Why would a government be willing to erect barriers to firms entering an industry?

Obstacles to entering a specific market

What are Barriers to Entry?

Barriers to entry are the obstacles or hindrances that make it difficult for new companies to enter a given market. These may include technology challenges, government regulations, patents, start-up costs, or education and licensing requirements.

American economist Joe S. Bain gave the definition of barriers to entry as “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 entrants to enter the industry.” Another American economist, George J. Stigler, defined a barrier to entry 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.”

A primary barrier to entry is the cost that constitutes an economic barrier to entry on its own. An ancillary barrier to entry refers to the cost that does not include a barrier to entry by itself but reinforces other barriers to entry if they are present.

An antitrust barrier to entry is the cost that delays entry and thereby reduces social welfare relative to immediate and costly entry. All barriers to entry are antitrust barriers to entry, but the converse is not true.

Types of Barriers to Entry

There are two types of barriers:

1. Natural (Structural) Barriers to Entry

• Economies of scale: If a market has significant economies of scale that have already been exploited by the existing firms to a large extent, new entrants are deterred.
• Network effect: This refers to the effect that multiple users have on the value of a product or service to other users. If a strong network already exists, it might limit the chances of new entrants to gain a sufficient number of users.
• High research and development costs: When firms spend huge amounts on research and development, it is often a signal to the new entrants that they have large financial reserves. In order to compete, new entrants would also have to match or exceed this level of spending.
• High set-up costs: Many of these costs are sunk costs that cannot be recovered when a firm leaves a market, such as advertising and marketing costs and other fixed costs.
• Ownership of key resources or raw material: Having control over scarce resources, which other firms could have used, creates a very strong barrier to entry.

2. Artificial (Strategic) Barriers to Entry

• Predatory pricing, as well as an acquisition: A firm may deliberately lower prices to force rivals out of the market. Also, firms might take over a potential rival by purchasing sufficient shares to gain a controlling interest.
• Limit pricing: When existing firms set a low price and a high output so that potential entrants cannot make a profit at that price.
• Advertising: These are sunk costs. The higher the amount spent by incumbent firms, the greater the deterrent to new entrants.
• Brand: A strong brand value creates loyalty of customers and, hence, discourages new firms.
• Contracts, patents, and licenses: It becomes difficult for new firms to enter the market when the existing firms own licenses, patents, or exclusivity contracts.
• Loyalty schemes: Special schemes and services help oligopolists retain customer loyalty and discourage new entrants who wish to gain market share.
• Switching costs: These are the costs incurred by a customer when trying to switch suppliers. It involves the cost of purchasing or installing new equipment, loss of service during the period of change, the efforts involved in searching for a new supplier or learning a new system. These are exploited by suppliers to a large extent in order to discourage potential entrants.

Barriers to Entry in Different Market Structures

Conclusion

Barriers to entry generally operate on the principle of asymmetry, where different firms have different strategies, assets, capabilities, access, etc. Barriers become dysfunctional when they are so high that incumbents can keep out virtually all competitors, giving rise to monopoly or oligopoly.

More Resources

Thank you for reading this guide on obstacles to entering a specific market. To continue learning and advancing your career as a certified financial modeling analyst, these additional CFI resources will be helpful:

• Market Economy
• Monopoly
• Law of Supply
• Economies of Scale