Barriers to Entry

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, and so limit 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 the need for new companies to obtain licenses or regulatory clearance before operation.

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 integrity of the industry and prevent new entrants from introducing inferior products into the market.

Generally, firms favor barriers to entry in order 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 over time 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 the case of commercial airlines, not only are regulations stout, but the government limits new entrants to limit air traffic and simplifying 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, a handful of states require government licensing to become a florist or an interior decorator. 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.

Industry-Specific Barriers to Entry

Industry sectors also have their own barriers to entry that stem from the nature of the business as well as 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 a special authorization by the FDA. These Abbreviated New Drug Applications, or ANDAs, are hardly abbreviated. As of 2017, the median review time from receipt of application to approval was 37 months.

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.

On average, it takes at least $2.6 billion to bring a new drug to market. Just as significantly, it can take up to 10 years for a drug to be approved for a prescription. Even if a startup company had the $2.6 billion to develop and test the drug according to FDA rules, it still might not receive revenue for 10 years. The FDA usually approves about one in 10 clinically tested drugs.

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 a large number of 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 to produce.

Established electronics companies, such as Apple (AAPL), may strategically build in 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 closely comply 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 that have 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.

What Are Some Barriers to Entry?

The most obvious barriers to entry are high start-up costs and regulatory hurdles which include 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 barrier 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.