What’s it: Strategic entry barrier is actions taken by existing companies (incumbents) to deter new players from entering their market. It can take various forms, such as limit pricing, product differentiation, and loyalty schemes.
Another term for strategic entry barriers is artificial barriers to entry or strategic entry deterrence.
The difference between strategic entry barriers and structural entry barriers
Structural entry barriers relate to the nature of the market, such as demand behavior and cost structure. Examples of structural entry barriers are network effects and economies of scale. Neither did the incumbent deliberately take tactical action.
Conversely, old players deliberately build defenses or barriers to prevent new players from entering under strategic entry barriers. Sometimes such efforts come under government scrutiny because they fall into the anti-competitive category.
Types of strategic entry barriers
The effectiveness of obstacles depends not only on the type of action taken by incumbents but also on time. New players will usually think twice if they need more time to compete effectively. They have to catch up with the incumbent and, at the same time, incur costs and lose profits during the process. Thus, the longer it takes to reach a profit and break-even, the less likely new players will enter the market.
The following are types of strategic entry barriers:
- Limit pricing
- Predatory pricing
- Contracts, patents, and licenses
- Loyalty schemes
- Switching cost
Under this approach, existing companies charge low prices. Also, they produce at a high rate, which reduces the chance for new players to get higher sales.
As a result, potential newcomers cannot make a profit at that price. They cannot benefit from economies of scale or experience effects due to low sales, making it difficult to lower prices. Existing firms cater to more market demands, leaving potential newcomers with much less room for growth in the market.
This approach requires commitment. For example, incumbents build more giant factories to generate excess capacity. Such efforts can be a credible deterrent.
Furthermore, even though they set a low price, incumbents still benefit from the lower cost structure. This strategy is optimal if the profit rate is still higher than when new players enter the market.
Predatory pricing is similar to limit pricing. Under this approach, incumbents set the selling price very low, below average variable cost. As a result, they suffer losses while adopting this strategy.
The main objective of predatory pricing is to reduce competition in the market. Predators deliberately lower prices to drive current competitors out of the market. On the other hand, the strategy also creates barriers for new players to enter.
When the intensity of competition decreases, the predator gains monopoly power, enabling it to gain profits in the long run and compensate for the losses in implementing this strategy.
Acquisitions are also another way of creating and increasing the credibility of barriers to entry. The incumbent takes over a potential rival by buying enough shares to gain a controlling interest. Or, they acquire another company in one production chain.
Say, the incumbent acquires a distributor company. If the distributor controls most of the marketing network, then the acquisition increases entry costs. New players must develop their own networks to compete effectively. And, that, of course, requires a large investment.
Incumbents are lowering prices as a signal that they are operating very efficiently. They should have a low-cost structure of being first-mover advantages and reach benefits from economies of scale and the experience curve.
Such signals must be trustworthy to be effective. For example, incumbents could charge low prices for an extended period. Thanks to the support of a lower cost structure, they can still achieve (albeit low) profits, which the newcomers cannot achieve.
Advertising and branding
Advertising spending contributes to building a strong brand image in the target market. The higher the amount an incumbent spends, the less likely it is for newcomers to enter.
Strong brand values create customer loyalty. Customers tend to be reluctant to switch to a newcomer product because they have no experience with the product.
To sell their product effectively, newcomers must match these costs to build awareness of their product. They must spend more time and money differentiating their product in the market and overcoming this loyalty.
Contracts, patents, and licenses
It is difficult for potential players to enter the market if the existing company has a license or patent. They have to develop a new product from scratch.
Apart from that, the incumbent can also lock in the customer through a contract. For example, suppose company A signs a contract with company B and company C. Both companies are the market leaders, for example, 70% of the total market demand. Both also have loyal customers. Thus, potential entrants will have fewer customers and, in turn, fewer profits.
Specialized schemes and services help incumbents maintain customer loyalty. For example, they develop programs such as discounts or vouchers to reward their customers. Or, they have superior after-sales support.
Such programs deter new entrants from gaining market share. They should consider implementing a similar reward system for switching customers. Of course, that increases the entry fee.
Switching costs are costs incurred by a customer when switching to an alternative product. These costs have many dimensions, including money, time, and effort.
- A new purchase requires installing new equipment. For complex products, it is often expensive and requires technical assistance from specialists. Therefore, when switching, they also have to bear the cost of installation.
- Customers need more time to learn the new system. For example, suppose you switched from a Windows operating system to Linux. In that case, it will take you some time to get up and running and become proficient.
- The alternative product is incompatible with some of the products the customer currently has. For example, some software on Windows is incompatible with Linux. So, you have to convert it first.
- Customers are missing out on potential benefits. For example, the company offers a reward system through a loyalty card. You have it and collect some points. When you turn to alternative products, you miss the opportunity to gain rewards.
- Customers bear the transportation costs. Incumbents sell premium brands and limit their marketing. You may have to take flights overseas because the incumbent does not sell them in your country.
High switching costs form a significant barrier to entry. That forces newcomers to incentivize customers to be willing to switch to their products.
New entrants may offer low prices to attract customers. However, it may not be effective if the intermediate costs in terms of monetary, effort, time, and uncertainty costs are higher than the difference in price between the entrant and the incumbent.