Barriers to entry – definition and meaning

Barriers to entry are the obstacles that make it extremely difficult for small or startup enterprises to get a foothold or thrive in a market or industry. The existing competitors are extremely big, dominant or established, making it virtually impossible for anybody new to come onto the scene and gain market share.

When barriers to entry are high, the startup costs and other obstacles prevent new competitors from easily entering a market or sector. The existing companies that are already operating in an industry are protected by these barriers, because new rivals are unlikely to emerge or succeed.

There are several types of barriers to entry, apart from the size and age of the existing competitors, such as tax benefits that existing firms enjoy, strong brand identity, customer loyalty, patents, and high customer switching costs.

Barriers to entry
Barriers to entry can come in many forms. The more of them there are, or the higher the hurdles, the fewer competitors there will be in a particular market.

As barriers to entry protect incumbent companies and restrict free competition in the market, they can contribute to disproportionately high prices and monopolies.

Monopolies typically exist when barriers to entry are insurmountable. If there were no barriers, or if they were low, other companies would have entered such markets.

According to the Financial Times Lexicon of business terms, barriers to entry are:

“Factors that make it difficult for a company to enter an industry or type of business and compete effectively. These can include incumbents’ high capital investment and strong economies of scale, restrictive government policies, labor unions, etc.”

Examples of barriers to entry

Government Regulation: restrictive licensing requirements or limiting the ability to get raw materials can make it virtually impossible for new players to enter a certain market.

For example, in many countries entrepreneurs wanting to set up their own radio network may have to face several government hurdles and costs.

Degrees of barriers to entry
A market with zero barriers to entry has free competition and many competitors – consumers have the widest choice, best prices, and probably optimum quality. When barriers are at their maximum, there is probably just one supplier, prices are likely to be artificially high, choice is very limited, and quality is unlikely to be very good.

Technology: in some industries the technology required to operate effectively and successfully is protected by patent. The only choice is to come to some kind of deal with the incumbent companies, which means the new player is probably no longer a competitor, or create new technology, which is risky and expensive to develop.

Start-Up Costs: the amount of capital required to get into, for example, the car manufacturing business is enormous, making it virtually impossible for 99.99% of businesses to even consider the possibility.

Economies of Scale: when more units of a good are produced, the cost of creating each one declines. However, in order to produce in large quantities you need lots of orders. This does not happen straight away when you enter a new market. Therefore, your initial unit costs are higher than those of the incumbent dominant players. They will be in a better position to undercut on price.

Well-established companies in a particular market or field may be tempted to raise the barriers to entry when they see a newcomer entering their perceived territory. They can do this, for example, by reducing prices, thus making the new competitor’s products less competitive. For the incumbents, lowering prices may be easy, especially if they have been higher than the free-market levels because of the high barriers.

Product Differentiation: this refers to making your product stand out – seem more attractive by contrasting its unique qualities with other competing products. A new business owner will have to spend a significant amount to educate consumers about the unique benefits and qualities of its products.

Luring away loyal customers from their existing brands or suppliers is not easy.

Aaron Levie barriers to entry qouteAaron Levie, an American entrepreneur, co-founder and CEO of cloud company, once said: “The only barrier to entry you can create is to consistently build a great product.” (Image: Wikipedia)

Access to Distribution Channels and Suppliers: – being unable to gain access to needed raw materials is the kiss of death to any new business. Incumbent firms may have long-term contracts with key suppliers, making it hard for a new player to elbow its way in.

Competitive Response: if you are an entrepreneur looking at new markets to break into, you are less likely to consider one where you know the existing players will compete aggressively to stop you from gaining market share. Competitive response may either kill off new entrants, make life extremely hard for them, or put them off before they even start.

There are many barriers that make the airline industry extremely uncompetitive. At major airports there are limits on take-off and landing slots, there are long-term leases that give airlines the exclusive use of airport gates, and regulations prohibiting flights of less than a certain distance have impeded new airlines’ access to airports for many decades.

The development of the Internet and e-commerce have turned old ideas about barriers to entry on their heads. By operating online, firms can often overcome traditional barriers with an ease that would have been impossible before.
Economies of scale, for example, are much less applicable when operations and functions are carried out electronically.

Barriers to exit
It is not only spies and mafia personnel who find it difficult to leave their sector, some businesses also have problems trying to get out because of barriers to exit.

Defining barriers to entry

Many scholars argue that obstacles are not barriers to entry if the incumbent companies had to face them when they first entered the market. Others insist that an entry barrier is anything that makes it harder to get in and has the effect of limiting or reducing competition.

For decades experts have been arguing about what the exact definition of barriers to entry is – without much success.

The OECD says that because there is still disagreement but various definitions continue being used as analytical tools, the possibility of confusion and ambiguity – and therefore flawed competition policy – has lingered for several decades.

If defining barriers to entry is difficult, it should be virtually impossible to set out competition policy, shouldn’t it? The OECD does not think so – in fact it says it is irrelevant.

What really matters in actual competition cases is not whether an obstacle satisfies some definition, but rather the more practical questions of whether, when, and to what extent it is likely to emerge and become a problem.

On its website, the OECD writes:

“Regardless of whether there is a consensus on a definition, or even whether the definition ultimately matters, it is undeniable that the concept of entry barriers plays an important role in a wide variety of competition matters because it is vital to the analysis of market power.”

“Entry barriers can retard, diminish, or entirely prevent the market’s usual mechanism for checking *market power: the attraction and arrival of new competitors.”

* Market power refers to the extent to which a company can influence the price of a product in the market.

Barriers to exit

There are also markets in which companies might find it extremely difficult to get out. For example, the cost of laying off staff, or contractual obligations might make it impossible to exit. If you want to get out but have five years to go on a ten-year rental contract on your premises, and the landlord refuses to negotiate, you will have a problem.

For a high-street bank with a large number of employees and hundreds or thousands of branches all over the country, the barriers to exit can be significant.

Some companies deliberately erect barriers to make it harder for them to get out of a market. This could be a subtle message to competitors that they are 100% committed and will do what it takes to maintain market share.

Video – barriers to entry

In this video, Jason Delaney talks about oligopolies – markets with very few companies. They exist because those markets have large barriers that make it hard for others to break in or gain market share.