Living Economics

The World Bank’s business survey found it took 50 days to establish a new business in the Philippines at a cost of 20% of the country’s average per capita gross national income. That compares with 8 days and 1.2% of per capita income in Singapore and 33 days and 6.7% in Thailand. (World Bank). The extra time and money cost resulted from excessive number of regulatory procedures that provide opportunities for underpaid government officials to secure kickbacks. Not surprisingly, 40% of the business in poor countries is underground without any official status.

In addition to regulatory procedures, there are other barriers to business entry relating to property rights. Some products are protected by exclusive patents and could be made only by the patent holders and their licensees. Imitators would be legally barred from entering this market. Another property issue relates to financing. Facing high transaction costs to get formal property title, many would-be entrepreneurs own informal assets that cannot be used as collateral to obtain loans. De Soto calls this “dead capital.” This lack of loan collateral adds to banks’ natural reluctance to lend to up-and-coming entrepreneurs.

Blocked by exclusive patents to enter at the high end and lack of credit financing at the middle, most business entries in poor countries are forced into the low end where capital requirement is low and the products generic. Even in rich countries where credit financing is available, most business entries are designed to share a safe but fixed market pie rather than to create a new market niche.

Business entry is, of course, induced by profit potentials. Profit is higher for innovative products due to strong pricing power. But innovative products are often protected by exclusive patents. Non-patent holders are not allowed to enter until the patents expired. Once the patents expire and the products become generic, entry restriction is gone, but so is the high profit. This process of eroding profit due to unrestricted entry happens even faster for new market niche that is unprotected by exclusive property rights. Even very low profit margin is not sufficient to discourage entry if capital and skill requirements are very low.

Uncoordinated entry tends to be excessive whenever it is unrestricted. Every new entry is prone to the self-delusion that it is better or luckier than existing business or competing entries. More importantly, there is a divergence between average returns and marginal returns. As long as the average returns cover cost, entry will continue even though marginal returns is negative. In other words, the tragedy of the commons is at work when entry continues even after total returns starting to fall.

Entry may also become excessive over time as the market matures over the life cycle of durable products. In a young market, most demand comes from first purchases. As the product matures, most of the demand is replacement purchases which are only a fraction of the first purchases. Capacity that matches the growing phases of the product cycle will become excessive during the replacement phase.