Entry and Exit in Determining the Evolution of Industry Structure - Assignment Example

ASSESSED ASSIGNMENT (30% OF TOTAL MARK). DEADLINE: 14th DEC 2007 (FRIDAY) WORD LIMIT: 1500 WORDS (excluding foot s and bibliography) PLEASE WRITE THE NAME OF YOUR TUTOR AND YOUR ASSIGNED TUTORIAL GROUP NUMBER ON THE COVER PAGE OF YOUR ASSIGNMENT. ANSWER THE FOLLOWING QUESTION. Question 1: Examine the role of entry and exit in determining the evolution of industry structure. Using the theory of contestable markets and suitable example(s), critically assess the idea that potential competition is an important influence on pricing behaviour. Introduction The main characteristic of a contestable markets is that there are no entry and exit barriers. Hence there is always a threat of new entrants. When the incumbent firms are always facing a threat of new entrants, what is the effect on pricing polices and how does the contestability affect a firm in perfect competition and in monopoly. Perfectly contestable markets A perfect competition market is contestable. The characteristics of perfect competition are as follows: 1. The industry is made up of a very large number of units. 2. Each firm is small relative to the size of the industry. 3. The firms all produce exactly identical products. 4. Firms are completely free to enter and exit the industry. 5. All producers and consumers have a perfect knowledge of the market. In this kind of market, the product/ service provided by all the competitors are the same. When there are few players in the market the demand is high, but the supply is less because of the less number of people in the competition. The price of the product/service is high and the profit margins are also high. This attracts new players to the field as there are no entry or exit barriers. When the number of players in the industry increases, the industry output increases. This reduces the profit margins of the firms. Will the entry of new players stop at this level No, the entry will not stop until the firms are able to make profits. But as the number of firms increases, the industry is squeezed of profits and the firms start making losses. When the firms start making losses, financially weak and the operationally inefficient leave the industry and that is also because there is no barrier to exit from the industry. When more and more number of firms exit from the industry, the output reduces and this helps to increase the market prices and increase the profits. Thus once again the equilibrium is attained. The example of the competition in the Video rental market in United States shows how the lack of entry or exit barriers help shape the industry. In the early 1980s when the Video cassette recorder(VCR) and video cassette player (VCD) was available to the consumers it became a must in many of the households. Statistics show that in 1980 less than 1% of American households owned a VCR. But by 1990 over 70% of families owned one. This led to a huge increase in demand for video cassettes. So movie tapes rental business was a very popular ones. The initial players in the industry had huge profits upto five dollars a night and they were able to recover the cost of the tape after a few rentals. But there was no entry barrier in the industry. Looking at the huge demand and the enormous profit levels, many people started the same business. This lead to increase in competition. So between 1982 and 1987 the number of movie tape rental outlets increased by 400%. Gas stations and grocery stores also rented tapes. This led to a downward pressure on the price, so by 1990 the tape rental rates had fallen down to $ 1.50 per night. The profits had fallen down and this caused many firms to exit from the industry. Entry had ceased. The industry had attained its equilibrium in the long run. With the advent of more modern technologies the movie rental industry is going to shrink even more. Due the fact that the product is identical and the industry has no entry and exit barriers, the firms in this kind of industry are price takers. They have very little control over the price, the profits for the firms depends on the industry output. But the consumers benefit from the low costs of economies of scale and gain from the low prices and high outputs due to contestability. Though in the real world it is very rare to have perfect competition in industries, it can be clearly observed in agriculture sector. We can understand if a farmer produces wheat, it is wheat whoever produces it. With no product differentiation, the farmer is clearly a price taker. He has a very negligible impact on the total output. Thus he enjoys only a normal profits, that is the profits that just cover his costs and make him continue the business. Contestable monopoly markets Basically a monopoly market is dominated by one firm. This may be because of various reasons like the availability of resources, skills possessed by the person, innovative ideas or technology development by one firm, etc. but he creates a condition where the customer has no other choice but to consume the product or service from that producer. The theory of contestable markets argues that it is the threat of competition, rather than actual competition which determines a firm's price and output. It puts its focus not what the market form is but more on the profitability of new firms entering the industry in the future. Thus a firm with a market monopoly would modify its pricing policy if there was a threat that another firm could enter and takeover its market. A firm may have monopoly at the moment, but what is the likelihood that other firms will be attracted to the industry in the future If the chances are high, then the firm will probably keep prices low and simply make normal profits in order to discourage entry by others. The contestable market theorists argue that the entry and exit costs determine the likelihood of future competition. An example of this is the expectation that Indian Pharmaceutical companies Ranbaxy and Dr Reddy's Laboratories to be major beneficiaries to take advantage of a multimillion dollar sales vacuum created by the patent by the expiry of the patents of two popular drugs in the US. One of the drugs is a cholesterol - cutting drug called Zocor and the other is an antidepressant drug named Zoloft. Merck earned huge profits from the sales of Zocor, whose patent expired on 23rd June. Pfizer lost its patent on 30th June. When a company loses its exclusive patent for a branded drug, it is no longer a monopoly in the market and the market opens for generic drug makers. This can lead to a drop of nearly 80% in the drug's price, resulting in a major gain for consumers as well as the makers of generic versions of the drugs. Indian companies are in good shape to gain from the patent expiries in developed markets like the US and Europe. They have a tremendous ability to create, manufacture and market generic drugs at low prices, aided by the availability of cheaper and skilled labour. The forces which shape the industry structure are the entry and exit costs. Entry costs can be the cost of constructing the plant, cost of setting up of the machinery, etc. The exit costs include the capital equipments that cannot be sold. A market is contestable of the sunk cost of entry is very low. If a market is contestable, the monopolistic firm or firms (in case of oligopoly) charge lower prices than the short run profit maximizing price. Thus the monopolist may flood the market with his products by creating a over capacity and drive down the price in the event of threat of new entrant. Predatory pricing is also possible. Also he can adopt aggressive marketing and branding strategies to tighten up the market. The threat of new entrant keeps the prices of the monopoly firm very low and its production efficient. The threat also ensures that it would take advantage of any economies of scale and technology improvements. Thus by keeping the costs as low as possible it remains unattractive to potential rivals. It can be understood that the single monopolist will have supernormal profits and with low entry and exit barriers the threat of other firms from entering would cause the monopoly to lower the process and increase the quantity. In the extreme case of a perfectly contestable market the monopoly would increase production, where the profit is normal. Another firm will enter only if it believes that it can knockout the first firm and takeover the whole market itself. It will not be possible to do this if the existing monopolist keeps the prices low, doesn't make supernormal profits and is efficient with respect to cost and technology. Thus , even though it is monopoly, the firm behaves very competitively, benefiting consumers and this is due to the fact that the market is contestable. There are high chances that firms will adopt hit and run tactics, i.e., as the entry and exit barriers are nil, many firms enter the industry for short run profits. As more number of firms enter the business, the industry output increases which brings down the prices. When the profit levels come down, they leave the industry, hence, called hit and run strategy. Another strategy the monopolist can adopt is the cream skimming strategy, i.e., identifying the high profit segments and catering to it. Example: The sectors that have become contestable recently are the internet service providers, Online Communications (including video conferencing; virtual reality games; publishing; home shopping; travel services; information services; databases), Home Banking and Financial Services, Electricity and Gas Supply, Parcel delivery, Opticians. Of all these industries, the retail banking industry has undergone a revolution in the recent years. Many former building societies in US including Halifax plc have de-mutualised and become fully-fledged commercial banks. National food retailers such as Tesco and Sainsbury have launched hugely successful banking operations with millions of customers. Tesco's Clubcard Plus scheme provides a full range of financial services including mortgages and travel insurance. The market for mortgage finance and long-term savings in equities and deposit accounts has been affected by the entry of companies such as Virgin Direct, Egg and Standard Life Bank. Standard Life has built up a "mortgage book" in excess of 1.7 billion even though its operation started in January 1999. It has taken a 15% share of the market for new mortgage lending. European and North American mortgage lenders are entering the UK market in increasing numbers. Egg smashed its way into UK retail banking in October 1998. Owned and run by Prudential - one of the world's largest insurance companies, EGG offered high-interest savings accounts (initially a guaranteed interest rate of 6% on all deposits) plus low mortgage rates (priced at 5.99%). Prudential set a target of attracting 5 billion worth of deposits in the first five years. This was exceeded in little more than six months! The cost of market entry was put at 77m in the first year, rising to 200m over three years. Egg is now limiting new accounts to those customers with Internet accounts - whose banking costs are much lower than traditional customers. One feature of a contestable market is that new entrants may seek to "cream skim" the most profitable segments of an industry. The trick is to identify which sectors of a market offer the best returns and then successfully target existing customers.The largest UK banks make profits of hundreds of millions of pound every year - but most of this money comes from user-services such as foreign exchange commission and high interest loans to a relatively small number of customers. Many accounts in high street banks are loss-makers - particularly those held by people with tiny savings balances who rarely use other bank services. Conclusion We can understand that contestability is not a feature of just perfect competition. It can be experienced in other market conditions like monopoly, oligopoly and monopolistic competition. When the markets are contestable, the consumers are at great advantage as they gain from the reducing prices. It makes the firms more efficient and economic. Hence, the barriers to entry into an industry, if it is created by the monopolist or by the government should be reduced to give the benefits to the ultimate consumer. References: 1. Blink Jocelyn and Dorton Ian, Economics, Oxford, Oxford University Press, 2007 2. Glanville Alan, Economics from a global perspective, Glanville Books Ltd, 2006 Read More