A2 Micro: Entry Barriers in Markets

Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the power of existing firms and maintain supernormal profits and increase producer surplus. These barriers have the effect of making a market less contestable - they are also important because they determine the extent to which well-established firms can price above marginal and average cost in the long run. Barriers to Entry and Exit from tutor2u

The 1982 Nobel Prize winning economist George Stigler defined an entry barrier as “A cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by businesses already in the industry”.

Another Economist, George Bain defined entry barriers as “The extent to which established firms elevate their selling prices above average cost without inducing rivals to enter an industry”.

The Bain interpretation of entry barriers emphasises the asymmetry in costs that often exists between the incumbent firm and the potential entrant. If the existing businesses have managed to exploit economies of scale and developed a cost advantage, this might be used to cut prices if and when new suppliers enter the market. This is a move away from short-run profit maximisation objectives – but it is designed to inflict losses on new firms and protect a dominant position in the long run. The monopolist might then revert back to profit maximization once a new entrant has been sent packing!

Another way of categorising entry barriers is summarised below
o Structural barriers (also known as ‘innocent’ entry barriers) – arising from differences in production costs.
o Strategic barriers (see the notes below on strategic entry deterrence).
o Statutory barriers – these are entry barriers given force of law (e.g. patent protection of franchises such as the National Lottery or television and radio broadcasting licences).

Entry barriers exist when costs are higher for an entrant than for the incumbent firms.

Theory of Early Mover or First Mover Advantage

Sometimes there are sizeable advantages to being first into a market – first-movers can establish themselves, build a customer base and make life difficult for new firms on the scene.

Barriers to Exit – (Sunk Costs)

Whilst textbooks tend to concentrate on the costs of entering a market, often it is the financial implications of leaving an industry that act as one of the most important barriers – hence we need to consider exit costs. A good example of these is the presence of sunk costs.

Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:
o Capital inputs that are specific to an industry and which have little or no resale value.
o Money spent on advertising, marketing and research and development projects which cannot be carried forward into another market or industry.

When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of new firms because they risk making huge losses if they decide to leave a market. In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk costs so the barriers to exit are low.

o Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery, stocks and the goodwill of a brand
o Closure costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property
o The loss of business reputation and goodwill - a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.
o A market downturn may be perceived as temporary and could be overcome when the economic or business cycle turns and conditions become more favourable

Strategic Entry Deterrence

Strategic entry deterrence involves any move by existing firms to reinforce their position against other firms of potential rivals. There are plenty of examples of this – including the following:
o Hostile takeovers and acquisitions – taking a stake in a rival firm or buying it up!
o Product differentiation through brand proliferation (i.e. investment in developing new products and spending on marketing and advertising to reinforce consumer / brand loyalty).
o Capacity expansions to achieve lower unit costs from exploiting internal economies of scale.
o Predatory pricing: Predatory behaviour is defined as a dominant company sustaining losses in the short run with the knowledge it will be able to recoup them once the competition is forced to exit, and is in breach of the Competition Act 1998. We return to this in the chapter on oligopoly and cartels.

Strategic barriers may be deemed anti-competitive by the British and EU competition authorities - The EU Competition Commission has been active in recent years in building cases against European businesses that have engaged in anti-competitive practices including price fixing cartels.

Despite the inevitability of entry and exit barriers markets are constantly evolving and we often do witness the entry of new suppliers even when one or more firms have a clear position of market power. Entry can occur in a variety of ways:
1. A takeover from outside the industry (sometimes known as the “Trojan-horse route” to by-pass any structural entry barriers that might exist within an industry.)
2. A transfer of brand names from one sector of the economy to another (for example the diversification practiced by both EasyGroup, Virgin and Stagecoach in recent years.)
3. Increasing competition from overseas – i.e. the liberalisation of markets around the world