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Barriers to Entry – Definition

Barriers to Entry Definition

Barriers to entry is a term used in economics throwing light on what challenges a competitor would encounter in terms of costs or other areas that stop them from making an entry to a specific sector or industry. These barriers to entry safeguard the interests of already prevailing firms, and help them in securing their incomes and profits.

Here are some general barriers to entry: exclusive tax-based privileges offered to current organizations, patents, powerful brand image, loyal customers, and a lot more. Besides, new organizations are required to have authentic license or go through a stringent set of regulations.

Note: Barriers to entry can occur naturally in the form of more start-up costs, be created by the government in the form of licensing costs and patents, or be a result of other firm’s strategies like buying a start-up company.

A Little More on What is a Barrier to Entry

Sometimes, barriers to entry can be a result of government policies, and other times, it can be due to natural forces prevailing in a free market. Usually, companies rely on the government to create new barriers to entry so as to safeguard the integrity and superiority of the industry, and avoid the entry of new firms launching poor quality products in the market. Companies also rely on barriers to entry in order to minimize competition and enjoy a bigger market share. There are some barriers to entry that take place gradually by time because of the market players being in the industry for a long period of time. Barriers to entry can be divided into two major categories: primary and ancillary. A primary barrier to entry is deemed to be a major barrier such as huge costs involved in starting up a business. Whereas an ancillary barrier is a combination of different barriers, and negatively impacts the potential of the firm from entering the market.

Key points

  1. Barriers to entry refers to an economic concept that disallows new companies from entering the market. It can be in the form of huge start-up costs, government restrictions, etc.
  2. Barriers to entry favor the current companies as they secure their monetary interests including profits and revenues.
  3. Barriers to entry can occur automatically, introduced by government, or present companies.
  4. Different industries have their own particular criterion of barriers to entry, and that’s why it is important for a new company to understand barriers associated with its industry or field.

Government Barriers to Entry

Government can impose its own barriers to entry on industries that are regulated by it on a large scale. For instance, airlines, cable organizations, etc. There can be several reasons that influence the government to make barriers to entry for such organizations. Say, for airlines, the government can prevent new firms from entering the market in order to reduce air traffic, and simply control policies. In case of cable companies, there are heavy regulations imposed because of more usage of public property for operational activities.

There are times when the government regulates barriers to entry because of lobbying pressure received from present companies. For instance, there are some provinces that ask for a specific government license in order to be an interior decorator, or even a florist. According to critics, these restrictions are useless, and only result in limiting the entry of new companies.

Natural barriers to entry

Depending on the statistics of the industry, the barriers to entry can occur in a natural manner. Such barriers including loyalty of customers towards a specific brand and an established brand image affect the entry of new competition in the industry. Brands like Jell-O have created such strong brand names in these years that their brand names represent the nature of products they produce.

Other barriers include higher costs associated with consumers switching from their brands. Here, new companies face problems to tempt and influence potential buyers to spend more money in order to go for a switch.

Industry-specific barriers to entry

Barriers to entry are specific to an industry based on the level of operations carried out by the business, and the authority of dominant officials.

Pharmaceutical Industry

The FDA allows a firm to manufacture and sell even the most basic pharmaceutical drug in the U.S. As per the 2006 stats, the average processing time for the Abbreviated New Drug Applications, or ANDAs was 17 months. Among the applications received, around 93% don’t get approved in the first round, and of these applications, 60% get rejected in the second round. Applicants need to incur huge application costs for filing the application. And while this process completes, the existing pharma companies can take advantage of duplicating the product that is in the line of review, and go for an exclusive 6-month market exclusivity patent, that results in making somebody else’s product their own, and leads to creating a short-term monopoly.

According to Forbes in 2012, it cost new companies around $1.3 billion to $4 billion to launch a new drug in the market. Considering the higher side, the costs could reach up to $12 billion. In spite of spending $100 million on 1 clinical trial, only 1 out 10 clinically tested drugs get approved by the FDA. And, even if gets approved, the average approval time for prescription is around 10 years. A firm having funds of $4 billion for drug creation and testing purposes may not see any revenues flowing for a period of 10 years.

Electronics Industry

Electronics industry dealing in consumer electronic products have barriers to entry and economies of scale. Economies of scale refers to a situation where an existing firm manages to manufacture and distribute more units of current products at lower prices because overhead costs including real estate and management, are allocated to a large size of units. A small-scale company that tries to manufacture the same number of units should ensure that overhead costs get divided comparatively by less number of units.

International companies like Apple make strategies of switching costs in order to sustain their customers in the long-run. Such strategies can involve contracts or agreements that are highly expensive, and impossible to end, or may build a software that is non-transferrable to new phones. Such contracts are usually seen in the smartphone sector where consumers may have to incur termination costs followed by the expenses related to reapplying for some other phone service provider.

Oil & Gas Industry

There are huge barriers to entry in the oil and gas sector, and they involve huge start-up costs, copyrights and patents in accordance with proprietary technology, more fixed operating costs, government and environment-based policies, etc. Owing to high start-up costs, there are very less organizations who even think of entering this industry, and this further eliminates or at least reduces the sense of competition from the beginning. In spite of having enough capital for meeting start-up costs, organizations can experience difficulty in terms of operations in the initial stage because of proprietary technology.

The presence of excessively high fixed operating expenses discourages organizations to enter the industry. Also, the domestic and global government authorities frame their own environment-based policies which they want new companies to adhere to. Such policies usually ask new companies to have adequate amount of capital, which can again be difficult for small-scale firms.

Financial Services Industry

Establishing a new financial organization can be too expensive because of more fixed costs and large sunk costs involved in the provision of wholesale financial services. This creates a barrier to entry for budding companies in terms of competition. Besides regulatory hindrances in the financial services sector, the compliance costs and litigation threats are enough from hampering new firms to launch new products, or even enter the market.

Compliance and license-based costs don’t act in favor of small organizations. A large-cap based financial institution is not required to allocate a big chunk of its funds for just ensuring that it doesn’t cause any troubles to Truth in Lending Act (TILA), Consumer Financial Protection Bureau (CFPB), Securities and Exchange Commission (SEC), Fair Debt Collection Practices Act (FDCPA), and many other laws and their institutions.

Reference for “Barriers to Entry

https://www.investopedia.com › Investing › Financial Analysis

https://en.wikipedia.org/wiki/Barriers_to_entry

https://corporatefinanceinstitute.com › Resources › Knowledge › Economics

Academics research on “Barriers to Entry

Barriers to entry, Demsetz, H. (1982). Barriers to entry. The American economic review72(1), 47-57.

A welfare analysis of barriers to entry, von Weizsacker, C. C. (1980). A welfare analysis of barriers to entry. The bell journal of economics, 399-420. It is widely believed that welfare would be improved by encouraging entry in circumstances where “barriers to entry” (in the sense of Bain) exist. Two models are developed herein which demonstrate that this view is incautious. Economies of scale and product differentiation are both held to be barriers to entry in the Bain scheme of analysis. I show that there are plausible parameter configurations for both economies of scale and goodwill (which is a variant of product differentiation) under which welfare would be improved by increasing, rather than decreasing, the protection of incumbents from the competition of entrants. Greater attention to detail in the analysis of industry circumstances and greater caution in reaching “obvious” welfare conclusions are needed.

Barriers to entry and market entry decisions in consumer and industrial goods markets, Karakaya, F., & Stahl, M. J. (1989). Barriers to entry and market entry decisions in consumer and industrial goods markets. Journal of marketing53(2), 80-91. The authors test six market entry barriers in consumer and industrial markets: cost advantages of incumbents, product differentiation of incumbents, capital requirements, customer switching costs, access to distribution channels, and government policy. They model market entry decisions of 137 executives in 49 major U.S. corporations with a decision-making instrument consisting of 32 market entry opportunities. Each respondent’s decisions are modeled by regression analysis. The differences in the importance of the six market entry barriers for early and late entry in consumer and industrial goods markets are investigated. The results indicate that marketing executives consider all six barriers in making market entry decisions. The cost advantages of incumbents are considered to be the most important of the market entry barriers. Major differences also are discovered among the other five barriers. Furthermore, the importance of the barriers differs between consumer and industrial goods markets.

Seller concentration, barriers to entry, and rates of return in thirty industries, 1950-1960, Mann, H. M. (1966). Seller concentration, barriers to entry, and rates of return in thirty industries, 1950-1960. The Review of Economics and Statistics, 296-307.

Economies of scale and barriers to entry, Schmalensee, R. (1981). Economies of scale and barriers to entry. Journal of political Economy89(6), 1228-1238. Dixit has recently presented a model in which established firms select capacity to discourage entry but cannot employ threats they would not rationally execute after entry. Entry deterrence in a slight modification of this model involves the classical limit-price output. Under linear or concave demand, however, the capital cost of a firm of minimum efficient scale is an upper bound on the present value of the monopoly profit stream that can be shielded from entry. It is argued that this suggests the general unimportance of entry barriers erected by scale economies.

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