The Relationship between Barriers to Entry and Economic Performance - Essay Example

The relationship between barriers to entry and economic performance [Professor’s name] [Date] Introduction Entering into a particular industry is not an easy task for a firm. It is generally assumed that a firm would be able to survive in an industry only if it is efficient enough to compete with other firms. But, the question of competition within an industry comes only when a firm possesses the ability to enter into it. The theory of perfect competition assumes that firms are free to enter into or exit from a market. In practice, it is quite difficult to find out a perfectly competitive industry where a firm does not face any impediments while entering into it. In fact in many markets there exist some dominating firms which play the roles of market leader. These large firms in order to maintain their market share create some barriers for new firm to enter into the market. (Baldwin, 1995) Barriers to entry into a particular industry have immense potential to diminish or entirely prevent the normal mechanism of that industry in attracting new firms towards it. To negatively affect competition in an industry along with the welfare of consumers, it is not always necessary for entry barriers to prevent firms from making their entry into that industry forever. In fact, very often these barriers can create significant effect on the performance of the market only by retarding the arrival of new entrants into it. It is of course true that consumer will suffer from monopoly level pricing for long if entry barriers prevent firms from entering into the market indefinitely, but along with this, it is also true that consumers will also suffer if decline in prices from increasing competition is delayed by delayed entry of new firms due to entry barriers. (Geroski, 1995) Theoretical models of barriers to entry The first important contribution in the area of discussion on entry barriers was made by Bain (1956). Bain made an attempt to define an entry barrier in terms of its effect on firms’ profitability. According to Bain if entry barriers exist in an industry then existing firms will be able to earn profits beyond their normal level without inducing other firms to make an entry into the market. Bain had argued that entry of new firms into an industry is determined by the level of advantages that the existing firm in the industry enjoys over the potential new entrants. He made a comparison between established firms’ profit prior to the entry of potential entrants and post entry profit level of new entrants. According to Bain, there will be an entry barrier if an entrant fails to attain the profit levels that established firms used to enjoy before the arrival of the entrant. The entry will be completely deterred if post entry profits of entrants are less than zero. This definition put forth by Bain, however, suffers from a complication. The complication lies in the fact that if an entry to barrier is so defines then it might be the case that what seems to be a barrier from a particular firm’s point of view, may not necessarily seem so from the point of view of another potential entrants. Looking at the complication of the definition of entry barriers forwarded by Bain, Stigler (1968) later offered a contrasting view on barriers to entry. Stigler defined a barrier to entry as a cost advantage that an incumbent enjoys over potential entrants. Weizsacker (1980), on the other hand argued that a cost advantage can be regarded as an entry barrier only if it has potential to reduce welfare. As far as the factors that determine barriers to entry into a certain industry are concerned, economists have found out a large set of factors which hinder new firms in making their smooth entry into the industry. Economists like Baumol, Panzar and Wiling (1982) were of the view that cost structure plays an important role in determining entry barriers. They argued that in the absence of sunk costs there is no impediment to entry and hence every existing firm in the industry uses to be under the pressure of new entry and therefore operate efficiently. In such a case, it can well be expected that prices will be approximately equal to average costs. However the problem is that in practice it is difficult to find an industry which does not have any sunk costs. A part of the costs of most of the industries is used to be sunk costs. Thus impediments to entry also exist. Apart from the cost structure, excess capacity also assumes an important place as an explanation to entry barriers. The theoretical models put forth by Spence (1977) and Dixit (1980) for the first time pointed out an asymmetry between an existing firm and a potential entrant. In these models, an incumbent is generally found to select a particular capacity level of production in the first period whereas in the second period both the incumbent and the potential entrant determine quantities simultaneously. In these models an incumbent is assumed to produce at or below the selected capacity level in the second period and its marginal costs becomes lower than that of potential entrants as the incumbent possesses the capacity of avoiding costs of capacity expansion in the second period. According to these models, a first mover advantage is enjoyed by the incumbent. These models generally followed the framework of the model forwarded by Stackelberg. Stackleberg had assumed in his model that barriers do exist at the time of entering into in an industry and all existing firms in the market possess market power to some extent. He also made a number of some crucial assumptions like the market leader knows that the follower will observe its action, the followers have no way of committing to a future non Stackelberg action and this inability of the follower is known by the leader. Thus following these assumptions if a follower strictly follows the action of the leader and this activity pattern of the follower is known by the leader, and then the best response on that part of the leader would be to play the follower action. According to this model, a firm will be interested to be a part of Stackelberg competition if it poses some advantage that would help it to move first. (Spence, 1977) Another important factor that causes barriers to entry is product differentiation. In the presence of horizontal (difference in varieties) and vertical (difference in qualities) product differentiation, products of the different firms within the same industry seem to be imperfect substitutes. If the process of introducing new bands is associated with very high costs, then product differentiation has potential to result in entry barriers in a persistent way. Very often existing firms in an industry are very much interested in differentiating their products and make attempts to increase the level of perceived differences of their products through advertising. Through advertising, existing firms try to increase their customers’ loyalty towards their products and in this way they create impediments in the way of entering into the market. In fact, advertisement costs are sunk costs and therefore they are quite capable of deterring potential entrants from entering into the market. (Spence, 1977; Collins and Preston, 1969) Apart from these, existing firms can also create entry barriers through innovation. Bain (1956) had identified the process of innovations as a cost reduction tool. Thus if existing firms spent money on R&D activities, then it will provide advantages to existing firms which in turn would result in reduced entry. However, there also exists an opposing idea in this context. It can also be said that as in a large number of cases many potential entrants are new group of innovators who try to extract benefits from their innovations’ market potential. Thus instead of impeding entry, innovation can in fact spur it. (Geroski, 1989) Relationship between economic performance and Barriers to entry The above theoretical discussion clearly shows that the existence of barriers of entry has some important consequences on economic performance. Economic performance not only depends on the firms’ performances, but also on consumers’ welfare. On the basis of the above discussion, it can be argued that barriers to entry significantly reduce competition within an industry. As found in theories, welfare is maximized within a perfectly competitive set up while welfare loss is maximized in a monopolistic market. In monopoly market only one firm dominate the entire market and new entrants are prevented from entering into that market. Monopolistic operation results in significant dead weight loss which in turn implies loss in economic efficiency. The higher the level of barriers to entry into a market, the higher will be the extent of monopoly power that exiting firms will enjoy. The most common argument against monopoly power of a firm in the market which deters other firms from entering into the market is that monopolistic producers have a tendency to earn abnormal profits at the expense of economic efficiency. When entry barriers results in loss in competition, economic efficiency gets declined which in turn affects the consumers’ as well as the society’s welfare. This issue of loss in efficiency in economic performance in the presence of barriers to entry can be illustrated in the following way: Production under high level of monopoly power which has resulted from higher level barriers to entry leads to three kinds of losses in efficiency in economic performance: allocative efficiency, productive efficiency and X efficiency. When a market deviates from a perfectly competitive set up, then prices are set at a level higher than marginal as well as average costs of production. This kind of price setting system leads to a loss in allocative efficiency and makes the market mechanism to fail as a firm with higher level of market power becomes able to earn a profit higher than the normal. (Varian, 2000; McConnell et al. 2004) Profit maximizing behavior of a firm in an imperfect market environment also results in productive inefficiency as at the equilibrium point, the producer is not operating at the lowest point on the average cost curve. In perfectly competitive market, a firm operates at the lowest point on the average cost curve in long run. It simply implies that at optimum level, average costs incurred by a monopolist is quite higher. Thus a firm with high market power fails to make efficient use of available scare resources. (McConnell et al. 2004; Blinder et al. 2001) Operation of a firm in an imperfect market set up also results in X-inefficiency. The term of X-inefficiency was first introduced by Harvey Libenstein. X inefficiency results from the absence of real competition. When real competition is not adequately present in a market, then producers have less incentive to make sufficient amount of investment in the generation of new innovative ideas or to take into account the aspect of consumer welfare. (McConnell et al. 2004; Blinder et al. 2001) All these kinds of economic inefficiency increase with increase in barriers to entry. If new firms can easily enter into any industry of an economy, then aggregate productivity growth of the economy will rise as the industries will be able to perform more efficiently. This productivity growth of economy originates from three sources. The first one is referred to as “within effect” which implies productivity growth if individual firm which is resulted from organizational changer, increased R&D activities, increased competition, introduction of new technologies etc. On the other hand, the other two sources of productivity growth from new entry are referred to as “external restructuring” which is generally done by two ways- first, creative destruction through which firms with low productivity are replaced by new high productive entrants (Aghion and Howitt, 1996), and second, a change in the level of market share among the existing firms (Aghion et al. 2003). A number of empirical studies have found that decrease in barriers to entry have resulted in increase in economic performance by increasing the productivity of the economy (Disney et al. 2003; Scarpetta et al. 2002; Martin and Jaaumandreu, 1999). For example, Scarpetta et al. (2002) have found that decrease in entry barriers contributed around 20 to 40 percent growth in productivity in many European countries including the UK. In another study Martin and Jaaumandreu (1999) have found positive relationship between entry and aggregate economic growth in Spain. Although, smooth entry into an industry has potential to increase economic performance as a whole, in many EU countries including UK a large number of industries have entry barriers. The retail industry is one of the most crucial examples of such entry barriers. These entry barriers have resulted in decrease in economic performances of the countries by causing inflation, reducing purchasing power of consumers which in turn negatively affected the productivity growth of the economies. EU has conducted some policy investigation to look into these matters and to provide some solutions to these. Conclusion One of the prime current concerns of almost all European government is the significant reduction in the purchasing power of consumers, particularly with regards to food. Inflation has been back in most of the EU nations including the UK. Among the important factors that are responsible for this is the abuse of market power by dominant firms in the presence of entry barriers. The sector in which significant barriers to entry and abuse of dominant positions by existing firms are the most visible is the retailing industry. In EU, retailers are very often accused of “abusively controlling access farmers and other suppliers to EU shoppers in forcing down prices to unsustainable levels and in imposing unfair conditions.” The European parliament has started to look into this matter more seriously now. It has made a declaration in written form that it would investigate the issue of entry barriers and abuse of market powers by supermarkets and try to remedy these. (Eurocommerce, 2008) Many European countries have started to take this declaration seriously. The UK has expressed huge concern on this issue and set up a Competition Commission which is investigating into the food retailing industry of the country. It is particularly examining the dominant positions created by a few supermarket chains in some local areas by controlling entry of new firms in those areas. (Eurocommerce, 2008) The written declaration has started to exert effects in many countries. For example, the investigation commission in France has found that one of the major causes of market power abuse by dominant firms is the regulatory framework that significantly acts as a barrier to entry in the retail industry. The commission has therefore stressed on weakening entry barriers through new policies. (Eurocommerce, 2008) It can therefore be conclude if government does not take sufficient measure to efficiently controlling barriers to entry into any industry, then economic performance will suffer and productivity growth will be negatively affected by decrease in the level of entry of new firms. References: 1. Aghion, P. and Howitt, P. 1996. “A Model of Growth through Creative Destruction”, Econometrica, vol. 60, no. 2, pp. 323-351. 2. Aghion, P., Blundell, R., Griffith, R., Howitt, P. and Prantl, S. 2003. “Firm Entry and Growth: Theory and Micro Evidence”, mimeo. 3. Bain, J. 1956. Barriers to New Competition, Harvard University Press. 4. Baldwin, J. 1995. The Dynamics of Industrial Competition, Cambridge University Press. 5. Disney, R., Haskel, J. and Heden, Y. 2003. “Exit entry and establishment survival in UK manufacturing”, Journal of Industrial Economics, 51, pp. 93-115. 6. Dixit, A. 1980. “The Role of Investment in Entry-Deterrence”, The Economic Journal, 90(357), pp. 95-106. 7. Foster, L., Haltiwanger, J. and Krizan, C. 1998. “Aggregate productivity growth: Lessons from microeconomic evidence”, NBER working paper n° 6803. 8. Geroski, P.A. 1989. “Entry, Innovation and Productivity Growth”, Review of Economics and Statistic, 71, pp. 572-78. 9. Geroski, P.A. 1995. “What Do We Know About Entry?”, International Journal of IndustrialOrganization, 13, pp. 421-440. 10. Martin, A. and Jaumandreu, J. 1999. “Entry, exit, and productivity growth in Spanish manufacturing during the eighties”, documentos de trabajo, Fundacion SEPI, Programa de investgaciones economicas, Madrid. 11. Scarpetta, S., Hemmings, P., Tressel, T. and Woo, J. 2002. “The role of policy and institutions for productivity and firm dynamics: evidence from micro and industry data”, Economic Working Paper (2002)15, OECD: Paris. 12. Eurocommerce. 2008. DO EUROPEAN GROUPS ACTIVE IN FOOD AND NON-FOOD WHOLESALE AND RETAIL ABUSE THEIR DOMINANT POSITION? Available at www.hec.edu/content/download/30193/.../eurocommerce_avril08.pdf [accessed on 24th august, 2009] 13. Baumol, W. J., Panzar, J. C. and Willig, R.D. 1982. Contestable Markets and the Theory of Industry Structure, Harcourt Brace Jovanovich, New York. 14. Collins, N. and Preston, L. E. 1969. Price-Cost Margins and Industry Structure, Review of Economics and Statistics 51, 271-286. 15. Spence, A.M. 1977. Entry, Capacity, Investment and Oligopolistic Pricing, Bell Journal of Economics 8, 534-544. 16. Stigler, G.J. 1968. The Organization of Industry, Chicago University Press, Chicago, IL. 17. Weizsäcker, C.C. 1980. A Welfare Analysis of Barriers to Entry, Bell Journal of Economics 11, 399-420. 18. Varian, H.R. 2000. Intermediate Microeconomics – A Modern approach. East-West Press. 19. Blinder, A.S; Baumol, W. J and Gale, C. L 2001. Microeconomics: Principles and Policy. Thomson South-Western 20. McConnell, C. R.,. Brue, S. L. and Campbell R. R. 2004. Microeconomics: principles, problems, and policies. McGraw-Hill Professional Read More