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Entry costs and market structure

Entry costs and market structure. There are many potential entrants into a market. Entrants simultaneously decide whether or not to enter the industry. Entry costs F, which is not recoverable if the firm decides to exit the industry.

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Entry costs and market structure

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  1. Entry costs and market structure • There are many potential entrants into a market. • Entrants simultaneously decide whether or not to enter the industry. • Entry costs F, which is not recoverable if the firm decides to exit the industry. • The number of firms in the industry becomes known, and firms compete in the market.

  2. Entry & market structure,con’t • What is the equilibrium number of firms in the market? • As more firms enter, profits decrease. • Let (n) represent the present value of each firm’s post-entry profits, as it depends on the number of firms that enter. • We need to find n* such that: • (n*)-F  0 > (n*+1)-F • n* is the “free entry equilibrium”.

  3. Entry & market structure,con’t • Assume: • Cournot competition. • All firms are identical and each firm has a constant marginal cost c. • Demand=(A-P)S where S = size of market. • Thus inverse demand is P = A - Q/S. • From our earlier analysis of the n-firm Cournot model, we determined that q* = (A-c)/[B(n+1)] • So q* = (A-c)/[1/S(n+1)] = s(A-c)/(n+1)

  4. Entry & market structure,con’t • Assume: • Cournot competition. • Each firm has a constant marginal cost c. • Demand=(a-P)S where S = size of market. • Then (n) = S[(a-c)/(n+1)]2/r - F. • Thus n*  (a-c)(S/rF)1/2 - 1. • n* is increasing in market size and decreasing in entry costs, although impact is less than proportional.

  5. Entry & social welfare • What happens when an additional firm enters a market? • Entrant receives profits • Existing firm profits decrease (business stealing as well as lower prices) • Consumer surplus increases (lower prices) • Entry is welfare enhancing only if cumulative effect is positive.

  6. Entry & social welfare, con’t • When can entry be welfare decreasing, i.e., inefficient? • If firms are colluding, then price will not change with entry so consumer surplus will not change nor will revenue. However, additional entry will increase costs. • If entrants falsely differentiate products, entry can cause inefficiency.

  7. Empirical Evidence of Advantages of Early Entry • Sutton study of soup markets in US/UK. • Campbells: pioneer in US, still dominant. • Heinz: pioneer in UK, still dominant. • Urban study of market share and order of entry in 47 markets. • First firm to enter after market leader has 29% lower market share than leader. • Second has 42% lower, third 49%, etc.

  8. Empirical Evidence of Advantages of Early Entry, con’t • Golder and Tellis studied entry order and success in 36 markets. • Half of all “pioneers” fail. Average current market share of pioneers is 10%. • Average current market share of “early market leaders” is 28%. • Sustained dominance: early market leaders tend to be current market leaders.

  9. Why Does Early Entry Matter? • Natural Advantages: • Brand loyalty • Learning-by-doing • Strategic Advantages: • Predatory pricing • Pre-emptive investments

  10. Sequential Entry and Prices • Pharmaceutical Case Study: • Developer of drug gets 17 year patent, once patent expires any firm can produce it subject to FDA approval. • 1984 Drug Price Competition and Patent Term Restoration act facilitated entry of generic drug products after expiration of patent by streamlining FDA requirements. • Study looks at the effect of generic entrants on drug prices.

  11. Pharmaceutical Price Analysis • 18 major drugs which were exposed to generic competition between 1983-1987. • Prices measured by average cost per unit paid by drugstores and hospitals. • Market share is measured by number of units sold. • Questions to be answered: • How fast does entry occur in new markets? • How fast does the market share of entrants grow? • How do prices respond to entry?

  12. Price Analysis, con’t • Within 1 year the avg number of generic suppliers is 17. Within 2 years, there are 25. • Serious erosion of the market share of the patented firm. After 2 years, generics had 50% of the market. • Generics come in at 60% of the patent firm’s price, on average. • Generic prices fall rapidly -- 22% lower at the end of the first year, 35% lower by the end of the 2nd. • Price of pioneers rises slightly after generic entry.

  13. Price Analysis, con’t • Conclusions: • Unique market. • Although products basically homogeneous, patented firm able to maintain considerably higher price and significant market share (50%). • Order of entry does make a difference both for patented firm and for generic entrants.

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