Major Barriers to Entry of New Firms into an Industry - Essay Example

Discuss the major barriers to entry of new firms into an industry and how these barriers can either give rise to or maintain a monopoly company. In economic theory, a variety of models has been developed within what is called the spectrum of competition. A firm in a highly competitive environment will behave differently from a firm facing little or no competition. Usually firms are divided into categories according to the degree of competition they face. At one extreme is perfect competition where there are numerous firms competing over a homogenous product. Each firm is so small compared to the industry that it has no power to influence price. However, on the other end of the spectrum is monopoly where one firm determines the price. Such firms face little or, in some cases, no competition at all. Each firm in perfect competition is a price taker. This means that changes in output by one firm do not shift the industry supply curve sufficiently to alter the price. If the whole industry makes more or less output, the supply will shift and the price will change but not if one firm increases or decreases output, this means each firm can sell all it wants at the given market price. This also indicates that marginal revenue equals price. Since each unit is sold for the same price in such a market structure, marginal revenue also tends to stay constant therefore giving us a straight horizontal line. However, a monopolist faces a downward sloping demand and is able to set either the price or the output, but not both. A profit maximizing monopolist would choose the output where marginal cost equals marginal revenue. This output will be somewhere over the price range where demand is pricing elastic and will be sold at the price consumers will pay. In most instances, the total revenue for such firms are higher than the cost hence enabling monopolies to earn abnormal profits in the short run as well as the long run. In order for a firm to maintain its monopoly power and abnormal profits there must be barriers to the entry of new firms. Barriers to entry are specifically designed to prevent potential firms from entering into a market. They provide firms a degree of market power without losing their existing market share. Barrier to entry anything that allows incumbent firms to earn supernormal profits without threat of entry (Boyes and Melvin, 220-222). The barriers that can be used to create or maintain a monopoly include: The high fixed cost or setup cost can be the toughest obstacle to tackle. The barrier here is access to capital. Only large firm will be able to fund the necessary investment. An established monopoly is likely to have developed specialized production and marketing skills. It is more likely to be aware of the most efficient techniques and the cheapest suppliers. In most cases, such firms have a major cost advantage because of economies of scale which allows them to operate on a lower cost curve. New firms would therefore not be able to compete and would eventually be driven out of the market. Advertising and brand names with a high degree of consumer loyalty may also prove to be a difficult barrier to overcome. Existing firms can make entry more difficult through brand proliferation where they give customers an abundance of choice hence closing all market niches. The firm’s monopoly position may also be protected by patents and other legal protection such as various forms of licensing or tariffs, which may hinder entrance of local and foreign firms. These provide firms with legal protection for their ideas or designs, which prevent other firms imitating them. If a firm governs the supply of vital inputs such as owning the sole supplier of some component part, it can deny access to these inputs to potential rivals. Moreover, monopolists can propose takeover bid for any new entrant. The sheer threat of takeover may also discourage new firms. Aggressive tactics and intimidation may also act as a barrier. For example, an established monopolist is likely to sustain losses for longer than a new entrant. Thus it can start a price war, mount massive advertising campaign, introduce new brands and so on. In some circumstances, the monopolist may also resort to various forms of harassment, legal or illegal, to sustain their market power and drive the new entrant out of the market (Sloman, 182-183). Other barriers such as sunk costs or collaboration between existing producers may also frighten the new entrant. Monopolists can be a positive force in the economy because to gain that position firms often have to innovate which helps them earn abnormal profits (Gillespie, 38). This acts as an encouraging factor for other firms to innovate in different ways to gain similar rewards. However, a monopoly, in most cases, is allocatively and productively inefficient. Productive efficiency is defined to be the production of goods and services at the lowest cost per unit. This means that it is not possible to make more of any one good without producing less of another. On the other hand, allocative efficiency is defined to be a situation where it is not possible to make one better off without making another consumer worse off (McKnight and Bailey). This occurs at the output where the social marginal benefit equals the social marginal cost. Usually firms in perfect competition are allocatively efficient because they produce where the extra benefit of a unit equals the extra cost, for example P=MC and also productive efficient because they tend to produce at the minimum point of the average cost curve. In contrast, monopolists are likely to charge price greater than marginal cost resulting in an overall welfare loss and may not produce at the minimum of the average cost curve resulting in economic inefficiency. To sum it all, when the barriers for new comers are strong, the market is likely to be dominated by a few large producers. New firms will only enter if they think that the economics returns will be greater the cost of breaking the barriers (Bamford, 170). Works Cited Gillespie, Andrew. AS & A Level Economics. United Kingdom: Oxford University Press, 2002. Print Bamford, Colin, et al. AS Level and A Level Economics. United Kingdom: Cambridge University Press, 2002. Print Sloman, John. Economics third edition. Hertfordshire: Prentice Hall, 1997. Print Melvin, Michael and Boyes, William. Microeconomics. Eighth Edition. Mason, USA: South West Cengage Learning, 2008. McKnight, Lee W. and Bailey, Joseph P. Internet Economics. Sixth Edition. USA: Library of Congress Cataloging-in-Publication Data, 2000. Read More