Barriers to Entry

Barriers to entry represent the costs that must be paid by a new market entrant but not by firms already in the industry. Barriers to entry reduce the threat posed by potential competitors by making a market less

contestable, and allow existing firms to maintain higher prices than would otherwise be possible.

Below we outline eight (8) examples of barriers to entry:

1. Economies of Scale

The existence of economies of scale in an industry creates a barrier to entry. Since existing firms are already producing they are often in a 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. Network Effects

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

3. 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.

Sources of product differentiation include:

3.1 Branding: If existing firms and products have strong brand recognition then this 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 products. This will increase the cost of gaining market share and deter entry into the market.

3.2 Customer service: If existing firms have strong customer

relationships formed through customer service and customer loyalty programs then it may be difficult for new entrants to gain market share.

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

4. 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 (that is, they are Sunk costs) then a 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 steep discount); and

 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.

5. Intangible Assets

Proprietary product technology: The existence of proprietary product technology represents 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 or costly to acquire, for

example, legal or medical certifications.

6. 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, then 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 often has stores in the best locations which makes it more difficult for new restaurants to compete with it.

Switching costs: If customers face high switching costs, then it will be more difficult for a new entrant to gain market share. Switching costs will be affected by various factors including the length of customer contracts, the existence of customer loyalty programs, and the price performance and compatibility of complimentary products.

7. Government Policy 7.1 Government Regulation

The government may limit or restrict entry into a market by requiring market participants to obtain a licence or other government approval in order to carry on business; examples include taxi licenses, safety

standard compliance certificates, mining permits, and 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.

7.2 Tariffs and Subsidies

Government regulations that subsidise or tax the activity of all industry participants do not represent a barrier to entry. For example, tariffs, quotas or subsidies that apply equally to incumbents and new entrants are not barriers to entry.

That being said, tariffs and quotas may pose barriers to entry where they protect the market share of existing firms or prevent new firms from gaining access to the market. Similarly, subsidies may pose a barrier to entry where they operate solely or predominantly for the benefit of incumbents.

8. 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 compete 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 new entrants without the profitability of incumbents 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; and

3. Incumbents are likely to cut prices due to industry wide excess capacity or a desire to retain market share.