Barriers to entry in a market are anything which prevent new firms from emerging and succeeding in that market. Common examples include:
- Sunk costs, payments initially required which cannot be recovered if the firm needs to exit the market.
- Government regulations, which can legally prevent firms from entrance.
- The networking effect, where an already existent firm's product is well integrated with other products, thus making it more difficult for a new firm to enter - a good example being Microsoft (MSFT) and their well networked products, Windows and Office.
- Customer loyalty, which, with companies like COKE and Pepsi seems to be quite strong - preventing products like RC Cola from entering.
- Vertical integration, which prevents middle companies from entering. Also distributor and supplier agreements.
As may be obvious, the concept of Barriers to entry and Economy of scale are very much interrelated, both involved in the creation and continued existence of oligopolies, and is thus a primary factor in Antitrust Legislation.
When investing in a firm just starting, it is important to consider barriers to entry involved in its market. If they are high, the firm may prove to risky for the average investor. However, incumbent firm whose market has high barriers to entry is generally a stable investment, though often one with only small returns.
A sudden lowering of barriers to entry - due to, say, a change in technology - would cause the incumbent firm's stock price to lower, while the upstart firm rises. A raise - perhaps through government regulation - would produce the opposite effect.
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