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Barriers to Entry

 

Disciplines > MarketingUnderstanding Markets > Barriers to Entry

Economies of scale | Product differentiation | Capital requirements | Cost disadvantages | Distribution channels | Government policy | Demand-side benefits | Switching costs | Retaliation | Discussion | See also

 

Entering an existing market is not always easy as there may be significant barriers that can make it more difficult for new competitors to set up and sell into the market.

Porter (1979) describes six major sources of entry barrier:

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

Porter (2008) adds:

  • Demand-side benefits
  • Customer switching costs
  • Expected retaliation

Economies of scale

As a company grows, not all costs increase with it, and some may even go down. Incumbent companies who have economies of scale can hence have a significant cost advantage over new entrants and smaller competitors.

Economies of scale can be demand-side or supply-side and may be found in the cost of:

  • Original research
  • Raw materials
  • Manufacturing and production
  • Marketing to larger audiences
  • Shipments and logistics
  • Service and support
  • Attracting talented personnel

Overcoming economies of scale requires innovation and bold moves, such as devising lower-cost manufacturing methods or sourcing overseas.

In practice, economies of scale are often not as significant as they may appear, as the costs associated with their increasing complexity can significantly offset any reduction in prices paid.

Product differentiation

When a brand is well-established, it is known to many in the market, and customer loyalty is more common. This leads to lower costs and hence greater profits.

Products which are different to others stand out and are the natural choice for those customers who seek what these products offer.

With such differentiation and sufficient demand, companies have the choice of charging higher prices or increasing sales through lower prices.

Lower prices, which is also a part of how a brand is differentiated, acts as a significant barrier. If you cannot make a product that is any better than one which is currently sold for the price that it is sold at, then entering this market will be very difficult.

Overcoming product differentiation barriers often needs strong innovation to create products that leapfrog existing competitor offerings in terms of both functionality and cost. The latter may be achieved through approaches such as parts reduction and assembly simplification.

Capital requirements

Some industries require significant investment in setting up and operating. Manufacturing, for example, can require large factories and specialist machines. Service also can be costly to set up, for example where a large number of service personnel needs to be recruited, trained and equipped.

High capital costs are typical when setting up for the first time. There may also be ongoing capital investments required, for example to cope with rapid changes in technology. Other capital costs include parts inventories, customer credit, and various other start-up losses.

Big and cash-rich companies are able to make a large capital investment required, or may be able to raise the funds elsewhere. Even so, this may require careful analysis that could result in a non-entry decision.  For smaller companies, capital requirements can be a significant barrier.

Overcoming capital requirements may be achieved by starting small and growing organically, from profit, rather than seeking large loans. When rapid growth is essential, this is a less valid approach and collaborative options such as partnering or licensing may be preferable.

When there is rapid change in the industry, with such as the need to replace out of date machinery, and incumbents are slow to made needed investments, then this can play to the advantage of new entrants.

Cost disadvantages

As well as capital costs there are all kinds of other types of cost that can give incumbents an advantage and new entrants a headache. These are often independent of the size of the company and can hence give smaller firms a big advantage over new-entrant large companies.

Such additional costs/advantages may include:

  • The learning/experience curve gained from trying different things in the marketplace.
  • The sheer extent of how much knowledge is required to operate in the market, and the accessibility of this.
  • Proprietary technology that cannot be copied.
  • Preferential access to limited supplies of materials and parts.
  • Assets bought when they were much cheaper.
  • Advantageous locations, from shopping mall positions to being close to customers.
  • Government subsidies and other national benefits.

Overcoming cost disadvantages depends on the size of the cost. One way to help with this is to leverage experience and benefits from an already-successful marketplace elsewhere.

Porter notes the importance of the experience curve and differentiates it from the learning curve (gaining skill through simple repetition). Where the rules of doing business are unwritten and different to other markets, then the only way to learn may be through a persistent cycle of trial and failure. Those who have made this journey may jealously guard marketing secrets to help sustain this barrier to entry.

Access to distribution channels

If you have products which you produce and distribute, and particularly if these channels are held by relatively few players, then you may have difficulty in connecting with these partners or suppliers.

It is also possible in developing economies that such channels simply do not exist or cannot be trusted to reliably and safely store and transport goods.

One way of overcoming a lack of access to distribution channels is to set up your own. This can be very expensive, but it may provide you with a period of advantage during which you can establish your market position.

Government policy

Governments in developing economies (and developed economies, for that matter) have a difficult task in both helping their own fledgling industries to develop while also encouraging foreign companies to set up locally. Inward investment helps by . creating more jobs and injecting investment into the wider economy.

As a barrier, governments may support local firms to the extent that new entrants find it much harder to find a profitable entry to the market. Local regulations may have subtle bias while other controls may blatantly limit new entrants.

Despite the need to support local firms, governments, especially in developed economies, like competition as it improves products for consumers and generally strengthens the economy.

Not all governments are uncorrupted and in some countries getting permissions is based more on bribery than law.

Governments may also be weak in some areas, for example in protection of intellectual property. In such cases companies with strong IP advantages may choose not to enter a local market where unfettered coping would be rife.

When the general law is weak, contracts may not be worth the paper they are written on when suppliers and others can ignore agreements with you at will. Again, this can make market entry more problematic.

Overcoming government blockages often needs one's own government to be involved in such as trade agreements and equalization around standards.

Demand-side benefits

Porter (2008) talks about 'demand-side benefits of scale', or 'network effects' as being where a buyer's willingness to pay increases with that of other buyers.

This is a characteristic of early adopters who tend to act as a herd. These people fear going first and being left with 'a turkey'. They also fear being left behind and when sufficient others start to buy they all pile in together and the market takes off.

Overcoming demand-side benefits of competitors can be a slow business that includes not only showing your product as superior but also promoting the stability of the firm and highlighting the popularity of the product.

Customer switching costs

When customers join a bank a lot of their transactions are automated, making it difficult to leave and join another bank. Such 'lock-in' systems make it more difficult for them to leave one supplier and move to another.

Switching costs can be financial, where moving has a distinct cost. These can also be legal, for example where a contract ties you to a fixed period.

Customers' motivation to switch can depend on a number of factors including:

  • Their dissatisfaction or frustration with the current supplier.
  • The importance of the product or service involved.
  • The financial cost of switching.
  • The time and hassle involved in switching.
  • The attractiveness of alternatives.

A way of overcoming switching costs from competitors is to do much of the work for customers, making it 'hassle-free'. Another way is by compensating them for any financial loss, although there must be a good expectation that this outlay cost will soon be recouped.

Expected retaliation

If new entrants to a marketplace are treated seriously by existing firms, they may find themselves under attack by these incumbents.

Factors that make retaliation a serious issue for market entrants include:

  • The size of competitors and their ability to attack.
  • The extent and duration of the retaliation.
  • The number of competitors who retaliate.
  • The ability of competitors to control access to resources, key suppliers and market channels.
  • Bias in governments or local bodies towards supporting existing incumbents.

Before this happens, when analyzing the market, the expected retaliation increases with:

  • The impact you will likely have on incumbents' business, for example by taking significant share in a static market.
  • The resources incumbents have that they could use to retaliate.
  • The history of retaliation by incumbents.
  • The likelihood of damaging competitive actions, including loss-making price cuts.

Discussion

Barrier generally operate on the principle of asymmetry, where different companies have different assets, capabilities, access and so on. If all companies were symmetrical, then there would be nothing to choose between them and competition would not exist. Barriers are hence essential in creating markets. There are similar considerations about symmetry in war, from which compensatory strategies may be borrowed.

Barriers become dysfunctional when they are so high that market incumbents can keep out virtually all competitors and so have an effective monopoly (only one organization serving a market) or oligopoly (only a few all-powerful companies). The result is that they have significant power over consumers (and perhaps even governments) and can charge high prices for limited-quality goods.

Depending on which side of the fence you are, this can be good or bad. When you are trading in, or creating, a market, then you need strong barriers to entry that dissuade others. If you are trying to enter, then lower barriers are better, though you still do not want many others to enter after you in a way that will end up making competition harder.

See also

Authority principle, Confusion principle, Persistence principle, Symmetry in War

 

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