Barriers to Entry
High barriers to entry generally entail more pricing power and less price competition, while low barriers to entry usually mean less pricing power and more price competition. Restaurants typically have low barriers to entry and thus the industry is highly competitive causing most new restaurants to fail within their first few years. On the other hand, credit card networks have high barriers to entry and can continue to charge prices that enable them to earn excellent returns on invested capital.
There are a number of exceptions to this relationship between barriers to entry and pricing power, and there are a couple of reasons behind the anomalies. Firstly, the customers may have significant pricing power even in industries with high barriers to entry because the industry is based on the sale of a commodity or the industry’s products have easily available substitutes. Secondly, some industries have high barriers to exit, which incentivizes the owners of the industry’s assets to continue unprofitable operations because they cannot easily redeploy the capital elsewhere. An example would include the airline industry. It’s worth noting that barriers to entry constantly fluctuate over time and thus it’s important to be forward-looking with all analysis.
Industry concentration is generally a good indicator that an industry has pricing power and rational competition. Fragmented industries tend to be highly competitive because (1) there are too many competitors to keep tabs on each member, (2) small gains in the market share of an industry participant may have a dramatic impact on its profit, and (3) the fragmented players think individualistically instead of as members of a larger group. The hairdressing industry is a good representative case of a fragmented industry.
In contrast, concentrated industries can more easily coordinate with their competition and have much less to gain in waging a price war. Concentrated industries without pricing power are usually capital-intensive industries with high exit barriers and primarily involve the sale of a commodity product or service that lacks differentiation. An example of a concentrated industry would be the soda insdustry, where Coca-Cola and Pepsico have a worldwide market share of well above 80%.
Tight, or limited, capacity gives participants more pricing power, whereas overcapacity leads to price cutting and a very competitive environment as excess supply chases demand. Current capacity is important, but future capacity must also be considered. A thorough analysis will examine how long it takes suppliers to react to changes in demand. While liquid capital can usually be easily re-purposed to earn higher returns, hard assets may take years to build/construct and might only be useful for one purpose.
Market Share Stability
Stable market shares typically indicate less competitive industries, while unstable market shares often indicate highly competitive industries with limited pricing power. High costs for switching between industry competitors generally correlates with a more stable market share environment while low switching costs may make industry market shares more volatile.
Which of the following companies is likely to face fierce price competition?
A. A company that sells a differentiated product within an industry with high barriers to entry
B. A company within a concentrated industry that requires minimal capital expenditures
C. A company within an industry characterized by high barriers to exit
The correct answer is C.
High barriers to exit usually cause unprofitable firms to continue competing on price.
Option A is incorrect. Generally, concentrated industries or industries with high barriers to entry are less price-competitive.
Option B is incorrect. A differentiated product and less capital intensive industries help companies maintain pricing power.
Reading 40 LOS 40g:
Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition