Barriers to Entry and Exit
Revised, October 2017
A barrier to entry is something that blocks or impedes the ability of a company (competitor) to enter an industry. For example, this could be a cost that constitutes an economic barrier or a cost that comes about by something that reinforces other established barriers. In general, one can look at barriers to entry as those “costs of producing” that must be borne by a firm entering an industry, but for one reason or another, is not borne by firms already in the industry.
In general, industries that are difficult for new competitors to enter may enjoy periods of good profitability and limited rivalry among competitors. Conversely, industries that are easy to enter attract new companies into the industry during periods of profitability. For this reason, there evolves intense competition among competitors.
A barrier to exit is something that blocks or impedes the ability of a company (competitor) to leave an industry. In many cases, with more firms forced to stay in a market, or stay in a market dominated by one or a few strong producers, competition creases to a point that the profits of all firms are negatively impacted. In an ideal balanced market, all firms would sustainably benefit. In the evolution of any market, this is seldom the situation. Industries that are difficult to exit have more rivalry than industries that are easy to leave. These pressures may force mergers or acquisitions, spin-off of unprofitable divisions, or discontinuation of unprofitable product lines.
Listed below are some of the common barriers to entry and exit.
Typical Barriers to Entry
- Economies of size (economies of scale) and Network effects – The need for a large volume of production and sales to reach the cost level per unit of production for profitability is a barrier to entry or expansion within a market. The thoughtful application of modern technology, outstanding customer service, or a “really cool look” or marketing campaign, can be helpful in creating niche markets or developing a brand following in spite of inequality of scale.
- Capital intensive – The large capital investment in “facilities-per-unit-of-output” by nature limits entry to many industries; let’s face it, “if you can’t pay, you can’t play.” In this case, that translates to the reality that, almost as a rule, most start-ups underestimate the capital required to get the first production unit out the door. Larger-than-planned capital investment also may be necessary for expansion within an existing market. Funds may be required for additional storage, excess spoilage or shrinkage, dealer programs and similar promotional expenses.
- Government standards and Permitting requirements – Industries where rigid industry standards, permitting and licensing exist, may have substantial barriers to entry. This includes government or non-government restrictive practices; any 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 needed investment. For example, air-transport agreements, that make it difficult for new carriers to obtain routes. Zoning restrictions can be another barrier where certain economic activity in specified in particular land areas but excludes others, perhaps inadvertently favoring established “grandfathered” businesses, thus allowing monopoly over land and location. Unfair taxes (high taxes or tax-breaks for others) also frequently constitute barriers to competition.
- Intellectual property – Patents, trademarks, service marks, and other types of proprietary intellectual property are very effective in limiting industry entry. Patents, intended to encourage invention and new-business development, give a firm the legal right to stop other firms from producing a product for a set period, and so restrict market entry. Licenses on these patents guarantee incentive proceeds. Trademarks and service marks reward those businesses that “blazed the trail,” but also may be something of an entry barrier if the market is dominated by one or a few well-known names.
- High switching costs – This is an easily overlooked intangible yet critical issue. One that can be a make-or-break issue for many startups trying to enter established markets. The tendency for buyers of an industry’s products to be reticent about switching to a new supplier tends to limit entry. At times, it may be too difficult or expensive for customers to switch providers. Trade tariffs are a barrier that can prevent entrance into foreign markets where those nations wish to protect sensitive markets.
- Distributor agreements - Exclusive agreements with key distributors, retail chains or well-known on-line outlets can impede or prevent market participation.
- Supplier agreements - Exclusive agreements with key suppliers within the supply chain can make it difficult for other manufacturers to timely produce competitively priced product within a given industry.
- Established brand identity and market power theory of advertising – Industries dominated by branded products are difficult to enter due to the large amount of time and money required to create a competing brand of similar market stature. 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.
- Other factors – There are many, depending on the situation. These may include market uncertainty, independent-of-scale cost advantages, vertical integration (and similar control of resources), research and development costs, and predatory pricing.
Typical Barriers to Exit
- Potential upturn – “Hope springs eternal.” Weathering any economic storm requires sound forecasting and an understanding of the factors that create the ups-and-downs of the market. All businesses face economic downturn. Planning for downturns lessens the pressure to exit a market and may create an opportunity to exploit the pressure on competitors. For example, in a tight market, competitors may eliminate dealer incentives. If you planned for this situation, you may be able to launch an unmatchable dealer incentive and increase market share.
- Redundancy costs – Large number of employees, employees with high salaries, or employees contracts that incur significant cost to a point where the company is no longer profitable or has the necessary agility to compete within its market.
- Specialized skills – Highly specialized skills and market knowledge, not transferrable to other industries, are a strong impediment to leaving a particular market.
- High fixed costs – High levels of dedicated fixed costs tend to be an impediment to leaving an industry. Frequently, this is usually in the form of non-transferable fixed assets, common for companies with heavy capital-investment in specialized equipment.
- Closure costs – Faced with pay-outs or buy-outs for early contract terminations, loans, employee agreements and similar contractual penalties, a firm may find that it is preferable to stay in production, perhaps with an eye toward market upturn, developing new product lines or strategic partnerships.
If we combine entry and exit, we can predict industry rivalry, stability and profitability. As shown in Figure 1, an industry that is easy to enter but difficult to leave has intense industry rivalry and low profitability. At the first sign of excess profitability in the industry, competitors flock to the industry. However, when profitability falls, it is difficult to leave the industry so profitability remains low.
Figure 1: Industries that are easy to enter but difficult to exit.
Conversely, an industry that is difficult to enter but easy to leave is shown in Figure 2. It has limited industry rivalry and tends to have good profitability. Competitors have a difficult time entering the industry during times of good profitability. However, during period of low profitability, competitors leave the industry easily.
Figure 2: Industries that are difficult to enter and easy to exit.
Industries that are easy to enter and easy to exit are shown in Figure 3. The size and composition of the industry is fluid and changes easily. Supply responds quickly to changes in demand and prices tend to stabilize. Rivalry is moderate due to the easy flow of businesses into and out of the industry.
Figure 3: Industries that are easy to enter and easy to exit.
Industries that are difficult to enter and difficult to exit are shown in Figure 4. The size and composition of the industry is static and changes slowly. Supply changes slowly due to market signals so price responds strongly to changes in demand. The amount of rivalry can change radically due to changes in demand.
Figure 4: Industries that are difficult to enter and easy to exit.