Economies of scale as a barrier, limit pricing, structural and strategic barriers, and the threat of entry.
To fly into Heathrow an airline needs a take-off and a landing slot. The airport is full, so a new airline cannot simply apply for one: it has to buy slots from an airline that already holds them. In 2016 Oman Air reportedly paid $75 million for a single daily pair. British Airways holds more than half of all the slots.
What does this do to competition on routes into London? And would it be just as hard to leave the market as to enter it?
Sources: The Sunday Times, reported by Travel Weekly (2016); The Points Guy.
A new firm wants to make cars to compete with Ford and Toyota.
What is most likely to stop it?
A new car maker starts small, and car production has huge economies of scale. At low output its cost per car is far above that of firms producing millions a year, so it cannot match their prices without making a loss. Economies of scale are a barrier to entry.
The long-run average cost curve for an industry. As a firm grows, cost per unit falls: economies of scale. Then it flattens.
The output where LRAC stops falling is the minimum efficient scale, MES: the smallest output at which a firm reaches the lowest cost per unit. Beyond it, getting bigger saves nothing.
An established firm, the incumbent, already produces beyond MES. Its cost per unit is as low as it gets: ACi.
A new firm usually starts small. At its output, the same LRAC curve gives a much higher cost per unit, ACe. That cost disadvantage is a barrier to entry. If MES is large compared with the whole market, there may only be room for a few firms.
Check: Why does a small new firm face a cost disadvantage here?
Producing a small output, it cannot reach minimum efficient scale, so its cost per unit is higher than the incumbent’s.
The incumbent knows its own cost per unit, ACi, is well below the entrant’s, ACe.
Check: What price could the incumbent set to keep the entrant out and still make a profit?
Above ACi the incumbent still covers its costs. Below ACe the entrant could not cover its costs, so it would make a loss by coming in.
The incumbent can use this. Any price between its own cost and the entrant’s still earns it a profit, but would leave the entrant making a loss. Setting a price like PL, low enough to keep entrants out, is limit pricing. It deliberately gives up some profit today to protect profit tomorrow.
Teacher tip: Do not confuse limit pricing with predatory pricing. A limit price stays above the incumbent’s own average cost, so it still makes a profit. A predatory price goes below its own cost, accepting a loss to drive a rival out.
Limit pricing is a barrier the incumbent chooses to put up. Others come from the industry itself.
Check: Which of these barriers comes from the nature of the industry rather than from the incumbent’s strategy?
Sunk costs, such as specialised plant, come with the industry: any firm entering would face them. The others are choices the incumbent makes to keep rivals out.
So there are two kinds of barrier. Structural barriers come from the industry itself: economies of scale, high sunk costs or control of a key resource. Legal barriers, such as patents and licences, are often grouped with them. Strategic barriers are put up deliberately by incumbents: limit pricing, predatory pricing, heavy advertising to build brand loyalty and exclusive deals with suppliers or retailers.
Barriers to exit matter too. These are the costs of leaving a market: sunk costs that cannot be recovered, redundancy pay for staff, penalties for ending contracts early and having to sell specialist equipment for far less than it cost. A firm that expects to be trapped if things go wrong is less willing to enter, so high exit barriers also deter entry. Heathrow slots are the opposite: an airline that leaves can sell them on.
Check: Which of these is a barrier to exit?
Redundancy pay is a cost a firm faces only when it leaves, so it makes leaving expensive. The others make it harder to get in.
Contestability. A market is perfectly contestable if firms can enter and leave freely, with no sunk costs. Then even a monopolist must keep its price close to average cost, or a rival can hit and run: enter, take the profit, and leave at no cost. The threat of entry, not the number of firms, keeps prices down. Sunk costs, such as rail track, specialised plant or advertising, make a market far less contestable.
Check: Which feature makes a market contestable?
Contestability is about how easily firms can enter and leave. If sunk costs are low, a rival can enter, take the profit and leave, so even a single firm must keep its price close to cost. A Heathrow slot can be sold on, so it is costly but not fully sunk.
LRAC is already at its lowest well before this output. MES is the smallest output at which the lowest cost is reached, where the curve first goes flat.
Explain how barriers to entry allow firms to keep abnormal profit in the long run, and how contestability changes this.
Abnormal profit normally attracts new firms. As they enter, supply rises and price falls until only normal profit is left. Barriers to entry stop this happening.
Structural barriers come from the nature of the industry. With large economies of scale, a new firm starts small, so its cost per unit is far above the incumbent’s and it cannot match its price. High sunk costs, patents and licences have the same effect.
Incumbents can also create strategic barriers, such as limit pricing, where they set a price above their own average cost but below a new firm’s, so entry would mean a loss. With barriers in place, the incumbent keeps its abnormal profit in the long run.
However, if a market is contestable, with low sunk costs and free entry and exit, a rival could enter, take the profit and leave. That threat alone forces incumbents to keep prices close to average cost, even if there are only one or two firms.
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