Barriers to entry

Short description: Economic theory

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.

## Contents

* 1 Definitions
* 2 Examples
* 2.1 Contentious examples
* 3 Classification and examples
* 4 Market structure
* 5 See also
* 6 References

## Definitions

Various conflicting definitions of "barrier to entry" have been put forth since the 1950s, and there has been no clear consensus on which definition should be used. This has caused considerable confusion and likely flawed policy.[1][3][4]

McAfee, Mialon, and Williams list seven common definitions in economic literature in chronological order including:[1][5]

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][6]

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

The following examples fit all the common definitions of primary economic barriers to entry.

* Distributor agreements – Exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry. In the earlier stage, the firms which enter the market would use intensive distribution strategies in order to restrict the potential entrants to access to distributors.[7]
* 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. The implementation including incumbent firms have exclusive right to use the brand name and can be costly for entrants to use those brand names.[7]
* Cost \- Many industries require invest huge amount of money to start the business at first, which conclude high start-up cost. For example, airline industry require millions of dollars for purchasing planes and staff training etc. Another one would be high sunk cost, huge amount of money invested but with the big risk. For example, some pharmaceuticals companies invest heavily on Covid vaccine, but it doesn't guarantee the success. They may end up with low treatment percentage and lose all the money being invested. These cost restrict firms with low cash flow to entry some specific fields.
* Restrictive practices – Establishing policies which protect existing players and may restrict others to entry, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports.
* Supplier agreements – Exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter an industry, such as exclusive product type. Often times, suppliers offer discount or launch their new product exclusively.
* Switching barriers – At times, it may be difficult or expensive for customers to switch providers. The objective of switching costs is to hinder buyers to change suppliers, and technological innovation usually would increase or decrease the cost.[7]
* 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.
* Zoning – Government allows certain economic activity in specified land areas but excludes others, allowing monopoly over the land needed.

### Contentious examples

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 offer 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] 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 – 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]
* 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. Licences required when entering the specific field, often times these industries are heavily protected by the government. Either the field is dominated by government-owned firms (E.g energy), or to protect the existing players in the market (E.g Taxi, TV) They set the barriers for not letting others to entry. Requirements for licenses and permits may raise the investment needed to enter a market, creating an antitrust barrier to entry.[7]
* 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.[8] 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.[8] 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.[8] This makes it hard for new competitors to gain consumer acceptance.[8] It reflected by brand promoting and the increase of customer loyalties.[7]
* Capital – Any investment into equipment, building, and raw materials are ancillary barriers, especially including sunk costs.[1] Sunk costs can increasing the strength of barriers to entry. However, it may also lead to monopoly profits, improper resource allocation and low efficiency.[7] And the implementation of capital includes to enable compete or enter the market, the firms need to invest enormous of financial resources to form a barrier to entry, and for the capital-intensive industries, it would need more the financial capital.[7]
* 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.
* Cost advantages independent of scale – Proprietary technology, know-how, favorable access to raw materials, favorable geographic locations, 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.[7]
* 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.
* 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 would use efficient investments in research and development to bar the entrants. It depicts in increase technological economies of scale, and boost the industry development, which makes the entrants lack of funding and resource to entre the market.[7]
* 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.
* 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.
* 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.
* 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.
* Occupational licensing – Examples include educational, licensing, and quota limits on the number of people who can enter a certain profession.
* Product differentiation of incumbents - The incumbent firms which show advantages in advertising, brands, customer loyalties or product differentiation can enable them to be the first in the market.[7]
* Number of competitors \- During the period when the number of companies is increasing, the possibility of market entry is higher, On the contrary, the likelihood of market entry is less during the period of a large number of business failures.[7]
* Price \- the intensive price competition can hinder the entrants, who may be unable to set their prices as low as the incumbents. Industries with high barriers to entry, often contain monopoly or oligopoly with dominant power in terms of price. They can charge a higher price. If other firms join the market, these firms are often quiet rich with sufficient cash flow, and use their market power include lower the price to beat other firms to join the market. [7]
* Technology and technological change \- It usually happens in high technology sectors which can have a heavy impact on economies of scale.[7]
* Market concentration \- Though a minor effect, it can still work against entrants.[7]
* Seller concentration \- It has a strong effect on the entrants under the high concentration environment, and it is uneasy for them to enter the market. And vice versa.[7]
* Divisionalization \- Typically happens in oligopolistic industries, because it is cheaper for the incumbent to establish a new department compared to the entrants.[7]
* Selling expenses \- The change in demand function may be endogenous to market entry due to sales efforts.[7]
* Incumbent's expected reaction to market entry \- If the incumbent firms expect the entrants would cause a threat to them, and incumbents are capable of preventing market entry, they may take action to prevent the entrants from competing.[7]
* Possession of strategic raw materials \- The ability to access to the strategic raw material would gain advantages for the companies, such as absolute cost advantage.[7]

## Classification and examples

Michael Porter classifies the markets into four general cases :

* 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)

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

1. Perfect competition: Zero barriers to entry. Due to the perfect competition results in firms are unable to control the prices and produce similar or the same goods, that firms can not form a barrier to entry strategy.[9]
2. Monopolistic competition: Medium barriers to entry. Because of 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, which can make barriers to entry higher.[10] However, due to the low cost of the information in monopolistic competition, the barrier of entry lower than in oligopoly or monopoly as new entrants come.[11]
3. Oligopoly: High barriers to entry, due to the size of the existing enterprises and the competitive advantages gained from that size.
4. Monopoly: Very high to absolute barriers to entry. The implementation of monopoly including the exciting firms can obtain tremendous profits through pure monopoly market because they want to continue to earn excess profits in the short and long term. Once they gain these profits, the other entrants want to enter the market due to the huge profit. As a result, the existing monopolies would obstacle to prevents new corporations from the distributors or economies of scales.[12] It can be achieved by creating large economies of scales, patent, trademark, etc.

## See also

* Anti-competitive practices
* Exclusive dealing
* Starting a Business Index
* Strategic entry deterrence
* Zero-profit condition

## References

1. ↑ 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 "When Are Sunk Costs Barriers to Entry?". http://authors.library.caltech.edu/11284/1/MCAaer04.pdf.
2. ↑ "Antitrust Aspects of Barriers to Entry". http://www.micronomics.com/articles/UCLA_Law_Institute_Barriers_to_Entry_Final.pdf.
3. ↑ "Competition and Barriers to Entry". http://www.oecd.org/competition/mergers/37921908.pdf.
4. ↑ "Entry Barriers and Contemporary Antitrust Litigation". http://blj.ucdavis.edu/archives/vol-7-no-1/entry-barriers-and-contemporary-antitrust-litigation.html.
5. ↑ "Archived copy". http://www.mcafee.cc/Papers/PDF/Barriers2Entry.pdf.
6. ↑ "Homepage of Oz Shy". http://www.ozshy.com/entry9.pdf.
7. ↑ 7.00 7.01 7.02 7.03 7.04 7.05 7.06 7.07 7.08 7.09 7.10 7.11 7.12 7.13 7.14 7.15 7.16 7.17 7.18 Karakaya, Fahri (April 1989). "Barriers to Entry and Market Entry Decisions in Consumer and Industrial Goods Markets" (in en). Journal of Marketing 53 (2): 80–91. doi:10.2307/1251415. https://www.researchgate.net/publication/257066666. Retrieved 2020-10-31.
8. ↑ 8.0 8.1 8.2 8.3 Moffatt, Mike. (2008) About.com The Market Power Theory of Advertising Economics Glossary – Terms Beginning with M. Accessed June 19, 2008.
9. ↑ Valence, Gerard de (November 2012). "The Significance of Barriers to Entry in the Construction Industry" (in en). Construction Economics and Building 7: 29–36. doi:10.5130/ajceb.v7i1.2975. https://www.researchgate.net/publication/287513194. Retrieved 2020-11-01.
10. ↑ Boland, Michael A.; Crespi, John M.; Silva, Jena; Xia, Tian; Boland, Michael A.; Crespi, John M.; Silva, Jena; Xia, Tian (2012) (in en). Measuring the Benefits to Advertising under Monopolistic Competition. doi:10.22004/ag.econ.122308. https://www.researchgate.net/publication/259673925. Retrieved 2020-11-01.
11. ↑ Todorova, Tamara (2016) (in en). Some Efficiency Aspects of Monopolistic Competition: Innovation, Variety and Transaction Costs. https://ideas.repec.org/p/zbw/esprep/148367.html.
12. ↑ Dilek, Serkan; Top, Seyfi (2012-10-12). "Is Setting up Barriers to Entry Always Profitable for Incumbent Firms?" (in en). Procedia - Social and Behavioral Sciences. 8th International Strategic Management Conference 58: 774–782. doi:10.1016/j.sbspro.2012.09.1055. ISSN 1877-0428. http://www.sciencedirect.com/science/article/pii/S187704281204517X.

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