At this point we inquire about the potential impact of new firms – firms who might enter the industry if conditions were sufficiently enticing – meaning high profits. Indeed we could ask if firms will necessarily enter a market such as the one described in the duopoly game above, if there is ‘freedom to enter and exit’.
A simple way to illustrate the possibilities is to change that illustration very slightly: in addition to the constant marginal cost of producing the good, suppose there is a fixed cost associated with setting up production. This might comprise the research and development costs necessary to launch production, and such costs are incurred by each firm that participates in the market.
In the foregoing example each of the two firms that competed for profit using Cournot behavior earned a profit of $36. Obviously then, if the fixed costs are less than this number, each firm continues to make a profit net of fixed costs, but if fixed costs are greater than $36 both firms cannot be profitable. So let us assume fixed costs are low enough such that each firm is profitable after all costs are considered. In addition there are no legal constraints preventing entry. Will new firms enter and compete for the market? The answer is ‘not necessarily’, even if the potential new firm has the same marginal and fixed costs: by entering, the market will now be split three ways and that may squeeze the profit margins of all three suppliers to such an extent that the operating margins are no longer sufficient to cover the fixed costs. If, at the time of entry, profit margins are low (fixed costs are almost large enough to swallow the operating margin of $36) the addition of a third firm may put every firm into a state of negative profit. Hence no entry will occur, because the potential new entrant recognizes she cannot make a profit.
To complete the discussion, let’s ask what would happen if fixed costs were greater than the operating profit of the two incumbents in the example as developed above. For example the government decided to levy a charge on firms that sell tobacco (as was done in the US in 2009). This charge effectively increases fixed costs. What are the dynamics of this situation? The answer here is that it may still be profitable for one firm to make a profit if the other exits. This is because the exit of one firm will result in a monopoly. Not only would the single producer produce more than each duopolist (and thereby reduce average costs as a result of scale economies), he may also be able to charge a higher price in the absence of a competitor.
The economic reasoning behind the foregoing results is that there are returns to scale in this industry. As illustrated in Monopoly, if the fixed costs are large relative to marginal costs, then the average cost continually declines, and it may be necessary to produce a large output in order to reduce average costs sufficiently to be competitive. The problem with having a third firm considering entry to a profitable duopoly is that each firm would be constrained to produce a reduced output, and such an output may be too small to enable them make a profit given the demand conditions. Clearly then, there is a scale economies reason for entry not materializing; the incumbent firms need not take any preemptive measures to prevent entry.
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