Effect of Entry Barriers on Prices Charged by Incumbent Firms. Strengths and Weaknesses of Underlying Economic Theory

Essay 2011 6 Pages

Economics - Finance



Entry prevention in imperfectly contestable industrial markets has been topic of extensive interest among academics. This paper seeks to explain effects of entry barriers on incumbent firms’ pricing decisions. Underlying economic theory is critically assessed, evaluating credibility of strategic pricing behavior models in the context of real-life business environment.

1. Introduction

Essentially, initiation of production and sales of a new firm on a market is regarded as market entry. An entrant could be a new firm (one that never existed before), an existing firm diversifying product portfolio or an existing firm diversifying geographically (Besanko, 2004, p.297-300). Distinction between types of entrants is strategically important because of different cost functions and subsequently different entry costs. Diversifying entrant for example may benefit from lower production costs through scope economies if existing capital equipment may be utilized. In addition, favorable corporate image would reduce sunk costs through decreased need for advertised expenditure. Results of numerous empirical studies reviewed by Gerosky (Gerosky, 1995, p.435-438) emphasize that business-continuity of new and diversifying entrants differs indeed, stressing the importance of such distinction. However, regardless of the type, size and cost structure of entrants, entry barriers can be created to hinder shift toward more competitive market. Besanko differentiates between structural and strategic barriers to entry (Besanko, 2004, p.301). For the simplicity of argument throughout this paper, unless states otherwise, monopoly market structure is assumed where incumbent is monopolist profit-maximizing firm.

2. Barriers to Entry

By definition, “barriers to entry are those factors that allow incumbent firms to earn positive economic profits, while making it unprofitable for newcomers to enter the industry” (Besanko, 2004, p.301). Barriers exist because entrants threaten incumbents in two ways. They gain incumbent’s market share and intensify competition, naturally reducing prices, hence shrinking incumbent firm’s profits. It can be distinguished between structural and strategic barriers to entry. Both have key implications on price setting decisions of incumbent firms.

2.1 Structural Barriers to Entry

Structural barriers to entry may include control of resource, economies of scale and scope, marketing advantages, direct “sunk cost investments” (Besanko, 2004, p.302-309). Kay (Kay, 1993, p.115-119) argues that these factors could establish strategic assets depending on market cost structure. At the extreme level, structural entry impediments would be so high that the incumbent firm may not need to undertake strategic actions and yet face blockaded entry, hence retaining monopoly positions in the long-term.

Control of resources refers to position where the incumbent firm possesses specialized know-how resources or exclusive access to input materials. In both cases the incumbent firm benefits from structural barriers resulting in better cost position relative to potential entrants. A firm may actively create such barriers by patenting of products or processes.

Economies of scale and scope of incumbent firms may prove invaluable strategic assets especially if sustained in the long run. Incumbent firm may gain substantial cost advantage over potential entrants if it moved down the minimum efficiency scale (MIS) through learning experience. Even if an entrant does possess production capacity to produce at MIS, it would not be able to capture high enough market share for complete production distribution in the short-run

Marketing advantages refer to reputation that the firm has build over time and credibility associated with its products. A brand umbrella in this case could prove entry barrier. Entrants would need to incur huge sunk costs to build and promote image. Nevertheless, this would only be the case if incumbent’s products are successful.

Direct “sunk cost investments” principally relate to capital intensive fixed assets such as land, plants, machinery that have already been incurred by monopolist firm

2.2. Strategic Barriers to Entry

Strategic barriers to entry relate to strategic corporate behavior aimed at long-term profit maximization through deterring entry of potential competitors (Rickard, 2006, p.339). Fundamentally an incumbent would pursue such strategies only if monopoly profits are larger than duopoly profits and if strategies would change expectation of entrants toward future behavior of incumbent firm. These assumptions are only viable if markets are imperfectly contestable (protected by entry and exit barriers), hence not vulnerable to hit and run strategies. If this is not the case, then price would only be as high as average cost since any increase in price will attract short-term profit seeking firms. Given that markets are imperfectly contestable, Besanko (Besanko, 2004, p.310-321) identifies three entry-deterring strategies each having direct implications on prices charged by incumbent firms.

2.2.1. Limit pricing

Possibly, the most classical example of strategic deterrence is the limit pricing model. Essentially, the strategy implies that the incumbent sets the price of output so low that it discourages potential entrants from contesting the market by sending credible signals about the monopolist’s production cost. This part of the paper combines and utilizes game theoretical models introduced by Rickard (Rickard, 2006, p.342) and Besanko (Besanko, 2004, p.310-321) to explain price effects of limit pricing on incumbent firms.

The model assumes that the market consist of a dominant monopolist and a potential entrant. It also assumes that only the monopolist has the technological capacity and know-how to operate on the market. Demand function of both firms is given by: P = 100 - Q, also Q = P - 100, where P denotes price of output and Q - demanded quantity. Output prices and demand functions are chosen randomly in accordance with basic economic principles regarding nature of competition and pricing. In Cournot and limit price equilibrium, market is shared equally. Pl and Pm stand for limit price and monopoly price strategy respectively. Π I and Π E stand for incumbent and entrant profit. Profit figures are aggregate for the two-year period and are calculated using the demand functions. The model implies only two years of business.

In the first year of business, monopolist can decide between limiting output price and keeping current monopoly price. If it concludes that monopoly profits would still be higher than profits from the best possible duopoly scenario - Cournot equilibrium, then the incumbent would choose to price its output at Pl. In this case the entrant will have the choice of entering business in the second year or staying out. The entrant may decide that such a low prior-to-entry price is a credible signal of the incumbent’s low cost structure, in which case it will not enter the market and end up with Π E = 0 whereas the monopolist firm will raise price back to Pm and generate Π I = 20,000, which would be the limit pricing outcome. In case the entrant irrationally decides that it is worth contesting the market (where the monopolist is also extremely cost effective), the incumbent would have to choose between sharing the market at Cournot equilibrium or limit price. Alternatively the monopolist may decide to keep price at Pm in year 1, further exploiting its monopoly profits. Subsequently, the entrant will need to choose whether to contest or exit the market. In the irrational event of leaving the market, the monopolist firm will reset its price at Pm exploiting the maximum possible profit of Π I = 27,200. In case entrant firm act rationally and enters a market where the output price is set high enough to allow for significant downward movement, the monopolist will need to choose limit or Cournot price equilibrium. The only equilibrium solution here is that the dominant firm earns 18,250 and the entrant - 4,650. Obviously Cournot equilibrium would maximize both firms’ profits in the short-term but assuming incumbent has early mover advantage, one might argue if a price war would not serve his needs better considering the wide dispersion between monopoly and duopoly profits.



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effect entry barriers prices charged incumbent firms strengths weaknesses underlying economic theory



Title: Effect of Entry Barriers on Prices Charged by Incumbent Firms.  Strengths and Weaknesses of Underlying Economic Theory