Threat Of New Entrants & Barriers To Entry

Today we will look at how you could be affected by the threat of new entrants in your market and how you can use barriers to entry to deter new competitors.

This is one of the forces in Michael Porter's Five Forces model of industry analysis.

This applies to any business of any size but can be particularly damaging if your market is a fixed size and suddenly you find that you have to share it with a competitor e.g. another shoe shop opens in a small town.

Why Should New Entrants Be Attracted To A Market?

Any indication that a market is growing, under-served or particularly profitable will trigger interest from an entrepreneur who believes that there is money to be made from your market.

Where the existing business is making good profits, an entrepreneur will see this as an opportunity too good to miss.

So before you order your Porsche and move house to a ten bedroom mansion, you need to think what these signs of success are saying to your competitors.

Barriers To Entry Make It More Difficult For New Entrants

To discourage new firms coming into your market and competing for your customers and profits, you need barriers to entry.

Common barriers include:

1. Entrants must make a big financial investment
    
2. Established firms have cost advantages unavailable to new entrants
    
3. There are supply restrictions, either from suppliers or to customers which make it more difficult for new entrants to become established
    
4. Customer loyalty makes it hard for new entrants to attract customers
    
5. Legal barriers and patents
    
6. Threat of retaliation from existing competitors

A More Detailed Look At How Barriers To Entry Can Be Used To Mitigate Against Against The Threat Of New Entrants

Financial Investment As A Barrier To Entry

Some industries require a large financial investment before a new business can start. This introduces doubt into the minds of the prospective entrepreneur and any financial backers.

Some potential competitors won't be able to raise the funds and others won't be prepared to risk so much on a new venture which may not succeed.

Other industries, for example my own business coaching and consultancy require virtually no financial investment (unless people choose to buy a franchise) so we have to rely on other barriers to entry.

Cost Advantages As A Barrier To Entry

Cost advantages can come from three main sources:

1. Economies of scale - the bigger the business, the lower the average unit costs. For more details see economies of scale.
    
2. The experience curve - the more you perform an activity, the more opportunity you have for finding the best ways to do it for the least cost.
    
3. Low cost input prices, either from a favourable location e.g. a lower wage economy or long term supply contracts at very good prices.

These factors naturally favour the existing companies in the market although increased globalisation is opening up many markets to competition from the lower wage economies for the first time. New technology can undermine the cost position of the existing competitors.

Where brand names are important, an new competitor has a major problem becoming known and accepted unless it is prepared to invest heavily in sustained advertising and/or buy market share at a low price.

Supply Restrictions As A Barrier To Entry

A new entrant in the market may find it difficult to buy the supplies necessary to compete (including skilled labour) or it may be that it finds that distribution channels to the customers/consumers are reluctant to add extra lines and won't drop existing proven products from their range.

Customer Loyalty As A Barrier To Entry

Happy customers who are delighted with the service and the products from the existing companies may be very reluctant to risk buying from a new competitor.

Depending on how important the product is, even a much lower price may not compensate for the uncertainty of dealing with a new company.

It may also be difficult for customers to suddenly switch from one supplier to another because of incompatibilities. For example it is a big decision to switch computer suppliers because of all the inconvenience and effort required.

Legal Barriers And Patents As A Barrier To Entry

New companies may have to deal with difficult legislation issues and even legislation that doesn't affect incumbents. When I worked for a company with an iron foundry back in the early nineties, we did not have to meet environmental legislation that a new competitors would have had to comply with.

The market may also be protected through effective patents which stop a competitor bringing out a product very similar to your own.

Threat Of Retaliation From Existing Competitors As A Barrier To Entry

Any new entrant is attracted by the prospects of high profit so if existing competitors can put together a convincing threat that they will stop this happening (by cutting prices or extensive advertising), the new company will see high profit will not materialise.

But it is difficult to pull off.

Threatening retaliation against a new entrant means sacrificing the short term profitability of existing businesses so the new competitor has to be seen as a major threat which justifies the costs.

Barriers To Entry - An Effective Deterrent?

High barriers to entry are good if you are already established in a market but bad if you are investigating a market as a possible route for expansion.

The factors can change which is why it is important to keep reviewing Michael Porter's Five Forces model and the danger is that once one entrant has succeeded, other copycats may see that entry barriers like the threat of retaliation were an illusion.

Barriers May Be Reduced From Closely Connected Industries

The other issue when assessing entry barriers is that your starting point matters.

If you already have relationships with the prospective customers, a well known brand which is portable to this new market or you have the supply capabilities, your ability to enter a new market successfully is very different from a totally new company.

Can You Increase The Barriers To Entry?

To make your industry analysis better and to protect your business from the threats of new entrants, can you find ways to move these factors in your favour?

Are you doing everything you could to capitalise on your cumulative experience so that you find better ways to provide your product or service?

Can you find ways to increase customer loyalty so that they are unlikely to be tempted away by new entrants or existing rivals?

Is your patent protection as strong as it could be?

Overcoming Barriers To Entry

The entire issue of the threat of new entrants and the issue of barriers to entry all depends on where you are coming from.

If you are already in the industry you want high barriers but if you are outside looking to get in, ideally you want low barriers for you but high barriers for every other possible entrant.

So after you have identified the potential barriers to entry for your industry, put yourself in the shoes of a new competitor eager to enter the market.

Ask yourself how you would get around the barriers.

Can you reconstruct the industry?

Traditional High Street operations like banks and insurance brokers have been disrupted by first telephone and then Internet technologies.

Amazon have done the same with books, CDs and DVDs replacing a bricks and mortar presence with a huge website with many more products and product reviews.

Can you separate out the constraining area and subcontract to take advantage of other companies economies of scale and learning?

Can you license trademarks, patents and products so that you collaborate with a key player and help them compete against the other competitors?

More on Industry Analysis and the Five Forces Model

My related blogs start with an introduction to industry analysis and Michael Porter Five Forces Model.

Your Thoughts On Barriers To Entry and the Threat of New Entrants

It will be great if you can share you thoughts and experience of barriers to entry? When have they protected your business or a business you know?

How have you managed to work around traditional barriers to entry which looked formidable?

Paul Simister is a business coach who helps small business owners to profit from differentiation, be distinctive in the eyes of their customers and stand out in a crowded marketplace.

You too can move past your profit tipping point by answering the 7 big questions of business success.

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Comments

[George Davis]

Nice summary of the threat of new entrants and the issue of barriers to entry Paul.

I am a coach as well although I concentrate more of life coaching. How easy it is for new coaches to appear is certainly an issue for me since anyone can call themselves a life coach and start to give advice.

It does force down fee rates but I differentiate myself through my years of experience and the large number of satisfied clients.

[Paul Simister]

Thanks for your comment George. It is always good when someone starts off.

I understand your concerns about the lack of barriers to entry in the coaching industry. It is something that I have blogged about elsewhere.

Doctors and lawyers are professions that are able to protect themselves and charge high fees because practitioners must meet tough qualification requirements.

I would add a couple of points

1 - barriers to entry is just one force and off the top of my head, I can't think of any industry that is strong in all five.

Because coaching sells to individuals, the client's buying power is weak. Closing one deal isn't make or break.

2 - the purpose of the Five Forces is to allow an assessment of the actual or possible changes in the factors. For example in the UK the debate about protecting the word "accountant" comes up every so often.

[Puthanial]

Hi Paul,

Beautiful explanation on the threat of new entrants.

Can you explain what we can do to overcome the fear of customers to accept a new product entry in the market..

[Paul]

It is difficult to be specific on how a new entrant can be accepted, partly because it depends on whether it is easy to compare one to the other.

If it is not, it might be a brand new market created meeting an old customer need. Think DVD and BlueRay, CDs and mp3s.

New products need to go through the cycle of appealing to innovators, early adopters etc while improved products need to highlight their relative performance advantages.

Think demonstrations, low cost trials, testimonials, product reviews & endorsements, education based marketing...

Plus take the perceived and actual risk away - company credibility issues, guarantees, delayed payments.

I don't want to go further since my blog on the threat of new entrants was more focused on assessing or protecting your industry from new entrants.

However I accept it is two sides of the same coin.

[Paul Simister]

The threat of new entrants is just one element of essential business strategy covered in Pillar 3 of my business development system, the Eight Pillars of Business Prosperity.

Pillar 3 looks at your Strategic Market Position and answers the big questions:

1 - how can you choose an market or industry where the odds of you making profit are stacked in your favour.

2 - how you can establish a viable position in that market, distinct or differentiated from your competitors but attractive to your customers.

You can find out more about my full system at http://YourProfitClub.co.uk

I hear some say that this business strategy stuff is unnecessary for small businesses.

I guess that's the people who don't understand it - I think it's essential and can save you years of frustration.

the ideas behind the threat of new entrants is a great example.

If you make lots of money doing something, then unless there is something to stop other people piling in your opportunities and growth threats will be reduced.

[Nick Naxor]

Corporations measure "willingness to switch" to a new product by offering a discount coupon for the new item. That way you can see how much lower the new product price has to be to get loyal customers to switch brands. A new life coach might choose to do something similar while he's building reputation - for instance, offer a "free" life coaching session to a local charity in a fundraising auction.