What are Barriers to Entry?

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Definition:

Barriers to entry are obstacles to starting a new business, such as high start-up costs, burdensome licensing requirements, or large competitors with significant market share.

🤔 Understanding barriers to entry

Barriers to entry are things that make it difficult for a new business to enter a market successfully. These barriers can come in several forms. One natural barrier is high start-up costs, such as needing expensive equipment. Government regulations also create barriers, such as needing a special permit or license that's difficult to get. Market dynamics, such as a large corporation with a dominant market share, sometimes pose strategic barriers to entry. In general, barriers to entry protect existing businesses from competition, which increases profits for those companies already operating in a given market space.

Example

Say you wanted to open a new airline. To start, you'd need airplanes. At the cost of millions of dollars, not just anyone can afford to jump into the industry. Even if you could afford the high start-up costs, getting licenses from the federal government might be a challenge. Then, convincing passengers that you'll be a safe choice, without a reputation to back it up, might add another problematic barrier to overcome. All of these are barriers to entry that routinely keep new airlines out of the aviation industry.

Takeaway

Barriers to entry are like hurdles on a race track…

If there were no obstacles, anyone could get on the track and run as fast as they can. Putting hurdles on the track changes the nature of the race. They are a literal obstacle to jump over. Barriers to entry are a figurative obstacle to overcome. And just as some runners are much better than others at jumping over hurdles, only some companies will be able to overcome barriers to entry.
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What are barriers to entry?

Barriers to entry are obstacles that new firms must overcome to enter a market. These barriers come in several shapes and sizes, all of which present financial, logistical, or timing challenges to overcome. In general, barriers to entry reduce competition and result in higher prices for consumers.

How do barriers to entry work?

Barriers to entry work by creating obstacles, which make it hard to get a new business off the ground in a given market. Imagine you wanted to open a barbershop. You can’t just hang a sign on your front porch. The government might tell you that your home isn’t zoned for commercial use, forcing you to rent a space somewhere else. Regulators might require that you have a business license before taking money. And in most places in the United States the government will require you to obtain training and licensing before serving the public.

All of these hoops that you must jump through have their purpose. But regulations and other impediments also make the process of starting a new business more cumbersome.

What are the types of barriers to entry?

Barriers to entry can come in several forms but fall into two broad categories: structural and strategic.

Structural (aka natural) barriers

Structural barriers naturally exist in the marketplace. They aren’t put there to prevent competition. Rather, these barriers just appear in the course of doing business. Some examples include:

High start-up costs can make it challenging to enter a market. Conducting business might require extensive construction or remodeling of a building, purchasing equipment, and producing or buying inventory. The thousands, or millions, of dollars necessary to get started might be too high a bar for many would-be entrepreneurs to hurdle. Even if capital is available, the difficulty in navigating the financing can deter good business plans from becoming successful businesses.

Economies of scale is a term for the tendency of average costs to go down as a company produces more of a good. That’s almost always a result of spreading high fixed costs over more units of production or finding efficiencies that come with a larger operation. These economies of scale typically allow more established and larger corporations to offer lower prices than a smaller competitor that’s just starting out.

Permitting and licensing create another structural challenge for aspiring business owners. While policymakers intend to protect the public with government regulations, ambitious entrepreneurs can get caught in all the red tape. All the rules, restrictions, permits, and licenses can create barriers to entry that potential new entrants can't overcome. (Sometimes, it should be noted, existing players in an industry will lobby for tighter licensing or regulatory requirements as a way of choking off potential competition.)

Market saturation can also prevent a business from successfully entering a market. If a lot of companies are competing in a market, there might not be room for another player to join and make a profit.

Establishing a consumer base can be an obstacle for new entrants. Building brand recognition and building an optimal supply chain can take years. If potential customers don’t like and trust your products, it’s hard to turn a profit. Getting established is a natural barrier to entry that can take a long time to overcome.

Strategic (aka artificial) barriers

Strategic barriers are those that companies in the market deploy to prevent competitors from taking their market share. Some examples include:

Predatory pricing refers to an established business reducing its price so low that a competitor can’t earn a profit. Once the competition leaves, the incumbent company might increase its prices again.

Acquisition offers make it difficult for a new business to get set up. By buying out the potential competitor, an incumbent company can avoid reducing its prices.

Marketing is another strategy an existing firm can use to fend off competition. Assuming the new entrant doesn’t have as large a marketing budget as the incumbent, the well-known firm can often win an advertising war.

Exclusive contracts with suppliers can also make it difficult for a potential competitor to gain a foothold in a market. Imagine if the established company signed sourcing contracts with non-compete clauses. A challenger would run into a huge barrier when it tries to construct their supply chain. Licensing exclusive patent rights falls in line with this strategy.

Switching costs are one more thing that an established company can take advantage of to make it hard for a new business to break into a market. Customer loyalty programs, price match guarantees, and other schemes that make it hard for customers to leave existing companies all create strategic barriers to entry for new players.

Which industries have high barriers to entry?

Most industries have some unique set of barriers to entry, some higher than others. Sectors like oil and gas development and pharmaceuticals are incredibly expensive and very risky, making them high-barrier industries. Sectors that need large networks and colossal infrastructure costs, like passenger air travel or telecommunications, are also hard to build from the ground up.

Conversely, professional services and small restaurants typically have very low barriers to entry. An entrepreneur can often open a small business with just their expertise after filing a few pieces of paper.

What are the barriers to entry in different market structures?

Different market structures have diverse barriers to entry, which depend on the number of competitors doing business in the market.

Monopoly

At one extreme, called a monopoly, there’s only one firm selling a product. That single company has 100% of the market share and enjoys a high level of profit. Such a firm can employ strategic barriers to entry to protect its market share and its profits.

One such barrier might be an exclusive government license to provide a utility, such as a water, electricity, or natural gas, in a locality.

Monopolies typically form in industries that have high natural barriers to entry. Adding the strategic obstacles that a monopolist can deploy makes this market structure the one with the highest barriers to entry.

Oligopoly

If there are only a handful of firms operating in a market, it’s called an oligopoly. In this market structure, there are fewer barriers to entry than in a monopoly. But the obstacles are still significant. Structural hurdles generally include high start-up costs and significant economies of scale (reduced average costs with higher production levels). The oligopolists are likely to control the supply chain and may even engage in some tacit collusion (informally agreeing to reduce prices to dissuade competition).

Monopolistic Competition

Many markets operate in what’s called a monopolistic competition structure, with many companies offering slightly different products that can easily substitute for one another — such as hotels or restaurants. It’s much easier to enter a market structured as monopolistic competition. The fact that several companies are engaged in the market suggests the barriers to entry are low. And the competitive nature of the market makes it hard to drive a new competitor out of the market with price reductions.

Perfect Competition

In theory, a market could have so much competition that any business trying to sell its product for even a penny more than everyone else would lose all of its customers. This market structure of perfect competition is more theoretical than directly seen in the real-world — Although some markets might get close.

In a perfectly competitive market, there would be few to no structural barriers to entry. Businesses that operate in such a market would have no pricing power (ability to adjust prices), suggesting there couldn’t be any strategic barriers either. The only obstacle would be that economic profits (revenues above all costs, including opportunity costs) in a perfectly competitive market, are zero. So, entering a perfectly competitive market is easy, but not profitable.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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