Barriers to entry

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In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market.[1] The term can refer to hindrances a firm faces in trying to enter a market or industry—such as government regulation and patents, or a large, established firm taking advantage of economies of scale—or those an individual faces in trying to gain entrance to a profession—such as education or licensing requirements.

Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices. The existence of monopolies or market power is often aided by barriers to entry.

Definitions

George Stigler defined an entry barrier as "A cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry."[2]

Franklin M. Fisher gave the definition "anything that prevents entry when entry is socially beneficial."[3]

Joe S. Bain defined as a barrier to entry anything that allows incumbent firms to earn supernormal profits without threat of entry.[4]

Barriers to entry for firms into a market

Barriers to entry into markets for firms include:

  • 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 or unable to staff and or undertake. This is known as the market power theory of advertising.[5] Here, established firms' use of advertising creates a consumer perceived difference in its brand from other brands to a degree that consumers see its brand as a slightly different product.[5] Since the brand is seen as a slightly different product, products from existing or potential competitors cannot be perfectly substituted in place of the established firm's brand.[5] This makes it hard for new competitors to gain consumer acceptance.[5]
  • Capital - need the capital to start up such as equipment, building, and raw materials
  • Control of resources - If a single firm has control of a resource essential for a certain industry, then other firms are unable to compete in the industry.
  • Cost advantages independent of scale - Proprietary technology, know-how, favorable access to raw materials, favorable geographic locations, learning curve cost advantages.
  • 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.
  • Distributor agreements - Exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry.
  • Economy of scale - The increase in efficiency of production as the number of goods being produced increases. 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.
  • Government regulations - A rule of order having the force of law, prescribed by a superior or competent authority, relating to the actions of those under the authority's control. Requirements for licenses and permits may raise the investment needed to enter a market, creating an effective barrier to entry.
  • Inelastic demand - One strategy to penetrate a market is to sell at a lower price than the incumbents. This is ineffective with price-insensitive consumers.
  • Intellectual property - Potential entrant requires access to equally efficient production technology as the combatant monopolist in order to freely enter a market. Patents give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and servicemarks may represent a kind of entry barrier for a particular product or service if the market is dominated by one or a few well-known names.
  • Investment - That is especially in industries with economies of scale and/or natural monopolies.
  • Network effect - When a good or service has a value that depends on the number of existing customers, then competing players may have difficulties in entering a market where an established company has already captured a significant user base.
  • Predatory pricing - The practice of a dominant firm selling at a loss to make competition more difficult for new firms that 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. See antitrust. In the context of international trade, such practices are often called dumping.
  • Restrictive practices, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports.
  • Research and development - Some products, such as microprocessors, require a large upfront investment in technology which will deter potential entrants.
  • Supplier agreements - Exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter an industry.
  • Sunk costs - Sunk costs cannot be recovered if a firm decides to leave a market. Sunk costs therefore increase the risk and deter entry.
  • Switching barriers - At times, it may be difficult or expensive for customers to switch providers
  • Tariffs - Taxes on imports prevent foreign firms from entering into domestic markets.
  • Taxes – Smaller companies typical fund expansions out of retained profits so high tax rates hinder their growth and ability to compete with existing firms. Larger firms may be better able to avoid high taxes through either loopholes written into law favoring large companies or by using their larger tax accounting staffs to better avoid high taxes.
  • Vertical integration - A firm's coverage of more than one level of production, while pursuing practices which favor its own operations at each level, is often cited as an entry barrier as it requires competitors producing it at different steps to enter the market at once.
  • Zoning - Government allows certain economic activity in specified land areas but excludes others, allowing monopoly over the land needed.

Barriers to entry for individuals into the job market

Examples of barriers restricting individuals from entering a job market include educational, licensing, and quota limits on the number of people who can enter a certain profession.

Classification and examples

Michael Porter classifies the markets into four general cases[citation needed]:

  • High barrier to entry and high exit barrier (for example, telecommunications, energy)
  • High barrier to entry and low exit barrier (for example, consulting, education)
  • Low barrier to entry and high exit barrier (for example, hotels, ironworks)
  • Low barrier to entry and low exit barrier (for example, retail, electronic commerce)
  • Markets with high entry barriers have few players and thus high profit margins.
  • Markets with low entry barriers have lots of players and thus low profit margins.
  • Markets with high exit barriers are unstable and not self-regulated, so the profit margins fluctuate very much over time.
  • Markets with a low exit barrier are stable and self-regulated, so the profit margins do not fluctuate much over time.

The higher the barriers to entry and exit, the more prone a market tends to be a natural monopoly. The reverse is also true. The lower the barriers, the more likely the market will become perfect competition.

Barriers to entry and market structure

  1. Perfect competition: Zero barriers to entry.
  2. Monopolistic competition: Medium barriers to entry.
  3. Oligopoly: High barriers to entry.
  4. Monopoly: Very High to Absolute barriers to entry.

See also

References

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  2. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  3. ↑ http://www.mcafee.cc/Papers/PDF/Barriers2Entry.pdf
  4. ↑ Lua error in package.lua at line 80: module 'strict' not found.
  5. ↑ 5.0 5.1 5.2 5.3 Moffatt, Mike. (2008) About.com The Market Power Theory of Advertising Economics Glossary - Terms Beginning with M. Accessed June 19, 2008.
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