New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. Prices can be bid down or incumbents’ costs inflated as a result, reducing profitabili–ty. Companies diversifying through acquisition into the industry from other markets often use their resources to cause a shake-up, as Philip Morris did with Miller beer. Thus acquisition into an industry with intent to build market position should probably be viewed as entry even though no entirely new entity is created.
The threat of entry into an industry depends on the barriers to entry that are present, coupled with the reaction from existing com-petitors that the entrant can expect. If barriers are high and/or the newcomer can expect sharp retaliation from entrenched competitors, the threat of entry is low.
1. BARRIERS TO ENTRY
There are six major sources of barriers to entry:
Economies of Scale. Economies of scale refer to declines in unit costs of a product (or operation or function that goes into pro-ducing a product) as the absolute volume per period increases. Econ-omies of scale deter entry by forcing the entrant to come in at large scale and risk strong reaction from existing firms or come in at a small scale and accept a cost disadvantage, both undesirable op-tions. Scale economies can be present in nearly every function of a business, including manufacturing, purchasing, research and devel–opment, marketing, service network, sales force utilization, and dis-tribution. For example, scale economies in production, research, marketing, and service are probably the key barriers to entry in the mainframe computer industry, as Xerox and General Electric sadly discovered.
Scale economies may relate to an entire functional area, as in the case of a sales force, or they may stem from particular opera-tions or activities that are part of a functional area. For example, in the manufacture of television sets, economies of scale are large in color tube production, and they are less significant in cabinetmaking and set assembly. It is important to examine each component of costs separately for its particular relationship between unit cost and scale.
Units of multibusiness firms may be able to reap economies similar to those of scale if they are able to share operations or func-tions subject to economies of scale with other businesses in the com-pany. For example, the multibusiness company may manufacture small electric motors, which are then used in producing industrial fans, hairdryers, and cooling systems for electronic equipment. If economies of scale in motor manufacturing extend beyond the num-ber of motors needed in any one market, the multibusiness firm di-versified in this way will reap economies in motor manufacturing that exceed those available if it only manufactured motors for use in, say, hairdryers. Thus related diversification around common opera-tions or functions can remove volume constraints imposed by the size of a given industry.2 The prospective entrant is forced to be di-versified or face a cost disadvantage. Potentially shareable activities or functions subject to economies of scale can include sales forces, distribution systems, purchasing, and so on.
The benefits of sharing are particularly potent if there are joint costs. Joint costs occur when a firm producing product A (or an operation or function that is part of producing A) must inherently have the capacity to produce product B. An example is air passenger services and air cargo, where because of technological constraints only so much space in the aircraft can be filled with passengers, leav-ing available cargo space and payload capacity. Many of the costs must be borne to put the plane into the air and there is capacity for freight regardless of the quantity of passengers the plane is carrying. Thus the firm that competes in both passenger and freight may have a substantial advantage over the firm competing in only one market.
This same sort of effect occurs in businesses that involve manufac-turing processes involving by-products. The entrant who cannot cap-ture the highest available incremental revenue from the by-products can face a disadvantage if incumbent firms do.
A common situation of joint costs occurs when business units can share intangible assets such as brand names and know-how. The cost of creating an intangible asset need only be borne once; the asset may then be freely applied to other business, subject only to any costs of adapting or modifying it. Thus situations in which intangible as-sets are shared can lead to substantial economies.
A type of economies of scale entry barrier occurs when there are economies to vertical integration, that is, operating in successive stages of production or distribution. Here the entrant must enter in-tegrated or face a cost disadvantage, as well as possible foreclosure of inputs or markets for its product if most established competitors are integrated. Foreclosure in such situations stems from the fact that most customers purchase from in-house units, or most suppliers “sell” their inputs in-house. The independent firm faces a difficult time in getting comparable prices and may become “squeezed” if in-tegrated competitors offer different terms to it than to their captive units. The requirement to enter integrated may heighten the risks of retaliation and also elevate other entry barriers discussed below.
Product Differentiation. Product differentiation means that established firms have brand identification and customer loyalties, which stem from past advertising, customer service, product differ-ences, or simply being first into the industry. Differentiation creates a barrier to entry by forcing entrants to spend heavily to overcome existing customer loyalties. This effort usually involves start–up losses and often takes an extended period of time. Such investments in building a brand name are particularly risky since they have no salvage value if entry fails.
Product differentiation is perhaps the most important entry barrier in baby care products, over-the-counter drugs, cosmetics, in-vestment banking, and public accounting. In the brewing industry, product differentiation is coupled with economies of scale in produc-tion, marketing, and distribution to create high barriers.
Capital Requirements. The need to invest large financial re-sources in order to compete creates a barrier to entry, praticularly if the capital is required for risky or unrecoverable up-front advertis-ing or research and development (R&D). Capital may be necessary not only for production facilities but also for things like customer credit, inventories, or covering start–up losses. Xerox created a ma-jor capital barrier to entry in copiers, for example, when it chose to rent copiers rather than sell them outright which greatly increased the need for working capital. Whereas today’s major corporations have the financial resources to enter almost any industry, the huge capital requirements in fields like computers and mineral extraction limit the pool of likely entrants. Even if capital is available on the capital markets, entry represents a risky use of that capital which should be reflected in risk premiums charged the prospective en-trant; these constitute advantages for going firms.
Switching Costs. A barrier to entry is created by the presence of switching costs, that is, one-time costs facing the buyer of switch-ing from one supplier’s product to another’s. Switching costs may include employee retraining costs, cost of new ancillary equipment, cost and time in testing or qualifying a new source, need for techni-cal help as a result of reliance on seller engineering aid, product rede-sign, or even psychic costs of severing a relationship.” If these switching costs are high, then new entrants must offer a major im-provement in cost or performance in order for the buyer to switch from an incumbent. For example, in intravenous (IV) solutions and kits for use in hospitals, procedures for attaching solutions to pa-tients differ among competitive products and the hardware for hang-ing the IV bottles are not compatible. Here switching encounters great resistance from nurses responsible for administering the treat–ment and requires new investments in hardware.
Access to Distribution Channels. A barrier to entry can be created by the new entrant‘s need to secure distribution for its prod-uct. To the extent that logical distribution channels for the product have already been served by established firms, the new firm must persuade the channels to accept its product through price breaks, cooperative advertising allowances, and the like, which reduce prof-its. The manufacturer of a new food product, for example, must per-suade the retailer to give it space on the fiercely competitive super-market shelf via promises of promotions, intense selling efforts to the retailer, or some other means.
The more limited the wholesale or retail channels for a product are and the more existing competitors have these tied up, obviously the tougher entry into the industry will be. Existing competitors may have ties with channels based on long relationships, high-quality service, or even exclusive relationships in which the channel is solely identified with a particular manufacturer. Sometimes this barrier to entry is so high that to surmount it a new firm must create an entirely new distribution channel, as Timex did in the watch industry.
Cost Disadvantages Independent of Scale. Established firms may have cost advantages not replicable by potential entrants no matter what their size and attained economies of scale. The most critical advantages are factors such as the following:
- Proprietary product technology: product know-how or de-sign characteristics that are kept proprietary through patents or secrecy.
- Favorable access to raw materials: established firms may have locked up the most favorable sources and/or tied up foreseeable needs early at prices reflecting a lower demand for them than currently exist For example, Frasch sulphur firms like Texas Gulf Sulphur gained control of some very favorable large salt dome sulphur deposits many years ago, before mineral rightholders were aware of their value as a re-sult of the Frasch mining technology. Discoverers of sulphur deposits were often disappointed oil companies who were ex-ploring for oil and not prone to value them highly.
- Favorable locations: established firms may have cornered favorable locations before market forces bid up prices to cap-ture their full value.
- Government subsidies: preferential government subsidies may give established firms lasting advantages in some bus-inesses.
- Learning or experience curve: in some businesses, there is an observed tendency for unit costs to decline as the firm gains more cumulative experience in producing a product. Costs decline because workers improve their methods and become more efficient (the classic learning curve), layout improves, specialized equipment and processes are developed, better performance is coaxed from equipment, product design changes make manufacturing easier, techniques for measure-ment and control of operations improve, and so on. Experi-ence is just a name for certain kinds of technological change and may apply not only to production but also to distribu-tion, logistics, and other functions. As is the case with scale economies, cost declines with experience relate not to the en-tire firm but arise from the individual operations or functions that make up the firm. Experience can lower costs in market–ing, distribution, and other areas as well as in production or operations within production, and each component of costs must be examined for the effects of experience.
Cost declines with experience seem to be the most significant in businesses involving a high labor content performing intricate tasks and/or complex assembly operations (aircraft manufacture, ship-building). They are nearly always the most significant in the early and growth phase of a product‘s development, and later reach di-minishing proportional improvements. Often economies of scale are cited among the reasons that costs decline with experience. Econo-mies of scale are dependent on volume per period, and not on cumu-lative volume, and are very different analytically from experience, although the two often occur together and can be hard to separate. The dangers of lumping scale and experience together will be dis-cussed further.
If costs decline with experience in an industry, and if the experi-ence can be kept proprietary by established firms, then this effect leads to an entry barrier. Newly started firms, with no experience, will have inherently higher costs than established firms and must bear heavy start–up losses from below- or near-cost pricing in order to gain the experience to achieve cost parity with established firms (if they ever can). Established firms, particularly the market share leader who is accumulating experience the fastest, will have higher cash flow because of their lower costs to invest in new equipment and techniques. However, it is important to recognize that pursuing experience curve cost declines (and scale economies) may require substantial up-front capital investment for equipment and startup losses. If costs continue to decline with volume even as cumulative volume gets very large, new entrants may never catch up. A number of firms, notably Texas Instruments, Black and Decker, Emerson Electric, and others have built successful strategies based on the ex-perience curve through aggressive investments to build cumulative volume early in the development of industries, often by pricing in anticipation of future cost declines.
The decline in cost from experience can be augmented if there are diversified firms in the industry who share operations or func-tions subject to such a decline with other units in the company, or where there are related activities in the company from which incom-plete though useful experience can be obtained. When an activity like the fabrication of raw material is shared by several business units, experience obviously accumulates faster than it would if the activity were used solely to meet the needs in one industry. Or when the corporate entity has related activities within the firm, sister units can receive the benefits of their experience at little or no cost since much experience is an intangible asset. This sort of shared learning accentuates the entry barrier provided by the experience curve, pro-vided the other conditions for its significance are met.
Experience is such a widely used concept in strategy formulation that its strategic implications will be discussed further.
Government Policy. The last major source of entry barriers is government policy. Government can limit or even foreclose entry in-to industries with such controls as licensing requirements and limits on access to raw materials (like coal lands or mountains on which to build ski areas). Regulated industries like trucking, railroads, liquor retailing, and freight forwarding are obvious examples. More subtle government restrictions on entry can stem from controls such as air and water pollution standards and product safety and efficacy reg-ulations. For example, pollution control requirements can increase the capital needed for entry and the required technological sophisti-cation and even the optimal scale of facilities. Standards for product testing, common in industries like food and other health-related products, can impose substantial lead times, which not only raise the capital cost of entry but also give established firms ample notice of impending entry and sometimes full knowledge of the new com-petitor’s product with which to formulate retaliatory strategies. Government policy in such areas certainly has direct social benefits, but it often has secondary consequences for entry which are un-recognized.
2. EXPECTED RETALIATION
The potential entrant‘s expectations about the reaction of exist-ing competitors also will influence the threat of entry. If existing competitors are expected to respond forcefully to make the entrant‘s stay in the industry an unpleasant one, then entry may well be de-terred. Conditions that signal the strong likelihood of retaliation to entry and hence deter it are the following:
- a history of vigorous retaliation to entrants;
- established firms with substantial resources to fight back, in-cluding excess cash and unused borrowing capacity, adequate excess productive capacity to meet all likely future needs, or great leverage with distribution channels or customers;
- established firms with great commitment to the industry and highly illiquid assets employed in it;
- slow industry growth, which limits the ability of the industry to absorb a new firm without depressing the sales and finan-cial performance of established firms.
3. THE ENTRY DETERRING PRICE
The condition of entry in an industry can be summarized in an important hypothetical concept called the entry deterring price: the prevailing structure of prices (and related terms such as product qual-ity and service) which just balances the potential rewards from entry (forecast by the potential entrant) with the expected costs of over-coming structural entry barriers and risking retaliation. If the cur-rent price level is higher than the entry deterring price, entrants will forecast above-average profits from entry, and entry will occur. Of course the entry deterring price depends on entrants’ expectations of the future and not just current conditions.
The threat of entry into an industry can be eliminated if incum-bent firms choose or are forced by competition to price below this hypothetical entry deterring price. If they price above it, gains in terms of profitability may be short–lived because they will be dis-sipated by the cost of fighting or coexisting with new entrants.
4. PROPERTIES OF ENTRY BARRIERS
There are several additional properties of entry barriers that are crucial from a strategic standpoint. First, entry barriers can and do change as the conditions previously described change. The expira-tion of Polaroid’s basic patents on instant photography, for in-stance, greatly reduced its absolute cost entry barrier built by propri-etary technology. It is not surprising that Kodak plunged into the market. Product differentiation in the magazine printing industry has all but disappeared, reducing barriers. Conversely, in the auto industry, economies of scale increased with post–World War II auto-mation and vertical integration, virtually stopping successful new entry.
Second, although entry barriers sometimes change for reasons largely outside the firm‘s control, the firm‘s strategic decisions also can have a major impact. For example, the actions of many U. S. wine producers in the 1960s to step up introductions of new prod-ucts, raise advertising levels, and undertake national distribution surely increased entry barriers by raising economies of scale in the industry and making access to distribution channels more difficult. Similarly, decisions by members of the recreational vehicle industry to vertically integrate into parts manufacture in order to lower costs have greatly increased the economies of scale there and raised the capital cost barriers.
Finally, some firms may possess resources or skills which allow them to overcome entry barrier into an industry more cheaply than most other firms. For example, Gillette, with well-developed distri-bution channels for razors and blades, faced lower costs of entry in-to disposable lighters than did many other firms. The ability to share costs also provides opportunities for low-cost entry. (In Chapter 16 we will explore the implications of factors like these for entry strat-egy in some detail).
5. EXPERIENCE AND SCALE AS ENTRY BARRIERS
Although they often coincide, economies of scale and experi-ence have very different properties as entry barriers. The presence of economies of scale always leads to a cost advantage for the large- scale firm (or firm that can share activities) over small-scale firms, presupposing that the former have the most efficient facilities, distri-bution systems, service organizations, or other functional activities for their size.5 This cost advantage can be matched only by attaining comparable scale or appropriate diversification to allow cost shar-ing. The large-scale or diversified firm can spread the fixed costs of operating these efficient facilities over a large number of units, whereas the smaller firm, even if it has technologically efficient facil-ities, will not fully utilize them.
Some limits to economies of scale as an entry barrier, from the strategic standpoint of incumbents, are as follows:
- Large-scale and hence lower costs may involve trade-offs with other potentially valuable barriers to entry such as prod-uct differentiation (scale may work against product image or responsive service, for example) or the ability to develop pro-prietary technology rapidly.
- Technological change may penalize the large-scale firm if fa-cilities designed to reap scale economies are also more spe-cialized and less flexible in adapting to new technologies.
- Commitment to achieving scale economies by using existing technology may cloud the perception of new technological possibilities or of other new ways of competing that are less dependent on scale.
Experience is a more ethereal entry barrier than scale, because the mere presence of an experience curve does not insure an entry barrier. Another crucial prerequisite is that the experience be propri-etary, and not available to competitors and potential entrants through (1) copying, (2) hiring a competitor’s employees, or (3) pur-chasing the latest machinery from equipment suppliers or purchas-ing know-how from consultants or other firms. Frequently, expe-rience cannot be kept proprietary; even when it can, experience may accumulate more rapidly for the second and third firms in the mar-ket than it did for the pioneer because followers can observe some aspects of the pioneer’s operations. Where experience cannot be kept proprietary, new entrants may actually have an advantage if they can buy the latest equipment or adapt to new methods unencum-bered by having operated the old way in the past.
Other limits to the experience curve as an entry barrier are as follows:
- The barrier can be nullified by product or process innovations leading to a substantially new technology and thereby creat–ing an entirely new experience curve. New entrants can leap-frog the industry leaders and alight on the new experience curve, to which the leaders may be poorly positioned to jump.
- Pursuit of low cost through experience may involve trade-offs with other valuable barriers, such as product differentia-tion through image or technological progressi For example, Hewlett-Packard has erected substantial barriers based on technological progressiveness in industries in which other firms are following strategies based on experience and scale, like calculators and minicomputers.
- If more than one strong company is building its strategy on the experience curve, the consequences for one or more of them can be nearly fatal. By the time only one rival is left pur-suing such a strategy, industry growth may have stopped and the prospects of capturing the experience curve benefits long since evaporated.
- Aggressive pursuit of cost declines through experience may draw attention away from market developments in other areas or may cloud perception of new technologies that nul-lify past experience.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.