Chapter 3 - External Analysis: Industry Structure
PESTEL model
A framework that categorizes and analyzes an important set of external factors (political, economic, sociocultural, technological, ecological, and legal) that might impinge upon a firm. These factors can create both opportunities and threats for the firm.
HHI (Herfindahl-Hirschman Index)
Another indicator of the amount of competition in an industry - The sum of the squares of the market share of each firm in the industry - Uses the market share of all firms in the industry - Gives more weight to larger firms; takes into account the relative size of the largest firms in the concentration ratio - Increase in the HHI generally imply a decrease in competition and an increase of market power Another indicator of the amount of competition in an industry - Takes into account the relative size distribution of the firms in a market; places higher importance to companies with larger market share - Increases both as the number of firms in the market decreases and as the disparity in size between those firms increases. - Range: 0 - 10,000 => Greater number indicate more highly concentrated industries (i.e., firms with greater market power) • HHI between 1,500 and 2,500 - moderately concentrated • HHI in excess of 2,500 points -highly concentrated
competitive industry structure
Elements and features common to all industries, including the number and size of competitors, the firms' degree of pricing power, the type of product or service offered, and the height of entry barriers.
government policy
Frequently government policies restrict or prevent new entrants. -Threat of entry is high when restrictive government policies do not exist or when industries become deregulated.
advantages independent of size
Incumbent firms often possess cost and quality advantages that are independent of size. -brand loyalty -proprietary technology -preferential access to raw materials and distribution channels -favorable geographic locations -cumulative learning and experience effects
Market concentration
Reflects the number and size distribution of firms in the industry 1) Concentration ratio 2) Herfindahl-Hirschman Index (HHI)
mobility barriers
Restricts movement between groups; industry-specific factors that separate one strategic group from another
customer switching costs
The additional cost a consumer incurs in moving from one vendor's products or services to another vendor's products or services.
the power of buyers
The advantage buyers have when they have leverage over suppliers and can demand deep discounts and special services; The pressure customers put on an industry by demanding: - A lower price or - Higher product quality
optimistic scenario
The best possible future situation
concentration ratio
The percentage of the market share owned by the largest firms in an industry. Indicates the degree of competition in the industry; the extent of market control of the largest firms in the industry - The sum of the market share percentage held by the largest specified number of firms in an industry - CR4/CR8: Market share of the four (eight) largest firm in the industry - output measured in terms of sales or volume of output - the higher the percentage of the firms, the less competitive the market; low CR implies greater competition among firms in the industry - Indicates the degree of competition, but..does not use the market share of a firms in an industry • Does not provide distribution of firm size 0~ 50%: low concentration 50~80%: moderately competitive 80% < : approaching monopoly *Limitation:* Does not provide information about the distribution of firm size
complementor
a company that provides a good or service that leads customers to value your firm's offering more when the two are combined
strategic group model
a framework that explains differences in firm performance within the same industry
Industry
a group of firms producing products that are close substitutes
Sociocultural factors
capture a society's cultures, norms, and values. Are constantly in flux. Differ across groups: Cultural aspects Trends, health consciousness, etc Career Expectations Demographics Life expectancies Aging population Rising affluence Changes in ethnic composition More women in workforce globally
co-opetition
cooperation by competitors to achieve a strategic objective
capital requirements
describe the "price of the entry ticket" into a new industry; Also need to consider the expected return on investment - E.g., investments to set up plants, start-up costs
Network effects
describe the positive effect that one user of a product or service has on the value of that product or service for other users. The value of the product or service for an individual user increases with the number of total users
rivalry among existing competitors
describes the intensity with which companies within the same industry jockey for market share and profitability. • Other 4 forces put pressure on this rivalry - The stronger the forces, the higher the intensity.
ecological factors
involve broad environmental issues such as the natural environment, global warming, and sustainable economic growth Ex.) the impossible burger
Non-market strategy
is a broad term that refers to a firm's activities outside of the marketplace that can help it gain competitive advantage
external factors
market forces, cost forces, government forces, etc
entry barriers
obstacles that determine how easily a firm can enter an industry and often significantly predict industry profit potential
exit barriers
obstacles that determine how easily a firm can leave an industry
4 Main Competitive Industry Structures
perfect competition, monopolistic competition, oligopoly, monopoly
Industry analysis
provides a more rigorous basis not only to identify an industry's profit potential (the level of profitability that can be expected for the average firm), but also to derive implications for one firm's strategic position within an industry
threat of entry
the risk that potential competitors will enter an industry.
pessimistic scenario
the worst possible future situation
Internal factors
turnovers of top managers, major accidents, et
Monopoly
when there is only one, often large firm supplying the market.
Bargaining power of suppliers is high when
• Concentrated (or limited) supplier industry • Suppliers offer differentiated products/There are no supplier substitutes • Incumbent firms face supplier switching costs • Suppliers not dependent on industry for majority of revenue • Suppliers can forward-integrate into the industry (closer to the end-customer)
Characteristics of perfect competition
- Fragmented - Many small firms similar in size and resources - Ease of entry - Consumers make purchasing solely on price since the commodity product offerings are more or less identical *Firms in perfect competition have difficulty in achieving even a temporary competitive advantage*
Why is the PESTEL framework important?
- Managers can mitigate threats & leverage opportunities - Gain understanding of potential impacts.
growth rates
- Measure of the change in the amount of goods and services produced by a nation's economy - Real growth rate: indicates the current business cycle of the economy - whether business activity is expanding or contracting
Oligopoly
A market structure in which a few large firms dominate a market. One of the key features in oligopoly is that competing firms are *interdependent* ➢ With only a few competitors, the actions of one competitor influence the behavior of the other competitors ➢ Thus, must consider the strategic actions of other competitors ➢ Often analyzed using game theory ➢ Due to strategic interdependence, companies in oligopolies have an incentive to coordinate their strategic actions to maximize their joint performance • Examples: ➢ Express-delivery industry: FedEx vs. UPS ➢ Soft drink industry: Coca-Cola vs. Pepsi ➢ Detergents: P&G vs. Unilever
HHI example
A monopoly with market share of 100%--> 100^2 = 10,000 An extremely competitive industry..let's say an industry of 100 firms, each with 1% of the market--> (1^2) * 100 = 100 Industry A (20^2) * 5 = 2,000 Industry B (70^2) + (5^2) + (3^2) + (2^2) + (1^2) * 20 = 4958
the power of suppliers
The advantage sellers have when there is a lack of competition and they can charge more for their products and services. This is one of Porter's five competitive forces.; Pressures that industry suppliers can exert on an industry's profit potential - Suppliers of raw materials & components, labor, services • Lowers industry profit potential/reduces a firm's ability to obtain superior performance when, - Suppliers demand higher prices for their inputs - Suppliers reduce quality
economic factors
factors in a firm's external environment are largely macroeconomic. Managers need to consider the following 5 macroeconomic factors can affect firm strategy: -growth rates -levels of employment -interest rates -price stability -currency exchange rates
Sources of barriers to entry
government policies, economies of scale, advantages independent of size (Brand loyalty, patents, knowledge and expertise), credible threat of retaliation (Price-wars, Sales promotion, litigation, product and service innovation), Network effects, capital requirements (Likelihood determined by level of capital & expected return on investment, Capital markets could provide necessary funds)
perfect competition
the degree of competition in which there are many sellers in a market and none is large enough to dictate the price of a product. 1) All firms sell an identical product 2) All firms are price takers - they cannot control the market price of their product because price is determined by supply and demand 3) All firms have a relatively small market share; there are no monopolies 4) Buyers have complete information about the product being sold and the prices charged by each firm 5) The industry is characterized by low barriers or no barriers to enter and exit an industry
Threat of Substitutes
the idea that products or services available from outside the given industry will come close to meeting the needs of current customers • Examples: - Energy drinks vs. coffee - E-mail vs. express mail - Videoconferencing vs. business travel
Ways a firm could benefit from entry barriers:
-economies of scale -network effects -customer switching costs -capital requirements -advantages independent of size -government policy -credible threat of retaliation
Porter's Five Forces Model
-threat of entry -power of suppliers -power of buyers -threat of substitutes -rivalry among existing competitors
what is rivalry intensity determined by?
1. Competitive industry structure (number and size of competitors, firms' degree of pricing power, type of product/service, height of entry barriers) 2. Industry growth 3. Strategic commitments (the more committed, the more intense the rivalry) 4. Exit barriers (fixed costs, social factors, etc)
two key insights from Porter's Five Forces
1. Firm's closest competitors ➔ competition must be viewed more broadly to encompass other forces in the industry (buyers, suppliers, potential new entry, threat of substitutes) than just direct competitors - Competition is the struggle among these forces to capture as much economic value created in the industry as possible 2. The profit potential of an industry is neither random/entirely determined by industry-specific factors, but a function of the five forces that shape competition
five forces model
A framework that identifies five forces that determine the profit potential of an industry and shape a firm's competitive strategy.
Threat of entry into an industry depends on...
Barriers to entry coupled with the reaction from incumbent firms ➔ If barriers to entry are high and/or newcomers except sharp retaliation from entrenched competitors, the threat of entry is low
monopolistic competition
a market structure in which many companies sell products that are similar but not identical. • Key to understanding this industry structure: firms now offer products or services that have unique features (quality, style, location, brand name, etc) • EX) Computer hardware industry ➢ Many firms compete in this industry (Apple, Dell, or HP have less than 20% market share) ➢ While products of competitors tend to be similar with each other, they are not identical. Thus, there is ability to raise prices
industry covergence
a process whereby formerly unrelated industries begin to satisfy the same customer need
complement
a product, service, or competency that adds value to the original product offering when the two are used in tandem
technological factors
capture the application of knowledge to create new processes and products. Application of knowledge: To create new processes, To create new products. • Innovations in process technology: - Lean manufacturing, Six Sigma quality, and biotechnology • Innovations in product technology: - Smartphones, computer tablets, and high-performing electric cars such as the Tesla Model S
economies of scale
cost advantages that accrue to firms with larger output because they can spread fixed costs over more units, employ technology more efficiently, benefit from a more specialized division of labor, and demand better terms from their suppliers.
legal factors
include the official outcomes of political processes as manifested in laws, mandates, regulations, and court decisions—all of which can have a direct bearing on a firm's profit potential. Political and legal factors are closely related Ex.) Electric vehicles
credible threat of retaliation
potential new entrants must also anticipate how incumbent firms will react. Signaling intention to take action • Signal to the industry to preempt/deter competition (probability, severity) • Intention to undercut competition & match rival's prices, rebates, other terms - Price wars • Initiate price wars, wait for new entrants to exit & raise prices again - Others: increased product & service innovation, advertising, sales promotion, et
strategic position
relates to its ability to create value for customers (V) while containing the cost to do so (C)
political factors
result from the processes and actions of gov't bodies that can influence the decisions and behavior of firms ex.) Political stability, power structure, level of corruption, government interference with business, tariffs, activities of lobbyists, etc. SUGAR TAX - public politics strategies: such as, lobbying and engaging with regulators - private politics strategies: such as, engaging with activists
strategic group
the set of companies that pursue a similar strategy within a specific industry -*competitive rivalry is strongest between firms that are within the same strategic group*
Bargaining power of buyers is high when
• Concentrated buyers or purchases large quantities • The industry's products are standardized or undifferentiated commodities. • Buyers face low or no switching costs. • Buyers can backwardly integrate into the industry (i.e., moving closer to the inputs of the value chain, if a company buys a supplier)
Expansion of business activity: Boom
• Consumer and business demand rise • Competition among firms frequently decrease • Boom periods can overheat and lead to speculative bubbles • EX: dot.com bubble during 1995-2001, housing bubble in early 2000s
What would incumbents do to prevent new players coming in to the industry? (With the threat of entry...)
• Incumbents might lower prices to make the industry less profitable -> reduce industry's profit potential • Incumbents spend more to satisfy existing customers -> reduce industry's profit potential if they cannot raise prices (willing to accept a lower profit margin to maintain market share)
Contraction of business activity: Recession
• Shrewd managers initiate strategic successes during economic downturns • EX: During a recessionary period in 2001, Apple boosted spending on R&D to design and develop the iPod. When the economy picked up again, Apple was ready to launch the iPod
threat of substitutes is high when
• The substitute offers an attractive price-performance trade-off. • The buyer's cost of switching to the substitute is low.
Characteristics of an oligopoly
❖ Few (large) firms ❖ Some pricing power - depends on the degree of product differentiation ❖ Differentiated product ❖ High entry barriers
Characteristics of monopolistic competition
❖ Many firms ❖ Some pricing power ❖ Differentiated product ❖ Medium entry barriers
Characteristics of a monopoly
❖ One firm ❖ Considerable pricing power ❖ Unique product ❖ Very high entry barriers ❖ Profitability tends to be high
Natural monopolies
➢ The government grants one firm the right to be the sole supplier of a product or service ➢ Usually to incentivize a company to engage in a venture that would not be profitable with more than one supplier ➢ EX) public utilities supplying water, gas, electricity (huge fixed costs to build plants and to supply) ➢ In the past few decades more and more of natural monopolies have been deregulated in the U.S.