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EXAMPLE 6.6 WAL-MART ENTERS GERMANY . . . AND EXITS

Having conquered nearly every nook and cranny of U.S. retailing, Wal-Mart in the 1990s looked to expand overseas. By 1998, Wal-Mart had over 500 stores in six foreign countries when it set its sights on Europe. Wal-Mart’s European strategy began in Germany when it purchased the 21-store Wertkauf chain and acquired 74 warehouse Interspar stores from Spars Handels AG. Wal-Mart immediately instituted the policies that had helped make it so successful in the United States, including door greeters, an ever-smiling staff, and the willingness to forgive shoppers who had more than the five-item express check-out limit. Many analysts forecast the inevitable WalMartization of Europe. It was a matter of “when,” not “if.” They could not have been more mistaken. On July 28, 2006, Wal-Mart announced it was closing up shop in Germany, shuttering the 85 remaining Wal-Mart supercenters.

Wal-Mart found entry to be deceptively easy, requiring little more than an (undisclosed) cash payment to Wertkauf and Interspar and the continuing use of their warehouse facilities. Wal-Mart also had little difficulty hiring workers in a German economy suffering from chronic unemployment. All that was left was to change the signs on the stores so as to announce the arrival of the “Big W.”

Success proved more elusive. Wal-Mart was surprised by customer resistance to some of its staple marketing strategies. Germans did not want retail clerks to bag their groceries, were put off by door greeters and smiling staff,

and objected when shoppers abused their express lane “privileges” by having too many items. Wal-Mart struggled just as hard to maintain employee relations. The company’s prohibition against workers flirting with one another met with resentment, and employees mounted a successful legal challenge against Wal-Mart’s telephone hotline used by workers to inform on each other. Workers also refused to work overtime or permit video surveillance. Perhaps most significantly, Wal-Mart was unable to drive down labor costs, paying wages comparable to those paid by the competition.

The competition, mainly from Metro, ultimately proved too tough for Wal-Mart. When Wal-Mart entered Germany, Metro was already operating over 1,000 warehouse-style and mass merchandise stores under a variety of names, and Aldi and Lidl were established powerhouses in the discount grocery sector, each with thousands of stores. With only 95 stores, Wal-Mart could not hope to match the warehousing and distribution capabilities of these rivals. Considering that its warehousing expertise was a key source of competitive advantage in the United States, it was surely short-sighted for Wal-Mart to compete overseas. Indeed, Metro immediately responded to Wal-Mart’s entry by launching a price war. At a disadvantage in customer relations, employee relations, and distribution costs, it was only a matter of time—less than 8 years to be exact—before Wal-Mart exited Germany.

Wal-Mart was fortunate to sell its retail stores and cut its losses. The buyer? Metro.

Predation and Capacity Expansion

Predatory pricing will not deter entry if the predator lacks the capacity to meet the increase in customer demand. Disappointed customers will simply turn to the entrant. Excess capacity makes the threat of predation credible. Marvin Lieberman has detailed the conditions under which an incumbent firm can successfully deter entry by holding excess capacity:18

•The incumbent should have a sustainable cost advantage. This gives it an advantage in the event of entry and a subsequent price war.

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•Market demand growth is slow. Otherwise, demand will quickly outstrip capacity.

•The investment in excess capacity must be sunk prior to entry. Otherwise, the entrant might force the incumbent to back off in the event of a price war.

•The potential entrant should not itself be attempting to establish a reputation for toughness.

Strategic Bundling

An incumbent firm that dominates one market can use its power to block entry into related markets through a practice known as strategic bundling. Bundling occurs when a combination of goods or services are sold at a price that is less than what it would cost to buy the same items separately. Examples abound:

•McDonald’s Happy Meals bundle sandwiches, French fries, and soft drinks.

•Vacation packages bundle transportation and lodging.

•Netflix bundles DVD rentals with Internet streaming.

Firms often bundle goods or services for convenience or marketing purposes. Shoe vendors could sell lefts and rights separately but nearly all consumers would rather buy the bundle. Bundling can also help sellers extract higher profits when consumers have imperfectly correlated preferences for related goods. For example, cable television services usually offer a wide range of programming, including channels that specialize in sports, food, drama, and news. Cable services could allow their customers to purchase channels “a la carte,” sports fans could purchase just the sports channels, and so forth. But cable services instead set a single bundled price that is not too much more than individual a la carte prices. (For example, the price for the “sports 1 food 1 drama 1 news” bundle is not much more than the price the service would charge for the sports package alone.) Since the cable service has essentially zero marginal cost of selling the bundle, this practice helps increase its profits.

In some cases, bundling can be used strategically to deter entry. An incumbent may consider strategic bundling if it is a monopoly in one market but is threatened in a second market. Strategic bundling works by giving consumers little choice but to buy the entire bundle from the incumbent rather than buy the monopolized good from the incumbent and the second good from competing firms.

To illustrate strategic bundling, consider a manufacturer of office supplies that is a monopoly seller of both sticky note paper and plain note paper. The firm’s customers are office supply retailers that purchase note paper by the box. The manufacturer currently charges $30 for a box of sticky note paper and $10 for a box of plain note paper. These are highly profitable prices, as marginal costs are $15 and $5, respectively. The manufacturer currently sells about 1 million boxes of each type of paper monthly, giving it total monthly profits of $20 million.

Several firms are considering entering the plain note paper market. (The technology for sticky note paper is protected by patent.) Should entry occur, prices in this segment would likely drop to $7.50 per box, which is just enough to cover the longrun average costs of an efficient entrant. In addition to experiencing this sharp price decline, the incumbent would also see its share of the plain paper market shrink, and its total monthly profits would fall to $15.5 million.

After crunching some numbers, the manufacturer announces the following pricing strategy to its retailers: continue to pay existing a la carte prices or buy a bundle

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consisting of one box of sticky and one box of plain note paper for $37. Here is why the manufacturer is confident that this will deter entry: the manufacturer knows that the price of plain note paper will not drop below $7.50. Thus, any retailer wishing to purchase note paper a la carte will have to pay $37.50, which is more than the $37 price of the bundle. Entrants can perform this calculation too and realize that they have no chance of making money selling plain note paper, so they stay out. Having deterred entry, the manufacturer enjoys monthly profits of $17.5 million, which exceeds the $15.5 million in profits it would have made had it not bundled the note papers and allowed entry to occur.

The U.S. Antitrust Modernization Commission recently proposed a test of whether bundled prices are anticompetitive and therefore violated antitrust laws against illegal monopolization.19 Here are the steps in the test:

•Compute the amount of the discount afforded by the bundle. In this example, the discount is $3.

•Apply the discount to the nonmonopolized, or “bundled” good. The idea is that the firm need not discount a product it monopolizes, so the purpose of the discount is to distort competition for the bundled good. In this example, we subtract $3 from $10 to get an “effective price” of plain note paper of $7.

•Assess whether the “effective price” is less than the cost of efficiently producing the bundled good. If the effective price is below the cost, then the manufacturer of the monopolized good cannot be making any money from the bundled good, unless the purpose of the bundle is to deter entry. In our example, the effective price of $7 is below the cost of efficiently producing a box of note paper, which is $7.50.

In 2007, a version of this test was implemented by a U.S. federal court in a case involving hospital services sold by the PeaceHealth system. The test is sometimes called the PeaceHealth test.

“Judo Economics”

We have argued that an incumbent firm can use its size and reputation to put smaller rivals at a disadvantage. Sometimes, however, smaller firms and potential entrants can use the incumbent’s size to their own advantage. This is known as “judo economics.”20 We have already given one theoretical rationale for judo economics—the revenue destruction effect. When an incumbent slashes prices to drive an entrant from the market, it stands to lose more revenue than its smaller rivals.

Incumbents may also be hamstrung by their own sunk costs. The rise of Netflix offers a prime example. At the turn of the twenty-first century, Blockbuster Video was the 800-pound gorilla in the video rental business. Its brick and mortar stores were stocked with vast inventories of new releases and classic films on video. Blockbuster enjoyed inventory economies of scale and purchasing economies that no one could touch. The release of movies on DVD posed a big threat to Blockbuster. DVDs retailed at a price point that minimized Blockbuster’s purchasing advantage. And DVDs were much smaller, lighter, and more durable than video tapes, which made them inexpensive to ship through the mail. It should have come as no surprise when Netflix launched its DVD rent-by-mail business in 1997 (the same year that the DVD was introduced).

Blockbuster could have matched Netflix’s business model, and with its purchasing clout it might have driven Netflix from the market. But in doing so, Blockbuster would have cannibalized its bricks and mortar operations, while hastening the devaluation of