Evolution of Industries and Barriers to Entry

THE RESULTS OF COMPETITION: WINNERS AND LOSERS

As firms compete with one another, eventually a firm or a set of firms gains a competitive advantage. Perhaps the firms gaining this advantage have greater skill, or were more ruthless, or were simply lucky. As one group of firms gain an advantage, the rest of the firm in an industry are placed at a competitive disadvantage. One consequence of a temporary disadvantage is, among other things, a smaller proportion of industry sales and lower profits for the disadvantaged firms. If sales and profits fall to low levels for long enough, the firms at a competitive disadvantage might be forced to leave the industry. Perhaps because of falling revenue, some firms are not able to pay their creditors these firms might be forced into bankruptcy. Or, perhaps the owners of the firm see the writing on the wall and fear they will never be able to earn high enough profits in the industry and they voluntarily leave the industry. Every year countless thousands of businesses shut their doors as they fail to make acceptable profit for the owners. But, as the losing firms exit the industry the existing firmsthe winners expand and take over the sales of the firms that have exited. Often, the winnersindividually and collectivelyfind that their profits are greater now that some of their competitors have been forced to leave the industry. In short, competition creates winners and losers. The winners expand that grab a larger share of the market and often benefit from higher profits. The

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losers lose market share, earn lower profits and, perhaps eventually, are forced to leave the industry. Yet nothing is given. A firm that appears to be on the way out might suddenly find some change in the produce that consumers really like or might sudden introduce a product much preferred by consumers. And, firms that have been successful for year-after-year by reinvesting profits might find some innovation they have introduced fails and consumers stop buying from the previously successful firm. In competition, all bets are off. Yet, at some point, firms will fall far enough behind the others in the industry. These firms might leave the industry either by choice or they might do so because they are forced to declare bankruptcy. Alternatively, some firms that were unable to win in competition might seek to become small niche producers: specializing in the sale of that part of what the industry produces that is much lower profit than sold by the winning firms or which is sold in only a small amount and bigger firms are not interesting in producing that particular item. Not every firm losing the main battle within the industry is able to remake themselves as a niche producer: most firms that lose the main competition within the industry are forced to exit the industry. Once the losers have left, or found small and often low-profit niches within the industry, the firms that have won in competition now do battle among themselves. The new batch of winners soon becomes split into winners and new losers.

THE INDUSTRY AFTER A PERIOD OF COMPETITION

After a long period of competition, an industry most likely has experienced a major decline in the number of competitors as the losers exit. The winners now battle among themselves and some past winners now become losers and they too exit the industry. Larger firms come to dominate the industry. However, a handful or perhaps a dozen or two of smaller firms might remain within the industry. These fringe firms might produce a variant of the product that is much less profitable than the bulk of what is sold in the industry. The large firms have not interest in producing these low-profit variant of the product and, so, they dont aim their competitive aggression at the small fringe firms. Collectively, though, these fringe producers account for only a relatively small amount of the industries product.

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The process involved in competition is illustrated in Figure 0-1. Competition transforms an industry from one in which a large number of small firms dominate the industry to one in which a small number of large firms dominate the industry. A few small firms might survive as niche producers that earn a level of profits too low to interest the main winners in the industry. Figure 0-1

Car industry 1910 Car industry 1940

Car industry 1960

COMPETITION AND MERGERS

Competition leads to fewer and larger firms as the winners expand and take sales away from loser firms. Competitionor the desire to win in competitioncan also lead firms to merge with one another. As will be discussed below, larger firms can have advantages over smaller firms. These advantages can lead to higher profits and greater competitive abilities. Firms, therefore, sometimes combine forces by merging. Part of the reduce firms in an industry and part of the increased size of these firms comes about simply because firms have merged in order to enhance their profitability.

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THE ENTRY OF NEW COMPETITORS IN AN INDUSTRY

But, before an industry becomes dominated by a relative small number of small firms a process can be set into motion that counteracts the development of large dominant firms. In capitalism, businesses want profits. Moreover, they want high profits. When existing businesses are looking to increase their profits by expending into new industries and when new businesses are looking for a good industry to enter, one of their goals is to find an industry in which the profits are high. High profit industries attract a lot of attention from those outside the industry. Low profit industries, on the other hand, often attract little attention. As competition within an industry occurs, winners expand and winners individually and collectivelyearn higher profits. In turn, these higher profits attract attention from outsider. The new winners find, much to their disappointment, that their success in competition (in particular, the resulting higher profits) leads outsiders to consider entering the industry. If these outsiders do enter the industry, competition heats up to a higher level and, most often, profits are again pushed down for all in the industry. This process is illustrated in Figure 0-2 below. Competition does lead to a reduction in the number of competitors and some firms do get larger. But the higher profits of these firms attract the attention of entrepreneurs and firms outside the industry. They enter the industry hoping to earn higher profits. But by entering the industryand increasing competitionthey drive down profits. Figure 0-2

Machine tool Industry

Car industry

Construction industry

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What the winners in an industry want is to find themselves a way to be not subjected to the continual appearance of new competitors. In such an industry, a high level of profits can last for a long time.

BARRIERS TO ENTRY
Firms want to earn high profits. Firms that have become winners in competition can find, however, that the high profits they achieve disappear as new firms enter the industry. As new firms enter the industry, competition increases and profits fall. Worse for the firms which once stood preeminent in the industry, one or more of the new firms entering the industry might talented or lucky enough to drive out of business the once preeminent firms in the industry. Not surprisingly, firms that have achieved profitable positions within an industry would like to keep new firms from entering the industry. In order words, they would like to construct barriers to entry for their industry. If they can successfully construct barriers to entry then firms within the industry can benefit from continued high profits. Alternatively, if firms are lucky to find themselves with barriers to entry (that were not intentionally constructed) they can also benefit from good profits for a lengthy period. BARRIERS TO ENTRY DEFINED Some industries are the site of relentless competition. Winners win and push out loser firms. But new firms appear to take the place of the exiting firms and competition never wanes. One of the new competitors might push out of business one of the firms in the industry that had previously been a winner. Other industries are able to find some release from continual relentless competition. Still other industries find they are successful in significantly reducing or, even, eliminating competition. It is the dream of every entrepreneur to find her/himself in the latter type of industry. Why do some industries face relentless competition? Why do others face only a medium level of competition? Why do a few industries face very little competition? The key is often the absence or existence of barriers to entry.

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Barriers to entry (or, BTE) are anything that hinders the movement of firms into an industry. That is, BTE reduce or eliminate the entry of new businesses into an industry. Sometimes BTE can be almost insurmountable: no new firms can enter an industry. Other times BTE can slow down the entry of new firms: new firms appear but only slow. Very low BTE, however, means that new firms can enter the industry relatively rapidly.

SELECTED BARRIERS TO ENTRY

What can act as a BTE? The list is very long. All of the following can provide a barrier to entry for firms outside the industry. Many other barriers to entry also exist. LEGAL RESTRICTIONS Government (at the federal, state, and local level) sometimes grants to individual firms the exclusive right to provide some good or service to buyers. For instance, the U.S. Postal Service has a monopoly over regularly scheduled daily delivery and pickup of mail. The food concession in a municipal stadium is a monopoly created by a local government. And, local governments often grant monopolies to cable companies. PATENTS Governments grant patents to inventors. These patents give to the inventor the exclusive right to control the use of the invention. The reason governments grant patents is to give an incentive for inventive activity. TECHNICAL SUPERIORITY Sometimes a business is so good at what they do, no one else can possibly compete with them. For instance, in the 1960s IBM was so good at producing mainframe computers that few could compete with them. ECONOMIES OF SCALE Economies of scale give large producers a significant cost advantage over small rivals. Where a firm has grown very large and significant economies of scale exist, they can rest easy: new competitors generally start small and therefore have much higher unit production costs than the giant firm. These new, small rivals find it nearly impossible to survive again the large rival because they just cant be price competitive given their much larger unit production costs.

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Entering certain industries often requires vast amounts of money. For instance, to enter the auto industry you likely need billions of dollars. The same holds true for many other industriesso much money is required that very few outsiders can ever hope to enter the industry. This major financial requirement services as a significant barrier to entry for many industries. CONTROL OF A SCARCE RESOURCE OR INPUT Sometimes a particular hard-to-find resource or input is needed to produce a good or service. If a company can gain control over this resource or input, they can gain a monopoly: only they will be able to produce the good or service because only they have access of the required input. ENTRY-DETERRING BEHAVIOR A firm can protect itself from competition by deliberately acting in a way that convinces potential competitors to not enter the industry. Some firms spend huge amounts of money on advertising to keep new rivals from starting up business. Or, firms can act exceedingly aggressive if faced with new competition by perhaps starting a major price war every time a new competitor enters their market. Lawsuits against new rivals have been used to drive them out of business or to, at the very least, raise the cost of entering the business to very high levels.

BARRIERS TO ENTRY AND PROFITABILITY

With a high level of BTE, new competitors are unlikely to appear in the industry and competition is generally limited to firms already within the industry. This has a very important consequence. Competition leads to winners and losers. As the losers exit the industry, a smaller number of old firms exist. This leads potentially to higher profits for the remaining firms. But, if barriers to entry keep out new competitors, these high profits might remain. Barriers to entry help create high profit industries in an economy. Other industries that do not benefit from significant barriers to entry remain perpetually low-profit industries.

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BARRIERS TO ENTRY AND THE NUMBER OF FIRMS IN AN INDUSTRY

One indirect (but imperfect) sign of high barriers to entry and one indirect (but imperfect) sign that high profits might exist in an industry is a small number of firms in the industry. Competition leads to winners and losers. Barriers to entry restrict the entry of new firms into the industry. Over time, then, industries with barriers to entry will often end up with a relatively few firms. And, these firms will often earn profits higher than in other industries with low barriers to entry. Over time, the number of firm in an industry might stabilize at, say, 5,000 if there are almost no BTE. In other industries, the number of firms might stabilize at 200 if moderate BTE exist. In still other industries, the number of firms might stabilize at 5 firms if fairly high BTE exist. A relatively small number of firms is not only an indirect (but imperfect) indicator that BTE and profits are high, it also independently contributes to a reduction in competition and to higher profits.

EROSION OF BARRIERS TO ENTRY

Moderate and high barriers to entry can give firms within the industry good profits. Firms outside the industry, however, cannot easily enter the industry because of these barriers to entry. However, if profits are high enough in these industries outsiders will try to find some way to enter the industry. As time passes, more and firm outside firms find ways to break though the barriers to entry. For instance, perhaps outsider firms find a way to produce the produce cheaply with new technology. Or, perhaps they innovate and find a better product than that sold by firms within the industry. Or, perhaps patent protection runs out and new firm are now able to enter the industry. Almost all barriers to entry are temporary. Eventually they are overcome by outsiders or they disappear on their own. This might take many yearsperhaps decadesbut high-profit industries protected by high barriers to entry will eventually disappear.