How does high exit barriers lead to industry over-capacity?
High exit barriers are aspects that make it difficult or costly for a firm to leave the industry. If there are large costs that must be incurred for decommissioning a facility, or it is difficult to re-enter an industry (i.e., a high opportunity cost associated with shutting a facility down permanently), then firms may opt to remain in an industry, even if market conditions mean that no firms are making money.
When exit barriers are low (i.e., little costs associated with leaving) then a downturn will naturally flush out companies. However, when exit barriers are high, firms opt to remain in the industry despite not making money. This leads to over-capacity, which can further impact the profitability of the industry.
The dangers of over-capacity from high-exit barriers to industry profitability
High-exit barriers mean that if there is a downturn, not only may the downturn impact profits, but the resulting industry-over capacity may further lead to reduced prices and profitability. This situation is common in industries with very high capital investments – such as steel production. The exit barriers of closing a steel mill are high – big decommissioning costs and or high challenge to restart a facility once it has been shut. As such, when there is a downturn, the industry quickly moves to being in over-capacity, with the high exit barriers resulting in firms remaining in the industry, even if they are not making any profit.