At this point we inquire about the potential entry and impact of new firms – firms who might enter the industry if conditions were sufficiently enticing, meaning the presence of economic profits. One way of examining entry in this oligopolistic world is to envisage potential entry barriers as being either intended or unintended, though the difference between the two can be blurred. Broadly, an unintended or 'natural' barrier is one related to scale economies and the size of the market. An intended barrier involves a strategic decision on the part of the firm to prevent entry.
Unintended entry barriers
Oligopolists tend to have substantial fixed costs, accompanied by declining average costs up to high output levels. Such a cost structure 'naturally' gives rise to a supply side with a small number of suppliers. For examples, given demand and cost structures, could Vancouver support two professional soccer teams; could Calgary support two professional hockey teams; could Montreal sustain two professional football teams? The answer to each of these questions is likely 'no'. Because given the cost structure of these markets, it would not be possible to induce twice as many spectators without reducing the price per game ticket to such a degree that revenue would be insufficient to cover costs. (We will neglect for the moment that the governing bodies of these sports also have the power to limit entry.) Fixed costs include stadium costs, staff payrolls and player payrolls. In fact most costs in these markets are relatively fixed. Market size relative to fixed and variable costs is not large enough to sustain two teams in most cities. Exceptions in reality are huge urban areas such as New York and Los Angeles.
Accordingly, it is possible that the existing team, or teams, may earn economic profit from their present operation; but such profit does not entice further entry, because the market structure is such that the entry of an additional team could lead to each team making losses.
Intended entry barriers
Patent Law
This is one form of protection for incumbent firms. Research and development is required for the development of many products in the modern era. Pharmaceuticals are an example. If innovations were not protected, firms and individuals would not be incentivized to devote their energies and resources to developing new drugs. Society would be poorer as a result. Patent protection is obviously a legal form of protection. At the same time, patent protection can be excessive. If patents provide immunity from replication or copying for an excessive period of time - for longer than required to recoup R & D costs - then social welfare declines because monopoly profits are being generated as a result of output restriction at too high a price.
Advertising
Advertising is a second form of entry deterrence. In this instance firms attempt to market their product as being distinctive and even enviable. For example, Coca-Cola and PepsiCo invest hundreds of millions annually to project their products in this light. They sponsor sports, artistic and cultural events. Entry into the cola business is not impossible, but brand image is so strong for these firms that potential competitors would have a very low probability of entering this sector profitably. Likewise, in the 'energy-drinks' market, Red Bull spends hundreds of millions of dollars per annum on Formula One racing, kite surfing contests, mountain biking events and other extreme sports. In doing this it it reinforcing its brand image and distinguishing its product from Pepsi or Coca-Cola. This form of advertising is one of product differentiation and enables the manufacturer to maintain a higher price for its products by convincing its buyers that there are no close substitutes.
Predatory pricing
This form of pricing constitutes an illegal form of entry deterrence. It involves an incumbent charging an artificially low price for its product in the event of entry of a new competitor. This is done with a view to making it impossible for the entrant to earn a profit. Given that incumbents have generally greater resources than entrants, they can survive a battle of losses for a more prolonged period, thus ultimately driving out the entrant.
An iconic example of predatory pricing is that of Amazon deciding to take on a startup called Quidsi that operated the website diapers.com. The latter was proving to be a big hit with consumers in 2009 and Amazon decided that it was eating into Amazon profits on household and baby products. Amazon reacted by cutting its own prices dramatically, to the point where it was ready to loose a huge amount of money in order to grind Quidsi into the ground. The ultimate outcome was that Quidsi capitulated and sold to Amazon.
Whether this was a legal tactic or not we do not know, but it underlines the importance of war chests.
Maintaining a war chest
Many large corporations maintain a mountain of cash. This might seem like an odd thing to do when it could be paying that cash out to owners in the form of dividends. But there are at least two reasons for not doing this. First, personal taxes on dividends are frequently higher than taxes on capital gains; accordingly if a corporation can transform its cash into capital gain by making judicious investments, that strategy ultimately yields a higher post-tax return to the stock holders. A second reason is that a cash war chest serves as a credible threat to competitors of the type described involving Amazon and Quidsi above.
Network externalities
These externalities arise when the existing number of buyers itself influences the total demand for a product. Facebook is now a classic example. An individual contemplating joining a social network has an incentive to join one where she has many existing 'friends'. Not everyone views the Microsoft operating system (OS) as the best. Many prefer a simpler system such as Linux that also happens to be free. However, the fact that almost every new computer (that is not Apple) coming onto the market place uses Microsoft OS, there is an incentive for users to continue to use it because it is so easy to find a technician to repair a breakdown.
Transition costs and loyalty cards
Transition costs can be erected by firms who do not wish to lose their customer base. Cell-phone plans are a good example. Contract-termination costs are one obstacle to moving to a new supplier. Some carriers grant special low rates to users communicating with other users within the same network, or offer special rates for a block of users (perhaps within a family). Tim Hortons and other coffee chains offer loyalty cards that give one free cup of coffee for every eight purchased. These suppliers are not furnishing love to their caffeine consumers, they are providing their consumers with an incentive not to switch to a competing supplier. Air miles rewards operate on a similar principle. So too do loyalty cards for hotel chains.
How do competitors respond to these loyalty programs? Usually by offering their own. Hilton and Marriot each compete by offering a free night after a given points threshold is reached.
Over-investment
An over-investment strategy means that an existing supplier generates additional production capacity through investment in new plant or capital. This is costly to the incumbent and is intended as a signal to any potential entrant that this capacity could be brought on-line immediately should a potential competitor contemplate entry. For example, a ski-resort owner may invest in a new chair-lift, even if she does not use it frequently. The existence of the additional capacity may scare potential entrants. A key component of this strategy is that the incumbent firm invests ahead of time – and inflicts a cost on itself. The incumbent does not simply say "I will build another chair-lift if you decide to develop a nearby mountain into a ski hill." That policy does not carry the same degree of credibility as actually incurring the cost of construction ahead of time. However, such a strategy may not always be feasible: It might be just too costly to pre-empt entry by putting spare capacity in place. Spare capacity is not so different from brand development through advertising; both are types of sunk cost. The threats associated with the incumbent's behaviour become a credible threat because the incumbent incurs costs up front.
A credible threat is one that is effective in deterring specific behaviours; a competitor must believe that the threat will be implemented if the competitor behaves in a certain way.
Lobbying
In our chapter on monopoly we stressed the role of political/lobbying activity. Large firms invariably employ public relations firms, and maintain their own public relations departments. The role of these units is not simply to portray a positive image of the corporation to the public; it is to maintain and increase whatever market power such firms already possess. It is as much in the interest of an oligopolistic firm as a monopolist to prevent entry and preserve supernormal profits.
In analyzing perfect competition, we saw that free entry is critical to maintaining normal profits. Lobbying is designed to obstruct entry, and it is also designed to facilitate mergers and acquisitions. The economist Thomas Philippon has written about the increasing concentration of economic power in recent decades in the hands of a small number of corporations in many sectors of the North American economy. He argues that this concentration of power contributes to making the distribution of income more favorable to corporate interests and less favorable to workers. In his recent book ("The Great Reversal: How America Gave up Free Markets" ), he shows that, contrary to traditional beliefs, Europe is now much more competitive than the US in most sectors of the economy. More broadband suppliers result in rates in Europe that are about half of US rates. Whereas in the US four airlines control 80% of the market, In Europe they control 40%. If scale economies were the prime determinant of corporate concentration we should not expect such large differences. Likewise, if globalization and technological change were the main determinants of corporate concentration, we should expect experiences in Europe and North America to be similar. But they are not. Hence, it is reasonable to conclude that entry barriers in North America are more effective, or that regulatory forces are stronger in Europe.
