A barrier to entry is any obstacle that prevents potential entrants from enjoying the benefits that accrue to incumbents (established firms). These obstacles may be classified as structural or strategic. The benefits that accrue to the established firms are usually defined in terms of long-run abnormal profits (price set above minimum long-run average cost), but may also include other advantages, for example, in research and development. The key point to emphasize about barriers to entry is that they yield rents that are only available to incumbent firms; such firms earn these rents precisely because they are established in a particular industry.
Structural Barriers
Structural barriers to entry depend on the factors that determine the competitiveness of an industry (for example, demand for a product and technology). Neither incumbent firms nor potential entrants can directly determine the size of these barriers. Examples of structural barriers include economies of scale, absolute cost advantages, and product differentiation. Economies of scale are defined as the rate at which long-run average costs of production fall as output is increased. The point at which these costs are minimized is the minimum efficient scale of production (MES). If the MES is very large in relation to market demand it may only be viable for one incumbent to exist in this industry.
Absolute cost advantages exist when the incumbent’s long run average cost is below that of the potential entrant’s for all levels of output. In other words, and unlike the case of economies of scale, the scale at which the potential entrant chooses to enter does not affect the cost disadvantage it experiences with respect to the incumbent. Exclusive access to superior technology via patents is one way in which absolute cost advantages are realized.
Product differentiation means that the output of one firm is not perceived by consumers to be a perfect substitute for the output of other firms. This, too, is another type of structural barrier to entry. For example, if consumers are loyal to established brands it can be very difficult (and expensive) for potential entrants to attract customers. Other factors that influence product differentiation barriers to entry include customer inertia, switching costs, product reputation, and established dealer systems.
Strategic Barriers
The major weakness of structural barriers is that they provide little information on how incumbents would respond if entry occurred. This is important because structural barriers may not in themselves be sufficient to deter entry. For example, a new entrant may be able to undercut the monopoly price of the incumbent and force the latter to exit the industry. To overcome this problem a variety of alternative theories of barriers of entry have been developed, which are classed as strategic. Strategic barriers to entry are the actions taken by incumbents to influence the behavior of potential entrants. A key insight of such theories is that actions taken by the incumbent pre-entry alter the post-entry returns available to the potential entrant. Recognizing that ex post returns are less attractive than was anticipated, the potential entrant does not enter.
Pricing policy and commitment are two types of strategic entry barrier that figure prominently in the literature. Limit pricing was one of the earliest theories used to examine the way in which the pricing decisions of an incumbent could deter entry. The limit price is the highest the incumbent believes it can charge without attracting entry. Two assumptions underlie this theory. First, the incumbent has exhausted economies of scale and therefore produces at the minimum of long-run average cost. Second, potential entrants believe that the incumbent will maintain its output at the pre-entry level even after entry. Effectively, the decision to enter will depend on whether it is profitable for the potential entrant to supply the residual demand function (that not met by the incumbent). However, the belief that the incumbent will not change output after entry has been questioned. For example, if entry occurred there is no guarantee that only the potential entrant would incur losses. Recognizing this, the incumbent may allow entry and collude in a market-sharing agreement with the new entrant. Alternatively, it may be more profitable for the incumbent to sell at the monopoly price and permit entry to occur.
Predatory Pricing
Predatory pricing is a strategy by which the incumbent reduces (or threatens to reduce) price to unremunerated levels when faced with actual (or potential) competition. Such a tactic is predatory because it conflicts with short-run profit maximization. However, if the use of this tactic is successful, the incumbent can continue to earn monopoly profits in the long run. Predatory pricing has a long history: in the United States, for example, one of the most famous cases involved Standard Oil in 1911.
The success of predatory pricing depends on a number of factors. For example, for it to be profitable, short-term losses must be less than long-term monopoly profits, but calculating these accurately is difficult; if the result is positive there still remains the problem of communicating the credibility of such action to a potential entrant. If the incumbent faces just one potential entrant, an aggressive pricing policy may succeed, but this outcome is less certain when a number of potential entrants are encountered: For example, while an aggressive response by the incumbent may deter the first potential entrant and all subsequent entrants, it is also possible that a sequence of costly price wars damage the financial resources of the incumbent to such an extent that the threat of an aggressive response is no longer perceived as credible by potential entrants.
Commitment Strategies And Product Proliferation
The basic premise of commitment strategies is that before entry occurs the incumbent has the opportunity to make irreversible decisions that alter the payoffs in the post-entry game. These commitments affect the incumbent’s response post-entry while simultaneously signaling to potential entrants the desirability of entering ex ante. For example, the decision by the incumbent to invest in extra capacity will reduce its unit cost of production and this will allow it to pursue an aggressive pricing/output policy postentry. Observing this, potential entrants will realize that they cannot profitably enter the industry.
Irreversible decisions involve sunk costs: Costs that cannot be recovered if the decision is made to exit the industry. Examples of these irreversible decisions include advertising, investment in large sunk production capacity, and product proliferation. Advertising is a type of promotional campaign designed to increase the demand for a product. One way in which advertising can act as a barrier to entry is by creating a cost asymmetry between the incumbent and the potential entrant. Advertising helps to create goodwill for a product: An advertising campaign today will continue to generate demand in the future even if no further advertising expenditure is undertaken. This cumulative effect of advertising means that in order to attract the same level of demand as an incumbent, the potential entrant needs to spend more on advertising.
The fact that advertising expenditure is a completely sunk cost may increase the difficulties experienced by potential entrants attempting to raise external funds to finance an advertising campaign: In the event of unsuccessful entry, physical plant has some salvage value that can be used as security for a loan, but a failed advertising campaign has no such value.
The established position of incumbents is reinforced if economies of scale in advertising are important. Such economies can arise from threshold effects (a minimum number of advertising messages are required to influence consumers) and also because as a sunk fixed cost, average costs decline as the volume of advertising increases. With large sunk capacity the incumbent incurs higher fixed costs to obtain lower marginal costs of production, and these, in turn, require larger outputs for profit maximization. Large sunk capacity commits the incumbent to a ‘tough’ strategy when confronted with entry because large-scale output is the profit-maximizing strategy irrespective of entry. Entry is deterred because the output decision of the incumbent reduces the demand available to the potential entrant. In these models, the barrier to entry is also a barrier to exit.
Product proliferation is the strategic decision by an incumbent to preempt entry by creating brands that satisfy every product niche (meaning there is little demand left for a new brand) and to enter profitable market niches before a potential entrant (which rules out profitable entry). Classic examples of industries in which there is significant product proliferation include laundry detergents, bathroom soap, and toothpaste.
Effects
Judgments on the welfare effects of barriers to entry are difficult and need to take account of a variety of factors. For example, significant scale of economies will mean that only a few firms can exist in an industry and be productively efficient. The fact that high profits are being earned in a concentrated industry might indicate the abuse of monopoly power, but such profits are also consistent with incumbent firms having superior technology compared to potential entrants.
The short-run disadvantages of barriers to entry need to be weighed against long-term benefits. For example, the existence of barriers to entry may allow incumbents to charge higher prices compared to a competitive industry and to make significant profits, but these profits may be used to finance research and development into cures for diseases. In this example, removing barriers to entry will make the industry more competitive and lead to lower prices and competitive rates of profit, but these profits may be insufficient to finance research and development.
In many countries the responsibility for investigating barriers to entry and determining whether they are legal or not rests with official bodies. In the United States, for example, the Federal Trade Commission is responsible for these inquires; in the United Kingdom, investigations have been conducted by the Office of Fair Trade.
Bibliography:
- W. Carlton and J. M. Perloff, Modern Industrial Organisation (Pearson/Addison-Wesley, 2005);
- Schmalansee and R. D. Willig, eds., The Handbook of Industrial Organisation, vol.1 (North Holland, 1989).
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