This is “High Cost to Initial Entrant and the Risk of Free Rider Producers”, section 8.9 from the book Managerial Economics Principles (v. 1.0).
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Next, we will consider the third generic type of market failure, or the inability for a market to form or sustain operation due to free riders, by looking at two causes of this kind of failure in this section and the next section. Although the sources are different, both involve a situation where some party benefits from the market exchange without incurring the same cost as other sellers or buyers.
New products and services are expensive for the first firm to bring them to market. There may be initial failures in the development of a commercial product that add to the cost. The firm will start very high on the learning curve because there is no other firm to copy or hire away its talent. The nature of buyer demand for the product is uncertain, and the seller is likely to overcharge, undercharge, or alternatively set initial production targets that are too high or too low.
If the firm succeeds, it may initially have a monopoly, but unless there are barriers of entry, new entrant firms will be attracted by the potential profits. These firms will be able to enter the market with less uncertainty about how to make the product commercially viable and the nature of demand for the product. And these firms may be able to determine how the initial entrant solved the problems of designing the product or service and copy the process at far less initial cost than was borne by the initial entrant.
If the product sold by the initial firm and firms that enter the market later look equivalent to the buyer, the buyer will not pay one of these firms more than another just based on its higher cost. If the market becomes competitive for sellers, the price is likely to be driven by the marginal cost. New entrant firms may do well, but the initial entrant firm is not likely to get a sufficient return on the productive assets it had invested from startup. In effect, the other firms would be free ridersA firm that benefits from the startup costs of an initial entrant in a market without having to contribute to those costs; a person who prefers to let someone else pay for a public good. that benefit from the startup costs of the initial entrant without having to contribute to that cost.
The market failure occurs here because, prior to even commencing with a startup, the would-be initial entrant may look ahead, see the potential for free riders and the inability to generate sufficient profits to justify the startup costs, and decide to scrap the idea. This market failure is a market inefficiency because it is hypothetically possible for the initial entrant, subsequent entrants, and buyers to sit at a negotiation and reach an arrangement where startup costs are shared by the firms or buyer prices are set higher to cover the startup costs, so that all firms and buyers decide they would be better off with that negotiated arrangement than if the market never materialized. Unfortunately, such negotiations are unlikely to emerge from the unregulated activities of individual sellers and buyers.
One of the main regulatory measures to address this problem is to guarantee the initial entrant a high enough price and sufficient volume of sales to justify the up-front investment. PatentsA means by which the developer of a product or service that incorporates a new idea or process is given a monopoly for a certain period of time. are a means by which a product or service that incorporates a new idea or process gives the developer a monopoly, at least for production that uses that process or idea, for a certain period of time. Patents are an important element in the pharmaceutical industry in motivating the development of new drugs because there is a long period of development and testing and a high rate of failure. Companies selling patent-protected drugs will sell those products at monopoly prices. However, the process for manufacturing the drug is usually readily reproducible by other companies, even small “generic” manufacturers, so the price of the drug will drop precipitously when patent protection expires. In fact, patent-holding firms will usually drop the price shortly prior to patent expiration in an attempt to extract sales from the lower portion of the demand curve before other firms can enter.
In cases where there is not a patentable process, but nonetheless a high risk of market failure due to frightening away the initial entrant, government authorities may decide to give exclusive operating rights for at least a period of time. This tool was used to encourage the expansion of cable television to the initial entrant in a region to justify the high up-front expenses.
Other government interventions can be the provision of subsidies to the initial entrant to get them to market a new product. The government may decide to fund the up-front research and development and then make the acquired knowledge available to any firm that enters the market so there is not such a difference between being the initial entrant or a subsequent entrant. Another option is for the government itself to serve in the role of the initial entrant and then, when the commercial viability is demonstrated, privatize the product or service.