Barriers – obstacles that make it difficult for new firms to enter a market such as high start-up costs, patents and established brands. It increases producer surplus and reduces contestability
Contestability – the ease with which new firms can enter the market
Barriers to entry make it harder to enter a market (less contestable). Perfect contestability has all the characteristics found in perfect competition, with no sunk costs and no barriers to entry. In reality, there are degrees of contestability in each market’
Barriers to entry include the following:
Product differentiation – if innovative products exist in that market then new firms will have to do more than just match the previous product if they want to do well.
Branding – big brands have customer loyalty so that can be difficult to compete against for new firms
Start-up costs – if it is expensive to begin in that market, it will deter new firms from setting up
Intellectual property rights – if a certain product or idea is legally owned by a company then it is difficult to enter the market e.g. Coca-Cola recipe
R&D and technology change – to develop new products can be expensive, and research for this can be expensive and often ends in failure which bigger companies can afford to lose but smaller ones cannot e.g.$2 billion per successful drug treatment for R&D
Predatory pricing – if bigger firms have a tendency to use predatory pricing to drive out new firms, then they will be deterred from entering this market
Sunk costs – if there are unrecoverable costs such as advertising, firms are less likely to enter as if they do not do well, they will not get this money back
Vertical integration – this is when a firm has more control over the supply chain, so it is difficult for new firms entering the market to find suppliers
Economies of scale – as bigger firms grow; their expansion allows their costs to decrease which makes it more comparatively expensive for them to compete
Legal barrier – a barrier that uses legislation to prevent people from entering the market/ copying product e.g. patents/ IPL
Natural barrier – usually when costs are too high for other firms to profitably enter a market
Artificial barrier – a barrier usually imposed by perceptions of the market or the large firms that dominate the market e.g. predatory pricing
Impact of barriers to entry on market structure
Contestability → high barriers to entry reduce contestability
→ makes it harder for them to contest the market
Oligopolies → high barriers lead to oligopolies
→ only a few dominant firms can survive as new firms will find it harder to start up
Natural monopoly → barriers to entry in a natural monopoly means that competitors are unable to make a profit
→ high start-up costs make it expensive, wasteful and impractical to enter
Entering/exiting the market → markets become more difficult to enter and exit
→ entering is often expensive/ difficult and through leaving a lot of money is lost i.e. sunk costs
Economies of scale – these occur when a firm grows larger, average costs of production fall as output increases. They are the benefits to a large firm due to their size.
The types of economies of scale are below:
Risk-bearing: When a firm becomes larger, they can expand their production range. Therefore, they can spread the cost of uncertainty. If one part is not successful, they have other parts to fall back on.
Financial: Banks are willing to lend loans more cheaply to larger firms, because they are deemed less risky. Therefore, larger firms can take advantage of cheaper credit. Managerial: Larger firms are more able to specialise and divide their labour. They can employ specialist managers and supervisors, which lowers average costs.
Technological: Larger firms can afford to invest in more advanced and productive machinery and capital, which will lower their average costs.
Marketing: Larger firms can divide their marketing budgets across larger outputs, so the average cost of advertising per unit is less than that of a smaller firm.
Purchasing: Larger firms can bulk-buy, which means each unit will cost them less. For example, supermarkets have more buying power from farmers than corner shops, so they can negotiate better deals
Why is there a discount for buying in bulk (purchasing economies of scale)?
- Saves time for supplier processing order
- Reduces transport costs
- Reduces packaging costs
- Reduces amount of stock being held and risk of expiring