In The Five Competitive Forces That Shape Strategy, Micheal E. Porter describes 7 barriers to entry that prevent new businesses from entering a market.
Companies that operate in industries with these barriers are strongly positioned to maintain market share and pricing power.
1. Supply-side economies of scale
A supply-side economy of scale is when a producer can create large volumes at a lower cost than their competitors. This can be achieved through more efficient technology or better terms with suppliers.
New businesses must either enter the market at a larger scale or accept a cost disadvantage.
Intel has supply-side economies of scale in chip making and research and development.
2. Demand-side benefits of scale
Demand-side benefits of scale are also known as network effects. A business has a network effect when its product becomes more attractive the more users it has.
eBay has demand-side benefits of scale because buyers and sellers know this is the best place to find trading partners.
Demand-side benefits of scale prevent new businesses from entering the market because customers are less likely to buy from them. The new business will need to lower its prices until it can build trust and a customer base.
3. Customer switching costs
Switching costs are costs a customer faces when they change suppliers. Switching costs include retraining employers to use a new product, altering product specifications, and modifying processes.
Adobe has switching costs because it takes considerable time and effort to learn its suite of products. The cost of training employees to use a different product would be high.
4. Capital requirements
The initial investment to enter a market can be so high that it prevents many newcomers. Capital may be required to build facilities, extend credit, purchase inventories, and sustain operating losses.
Capital requirements are a substantial barrier where the capital is unrecoverable, such as spending on advertising or research and development. It is less of a barrier when the capital can be recovered, for example, an airline can recover its capital by selling its planes to other airlines.
The mining and energy industries have high and sometimes unrecoverable capital requirements for exploration, drilling and extraction of resources which prevent new entrants to the market.
5. Incumbency advantages independent of size
Existing companies can have advantages over new entrants not relating to their size. These advantages include better technology, preferential access to raw materials, favorable geographic location, established branding or greater experience.
6. Unequal access to distribution channels
A new company must develop a distribution network to sell its product. This can be difficult when the newcomer must displace the current product.
Supermarkets have limited shelf space. It would be nearly impossible for a new soda company to convince the supermarkets to put its product on the shelves in place of Coca-Cola’s.
New entrants can try to bypass this barrier by selling directly to consumers. The internet has made this easier for businesses.
7. Restrictive government policy
Government policy can make it difficult for new companies to enter the market by requiring licenses and permits, or flat out banning them. For example, Facebook and Twitter are banned in China and Tik Tok is banned in India.
These policies can open the market to domestic companies such as WeChat in China.
A company that commands any one of these 7 forces has an easier time maintaining market share and pricing power. Newcomers will face difficulties in these markets and will often try to find ways to circumvent these barriers.
Michael E. Porter is the Bishop William Lawrence University Professor at Harvard University, based at Harvard Business School in Boston. He is a six-time McKinsey Award winner, including for his HBR article, “Strategy and Society,” co-authored with Mark R. Kramer (December 2006).