Let’s suppose that an airline has been incurring recurring losses and wants to shut shop to avoid further losses. However, the airline owes a considerable amount of debt to its investors, using whose money the airline purchased airplanes in the first place.
Scraping the airplanes would not give enough return on their original value. Another airline looking to amp up its fleet numbers would be ideal to buy the planes. But finding such a buyer when the struggling airline is looking to exit the business would be an uphill task. If the airline doesn’t find a buyer, it would have to sell to the government.
This whole scenario, wherein the sale of airplanes, prevents the airlines from exiting the industry, can be regarded as a barrier to exit.
Just like barriers to entry are obstacles that prevent newcomers from entering a market or an industry, barriers to exit are impediments that prevent a company from exiting a market. Barriers to exit are categorized into four types: Tax and Regulatory barriers, Equipment and Labour Related exit costs, Sunk costs, and Long-term contracts.
Tax and Regulatory barriers
To incentivize companies to set up shop in their city and boost employment, governments might offer significant tax breaks. However, these same incentives can turn into penalties if the company attempts to shift operations before fulfilling the terms of the deal, creating a barrier to exit.
Similarly, industries can get caught up in exit costs like cleaning up the factory of materials that could cause environmental hazards at the site. In some cases, the expense of removing the hazardous material could outweigh the benefit of relocating operations, leading to an exit barrier.
Equipment and Labour Related exit costs
Just as we saw in the airlines’ examples at the beginning of the article, the inability to sell expensive equipment can hinder exit from the market.
In some cases, firms might be reluctant to terminate employee contracts due to labor-related exit costs like severance pay and insurance benefits.
Sunk Costs are irrecoverable costs, which can deter firms from exiting a market in the hope of a better summer down the line. Examples of sunk costs include product development costs, advertisement costs & research and development costs.
Suppose a retailer wishes to eliminate underperforming outlets in specific locations because the competition has already established a dominant presence, making the retailer’s growth unlikely. The retailer might be keen to move to a place that offers better growth potential but being locked into a long-term lease that makes it challenging to shut shop can be a barrier to exit.
If you liked reading this piece, you might also enjoy our article covering ‘Barriers to Entry and Types of Barriers to Entry.