What’s it: Barrier to entry is an obstacle that prevents or minimizes the opportunities for a new company to enter a market. A barrier arises because it is deliberately created by existing companies (incumbents) through predatory pricing and distribution networks control. Or, it arises because of structural factors or the nature of markets such as economies of scale and high initial costs.
Newcomers threaten the position and profits of the incumbent. They bring new capacities to the market, intensify competition, and reduce profitability. They also seek to build a customer base and grab customers from incumbents.
Therefore, in some markets, the entry of newcomers leads to retaliation from the incumbent. The incumbents build barriers to prevent new players from entering the market. It may be successful and discourage new players from entering. However, in other cases, retaliation is ineffective at preventing new entrants from entering the market.
Long story short, potential new players consider the long-term profits when deciding to enter the market. Despite facing strong retaliation from the incumbent, they are likely to step in if the long-term profits outweigh the hurdle’s costs.
The relationship between market structure and barriers to entry
Barriers to entry vary between market structures. Under perfect competition, each company has no market power. They cannot prevent new entrants from entering the market. When several companies gain economic gain in the short term, it is a signal for potential new players to enter.
Their entry into the market pushes prices down. A fall in prices causes economic profit to be zero (normal profit). Thus, low entry barriers prevent firms in perfectly competitive markets from gaining economic profit in the long run.
Furthermore, the barriers to entry are slightly higher than in monopolistic competition. Incumbents try to differentiate their offerings from those of competitors. They have some market power. However, because the market consists of many players, and none of them dominate, both retaliation and entry barriers are relatively low.
Barriers to entry are high in oligopoly and monopoly markets. In both markets, the incumbent dominates the market and even becomes the sole supplier for monopoly cases. They will strive to maintain dominance and prevent new players from entering by building a barrier and signifies a strong retaliation.
Types of entry barriers
In general, experts classify the barriers to entry into two:
- Structural entry barriers
- Strategic entry barriers
Structural barriers to entry arise from the market’s nature, such as technology, costs, and demand. The incumbent does not deliberately create it to discourage other competitors from entering. Some examples of structural entry barriers are network effects, capital requirements, enormous sunk costs, resource control, and economies of scale.
Another factor is product differentiation. It creates an advantage for the incumbents because entrants have to overcome brand loyalty. They must develop products that are attractive to customers so that they are willing to move away from the incumbent product. In this case, the incumbent did not create it to discourage new competitors from entering. Instead, it created a competitive advantage and differentiated the offer from existing competitors.
Likewise, incumbents often have absolute cost advantages and achieve a low-cost structure. They reach it through various sources, including the benefits of experience effects and economies of scale. With their low-cost structure, they can offer a relatively inexpensive product.
In contrast, potential newcomers come with higher unit costs because there is no effect of experience or economies of scale. That puts them in a less competitive position.
Furthermore, strategic entry barriers arise from the behavior of the incumbent. In particular, they seek deliberately to create entry barriers and increase structural barriers in the market. They also give off strong retaliatory signals if a potential player steps in.
To be effective at deterring entry, the incumbent’s efforts must be credible and credible. Say, the incumbent sets a predatory price. The predator drops prices below average cost and operates at a loss. It is credible if the predator can sustain it for a sufficiently long period.
Categorizing to both may be quite ambiguous. Some structural barriers may fall into strategic barriers if the incumbent tries to or amplify them deliberately. For example, a sunk cost is an example of the structural barrier. However, incumbents can scale up through vertical integration, forcing new potential players to take similar steps.
Likewise, regulation can also be a structural barrier. For example, the government limits the percentage of foreign ownership in specific industries. To maintain dominance, the incumbents or associations lobby the government to increase its percentage or add new regulations to prevent foreign players from entering.
Subsidy
Subsidies reduce the company’s operational costs. They can sell at a lower price.
Meanwhile, prospective newcomers, because they do not receive subsidies, must operate at a higher cost. That puts them in a position of disadvantage.
Trade barriers
Trade barriers reduce competitive pressure from imported products. They make foreign firms less competitive when selling in the domestic market.
Two common examples of trade barriers are import tariffs and quotas. Under the tariff, the government increases the tax on the price of imported products. Therefore, when they enter the domestic market, their prices are too high. That keeps domestic customers from buying them and turning to domestic suppliers.
Meanwhile, quotas work through the volume of imports. When implementing quotas, the government limits the quantity of imported products that enter the domestic market. Fewer incoming products mean less competition from foreign producers.
Network effect
Network effects work through the number of people using them. The more people who use it, the more valuable a product is. In the end, it will stimulate even more demand because customers are more likely to be willing to recommend it.
By doing so, the incumbent would immediately attain a dominant position in the market. Strong demand enables them to build superior resources and capabilities. The dominance of Google Search and Facebook is mainly due to the network effect. New players find it challenging to shift their position and are forced to operate in slightly different segments.
Economies of scale
Incumbents have a low-cost structure compared to new players, allowing them to sell at a lower price. We call it the absolute cost advantage.
Incumbents operate on a larger scale, enabling them to achieve economies of scale. The cost per unit falls as the production volume increases.
The reduction in costs came from a variety of sources. They get a price discount for buying inputs in large quantities. They can also spread fixed costs over many outputs, lowering the fixed costs per unit.
In contrast, new players don’t have that kind of advantage. They operate at higher cost levels because they have not yet reached economies of scale.
Licensing
As barriers to entry, licensing policies can take various forms. The government may restrict investment in specific sectors or even not allow it. This usually applies to strategic sectors such as the electricity, banking, water, and weapons industries.
The government may also limit the percentage of ownership. The percentage of ownership usually hurts new players because they have no control over the company. For example, in Indonesia, the government limits foreign ownership in banks to around 40% with an additional condition. They buy two local banks and merge them.
Other obstacles arise from the area of operation (zoning restrictions). The government usually only allows new players to operate in certain designated areas. Such requirements may be less favorable and make their operations less feasible.
Intellectual property
Patents, like technology, give incumbents the legal right to use them for a specified period. As long as it is valid, prospective new players cannot duplicate or take advantage of such technology. It is a barrier to entry because it forces potential new players to develop other technologies that are just as efficient if they are to enter the market.
Apart from the technology sector, patents are also an entry barrier in several industries, such as pharmaceuticals.
Special tax relief
Unfair taxes are also often a barrier to competition. The government may impose high taxes on newcomers and tax breaks for incumbents. The incumbent might lobby the government to adopt such a policy.
Aggressive pricing
To discourage potential new players, the incumbent sets a low selling price. So, at this price, the potential entrants do not make a profit.
In fact, the incumbent may even adopt a more aggressive strategy, namely predatory pricing. It takes losses and lower prices below average variable cost. The aim is not only to establish barriers to entry but also to remove competitors from the market.
Long story short, predatory pricing reduces competition. When successful, predators enjoy monopoly power and raise prices to compensate for losses during this strategy.
Heavy ads
Incumbents create entry barriers by spending large sums of money on advertising. They strengthen their position by reaffirming their image and enforcing confidence in the product.
It creates a superior perception of their product, making it difficult for newcomers to gain consumer acceptance. New players must have a similar budget to compete effectively.
First-mover advantages
First-to-market firms have an edge in technology leadership and upfront resource purchases. That gives them high-profit margins and some monopoly power.
Also, they benefit from a stronger brand image as they have built it over a long period. That increases the switching costs. Customers may rationally trust the first brand more than the new brand because it is familiar and satisfactory. Such an advantage is difficult for potential new players to imitate.
Also, first movers have several advantages that newcomers lack, including economies of scale, experience effects, access to scarce inputs, and a more extensive distribution network.
Capital requirement
Industries, such as oil and gas, have the characteristics of expensive initial investments. To overcome this, prospective entrants must incur high costs. They have to build production facilities, develop distribution networks, and buy machines.
Some such investments are sunk costs. Thus, when such initial investments are not recovered and once failed, they incur huge losses. Because they pose a significant risk, they take this into account when trying to enter the market.
Vertical integration
Vertical integration means gaining control over the various stages of the current production chain, both upstream and downstream. Incumbents carry out this strategy by acquiring existing companies or establishing new companies. Say, they chose to acquire their distributors and suppliers.
The acquisition secures the input or distribution channel. It allows for a lower cost structure and captures value at this stage of the production chain.
Conversely, for potential new players, vertical integration makes it difficult for them to enter. They have to find cheap suppliers or build a wide distribution network to compete effectively.
Favorable location
A common example is a retail store. The incumbent may have an advantageous location, for example, in the city center, to close to the customer. They may get it at a lower price.
On the other hand, prospective new players find it challenging to find a similar location because the available land is limited. It forces them to pay a significant price to buy it.
Limited access to input
For example, an existing company binds raw material suppliers through long-term contracts. That leaves little opportunity for potential entrants to find qualified and inexpensive suppliers.
Research and development
Research and development is a substantial barrier to an industry like technology. Incumbents have invested a long time and money to produce a superior product. They patented it so that there was little opportunity for potential newcomers to copy it.
Also, the incumbent product may have become a standard in some user industries. So, when a potential entrant launches a product, market acceptance is likely to be low, increasing the risk of failure.
Customer loyalty
Customer loyalty increases switching costs. When customer loyalty is high, potential entrants have to spend a lot of money and effort to get them to try their product.
Brand image is significant in influencing customer loyalty. The strong brand image of the incumbent’s products reflects trust and quality assurance. For example, Coca-Cola and McDonald’s have offered quality products at fair prices and signal that they are the best. Customers are satisfied with both products and are reluctant to switch to products that don’t have a track record.
Trying something new runs the risk of dissatisfaction. That is the reason why the acceptance of new products is usually low.
Distribution network control
Apart from vertical integration, incumbents can also secure marketing channels through long-term contracts with their distributors. That reduces potential entrants’ access to distribution channels and markets. They may have to develop a distribution network internally, which is often expensive.
Standardization regulations
Regulations such as safety requirements, product testing, accreditation, and factory safety represent additional costs. This is a barrier to entry for potential entrants. They need time, money, and effort to comply with such rules.
Impacts of barriers to entry
The entry barrier affects the number of players and competition in the market. If the barriers to entry are higher, the competitive pressure is lower. That allows the incumbents to maintain their current profitability.
Conversely, if the entry barrier is low, the number of players increases. New players add new capacity to the market, increase supply, and push prices down. That reduces the current profitability. They force the incumbents to share the market with them.
Furthermore, entry barriers are essential to explain market inefficiencies in some industries. Consumers pay a higher price than when the competition is present in the market. A high entry barrier allows the incumbent to have market power and sell at a price above the equilibrium price. Such power will decrease if entry barriers are low as new players increase supply and push prices down.
Entry barriers and exit barriers
The rivalry intensity depends not only on barriers to entry but also on barriers to exit. Furthermore, both of them also affect the level of profitability of a market.
By drawing these two variables, we can produce the following four possibilities:
- Low entry barrier and high exit barrier
- High entry barrier and high exit barrier
- Low entry barrier and low exit barrier
- High entry barrier and low exit barrier
Low entry barrier and high exit barrier
High profits signal several players to enter the market. It intensifies competition and depresses profitability. Because they find it difficult to leave the market, competition continues. It keeps market profitability low. An example is the hotel industry.
High entry barrier and high exit barrier
Incumbents have a greater opportunity to exploit the market and maintain current levels of profitability. Competition may be intense, and players wrest market share from competitors, significantly when demand is growing more slowly or falling.
However, they may also choose to adopt tacit collusion, which brings stability to competition and profitability. Two examples of industries that have these characteristics are energy and telecommunications.
Low entry barrier and low exit barrier
The competitive landscape is regularly changing, as it is easy for players to enter and exit the market. An example is in the retail industry.
Say, in the short term, some players make high profits due to strong demand. That prompts several companies to enter the market. They intensify competition and push profitability down.
When the incumbents are unable to compete, they exit the market easily. The exit of several players loosens up the competition. Profitability should improve, assuming demand doesn’t change.
High entry barrier and low exit barrier
The level of competition is relatively low. Meanwhile, profitability should be high. New companies are less likely to enter the industry during good profitability in the short term as the entry barriers are high. On the other hand, during low profitability, some incumbents quickly leave the industry.
In such an environment, the dominant firm may try to take out competitors by placing them in a non-competitive position. By doing so, the dominant firm increases market power and profitability. Due to high entry barriers, the company can maintain its profitability and dominance over a more extended period.
