L7+8 - Barriers to entry Flashcards
What are the 3 classic entry barriers?
Economies of scale, absolute cost advantage and product differentiation
What are the 5 strategic entry barriers?
Switching costs, network externalities and brand profileration, limit pricing and predatory pricing
What are 3 other entry barriers?
Patents, geography, legal environment
How can barriers to entry be defined?
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
How does the Chicago school perceive entry barriers?
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
How can economies of scale be an entry barrier?
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
What options do entrants have if there are economies of scale in the industry?
Entrant has 2 options:
- Accepting risk associated with large-scale entry - expansion in industry capacity might disrupt equilibrium, depressing prices and inviting retaliation
- Small-scale entry and absorbing average cost penalty
What is an absolute cost advantage entry barrier?
Absolute cost advantage entry barrier if the LRAC function of the entrant lies above that of the incumbent
When are patents an entry barrier and how can patents be an absolute cost advantage entry barrier?
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)
Name 5 reasons why an incumbent may have an absolute cost advantage (other than patents)
(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)
What is an alternative perspective on absolute cost advantages?
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
How can product differentiation act as an entry barrier?
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.
What are legal barriers to entry? How are they perceived by the Austrian and the Chicago School?
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
What are geographic entry barriers?
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
How can switching costs be an entry barrier?
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
How can network externalities be an entry barrier?
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
How can brand proliferation be an entry barrier?
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.
How can incumbents defer entry using limit pricing? And does it violate the competition act?
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
What are the assumptions of limit pricing?
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
How does limit pricing work if the incumbent has an absolute cost advantage?
(Threat of small-scale entry, many small potential entrants)
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
How does limit pricing work if the incumbent has economies of scale? (Threat of large scale entry, potentially only one big competitor)
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
What are 6 critique points of limit pricing?
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
What is predatory pricing?
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
How is predatory pricing looked upon by the DCA?
§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 […]
