Barriers to Entry: A Combined and Expanded Blast from the Past

dean_castle_gatehouse

A couple of years ago, starting with a nice parable produced by Frederick Bastiat, I talked a bit about capital and interest and why those who own capital–the means of production (not money; money is just something that can be traded for capital).–are entirely deserving of being compensated for making that capital available to others to use and that the compensation is based on what capital is made available not how much a particular person has.  A particular amount of capital rates so much compensation, whether that capital is owned by one person or split up between two, ten, or ten thousand.  You can’t charge too much for the use of that capital (Whether it’s a plane, or a rolling mill, or a semiconductor fabrication facility) or people will produce their own rather than use yours and pay the compensation you demand.

Or that will be the case if there aren’t barriers to entry.

Let’s go back to James and his plane.  James wants to charge more for his plane but he finds when he does so his customers, instead of paying his higher charges, say “no” and take the time to make their own planes.  The revenue they lose for taking the time to make their own plane (opportunity cost in economic terms) is less than James is charging.  James either has to lower his prices or watch his customers go away.

Enter government to provide a third option.

James goes to the local Baron shows him his plane, explains how using that plane folk can make fine, splinter-free thrones for the Baron to sit upon and fine tables for his feast halls.  But other people are making planes too.  And, well, who knows what quality they are.  Really, they should not be able to do that.  And if those inferior planes were prohibited and only James were allowed to make planes, why James would be able to contributed, say 10% of the charge from renting out planes to the Baron’s feast fund.

The Baron’s stricture that only James shall be allowed to make and provide planes in the Barony is what we call a Barrier to Entry.

Barriers to Entry are anything that gets in the way of competition.

And you don’t need a complete ban to have a barrier to entry.  If, for instance, James simply suggested that anyone making planes should complete a year long “plane building course” then anyone coming in would have to charge for their planes based on the cost to them of that year spent just completing the course.  And James, already comfortably in the field, can charge that higher price confident that no one is going to undersell him.

Some barriers to entry are natural.  If a particular field requires unusual skill or talent few people will be successful in it.  The ability to hit a major league fastball is a pretty strong barrier to entry to playing major league baseball (and/or throw or field that major league fastball).  This means players can charge pretty high salaries without fear of thousands of others who can do the same thing for less money.

Same principle if something requires a rare or difficult to access resource.  Lack of that resource, or lack of access to it, is a barrier to entry.

This is how monopolies happen.  There are only two ways you can have a monopoly.  The first is that someone is so good at providing a good or service that they give better value than any potential competitors.   The second is where barriers to entry are imposed artificially.  And while there are some “natural monopolies” (rare skill set or access to resources providing the barrier)  this second category is usually the result of government regulation.  It takes force to impose such a barrier.  And the only organization that can lawfully (pretty much by definition) use force is government.

Government regulation serves as a barrier to entry and always either increases the cost of goods and services or creates a shortage.  Or both.

Now let’s look at that first category of monopoly–where someone is so good that they can undersell all competitors and so the competitors go out of business.  When that happens, people wring their hands and worry that once the competition is gone, the monopoly can then raise its prices without limit.  However, in the absence of barriers to entry the moment they do that competitors can once again arise.  They cannot raise their prices higher than that required to make competitors profitable.  So, while there may be no competitors (nobody’s able to match that first person’s ability to produce at low cost) there’s still competition because other folk are just waiting, champing at the bit to jump in should prices rise.  Others are looking diligently for their own ways of being able to produce the good at a price less than the “monopolist” so they can get all the customers and make all the money.  In this case, it’s the consumers who benefit by the lower cost of the goods and services.

When there are strong barriers to entry, however, the monopolist (or oligopolist) can safely raise prices until customers groan, save in the knowledge that those barriers will prevent others from entering the market and underselling him.  Yay for him.  For the consumer, not so much.

When the barriers to entry are “natural” there remains the risk that someone else will break in.  Someone else may develop the requisite skills or find a way to accomplish the same end without such skills (teletype replacing Morse telegraph operators as one example and that largely replaced by telephone with telephone operators largely replaced by computers and so on). New sources for difficult to access resources can be found or, again, new ways of providing the same consumer desires found.  Artificial barriers, raised by government, are not so amenable to “work around” largely because government adapts to “work around” attempts and shuts them off too. (The rise of freight trucking providing an alternative to rail freight instead of eliminating or reducing the need to “regulate” rail instead led to equally, if not more, restrictive regulation of interstate trucking.)

It’s those artificially imposed barriers to entry that really screw things up for the consumer.  So the question should not be “is there a monopoly” but rather “is the monopoly caused by artificially imposed barriers to entry.  From a strictly economic point of view, you want the fewest barriers to entry as possible.  Ideally only natural ones and even those we would do well to mitigate.

Now, there are situations where its advisable, for reasons other than economic to distort things from the ideal “minimum barriers to entry–let everything sink or swim on its own” approach.  But that’s a topic for another day.

Another aspect of barriers to entry is the effect they have on economic profits.

This is a bit more complex than some of the topics I’ve talked about here, not because the concepts are difficult, but because it brings together several seemingly disparate ideas.

First there’s “Economic Profit.” As defined in my Introduction to Microeconomics course it’s profit where you include not only the expenditure, but also the “opportunity cost”.  Allow me to expand on that a bit.  Opportunity cost (metioned above) is counting as a cost whatever would be the most valuable use for a given resource.  If the resource is money, it’s the “opportunity” you lose by spending it on one thing rather than another.  This is a little complicated, so let me illustrate with an example if you could invest $100 in an investment that has a 5% rate of return your opportunity cost of some other use of that money is the present value of the $100 plus what it would gain in interest.  First let me briefly address the idea of present value.  Present value simply means that some resource today is more valuable than having that same resource in the future.  See my telling of Bastiat’s The Plane for an illustration of how that works.  For instance, if we presume an interest rate for calculating PV of 3% (including both inflation and the loss of the use of the money in the interim) and invested that $100 in something offering 5% (compounded annually) for 10 years, the future value at the end of the 10 years would be $162.89 and the Present Value would be $121.21 (inflation eats up about $40 of that future value).  This assumes that there is no risk in the investment and that you can rely on inflation to be stable.  Investment risk and uncertainty in inflation would tend to reduce the present value to reflect the chance of lesser returns or greater inflation cutting into the value of that money.

So, if that 5% investment is the best you could do with that money the “opportunity cost” of using that $100 is $121.21 rendered as present value.  Whatever you use that $100 for doesn’t just cost you $100 (although it’s convenient to think of it that way).  It costs you the $121 of present value you could have had if you’d invested it.

With that idea in mind, an economic profit is one where the return is greater than the opportunity cost of the invested resources.  Basically, it has to return more (after adjusting for risk and uncertainty) than anything else that could be done with those resources.  In short, it has to be the best possible use of that money, better than any other use you could make.

Generally speaking and left to themselves, investments won’t be economically profitable, at least not for long.  If, for instance, you had a business that sells widgets at higher price, with a lower cost to produce, than other people, competitors will see that and say “I’m gonna get me some of that!” and start producing those widgets too.  This will increase the supply and tend to drive the costs down you’re back in line with everything else of similar risk.  This doesn’t happen in an instant, of course, so a business can be economically profitable for a while before others grab on.  Note, this does not mean that all investments will tend to have the same return because risk factors in.   More risky investments will have to have higher returns to compensate for the increased likelihood of losing some or all of the initial investment.

Don’t confuse economically profitable with “profit” as a business considers it.  Balance sheets don’t generally show opportunity cost.  A business can be making money, making a profit as its investors and the IRS sees it, but only if it’s making a higher profit than businesses of similar risk is it economically profitable.

As I said, left to themselves businesses and investments won’t generally be economically profitable for long.  But there is something that can make them so.  That’s “Barriers to entry.” What prevents a business from becoming economically profitable is competition, others being able to see those profits and coming in, increasing supply until the market brings the profitability down to everyone else.  If you can prevent others from doing that, then you can continue being economically profitable.

One barrier to entry is if your business requires a talent or skill that’s in short supply.   Sports franchises are an example of this.   You can’t just pick up 53 people off the street and throw them (in groups of 11) at an NFL team.  Sports franchises aren’t the only example.

The big barrier to entry, however as mentioned above, is government regulation and licensing.  If you can get the people who are allowed to use actual force to stop others from competing with you, then you’ve got one massive barrier to entry.  It may be a relatively porous barrier (pay a modest fee, sign your name, and get your license).  It may be a solid one (only a handful, or even a single, government chosen business need apply).  Those barriers can include such things as requiring long and expensive training before being allowed to work in the field (Doctors, Lawyers, Barbers…Barbers?).  Anything the government puts in the way that makes it harder for someone to enter a field is a barrier to entry.  And all barriers to entry, all licensing and regulation by government, act to stifle competition, limiting supply and therefore keeping prices high.  Attempts to alleviate the price problem by further regulation merely aggravates the shortages.  (Barriers to entry reduce supply.  Price controls reduce supply.  Both is a double whammy.)

This is why you’ll often find the strongest supporters of government regulation and licensing among those already in the field.  After all, it’s barriers to entry, not barriers to those already in the field.  As Thomas Sowell and the late Milton Friedman were frequently wont to point out, government regulation usually means protection for incumbents already in a field (at the expense of anyone who might enter the field and the customers those new entrants might serve).  Existing companies can get the government to restrict future competition that might cut into their business?  What’s not to love (if you’re in that field wanting to make money). It may not even be deliberate cupidity on their part.  They may honestly believe their rhetoric about safety and protecting the public and the consumers.  But the incentive is there and will have an effect.

This is not to say that the regulation and/or licensing is always a bad thing on balance.  But all too often people proposing regulation neglect to consider the economic effects of that regulation.  One cannot ignore those economic effects however justified one may believe the regulation is on other grounds.  And since one of the effects is reduction of supply of the regulated good, the question then becomes if you’re really trying to protect people, ensure “exceptional quality”, or whatever legitimate reason you have for the regulation, the question becomes, what are the people who aren’t able to obtain the good because of the reduced supply supposed to do?  Just do without?  Are they really better off than if, say, some lower quality were available under less strict regulations?  Is “nothing” really the better option for those people?

These are questions everyone needs to ask themselves whenever new barriers to entry are proposed or an old barrier comes under scrutiny.  The whole package, not just the heartfelt rhetoric.

5 thoughts on “Barriers to Entry: A Combined and Expanded Blast from the Past”

  1. The really fun thing about barriers to entry is the long term unintended consequences and perverse incentives they bring about, and all the ways it can backfire.
    James thinks that he has a monopoly on plane making, but he finds he’s not getting any business. Turns out that people are smuggling in cheap planes from the Dutchy of Freedonia. James goes to the Baron to complain, and finds that his hands are tied, as Duke Firefly gets a nice kickback from the business, and would not look kindly on any real efforts to enforce a ban on smuggling.
    OR, people just suddenly decide that rustic furniture is somehow fashionable.
    OR, the High Sheriff’s brother in law goes into the plane making business, and suddenly- a mysterious fire breaks out in James’ factory. Shame, really.

    Like

  2. There are only two ways you can have a monopoly.
    Well, there is a third. You can buy out all the competition as they arise.
    I’m not sure if it’s a variation on the “so good” one, or a combination of the two (I think it can be), or something a bit different, but that’s at least partly how several current Tech Lords have achieved their hegemony.
    It’s a little good-little bad sort of arrangement, too. Yay! for little guy who makes bucks creating something and selling it. Boo! for the bigger guy sucking it into his maw and all that accompanies that.

    Government regulation … always … creates a shortage.
    Let’s specify (you do, later) that this is not always a bad thing. If the shortage it creates is drinking water, because it stops the consumption of contaminated water, then the trade-off is good. It IS a trade-off, but that sort of shortage is perfectly okie-dokie. The problem, of course, being that the regulations seldom stop there……
    (And here is where you can go off on an extended rant about marginal cost/marginal benefit, etc.)

    largely because government adapts to “work around” attempts and shuts them off too
    That’s because, when you’re going around those barriers to entry, you’re competing with gov’t. So, they respond in the natural fashion to competition. Just like weeds when you pull them up.

    So the question should not be “is there a monopoly” but rather “is the monopoly caused by artificially imposed barriers to entry.[“]
    The issue – partly – is human nature. Once a monopoly is achieved, the one achieving it nearly always sets out to raise barriers to entry. So, the thinking goes, better to raise… ummm… barriers to entry to monopoly status, so the monopolist never gets in the position to exploit their monopoly.
    Of course, that comes with all its own basket of issues.

    the best possible use of that money
    Which is where economics leaps mightily off the science platform and plunges deep into the murky, cold waters of, frankly, metaphysics. Ain’t no way in the world to calculate that solely with math.

    You can’t just pick up 53 people off the street and throw them (in groups of 11) at an NFL team.
    The Cincinnati Bengals (0-10) challenge you to prove that.

    Barbers?
    Dude, you want some schlemiel off the street with a razor that close to your throat? *looks at your picture* Never mind……. 😉

    government regulation usually means protection for incumbents already in a field
    That includes politicians!

    Excellent post.

    Like

    1. Well, there is a third. You can buy out all the competition as they arise.

      Well, you can, but that can backfire badly. If you’re charging “monopolistic” (read “significantly higher than a free market would support”) prices for whatever it is you supply, then there’s incentive for people to come into competition. That extra money you’re making? You’re spending a good chunk of it buying out competitors. And if you get in the habit of doing that? You’ve just created a new business plan for people: start a competing business and make their own profit when you buy them out.

      The fact that they can start up, whether you end up buying them out or not, is competition. It’s the difference, which Sowell goes into, between “competition” and “competitors.” You can have competition even in the absence of current competitors because the threat of competitors starting is itself a check on rapaciousness.

      Like

      1. Yes, you can still have competition. Except that monopoly status means they’re going to be very tempted to build those barriers to entry. So, they’re buying up competitors (not innovating themselves) and simultaneously setting up the game so no one can ever actually contest their dominance. As I said, it is a variation and a combination, I think.

        Like

        1. To “build” those barriers to entry requires government–the license to use force. And, so, we’re back to that. Simply buying up competitors or potential competitors only creates a cost drain for the buyer and a new business opportunity for others (be a potential competitor and get bought out). It can’t seriously created a dangerous monopoly until government gets involved limiting that new “business opportunity” (and thus the cost drain of having to buy up everyone that wants a piece of that action.

          Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s