4-The Determinants of Industry Concentration Barriers to Entry

BITS, PILANI – K. K. BIRLA GOA CAMPUS

The Determinants of Industry

Concentration & Barriers to

Entry

ASWINI KUMAR MISHRA


There are many systematic determinants of seller concentration:

These factors include economies of scale, entry and exit barriers, regulation, the scope for discretionary sunk cost expenditure on items such as advertising and research.

Fundamentally, entry(and exit) conditions play a key role in determining industry concentration.


Perfectly competitive markets have many producers because the cost of entry and exit is zero. In contrast, barriers to entry insulate a sole firm in a monopoly market from competition.

Economists have defined the concept of a barrier to entry in several different ways:

Bain (1959) defines it as a market condition that raises the cost of entering the market to such an extent that incumbent firms earn long-run economic profits.

Stigler (1968) argues that a barrier to entry exists only if the cost of entry is higher for new entrants than it was for established firms.

Classification of barriers to entry

There is no unique, agreed system for classifying the many factors that may impede entry.

Broadly speaking, however, entry barriers may be subdivided into those that stem from the structure of the industry itself (structural barriers to entry), providing shelter for the incumbent firms, and

Those that are created by the incumbent firms deliberately, in order to keep out potential entrants or at least retard the rate of entry (strategic barriers to entry)

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Structural barriers to entry

Barriers that are caused by basic economic conditions are called natural/structural barriers to entry.

These barriers might derive from basic demand and cost conditions, because demand conditions are determined by consumers and cost conditions are technologically determined.

Under this heading, we consider the three types of entry barriers originally discussed by Bain: 1) economies of scale, 2) absolute cost advantage and 3) product differentiation.

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1. Economies of scale: Economies of scale exist when the long-run average cost (AC) curve has a negative slope.

The minimum level of production needed to take advantage of all economies of scale is a useful concept in industrial economics and is given a special name, minimum efficient scale (MES).

There are economies of scale until output reaches q’.

Beyond q’, AC has a positive slope, indicating diseconomies of scale. The smallest output for which AC is at its minimum, q’, is called minimum efficient scale (MES).

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1. Economies of scale: Economies of scale can act as an entry barrier is when average costs associated with a production level below the MES are substantially greater than average costs at the MES.

Figure 2: MES as a barrier to entry

In both industry A and industry B, the penalty for producing at 50 per cent of the MES is C1 − C2. This penalty is much greater in industry B than in industry A, due to the difference in slope between the two LRAC functions.

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1. Economies of scale: One way to see how demand and cost conditions affect entry barriers and concentration is to review the theory of a natural monopoly.

A natural monopoly occurs when there are substantial scale economies relative to the size of the market (represented by market demand), making it productively inefficient to have more than one firm produce total market output.

In other words, in this case, demand and cost

conditions make it productively efficient and most profitable for a single firm to serve the entire market.

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1. Economies of scale: In the following figure, AC is long-run average cost and D represents market demand. In this example, MES equals 4 (million units), which corresponds to an average cost of $10.

Figure 2: MES as a barrier to entry Baumol et al. (1982) define the cost-minimizing industry structure as the number of firms in an industry that are needed to produce industry output (x) at minimum cost, which is: x/MES=n*.

When this occurs, the industry is productively efficient. To demonstrate, when x=20, five symmetric firms minimize the total cost of producing at MES=4. Thus, the cost-minimizing industry structure is five firms.

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1. Economies of scale: The concept of a cost-minimizing industry structure provides a simple way of showing how scale economies in relation to the size of the market affect industry concentration.

That is, when x is small and the cost minimizing number of firms is 1, then the industry is a natural monopoly. If x is very large, then the industry is naturally competitive.

At intermediate values of x, we have the natural oligopoly. Thus, when scale economies increase (decrease), causing MES to shift right (left), the cost minimizing number of firms decreases (increases) and concentration rises (falls). When demand increases (decreases), the cost minimizing number of firms increases (decreases) and concentration falls (rises).

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2. Absolute Cost Advantage: An incumbent has an absolute cost advantage over an entrant if the LRAC function of the entrant lies above that of the incumbent, and the entrant therefore faces a higher average cost at every level of output.

Figure 2: Absolute cost advantage as a barrier to entry

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2. Absolute Cost Advantage: There are several reasons why an entrant may operate on a higher LRAC function. First, an incumbent may have access to a superior production process, hold patents, etc.

Second, incumbent firms may have exclusive ownership of factor inputs. They may control the best raw materials, or have recruited the most qualified or experienced labour or management personnel. Consequently entrants are forced to rely on more expensive, less efficient or lower-quality alternatives.

Third, incumbents may have access to cheaper sources of finance, if they are viewed by capital markets as less risky than new firms.

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2. Absolute Cost Advantage: Finally, the presence of vertically integrated incumbents.

In industries such as biotechnology, brewing, iron, mobile telephones, steel or chemicals may force an entrant to operate at more than one stage of production if it wishes to overcome the incumbents’ absolute cost advantage.

It is worth noting that an absolute cost differential need not always work in favour of the incumbent. It is possible that an incumbent has overpaid for its assets, in which case the entrant may be favoured. This might be true in industries reliant on rapidly changing technologies, such as computer hardware or software, whose costs fall rapidly over time.

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3. Natural product differentiation: A structural entry barrier exists if customers are loyal to the established brands and reputations of incumbents.

A successful entrant will need to prize customers away from their existing suppliers, or at least stir customers out of their inertia.

This might be achieved either by selling the same product at a lower price, or launching advertising, marketing or other promotional campaigns.

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Threats to Structural barriers to entry

Bain (1956) argues structural entry barriers arising from economies of scale, absolute cost advantage and product differentiation are generally stable in the long run.

However, this does not imply these barriers should be regarded as permanent. The same comment also applies to legal and geographic entry barriers.

Market structures can and do change eventually, and the importance of any specific entry barrier can increase or decrease over time.

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Threats to Structural barriers to entry

For example, new technology may re-shape the LRAC functions of both incumbents and entrants, transforming the nature of an economies of scale entry barrier.

New deposits of a raw material may be discovered, reducing the absolute cost advantage enjoyed by an incumbent.

One highly original or innovative marketing campaign might be sufficient to completely wipe out long established brand loyalties, or other product differentiation advantages of incumbents. 20

Legal and Geographic barriers to entry

Legal Barriers: Legal barriers to entry are some of the most effective of all entry barriers, as they are erected by government and enforced by law. Examples of legal barriers include:

Registration, certification and licensing of businesses and products.

Monopoly rights. Monopoly rights may be granted by legislation. Government may allow certain firms exclusive rights to produce certain goods and services for a limited or unlimited period.

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Legal and Geographic barriers to entry

Geographic Barriers: Geographic barriers are the restrictions faced by foreign firms attempting to trade in the domestic market.

Such barriers affect the extent and type of entry (either through acquisitions and joint ventures) pursued by foreign firms. Examples of geographic entry barriers include:

Tariffs, quotas, subsidies to domestic producers. All such measures place foreign producers at a disadvantage.

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Strategic Barriers to Entry

Structural barriers stem from underlying product or technological characteristics, and cannot be changed easily by incumbent firms.

There is however a second class of entry barrier over which incumbents do exercise some control.

Incumbents can create or raise barriers of this second kind through their own actions. Relevant actions might include changes in price or production levels, or in some cases merely the threat that such changes will be implemented if entry takes place.

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We discuss four major entry-deterring strategies.

The first two are pricing strategies: limit pricing and predatory pricing. The third is strategic product differentiation.

The fourth, creating and signalling commitment, involves an incumbent demonstrating its willingness to fight a price war in the event that entry takes place, by deliberately incurring sunk cost investment expenditure.

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1. Limit Pricing: Suppose a market is currently serviced by a single producer, but entry barriers are not insurmountable (impossible).

The incumbent therefore faces a threat of potential entry.

According to the theory of limit pricing, the incumbent might attempt to prevent entry by charging a price, known as the limit price, which is the highest the incumbent believes it can charge without inviting entry.

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1. Limit Pricing: The limit price is below the monopoly price, but above the incumbent’s average cost.

Therefore the incumbent earns an abnormal profit, but this abnormal profit is less than the monopoly profit.

In order to pursue a limit pricing strategy, the incumbent must enjoy some form of cost advantage over the potential entrants. In the limit pricing models developed henceforth, this is assumed to take the form of either an absolute cost advantage or an economies of scale entry barrier.

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1. Limit Pricing: A critical assumption underlying models of limit pricing concerns the nature of the reaction the entrants expect from the incumbent, if the entrants proceed with their entry decision.

A key assumption of these models, is that entrants assume the incumbent would maintain its output at the pre-entry level in the event that entry takes place.

Limit pricing theory begins with the logical assumption that rational firms should maximize long-run, not short-run profits.

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1. Limit Pricing to deter entry: (a) Absolute Cost/Sunk Cost Advantage

Inverse demand curve of incumbent monopolist: P = 100 – qM & MC

M=$40.This implies q

M=30,

PM=$70, Profit

M= ($70 – $40) x $30 =$ 900.

Residual demand curve of potential entrant: P = (100 – qM) – q

PE=70-q

PE & MC

PE=$50.This

implies qPE

=10, PPE

=$60, Profit PE

= ($60 – $50) x 10 = $100( Given the assumption that the monopolist will maintain its output forever).

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1. Limit Pricing to deter entry: (a) Absolute Cost/Sunk Cost Advantage

However, once the new entrant starts charging a price of 60, the incumbent monopolist can no longer continue to charge a price of 70. It has to match the price of the new entrant. Now, monopolist matches the potential entrant’s price(i.e., P

M=$60).

New profit: Profit M

= ($60 – $40) x $30 = $600. The arrival of new entrant has resulted in a 33% decline in monopolist’s profit(from $900 to $600).

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1. Limit Pricing: To deter entry, the monopolist must lower its price sufficiently to ensure that the potential entrant’s residual demand curve lies everywhere below the potential entrant’s average cost curve.

Since the incumbent monopolist does not want competition from the new entrant, it threatens to charge the limit price.

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1. Limit Pricing: Note that the incumbent has a cost advantage over the new entrant; the average cost of the former is $40, while that of the latter is $50. If, therefore, the incumbent charges a limit price that is just less than $50 per unit, the entrant (who will have to match this price) will necessarily make a loss.

However, since this price is above 40, the incumbent monopolist will continue to make a profit.

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1. Limit Pricing to deter entry: (b) With Economies of Scale and No Absolute Cost Advantage for the Incumbent Firm

What if the incumbent monopolist does not have a cost advantage over the new entrant?

If MC (= AC) does not change with output, incumbent will not make any profit with limit pricing. As in our previous example, if P = 100 – (q

M+ q

PE) & MC

M= MC

M =$40.The limit

price would therefore equal $40 and profits fall to zero as soon as the incumbent adopts the limit pricing policy.

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1. Limit Pricing to deter entry: (b) With Economies of Scale and No Absolute Cost Advantage for the Incumbent Firm

With the industry demand curve:P=100-1.25Q and the residual demand curve faced by the

potential entrant will depend on the price charged by the incumbent.

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1. Limit Pricing to deter entry: With Economies of Scale and No Absolute Cost Advantage for the Incumbent Firm

Inverse demand curve of incumbent monopolist: P = 100 –

1.25 qM & LRAC is minimum at LRAC=$20 and the corresponding

qM=34, P

M=$57.5, Profit

M= ($57.5– $20) x $34 =$ 1275.

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For the above mentioned Residual demand curve: P =57.5-1.25qPE

, the profitable range of output is between Q1 &Q2 because the demand curve is above the LRAC for those outputs.

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What is the limit price in this case?

Assuming that the monopolist will maintain the same output after entry, the monopolist must lower its price sufficiently to ensure the potential entrant’s residual demand curve lies everywhere below the LRAC.

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For PM=$40, the residual demand curve of potential entrant is : P

PE = 40 – 1.25 q

PE

& here, the residual demand curve is just tangent to the LRAC at output level q

PE=10. Any price less than $40, even by an infinitesimal amount, will shift the

potential entrant’s residual demand curve to the left and deter entry. 43



Thus, in general, monopolist must set its output at a level such that the residual demand curve of the new entrant is DPE. All points on this demand curve lie below the average cost curve (AC), i.e., the new entrant cannot charge any price at which it can make a profit. However, since the incumbent monopolist has a positive output level, it enjoys economies of scale, such that its average cost is now reduced, and it can therefore earn a profit.

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Strategic Barriers to Entry-Will a dominant firm always choose to keep entrants out?

1. Limit Pricing to deter entry: Will a dominant firm always choose to keep entrants out?

A dominant firm will pursue the strategy that yields the largest profit. If it will reap a greater profit by letting a rival into the market than by keeping it out, it will prefer to let the rival in. Based on market size and sunk costs, there are three possibilities :

If the market is large and sunk entry costs are small, a dominant firm will have to produce far more than a monopolist, and charge a price only slightly above the entrant’s MC, to preclude entry.

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In large markets with easy entry, a dominant firm will make a greater profit by charging a higher price and sharing the market with a competitive fringe than it will by setting a low price and keeping the fringe out.

On the other hand, if the market is very small and sunk entry costs are small, a dominant firm can keep an entrant out is to set a price that yields zero economic profit.

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However, 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.

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ACe

D

P

Q 0

Pm

Qm

MCdf

Strategic Barriers to Entry -Blockaded Entry

Strategic Barriers to Entry-Criticisms

1. Limit Pricing: The theory is being criticized on the following grounds:

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 that there is no market available if entry takes place.

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Strategic Barriers to Entry-Criticisms

1. Limit Pricing: The theory is being criticized on the following grounds:

Market structure is ignored. Applied to the case of oligopoly, the theory assumes all incumbent firms would implement a limit pricing strategy. For this strategy to succeed, a high level of coordination or collusion would be required.

Limit pricing implies perfect information regarding the market demand function, the incumbent’s own costs, the entrants’ costs, and so on. These would be impossible to estimate with any degree of precision.

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2. Predatory Pricing(also undercutting): It is a pricing strategy where a product or service is set at a very low price, intending to drive competitors out of the market.

Here, the incumbent adopts the role of predator, sacrificing present 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.

Strictly speaking, predatory pricing is a post-entry strategy.

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https://en.wikipedia.org/wiki/Pricing_strategies



https://en.wikipedia.org/wiki/Market_(economics)


2. Predatory Pricing: There are two questions to keep in mind:

First, what kind of market structure is required for predatory pricing to be profitable at all, so that it is a strategy that a dominant firm would consider?.

Second, in which circumstances is predatory pricing the most profitable strategy for maintaining dominance, so that it would be strategy actually chosen by a dominant firm?

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Strategic Barriers to Entry-Predatory Pricing and the Role of Market Structure

2. Predatory Pricing: Kind of market structure Required:

One prerequisite for the use of predatory pricing as a strategy toward rivals is that the predatory firm has the market power in some markets like Wal-Mart, Reliance Fresh, etc. that operate in many local geographic markets.

In one market where its actions are constrained by a fringe of small competitors, it sets price below cost. By so doing, it loses money in that market. But the dominant firm is sustained by its operations in other markets as in these markets it sets price above marginal cost.

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Strategic Barriers to Entry-Predatory Pricing and the Role of Market Structure

2. Predatory Pricing: While adopting this strategy, there is no way to avoid the time element:

The losses come now, the profits come later.

Predatory pricing is an investment in market power, and like all investments, it is inherently dynamic.

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Strategic Barriers to Entry-Predatory Pricing-When will it be Profitable?

2. Predatory Pricing: Two simple assumptions are required to make predation profitable.

Before the predatory campaign, P=LRAC (i.e., the status quo is long-run competitive equilibrium).The producer can produce in other markets to supply the target market with very low transportation costs.

The target firm is a price taker. It maximizes its profit, given the price sets by the producer. Thus, for it, the supply curve is its SRMC curve, above the shutdown point (=Min. pt. on the SRAVC curve).

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2. Predatory Pricing: Stage 1-Losses (for both predator and victim?)

During the first stage of predation, the predator lowers price below LRAC and sets ppred as the price. As a result of which, the victim reduces output from qc to qpred. Total losses for the victim is given by the area ALMJ and this is for a single period, the firm will lose this much, per period, as long as it continues to operate.

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2. Predatory Pricing: Stage 2-Profit (The dominant firm as a monopolist in the local market?)

The monopolist profit is given by the area BNRS and the deadweight welfare losses is given by the area SRF.

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Strategic Barriers to Entry: Predatory Pricing-Criticisms

2. Predatory Pricing: The (anti-interventionist) Chicago school is rather sceptical about the reality of predatory pricing.

First, the predator’s gain in profit in the long run must exceed the loss resulting from price-cutting in the short run. It may be difficult for a predator to be certain this condition will be met.

Second, for a predatory pricing strategy to succeed in deterring entry, the predator has to convince the entrant it is prepared to maintain the reduced price and sustain losses for as long as the entrant remains in business.

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2. Predatory Pricing: The (anti-interventionist) Chicago school is rather sceptical about the reality of predatory pricing.

Third, as suggested above, for a predatory pricing strategy to be worthwhile, the predator has to be sure that having forced its rival out of business and raised its price, the entry threat will not return, either in the form of the same rival, or some other firm.

Finally, if an incumbent and an entrant have identical cost

functions, a predatory pricing strategy could just as easily be used by the entrant against the incumbent as the other way round.

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3. Strategic Product Differentiation: For many product types, a certain amount of product differentiation is quite natural, in view of basic product characteristics and consumer tastes.

Recall that natural product differentiation was interpreted as a structural barriers to entry.

In some imperfectly competitive markets, however, incumbents may employ advertising or other types of marketing campaign in order to create or strengthen brand loyalties beyond what is natural, in order to raise the start-up costs faced by entrants.

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3. Strategic Product Differentiation: Many firms wishing to establish a new brand incur significant sunk costs in the form of advertising and other promotional expenditure.

Spurious product differentiation or brand proliferation ( for example, in detergents and processed foods) refers to 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.

In July 2003, ITC forayed into the Biscuits market with the Sunfeast range of Glucose, Marie and Cream Biscuits(pls. visit http://sunfeastworld.com/)

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http://sunfeastworld.com/







As many as 12 varieties of biscuits can be found under Sunfeast brand name. Compared to this, Britannia also has had many varieties of biscuits (pls. visit http://www.britannia.co.in/overview.htm)

Existing brand loyalties, and therefore entry barriers, are strengthened in cases where consumers incur significant switching costs: costs associated with switching to another supplier.

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http://www.britannia.co.in/overview.htm













Customers with high switching costs are committed to remaining with their existing suppliers, and cannot easily be lured elsewhere.

Examples of products which may have high switching costs include bank accounts, computer software, and supermarkets and other stores that offer loyalty cards.

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4. Creating and Signalling Commitment: An incumbent firm attempts to deter entry by deliberately increasing its sunk cost expenditure(like creating additional productive capacity) before entry takes place.

The incumbent creates and signals a commitment to fight entry by engaging the entrant in a price war, in the event that entry subsequently occurs.

Incumbent can be passive or committed one.

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4. Creating and Signalling Commitment: Passive Vs. Committed Incumbent

A passive incumbent does not pre-commit to fighting the entrant, in the event that entry subsequently takes place.

In other words, a passive incumbent waits to see if entry occurs, before investing in the additional productive capacity or the aggressive marketing campaign that will be required in order to fight a price war.

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4. Creating and Signalling Commitment: Passive Vs. Committed Incumbent

A committed incumbent does pre-commit, by incurring the sunk cost expenditure that will be required in order to fight in advance, before it knows whether or not entry will actually take place.

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References

Bain, J.S. (1956) Barriers to New Competition. Cambridge, MA: Harvard University Press.

Comanor, W.S. (1967a) Market structure, product differentiation and industrial research, Quarterly Journal of Economics, 18, 639–57.

Comanor, W.S. (1967b) Vertical mergers, market power and the antitrust laws, American Economic Review, Papers and Proceedings, 57, 254–65.

Martin, Stephen(1988) Industrial Economics. Macmillan, USA.

Lypczynski, John et al. (2005) Industrial Organisation-Competition, Strategy, Policy. Pearson Education Limited.

Stigler, G.J. (1968) The Organisation of Industry. Holmwood, IL: Irwin.

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4-The Determinants of Industry Concentration Barriers to Entry

Documents

cost of entry

types of entry barriers

naturalstructural barriers

classification of barriers

cost conditions

diseconomies of scale

minimum efficient scale

entry aswini kumar mishra