JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.. The Econometric Society is collaborating with JSTOR to digitize, preserve and extend access to Econometrica.A model is constructed in which a potential entrant uses prices to make inferences about industry conditions. Stochastic demand shocks occur after the incumbent firm's action, so that prices reveal only statistical information about the incumbent's private information. The equilibrium differs from standard signalling equilibria in that it can be unique, it depends on prior beliefs, and it is rich in comparative statics. Conditions are obtained for entry threats to result in limit pricing, lower entry probabilities, and lower expected profits for potential entrants.
INTRODUCTION AND BACKGROUNDECONOMISTS HAVE LONG BELIEVED that the price level in an industry influences firms contemplating entry. This belief is justified on the basis that current prices convey information about post-entry profitability to potential entrants. However, it has been difficult to describe logically how such information is embodied in prices.The limit pricing literature separates roughly into two strands, depending upon which of two determinants of post-entry profit prices are assumed to indicate. Both determinants of post-entry profitability were alluded to in a seminal paper by Joe S. Bain: "Even if [the potential entrant] does not believe the observed price will remain there for him to exploit, he may nevertheless regard this price as an indicator both of the character of industy demand and of the probable character of rival policy after his entry." [1, p. 453].In early models, current prices indicate "the probable character of rival policy" that would be adopted by established firms if entry occurred. For example, the established firm in the models of [1, 2, 12, 23] threatens to maintain the output consistent with the current price. A potential entrant who believes this threat may therefore be deterred by a low price (high output). But output maintenance is not a believable threat, since it is not in the best interest of the established firm once entry actually occurs. Consequently, output maintenance cannot be sustained in a perfect Nash equilibrium (Selten [18, 19]) involving a rational potential entrant.It is not necessary to address the credibility problem in order to study the effects of threatened entry on industry behavior. Consequently, it is simply postulated that entry is deterred by low prices in many studies of the effects of entry [7, 8, 9, 13]. More recently, e.g., in [4, 5, 16, 17, 21, 23], it has been shown 'Support for this research from NSF Grant SES-8107103 is gratefully acknowledged. 2Support for this research from NSF grants SOC-7905900 and SES-8106207 is gratefully acknowle...
