What this lesson teaches
I can explain how current and possible competition shapes a firm's decisions.
Syllabus 9570, 2.2.3(b). Firms' Decisions and Strategies: Firms consider the existing and potential levels of competition in the industry when making decisions and engaging in strategies
Make a guess
Only one airline flies a route, but any rival could move a plane onto it within weeks and leave cheaply if it failed. Can the airline charge very high fares for long?
- Yes, as long as it offers better service than others.
- No. The threat of entry keeps its fares close to cost.
- Yes. With no rival on the route, it is a monopoly.
Show the answer
No. The threat of entry keeps its fares close to cost.
The route is contestable: entry and exit are cheap. High profits would quickly draw in a rival, so even a lone airline keeps fares in check.
Barriers to entry protect existing firms from new rivals, so they can keep earning supernormal profit.
Firms compete with existing rivals and with potential rivals who might enter if profits look attractive.
Barriers to entry make it hard for new firms to enter. Examples include legal barriers such as licences and patents, high start-up costs, economies of scale enjoyed by existing firms, and control of key inputs.
Network effects are a strong barrier for platforms. A ride-hailing app is more useful when it has many drivers and many riders, so a new app struggles to attract either side.
When barriers are high, supernormal profit can last into the long run. When they are low, new firms enter and compete profits away.
Put these in order
Bubble tea shops are earning supernormal profit, and entry is easy. Put what happens next in order.
- New bubble tea brands open shops nearby.
- Entry stops when shops earn only normal profit.
- Profit per shop falls.
- Each shop's demand falls and becomes more price elastic.
- Existing bubble tea shops earn supernormal profit.
Show the answer
- Existing bubble tea shops earn supernormal profit. High profits signal to outsiders that this market pays well.
- New bubble tea brands open shops nearby. Each customer now has more close substitutes to choose from.
- Each shop's demand falls and becomes more price elastic. With AR shifted left and flatter, the gap between price and average cost narrows.
- Profit per shop falls. As long as some supernormal profit remains, more brands keep entering.
- Entry stops when shops earn only normal profit.
The number of firms is not the whole story. A market is contestable when firms can enter and leave cheaply, with few sunk costs (costs that cannot be recovered on leaving). Then even one or two firms must keep prices close to average cost, because high profits would quickly draw in rivals.
In 2004 budget airlines such as Tiger Airways and Jetstar Asia began flying from Singapore. A plane can be moved to another route, so an airline that enters a route and fails loses little, and the threat of entry keeps fares in check.
Incumbents may also deter entry on purpose. With limit pricing, a firm charges no more than the lowest average cost an entrant could reach, so entering would not pay. It gives up some profit now to protect it later. Other tactics include building spare capacity to threaten a flood of output, launching many brands to fill shelves, and signing exclusive deals with suppliers or retailers.
- Barriers
- Licences, patents, start-up costs, economies of scale, network effects.
- Effect
- Supernormal profit can last into the long run.
- Contestable market
- Cheap entry and exit, few sunk costs: the threat of entry keeps prices near AC.
- Limit pricing
- Price at the entrant's lowest AC, so entry does not pay.
Worked example: A new delivery app
An established food delivery platform has thousands of restaurants and users. A new platform can build an app cheaply, but restaurants will not join without customers, and customers will not join without restaurants.
- Building the app is not the barrier; attracting both sides is.
- This is a network effect: the existing platform is valuable because of its size.
- Exclusive contracts with restaurants would make entry even harder.
Watch out for this
High profits always mean high barriers to entry.
High profits can also come from lower costs or better products, and may be temporary. Barriers explain why high profits last, not why they exist.
Check your understanding
Which is a barrier to entry?
- A fall in demand for the product, which makes new firms less keen to enter.
- Exclusive contracts that stop suppliers from dealing with new rivals.
- Many firms already in the market, so a newcomer has to share customers.
Show the answer
Exclusive contracts that stop suppliers from dealing with new rivals.
Right. They deny new firms access to key suppliers.