Within the five forces model, the factor of Threat of New Entrants analyzes how likely it is for a new entrant or entrants to enter the competitive environment a company operates within. There is less chance of this happening if there are at least some form of barriers to entry into the industry such as strict regulations, need for specialized knowledge or high investment requirements. Conversely, there is less chance of new companies entering the market if there is significant profit potential and not many obstacles in the way to achieving this profit.
In this article, we will look at an 1) introduction to the threat of new entrants, 2) determining the nature of the threat, 3) responding to new entrants – strategic entry deterrence, and 4) an example of amazon.com and the threat of new entrants.
Porter believed that the possibility of new entrants had a significant part to play in developing and changing the competitive dynamics of any industry. Porter’s definition helped people see this threat as substantial and influential. According to his model, this threat changes the competitive environment and directly impacts the profitability of an existing firm. If there is a higher threat of new entrants, this means that there are low barriers to entry and there is high possibility that the industry profit potential will decrease as a whole. This is because more competitors will fight for the same amount of business. Sales and market shares will be redistributed and there may be an effect on price and product quality.
Means of Entry into a Market
How a new firm enters a market can happen in a number of ways:
- Take-over: A company from outside the industry may take-over an existing firm, thereby avoiding any of the traditional barriers to entry within the firm. This firm may bring new and innovative expertise to the industry, thus changing the competitive dynamics for everyone.
- Diversification: Product diversification from existing firms into other categories.
- Competitive advantage: Foreign based competition, through development of a specific competitive advantage can also be a threat.
- Demand: Increased demand may result in increased prices thereby allowing a new entrant to make use of this increase and offset any high costs of market entry.
- Control: Existing firms may choose to control how a new firm enters the market rather than attempt to stop any new competitors from emerging.
DETERMINING NATURE OF THREAT
There may be many ways to determine whether there is an active threat to a market or industry from new entrants. Most of these can be categorized within the potential barriers to entry that exist for that industry.
Conditions within a competitive environment that affect a company’s decision to enter into a market or not are called barriers to entry. These barriers may make it easy or difficult for a business to enter into the market and establish their presence. Barriers may exist in some industries or in some markets but not in others. There is also a chance that they exist but are not enforced strictly. There are many types of barriers to entry including those created by the government, by the existing companies, by the nature of the business and by the existing industry structure.
Types of Barriers to Entry
There are many types of barriers to entry into a market. Some of these include:
- Economies of Scale: When manufacturing or selling at a large scale, companies are able to avail cost advantages because per unit costs of the product fall. So the more the company produces in quantity the more the benefit. When existing companies have this advantage, it can act as a barrier to entry because a new entrant will have to try to match the scale to achieve the same cost advantage as the existing company. This may not be possible at the initial stage.
- A Differentiated Product: If the product being sold by the existing company or companies is highly differentiated or enjoys strong brand loyalty, then this can act as a strong barrier to entry. The new entrant will have to invest in creating a product with newer and unique features and benefits that surpass those offered by the old company. In addition, there will need to be strong efforts to break existing brand loyalties and shift them to a new untested company.
- High Capital Costs: If an industry requires huge capital investments at the onset, then this will act as a barrier to entry for many of the potential entrants. Only those will attempt to enter the competitive fray who have the resources to make this high initial investment.
- Other Cost Advantages: Apart from those cost benefits that come from economies of scale, there are other advantages that an existing firm may enjoy. These include access to the best suppliers, an understanding of existing materials and knowledge of their quality, possession of any necessary and important patents, and proprietary information and technological knowledge. There are also learning advantages, achieved over years of business and experience.
- Cost of Switching: The cost associated with a consumer’s move from one company or product or another is called the switching cost. If there are significant switching costs, then a new entrant may not be able to create means of removing these. Or, they may have to offer significant advantage to counter these switching costs at their own expense.
- Distribution Network: Often, distribution relationships are well established and may prove to be a strong barrier to entry for a new company. A new entrant will obviously need access to these distribution channels but will need to invest extra in order to engage distributors who have established relations with existing competitors.
- Suppliers: As with distributors, suppliers may be vital to the operations of a new business. Existing suppliers may have contracts or loyalties with existing companies and may prove to be difficult to form relationships with.
- Legal and Government Created Barriers: Government and regulatory requirements such as permits and licenses may be a strong barrier to entry. There may also be laws governing ways to conduct business that may conflict with a company’s practices in other countries.
- Barriers to Exit: Interestingly, barriers to exit may act as a deterrent to entry by new companies. If a company is unable to easily leave a competitive environment in case business does not work out, then it will have to stay and compete even if that is a detrimental business practice. In this case, the company may choose to not enter the market in the first place.
Analyzing Entry Barriers
When analyzing the threat of new entrants, there are two things to keep in mind. One is that not all possible barriers to entry may apply to all organizations, and two, the existence of barriers to entry does not mean that the decision to enter the market should be cancelled. Instead, there needs to be an analysis and understanding of these barriers and strategies formed to counter these threats. As an existing company, it is also a good idea to keep a check on the industry dynamics to anticipate the threat of new entrants as the industry changes and evolves. Some questions to ask are given below. These may help in determining if the barriers to entry are low or high. These will then directly impact whether the threat of new entrants is high or low.
- Does profitability require economies of scale?
- Are products generic and undifferentiated?
- Are brand names strong and well recognized?
- Is there a need for high initial capital investment?
- Are there any significant switching costs for consumers?
- Is it possible to align with and access existing distribution channels?
- Is location an issue?
- Is there any proprietary technology required?
- Is there any proprietary or specialized raw material required?
- How complicated are the government regulations, laws and policies?
- How strong is the expected retaliation from existing firms?
Answering these questions realistically and candidly will help a company establish the barriers surrounding a potential new market or its own market and consequently, the nature of the threat from new entrants.
Existing firms in the market can take concrete steps to discourage new entrants from making moves to enter the market. These steps, or strategic entry deterrence, can be any action towards creating or strengthening barriers to entry for the industry. Not all of these activities are positive actions however, and several can come under anti-competitive practices and may open a company up to scrutiny and in violation of competition laws and regulations.
Some of these activities include:
- Limit Pricing: A company may choose to produce a larger output of products at a lower price than what competitors would be able to sell at if they were to enter the market. This strategy is known as limit pricing. If this method is used successfully, not only will the incumbent affect price, but will also end up serving a larger share of the market, thus leaving less open for a competitor. A company may only be able to do this if it has been enjoying higher than normal profits for a whole and has the capacity to increase production at minimal cost increases. In addition, it is only a viable strategy if the profits earned at limit pricing are still higher than what would be risked if a competitor was to enter the market.
- Signaling: If information regarding an existing firm’s operations is not widely available, then this company can use different moves to send signals that will affect a potential new entrant’s decision to enter a market or not. Since the new company will be assuming information, the incumbent can send any signal it wants to achieve the desired results. An example could be limit pricing, thereby sending a signal of potential lack of substantial profits. Any signal sent needs to be backed by actual ability to make the signal last over a longer period of time.
- Preemptive Deterrence: Another way to hold off competitors is to engage customers such that switching becomes a less viable or desirable option. This can be achieved through the creation of strong brand loyalty, strong market visibility, special benefits or promotions, or some form of memberships of contracts that need to be completed. These strategies may warrant price drops or special offers from a new entrant which will be at the cost of profit margins and may end up discouraging entry into the market.
- Predatory Pricing: One form of strategic deterrence is predatory pricing, where a company may price below its actual profits. The idea is to discourage entry into the market or drive a competitor out of business. Once this end is achieved, the incumbent will simply raise prices back up to former levels. An aggressive strategy, this method sends a clear signal to the potential new entrant that strong retaliation can be expected in the market. Though this method seems to be extreme in terms of the lost profit, it has long term benefits of not only deterring the current new entrant threat but also any future threats by establishing an aggressive reputation of the incumbent.
This action can come under anti-trust practices and monopoly concerns so the decision to use this should be taken after careful consideration of possible repercussions.
Predicting Incumbent Response
How an incumbent firm or firms respond to the threat of a new entrant can depend on a number of factors. No all industries and not all companies will respond in a similar way. In addition, the strength and aggression of the response can also vary according to current market conditions, trends and consumer behavior.
Some instances where a strong reaction can be expected include:
- If there has been an established history of aggressive response from incumbents in an industry, then the likelihood of this behavior being repeated is high.
- If the existing firms have strong cash flows, strong brand loyalty, strong market visibility, established partnerships with distributors and suppliers and a high capacity to produce goods then there is a strong chance that they will protect their position in the market with a strong response to potential new competitors.
- If an incumbent has committed to the industry and in the low run seeks to stay relevant and competitive, then it is highly likely that it will try to prevent new entrants from joining the fray.
- If the industry growth has been slow or has slowed down over time, there will be stronger motivation for a company to protect its sales and market share by not allowing a new company to come in and steal a part of the pie. In this case, a hard stance should be expected by a new entrant.
EXAMPLE – AMAZON.COM
Amazon.com, an international e-commerce company, went online in 1995 from the USA. It remains the largest online retailer in the world with separate websites for the US, Mexico, Brazil, Canada, the UK, France, Germany, Italy, Spain, Japan, China, India and Australia. Additional country specific sites are being developed with international shipping available on some products to other parts of the world.
Amazon began as an online supplier of books. Operations soon expanded to include items such as DVDs, CDs, video and audio downloads, software, video games, electronics, clothes, furniture, food items, children’s items and toys, as well as jewelry. The company has also diversified into consumer electronics production and distribution with the most popular items being the Kindle E-book reader and Kindle Fire tablets. Another new technology being offered is cloud computing services.
Threat of New Entrants
Given the nature of the business, there is always a threat of new entrants as it is relatively less costly to enter the market and setup operations. There is no additional cost incurred to set up any physical stores and locations. In addition, traditional established physical stores can easily move into online retailing and bring with them their substantial consumer base. These stores such as Target or Walmart, already enjoy economies of scale, have recognizable brands and a strong supply chain. So they do pose strong competition to Amazon.
That said, the threat from brand new entrants remains low as it would be nearly impossible for a new company to match the cost advantages, economies of scale and variety of offering as Amazon.com. These advantages will deter most brand new entrants to the market.
- Substantial Economies of Scale
Amazon works with over 10,000 vendors and boasts an impressive 75 percent repeat purchasers. Its market capitalization is substantially ahead of its nearest competitors.
- First Mover Advantage
As the pioneer online retailer, Amazon has the necessary brand awareness and credibility as a strong reliable presence in the market.
- Massive product Variety
Way beyond a bookstore now, Amazon.com provides any type of product there is in its online stores. This means that there is a strong supplier base relationship that cannot be replicated. In addition, as a bookseller and a provider of other entertainment channels such as movies, videos and music, Amazon.com has established relationships with publishers, producers, movie studies and music producers which are not easy to form and replicate.