Barriers to entry

 

Barriers to entry are factors that prevent a company from entering a particular market. As a whole, they comprise one of the five forces that determine the intensity of competition in an industry (the others are industry rivalry, the bargaining power of buyers, the bargaining power of suppliers and the threat of substitutes). The intensity of competition in a certain field determines the attractiveness of a market (i.e., low intensity means that the market is attractive).

Factors involved as barriers to entry may be either innocent (e.g., the dominating company’s absolute cost advantage) or deliberate (e.g., high spending on advertising by incumbents make it very expensive for new firms to enter the market).

Barriers to entry act as a deterrent against new competitors. They serve as a defensive mechanism that imposes a cost element to new entrants, which incumbents do not have to bear. Start-ups need to understand any barriers to entry for their business and market for two key reasons:

1. Start-ups might seek to enter a business with high barriers to entry. Doing so would put the start-up at a significant disadvantage that is difficult to overcome.
2. Start-ups that become market leaders must understand how to protect their position by building barriers to entry

Sources of barriers to entry

There are seven sources of barriers to entry:

• Economies of scale: These are declines in the unit costs of a product as the absolute volume per period increases. These force the entrant to either come in at a large scale (risking strong reaction from incumbents) or a small scale (forcing a cost disadvantage).
• Product differentiation : Incumbents have brand identification and customer loyalties. This forces entrants to spend heavily to overcome these loyalties. Start-ups may bring a different product to market, but its benefits must be clearly communicated to the target customer. Start-ups must find an effective positioning, which often requires marketing resources beyond their means.
• Capital requirements: These are the financial resources required for infrastructure, machinery, R&D and advertising. Start-ups may get around capital requirements by outsourcing parts of the operation to companies that can leverage existing investments.
• Switching costs: These are one-time costs the buyer faces when switching an existing supplier’s product to a new entrant (e.g., employee retraining, new equipment, technical support).
• Access to distribution channels: This can be a barrier if logical distribution channels have been locked up by incumbents.
• Cost disadvantages independent of scale: Incumbents may have cost advantages that cannot be replicated by a potential entrant. Factors include the learning or experience curve, proprietary product technology, access to raw materials, favourable locations and government subsidies.
• Government policy: Governments can limit or prevent entry to industries with various controls (e.g., licensing requirements, limits to access to raw materials). Start-ups in highly regulated industries will find that incumbents have fine-tuned their business according to regulation.

Expected response to new entrants

The expected reaction of industry incumbents towards a new entrant influences the prospect or threat of entry by a new competitor. A number of conditions indicate the likelihood of retaliation to entry:

• a history of strong retaliation to entrants
• established firms with substantial resources to retaliate (e.g., excess cash, distribution channel leverage, excess productive capacity)
• established firms with commitment to the industry and highly illiquid assets
• slow industry growth

 

References

Porter, M. (1998).Competitive Strategy.New York: Free Press.

Tags: barriers, competition, strategic-analysis