Barriers to entry are those aspects of an industry that make it harder for new companies to enter the industry profitably. Typical barriers to entry include brands, patents, large assets required to achieve economies of scale, regulation, network effects, control of scarce resources. Economic theory states that without any barriers to entry, businesses cannot earn sustainable profit beyond their cost of capital, because new entrants will be attracted in and compete those profits down to cost of capital. The stronger the barriers, the higher the economic rent/profit potential.
Barriers to entry feature prominently in Porters industry analysis, as one of the key determinants of industry profitability alongside competitive behaviour and supplier/customer balance of power.
When is it useful?
When you are crafting your strategy, ask yourself “How will my strategy build barriers to entry in my markets?” For example, Coca Cola have created a huge barrier to entry in the carbonated cola market through their cumulative advertising spend over a hundred years. Warren Buffet describes this as a deep moat around the business:
“If you gave me $100 billion and said, ‘Take away the soft-drink leadership of Coca-Cola in the world,’ I’d give it back to you and say it can’t be done.”
This concept is critical when you are entering new markets. “How are you going to overcome barriers to entry?”. For example, attacking Coca Cola head-on with massive advertising expenditure in the carbonated drinks market makes little sense. Red Bull bypassed this barrier to entry with an on-premise, viral and trendy marketing approach.
There are many different types of barrier to entry:
Brands: To enter the carbonated beverage market it would take you billions of dollars and many years to build a brand
Patents: If you want to enter the pharmaceutical industry, you will either need to spend millions and years on your own R&D, or license patents from an incumbent
Distribution Networks: McDonalds has taken decades building its distribution network until much of the world is within lunch distance from a store.
Know-how/Talent: Creating a hit movie requires many things to go right. Even if you throw money at it, you are not quaranteed a result (e.g. John Carter of Mars)
Capital investment If you want to compete with Intel in manufacturing the next generation of microprocessors, you will need to match the cost of its factory in Chandler, a cool $4 billion
Licences: If you would like to enter the Chinese mobile telecoms market….hard luck. There are only 3 licences and they are not for sale or rent.
Installed Base: If you want to enter the printer market, it will take you many years selling loss-leading printers while your profitable cartridge consumables business only rises slowly.
How do you do the analysis?
In order to identify barriers to entry, put yourself in the shoes of a new start-up that wants to enter the market. What will they have to do in order to enter successfully?
When you have mapped out all these steps, identify which ones are going to be the most challenging – because of the cost involved, the time that it will take or the scarce skills that are required.
Beware – disruptive business models may allow entry into an industry bypassing the barriers to entry you have identified. Barriers to entry are like fixed defences. They are most important to think about in stable industries, like FMCG or basic materials. When industries are going through inflection points, or in the most innovative industries, they can be as useful as the Maginot Line in 1940.
I want to know more
Every strategy textbook will have a section on barriers to entry
For wikipedia look here