IUE e-chapter 4: applying the general sequence model to industries with significant sunk costs

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This chapter applies the general sequence model developed in Chapter 3 to industries with significant sunk costs – the classic heavy utilities of electricity, gas, water and wastewater. It begins with zero entrants and applies the standard entry conditions for the first and all subsequent entries. Simultaneous entry is regarded as a special case of sequential entry. Dynamic market concepts of reachable and active customers are explained, as well as non-adopters, penetration rate and common carriage. Duopoly is properly distinguished from parallel monopoly, and the prevalence of parallel monopolies, and scarcity of genuine duopolies, convincingly explained. Business strategy models (simple systems models) are built and carefully explained using simplified diagrams; dynamic electronic versions of these models are available online for any reader to try. The importance for any rational Second Mover of not allowing the First Mover in a market of significant sunk costs to “scoop the market” is explained, particularly if consumers incur their own sunk costs; these might seem small compared to an entrant’s own sunk costs, but if the Second Mover can only gain customers by making them switch from Mover One, Mover Two will have to pay thousands of these, as well as its normal costs of gaining an active customer. And that is the analysis before Mover One has decided how to react to Mover Two’s entry (and under all scenarios Mover One will react).

All options for Mover Two to persuade customers to switch are scrutinised, including the obvious ones of differentiation (difficult with a homogenous product) and cutting price. If two players have entered we have a duopoly, rather than a parallel monopoly, and traditional repeated game theory or the familiar mid-game strategies from Business Strategy theory apply. If a Third Mover enters a market with significant sunk costs they must be sure the market will grow strongly and very confident of their own dynamic competitive advantages.  Finally the end-game market structures are revealed in a diagram familiar to experienced economics teachers as the logical outcome of the combination of initial conditions.

This chapter is seminal for most of the succeeding chapters of the book, as it forms the core model of a utility examined more closely in chapters 5, 6, 7 and 8, and in the following chapters where we examine the record of utility restructuring and privatization against the fundamentals of this chapter.

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