Prepared by: Enrique, Lihong, John, Jongkuk Beyond the Reach of the Invisible Hand: Impediments to Economic Activity, Market Failures, and Profitability (Dennis A. Yao) Prepared by: Enrique, Lihong, John, Jongkuk

Introduction Perfectly competitive markets lead to long-run profits that are average or normal We observes companies that makes excess profit over a long time horizon. What might account for such outcome? Barriers of entry (Bain 1956, Caves 1977) Imperfect competition - “ market inefficiencies” Condition for market efficiencies price takers No transactions costs and completeness of markets Perfect information Impediments to economic activities Production economies and sunk costs Transactions costs and incompleteness of markets Imperfect information Barrier of entry: industry characteristics that make new entry into an industry difficult and, therefore, buffer Individual market failures have been studied in the literature but impediments to economic activities that lead to market failure have not systematically related to the entry barriers theory and have only be related to profitability on a case by case basis

Some limitations of the entry barriers theory Barriers to entry economies of scale product differentiation capital requirements switching costs access to distribution channels government policy barriers to imitation Theory does not provide a systematic way to assess the significance or importance of a barrier in any particular application (need to consider additional factors) Product differentiation + uninformed buyers Access to distribution channels + information + concentration in the retailer market These examples suggest that there is a set of factors more basic than entry barriers that may be used to asses the potential profitability of a market. These factors – impediment to economic activity-which are derived from the economic theory of competitive markets are:

Impediments to economics activity, market failures and profitability 1) Production economies and sunk costs Violation of price taking condition In the absence of government interference the number of firms that will be sustained in an industry depend on the size of production economics and the size of the market The number of firms is important because, with few firms, it is less likely that the price-taking assumption of the pure competitive model is valid and therefore prices may not be competitive With sunk cost and non-government regulation, economies of scale lead to a natural monopolies or oligopolies Few firms, production economies and sunk cost suggest that strategies oriented toward entry deterrence via product positioning, capacity choice and pricing are particularly relevant

Impediments to economics activity, market failures and profitability 2)Transactions costs Violation of complete market conditions Transaction costs are often cited as a basic cause for the non-existence or incompleteness of markets Cost of excluding non-buyers from the use of the product or service The cost of communicating and information For a market to fail to exist transaction cost > value of exchange in the market

Impediments to economics activity, market failures and profitability 3) Imperfect information Violation of the perfect information condition Buyers with perfect information will not purchase higher-priced good if a lower-priced good of equal quality exists. Information problems can be exploited via information-oriented strategies: development of reputation, product differentiation through advertising, signaling quality – positive information lead consumers to buy the product

Impediments to economic activities Reinterpreting barriers to entry: some applications of the IEA perspective While barriers to entry may cause market failures, the underlying basis for these failures is in the significant presence of the impediments to economic activities The absence of such impediments implies that barriers to entry will not provide profit opportunities via market failures Tthe profitability of product differentiation strategies depends on imperfect information on the part of consumers. The value of the impediments perspective is that this approach will help a strategist predict the strength of various barriers to entry and will provide an independent means of assessing profitability. Impediments to economic activities Barriers to entry Market Failure IEA and entry barriers are closely related

Connections among the IEA and entry barriers What causes product differentiation to be an entry barrier? Automobile market – Product differentiation poses an entry barrier if the existing attributes combinations in the market is such that no new attributes combination exist such that will generate enough demand to justify entry by new firms. Incumbent makes profit (product spacing strategy) even if all new firm will find it unprofitable to enter. With no minimum efficient scale – the cost to make different product is the same as to make only one product. The effectiveness of product differentiation through actual product differences is based on the significant presence of the production economies (of scope) and sunk cost impediments. Product differentiation exists when product are not viewed as perfect substitutes ( actual product differences or perceived product differences)

Connections among the IEA and entry barriers Information failures and capital requirements Large capital requirement and the uncertainty associated with new entry constitutes an entry barrier in some industries Constraint on borrowing should not exist in a perfect capital markets and with perfect information because lending rates appropriate to each level of risk will always be available. With imperfect information, restriction on capital for some project will exits. Capital required for entry depends on efficient scale considerations. If production, distribution and marketing economies are reached at low levels, capital requirements will not be a problem With large capital requirement but small sunk cost, the capital requirement barrier will be small. Capital requirement entry barrier depends on production economies and sunk costs in the product market, and on imperfect information in the upstream capital market. Lending institution are have problems determining the credit worthiness of the borrowers.

Connections among the IEA and entry barriers Sunk cost sand switching costs For example: Keyboard configuration The basis for the switching is a sunk cost that the consumer has made in operating knowledge, which affects the producing cost of keyboard. The consumers has given the old vendors an economy of scale over the other vendors. Interestingly, the keyboard producers get some of the economic rents to the user’s investment. The specificity of the knowledge to the extent to which it is sunk as well as the production economies that are involved determine the size of switching costs.

Implication for strategy Economics theory emphasizes the effectiveness of the market in limiting profit to an average level base on price taking, completeness of markets and perfect information assumptions. When one of these 3 assumption is absent because of the presence of the IEA, opportunities to generate sustained supra-normal profits via market failures may also be present. Among IEA, the imperfect information is particularly important and pervasive. Understanding the fundamental economic mechanisms that lead to profitability is an important step toward information strategic actions.

Implication for Strategy From a managerial perspective, the values perspective is that it provide a basis from which market failures can be identified and appropriate strategies can be determined Strategies that attempt to exploit market failures may not always be successful in generating excess profit, ignoring the implication of market failures for strategy will generally lead to subnormal profit Identifying impediments and exploiting the market failures associated with those impediments are more than just necessary for profitability, such actions may also be necessary for survival