Lecture 3 - Entry Flashcards
Traditional approach to the analysis of industry structure
The smaller the number of firms operating in the market, the more likely it is that competition will be restricted
- So barriers to entry contribute to profitability in such markets
What are barriers to entry
- Market conditions that allow established firms or incumbents to earn abnormal profits without attracting entry (Bain, 1956)
- Competitive advantage that established firms have over potential entrants (Spulber, 2003)
- Government based restrictions on entry (Demsetz, 1982)
What are barriers to exit
Sunk costs - It is costly to exit of production requires sunk cost investment expenditures
- Barriers to exit affect the decision to enter the industry in the first place
What are sunk costs
They’re costs that cannot be recovered if the firm subsequently decides to close down or exit (for example investment on capital equipment)
What will happen if price is greater than marginal cost (P>MC) in perfect competition
- P>MC means abnormal profits, more firms will be attracted in the market (no entry barriers), abnormal profits competed away, Entry will cease (no exit barriers), long run equilibrium
- Normal profits and allocative efficiency
Types/sources of barriers to entry
The two types of barriers
Structural / Exogenous barriers
Strategic barriers
Examples of structural / exogenous barriers
- Economies of scale
- Absolute cost advantage
- Product differentiation
- Switching Costs
- Network externalities
- Geographic
Examples of strategic barriers
- Pricing strategies (limit pricing, predatory pricing)
- Product differentiation
- Brand proliferation
- Loyalty discounts
Economies of scale can act as barriers to entry in two ways
- If the Minimum Efficient Scale (MES) is large relative to the total size of the market (firms are large in relation to the market to be efficient; natural monopolies
- When The AC at production level below MES are substantially greater than the AC at the MES
what is Absolute cost advantage
How is it possible?
An incumbent has an absolute cost advantage over an entrant (LRAC is Cheaper than the entrants)
- Can be Because incumbent has access to superior production process
- Incumbent has experienced labour, best raw materials
- Incumbent has access to cheaper sources of finance (less risky than new firms)
How can a new entrant persuade customers to switch from their existing suppliers
Lowering price it will charge
Launching advertising campaigns
What are switching costs
Costs incurred when a consumer faces additional costs when deciding to change the supplier of a product/service (search costs, Learning costs, installation/disconnection charges)
- Users become locked in to an existing supplier
What are network externalities
They arise when the value of a product or service to a consumer depends upon the number of other consumers using the same product or service
- Users get extra gain when the size of the network of users increases
- Would be difficult for a entrant if Incumbent has already established a large user network (Microsoft Office)
What are Legal barriers to entry
This type of barriers are erected by governments and enforced by law
Examples:
- Certification and licensing (airline industry)
- Monopoly rights (Natural monopolies)
- Patents and exclusive rights
- Government policies (tariffs taxation, employment laws)
Chicago and Austrian schools of thought consider this highly damaging to competition
What are geographic barriers to entry
Restrictions faced by foreign firms attempting to trade in the domestic market
Examples
- Language
- Technical, fiscal, physical barriers
Are structural barriers stable?
Structural, I.e. stable and long term
- An important structural condition of market structure
- However doesn’t imply they should be regarded as permanent - Technical change can affect economies of scale
Chicago school of thought view on are structural barriers stable?
Focus not on the existence of entry barriers but on how quickly they can be surmounted
- Firm with High absolute cost disadvantage or scale economies compared with a firm faced with lower barriers will take longer time to organise its resources efficiently to ensure profitable entry
What is limit pricing (strategic barrier)
Incumbent attempt to prevent entry by charging a price, known as the limit price, defined as the highest price the incumbent believes it can charge without inviting entry
- Limit price is below monopoly price but above the incumbents average cost
-Incumbent earns abnormal profit - To pursue a limit pricing strategy Incumbent must enjoy cost advantage over potential entrants
- Ensures Entry is unprofitable
What is predatory pricing (strategic barrier)
Prices set by incumbents below AVC
- Incumbent May forgo short run profits to reduce profitability of entrants or existing competitors
- Higher market power and profits in the long run
-
How can Product differentiation be a barrier to entry
Different from competitors
Strengthen brand loyalties alongside advertising
What’s brand proliferation
Efforts by an incumbent firm to crowd the market with similar brands, denying an entrant the opportunity to establish a distinctive identity for its own brand
- Common In processed foods and detergent markets
- Incumbent firm May also raise its own average costs relative to those of an entrant
Where is Entry high
Where is Entry slow
Where is exit high
Entry is high in profitable industries / high average growth rates
Entry is slower for industries where the incumbent holds absolute cost advantage or capital requirements are substantial
Exit is higher for industries where profits are low and sunk costs insignificant
