Barriers to entry and exit are an important characteristics to consider when analyzing a market. In perfectly competitive markets, there are no barriers to entry or exit. This is a critical characteristic of perfectly competitive markets because firms are able to freely enter and exit in response to potential profit. Therefore, in the long-run firms cannot make economic profit but can only break even.
However, in most other types of markets barriers do exist. These types of barriers, defined below, prevent free entry to or exit from markets.
Barriers to Entry
Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry. Barriers can also be obstacles an individual faces in trying to gain entrance to a profession, such as education or licensing requirements.
Because barriers to entry protect incumbent firms and restrict competition in a market, they can distort prices. Monopolies are often aided by barriers to entry. Examples of barriers to entry include:
- Capital: need the capital to start up such as equipment, building, and raw materials.
- Customer loyalty: Large incumbent firms may have existing customers loyal to established products. The presence of established strong brands within a market can be a barrier to entry in this case.
- Economy of scale: The increase in efficiency of production as the number of goods being produced increases. Cost advantages can sometimes be quickly reversed by advances in technology.
- Intellectual property: Potential entrant requires access to equally efficient production technology as the combatant monopolist in order to freely enter a market. Patents give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and service marks may represent a kind of entry barrier for a particular product or service if the market is dominated by one or a few well-known names .
A patent is an example of an intangible asset with a limited life.
Patents are an example of intellectual property. If a firm does not own intellectual property relevant to the industry, that could prove to be a significant barrier to entry into that market.
Barriers to Exit
Barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it doing so. If the barriers of exit are significant; a firm may be forced to continue competing in a market, as the costs of leaving may be higher than those incurred if they continue competing in the market. The factors that may form a barrier to exit include:
- High investment in non-transferable fixed assets: This is particularly common for manufacturing companies that invest heavily in capital equipment which is specific to one task.
- High redundancy costs: If a company has a large number of employees, employees with high salaries, or contracts with employees which stipulate high redundancy payments, then the firm may face significant cost if it wishes to leave the market.
- Other closure costs: Contract contingencies with suppliers or buyers and any penalty costs incurred from cutting short tenancy agreements.
- Potential upturn:Firms may be influenced by the potential of an upturn in their market that may reverse their current financial situation.