Unit EC480 Level 2 Selected Topics in Industrial economics By Pauline Dixon. Barriers to entry

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1 Unit EC480 Level 2 Selected Topics in Industrial economics By Pauline Dixon Barriers to entry the advantages of established sellers in an industry over potential entrant sellers, these advantages being reflected in the extent to which established sellers can persistently raise their prices above a competitive level without attracting new firms to enter the industry. Bain (1956) ¹ Dominant Firm, Barriers to Entry and Predatory Pricing The Dominant Firm A dominant firm faces a problem that the monopolist does not: the possibility that a price increase will induce some customers to begin to buy from firms in the fringe of small competitors. The dominant firm, in other words, must take into account the reaction of its fringe competitors. Because dominant firms face fringe competition, we ask not only what a dominant firm does with its position, but also how it acquires that position and how it keeps it. Dominant firm markets are as close as we get in the real world to monopoly. A dominant firm with full information about market demand and industry costs can set prices so that it earns economic profit whilst the passive fringe earns a normal rate of return. How can dominant firms maintain their position? They have two methods of keeping their position, firstly by erecting barriers to entry and secondly by implementing predatory pricing. What do we mean by an entry barrier? Entry barriers may be defined as obstacles that prevent new firms from engaging in the production and sale of products in a market. They may enable existing firms to obtain larger profit margins on their sales than would otherwise be the case. Barriers to entry impede competitive forces and may prevent the attainment of both technical and allocative efficiency. Barriers to entry can be high or low. Bain s definition above is a good starting point as an explanation for entry barriers, but it doesn t capture the diversity of the subject. Different firms face different heights of barrier. A distinction is often made between de novo entrants, that is those who have to make new investments to enter, and firms who are able to enter by modifying existing productive capacity or diversification from a related market. One important factor in assessing the height of the barriers is the time that it takes for new entrants to enter the industry and become effective competitors. There are time periods to consider on both the demand and supply side. On the supply side we need to consider the time it take to build plants and get production going, especially so in the case of de novo entrants. On the demand side the time period may refer to the time it takes for a product to become established. An entry barrier need not mean that entry cannot occur. Firms may be able to enter the market but only on the terms that are favorable for the incumbent(s). Even though entry can take place, it allows the incumbent to maintain prices above the competitive level. For Stigler a barrier to entry was defined as a cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry, but is not borne by firms already in the industry Stigler If the investment needed by the entrant implies high sunk costs then this may be a barrier to entry. Sunk cost is the cost of acquiring an asset, tangible or intangible that cannot be recouped by selling the asset or redeploying it in another market. Sunk costs impede entry because they make the act of exit costly. Sunk 1

2 costs can also affect the behaviour of incumbents. Incumbents can make entry difficult by over investing in assets that involve sunk costs. This alters the entrant s calculations and, by lowering the entrant s prospective profits, makes it less likely that entry will occur in the first place. This is known as strategic entry deterrence. Contestability is the idea that there are no sunk costs. The incumbent firm is constrained by the threat of entry. A perfectly contestable market implies that there are; no sunk costs; the potential entrant suffers no disadvantage in terms of production technology or perceived product quality compared with the incumbent; the entrant can engage in hit and run entry. So to conclude this section and decide what an entry barrier is we may say that the rule of thumb is that anything that yields an advantage to incumbents and makes entry difficult should be considered a barrier to entry when making the assessment of competition. Entry Barriers: To maintain or enhance their position, dominant firms use a variety of tactics and strategies. Barriers can be seen as dykes holding back the sea of competition. (The firm already in the market is an incumbent). Barriers are the conditions that make entry difficult. Bain emphasised four main sources of barriers, which would influence their height. Four further decades of analysis have added many other sources. The list is now at least 22. The sources can be exogenous or endogenous. In the article by Geoffrey Myers (1993) Barriers to Entry, Economics and Business Education, pp , there are six broad categories under which barriers can be placed. 1) Incumbent dominance; 2) Exclusivity; 3) Lack of availability of inputs; 4) Insufficient market size; 5) Brand image; 6) Government regulation. Exogenous: these are innocent or structural barriers. Exogenous sources are embedded in the underlying conditions of the market: the technology, the nature of the product, the need for large-scale capital, and vertical integration. Bain stressed these factors as they are outside the control of the leading firms. They are fundamental causes that cannot be altered. Endogenous: these are strategic or behavioral barriers. Conditions and strategic actions are at the dominant firm s own discretion, done strictly voluntarily. The firm can create barriers simply by electing to take a variety of severe actions against an entrant. These barriers are difficult to specify as they express the willingness and ingenuity of the firm in taking actions to anticipate and/or retaliate against its small rivals and newcomers. The dominant firm can exploit the imperfections within a market and use then against the existing rivals and any possible newcomer. (In the article by Myers, Barriers to Entry there is a list of six broad categories Incumbent dominance, Exclusivity, Lack of availability of inputs, Insufficient market size, Brand image and Government regulation. Each one of these categories is then shown and illustrated by an example. The following is a more extensive list, but learning the examples and types in Myers s article would be of benefit). Thirteen exogenous sources are (innocent or structural): 1. Capital Requirements: The established firm may benefit from cheaper an ample capital as it has greater size and security. This size barrier to entry especially inhibits entry into large, capital intensive industries where minimum efficient scale is large. 2. Scale Economies: If the economies of scale are large, the established firms are likely to have large market shares and be able to inflict sharp penalties on the newcomer. 3. Absolute Cost Advantage: These could arise from patented processes, special access to raw materials and favourable locations. 4. Product Differentiation: This barrier arises from advertising, marketing strategies and other conditions such as an established brand. 5. Sunk Costs: Costs may be impossible to recover upon exit. 2

3 6. Research and Development Intensity: Large R & D spending may be necessary in order to get started in a market, this investment may also be needed to be long term. 7. Asset Specificity: If the assets used by a firm are specifically directed for the use of a single purpose, they may not be able to be adapted to other uses and imply high losses if entry fails. 8. Vertical integration: When an incumbent is vertically integrated the entrant must enter at more than one stage of the process in order to match the existing firms costs. This implies a larger commitment and increases the likely hood of failure. An example would be the brewing industry; i.e. brewers are involved in brewing, wholesale and retail. 9. Diversification by Incumbents: When a firm needs to react in order to prevent entry, if it is diversified it will be able to deploy its resources where needed. These resources would include funds, marketing staff, advertising resources and R&D. 10. Switching costs: As Myers s article states customers can become locked into the incumbent. They can switch to another supplier but it becomes costly for them to do so. Myers cites the example of Racal and Marine Radio Navigation Receivers (1987). 11. Special Risks and Uncertainties: New entrants face higher risks than incumbents, because they have less reliable knowledge about the market s conditions. 12. Less information: The incumbent possesses more information about the market than a new entrant. To get this information may be costly. 13. Formal, Official Barriers by Governments or Industry Groups: Myers states that structural entry barriers may be created by rules and regulations imposed by national or local governments. In the white salt market the barrier arose from local authority planning restrictions. A dominant firm may shape industry wide rules to its advantage so as to make entry difficult. Nine Endogenous sources of barriers which incumbents can influence or wholly control (behavioral or strategic) are: 1. Retaliation and Preemptive Actions: this embraces a large category of devices including prices, advertising, targeted innovations and counteractions in related markets. Myers states that in the market for white salt the dominant salt producers placed clauses in their customer s contracts that were competition clauses. This allowed the buyer to obtain a lower contract price if evidence could be produced that they had been offered a lower price by a competitor. Competition clauses are a contractual means of engaging in selective price cuts. Price cutting may be a strategy used by the incumbent in response to entry with the intention of reducing an entrant s profitability and persuading it to exit. If an incumbent can gain a reputation for responding aggressively to entry, this implies to prospective entrants that entry will be less profitable. Potential Entrant Enter Stay out High Price (Accommodate (50,10) (100,0) in the event of entry) Incumbent Monopolist Low Price (30, -10) (60,0) (Warfare in the event of entry) 3

4 As an illustration of how an incumbent who has gained a reputation for responding aggressively to entry can erect a barrier we can use the above dilemma game. The potential entrant must decide whether or not to enter a particular market. Enter I Soft (accommodate) (10, 50) E Tough (-10, 30) Stay out Soft (accommodate) (0, 100) I Tough (0, 60) The dilemma game can be represented in a two-stage entry game. In this game the entrant moves first by deciding whether to enter or stay out, the incumbent then decides whether to play tough and engage in warfare or play soft and accommodate the entrant. The payoffs, in this case the profits of the two firms are given on the right hand side with the entrant s listed first. The entrant s payoffs are zero for staying out, 10 on entry if the incumbent is soft and 10 if the incumbent is tough. The potential entrant must decide whether or not to enter. Entry is only profitable if the incumbent will accommodate entry (profit of 10 compared with 0), but if it is anticipated that the incumbent will fight entry, not entering is the preferred option (profit of 0 is better than making a loss of 10). If an incumbent has a reputation or past history of aggressive response to entry the potential entrant will prefer to stay out of the market. In the above a rational incumbent would accommodate the entrant rather than fight as 50 million > 30 million. In this case the threat of entry deterrence is not credible, it is an empty threat. Enter I Soft (accommodate) (10, 20) E Tough (-10, 30) Stay out Soft (accommodate) (0, 70) I Tough (0, 60) The incumbent has to deter entry by making a credible commitment. Making an additional investment such that it will lose out if the investment is not used. In the new game above that commitment is a sunk cost of 30 million. Now a rational incumbent will not accommodate the entrant and will fight as 30> Excess capacity: By creating and carrying excess capacity, a dominant firm warns other firms that it can block entry easily by expanding its output quickly. 3. Advertising: This can be associated with brand image and loyalty. It may be very difficult for an entrant to attract consumers away from the well-known, established brand. A heavy advertising outlay may be required by an entrant, which will involve sunk costs. Myers gives the examples of condoms known as Durex and so consumers buy from the London Rubber Company, and CalorGas being Liquid Petroleum Gas provided by Calor. 4. Creation or Accentuation of Market Segmentation 5. Patents: Strategic patenting is important in industries, such as the drug industry, in preventing or controlling new competition. 4

5 6. Controls over Strategic Resources: By getting control of the best ores, the best locations, or the best managers or inventors, the incumbent may be able to deter new competition. Examples could be National Express Coaches, who enjoy the privileged access to Victoria Coach station, and many other major terminals throughout the country, as they are owned by NBC (National Bus Company). The NBC can therefore deny access to these major terminals to those wishing to compete with National Express. 7. Raising Rivals or Entrants Costs: The incumbent may have a variety of ways to impose extra costs on rivals or entrants. 8. Packing the Product Space: The product space can be packed by a proliferation of branded items so that new forms have no niches in which to gain a foothold. Proctor and Gamble or Lever could be examples. 9. Secrecy: Knowledge regarding markets and opportunities may be known only to the incumbent. Blockaded Entry to enter or not to enter The basic factor affecting the entry decision, is profit. If there is an economic profit, more than the normal rate of return, to be made after entry, a potential entrant will come into the market. Otherwise it will not. Whether or not there is a profit to be made after entry will depend on the post-entry price and on costs, including entry as well as operating costs. The post-entry price will depend on the combined output of the dominant firm and the entrant. If the potential entrant expects the dominant firm to maintain output at its current level if entry occurs, it can maximise its profit by acting like the monopolist in the portion of the market left for it by the dominant firm. P Market demand curve Residual demand curve Pe ACe qd AC (entrant) MC (entrant) Qe residual marginal revenue curve FIGURE 1 As shown in Figure 1, the residual demand curve shows what remains of the market demand curve after the dominant firm has disposed of its output. The residual demand curve is obtained from the market demand curve by subtracting the dominant firm s output from the quantity demanded at every price. The dominant firm s output is qd. The residual demand curve shows the quantity demanded from the entrant at any price, after the dominant firm has sold its output. (The residual demand curve is obtained by sliding the market demand curve horizontally to the left by a distance equal to the dominant firm s output) From the residual demand curve comes a residual marginal revenue curve. To maximise profits the entrant will decide what to produce by picking an output that makes its marginal cost equal to its marginal Q 5

6 revenue. In Figure 1 the entrant will produce an output qe, if it produces at all. The total output supplied to the market is qd + qe. The price at which this output will be willingly demanded is Pe. Whether or not the entrant can make a profit depends, in turn, on its average cost. If the AC curve is as in Figure 1, if the entrant produces qe units, its average cost is Ace per unit. In figure 1, the entrant s average cost at this profit-maximising output is less than the market price, so the entrant will make a profit on every unit sold. The entrant s total profit is shown as the shaded area in Figure 1. The entrant will enter as it can make a profit. Figure 2 shows limit output and limit price. Sunk costs place the entrant at a fixed and marginal cost disadvantage compared to the incumbent. The incumbent can exploit this disadvantage to maintain its position. The more output the dominant firm puts on the market, the closer will the residual demand curve be to the origin, If the dominant firm puts enough output on the market, it can push the residual demand curve below the entrant s average cost curve. In Figure 2, if the monopolist puts ql units of output on the market, the best price the entrant could get after entry, PL, will just equal the entrant s average cost. The entrant would make only a normal rate of return on its investment if it came into the market. By producing slightly more than the limit output ql, the incumbent can push the best price the potential entrant can get below the limit price PL, producing losses for the entrant. In this case, a profitmaximising potential entrant will stay out of the market. P Market demand curve Residual demand curve ql PL AC (entrant) MC (entrant) Q Residual marginal revenue curve FIGURE 2 Limit Pricing Blockaded Entry If the market is very small and entry costs are very high, it will not be profitable for an entrant to come in even if the existing firm charges the monopoly price. This is the case of blockaded entry, which is shown in Figure 3. If entry is blockaded, the monopoly model applies. Such a market is a natural monopoly, a candidate for government regulation. 6

7 P Market demand curve Pm qm Marginal revenue curve AC (entrant) MC (Dominant firm) Q FIGURE 3 Blockaded entry qm = monopoly output Pm = monopoly price Should we worry about entry barriers? Barriers may not be detrimental to economic welfare. It could be said that firms who invent or innovate should be protected. If the market can only sustain one firm then entry should be forbidden unless we want destructive competition. This would be so in the case of a natural monopoly. When there is not room for competition in the market then competition for the market may be appropriate. (Franchising in the railway industry) There are certainly occasions where strategic entry barriers constitute anti-competitive behaviour. Contestable Markets A perfectly contestable market is perhaps most usefully defined as one in which all firms have equal access to all customers, to the same technological options, and in which entry incurs no sunk costs. That is, the entrant Must not be precluded from or penalised for selling his product to any or all of the incumbent s customers. He must not be denied the use of any type of process or equipment that is available to the incumbent if the entrant is willing to pay the same price for it as was paid by the incumbent, and finally The nature of the entrant s outlays must be such that he can recoup his money quickly and easily in the event his incursion into the industry proves to have been a mistake. There is an absence of sunk costs. There is complete freedom of entry and exit. Any player who does not like the game can at any point pick up his equipment and leave the industry without a loss to himself. A market, which has the three characteristics that have just been described, is obviously one in which entry and exit are free. Indeed, complete freedom of exit and entry may be taken to be the attribute that makes a market perfectly contestable. A market that is perfectly contestable is completely vulnerable to competitive entry. Perfectly contestable markets possess four attributes, which include all of the benefits perfect competition can promise: no excess profits, no inefficiency in production, ideal pricing and efficiency in resource allocation. Sources: ¹Bain. J. Barriers to New Competition, Harvard University Press, Cambridge, Mass. (1956). Martin, S. Industrial Economics, second edition (1994). Prentice Hall. Chapter 5. Myers. G, Barriers to Entry, (1993). Economics and Business Education, pp Shepherd, W. G. The Economics of Industrial Organisation, Fourth Edition (1997), Prentice Hall. Chapter 9. 7