Thursday, April 28, 2016

Barriers To Entry

In the business world, a "barrier to entry" is a hurdle you must leap in order to enter into a market.  Are these ultimately detrimental or helpful to the consumer?

Say you want to start a business.  In order to do so, you have to jump through a number of hurdles.   If it is a traditional business, you may need to raise capital, take out loans, find office space, hire employees, collect taxes, and do all the number of difficult, expensive, and risky things you need to do to start a business.   And likely, you will lose all of your money doing this - the success rate of new businesses is pretty pathetic.

In addition to all of those other factors, however, there may be other barriers to entry.   These could be anything from restrictive Patents or other Intellectual Property, to an existing monopoly or duopoly in the business, to unions, and even to organized crime.    In order to survive, you may need to rapidly grow to a certain size in order to take advantage of economies of scale.  And these barriers can develop over time.  In new emerging industries, few barriers may exist.  However, such industries quickly settle out to a few main players and at that point, it becomes very hard to jump in late in the game.

Take the car business, for example.   At the dawn of the automotive age, around 1900, the automobile, as primitive as it was, was arguably the most complex piece of technology ever owned by individuals up until that point.   Manufacturing an automobile required a number of different technologies and trades - everything from a forge plant, to a casting plant, a machining shop, to a carpentry shop, to a coachworks, to an upholstery shop.  And all of this had to be done at a price that was affordable to at least some customers.

In the early days, automobiles were largely hand-built for only the richest customers.   And while a number of companies sprung up to build them, they quickly formed a manufacturer's guild to keep out new competition.   A Patent Attorney name Selden from Rochester, New York, obtained a Patent on an automobile and if you wanted to build cars, you had to pay him and his manufacturing association - if they would give you a license.   This was a barrier to entry.

This sort of practice kept the number of competitors low and prices high and arguably allowed for the infant industry to develop in an incubator fashion.   Cut-throat business practices and low-cost competition didn't exist until a fellow named Henry Ford came along.   Ford, refused a license by the cartel, went his own way and came up with new cost-cutting measures and ways to make a car for an alarmingly low price.   Within a few years, the old-line car companies were largely out of business and a host of new, larger companies with assembly-line manufacturing techniques, came into being.   The "brass lamp" era of automobiles was gone for good.

While one barrier to entry was dropped (the automotive cartel and the Selden Patents, which by now had expired) a new barrier was erected.   In order to make cars, you had to be big, or get big fast.   With prices dropping from year to year, car companies had to consolidate and also acquire lower cost parts by buying up parts companies.  General Motors was created and went on an acquisition spree which nearly drove it to bankruptcy.   Eventually, they were able to turn things around and become the largest car company in the world.

Ford meanwhile build the largest factory in the world - the Rouge plant, where raw iron ore went in one end and finished cars came out the other.   Smaller car companies and specialty car companies would buy manufactured parts (e.g., Many small car companies used Continental engines) but by doing so were always at a price disadvantage.   Within a few years, those "car assemblers" went out of business, and the American automobile industry was reduced to the "Big 3" plus the makings of AMC.

As Preston Tucker discovered after World War II (and as Paul Elio is discovering today) trying to start a car company is next to impossible, at least in terms of mass production.   Going from 0 to GM in 10.5 seconds is impossible to do.   The amount of capital needed is intense.   Setting up a dealer and distribution network is a staggering job.   Meeting all of the regulations to build a new car today is frighteningly expensive.   Few, if any people, can succeed at this.

Tesla has certainly made strides in starting a new car company.  However, if you look at their incremental approach to the business, you can see where they cut corners or jumped over hurdles.   Their first car was a chassis and body bought from Lotus, with a Tesla drivetrain installed.  It was staggeringly expensive and sold as a toy to millionaires - much as the first automobiles in 1900 were sold.   His next car was far more refined, but still staggeringly expensive.   Rather than invest in a dealer network, they opened storefronts in malls - bypassing that barrier to entry.

His products have had their teething problems.   After calling the Tesla the "perfect car", Consumer Reports retracted their evaluation and now rate it unacceptable (so much for the credibility of Consumer Reports!).    Problems continue with their newer cars as well - mostly electrical glitches, of course, which are the bugaboo of any modern car - as cars become more electronic.   And the Tesla is about as electronic as you can get.

The real problem for Elon Musk is that some other car company, who already has the infrastructure to build cars, the dealer network to repair them, and the branding and advertising will steal his thunder and build an equivalent car for far less money.   And in fact, many already are.   If you want an electric car, your local Chevy, Nissan, and KIA dealer are selling them right off the lot.  However, no one will notice you if you drive one.

It will be interesting to see if Tesla can continue to go it alone, or whether, like so many other "start-up" companies, it becomes acquired by another.   With companies like Fiat-Chrysler hoping to be bought out, you have to wonder how tiny Tesla could continue solo.  (Speaking of which, VW looks to be a good mate for F-C, as they are already selling Chrysler's minivan, and have very little presence in the SUV market and none in the truck market.   But the diesel scandal might make it a bad time for mergers).

But getting back to the point, barriers to entry keep the "me too!" competitors out of the market.  Once a market is mature, you either have to find something else to do, or find a new way to compete - as Musk has done - by hopscotching these barriers.

And this pattern repeats in any emerging market.  Not a few years ago, the Internet was a Wild West of opportunity and lawlessness.   If you wanted to start an online business, all it took was a website and a few computers.   Today, the Internet is still a land of opportunity, but it is quickly sorting itself out into a number of major players and a host of has-beens and wanna-bes.

If you want to start a social network today, it is probably too late.   You need that critical mass of users, and Facebook and Twitter have sucked all the oxygen out of the room.  Similarly, if you want to start an online retailer, you will have to go up against Amazon (which is actually losing money) and eBay.  You will need that critical mass or some compelling feature to make it.

This is not to say that you can't succeed.   Niche markets have always thrived even when barriers to entry in major market block competition.   Maybe you can't be the next Amazon, but you can sell specialty goods online, and maybe even use the platforms of Amazon or eBay to do so.

Barriers to entry are, in a perverse way, beneficial to consumers.   While competition is a good thing, too much competition can be ruinous.  The consumer is often better off having a choice of two or three major product lines than having hundreds or thousands of products to choose from.   With too many products comes confusion.   Not only that, it is inefficient use of manufacturing and market space.   Three huge car companies can make cars far more cheaply than 100 boutique brands.   In fact, that is Fiat-Chrysler's argument - that the market would benefit from further consolidation as it has matured further and staggering product development costs need to be shared.

Barriers also provide uniformity in the marketplace.  In the early days of the PC, there was a plethora of formats, operating systems, and computer languages - and I know because I used them all.   In one company, we might have computers from Mostek (the old Zilog Z-80), Apple, Tektronics, HP, IBM, PRIME, Control Data, and even Olivetti (don't ask, it was Italian), each running stand-alone.  Today, computer systems are standardized and cheaper than in the past (and far better).   But along the way, a lot of small competitors went belly-up when they couldn't adapt to new conditions.  The consumer is better served today by fewer competitors, ironically.

Barriers to entry also benefit the consumer in that "fly by night" operators are discouraged.  In the early days of the automobile, the computer, and the Internet, many small companies would start up, offer products, and then disappear from the marketplace - leaving consumers with orphaned products with no support or parts, or products that never worked well in the first place.

In this regard, Americans are schizophrenic when it comes to the marketplace.   We all like to decry "the big corporations" and the Bernie Sanders of the world want to "break them up" into smaller companies.   But such smaller companies would not necessarily be more efficient, provide better service, or lower prices.   And the history of anti-trust law in this country backs this up.

For example, Standard Oil was a ruthless monopoly that swallowed up smaller companies.  One of the "barriers to entry" in the oil business (or any business) was that huge companies can afford to sell below cost in order to put you out of business.   Again, you have to get large quickly or go home, particularly in commodity businesses.   After many years, Standard oil was broken up into a number of companies - Esso, Standard Oil, Mobil, and so forth.   And after many more years, these same companies were consolidated yet again into Exxon-Mobil.   So in effect, we are back where we started.

Similarly, the telephone company, "Ma Bell" was broken up into the "Baby Bells" in order to foster competition.   Today, they are again consolidated into AT&T - right back where we started.   Of course, there is still competition, but this time around in the form of different types of communication - satellite, cable, fiber, wireless.

The Justice Department ran a long-standing campaign against IBM for anti-trust.  We know how that worked out.  Technology changed and IBM is no longer seen as a threat to society.  A similar suit was filed against Microsoft, which itself struggles to remain relevant in a smart phone world.
So "breaking up the big banks" may sound like a swell idea.   But frankly, I like the fact I can go from State to State and use the same bank.   Maybe this isn't "fair" to Ma and Pa Kettle's local bank, but it is the way things are going.  Smaller banks are giving way to regional or national banks.  And increasingly, banking is something done over the Internet and not at a "branch" or office.  Our local Bank - Ameris - is growing rapidly by buying up old Bank of America offices.   But this growth model might be short-sighted.  They are snapping up the costly and difficult "teller" customers at the expense of the low-cost and profitable online ones.

Of course, there reaches a point where barriers to entry might be too high.   When competition grinds to a halt and an effective monopoly is created, consumers can be hurt by arbitrary high prices.   Railroads were accused of this back in the late 1800's.   Farmers would move out West and start raising grain and cattle - often on land bought from the railroads (who were given extensive rights-of-way across the country).   Their crops would be shipped to feed the folks in the big city by railroad.   But the railroads quickly realized they had the farmers over a barrel.  Without a means to ship their products, they would starve to death.   Eventually regulation of freight rates had to be implemented.

Of course, the railroads got their comeuppance later on.   And when competing with peers of an equal size, they had to compete on price.  Rockefeller famously played one railroad off against another with his "rebate" schemes, and used alternative technologies (the pipeline) as a means of keeping competition in check.  But the small local farmer didn't have such options, at least not until our highway system was developed and the tractor-trailer invented.   Folks who pine for the old days of railroads fail to remember why people disliked them so.   A few trips on Amtrak usually reminds them.

I am not sure what the point of all of this is, other than barriers to entry can in fact be a good thing for the consumer.  Just because you get it into your head - as Paul Elio has - that you should start a car company, doesn't mean it is a good idea for you or the consumer.   The consumer benefits from mass production, consolidation, and the resulting low prices as much as he benefits from the competition that creates these low prices.

And in many fields, such as law or medicine, we use regulation to control the number of competitors in the field and insure they are qualified to practice.   Would you really want to live in a Libertarian world where anyone who claims to be a doctor could be one?   We are already sort of doing this today with these quasi-legal "holistic medicine" and "nutritional supplement" quacks plying their wares.  Having a guild does provide some benefit to the consumer.

Finally, as illustrated by the Musk example, a barrier to entry can act to stimulate innovation.   If Musk had tried to build Tesla along the lines of a traditional car company, he would have failed long ago from lack of capital.   By coming up with new and innovative ways of building and selling his product, he has managed to survive (at least for the time being) where others have failed.   By doing an end-run on the barriers, an innovator can still succeed.   Trying to compete doing the same old thing not only isn't going to work, but it really doesn't enhance the marketplace for the consumer by merely adding another look-alike competitor.

Barriers to entry can and are beneficial to the consumer, and indeed most of our manufactured goods today would not be available to us in such quantities and quality if such barriers did not exist.