Practice Exam Questions
Barriers to Entry and Economic Profit (Revision Essay Plan)
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Last updated 2 Jun 2018
Here is a suggested answer to the following question: Examine the role of barriers to entry in earning economic profit.
Defining key terms as an introduction
Economic profit is also known as super-normal or abnormal profit and we associate it in particular with imperfectly competitive marks such as monopoly and oligopoly where there are barriers to entry in markets that allow existing, established businesses to continue to earn economic profit. Assuming that normal profit is included in average cost, then a firm will make economic profit when price per unit (AR) exceeds cost per unit (AC). This is shown in the diagram below which shows the price and output a profit maximising monopolist.
Barriers to entry are factors which make it difficult or expensive for new firms to enter a market to compete with existing suppliers. Examples of barriers include patents; brand loyalty among consumers; the high costs of buying capital equipment and the need to win licences/franchises. In my answer I will examine three examples of barriers to entry in action.
The first example of a barrier is the used of patents and trademarks designed to protect the intellectual property of a business and restrict the amount of competition. A patented drug for example gives the patent holder exclusive rights for a certain period (usually a maximum of seven years) to manufacture and sell that drug in a given market. The absence of competition allows a drug company to set a high price and earn enough revenue to cover the cost of researching and testing new drugs as well as earning a supernormal return for shareholders. Novartis (Swiss) spent nearly $10billion on research and development in 2016 compared to revenues of $60 billion. Other companies such as Pfizer and Hoffman-La-Roche do the same. They understand the value of patents to their business for when a patent expires, the drug can be manufactured and sold by other companies. Price then fall and economic profit is reduced.
To evaluate, the importance of patents will vary by industry. Companies in sectors such as bio and nano-technologies industries have very high patent application rates (65% and 62% respectively) in part because of the super-high cost of developing new products and technologies. In contrast, “soft tech” industries like app developers, online news platforms and video game businesses have less need for patents because they can scale their businesses using freely or cheaply-available platforms. In these industries the barriers to entry have come down leading to an increase in market contestability and lower profit margins. There is also no guarantee that owning a patent will lead to supernormal profits, for example in some countries, legal protection of patents is weak leading to imitation and copying which damages revenues and profits.
My second example of a barrier to entry is the use of internal economies of scale. Existing businesses in a market - perhaps those who have arrived first in an industry - may be able to reap the benefits of economies of scale which then leads to a fall in long run average cost. Examples of economies of scale including increasing returns to scale from using large units of capital, financial economies from being able to borrow money more cheaply and marketing economies that flow from building a base of customers who then develop strong brand loyalty. Economies of scale give cost advantages to established businesses and make it harder for new firms to enter an industry to compete. This is particularly the case with a natural monopoly which has such extensive economies of scale that the minimum efficient scale is large relative to market demand. There may only be room for one firm in the industry to reach MES.
However although in theory economies of scale are a major barrier to entry and allow firms to enjoy supernormal profits in the long run, in practice, smaller firms can still be profitable even in industries dominated by fully-scaled competitors. Smaller businesses can charge premium prices for bespoke products and are often more nimble in responding to changing consumer tastes and preferences. They might also be at less risk of suffering from diseconomies of scale which can cut the profits of larger operators. In the UK food retail sector for example, the rapid growth of Aldi and Lidl reminds us that challenger firms can make serious in-roads into the market share of dominant businesses such as Tesco whose profits (until recently) have suffered as a result of increased contestability and intense price competition.
A third example of barrier to entry is by holding a franchise which gives the franchise holder some monopoly power. A good example of this is in the UK rail industry where train operating companies such as Virgin, Arriva, Go-Ahead and Stagecoach bid for multi-year franchises to run services on the infrastructure owned by Network Rail. On most lines in the UK, there is no direct competition between train companies and this monopoly power is a factor behind many businesses making high annual profits. The west coast line generated profits for the Virgin/Stagecoach joint venture of of £67million in the year to March 2017. Although some fares are regulated, rail monopolies can use price discrimination and peak & off-peak pricing strategies to increase their revenues and profits. Only on a few lines - an example being the East Coast line from London to York - are there any open access operators such as Grand Central and First Hull trains that create some contestability in the market.
However, in evaluation, holding a franchise - and with it some monopoly power - does not guarantee making profit. Stagecoach and Virgin signed a deal to run the UK East Coast line from 2015 to 2023, promising to pay the government £3.3bn to run the service but their franchise is coming to an end three years early because of lower passenger numbers than forecast and mounting losses. Although a franchise is a barrier to entry in rail travel, there are of course substitute forms of transport including low-cost flights and a growing network of cheaper inter-city coach services that might have affected demand, revenues and profits.
Final reasoned comment
Barriers to entry are important in many industries - from patents in pharmaceuticals, to vertical integration in the oil and gas sector and strong brand loyalty in consumer-facing sectors such as retailing. In theory they help to maintain super-normal profits in the long run, but their significance will vary from industry to industry. The rapid adoption of new digital technologies appears to have brought down barriers to entry in some markets and made them more contestable. Smaller innovative firms with big quality products can be profitable even if competing in the land of the giants! A market will be more contestable when the sunk costs (exit barriers) are low rather than entry barriers being high.
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