Examine The Impact of an Increase in Barriers to Entry on Prices & Profits:
Barriers to Entry: The inability for a firm to enter the market due to infrastructural, legal, cost, financial, and brand barriers. If there is a high cost to enter the market it discourages smaller firms from entering, therefore limiting competition. This is why high barriers to entry are a signal of the existence of monopoly or oligopoly power.
Normal Profit & Abnormal Profit: Normal profit covers the average total cost of the firm, whereas the existence of abnormal profits means the firm can reinvest the profits into R&D, increase the wages of workers, and pay-out dividends to shareholders. Abnormal profit identifies the existence of monopoly or oligopoly market structure.
If there is an increase in the barriers to entry for a given market it may mean that the market becomes:
- Less competitive
- Greater representation of monopoly or oligopoly structure
- Possible increase in profits for firms
- Possible increase of prices, since less competition or substitute goods means that the firm could become a price setter rather than taker.
A comprehensive example of increasing barriers to entry having an effect on prices and profit can be identified in the car industry for hatchbacks within Europe. Volkswagen is notable for their immense economies of scale, therefore posing a high barrier to entry for their share of the market. Volkswagen is able to offer affordable hatchbacks and still maintain a high quality product without incurring a loss and maintaining the majority of the market share. However, their main rival PSA Peugeot Citroën is able to create cars of a similar standard but at a marginally higher price. These are the two biggest firms in the hatchback market, since they already have a foothold in the market, and successful brand recognition it makes it difficult for firms like Kia to enter the market.
Due to the existence of market power through the high barriers to entry Volkswagen and PSA have an oligopoly like relationship within the hatchback market. Therefore, both firms have abnormal profits and tend to have similar prices while pushing out possible foreign competition. Shown below is a graph exhibiting a kinked demand curve and the market of hatchbacks.
The above shows limited competition on price. The higher marginal cost of PSA can be justified by the lack of economies of scale similar to Volkswagen, meaning they will not be as efficient or productive with given resources. Shown on the graph is the hypothetical point at which Kia were to operate, they would suffer from high marginal costs at a restricted quantity of units due to export/import fees and the cost involved in the transport of the cars. There is also the issue that Kia does not have the same brand recognition as PSA or Volkswagen.
If the barriers to entry were to increase there would be a greater difficulty for the firms such as Kia to enter the European market. This is what establishes the oligopolistic relationship between Volkswagen and PSA. Barriers to entry are what ultimately cause the formation of monopolies or oligopolies. This then has a consequent impact on the prices of products in a certain market (a possible increase) and a greater opportunity to reach a point of abnormal profit through profit maximisation.
There are various methods of getting around the high barriers to entry, but it would require a firm to either innovate or be able to obtain investors to help launch it into the market. Kia could offer cars with newer technology, better engines, and greater fuel efficiency in an attempt to win market share within Europe. Kia would probably have to compete on price and offer more in a car than the firm’s rivals. Kia will benefit from cheap East Asian production, but there are still issues surrounding the transport of the vehicles. To circumnavigate the high barriers to entry the firm must be willing to take on debt to attempt to pay high fixed costs, or attract investors which would usually require innovation to persuade investors away from the dominant firms.
The diversification of the market for hatchbacks would benefit the consumer, as the firms are more likely to compete on price as well as offer cars with better base packages (i.e. included option in the car such as xenon headlights). However this may create an unsustainable loss for firms like PSA who suffer from a high fixed cost of wages due to its central production being based in France. PSA has already begun to lose its position as the main competitor of Volkswagen as Ford has vigorously entered the market.
Overtime the high barriers to entry may fall as there is greater symmetry of information in the market, as well as the reduction of the impact of economies of scale through the development of new technologies and tools that can produce cars more efficiently. There will always remain however the high fixed cost of the factory, but over time the issue that will affect firm’s profits and the prices of cars will be the variable costs such as where materials are sourced.
This is why the example of the car industry is good for displaying the effect of barriers to entry, and their entailing effect on the price of the good; as well as the potential for normal or abnormal profit within the market.