Barriers to entry

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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.[1][2] 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. [3] 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. [4]

Definitions[edit]

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. [1][5][6]

McAfee, Mialon, and Williams list seven common definitions in economic literature in chronological order including:[1][7]

In 1956, Joe S. Bain used the definition "an advantage of established sellers in an industry over potential entrant sellers, which is reflected in the extent to which established sellers can persistently raise their prices above competitive levels without attracting new firms to enter the industry." McAfee et al. criticized this as being tautological by putting the "consequences of the definition into the definition itself."

In 1968, George Stigler defined an entry barrier as "A cost of producing that must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry." McAfee et al. criticized the phrase "is not borne" as being confusing and incomplete by implying that only current costs need be considered.

In 1979, Franklin M. Fisher gave the definition "anything that prevents entry when entry is socially beneficial." McAfee et al. criticized this along the same lines as Bain's definition.

In 1994, Dennis Carlton and Jeffrey Perloff gave the definition, "anything that prevents an entrepreneur from instantaneously creating a new firm in a market." Carlton and Perloff then dismiss their own definition as impractical and instead use their own definition of a "long-term barrier to entry" which is defined very closely to the definition in the introduction.

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.[1][8]

An antitrust barrier to entry is "a cost that delays entry and thereby reduces social welfare relative to immediate but equally costly entry".[1] This contrasts with the concept of economic barrier to entry defined above, as it can delay entry into a market but does not result in any cost-advantage to incumbents in the market. All economic barriers to entry are antitrust barriers to entry, but the converse is not true.

Examples[edit]

Porters Barriers to Entry[edit]

An article produced on Michael Porter in 2008 showed stated new entrants to an industry have the desire to gain market share, and often substantial resources. The seriousness of the threat of entry depends on the barriers present and on the reaction from existing competitors. The following shows the 6 main sources of barriers to entry:[9]

  • Economies of scale
  • Product differentiation
  • Capital requirements
  • Cost disadvantages independent of size
  • Access to distribution channels
  • Government policy

Furthermore, a potential new market entrants expectations about the reaction of the existing competitors within the industry will also be a contributing factor on their decision to enter the market. The company will likely have second thoughts if incumbents have previously lashed out at new entrants or if:

  • Incumbents possess substantial resources to fight back, such as excess cash and unused borrowing power.
  • Incumbents seem likely to cut prices because of a desire to keep market shares or because of industry wide excess capacity.
  • Industry growth is slow, affecting its ability to absorb the new arrival, likely causing the financial performance of all parties to decline. [10]

Primary Economic Barriers to entry[edit]

  • 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.[11] In response, if access to existing distribution channels is too difficult, new entrants may create their own. For example, new low-cost airlines often encourage passengers to book online instead of through travel agents.[9]
  • Intellectual property – A potential entrant requires access to production technology as efficient as that of the combatant monopolist in order to freely enter a market. Patents, however, give a firm the legal right to stop other firms from producing a product for a given period of time, and so restrict entry. 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. Incumbent firms may have an exclusive right to use the brand name, making it expensive or impossible for new entrants to license rights to names.[11]
  • Capital requirements - Many industries require the investment of large financial resources to start a new business, which deters new entrants. For example, new airlines require millions of dollars for purchasing planes, staff training etc. In addition, new entrants often experience serious difficulties in raising funds for unrecoverable expenses, such as advertising and R&D. In the pharmaceutical industry, for instance, companies may invest heavily in research in order to develop Covid vaccines, then end up with disappointing results and lose all of their investment. [9]
  • Restrictive practices – Established policies may protect existing players and restrict entry. For instance, air transport agreements may make it difficult for new airlines to obtain landing slots at some airports. Or Certificate of Need (CON) laws in some of US states may require medical service providers to file an application and prove community need before offering their services--a practice that has been found to benefit incumbents.[12]
  • 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.[9] Indeed, switching costs are often intentionally made high in order to discourage customers from changing suppliers and adopting the technological innovations provided by others.[11]
  • Tariffs – Taxes on imports prevent foreign firms from entering into domestic markets.
  • Taxes – Smaller companies typically 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 paying the higher taxes.
  • Zoning – Government allows certain economic activity in specified land areas but excludes others, allowing monopoly over the land needed.

Contentious examples[edit]

The following examples are sometimes cited as barriers to entry, but don't fit all the commonly cited definitions of a barrier to entry. Many of these fit the definition of antitrust barriers to entry or ancillary economic barriers to entry.

  • Economies of scale – Cost advantages raise the stakes in a market, which can deter and delay entrants into the market. Bulk buying offers buyers larger negotiating power to get the lowest price and they take advantage on that. This makes scale economies an antitrust barrier to entry, but they can also be ancillary.[1] The per-unit cost will be lower in scale economies due to the spread of fixed costs to larger volumes, technology efficiencies and better supplier terms, therefore new entrants join the industry either on a large scale or at a cost disadvantage. [9] 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.
  • Network effect/Demand-side benefits of scale – When a good or service has a value that increases on average for every additional customer, this exerts a similar antitrust and ancillary barrier to that of economies of scale.[1] Customers are more willing to buy crucial products from larger companies than newcomers. It increases the difficulty of entering the industry or reduces the initial profit margins for new entrants.[9]
  • Government regulations – Government regulations are rules having the force of law, prescribed by a superior or competent authority, relating to the actions of those under the authority's control. Licences, for example, may be required when entering a specific field, particularly in industries that are heavily protected by the government. As a result, the field is dominated by government-owned firms (e.g energy), or existing players are protected in the market (e.g Taxi service or TV). The regulations themselves may set the barriers for not letting others to enter a market, or requirements for licenses and permits may raise the level of investment required, creating an antitrust barrier to entry.[11][9] However, sometimes government regulations may make entry easier, such as AIR-21 which requires airports to make facilities available to access by all carriers.[13]
  • 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.[14] 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.[14] 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.[14] This makes it hard for new competitors to gain consumer acceptance.[14] It reflected by brand promoting and the increase of customer loyalties.[11]
  • CapitalInvestments in equipment, building, and raw materials may represent ancillary barriers, particularly in the case of sunk costs,[1] which can increase the strength of barriers to entry. Sunk costs may also lead to monopoly profits, improper resource allocation and low efficiency.[11] For capital-intensive industries, entrants will also need much more financial capital.[11]
  • Uncertainty – When a market actor has various options with overlapping possible profits, choosing any one of them has an opportunity cost. This cost might be reduced by waiting until conditions are clearer, which can result in an ancillary antitrust barrier.
  • Incumbency advantages independent of scale – Incumbents often have advantages over newcomers, including proprietary technology, know-how, favorable access to raw materials, favorable geographic locations, established brand reputation and learning curve cost advantages. It is reflected by learning curve effects and economies of scale, and it is one of the most critical barriers to entry strategies.[11][9]
  • Vertical integration – 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 a similar large-scale effort on the part of competitors.
  • Research and development – Some products, such as microprocessors, require a large upfront investment in technology which will deter potential entrants. The existing firms in the market may also use efficient investments in research and development to increase technological economies of scale, and boost industry development, which work against entrants who lack the funding and resources to enter the market.[11] However, critics also point out that entry barriers can reduce the efficiency of R&D because firms have no incentive to efficiently invest in innovation.[15]
  • 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.[11]
  • Number of competitors - During a period when the number of companies is increasing, the possibility of market entry is higher, Conversely, the likelihood of market entry is less during a period defined by a large number of business failures.[11]
  • Price - Intensive price competition can hinder entrants, who may be unable to set their prices as low as incumbents. As a result, industries with high barriers to entry often contain a monopoly or oligopoly with dominant power in terms of price. This dominance allows them to charge a higher price or, if other firms join the market, to use their market power and cash flow to lower prices, beating out the new competition. [11]
  • Technology and technological change - Technological change, often seen in high technology sectors, can have a tremendous impact on economies of scale.[11]
  • Market concentration - Market concentration, though it usually has only a minor effect, can still work against new entrants.[11]
  • Seller concentration - Seller concentration can have a major effect on new entrants, making it difficult for them to enter the market, contributing further to seller concentration.[11]
  • Divisionalization - Typically in highly profitable oligopolistic industries, it is cheaper for an incumbent to establish a new department than it would be for new entrants.[11]
  • Selling expenses - A change in demand function may be endogenous to market entry due to sales efforts.[11]
  • Incumbent's expected reaction to market entry - If incumbent firms expect new entrants to represent a threat, and are capable of preventing market entry, they may take action to prevent new entrants from competing.[11]
  • Possession of strategic raw materials - An ability to access strategic raw materials provides advantages for the accessing companies, such as an absolute cost advantage.[11]

Classification and examples[edit]

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

These markets combine the attributes:

  • Markets with high entry barriers have few players and thus high profit margins.
  • Markets with low entry barriers have many 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.

Market structure[edit]

A structural barrier to entry is a cost incurred by new entrants to a market that is caused by inherent industry conditions, such as upfront capital investment, economies of scale and network effects.[16] For example, the cost to develop a factory and obtain the initial capital required for manufacturing can be seen as a structural barrier to entry.

A strategic barrier to entry is a cost incurred by new entrants that is artificially created or enhanced by existing firms.[16] This could take the form of exclusive contracts, whether supply or demand-side, or through price manipulation in non-competitive markets.

A market with perfect competition features zero barriers to entry.[17] Under perfect competition firms are unable to control prices, and produce similar or identical goods.[18] This means that firms cannot operate strategic barriers to entry. Perfect competition implies no economies of scale;[18] this means that structural barriers to entry are also not possible under perfect competition.

Monopolistic competition can allow for medium barriers to entry. Because the enterprises can earn their short-term revenue through innovation and marketing new products to push the price higher than average costs and marginal costs, barriers to entry can be made higher.[19] 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.[20]

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,[21] which allows them to engage in temporarily loss-inducing behaviour to force any potential competitor out of the market.[22]

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.[23]

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.[24] These barriers can take several forms, including cost advantage, advertising, and strategic reaction in the form of temporary deviation from equilibrium behavour.[24]

See also[edit]

References[edit]

  1. ^ a b c d e f g h "When Are Sunk Costs Barriers to Entry?" (PDF). caltech.edu. Archived (PDF) from the original on 27 March 2016. Retrieved 3 May 2018.
  2. ^ "Antitrust Aspects of Barriers to Entry" (PDF). micronomics.com. Archived (PDF) from the original on 17 May 2017. Retrieved 3 May 2018.
  3. ^ Boyce, Paul. "Barriers to entry Definition".
  4. ^ Hayes, Adam. "Barriers to Entry".
  5. ^ "Competition and Barriers to Entry" (PDF). oecd.org. Archived (PDF) from the original on 29 August 2017. Retrieved 3 May 2018.
  6. ^ "Entry Barriers and Contemporary Antitrust Litigation". Archived from the original on 2016-03-29.
  7. ^ "Archived copy" (PDF). Archived (PDF) from the original on 2009-05-21. Retrieved 2009-12-16.{{cite web}}: CS1 maint: archived copy as title (link)
  8. ^ "Homepage of Oz Shy" (PDF). ozshy.com. Archived (PDF) from the original on 21 December 2016. Retrieved 3 May 2018.
  9. ^ a b c d e f g h Porter, Michael (2008). "The five competitive forces that shape strategy". Harvard Business Review. 86 (1): 78–137. PMID 18271320.
  10. ^ Porter, Michael (2008). "How Competitive Forces Shape Strategy". Harvard Business Review. 86: 78–137.
  11. ^ a b c d e f g h i j k l m n o p q r s Karakaya, Fahri (April 1989). "Barriers to Entry and Market Entry Decisions in Consumer and Industrial Goods Markets". Journal of Marketing. 53 (2): 80–91. doi:10.2307/1251415. JSTOR 1251415. Retrieved 2020-10-31.
  12. ^ Baker, Matthew C.; Stratmann, Thomas (2021-10-01). "Barriers to entry in the healthcare markets: Winners and Losers from certificate-of-need laws". Socio-Economic Planning Sciences. 77: 101007. doi:10.1016/j.seps.2020.101007. ISSN 0038-0121.
  13. ^ Snider, Connan; Williams, Jonathan W. (2015-12-01). "Barriers to Entry in the Airline Industry: A Multidimensional Regression-Discontinuity Analysis of AIR-21". The Review of Economics and Statistics. 97 (5): 1002–1022. doi:10.1162/REST_a_00455. ISSN 0034-6535. S2CID 57571664.
  14. ^ a b c d Moffatt, Mike. (2008) About.com The Market Power Theory of Advertising Archived 2008-04-05 at the Wayback Machine Economics Glossary – Terms Beginning with M. Accessed June 19, 2008.
  15. ^ Cullmann, Astrid; Schmidt-Ehmcke, Jens; Zloczysti, Petra (2012-01-01). "R&D efficiency and barriers to entry: a two stage semi-parametric DEA approach". Oxford Economic Papers. 64 (1): 176–196. doi:10.1093/oep/gpr015. ISSN 0030-7653.
  16. ^ a b West, Jeremy (2007). "Competition and Barriers to Entry" (PDF). Organisation for Economic Co-operation and Development. Retrieved 2022-04-19.
  17. ^ Stigler, George (1957). "Perfect Competition, Historically Contemplated". University of Chicago Press Journals. 65: 1–17. doi:10.1086/257878. S2CID 153919760. Retrieved 2022-04-20.
  18. ^ a b Curtis, D (2017). "Principles of Microeconomics". Open Textbook Library. Retrieved 2022-04-20.
  19. ^ Boland, Michael A.; Crespi, John M.; Silva, Jena; Xia, Tian; Boland, Michael A.; Crespi, John M.; Silva, Jena; Xia, Tian (2012). "Measuring the Benefits to Advertising under Monopolistic Competition". Journal of Agricultural and Resource Economics. doi:10.22004/ag.econ.122308. Retrieved 2020-11-01.
  20. ^ Todorova, Tamara (2016). "Some Efficiency Aspects of Monopolistic Competition: Innovation, Variety and Transaction Costs". {{cite journal}}: Cite journal requires |journal= (help)
  21. ^ Lieberman, Marvin (1987). "Excess Capacity as a Barrier to Entry". University of Chicago Press Journals. doi:10.2307/2098590. JSTOR 2098590. Retrieved 2022-04-22.
  22. ^ Ayres, Ian (1987). "How Cartels Punish: A structural theory of self-enforcing collusion". Columbia Law Review. 87 (2): 295–325. doi:10.2307/1122562. JSTOR 1122562. Retrieved 2022-04-22.
  23. ^ Dixit, Avinash (1979). "A Model of Duopoly Suggesting a Theory of Entry Barriers". The Bell Journal of Economics. 10 (1): 20–32. doi:10.2307/3003317. JSTOR 3003317. Retrieved 2022-04-22.
  24. ^ a b Dilek, Serkan; Top, Seyfi (2012-10-12). "Is Setting up Barriers to Entry Always Profitable for Incumbent Firms?". Procedia - Social and Behavioral Sciences. 8th International Strategic Management Conference. 58: 774–782. doi:10.1016/j.sbspro.2012.09.1055. ISSN 1877-0428.