3 analuzing the industry enviroment

8/3/2019 3 Analuzing the Industry Enviroment

1/33

447of

Create Value

50 (1943):that

tial that goes

3Analyzing the IndustryEnvironm.ent

The reinsurance business has the defect of being too attractive-looking tonew entrants for its own good and will therefore always tend to be theopposite of, say, the old business of gathering and rendering dead horsesthat always tended to contain few and prosperous participants.

-Charles T. Munger, Chairman, Wesco Financial Corp.(extract from the 1986 Annual Report)

OUTLINE INTRODUCTION AND OBJECTIVES FROM ENVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSIS TH E DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION ANALYZING I ~ D U S T R Y ATTRACTIVENESS

Porter's Five Forces of Competition FrameworkCompetition from SubstitutesThreat of EntryRivalry Between Established CompetitorsBargaining Power of BuyersBargaining Power of Suppliers

ApPLYING INDUSTRY ANALYSISForecasting Industry ProfitabilityStrategies to Alter Industry Structure DEFINI NG INDUSTRIES: IDENTIFYING THE RELEVANT MARKET

BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, ANDCOOPERATION

Schumpeterian CompetitionHypercompetitionThe Contribution of Game Theory

OPPORTUNITIES FOR COMPETITIVE AnvANTAGE: IDENTIFYING KEy SUCCESSFACTORS

SUMMARY

51


2/33

52 A N A L Y Z I ~ G THE INDUSTRY ENVIRONMENT~ INTRODUCTION AND OBJECTIVES

In this chapter and t he next we turn our attention to analyzing the external environment of the firm. In Chapter 1 we observed that profound understanding of thecompetitive environment is a critical ingredient of a successful strategy. We furthernoted that for business enterprises, strategy is essentially a quest for profit. Our primary task in this chapter is to identifY the sources of profit in the business environment.

The distinction between corporate-level and business-level strategy is relevanthere. Corporate strategy is concerned with deciding which industries the firmshould be engaged in and with the allocation of corporate resonrces among them. Tomake such decisions, it is vital that the firm evaluate the attractiveness of differentindustries in terms of their potential to yield profit in the future. The primary objective of this chapter is to analyze how competition determines industry profitability.Once the determinants of industry profitability are understood, it is possible to forecast the future profit potential of an industry.

Business strategy is concerned with establishing competitive advantage. IdentifYing the basis of and opportunities for competitive advantage requires an understanding of competition within the industry. It also requires that we understand customers,their needs and motivations, and the means by which these needs are satisfied.

By the time you have completed this chapter you will be able to: IdentifY the main structural features of an industry that influence competition and profitability. Appl y this analysis and explain why some industries are more profitable than

others. Use evidence on structural trends within industries to forecast changes in

industry profitability in the future. IdentifY the opportunities available to influence industry structure in order to

alleviate the pressures of competition and improve industry profitability. Appreciate the roles of both competitive and cooperative behavior in seeking

profit within an industry. FI Analyze competition and customer requirements in order to identifY oppor

tunities for competitive advantage within an industry.

FROM E1\TVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSISTh e business environment of the firm consists of all the external influences thatimpact a firm's decisions and performance. Th e problem here is that, given the vastnumber and range of external influences, how can managers hope to monitor, letalone analyze, environmental conditions? The starting point is some kind of systemor framework for organizing information. For example, environmental influences canbe classified by source into economic, technological, demographic, social, and governmental factors; or by proximity: the "micro-environment" or "task environment"can be distinguished from the wider influences that form the "macro-environment."

Though systematic, continuous scanning of the whole range of external influences might seem desirable, such extensive environmental analysis is unlikely to becost effective and creates information overload. The Royal Dutch/Shell Group, one


3/33

53ROM ENVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSIS

of theOu r pri environrelevant

Todifferent

Identi

than

seekingoppor

system

FIGURE 3.1The Business Environ ment

of the world's largest and most international enterprises, invests more heavily in thesystematic monitoring and analysis of its business environment than most othercompanies. Its scenario analysis (which we look at in detail in Chapter 10) is exceptionally far-sighted and wide-ranging in assessing its business environment. Nevertheless, the group's environmental scanning and analysis focuses on factors that aredirectly relevant to its strategic planning: in particular, those factors that influencethe demand and supply of oil and refined products.1

Th e prerequisite for effective environmental analysis is to distinguish the vitalfrom the merely important. Let's return to first principles. For the firm to makeprofit it must create value for customers. Hence, the firm must understand its customers. Second, in creating value, the firm acquires goods and services from suppliers. Hence, the firm must understand its suppliers and how to form businessrelationships with them. Third, the ability to generate profitability from value-creating activity depends on the intensity of competition among the firms that vie for thesame value-creating opportunities. Hence, the firm must understand competition.Thus, the core of the firm's business environment is formed by its relationships withcustomers, suppliers, and competitors. This is the firm's industry environment.

This is not to say that macro-level factors such as general economic trends,changes in demographic structure, or social and political trends are unimportant tostrategy analysis. These factors may be critical determinants of the threats andopportunities a company will face in the future. The key issue is how these moregeneral environmental factors impact the firm's industry environment (Figure 3.1).For most firms, global warming is not a crtical issue. For the producers of automobiles, oil, and electricity, it is important since government measures to restrict theproduction of carbon dioxide and other greenhouse gases will directly affect thedemand for their products and their costs of doing business. By focusing on theindustry environment, we can determine which of the macro-level influences areimportant for the firm and which are not.'


4/33

54 ANALYZING TH E INDUSTRY ENVIRONMENTTH E DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION

If the purpose of strategy is to help the firm to survive and make money, the startingpoint for industry analysis is: What determines the level of profit in an industry?

As already noted, business is about the creation of value for the customer. Firmscreate value by production (transforming inputs into outputs) or arbitrage (transferring products across time and space). Value creation requires that the price the customer is willing to pay the firm exceed the costs incurred by the firm. But valuecreation does not translate directly into profit. Th e surplus of value over cost is distributed between customers and producers by the forces of competition. The stronger the competition among producers, the lower the price actually paid by customerscompared with the maximum price they would have been willing to pay. In otherwords, the greater the proportion of the surplus gained by customers (consumer sur plus), the less is earned by producers (producer surplus or economic rent). A single supplier of bottled water at an all-night rave can charge a price that fully exploits thedancers' thirst. If there are many suppliers of bottled water, then, in the absence ofcollusion, competition causes the price of bottled water to fall toward the cost ofsupplying it.

The surplus earned by producers over and above the minimum costs of production is not entirely captured in profits. Where an industry has powerful suppliersmonopolistic suppliers of components or employees united by a strong laborunion-then a substantial part of the surplus may be appropriated by these suppliers(the profits of suppliers or premium wages of union members).The profits earned by the firms in an industry are thus determined by threefactors:

Th e value of the product or service to customers The intensity of competition The relative bargaining power at different levels in the production chain.Our industry analysis brings all three factors into a single analytic framework.

-1 ANALYZING INDUSTRY ATTRACTIVENESSTable 3.1 shows the average rate of profit earned in different U.S. industries. Someindustries (such as tobacco and pharmaceuticals) consistently cam high rates ofprofit; others (such as iron and steel, nonferrous metals, airlines, and basic buildingmaterials) have failed to cover their cost of capital. The basic premise that underliesindustry analysis is that the level of industry profitability is neither random nor theresult of entirely industry-specific influences, bu t is determined, in part at least, bythe systematic influence of industry structure. As an example of how an attractivelystructured industry can support a superior profitability, consider the cases of the sausage skin manufacturer, Devro, and tobacco products supplier, US T (see Exhibit 3.1).

The underlying theory of how industry structure drives competitive behaviorand determines industry profitability is provided by industrial organization (10)economics. Th e two reference points are the theory of monopoly and the theory ofperfect competition, which represent the two ends of a spectrum of industry structures. A single firm protected by barriers to the entry of new firms forms a monopoly in which it can appropriate in profit the full amount of the value it creates. Bycontrast, many firms supplying an identical product with no restrictions on entry or


5/33

AiYZING INDUSTRY ATTRACTIVENESS 55

Industry Return on Equity (1985-95)the starting

But valueis dis

The stron pay. In other

(consumer Jur A single sup

theofof

of producsuppliers

three

DrugsFood and kindred products- o f which Tobacco productsInstruments and related productsPrinting and publishingElectrical and electronic equipmentAircraft, guided missiles, and partsFabricated metal productsRubber and misc. plastics productsPaper and allied productsRetail trade corporationsPetroleum and coal productsTextile mill productsWholesale trade corporationsStone, glass and clay productsMachinery, exc. electricalNonferrous metalsMotor vehicles and equipmentIron and steelMining corporationsAirlines

19.39%13.85%18.60%11.24%10.16%10.00%

.8.36%8.15%9.95%8.47%8.37%7.88%7.25%5.72%5.28%4.29%4.21%2.61%1.30%1.24%

(2.84%)

framework.

of

attractivelyof the sau

Exhibit 3.1).(10)

ofry struc

a monop t creates. Bytry or

Source: Federal Trade Commission

exit constitutes perfect competition: the rate of profit falls to a level that just covers firms' cost of capital. In the real world, industries fall between these twoextremes. The U.S. market for smokeless tobacco is close to being a monopoly, theChicago grain markets are close to being perfectly competitive. Most manufacturing industries and many service industries tend to be oligopolies: they are domi nated by a small number of major companies. Figure 3.2 identifies some key pointson the spectrum. By examining the principal structural features and their interactions for any particular industry, it is possible to predict the type of competitivebehavior likely to emerge and the resulting level of profitability.Porter's Five Forces of Cmnpet i t ion FrameworkFigure 3.2 identifies four structural variables influencing competition and profitability. In practice, there are many features of an industry that determine the intensity ofcompetition and the level of profitability. A helpful, widely used framework for classifYing and analyzing these fators is the one developed by Michael Porter of Har vard Business School.2 Porter's Five Forces of Competition framework views theprofitability of an industry (as indicated by its rate of return on capital relative to its


6/33

00 ANALYZING THE INDUSTRY E ~ V I R O N M E N T

EXHIBIT 3.1Sausage Skins and Chewing Tobacco: The Joys of Dominating Niche MarketsDevro International pte is a Scottish companywith headquarters in the village of Moodiesburnnear Glasgow. With 930 employees and plants inScotland, Australia, and the United States, Devroholds 56 percent of the world market for collagen sausage skins. The company was listed onthe London Stock Exchange in 1993, two yearsafter a management buyout from its parent,Johnson & Johnson. During 1991 and 1992, operating profits averaged 25 percent of sales revenue. Devro holds 94 percent of the UK market,83 percent of the Australian market, and 40 percent of the U.S. market. Although collagen casings are a substitute for natural gu t sausagecasings, collagen possesses some clear advantages that have resulted in the steady displacement of natural gut. Scale economies.,technology, and Devro's absolute cost advantages pose substantial barriers to would-beentrants. Because casings account for only asmall proportion of the sausag.e manufacturers'total costs, they are relatively insensitive to theprice of casing and do no t exert substantial bargaining power.UST Inc. (Formerly U.s. Tobacco) has the distinction of earning th e highest return on equity

FIGURE 3.2The Spectrumof IndustryStructures

of any company in Fortune's listings (165 percentin 1996, 146 percent in 1995). UST dominates theU.S. market for "smokeless tobacco" (chewingtobacco and snuff) with a market share of 78percent (in a range of brands including Skoal,Copenhagen, Long Cut, and Red Seal). Despite itsassociation with a bygone era of cowboys andrural poverty, chewing tobacco has been agrowth market over the past two decades with asurprisingly large number of young consumers.usn l o n g ~ e s t a b l i s h e d brands, its distributionthrough tenS of thousands of small retail outlets,and the unwillingness of major tobacco companies to enter thiS market (due to the poor imageand social unacceptability of the product), havesupPorted UST's unassailable market position.Federal controls on the advertising of smokelesstobacco products introduced in 1986 have buttressed UST's market position by limiting theopportunities for would-be entrants to markettheir products.

Source: James Buxton, "A Leaner Business ThatHas More Bite," Financial Times, April 16, 1993,p. 33; Standard & Poor's Stock Reports.

.."


7/33

ANALYZI,\lG INDUSTRY ATTRACTIVENESS 57

percentth e(chewingof 78

Skoal,andbeen a

outlets.compa imagehaveosition.

but

markat

That1993,

cost of capital) as determined by five sources of competitive pressure. These fiveforces of competition include three sources of "horizontal" competition: competitionfrom substitutes, competition from entrants, and competition from establishedrivals; and two sources of "vertical" competition: the bargaining power of suppliersand buyers (see Figure 3.3).

The strength of each of these competitive forces is determined by a number ofkey structural variables as shown in Figure 3.4.

Competition from Substitutes .The price customers are willing to pay for a product depends, in part, on the avail ability of substitute products. Th e absence of close substitutes for a product, as inthe case of gasoline or cigarettes, means that consumers are comparatively insensi tive to price, i.e., demand is inelastic with respect to price. Th e existence of closesubstitutes means that customers will switch to substitutes in response to priceincreases for the product, i.e., demand is elastic with respect to price. The intro duction of digital personal communication services (peS) in the United States bySprint Spectrum and Nextel and in the UK by Hutchinson Orange has increasedthe substitute competition faced by traditional cellular companies and loweredtheir margins.

FIGURE 3 .3Porter's Five Forces ofCompetition Frame work


8/33

58

FIGURE 3.4The Structural Deter minants of Competi tion and Profitabilitywithin th e PorterFramework

ANALYZING THE INDUSTRY ENVIRONMENT ANA

SUPPLIER POWERFactors determining power of suppliers

relative to producers; same as thosedetermining power of producers relative

to buyers see "Buyer Power" box .

Economies of scale Absolute cost advantages Capital requirements Product differentiation Access to distributionchannels Government and legalbarriers Retaliation by established

producers

The extent to which substitutes limit prices and profits depends on the propensity of buyers to substitute between alternatives. This, in turn, is dependent ontheir price-performance characteristics. If city-center to city-center travelbetween Washington and New York is two hours quicker by air than by train andth e average traveler values time at $25 an hour, the implication is that the trainwill be competitive with air at fares of $50 below those charged by the airlines.The more complex the needs being fulfilled by the product and the more difficultit is to discern performance differences, the lower the extent of substitution bycustomers on the basis of price differences. The failure oflow-priced imitations ofleading perfumes to establish significant market share reflects, in part, consumers'difficulty in discerning the performance characteristics of different fragrances.


9/33

to substituteof

proon

and

of

nces.

nING INDUSTRY ATTRACTIVENESS 59Threat of EntryIf an industry earns a return on capital in excess of its cost of capital, that industryacts a magnet to firms outside the industry. Unless the entry of new firms is barred,the rate of profit will fall toward its competitive level. Th e U.S. bagel industry, forexample, faced a flood of new entrants in 1996, which caused a sharp diminution ofprofit prospects. Th e threat of entry rather than actual entry may be sufficient toensure that established firms constrain their prices to the competitive level. OnlyAmerican Airlines offers a direct service between Dallas/Fort Worth and SantaBarbara, California. Yet American may be unwilling to exploit its monopoly position if other airlines can easily extend their routes to cover the same two cities. Anindustry where no barriers to entry or exit exist is c o n t e ~ t a b l e : prices and profitsremain at the fully competitive level, regardless of the number of firms within theindustry.3 Contestability depends on the absence of sunk costs. Sunk costs existwhere entry requires investment in industry-specific assets whose value cannot berecovered on exit. An absence of sunk costs makes an industry vulnerable to "hitand-run" entry whenever established firms raise their prices above the competitivelevel.

In most industries, however, new entrants cannot enter on equal terms withthose of established firms. The size of the advantage of established over entrant firm(in terms of unit costs) measures the height of barriers to entry. which determinesthe extent to which the industry can, in the long run, enjoy profit above the competitive level. The principal sources of barriers to entry are: capital requirements, economies of scale, cost advantages, product differentiation, access to channels ofdistribution, governmental and legal barriers, and retaliation.Capital Requirements. The capital costs of getting established in an industrycan be so large as to discourage all bu t the largest companies. The duopoly of Boeingand Airbus in large passenger jets is protected by the prohibitive costs of establishingsuch a venture. In satellite television broadcasting in Britain, Rupert Murdoch's SkyTV incurred almost $1 billion in capital costs and operating losses and Robert Maxwell's British Satellite Broadcasting spent some $1.8 billion before the two mergedin 1991. In other industries, entry costs can be modest. Start-up costs for franchisedfast-food restaurants are around $280,000 for a Wendy's and $800,000 for a BurgerKing.4Economics of Scale. In industries that are capital or research or advertisingintensive, efficiency requires large-scale operation. Th e problem for new entrants isthat they are faced with the choice of either ente ring on a small scale and acceptinghigh unit costs, or entering on a large scale and running the risk of drastic underutilization of capacity while they build up sales volume. Thus, in large je t engines,economies of scale in R& D and manufacturing have caused consolidation into justthree producers (General Electric, Pratt & Whitney, and Rolls-Royce), which areprotected by very high barriers to entry. Economies of scale in automobiles havedeterred entry into that industry: recent entrants such as Ssangyong of Korea andProton of Malaysia have incurred huge losses trying to establish themselves.Absolute Cost Advantages. Apart from economies of scale, established firmsmay have a cost advantage over entrants simply because they entered earlier.


10/33

60 ANALYZING THE INDUSTRY ENVIRONMENT ANA

Absolute cost advantages tend to be associated with the acquisition of low costsources of raw materials or economies of learning.Product Differentiation. In an industry where products are differentiated,established firms possess the advantages of brand recognition and customer loyalty.The percentage of U.S. consumers loyal to a single brand varies from under 30 percent in batteries, canned vegetables, and garbage bags, up to 61 percent in toothpaste, 65 percent in mayonnaise, and 71 percent in cigarettes.5 New entrants to suchmarkets must spend disproportionately heavily on advertising and promotion to gainlevels of brand awareness and brand goodwill similar to that of,established companies. One study found that, compared to early entrants, late entrants into consumergoods markets incurred additional advertising and promotional costs amounting to2.12 percent of sales revenue.6 Alternatively, the new entrant can accept a nicheposition in the market or can seek to compete by cutting price. In producer goodstoo, reputation and close customer-supplier relationships impose similar problemsfor new entrants. Despite their huge financial resources, most U.S. commercialbanks have chosen to enter investment banking by means of acquiring existinginvestment banks.Access to Channels ofDistribution. Whereas lack of brand awarenessamong consumers acts as a barrier to entry to new suppliers of consumer goods, amore immediate barrier for the new company is likely to be gaining distribution.Limited capacity within distribution channels (e.g., shelf space), risk aversion byretailers, and the fixed costs associated with carrying an additional product result indistributors'reluctance to carry a new manufacturer's product. In the United Statesand Britain, food and drink processors are increasingly required to make lump-sumpayments to the leading supermarket chains in order to gain shelf space for a newproduct.Governmentaland Legal Barriers. Some economists claim that the onlyeffective barriers to entry are those created by government. In taxicabs, banking,telecommunications, and broadcasting, entry usually requires the granting of alicense by a public authority. In knowledge-intensive industries, patents, copyrights,and trade secrets are major barriers to entry. Xerox Corporation's near monopolyposition in the wor ld plain-paper copier business until the mid-1970s was protectedby a wall of over 2,000 patents relating to its xerography process. In industries subject to regulation and environmental and safety standards, new entrants may be at adisadvantage to established firms because compliance costs weigh more heavily onnewcomers.Retaliation. Th e effectiveness of the barriers to entry also depends on theentrants' expectations as to possible retaliation by established firms. Retaliationagainst a new ent rant may take the form of aggressive price cutting, increased advertising, sales promotion, or litigation. British Airways' retaliation against competitionfrom Virgin Atlantic on its North Atlantic routes included not only promotionalprice cuts and advertising, bu t also a variety of"di rty tricks" such as accessing Virgin'scomputer system, poaching its cus!omers, and attacking Virgin's reputation. Southwest and other low-cost airlines have alleged that selective price cuts by Americanand other major airlines amounted to predatory pricing designed to drive them ou t of


11/33

ANALYZING INDUSTRY ATTRACTIVENESS 61

tooth such

lump-sumfor a new

banking,of a

ts,

protected

heavily on

Retaliation

. Southout of

business. Th e likelihood of retaliation is influenced by the scale of entry. When Japanese firms first entered the U.S. car and consumer electronics markets, they sought toavoid retaliation by introducing small products in segments that were deemedunprofitable by U.S. producers. A successful retaliatory strategy is one that detersentry by using a threat that is credible enough to intimidate would-be entrants. 7

The Effect;veness ofBarriers to Entry. Studies by Bain8 and Mann9 foundprofitability was higher in industries with "very high entry barriers" than in thosewith "substantial" or "moderate to low" barriers. Capital intensity and advertising arekey variables that increase entry barriers and raise industry profitability. 10Whether barriers to entry are effective in deterring potential entrants dependson the resources of the potential entrants. Barriers that are effective for new companies may be ineffective for firms that are diversifying from other industries. GeorgeYip found no evidence that entry barriers deterred new entry.ll Entrants were ableto successfully overcome entry barriers for one of two reasons. Some possessedresources and capabilities that permitted them to surmount barriers and competeagainst incumbent firms using similar strategies. American Express, for example,used its brand name to enter a broad range of financial service markets, and Marsused its strong position in confectionery to enter the ice cream market.12 Otherssuccessfully circumvented entry barriers by adopting different strategies from thoseof incumbent firms. Southwest Airlines used a low-cost, "no-frills" strategy to challenge the major U.S. airlines. De ll Computer used direct-mail distribution and telephone-based customer service to bypass established distribution channels.Rivalry Between Established COlllpetitorsFor most industries, the major determinant of the overall state of competition and thegeneral level of profitability is competition among the firms within the industry. Insome industries, firms compete aggressively-sometimes to the extent that prices arepushed below the level of costs and industry-wide losses are incurred. In others, pricecompetition is muted and rivalry focuses on advertising, innovation, and other nonprice dimensions. Six factors play an important role in determining the nature andintensity of competition between established firms: concentration, the diversity ofcompetitors, product differentiation, excess capacity, exit barriers, and cost conditions.ConcentraNon. Seller concentration refers to the number and size-distributionof firms competing within a market. Seller concentration is most commonly mea sured by the concentration ratio: the combined market share of the leading pro ducers. For example, the four-firm concentration ratio (conventionally denoted"CR4") is the market share of the four largest producers. A market dominated bya single firm, e.g., Xerox in the U.S. plain-paper copier market during the early1970s, or US T in the U.S. smokeless tobacco market, displays little competitionand the dominant firm can exercise considerable discretion over the prices itcharges. Where a market is dominated by a small group ofleading companies (anoligopoly), price competition may also be restrained, either by outright collusion,or more commonly through "parallelism" of pricing decisions. 13 Thus, in marketsdominated by two companies, such as alkaline batteries (Duracell and Eveready),color film (Kodak and Fuji), and soft drinks (Coke and Pepsi), prices tend to besimilar and competition focuks on advertising, promotion, and product development. As the number of firms supplying a market increases, coordination of prices


12/33

62 ANALYZING THE INDUSTRY ENVIRONMl:iNT

TABLE 3.2The RelationshipBetween RealMarket Growthand Profitability

becomes more difficult, and the likelihood that one firm will initiate price cuttingincreases. Despite the strong theoretical arguments, the effect of seller concentration on profitability has been hard to pin down empirically. Richard Schmalenseeconcludes that: "The relation, if any, between seller concentration and profitability is weak statistically and th e estimated effect is usually small.,,14Diversity of Competitors. Th e ability of firms in an industry to avoid pricecompetition also depends on their similarities in terms of origins, objectives, costs,and strategies. Th e cozy atmosphere of the U.S. steel industry prior to the advent ofimport competition and the new mini-mills was possible because of the similarities ofthe companies and the outlooks of their senior managers. By contrast, the inability ofOPEC to maintain prices and ou tput quotas is a consequence of differences in objectives, production costs, language, politics and religion among member countries.Product Differentiation. The more similar the offerings among rival firms, themore willing customers are to substitute and the greater the incentive for firms to cutprices to increase sales. Where the products of rival firms are virtually indistinguishable,the product is a commodity and price is the sole basis for competition. Commodityindustries such as agriculture, mining, and basic materials tend to be plagued by pricewars and low profits. By contrast, in industries where products are higWy differentiated(perfumes, pharmaceuticals, restaurants, management consulting services), price competition tends to be weak, even though there may be many firms competing.Excess Capacity and Exit Barriers. Wh y does industry profitability tend tofall so drastically during periods of recession? Th e key is the balance between demandand capacity. Unused capacity encourages firms to offer price cuts to attract new business in order to spread fixed costs over a greater sales volume. Excess capacity maynot be just cyclical, but part of a structural problem due to over-investment and stagnant or declining demand. In such situations, the issue is whether excess capacity willleave the industry. Barriers to exit are costs associated with capacity leaving an industry. Where resources are durable and specialized, and where employees are entit led tojob protection, barriers to exit may be substantial. 15 Depressed profits in the European oil refining industry are the result oflow demand, over-investment, and barriersto exit in the form of refinery dismantling, environmental cleanup, and employeeredundancy. Conversely, growth industries tend to be subject to capacity shortages,which boost profitability, although cash flow in rapidly growing industries can benegative due to high rates of investment (see Table 3.2).

REAL ANNUAL RATE OF MARKETGROWTHLess than -5% -5 % to 0 Ot o 5% 5% to 10% Over 10%

Gross margin on sales 23.5 25.6 26.9 25.7 29.7Return on sales 7.8 8.3 9.1 8.3 9.4Return on investment 20.6 23.0 23.2 22.2 26.6Cash flow/Investment 6.0 4.9 3.5 2.4 -0.1Source: R. D. Buzzell and B. T. Gale. The PIMS Principles (New York: Free Press, 1987) pp. 56-57.


13/33

63ANALYZING INDUSTRY ATTRACTIVENESSprice cuttingSchmalensee

avoid priceofofof

in objectries.firms, the

edprice com

dcapacity maycapacity willg an indusentitled to

in the Euro

Over 10%

-0.1

pp. 56-57.

Cost Conditions: Scale Economies and the Ratio ofFixed to variable Costs.When excess capacity causes price competition, how low will prices go? Th e key factor iscost structure. Where fixed costs are high relative to variable costs, firms will take onmarginal business at any price that covers variable cost. Th e consequences for profitability can be disastrous. From 1990 to 1995, the total losses of the U.S. airline industryexceeded total profits during the previous three decades. Th e willingness of airlines tooffer heavily discounted tickets on flights with low bookings reflects the fact that thevariable costs associated with filling empty seats on a scheduled flight are close to zero.Th e devastating impact of excess capacity on profitability in petrochemicals, tires, steel,and memory chips is a result of high fixed costs in these busif\esses and the willingness offirms to accept additional business at any price that covers variable cost.

Scale economies may also encourage companies to compete aggressively onprice in order to gain the cost benefits of greater volume. In consumer electronics,automobiles, and semi-conductors, the cost benefits of market leadership are powerful drivers of inter-firm competition.Bargaining Power of BuyersTh e firms in an indust ry operate in two types of markets: in the markets for inputsthey purchase raw materials, components, and financial and labor services from thesuppliers of these factors of production; in the markets for outputs they sell theirgoods and services to customers (who may be distributors, consumers, or othermanufacturers). In both markets, the relative profitability of the two parties in atransaction depends on relative economic power. Dea ling first with the sales to customers, two sets of factors are important in determining the strength of buyingpower: buyers' price sensitivity and relative bargaining power.Buyers Price Sensitivity. The extent to which buyers are senSItIve to theprices charged by the firms in an indust ry depends upon four major factors.

The greater the importance of an item as a proportion of total cost, the moresensitive buyers will be about the price they pay. Beverage manufacturers arehighly sensitive to the costs of metal cans because this is one of their largestsingle cost items. Conversely, most companies are no t sensitive to the feescharged by their auditors, since auditing costs are such a small proportion ofoverall company expenses.

Th e less differentiated the products of the supplying industry, the more willing the buyer is to switch suppliers on the basis of price. The manufacturersofT-shirts, light bulbs, and blank videotapes have much more to fear fromWal-Mart's buying power than do the suppliers of perfumes.

Th e more intense the competition among buyers, the greater their eagernessfor price reductions from their sellers. As competition in the world automobile industry has intensified, so component suppliers are subject to greaterpressures for lower prices, higher quality, and faster delivery.

The greater the importance of the industry's product to the quality of thebuyer's product or service, the less sensitive are buyers to the prices they arecharged. Th e buying power of personal computer manufacturers relative tothe manufacturers or microprocessors (Intel, Motorola, Advanced MicroDevices) is limited by the critical importance of these components to thefunctionality of their product.


14/33

64 ANALYZING THE INDUSTRY ENVIRONMENTRelative Bargaining Power. Bargaining power rests, ultimately, on refusal todeal with the other party. Th e balance of power between the two parties to a transaction depends on the credibility and effectiveness with that each makes this threat.The key issue is the relative cost that each party sustains as a result of the transactionno t being consummated. A second issue is each party's expertise in leveraging itsposition through gamesmanship. Several factors influence the bargaining power ofbuyers relative to that of sellers.

Size andconcentration ofbuyers relative to suppliers.The smaller the number of buyers and the bigger their purchases, the greater the cost of losing one. Because oftheir size, health maintenance organizations (HMOs) can purchase health carefrom hospitals and doctors at much lower cost than caIi 6individual patients.

Buyers' information . The better informed buyers are abou t suppliers and theirprices and costs, the better they are able to bargain. Doctors and lawyers donot normally display the prices they charge, nor do traders in the bazaars ofTangier and Istanbul. Keeping customers ignorant of relative prices is aneffective constraint on their buying power. But knowing prices is of littlevalue if the quality of the product is unknown. In the markets for haircuts,interior design, and management consulting, the ability of buyers to bargainover price is limited by uncertainty over the precise attributes of the productthey are buying.

Ability to integrate vertically. In refusing to deal with the other party, thealternative to finding another supplier or buyer is to do-it-yourself Largefood processors such as Heinz and Campbell's Soup have reduced theirdependence on the oligopolistic suppliers of metal cans by manufacturingtheir own. The leading retail chains have increasingly displaced their suppliers' brands with their own brand products. Backward integration need no tnecessarily occur-a credible threat may suffice.

Empirical evidence points to the tendency for buyer concentration to depressprices and profits in supplying industries.16 PIMS data show that the larger the average size of customers' purchases and the larger the proportion of customers' total purchases the item represents, the lower the profitability of supplying firms. 17

Bargaining Power of SuppliersAnalysis of the determinants of relative power between the producers in an industryand thei r suppliers is precisely analogous to the analysis of the relationship betweenproducers and their buyers. Since the factors that determine the effectiveness of supplier power against the buying power of the industry are the same as those thatdetermine the power of the industry against that of its customers, they do notrequire a separate analysis.

Because raw materials, semi-finished products, and components tend to be commodities supplied by small companies to large manufacturing companies, their suppliers usually lack bargaining power. Hence, commodity suppliers often seek to boost theirbargaining power through cartelization---e.g., OPEC, the International Coffee Organization, and farmers' marketiog cooperatives. A similar logic explains labor unions.

PIMS studies of the impact of suppliers' bargaining power on firms' profitabilityis complex. Increasing concentration of a firm's purchases is initially beneficial since itpermits certain economies of purchasing. Thereafter, increasing concentration among


15/33

65

197.9

Over 75%187.9

239.0

249.0

PERCENTAGE OF EMPLOYEES UNIONIZED1% TO 35% 35% TO 60% 60% TO 75%

2510.8

None

Forecasting Industry ProfitabilityDecisions to commit resources to a particular industry must be based on anticipatedreturns five to ten years in the future. Over these periods, profitability cannot beaccurately forecast by projecting current industry profitability. However, we can predict changes in the underlying structure of an industry with some accuracy. Structural changes are driven by current changes in product and process technology, thecurrent strategies of the leading players, the changes occurring in infrastructure andin related industries, and by government policies. I f we understand how industrystructure affects competition and profitability, we can use our projections of structural change to forecast the likely changes in industry profitability.

Th e first stage is to understand how past changes in industry structure haveinfluenced competition and profitability. Exhibit 3.2 explains deteriorating profitability of the world automobile industry in terms of the structural changes that haveaffected the five forces of competition. The next stage is to identify current structuraltrends and determine how these will impact the five forces of competition andresulting industry profitability. Consider the U.S. casino gambling industry (seeExhibit 3.3). The current strategies of the companies and actions by regulatoryauthorities have clear implications for structural changes in the industry. Thesestructural trends directly influence competition and profitability.

While it is not possible to predict with any confidence the quantitative impactof structuraL changes, their qualitative impact is easier to assess. Th e main problemis the difficulty of appraising the aggregate effect of multiple structural changeswhere some are beneficial to profitability, others are detrimental. Thus, a key issue inthe casino industry is wheth.er the current merger wave will offset the tendency forincreasing excess capacity to depress profitability.

Once we understand how industry structure drives competition which, in turn, determines industry profitability, then we can apply this analysis, first, to forecasting industryprofitability in the future and, second, to devising strategies to change industry structure.

purchasers results in decreased profitability due to increased supplier power. Supplierpower is significantly increased by forward integration into its customer's own industry. When a firm faces its suppliers as competitors within its own industry, its ROI isreduced by two percentage points. Unionization is unambiguously associated withdecreasing profitability (see Table 3.3) .

Source: R.D. Buzzell and B.T. Gale. The PIMS Principles: Linking Strategy to Performance(New York: Free Press. 1987). p.67.

ROI(%)ROS(%)

APPLYING INDUSTRY ANALYSIS

of buyof

patients.their

doin the bazaars of

prices is anis of little,

of the productother party, the

reduced theirmanufacturing

their supplino t

ers' total pur 17

their supplito boost theirCoffee Orga

it

in an industryhip between

of sup as those thatthey do not

ENVIRONMENT

makes this threat.of the transaction in leveraging its

of


16/33

66 ANALYZING THE INDUSTRY ENVIRONMENT

EXHIBIT 3.2Competition and Profitability in the World Automobile IndustryDespite record profits earned by th e U.S. BigThree (GM, Ford, and Chrysler) from 1994t6 1997and recovery of Japanese and German car makersin 1996-1997, the overall profitability of theworld auto industry during the 1990s was dismal.During the six year period from 1990 to 1995, theaverage return on equity earned by the world's10 largest car makers Was 3.4 percent'""""'Substan tially below thE!ir cost of equity capital. Profitability was far below the levels earned during the1960s. What factors can explain the deteriorationin industry profitabilitY?Substitute competition remained modest.Despite dire warnings over the imminent demiseof private motoring, the automobile increased itsposition as the dominant mode of personal transportation in the industrialized countdes.Despitegrowing congestion, little shift to public transportation occurred while telecommuting remained inits infancy.

New entry was also limited, due maihly tothe huge costs of establishing manufacturingand distribution facilities and the large scaleeconomies in the business. New entrants duringthe 1980s and 1990s included Proton (Malaysia),Ssangyong and Samsung (Korea), and somesmall companies producing for their domesticmarkets.The major force of increased competitionwas increased rivalry among existing car makers.At the global level, industry .concentrationincreased as many small and medium-sized producers were merged or acquired: in France, Peugeot and Citroen merged; Chrysler acquiredAMC; VW acquired Seat .. and Skoda; BMWacquired Rover; Ford acquired Jaguar. Yet,loo.kingat national markets, the picture was quitedifferent. During the 1960s, national car makersdominated their domestic markets. The processof internationalization resulted itl increasedimport competition and building of foreignplants with the result that every national marketfeatured more companies and lower concentration than three decades earlier. The U.S. marketshare of the Big Three dropped!rom 85 to 64percent, Fiat's share of th e Italian market feUfrom 66 to 40 percent, Rover (formerly BtitishLeyland) saw its UK market share decline from 40to 11percen1; in Germany, the market share ofVW and Mercedes declined from 50 to 28 percent. The leading motor vehicle manufactures in

1994 in terms of number of cars and trucks produced were as follows (figures in thousands):GM u.s. 8,619Ford U.S. 6,462Toyota Japan 4,465Volkswagen Ge.rmany 3,299Nissan J a ~ a n 2,839Chrysler U.S 2,808R h ~ M Peugeot France 1,890Renault France 1.761Honda Japan 1,765Mitsubishi Japan 1,529Hyundai S. Korea 1,255Mazda Japan 974~ w ~ ~ ~ Daimler-Benz German 930Kia S. Korea 691Daihatsu Japan 606BMW Germany 563VAl Russia 585DaeWoo S. Korea 523Isuzu Japan 456Volvo Sweden 448Fuji Japan 419

Not only were there more competitors, buttheir products were becoming increasingly simi lar. Increasing standardization of designs, technologies, and features resulted in differentmanufacturers' vehicles In each product categorybecoming increasingly sjmHar. Competitioh wasfurther enhanced by exceSs capacity. Although astrong U.S. economy kept capacity utilizationhigh in North America during 1995 to 1997, elseWhere, the picture was less satisfactory. InEurope, glpacity utilization remained low, andunion agreements and political pressures presented major barriers to exit. Substantial excesscapacity also existed in Japan and Korea.. W o r l d ~ wide, heavy investment in new plants and newprocess technologies was causing productioncapacity to grow faster than demand.The manufacturers were also pressured byincreased vertical bargaining power. The powerof suppliers had increased greatly. Suppliers ofcomponents and sub-assemblies such as Bosch,TRW, Verity, Aisln Seikl, Dana, and Eaton rivaledthe auto manufacturers in terms of size and multlnationality. Increa:singly, technology development was led by the component manufacturers,


17/33

67APPLYING INDUSTRY ANALYSIS

EXHIBIT 3.2(Continued)

pro

8

not the auto companies. At th e buyer level,there were signs the auto manufacturers mightbe losing control over their distribution channels. In th e United States, th e traditional dealersystem was being challenged by new "automo bile supermarkets" including Automax (owned

EXHIBIT 3.3

by Circuit City) and AutoNation (owned byRepublic Industries), as well as by Internet sales.

Source: R. M. Grant, "The World AutomobileIndustry," Georgetown School of Business, 1997.

How Will Structural Change Affect the Profitability of U.S. Casinos?The 1990s were a period of rapid developmentfor the U.S. casino gambling industry. Increasingly, th e industry was viewed, no t just by th eexisting casino operators, but also by municipalities, states, and entertainment companies asoffering huge economic potential. The result wasexpansion on multiple fronts.In terms of new entry, casino gamblingexpanded well beyond its traditional locations inNevada and Atlantic City, NJ. The potential forgambling to offer new revenue sources to governments and opportunities for economic development encouraged th e licensing of casinos inMississippi and th e introduction of riverboat casinos. By 1996, 10 states had licensed casinos. The1988 Indian Gaming Regulatory Act opened th eway for some 70 casInos on Indian reservations in17 states. One of the biggest reservation casinosis Foxwood's, owned by the MashantucketPequot tribe in Ledyard, CT.Additional sources of new capacity havebeen expansion by existing casino companies inLas Vegas and Atlantic City. In Las Vegas, competition to build th e "biggest and best" hasresulted in th e demolition and rebuilding of anumber of leading casinos. Between 1996 and2000, th e number of hotel rooms at Las Vegascasinos will double. New "megacasinos" includethe $390 million Luxor, th e $450 million TreasureIsland, th e $1 billion MGM Grand resort, and th e$2.5 billion Bellagio (by Mirage Resorts). Rivalrybetween Donald Trump and Mirage Resorts'Steve Wynn has also expanded capacity in Atlantic City. where excess capacity is already causIngseveral casinos to lose money. Mirage will own

5,500 rooms by 1998. The problems of excesscapacity are exacerbated by th e high fixed costsof operating casinos.

Increasingly. th e Las Vegas casinos are competing through ever more ambitious differentiation. New casinos such as New York, Bellagio, andMonte Carlo are breakIng new ground in spectacle, entertainment, theming, and sheer scale.However, th e geographical proximity of thesecasinos means despi te differentiation, th e casinoswill still be battling forthe same pool of gamblers.At th e substitute level, Americans' dreams ofquick riches were also being met by an expandingnumber of state lotterIes, and an increasing use ofgames of chance as vehicles for marketing magazines, soft drinks, and credit cards. Traditionalforms of gambling such as horse and greyhoundracing were attempting to revitalize their appealthrough th e addition of slot-machine gambling.The expansion of cruIse-ship vacations provIdednew opportunities for offshore gambling.

Whether the pressures of new entry andexcess capacity will cause industry margins to collapse depends on th e extent to new supply willcreate its own demand. If new gambling opportunities attract a new breed of gamblers and ifth e themed megacasinos attract vacationingfamilies, it may be possible for th e market toabsorb th e new capacity. Certainly, gambling inth e UnIted States is a growth industry with totalrevenues rising from $124 billion in 1982 an d$304 billion in 1991, to over $500 billion in 1996.B,!Jt, if th e new casinos are simply increasing competition for th e narrow group of "high rollers,"then th e prospects look gloomy.


18/33


Resorts, Circus Circus,a big. players seekingplayers. A battle for mn asmall number of

h o r t ~ m e d i u m term s ut resultinga more favorable long-term structure.

In other industries, there may be little ambiguity about the impact of structuralchanges on profitability since the main structural changes are pulling in the samedirection. For example:

It seems likely that the profitability of U.S. network broadcasting willdecline over the next ten years (1998-2007) in response to an increasednumber of broadcast networks (the big three-ABC, CBS, and N B C were joined first by Fox, then by Time Warner); increased competitionfrom substitutes such as direct satellite TV, the Internet, and videogames; and increased bargaining power of production studios and localTV stations.

The situation is similar with the issuers of bank credit cards. More competition due to increasing numbers of competitors (including non-bank issuerssuch as GM, GE , and AT&T), entry from various co-branders (rangingfrom universities and churches to clubs and airlines), lower demand due toincreased consumer indebtedness, and increased substitute compet ition fromAT M cards and electronic transactions through the Internet and othermedia may affect profitability.

Strategies to Alter Industry StructureUnderstanding how the structural characteristics of an industry determine theintensity of competition and the level of profitability provides a basis for identifYingopportunities for changing industry structure in order to alleviate competitive preassures. The first issue is to identifY the key structural features of an industry that areresponsible for depressing profitability. Th e second is to consider which of thesestructural features are amenable to change through appropriate strategic initiatives.For example:

In consumer electronics, suppliers of leading brands (such as Sony and Pioneer) have sought to limit the buying power of discount chains by refusing tosupply those chains that advertise cut prices or that do no t display theirproducts within "an appropriate retailing environment."

In the European and North American oil refining industry, most firmshave earned returns well below their cost of capital due to many competitors, excess capacity, and commodity products. Efforts to improve industry

DEI


19/33

69NING INDUSTRIES: IDENTIFYING THE RELEVANT MARKET

of structuralin the same

willincreased

N B C

and videoand local

competi

due toother

th e

that areof these

Pioto

their

competiindustry

profitability include mergers between BP and Mobil in Europe, betweenShell and Texaco in the United States (aimed at facilitating capacity reduction), and attempts at product differentiation through performanceenhancing additives to gasoline.

Excess capacity has also been a major problem in the European petrochemicals industry. Through a series of bilateral plant exchanges, the number ofcompanies producing each product group has been reduced and capacityrationalization has been facilitated. 1S During 1993, IC I initiated a programof plant swaps with BASF, Bayer, and Dow to reduce excess capacity inEuropean polyurethane production.19

Building entry barriers is a vital strategy for preserving high profitability inthe long run. A primary goal of the American Medical Association has beento maintain the incomes of its members by controlling the numbers of doctors trained in the United States and imposing barriers to the entry of doctors from overseas.

DEFINING INDUSTRIES: IDENTIFYING THE RELEVANT MARKETOn e of the most difficult problems in industry analysis is defining the relevantindustry. Suppose Jaguar, a division ofFord Motor Company, is assessing its outlookover the next ten years. In forecasting the profitability of its industry, should Jaguarconsider itself part of the "motor vehicles and equipment" industry (SIC 371), theautomobile industry (SIC 3712), or the luxury car industry? Should it view itsindustry as national (UK), regional (Europe), or global?

The first issue is clarifYing what we mean by the term "industry"? Economistsdefine an industry as a group of firms that supplies a market.20 Hence, the key todefining industry boundaries is identifYing the relevant market. By focusing on therelevant market, we do no t lose sight of the critical relationship among firms withinan industry: competition.

A market's boundaries are defined by substitutability, both on the demand sideand the supply side. Thus, in determining the appropriate range of products to beincluded in BMW's market, we should look first at substitutability on the demandside. If customers are unwilling to substitute trucks for cars on the basis of price differences, then Jaguar's market should be viewed as automobiles rather than all motorvehicles. Again if customers are willing to substitute among different types of automobiles-luxury cars, sports cars, family sedans, sport utility vehicles and stationwagons-on the basis of relative price, then Jaguar's relevant market is the automobile market rather than just the luxury car market.

Even if there is limited substitution by customers between different types ofautomobile, if manufacturers find it easy to switch their production from luxurycars to family sedans to sports cars and the like, then such supply-side substitutability would suggest that Jaguar is competing within the broader automobilemarket. Th e ability of Toyota, Nissan, and Honda to penetrate the luxury carmarket suggests that supply-side substitutability between mass-market autos andspecialty autos is moderately high. Similarly, the automobile industry is frequently defined to include vans and light trucks, since these can be manufacturedat the same plants as automo}:liles (often using the same platforms and engines).So too with "major appliance" manufacturers. They tend to be classified as a single industry, no t because consumers are willing to substitute between refrigerators


20/33

70 ANALYZING THE INDUSTRY ENVIRONMENTand dishwashers, but because the manufacturers can easily substitute among different appliances.

Th e same considerations apply to the geographical boundaries of markets.Should Jaguar view itself as competing in a single global market or in a series of separate national or regional markets? The criterion here again is substitutability. If customers are willing and able to substitute cars available on different national markets,and/or if manufacturers are willing and able to divert their output among differentcountries to take account differences in margins, then a market is global. Whereas themarket for je t aircraft is clearly global and the market for dairy products clearlynational (or local), automobiles are an especially difficult case. To the extent that mostauto manufacturers are multinational corporations, there is considerable supply-sidesubstitutability. However, to the extent that national markets are separated by traderestrictions, regulations, and the manufacturers' tightly controlled distribution channels, the international auto market may be seen as a conglomeration of many nationalmarkets with imperfect demand and supply-side substitutability among them.

Ultimately, drawing boundaries around industries and markets is a matter of judgment that must account for the purposes and context of the analysis. Substitutabilitytends to be higher in the long run than in the short term. Hence, if Jaguar is planningits strategy over a ten year period, its relevant business environment is the global automobile industry. If it is considering its competitive strategy over the next three years, itmakes sense to focus on specific national and regional markets--the United States,Japan, the EU, and Mercosur--and on the luxury car market rather than the automobile market as a whole.Fortunately, the precise delineation of an industry's boundaries is seldom criticalto the outcome of industry analysis so long as we remain wary of external influences.Because the five forces framework includes influences from outside the industryentrants and substitutes-the risks of defining the industry too narrowly are mitigated. For example, if we choose to identify Jaguar's industry as comprising themanufacturers ofluxury cars, then we can view substitute compet ition as sports cars,family sedans, and sport utility vehicles, and view the manufacturers of these vehicles as potential entrants into the luxury car market.

BEYOND THE FIVE FORCES MODEL: DYNAMICS,GAME THEORY, AND COOPERATION

Despite being widely used as a framework for analyzing competition and predictingprofitability, Porter's Five Forces of Competition framework is not without its critics. Economists criticize its theoretical foundations. Its basis is the structure-conduct-performance approach to industrial organization economics, which has beenlargely displaced by game theory approaches. Researchers at McKinsey & Companyhave identified a number of assumptions in the structure-conduct-performancesapproach which do not hold in practice. For example, business relationships are no talways arms-length. Many relationships are characterized by privilege through affection or trust; others are co-dependent systems formed by webs of companies, wherecompetition exists between webs and within webs. Thus the "Win tel" web competeswith the A p ~ l e web, while within the Wintel web, Compaq and Dell compete withone another. 1 Apart from unease over its dubious theoretical foundations, the FiveForces model is also limited by its static nature: it views industry structure as stableand externally determined. This determines the intensity of competition, which in


21/33

BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, AND COOPERATION 71

of markets.of sepaIf cus

t

of judgis planning

are no t

ete withas stable

turn influences the level of industry profitability. Bu t competition is no t some constrained process that determines prices and profits and leaves industry structureunchanged. Competition is a dynamic process through which industry structureitself changes through evolution and transformation. Thus, a model that does no ttake these features into account fails to recognize that competition changes industrystructure both consciously by firms' strategic decisions and as an outcome of theresulting competitive interaction.

Th e essence of competition, then, is a dynamic process in which equilibrium is never reached and in the course of which industry structures are continually reformed. This is evident in the structural transformation of deregulatedindustries.

By the mid-1990s, the U.S. airline industry had developed a structure thatfew of the architects of deregulation had predicted. Th e economists of theCivil Aeronautics Board had predicted that, in the absence of governmentregulation of routes and fares, entry would be easy, concentration would fall,and fares would drop to their competitive levels. In practice, the industry hasbeen shaped by the strategies of the leading players: mergers and acquisitionshave increased concentration; the hub-and-spoke system has given rise toseveral local near-monopolies; selective price competition has driven a number oflow-cost entrants into bankruptcy; and barriers to entry have been created through control of airport gates and landing slots, computerreservations systems, and frequent flyer programs. Th e privatization of British Telecom and the deregulation of the Britishtelecommunications industry heralded a new era of intense competition andrapid and radical structural change. Competition from Mercury was soonfollowed by cellular phone competitors such as Vodaphone, PCS competitorssuch as Orange, and cable TV companies offering telephone service.

SchUlllpeterian COlllpetitionJoseph Schumpeter was the first to recognize and analyze the dynamic interactionbetween competition and industry structure. Schumpeter focused on innovation asthe central component of competition and the driving force behind industry evolution. Innovation represents a "perennial gale of creative destruction" through whichfavorable industry structures-monopoly in particular-contain the seeds of theirown destruction by providing incentives for firms to attack established positionsthrough new approaches to competing. Although identified here with Schumpeter,this view of competition as dynamic process of rivalry is associated more widely withthe Austrian school of economics.22

The key issue raised by Schumpeter is whether we can use current industrystructures as a reliable guide to the nature of competition and industry performancein the future. The relevant consideration is the speed of structural change in industry. I f the pace of transformation is rapid, if entry rapidly undermines the marketpower of dominant firms, if innovation speedily transforms industry structure bychanging process technology, by creating new substitutes, and by shifting the basison which firms compete, then there is little merit in using industry structure as abasis for analyzing competition and profit.

Most empirical studies e>f changes over time in industry structure and profitability show Schumpeter's process of "creative destruction" to be more of a breeze


22/33


than a gale. Studies of United States and Canadian industrr3 have found thatentry occurs so slowly that profits are undermined only slowly. One survey commented: ". . . th e picture of the competitive process . . . is, to say the least, sluggishin the extreme.,,24 Overall, the studies show a fairly consistent picture of the rateof change of profitability and structure. Both at the firm and the industry level,profits tend to be highly persistent in the long run.25 Structural change-notablyconcentration, entry, and th e identity of leading firms-also appears to be, onaverage, slow.26

Some industries, however, conform closely to Schumpeter's model. Jeffrey Williams identifies "Schumpeterian industries" as those subject to rapid product innova tion with relatively steep experience curves. In these industries, structure tends to beunstable. In computers, telecommunication services, Internet access, and electronicgames, using current trends in industry structure to forecast profitability severalyears ahead is unreliable for two reasons: the relationship between competition andindustry structure is unstable, and changes in industry structure are rapid and diffi cult to predict. We return to the issues of industry evolution and forecasting industrystructure in Chapter 10.

H ypercOInpetitionSchumpeter's ideas of competition as a process of creative destruction have beendeveloped and extended in Rich D'Aveni's concept of hypercompetition.

Hypercompetition is an environment characterized by intense and rapidcompetitive moves, in that competitors must .move quickly to build advan tages and erode the advantages of their rivals. This speeds up the dynamicstrategic interactions among competitors.Hypercompetitive behavior is the process of continuously generating newcompetitive advantages and destroying, obsoleting, or neutralizing theopponent's competitive advantage, thereby creating disequilibrium,destroying perfect competition, and disrupting the status quo of the market place. This is done by firms moving up their escalation ladders faster thancompetitors, restarting the cycles, or jumping to new arenas.27The driving force of competition is the quest for profit through establishing

competitive advantage. However, rivalry for competitive advantage means that competitive advantage is transitory. Only by continually recreating and renewing competitive advantage can firms sustain market dominance and superior performanceover the long haul.

The Contribution of GaIlle TheoryCentral to the criticisms of Porter's Five Forces as a static framework is its failure totake full account of competitive interactions among firms. In Chapter 1, we notedthat the essence of strategic competition is the interaction among players such thatthe decisions made by anyone player are dependent on the actual and anticipateddecisions of the other players. By relegating competition to a mediat ing variable thatlinks industry structure with profitability, the Five Forces analysis offers little insightinto firms' choices of whether to compete or to cooperate; sequential competitive


23/33

73

thatcom

of the rate

on

Wilt innovatends to be

and

have been

than

~ a comcom

we notedthatthat

le insigh t

BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, AND COOPERATION

moves; and the role of threats, promises, and commitments. Game theory has twoespecially valuable contribu tions to make to strategic management.

1. It permits the framing of strategic decisions. Apart from any theoreticalvalue of the theory of games, the description of the game in terms of: Ident itying the players, Specitying each player's options, Establishing the payoffs from every combination of options, Defining sequences of decisions using game trees,

permits us to understand the structure of the competitive situation andfacilitates a systematic, rational approach to decision making.

2. Through the insight it offers into situations of competition and bargaining,game theory can predict the equilibrium outcomes of competitive situationsand the consequences of strategic moves by anyone player. Game theoryprovides penetrating insight into central issues of strategy that go wellbeyond pure intuition. Simple game models (e.g., "prisoner's dilemma") predict cooperative versus competitive outcomes, whereas more complex gamespermit analysis of the effects of reputation,28 deterrence,29 information,30and commitment31-especially within the context of multiperiod games.Particularly important for practicing managers, game theory can indicatestrategies for improving the structure and outcome of the game throughmanipulating the payoffs to the different players.32Despite the explosion of interest in game theory during the 1980s, practical appli

cations, especially in the area of strategic management, remained limited until the1990s. Interest in game theory has grown recently as a result of a number of practicalguides to the application of the game theory's tools and insights.33 Game theory hasprovided illuminating insights into a wide variety of situations, including the Cubanmissile crisis of 1962,34 President Reagan's 1981 tax cut,35 subsidies for Airbus Ind ustrie, the problems of OPEC in agreeing to production cuts, the competitive impact ofPhilip Morris's cutting cigarette prices on 'Marlboro Monday' in 1993,36 and the auctioning of licenses of wavelengths for telecommunications by the U.S. and NewZealand governments.3?

One of the greatest benefits of game theory is its ability to view business interactions as comprising both competition and cooperation. A key deficiency of theFive Forces framework is in viewing rivalry and bargaining as competitive in nature.Th e central message of Adam Brandenburger and Barry Nalebuff's book, Co-opetition, is recognizing the competitive/cooperative duality of business relationships.Whereas Coca-Cola's relationship with Pepsi-Cola is essentially competitive, thatbetween Intel and Microsoft is primarily complementary. Thus,

A player is your complementor if customers value your product more whenthey have the other player's product than when they have your product alone.

A player is your competitor if customers value your product less when theyhave the other player's product than when they have your product alone.

Th e ValueNet recognizes these two types of relationship (see Figure 3.5). It is important to recognize that a player may occupy multiple roles. Microsoft and Netscape compete fiercely to dominate the Rlarket for Internet browsers. At the same time, the twocompanies cooperate in establishing security protocols for protecting privacy and guard


24/33

74 OPINALYZING THE INDUSTRY ENVIRONMENT

FIGURE 3.5The Value Net

ing against credit card fraud on the Internet. Similarly, with customers and suppliers,though these players are essentially partners in creating value, they are also bargainingover sharing that value. The desire of competitors to cluster together--antique dealers inLondon's Bermondsey Market and advertising agencies on Madison Avenue--points tothe complementary relations among competitors in growing the size of their market anddeveloping its infrastructure.

Th e most important insights that game theory provides are its ability to identifyopportunities for a player to change the structure ofa game in order to improve payoffs.Consider the following examples:

Th e benefits ofrepeated games. A classic case of "prisoners ,dilemmd' is purchasing a product where the quality cannot be easily discerned prior to purchase (e.g.,a used car). The seller has an incentive to offer low quality, the buyer has anincentive to offer a low price in the likelihood that quality will be poor (seeChapter 9 for a fuller analysis). Both parties would benefit from ensuring thatthe product was high quality. How can this dilemma be resolved? One answer isto change a one period game (single transaction) into a repeatedgame (long-termvendor relationship). Faced with the possibility of a long-term business relationship, the seller has the incentive to offer a quality product, the buyer has theincentive to offer a price that offers the seller a satisfactory return.

Deterrence. Th e payoffs in a game can be changed through increasing thecosts to other players of choices that are undesirable to the firm. By establishing the certainty that deserters would be shot, the British army madedesertion a less attractive alternative for troops than advancing over noman's-land to attack German trenches during World War I. Similarly, established airlines have sought to deter Southwest from expanding its route net work by the threat of matching Southwest's fares on the new routes.

Bringing in competitors. "Establishing alliances and agreements with competitors can increase the value of the game by increasing the size of the market and


25/33

75OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KEY SUCCESS FACTORS

suppliers,bargainingdealers in

payofft.purchas

poor (seeis

relation

estabno

estab

building strength against other competitors. Th e key is converting win-lose (oreven lose-lose) games into win-win games. When Intel developed its 8086microprocessor, it gave up its monopoly by offering second-sourcing licensesto AMD and IBM. Although Intel was creating competition for itself, it wasalso encouraging the adoption of the 8086 chip by computer manufacturers(including IBM) who were concerned about overdependence on Intel. OnceIntel had established its technology as the industry standard, it developed itsfamily of 286, 386, 486, and Pentium processors and became much morerestrictive over licensing. A cooperative solution was also found to NorfolkSouthern's competition with CS X for control of Conrail. Th e 1997 biddingwar was terminated when CSX and Norfolk Southern agreed to dismemberand share Conrail.

Game theory permits considerable insight into the nature of situations involvinginteractions among multiple players. It clarifies the structure of relationships andnature of interactions among players, and it identifies the alternative actions availableto different players and related these to possible outcomes. Game theory has providedvaluable decision support in negotiations and in simulating competitive patterns ofaction and reaction. War gaming, based on game theory principles, is a popular technique both among military planners and management consultants such as Booz Allenand Coopers & Lybrand. The weaknesses are in the ability to apply game theory tospecific business situations and generate unambiguous, meaningful, and accurate predictions. Game theory is excellent in providing insights and understanding; it hasbeen less valuable in predicting outcomes and designing strategies. Th e cost of gametheory's mathematical rigor has been narrowness of application. Game theory provides clear prediction in highly stylized si tuations involving few external variables andhighly restrictive assumptions. Th e result is a mathematically sophisticated body oftheory that suffers from unrealistic assumptions, lack of generality, and an analysis ofdynamic situations through a sequence of static equilibria.38 When applied to morecomplex (and more realistic) situations, game theory frequently results in either noequilibrium or multiple equilibria, and outcomes that are highly sensitive to smallchanges in the assumptions. Experience in applying game theory has been mostlydisappointing. Th e game theory-designed FCC auctions for PC S licenses are generally viewed as being a disaster, both for the FC C and for the bidders who used gametheory to formulate their bidding strategies. Although game theory is in a phase ofrapid development, it is far from providing the theoretical foundations for strategicmanagement. Though we draw on game theory in several places in this book, theemphasis of analysis is less on the analysis of action and response between rivals andother approaches to "playing the game," and more about the transformation of com petitive games through building sustainable competitive advantage.39

OPPORTUNITIES FOR COMPETITIVE ADVANTAGE:IDENTIFYING KEY SUCCESS FACTORS

Our discussion of hypercompetition and game theory has taken us well beyond theconfines of the Five Forces framework. Remember that the primary purpose of thatmodel is to analyze industry attractiveness in order to forecast industry profitability.Hypercompetition explicitly recognizes that competition is a battle for competitiveadvantage. Game theory also focuses on positioning and maneuvering for advantage.


26/33

76 ANALYZING THE INDUSTRY ENVIRONMENTTh e purpose of this section is to look explicitly at the analysis of competitive advantage. In subsequent chapters, we develop a more comprehensive analysis of competitive advantage. The purpose here is to identifY the potential for competitiveadvantage within an industry in terms of the factors that determine a firm's ability tosurvive and prosper-its Key Success Faetors. 40 In Exhibit 3.4, Kenichi Ohmae ofMcKinsey and Company in Tokyo discusses Key Success Factors in forestry and theirlink with strategy.

Like Ohmae, our approach to identifYing key success factors is straightforwardand commonsense. To survive and prosper in an industry, a firm must meet two criteria: first, it must supply what customers want to buy, second, it must survive competition. Hence, we may start by asking two questions:

What do our customers want? What does the firm need to do to survive competition?

EXHIBIT 3.4Probing for Key Success FactorsAs a consultant faced with an \4Mamiliar b ~ i n e s s or industry, I make a point of first Bsking the speciaUsts in the business. "What i ~ t h e secret of s u c ~ cess in this industry?" Needless to my, I seldQrn getan immediate a n s w e ~ a n d s o l p u r ~ u e t ~ ~ inquiryby asking other quemonsfrom a variety of a n g l ~ in order to establish as Cluickly. as possible somereasonable hypotheses as to keyfaetors for syution: "Then under theopposite conditions, where. there is plenty ofwater but. too little sUnshipe-for example,around the lower reaches of th e Columbia River- the key factors shoulc! be fertilizers to speedup th e growth and the choice of tree varietiesthat don't need so much sUf'shine."Having established in. a few minutes thegeneral framework of what we we[egoing totalk: about, I spent th e rest of th e long flightvery profitably hearing from him in detail howeach of these factors was being applied.Source:KenichiOhmae, The Mind of the Strate gist (Harmondsworth. U.K.: Penguin, 1982): 85.

.


27/33

77ive advan

competiability to

Ohmae of

OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KEY SUCCESS FACTORS

To answer the first question we need to look more closely at customers ofthe industry and to view them, not so much as a source of bargaining powerand hence as a threat to profitability, bu t more as the basic rationale for theexistence of the industry and as the underlying source of profit. This impliesthat the firm must identify who its customers are, identify their needs, andestablish the basis on which they select the offerings of one supplier in prefer ence to those of another. Once we have identified the basis of customers' pref erence, this is just the starting point for a chain of analysis. As Table 3.4 shows,if consumers select supermarkets primarily on the basis of price, and if lowprices depend on low costs, the interesting questions concern the determinantsof low costs.

TABLE 3.4Identifying Key Success Factors: Some Examples

WHAT DO CUSTOMERS HOW DOES A FIRMWANT? SURVIVE COMPETITION? KEY SUCCESS(Analysis of demand) (Analysis of Competition) FACTORS

Steel Customers include auto,engineering, and containerindustries. Customersacutely price sensitive. Cus tomers require product consistency and reliability ofsupply. Specific technicalspecifications required fo rspecial steels.

Competition primarily onprice.Competition intensedue to declining demand,high fixed costs, excesscapacity, low-costimports, and exit barriershigh. Transport costshigh. Scale economiesimportant.

Cost efficiency throughscale-efficient plants, lowcost location, rapid adjustment of capacity to out put, efficient use of labor.Scope fo r differentiationthrough quality serviceand technical factors.

FashionClothing Demand fragmented by garment, style, quality, color.Customers' willingness topay price premium fo r fashion, exclusivity, and quality.Mass market highly pricesensitive. Retailers seek reliability and speed of supply.

Low barriers to entry andexit. Low seller concentration. Few scale economies.International competitionstrong. Retail chains exercise strong buying power.

Need to combine effective differentiation withlow-cost operation. Keydifferentiation variablesare speed of response tochanging high fashions,style, reputation andquality.

Supermarkets Low prices. Convenient location. Wide range of prod ucts. Product range adaptedto local customer prefe rences. Freshness of produce.Cleanliness, service, andpleasant ambience.

Markets localized andconcentration normallyhigh. But customer pricesensitivity encourages vigorous price competition.Exercise of bargainingpower an importantinfluence on input cost.Scale economies in operatioC1 and advertising.

Low cost operationrequires operational effi ciency, scale efficientstores, large aggregatepurchases to maximizebuying power, low wagecosts. Differentiationrequires large stores (toallow wide productrange), convenient location, easy parking.


28/33

78 ANALYZING THE INDUSTRY ENVIRONMENT OPI

FIGURE 3.6Identifying Key Suc cess Factors

The second question requires that the firm examine the basis of competitionin the industry. How intense is competition and what are its key dimensions? Ifcompetition in an industry is intense, then, even though the product may behighly differentiated and customers may choose on the basis of design and quality rather than price, low cost may be essential for survival. Retailers such asHarrods, Nordstrom, and Tiffany's do no t compete on low prices, bu t in afiercely competitive retailing sector, their prosperity depends on rigorous costcontrol.

A basic framework for identifying Key Success Factors is presented in Figure3.6. Application of the framework to identify Key Success Factors in three industriesis outlined in Table 3.4.

Key Success Factors can also be identified through the direct modeling of profitability. In the same way that our Five Forces analysis models the determinants ofindustry-level profitability, we can also attempt to model firm-level profitability interms of identifying the key factors that drive a firm's relative profitability within anindustry. In Chapter 2, we made some progress on this front. By disaggregating afirm's return on capital employed into individual operating factors and ratios, we canpinpoint the most important determinants of firm success (see Figure 2.2). In manyindustries, these primary drivers of firm-level profitability are well-known and widelyused as performance targets. Exhibit 3.5 gives a well-known profitability formula usedin the airline industry then identifies the factors that drive the profitability ratios.


29/33

OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KE'{ SUCCESS FACTORS 79competition

I fbe

qual as

bu t in a

of profitof

aggregating aratios, we can2.2). In many

EXHIBIT 3.5'Identifying Key Success Factors Through Modeling Profitability: The Airline BusinessProfitability, as measured by operating income per Matching airpla ine size to demandavailable seat-mile (ASM), is determined by three fo r individual flights.factors: Yield, total operating revenues divided bythe number of revenue passenger miles (RPM);Load factor, the ratio between RPMs and APMs;and Cost total operating expenses divided byASMs. Where an ASM is one seat flown one milewith a passenger in it or not, RPM is one seatflown one mile with a passenger in it. Thus:

~ ~ ~ ~ e =R ~ v p e ~ ~ e X ~ ~ _ E X A ~ ~ ~ s Some of the primary determinants of each ofthese measures are the following:Revenue/RPMs

Intensity of competition on routesflown. Ability to quickly adjust prices andprice structures to changing marketconditions through effective yieldmanagement. Ability to attract business customers. Offering superior customer service.

load factors Competitiveness of prices. Efficiency of route planning (e.g.,

through hub-and-spoke systems) Building customer loyalty throughquality of service. frequent-flyerprograms.

ExpenseslASMs Wage rates and benefit levels. Fuel efficiency of aircraft. Productivity qf employees (determined partly by their job flexibility). load factors. level of administrative cost.

In their quest fo r survival and competitiveadvantage, th e airlines have sought to optimize as many of these factors as possible inorder to improve their profitability. tn terms ofrevenue enhancement, several airlines havewithdrawn from the most intensely competitive routes, others have sought to achieve afare premium over the cut-price airlinesthrough punctuality, convenience. comfort,and services (e.g., inflight telephones. personalvideo monitors with choice of movies). Toimprove load factors, companies have soughtfleXibility in allocating plane capacity toroutes. and used their computer reservationsystems and Internet sales to achieve moreflexible pricing. Most notably, companies havesought cost economies through increasingemployee productivity, reducing administrative overhead through outsourcing, investingin fuel-efficient aircraft, and reducing wagesand benefits.

More generally, the approach introduced in Chapter 2 (see Figure 2.2) to disaggregatereturn on capital into its component ratios can be extended to identifY the specificoperational and strategic drivers of superior profitability. Fig,ure 3.7 applies this analysis to identifY success factors in retailing.

The value of success factors in formulating strategy has been scorned by somestrategy scholars. Pankaj Ghemawat observes that the" . . . whole idea of identifYing asuccess factor and then chasing it seems to have something in common with the illconsidered medieval hunt for the ,ghilosopher's stone, a substance that would transmuteeverything it touched into gold." 1 Th e objective here in identifYing Key Success Factors is less ambitious. There is no universal blueprint for a successful strategy, and evenin individual industries, there is no "generic strategy" that can guarantee superior profitability. However, each market.is different in terms of what motivates customers andhow competition works. Understanding these aspects of the industry environment is a


30/33


FIGURE 3.7Identifying Key Suc cess Factors in Retail ing ThroughAna

3 analuzing the industry enviroment

Documents