SBP 6f: Lowered Entry Barriers

This principle occurs because of various symptoms and implications coming from the Unified Services Theory, as will be discussed below.

Perhaps the most commonly referred to list of barriers to market entry are those published some years ago by Michael Porter. His general list (not exclusive of manufacturing or service organizations) includes the following:¹⁾

• economies of scale (It is not worth it to enter a market in a small way.),
• product differentiation (It can be hard to overcome brand loyalty for current producers.),
• capital requirements (Start-up often involves significant capital investment: plant, equipment, working capital, etc.),
• access to distribution channels (It may be difficult to compete in wholesale or retail channels that already carry competing products.),
• government policy (It may be difficult to comply with government regulations, especially for a new market entry.), and
• cost advantages independent of size (e.g. experience curves, proprietary technology, access to the best sources of inputs, assets purchased at pre-inflation prices, government subsidies, favorable locations).

For each of the barriers described by Porter, we will consider how (a ) the Unified Services Theory impacts the barrier's manifestation in services industries, (b ) whether the barrier is generally higher or lower for services, and (c ) how current service providers might fortify that barrier. As with all Service Business Principles in this workbook, this evaluation of barriers is founded in the Unified Services Theory. We will consider the first five barriers listed above, followed by a number of barriers pertaining to “cost advantages independent of size.”

Economies of Scale. As mentioned in the Heterogeneous Production Service Business Principle, the individual units of output of many service processes are unique. Since customers provide inputs, the inputs are unique. This implies that the entire production process may need to be tailored to each individual customer. As such, economies of scale are much less likely to occur in services.

If economies of scale is a much lower barrier to entry for services, how might current service providers fortify the barrier? For most service companies, some parts of the process do not have customer inputs and thus can be treated the same as they would in manufacturing. For example, at a restaurant, the process of taking orders, preparing food to order, and serving the food for consumption in a pleasant atmosphere involves customer inputs, which hinders economies of scale. However, the procurement of food (raw materials) and other supplies can happen independent of the customer. Therefore, the procurement processes can enjoy the benefits of economies of scale. An example of this is large restaurant chains which have centralized purchasing functions. This gives large chains an advantage over new market entries who likely purchase in smaller amounts.

Another area where the economies of scale barrier can be fortified is in mass marketing, which again can be accomplished without customer input (customers just consume the output of mass marketing). Again, large producers can have their mass marketing efforts work for multiple locations. Consortiums of auto dealers (e.g. the metropolitan area Ford dealers) have an advantage of pooling their advertising dollars to increase the breadth of exposure.

Product Differentiation.

Services production is often nonstandard for reasons described previously. Therefore, every unit of production can practically be differentiated from every other unit. The production of current producers may be different over time depending on customer inputs. So then, why would it not be easy for new competitors to likewise differentiate?

In addition, “quality” is often hard to define for services. This is because much of quality depends on customer inputs. What is quality of education? An important part of quality of output is quality of input. Is ability part of quality? What about adaptability? If quality is indeed hard to define for services, then it would be easy for a new market entry to claim higher quality without easily accomplished verification.

Also, services tend to be high in “credence” properties, which are those properties that cannot be easily evaluated even after purchase and consumption.²⁾ How does one student know if he received a better education than another? How does a patient know if she got better surgery from one hospital than she would have received from another hospital? With credence properties, the customer has to take the word of some expert–often the service provider (doctor, professor)–that the product is better. New entries can (and often do) claim to be different and better than current providers, which can be hard to either prove or disprove.

So, product differentiation is also tends to be a lower barrier for services. How might present providers fortify this barrier? One way is to emphasize personalization, which is to customize production to the individual characteristics and needs of individual customers. If we are meeting specific needs of individual customers, any attempts to “differentiate” by competitors may be considered of little value to the customer. In other words, if we are already hitting the target, differentiating from where we are hitting means missing the target.

Capital Requirements. One of the major capital requirements of manufacturing organizations is working capital to pay for inventories of raw materials and purchased parts to use for production. With many services, customers provide most of the inputs, and the company does not have to pay the customer for these inputs, leading to a lower working capital requirement. For example, the primary input in auto repair is automobiles with problems. Auto shops do not have to pay for that input, which is good, since it represents what would otherwise be the most expensive input.

Another demand on working capital is financing inventories. Since service customers often resist extended inventories, this is also less of a cost.

Therefore, as far as working capital goes, there are reasons that the barrier to entry for service industries might be lower than for manufacturing industries. However, the capital requirements barrier can be fortified by concentrating on other types of capital requirements such as plant and equipment. A hotel could provide nicer facilities. A shipping company could provide more advanced computer technology for tracking packages. An Internet Service Provider could provide faster modems, which would be more expensive. In these ways, current providers can raise customer expectations for service and make it more expensive for new market entries to compete.

Access to Distribution Channels.

In manufacturing, the distribution channels are the means of getting the production output from the factory to the customer. Companies like Frito Lay or Coca-Cola have access (or own) distribution channels and command premium shelf space at supermarkets. A real challenge for a new auto manufacturer would be finding out where to sell the product.

With many services, production takes place when the customer is present as an input, or is providing inputs. Therefore, every customer represents a unique distribution channel. New competitors who have access to customers simultaneously have access to the distribution channels.

As a lower barrier, access to distribution channels can be fortified for services by making exclusive distribution arrangements with customers. The retailer Sam's Club does this by charging an annual membership fee. Airlines have a membership arrangement in the form of frequent flier programs. Other companies make ties to customers by providing distribution technology on-site. The drug distributor McKesson installs computer terminals for placing orders in hospitals and pharmacies. The Internet Service Provider WebTV (or Microsoft) controls the distribution channel into customers' homes by selling customers the TV-top box that controls the access.

Government Policy.

Complying with government policies and regulations can be a challenge, particularly for new market entries. The question is, do service businesses tend to be more or less regulated by governments? To answer this we might ask why governments regulate businesses. Very often, the answer is to protect consumers (i.e. voters and taxpayers). In this regard, how do services differ from manufacturing organizations? Again, by the UST we see that customers are providing inputs to service production processes, and are very often the inputs themselves. As such, we might suppose that governments are more likely to regulate service businesses.

In manufacturing, if there is a product defect, the company simply issues a product recall. Examples in recent memory are lawn darts and exploding gas tanks. Tens of thousands of vehicles were produced with faulty gas tanks, yet only a handful of people were harmed as a result.

On the other hand, consider the effect of a problem with a service process with its customer-provided inputs. Banks act on peoples' money. Dentists act on peoples' teeth. Airlines act on customers' selves. Think how highly regulated these industries are. Why? If a certain dental procedure produces defects in ten thousand units of production, every one of those customers is affected by that defect, even if a recall is initiated.

We thus have reason to believe that the government policy barrier would be generally higher for service companies than for manufacturing companies. Nevertheless, current producers may still want to fortify that barrier, or at least get as much “milage” as possible out of the existing barrier. The barrier can be fortified by seeking more government regulation (heaven forbid), such as by hiring lobbyists. An example of this can be seen in the banking industry. Credit unions, who enjoyed the benefits of fewer regulations and taxes than traditional banks, desired to offer many of the investment services provided by banks. The traditional banks desired to protect their market positions by encouraging more government regulation of credit union activities.

One way for current producers to get milage out of government regulation barriers is to publicize their compliance with the regulations. In this way, potential new competitors will see this as a barrier, with compliance coming at a cost. A manufacturing example is automakers who publicize that they comply with safety regulations, such as air bags, prior to the time they are required by law. Service companies such as airlines could likewise publicize superior compliance with government-imposed safety regulations.

Cost Advantages Independent of Size.

Porter lists six of these other cost advantages in his original article.³⁾ The application of the Unified Services Theory makes each of them quite interesting. Therefore, this section will look at these other cost advantages in detail. Since they were listed but not described in the prior section, their manufacturing application is included here for reference. As with the prior six barriers, I will describe the implications of the Unified Services Theory for each of these cost advantages, and how current service providers might fortify the barrier to entry.

Experience Curves.

With manufacturing, current producers have a cost advantage because they have moved down the experience curve–or have learned how to produce more efficiently and effectively. With service companies, it is hard to gain experience when every customer presents unique inputs and every unit of production is potentially unique. Experience is more likely to be gained by production components that tend to be common across the various units of production. However, generally the cost advantage do to experience curves will be lower for service providers than for manufacturers. Current service providers can fortify this cost advantage barrier by decreasing employee turnover and standardizing procedures where appropriate.

Proprietary Technology.

Manufacturers with proprietary technologies often require employees and plant visitors to sign non-disclosure agreements. This protects the advantage brought of those technologies. With many services, customers have free access to production facilities and technologies, since they are providing inputs. (see SBP: The Ephemeral Secret Service) Potential competitors posing as customers can study the production technologies, allowing competing companies to more easily duplicate those technologies. For example, when Federal Express came out with their on-line tracking of packages, we can be sure that competitors posing as customers studied the technology to see how it interacted with customers. This would greatly simplify the process of developing similar technologies. These technology imitating companies have the advantage of not having to design the technology purely from a blank drawing board.

In addition, many service process technologies are very intangible (even though the service overall service has many tangible elements) and not patentable, which limits the legal protection of proprietary technologies. (also see SBP: The Ephemeral Secret Service)

Current producers can fortify the technology cost advantage by investing in Research and Development to develop production technologies that continually offer new features. Thus, they become a moving target with technologies that are difficult to keep up with.

Access to the Best Sources of Inputs.

Manufacturers may own the input source or have some exclusive agreement for obtaining raw materials or component parts. The fact that IBM makes computer memory chips certainly helped their ability to compete when the memory shortage occurred a few years ago. With service processes, primary inputs come from customers, who are not owned by the service producer, and who are less likely to make an exclusive agreement. Therefore, by gaining access to customers, new competitors have access to these key sources of inputs.

As with “access to distribution channels” discussed previously, this cost advantage may be fortified by establishing membership or other relationships with customers. For example, a dry cleaning service may establish contracts with customers to pick up soiled clothing, which is a major input in the dry cleaning process.

Assets Purchased at Pre-inflation Prices.

Current producers of manufactured goods can have a cost advantage over new entries because of lower book values of assets, implying not only lower purchase price but also lower depreciation expense. It can certainly be an advantage for a manufacturer to have an older facility that is paid for. Further, the customer does not care (or is not aware) that the goods are being produced in an older facility.

With services, the customer often sees the service provider's facilities when she is providing inputs. Do service customers prefer new production assets to older assets? Do customers prefer new hotels to older hotels? New hospitals to older hospitals? New retail facilities to older facilities? Generally, yes. Therefore, it can, in fact, be a disadvantage for a service provider to have older facilities. Further, changes in architectural styles or construction coding may make it very expensive to upgrade old facilities. New competitors may very well have an advantage. When assets represent changing technologies, such as the modems used by Internet Service Providers, the old technologies may not even be paid for when new technologies need to be purchased.

The cost advantage for older producers can be somewhat reclaimed by conscientiously planning expenditures to keep assets in new condition. In this way, the costs of providing updated assets and facilities can be planned and controlled.

Government Subsidies.

Very often, the government subsidizes current producers of goods to protect the existence of those current producers. Common examples are farming and aerospace, where the government protects industries for national security reasons. How does the government determine where to provide subsidies? Very often the subsidies are given based on the producers' prior production. For example, farmers involved with protected crops will typically receive a subsidy based on the average production over the last five or so years. (Sometimes this subsidy is payment to produce less grain in the future in order to keep prices up.) New competitors have less prior production, and thus have less access to government subsidies.

Government subsidies provide less cost advantage to current service providers. One reason for this is that with manufacturing, the subsidies are generally to protect the producers, whereas with services, the subsidies are often to protect the consumers (i.e. voters and taxpayers), who are providing inputs into the production process. Health care is subsidized not so much to protect the doctors and hospitals, but to protect the patients. Education is subsidized more to protect the interests of needy students than to protect the educational institutions. Therefore, new competitors who have access to subsidized customers have access to the subsidies.

Current producers might fortify this cost advantage somewhat by specifically catering to the needs of customers with subsidies, thus improving the access to those subsides. For example, medical clinics might hire employee with particular skill in processing government subsidized medical claims.

Favorable Locations.

Some manufacturers have cost advantage by being located near a key resource. One computer peripheral manufacturer moved its production facility to Malaysia, which was nearer to parts suppliers. This would supposedly give that company advantage by shorter distances from suppliers and thus greater responsiveness. A steel manufacturer might be located near a major source of ore or near a centralized railroad hub for inexpensively shipping the product.

Service businesses often have to be located near the customers, so that customer can easily provide their inputs (see SBP: Customer Proximity). This means that many services need to have decentralized production facilities. (You cannot locate a copy center or dry cleaners in Kansas City and serve the entire Midwest.) Being decentralized, the production facilities are often small and dispersed. New market entries can thus position their service facilities in between competitors facilities. In fact, often the best place for a new market entry to locate their facilities is right next door to competing facilities. The best place to locate a new restaurant is often near a current restaurant that is doing well. (Burger King does this all the time with McDonald's.) There is an advantage for retail companies to locate near competing retail companies, such as in a mall or shopping center. Auto sales and service companies tend to locate near one another for similar reasons.

Thus we conclude that the cost advantage of favorable locations is often a weak barrier to new service companies. Current service providers can attempt to fortify this cost advantage by making arrangements with complementary service providers to share locations. For example, a restaurant chain might make an exclusive agreement to locate a facility within a hospital or an educational institution.

Current service providers must decide how to prepare for the threat of new entrants. New entrants need to decide if any barriers are a threat to success in a service industry.

Examples of how to fortify various barriers were described above.

(General examples were given in the details section above.)

Economies of scale might be a barrier for transoceanic airlines, which need sufficient numbers of passengers to justify flying large long-range planes (like 747s). But for shorter-range routes, small airlines can compete by flying smaller planes and feeding passengers into other airlines' hub airports.

Product differentiation is generally not a major barrier, since many passengers view air travel as a commodity and are thus not very loyal to current providers. (In the Positioning Amid Customers and Competitors Service Business Principle, I described the Concorde jet as effectively differentiating. Yet there are not a lot of customers willing to pay for such non-commodity travel.)

Capital requirements might be a significant barrier, given the high cost of aircraft. However, startup companies can lease jets, requiring much less up-front capital.

Access to distribution channels can be a barrier when there are a limited number of gates at certain airports. (Air travel is “distributed” at airport gates.) Airlines can get around the gate availability barrier by sharing gates or leasing them from other carriers.

Government policy might be a barrier for highly regulated regions. For example, an absurd legislative agreement in the state of Texas restricts Southwest airlines from having flights out of Dallas's Love Field to any state that does not border Texas. (What ever happened to deregulation?)

(Cost advantages independent of size…)

Experience curves might bring an airline cost advantages if they have skills at efficient operations. However, as discussed in other Service Business Principles, the inefficient traditions of most airlines makes this a weak barrier to new entrants.

Proprietary technology there was a time when some airlines thought reservations systems like Saber provided advantage to the airlines who owned them. However, with the Internet, any airline can provide automated reservation systems at relatively low cost.

Access to the best sources of inputs is a weak barrier since the inputs to the airline process are available to anyone who seeks them. Some airlines may have preferred provider agreements with large companies, but the commodity nature of air travel makes these agreements subject to competitive bidding each time the agreement is renewed.

Assets purchased at pre-inflation prices can be an advantage when the price of aircraft is going up. However, the cost goes up when those older aircraft need to be retired. The vice president of one startup airline said that his company gained a great advantage by purchasing used 737 jets at dramatically discounted prices.

Government subsidies are certainly a barrier which gives advantages to aircraft manufacturers like Airbus Industries. One regional discount airline was supposedly subsidized by its home state in the Southeast–probably to provide inexpensive service where it was not otherwise available. But generally, the multi-regional and international nature of air travel can make it unnecessary for governments to subsidize what foreign air travelers can easily provide.

Favorable locations might mean favorable locations in airports, which was discussed above. The location of airplanes in the air is subject to national airspace approval, but is otherwise open to anyone who wants to fly.

The conclusion is that the barriers to entry in the airline industry are relatively low, or can be easily overcome by new entrants into the industry. This probably explains why so many airlines have sprung up over the past few decades. And many of these airlines startups have gone bankrupt–since it is easier to enter the airline business than it is to operate in it profitably. (They needed to take my Services Management course.)

With manufacturing, a number of significant entry barriers exist, as discussed under this Service Business Principle.

1. Consider the traditional entry barriers: economies of scale, product differentiation, capital requirements, cost advantages, access to distribution channels, and government policy. Also, consider other cost advantages for current producers such as experience curves, proprietary technology, access to the best sources of inputs, assets purchased at pre-inflation prices, government subsidies, and favorable locations.
2. What traditional barriers to entry are significant in this industry (preventing new entrants from easily competing)?
3. In what ways can weak barriers to entry be fortified? Or, how can current producers increase their competitive (or contributive) advantage of being current producers?

Identify which two or three of the barriers to entry give the greatest advantage to current service providers. In other words, what barriers make it most difficult for new service providers to enter as competition? Describe why they are so significant in your industry. Next, identify which of the barriers are of little concern to potential new competitors–or which of Porter's barriers give relatively little advantage to current service providers. Describe how two or three of them could be fortified to give current service providers additional advantage. (Porter's barriers include

• economies of scale
• product differentiation
• capital requirements
• access to distribution channels
• government policy

cost advantages independent of size, which includes

• experience curves
• proprietary technology
• access to the best sources of inputs
• assets purchased at pre-inflation prices
• government subsidies
• favorable locations)