What is Barrier to Entry?
Barrier to entry is a high cost or other type of barrier that prevents a business startup from entering a market and competing with other businesses. Barriers to entry can include government regulations, the need for licenses, and having to compete with a large corporation as a small business startup.
As an example, the large company is able to produce a large amount of products efficiently and more cost-effectively than a company with fewer resources. They have lower costs because they are able to purchase materials in bulk, and they have lower overhead because they are able to produce more under one roof. The smaller company would simply have a hard time keeping up with that, which can result in them avoiding entering the market altogether.
Barriers to entry can have a negative effect on prices since the playing field is not level and competition is restricted. It’s not really an ideal situation for anyone except the large company that holds the monopoly. However, barriers to entry are not always completely prohibitive. In fact, many business startups encounter some sort of barrier to entry that they must overcome, whether that’s initial investments, acquiring licenses, or obtaining a patent – it’s just part of doing business.
Sources of Barriers to Entry
Barriers to entry come from seven sources:
- Economies of scale: the decline in the cost of operations due to higher production volume
- Product differentiation: the brand strength of the product as a result of effective communication of its benefits to the target market
- Capital requirements: financial resources required for operating the business
- Switching costs: one-time costs the buyer must incur for making the switch to a different product
- Access to distribution channels: does one business control all of them, or are they open?
- Cost disadvantages independent of scale: when a company has advantages that cannot be replicated by the competition, such as proprietary technology
- Government policy: controls the government has placed on the market, such as licensing requirements
Building Barriers to Entry
Some businesses want there to be high barriers to entry in their market because they want to limit competition or hold on to their place at the top. Therefore, they will try to maintain their competitive advantage any way they can, which can make entry even more difficult for new businesses. They might do something like spend an excessive amount of money on advertising (in other words, on product differentiation), because they have it and they can, and any new entrant would not be able to do that, giving them a significant disadvantage.
When starting a business, evaluating all potential barriers to entry is a crucial step in deciding whether or not to enter a chosen market.