Thursday, October 23, 2008

Barriers To Entry...Something You Might Want To Know About Business

Barriers to entry

Definition: Obstacles that make it difficult or impossible for new firms to enter an industry

Barriers to entry is very much synonym to monopoly & oligopoly market structure. On the other extreme, perfect market is assumed to have no barriers to entry & exit causing the market to be flooded with sellers

Types of barriers:

(1) Globalisation. At the international level, trade restrictions such as tariffs & quota are also considered a form of barrier into the market of another country. The common one is the Common Agriculture Policy (CAP) which is argued to have hurt millions of farmers in developing countries. Due to the CAP, surpluses of agriculture produce in Europe are dumped into the Third World countries & simultaneously preventing those farmers to export themselves out of poverty by erecting various barriers

(2) Vertical integration. Some large firms may have some control over key inputs of production especially raw materials. Good example will be Bridgestone (tire manufacturer) that had acquired some rubber plantations in Malaysia & Indonesia. By having access & control over important source of inputs they can place existing rivals & potential ones at a disadvantage. In this case will be difficulty to obtain inputs & even if rivals can, it may not be at a low price. This is because Malaysia has comparative advantage in producing it, resulting in lower costs of production. This is called backward-vertical integration

Another is forward-vertical integration. By having good ties or agreements with key retailers & distributors, they can also prevent or limit the ability of rivals or potential firms from getting access into certain market. Example, most of the time Nestle brand product would dominate supermarket & hypermarket shelves & they are placed in a strategic way where it’s easier for in-store shoppers to see. Rival goods may be placed say at the bottom. Also, some may fixed an agreement with distributors to store only their brands, thus totally eliminate the chance of entry by other firms. Coca-Cola had done this before

(3) Predatory pricing & limit pricing. The first refers to the practice of selling at a loss making level to force an existing competitor out of the market. Normally the existing rival is one which is smaller, relatively new & does not enjoy as much supernormal profit as the large one does. Upon successfully doing so, the incumbent firm will then raise the price of its goods or services once again. The ability to do so, lies in the strong cash reserves position of the monopolist or oligopolist

Meanwhile, limit pricing is the practice of selling at a price where new firms find it unprofitable to join the industry. These 2 types of pricing have very much to do with the significant EOS & supernormal profits enjoyed by established firms

(4) High advertising expenditure. Established large firms can afford to spend heavily in advertising to create brand loyalty, by persuading the consumers to think that the goods or services they produced are slightly different from the others. In other word, their goods are not easily substituted by the goods from existing or potential rivals. Also, it can cause demand for their goods to be more inelastic (PED lower than 1)

In such situation, new firms will have to spend much heavier to break the customers’ loyalty towards existing brand & to create powerful household names. In reality, new firms are very much reluctant to take the gamble as there is no guarantee over the success. All those costs will be sunk costs at the end of the day

(5) Economies of scale (EOS). It is defined as fall in the long run average cost curve associated with an increase in output. Large established firms enjoy all sorts of EOS such as financial, managerial, marketing, technical etc because they produce in large quantity owing to the large customer base that they have. This results in cost saving which can be passed on to the customers. New firms tend to be more inefficient as their average costs (AC) will be greater than those realised by large firms. Therefore they lose out in terms of pricing competitiveness

(6) High set up costs. Normally those businesses in oligopoly or monopoly market structure required large upfront investment such as specialised machineries & technologies. This is very obvious in car manufacturing, jet manufacturing, telecommunication industry, IT related business, information news dissemination such as Reuters & Bloomberg etc. In other word, high ratio of fixed to variable costs. All these are considered as sunk costs, as they are not easily converted to other form of usage shall a firm consider to exit the industry. Therefore we say high sunk costs act as a barrier to entry & exit

(7) Legal barriers. Often created by government policy. One good example is patents. It is actually meant to encourage invention & technological progress. Once the good obtains patents, the incumbent firm has the sole right to produce that particular good for a certain period of time. Within that period, the firm which made the discovery can reap supernormal profits as there are no rivals that come up with similar goods. Even if there is, that firm can be sued. One good example will be the legal tussle between Polaroid Corp & Eastman Kodak. Polaroid Corp made the discovery on instant camera. Observing the supernormal profits reaped, Kodak then enter the market with its version of instant camera & this caused Polaroid to suffer from falling profits due to falling price. Kodak was taken legal & asked to pay Polaroid compensation


Catzy said...

I have been searching for a useful blog to read and now I have finally found one!
Thanks for a great blog from an economics student :)

Lawrence Low said...

Thanks Catzy, do come in more often to look out for more info