MBA 814

The Structural Analysis of Industries

The essence of developing a business strategy is ``relating the company to its environment.'' The long-term profitability of a business depends on variety of factors each of which determines the competitiveness of the industry. Because competition among firms in an industry drives down the rate of return on capital, the better off shareholders are, the better the firm is shielded from competition. The problem is that high returns a hallmark of a non-competitive industry encourages additional investment This additional investment in physical and human capital serves to drive down rates of return to competitive levels. A goal of a business strategy is to develop a plan for defending the firm's position from competitive forces or to reposition the firm to a position where it can better defend itself from competition. To this end, and before such a strategy can be devised, the firm must analy e the underlying economic structure of its industry. This lecture presents a check list that a firm could consider when performing such an analysis of industrial structure. o !remise" e#tent of competition among rivals derived from underlying economic structure. $nowledge of this structure essential for developing a successful strategy o %orces e#ternal to the industry have similar effects on all rivals &hat is an industry' o identify firms that produce products that are close substitutes. (ust look beyond the product's physical characteristics to function when defining industry. )g. A garden store that sells grass seeds, turf, shrubs, is really in the business of ``delivering'' beautiful lawns and gardens to households. - *ncreasingly a dynamic concept +eg. ,(- in retail grocery stores. &hat determines the state of competition in an industry' /. Threat of entry o Barriers to entry by new or e#isting firms - )conomies of scale +production, research, marketing, service network. Breakdown economies on a component basis. )g. &hen making television sets large scale economies in color tube production but not in cabinet making and set assembly. (ay be difficult to achieve if products are customi ed instead of standardi ed.

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- )conomies of scope +sharing of operations or functions. Brand names" e#pensive to establish and maintain. 1nce established additional cost of applying it to other related products is low. -eady to eat breakfast cereal companies. Automobile companies. Air travel and air cargo services" Technological considerations make it impossible to fill plane up with people. 2pace for cargo. *ncremental cost of e#panding into cargo business is very low. - 3apital re4uirements 1ften sunk capital re4uired. )g. (ineral e#traction companies. - !roduct 5ifferentiation ``3ustomer loyalties.'' *nvestment made through advertising, customer services, and product design differences. )ntrant faces large start up costs to overcome this advantage. These costs are sunk and have no ``salvage value'' if they fail. )g. baby care products, baby food, over the counter drugs. - 2witching costs for buyers 5oes buyer have to incur costs when buying entrant's products' )g. kits used for medical diagnoses, heavy machinery, computer operating systems. - Access to 5istribution 3hannels 3ost associated with forming new relationships with wholesalers and retailers. 5oes entrant have create its own distribution channel' )g. food processing firms, mail order catalogue companies. - *ncumbent cost advantages !roprietary knowledge or technology. !atents, secret formulas +3oca 3ola, American ,ome !roducts.. 6ocation is a scarce resource7 )#perience or position on the ``learning curve.'' A type of technological change that occurs only as a result of producing and selling. )g. %irms with skilled labor, universities, investment banks, accounting firms etc.8 also comple# assembly re4uirements. This barrier is not the same as economies of scale7

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- 9overnment policy 6icensing re4uirements8 pollution controls and standards for product testing increase fi#ed cost of entry. 2ome regulations may delay entry providing incumbents with time to ad:ust strategies. )#piration of !atents. )g. )stablished drug faces competition from ``generic'' drugs8 $odak enters to compete with !olaroid's instant camera. o )#pected retaliation - 5o firms in the industry have a history of engaging in price cutting when encountering new rivals' 5o they have the resources to engage in a prolonged period of price discounting' )g. ma:or airlines with new carrier begins service on one of their routes. o )ntry 5eterring !rice - 5o firms price at a point where short run marginal revenue is less than short run marginal cost. This means output is larger and price lower as a way of deterring entrants. *f economies of scale a factor as output e#pands this would be a further deterrent. 0. *ntensity of -ivalry Among *ncumbents o 3ompetition occurs because a rival sees an opportunity of improve its position +ie. profitability.. ,owever, rivals ``moves'' have effects on the firm as well as other competitors. The pattern of reaction among competitors may or may not leave the producer better off. - !rice competition especially dynamic. !rice reductions easily met by rivals. 3ompetition occurs not only with price, but with product 4uality, service, warranties, advertising etc. *ndustry may derive more benefits from some forms of non-price competition. o %actors contributing to intensity of rivalry. - ,igh e#it barriers" 2peciali ed assets with low salvage values often associated with substantial economies of scale +see ne#t tick. 8 interrelationships between business unit and other units in the firm8 especially common outside the ;nited 2tates, government restrictions. )g. *n *ndia, legal environment makes closing a plant with <= > employee difficult. - ,igh fi#ed costs production methods" &hen ``e#cess capacity'' is present +ie. very low marginal costs. price cutting occurs. )g. *n paper products industry, production

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process often most efficient when let to run 0? hours a day @ days a week. 2torage or inventory costs associated with bulky items becomes important consideration in pricing. %ishing industry faces similar challenges. - *nability to differentiate product" 2uccessful product differentiation makes producersA product a poorer substitute for other products in the industry. This differentiation makes the demand for the producer's product less sensitive to price changes. 6ow consumer ``switching'' cost intensifies competition in a similar manner. - (any e4ually balanced competitors +including foreign competitors." *ndustry with many firms and little concentration likely will e#perience more intense competition than one with a similar number of firms, but greater concentration of output among a few firms. +3orresponds to Biew C0 in lecture on *ndustries &ith %ew 2ellers.. - 2low industry growth" 3ompetition over the si e of producer's market share appears to be more important part of its strategy. D. 3ompetition %rom 2ubstitute !roducts o *ndustries selling substitute products limit profit potential because their product prices create a ``ceiling'' on the producer's prices. *dentify such products by finding those that while different perform the same function. + )g. ``6ow end'' chain restaurants and ,(programs in grocery stores8 2ugar producers compete with corn syrup industry8 fiberglass insulation and rock wool and styrofoam8 security guards and electronic alarm and surveillance systems.. ?. Bargaining !ower of Buyers o Buyers affect industry profitability by their ability to hold out for lower price, higher 4uality, better service. An important determinant is the number of buyers +consumers. in the industry. )g. ready to wear clothing producers and retail department stores. *n the e#treme case, there may be only one or a few buyers of a service. )g. tank gunners may find employment only with the military or as a mercenary. An even better e#ample is the E3AA. The buyers do not take price +wage. as given and instead reali e that their decisions about the employment of factors affect price. &hen there also are few sellers, prices determined as a result of bargaining +although more advanced economic analyses suggests the range of ``rational'' price and output outcomes is limited. o 1ther factors affecting buyer power. - !roduct is a significant fraction of buyer's +consumer's. total cost - !roducts purchased from an industry producing standardi ed +as opposed to customi ed. products

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- Buyer +3onsumer. encounters low switching costs. - Buyers could integrate backwards and produce the product themselves" ,istorically true in the ;.2. automobile industry. - Buyer +consumer. is well informed <. Bargaining !ower of 2uppliers o 2imilar analysis as with buyers, but here very important to analy e the state of labor relations. *mplications of unioni ation differs substantially among countries. F. 9overnment !olicy o !roducer faces an ``alphabet soup'' of regulations at the national, state, and local level. *f the firm does business internationally, the regulatory environment is even more comple#. *mportant to understand the uni4ue impact that the public sector has on competition +rivalry. in the industry.