In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a cost that must be incurred by a new entrant into a market that incumbents do not have or have not had to incur.
Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies or give companies market power.
Various conflicting definitions of "barrier to entry" have been put forth since the 1950s, and there has been no clear consensus on which definition should be used. This has caused considerable confusion and likely flawed policy.
McAfee, Mialon, and Williams list 7 common definitions in economic literature in chronological order including:
In 1956, Joe S. Bain used the definition "an advantage of established sellers in an industry over potential entrant sellers, which is reflected in the extent to which established sellers can persistently raise their prices above competitive levels without attracting new firms to enter the industry." McAfee et al. criticized this as being tautological by putting the "consequences of the definition into the definition itself."
In 1968, George Stigler defined an entry barrier as "A cost of producing that must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry." McAfee et al. criticized the phrase "is not borne" as being confusing and incomplete by implying that only current costs need be considered.
In 1979, Franklin M. Fisher gave the definition "anything that prevents entry when entry is socially beneficial." McAfee et al. criticized this along the same lines as Bain's definition.
In 1994, Dennis Carlton and Jeffrey Perloff gave the definition, "anything that prevents an entrepreneur from instantaneously creating a new firm in a market." Carlton and Perloff then dismiss their own definition as impractical and instead use their own definition of a "long-term barrier to entry" which is defined very closely to the definition in the introduction.
Primary and ancillary barriers to entry
A primary barrier to entry is a cost that constitutes an economic barrier to entry on its own. An ancillary barrier to entry is a cost that does not constitute a barrier to entry by itself, but reinforces other barriers to entry if they are present.
Antitrust barriers to entry
An antitrust barrier to entry is "a cost that delays entry and thereby reduces social welfare relative to immediate but equally costly entry". This contrasts with the concept of economic barrier to entry defined above, as it can delay entry into a market but does not result in any cost-advantage to incumbents in the market. All economic barriers to entry are antitrust barriers to entry, but the converse is not true.
The following examples fit all the common definitions of primary economic barriers to entry.
- Distributor agreements - Exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry.
- Intellectual property - Potential entrant requires access to equally efficient production technology as the combatant monopolist in order to freely enter a market. Patents give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and servicemarks may represent a kind of entry barrier for a particular product or service if the market is dominated by one or a few well-known names.
- Restrictive practices, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports.
- Supplier agreements - Exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter an industry.
- Switching barriers - At times, it may be difficult or expensive for customers to switch providers
- Tariffs - Taxes on imports prevent foreign firms from entering into domestic markets.
- Taxes - Smaller companies typical fund expansions out of retained profits so high tax rates hinder their growth and ability to compete with existing firms. Larger firms may be better able to avoid high taxes through either loopholes written into law favoring large companies or by using their larger tax accounting staffs to better avoid high taxes.
- Zoning - Government allows certain economic activity in specified land areas but excludes others, allowing monopoly over the land needed.
The following examples are sometimes cited as barriers to entry, but don't fit all the commonly cited definitions of a barrier to entry. Many of these fit the definition of antitrust barriers to entry or ancillary economic barriers to entry.
- Economies of scale - Cost advantages raise the stakes in a market, which can deter and delay entrants into the market. This makes scale economies an antitrust barrier to entry, but they can also be ancillary. Cost advantages can sometimes be quickly reversed by advances in technology. For example, the development of personal computers has allowed small companies to make use of database and communications technology which was once extremely expensive and only available to large corporations.
- Network effect - When a good or service has a value that increases on average for every additional customer, this exerts a similar antitrust and ancillary barrier to that of economies of scale.
- Government regulations - A rule of order having the force of law, prescribed by a superior or competent authority, relating to the actions of those under the authority's control. Requirements for licenses and permits may raise the investment needed to enter a market, creating an antitrust barrier to entry.
- Advertising - Incumbent firms can seek to make it difficult for new competitors by spending heavily on advertising that new firms would find more difficult to afford or unable to staff and or undertake. This is known as the market power theory of advertising. Here, established firms' use of advertising creates a consumer perceived difference in its brand from other brands to a degree that consumers see its brand as a slightly different product. Since the brand is seen as a slightly different product, products from existing or potential competitors cannot be perfectly substituted in place of the established firm's brand. This makes it hard for new competitors to gain consumer acceptance.
- Capital - Any investment into equipment, building, and raw materials are ancillary barriers, especially including sunk costs.
- Uncertainty - When a market actor has various options with overlapping possible profits, choosing any one of them has an opportunity cost. This cost might be reduced by waiting until conditions are clearer, which can result in an ancillary antitrust barrier.
- Cost advantages independent of scale - Proprietary technology, know-how, favorable access to raw materials, favorable geographic locations, learning curve cost advantages.
- Vertical integration - A firm's coverage of more than one level of production, while pursuing practices which favor its own operations at each level, is often cited as an entry barrier as it requires competitors producing it at different steps to enter the market at once.
- Research and development - Some products, such as microprocessors, require a large upfront investment in technology which will deter potential entrants.
- Customer loyalty - Large incumbent firms may have existing customers loyal to established products. The presence of established strong brands within a market can be a barrier to entry in this case.
- Control of resources - If a single firm has control of a resource essential for a certain industry, then other firms are unable to compete in the industry.
- Inelastic demand - One strategy to penetrate a market is to sell at a lower price than the incumbents. This is ineffective with price-insensitive consumers.
- Predatory pricing - The practice of a dominant firm selling at a loss to make competition more difficult for new firms that cannot suffer such losses, as a large dominant firm with large lines of credit or cash reserves can. It is illegal in most places; however, it is difficult to prove. See antitrust. In the context of international trade, such practices are often called dumping.
- Occupational licensing - Examples include educational, licensing, and quota limits on the number of people who can enter a certain profession.
Classification and examples
Michael Porter classifies the markets into four general cases :
These markets combine the attributes:
- Markets with high entry barriers have few players and thus high profit margins.
- Markets with low entry barriers have lots of players and thus low profit margins.
- Markets with high exit barriers are unstable and not self-regulated, so the profit margins fluctuate very much over time.
- Markets with a low exit barrier are stable and self-regulated, so the profit margins do not fluctuate much over time.
The higher the barriers to entry and exit, the more prone a market tends to be a natural monopoly. The reverse is also true. The lower the barriers, the more likely the market will become perfect competition.
- Perfect competition: Zero barriers to entry.
- Monopolistic competition: Medium barriers to entry.
- Oligopoly: High barriers to entry.
- Monopoly: Very High to Absolute barriers to entry.