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David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Threat of Entry: Factors that Increase Cost for New Entrants
Threat of Entry: Factors that Increase Cost for New Entrants
MANEC 387MANEC 387
Economics of StrategyEconomics of Strategy
MANEC 387MANEC 387
Economics of StrategyEconomics of Strategy
David J. BryceDavid J. Bryce
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
The Structure of IndustriesThe Structure of Industries
Competitive Rivalry
Threat of newEntrants
BargainingPower of
Customers
Threat ofSubstitutes
BargainingPower of Suppliers
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Entry and Market StructureEntry and Market Structure
• Concentration and product differentiation determine market structure
• An industry is concentrated when there are relatively few, powerful firms
• The degree of price competition is directly proportional to the number of rivals in the market
• If firms are to earn economic profits in the long-run, something must prevent entry
• Concentration and product differentiation determine market structure
• An industry is concentrated when there are relatively few, powerful firms
• The degree of price competition is directly proportional to the number of rivals in the market
• If firms are to earn economic profits in the long-run, something must prevent entry
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
4
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Measuring Industry ConcentrationMeasuring Industry Concentration
• Industry concentration may be measured as follows:– Four firm concentration ratio (C4)
– Herfindahl-Hirschman index (HHI)
• Industry concentration may be measured as follows:– Four firm concentration ratio (C4)
– Herfindahl-Hirschman index (HHI)
T
i imsHHI1
2000,10
• Limitations: ignores foreign imports (bias upward), ignores local/regional market power (bias downward), and industry definitions.
• Limitations: ignores foreign imports (bias upward), ignores local/regional market power (bias downward), and industry definitions.
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Concentration in Selected IndustriesConcentration in Selected Industries
Industry C4 HHI
Breakfast Cereals 83 2446
Computers 45 728
Fluid Milk 21 205
Household Appliances 82 2025
Motor Vehicles 82 2506
Ready-mix Concrete 7 29
Semiconductors 34 414
Soft Drinks 47 800
Snack Foods 63 2619
Tires 73 1814Source: US Bureau of the Census (1997)
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Barriers to EntryBarriers to Entry
• A barrier to entry is any factor that – Increases the costs born by potential
entrants (relative to incumbents), after they enter the market
– Decreases the market share potential of entrants upon entering the industry
– Other factors• Trade restrictions (tariffs, quotas, voluntary export
restraints, infant industry protection, embargoes)• Government regulation of industries• Industry certification boards (CPAs, Actuaries)
• A barrier to entry is any factor that – Increases the costs born by potential
entrants (relative to incumbents), after they enter the market
– Decreases the market share potential of entrants upon entering the industry
– Other factors• Trade restrictions (tariffs, quotas, voluntary export
restraints, infant industry protection, embargoes)• Government regulation of industries• Industry certification boards (CPAs, Actuaries)
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Barriers that Increase CostBarriers that Increase Cost
• Access to capital markets• Proprietary technology (patents, copyrights,
trade secrets)• Know-how (knowledge, routines, capabilities)• Access to raw materials (unanticipated
value)• Geographic locations• Economies of scale/Learning by doing
• Access to capital markets• Proprietary technology (patents, copyrights,
trade secrets)• Know-how (knowledge, routines, capabilities)• Access to raw materials (unanticipated
value)• Geographic locations• Economies of scale/Learning by doing
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Defining Economies of ScaleDefining Economies of Scale• A range of economies of
scale exists when average total cost (ATC) declines as output rises.
• A range of diseconomies of scale exists where ATC rises as output rises.
• The Minimum efficient scale (MES) is the smallest output that can achieve minimum average cost.
• A range of economies of scale exists when average total cost (ATC) declines as output rises.
• A range of diseconomies of scale exists where ATC rises as output rises.
• The Minimum efficient scale (MES) is the smallest output that can achieve minimum average cost.
ATC(Q)ATC(Q)
Econ ofEcon ofScaleScale
Disecon Disecon of Scaleof Scale
MESMES
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Sources of Economies and Diseconomies of ScaleSources of Economies and Diseconomies of Scale
• Economies of scale– Indivisibility and the spreading of fixed costs
– plant & equipment, overhead, advertising, inventory, R&D
– Increasing efficiency through specialization
• Diseconomies of scale– Physical limits to efficient size– Limits to managerial cognition—the cost of
complexity– Worker motivation– Distance to suppliers and markets
• Economies of scale– Indivisibility and the spreading of fixed costs
– plant & equipment, overhead, advertising, inventory, R&D
– Increasing efficiency through specialization
• Diseconomies of scale– Physical limits to efficient size– Limits to managerial cognition—the cost of
complexity– Worker motivation– Distance to suppliers and markets
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Example: Diseconomies of ScaleExample: Diseconomies of Scale
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Economies of Scale as a Barrier to EntryEconomies of Scale as a Barrier to Entry
• Capital costs• Risk and/or inefficient capital markets• Time compression diseconomies• Disproportional marketing costs to
achieve market share equal to MES• High minimum efficient scale relative to
demand
• Capital costs• Risk and/or inefficient capital markets• Time compression diseconomies• Disproportional marketing costs to
achieve market share equal to MES• High minimum efficient scale relative to
demand
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Example of High (Relative) MESas an Entry BarrierExample of High (Relative) MESas an Entry Barrier
• All firms produce with an identical technology that exhibits minimum efficient scale of four units.
• How many firms will enter?
• What will the equilibrium price and quantity be?
• All firms produce with an identical technology that exhibits minimum efficient scale of four units.
• How many firms will enter?
• What will the equilibrium price and quantity be?
22 44 8866 1010
22
44
66
88
1010
Price/CostPrice/Cost
P(Q)
MC(Q)
AC(Q)
QQMESMES
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Example of High (Relative) MESas an Entry BarrierExample of High (Relative) MESas an Entry Barrier• Two firms produce at
MES=4• (Dis)economies of scale
are steeper than demand and do not justify producing above MES.
• Other firms would enter but must produce at MES
• Four more units lowers price below cost – entry is deterred
• Two firms produce at MES=4
• (Dis)economies of scale are steeper than demand and do not justify producing above MES.
• Other firms would enter but must produce at MES
• Four more units lowers price below cost – entry is deterred
22 44 8866 1010
22
44
66
88
1010
Price/CostPrice/Cost
P(Q)
MC(Q)
AC(Q)
QQMESMES
Rents to each firmRents to each firm
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Defining Learning by DoingDefining Learning by Doing
• Variable cost falls as increasing experience generates increasing productivity.
• The traditional learning curve is CN = C1 N- – Where CN is cost of the Nth unit, C1 is cost of the first
unit, N is cumulative volume (Nth unit), and is the rate of learning by doing.
• It is common to assume an 80% learning curve – every doubling in cumulative output generates a 20% cost reduction.– Note that cost falls from $10 to just over $2
after only 100 units in an 80% curve.
• Variable cost falls as increasing experience generates increasing productivity.
• The traditional learning curve is CN = C1 N- – Where CN is cost of the Nth unit, C1 is cost of the first
unit, N is cumulative volume (Nth unit), and is the rate of learning by doing.
• It is common to assume an 80% learning curve – every doubling in cumulative output generates a 20% cost reduction.– Note that cost falls from $10 to just over $2
after only 100 units in an 80% curve.
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Learning by Doing as a Barrier to EntryLearning by Doing as a Barrier to Entry
• Early entry provides potentially insurmountable cost advantages
• Learning facilitates fighting the entry of rivals
• Early entry provides potentially insurmountable cost advantages
• Learning facilitates fighting the entry of rivals
AVC(Q)AVC(Q)
Qi Qi
Too flat
AVC(Q)AVC(Q)
Qi Qi
Too steep
AVC(Q)AVC(Q)
Qi Qi
Just Right
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
“Strategic Management” of the Learning Curve“Strategic Management” of the Learning Curve
• Win the market share battle– highest market share has the highest volume and
cumulative volume growing at fastest rate, descending the learning curve fastest to the lowest cost.
• Price aggressively to increase volume and learning – communicate lowest cost (cost level that will attain)
to marketing to promote sales.
• Win the market share battle– highest market share has the highest volume and
cumulative volume growing at fastest rate, descending the learning curve fastest to the lowest cost.
• Price aggressively to increase volume and learning – communicate lowest cost (cost level that will attain)
to marketing to promote sales.
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
“Strategic Management” of the Learning Curve“Strategic Management” of the Learning Curve
• Managing knowledge and learning– Incentive systems, bonus plans, zero defect
programs, etc.– Engineering effort (experiments and analysis)– Teamwork– Turnover– R&D practices– Technology transfer practices
• Managing knowledge and learning– Incentive systems, bonus plans, zero defect
programs, etc.– Engineering effort (experiments and analysis)– Teamwork– Turnover– R&D practices– Technology transfer practices
We might concede the market share battle and win the cost warWe might concede the market share battle and win the cost war
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Limitations of Strategy on the Learning CurveLimitations of Strategy on the Learning Curve
• Market share does not guarantee substantial cost advantages– What is the cost of market share?– Learning curve flattens with high experience
• “Spillovers” leak knowledge to rivals without full costs of learning
• Short product cycles reduce time to enjoy cost advantages
• Aging equipment can impede continued learning and cost advantages
• Market share does not guarantee substantial cost advantages– What is the cost of market share?– Learning curve flattens with high experience
• “Spillovers” leak knowledge to rivals without full costs of learning
• Short product cycles reduce time to enjoy cost advantages
• Aging equipment can impede continued learning and cost advantages
David Bryce © 1996-2002Some portions adapted from Baye © 2002David Bryce © 1996-2002Some portions adapted from Baye © 2002
Summary and TakeawaysSummary and Takeaways
• Barriers to entry increase industry concentration by raising the cost of entry above the benefits of entry.
• Barriers to entry are necessary but not sufficient to ensure firms will avoid price competition
• When firms overcome entry barriers, they must worry that they invite others to enter.
• Barriers to entry increase industry concentration by raising the cost of entry above the benefits of entry.
• Barriers to entry are necessary but not sufficient to ensure firms will avoid price competition
• When firms overcome entry barriers, they must worry that they invite others to enter.