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Q. Using suitable examples define barriers to entry.

Explain how barriers to entry affect our firm’s profits.

Before a firm can compete in a market, it has to be able to

enter it. Many markets have at least some impediments that
make it more difficult for a firm to enter a market. A debate
over how to define the term “barriers to entry” began decades
ago, however, and it has yet to be won. Some scholars have
argued, for example, that an obstacle is not an entry barrier if
incumbent firms faced it when they entered the market. Others
contend that an entry barrier is anything that hinders entry and
has the effect of reducing or limiting competition. A number of
other definitions have been proposed, but none of them has
emerged as a clear favourite. Because the debate remains
unsettled but the various definitions continue to be used as
analytical tools, the possibility of confusion – and therefore of
flawed competition policy – has lingered on for many years.

The economist Joseph Stigler defined an entry barrier as "A cost

of producing (at some or every rate of output) which must be
borne by a firm which seeks to enter an industry but is not
borne by firms already in the industry". Barriers to entry are
obstacles on the way of potential new entrant to enter the
market and compete with the incumbents. The difficulties of
entering a market can shelter the incumbents against new
entrants. Incumbents' profits are potentially higher than in a
truly competitive market, at the expenses of their suppliers and
buyers. The higher the barriers to entry, the more power in the
hand of the incumbents.

According to Ison &Wall (2007), barriers to entry are

Impediments, either legal or natural, protecting firms from
competition from potential entrants into a market. Giving the
firm the legal protection to produce a patented product for a
number of years can be a form of a barrier to entry. For
example in Zimbabwe the telecommunications industry is a
regulated industry. Post and telecommunications regulatory
authority (POTRAZ) holds the sole patent for the supply of fixed
telecommunication network. Government policy is a barrier to
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entry in this business as it would involve repealing acts of

parliament to allow new competitors.

Developing consumer loyalty by establishing branded products

can make successful entry into the market by new firms much
more expensive. This is particularly important in markets such
as cosmetics, confectionery and the motor car industry. Car
making requires high upfront capital investment in
manufacturing equipment; compliance with safety and
emission rules and regulation, access to parts suppliers,
development of a network of car dealerships, big marketing
campaign to establish a new car brand with consumers.
Willowvale Mazda Motor industries is the only remaining
established car assembly plant in Zimbabwe owing to the high
input costs which makes it prohibitive for new players to come
and invest in new business in this industry.

Heavy spending on research and development can act as a

strong deterrent to potential entrants to an industry. Clearly
much research and development spending goes on developing
new products but there are also important spill-over effects
which allow firms to improve their production processes and
reduce unit costs. This makes the existing firms more
competitive in the market and gives them a structural
advantage over potential rival firms. Mining is one such
industry where access to inputs is restricted through natural
distribution and government licenses are required. Very
specific/proprietary exploration knowledge and big investment
in machinery impedes new players to venture into the industry.
BHP for example, invested in ten years of geological feasibility
studies in the Platinum mining which makes entry into such
business capital intensive and prohibitive.

Some industries have very high start-up costs or a high ratio of

fixed to variable costs. Some of these costs might be
unrecoverable if an entrant opts to leave the market. This acts
as a disincentive to enter the industry. Sunk Costs are costs
that cannot be recovered if a businesses decides to leave an
industry. Examples include Capital inputs that are specific to a
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particular industry and which have little or no resale value;

money spent on advertising / marketing / research which
cannot be carried forward into another market or industry.
When sunk costs are high, a market becomes less contestable.
High sunk costs (including exit costs) act as a barrier to entry of
new firms (they risk making huge losses if they decide to leave
a market).

A good example of substantial sunk costs occurred in 2001

when British Telecom announced it was scrapping its loss-
making joint venture with US telecoms firm AT&T. The closure
was estimated to lead to the loss of 2,300 jobs - almost 40% of
Concert's workforce. And, it will cost BT $2bn in impairment
charges and restructuring costs, and AT&T $5.3bn.

Profits and losses signal the existence of excess supply or

demand (Mueller, 1986; Stigler, 1963).1 When firms are free to
respond to these signals, they enter and exit markets until risk
adjusted returns are equalized across markets. However,
because of entry barriers, this normalization may not obtain, at
least in the short run. For this reason, barriers to entry directly
impact a firm’s current and future profitability. Moreover, the
over-time effect of barriers to entry on profitability impacts the
assumptions incorporated into forecasting and valuation
models.

In analysing firm profitability, it is necessary to consider the

amount of risk the firm incurs. Firms undertaking greater
(lesser) amounts of risk would be expected to be compensated
with higher (lower) levels of profitability. That is, the level of
economic profitability of a firm is expected to relate to the
amount of risk incurred by the firm. Thus, convergence of
profitability to a common value would not be expected without
consideration of the level of associated risk. For this reason, it
is necessary to analyse risk-adjusted profitability. An example
of Econet’s massive investment in the 3G technology is a case
of a business which takes high risk investments to maximise
profits.

Economies of scale: Increasing gross profit margin (GPM)

captures either an increase in sales while holding costs
constant, or a decrease in costs while holding sales constant,
either of which would be symptomatic of increased economies
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of scale. Gross profit margin is expected to have a positive

effect on profitability. Oster (1990) points out that economies of
scale can arise from
efficient use of assets or from specialization of labour. As such,
this variable will capture economies of scale incremental to the
level of capital intensity.

Product Differentiation: Product differentiation is the ability of a

firm to establish brand identification that represents a barrier to
new entrants. If a firm with a differentiated product can
continually earn above-normal profits, it must be that other
firms are prevented from developing a close substitute to
eliminate the profit advantage of the differentiating firm (Caves
and Porter, 1977; Mueller, 1986). Profitability should be
positively related to product differentiation. Take for example
the soft drink producer Coca-cola bottling company, it has
established the brand to an extent that new players find it
difficult to make another product that could be equated to
Coke. Although Waring (1996) reports that advertising
intensity, as a proxy for product differentiation, is insignificant
for explaining industry-adjusted persistence of profitability, it
may explain profitability at the firm level after consideration of
operational risk.

The advertising intensity ratio is measured as advertising

expense divided by net sales. Firms that spend more on
innovation through research and development (R&D) and
patents should have higher future profitability if they are
positive net present value projects; that is, there exists a
positive probability that those expenditures will be incorporated
into future products or services at a price that exceeds their
development cost.

Innovation is used to capture the degree of a firm’s proprietary

technology and is measured as the sum of R&D expense and
patent amortization expense divided by net sales. Waring
(1996) reports that R&D intensity is positively associated with
industry-adjusted persistence of profitability.
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References

Caves, R. E. and M. E. Porter 1977. From entry barriers to

mobility barriers: Conjectural decisions and contrived
deterrence to new competition. Quarterly Journal of Economics
91: 241-62.

Ison, S. & Wall, S. 2007. Economics (4th Ed). Essex: Pearson

Education

Mueller, D. C. 1986. Profits in the Long Run. Cambridge, MA:

Cambridge University Press.

Oster, S. 1990. Modern Competitive Analysis. New York, NY:

Oxford University Press.

Porter, M. E. 1980. Competitive Strategy: Techniques for

Analyzing Industries and Competitors. New York, NY: The Free
Press.
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Stigler, G. 1963. Capital and Rates of Return in Manufacturing

Industries. Princeton, NJ: Princeton University Press.

Waring, G. F. 1996. Industry differences in the persistence of

firm-specific returns. American Economic Review 86: 1253-
1265.