Sunday, December 4, 2011

Barriers to Entry and Fixed Costs - Part II

In my prior post, I described some thoughts on how fixed costs borne by customers (both monetary and temporal) affect industry barriers to entry.  Here I'd like to discuss barrier to entries resulting from fixed costs borne by the company.

My overall theme across these posts is that fixed costs drive barriers to entry.  Despite this theme, I also want to explain how the presence of fixed costs within a company's cost structure do not translate into barriers to entry.  That is, certain characteristics of a company's fixed costs enable those fixed costs to create barriers to entry, while other characteristics prevent fixed costs from becoming a barrier to entry.

Fixed costs enable economies of scale.  As more units are sold, the fixed costs are spread over more units.  Profitability per unit increases as the unit sales increase.  Economies of scale exist only to a point, however.  For example, flight crew and fuel costs are fixed once an airline schedules a flight.  As more travelers are added to the flight, profitability (loss) per passenger increases (decreases). A flight only half filled is unlikely to be profitable for the airline, as the costs per passenger are significant. This is why airlines adjust prices in attempt to fill their flights.  There are capacity constraints on economies of scale per flight, however.  Airlines must limit the passengers on a given flight to the seats available.

This brings me to an important term known as minimum efficient scale.  This is the smallest size of operations that will allow any firm to have a competitive cost structure.  Other firms may be larger, but the additional size beyond the minimum efficient scale does not translate to economies of scale.

When minimum efficient scale is large relative to the market size, economies of scale translate into barriers to entry.  Consider a market with a size of 100 units given existing costs of production (i.e. if companies set price so that they could just recover their costs of material, labor, rent and costs of capital, demand at this price would be 100 units.).  For convenience, we'll say the price at a market size of 100 is $10 per unit.  The minimum efficient scale to serve this market is 40.  Two companies operate at the minimum efficient scale, produce 80, and hence enables them to charge a higher price.  At a market size of 80, the market price is $12.  Hence, each firm earns "extra profits" of $80 (40 produced * $2 elevated price per unit)

A potential new entrant could spot these extra profits and consider entering this market.  If the potential new entrant thought carefully, he or she would realize that two options exist:

a) Enter at a scale of less than 20, so that prices elevated above $10 could persist.  Lets say that the new entrant chose to produce 10, and the market price at a total supply of 90 was $11. If the entrepreneur chose this option, his or her firm would operate at a competitive disadvantage to the incumbent firms, given the minimum efficient scale in the industry of 40 units.  This means the new entrant will have a higher cost structure, possibly even higher on a per unit level than the market clearing price.  In addition, incumbents would be able to lower prices to the $10 minimum price, and still cover all their costs.  The new entrant could not cover all costs at a $10 price, as we know that the minimum efficient scale is greater than scale chosen by the entrant for production.  As a result, a $10 price would result in losses for the new entrant, and persistent pricing at this level would drive the new entrant from the market.

b) Enter at a scale of 40 to achieve competitive parity with the incumbent firms.  Total production would be 120 units.  At 120 units, the market clearing price is $8 per unit.  We know that total costs per unit (including cost of capital) is $10 at the most efficient scale.  Therefore, all three companies would operate at a loss due to excess capacity.  None of the three companies would be willing to reduce capacity, because it puts them at a competitive disadvantage relative to the other two (see a, above, for discussion of this situation).  The most likely situation is that one of the companies exit the industry or go out of business, enabling the other two companies to begin profitable operations again.

In both scenarios above, the profit opportunities for a new entrant appear unlikely.  This prevents new entrants in the industry, despite incumbent profitability.  Here we have true barriers to entry.

Contrast the situation above with an alternative situation where the minimum efficient scale is small relative to the size of the market. Lets say another market had a total size of 10,000 units given existing costs of production, and the minimum efficient scale for operations was 40 units. Price at a total production of 10,000 is $10 per unit. In this case, there are likely to be 250 firms operating at minimum efficient scale*, and each earning only enough to cover total costs.  Lets put aside this likelihood and consider what would happen if there were only 200 firms, each operating at minimum efficient scale.  Production would be 8,000 units, the price charged exceeds $10, and incumbent firms all make extra profits.

How does a potential new entrant evaluate the industry above?  In this case, the entrant realizes he or she can enter at the efficient scale and take some of the extra profits.  Incumbent firms will not possess competitive cost advantages necessary to drive out new entrants.  In this market, new entrants should arrive quickly, until all excess profits are eliminated.

Examples:  I think its helpful to provide specific examples two industries that each have high fixed costs, but one with large minimum efficient scale relative to the market size and the other with small minimum efficient scale relative to the market size.

Large minimum efficient scale - utility (power) companies.  The cost of generation and creating the infrastructure to serve a market are largely fixed.  Power companies generally serve a limited market size as well.  The barriers to entry are so significant in power companies they are often labeled as "natural monopolies", which is another way to say that the minimum efficient scale is the entire size of the market.  Why aren't utility companies wildly profitable then?  Because of the huge barriers to entry, the government has identified the potential for monopoly pricing and regulates prices in these industries.  So although barriers to entry do not translate into high returns on capital for utility companies, this is a result of government intervention in response to existing barriers to entry in the industry.

Small minimum efficient scale - airline industries.  Airline costs exist at the flight and airport level.  Only minimal costs exist at the passenger level, which would be considered variable costs.  An extremely important aspect of the airplane industry is that the capital used in the industry (i.e. airplanes) are mobile, making the relevant market for assessing fixed costs as the global market for flights.  For example, because airplanes can be redeployed to other airports, any profitable routes that emerge will immediately see additional flights offered until profitability is eliminated.  Due to the fixed costs that exist for flights and airport service, airlines seek maximum capacity on flights.  Prices are lowered to gain additional passengers to help recover the costs for flight crew, ground crew, fuel, and airplane leases.  With the number of airlines in the market (remember the relevant market is global due to the ability to redeploy airplanes, even if individual airlines choose to operate only domestically or regionally), price competition erodes all extra profits.  The recent merger between Continental/United and the bankruptcy filing of American indicates just how difficult the airline industry is, despite cost structures for each company that largely consist of fixed costs.

*There of course could be fewer than 250 firms, because individual firms could operate at any scale that is a multiple of 40 and still be operating at an efficient scale.

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