How Barriers to Entry Confused Me Terribly, and What I Figured Out So Far
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Ok, this one might be a little different from all of the other Evergreen Collections, for a few reasons:
- Barriers to Entry are written about much less often than I anticipated.
- Where they are written about, they are often hopelessly conflated with Competitive Advantage.
This leaves me in a weird spot, which is to either A) pass on what I consider unhelpfully vague information, or B) try to create my own bumbling patchwork of ideas which may not make any sense. (which is not usually the purpose of this project.)
I’m going to go with option B.
Read on knowing that this is a little more personal speculation than these collections are normally, and maintain a healthy skepticism for the ideas. If you see something off, wrong, or plum dumb, please let me know so I can change it before anyone else reads it. (jk. kinda.)
Barriers to Entry vs. Competitive Advantage
I always thought (with no citation) that these were two distinct things. Competitive Advantage was a trait developed by a company to distance itself from rivals. Barrier to Entry was more like a trait inherent to an industry, which determined how hard it was for new firms to enter.
This definition holds up, according to Investopedia:
Barriers to entry are the existence of high start-up costs or other obstacles that prevent new competitors from easily entering an industry or area of business.
(It seems important to point out that it makes no distinction as to whether the obstacle is inherent to the industry or created by competitors)
Many of the resources (and very smart people) who are writing about this lumped Barriers to Entry and Competitive Advantage together as ‘business obstacles’, referring to the whole group as competitive advantage, moats, barriers, etc.
But I think there is a benefit to making a more precise attempt at a definition, because each has its own implications and deserves to be thought of independently.
A quick metaphor, because I like metaphors:
Barriers to Entry: What it takes to get a car, get entered into the race, get it to the start line, and get off the line when the light turns green.
Competitive Advantage: What it takes to win (or survive) the race.
Now, clearly you cannot win without first getting to the line and starting the race. However, to step away from the metaphor, there are many different ways to ‘win the race’ and that is the purpose of Strategy.
Evaluating how likely a business is to succeed requires understanding both the Barriers to Entry (how to get in the game, and what it will cost) as well as Competitive Advantage (how to win, or make your own kind of victory).
These are different processes, with different goals and different purposes.
A little more complicated now…
Barriers to Entry are obstacles to starting the business, and Competitive Advantages are obstacles to beating rival companies.
Ok, so they are different concepts. But there are some obstacles which fit well under both concepts. Network Effects, as an example, are constructed by a incumbent company. Yet they can be considered inherent to an industry as well (social networking will always have Network Effects.)
In fact, if we list out the possible Barriers to Entry, and the possible Competitive Advantages, we can see the almost all of them can be reasonably classified under both, depending on how you look at them.
Purely Competitive Advantages:
Purely Barriers to Entry:
- Licensing and Legal Barriers
- Capital Requirements
Reasonably considered a Competitive Advantage AND a Barrier to Entry:
- Proprietary Technology/Process
- Network Effects
- Economies of Scale
- Scarce Ownership or Access
- Exclusive Supplier Agreements
- Exclusive Distribution Agreements
- Protected Intellectual Property
In this last category, each of these dynamics is an obstacle erected by a rival company. And each of them both makes it harder to start your business and harder to win against them.
Looking at this, it is no wonder Barriers to Entry and Competitive Advantage are so terribly conflated, they have about an 80% overlap in what concepts make them up.
Though these concepts can fit under both perspectives, it is a costly oversimplification to only think of them as a Competitive Advantage.
Understanding the strengths of competitors and the challenges of the industry are both distinct, crucial aspects of success.
Beyond that — evaluating Barriers to Entry can be a very helpful guide to disrupting a competitor (or an industry).
The Barrier-to-Entry Targeting System
For every advantage on that list, we can name a company that has been disrupted despite having that barrier up. In fact, some of them have been subverted on the very points where they thought they were most secure.
Taxi medallions have given Taxi operators security and steady profits for decades — Uber flaunted that regulatory barrier and undermined their entire business.
Craigslist destroyed the profitability of local newspapers by sidestepping the distribution obstacle that incumbents had benefitted from.
Knowing where the obstacles are and where competitors believe themselves to be safest makes for a very handy map for a disruptor. Attack the weak spots, and subvert the strengths by creating new angles to approach.
Subverting Barriers to Entry
This Harvard Business School case about Tesla is the most extreme example I could find of Barriers to Entry being overcome, avoided, or subverted. The auto industry had become notoriously impenetrable. From the case:
Thirty-five years ago, Porter wrote: “In the auto industry economies of scale increased enormously with post-WWII automation and vertical integration — virtually stopping successful new entry. At that time, GM, Ford, Chrysler, Honda, Nissan, and Toyota constituted six of the seven top-selling car companies in the US, and the same is true today.
The case goes on to detail all of the ways that Tesla worked their way into the market and eventually got enough of a hold to grow and prosper.
Rather than looking at the market and assuming that matters will always be that way, Musk saw and unmet need and used innovation to fulfill it. Starting with a minimum viable product, partnering with other firms, recycling capital, and subsidizing aspects of the electric vehicle network, Tesla has altered the landscape of the auto industry.
This is an (admittedly extreme) example of the power of startups. Nimble, original, and able to maneuver under or around obstacles that seem so solid.
The Threat of New Entrants
Michael Porter has the best exploration of this topic — one of the Five Forces of his famous framework is “Threat of New Entrants”, which assesses the ability of new firms to enter an industry.
For an intimidatingly thorough and non-conflated exploration of Barriers to Entry, this book is the original and still champion.
Thanks to Grzegorz Nowak for contributing this classic book!
Entry by Industry
The classic paper by Michael Mauboussin, Measuring the Moat, is a great resource for many things, and there is a section where he applies the theory behind Barriers to Entry to practical investment decisions.
There is a strong correlation between the rate of entry and exit for each sector. For instance, manufacturing has low rates of entry and exit, while construction has very high rates, suggesting that the manufacturing sector possesses stronger barriers to entry and exit.
Well worth a read, this paper is full of small gems that deepen the applicable understanding of Barriers to Entry (and many other things along the way).
That’s all I got.
I’m going to resist writing any more about this, because I already feel I have over-spoken relative to my understanding. I do feel good about the effort of detangling Barriers to Entry from Competitive Advantage, though I still don’t feel like this is a complete or successful attempt.
I welcome and appreciate all corrections, subtractions, and additions as we work together to build a meaningful and reliable resource library for all.
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