One of the main reasons for deregulating markets that were previously subject to severe regulation is to reduce artificial barriers to entry. Since many markets cannot economically be served by a large number of firms, the intent of removing artificial entry barriers is to increase the degree of potential rather than actual competition. Under oligopoly, however, potential competition in the form of reduced barriers to entry is not necessarily effective in disciplining the behaviour of incumbent firms, especially since their pricing responses to entry are typically very rapid.
In Discussion Paper No. 396, Research Fellow Paul Seabright develops a model in which potential competition has no direct effect upon the pricing behaviour of incumbents, but does affect their ability to maintain cost levels higher than those faced by entrants, while still credibly deterring their entry. They achieve this by investing in cost-reducing technologies, and if these technologies can be implemented sufficiently quickly, then the mere possibility of such investment may suffice to deter entry. If reducing such costs takes time, however, a reduction in the sunk costs of entry will lead to a reduction in incumbents' maximum sustainable cost levels, and actual investment will be required. In the limit, as the sunk costs of entry approach zero, incumbents' costs approach those of potential entrants, but contrary to the predictions of contestable market models, incumbents' profits do not approach zero. On the contrary, they tend instead to the monopoly profits of a firm operating at the marginal costs of entrants. This is because potential competition has no direct effect on prices, since incumbents continue to price at monopoly levels in all periods, but the monopoly price is itself an increasing function of the sunk costs of entry, and it is therefore indirectly affected by the influence of potential competition on costs.
It is not always easy, however, to establish how low entry barriers really are, and Seabright develops a second model in which there is uncertainty about whether a rival will enter the market, and asymmetric information in the presence of small search costs can act as a significant entry barrier. The key to the model is the presence of increasing returns: given fixed costs there will exist equilibria in which few consumers are willing to incur the search cost because they believe the probability of entry to be low, and because few consumers search the probability of profitable entry is indeed low. In addition, even when entry does take place, search costs have the effect of segmenting the market and diminishing the force of price competition between firms.
The second model therefore qualifies the findings of the first. Lowering barriers to entry may have beneficial effects on the behaviour of incumbents even when potential competition is powerless to affect their ability to charge a monopoly price, but some entry barriers are larger than they look. Thus the impact of reducing barriers to entry in particular industries cannot be determined a priori, but needs to be the subject of careful empirical research.
Finally, Seabright uses these models to cast light on a number of empirical anomalies in the experience of the US airline market since deregulation.

Can Small Entry Barriers Have Large Effects on Competition?
Paul Seabright

Discussion Paper No. 396, March 1990 (AM)