out of the market. Strategic capacity expansion involves increasing production capacity to signal to potential entrants that the market is already saturated.

The potential entrant, on the other hand, must decide whether to enter the market despite the deterrent actions of the incumbent firm. The potential entrant considers factors such as the profitability of entering the market, the likelihood of success, and the potential retaliation from the incumbent firm.

Game theory provides a framework to analyze these strategic interactions and determine the equilibrium outcome. The analysis helps to understand the incentives and strategies of both the incumbent firm and the potential entrant, and how these strategies may affect market outcomes such as entry, pricing, and profitability.

Overall, game theory provides a valuable tool for analyzing strategic entry deterrence and understanding the dynamics of competition in markets.