What are Barriers to Entry?
Barriers to Entry deter new entrants from entering a market and protect the profits of existing incumbents.
The existence of barriers to entry within a particular industry causes the market to become less attractive and reduces competition.
Barriers to Entry Definition in Economics (High vs. Low)
In economics, the term “barriers to entry” describes the factors that prevent outside parties from entering a given market.
Generally speaking, the higher the barriers to entry, the more limited the competition within an industry would be – all else being equal.
From the perspective of industry incumbents, the barriers are obstacles that protect their existing market share from new entrants, resulting in fewer competitors and thus higher prices for consumers.
- High Barriers to Entry → High Difficulty in Market Entrance (Low Competition)
- Low Barriers to Entry → Low Difficulty in Market Entrance (High Competition)
In theory, long-term profits can be sustained only with barriers to entry in place to protect existing incumbents.
On the other side, new entrants view those barriers as the obstacles needed to be successfully overcome in order to have a chance at obtaining market share.
In order to disrupt an industry with high barriers in place, potential new entrants – most often startups or companies attempting to expand their reach into different end markets – are taking on more risk.
Markets with low barriers to entry are thus prone to more disruption and viewed as attractive industries to startups (and existing companies are placed in a vulnerable position).
Types of Barriers to Entry: Market Examples
There are various types of barriers to entry, but some common examples are as follows:
- Network Effects → Network effects refer to the incremental benefits derived from a higher number of users joining a platform, wherein once the platform has attained an inflection point in user count and product adoption, taking market share becomes very challenging for new entrants.
- Economies of Scale → The economies of scale concept refers to the cost structure benefits from the increased scale of operations, i.e. the unit costs of a product decline with greater volume output. Since new entrants must compete with companies already benefiting from scale, there is effectively a barrier to entry that deters competition as new entrants come in at an immediate cost disadvantage.
- Proprietary Technology → Companies in possession of proprietary technology provide a differentiated offering that no other company in the market can sell, often due to patents and intellectual property (IP). Competition around highly technical products tends to be non-existent (or very minimal), especially in the early stages of a given industry.
- Significant Capital Expenditure Requirements → The need for substantial Capex requirements related to infrastructure, equipment, machinery, and research and development (R&D) tend to deter new entrants.
- Switching Costs → Switching costs are the burden incurred by the end customers from switching providers (i.e. sellers). The more expensive, disruptive, or inconvenient the switching costs are, the less customer churn, so the switching costs function as a barrier. In order for a new entrant to convince customers to leave their current provider, the value proposition of their product/service must be far better than the existing offerings.
- Regulatory Hurdles → The legal requirements established by the government and other regulatory bodies can often serve as barriers to entry, especially around highly-regulated areas such as the healthcare and pharmaceutical industries. For instance, the time-consuming, challenging requirements faced in the process of receiving regulatory approval to begin selling a drug could deter new entrants but benefit incumbents.
Google Search Engine Market: High Barrier Example
A real-life example of a company protected by high barriers to entry is Alphabet (NASDAQ: GOOGL).
The search engine market is highly scrutinized by regulatory bodies, particularly related to anti-trust.
The Google search engine platform is the dominant player in the market by a substantial margin, with an estimated 90%+ market share.
Google has created a durable moat over time stemming from various factors, such as the network effects where the search results received by a user are more accurate due to the accumulation of user data collection and proprietary algorithms.
In effect, Google’s continuous collection of user data causes positive feedback loops that form the basis of their network effects.
The sheer amount of historical data on hand, investments into security infrastructure and servers, and the internal development of their technologies each represent reasons that contribute to Google’s dominance over the search engine market.