Barriers to Entry

You may want to launch a new product, start a new business or enter a new market. What’s stopping you?

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BARRIERS to entry are costs that must be paid by a new entrant but not by firms already in the industry.  Barriers to entry have the effect of making a market less contestable and allow existing firms to maintain higher prices than would otherwise be possible.

Here are seven (7) examples of barriers to entry:

1. Economies of Scale

The existence of economies of scale in an industry creates barriers to entry. Since existing firms are already producing they are often better position to exploit economies of scale than a new entrant and, as such, can often undercut on price. A new entrant is forced either to accept the cost disadvantage or enter the industry on a large scale (which increases the likely financial loss if they are later forced to exit the industry).

2. Product Differentiation

If there is a high level of product differentiation in the industry then this creates a barrier to entry since new entrants will not be able to compete merely on price, but will need to provide a unique value proposition.

Brand recognition: If existing firms and products have strong brand recognition that will deter new entrants. If customers perceive existing products as unique or high quality then a new entrant will need to spend money to educate customers about the unique qualities and benefits of its new products.  This will increase the cost of gaining market share and deter entry into the market.

Customer service: If existing firms have strong customer relationships formed through strong customer service and customer loyalty programs then it may be difficult for new entrants to gain market share.

Network Effects: The term “network effect” refers to the situation where a product or service becomes more valuable as more people use it. One example is eBay; as more buyers use the online auction site it becomes more valuable to each seller, and as more sellers use the site it becomes more valuable to each buyer.

If existing products or services in the industry benefit from network effects then it may be difficult for new firms to enter the industry.

Product differences: Existing products in the industry may be different due to differing design, quality, benefits, and other features.

3. Capital Requirements

High start-up costs: High fixed start-up costs will deter new firms from entering an industry. Examples of capital intensive industries with high fixed costs include the automotive and telecommunications industries.

High sunk costs: If a large portion of the start-up costs cannot be recovered (i.e. they are sunk costs) then the new entrant risks having to absorb the loss if it decides to exit the industry. Examples of sunk costs include:

  • Specialised assets: Highly specialised technology or equipment that cannot be used for other purposes and which cannot be sold (or can only be sold at a massive discount).
  • Industry specific expenditure: Industry specific expenditure, such as marketing or R&D, which cannot be used to benefit the firm’s operations in other industries.

4. Intangible Assets

Proprietary product technology: The existence of proprietary product technology represent a barrier to entry. If an existing product is protected by patent then it will not be possible for a new entrant to use the patented technology without permission from the patent owner.

Specialised knowledge: Incumbents may possess specialised knowledge, skills or qualifications which are difficult and costly to acquire: e.g. legal or medical skills.

5. Access to Suppliers and Buyers

Access to raw materials: If a new entrant cannot gain access to raw materials then this represents a barrier to entry. If existing firms have exclusive long term contracts with suppliers (or existing firms own key suppliers) this will make it difficult for a new entrant to obtain the raw materials it needs to operate effectively in the industry.

Access to distribution channels: If a new entrant cannot gain access to distribution channels then this represents a barrier to entry. If there are a limited number of wholesale or retail distribution channels, or existing firms have exclusive long term contracts with distributors then this will make it difficult for a new entrant to reach the customer. For example, McDonalds has stores in the best locations which makes it more difficult for new entrants to compete.

6. Government Regulation

The government may limit or restrict entry into a market by imposing licencing requirements or controlled access to raw materials.

Market participants may require a licence or other government approval in order to carry on its business; examples include taxi licenses, safety standard compliance certificates, mining permits, or investment approvals.

In extreme cases, the government may make competition illegal by establishing a statutory monopoly. For example, AT&T had a statutory monopoly in the telecommunications industry in the United States until the early 1980s.

Note that government regulations that limit or restrict the activity of all industry participants would not be considered as barriers to entry. For example, tariffs or quotas that apply equally to incumbents and new entrants would not be a barrier to entry.

7. Competitive Response

A potential entrant’s expectations about how existing firms will respond to market entry by a new player will affect their entry decision. If a potential entrant reasonably expects, or irrationally fears, that existing firms will competing aggressively then this may deter entry.

Expectations of a strong competitive response from incumbents will be higher where:

  1. Industry growth is slow, which means the industry will not be able to absorb a new entrant without incumbent firm profitability being hurt.
  2. Incumbents have a lot of fighting potential including large cash balance, strong cash flow, unused credit facilities, or clout with government, distribution channels and customers.
  3. Incumbents are likely to cut prices due to industry wide excess capacity or a desire to retain market share.

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