Buyers and Entry Barriers

David T. Scheffman and Pablo T. Spiller
Working Paper:

This paper develops an analysis of markets in which sellers have significant sunk investments; it takes considerable time to enter; and buyers can make credible commitments to obtain alternative sources of supply. We show that in markets with these characteristics the market power of sellers is more attenuated than models with unsophisticated buyers would predict. In particular, current prices are critical to the decision whether or not to "enter," so that limit pricing is a likely form of equilibrium pricing, even in the presence of full information. The limit price is predicted to increase with the amount of time it takes to enter, the number of buyers, and with the level of buyers' switching costs, but to fall with the level of sunk investments. Thus, in such markets, sunk costs restrain. rather than increase, the ability of sellers to exert market power, and hence do not constitute entry barriers. Entry lags and switching costs. however, do enhance the ability of sellers to exert market power. This paper, then, questions the standard prediction of an inverse relationship between market performance and sunk investments.