The above discussion gives a passive view of barriers to entry. Business is run by managers and they will react aggressively if they believe that entry could significantly affect profitability of their firms. Some of their strategic behaviour are given below:
Limit Pricing: JS Bain pointed out that when an existing firm — be it a monopolist or oligopolist — is making positive economic profit, it may decide to set the price below the profit maximising level in order to reduce the possibility of entry of new firms into the market.
The low price level over a long period of time will deter entry of new firms producing at an output rate higher than that of existing firms and thus cannot earn a normal profit. The size requirement makes entry more difficult and thus less likely.
Price Retaliation: Firms may retaliate by reducing prices when entry actually occurs or if it appears imminent. When the danger has diminished, prices can be increased to appropriate level. If a firm establishes a consistent pattern of reacting to entry by drastically reducing prices, then potential rivals may become convinced that they will face the same response and decide not to compete. Thus, by firmly establishing a reputation for dealing harshly with all new entrants, the firm may create an effective barrier to entry.
Capacity Expansion: The threat of price retaliation may not be credible if existing firms are unable to produce enough output to meet extra demand resulting from lower prices. In a rapidly growing market, a new entrant may be able to survive by serving new customers that the existing firms cannot supply with their present production capacity. A strategic response by established firms to prevent this from occurring would be to invest in additional capacity. Once this investment has been made, it becomes a sunk cost and places existing firms in a position to expand their production at a relatively low cost. The existence of excess capacity provides a strong signal that the established firms can reduce prices as a strategic response to entry in their market.
Investment in excess capacity reduces the profits earned by an existing firm. Hence, this investment will be undertaken only if management believes that the certain and immediate loss of profit from making the investment is less than the expected future profit/loss resulting from entry.
Market Saturation: The geographic location of the productive capacity can also cause barriers to entry. When costs of transporting a good are high relative to its value, consumers who are not close to a production facility may be required to pay substantially higher prices to have the good delivered to their location. Thus, firms that locate closer to those consumers will have a cost advantage and should be able to attract those customers.
Application of Oligopoly
An oligopoly market structure is characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry. This is one of four basic market structures. Oligopoly finds a major share in the modern economic scene. Oligopolistic industries are quite diverse and widespread, covers almost all production areas.
Oligopoly is a market structure characterized by a small number of relatively large firms that dominate an industry. The market can be dominated by as few as two firms or as many as twenty, and still be considered oligopoly. With fewer than two firms, the industry is monopoly. As the number of firms increase (but with no exact number) oligopoly becomes monopolistic competition.
Under oligopoly, firm is relatively large compared to the overall market, it has a substantial degree of market control. It does not have the total control over the supply side as it happens in the case of monopoly. There is an interdependence among firms in an industry, which is a key feature of oligopoly. The actions of one firm depend on and influence the actions of another. The interdependence of firms creates a number of economic issues. One is the tendency for competing oligopolistic firms to turn into cooperating oligopolistic firms.
The cigarette industry was an example of this practice. Over time R.J. Reynolds emerged as the price leader, and the other two major firms never changed prices until Reynolds did. There is not as much evidence of such leadership today, but there was little price competition among cigarette producers until 1993, when strong price competition from discount brands led to a period of price cutting.
Oligopoly structure has both good and bad effects.