Introduction to

UNIT 11 MARKET STRUCTURE AND Microbes

BARRIERS TO ENTRY
Objectives
After going through this unit, you should be able to:
understand the concept of market structure and the impact it has on the
competitive behaviour of the firms;
classify different types of market structures;
analyse the factors that influence the pricing decisions of a firm;
identify the barriers to entry of firms in the market.

Structure
11.1 Introduction
11.2 Classification of Market Structures
11.3 Factors Determining the Nature of Competition
11.4 Barriers to Entry
11.5 Strategic Entry Barriers–A Further Discussion
11.6 Pricing Analysis of Markets
11.7 Summary
11.8 Key Words
11.9 Self-Assessment Questions
11.10 Further Readings

11.1 INTRODUCTION
One of the most important decisions made by managers is setting the price of the
firm’s product. If the price set is too high, the firm will be unable to compete with
other suppliers in the market. On the other hand, if the price is too low, the firm
may not be able to earn a normal rate of profit. Pricing is thus a crucial decision
area, which needs much of managerial attention.

In this unit we will examine the factors that govern this key decision area.
Traditional economic theory explains this in term of demand and supply functions.
According to traditional analysis, firms aim towards maximisation of profits. The
interplay of demand and supply in the market determines the price, which is often
referred to as equilibrium price.

There are, however, many other factors that influence the pricing decision of a
firm. These are – the number of firms in the industry, the nature of product, and the
possibility of new firms entering the market and so on. In this unit you will understand
more about some of the crucial factors that operate in the market place. In the
process, you should gain valuable insights into the operations of firms under different
market structures, which are more typical of the existing real world situations.

11.2 CLASSIFICATION OF MARKET STRUCTURES

The structure of a market depicts the existence of firms in a particular market and
to what extent the firms constituting a specified market are functionally interrelated
to each other. The term ‘market structure’ refers to the degree of competition
1
Pricing Decisions prevailing in that particular market. The power of an individual firm to control the
market price by changing its own output determines the degree of competition and
this power varies inversely with the degree of competition. The higher the degree
of competition, the less market power the firm has and vice-versa. Market power
is generally thought to be the ability of the firm to influence price.

A firm behaves according to its policies and practices regarding price, output
decisions etc. The firm’s performance is an indicator of its outcome or results of its
conduct. The whole concept explains the Structure-Conduct-Performance (S-C-P)
hypothesis. Hence in microeconomics theory, this hypothesis states that the
performance of a firm is determined by its conduct, which in turn is determined by
the structure of the market in which it is operating. The performance and the
conduct of a firm vary from market to market. If the market is highly competitive
then the performance and conduct of the firm is different as compared to that of
the market with little or no competition. For example, pricing behaviour of firms in
the fast moving consumer goods (FMCG) sector where there are a large number
of rivals is very different from the pricing in the Airline industry where there are
fewer firms.

Pricing decisions are affected by the economic environment in which the firm
operates. Managers must, therefore, make their decisions to the specific market
environment in which their firms operate. The central phenomenon in the
functioning of any market is competition. Competitive behaviour is moulded by the
market structure of the product under consideration. Since the decision-making
environment depends on the structure of the market, it is necessary to have a
thorough understanding of this concept.

The structure of a particular market plays an important role in defining the

determinants that affect these market structures. Determinants like price, product
differentiation etc. are affected by the competitive structure of the market. The
classification of markets in terms of their basic characteristics helps identify a
limited number of market structures that can be used to analyse decision-making.
The four characteristics used to classify market structures are: i) Number and size
distribution of sellers, ii) Number and size distribution of buyers, iii) Product
differentiation and iv) Conditions of entry and exit.
i) Number and size distribution of sellers
The firm’s ability to affect the price and the quantity of a product supplied to the
market is related to the number of firms offering the same product. If there are a
large number of sellers, the influence of any one firm is likely to be less. Consider
the number of firms selling fruits and vegetables in your locality. It is unlikely that
any one of them will exercise a great influence over price. On the contrary, if
there are only few sellers in the market, an individual firm can exercise greater
control over price and total supply of the product. Considering this fact the number
of firms can be classified into large, few, two and one.
ii) Number and size distribution of buyers
Markets can also be characterized by the number and size distribution of buyers,
where there are many small buyers of a product and all are likely to pay about the
same price. Consider a big firm in a city. For example, TISCO in Jamshedpur is a
large and perhaps the only firm in the area. TISCO will thus be able to exercise
considerable influence on the price at which it buys inputs from suppliers in the
area. Similarly, Maruti Udyog Limited (MUL) in Gurgaon is one of the large
automobile manufacturers and has considerable influence over the price at which it
buys inputs such as glass, radiator caps and accessories from other suppliers
located in the region. Both MUL and TISCO are firms that are said to have
‘monopsony’ power in their buying decisions. However, if there are a large number
2 of buyers they will be unable to demand lower prices from sellers. One reason why
large firms are able to negotiate lower prices is because of large volume purchases. Market Structure and
Barriers to Entry
iii) Product Differentiation
If the products competing in the market are not identical or homogeneous, they are
said to be differentiated and hence ‘product differentiation’ exists in the market.
Product differentiation is a fact of life and there is some amount of differentiation
for almost all products that we buy in markets. For example, ingredients in
different soaps could be different as can be the packaging, advertising etc. Even
seemingly homogeneous goods such as apples and bananas are at present
differentiated on the basis of the orchards where they have been grown and the
way these are marketed. Wheat is a good example of a product that can be
considered undifferentiated. The degree of substitutability or product differentiation
is measured by cross-elasticity of demand between two competing products. This
feature was explained in unit 5. Products can be classified into perfect substitutes
or homogeneous products, close substitutes like soaps of different brands, remote
substitutes like radio and television and no substitutes like cereals and soaps.
Further, perfect substitutes for one consumer may not be so for another. For
example, Rahul may feel that Coke and Pepsi are perfect substitutes while Sachin
may have a strong brand preference for Pepsi. Product differentiation is a basis
for a lot of advertising that is seen in the media where the focus is to create a
strong brand preference for the product being advertised.
iv) Conditions of Entry and Exit
Entry or exit of firms to an industry refers to the difficulty or ease with which a
new firm can enter or exit a market. In short run, where the capital of firms is
fixed, entry and exit does not make much difference. Ease of entry and exit is
however a crucial determinant of the nature of a market in the long run. When it is
difficult for firms to enter the market, existing firms will have much greater
freedom in pricing and output decisions than if they had to worry about new
entrants. Consider a firm such as Ranbaxy that has a patent on a particular drug.
A patent is an exclusive right to market the product for a given period of time, say
12 years. If there are no close substitutes to that drug, the firm will be free from
competition for the duration of the patent. Thus the barriers to entry in the market
for this drug are high. Similarly, since Indian Railways, is a public monopoly no new
entrant can enter the market. Microsoft too has been able to create substantial
entry barriers in the market making it difficult for new firms to enter in the market.
On the other hand, retail outlets and the restaurant business witness several new
firms entering the market periodically, implying that entry barriers are relatively low.

Based on the above characteristics markets are traditionally classified into four
basic types. These are Perfect Competition, Monopoly, Oligopoly and Monopolistic
Competition.

Perfect competition is characterised by a large number of buyers and sellers of

an essentially identical product. Each member of the market, whether buyer or
seller, is so small in relation to the total industry volume that he is unable to
influence the price of the product. Individual buyers and sellers are essentially
price takers. At the ruling price a firm can sell any quantity. Since there is free
entry and exit, no firm can earn excessive profits in the long run.

Monopoly is a market situation in which there is just one producer of a product.

The firm has substantial control over the price. Further, if product is differentiated
and if there are no threats of new firms entering the same business, a monopoly
firm can manage to earn excessive profits over a long period.

Perfect Competition and Monopoly are discussed in more detail in unit 12.

Monopolistic competition a term coined by E. M. Chamberlin implies a market 3

Pricing Decisions structure with a large number of firms selling differentiated products. The
differentiation may be real or is perceived so by the customers. Two brands of
soaps may just be identical but perceived by the customers as different on some
fancy dimension like freshness. Firms in such a market structure have some control
over price. By and large they are unable to earn excessive profits in the long run.
Since the whole structure operates on perceived product differentiation, entry of
new firms cannot be prevented. Hence, above normal profits can be earned only in
the short run.

Oligopoly is a market structure in which a small number of firms account for the
whole industry’s output. The product may or may not be differentiated. For
example, only 5 or 6 firms in India constitute 100% of the integrated steel industry’s
output. All of them make almost identical products. On the other hand, passenger
car industry with only three firms is characterised by market differentiation in
products. The nature of products is such that very often one finds entry of new
firms difficult. Oligopoly is characterised by vigorous competition where firms
manipulate both prices and volumes in an attempt to outsmart their rivals. No
generalisation can be made about profitability scenarios.

We will discuss Monopolistic Competition and Oligopoly in detail in unit 13.

It must also be noted that these market structures can be classified in only two
fundamental forms – Perfect Competition and Imperfect Competition. Under
this classification, Monopoly, Oligopoly and Monopolistic Competition are treated as
special cases of markets, which are less than perfect. Thus these forms illustrate
the degree of imperfection in a market by using the number of firms and product
differentiation as basic criteria. Table 11.1 provides a ready reference for different
types of markets based on their characteristics.

Table 11.1 Classification of markets based on their characteristics

Type of market Basis of Distinction

structure

Number of Seller Product Condition of

independent sellers concentration differentiation entry

Perfect or Pure Large Non-existent Homogeneous Free or easy

competition product

Monopolistic Large Non-existent Products are Free or easy

competition or low close substitutes

Oligopoly Few Medium or high Products may be Difficult

homogeneous or
close substitutes

Duopoly Two High Products may be Very difficult

homogeneous or or impossible
close substitutes

Monopoly One Very high Remote Barred or

substitutes impossible

Activity 1
Suppose you are working in a company dealing with fast moving consumer goods.
Classify the products of your company and its competitions under the type of
competition it operates in and why?
...........................................................................................................................
4 ...........................................................................................................................
........................................................................................................................... Market Structure and
Barriers to Entry
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

11.3 FACTORS DETERMINING THE NATURE OF

COMPETITION
We have already seen that the number of firms and product differentiation are
extremely crucial in determining the nature of competition in a market. It has been
tacitly assumed that there are a large number of buyers. What would happen if
there are several firms producing standardised product but only one buyer?
Obviously, the buyer would control the price, he will dictate how much to buy from
whom. The entire price-volume decision takes on a different qualitative dimension.
Similarly, product features and characteristics, the nature of production systems, the
possibility of new entrants in a market have profound impact on the competitive
behaviour of firms in a market. The ‘entry’ of new firms has special relevance in
business behaviour which we discuss in the next section and deal with other issues
in the present one.
Effect of Buyers
We have already referred to the case where there is only one buyer. Such a
situation has been referred to as monopsony. For example, there are just six firms
in India manufacturing railway wagons all of which supply to just one buyer, the
Railways. Such a situation can also exist in a local labour market where a single
large firm is the only provider of jobs for the people in the vicinity. More frequently
encountered in the Indian markets is a case of a few large buyers, defined as
oligopsony. The explosive industry which makes detonators and commercial
explosives, has three major customers: Coal India Ltd. (CIL), Department of
Irrigation and various governmental agencies working on road building activities. Of
these, just one customer, CIL takes nearly 60% of the industry’s output. There are
about 10 firms in the industry, which negotiate prices and quantities with CIL to
finalise their short-term plans.

Most industries manufacturing heavy equipment in India are typically dominated by

a few manufacturers and few buyers with the Government being the major buyer.
Price and volume determination in such products often takes the form of
‘negotiation across the table’ rather than the operation of any market forces. Since
the members in the whole market inclusive of buyers and sellers are not many, very
often they know each other. In other situations, like the consumer goods, firms have
no direct contact with their customers.
Production Characteristics
Minimum efficient scale (MES) of production in relation to the overall industry
output and market requirement sometimes plays a major role in shaping the market
structure. MES is the minimum scale of output that is necessary for a firm to
produce in order to take advantages of economies of scale. For example, the
minimum efficient scale for an automobile firm is very high. This is intuitively
appealing because if only 100 cars are produced in a capital intensive automobile
plant, the average costs will be high, while a larger volume of cars will allow the
fixed costs to be spread over a number of cars, thus reducing average costs and
increasing the minimum efficient scale. MES for a service firm such as a travel
agent will accordingly be relatively small.

The reason why there are no more than say, 5 or 10 integrated steel plants even in
5
Pricing Decisions an advanced country like the U. S. A. can be partly explained by economies of
scale and thus MES. Since the minimum economic size of such a steel plant is a
few million tonnes, the entire world steel industry can have no more than 100
efficient and profitable firms. Thus every country has only a handful of steel plants.
On the other hand, when one comes to rolling mills which take the steel billets or
bars as input, the minimum efficient size comes down considerably, and given the
existing demand, several firms can be seen to operate.

Further, the minimum size does not remain constant but changes drastically with
technological advancements. When technical changes push up the economic size of
a plant, one notices that the number of firms decline over time. This can be noticed
in some process industries like synthetic fibre. Conversely, technological innovations
may make it possible for smaller sized plants to economically viable. In such a case
a lot of new entrants come and soon the market becomes highly competitive as has
happened in the personal computer industry in India.

Apart from minimum plant size, factors like the availability of the required raw
material, skilled labour etc. can also mould market structures. Presently, only one
Indian source (IPCL) provides all the raw materials for plastic products. Likewise,
enough skilled people are not available to work on the sophisticated machines.
These factors sometimes restrict output and push up prices even though adequate
market potential for expansion exists.
Product Characteristics
We have already stated that product differentiation is an important market
characteristic because it indicates a firm’s ability to affect price. If a firms product
is perceived as having unique features, it can command a premium price and the
firm is said to possess market power. For example, the Rolls Royce has come to
be regarded as the ultimate in automobile luxury and therefore commands a high
price. Consumers are willing to pay that premium for the product. The degree of
competition faced by Rolls Royce or Mercedes Benz is thus very low. One could
also consider the market for Cable TV service. Most households in India are
serviced by a local cable TV monopoly and are thus dependent upon their local
cable provider for service. Thus the market for provision of cable TV service is
not competitive in the sense that only one operator provides the facility. Are there
any close substitutes for cable TV service? At present not many channels besides
Doordarshan are available that are free to air (FTA). Thus, the FTA service could
at best be considered an imperfect substitute for cable TV, since the latter offers a
larger bouquet of services. On the other hand, for a product like soap or
detergents, there are many firms producing a large variety of substitutable
products. Therefore, one notices more violent competition, in the detergent market
than in the cable TV market. The physical characteristics of a product can also
influence the competitive structure of its market. If the distribution cost is a
major element in the cost of a product, competition would tend to get localised.
Why do you see so many Fiat taxis in Mumbai, while Kolkata is dominated by the
ageless Ambassador? Similarly, for perishable products, the competition is
invariably local.
Conflict between physical characteristics and minimum economic size
An interesting question arises in the case of a product like cement. For reasons of
minimising the transport costs on raw materials, most cement plants in the country
are located near mine sites. A large efficient plant near a mine site can
manufacture cement at the optimum cost, but the local demand is never large
enough. If such a plant has to sell in far away markets (from Gujarat to Kerala, for
example) the transport costs can be quite high. Customers located in such areas
will always buy cement at a much higher price. The government partly offsets this
by using the mechanism of levy price which is the same throughout the country.
6
 Different Structural Variables Market Structure and
Barriers to Entry

No. of Independent Degree of Product Conditions

Sellers & Buyers Seller Concentration Differentiation of Entry

Large Non-existent Perfect Free or easy

Substitutes Or
homogenous
Products
Few Low Close Difficult
substitutes entry
or slight
differentiation
Two Medium Remote Entry
substitutes barred Or
impossible
One High No substitutes

11.4 BARRIERS TO ENTRY

Market selection: Entry and Exit

Market selection process includes firm’s entry, then its survival and finally the exit
process. The selection and expansion depends how efficient the firm is. The
efficient firms enter and the inefficient ones exit.

Conditions of Entry: The entry of a new firm in an industry or a market depends

on the ease with which it can enter. If we see the long-term perspective, the
number of firms and the degree of seller concentration depends on the conditions of
entry. In case of free entry, the number of sellers is large in number and in case of
restricted entry, the number of sellers tend to reduce. In the long run the degree of
competition depends on the condition of entry. A new entrant could bring with it the
following advantages.
Provides new goods and services,
Changes the balance between different sectors,
Comes with new technological and managerial techniques,
Increases opportunities.
Factors determining conditions of entry
The following are some of the factors that determine the structure of any market.
This list is not meant to be exhaustive, but is likely to cover a large part of real
world situations.
Legal barriers
Initial capital cost
Vertical integration
Optimum scale of production
Product differentiation

Legal barriers: Almost all countries have their set of rules and regulations. Patent
law is one such regulation, which promotes and protects the interests of inventors
and innovators. Under this law, no firm other than the patent holder or the licensed
firm is allowed to make use of the process. India has its own legal barriers and it
has certain laws like Industrial Licensing Regulation and Reservation of products,
which restrict entry and thus protect the incumbent firm from competition. 7
Pricing Decisions Initial capital cost: For industries producing basic inputs like coal, steel, power
etc., the initial capital cost is quite high. Therefore, it becomes difficult for new
entrepreneurs to enter. In industries where the capital requirement is high, the
market is dominated by a few firms, whereas for industries such as non-durable
consumer goods, the initial capital cost is less and therefore the number of firms in
the market can be quite large.

Vertical integration: A vertically integrated firm is one that produces raw

material i.e. an intermediate product as well as the final product. Examples of
vertically integrated firms in India are integrated steel plants such as SAIL and
TISCO and Reliance in telecommunications and synthetic fibres. Entry in this case
is restricted to limited producers as here the existing producer produces raw
material or an intermediate product along with the final product. New entrants will
find that their capital requirements are high and hence it will not be easy for them
to enter the market.

Optimization: Optimum scale of production means the scale of output at which

the long run average cost of production is minimum. As defined earlier this is the
minimum efficient scale of production for the firm. If the optimum scale of output
for any product is quite large and if the total market is can be efficiently served by
a few firms, the new entrants will find it difficult to enter such markets. Examples
of such markets are electricity generation and aircraft production.

Product differentiation: New entrant faces difficulty to enter the market where
the products are highly differentiated. Consider the ready to eat breakfast cereal
industry in the US. Kellogs is the market leader and produces more than 40
different kinds of cereal ranging from the ordinary corn flakes to granola flakes and
mueslix. With such a wide variety, new entrants find it difficult to compete with
Kellogs for shelf space in retail outlets which is crowded with Kellogs products.
By implementing such widespread product differentiation, Kellogs has managed to
increase the cost of entry for potential entrants in the market.

Related to entry conditions is the concept of entry barriers. Any manager is

concerned about his firms market share and thus threat to its competitive position.
By establishing an entry barrier a firm not only preserves its market share but could
also increase it. This is perhaps the most interesting aspect of market structure and
its analysis. Such attempts are made everyday by managers and are widely visible
in the environment around us. An example of an entry barrier is advertising
expenditure by firms. Think about the enormous advertising spend of firms such as
Coke and Pepsi and examine whether it is possible for a new entrant to try and
compete with such large existing brands even if it come up with an equally good
beverage. We will study this feature of markets in detail now.

A barrier to entry exists when new firms cannot enter a market. There are many
types of barriers, which become sources of market power for firms. Entry barriers
can be broadly classified as: Natural barriers, Legal Barriers and Strategic
Barriers.

Natural barriers: Economies of scale create a natural barrier to the entry of new
firms and it occurs when the long run average cost curve of a firm decreases over
a large range of output, in relation to the demand for the product. Due to the
existence of substantial economies of scale, the average cost at smaller rates is so
high that the entry is not profitable for small-scale firms. This results in existence of
natural monopoly. Power generation, Aircraft manufacturers, Railways, etc. are
examples of natural monopolies. You should keep in mind that technological
progress often undermines the natural monopoly character of certain industries.
This has happened in telecommunications, which not very long ago used to be
8 considered a natural monopoly.
Legal barriers: Patents, as discussed above, are an example of a legal entry Market Structure and
Barriers to Entry
barrier. Industrial licensing that used to be common in India in the 1970s and 80s is
another example of such a barrier. By giving a license to a firm the government
provided exclusive rights to that firm or a few firms to produce. This restricted the
number of players in the market through industrial licensing, thus creating a legal
entry barrier.

Figure 11.1: Entry Limit Pricing

Figure 11.1 : Entry Limit Pricing

(a)
LRAC

Price
Price&&
Cost
Cost
(Rs.)
(Rs.)

60

0
Output(Thousands)
Output (Thousands)
(a) Potential Entrant

(b)
Cost
&Cost
(Rs.)

LRMCE
(Rs.)
Price &
Price

70

60
50

LRACE

0
40 50 60 70
Output (Thousands)
Output (Thousands)
(b) Established Firm 9
Pricing Decisions Strategic barriers: Such barriers exist exclusively due to the strategic behaviour
of existing firms. Managers undertake investments to deter entry by raising the
rivals entry costs. To bar or restrict the entry of a new entrant, an established firm
may change price lower than the short-run profit-maximizing price. This strategy is
known as entry limit pricing. The entry limit pricing depends on established firm
taking a cost advantage over potential entrants. The established firm must have a
long run average cost curve below that of the other firm in order to lower its price
and continue to make an economic profit.

For example, established firm lowers its price below profit-maximizing level. Figure
11.1 shows demand and marginal revenue curves for an established firm and also
the firm’s long run average (LRAC) cost and marginal cost (MC) curves as
LRACE and LRMCE.

To maximize profit, the firm produces 50,000 units of output when MR=MC and fix
a price of Rs. 100 from the demand curve. Therefore the firm’s profit becomes:

P = (Rs. 100– Rs. 80) * Rs. 50,000 = Rs. 10,00,000

The LRAC for a new entrant into the market is shown as LRACN in figure11.1. If
the price is Rs. 100, the new firm could enter the market, but a little lower price
would resist the entry. Here, LRACN reaches minimum at slightly more than
Rs. 91, while LRACE reaches minimum at approximately Rs. 85. Therefore, the
established firm could change a price slightly below the new firm’s minimum
LRACN (Rs. 91) but above its own LRACE i.e. Rs. 85. Therefore, the price should
be set between Rs. 91 and Rs. 85.

Suppose the established firm sets the prices at Rs. 90 for say 70,000 units of output,
the new entrant would not be able to cover the average cost as it would be making
loss. The economic profit of the established firm now would be:

EP = (Rs. 90 – Rs. 80) * Rs. 70,000 = Rs. 7,00,000

Though this profit is less than the original profit but if we look at the practical point,
it is found that even if the established firm incurs a loss, the sales of the firm can be
increased in the future regarding the difficulties posed for the new entrant. The
lower profit would be higher had the new firm entered the market and would have
taken away some share of the sales from the established firm. This example shows
that entry-limit pricing is not feasible without the cost advantage.

Building Excess Capacity: Another way to restrict the entry is to build and
maintain excess capacity over and above the required amount. This poses a threat
to the new entrant deliberating the fact that the established firm is prepared to
increase the output and lower the price if and when entry occurs. The excess
capacity can be built up easily as it takes a longer time for the new entrant to build
a factory of such capacity. This type of barrier is also known as capacity barrier
to entry.

Producing Multiple Products: Economies of scope arise when cost of producing

two or more goods together is less costly than producing the two goods separately.
The process goes on and becomes cost effective as more goods are produced. This
acts as entry deterrent for new firms.

New Product Development: Producing substitutes for its own product in the
market can discourage the entry for the new firms. For example HLL producing
different types of soaps targeted to different customer base. The more the number
of substitutes, the lower and more elastic is the demand for any given product in the
10 market. This makes the entry of new firm more difficult.
Take the case of IBM. Why does every other personal computer (PC) that one Market Structure and
Barriers to Entry
comes across claim to be an IBM compatible. It has to be so, because all the
software is developed by using IBM standards. The PC cannot work without
software. By developing industry level standards, IBM has created ‘high switching
costs’ in an attempt to create entry barriers.
Activity 2
Given below is the list of some industries. Indicate in column 3 whether the entry
barriers are high or low. Give reasons in column 4.

S.No. Name of the Industry Entry Barriers Reasons

1. Software
2. Hardware
3. Oil-field chemicals
4. CNC machine tools
5. Breakfast cereals
6. Aluminium
7. Ball-point pens
8. Television Sets
9. Cement
10. Chocolates

11.5 STRATEGIC ENTRY BARRIERS — A FURTHER

DISCUSSION
No one likes competition and companies with a leading position in a market will go
to considerable lengths to keep out likely new opponents. Although all companies
strive to develop one form of competitive advantage or another, relatively few are
persistently successful over long periods. Innovative activity is almost always
followed by waves of imitation and relatively few first movers are able to maintain
their initial market position.

Although Tagamet was both revolutionary and one of the best-selling drugs of all
time, an imitator, Zantac, eclipsed it in an embarrassingly short time. Similarly,
companies such as Thorn – EMI, which first developed the CAT scanner, and
Xerox, whose Palo Alto research labs developed many of the innovations that
created personal computers, failed to generate any lasting success from ideas that
have created whole new industries. The simple truth is that most large-scale
expenditures designed to create competitive advantage are unlikely to realise a
return unless that advantage can be sustained.

Economists think about this problem as one of creating, or strategically exploiting,

barriers to entry or mobility barriers. Entry barriers, as defined above are structural
features of a market that enable incumbent companies to raise prices persistently
above costs without attracting new entrants (and, therefore, losing market share).
Entry barriers protect companies inside a market from imitators in other industries.
Entry barriers give rise to persistent differences in profits between industries.
Although different commentators produce different lists, almost all sources of entry
barriers fall into one of the three following categories: product differentiation
advantages, absolute cost advantages, and scale-related advantages. Product
differentiation arises when buyers distinguish the product of one company from that
of another and are willing to pay a price premium to get the variant of their choice.
Such differences become entry barriers whenever imitators, whether they be new
entrants or companies operating in other niches of the same market, cannot realise
the same prices for an otherwise identical product as the incumbent. On the face of
it, it is hard to understand how this might come about since consumers will (surely)
always prefer the lower-priced variant of two otherwise identical products. 11
Pricing Decisions However, if it is costly for consumers to change from purchasing one product to
purchasing another, then prices for otherwise identical products can differ for long
periods of time.

Economists call costs of this type switching costs and business managers always
try to create switching costs by locking consumers into their product. Habit
formation is an obvious source of switching costs and many marketing campaigns
are designed to reinforce the purchasing patterns of existing customers and raise
their resistance to change. Further, many consumers sink costs into gathering
information about new products and, once they have made a choice that satisfied
them, they are likely to resist making further investments.

Both sources of switching costs are often reinforced by the use of brand names to
help consumers quickly find familiar products. The value of these labels depends,
of course, on the size of the switching costs that they help to sustain. Finally,
switching costs also arise when consumption involves the purchase of highly
specific complementary products that lock consumers into existing purchasing
patterns. Buyers of IBM mainframes often found that the large costs of rewriting
software and recording data dwarfed price or performance differences that might
otherwise have induced them to switch to one of IBM’s rivals.

Absolute cost advantages arise whenever the costs of incumbent companies are
below those of new rivals and they enable incumbents to under-cut the prices of
rivals (by an amount equal to the cost disadvantage) without sacrificing profits.
There are many sources of absolute cost advantages. Investments in R&D and
learning-by-doing in production can be important in many sectors and they can
occasionally be protected by patents. Similarly, privileged access to scarce
resources (such as deposits of high-quality crude oil, much sought after airport
landing slots or the odd scientific genius) can open up substantial differences in
costs between companies producing identical products. Many companies vertically
integrate upstream to assure control over limited natural resources or downstream
to assure access to the most valuable distribution channels, actions that can make
entry anywhere in the value chain difficult.

Scale-related advantages create the most subtle form of entry barriers. They arise
whenever a company’s costs per unit fall as the volume of production and sales
increases. Economies of scale in production (created by set up costs, an extensive
division of labour, advantages in bulk buying and so on) are the most familiar source
of scale advantages but economies can also arise in distribution. One way or the
other, the important implication of scale advantages is that they impede small-scale
entry. If costs halve as production doubles, then a small entrant will have costs per
unit twice as high as an incumbent twice its size. Since it is unlikely that such an
entrant will be able to differentiate its product enough to justify a price difference
of this size, it must either enter at a scale similar to that of the incumbent or not
enter at all. Needless to say, this compounds its problems, since raising the finance
to support a large-scale (and therefore much riskier) assault on a privileged market
can be much more difficult than raising funds for a much more modest endeavour.

As stated above, few markets naturally develop entry barriers and, even when they
do, very few incumbent companies rely on structural features of market alone to
protect them. Whether it be creating or exploiting entry barriers, companies with
profitable market positions to protect usually need to act strategically to deter entry.
Although there are as many different examples of strategic entry deterrence, there
are at least three types of generic strategies that companies typically employ: sunk
costs, squeezing entrants and raising rival’s costs.

Sunk costs: Displacing incumbents is possibly the most attractive strategy for an
12 entrant to follow since, if successful, it enables the entrant both to enter a market
and monopolise it. Some what more modestly, if an entrant can at least partially Market Structure and
Barriers to Entry
displace an incumbent, it will make more profit after entry than if it has to share the
market on a less equal basis.

To deter entrants from following this strategy, an incumbent needs to lock itself into
the market in a way that raises the cost to the entrant of displacing it. This usually
requires the incumbent to make investments whose capital value is hard to recover
in the event of exit. Sunk costs raise the costs of exit (and so make it that much
harder for the entrant to force the incumbent out). Some incumbents do this by
investing in highly dedicated, large-scale plant and equipment since this also enables
them to reap economies of scale in production. These activities also have the
additional benefit of creating product differentiation or absolute cost advantages.

Squeezing entrants: It is usually all but impossible to deter very small-scale entry
and frequently it is not worth the cost. However, capable entrants interested in
establishing a major position in a market are a much more serious threat and many
entry-deterring strategies work by forcing entrants to enter at large scale while at
the same time making this too expensive. Squeeze strategies usually build on scale
economies that prevent small-scale entry by forcing entrants to incur even more
fixed costs (say through escalating the costs of launching a new product by
extensively advertising), which increases their minimum scale of entry. Further, if
these fixed costs are also sunk then these activities also increase the risks
associated with entry. The squeeze comes through actions that limit their access to
customers, making the larger scale of entry much more difficult and expensive to
realise than a more modest market penetration strategy might have been. This is
often done by filling the market with more and more variants of the generic product,
developing fighting brands closely targeted on the entrant’s product or limiting
access to retail outlets.

A simple glance at the shelves of most super markets will reveal many instances
where the multiple brands of a single company (or a small group of leading
companies) completely fill all the available space, leaving little or no room for an
entrant (examples might include laundry detergents of HLL, ready to eat breakfast
cereals of Kellogs).

Raising rival’s costs: Even when an incumbent is sure that it cannot be displaced
by an entrant and it has managed to squeeze the entrant into a tiny niche of an
existing market, entry can sometimes be profitable when the market is growing.
Indeed, market growth is an important stimulus to entry since it automatically
creates room for the entrant without reducing the incumbent’s revenues. However,
most entrants have only modest financial support and any strategy that raises costs
in the short run and slows the growth of their revenues may make it difficult for
them to survive long enough to penetrate the market and turn a profit. One rather
obvious strategy of this type is to escalate advertising and, indeed, this is a very
frequent response to entry by incumbents. Advertising is a fixed cost (which,
therefore, disadvantages small-scale entrants) and it is often the case that what
matters is the relative amount of advertising a company does rather than the
absolute amount. An advertising war initiated by an incumbent that raised total
market advertising but keeps the advertising shares of companies relatively
constant will, therefore, raise the entrant’s costs without raising its revenues. The
interesting feature of this strategy is that an advertising war will also raise the
incumbent’s costs. What is more, investments in advertising are often sunk,
meaning that they are likely to raise the exit costs of the incumbent is able to turn
what, on the fact of it, appears to be a disadvantage to its advantage because
entrants are more adversely affected by an advertising war than the incumbent is.
That is, some investments that incumbents make seem irrational because they raise
costs without generating much, if any, additional revenues. When successful,
however, they are justified by the fact that they protect existing revenue streams 13
Pricing Decisions from entrants. This points to one of the most characteristic features of investments
in entry deterrence: they do not generate net revenue so much as they prevent it
from being displaced.

A company that successfully deters entry will have lower profits than a company
that did not face an entry threat but that is not an interesting observation. What
matters is that a company that successfully deters entry will preserve its profits
while a company that has not been able to deter entry will see its market position,
and the profits that it generates, gradually disappear.

11.6 PRICING ANALYSIS OF MARKETS

Pricing is an important function of all firms. Every firm is engaged in the
production of some goods and/or services, incurring some expenditure to sell them
in the market. It must, therefore, set a price for its product. It is only in extreme
cases that the firm has no say in pricing its product because there prevails perfect
competition in the market or the good has so much public significance that its price
is decided by the government. Otherwise, in large number of cases, the individual
producer plays the role in pricing his/her product.

Table 11.2 Demand-Supply Schedule

Price Demand Supply

5 100 200
4 120 180
3 150 150
2 200 110
1 300 50

Setting the right price for its product is crucial for any firm in the market. This is
because the price is such a parameter that it exerts a direct influence on the
demand for and supply of the product and thereby on its sales and profit – the
important yardsticks for the success or failure of the firm. If the price is set too

Figure 11.2: Demand-Supply curve

D S
5

4
Price

2
D
S
1

0 100 150 200 300

Quantity
14
high, the seller may not find enough customers to buy his/her product. On the other Market Structure and
Barriers to Entry
hand, if the price is set too low, the seller may not be able to recover his/her costs.
Further, demand and supply conditions vary over time and the managers must
therefore review and reformulate their pricing decisions from time to time.

It is clear that the price of a product is determined by the demand for and supply of
that product. Table11.2 illustrates the demand and supply schedules of a good.

Figure 11.3 : Effect of a change in demand on price and quantity

S1

P2

P1

D1 D2

0 Q1 Q2

(a) Increase in D

S1

P1

P2

D1

D2

0 Q2 Q1

(b) Decrease in D 15
Pricing Decisions Let us assume that in the above example the market price, P = 3 and no other price
prevails in the market (Figure 11.2). Because if P = 5, supply exceeds demand and
the producers may not be able to find enough customers for their product. This
would result into competition among the producers forcing them to bring down the
price to 3. On the other hand, if P = 1, the demand exceeds supply which would
give rise to competition among the buyers of the product, pushing the price up to 3.
Therefore, at P = 3, demand equals supply, which is called equilibrium price. The
equilibrium price is thus determined by the interaction of demand and supply.

We have seen in Block 2 that the demand for a good depends on a number of
factors as does supply of a good. Therefore, the factors which affect either
demand or supply are also determinants of price. A change in demand and/or
supply would bring in a change in price. For instance, if the supply of a good is
fixed, as shown in figure 11.3, the level of demand appears to determine the
equilibrium price. In this case, the price is determined by the ‘other factors’
influencing the level of demand curve. An increase in demand from D1 to D2,
leads to an increase in equilibrium price from P1 to P2 and an increase in quantity
from Q1 to Q2 (see figure11.3 a). Quite the opposite holds true in the event of a
decrease in demand which is shown in figure 11.3b.

If the demand for a commodity is fixed, as shown in figure 11.4 the level of the
supply curve determines the equilibrium price of the commodity. The equilibrium
price would, therefore depend on the ‘other factors’ underlying the supply curve of
the commodity. Figure 11.4 (a) shows that an increase in supply from S1 to S2
causes price to fall from P1 to P2 and the quantity to increase from Q1 to Q2.
Figure 11.4 (b) shows exactly the reverse case.

So far we have discussed the general equilibrium price which is determined by the
interaction of demand and supply. However, the actual shapes of the demand and
supply schedules depend on the structure of the product, market and the objectives
of the firm. Thus market structure and firms’ objectives also have a bearing on
Figure 11.4: Effects of a change in supply on price and quantity

S1

S2

PP1
2

PP2
1

D1

0 Q1 Q2

16 (a) Increase in S
 SS2 Market Structure and
1 Barriers to Entry

SS1
2

P2

P1

D1

0 Q2 Q1

(b) Decrease in S

price. Since market structure influences price and different product groups fall
under different market structures, pricing decisions depend upon market structure.
For instance, automobile prices are set quite differently from prices of soap
because the two products are produced by firms in different market structures.
Accordingly, in the subsequent units we shall discuss price determination under pure
competition and pure monopoly, and monopolistic competition and oligopoly (Units
12 and 13 respectively).

A large firm may produce a number of products, which are sold in variety of
markets catering to the needs of different sections of the society. Let us take the
example of HLL, which produces products ranging from cosmetics to food
products. Here comes the real task to be performed. At times it happens that price
set for one of such products may affect the demand for the other product sold by
the same firm. For example, the introduction of Alto from MUL had an effect on
the price of Zens sold in the market.
Pricing of multiple products/a number of products produced by the same
firm
It is difficult to set a price of multiple products but once it is set, the products make
their own place in the market. Take the example of Hindustan Lever Limited
(HLL) referred to earlier. Lever Brothers Limited was started in the summer of
1888, as a branded marketing and packaged mass consumption goods (PMCG)
company and Sunlight was the most popular brand from England. In 1933, Lever
Brothers India Limited was formed which was finally named HLL in 1956. This is
India’s largest PMCG. The vision of the company is to meet the everyday needs of
the people everywhere. Over the past seventy years HLL has introduced
somewhere around 110 brands, most of which have become household names in
the country. The products vary from personal care products to beverages. A list of
such products of HLL is provided in Table 11.3. This example also gives an idea of
product differentiation. In this case the price of each product is different because it
caters to different segments of the market.
17
Pricing Decisions Table 11.3: List of products by HLL

Personal Care Soaps and Food and

Products Detergents Beverages

SKIN CARE Fair & Lovely FABRIC Surf Brookebond

Pond’s WASH Rin Tajmahal
ORAL CARE Pepsodent Wheel Red Label
Close-up PERSONAL Lifebuoy Taaza
WASH
HAIR CARE Sunsilk Liril Bru
Clinic Lux Knorr
Annapurna Atta
Breeze Knorr
Annapurna Salt
DEODRANTS Axe HOUSEHOLD Vim Modern foods
CARE range etc.
Pond’s
Rexona
COLOUR Lakme
COSMETICS

Source: www.hll.com

Activity 3

1) List five examples where the price of one product affects the demand for the
other and vice-versa.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

2) List (any five) the name and product of the companies producing multiple
products.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

11.7 SUMMARY
In this unit, we have made an attempt to understand the concept of market
structure and the impact it has on the competitive behaviour of firms. Various
competitive market situations were defined and broadly discussed. The number of
firms and product differentiation are crucial determinants of the nature of
competition in the market. The level of competition also gets influenced by number
of sellers and buyers, buyers’ behaviour, characteristics of product and production.

The pricing analysis of markets helps to understand how the equilibrium price is
determined by the interaction of demand and supply. This forms the basis for
analysing the price-output decisions of firms under different competitive situations.
18
 Market Structure and
11.8 KEY WORDS Barriers to Entry

Market structure refers to the number and size distribution of buyers and sellers
in the market for goods or service.

Perfect competition is a market structure where a large number of buyers and

sellers deal in nearly identical products. Each is individually so small in relation to
the total output that all members are ‘price takers’.

Monopoly situation is characterised by just one producer of a product or service.

Monopolistic competition is characterised by many sellers of a differentiated

product.

Oligopoly situations have fewer sellers with or without the existence of product
differentiation.

Product differentiation refers more to the differences in products as perceived by

the customers than in real or technical difference in specifications.

Competition is the collective outcome of the forces generated within a given

market structure (for a product or service) in combination with product
characteristics, number of buyers, potential entrants and government policy.

Barriers to entry refer to the obstacles that impede the entry of new firms in an
industry.

11.9 SELF-ASSESSMENT QUESTIONS

1. Classify the market structures based on certain factors and support your answer
with the help of examples.
2. Discuss the different structural variables. Illustrate your answer with the help of
examples.
3. Discuss the important technical barriers to entry.
4. Take the example of a hypothetical firm. Apply the strategic barriers to the firm
and discuss.
5. The paperback books and the hardcover books are sold at different prices.
Explain.
6. What are switching costs? Cite one example of a switching cost and examine
how a firm can advantage from the existence of switching costs?

11.10 FURTHER READINGS

Mote, V.L., Samuel Paul and G.S.Gupta, 1977. Managerial Economics-Concepts
and Cases, Tata McGraw Hill.

Maurice, Charles, S., Thomas, Christopher, R and Smithson, Charles, W. 1992.

Managerial Economics- Applied microeconomics for decision making. Irwin.

Dholakia, Ravindra, H. and Oza, Ajay, N. 1996. Microeconomics for management

students. Oxford University Press.

19