MBS Professor Dr. habil. Florian Bartholomae joint with Univ.-Prof. Dr. Karl Morasch from the Bundeswehr University, and Diplom-Volkswirtin Rita Orsolya Seebode from Gallup published an article in “Managerial and Decision Economics”, a highly ranked academic journal that publishes articles applying economic reasoning to managerial decision-making and management strategy.
In this article, the authors analyze methods for entering a market with switching costs that is initially served by a monopolistic incumbent. Prominent examples are retail markets for electricity and natural gas. They find that an offer to undercut the incumbent by a fixed margin dominates traditional entry with a binding price offer. This is because undercutting by a fixed margin restrains the ability of the incumbent to block entry by limit pricing – this is a typical strategy of monopolists to maintain their predominance in the market. The authors also consider adding a price ceiling to ensure customers against future price increases. This combined strategy turns out to be optimal when entering markets with elastic demand, i.e., the demand reacts to price changes, as long as cost uncertainty is not an issue.
For this, the authors analyze two market entry strategies: fixed margin price undercutting with and without price ceiling. In a rather simplified setting where all consumers have equal valuations and switching costs, they show that traditional price competition yields prices that equal marginal costs plus switching costs as markup resulting in no entry (limit pricing by the monopolist). However, under fixed margin price undercutting, the entrant will set the margin slightly higher than the switching costs and, as the incumbent cannot gain by reducing its price, all consumers will switch (the price is the monopoly price less the switching costs).
Finally, the authors extend the analysis to more realistic scenarios with elastic demand. They show that the incumbent may raise its price in the second period above the monopoly level in order to make switching less profitable. Fixed margin price undercutting by the entrant is then definitely anti-competitive.
With this article, the authors can show firstly how important it is to find the right entry strategy for each market and, secondly, under which conditions society benefits, or does not benefit from (supposedly) more competition.