Barriers to entry

Overview

Barrier to entry, patents and other legal protections create monopoly power and network effects.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a barrier to entry, and why does its existence matter more than the current number of firms in a market?

   Model answer

   A barrier to entry is anything that raises the cost, the risk or the delay faced by a firm trying to start supplying a market, or that lowers the return it could expect once inside. It matters more than the head count because it determines whether supernormal profit can survive. Without barriers, profit attracts entry and is competed away however few firms there are today; with barriers, profit persists however many firms there appear to be. Barriers are therefore the mechanism that converts market share into lasting market power.

2. 2

   Distinguish innocent barriers to entry from strategic ones, with an example of each.

   Model answer

   An innocent barrier arises from the technology or the law rather than from any deliberate act of the incumbent: large economies of scale relative to market size, or a licence requirement imposed by government, exist whether or not the incumbent wants them. A strategic barrier is erected on purpose to deter entry, such as heavy advertising that builds brand loyalty, deliberately holding spare capacity so that entry can be met with a flood of output, or setting a limit price low enough to make entry unattractive. The distinction matters because strategic barriers are the ones policy can sensibly attack.

3. 3

   Explain how economies of scale can act as a barrier to entry.

   Model answer

   Where average cost falls steeply with output, a large incumbent producing at high volume has a much lower cost per unit than a newcomer could achieve at a small starting scale. The entrant faces a hard choice: enter small and be undercut, or enter at full scale and add so much output to the market that the price collapses before it has any customers. Either way the expected return is poor, so entry does not happen. The barrier is higher the larger the minimum efficient scale is relative to the size of the market.

4. 4

   A firm's average cost is lowest, at about £20.95 per unit, when it produces roughly 5.5 units. Explain what this implies about how many firms a market absorbing 11 units at that price can support efficiently.

   Model answer

   Minimum efficient scale is the smallest output at which average cost reaches its minimum, here about 5.5 units at £20.95. A market that takes 11 units at that price can accommodate 11 ÷ 5.5 = 2 firms operating at efficient scale. Any third entrant would have to produce well below 5.5 units and would face a higher average cost than the two incumbents, so it could not match their prices. Scale therefore limits the market to a duopoly without any deliberate barrier being erected, and if the market absorbed only 5.5 units it would support a single firm.

5. 5

   How do patents and other legal protections create monopoly power?

   Model answer

   A patent gives its holder the exclusive legal right to exploit an invention for a fixed period, so rivals cannot copy the product or process however profitable it is. Copyright, trademarks, licences and statutory franchises work similarly by making imitation or entry unlawful rather than merely difficult. The barrier is absolute while it lasts, so the holder can set price well above marginal cost. It is also temporary by design, since the protection is granted to reward innovation and expires so that competition can eventually take over.

6. 6

   Explain how control of an essential input or distribution channel can keep rivals out of a market.

   Model answer

   If one firm owns the only usable deposit of a raw material, the only pipeline or grid, or the shelf space through which the product reaches buyers, a rival cannot get its product to market whatever its costs are. Vertical integration into supply or retailing achieves the same effect deliberately, since the integrated firm can refuse access or offer it only on terms that leave no margin. The barrier is not about cost or scale at all; it is about physical control of a link in the chain that cannot be bypassed.

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