L7+8 - Barriers to entry

Question 1

What are the 3 classic entry barriers?

Answer 1

Economies of scale, absolute cost advantage and product differentiation

Question 2

What are the 5 strategic entry barriers?

Answer 2

Switching costs, network externalities and brand profileration, limit pricing and predatory pricing

Question 3

What are 3 other entry barriers?

Answer 3

Patents, geography, legal environment

Question 4

How can barriers to entry be defined?

Answer 4

Barriers to entry: conditions that allow established firms or incumbents to earn abnormal profits without attracting entry

Or: a cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry

Any competitive advantage established firms have over potential entering competitors

Question 5

How does the Chicago school perceive entry barriers?

Answer 5

Chicago-school opposes: cost differentials above rarely last in the long run -> not entry barriers per se important BUT the speed at which barriers can be overcome

Question 6

How can economies of scale be an entry barrier?

Answer 6

1: If MES is very large relative to total market output, firm has to get a big market
share in order to be able to produce at MES - most extreme case when LRAC is always decreasing for all possible output sizes: natural monopoly

2: When average costs associated with a production level below MES are substantially greater than average costs at MES i.e. large penalty for entering but only producing at e.g. 50% of MES

Question 7

What options do entrants have if there are economies of scale in the industry?

Answer 7

Entrant has 2 options:

1. Accepting risk associated with large-scale entry - expansion in industry capacity might disrupt equilibrium, depressing prices and inviting retaliation
2. Small-scale entry and absorbing average cost penalty

Question 8

What is an absolute cost advantage entry barrier?

Answer 8

Absolute cost advantage entry barrier if the LRAC function of the entrant lies above that of the incumbent

Question 9

When are patents an entry barrier and how can patents be an absolute cost advantage entry barrier?

Answer 9

When low demand and asymmetric information: patents defer entry

When high demand: patents do not defer entry

Process patenting - patenting everything you can - Performing a pre-emptive patent strategy - publication of knowledge (which you do not even need) to harm its competitors’ patent opportunities (known knowledge cannot be patented)

Question 10

Name 5 reasons why an incumbent may have an absolute cost advantage (other than patents)

Answer 10

(2) Incumbent firms may have exclusive ownership of factor inputs (e.g. best raw materials, most qualified labour)
(3) Incumbents may have access to cheaper sources of finance (might be viewed as less risky) - If it is impossible to borrow or raise other external funds for new firms, even if willing to pay higher risk premia we speak about capital market entry barriers
(4) If incumbents vertically integrated, if may force entrant to operate at more than one stage of production
(5) Experience in the market/ experience with production - cumulative effect
(6) Unique, rare, value-generating and not replicable resources - maybe due to path dependency in reaching lower costs - sustained ? (sustainable competitive advantage)

Question 11

What is an alternative perspective on absolute cost advantages?

Answer 11

Sometimes they work in favour of entrant: might be spared the cost of convincing consumers to accept a new idea/product

The existence of the current cost advantages do not necessarily represent the permanent benefits (remember Chicago school argument)

Could be very expensive to acquire absolute cost advantages. Especially if the technological development is fast

First mover advantage might be a disadvantage - everyone else can learn from you

Question 12

How can product differentiation act as an entry barrier?

Answer 12

High sunk costs for new businesses - e.g. high advertising imposes additional costs on entrants (absolute cost advantage entry barrier)

If entry takes place on a small scale, the entrant will not benefit from economies of scale in advertising

The funds needed to finance an advertising campaign may incur a risk premium, as this type of investment is high risk. Furthermore, it creates no tangible assets that can be sold in the event of failure.

Question 13

What are legal barriers to entry? How are they perceived by the Austrian and the Chicago School?

Answer 13

Both the Chicago and Austrian schools view legal barriers as highly damaging to competition.

Registration, certification and licencing of businesses and products (e.g. pharmaceuticals, pubs)

Monopoly rights - the government might allow certain firms exclusive rights to produce certain goods and services for a limited or unlimited period (e.g. franchised monopolies as railways, television). Franchised monopolies often awarded when there is natural monopoly or when firms require guarantee to make heavy investments

Patents

Government policies e.g. tariffs, tax policies, employment laws

Question 14

What are geographic entry barriers?

Answer 14

Restrictions faced by foreign firms attempting to trade in domestic market

Physical barriers (frontier controls), technical barriers (requirements for technical standards, safety regulations), fiscal barriers (exchange controls, tariffs), preferential public procurement policies (government purchasing policies might prefer domestic firms) and language and cultural barriers

Question 15

How can switching costs be an entry barrier?

Answer 15

Users become locked into an existing supplier, supplier acquires ex post market power

Bargain-then-tipoff pricing - offering new customers a low price - works best when locked in customers can be separated from new ones

Question 16

How can network externalities be an entry barrier?

Answer 16

Arise when the value of a product or service depends on the number of others using it

Direct network externalities exist when the network becomes more attractive to new users as the level of adoption increases.

Indirect network externalities arise when increased adoption affects a related market.

Bandwagon effects

Question 17

How can brand proliferation be an entry barrier?

Answer 17

Incumbents may try to strengthen brand loyalties beyond what is natural to raise start-up costs

Flood market products in various flavours, with closely related but distinguished attributes.

Consequence: only small segments of potential new entrants to compete on.

Disadvantage: reduces economies of scale, as the plant will produce many variants. Consequence: cost disadvantage of new entrants is relatively smaller.

Question 18

How can incumbents defer entry using limit pricing? And does it violate the competition act?

Answer 18

Limit price: the highest price the incumbent can charge without inviting entry - below monopoly price but above AC - incumbent earns abnormal profit but not monopoly profit

Does not usually violate the competition act

Question 19

What are the assumptions of limit pricing?

Answer 19

Key assumption of the model: zero conjectural variation assumption - entrants assume incumbent would maintain output at pre-entry level if there is entry

To pursue limit pricing: incumbent must have a cost advantage over potential entrants - either absolute cost advantage or economies of scale entry barrier

There are sunk costs associated with market penetration – (Always an important foundation behind the expected impact of strategic behaviour)

Assume perfect information about the demand curve and the cost curve

Interpretation of these assumptions: the management of the potential entrant can’t ex ante estimate how much the price will fall ex post, i.e.
after entry!

The same applies to existing companies in the market – this is important for determining the correct limit price

Question 20

How does limit pricing work if the incumbent has an absolute cost advantage?
(Threat of small-scale entry, many small potential entrants)

Answer 20

Monopoly price and output of incumbent: (P_M,Q_M) but chooses to operate where P*= the LRAC for the competitive fringe

If they enter the market, industry output will be above the quantity which corresponds to P, which will cause the prices to fall below P - they cannot earn a normal profit.

The incumbent’s position at (P, Q), is sustainable in both the pre-entry and post-entry periods.

Incumbent produces Q, entrants produce Q- Q_M

Question 21

How does limit pricing work if the incumbent has economies of scale? (Threat of large scale entry, potentially only one big competitor)

Answer 21

LRAC is the same for incumbent and entrant

The incumbent can prevent entry by operating at P* and Q*

Residual demand function: demand function when incumbent is producing Q*
The residual demand function lies below LRAC at all output levels. If the entrant produces a low output, it fails to benefit from economies of scale. If the entrant produces a high output, it benefits from economies of scale, but the extra output causes price to drop to a level that is unprofitable. Therefore, the entrant concludes it cannot earn a normal profit at any output level

Question 22

What are 6 critique points of limit pricing?

Answer 22

Why is it more profitable to attempt to restrict all entry rather than retard the rate of entry?

Why should the entrant believe the incumbent would not alter its pricing and output policies if entry takes place?

If an industry is growing, it may be difficult to persuade a potential entrant there is no market

Market structure is ignored - e.g. if applied to oligopoly, all would purse the strategy which would require high level of coordination or collusion

Implies perfect information of market demand function, costs

Ignores status of entrant

Question 23

What is predatory pricing?

Answer 23

PP is a post-entry strategy, which is used to squeeze competitors out of the market by setting its prices lower than average variable costs.

The incumbent adopts the role of predator, sacrificing profit and perhaps sustaining losses in the short run, in order to protect its market power and maintain its ability to earn abnormal profit in the long run.

Cross subsidising

Post-entry strategy, however, an incumbent threatened by possible entry may try to convince potential entrant that it will use predatory pricing if entry takes place

Question 24

How is predatory pricing looked upon by the DCA?

Answer 24

§11.(1) Any abuse by one or more undertakings etc. of a dominant position is prohibited. […]

(3) Abuse as set out in subsection (1) may, for example, consist of
i) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions […]

Question 25

What are 3 responses to predatory pricing?

Answer 25

Convince predator to merge or otherwise share market

Convince customers not to accept price cuts

Reduce output, forcing predator to raise output in order to maintain reduced price. If reduced price is below predator’s AC, the predator’s losses are increased, and they might not be able to sustain the price-cutting strategy for tool long

Question 26

Wha is the Chicago School’s take on predatory pricing?

Answer 26

Sceptical: predator’s gain in long run must exceed losses

Predator has to convince possible entrant they can and will maintain reduced price as long as entrant is in business

Have to be sure entry threat will not return

If entrant and predator have same cost functions, entrant could use predatory pricing

Question 27

What is the idea of signalling commitment? And what is one key assumption?

Answer 27

Key idea: by incurring a sunk investment (sunk cost) the incumbent can credibly signal to the market that in case of entry there will be a price war for sure (and incumbent has an advantage when it comes to price war)

This does not mean that there will be actually a price war: by credibly influencing the expectations of potential entrants, the incumbent can prevent entry

One key assumption: when there is a price war, incumbent can realize economies of scale due to the sunk investment (for example, has
invested in overcapacity, so can adjust output easily with decreasing costs)

Question 28

Why might signalling commitment work?

Answer 28

Key for keeping the entrants out: fighting is the credible strategy by the incumbent only because of the sunk investment. Without the sunk cost, incumbent would always share the market. Without the sunk cost the entrants know that market division is better for the incumbent than a price war

Question 29

What is the difference between a passive and a committed incumbent (signalling commitment)?

Answer 29

Passive incumbent: does not pre-commit to fighting the entrant, i.e. waits to see if entry occurs before incurring extra sunk costs to signal commitment

Committed incumbent: pre-commits

Question 30

What happens if the incumbent is passive (signalling commitment)?

Answer 30

If entrant stays out: incumbent earns monopoly profit and entrant earns nothing

If entrants enter either:

Price war, both earn loss

or accommodate, duopoly profit

Assuming that the duopoly profit is higher than 0, and smaller than or equal to monopoly profit as well as the loss making profit below 0 - the final outcome is thus the duopoly profit

Question 31

What happens if the incumbent is committed (signalling commitment)?

Answer 31

If entrant stays out: monopoly profit reduced by sunk costs C

If entrants enter either:

Price war, both earn loss of

Or accommodate, duopoly profit

Assuming that the sunk costs are higher than zero and higher than the duopoly profit, that the monopoly profit is higher than the sunk costs and that the loss incurred from a price war is larger than duopoly profit minus costs - price war is the final outcome

Question 32

What are the assumptions for the theory of contestable markets?

Answer 32

Industry: small number of incumbent firms or single incumbent whose market power is constrained by potential entry

Despite few incumbents: threat of entry makes them keep prices relatively low and constrains their ability to earn abnormal profits

To be perfectly contestable: no significant entry or exit barriers: theory thus excludes structural entry barriers, entry-deterring strategies and sunk costs

Question 33

What are the assumptions for a hit-and-run entry?

Answer 33

A potential entrant can identify consumers who will purchase its output at or below the current market price.

The entrant has sufficient time to sell to these consumers before the incumbent has time to react.

At the prices quoted, the entrant earns sufficient revenue to cover its fixed and variable costs.

Question 34

What are the critiques of the contestable markets model?

Answer 34

No markets 100% contestable

Exclusion of sunk costs unrealistic (at least for many industries)

It ignores possible strategic price discrimination by the incumbent, which would decisively defeat entry while permitting excess profits’ - as the theory is restricted to a short-run period where the incumbent does not have time to react and there is only one price

Unrealistic entrant does not have cost disadvantage

Most empirical tests reject the theory of contestable markets

Question 35

Why are prices kept close to the competitive level in the contestable market theory?

Answer 35

Even though the incumbents are few in number, and the industry appears to be highly concentrated, the threat of hit-and-run entry keeps prices close to the competitive level. Hence, a large number of competing firms is not a necessary condition for industry price and output to be set at the perfectly competitive level. Threatened competition from potential entrants may be sufficient to produce the same effect.