Barriers to entry
Oligopolies and monopolies may maintain their position of dominance in a market because it is siply too costly or difficult for potential rivals to enter the market. Obstacles to entry are called barriers to entry. They can be erected deliberately by the incumbent(s) – called strategic or artificial barriers – or they can exploit barriers that naturally exist in the market, also called structural barriers.
Natural (or structural) entry barriers include:
Economies of large scale production.
If a market has significant economies of scale which have already been exploited by the incumbents, new entrants are deterred.
A network effect is the effect that multiple users have on the value of a good or service to other users. The greater the number of people using the specific good or service the greater the individuals benefit. If a strong network already exists it may limit new entrants who fail to gain sufficient numbers of users to create a positive network effect. The spread of popularity of the telephone in the 20th Century, and more recently the increased popularity of social media, are example of strong network effects.
Ownership or control of a key scarce resource.
Owning scarce resources, which other firms could use, creates a considerable barrier to entry, such as an airline controlling access to an airport.
High set-up costs.
High set-up costs deter initial market entry. Many of these costs are sunk costs. Sunk costs are those that cannot be recovered when a firm leaves a market, and include marketing and advertising costs and other fixed costs.
High R&D costs
When firms spend money on research and development (R & D), it is often a signal to potential entrants that they have large financial reserves. In order to compete, new entrants will have to match, or exceed, this level of spending in order to compete in the future. This deters entry and is widely found in oligopolistic markets such as pharmaceuticals and the chemical industry.
Artificial (or strategic) barriers include:
A firm may deliberately lower price to try to force rivals out of the market.
Limit pricing means the incumbent firm sets a low price, and a high output, so than entrants cannot make a profit at that price. This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make. The incumbent is exploiting its superior knowledge of the market, and production costs, for its own advantage.
This involves taking over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators, like the Competition Commission, may prevent this as it would reduce competition.
Switching costs are those costs incurred by a consumer when trying to switch suppliers. They can involve costs of purchasing or installing new equipment, loss of service during the switching process, and the effort involved in searching for a new supplier or learning a new system. These are common when switching energy suppliers, banks, TV and telephone suppliers. While these may also be structural in nature it is common to refer to them as strategic barriers as they are understood and exploited by suppliers.
Research by the Commission on Banking found that, in the UK people only change bank accounts once every 26 years – it was against this that in September 2013 UK banks were forced to make switching accounts much easier.
Advertising is another sunk cost – the more that is spent by incumbent firms the greater the deterrent to new entrants.
A strong brand
This creates loyalty, ‘locks in’ existing customers and deters entry.
Exclusive contracts, patents and licenses
Contracts, patents and licenses make entry difficult as they protect existing firms who have won the contract, or who own the license or hold the patent. For example, contracts between specific suppliers and retailers can exclude other retailers from entering the market.
This can ‘tie up’ the supply chain and make life difficult for potential entrants, such as a manufacturer having its own retail outlets, such as a brewer owning its own pubs.