Barriers to Entry

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Define ‘barriers to entry’

These are blockages put in place that are designed to block potential entrants from entering a market profitably.

Define ‘barriers to exit’

Any obstacle/obstruction in place that may stop firms from leaving an industry.

Define ‘contestable market’

This is a market that has very low barriers to entry and exit and the cost to new firms is the same as incumbent firms.

Define ‘Sunk Costs’

These are costs that cannot be recovered if a business decides to leave an industry. Examples include: – Capital inputs that are specific to a particular industry and which have little or no resale value. – Money spent on advertising/marketing/research which cannot be carried forward into another market or industry.

Explain 8 examples of barriers to entry.

• Patents: A patent keeps an invention the property of the inventor for a number of years thus granting them the sole right to exclude others from making, using, or selling that invention. • Limit-pricing: Firms may adopt predatory pricing policies by lowering prices to a level that would force any new entrants to operate at a loss. • Cost advantages: This is when incumbent firm can lower costs, perhaps through experience of being in the market for some time, which allows them to cut prices and win price wars. • Advertising and marketing: Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive. This is particularly important in markets such as cosmetics, confectionery and the motor car industry. • Research and Development expenditure: Heavy spending on R&D can act as a strong deterrent to potential entrants to an industry. Most of the R&D expenditure goes towards developing new products but it also allows for firms to improve their production processes and reduce unit costs. This makes the existing firms more competitive in the market and gives them a structural advantage over potential rival firms. • Presence of Sunk Costs: some industries have very high start-up costs or a high ratio of fixed to variable costs. Some of these costs might be unrecoverable if an entrant opts to leave the market. This acts as a disincentive to enter said market. When sunk costs are high, a market becomes less contestable. High sunk costs (including exit costs) act as a barrier to entry of new firms (they risk making huge losses if they decide to leave a market). • International trade restrictions: Trade restrictions such as tariffs and quotas should also be considered as a barrier to the entry of international competition in protected domestic markets. • Economies of Scale: allows large firms to enjoy low costs of production and therefore new firms operating on a smaller scale will find it hard to compete.

Explain 5 examples of barriers to exit.

• Asset-write-offs: e.g. the expense associated with writing-off items of plant and machinery, stocks and the goodwill of a brand. • Closure costs: including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property. • The loss of business reputation and consumer goodwill: a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult of impossible to obtain. • A market downturn: may be perceived as temporary and could be overcome when the economic or business cycle turns and conditions become more favourable. • Sunk Costs: since these are costs that are not recoverable should the business decide to leave, this disincentives incumbent firms from leaving the market.

Define ‘goodwill’

The established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold.

What is a perfectly contestable market?

A perfectly contestable market is a marker in which there are no barriers to entry and exit and the costs facing incumbent and new firms are equal.

Is this possible in reality?

In reality the concept of a perfectly contestable market does not exist. Rather, degrees of contestability are more applicable to real life situations. Some markets are very contestable (e.g. fast food industry) whereas others are not very contestable (e.g. motor car industry).

What is meant by ‘hit-and-run entry’?

This is short run entry into a contestable market seeking to take some of the monopoly profits available and then exiting just as quickly. This is made possible only when the entry and exit costs are low and is only possible when the existing firm are charging high prices relative to cost.

What is meant by ‘cream-skimming’?

This strategy involves finding segments of the market that are high in value added (or high profit margins) and exploiting those markets by selling only to the most profitable parts of the business. Thus a business may provide a product or a service to only the high-value or low-cost customers of that product or service, while disregarding clients that are less profitable for the company.

What are the 7 ways a market can become more contestable?

• Technological spill-over: This can lead to the development of rival products that copy or imitate the characteristics of the incumbent firms. • Technological change: The impact of new technology is having a huge effect, not least because it brings down some of the entry costs in some markets (leading to an increase in capital mobility). The rapid expansion of e-commerce for example has led to the emergence of new players in the travel sector and online gambling, insurance and many other markets. • Entrepreneurial zeal: It is often the case that markets become more competitive because of the persistence of entrepreneurs who simply do not accept that the existing market structure is a given. Decisions to enter markets where there are already dominant businesses with significant industry experience involves taking risks – but a new supplier may have the advantage of product innovation or a more competitive business model based on different pricing strategies. • De-regulation of markets: (aka market liberalisation), de-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist. Good examples of recent deregulation include the main utilities such as gas and electricity and also the liberalisation of telecommunications and postal services as part of the EU competition initiatives. • Competition policy: Tougher competition laws acting against predatory behaviour by existing firms are designed to make markets more contestable. In both the UK and the EU this has included tougher rules against price fixing cartels. When market contestability is weak, there is nearly always greater scope for cartel-type behaviour by the existing firms, particularly if the market structure in which they operate comes close to an oligopoly. • The European single market: The development of the single European market has opened up markets for member nations. E.g. home and car insurance and also the entry of western European clothes retailers onto the UK high streets and shopping malls. • The recession: an economic downturn can have the effect of opening up markets to new businesses. For example, the recession and subsequent slow recovery has also led to an increase in market share for a number of discount food retailers such as Aldi and Lidl – taking away some of the market share from dominant food retailers.

Give 4 examples where this has happened in UK markets.

• Free newspapers e.g. Metro • Low cost airlines (Ryanair and EasyJet) • Contestability in the broadband market. • Fitness franchises.

Describe barriers to contestability.

What is meant by the term ‘pure monopoly’?

A pure monopoly is where only one producer exists in the industry.

Can this exist in reality?

No because there’s always some form of substitute available.

At which point may firms be investigated by the competition commission for examples of monopoly power?

When market share exceeds 25%.

What assumptions are made when discussing the monopoly model?

• There is a single seller of a good. • There are no substitutes for the good, either actual or potential. • There are high barriers to entry into the market. • The firm aims to maximise profits by restricting quantity.

Explain what is meant by the term ‘natural monopoly’

A market where long-run average costs are lowest when output is produced by one firm.

Explain what is meant by the term ‘legal monopoly’

A market where a firm has a share of 25% or more.

Explain what is meant by the term ‘monopoly power’

This refers to cases where firms influence the market in some way through their behaviour – determined by the degree of concentration in the industry.

What are the characteristics of firms exercising monopoly power?

Price: could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency: could be inefficient due to a lack of competition or could be higher due to exploitation of economies of scale. Innovation: could be high because of the promise of high profits, possibly encourages high investment in research and development which acts as a barrier to entry.

What are the problems with the monopoly model?

• Often difficult to distinguish between a monopoly and an oligopoly – both may exhibit behaviour that reflects monopoly power. • Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation in reality. • Degree of contestability of the market may influence behaviour. • Monopolies not always ‘bad’ – may be desirable in some cases but may need strong regulation. • Monopolies don’t have to be big – could exist locally.

Draw the monopoly diagram indicating the point at which profit is maximised, the market equilibrium, the point of efficiency and how supernormal profits are generated.

Define ‘productive efficiency’

This exists when production is achieved at the lowest cost.

Define ‘allocative efficiency’

This is concerned with whether the resources are used to produce the goods and services that customers wish to buy. Hence it is where price is equal to marginal cost. Thus the price paid by the consumer is equal to the ‘price’ paid of production.

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