When Are Sunk Costs Barriers to Entry? Entry Barriers in Economic and Antitrust Analysis†

WHEN ARE SUNK COSTS BARRIERS TO ENTRY? ENTRY BARRIERS IN ECONOMIC AND ANTITRUST ANALYSIS† What Is a Barrier to Entry? By R. PRESTON MCAFEE,HUGO M. MIALON, AND MICHAEL A. WILLIAMS* In the Papers and Proceedings of the Forty- ing the concept of barriers to entry. We begin by eighth Meeting of the American Economic As- contrasting the definitions of an entry barrier sociation, Donald H. Wallace (1936 p. 83) proposed in the economics literature. We then proposed a research program that proved vision- introduce a classification system to clear up the ary: “The nature and extent of barriers to free existing confusion, and we employ it to assess entry needs thorough study.” Fifteen years later, the nature of the barriers posed by scale econ- Joe S. Bain published a book that was the first omies and sunk costs. thorough study of entry barriers. In this book, Bain (1956) defined an entry I. History of the Concept barrier as anything that allows incumbents to earn above-normal profits without inducing en- In chronological order, the seven principal try. He believed that economies of scale and definitions of an entry barrier proposed in the capital requirements meet his definition because economics literature are as follows. they seem to be positively correlated with high profits. George J. Stigler (1968) later defined an Definition 1 (Bain, 1956 p. 3): A barrier to entry barrier as a cost advantage of incumbents entry is an advantage of established sellers in an over entrants. With equal access to technology, industry over potential entrant sellers, which is scale economies are not an entry barrier accord- reflected in the extent to which established sell- ing to this definition, and neither are capital ers can persistently raise their prices above requirements, unless incumbents never paid competitive levels without attracting new firms them. to enter the industry. With respect to scale economies and capital costs, the definitions of Bain and Stigler are at Definition 2 (Stigler, 1968 p. 67): A barrier to variance, which has resulted in controversy entry is a cost of producing (at some or every among economists and antitrust lawyers, both rate of output) that must be borne by firms over the definition of an entry barrier, and the seeking to enter an industry but is not borne by question of whether scale economies and capital firms already in the industry. costs each constitute one. The present article is an attempt to resolve the controversies concern- Definition 3 (James M. Ferguson, 1974 p. 10): A barrier to entry is a factor that makes entry unprofitable while permitting established firms to set prices above marginal cost, and to persis- † Discussants: Steve Berry, Yale University; Michael H. Riordan, Columbia University; Michael Whinston, North- tently earn monopoly return. western University. * McAfee: Humanities and Social Sciences, California Definition 4 (Franklin M. Fisher, 1979 p. 23): Institute of Technology, Pasadena, CA 91125 (e-mail: A barrier to entry is anything that prevents entry preston@mcafee.cc); Mialon: Department of Economics, when entry is socially beneficial. Emory University, Atlanta, GA 30322-2240 (e-mail: mialon@eco.utexas.edu); Williams, ERS Group, 2000 Pow- ell Street, Suite 500, Emeryville, CA 94608 (e-mail: Definition 5 (C. C. von Weizsacker, 1980 p. mwilliams@ersgroup.com). We thank Sue Mialon for valu- 400): A barrier to entry is a cost of producing able comments. that must be borne by a firm seeking to enter an 461 462 AEA PAPERS AND PROCEEDINGS MAY 2004 industry but is not borne by firms already in the harmful only if potential entrants make a calcu- industry, and that implies a distortion in the lation that is different from the one that society allocation of resources from the social point of would want them to make in deciding whether view. to enter an industry that possesses the barrier in question. Definition 6 (R. Gilbert, 1989 p. 478): An entry Von Weizsacker’sdefinition is also norma- barrier is a rent that is derived from tive, but it follows Stigler’sdefinition. He ar- incumbency. gues that a cost differential is an entry barrier only if it reduces welfare. His point is that the Definition 7 (Dennis Carlton and Jeffrey Per- number of firms in a Cournot industry can be loff, 1994 p. 110): A barrier to entry is anything greater than the socially optimal number. In this that prevents an entrepreneur from instanta- case, entry barriers serve a socially desirable neously creating a new firm in a market. A purpose. long-run barrier to entry is a cost necessarily Gilbert’sdefinition focuses on the advantages incurred by a new entrant that incumbents do of incumbents rather than the disadvantages of not (or have not had to) bear. entrants. According to him, an entry barrier is the additional profit that firms can earn as a sole Bain’sdefinition is flawed in that it builds the consequence of being established in the indus- consequences of the definition into the defini- try. This definition has an immediate problem in tion itself. Moreover, one can imagine an indus- that a profit is not a barrier. try with competitive pricing due to the presence Carlton and Perloff offer two definitions. of many incumbents but with no possibility of They argue that the first is not practical because entry (e.g. by government fiat); such an industry it implies that any capital requirement is an has no entry barriers according to Bain’s entry barrier, and that any industry in which definition. entry takes time has an entry barrier. They note Stigler’sdefinition avoids tautology by identi- that the term “barrier to entry” is often used to fying an entry barrier in terms of its fundamental refer to both costs of entering and the time characteristics, emphasizing the differential costs required to enter. However, to our knowledge, between incumbents and entrants. However, the they are the first to propose a definition that present tense “is” in the definition is confusing. explicitly includes a time dimension. Literally, the definition implies that a cost that Unfortunately, they avoid the timing issue by only entrants (not incumbents) have to bear considering only entry barriers in the long run. today is an entry barrier, even if incumbents had They argue that a firm can only earn profits in to bear it in the past (when they entered the the long run if it has an advantage over potential market). entrants, which leads them to adopt a modern Stigler’sdefinition is narrower than Bain’s: version of Stigler’sdefinition. Notice that their some costs are barriers according to Bain and version clears up the confusion about the not according to Stigler; but all Stiglerian bar- present tense “is” in Stigler’sdefinition. riers meet Bain’sdefinition. Scale economies and capital requirements are Ferguson’sdefinition follows Bain’s, but entry barriers according to Bain’sdefinition be- with the additional requirement that incumbents cause they seem to be positively correlated with earn monopoly profits. Pricing above marginal profits. Scale economies are not an entry barrier cost is not sufficient for incumbents to persis- according to Stigler’sdefinition provided en- tently earn above-normal profits. Incumbents trants and incumbents have equal access to tech- only earn above-normal profits if prices exceed nology. Capital requirements are not Stiglerian average cost. Prices may not exceed average entry barriers either, unless the incumbent never cost even though they exceed marginal cost paid them. because of price or quality competition among Fisher also claims that capital requirements incumbents. are not entry barriers according to his definition. Fisher’sdefinition follows those of Bain and Consider, as Fisher does, an industry that firms Ferguson, but it is normative rather than posi- can only enter if they make a large capital tive. For Fisher, an entry barrier is socially expenditure. A firm will not enter if the profits VOL. 94 NO. 2 WHEN ARE SUNK COSTS BARRIERS TO ENTRY? 463 that it anticipates in the long run will not be definition, while they are not according to sufficient to justify the initial capital cost. But, Stiglerian definitions, since all entrants must argues Fisher, this is exactly the calculation that bear them equally. Similarly, Carlton and Per- society would want the potential entrant to loff exclude sunk costs as entry barriers (under make. The capital expenditure would be so- their second definition) since there are no sunk cially wasteful if it did not guarantee a rate of costs in the long run. return that exceeded that which it could earn elsewhere. Fisher therefore concludes that, ac- II. Economic Analysis cording to his definition, capital requirements, no matter how large, are not entry barriers. As we have shown, the concept of an entry Note, however, that Fisher’s argument ig- barrier has a rich and confused heritage in eco- nores consumer surplus, which enters into soci- nomics. To clear up the confusion, we offer the ety’s calculation, but not into the potential following new classification of entry barriers. entrant’s calculation. The addition of another firm to the industry could increase competition, Definition 8: An economic barrier to entry is a and hence consumer surplus, enough to com- cost that must be incurred by a new entrant and pensate for the entrant’s profit loss in society’s that incumbents do not or have not had to incur. calculation. Governments have operated firms on this theory, to create price competition where Definition 9: An antitrust barrier to entry is a there would otherwise be a natural monopoly. cost that delays entry and thereby reduces social Capital requirements or scale economies may welfare relative to immediate but equally costly not constitute entry barriers according to von entry.

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