Let’s suppose someone wants to start a lemonade stand. Getting one up and running would be relatively easy and within the financial reach of the majority of the population. In this case, one could say that the barriers to entry to starting a lemonade stand business are low.
On the other hand, if you wanted to start a new airline, getting one up and running would be relatively more difficult than starting a lemonade stand and outside the financial reach of the majority of the population. And say even if you had the financial resources needed to create an airline, the risk of losing the high upfront investment in case of failure would lead to caution. So, in the airline case, one could say that the barriers to entry are high.
As you might have guessed already, barriers to entry are simply obstacles that prevent newcomers from entering a market or an industry. These barriers to entry are categorized into four types: legal, technical, strategic, and brand loyalty. Let’s have a look at each of them and the sub-categories within them.
Legal Barriers to Entry
Legal Barriers to Entry are of three main types: Patents, Government Regulation & Trade Barriers.
Patents give companies an exclusive right over the production of their invention for a specified time, restricting competitors from legally entering the market.
Government Regulations such as the need for permits or licenses add an added layer of friction to entering a market or an industry.
Local governments often introduce Trade Barriers like quotas, tariffs, and trade restrictions to de-incentivize imports and boost consumption of local goods. Such trade barriers augment the barrier to entry for foreign entrants, and at times, it can also lead to fewer choices for consumers and higher prices.
Technical Barriers to Entry
Technical Barriers to Entry come in three main types: technical knowledge, sunk costs & economies of scale.
In industries like technology and science, the technical knowledge and expertise required to break in can create barriers to entry.
Sunk Costs are irrecoverable costs, leading to more risk and deterring market entry. If a new business fails, money spent on research, product development, and marketing will fall under sunk costs.
As the name suggests, Economies of Scale are how the economics change when companies operate at a huge scale. For example, large restaurants chains might negotiate better prices from suppliers than a newer, single outlet restaurant — increasing the barriers to entry for new entrants.
Strategic Barriers to Entry
Strategic Barriers to Entry come in three main types: Predatory Pricing, Vertical Integration & First Mover Advantage.
Predatory pricing is when a dominant firm sells at a loss to make competing difficult for new companies that can’t afford such losses, creating an artificial barrier to entry.
As evident from the name, a First mover advantage occurs when a company is first to market. In many cases, strong credibility established by a first-mover in a new market can be a barrier to entry for newer players.
Vertical integration refers to a strategy wherein a company takes over one more stage in the production or distribution of a product, in most cases, by acquiring other companies. Such mergers increase efficiency for the acquirer, undercutting the ability of competitors.
Brand Loyalty Barrier To Entry
Most of us would like to think that we make buying decisions rationally, but we’re less likely to seek alternatives once we’ve developed an affinity towards a brand. For example, it would be difficult for a new mobile company to get an Apple loyalist to buy from them instead of Apple. This type of consumer behavior would require, at its minimum, a considerable amount of money spent on advertising to change consumer brand preference, making it difficult for new entrants to break into the industry.
Are Barriers to entry undesirable?
There’s no blanket answer to the question of whether barriers to entry are desirable or not. In some cases, they are desirable. In other cases, they are undesirable.
You don’t want anyone to enter the food industry without passing through a strenuous check by food authorities. But you also don’t want a situation where one company captures enough of the market to become a monopoly because that would be unfavorable for customers.
So whether barriers to entry are good or bad depends on the specific situation and the type of barrier.