What Are Barriers to Entry?
Barriers to entry is an economics and business term describing factors that can prevent or impede newcomers into a market or industry sector limiting competition. These can include high start-up costs, regulatory hurdles, or other obstacles that prevent new competitors from easily entering a business sector. Barriers to entry benefit existing firms because they protect their market share and ability to generate revenues and profits.
Common barriers to entry include special tax benefits to existing firms, patent protections, strong brand identity, customer loyalty, and high customer switching costs. Other barriers include requiring new companies to obtain licenses or regulatory clearance before operation.
KEY TAKEAWAYS
- Barriers to entry describe the high start-up costs or other obstacles that prevent new competitors from easily entering an industry or area of business.
- Barriers to entry benefit incumbent firms because they protect their revenues and profits and prevent others from stealing market share.
- Barriers to entry may be caused naturally, by government intervention, or through pressure from existing firms.
- Each industry has its own specific set of barriers to entry that startups must contend with.
- Barriers to entry may be financial (high cost to enter a market), regulatory (laws restricting trade), or operational (trying to attract loyal customers or inaccessibility of trade channels).
Understanding Barriers to Entry
Some barriers to entry exist because of government intervention, while others occur naturally within a free market. Often, companies lobby the government to erect new barriers to entry. Ostensibly, this is done to protect the industry’s integrity and prevent new entrants from introducing inferior products into the market.
Generally, firms favor barriers to entry to limit competition and claim a larger market share when they are already comfortably ensconced in an industry. Other barriers to entry occur naturally, often evolving as certain industry players establish dominance. Barriers to entry are often classified as primary or ancillary.
A primary barrier to entry presents as a barrier alone (e.g., steep startup costs). An ancillary barrier is not a barrier in and of itself. Rather, combined with other barriers, it weakens the potential firm’s ability to enter the industry. In other words, it reinforces other barriers.
Barriers to entry may be natural (high startup costs to drill a new oil well), created by governments (licensing fees or patents stand in the way), or by other firms (monopolists can buy or compete away startups).
Government Barriers to Entry
Industries heavily regulated by the government are usually the most difficult to penetrate. Examples include commercial airlines, defense contractors, and cable companies. The government creates formidable barriers to entry for varying reasons. In commercial airlines’ case, regulations are stout, and the government limits new entrants to limit air traffic and simplify monitoring. Cable companies are heavily regulated and limited because their infrastructure requires extensive public land use.
Sometimes, the government imposes barriers to entry not by necessity but because of lobbying pressure from existing firms. For example, one state requires government licensing to become a florist, and four states require government licensing to become an interior designer. Critics assert that regulations on such industries are needless, accomplishing nothing but limiting competition and stifling entrepreneurship.
Natural Barriers to Entry
Barriers to entry can also form naturally as the dynamics of an industry take shape. Brand identity and customer loyalty serve as barriers to entry for potential entrants. Certain brands, such as Kleenex and Jell-O, have identities so strong that their brand names are synonymous with the types of products they manufacture.
High consumer switching costs are barriers to entry as new entrants face difficulty enticing prospective customers to pay the additional money required to make a change/switch.
Barriers to entry may also be referred to as barriers to competition, entry barriers, or market entry barriers.
Industry-Specific Barriers to Entry
Industry sectors also have barriers to entry that stem from the nature of the business and the position of powerful incumbents.
Pharmaceutical Industry
Before any company can make and market even a generic pharmaceutical drug in the United States, it must be granted special authorization by the FDA. The FDA cites that even the most important drugs for general public health may take up to six months to approve. Although the standard review timeline is around 10 months, more complex drugs or applications may be required to enter this review cycle multiple times due to revisions.
Moreover, just 18% of applications are approved in the first cycle. Each application is incredibly political and even more expensive. In the meantime, established pharmaceutical companies can replicate the product awaiting review and then file a special 180-day market exclusivity patent, which essentially steals the product and creates a temporary monopoly.
It may take billions of dollars to bring a drug to market. Equally as important, it can take up to 10 years for a drug to be approved for a prescription. Even if a startup company had the capital to develop and test the drug according to FDA rules, it might still not receive revenue for 10 years.10 Last, ultimate success is far from guaranteed. From 2011 to 2020, the likelihood of approval for development candidates for just Phase I was 7.9%.
Electronics Industry
Consumer electronics with mass popularity are more susceptible to economies of scale and scope as barriers. Economies of scale mean that an established company can easily produce and distribute a few more units of existing products cheaply because overhead costs, such as management and real estate, are spread over many units. A small firm attempting to produce these same few units must divide overhead costs by its relatively small number of units, making each unit very costly.
Established electronics companies like Apple (AAPL) may strategically increase switching costs to retain customers. These strategies may include contracts that are costly and complicated to terminate or software and data storage that cannot be transferred to new electronic devices. This is prevalent in the smartphone industry, wherein consumers may pay termination fees and face the cost of reacquiring applications when they consider switching phone service providers.
Oil and Gas Industry
The barriers to entry in the oil and gas sector are extremely strong and include high resource ownership, high startup costs, patents and copyrights in association with proprietary technology, government and environmental regulations, and high fixed operating costs. High startup costs mean that very few companies even attempt to enter the sector. This lowers potential competition from the start. In addition, proprietary technology forces even those with high startup capital to face an immediate operating disadvantage upon entering the sector.
High fixed operating costs make companies with startup capital wary of entering the sector. Local and foreign governments also force companies within the industry to comply closely with environmental regulations. These regulations often require capital to comply, forcing smaller companies out of the sector.
Financial Services Industry
It is generally very expensive to establish a new financial services company. High fixed costs and large sunk costs in the production of wholesale financial services make it difficult for startups to compete with large firms with scale efficiencies. Regulatory barriers exist between commercial banks, investment banks, and other institutions, and, in many cases, the costs of compliance and threat of litigation are sufficient to deter new products or firms from entering the market.
Compliance and licensure costs are disproportionately damaging to smaller firms. A large-cap financial services provider does not have to allocate as large of a percentage of its resources to ensure it does not run into trouble with the Securities and Exchange Commission (SEC), Truth in Lending Act (TILA), Fair Debt Collection Practices Act (FDCPA), Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), or a host of other agencies and laws.
Fair Trade Commission. “Fair Debt Collection Practices Act.”
How to Overcome Barriers to Entry
Companies deploy several strategies to avoid or overcome barriers to entry. Here are some common barriers and potential solutions to address them.
Trade and Economic Barriers
If governments are employing trade sanctions, it may be more difficult to import or export goods concerning that country. Companies may seek different markets to work with or seek which products are specifically excluded from trade sanctions. If all else fails, a company may delay the timing of transacting with the country with the sanction, as many government sanctions are temporary.
Tariffs and Tax Barriers
Companies may pre-emptively decide to burden the consumer with additional barrier charges such as import tariffs or taxes. Companies may also seek ways to avoid taxes, such as partnering with local organizations to manufacture goods or develop value-added activities in the local market so the imported goods are assessed at a lower value (and assessed lower fees).
Information Barriers
A company seeking to join or create a brand new market may not have enough information needed to feel it may be successful. It may be best for the company to develop a minimum viable product for market research for these types of barriers. This test product may be used to elicit consumer feedback and shape financial planning expectations.
A company may also consider acquiring an existing company within the market it seeks to join. Not only will this company have already overcome some if not all aspects of the barriers to entry, but the company may have knowledge and information useful to the long-term success of the company.
Market Dominance Barriers
In some cases, the market leader position is so advanced, it’d nearly impossible they’ll be caught in the short-term. For these barriers, companies may consider using a disruptive pricing model and even incurring a short-term loss to steal long-term customers. A company may also set different objectives such as “be the lowest cost producer”.
Cost Barriers
Though many costs likely can’t be overcome, a company may consider using open-source software instead of custom, proprietary software to cut costs. The company may seek short-term leases instead of capital investments for equipment to gauge financial success in the near term. The company may also choose only to manufacture on-demand or in order to avoid over-committing resources that could have been used elsewhere.
What Are Some Barriers to Entry?
The most obvious barriers to entry are high start-up costs and regulatory hurdles, including the need for new companies to obtain licenses or regulatory clearance before operation. Also, industries heavily regulated by the government are usually the most difficult to penetrate. Other forms of barriers to entry that prevent new competitors from easily entering a business sector include special tax benefits to existing firms, patent protections, strong brand identity, customer loyalty, and high customer switching costs.
Why Would a Government Create a Barrier to Entry?
Governments create barriers to entry for varying reasons. In some cases, such as consumer protection laws, these barriers are intended to protect public safety but have the unintended effect of favoring incumbent businesses. In other cases, such as broadcasting licenses or commercial airlines, the barriers are due to the inherent scarcity of the public resources needed by these industries. In some cases, the government may impose barriers to entry explicitly to protect favored industries.
What Are Natural Barriers to Entry?
Barriers to entry can also form naturally as the dynamics of an industry take shape. Brand identity and customer loyalty serve as barriers to entry for potential entrants. Certain brands, such as Kleenex and Jell-O, have identities so strong that their brand names are synonymous with the types of products they manufacture. High consumer switching costs are barriers to entry as new entrants face difficulty enticing prospective customers to pay the additional money required to make a change/switch.
Which Industries Have High Barriers to Entry?
Industries requiring heavy regulation or high upfront capital often have the highest barriers to entry. Telecommunications, transport (i.e., car or airplane), casinos, parcel delivery services, pharmaceuticals, electronics, oil and gas, and financial services often require substantial initial investments. Each industry is also heavily regulated or requires substantial oversight from governing bodies.
The Bottom Line
Many aspects of many industries prevent companies from entering into a market. These barriers to entry may be set by government policy, created due to high financial costs, or occur naturally due to the industry itself. For companies already within the industry, barriers to entry protect against competition, easily stealing market share. For companies seeking entry, it’ll be a larger hurdle trying to overcome the hurdles preventing easy access into an industry.