Porter's 5 Forces -Barriers and Threats to Entry © Jeff Miles Business Doctor Secrets

Today we will look at one of the five factors in the Porter's 5 Forces Analsys:  Barriers/Threats to Entry

When analyzing threats to entry, it isn't just existing competitors that are a threat. The possibility of new companies entering the industry also affects the competition.

In most markets, any company should be able to enter and exit a market and profits should usually be steady. But in reality, some markets have the ability to inhibit new companies from entering a market and protect existing companies. These are called barriers to entry.

Barriers to entry are more extreme than just the normal everyday adjustments that markets have to mark. For example, when profits increase in an industry, new firms typically enter the market to take advantage of the high profits, which drives down profits for all firms over time. When profits decrease, some firms exit the market and this restores the equilibrium.

Falling prices, or the anticipation that prices will fall in the near future, keeps rivals from entering a new market. Companies can also be reluctant to enter markets that are unknown or uncertain, especially if start-up costs are high. All of these adjustments to a market are normal.

 

Sometimes, however, firms will keep prices artificially low. They can't do this as a group (that would be illegal collusion) but they can individually decide to keep prices low to prevent new rivals from entering a market. This is called "entry-deterring pricing" and is considered a barrier to entry.

Barriers to entry are unique to each industry. They reduce the number and rate of new rival firms entering the market and protect those already in the market.

These barriers come from several sources:

1.   The Government. Even though the government seeks to preserve competition, the government also restrictions competition through granting monopolies and through regulation.

For example, utilities are considered monopolies because it's much more efficient to have one utility company providing service to a community than several utility companies.

To keep utilities from exploiting this monopoly the government enforces certain regulations. So this is a barrier to entry the cable industry is another example of this. When a cable franchise is granted to a company there are regulations to protect the consumer so that the cable company can't gouge the consumer with unfair pricing, etc.

When the government deregulated the banking industry in the 1970's, this greatly intensified the rivalry and created new uncertainties for banks as they scrambled to maintain their market share.

2.   Patents and Other Proprietary Knowledge. Special knowledge and ideas that give a company competitive advantages are treated as private property and protected by patents. This prevents others from using that same knowledge and this creates a barrier to entry as a result. If a competitor tries to use this knowledge they can be sued.

For example: Polaroid acquired the patent for instant photography in 1947. When Kodak sold a similar camera in 1975 they were sued and lost, thereby keeping Kodak out of the instant camera market.

3.   Asset specificity. In other words, special technology that is expensive or difficult to acquire. This inhibits potential companies from entering the market because they are reluctant to commit to investing in the specialized technology. It would be difficult to resell the equipment if the business was to fail and it wouldn't be possible to use the same equipment in a new business.

When a business has these assets they aggressively protect them. To return to a photography example, Kodak invested a lot of capital in its photographic equipment business. It resisted efforts by Fuji to enter this same market. These assets are highly specific and can only be used in this industry.

4.   Economies of Scale. The most cost efficient level of production is referred to as Minimum Efficient Scale (MES). The MES is the lowest minimum at which a unit can be manufactured. It is the most cost efficient level of production.

If the MES for a firm is known throughout the industry then it is possible for competitors to determine how much market share they would need to enter the market and how much it would take to maintain the same MES.

For example, in the telecommunications market, a 10% market share is necessary to maintain MES. If a company fails to acquire 10 percent market share then the firm is not competitive.

Therefore the MES economy of scale creates a barrier to entry for new companies. The greater the difference between an industry's MES and the entry unit costs, the greater the barrier to entry. Industries with a high MES discourage the entry of new, start-up businesses into a market.

To operate a business at less than MES the firm must have the ability to sell their goods at a premium price to make up for the lack of market share.

There are also barriers to exit in addition to barriers to entry.

If there are difficult exit barriers, it can prevent a new company from entering the market in the first place.

If a company is inhibited in their ability to leave the market it increases rivalry because in order to stay in the market the company has to compete.

Exit and entry barriers can be summarized as follows:

Easy to enter if there is:

*Easy to acquire technology
*Easy access to distribution channels
*A low scale threshold

Difficult to enter if there is:

*Patented or proprietary knowledge
*Difficulty in switching brands
*Limited distribution channels
*High scale threshold

Easy to exit if there are:

*Low exit barriers and costs
*Independent businesses
*Assets that can easily be sold

Difficult to exit if there are:

*Highly specialized assets
*High exit costs
*Businesses that are inter-connected and interrelated

Any analysis of an industry has to keep in mind that business is not static. Change is constant. Even industries that are easy to generalize, like the automobile industry, are prone to change. New technology and frequent mergers keep everyone on their toes. The Porter analysis places an emphasis on understanding these dynamic forces that are always at work.