4.6 Entry and Exit

 

[4.2 Market Power]   [4.3 Pricing with Market Power

[4.4 Pricing Strategies [4.5 Pricing in Competitive Markets]

 

 

In this topic you will learn about the effects of entry and exit on competition and prices in a market. You will first learn about the effects of entry and exit in a particular kind of market environment that is known as perfect competition. Perfectly competitive markets are characterised by very low costs of entry and exit. Furthermore, firms in a perfectly competitive market have no market power and so are price-takers (those that take the prevailing market price as given rather than setting their own price). Moreover, all firms and consumers have perfect information. As you will see, these characteristics make perfectly competitive markets a good example for studying the effects of entry and exit.

 

You will learn that the effects of entry in a perfectly competitive market, in particular the in the long run, will result in firms earning zero profits. The reasons for this surprising result are (1) free entry and free exit and (2) the fact that perfectly competitive firms are price takers. This topic will also cover the effect of these factors on markets that are not perfectly competitive.

 


Characteristics of a Perfectly Competitive Industry

A perfectly competitive industry is a collection of firms satisfying four major characteristics.

1. Large number of firms

A perfectly competitive industry consists of a large number of firms and an environment in which each firm's output is small relative to the output of the industry. Each firm produces only a very small share of industry output and its output decisions will have a small impact on the price in the industry. If a firm decides to expand or reduce output, then given that the firm is small relative to the industry, there will be a negligible effect on industry supply and therefore market price.

2. Identical products

All firms in the perfectly competitive industry produce and sell an identical product, ie, consumers cannot differentiate between the product of one firm and that of another. Firms do not advertise in order to distinguish their product from those of their competitors, and no firm commands any "brand loyalty" in the market. Thus, the products sold in a perfectly competitive market will most often be what you would consider commodity products, such as wheat, corn, or computer memory chips.

3. Free entry and exit

Many markets are characterised by substantial costs of entry or exit. Costs for exiting an industry can include such things as severance pay for workers or disposal of inventory. Entry into a market often involves substantial reduced costs for the purchase or rent of new equipment and advertising expenditures to develop product awareness. Other common costs of entering a market, commonly known as barriers-to-entry, include

Although such high entry and exit costs are standard in many markets, in perfectly competitive markets firms do not face costs to either enter or exit a market. Perfectly competitive firms are free to enter an industry if there is a potential for profit, or to exit the industry in the event of losses.

 

Free entry means that new firms (either those operating in other industries or start-up firms) can easily enter the market, thereby increasing market supply and reducing profit margins. Similarly, free exit means firms can easily exit the industry, thereby reducing market supply and increasing profit margins. Firms do not face barriers-to-exit because of governmental regulation (as in the case of utility companies). Free entry and exit will have important implications for the profit margins of firms operating in a perfectly competitive industry.

4. Perfect information

In many markets, firms and consumers may have less-than-perfect information about conditions in the market. For instance, consumers may not know the prices charged by every firm in the market. In perfectly competitive markets, however, all parties in the market, firms and consumers, have all of the information they need to make decisions. All firms are fully informed about the prices and costs of their competitors. Similarly, buyers have full information about prices.

 


 

An important feature of perfectly competitive firms is that they are price takers. By price-taking, we mean that perfectly competitive firms take the prevailing market price as a given rather than setting their own prices. Why do they do this? The reason is that perfectly competitive firms lack market power.

 

Because firms produce a commodity product that is identical to that of their competitors, each firm in the market must charge a price no higher than that of its competitors, otherwise it will not sell its product. Moreover, each firm, given its small size relative to the industry, cannot influence the market price by changing its supply. The market price is determined by consumer demand and the total supply of all firms in the industry. Once an equilibrium price has been established, each firm takes this price as given. The only variable that a firm can control in order to maximise profits or minimise losses is its output. This important price-taking feature of perfect competition is a direct consequence of the fact that there are a large number of firms, and all firms are producing an identical product.

 

An example of a perfectly competitive market is wheat - a global market in which the product is close to homogeneous and the number of producers is very large. No one producer in the wheat market produces a significant fraction of the total output of the industry. Farmers in this market must charge the going market price for their output - any higher price and wheat buyers will go elsewhere. Also, because each wheat farmer produces such a small share of market output, the farmer's decision of how much to produce will have no effect on market price. The farmer's decision on how much wheat to produce will be therefore based on factors other than affecting the market price.

 

Short Run Versus Long Run

Segment 3 described that it is often useful to think separately about what happens over two different time horizons - the short run and the long run.

 

The short run is the time period over which a firm is unable to alter the manufacturing plant and equipment that it uses in production. Over the short run, a firm can vary inputs such as labour and raw materials; however, a firm's fixed inputs, like its plant and equipment, must remain unchanged. In the long run, a firm is free to vary its fixed inputs, like its plant and equipment. In the long run, a new firm can also enter a market and purchase its own plant and equipment.

 

In general terms, the long run is a time period of sufficient length to allow a firm the opportunity to vary its factors of production. In the long run, all factors of production are variable and all costs are variable.

 

Firm Demand Versus Industry Demand

In perfect competition, a distinction is made between the demand curve of the firm and that of the industry. The industry faces a demand curve from consumers that is downward-sloping. Together with industry supply, this determines the equilibrium price in the market. An individual firm in the industry, on the other hand, is a price-taker and therefore perceives firm demand to be horizontal at the equilibrium price. This happens because the firm knows that it cannot influence the price established by the industry (ie, by market demand) and the aggregate supply of all firms in the industry. Therefore, irrespective of quantity demanded, the firm can charge only the price set by the industry.

The firm's demand curve is shown below. Market demand and market supply (the aggregate supply of all firms in the industry) determines a price, P. Once this price is established by the industry, each firm charges the price P per unit irrespective of the quantity demanded by the firm's consumers. Therefore, the firm's demand curve is shown as horizontal at the equilibrium price established by the industry.

 

 

 

 


Short-Run Profit Maximisation

The P=MC rule for competitive firms

You can combine information on MR and MC together to determine the profit-maximising output for a firm. First, remember an important property of MR for price-taking firms - MR is equal to price, ie, MR=P.

 

MR is less than price for firms in price-setting industries. Why is it that MR=P for firms in perfectly competitive industries? The reason is that firms in perfectly competitive industries are price-takers. Remember that in perfectly competitive industries, the price is set by the market, and that the firm is free to sell as many units as it wants at the prevailing market price. Because the firm receives the market price P for every unit it produces, the MR for a perfectly competitive firm is equal to price.

 

First of all, given any output Q, note the following marginal rule that specifies whether a firm should or should not expand output from Q to Q+1:

 

        P>MC at output Q+1: Competitive firm should increase output from Q to Q+1

        P<MC at output Q+1: Competitive firm should not increase output from Q to Q+1

 

The explanation for the two rules above is as follows: P, which equals MR, is the additional revenue generated if the competitive firm increases output by one unit from Q to Q+1. On the other hand, MC is the additional cost of producing this one unit of output. If P>MC, then the additional revenue generated from the selling unit Q+1 is greater than the additional cost. Therefore, it is profitable for the firm to produce and sell this unit of output. If, on the other hand, P<MC, then producing and selling this unit of output loses money for the firm; therefore, this unit of output should not be produced.

 


 

Long-Run Entry and Exit

What effect do entry and exit have in a perfectly competitive industry? Can perfectly competitive firms make profits or losses in the long run? In the long run, firms in perfectly competitive industries will always earn zero profits. In other words, entry and exit in these markets will always push profits to zero.

 

Why the strange result? How can it be that profits in such industries will always be driven to zero? This is because of an important characteristic of perfectly competitive industries: free entry and exit. Profits and losses send valuable signals to firms operating in the existing industry as well as in other industries and start-up firms. These signals induce firms, both inside and outside the industry, to take actions that cause profits and losses to dissipate.

 

Click the link here to read about the ways in which long run equilibrium in a market adjusts to changes in demand.

  

Such entries and exits are possible only in the long run. In the long run, existing firms are not constrained to remain in an industry because of their investment in fixed inputs such as capital (machines) and buildings. Moreover, new firms can build new plants and obtain equipment to produce in the market. None of this is possible in the short run. In the short run, investment in industry-specific capital and land prevents new firms from entering, and existing firms from exiting.

 

When firms in the industry are making profits in the short run, the lure of these profits induces firms operating in other industries or start-up firms to enter the competitive industry. This entry increases industry output and reduces the market price and per-firm profits. However, as long as profits are being made by firms in the industry, entry of new firms will continue. Entry will stop when profits have been reduced to zero.

 

Similarly, if firms in the industry have been making losses in the short run, then these firms will exit in the long run. This exit decreases industry output and causes an increase in the market price and reduction in losses. However, as long as some firms are making losses, exit will continue. The process of exit stops when losses for all firms have been reduced to zero.

 

Because of free entry and exit, the only equilibrium in the long run is one in which all firms in the perfectly competitive industry earn zero profits. Long-run equilibrium in the perfectly competitive industry is shown in the graphs below. As in the learning resource on long run cost, the graph shows a U-shaped long run average cost curve. Falling average cost reflects economies of scale in production (ie, a doubling of output less than doubles costs of production). On the other hand, rising average cost reflects diseconomies of scale in production because of the problems of efficiently managing a large firm. In long-run equilibrium, the perfectly competitive firm is producing efficiently at minimum average cost, shown at the intersection of line P* at point Q*. In the Market graph below, you see that price, P*, is found at the intersection of market supply and market demand.

 

Now look at how this equilibrium is reached in more detail in the graphs below.

 

 

 

 

Effects of entry

Consider an industry in which all firms have the same cost function and price (P) greater than average total cost (ATC) at the output at which P=MC. If P>ATC, then PQ>(ATC)Q, ie, total revenue is greater than total cost. Thus, firms in this industry are making positive profits.

 

Profits such as this in a perfectly competitive industry will attract outside firms to enter the industry. This entry has the effect of shifting the industry supply curve to the right, thus reducing the market price while raising industry output. The downward pressure on prices means that a firm's output and profits are reduced. In the long run, firms in such an industry will earn zero profits!

 

The following animation shows the effects of entry on prices and firm outputs in a perfectly competitive industry.

 

To further understand the effects of entry and exit on a market, consider the market for gardening and landscape services in suburban Philadelphia. The following table shows the number of households who demand landscaping services at different prices.

 

Price Per Household

($)

Number of Households

($)

100

10,000

90

20,000

80

30,000

70

40,000

60

50,000

50

60,000

40

70,000

30

80,000

 

Currently 100 firms supply landscape services. Each firm can service only 100 households at a constant MC of $50 per household. Note that because MC is constant at $50, firms in this market will try to serve as many households as they can (ie, 100) so long as P>50=MC. Moreover, suppose in this example that these landscaping firms have no fixed costs, so that average costs will be constant and equal to MC for all output levels, ie, AC=50.

 

The industry can service a total of 10,000 households. Therefore, the equilibrium price at which supply of 10,000 is equal to demand is $100 per household. Each firm makes a profit of (PAC)Q=$5,000.

 

The profits made by existing firms will attract entry by new firms. Suppose that 100 additional firms enter the industry. The new firms are identical to the existing firms and can also service only 100 households at an average cost of $50 per household. The industry can now service 20,000 households, reducing the equilibrium price to $90. Firms earn lower profits of $4,000.

 

But how far can the price reduction go? Prices fall to the point at which P=AC so that revenue is equal to cost and firms earn zero profit. If prices fall further, such that P<AC, firms incur an economic loss and have an incentive to exit the industry. This exit places upward pressure on prices. Hence, entry pressures exist when firms have profits of zero.

 

If profits can be made in the market for landscaping services, entry will continue. Equilibrium will be reached when there are 600 firms in the industry. The industry can now service 60,000 households. The equilibrium price falls to $50 per household, which is equal to the firm's average cost. Each firm's profits are now zero, and so no further entry will occur.

 

Effects of exit

The animation below depicts an industry in which there are identical firms and each firm is making a loss. Losses induce firms to exit the industry. Exit has the effect of shifting the industry supply curve to the left, increasing the market price while reducing industry output. Because MC is increasing with output, the increase in prices caused by exit means that each firm would increase output to equate MC with the new price. Moreover, each firm's profits will increase.

 

Click on the link below to view the here.

 

Click on the link here for an advanced explanation of examining the effects of entry in markets in which outputs vary continuously.

 

Effects of entry and exit barriers

You just learned a very surprising fact - in perfect competition, entry and exit will drive long-run profits for all firms in an industry to zero. But what if there are costs to entry and/or exit? Many factors, such as government restrictions, patents or other legal restrictions, can increase the costs of entering into an industry. In fact, as you might expect, most industries have some cost of entry associated with them.

 

What effects will entry have on an industry with commodity (undifferentiated) products but in which there are costs to entry? Recall that firms should enter so long as the profits they expect to obtain are positive. Thus, if there are entry barriers to an industry, entry will continue in such industries up to the point at which the profits from operating in such an industry exceed the costs of entry.

 

For instance, suppose you are interested in opening up a stand selling soft pretzels. The MCs of selling soft pretzels are $0.50 per unit, and there is a $100 fee required to obtain a permit from the city to sell soft pretzels. Suppose also that because of the small size of your stand, your stand can sell a maximum of 100 pretzels. In this case, entry will continue until P is equal to (P0.50)100=100, or P=$1.50.

 

Note that this price is higher than that had there been no cost of entry (no permit fee to pay to the city). In that case, (P0.50)100=0, or P=$0.50. This illustrates a more general point about the effects of entry barriers on long run prices in a market: The higher the entry barriers, the higher the long-run prices in a market.

 

Click the link here to find out how entry costs affect the long-run equilibrium in a market.

 

Click the link here to find out what happens when firms sell differentiated products.

 

To see how to analyse entry and exit in the computer industry, click the here for a guided practice.

 

Click on the link here for details on your discussion activity.

 


Topic Summary