First mover advantage and barriers to entry

Much of the discussion below comes from my reading of Michael Porter's Competitive Strategy and Richard D'Aveni's Hyper-Competition.

A firm that is first to enter a market has the opportunity to proceed to erect formidable barriers to entry. This is known as first-mover advantage and it can translate into an ability to keep competitors from entering the space. Here are some of the advantages to being a first mover:
• Economic rents: Before competitors enter the space, the first mover gets to act as a monopolist and capture substantial economic rents (through the ability to use monopoly pricing). This advantage does not translate to a barrier to entry – if anything, the high margins commanded by the incumbent serve as a honeypot, attracting competitors into the space.
• Market control: The first mover has the opportunity to gain control of the market before competitors begin to hammer at the doors. With strong network effects, market share itself creates value. Ebay is an example of this.
• Economies of scale: In situations where there are scale economies, first movers have the ability to capture large market share, which can translate into lower marginal costs of production. This can translate into an entry barrier because subsequent market entrants have to achieve a similar scale (by stealing market share) before they can reach the same cost points and be competitive. When the minimum efficient scale is large relative to the market size, this can be a powerful deterrent to entry. In practice this means new entrants have to be willing to sustain potential significant losses in the short term till they attain these efficiencies of scale. This advantage is tied to the advantage of experience curve effects – being first to market confers a time advantage which can be translated to a deeper knowledge of the customer, etc. that will have to be painfully re-learned by new entrants. To the extent to which these experience curve effects translate to lower costs of production, for instance, this can be a powerful barrier to entry.
• Switching costs: The first mover has the opportunity to create large switching costs which (once critical mass is achieved) have the effect of excluding competitors. Strong network effects, as in the case of eBay, can enhance this effect. Another example of switching costs is Microsoft Office, which has created lock-in through its proprietary closed formats and erected formidable consumer re-education barriers.
• Channel control: The first mover has the opportunity to create a barrier to entry through strong exclusive control of distribution channels.
• Control of scarce assets: First movers have first dibs at scarce resources: natural resources, land, shelf space, etc. This may only confer a temporary advantage. However, in some industries (think De Beers in diamonds), this can be a source of sustained advantage.

As noted above, many elements of the first mover advantage can be leveraged into creating strong barriers to entry. Here are some of the other barriers to entry into a space (besides the ones discussed above):
• Capital requirements: Industries that require large capital investments for entry are likely to deter those without the deep pockets or the ability to raise sufficient capital.
• Differentiated products, product space filled by existing firms: in this situation, all the generic strategies have already been implemented (low-cost low-end, high-cost premium product, intermediates).
• Governmental regulations: Subsidies or protections afforded by governmental regulation.
• Patents: self-explanatory.
• Exit barriers: Low exit barriers can serve as an inducement for entry. The converse is also true.

The entry barriers created will persist at least for a while. D’Aveni, however, makes the point that, in hypercompetitive markets, entry barriers are not a source of sustainable advantage (there are no sustainable advantages in a hypercompetitive market), merely a temporary one that allows the firm a limited window of time within which to capture substantial rents. Soon enough, competitors will find ways to evade or circumvent each of these barriers to entry.

D'Aveni offers a catalogue of follower strategies for second movers. Many of them are obvious (find an underserved niche, offer a stripped down version of the product, use superior skill or knowhow to achieve a lower cost of production). One strategy that I found interesting was using compatibility with the incumbent's product in cases where there are switching costs and user-base effects (network externalities). For example, OpenOffice is compatible with all MSFT formats (.doc, .ppt, .xls, etc.). What’s more, the UI is pretty much the same (same menus, etc.), so the customer does not need extensive re-education on how to use the product. This is one important reason why OpenOffice is going to take off in a big way (initially internationally and in small and medium enterprises). Other reasons are cost, support of open formats, open source nature, etc.