Entry, Exit, Marginal Revenue, and Barriers to Entry

Marginal Revenue: Two Opposing Forces

• Your decision to change price triggers two countervailing effects on revenue.
• Output effect – selling an extra unit raises revenue by an amount equal to its price.
• Discount effect – the price cut applies to all inframarginal units, reducing revenue by (\Delta P \times Q).
• The marginal revenue (MR) from selling one more unit equals:
• MR = \text{Output effect} \, - \, \text{Discount effect}.
• Because the discount effect grows with quantity, MR falls as output rises.

Example: Computing MR for the Third Car

• Price schedule (cars): 1 \; @ \; \$24{,}000,\; 2 \; @ \; \$23{,}000,\; 3 \; @ \; \$22{,}000,\; 4 \; @ \; \$21{,}000.
• Total revenue (TR) rises from \$46{,}000 (two cars) to \$66{,}000 (three cars).
• Output effect for the third car = its selling price = \$22{,}000.
• Discount effect = \$1{,}000 \times 2 = \$2{,}000 because the first two cars are now discounted.
• MR_3 = \$22{,}000 - \$2{,}000 = \$20{,}000. This matches the observed TR change 66{,}000 - 46{,}000 = 20{,}000.
• Lesson: MR declines more steeply than price—the bigger the volume, the bigger the discount effect.

Market Dynamics When Rivals Enter or Exit

• Entry of a new competitor:
• Customer loss ⇒ firm’s demand curve shifts left (lower quantity).
• Lower market power ⇒ demand curve flattens (more elastic) ⇒ firm must charge a lower price.
• Exit of an incumbent:
• Customer gain ⇒ demand curve shifts right.
• Higher market power ⇒ curve steepens (less elastic) ⇒ firm can charge a higher price.

Profit Dynamics Under Entry & Exit

• Positive economic profits
• Attract new entrants, eroding incumbents’ market share & power.
• Quantity ↓, price ↓, and profit margins shrink until \pi = 0.
• Negative economic profits
• Trigger exits, raising demand for survivors.
• Quantity ↑, price ↑, and losses shrink until \pi = 0.
• Free entry and exit thus act as a feedback loop pushing long-run economic profit toward zero.

Threat Effects: The Southwest Airlines Case

• Empirical finding: Incumbent airlines cut fares ≈30 % when Southwest actually enters a route.
• Even the mere possibility of entry lowers fares on routes Southwest could plausibly serve.
• Take-away: Potential competition can discipline prices almost as effectively as actual competition.

Long-Run Equilibrium: Zero Economic Profit & P = AC

• Your firm’s demand curve is its average-revenue curve: AR = \text{Price}.
• Entry if demand intersects average cost (AC) above the AC minimum ⇒ drives price toward AC.
• Exit if demand lies wholly below AC ⇒ raises price toward AC.
• Long-run equilibrium occurs where demand just touches AC:
• P = AC\quad \text{and}\quad \pi = (P - AC)Q = 0.
• Interpretation: Zero profit is not failure—it equals the return in your next-best opportunity.

Summary: Free Entry & Exit

• Enter when \pi > 0; exit when \pi < 0. Continues until \pi = 0.
• Entry: demand shifts left & flattens → lower Q & lower P.
• Exit: demand shifts right & steepens → higher Q & higher P.

Barriers to Entry: Four Strategic Families

• Purpose: forestall entry so incumbents can preserve positive profits.
• Four broad categories:

1. Demand-side (customer lock-in)

2. Supply-side (cost advantages)

3. Regulatory (government-created obstacles)

4. Entry deterrence (credible threats)

Demand-Side Barriers: Creating Customer Lock-In

• Switching costs
• Example: iPhone users face proprietary chargers, OS learning costs, data transfer hassle.
• Goodwill & reputation
• Example: Long-term doctor–patient relationships reduce propensity to switch.
• Network effects
• Value of product ↑ as user base ↑ (e.g., WhatsApp). Newcomers face chicken-and-egg problem.

Supply-Side Barriers: Cost Advantages Newcomers Can’t Match

• Learning-by-doing & experience curves
• Higher cumulative output ⇒ lower marginal & average costs. Virtuous cycle strengthens incumbents.
• Economies of scale & mass production
• Small entrants (e.g., Etsy artisans) have higher unit costs than large-scale producers (e.g., H&M).
• Research & development (R&D)
• Innovations create unique products or cheaper processes (Amazon’s cloud infrastructure).
• Superior input contracts & access
• Buyer power yields discounts (Walmart) or exclusive access to scarce inputs (US Airways gate lease).

Regulatory Barriers: Leveraging Government Rules

• Intellectual-property protection (patents, copyrights, trademarks)
• Incentivises innovation by granting temporary legal monopoly.
• Licensing and registration hurdles
• Multiple procedures raise fixed costs (child-care centers, hospitals, dispensaries).
• Lobbying for stricter regulations
• Incumbents seek burdens that disproportionately hurt potential entrants.

Entry Deterrence: Credible Threats to “Crush” Entrants

• Excess capacity commitment
• Building plants today signals ability to flood the market tomorrow.
• Deep financial pockets
• Cash reserves (Apple’s \$194\text{ billion}) convince rivals you can outlast a price war.
• Brand proliferation
• Saturating shelf space (cereal aisle) eliminates profitable niches.
• Reputation for aggression
• Amazon’s >\$100\text{ million} diaper-market price war serves as a cautionary tale.

Big-Picture Implications

• Free entry eliminates especially attractive profit opportunities in most markets.
• Real-world analogies: all grocery lines eventually equalize; real-estate bargains disappear.
• Barriers to entry are the only sustainable pathway to long-run positive profits.
• Policy angle: Balancing innovation incentives (via IP) against consumer welfare (via competition).