BARRIERS TO ENTRY

Market selection: Entry and Exit

Market selection process includes firm’s entry, then its survival and finally the exit process. The selection and expansion depends how efficient the firm is. The efficient firms enter and the inefficient ones exit. 

Conditions of Entry: The entry of a new firm in an industry or a market depends on the ease with which it can enter. If we see the long-term perspective, the number of firms and the degree of seller concentration depends on the conditions of entry. In case of free entry, the number of sellers is large in number and in case of restricted entry, the number of sellers tend to reduce. In the long run the degree of competition depends on the condition of entry. A new entrant could bring with it the following advantages.

-Provides new goods and services,

-Changes the balance between different sectors,

-Comes with new technological and managerial techniques,

-Increases opportunities.

 Factors determining conditions of entry

The following are some of the factors that determine the structure of any market. This list is not meant to be exhaustive, but is likely to cover a large part of real world situations.

  • Legal barriers
  • Initial capital cost
  • Vertical integration
  • Optimum scale of production
  • Product differentiation

barriers-to-entry-featuredLegal barriers: Almost all countries have their set of rules and regulations. Patent law is one such regulation, which promotes and protects the interests of inventors and innovators. Under this law, no firm other than the patent holder or the licensed firm is allowed to make use of the process. India has its own legal barriers and it has certain laws like Industrial Licensing Regulation and Reservation of products, which restrict entry and thus protect the incumbent firm from competition.

Initial capital cost: For industries producing basic inputs like coal, steel, power etc., the initial capital cost is quite high. Therefore, it becomes difficult for new entrepreneurs to enter. In industries where the capital requirement is high, the market is dominated by a few firms, whereas for industries such as non-durable consumer goods, the initial capital cost is less and therefore the number of firms in the market can be quite large.

Vertical integration: A vertically integrated firm is one that produces raw material i.e. an intermediate product as well as the final product. Examples of vertically integrated firms in India are integrated steel plants such as SAIL and TISCO and Reliance in telecommunications and synthetic fibres. Entry in this case is restricted to limited producers as here the existing producer produces raw material or an intermediate product along with the final product. New entrants will find that their capital requirements are high and hence it will not be easy for them to enter the market.

Optimization: Optimum scale of production means the scale of output at which the long run average cost of production is minimum. As defined earlier this is the minimum efficient scale of production for the firm. If the optimum scale of output for any product is quite large and if the total market is can be efficiently served by a few firms, the new entrants will find it difficult to enter such markets. Examples of such markets are electricity generation and aircraft production.

Product differentiation: New entrant faces difficulty to enter the market where the products are highly differentiated. Consider the ready to eat breakfast cereal industry in the US. Kellogs is the market leader and produces more than 40 different kinds of cereal ranging from the ordinary corn flakes to granola flakes and mueslix. With such a wide variety, new entrants find it difficult to compete with Kellogs for shelf space in retail outlets which is crowded with Kellogs products. By implementing such widespread product differentiation, Kellogs has managed to increase the cost of entry for potential entrants in the market.

Related to entry conditions is the concept of entry barriers. Any manager is concerned about his firms market share and thus threat to its competitive position. By establishing an entry barrier a firm not only preserves its market share but could also increase it. This is perhaps the most interesting aspect of market structure and its analysis. Such attempts are made everyday by managers and are widely visible in the environment around us. An example of an entry barrier is advertising expenditure by firms. Think about the enormous advertising spend of firms such as Coke and Pepsi and examine whether it is possible for a new entrant to try and compete with such large existing brands even if it come up with an equally good beverage. We will study this feature of markets in detail now.

A barrier to entry exists when new firms cannot enter a market. There are many types of barriers, which become sources of market power for firms. Entry barriers can be broadly classified as: Natural barriers, Legal Barriers and Strategic Barriers.

Natural barriers: Economies of scale create a natural barrier to the entry of new firms and it occurs when the long run average cost curve of a firm decreases over a large range of output, in relation to the demand for the product. Due to the existence of substantial economies of scale, the average cost at smaller rates is so high that the entry is not profitable for small-scale firms. This results in existence of natural monopoly. Power generation, Aircraft manufacturers, Railways, etc. are examples of natural monopolies. You should keep in mind that technological progress often undermines the natural monopoly character of certain industries. This has happened in telecommunications, which not very long ago used to be considered a natural monopoly.

Legal barriers: Patents, as discussed above, are an example of a legal entry barrier. Industrial licensing that used to be common in India in the 1970s and 80s is another example of such a barrier. By giving a license to a firm the government provided exclusive rights to that firm or a few firms to produce. This restricted the number of players in the market through industrial licensing, thus creating a legal entry barrier.

fig-1-a-entry-limit-pricing

fig-1-b-entry-limit-pricing

Strategic barriers: Such barriers exist exclusively due to the strategic behavior of existing firms. Managers undertake investments to deter entry by raising the rivals entry costs. To bar or restrict the entry of a new entrant, an established firm may change price lower than the short-run profit-maximizing price. This strategy is known as entry limit pricing. The entry limit pricing depends on established firm taking a cost advantage over potential entrants. The established firm must have a long run average cost curve below that of the other firm in order to lower its price and continue to make an economic profit.

For example, established firm lowers its price below profit-maximizing level. Figure 1 shows demand and marginal revenue curves for an established firm and also the firm’s long run average (LRAC) cost and marginal cost (MC) curves as LRACE and LRMCE

To maximize profit, the firm produces 50,000 units of output when MR=MC and fix a price of Rs. 100 from the demand curve. Therefore the firm’s profit becomes:

P = (Rs. 100– Rs. 80) * Rs. 50,000 = Rs. 10,00,000

The LRAC for a new entrant into the market is shown as LRACn in figure-1. If the price is Rs. 100, the new firm could enter the market, but a little lower price would resist the entry. Here, LRACN reaches minimum at slightly more than Rs. 91, while LRACE reaches minimum at approximately Rs. 80. Therefore, the established firm could change a price slightly below the new firm’s minimum LRACn (Rs. 91) but above its own LRACn i.e. Rs. 80. Therefore, the price should be set between Rs. 91 and Rs. 80.

Suppose the established firm sets the prices at Rs. 90 for say 70,000 units of output, the new entrant would not be able to cover the average cost as it would be making loss. The economic profit of the established firm now would be:

EP = (Rs. 90 – Rs. 80) * Rs. 70,000 = Rs. 7,00,000

Though this profit is less than the original profit but if we look at the practical point, it is found that even if the established firm incurs a loss, the sales of the firm can be increased in the future regarding the difficulties posed for the new entrant. The lower profit would be higher had the new firm entered the market and would have taken away some share of the sales from the established firm. This example shows that entry-limit pricing is not feasible without the cost advantage. 

Building Excess Capacity: Another way to restrict the entry is to build and maintain excess capacity over and above the required amount. This poses a threat to the new entrant deliberating the fact that the established firm is prepared to increase the output and lower the price if and when entry occurs. The excess capacity can be built up easily as it takes a longer time for the new entrant to build a factory of such capacity. This type of barrier is also known as capacity barrier to entry. 

Producing Multiple Products: Economies of scope arise when cost of producing two or more goods together is less costly than producing the two goods separately. The process goes on and becomes cost effective as more goods are produced. This acts as entry deterrent for new firms. 

New Product Development: Producing substitutes for its own product in the market can discourage the entry for the new firms. For example HLL producing different types of soaps targeted to different customer base. The more the number of substitutes, the lower and more elastic is the demand for any given product in the market. This makes the entry of new firm more difficult.

Take the case of IBM. Why does every other personal computer (PC) that one comes across claim to be an IBM compatible. It has to be so, because all the software is developed by using IBM standards. The PC cannot work without software. By developing industry level standards, IBM has created ‘high switching costs’ in an attempt to create entry barriers. 

STRATEGIC ENTRY BARRIERS : A DEEP INTROSPECTION

No one likes competition and companies with a leading position in a market will go to considerable lengths to keep out likely new opponents. Although all companies strive to develop one form of competitive advantage or another, relatively few are persistently successful over long periods. Innovative activity is almost always followed by waves of imitation and relatively few first movers are able to maintain their initial market position.

Although Tagamet was both revolutionary and one of the best-selling drugs of all time, an imitator, Zantac, eclipsed it in an embarrassingly short time. Similarly, companies such as Thorn – EMI, which first developed the CAT scanner, and Xerox, whose Palo Alto research labs developed many of the innovations that created personal computers, failed to generate any lasting success from ideas that have created whole new industries. The simple truth is that most large-scale expenditures designed to create competitive advantage are unlikely to realise a return unless that advantage can be sustained.

Economists think about this problem as one of creating, or strategically exploiting, barriers to entry or mobility barriers. Entry barriers, as defined above are structural features of a market that enable incumbent companies to raise prices persistently above costs without attracting new entrants (and, therefore, losing market share). Entry barriers protect companies inside a market from imitators in other industries. Entry barriers give rise to persistent differences in profits between industries. Although different commentators produce different lists, almost all sources of entry barriers fall into one of the three following categories: product differentiation advantages, absolute cost advantages, and scale-related advantages.

Product differentiation arises when buyers distinguish the product of one company from that of another and are willing to pay a price premium to get the variant of their choice. Such differences become entry barriers whenever imitators, whether they be new entrants or companies operating in other niches of the same market, cannot realize the same prices for an otherwise identical product as the incumbent. On the face of it, it is hard to understand how this might come about since consumers will (surely) always prefer the lower-priced variant of two otherwise identical products. However, if it is costly for consumers to change from purchasing one product to purchasing another, then prices for otherwise identical products can differ for long periods of time.

Economists call costs of this type switching costs and business managers always try to create switching costs by locking consumers into their product. Habit formation is an obvious source of switching costs and many marketing campaigns are designed to reinforce the purchasing patterns of existing customers and raise their resistance to change. Further, many consumers sink costs into gathering information about new products and, once they have made a choice that satisfied them, they are likely to resist making further investments.

Both sources of switching costs are often reinforced by the use of brand names to help consumers quickly find familiar products. The value of these labels depends, of course, on the size of the switching costs that they help to sustain. Finally, switching costs also arise when consumption involves the purchase of highly

specific complementary products that lock consumers into existing purchasing patterns. Buyers of IBM mainframes often found that the large costs of rewriting  oftware and recording data dwarfed price or performance differences that might otherwise have induced them to switch to one of IBM’s rivals.

Absolute cost advantages arise whenever the costs of incumbent companies are below those of new rivals and they enable incumbents to under-cut the prices of rivals (by an amount equal to the cost disadvantage) without sacrificing profits. There are many sources of absolute cost advantages. Investments in R&D and learning-by-doing in production can be important in many sectors and they can occasionally be protected by patents. Similarly, privileged access to scarce resources (such as deposits of high-quality crude oil, much sought after airport landing slots or the odd scientific genius) can open up substantial differences in costs between companies producing identical products. Many companies vertically integrate upstream to assure control over limited natural resources or downstream to assure access to the most valuable distribution channels, actions that can make entry anywhere in the value chain difficult.

Scale-related advantages create the most subtle form of entry barriers. They arise whenever a company’s costs per unit fall as the volume of production and sales increases. Economies of scale in production (created by set up costs, an extensive division of labour, advantages in bulk buying and so on) are the most familiar source of scale advantages but economies can also arise in distribution. One way or the other, the important implication of scale advantages is that they impede small-scale entry. If costs halve as production doubles, then a small entrant will have costs per unit twice as high as an incumbent twice its size. Since it is unlikely that such an entrant will be able to differentiate its product enough to justify a price difference of this size, it must either enter at a scale similar to that of the incumbent or not enter at all. Needless to say, this compounds its problems, since raising the finance to support a large-scale (and therefore much riskier) assault on a privileged market can be much more difficult than raising funds for a much more modest endeavour.

As stated above, few markets naturally develop entry barriers and, even when they do, very few incumbent companies rely on structural features of market alone to protect them. Whether it be creating or exploiting entry barriers, companies with profitable market positions to protect usually need to act strategically to deter entry. Although there are as many different examples of strategic entry deterrence, there are at least three types of generic strategies that companies typically employ: sunk costs, squeezing entrants and raising rival’s costs. 

Sunk costs: Displacing incumbents is possibly the most attractive strategy for an entrant to follow since, if successful, it enables the entrant both to enter a market and monopolise it. Some what more modestly, if an entrant can at least partially displace an incumbent, it will make more profit after entry than if it has to share the  market on a less equal basis.

To deter entrants from following this strategy, an incumbent needs to lock itself into the market in a way that raises the cost to the entrant of displacing it. This usually requires the incumbent to make investments whose capital value is hard to recover in the event of exit. Sunk costs raise the costs of exit (and so make it that much harder for the entrant to force the incumbent out). Some incumbents do this by investing in highly dedicated, large-scale plant and equipment since this also enables them to reap economies of scale in production. These activities also have the additional benefit of creating product differentiation or absolute cost advantages.

Squeezing entrants: It is usually all but impossible to deter very small-scale entry and frequently it is not worth the cost. However, capable entrants interested in establishing a major position in a market are a much more serious threat and many entry-deterring strategies work by forcing entrants to enter at large scale while at the same time making this too expensive. Squeeze strategies usually build on scale economies that prevent small-scale entry by forcing entrants to incur even more fixed costs (say through escalating the costs of launching a new product by extensively advertising), which increases their minimum scale of entry. Further, if these fixed costs are also sunk then these activities also increase the risks associated with entry. The squeeze comes through actions that limit their access to customers, making the larger scale of entry much more difficult and expensive to realise than a more modest market penetration strategy might have been. This is often done by filling the market with more and more variants of the generic product, developing fighting brands closely targeted on the entrant’s product or limiting access to retail outlets.

A simple glance at the shelves of most super markets will reveal many instances where the multiple brands of a single company (or a small group of leading companies) completely fill all the available space, leaving little or no room for an entrant (examples might include laundry detergents of HLL, ready to eat breakfast cereals of Kellogs).

Raising rival’s costs: Even when an incumbent is sure that it cannot be displaced by an entrant and it has managed to squeeze the entrant into a tiny niche of an existing market, entry can sometimes be profitable when the market is growing. Indeed, market growth is an important stimulus to entry since it automatically creates room for the entrant without reducing the incumbent’s revenues. However, most entrants have only modest financial support and any strategy that raises costs in the short run and slows the growth of their revenues may make it difficult for them to survive long enough to penetrate the market and turn a profit. One rather obvious strategy of this type is to escalate advertising and, indeed, this is a very frequent response to entry by incumbents. Advertising is a fixed cost (which, therefore, disadvantages small-scale entrants) and it is often the case that what matters is the relative amount of advertising a company does rather than the absolute amount. An advertising war initiated by an incumbent that raised total market advertising but keeps the advertising shares of companies relatively constant will, therefore, raise the entrant’s costs without raising its revenues. The interesting feature of this strategy is that an advertising war will also raise the incumbent’s costs. What is more, investments in advertising are often sunk, meaning that they are likely to raise the exit costs of the incumbent is able to turn what, on the fact of it, appears to be a disadvantage to its advantage because entrants are more adversely affected by an advertising war than the incumbent is. That is, some investments that incumbents make seem irrational because they raise costs without generating much, if any, additional revenues. When successful, however, they are justified by the fact that they protect existing revenue streams from entrants. This points to one of the most characteristic features of investments in entry deterrence: they do not generate net revenue so much as they prevent it from being displaced.

A company that successfully deters entry will have lower profits than a company that did not face an entry threat but that is not an interesting observation. What matters is that a company that successfully deters entry will preserve its profits while a company that has not been able to deter entry will see its market position, and the profits that it generates, gradually disappear.

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