Barriers to Entry

Definition

Barriers to entry are obstacles or factors that make it difficult for new firms to enter a particular industry or market. These barriers can protect incumbent firms from competition and allow them to maintain higher prices and profits.

5 Must Know Facts For Your Next Test

1. Barriers to entry can allow incumbent firms to maintain higher prices and profits by limiting competition.
2. Economies of scale, where larger firms have cost advantages, can create a barrier to entry for smaller firms.
3. Absolute cost advantages, such as access to better technology or resources, can make it difficult for new firms to match the costs of incumbents.
4. Network effects, where the value of a product or service increases with the number of users, can discourage new entrants.
5. Government regulations, such as licensing requirements or patents, can also act as barriers to entry in certain industries.

Review Questions

• Explain how economies of scale can create a barrier to entry in an industry.
  • Economies of scale refer to the cost advantages that larger firms enjoy due to their scale of operation. As firms increase their output, their average costs per unit tend to decrease. This can create a barrier to entry for smaller firms, as they may not be able to match the low costs and prices of the incumbent large firms. New entrants would need to achieve a large enough scale to compete effectively, which can be difficult and costly, deterring them from entering the market.
• Describe how absolute cost advantages can act as a barrier to entry.
  • Absolute cost advantages occur when incumbent firms have lower production costs compared to potential new entrants. This can be due to factors such as access to better technology, superior production techniques, or preferential access to raw materials or other resources. When new firms cannot match the cost structure of the incumbents, they face a significant barrier to entry, as they may not be able to compete on price. This allows the incumbent firms to maintain higher prices and profits in the market.
• Analyze how network effects can create a barrier to entry in a market.
  • Network effects occur when the value of a product or service increases as more people use it. This can create a barrier to entry for new competitors, as users are less likely to switch to a new product or service with a smaller user base. The larger the network of users, the more valuable the product becomes, making it difficult for new entrants to attract customers and achieve the same level of network effects. This can allow incumbent firms to maintain their market position and pricing power, deterring new firms from entering the market.

Related terms

Economies of Scale: The cost advantages that businesses obtain due to their scale of operation, with costs per unit of output generally decreasing with increasing scale.

Absolute Cost Advantage: When an incumbent firm has lower costs of production compared to potential entrants, making it difficult for new firms to compete on price.

Network Effects: A situation where the value of a product or service increases as more people use it, creating a barrier to entry for new competitors.