EBF 200
Introduction to Energy and Earth Sciences Economics

 

Barriers to Entry

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Reading Assignment

This material is discussed in Section 9.1 of the text, in Chapter 9. You should have read Chapter 9 for the previous lesson, so this will be review for you.

In the previous lesson, we spoke about monopolies and oligopolies. These are markets where there is only one or are only a few sellers, and therefore, suppliers in these industries are able to earn greater than zero economic profits by charging at prices above the point where P = MC.

In a competitive market, this would be a signal to other suppliers to enter the market and compete for business with other suppliers by driving price down to marginal cost, and economic profits down to zero. In a monopoly, this does not happen. This is one of the violations of the assumption of "free entry and exit." Here we will talk about "free entry," or the ability of firms to enter a market. Another manifestation of this assumption is the notion of "free exit," meaning that an individual is free to choose to not participate in an economic transaction. When people are negatively and involuntarily affected by some economic transaction they do not willingly participate in, we have the issue of "externalities." This will be addressed in the following lesson.

As I said in the previous lesson, there is a very limited set of reasons why monopolies can persist. These are:

  1. A monopoly has government protection.
  2. A monopoly involves having total control over a limited-supply good.
  3. A natural monopoly exists, where it is economically efficient to have only one seller.

The third of these types of market, a natural monopoly, will be talked about in the next section of this lesson. In this section, we will talk about the first two types of monopoly.

Economists generally believe that market forces are always powerful enough to break a monopoly. For a monopoly to be able to stay in existence over time, it must need some protection from market forces, and such protection can only typically come from government. In most cases, government generally acts to try to reduce monopoly power, since we demonstrated in the past lesson that monopolies are detrimental to economic efficiency, as well as hurting equity. Put in simpler words, we don't like monopolies for a couple of reasons: they tend to concentrate wealth into the hands of already wealthy individuals, and they hurt the total wealth of a society by causing unsatisfied demand to exist - there are people who are willing to purchase a good at a price higher than the marginal cost, but are unable to because monopolists refuse to produce the goods, instead restricting output to the point where MC = MR.

So, governments generally discourage monopolies. At the Federal level in the US, this is typically performed by the Federal Trade Commission, or FTC, which is a branch of the Department of Justice responsible for maintaining fair and open markets. Another group that polices markets, specifically in the energy arena, is the Federal Energy Regulatory Commission (FERC). I strongly suggest that you take a look at the FERC website if you are interested in how the energy industries are regulated at the Federal level. There is a wealth of information available at that website. If firms act in ways that are deemed to be detrimental to competitive markets, they can be sued, fined, or punished in other ways. One famous case involved the Department of Justice suing Microsoft for being an illegal monopoly, and seeking to break Microsoft up into three companies, two operating system developers, and one applications developer. Microsoft was able to defeat that lawsuit. Another famous case was the breakup of Standard Oil in the first decade of the last century. I suggest you read about the Standard Oil case.

However, despite the fact that government generally fights monopoly, there are some instances where governments either allow, encourage, or even protect monopolies. These, and some other barriers to free entry in a market, are described below.

Types of Barrier to Entry

Legal Restrictions

Governments sometimes restrict competition, either from domestic or international competitors. This is sometimes done to help develop a native industry where none existed, sometimes for nationalistic reasons, and sometimes because a firm has lots of influence with the government. For example, the United States restricts the importation of sugar into the country, protecting from global competition the 800 or so firms in the US that make sugar. This harms American citizens who consume sugar by making it about twice as expensive as in neighboring countries. It also drives candy manufacturing to Canada, because the cost of making candy is cheaper there, and there are few barriers to the entry of candy into the country.

Licensing Requirements

In many cases, in order to enter a profession, a government either sets licensing requirements, or empowers some other body to set such conditions. In many cases, this is generally approved of by the public: we like knowing that our doctors know what they are doing, and that our accountants are certified as competent. However, such rules apply to many other professions. In many states, if you wish to buy a casket to bury a deceased relative, you have to buy one from a funeral director, and to become a funeral director you have to get a licence. The awarding of licenses is typically controlled by commissions that are dominated by members of the funeral profession. Therefore, an industry is able to restrict free entry by competitors, enabling the incumbent members to set prices higher than in a free market. The same is true of flower arrangers, or hair cutters, or tour guides in many states. The industry in question will have licensing commissions, whose role is nominally to protect the public from fraud or incompetence, but which, in reality, merely serve to restrict entry and stifle competition.

Another example of this is taxi commissions. In most cities, if you wish to operate a taxi cab, you need a licence, often referred to as a "medallion." In most cities, the number of medallions available is limited. For example, in New York City, there are 13,000 taxi medallions available. Many people believe that this is far too few for a city the size of New York, and one of the effects is that a lot of unlicensed "gypsy" cabs operate, completely out of the view of the authorities, in violation of regulations.

Patents

A patent is a government license to have a monopoly for a certain length of time in a certain good. Patents raise the price of a good, but are felt necessary to promote invention and technological progress.

The above paragraphs refer to methods by which government erects barriers to entry. Below are some other methods that can be employed by firms, that are of various levels of legality. In many cases, these behaviors will be challenged by governments, but it is not always easy to observe and verify that such actions are taking place, and, if they are, whether they cross the line from "aggressive business behavior" to "illegality."

High Fixed Cost versus Small Margins

In many industries, you have to spend a lot of time and money before you are able to sell anything. The longer into the future the potential profits are, the more uncertain the return, and the more uncertainty, the greater profit required. Many such industries fall into the category of "natural monopoly," which will be addressed in the next section.

Predatory Pricing

This is connected to the above point: a firm that is established has often recovered its capital costs (its buildings and machines are paid for). This means that it can lower its price, and it will not be harmed as much as a competitor with high capital costs. So a predatory pricer will lower his price to drive his competitors out of business. In reality, this does not happen often, and economists believe that it generally does not work. But sometimes the threat of predatory pricing is enough to stop a competitor from entering a market.

Excess Production Capacity

This is also related to the above point: an existing monopolist will usually keep some spare production capacity. If a new firm enters, the old firm will increase production, thus driving down the price and making it less profitable for both firms. This is tied in with the idea of economies of scale.

Bundling

Also called “tying,” this means selling several items as a package. Perhaps the best example was Microsoft adding an Internet browser for free to their operating system. This destroyed the previous market leader, Netscape, who used to sell their browser software.

Brand Loyalty

As mentioned in the monopolistic competition section, every firm would like to have a monopoly, and the legal way to get this is through product differentiation from advertising. If you develop a valuable brand, it is difficult for people to compete – imagine launching a new drink to compete against Coca-Cola.