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millions of dollars of sunk investments in construction facilities, tools, and training. To a newcomer, these would represent incremental costs rather than sunk costs.

Asymmetries also arise from relationships with customers and suppliers that can take years to build. United Airlines spent many years establishing good relationships with its Mileage Plus travelers, employees, government agencies, and Star Alliance partners. These relationships are somewhat specific to Chicago, Denver, and United’s other hub cities. An upstart carrier could establish the same relationships, but this would take time, during which it could suffer significant losses. From United’s point of view, these costs are sunk. But a new carrier has yet to incur them, creating an asymmetry that deters entry. Of course, United can destroy these relationships, for example, by making dramatic changes to its Mileage Plus program, and if it does, it will lose any advantage it may have over upstart firms and might be better off selling its assets to another carrier, even a newcomer.

As we discuss entry barriers, bear in mind that entrants may enjoy many of the attributes that we normally associate with the incumbent firm. Diversifying entrants are particularly likely to have sunk investments in facilities, tools and training, and have established relationships in the vertical chain of production. If so, entrants can turn these attributes to their own advantage, turning entry-deterring strategies into “incumbent-removing” strategies.

Structural Entry Barriers

To assess entry conditions, the incumbent firm must understand the magnitude of structural entry barriers and consider the likely consequences of strategic entry barriers. We discuss structural entry barriers in this section and strategic entry barriers in the next section.

The three main types of structural entry barriers are:

•Control of essential resources

•Economies of scale and scope

•Marketing advantages of incumbency

Control of Essential Resources

An incumbent is protected from entry if it controls a resource or channel in the vertical chain and can use that resource more effectively than newcomers. One reason why Nintendo dominated the video gaming market in the early 1990s is that its Nintendo Entertainment System (NES) was a superior platform for gaming programmers, who naturally devoted most of their energies to developing games for the NES. This stranglehold was broken when Sony introduced the Playstation system, which proved to be an especially attractive platform for sports games.

Some firms attempt to purchase the resources and channels in the vertical chain, preventing potential entrants from acquiring raw materials and/or getting final goods to market. The International Tin Council, DeBeers diamonds, and Ocean Spray cranberries all maintained or continue to maintain monopolies by controlling the raw materials at their source. Firms that attempt to secure their incumbency by tying up the vertical chain face several risks. First, substitutes can emerge. For example, International Tin succumbed to technological advances in aluminum packaging. Second, new channels can open. For example, several diamond finds in northwest Canada loosened DeBeers’s grip on the worldwide diamond market. Third, the price to acquire other firms in the vertical

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chain can be excessive. DeBeers has tried to buy much of the Canadian diamonds, but the high price cut into the cartel’s profits. Finally, firms that attempt to tie up channels via acquisition may face antitrust challenges. In 2002, Northland Cranberries filed an antitrust lawsuit against Ocean Spray, alleging that Ocean Spray had used its dominant position to prevent rivals from having access to retailers. (This is an allegation of vertical foreclosure, which was discussed in Chapter 3.) The private litigation ended in 2004, when Ocean Spray acquired Northland Cranberries’ production facilities.

Incumbents can legally erect entry barriers by obtaining patents to novel and nonobvious products or production processes. An individual or firm that develops a marketable new product or process usually applies for a patent in its home country. In Europe, Japan, and India, the patent rights go to the first person to apply for the patent. In the United States the first person to invent the idea gets the patent (although this rule is currently up for debate). As might be expected, firms seeking U.S. patents often go to considerable expense to document precedence of discovery. Once the patent is approved (which usually takes one to two years, during which time the invention is protected from imitation), anyone who wishes to use the process or make the product must obtain permission from the patent holder, at a price determined by the patent holder. Patent lives are currently 20 years in most developed nations. Patent laws in some countries, such as China, are very weak.

Entrants can try to “invent around” existing patents. This strategy can succeed because a government patent office sometimes cannot fully distinguish between a new product and an imitation of a protected product and also because courts may be reluctant to limit competition. As a result, some innovations, such as rollerblades and the personal computer, seem to have had no patent protection whatsoever. Conversely, incumbents may file patent-infringement lawsuits against entrants whose products are seemingly different from the incumbent’s. Some observers claim that Intel used this strategy to protect its microprocessors from entry by Advanced Micro Devices. It took a pair of U.S. Supreme Court decisions in the late 1990s to loosen Intel’s grip on this market. Firms often stockpile patents so that they can countersue in patent infringement cases. Considering that mobile phone networks involve tens of thousands of patents, it is easy to believe that a lawsuit between Google and Apple could last longer than Jarndyce v. Jarndyce, the inheritance case in Dickens’s Bleak House that takes several decades to wind its way through Chancery court.

Incumbents may not require patents to protect specialized know-how. CocaCola has zealously guarded its cola syrup formula for more than a century, and no one has learned how to duplicate the sound of a Steinway piano or the beauty of Daum crystal. Rivals may turn to the legally and ethically questionable practice of industrial espionage to steal such information. In 2006, Korean manufacturer Kolon Industries hired a disgruntled former DuPont employee Michael Mitchell, who allegedly provided his new employer with confidential information about DuPont’s Kevlar products. When Mitchell started asking his former colleagues at DuPont for more information, his former employer got suspicious and notified the FBI. Mitchell was sentenced to 18 months in prison. DuPont subsequently sued Kolon for allegedly stealing trade secrets; the trial in U.S. district court began in the summer of 2011.

Economies of Scale and Scope

When economies of scale are significant, established firms operating at or beyond the minimum efficient scale (MES) will have a substantial cost advantage over smaller entrants. The average cost curve in Figure 6.1 illustrates the problem facing a potential

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entrant in an industry where the MES is 1,000 units and total industry sales are 10,000 units. An incumbent with a market share of 10 percent or higher reaches the MES and has an average cost of ACMES. If the entrant only achieves a market share of, say, 2 percent, it will have a much higher average cost of ACE. The market price would have to be at least as high as ACE for entry to be profitable.

This analysis presumes that there is some asymmetry giving the incumbent the advantage in market share. We can easily imagine this advantage to be the incumbent’s brand reputation, built up through years of operation. The entrant might try to overcome the incumbent’s cost advantage by spending to boost its market share. For example, it could advertise heavily or recruit a large sales force. Although this strategy may allow the entrant to achieve a market share greater than 2 percent and average production costs below ACE in Figure 6.1, it involves two important costs. The first is the direct cost of advertising and creating the sales force, costs that the incumbent may have already incurred. Second, the entrant must also be concerned that if it ramps up production, the incumbent may not cut back its own output, as many of the incumbent’s costs associated with procuring inputs and paying for labor are sunk. Recall from Chapter 5 that when overall industry output increases, prices and individual firm profits fall. The entrant thus faces a dilemma: to overcome its cost disadvantage, it must increase its market share. But if its share increases, prices will fall.

Fierce price competition frequently results from large-scale entry into capitalintensive industries where capital costs are largely sunk. The U.S. gunpowder industry in the nineteenth century offers an interesting example. In 1889, eight firms, including the industry leader DuPont, formed a “gunpowder pool” to fix price and output. In the early 1890s, three new firms entered the industry. Their growth challenged the continued success of the pool. DuPont’s response to one entrant was to “put the Chattanooga Powder Company out of business by selling at lower prices.”8 In this way, the gunpowder pool survived until antitrust enforcers broke it up. In an infamous recent example, rapid entry by fiber-optic telecom providers intensified price competition, saddling market leader WorldCom with over $20 billion in debt and driving it into bankruptcy.

Incumbents may also derive a cost advantage from economies of scope. The U.S. ready-to-eat breakfast cereal industry provides a good example.9 For several decades, the industry has been dominated by a few firms, including Kellogg, General Mills, General Foods, and Quaker Oats. Although dozens of new cereals have been launched over the years, nearly all are products of the big incumbents, who increased the number of cereals offered for sale from 88 in 1980 to over 200 in 2005. New entrants have had a difficult time gaining even a toehold in the market.

Diversified incumbents may also enjoy scope economies. For example, there are significant economies of scope in producing cereal, stemming from the flexibility in materials handling and scheduling that arises from having multiple production lines within the same plant. These economies make it relatively inexpensive for an incumbent to devote part of an existing production line to a new formulation. A newcomer might have to build an entire new production line, putting much more capital at risk.

Incumbents have established brand names that give them marketing economies (such as Kellogg’s Bite-Size Mini-Wheats, a spinoff of Original Frosted MiniWheats). Entrants would have to build brand awareness from scratch, and it has been estimated that for entry to be worthwhile, a newcomer would need to introduce 6 to 12 successful brands.10 Even when incumbents enjoy advantages, the principle that profits attract entrants remains in effect. By the mid-1990s, gross