Friday, February 6, 2015

Barriers to Entry and Natural Monopolies

One way to assess a business opportunity is to weigh the market's barriers-to-entry and any natural monopolies the new business might enjoy.


Barriers-to-entry make it difficult for new players to enter a market.  They allow the businesses that are already serving the market to charge higher prices than might otherwise be the case.

Most businesses require some degree of investment to enter a market.  Sometimes those investments are purely financial.  Other times those investments include sweat equity like getting a medical degree of some other form of certification.  Sometimes it is a matter of physical gifts like beauty or being physically fit.

Some of those investments can be recovered when the participant leaves the market.  You might be able to recover ninety cents on the dollar for certain types of equipment like injection molding machines.  It would be even smarter, of course, to lease that kind of equipment.  Recoverable investments are porous barriers to business entry provided credit is available and accountants can perform simple math.

Other investments are lost.  A medical degree loses much of its value if the degree holder enters a businesses outside of medicine.  Sports apparel branded with the losing Superbowl contestant has little value.  Investments that cannot be recovered are barriers that are supremely effective at limiting the entry of new supplies into a market.

Often, barriers-to-entry are a legacy of the guild system which sought to integrate an orderly supply of well trained artisans, the needs of the market, maintain institutional knowledge and the desire to maintain a fee structure.  A mathematical modeler would call this a damped response, much like the shock absorbers on your truck.  Damping a response reduces or eliminates overshoot at the cost of a slower response time.  The elimination of supply overshoot helps avoid price wars and the resulting business death spirals.

For reasons that are beyond the scope of this essay, local and Federal government agencies run in parallel with the guild system (now called "Unions").  That results in the business person attempting to serve multiple masters:  The customer, the guild and the government.  It is a case of the proverbial "One foot on the dock and the other foot planted in the canoe."  It is not a comfortable place to be.

One ramification of this triad of masters is that the lack of coherence between them makes it impossible to perform meaningful business planning.  Perhaps even more toxic to business formation is lack of coherence within a cluster of masters.  Consider a business regulator who sends different inspectors to a work site.  They will tie the business owner into knots if they cite the owner for wildly differing infractions.

Another risk that is inherent in external regulation is the gravitational pull for governmental agencies to become "activist".  It is an inflationary mindset.  You are falling behind if you are not moving forward.

Natural Monopolies

A natural monopoly is a specific type of barrier-to-entry.  Natural monopolies allow businesses to charge higher prices than would otherwise be the case.

Rail map, mid-West.  Image from HERE
Natural monopolies come in a wide range of flavors.  Many are geographic.  Some areas are blessed with hydroelectric potential, other places can grow lemons,  still other places are blessed with good harbors, navigable rivers and others (like Chicago) are located where natural features funnel traffic.

Some natural monopolies are created by the nature of the product.  Some products are very perishable.  Raspberries are fragile.  The root-balls of large shade trees are both heavy and fragile.    Iron ore, coal and limestone are heavy and bulky. Children don't always transport well.

Consequently, fertile soil near sophisticated populations are wonderful places for growing tender, gourmet foods.  Tracts of land that will be subdivided in 8-to-15 years are wonderful places to establish nurseries for shade trees.  Pittsburgh was a great place to smelt iron.  And there is a need for daycares near employers, schools and in bedroom communities to minimize incremental travel with the wee-ones on board.

Image from HERE
Another form of natural monopoly involves intellectual property.  The bronze casting guild had the institutional knowledge of how to mix clay, sand and flour to make the molds.  They knew how to bake the mold to drive out moisture before pouring the molten metal.  They knew how to mix different base metals to produce alloys with the desired characteristics.  It was simply more efficient to go to the bronze caster for your belt buckles and spear points than to try to reinvent that knowledge on your own.  This is less of a factor than it used to be as we have a much better understanding of the science of reverse-engineering.

A third form of natural monopoly occurs when a single business is able to saturate the market.  A town may be large enough to support one florist.  A second florist would cause both to fail unless the second florist was subsidized by outside resources.

Image from HERE

For reasons that are difficult to understand, bars and churches seem to be immune to the saturation effect.  It may be that sinners find solace in the fact that we are sharing the same laundry basket with the same kind of dirty laundry.

Image from HERE

A fourth kind of monopoly involves breaking into a family business. One might think one could marry into "family".  However, it did not do Carlo Rizzi or Saddam Hussein's sons-in-law any good.

1 comment:

  1. Heh, that last one is DEFINITELY one to think about... :-)