Will Espn Practice Strategic Entry Deterrence?

Lynne Kiesling

This observation on the NHL broadcast contract negotiations from The NHL is Back highlights an important economic concept:

ESPN is seriously considering matching Comcast’s offer for the NHL. It’s not so much that ESPN wants hockey back as they want to keep a potential competitor from getting off the ground. The figure was supposed to be $100 million over two years, but the Buffalo News is reporting it has been raised to $135 million. This is the only place I’ve seen this figure so take it with a grain of salt.

This CNN Money column provides additional analysis:

More sports networks would mean more bidders for their broadcast rights, and more money for team owners.

Others, including Time Warner (CNN/SI) have taken on ESPN only to fail spectacularly. But while the costs of taking on ESPN are substantial, the payoff from a successful effort could be huge.

ESPN and Fox Sports Net, the collection of regional sports networks from Fox, are the two networks that see by far the greatest per-subscriber fee from cable operators. And ESPN has become the key profit driver for Walt Disney Co.

“People used to ask if there was enough sports to support one all sports network. Now ESPN has three. They questioned if could have an all-news station. Now you have CNN, Fox News and MSNBC,” said John Mansell, senior analyst with Kagan Research. “The only question is whether or not ESPN is willing to pay what is likely to be a substantial premium to keep a new entrant from entering the fold, or whether a new entrant will pay that premium to get in the game.”

In economics this phenomenon is known as strategic entry deterrence, and there’s a substantial literature devoted to analyzing it. In a 1979 paper in the American Economic Review Papers & Proceedings, Stephen Salop noted that

[b]y making binding committments and communicating them during the preentry period, a strategically minded established firm is able to exploit its leadership role. If the committments imply negative profits to the entrant in the postentry game, then entry will be successfully deterred.

Salop then goes on to look at models of entry deterrence with the assumption of costless, perfect information. This is easy for the incumbent, because it can observe the cost function of the entrant, and thus can price just low enough that the entrant wouldn’t profit from entry. He then moves on to discuss the use of limit pricing in the case of imperfect information. In this case, the incumbent has an incentive to price lower than they otherwise would to reduce the apparent profit to entry, and this would lead the potential entrant to form expectations that the incumbent’s costs are low.

Paul Milgrom and John Roberts expand on this theme in two seminal 1982 articles, one in Econometrica on limit pricing and one in Journal of Economic Theory on using predation and reputation formation in entry deterrence. In their limit pricing article Milgrom and Roberts show that limit pricing arises due to incomplete information, and that it would not happen in a full-information equilibrium. However, they also show that with limit pricing, the probability of entry varies depending on whether or not the limit price chosen “fools” the entrant. In their model it’s possible that the incumbent limit prices, the entrant does not believe that the price signals that the incumbent’s cost is lower than theirs, and the entrant chooses to enter. Thus you can get a range of possible social benefit outcomes, depending on the response of the entrant.

Do these models tell us anything useful in the NHL/OLN/ESPN context? I have a few thoughts. The fact pattern isn’t exactly analogous, because here we are looking at a bilateral monopoly (NHL and ESPN), and wondering whether or not OLN will enter on the demand side, thereby reducing ESPN’s monopsony (not monopoly) power. So since the entry deterrence is on the demand side, we have to flip the logic: if ESPN practices limit pricing, they want to bid high enough that they deter OLN from entering, but not so high that their bid exceeds their expected value from the contract.

Using the Salop/Milgrom/Roberts logic, that higher bid would signal to OLN that ESPN has a higher value than OLN does, and if successful would deter OLN’s entry. But the Milgrom & Roberts model also suggests that, although OLN cannot observe ESPN’s true value, if OLN does not believe that ESPN’s bid reflects their true value, they might go ahead and enter anyway. A successful bid that’s high enough to deter OLN’s entry may be higher than ESPN is willing to go.

ESPN’s monopsony power has thus far enabled them to pay lower bids, but they can also claim that hockey is not profit maximizing for them. Last season, when they showed college basketball instead of NHL, their ratings increased substantially. I think this fact limits the credibility of limit-pricing style bids, because they can’t credibly claim that their value of the rights is that high.

So I think ESPN is in a tricky position. They have the monopsony position, they have the resources, but if they bid too high to deter OLN they might end up with a winner’s curse instead of a profitable NHL deal. If ESPN was really interested in entry deterrence, would they have decided not to exercise their monopsony option in the first place? Or is it likely that ESPN decided not to exercise their right based on their assessment of the probability that OLN would enter, and they guessed wrong?

In any case, thinking about entry deterrence and limit pricing models sharpens the analysis.