How is it that if a firm increases fixed costs, the barriers to entry in the whole industry increases? The idea looks weird and shouldn’t be a major factor in considering industry structures. I’d appreciate your help.
A established company invests in factory/plant/equipment - and builds up its investments
since it has invested more in these items - it would need to increase the amount of product it produces - so as to be able to show a ROI (return on investment) and to be able to apportion the costs across a higher product base.
once that happens - a new entrant is in a worse off state - since it cannot match the bigger producer on costs (unless it increases the volumes in a big enough way or has some other competitive advantage that allows it to produce products cheaper).
Think of the semiconductor industry - the fabs that manufacture these things use very cutting edge expensive technology to stay ahead of their competition. As these fabs become more and more expensive it costs more and more to enter the semiconductor fabrication industry and build more capacity.
Compare this to a clothing store: It’s easier to start a clothing store because you don’t need a $1b check to open a store, unlike the semiconductor production biz where you’ll definitely need that much and more to construct and open a semiconuctor fab facility. Hence, there is a barrier to entry into the semiconductor fab market that is not present in the retail store market, and the semiconductor fab business has a higher cost of entry, higher fixed costs, and a higher barrier to entry based on this dynamic.
I saw an example in Schweser’s notes where this is not the case. It’s the caselet in EOC in Reading #32. Question number 14 to be precise.
I looked up the reading and I think I understand what the qualm is here. It’s mostly the way the question is worded but I think we need to think about the way the questions are worded on the test so it’s a good opportunity to learn.
So we also know that an increase in capacity will increase competition/rivalry because there is more capacity in the overall marketplace for office furniture and suppliers will then cut prices to fill the capacity. We also know that this excess capacity can increase the buying power of customers because of lower prices and the suppliers desire to utilize its capacity. This question is a little tricky because it’s asking what is least likely, and I would argue that the increase in barriers to entry is least likely because it does not increase the fixed costs of producing a line of furniture and no business must be reliant on the example’s furniture when they could easily switch to another producers that did not expand and increase its fixed costs.
To relate this to my previous example; think of the increase in manufacturing capacity like opening another store in California, while you are already operating one store in New York. There are no efficiency gains here so there is just an increase in the fixed costs while anyone can still enter your marketplace. There is no increase in the barriers to entry because your business is not more efficient. On the other hand, using my previous semiconductor fab example, when a fab increases size and expands there are typically gains in efficiency, and while the overall fixed costs will increase the cost-per-unit tends to decline due to economies of scale/efficiency/etc. Because the cost-per-unit is cheaper the business is more competitive than if you are just starting out and there is a higher barrier to entry.
This would be similar for something where your technology is imperative to use versus a competitors as well, which is the key that this question is differentiating for us to learn. If the example’s furniture was better for some reason that customers really need (maybe the only desks with computers or something), and they expanded capacity and made it cheaper to produce their goods somehow, then in order for you to enter the marketplace and compete with them you’d need a large, efficient, more expensive facility. In this case the expansion would cause an increase in the barriers to entry.
Hope this helps