Can Small Entry Barriers Have Large Effects on Competition?

One of the main aims of the deregulation of previously heavily regulated markets is to diminish artificial barriers to entry. But in oligopolistic markets, the mechanisms whereby potential competition can discipline the behaviour of incumbent firms are not very well understood, especially since pricing responses to entry can typically be very rapid. This paper develops a model in which potential competition has no direct effect upon the pricing behaviour of incumbents, but affects the extent to which they can maintain cost levels higher than those of entrants while credibly deterring entry. This effect upon costs then has an indirect impact upon pricing behaviour. In the limit, as sunk costs of entry approach zero, incumbents' costs approach those of potential entrants, but incumbents' profits do not approach zero; on the contrary, lower entry barriers imply higher profits for incumbents. It is not always easy, however, to establish how low entry barriers really are: a second model is developed in which asymmetric information in the presence of small search costs can act both as a significant entry barrier, as well as helping firms to segment the market in a way that blunts the force of price competition. These models are used to explain empirical anomalies in the experience of the US airline market since deregulation.