2.4.

Barriers to Entry
 Introduction
• Barriers to entry are factors that can prevent or impede
newcomers into a market or industry sector, and so limit
competition.
• Barriers to entry are conditions that allow established
firms (incumbents firms) to earn abnormal profits
without attracting entry.
• Entry barriers are costs of producing which must be
borne by a firm which seeks to enter an industry but is
not borne by firms already in the industry
• An entry barrier is any competitive advantage that
established firms have over potential entrants
• Many of the factors that give rise to the barriers to entry
may be beyond the direct control of the incumbent firms.
• However, sometimes incumbents are able to take
steps that increase the difficulties that new entrants
will have to overcome if they are to establish
themselves on a profitable basis.
• This is the entry-deterring strategies that includes
– Limit pricing,
– Predatory pricing, and
– Brand proliferation.
 Types of Barrier to Entry
1) Economies of Scale
• Economies of scale can act as a barrier to entry in two
ways.
i. There is an entry barrier if the minimum efficient
scale (MES) is large relative to the total size of the
market. It results in natural monopoly
ii. If new firms enter the market with less than MES
output, its average cost is higher than the incumbent
firm’s average cost so it cannot compete with it
2) Absolute Cost Advantage
• An incumbent firm has an absolute cost advantage
entry barrier over an entrant if the LRAC function of
the entrant lies above that of the incumbent,
• The entrant therefore faces a higher average cost at
every level of output.
• Why an entrant may operate on a higher LRAC
function?
– An incumbent may have access to a superior
production process, hold patents, or be party to
trade secrets.
– Incumbent firms may have exclusive ownership of
factor inputs
– Incumbents may have access to cheaper sources of
finance, if they are viewed by capital markets as
less risky than new firms.
– The presence of vertically integrated incumbents
may force an entrant to operate at more than one
stage of production if it wishes to overcome the
incumbents’ absolute cost advantage.
3) Product Differentiation
• A barrier to entry exists if customers are loyal to the
established brands and reputations of incumbents.
• A successful entrant will need to persuade customers
to switch from their existing suppliers
• This might be achieved either by selling the same
product at a lower price, or launching advertising,
marketing or other promotional campaigns
• Product differentiation entry barriers include the
following:
– High advertising imposes additional costs upon
entrants.
– If entry takes place on a small scale, the entrant
will not benefit from economies of scale in
advertising.
– The funds needed to finance an advertising
campaign may incur a risk premium, as this type of
investment is highly risk
4) Switching Costs
• Switching costs are incurred when customers face
additional costs if they decide to change the supplier of
a product or service.
• Switching costs may include:
– Search costs incurred in acquiring information about
alternative products or services;
– The costs of learning how to use a different product
or service; and
– Installation or disconnection charges.
• Switching cost is also a barrier when the product is tied
to its complimentary product like printer and its ink
5) Network Externalities
• Network externalities arise when the value of a product
or service to a consumer depends upon the number of
other consumers using the same product or service
• Each consumer purchases the product or service for
their own benefit, but by doing so they
(unintentionally) create a benefit for other users who
gain extra value as the size or coverage of the network
of users increases.
• Example:
• Telephones, banks, facebook, twitter, telegram, imo etc.
6) Legal Barriers to Entry
• Legal barriers to entry are erected by governments
and enforced by law
• Examples of legal barriers include the following
– Registration, certification and licensing of
businesses and products (firms that do not meet
industry standards are not allowed)
– Monopoly rights. Monopoly rights may be granted
by legislation (eg. Franchised Ethio-telecom)
– Patents: only the one with patent rights supply
– Government policies: tariffs, tax policies and
employment laws may all impede entry, either
directly or indirectly.
7) Geographic Barriers to Entry
• Geographic barriers to entry include restrictions faced
by foreign firms attempting to trade in the domestic
market.
• Examples of geographic entry barriers include the
following:
• Physical barriers. Frontier controls and customs
formalities create administrative and storage costs,
and lead to delays in transactions being completed.
• Technical barriers: Technical barriers include
requirements to meet specific technical standards,
employment regulations, health and safety regulations
and transport regulation
• Fiscal barriers: Aspects of a country’s fiscal regime
may disadvantage foreign firms. Exchange controls
may impose costs on foreign firms that need to
convert currencies in order to trade. Tariffs, quotas or
subsidies to domestic producers may place foreign
producers at a disadvantage relative to domestic
producers.
• Preferential public procurement policies. Purchasing
policies practiced by national governments may give
preferential treatment to domestic firms, placing
foreign competitors at a disadvantage.
• Language and cultural barriers. Language or other
cultural differences between countries may also be
considered as a geographic barrier to entry
 Entry-deterring Strategies
• The barriers to entry examined above stems from
underlying product or technological characteristics,
and cannot be changed easily by incumbent firms.
• In contrast, entry-deterring strategies are barriers to
entry that are created or raised deliberately by
incumbents through their own actions.
• The entry deterring strategies include
– Limit pricing
– Predatory pricing
– Product proliferation
a) Limit pricing
• Suppose a market is currently serviced by a single
producer but entry barriers are not insurmountable.
• The incumbent therefore faces a threat of potential
entry.
• According to the theory of limit pricing, the
incumbent might attempt to prevent entry by charging
a price, known as the limit price, defined as the
highest price the incumbent believes it can charge
without inviting entry.
• The limit price is below the monopoly price, but
above the incumbent’s average cost.
• Therefore the incumbent earns an abnormal profit,
but this abnormal profit is lower than the monopoly
profit
• To pursue a limit-pricing strategy, the incumbent
must enjoy some form of cost advantage over the
potential entrants. The cost advantages are
– An absolute cost advantage or
– An economies of scale cost advantage
• It is therefore assumed that a structural barrier to
entry exists, but this barrier may be surmountable
unless the incumbent adopts a pricing strategy that
makes it unattractive for entrants to proceed.
b) Predatory pricing
• Predatory pricing strategy is cutting price in an
attempt to force a rival firm out of business.
• By doing so the incumbent firm loses
• When the rival has withdrawn, the incumbent raises
its price.
• The incumbent sacrifices profit and perhaps
sustaining losses in the short run, to earn abnormal
profit in the long run.
• Predatory pricing is a post-entry strategy.
• However, an incumbent faced with threatened entry
might attempt to ward off the threat by convincing
the potential entrant it would implement a predatory
pricing policy in the event that entry takes place
• For regulators, it is often difficult to determine
whether a specific price-cutting campaign constitutes
predatory pricing, which is likely to be unlawful
under competition legislation, or whether it
constitutes a legitimate strategy to acquire market
share that will also benefit consumers.
C) Brand proliferation
• Product proliferation (spurious product
differentiation) occurs when incumbent supply many
variations of the same products and highly advertise
it
• Brand proliferation is efforts by an incumbent firm to
crowd the market with similar brands, denying an
entrant the opportunity to establish a distinctive
identity for its own brand.
• This can be done through different color
combinations, product sizes and different product
uses.
• In some imperfectly competitive markets, however,
incumbents may employ advertising or other types of
marketing campaign to create or strengthen brand
loyalties beyond what is natural, in order to raise the
start-up costs faced by entrants.
• New entrants would incur significant sunk costs in
the form of advertising and other promotional
expenditure.
Example: Suave product proliferation