Barriers to Entry and Price-Setting Ability

Question

Using relevant examples, explain how barriers to entry determine the price-setting ability of firms in different market structures. [10]

Answer

Barriers to entry are the obstacles that prevent new firms from competing on an equal basis with existing firms in an industry. They may be natural — such as the substantial economies of scale that follow from high start-up costs — or artificial — such as brand loyalty, limit pricing, patents and licences. The height of these barriers determines the market structure an industry settles into, and with it the degree of price-setting ability its firms possess. This answer contrasts two cases: high barriers in oligopoly and the absence of barriers in perfect competition.

High barriers give oligopolists strong price-setting power. Natural barriers arise where an industry carries high fixed start-up costs. Incumbents that operate at scale spread these costs over a large output and so enjoy substantial internal economies of scale; a new entrant, producing little, faces a far higher unit cost and is deterred. In the ride-hailing industry — Grab, Gojek, Ryde, ComfortDelGro — entry demands heavy capital outlay on a fleet, garages and a technology platform, which keeps new firms out. Artificial barriers reinforce this. Brand loyalty, built through high-budget marketing and reward schemes such as Grab Unlimited subscriptions or accumulated ride points, makes consumers reluctant to switch, so a new entrant faces weak demand.

These barriers leave a few large firms dominating the industry with a high market-concentration ratio. Each faces a steep, price-inelastic demand curve because close substitutes are scarce, and so can set price above marginal cost at its chosen output. The result that price exceeds marginal cost ($P > MC$) is the signature of genuine price-setting ability.

The absence of barriers makes perfectly competitive firms price-takers. Where there are neither natural nor artificial barriers, new firms enter freely; start-up fixed costs are negligible, so incumbents enjoy no economies of scale that an entrant cannot also obtain. A close real-world approximation is fishmongers selling an essentially homogeneous product, each with an insignificant market share and no consumer preference for one seller over another.

With a large number of perfect substitutes, each firm faces a perfectly price-elastic (horizontal) demand curve and must accept the price set by industry demand and supply. It cannot raise price without losing all its custom, and has no reason to lower it. At its profit-maximising output, price equals marginal cost ($P = MC$), which is precisely the lack of price-setting ability that defines a price-taker.

Conclusion. The height of barriers to entry therefore determines the degree of market power a firm holds, and so its price-setting ability. High barriers, as in oligopoly, sustain the market power needed to set price above marginal cost; their absence, as in perfect competition, leaves firms as price-takers with no power to determine price at all. (Monopolistic competition sits between these poles — low barriers confer only a small degree of price-setting power.)