View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics Research Report H200301 Barriers to Entry Differences in barriers to entry for SMEs and large enterprises Jasper Blees Ron Kemp Jeroen Maas Marco Mosselman Zoetermeer, May 2003 SCALES SCientific AnaLysis of Entrepreneurship and SMEs ISBN: 90-371-0893-8 Order number: H200301 Price: € 50.- This report is published under the SCALES-initiative (Scientific AnaLyses of Entrepreneurship SMEs), as part of the SMEs and Entrepreneurship' programme financed by the Netherlands' Ministry of Economic Affairs. Most recent EIM reports and much more on SMEs and Entrepreneurship can be found at: www.eim.nl/smes-and-entrepreneurship. The responsibility for the contents of this report lies with EIM. Quoting numbers or text in papers, essays and books is permitted only when the source is clearly mentioned. 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EIM does not accept responsibility for printing errors and/or other imperfections. 2 Contents Summary 5 1 Introduction 7 2 Literature on barriers to entry 9 2.1 Industrial organisation on barriers to entry 9 2.2 Strategic-management literature 17 2.3 Conclusion 24 3 Barriers to entry: descriptions 27 3.1 Absolute cost advantages 28 3.2 Access to distribution channels 31 3.3 Advertising 34 3.4 Asset specificity 38 3.5 Availability of skilled labour 40 3.6 Brand name 42 3.7 Capital requirements 44 3.8 Causal ambiguity 47 3.9 Control over strategic resources 51 3.10 (Transaction) Costs of operating in foreign markets 54 3.11 Cultural distance 56 3.12 Customer loyalty 58 3.13 Customer-switching costs 60 3.14 Divisionalisation 64 3.15 Dynamic limit-pricing 68 3.16 Economies of scale 71 3.17 Excess capacity 76 3.18 Experience advantages 79 3.19 Gaps and asymmetry of information 82 3.20 Government licences 86 3.21 Government policies 88 3.22 High wages for employees and managers 92 3.23 Investment risk 96 3.24 Know-how 99 3.25 Level of technology 102 3.26 Location 104 3.27 Packing the product space 107 3.28 Patents (product or process) 109 3.29 Product differentiation 111 3.30 Research and development intensity 115 3.31 (Expected) Retaliation by incumbents 117 3.32 Seller concentration 121 3.33 Selling expenses 124 3.34 Special risk and uncertainties of entry 126 3.35 Sunk cost 128 3.36 Technological change 131 3.37 Vertical integration 133 3 4 Synthesis 135 4.1 Importance of barriers for SMEs 135 4.2 Influencability of barriers 137 4.3 Conclusion 140 4.4 Suggestions for future research 141 Literature 143 Annex I Research process and periodicals scanned 151 4 Summary Entry of firms into a market is an important mechanism in the economy. Entrants have an equilibrating function. Firms will enter the market if the profit level is above the long-run competitive level. As a result of entry, the profit level will decrease to the long- run competitive level. Entrants are also important agents of change. Firms with new ideas or production processes will enter the market. Thus these two effects of entry contribute to allocative as well as to dynamic efficiency in the market. However, several mechanisms can prevent firms from entering the market. In other words, there can be barriers to entry that harm the allocative and dynamic efficiency and are therefore det- rimental for industry dynamics and economic welfare. From this perspective, it is clear that lowering barriers to entry or preventing that these barriers are created is an impor- tant issue in competition policy. In this report, we identify different barriers to entry and discuss the mechanisms behind these barriers. The central research question is: Which barriers to entry exist, how do they work and to what extent is the mechanism influenced by the size of the (potential) entrant? The report is based on two different literature traditions, industrial organisation and strategic management. Barriers to entry in the industrial-organisation literature go back to Bain (1956). He fo- cused on the consequences of the barriers to entry, i.e. a higher price than the price hypothetically attributed to long-run equilibrium in pure competition. If the most effi- cient entrant of all potential entrants cannot enter the market then there is said to be a barrier to entry. The barriers are based on structural aspects of the market and behav- iour of the incumbents to influence the conditions of entry. The structural conditions permit incumbents to raise the price above the minimum average cost of potential en- trants. A slightly different perspective in the industrial-organisation literature (Chicago school) is to look at the costs that must be borne by an entrant to a market that need not to be borne by an incumbent already operating in the market (asymmetry of costs). This im- plies that the incumbents and entrants are not equally efficient after the costs of enter- ing are taken into account (i.e., the conditions for entering for the incumbents were less difficult than for later entrants). In strategic-management literature, one tries to explain (and prescribe) the behaviour of individual companies that pursue maximal profit and other organisational goals. In pur- suing these goals, companies interact with their environment (competitors, stake- holders, government, etc). This interaction influences the final profit of the individual company and industry as a whole. There are different strategies and tactics that com- panies can use to sustain their position. Examples of these strategies and tactics are raising structural barriers (e.g., blocking access to distribution channels) and increasing expectations about retaliation (signal commitment to defend). An important author in this line of thinking is Porter (1980, 1985). Based on the two literature traditions, we identified 37 distinct barriers to entry. For each barrier, we give a short description in which the mechanism how the barrier works is discussed. There is a discussion on the possible size effect related to the barrier, the sustainability of the barrier (what can the incumbent do to sustain the barrier and the 5 entrant to avoid the barrier). Finally, we discuss for each barrier if they are related to other barriers and how they are measured in empirical studies. The report is ended with a synthesis in which the barriers are evaluated on the impact of size on the barrier and to what extent the barriers can be influenced by SMEs, large enterprises or the government. It proves that especially incumbents and the government can influence a lot of barriers to entry. SMEs are to a larger extent than large firms in- fluenced by the existence of barriers to entry. 6 1 Introduction According to the traditional view in industrial organisation (IO), a level of profitability in excess of equilibrium induces entry into an industry. First, new entrants provide an equilibrating function in the market; the levels of profitability and prices are restored to their long-run competitive levels. Second, entrants are viewed as agents of change (Audretsch, 2001). The threat of entry forces existing companies to introduce new products and processes. In this perspective, small firms are not founded to be smaller clones of big firms but they serve as agents of change through innovative activities. As a result, entrants are important because of their disequilibrating influence as well (Audretsch and Mata, 1995). Hence, they play an important role in the dynamics of markets and competition. Given both arguments, entry is viewed as important for the dynamics of an industry. If barriers to entry exist, this is detrimental for industry dynamics and economic welfare. Therefore, lowering barriers to entry or preventing that these barriers are created is an important issue in competition policy. A reduction in barriers to entry is currently per- ceived as one of the main objectives (rather than as a means) of competition policy (Burke and To, 2001). Entry can take different forms, a green-field firm (start-ups), an existing company that enters a new industry (a new plant), an existing company that buys an existing plant, an existing company that adjust its existing product mix and a foreign company that enters the market with one of the previous four forms (Geroski, 1991). From a competition perspective, the British competition authority (Office of Fair Trading, OFT) has defined new entry as ‘a situation in which both a new undertaking is established in the industry and that new productive capacity is set up in that industry’ (OFT, 1999), narrowing the perspective of Geroski on entry forms. One may expect that barriers to entry differ for the various forms of entry. For instance, it will be easier for an existing big company to finance the required investments to enter a new market than it is for a new start-up. One may also expect that firms of different sizes will face different barriers to entry. Big companies can overcome certain barriers to entry much easier (e.g., economies of scale) and they may be able to influence the competitive positions in an industry to a greater extent than smaller companies can. Small companies are often the first and most di- rectly affected by the harm caused by price fixers and market allocators or anti- competitive behaviour of incumbents1 (Golodner, 2001). The size of the entry (in terms of new production capacity) influences the consequences for the incumbent. Incumbents might allow small entrants or fringe companies in the market in order to keep bigger competitors out of the market.