Page 199 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes in entering an industry are often referred to as barriers to entry. It has been defined in two
alternate way.
1. JS Bain (1956) argues that entry barriers should be defined in terms of any advantage that
existing firms hold over potential competitors.

2. GJ Stigler (1968) contends that for any given rate of output, only those costs that must be
borne by new entrants but that are not borne by firms already in the industry should be
considered in assessing entry barriers.
If a firm has control over all iron ore deposits in a country, new entrants in the steel industry
could get ore only by transporting it from another foreign supplier. This will increase cost of
producing steel as compared to those of the existing firm and prevent the new firm from
successful entry. Both Bain and Stigler criteria for a barrier to entry are satisfied in this example.
But if iron ore deposits are equally available to the established firm and new entrants and the
existing firm is large enough to take advantage of highly efficient production technologies, then
the new entrants require to build large plants which are able to take advantage of economies of
scale. Small plants of new entrants will increase costs such that they cannot sell steel at a price
competitive with the established firm. Bain would consider this as a barrier to entry because of
difficulty in coordinating and raising capital for large scale entry. However, Stigler's definition
would not recognise scale economies as an entry barrier because the old and new firms both face
same cost conditions. That is, for any given rate of output produced, the cost per unit would be
same for the new and existing firm. Stigler's position has appeal but Bain's definition is more
useful as it includes all factors that impede entry and provides a better framework for
understanding the determination of market structure.
Four important sources of barriers to entry are:
1. Product differentiation: A firm may have convinced consumers that its product is
significantly better than the product of new entrants. The new firm may be forced to sell
at lower price and reduce profit though the existing product may not essentially be superior.
(e.g., Bayer's Aspirin despite presence of chemically identical brands).

2. Control of inputs by existing suppliers: Examples are scarcity of natural resources, locational
advantages and managerial talent.
3. Legal restrictions: Examples are patents, licenses, exclusive franchises granted by
government.
4. Scale economies: A new firm entering the industry on a small scale will have higher
average cost of production. On the other hand, large scale entry may require gouge,
capital organisation, etc. Thus the ability of existing firms to expand gradually as compared
to the need for new entrants to start out with considerable production capacity can be a
substantial advantage for existing firms (automobile industry).

12.5 Strategic Behaviour

The above discussion gives a passive view of barriers to entry. Business is run by managers and
they will react aggressively if they believe that entry could significantly affect profitability of
their firms. Some of their strategic behaviour are given below:
1. Limit Pricing: JS Bain pointed out that when an existing firm — be it a monopolist or
oligopolist — is making positive economic profit, it may decide to set the price below the
profit maximising level in order to reduce the possibility of entry of new firms into the
market.
The low price level over a long period of time will deter entry of new firms producing at
an output rate higher than that of existing firms and thus cannot earn a normal profit. The
size requirement makes entry more difficult and thus less likely.

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