When it is apparent that competitive advantage can be lost in the first two arenas—cost and quality, timing and know-how—firms resort to using the powerful impact of entry barriers. By creating hurdles for their potential competitors, established firms try to head off competitors that might engage in the price-quality and timing-know-how cycles before they enter the battlefield. Established firms build high barriers that exclude competitors and define the firm’s turf for its exclusive use. This turf (or stronghold) may be bounded geographically (Japan, for instance) or by product and customer need or type (such as luxury watch consumers) or both.
Limiting competitors to a small number of firms produces several advantages:
- Tacit cooperation among rivals A small number of competitors makes it easier for the firms to arrive at an “oligopolistic bargain.” That is, they can find a way tacitly to cooperate by signaling to each other what behavior each expects of the other. They may tacitly agree on a “focal” price that is higher than the one that would have resulted if they had competed aggressively. They may implicitly divide the market up into segments with each competitor dominating a different segment and avoiding the segments of other competitors. Or they may agree on quality and design standards that benefit their respective firms. They may even decide to restrict the industry’s output quantity to create shortages that result in price increases. Occasionally such cooperative arrangements can be sustained for years if the parties have an incentive to cooperate. While sitting down over a table and agreeing to fix prices is clearly illegal, even tacit coopera-tion can sometimes be in the gray areas of antitrust, but it is a frequent strategy of many companies.
- Power over buyers A small number of competitors generates power over buyers. Customers who want the product have only a few options. They cannot shop around too much, so they must take what they can get when they can find it.
- Power over suppliers Similarly, a small number of competitors limits the options of suppliers. If suppliers have output to sell, they must sell it to whomever they can. Fewer options reduce the suppliers’ ability to hunt around for firms who are willing to pay a higher price because of a greater need for the input.
- Power over potential entrants and substitutes If the barriers are high, potential entrants and makers of substitute products are forced to deal with one of the few competitors who are already established inside the walls surrounded by the barriers. U.S. firms seeking access to Japanese markets are often told to joint-venture with or license to an incumbent Japanese firm if they want any chance of selling in that market. This allows the Japanese firms access to U.S. product designs and technologies, which they can improve in their protected Japanese market. Later they can sell the improved version in the U.S. markets. The small number of competitors makes it difficult to find a more benevolent partner when shopping for a way to enter Japan.
Tacit cooperation and power over buyers, suppliers, and entrants allow firms to earn profits that would not be available if the market were more competitive. They allow firms to raise price above competitive levels, control quality below competitive levels, and remove the incentive to escalate costs by innovating and imitating each other. Thus, they slow movement up the escalation ladders discussed in the previous two chapters. Of course, as more competitors enter the industry, these advantages are reduced. Thus, entry barriers are crucial to the maintenance of limited numbers and to slowing the escalating conflicts outlined in earlier chapters.
1. Traditional Static Views of Strongholds and Entry-Barrier Advantages
According to traditional models, building barriers around a stronghold is an important source of competitive advantage because these barriers allow the company to earn profits in a protected market that can be used to fund price wars, R&JD, and other actions in other, more competitive, markets.
Porter identifies six major barriers to entry that can be used to create a stronghold: economies of scale, product differentiation, capital requirements, switching costs, access to distribution channels, and cost disadvantages other than scale.1
- Economies of scale enjoyed by the incumbent make it difficult for a new entrant to offer competitive prices because the incumbent’s higher volume reduces its costs. The entrant would have to find a way around this cost disadvantage to enter the market profitably.
Gallo Winery’s dominant hold on the U.S. wine market, with 31 percent of the low-priced market in 1985, has given the company power with grape growers and distributors, as well as allowing Gallo to underprice competitors. Their size allowed them to launch extensive marketing campaigns and establish a distribution network in a market which previously had no central distribution. As a 1986 article in Fortune noted, “When it comes to business, the brothers Ernest and Julio Gallo brook neither waste nor weakness. Just ask the scores of companies, large and small, that over the past five decades have made the mistake of venturing onto their turf…. They are not afraid to exercise their power over grape growers, distributors, or anyone else.”2
- Product differentiation involves the reputation of the incumbent for quality. An incumbent with a strong brand image or sophisticated, higher-quality product is more difficult to attack since the entrant must find a low cost way to catch up with the incumbent’s image or quality.
Haagen-Dazs used product differentiation to capture the emerging superpremium ice cream market in the United States and later moved aggressively into European markets. It offered traditional ice cream flavors, but with a “premium” taste derived from high-quality, all-natural ingredients and 15 percent more butterfat. This high-quality image, reinforced by marketing that stressed ice cream as an “affordable luxury,” helped make Haagen-Dazs “the Rolls-Royce of U.S. ice creams.”2
- Capital investments needed to enter an industry sometimes make it very difficult for other firms to enter. Entrants must find a low-cost way to replicate the incumbent’s investments in equipment, research, or technology.
- Switching costs, the one-time expenses for customers who switch to a competitor’s products, can make it difficult for a firm to enter a market. If customers are locked into the products of the incumbent, the entrant will have to find a way to lower the cost of switching or to woo them away from the incumbent with such improved value that the switching costs are trivial
Nintendo gained a lock on the U.S. home video game market by blanketing the market with their video game system. By 1988 Nintendo controlled an estimated 80 percent of the U.S. video game market.4 The expense of the system and the incompatibility of Nintendo cartridges with other systems created large switching costs for consumers who wanted to switch to another system. They would not only have to buy a new system but also replace all their cartridges. Nintendo’s license arrangements with some thirty software developers (including competitor Atari) also help ensure that many new games appeared on Nintendo’s cartridges, reducing the incentive for customers to switch systems to gain access to new game programs and making it harder for competitors to offer such a wide variety of programs.
- Access to distribution channels controlled by the incumbent can be a key entry barrier. If incumbents have agreements with existing distributors that tie up distribution channels, it can be much more difficult for companies to enter. The new entrant would face the challenge of breaking into these distribution networks or establishing channels of its own.
IBM’s control of distribution channels, through its direct-sales force and large dealer network, made it difficult for many smaller companies to penetrate the market for mainframes and, later, personal computers. IBM’s direct-sales force provide sales and service to major customers, ensuring a close relationship with these firms. The network of IBM dealers served smaller business and private computer buyers. The sales representatives and dealers provided technical support in addition to equipment, which was particularly valuable for early buyers who did not have computer expertise on staff. The distribution network gave Big Blue a tight grip on the market.
Another example of the control of distribution channels is the control the major networks achieved through limited frequencies available for broadcasting. The limitation on the number of distribution channels allowed local stations and national networks to gain a strong grip on the television market.
- Cost disadvantages other than scale may be created by nonscale manufacturing advantages, ownership of low-cost supplies of raw materials, favorable locations, or government subsidies. All these advantages of the incumbent make it more difficult for competitors to break into the market because the entrant’s costs will exceed the incumbent’s costs. Thus, the entrant must find a way to lower its costs by replication or by circumventing the incumbent’s cost advantages.
The Japanese shipbuilding industry emerged as a leading player in the industry after World War II, rising in the world market from 8 percent in 1954 to nearly 50 percent in 1973. Japanese companies were aided by a number of barriers that gave them cost advantages over non-Japanese firms. The government targeted shipbuilding as a strategic industry and provided subsidies. Companies also had access to low-priced, high-quality steel. The top seven shipbuilders were integrated heavy-machine companies that could take advantage of economies of scope and synergies to increase quality and lower costs. In addition, Japanese shipbuilders were helped by an advantage in engine development and experience in high technology and design. This combination of production efficiencies, technology advantages, and government support created a substantial advantage over other companies in the industry.
- Government policy Although not one of Porter’s original barriers, these barriers have become increasingly significant in global markets. Beyond government subsidies, countries can create direct barriers to entry to prevent foreign competitors from moving into the country. This creates strong geographic barriers. Government regulations can help strengthen the other six barriers. Government barriers have traditionally been very powerful obstacles to outside competitors.
National telecommunications monopolies are among the most unassailable geographic strongholds. The power of these monopolies can be seen in Europe’s PTT (post, telephone, and telegraph) monopolies. The PTTs have held a tenacious grip on the market despite poorer service, less technological sophistication, and higher prices than foreign competitors.
Japan’s strong entry barriers and support for its internal industries helped it rebuild after the devastation of World War II. Tight relationships between companies and government agencies and the strength of the keiretsu system make it difficult for outsiders to enter. These seemly impenetrable barriers created resentment among U.S. competitors, who felt shut out of the Japanese market while Japanese competitors moved into U.S. markets.
The Soviet Union, with its central government and tightly controlled market, offered tremendous barriers to outsiders. Political control at the national and local level made it hard for foreign firms to break through. Shortages of supplies and infrastructures also inhibited outside development. And a commitment to communist principles, in sharp contrast to the goals of any moneymaking enterprise, tended to discourage outside investment.
Many of these barriers are derived from actions in the the first two arenas—cost-quality and timing-know-how—but the focus here is on how these barriers prevent the movement of companies into geographic or market strongholds. These barriers play an important role in reducing the threat of entry by potential competitors who offer similar products or even a substitute product. So long as the incumbent firms have very low costs relative to the potential entrants (with similar or substitute products), the potential entrant is less likely to attack. Even if incumbents sell at a high price, their lower cost positions them to retaliate and drive out entrants as they appear.
2. Useful Insights Resulting from This View of Competitive Advantage
Michael Porter, synthesizing years of work by industrial organization economists, developed his now-famous Five Forces model.”5 Based on the view that limiting competition improves profitability, he asserts there are five influences on the profitability of a firm: threat of new entrants (prevented by entry barriers), intensity of industry rivalry, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers. Limiting the number of competitors improves profits by reducing the aggressiveness of the rivalry among competitors in the industry, the power of buyers over the firm, the power of suppliers over the firm, and the threats posed by potential entrants with similar or substitute products. Since its introduction in 1980, the Five Forces model has become a staple. Almost every consulting firm, strategic planning department, and MBA now uses this model as an analytical tool to identify how the firm can reduce the aggressiveness of rivalry, the power of buyers and suppliers, and the threat of entrants and substitutes.
Source: D’aveni Richard A. (1994), Hypercompetition, Free Press.