Barriers to Entry
August 2007 (Wikipedia)
In economics and especially in the theory of competition, barriers to entry are obstacles in the path of a firm which wants to enter a given market.
The term refers to hindrances that an individual may face while trying to gain entrance into a profession or trade. It also, more commonly, refers to hindrances that a firm may face (or even a country) while trying to enter an industry or trade grouping.
Barriers to entry for firms into a market
Barriers to entry into markets for firms include;
- Investment, especially in industries with economies of scale and/or natural monopolies.
- Government regulations may make entry more difficult or impossible. In the extreme case, a government may make competition illegal and establish a statutory monopoly. Requirements for licenses and permits, for example, may raise the investment needed to enter a market.
- Predatory pricing - the practice of a dominant firm selling at a loss to make competition more difficult for new firms who 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.
- Patents give a firm the sole legal right to produce a product for a given period of time. Patents are intended to encourage invention and technological progress by offering this financial incentive.
- Economy of scale - Large, experienced firms can generally produce goods at lower costs than small, inexperienced firms. 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.
- 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.
- 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.
- Research and development - some products, such as microprocessors, require a massive upfront investment in technology which will deter potential entrants.
- Sunk costs - sunk costs cannot be recovered if a firm decides to leave a market; they therefore increase the risk and deter entry.
- Network effect - when a good or service has a value that depends on the number of existing customers, then competing players may have difficulties to enter a market where a strong player has already captured a significant user base.
- Restrictive practices, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports. .
- Distributor agreements, exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry. .
- Supplier agreements, exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter the industry. .
- Inelastic demand, a strategy of selling at a lower price in order to penetrate markets is ineffective with price-insensitive consumers.
Classification and examples
Michael Porter classifies the markets into four general cases:
High barrier to entry and high exit barrier - Examples: Telecommunications, Energy
High barrier to entry and low exit barrier - Examples: Consulting, Education
Low Barrier to entry and high exit barrier - Examples: Hotels, Siderurgy
Low barrier to entry and low exit barrier - Examples: Retail, E-commerce
Those markets with high entry barriers have few players and thus high profit margins. Those markets with low entry barriers have lots of players and thus low profit margins. Those markets with high exit barriers are unstable and not self-regulated, so the profit margins fluctuate very much along time. Those markets with a low exit barrier are stable and self-regulated, so the profit margins do not fluctuate along time.
The higher the barriers to entry and exit the more prone a market tend to be a natural monopoly. The reverse is also true. The lower the barriers the more likely to become a perfect competition.