Today we will look at how you can use barriers to entry to reduce the threat of new entrants into your market.
The threat of new entrants is one of the forces in Michael Porter’s Five Forces model of industry analysis.
This threat applies to any business of any size, big or small.
It can be particularly damaging if your market is a fixed size and suddenly you find that you have to share it with a competitor who has decided that they see an opportunity.
A simple example is if you own the only shoe shop in a small town selling shoes and boots for men, women and children. The demand and supply balance is in your favour until another entrepreneur opens up a women’s shoe shop with the latest, fashionable designs.
Why New Entrants Will Be Attracted To A Market?
Any indication that a market is growing, that it is under-served in meeting customers specific needs or particularly profitable will trigger interest from an entrepreneur who believes that there is money to be made from taking part in your market.
Evidence that existing businesses are making good profits will persuade entrepreneurs that this as an opportunity too good to miss.
So before you order a second Porsche for your wife (or husband) and move into a ten bedroom mansion, you need to think what these signs of success are saying to potential competitors.
Barriers To Entry Make It More Difficult For New Entrants And Reduce The Threat Of Entry
To discourage new firms entering your market and competing for your customers and profits, you need to have barriers to entry in place as a defensive strategy.
Without them, potential rivals are free to entry the market whenever they want.
The Common Barriers To Entry
Common barriers to entry include:
- Entrants must make a big financial investment to buy equipment, in research and development, in stocks / inventory or to build a brand.
- Established firms have cost advantages unavailable to new entrants
- There are supply restrictions, either from incoming materials from suppliers or outgoing to customers which make it more difficult for new entrants to become established
- High customer loyalty from buyers makes it much harder for new entrants to attract customers or even low cost trials
- Legal barriers and patents
- Threat of retaliation from existing competitors
A More Detailed Look At How Barriers To Entry Can Be Used To Reduce The Threat Of New Entrants
Financial Investment As A Barrier To Entry
Some industries require a large financial investment before a new business can start which creates a financial barrier and psychological barrier to entry.
Investments may be in:
- Plant & equipment
- Lease commitments for buildings – even though the financial commitment isn’t paid upfront, landlords may want guarantees
- Research and/or development
This introduces doubt into the minds of the prospective entrepreneur and any financial backers.
Some potential competitors won’t be able to raise the funds and others won’t be prepared to risk so much on a new venture which may not succeed.
Other industries require virtually no financial investment which makes entry into those markets look very attractive for any cash-poor entrepreneur. These businesses need rely on other barriers to entry.
Cost Advantages As A Barrier To Entry
Businesses enter new markets because they expect to earn a profit – i.e. that revenues will exceed costs. If the new entrant isn’t cost competitive with existing companies, then it is clear that a profitable opportunity doesn’t exist.
Cost advantages can come from three main sources:
- Economies of scale – the bigger the business, the lower the average unit costs. For more details see economies of scale.
- The experience curve – the more you perform an activity, the more opportunity you have for finding the best ways to do it for the least cost.
- Low cost input prices, either from a favourable location e.g. a lower wage economy or long term supply contracts at very good prices.
These factors naturally favour the existing companies in the market although increased globalisation is opening up many markets to competition from the lower wage economies for the first time.
New technology can undermine the cost position of the existing competitors.
Where brand names are important, a new competitor has a major problem becoming known and accepted unless it is prepared to invest heavily in sustained advertising and/or buy market share at a low price to stimulate trial and hopefully repeat purchases.
Supply Restrictions As A Barrier To Entry
A new entrant in the market may find it difficult to buy the supplies necessary to compete (including skilled labour) or it may be that it finds that distribution channels to the customers/consumers are reluctant to add extra lines and won’t drop existing proven products from their range.
Customer Loyalty As A Barrier To Entry
Happy customers who are delighted with the service and the products from the existing companies may be very reluctant to risk buying from a new competitor.
Depending on how important the product is, even a much lower price may not compensate for the uncertainty of dealing with a new company.
It may also be difficult for customers to suddenly switch from one supplier to another because of incompatibilities. For example, it is a big decision to switch computer suppliers because of all the inconvenience and effort required.
Legal Barriers And Patents As A Barrier To Entry
New companies may have to deal with difficult legislation issues and even legislation that doesn’t affect incumbents. When I worked for a company with an iron foundry back in the early nineties, we did not have to meet environmental legislation that a new competitor would have had to comply with.
The market may also be protected through effective patents which stop a competitor bringing out a product very similar to your own.
Threat Of Retaliation From Existing Competitors As A Barrier To Entry
Any new entrant is attracted by the prospects of high profit so if existing competitors can put together a convincing threat that they will stop this happening (by cutting prices or extensive advertising), the new company will see high profit will not materialise.
But it is difficult to pull off.
Threatening retaliation against a new entrant means sacrificing the short term profitability of existing businesses so the new competitor has to be seen as a major threat which justifies the costs.
Barriers To Entry – An Effective Deterrent?
High barriers to entry are good if you are already established in a market but bad if you are investigating a market as a possible route for expansion.
The factors can change which is why it is important to keep reviewing Michael Porter’s Five Forces model and the danger is that once one entrant has succeeded, other copycats may see that entry barriers like the threat of retaliation were an illusion.
Barriers To Entry May Be Reduced From Closely Connected Industries
The other issue when assessing entry barriers is that your starting point matters.
If you already have relationships with the prospective customers, a well known brand which is portable to this new market or you have the supply capabilities, your ability to enter a new market successfully is very different from a totally new company.
Can You Increase The Barriers To Entry?
To make your industry analysis better and to protect your business from the threats of new entrants, can you find ways to move these factors in your favour?
Are you doing everything you could to capitalise on your cumulative experience so that you find better ways to provide your product or service?
Can you find ways to increase customer loyalty so that they are unlikely to be tempted away by new entrants or existing rivals?
Is your patent protection as strong as it could be?
Overcoming Barriers To Entry
The entire issue of the threat of new entrants and the issue of barriers to entry all depends on where you are coming from.
If you are already in the industry you want high barriers but if you are outside looking to get in, ideally you want low barriers for you but high barriers for every other possible entrant.
So after you have identified the potential barriers to entry for your industry, put yourself in the shoes of a new competitor eager to enter the market.
Ask yourself how you would get around the barriers.
Can you reconstruct the industry?
Traditional High Street operations like banks and insurance brokers have been disrupted by first telephone and then Internet technologies.
Amazon have done the same with books, CDs and DVDs replacing a bricks and mortar presence with a huge website with many more products and product reviews.
Can you separate out the constraining area and subcontract to take advantage of other companies’ economies of scale and learning?
Can you license trademarks, patents and products so that you collaborate with a key player and help them compete against the other competitors?
More On Industry Analysis and the Five Forces Model
My related blogs start with an introduction to industry analysis and Michael Porter Five Forces Analysis Model.
I’ll also be writing about
Your Thoughts On Barriers To Entry and the Threat of New Entrants
It will be great if you can share your thoughts and experience of barriers to entry? When have they protected your business or a business you know?
How have you managed to work around traditional barriers to entry which looked formidable?