Barriers to Entry

A barrier to entry is any obstacle that prevents potential entrants from enjoying the benefits that accrue to incumbents (established firms). These obstacles may be classified as structural or strategic. The benefits that accrue to the established firms are usually defined in terms of long-run abnormal profits (price set above minimum long-run average cost), but may also include other advantages, for example, in research and development. The key point to emphasize about barriers to entry is that they yield rents that are only available to incumbent firms; such firms earn these rents precisely because they are established in a particular industry.

Structural Barriers

Structural barriers to entry depend on the factors that determine the competitiveness of an industry (for example, demand for a product and technology). Neither incumbent firms nor potential entrants can directly determine the size of these barriers. Examples of structural barriers include economies of scale, absolute cost advantages, and product differentiation. Economies of scale are defined as the rate at which long-run average costs of production fall as output is increased. The point at which these costs are minimized is the minimum efficient scale of production (MES). If the MES is very large in relation to market demand it may only be viable for one incumbent to exist in this industry.

Absolute cost advantages exist when the incumbent's long run average cost is below that of the potential entrant's for all levels of output. In other words, and unlike the case of economies of scale, the scale at which the potential entrant chooses to enter does not affect the cost disadvantage it experiences with respect to the incumbent. Exclusive access to superior technology via patents is one way in which absolute cost advantages are realized.

Product differentiation means that the output of one firm is not perceived by consumers to be a perfect substitute for the output of other firms. This, too, is another type of structural barrier to entry. For example, if consumers are loyal to established brands it can be very difficult (and expensive) for potential entrants to attract customers. Other factors that influence product differentiation barriers to entry include customer inertia, switching costs, product reputation, and established dealer systems.

Strategic Barriers

The major weakness of structural barriers is that they provide little information on how incumbents would respond if entry occurred. This is important because structural barriers may not in themselves be sufficient to deter entry. For example, a new entrant may be able to undercut the monopoly price of the incumbent and force the latter to exit the industry. To overcome this problem a variety of alternative theories of barriers of entry have been developed, which are classed as strategic. Strategic barriers to entry are the actions taken by incumbents to influence the behavior of potential entrants. A key insight of such theories is that actions taken by the incumbent pre-entry alter the post-entry returns available to the potential entrant. Recognizing that ex post returns are less attractive than was anticipated, the potential entrant does not enter.

Pricing policy and commitment are two types of strategic entry barrier that figure prominently in the literature. Limit pricing was one of the earliest [Page 118]theories used to examine the way in which the pricing decisions of an incumbent could deter entry. The limit price is the highest the incumbent believes it can charge without attracting entry. Two assumptions underlie this theory. First, the incumbent has exhausted economies of scale and therefore produces at the minimum of long-run average cost. Second, potential entrants believe that the incumbent will maintain its output at the pre-entry level even after entry. Effectively, the decision to enter will depend on whether it is profitable for the potential entrant to supply the residual demand function (that not met by the incumbent). However, the belief that the incumbent will not change output after entry has been questioned. For example, if entry occurred there is no guarantee that only the potential entrant would incur losses. Recognizing this, the incumbent may allow entry and collude in a market-sharing agreement with the new entrant. Alternatively, it may be more profitable for the incumbent to sell at the monopoly price and permit entry to occur.

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