Sunday, November 20, 2011

Barriers to Entry and Fixed Costs - Part I

Much has been written about barriers to entry in assessing industry dynamics.  My favorite author on the subject is Bruce Greenwald - especially because he is both an economist and a value investor.  His book Competition Demystified offers insights to barriers to entry that can relatively easily be added to an investor's toolkit.  He discusses similar thoughts in other books, such as Curse of the Mogul.  All are informative and interesting.

I'd like to begin by address the term "barriers to entry."  When I first became interested in learning about competitive forces and competitive advantages, I took the phrase "barriers to entry" quite literally.  I thought the term meant that when barriers to entry existed, new firms were prevented from entering the market.  Sometimes this is true, such as in the case of when government licenses and patents prevent others from copying the incumbent's business model.  In other instances, the "barrier" in "barriers to entry" simply refers to the rational behavior from potential entrants.  By this, I mean that despite profits earned by industry incumbent(s), potential entrants realize there is no opportunity for abnormal profits on the margin.  With this in mind, the potential entrants rationally choose not to enter.  The assumption that firms will act rationally serves as the barrier to entry in this circumstance.

How can it be true that a firm in the industry can earn above average profits, but potential entrants all believe that they will be unable to do the same? From what I've learned, it largely occurs when fixed costs are present. Fixed costs are costs incurred that do not vary with the number of units produced or sold.  Fixed costs relevant to the evaluation of barriers to entry exist at the company, its suppliers, and its customers.   Here, I'd like to focus on evaluating barriers to entry resulting from analysis of the company's customers.

Multiple customer-related rational barriers to entry exist.  Commonly cited examples include search costs, switching costs, and network externalities.  A brief description of each of these follows below:

Search costs:  Costs involved in looking for a new supplier or service provider.  It can include monetary costs of the search, or time spent and the inconvenience of conducting the search.  For example, if one wanted to change financial advisors, the selection of a new advisor would likely involve an in person discussion of philosophies, investment objectives, and investment capabilities.  After undergoing these discussions, there is no guarantee one would find an investment advisor better than the one used previously.

Switching costs:  Costs involved in using a new product.  A common example includes time and effort learning how to successfully use the product.  I remember when I was an adolescent I stuck with Nintendo video game system when the Sega Genesis became available, because I had become used to the Nintendo game controller and did not want to learn to use the Genesis controller.

Network externalities:  An externality is a cost or benefit not born by those involved in a transaction. In some markets, the product or service becomes more valuable as the customer base grows.  Microsoft Office became more valuable as more individuals and companies utilized the software - sharing electronic files in a compatible format is often quite valuable.

The one common theme between each of these customer-related barriers to entry is that fixed costs incurred by the customer are involved.  Search costs are fixed costs, provided the customer finds the product or service purchased acceptable for repeat purchase. If the customer is willing to choose the same supplier or service provider for the next purchase, no search costs are necessary.  Likewise, the very name "switching costs" identifies that it will not be incurred if the customer chooses to stay with existing suppliers/service providers.

Network externalities are slightly more complicated.  In many instances, the benefit derived from the increasing customer base is that sharing becomes easier or more beneficial.  Sharing can occur between customers (e.g. Microsoft Office, EBay) or indirectly by providing feedback information through the supplier (e.g. Google, Netflix).  To share information effectively, users generally must become sufficiently familiar with the product or service.  The time invested in gaining familiarity is a fixed cost.  Although the cost of gaining familiarity with a competing product or service may be small, habits are hard to break.  I have not considered trying Bing to perform internet searches because I am in the habit of using Google, although I imagine it wouldn't require a significant investment of time and effort to become fairly proficient in using Bing.

When looking at barriers to entry from a customer-related sources, the label of the source as search costs, switching cost, or network externality is generally more important in evaluating the strength of the barrier than in identifying barriers that exist.*  In fact, I believe these labels may obfuscate important observations if they don't fit neatly into a discrete category. For example, switching costs can also serve as network externalities, as in the case of Microsoft Office.  What is important, however, is the identification of customer related fixed-costs already incurred.  Whether monetary or temporal, the presence of customer fixed costs provides a hurdle for any potential entrant's efforts to acquire customers.  The larger the fixed cost relative to the price of the product or service, the larger  the hurdle becomes and the more durable the company's advantage may be.

* I do note that the presence of search costs and switching costs likely serve to defend a company's existing market share,  while the presence of network externalities may suggest growth of market share may persist.

No comments:

Post a Comment