What happens to profits if barriers to entry are introduced into perfect markets?

 

A perfect market is one in which an homogenous product is freely traded to sovereign consumers. Perfect knowledge and perfect information exist, so that all sellers, of whom there are many, know the production and sales techniques of all others and can replicate them, and all consumers know where they can always obtain the cheapest products. There are no legal, supply chain, or cost barriers to entry or exit into the market, and consumers are completely elastic, so that average revenue is equal to marginal revenue at the equilibrium price. The price is set purely by the meeting of supply and demand.

In such circumstances, normal economic rules apply. Consumers would be seeking to maximise their utility and producers would be seeking to maximise their profits. Profit is the difference between revenue and cost and is maximised where marginal revenue is equal to marginal cost. This means that in a perfect market all profits are normal profits. Firms will only operate to cover opportunity cost, which in such an idealised market will have an identity with break-even levels of profit in which they do not make money, but do not lose money either.

If barriers to entry are introduced, some firms will be within the market and able to take advantage of the barriers, whereas others will not be able to enter. This will lower the costs of the firms which benefit. Those firms will have lower costs than revenue, and will then experience abnormal profit. This might allow them, through advertising or mergers, to alter price or supply, and make even greater profits, leading to more takeovers, economies of scale, and ultimately greater barriers which benefit them. If consumer demand changes as information changes, consumers become less concerned with price because of advertising or marketing, or because the goods of the profitable firms begin to be differentiated, this will change AR and MR, which will slope. This will allow for more profit, and lower consumer surplus. Allocative and productive efficiency will decline, and the market could become oligopolistic or monopolistic.

Three factors will constrain this process. One is the incentive to firms outside of the barriers to get around them or to develop parallel markets in near-substitutes. A second is the possibility that government might intervene to remove the barriers if ‘excess’ profits lead to public protest or disquiet. A third is whether the profits being made attract in larger companies from outside the original market to increase competition again, though this will reallocate profit rather than improve consumer surplus. If a market with differentiated products turns into one in which others enter at a higher level of price, then some firms’ revenues will decline, costs will rise, and an ‘arms race’ in branding which raises fixed costs like advertising and squeezes variable ones like wages will occur.

The exact effect on a firm’s profit if barriers to entry develop therefore depends on the size of the firm initially, whether it is structured to profit-maximise or profit satisfice, the attentions of government, and what sort of barrier emerges.