MARKETING SCIENCE /Vol. 17, No. 4, 1998 pp. 380–405 0732-2399/98/1704/0380$05.00 Copyright  1998, Institute for Operations Research and the Management Sciences Response to Competitive Entry: A Rationale for Delayed Defensive Reaction Ajay Kalra • Surendra Rajiv • Kannan Srinivasan Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213-3890 Graduate School of Business, University of Chicago, Chicago, Illinois 60637 Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213-3890 kannans@andrew.cmu.edu Abstract Empirical studies examining responses to new product en- tries come to the puzzling conclusion that, in general, an in- cumbent reacts to a new entrant after a significant delay. Even easy-to-implement price cuts are observed after signifi- cant lag following entry. These findings seem to contradict the existing literature that either implicitly assumes or strongly advocates immediate defensive responses to limit competitive encroachment. When a competing firm enters the market, consumers may be uncertain about the entering firm’s product quality. The incumbent firm (through rigor- ous tests) may fully know the entrant’s quality. Suppose the incumbent aggressively lowers price. This may cause the consumers to wonder if indeed the entrant’s quality is high. In other words, an incumbent’s reaction may cause the con- sumers to make inferences about the entrant’s quality. Such strategic implications of the incumbent’s reactions have to be carefully analyzed before determining the optimal response by the incumbent. In this paper, we propose a conceptual framework for un- derstanding differences in the magnitude and timing of in- cumbents’ responses to competitive entries. We consider a model in which a monopolist incumbent firm faces compet- itive entry. The incumbent firm knows the true quality of the entrant with certainty. Although consumers are aware of the incumbent’s product quality through their prior experience, they are initially uncertain of the entrant’s product quality. In such a situation, a high-quality entrant has the incentive to signal her true quality through her strategic price choice. However, the uncertainty about the entrant’s quality is fa- vorable to the incumbent in the sense that consumers believe with a high probability that the entrant’s quality is low. As a result, the strategic incentives facing the incumbent and the entrant oppose each other. While the entrant wants to signal her high quality, the incumbent wants to prevent her from doing so. We demonstrate that one way the incumbent can prevent the quality signaling is to select a higher than his optimal competitive (duopoly) price. In other words, the in- cumbent can prevent or “jam” the entrant’s quality signaling by choosing a price higher than his optimal competitive price when consumers are fully informed about the entrant’s true quality. Though the signal-jamming price is lower than the monopoly price, the price is substantially higher than the competitive price. This marginal reduction in the incum- bent’s price from the pre-entry monopolistic price represents a muted or lack of response by the incumbent to the com- petitive entry. However, once the entrant’s quality gets re- vealed in subsequent periods through consumer usage and word of mouth, the entrant has no incentive to engage in quality signaling and the incumbent has no incentive to jam it. Therefore, the market reverts to the complete-information competitive prices, and the incumbent lowers his price con- siderably. This temporal pattern of muted price reduction in the first period followed by a sharp price reduction in the second period corresponds to a delayed defensive reaction in our model. Although the empirical studies suggest that the delayed reaction may arise due to factors such as man- agerial inertia or indecision, we demonstrate that such a be- havior is indeed an optimal strategy for a profit-maximizing firm. Thus, our model reconciles empirical results with the equilibrium outcome of a strategic analytical framework. Furthermore, in an experimental setting, we test the pre- dictive power of our framework and establish that consum- ers indeed form conjectures about the entrant’s quality based on the incumbent’s reactions. In the first experimental study, we find strong support for the notion that the incumbent’s price reaction may indicate entrant’s quality. In a follow-up study, we observe that whenever the incumbent lowers prices, respondents judge the quality of the entrant to be higher as compared to the case when prices are the same or increased. The managerial implication of this paper is that well-established incumbent firms should be cautious in the implementation of their defensive responses to product in- troductions of uncertain quality by competitors. Of particular concern are situations where the reactions are easily observ- able by consumers. A strong reaction may suggest that the incumbent takes the competitive threat seriously, leading consumers to believe in the quality of the competitor’s product. (New Product Entry; Defensive Reaction; Quality Signaling; Price-Quality Relationship; Signal Jamming; Asymmetric Information)