Entry, Exit and Long-Run Profitability - How to get ahead in the Market

Himalaya.
Hey Betsy, what time is it time for coffee?
My name is Samir Benoir and I own Milka Coffee
Roasters here in Sacramento, California. We're a coffee shop and
roast tree serving specialty coffee.
Our friend Samir has told us a lot about the
decisions business owners like him make every day.
He told us that he really needs to consider his rivals.
It's not just Samir's current rivals that he needs to
worry about. He needs to keep an eye on potential
rivals who could open up shop, take away some of
his customers, and drive his profits down.
Sacramento is definitely a coffee town. Milka Coffee Rosters is
located in downtown Sacramento. We've got one coffee shop that's
literally one block up from us, and then two more
coffee shops that are about three blocks down the street
closer to the city center. And I would be worried.
If someone were to come in like one more shop,
I think would be fine, But if it was like
two to three more shops, like one to two blocks away,
I think we would see oversaturation in the market, and
that would bring all of us down and possibly cause
one of us or a few of us to exit
the market.
These are all considerations about entry into a market and
exit from a market. They're the central forces that guide
how profitable a business is going to be in the
long run. An entry, exit and long run profitability are
our topics on this edition of Think Like an Economist
with me Betsy Stevenson and I'm.
Justin Wolfus.
Wall.
He had to teach you the super tools of economics
to transform your life. Nestra and Tubacoli fires with us.
So many people dream of starting their own business, and
these days everyone talks about passion and purpose and changing
the world and all these big concepts, but ultimately you're
going to want to make money.
Yeah. We economists tend to see through the romance at things,
and the reality is that people tend to start businesses
when they smell profits, and there's a ready supply of
entrepreneurs willing to enter a market if they think they
can make a buck.
Samir just told us how Sacramento is a coffee town
and that's why he thinks he can make money selling
coffee and Sacramento.
The same logic works elsewhere. Maybe you live near office
building so you could set up a dry cleaner cleaning
people's suits and pressing their business shirts. Or perhaps you
live near a baseball park or a football stadium, so
you can make money selling hot dogs or T shirts
just around the stadium. There are endless examples. Really.
In each case, new businesses will keep opening up in
a market as long as they think they can make
a profit.
And perhaps this sounds surprising, but this idea that profits
attract new entrants, that idea will ultimately the market's profitability.
So it is kind of a crazy, counterintuitive idea. The
fact that there is profits is what's going to destroy
your profits.
Let me explain, and we'll stick with Samir's market. If
he's making good money selling coffee and Sacramento, let's say
he's making a dollar of profit on every coffee he sells. Well,
that's pretty lucrative.
And that profitability is great news for Samir. But it's
also a message to potential entrepreneurs that they can make
good money if they open a coffee shop in Sacramento.
So that'll encourage more people, more entrepreneurs to open coffee shops.
We call this the rational rule for entry. This is
the idea that smart entrepreneurs will enter market if they
think it's likely to be profitable.
So let's work through those next steps. The new coffee
shops are new competitors for Samir, so he might lose
some of his customers to them. He might also have
to cut his prices to try to stay competitive.
So the sad fact for Samir and he's fellow coffee
shop owners is that this greater competition will mean that
they're each selling less coffee at a lower price. That'll
reduce their profitability.
That'll reduce everyone's profits a bit. But if it's still
a profitable industry, then even more entrepreneurs might decide to
open up new coffee shops.
Those new entrepreneurs are going to reduce profitability some more.
But if the industry is still profitable, even more are
going to enter.
So this process of new coffee shops entering the market
and reducing the sector's profitability will continue until there's no
more incentive to start a new coffee shop.
That happens when the sector is no longer profitable. And
so new businesses keep entering a market until it's no
longer worth it. And that happens when no one's making
a profit anymore.
Yeah, and the reverse to all this happens as well.
Sami says that if two or three more shops open
up nearby, then some of the existing coffee shops are
likely to close and exit of the market.
If there's too many coffee shops and not enough demand,
then it may not be profitable for some of them
to be in business anymore.
They're losing money, so they might be better off closing,
which is the same as saying they'll exit the market.
There's no point doing business if they aren't making profits.
And so with some of these shops closed, that means
the remaining coffee shops are going to regain some of
their profitability, is they get some of those customers back
and they can raise their prices a bit.
The number of coffee shops adjust so that in the
long run, no one makes any profits.
Wait, no one makes any profits.
That's right, nas, no profits. Let's dig into what we
mean by this.
So what do you mean that no one's making profits
in the long run? Do you mean that no one's
making any money?
Literally?
Not quite. When economists talk about profits, they're talking about
what we call economic profits, which is money above and
beyond a normal return to an entrepreneur on the time
and money they invest.
So business owners like Samir aren't starving. They're just doing
a normal profit enough to get by, but not more
than they'd earn if they've got a regular job.
Instead, think about it, it's enough to keep Samir doing
what he's doing rather than taking its next best option.
So when economists talk about zero profits in the long run,
think of it as being zero profits after we pay
the entrepreneurial wage for the time they spend running the business,
and we pay them interest on the money that they've
put into it.
Okay, And so what does this mean for prices in
the long run?
As simple trick here is to think of year profit
margin per item that you sell. So for Samir that
means thinking about his per unit profit margin as the
price he sells a coffee for minus the average cost
of a cup of coffee.
And remember that his average costs include accounting for the
fact that he has to efficively pay himself a salary
to run the business.
So if new coffee shops enter the market until economic
profits are driven down to zero, this means that their
profit margin per cup must also be zero.
Okay, So Samir's profit margin is the price he sells
a coffee for less his average cost of making a coffee.
Then if the profit mind and a zero, that must
mean the price of coffee is equal to the average
cost of making it.
That's right.
In any industry where businesses can freely enter or exit
the market, the price is going to be equal to
the average cost of whatever they're making.
So if the price is above average cost, then the
industry is profitable, which causes new firms to enter and
this competition will push the price down. And if the
price is less than the average cost, then the industry
is unprofitable because there's too many businesses in the market,
so some of them will shut down, and this reduced
competition is going to push the price up.
That's right.
The big idea here is that in the long run,
prices are determined by entry and exit dynamics.
We've covered how if we have free entry and exit
in a market, then in the long run profits will
be zero.
Yeah.
Yeah, And I don't want it to press Samir or
our listeners or units, because it's still possible to make money.
The crucial word you said in that last sentence is
if if businesses can easily into a market, they'll drive
profits down to zero, and if.
They can't, well, your business just might remain profitable in
the long run.
This big if is what a lot of business school
in the field of business strategy is all about.
Existing businesses understand that if they can make it hard
for new rivals to set up shop, then these existing
businesses can earn excess profits or earning economic profits. So
they'll do what they can to deter new rivals from
opening up.
Businesses can be strategic and try to construct barriers to entry,
these obstacles which make it hard for a new business
to enter the market.
Different firms will use different strategies, but there are four
big ideas that they're all drawing on.
The first set of strategies to prevent new businesses from
entering your market are called demand side strategies because they're
all about focusing on your customers.
One of the things businesses try to do is create
customer lock in. What they're doing there is trying to
get their customers to stick with them even if new
companies are entering their market and offering lower prices.
One way to lock in your customers is to create
switching costs, which will make it hard for them to
switch to buying from another business. A great example is
the way that Apple makes it hard for you to
switch phones. If I use an iPhone, then I've also
purchased a ton of apps. If I want to buy
an Android phone, I'll have to buy those apps again
because I'll need to buy the Android version, so I'm
stuck using Apple.
Another common example is when airlines give you frequent flyer points.
By collecting points, you can get a discount on future flights,
so it's an incentive for you to keep flying with
that airline and effectively make it costly for you to
switch to a different airline.
Submith told me about one way they encourage their customers
to keep coming back to milk or coffee roasters.
We try to build loyalty in our customers by giving
them kind of a rewards program where they'll get five
dollars off for every fifty dollars they spend. It's pretty generous,
but I think that really for our regulars, they really
like they love that, and they spend a lot of
money here, so we want to make sure that they
feel like we're giving them something back without a lot
of strings attached.
Another way to create customer lock in is through network effects.
Yeah.
These are about how a product is more useful if
more people use it. A good example is messaging apps.
You can only use a messaging app if other people
are using it as well. So even if I don't
like WhatsApp, for example, I'm still gonna have to use
it if all of my friends are using it.
Yeah.
Right, So you're not gonna swap to some other messaging
app if none of your friends are using it, who
would you message.
Business managers understand all this, so they work hard to
create network effix because it makes it harder for new
firms to entermarket and succeed. These managers are pretty savvy
and they come up with some pretty subtle ideas.
An example is thinking about how people by cars. People
tend to stick with well known brands, and it's not
just because Toyota and Ford make good cars. It's also
because of the network effects that come from the big
network of dealers that can offer you repairs on the
road no matter where you are. If you've gone on
a car trip, you know you can pull into that
Toyota dealer and get your car fixed and have the
part hopefully in stock.
Okay, So demand side strategies focus on making your customers
stick with you even if you rivals into your market.
The second approach to maintaining these excess profits or positive
economic profits is to use supply side strategies. These strategies
focus on the businesses which are the supply side of
the market.
The key idea here is you want to develop unique
cost advantages so your business will continue being profitable even
if it isn't profitable for potential rivals to enter the market.
So the marginal principle is key here. Remember we've already
said how businesses will keep opening up in a market
until profit are zero. Well, that's another way of saying
that the last firm that enters or exit a market,
the marginal firm, expects that its profits will be zero.
Its profits will be zero. But if you have lower costs,
then your firm will be profitable. You've just got to
develop cost advantages that that marginal firm can't easily copy.
Businesses can reduce their costs by becoming more efficient. This
is often a result of just doing something long enough
to become.
Expert in it.
Economists call this learning by doing.
Another approach to creating cost advantages is through research and development.
It's not just about developing new products. Research and development
can also be about creating new and more efficient ways
to do what you already do.
Toyota is especially famous for this, and it produces cars
at a lower cost than many of its competitors. This
makes it hard for new car manufacturers to enter the market.
Speaking of Toyota, mass production also pushes its costs down.
It's cheaper to make car parts for ten thousand cars
than to make car parts for five cards. All this
prevents newer and smaller firms from entering the car market.
Supply side strategies really revolve around inputs. Given these strategies
are about reducing costs.
Yeah, so another way to get cheaper inputs is through
your relationships with suppliers. If you're a valued customer for supplier,
they're going to want to keep doing business with you
as you grow. Paw of Walmart success is it's so
big that it has more bargaining power than anyone else,
and so it's suppliers off a Walmart better wholesale prices.
Yeah.
In this example, bigger firms can have greater leverage with supplies,
and the supplies are likely to really depend on bigger businesses.
Supply side strategies can be harder for smaller businesses to use.
As Samer explains, currently, we're not a big enough company
to have special relationships with suppliers, and most of our
suppliers are small companies that are local that we want
to make sure we pay them what they're worth.
Another thing big companies can do is try to limit
access to key inputs for their competitors. A lot of
startups in Silicon Valley complain that it can be hard
to hire really talented computer programmers as they're likely to
be working for a big company such as Google. If
you are a startup, it could be hard to compete
with Google for that top talent, and that effectively shuts
you out of the software market entirely.
The third way to create barriers which prevent new firms
from entering a market is through the use of government regulations.
These can make it really hard to start doing business.
In some countries, it's really hard to set up a
new business, which of course helps the existing businesses. There
are all sorts of procedures you need to follow. On average,
it takes eighty four days to start a business in
Brazil compared to six days in the US and around
one day in New Zealand. By the way, regulations aren't
always bad. In the US. You can't just open up
a school or a hospital, and that's for pretty good reasons.
You may also need a license to enter certain markets,
such as if you want to sell real estate. These
end up limiting competition.
The other thing that limits competition is patents, and these
are really important in say the pharmaceutical market. If you
invent a new product, then you can apply for a
patent from the government, which basically says that no one
else can use your idea without your permission. A patent
essentially gives your company monopoly. The government grants patents so
that businesses will invest in research and development, but it
means that no one else can enter their market.
Some firms will lobby the government to create new regulations
that can make it hard for new firms to enter
a market. For instance, lobbyists for taxi companies argue that
it's really important for public safety that only licensed taxi
drivers be allowed to drive passengers around, but they didn't
really care about public safety. They're really interested in limiting
competition from ride sharing companies like Uber, and.
In some cities that have succeeded in persuading politicians to
ban Uber, and that has kept taxi company profits high
in those cities.
Sometimes people are surprised to see businesses going to the
government to lobby for regulation. I mean, our businesses supposedly
hate regulation.
But when you're a bit more cynical, you see that
it's really about defending the public interest and it's more
about preventing new companies from being able to compete with them.
And no, in a lot of ways, that's what we
saw with taxi drivers lobbying to try to keep Uber out.
We've looked at a range of ways to deter new
firms from entering a market, from the demand and supply
sides to using government regulations. Now there's another way too,
and that's simply by using brute force.
Yes, sometimes companies will really threatened to crush new rivals,
and this can scare a new firm off from even
trying to enter.
Yeah, and there are infamous tales of companies threatening their rivals.
So for example, CEOs taking rivals on private jets and
detailing all the ways they're going to crush the other company.
Yeah, and a company needs to be able to back
this up. For this threat to be credible and therefore
for it to work. One way is to build excess capacity.
That's a way signaling you have not only the desire
to flood the market, but also the ability, and that
could very quickly make entering the market very unprofitable.
Having deep pockets also shows that a business is willing
to fight arrival. Apple has around two hundred and forty
billion dollars of cash on hand. It's an extraordinary amount
of money, you know. Business experts see this as a signal,
a way of Apple telling potential rivals that it can
survive a long and costly fight for its share of
the market.
We seem to be speaking about fighting quite a lot.
Yep.
This can be like a war, and a firm's reputation
for fighting can be really helpful. You mentioned Uber, who
at their peak had a reputation for crushing rivals, and
my guess is they deterred other ride checked companies from
entering their market.
There's another method to deter your rivals, and that's really
to leave them no space in the market by dominating
the market with your brand. We see this a lot
in the food industry, Kelloggs makes a huge range of
breakfast cereals, from brand flakes to cocoa pops and everything
in between. It's really hard for a new firm to
figure out where they're going to enter amongst all those
Kellogg's cereals.
Business executives spends a lot of resources building these barriers
to entry to prevent new firms from entering markets. But
are these actually good for society?
Well, from the narrow perspective of an individual business, they're
great for that business because it's the only way for
that business to continue being profitable. But from everyone else's perspective,
they're terrible.
Part of the problem is that barriers to entry prevent
potentially productive businesses from being started, and.
Markets work best when new businesses enter and compete with incumbents,
driving prices lower. New businesses drive inefficient incumbents out of
the market and provide a constant source of renewal.
Consumers do best when there's a lot of competition, so
you have a lot of options to choose from and
you can get the best product at the best price.
But existing businesses earn the most excess profit when they
create barriers that limit the competition.
Betsy's describing attention at the heart of capitalism, which is
that markets work well when they're competitive, but businesses will
do all they can to create barriers to entry to
throttle that competition.
So markets work best with face competition, but because competition
destroys profits, businesses try to destroy competition.
YEP. The tension here is that markets work best when
there's vibrant competition, but incumbent businesses are often going to
do all they can to crush that competition.
This understanding leads to a new way for thinking about
our policy debates. A lot of people who think they
get economics will say that they're pro business, But what
economic reasoning points to is the need for policies to
be pro market, and pro market is not always p.
Pro business policies help existing businesses, but pro market policies
help market spur competition, and what businesses are always going
to want help it's market competition that really serves the
interests of consumers.
So what we need to remember is that a strategy
or policy that's pro business is not necessarily good for
the market overall.
Right, and that also means it's not necessarily good for consumers.
Or people, or our society overall.
Betsy Justin, we've been talking about businesses and all these
big entities. Is there a way we can see these
dynamics about entry, exit and long run profitability in our
day to day.
These dynamics are a big part of our lives because
we earn the equivalent of excess profits in other ways.
Say you've just discovered a terrific restaurant, Well, if other
people also discover that they could make a taste profit
by going to the same restaurant, well they're going to
start calling up and taking all the reservations. They're competing
with you for those scarce spots, and they might compete
until it becomes difficult for you to get a spot too.
And if you want to think about what businesses do right,
that's why you might not tell all your friends and family,
or you might not post it on social media. You
might think, Ah, this spot, it's too special to let
the world know about.
The only way you'll keep your culinary profit is by
erecting barriers to entry.
So if you discover something good, don't tell anyone about it.
That's the good picture to the epistet