Chapter 10 Industry Analysis

Chapter Contents

1) Introduction 2) Performing a Five-Forces Analysis

3) 4)

5) 6)

Chapter Summary The roots of the field of industry economics and market competition can be traced to the 1930s or earlier. However, they had little impact on business strategy until Michael Porter published a series of articles in the 1970s that culminated in his pathbreaking book Competitive Strategy. In his book, Porter presented a convenient framework for exploring the economic factors that affect the profits of an industry and classified these factors into five major forces. This chapter reviews the five-forces framework in the context of the economics of firms and industries. One assesses each force by asking Is it sufficiently strong to reduce or eliminate industry profits? Because the framework is comprehensive, the process of working through each of the five forces requires the systematic evaluation of all the significant economics factors affecting an industry. The five-forces framework does have several limitations: (1) it is not concerned with the magnitude or growth in demand, (2) it focuses on the entire industry, rather than on that industrys individual firms, (3) it does not explicitly account for the role of the government, and (4) it is only qualitative. The chapter further uses the fiveforces framework to analyse three specific industries: hospitals, tobacco, and Professional Sports.

Approaches to Teaching this Chapter Purposes of the Framework Provides for assessment of industry profitability Identifies opportunities for success and threats to success Provides basis for generating strategic choices Applies equally well to industrial and service sectors Internal Rivalry Internal rivalry refers to the jockeying for share by firms in the market. As was discussed in Chapters 79, firms may compete on a number of price and nonprice dimensions. Do firm interactions erode profits? Fierce competition between firms within an industry can force prices downward toward costs, thereby eroding profits. Internal rivalry is likely to be a problem when: there are numerous or equally balanced competitors slow industry growth high fixed costs or storage costs lack of differentiation or switching costs capacity augmented in large increments diverse competitors high strategic stakes-- how important is this industry? high exit barriers

Barriers to Entry Does the threat of entry erode profits? If entrants are not substantially differentiated from incumbents, then entry has two deleterious effects: 1)-market shares of incumbent firms fall and 2) competition to protect share leads to lower prices and therefore to lower profit margins. Entry is a key threat to the stability of markets in which there has been low internal rivalry. For example, an entrant may lower prices below collusive levels in order to penetrate the market. Earlier chapters discussed factors that affect the likelihood of entry and the ability of firms to deter entry. Entrants can be ignored if they are small, but failure to retaliate may invite more entry. Anything that makes it difficult for entry to occur is called an entry barrier. Barriers to entry are high when: there are economies of scale product differentiation capital requirements are high there are switching costs access to distribution channels (for example, channel crowding) cost disadvantages independent of scale proprietary product technology favorable access to raw materials favorable locations government subsidies learning or experience curve government policies

Substitutes and Complements Do substitute/complement products threaten to erode profits? Substitute products have similar product performance characteristics, that is, they perform a similar function, at least to a certain extent. Substitute products have the same effect as entry, the distinction is more a matter of degree. Close substitutes lead to greater price rivalry and theft of market share than do weak substitutes. Substitute products pose the greatest threat when they represent new technologies that will benefit from a learning curve and may eventually prove superior to the technologies they substitute for. Complements boost

demand for the product in question, thereby enhancing profit opportunities for the industry. One must be wary of: trends which improve the price-performance of substitutes for the industrys product substitutes produced by industries with higher profits than the industry under consideration trends which reduce the price-performance of complements to the industrys product Ask students for ideas on how to qualitatively describe a market. Some ideas include: 1) products have similar product performance characteristics (what the product does for the consumer), 2) products have similar occasions of use, and 3) products are sold in the same geographic market. Ask students to give examples of substitute and complement products, i.e., What is a substitute for airline travel? Answers may include train, car, fax, depending on the distance of travel, relative prices and purpose of travel. What is a complement to airline travel? Answers may include hotels, taxis, and rental cars. Buyer Power Do buyers have sufficient power to threaten industry profits? High buyer power leads to intense internal rivalry since small price reductions can generate large gains in market share. Buyer power is high when: Buyer purchases a large volume relative to sellers sales Buyers purchases represent a significant fraction of the buyers total costs Products purchased are standard or undifferentiated Buyer faces few switching costs Buyers pose a threat of backward integration Industrys product is unimportant to the quality of the buyers output Buyer has full information

Supplier Power Do suppliers have sufficient power to threaten industry profits? Again, this is related to concentration and the ability to shop around. Supplier power is high when; Suppliers industry is dominated by few companies and is more concentrated than the industry it is selling to Suppliers do not have to contend with other substitute products for sale to the industry The industry is not an important customer of the supplier industry The suppliers products are differentiated or it has built up switching costs The supplier group poses threat of forward integration The Value Net The Value Net framework (attributed to Brandenberger and Nalebuff) addresses weaknesses of Porters five forces analysis. While Porters five forces framework focuses on the negative spillovers of a firms actions with respect to other firms, the Value Net captures the notion that some actions firms take have positive spillover effects on other firms in the industry. The Value Net, which consists of suppliers, customers, competitors, and complementors, assesses both threats and opportunities to the industry. The Value Net is, therefore, a complement to a five forces analysis. The chapter contains several excellent examples. Students should be able to make the connection of buyer and supplier power to some of the concepts discussed in Chapter 3 and 4, for example: Contracting costs: Chapters 3 and 4 address why vertical integration might be a good alternative to market contacting. Indeed the degree to which vertical integration reduces transactions costs and

improves dispute resolution, adaptability, and repeated exchanges, it is often preferable to using market specialists. When market specialists are used, however, relative buyer/supplier power affects these issues and may raise the cost of exchange. Hold-up: As discussed in Chapter 4, the holdup problem raises the costs of exchange by increasing the amount of time and money parties spend in negotiations, reducing trust in the relationship, encouraging overinvestment, or leading one party to threaten to refrain from making relationshipspecific investments. All of these behaviors affect the relative level of either buyer or supplier power. Switching costs: Can buyers/sellers switch to other firms? When a relationship involves relationship-specific assets, parties cannot switch trading partners costlessly. If you buyers have no options, then, you have supplier power. If the supplier has no options, then the buyer owns the power. This is discussed in Chapter 4. Forward or backward integration: The ability of a buyer to backward integrate or a supplier to forward integrate can reduce the power of their contracting party. Vertical integration is discussed primarily in Chapters 3 and 4. Ask students to prepare thoughts on the following questions before the lecture: Consider the industry you worked in before returning to (graduate) school. What were the key forces shaping the nature of competition and the opportunities for making profit in that industry? What, if anything, did firms do to insulate themselves from these forces? A business consultant once argued that it is undesirable to enter industries that are easy to enter. Is there any wisdom in this advice? Why or why not?

Suggested Harvard Case Studies Caterpillar HBS 9-385-276 (see earlier chapters) Crown Cork and Seal, HBS 9-378-024, rev. 3/84. Describes the technical, economic, and competitive trends in the metal container industry. The strategy of Crown Cork and Seal is then described in relation to these trends. Potential threats to Crowns future are outlined. This case could be used to introduce students to Porters five forces model, and as the case describes the production process a discussion about optimal scale is appropriate. You may want to ask students to think of the following questions in preparation for the case: a) Perform a five forces analysis of the can manufacturing industry as of 1977. When possible, back up your analysis with information from the case. b) Identify viable strategic positions in this industry. How important are economies of scale in this industry? c) Identify the current strengths and weaknesses of CCS. What opportunities and threats does the current environment pose? d) Does CSS have a strategic position? What is it? What do you think it should be? Prepare a mission statement for CCS based on the position you think it should adopt. e) Identify concrete steps that Connelly should take to improve Crowns position. Be sure to discuss the move to aluminum, the growth of environmentalism, and opportunities overseas. Try to develop as cohesive a plan as possible. Does your plan address the opportunities and threats identified by your economic analysis? Hudepohl Brewing Company HBS 9-381-092 (see earlier chapters) Ingvar Komprad and IKEA HBS 9-390-132 (see earlier chapters) Tombow Pencil Co., Ltd. (HBS # 9-692-011 and Teaching Note # 5-693-027): This case illustrates how another firm (in another country!) struggles with a similar make-or-buy problem. While the most prominent issues in the case are the boundaries of the firm questions, the case also raises issues related to product market competition and the role of product variety, marketing channels, and organizational issues involving the coordination of marketing, sales, and production inside Tombow. The case also presents the differences between Keiretsu (networks of long-term relationships) and arms-length market contracting. It introduces students to the idea that assignment of ownership rights can solve problems that arise due to physical asset specificity (hold-up, human asset specificity). As with Nucleon (see chapter 3), it shows that there are strong relationships between production strategy, product market strategy, and the make-or-buy decision. This case can be taught with some combination of the following chapters: 3, 4, 5, 11, 12, 15, and 16. You may want to ask students to think of the following questions in preparation for the case: a) What is Tombow Pencils current financial position? Look at Tombows financial statement, and compare their financial ratios to Mitsubishis. In particular what would the impact be on Tombows profits if they could reduce their inventory/sales ratio to Mitubishis level?

b) c)

d)

Is the Japanese pencil industry profitable? Are there some segments that are more profitable than others? Compare the vertical chains for wooden pencils and the Object EO pencil (which will be our metaphor for mechanical pencils in general). Are the differences in the vertical scope/vertical boundaries in these two chains consistent with the underlying economics of make or buy decisions? Why does Ogawa feel the need to reexamine the production system for the EO pencil, given that Tombows vertical relationship have served them well for so long? What recommendations would you make for Tombow? Consider both the market position (product line, quality, price point, etc.) the horizontal and vertical scope, and the organization of the company.

Extra Readings It may be useful to distribute the following to students: McGahan, A. Selected Profitability Data on U.S. Industries and Companies. Porter, Michael E. A Note on the Structural Analysis of Industries, Boston: Harvard Business School, 1975. Porter, Michael E. How Competitive Forces Shape Strategy, Harvard Business Review, March-April 1979. Porter, Michael E. Strategy and the Internet, Harvard Business Review, March, 2001. Grant, R.M. Notes on Key Success Factors, excerpts from Contemporary Strategy Analysis: Concepts, Techniques, Applications, Cambridge, MA: Blackwell Business, 1991, pages 57-60.

Antitrust Guidelines for Collaborations Among Competitors, issued by the Federal Trade Commission and the U.S. Department of Justice. 2000. http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf
For the book on the five forces analysis method: Porter, Michael E. Competitive Strategy: Techniques for analyzing industries and competitors, New York: Free Press., 1980.

Answers to End of Chapter Questions 1. It has been said that Porters five forces analysis turns antitrust lawlaw intended to protect consumers from monopolieson its head. What do you think this means? Porter frames the forces that prevent industry profits from falling to the level that would exist in a competitive industry as a positive. When a force is such that profits are held above the competitive level, the five forces framework suggests this force is for the good of the industry. The antitrust laws are intended to push industry profits toward the competitive floor, for the benefit of consumers (and market efficiency). 2. Comment on the following: All of Porters wisdom regarding the five forces is reflected in the economic identity: Profit = (Price Average Cost) x Quantity The distribution of profits, as defined in the above equation, rationalizes the analysis behind Porters five forces. Each of the variables in the equation bears on or is affected by one or more of the five forces discussed in the Porter model. Thus, the relationships between the forces influencing an industry are captured in the simple equation for economic profits. Rivalry: The existence of rivalry would be reflected in price as well as in quantity. The prediction is that increased rivalry would drive prices down and could also cause a redistribution of market shares. Rivalry can also increase competition for scarce input resources and drive up costs. Substitute goods: The existence of close substitutes would limit the price producers in the industry could charge. Substitute products can also reduce quantity when those substitutes are perceived to be better at satisfying customers needs or when they are priced lower and demand for the product is elastic. Buyer power: Buyers can force price down if they hold more bargaining power than producers, thereby converting producer profits to consumer surplus. Barriers to entry: High barriers to entry will prevent competitors from entering to drive prices down, allowing the current producers to maintain higher prices as well as larger quantities. Supplier power: If manufacturers of an input hold bargaining power, then they can increase the prices they charge for inputs the suppliers can capture a portion of the profits in the value chain. The existence of profits suggests that competitors will certainly attempt to enter the industry. The five forces analysis identifies the factors that affect the distribution of value creation within the industry (whether it is to buyers (consumer surplus), suppliers (producer surplus in another industry) or competitors (competition for producer surplus)), and qualifies the extent to which the capturing the profits appears feasible. The equation can act as a simple model for Porters paradigm. 3. How does the magnitude of scale economies affect the intensity of each of the five forces? Economies of scale exist when the average cost of producing output declines as the absolute volume of output increases. Scale economies affect the number of competitors that can compete successfully in an industry. There are likely to be fewer firms in an industry with high scale economies relative to total industry output than in an industry where scale economies are exhausted at relatively low levels of output. Since there are fewer players, the established incumbents would each have large market share and incur low unit production cost. In this context, scale economies will affect the five forces in the following way. Barriers to entry: Scale economies raise the entry barriers. To bring cost to a level comparable to those of existing players, an entrant would have to enter the industry with large capacity and risk

strong reaction from the incumbents. An alternative would be to enter at a small scale and face a cost disadvantage. Both options are undesirable to new entrants. Rivalry: Scale economies can have competing effects on rivalry. On the one hand, scale economies may intensify rivalry because the players have the incentive to increase their market share to sustain and deepen their scale economies. Rivalry may take the form of price competition, advertising battles and new product introductions. On the other hand, scale economies may result in fewer firms that could facilitate communication and peaceful coexistence among industry players. Substitutes: Scale economies increase the threat of the substitute products. If the priceperformance trade-off of a substitute product improves, firms within the industry lose share which reduces the industrys own price-performance trade-off. Bargaining power of suppliers: If high scale economies result in fewer firms in the industry, it is possible that the bargaining power of suppliers decreases. Fewer firms could co-ordinate their purchases from suppliers, negotiating lower prices and thereby increasing value creation in the industry. Bargaining power of buyers: Using the same reasoning for supplier power, scale economies that lead to higher industry concentration could decrease the bargaining power of buyers. Fewer firms could co-ordinate their pricing activities, thereby reducing consumer surplus. On the other hand, however, the existence of scale economies increases the power of buyers who purchase very large quantities. 4. How does capacity utilization affect the intensity of internal rivalry? The extent of entry barriers? Either of two factors tends to cause capacity utilization to aggravate the intensity of internal rivalry and the threat of new entry; high fixed costs, or capacity augmented in large increments. Firms with high fixed costs, operating well below their capacity, have a strong incentive to lower price in order to increase market share, since increasing production volume will tend to lower per unit costs, thereby offsetting the price reductions. In this case, the intensity of rivalry would be high. This competitive environment would tend to create high barriers to entry, since profit margins would be low, and market penetration pricing by a new entrant would trigger a price war in retaliation. Firms with capacity that must be augmented in large increments, operating at or near their full capacity, have less incentive to lower price and increase market share, since they lack the ability to increase production volume incrementally. Firms operating in excess of their capacity, accumulating unfilled orders or backorders, would have an incentive to slightly increase prices in order to soften demand to match capacity (or risk losing loyal customers who will switch to avoid delivery delays). In these cases, the intensity of rivalry would be low. This competitive environment would tend to lower barriers to entry, especially in the latter situation, since profit margins would be strong, and the incentive for a price war minimal. 5. How does the magnitude of consumer switching costs affect the intensity of internal rivalry? The extent of entry barriers? The presence of switching costs would reduce the intensity of internal rivalry. Switching costs are costs that consumers incur when they switch from one suppliers product to anothers. As such, consumers when faced with switching costs would not switch product unless a competitor can offer a major improvement in either price or performance. If switching costs are low, consumers are inclined to switch products when a competitor offers better price or service. This could result in price and service competition that would intensify the rivalry among competitors. In the presence of consumer switching costs, the bar for entrants is set higher. The entrant may have difficulty attracting consumers away for incumbents. Entrants should expect to more easily attract consumers who have yet to participate in the product vs. the customers of existing firms. 6. How do exit barriers affect internal rivalry? Entry?

High barriers to exit, typically associated with investment in strategic assets that have zero alternative employment, tend to increase the intensity of rivalry since there is no alternative to fighting for survival in the industry. High barriers to exit tend to discourage entry of new firms, since retaliation by competitors is highly likely, and this, combined with the lack of options for exit, makes this a high risk strategy, increasing the cost of capital for the new venture and thereby decreasing the value of the potential earnings. 7. Consider an industry whose demand fluctuates over time. Suppose that this industry faces high supplier power. Briefly state how this high supplier power will affect the variability of profits over time. Given an industry whose demand fluctuates over time and an input supplier with high supplier, the industrys variability of profits would decrease. High supplier power exists when an input supplier is able to negotiate prices that extract profits from their customers. In this case, the suppliers power would be reflected in his/her ability to change prices to reflect demand within the customers industry over any given period of time. For example, if the industry is doing well, the supplier could raise prices to extract a share of the industrys profits. Conversely, if the industry was doing poorly, the supplier could lower prices. The underlying demand volatility would be reflected in the suppliers profits rather than the industrys profits. The industrys profits would stabilize (at a low level). 8. What does the concept of coopetition add to the five forces approach to industry analysis? Coopetition is the concept that the forces that shape industry profits are to a great extent the result of choices made by the individual firms within the industry. As these firms become more savvy regarding the reaction of rivals to their own actions, they will choose actions that reduce the likelihood of losing industry profits to price wars, consumer surplus, and/or ineffective negotiations with suppliers. As each firm comprehends its own role within the industry, firms can collectively fashion strategies which cause a force to have only a limited effect. If firms ignore the concept of coopetition, they must resign themselves to simply reacting to the industry forces. 9. Coopetition often requires firms to communicate openly. How is this different from collusion? How can antitrust enforcers distinguish between coopetition and collusion? In general, open communication is not illegal, however, agreements that result from open communication may be illegal. Thus, the difference between open communication for coopetition and collusion is based on the outcome of any resulting agreement. Antitrust enforcers are the Federal Trade Commission and the U.S. Department of Justice. The distinguishing feature that makes an agreement per se illegal is if the outcome tends to raise price or reduce output. An agreement that is not considered per se illegal is still subject to the Rule of Reason which questions whether the relevant agreement likely harms competition by increasing the ability or incentive profitably to raise price above or reduce output, quality, service, or innovation below what likely would prevail in the absence of the relevant agreement.

See: Antitrust Guidelines for Collaborations Among Competitors, issued by the Federal Trade Commission and the U.S. Department of Justice. 2000. http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf
10. The following table reports the distribution of profits(on a per disc basis) for different steps in the vertical chain for music compact discs:

Industry Artist

Profits $.60

Record Company Retailer

$1.80 $.60

Use the five forces to explain this pattern. (Note: The record companies, including the Big 6 Warner, Sony, MCA, EMI, Polygram and BMG as well as smaller labels, are responsible for signing up artists, handling technical aspects of recording, securing distribution and promoting the recordings).

Recorded Material Industry: The industry is comprised of record labels that produce, promote and distribute recorded material mainly for home use.
Barriers to Entry: Economies of scale in marketing, reputation and established distribution networks create barriers to entry. Established firms also have brand identification and customer loyalty, which stem from past customer experiences with a particular label. Existing competitors have ties with retail channels based on long relationships. In addition, the experience curve gives existing competitors cost advantages. In sum, knowing the right people is a clich that cannot be understated in this industry. Relationships between distributors and the media and retail stores determine the success of an album. As these relationships take time and are costly to develop, they pose a formidable barrier to entry. Rivalry: Labels primarily engage in product differentiation. Record companies each have artists signed on to exclusive recording contracts. Rivalry may take the form of competing for the best artists, however, rivalry generally does not result in price competition. Supplier Power: Because there are many artists in the market (just add up every waiter and waitress in the U.S.) and few record labels, supplier power is low. The record company is responsible for recording, distribution and promotion. Thus, the artist depends heavily on the record companys activities if the artist hopes to become a hit. Initially the artist has little power to negotiate profits away from the record label. However, once the artist becomes a hit, his/her power within the relationship may increase. The extent to which the artists power increases depends on how confident the record label is that they can invent a new star from the large pool of wanna bees. If stars are difficult to emulate or replace, their share of profits along the vertical chain increases. Buyer Power: The music industry sells its output to retailers. The retailer stocks products that appeal to the individuals who purchase the output and use the output to generate home entertainment. Reputation is an important asset in music retailing. Consumers prefer to go to retailers who have a reputation for being well stocked with a large selection of products that appeal to the consumers tastes. Retailers also attract more customers if they have a reputation for being knowledgeable about the artists, courteous about replacing damaged material and reasonably priced, among other attributes. As reputation may impose a moderate barrier to entry, retailers have a degree of power within the vertical chain. Higher the barriers to entry are in retailing, the more profits retailers earn along the vertical chain. Substitutes: Examples of substitutes for recorded material are books, magazines, television, movies, and any other form of entertainment that can be consumed in the home. How consumers collectively feel about these substitutes effects the sum of profits along the vertical chain.