Barriers to entry

In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have not had to incur.

Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies and oligopolies, or give companies market power.

Barriers of entry also have an importance in industries. First of all it is important to identify that some exist naturally, such as brand loyalty.

Governments can also create barriers to entry to meet consumer protection laws, protecting the public. In other cases it can also be due to inherent scarcity of public resources needed to enter a market.

Definitions

Various conflicting definitions of "barrier to entry" have been put forth since the 1950s. This has caused there to be no clear consensus on which definition should be used.

McAfee, Mialon, and Williams list seven common definitions in economic literature in chronological order including:

A primary barrier to entry is a cost that constitutes an economic barrier to entry on its own. An ancillary barrier to entry is a cost that does not constitute a barrier to entry by itself, but reinforces other barriers to entry if they are present.

An antitrust barrier to entry is "a cost that delays entry and thereby reduces social welfare relative to immediate but equally costly entry".

The first barrier to entry found in the article is the supply-side economies of scale. These scales arise when incumbents produce larger volumes of their product for a lower total cost. This can occur if they spread their fixed costs over more units, utilize a more efficient technology or are on better terms with their suppliers.

The second barrier to entry is the demand-side benefits of scale or network effects. According to Porters article, this arises when a buyer's willingness to pay for a company's product increases with the number of other buyers who also patronize the company. Essentially, through network effects the buyers may trust the larger companies more than smaller ones. This barrier discourages the entrant due to incumbent's embedded data and the structural adjustment programs made internally.

The third barrier is capital requirements for the initial investment and running of a company. Companies often require a large amount of capital when starting to pay for fixed facilities but also produce their inventory and fund start-up losses. The magnitude of the barrier increases if the capital is required for unrecoverable expenditure such as advertising and research and development.

The fourth barrier is incumbency advantages independent of size. For the incumbent, this barrier theoretically gives them a cost and quality advantage over the entrants. Specifically, these are often regarding proprietary technology, preferential access to raw materials, favourable geographic locations, established brand identities and even cumulative experience. This barrier more specifically outlines the favourable traits incumbents adopt over-time due to their established place in the industry, making it unavoidable for entrants in certain industries.

The fifth barrier is the unequal access to distribution channels between the incumbents and the entrants. Most companies require some type of distribution channel for the transport of their product. In the case where entrants cannot bypass this barrier, they end up forming their own distribution channel. The problem for entrants is that the more limited the wholesale and retail channels are, the more competitors have tied them up and consequently the more difficult entry into the industry will be.

The final barrier is restrictive government policy. Importantly, this barrier can either aid or hinder an entrant and even effect the other barriers. Restrictive government policies can block entrance through licensing requirements and restrictions on foreign investments. A clear example these may include the alcohol and taxi industries. Policies can heighten other entry barriers through intellectual property laws and even environmental and safety regulations that raise economies of scale for entrants.

Furthermore, a potential new market entrant's expectations about the reaction of the existing competitors within the industry will also be a contributing factor on their decision to enter the market.

An entrant may reconsider entering an industry or choose a new one altogether if incumbents have displayed conscious reactions to entrants in the past. Another discouraging indication for an entrant is if the incumbent is in possession of substantial resources to respond to an entrant. These resources generally consist of excess cash and unused borrowing power. This may also allow for incumbents to lower prices to either keep their market share or lower their excess capacity, another discouraging sign for an entrant.

Primary economic barriers to entry

Distributor agreements – Exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter an industry. This is a particular problem if, prior to entry, the other firms in the market use intensive distribution strategies in order to restrict the access of potential entrants to distributors.
Supplier agreements – Exclusive agreements with businesses that represent key links in the supply chain can make it difficult for other manufacturers to enter an industry, e.g. when suppliers offer significant discounts to certain buyers or offer their product exclusively.
Customer Switching barriers – At times, it may be difficult or expensive for customers to switch providers, especially if they have to retrain employees or modify internal information systems.
Grandfather clauses can result in a bias against new entrants.
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. 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.
Customer loyalty – Large incumbent firms may have existing customers loyal to established products. As a result, the presence of established strong brands within a market can be a barrier to entry.
Control of resources – If a single firm has control of a resource essential for a certain industry, then other firms may be unable to compete in the industry.
Inelastic demand – One strategy to penetrate a market is to sell at a lower price than the incumbents. This, however, is ineffective with price-insensitive consumers.
Predatory pricing – Predatory pricing is the practice of selling at a loss to make competition more difficult for new firms that cannot bear such losses as easily as a large dominant firm with large lines of credit or cash reserves. Illegal in most places, predatory pricing, however, is difficult to prove. See antitrust. In the context of international trade, such practices are often called dumping.
Occupational licensing – Examples include educational, licensing, and quota limits on the number of people who can enter a certain profession.
Product differentiation of incumbents - Incumbent firms show advantages in advertising, brands, customer loyalties or product differentiation which can enable them to be first in the market. Under perfect competition firms are unable to control prices, and produce similar or identical goods. This means that firms cannot operate strategic barriers to entry.

Perfect competition implies no economies of scale; However, due to the low cost of the information in monopolistic competition, the barrier of entry is lower than in oligopolies or monopolies as new entrants come.

An Oligopoly will typically see high barriers to entry, due to the size of the existing enterprises and the competitive advantages gained from that size. These competitive advantages could arise from economies of scale, but are also commonly associated with the excess capacity of capital held by incumbent firms, which allows them to engage in temporarily loss-inducing behaviour to force any potential competitor out of the market.

The distinguishing characteristic of a duopoly is a market featuring solely two firms. Competition in a duopoly can vary due to what is being set in the market: price or quantity (see Cournot competition and Bertrand competition). It is generally agreed that a duopoly will feature higher barriers to entry than an oligopoly, as firms within a duopoly have a greater potential for absolute advantage with respect to demand.

A market with a monopolistic firm will often have very high to absolute barriers to entry. The incumbent firm can obtain tremendous profits through a pure monopoly market, therefore there are very large incentives for the creation of strategic barriers, as they want to continue to earn excess profits in the short and long term. These barriers can take several forms, including cost advantage, advertising, and strategic reaction in the form of temporary deviation from equilibrium behaviour. One dataset with barriers to entry to the political competition by country is the "Barriers to parties" indicator in V-Dem Democracy indices.

Barriers to entry

Definitions

Primary economic barriers to entry

See also

References