Lobbying can lead to monopolies (which can lead to higher prices and/or lower quality)

Competition is not just about the number of firms on a market. It’s also about allowing new entrants to challenge incumbent firms. Thus, because competition is the best way to improve the well-being of consumers, barriers to entry should concern us.

The reason for this is simple enough. Firms innovate and improve their practices to gain market shares. In practice, this could lead a few firms—or even by a single firm—to dominate some markets. Even though these firms may have come to dominate their markets by becoming more efficient (and lowering prices for consumers), their dominant status could lead them to abuse their position given the lack of option for consumers.

However, this is not an option if, once they start increasing prices or cutting down on quality, new firms can enter the market and challenge the incumbent. So even if a firm is alone on a market, it will act in a competitive manner for fear of encouraging a new player to enter the market.

That disciplining fear extends also to incumbent firms inventing new substitute products or services that could replace the ones produced by the firm. Subsequently, as long as barriers to entry are few and not too cumbersome, the number of existing firms is a poor indicator of competition.

What causes barriers to entry?

Sometimes, natural factors such as geography may be at play. Other times, it has to do with the initial “upfront sunk” cost needed to start the business. However, more often than not, the barriers are institutional, erected by governments. For example, when governments adopt heavy regulations, the cost of entry is increased for new firms. For example, licencing requirements or approval requirements from boards of industry members (such as the case with hospitals in the United States, which are licensed by government in the while physicians and other practitioners are licensed by medical boards).

Sometimes, the barriers are more explicit as firms will be granted monopolies by force of law, or will be shielded from competition to some degree through legislative actions. As I recently noted in a study for the Fraser Institute, there are many barriers to entry in Canada that amount to roughly 35 per cent of the economy being shielded from competition to one degree or another.

However, it’s hard to measure the evolution of barriers to entry over time. It requires a certain level of data richness. Yet it’s incredibly important because barriers to entry—as they affect competition and innovation—strongly influence the overall pace of economic growth.

A recently published working paper from the National Bureau of Economic Research (authored by Germán Gutiérrez and Thomas Philippon) assembled data on entries and exits across American industries over the last four decades, allowing the researchers to measure “elasticity of entry,” which captures how responsive potential entrants are to opportunities in each industry. They confirm a generally well-admitted trend that entry rates have fallen over the last few decades.

What caused this downward trend? Gutiérrez and Philippon argue that lobbying efforts and new regulations (especially in the 1990s) erected barriers to entry. They found that a one per cent increase in regulatory burdens reduced the rate of entry by 0.015 percentage points. In concordance with this, they found that recent increases in regulatory burdens are associated with increased profit margins for incumbent firms. And that the ability of entrants to grow is also adversely affected. Thus, even if new firms manage to enter the market, they have a harder time growing.

The researchers also assembled evidence on lobbying expenditures by industry. The idea is that lobbying serves to acquire privileged treatments from politicians. In industries with high levels of lobbying expenditures, it also serves as an extra cost for new entrants (which deters entry). Again, the researchers found evidence that conforms with their hypothesis—the greater the level of lobbying expenditures, the lower the rate of entry into an industry.

As they assess these effects over time, Gutiérrez and Philippon provide a clear story of how barriers to entry have increased. As many economists today are worried about a slowdown in economic growth, it seems only logical to consider the role of barriers to entry in that slowdown.