Foundations of Competitive Strategy Industry Analysis

Strategy Flowchart Where do we want to be? Where are we now? How do we get there? Industry & Organizational Analysis Mission, Vision, & Target Setting Competitive & Organizational Actions

Where are we now? Strengths Weaknesses Opportunities Threats Organizational Analysis Environmental/Industry Analysis VRIOPorter Forces Model

Industry Analysis As the Cramer case showed, it is critical to understand your industry. Cronin had the wrong model of what his industry was about. Industry analysis is about:  Where are we now?  What are our opportunities?  What are our threats?  Who is in position to capture the value that we create?

Value The value of (surplus from) an activity is the difference between its benefit and its cost. Cost recall is defined in terms of economic cost.  economic cost ignores sunk expenditures (i.e., expenses that cannot be affected by decisions over the relevant decision-making horizon)  economic cost pays attention to imputed costs (e.g., an opportunity to utilize a resource in a different way).

The Value of Trade When a good or service is traded, the value or surplus from that transaction is the difference between the buyer’s benefit and the seller’s cost. Two issues:  Efficiency: a transaction should take place if and only if the buyer’s benefit is not less than the seller’s cost.  Capture of surplus: how is the surplus (value created) divided between buyer and seller?

An Experiment Six people will write their value of a candy bar on a 3x5 card (and their names). Three pairs will be formed at random. One player in each pair will be assigned to be the buyer and one the seller. Trade will take place under rules to be defined; however, the rules will prevent you from making or refusing a trade inconsistent with your stated value for the candy bar.

Notes on Experiment

Division of Surplus p b c b c b c p p Buyer’s power increasing Seller’s power increasing

Profits Profits are revenue minus costs (economic costs, of course). Profits go up when revenue goes up or costs go down or both. Hence, profits a function of  Total surplus  Power of firm to capture surplus More power as seller (revenues go up) More power as an input buyer (costs go down)

Traditional Industry Taxonomies Monopoly is when there is only one producer. Oligopoly is when there are only a few producers, each of whom can be expected to react to the actions of the others. A competitive market is one in which there are many producers, none of whom can be expected to react to the actions of the others.

Porter Forces Model

Porter Industry competitors: The impact that the rivalry among existing firms has on a firm's competitive strategy. Potential entrants: The impact that potential entry by new firms has on a firm's strategy. Substitutes: The impact that substitute products have on a firm's competitive strategy.

Porter Complements & networks: For some products, complements or network externalities (or both) have important effects on what its producer can do. Suppliers: The behavior of suppliers has an impact on strategy. Customers: The behavior of customers can have an impact on strategy.

Porter Government: All firms operate in an environment affected by the laws, rules, and practices of government.

Issues with Suppliers What is the bargaining power of suppliers?  The more bargaining power they have, the more surplus they capture.  The suppliers’ bargaining power is a function of their market structure. The potential for vertical integration and being locked out.  Vertical integration can be way to protect yourself against changes in supplier structure  Vertical integration can sometimes increase the pie.

The Issue with Customers Customers’ bargaining power, which is a function of  their costs of switching to competitors or substitute products  the size of a single customer as a proportion of all your customers.  market structure of customers (if you sell an intermediate good or service). Generally, like a competitive market downstream: a competitive market maximizes value and multitude of competitors shifts market power to you.

The Main Issues with Competitors Loosely, more competitors mean customers have more choice; more choice means you have less market power; hence: competition   sellers’ share of surplus  But also fierceness and discipline among competitors affects whether industry retains market power or it shifts to customers.  “air service” experiment  Electronic components Distributors don’t Active component sellers do  Coke & Pepsi

Issues with Competitors Intensity of competition  the more intense the competition, the lower profits will be. The number of competitors  the more competitors there are, the lower profits will be if only because pie divided among more. Relative size of competitors  large, dominant firm can often impose discipline  similarly sized firms usually compete more fiercely.

Rivalry among existing firms The dimensions along which firms compete and the fierceness of that competition. Firms compete on many dimensions. The most important of which is price.  Why? Because its the dimension firms most want to avoid competing on.  Going head-to-head on price is bad news for firms! – Recall the Bertrand Trap!

The Fundamental Rule of Competitive Strategy Competitive strategy is like driving, not football: Head-on collisions are to be avoided.

Key issue: Fierceness of price competition Homogeneity of product. More homogenous, fiercer price comp. Customers’ knowledge of prices. More know, fiercer. Customers’ switching costs. Lower costs, fiercer. Firm production capacities. More capacity, fiercer Number of firms. More, fiercer Frequency of interaction & non-myopic play Variability in demand. More variable, fiercer “Barriers” to exit. More barriers, fiercer

The Issues with Potential Entrants If potential entrants enter, they are new competitors. Deterring potential entrants from entering is a strategic issue that affects your competitive strategy.

Threat of Entry An entrant is a potential competitor Entry is bad because  can result in more intense price pressure (lower margins)  can result in smaller mkt. share even if prices not much affected  or both! Principal issue: Is entry deterred? Can it be deterred?

Inherent Barriers to Entry Protections on intellectual property Legal or regulatory restrictions High consumer switching costs High supplier switching costs Recouping industry-specific initial investments Text in red can also be strategic barriers to entry—a topic for later. Can sometimes leverage non-red items strategically to deter entry (also a topic for later).

The Issue with Substitutes and Complements Pricing and availability of substitutes and complements affects demand for your product.  Availability of complements affects competition among rivals (e.g., lack of software for OS/2 vs. abundance of software for Windows).  As you saw in MBA 201A, demand for your product shifts with the prices of complements & substitutes.

Substitute goods & services Recall what substitute goods are.  example: air vs. rail Issues w/ substitutes  how close substitutes are  level of price competition in substitute mkt. P Q D(p sub = high) D(p sub = low)

Complements & Networks Recall complementary goods (e.g., cars & gasoline) Strategic success can depend on what happens in complementary market  prices  standards Network externalities P Q D(p comp = low) D(p comp = high)

Network Externalities An externality, recall, is an effect that one entity’s action has on another that the first entity does not consider in deciding what action to take.  Air pollution   Painting your house   Getting a telephone   Getting a credit card   Using a Linux-based computer   Buying a DVD player  The ones in red are network externalities. The last two (with 2 thumbs) exhibit positive & negative network externalities.

Consequences of Network Externalities … on pricing  Need to establish an installed base can require low introductory pricing  Issues in how price to different parts of market for incentive reasons Who should pay for a phone call? How should fees be set for credit cards? … work directly with complements providers  Encourage development  Deal with ancillary concerns (e.g., IP) … effect on market structure  Natural monopoly generation

Standards An issue in many network industries is standards setting Proprietary standards affect market power  Can create monopoly  But can hinder growth, particularly if there’s a standards war Common standards generally …  … good for software producers  … good for consumers (except for market power concerns)  … mixed for hardware producers negative if fosters competition positive if foster software production positive if increase network size

A “Seventh Force” The government  antitrust law and its enforcement  regulation  infrastructure (complement)  intellectual property law  differences in these factors across governmental jurisdictions.  trade policy  lobbying competition