Barriers to Entry

What Are Barriers to Entry?

Barriers to entry is an economics and business term describing factors that can prevent or impede newcomers into a market or industry sector, and so limit competition. These can include high start-up costs, regulatory hurdles, or other obstacles that prevent new competitors from easily entering a business sector. Barriers to entry benefit existing firms because they protect their market share and ability to generate revenues and profits.

Barriers to entry are factors that can delay or prevent the new competitors from entering an existing market or producing a product. Barriers are typical in monopolistic markets making it difficult for competitors to enter or compete in the space.

Common barriers to entry include special tax benefits to existing firms, patent protections, strong brand identity, customer loyalty, and high customer switching costs. Other barriers include the need for new companies to obtain licenses or regulatory clearance before operation.

What Does Barriers to Entry Mean?

Structural barriers to entry are more related to the market settings such as demand and supply that may create economies of scale, network effects or brand loyalty. Structural barriers are easy to quantify because the cost of increased output that lowers a firm’s average cost (economies of scale) can be quantified.

On the other hand, strategic barriers are related to the behavior of the firms in the market that create these barriers to deter new competitors from entering the market. Some examples include mergers and acquisitions or limit pricing. Strategic barriers cannot be quantified because it is not clear in advance if a firm’s strategic behavior aims to deter entry or to sustain market share. Of course, in most cases, vertical integrationor limit pricing may lead to monopolistic structures.

How Barriers to Entry Work

Some barriers to entry exist because of government intervention, while others occur naturally within a free market. Often, companies lobby the government to erect new barriers to entry. Ostensibly, this is done to protect the integrity of the industry and prevent new entrants from introducing inferior products into the market.

Generally, firms favor barriers to entry in order to limit competition and claim a larger market share when they are already comfortably ensconced in an industry. Other barriers to entry occur naturally, often evolving over time as certain industry players establish dominance. Barriers to entry are often classified as primary or ancillary.

A primary barrier to entry presents as a barrier alone (e.g., steep startup costs). An ancillary barrier is not a barrier in and of itself. Rather, combined with other barriers, it weakens the potential firm’s ability to enter the industry. In other words, it reinforces other barriers.

The Importance of Barriers to Entry

A barrier to entry prevents and restricts competition, so it is in the interest of existing firms to create or perpetuate new and existing barriers. Businesses often do this through lobbying governments to add new regulations, grant patents, or provided favourable treatment.

It is important to understand that some barriers to entry exist naturally and therefore little can be done about them. Brand loyalty, for instance, presents a barrier to entry. If we take Amazon for example – there are few online distributors that would be able to compete. This is because customers have become accustomed to trusting the brand. Trust that would not be so forthcoming to competitors.

We can look at barriers to entry in two ways. First of all, we have ‘un-natural barriers to entry’ – so those that are man-made via government. Then second, we have ‘natural barriers to entry’. For example, brand loyalty, geographical barriers, and economies of scale.

Un-natural barriers such as patents, regulations, and trade, are all government made. Yet they prevent competition. Each has a reason for existing, but it is whether these are worth restricting competition and increasing prices.

Examples

The following examples fit all the common definitions of primary economic barriers to entry.

  • Distributor agreements – Exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry.
  • Intellectual property – Potential entrant requires access to equally efficient production technology as the combatant monopolist in order to freely enter a market. Patents give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and servicemarks may represent a kind of entry barrier for a particular product or service if the market is dominated by one or a few well-known names.
  • Restrictive practices, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports.
  • Supplier agreements – Exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter an industry.
  • Switching barriers – At times, it may be difficult or expensive for customers to switch providers
  • Tariffs – Taxes on imports prevent foreign firms from entering into domestic markets.
  • Taxes – Smaller companies typical fund expansions out of retained profits so high tax rates hinder their growth and ability to compete with existing firms. Larger firms may be better able to avoid high taxes through either loopholes written into law favoring large companies or by using their larger tax accounting staffs to better avoid high taxes.
  • Zoning – Government allows certain economic activity in specified land areas but excludes others, allowing monopoly over the land needed.

Contentious examples

The following examples are sometimes cited as barriers to entry, but don’t fit all the commonly cited definitions of a barrier to entry. Many of these fit the definition of antitrust barriers to entry or ancillary economic barriers to entry.

  • Economies of scale – Cost advantages raise the stakes in a market, which can deter and delay entrants into the market. This makes scale economies an antitrust barrier to entry, but they can also be ancillary. Cost advantages can sometimes be quickly reversed by advances in technology. For example, the development of personal computers has allowed small companies to make use of database and communications technology which was once extremely expensive and only available to large corporations.
  • Network effect – When a good or service has a value that increases on average for every additional customer, this exerts a similar antitrust and ancillary barrier to that of economies of scale.
  • Government regulations – A rule of order having the force of law, prescribed by a superior or competent authority, relating to the actions of those under the authority’s control. Requirements for licenses and permits may raise the investment needed to enter a market, creating an antitrust barrier to entry.
  • Advertising – Incumbent firms can seek to make it difficult for new competitors by spending heavily on advertising that new firms would find more difficult to afford or unable to staff and or undertake. This is known as the market power theory of advertising. Here, established firms’ use of advertising creates a consumer perceived difference in its brand from other brands to a degree that consumers see its brand as a slightly different product. Since the brand is seen as a slightly different product, products from existing or potential competitors cannot be perfectly substituted in place of the established firm’s brand. This makes it hard for new competitors to gain consumer acceptance.
  • Capital – Any investment into equipment, building, and raw materials are ancillary barriers, especially including sunk costs.
  • Uncertainty – When a market actor has various options with overlapping possible profits, choosing any one of them has an opportunity cost. This cost might be reduced by waiting until conditions are clearer, which can result in an ancillary antitrust barrier.
  • Cost advantages independent of scale – Proprietary technology, know-how, favorable access to raw materials, favorable geographic locations, learning curve cost advantages.
  • Vertical integration – A firm’s coverage of more than one level of production, while pursuing practices which favor its own operations at each level, is often cited as an entry barrier as it requires competitors producing it at different steps to enter the market at once.
  • Research and development – Some products, such as microprocessors, require a large upfront investment in technology which will deter potential entrants.
  • Customer loyalty – Large incumbent firms may have existing customers loyal to established products. The presence of established strong brands within a market can be a barrier to entry in this case.
  • Control of resources – If a single firm has control of a resource essential for a certain industry, then other firms are unable to compete in the industry.
    Inelastic demand – One strategy to penetrate a market is to sell at a lower price than the incumbents. This is ineffective with price-insensitive consumers.
  • Predatory pricing – The practice of a dominant firm selling at a loss to make competition more difficult for new firms that cannot suffer such losses, as a large dominant firm with large lines of credit or cash reserves can. It is illegal in most places; however, it is difficult to prove. See antitrust. In the context of international trade, such practices are often called dumping.
  • Occupational licensing – Examples include educational, licensing, and quota limits on the number of people who can enter a certain profession.

Classification and examples

Michael Porter classifies the markets into four general cases:

  • High barrier to entry and high exit barrier (for example, telecommunications, energy)
  • High barrier to entry and low exit barrier (for example, consulting, education)
  • Low barrier to entry and high exit barrier (for example, hotels, ironworks)
  • Low barrier to entry and low exit barrier (for example, retail, electronic commerce)

These markets combine the attributes:

  • Markets with high entry barriers have few players and thus high profit margins.
  • Markets with low entry barriers have many players and thus low profit margins.
  • Markets with high exit barriers are unstable and not self-regulated, so the profit margins fluctuate very much over time.
  • Markets with a low exit barrier are stable and self-regulated, so the profit margins do not fluctuate much over time.

The higher the barriers to entry and exit, the more prone a market tends to be a natural monopoly. The reverse is also true. The lower the barriers, the more likely the market will become perfect competition.

Market structure

  • Perfect competition: Zero barriers to entry.
  • Monopolistic competition: Medium barriers to entry.
  • Oligopoly: High barriers to entry.
  • Monopoly: Very high to absolute barriers to entry.