Essay, Micro: Market power and barriers to entry

a. Explain how barriers to entry influence the market power of firms. (10)

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def Barriers to entry prevent firms from entering an industry, and may be constructed artificially or arise naturally due to the nature of the industry. They can take the form of cost advantages, control over supplies, patents and trademarks, legislation, product differentiation, control over distribution, and credible threats of price wars.

def Market power refers to the ability of firms to set and maintain prices over the marginal cost without significant loss of market share.

thesis In general, high barriers to entry leads to higher market power and higher prices. In an industry with high barriers to entry, there are a low number of substitutes as competitors are unable to enter the market to offer alternatives. This leads to a more price inelastic demand for the incumbent, who is then able to charge higher prices.

example For example, Microsoft is a monopolist over Windows and Office software, which is bought by almost all businesses as there are no suitable close substitutes. Although the marginal cost of distributing software can approximate zero, Microsoft is able to charge high prices for its software.

On the other hand, in markets with low barriers to entry, such as in monopolistic competition, a large number of firms compete with each other and each firm faces a relatively small price elastic demand. This leads to lower market power and firms are restricted in their ability to raise prices.

 Low entry to barrier in the hawker market. Eric Pesik, Hainanese Chicken Rice, via  flickr.com

Low entry to barrier in the hawker market. Eric Pesik, Hainanese Chicken Rice, via flickr.com

antithesis On the other hand, high barriers to entry may not necessarily lead to market power, and this is clear in the case of regulated public utilities.

example For instance, although public utilities are a natural monopoly and high fixed costs is a barrier to entry for another firm to enter, they are usually regulated by the government. In such a case, while they have an incentive to maximise profits by raising prices, the government may limit their pricing to marginal cost pricing.

In oligopolistic markets where there are only a few dominant firms, the ability of each firm to raise prices is also curtailed by the mutual interdependence between the firms. For instance, Singtel, one of the three major telco companies in Singapore, may not raise prices as they would lose many of their customers to their competitors if they choose to react by not similarly raising prices.

conclusion In conclusion, while barriers to entry are necessary to sustain market power, an analysis on whether barriers to entry are sufficient to lead to market power will depend on the exact nature of the industry and the influence of legislation, mutual interdependence, and market contestability.


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