15.2 Free Entry and Exit in the Long Run
IBM’s failure to see that new rivals would emerge and challenge its dominance in the computer industry stands as one of the great management failures of modern times. Let’s take a look at whether it should have forecast the arrival of new entrants into its market, and then assess the consequences of this heightened competition.
Entry Decreases Demand and Your Profits
The simplest way to predict whether new businesses will enter a market is to put yourself in a potential rival’s shoes. Imagine yourself as an aspiring entrepreneur looking to start a new business, or perhaps a manager of an existing firm looking to expand her lines of business. What would lead you to enter a specific market?
New competitors will enter profitable markets.
The cost-benefit principle provides clear guidance: It’s worth entering a new market if the benefits exceed the costs. The benefit of entering (or staying in) a market is the revenue you’ll earn. The relevant costs, according to the opportunity cost principle, include both explicit financial costs, and also implicit opportunity costs, including forgone wages and interest. Economic profit measures the difference between these benefits and these costs. And so this says that it’s worth entering a new market if you expect to earn a positive economic profit. This yields a useful guideline for aspiring entrepreneurs:
The Rational Rule for Entry: You should enter a new market if you expect to earn a positive economic profit, which occurs when the price exceeds your average cost.
This rule simply says that if there’s an opportunity to earn an economic profit, you should take it!
Just as nectar attracts bees, profits attract new competitors.
As IBM discovered, entrepreneurs actually follow this advice. Profits are a powerful incentive drawing new competitors to your market. And there are many potential new rivals who might respond to this incentive. Your future competitors might include entrepreneurs starting new businesses, existing competitors opening new outlets or factories, or managers in related industries expanding their offerings to include new products that compete with yours. Indeed, there are so many potential entrants that it’s hard to keep tabs on them all. If your industry is extra profitable, you should expect some of them to try compete with you for those profits.
Viewed through this lens, the threat to IBM should have been obvious. Let’s now trace out the consequences of new rivals entering a market.
New competitors make your market less profitable.
When a new supplier enters your market, or an existing rival expands, you’ll probably lose some market share as some of your customers will buy from the new entrant instead of you. This decrease in demand will lead you to sell a smaller quantity at any given price, shifting your firm’s demand curve to the left.
The arrival of new competitors also gives your customers more choices, which means they’re less likely to stick with you if you raise your price. (You might recognize this insight from Chapter 5, which suggested that the price elasticity of demand depends on the availability of substitutes.) As a result you have less market power, which means that your firm’s demand curve is flatter, or relatively more elastic. Businesses with less market power typically charge a lower price, earning a lower profit margin. The left panel of Figure 4 illustrates these consequences.
Figure 4 | Entry and Exit Shift Your Firm’s Demand Curve
All told, the entry of new rivals into your market will decrease your profits because you’ll sell a smaller quantity (due to the decrease in demand) at a lower price with a lower profit margin (because you have less market power). Indeed, as new rivals entered the computer industry, IBM struggled to maintain profitability.
Exit Increases Demand and Your Profits
There’s a flip side to all this too. Just as the prospect of earning profits lures new firms to enter a market, the prospect of losses drives existing competitors to exit your market.
Existing competitors exit unprofitable markets, which helps restore profitability.
Put yourself in the shoes of the manager of a business trying to decide whether or not to stay in the market. The cost-benefit principle says that if the costs of staying in the industry exceed the benefits, then you should exit. Economic profit measures the balance of these costs and benefits, and if it’s negative, the costs of staying in the market exceed the benefits. This yields the following advice:
The Rational Rule for Exit: Exit the market if you expect to earn a negative economic profit, which occurs if the price is less than your average costs.
This simple rule says that if economic profits are negative, managers should exit the market, either by shutting down or by shifting their focus to another market.
When one of your rivals exits the market, it changes conditions for those businesses that remain. You’ll probably win some of their market share as you sell to the folks who used to be customers of your recently departed rival. This increase in demand will shift your firm’s demand curve to the right. With fewer rivals, you’ll have more market power, which means that your firm’s demand curve will be steeper, or relatively more inelastic. The right panel of Figure 4 illustrates both of these consequences.
The net effect is that as rivals exit the market your profits will recover, because you’ll sell a larger quantity (due to the increase in demand) at a higher price (as you exploit your enhanced market power).
Economic Profits Tend to Zero
Okay, we’ve established four important facts. First, if your industry is currently profitable, new rivals will sniff out this opportunity and enter your market. Second, this extra competition will reduce the market share and market power of existing businesses, leading each of them to sell a smaller quantity at a lower price, which reduces their profitability.
Third, the same dynamics also work in reverse, as negative economic profits lead some producers to exit the market. And fourth, the exit of a rival firm reduces competition, increasing the market share and market power of the remaining businesses, leading each of them to sell a larger quantity at a higher price, which helps restore their profitability.
Let’s explore how this process plays out in the long run.
Free entry pushes economic profits down to zero, in the long run.
Things are going well in your industry, and your business is earning a nice economic profit. If your industry has free entry, which means there are no factors making it particularly difficult or costly for a new business to enter (or exit) the market, what do you forecast will happen next?
Aspiring entrepreneurs who get wind of this profit opportunity will follow the Rational Rule for Entry and enter your market. This extra competition will drive everyone’s profits down a bit. What next? If your industry is still profitable, expect new entrepreneurs to continue entering your market. New rivals will continue to enter as long as economic profits are positive, with each additional competitor pushing profits down a bit further.
And so the process continues, until there’s no longer any incentive for new businesses to enter your market. This occurs when the economic profits available to new entrants fall to zero.
Free exit ensures industries won’t remain unprofitable in the long run.
On the flip side, the possibility that your rivals may exit means that if your industry is currently unprofitable, it’s likely that business conditions will eventually improve. Why? Those rivals facing the prospect of ongoing losses will follow the Rational Rule for Exit and leave the market. With fewer competitors, the profitability of the remaining businesses—including yours—will improve. If the market is still unprofitable, more businesses will choose to exit, and their exit will again bolster the profitability of those that remain. Managers will keep leaving as long as economic profits remain negative, with each additional exit improving the profitability of those that remain.
This process of unprofitable businesses leaving the market (or contracting) continues until the market is no longer unprofitable. This occurs when the economic profits enjoyed by incumbent businesses rise to zero.
Economic profits tend toward zero in the long run.
Taken together, the dynamics of businesses freely entering and exiting a market—and of existing rivals expanding and contracting—tends to push economic profits to zero in the long run. That sounds like bad news. Perhaps. But don’t overreact—it’s not that bad. We’re talking about economic profits of zero here, and economic profits effectively pay the entrepreneur for their time and money. If you earn zero economic profits in the long run, that means that you’re doing as well running this business as in your next best alternative.
Desirable opportunities tend to disappear.
In fact, there’s a much broader idea at play here. Positive economic profits are just one example of a desirable opportunity, and free entry tends to eliminate especially desirable opportunities.
You can see this at the supermarket. Next time you’re checking out, observe what happens if there’s a shorter line for one of the cashiers. Your fellow shoppers understand that they can make a time profit if they join the shorter line. New shoppers will continue to enter the shorter line until this profit opportunity is extinguished. This occurs when that line becomes as long as the others. This dynamic means that in the long run, all the lines are of roughly the same length.
Sadly, the supermarket line is a metaphor for life. As the next case studies illustrate, there are many domains in which long-run entry and exit dynamics lead especially desirable opportunities to disappear.
EVERYDAY Economics
How free entry and exit shapes your chances of getting a table, how crowded your local surfing spot is, which classes are crowded, and where you’ll move after college
As Yogi Berra once said: “Nobody goes there anymore. It’s too crowded.”
Free entry is a powerful force that shapes outcomes in many areas of your life. The key insight is that any extraordinary opportunity plays the role that profits do—they’re a signal beckoning new competitors to enter your market, and as they enter, those profits will dissipate. Think more broadly about what it means to earn a profit, and you’ll find this insight applies elsewhere:
- Perhaps you’ve discovered an amazing restaurant—great meals at very reasonable prices. It’s so good that it offers you a culinary “profit opportunity.” Here’s where free entry comes in: Other people will discover that restaurant, too, and the same thing that attracts you to the restaurant will attract them. As more people discover your hidden gem, it’ll get crowded. The wait for a table will become uncomfortably long, and perhaps the restaurant will use its popularity as an excuse to raise its prices. Even so, as long as it remains better than alternative restaurants, even more people will keep flocking to it. They’ll keep coming until the restaurant is no longer more enjoyable than other restaurants—the prices are too high, the wait is too long, or the waitstaff become too snooty. The free entry of new diners to your favorite restaurant effectively pushed your culinary profit toward zero.
- The same dynamics spoil all the best surf spots. If you’ve discovered an unusually good break, enjoy your “surfing profit” now, because it won’t last. As other people discover it, your favorite spot will become more crowded, and soon you’ll be fighting other surfers for a wave. The free entry of surfers will push your surfing profit back toward zero, and in the long run, no surfing break offers an unusually gnarly day.
- You’ve probably observed something similar with your classes. Every university has a few fantastic professors, and taking a class with one of them is a great opportunity. But this “educational profit opportunity” won’t last. Next year more students will enroll in their class, and if it remains great, even more will enroll the next year. Give it a few years, and that class will be held in a massive lecture hall, with late arrivals watching a video feed in an overflow room. The free entry of new students into the most popular classes continues until the experience is no longer any better than taking an obscure seminar on eighteenth-century underwater basket weaving.
- When you graduate you’ll have to decide what city to move to. If jobs are more abundant in Atlanta than elsewhere in the country, new graduates will flock to Atlanta to take advantage of those opportunities. As more people move to Atlanta, it’ll become increasingly harder to land one of those jobs. Free entry of job-seekers across city lines will continue until the opportunities in Atlanta are no longer better than elsewhere in the country. Over time the free entry of job-seekers into different labor markets tends to eliminate the “profit opportunity” of especially abundant high-quality jobs. Indeed, in the long run, the quality of job opportunities tends to be roughly similar around the country.
Price Equals Average Cost
So far we’ve explored how free entry and exit shape your firm’s long-term profitability. Let’s now explore what this means for where the price will settle in the long run.
Free entry pushes the price down toward average cost.
Her entry means your days of high profits are ending.
If the price exceeds your average cost, then you’re making an economic profit. To repeat our earlier analysis: that economic profit is a signal for new entrepreneurs to enter the market. This reduces the profits of the incumbents, because the new entrants steal some of their customers (shifting their firm demand curves to the left), and rob them of some market power. This process of new firms entering and reducing industry profitability will continue until the Rational Rule for Entry says that it’s no longer worth entering the industry. This occurs when economic profits return to zero, which means that price is equal to average cost.
Free exit pushes the price up toward average cost.
Their exit makes it easier for you to charge higher prices.
But, if the price is less than average cost, then your market is currently unprofitable. Those economic losses are an incentive for some companies to exit the market. Their exit increases the profitability of the businesses that remain, because they’ll each win some customers from the departing company (shifting the firm demand curve of the remaining businesses to the right), and they’ll each gain a bit more market power. This process of unprofitable companies exiting the market, thereby increasing the profitability of those that remain, will continue until the Rational Rule for Exit says that it’s no longer worth leaving the market. This occurs when economic profits return to zero, which means that price is equal to average cost.
In the long run with free entry (and exit), price equals average cost.
Put the pieces together, and it says that if businesses can freely enter and exit the market they’ll do so until new entrants can’t earn a positive profit, and incumbent businesses aren’t making losses. Thus, in the long run, you should expect:
Price = Average cost
The big idea here is that in the long run, prices are determined by entry and exit dynamics. This is a big deal, because it says that average costs will be the dominant factor determining prices in the long run.
This puts our short-run analysis in Chapter 14 in a different light. There, we discovered that businesses with market power can charge high prices—much higher than their costs—and earn high profits. But in a long-run analysis, if there’s free entry into your market, then high prices yielding large profit margins are fleeting, because new firms will enter your market, undercut you, and compete your profits away.
Interpreting the DATA
Entry and exit are powerful forces
Our long-run analysis emphasizes how ongoing entry and exit can reshape your competitive landscape. Indeed, most industries are in a state of constant churn as new start-ups enter and older businesses exit, a process known as creative destruction.
Across the whole economy, there are around 7 million business establishments. In a typical year, roughly 9% of existing establishments shut down, to be replaced by a similar number of new entrants entering the market. The rates of entry and exit are roughly similar across different industries. This suggests that you should expect your competitive landscape to be in constant flux, as some rivals die off, and new rivals are born.
Your firm’s demand curve just touches your average cost curve.
Figure 5 illustrates the long-run equilibrium under free entry. Notice that this long-run equilibrium occurs where your firm’s demand curve has been pushed left (or right) until it just touches the average cost curve. At the point where the curves touch, the best choice a manager can make—the only one point on the firm’s demand curve that avoids a loss—is to set price equal to average cost.
Figure 5 | Free Entry Continues Until Price Equals Average Cost
To see why the two curves have to just touch, realize that if any part of the demand curve lies above average costs, there’s a profit opportunity—because price exceeds average costs. Free entry will continue until this opportunity is eliminated. And, if the demand curve lies entirely below average costs, then incumbent businesses must be making losses because price is always below average costs. Incumbent businesses will exit until these losses are eliminated. When the two curves touch, the best a company can do is make zero economic profits, which is a long-run equilibrium, because it’ll lead the industry to neither expand (through entry) nor contract (through exit).
Average costs matter, because they determine the profitability of the marginal firm.
The centrality of average costs to determining prices in the long run might seem surprising, since the marginal principle has typically led us to focus more on marginal costs. But in fact, this focus on average costs follows directly from applying the marginal principle to a long-run analysis.
To see why, realize that in the short run, the relevant question is whether to produce one more unit. So what matters in the short run is the marginal cost and marginal benefit of that extra unit. But in the long run, the relevant question is whether one more business will enter or exit. So what matters in the long run is the profitability of that marginal business—that’s the company right on the cusp of entering or exiting—and that company’s profit margin depends on their average costs. So it’s actually the marginal principle that leads us to focus on average costs.
Interpreting the DATA
Is the mere threat of entry sufficient to lower prices?
Even just the threat that Southwest will fly on a route causes prices to fall.
Next time you get a cheap flight, you might want to thank Southwest—even if you fly on a different airline. Southwest is an aggressive discounter—so aggressive that if it enters a new market, the incumbent airlines like American, Delta, or United have to cut their prices to compete. In fact, on the routes Southwest flies, the incumbent airlines typically cut their prices by about 30%.
But sometimes Southwest causes prices to be lower even on routes that it doesn’t fly. In particular, economists analyzed the prices of flights between any two cities where Southwest has a base—even if Southwest doesn’t offer service between those airports. They found that Southwest’s rivals offered large discounts on those routes. The explanation is that the other airlines fear that Southwest will soon start offering service between those two cities. This fear—which is based on the mere threat of entry—has been sufficient to cause Southwest’s rivals to cut their prices. Indeed, the threat of entry led Southwest’s rivals to offer discounts that were nearly two-thirds as big as they would offer if Southwest actually entered the market and started competing with them!
Recap: Your long-run profitability depends on barriers to entry.
We’ve come a long way, so it’s time to catch your breath, and pan back to the big picture. We can summarize it in one sentence: If there’s free entry and exit, then in the long run economic profits will be eliminated and price will equal average cost.
The rest of this chapter will be about just one of those words: If. That word points to your best chance for maintaining your long-run profitability. It suggests that if new rivals don’t enter, then perhaps your profits won’t be competed away.
This insight should change how you think about business strategy. You need to adjust your focus to look beyond outcompeting your existing competitors, so that you also deter new rivals from entering your market. Potential entrants are a threat to your long-run profitability, and your continuing success depends on finding a way to outflank them. Fortunately the business world provides dozens of examples of managers whose savvy strategic choices deterred potential rivals from entering and competing away their profits. And so our next task is to draw out the underlying logic of these strategies, so that you’ll be equipped to adapt and apply them in your career.