Industry Analysis

Key Concept of Business: Economic Profit Economic profit is the revenue earned by a firm above the economic cost required to generate that revenue. – Economic Cost = Accounting Cost + Opportunity Cost – Opportunity cost is the return available from the next best use of the resources used in the venture – Economic Profit = Accounting Profit–Opportunity Cost Why do we include opportunity cost? Because a key cost of using resources in one way is not being able to use them in another way. Economic Profits

Firms use invested capital to purchase resources – Investors will require the best available estimated return, accounting for the risk of the venture – So, the cost of capital provides a measure of the opportunity cost A convenient definition for economic profits that we use: Economic Profit = Revenue – Accounting Cost – Capital Cost Economic Profits: Measuring Opportunity Cost

Firms exist to generate economic profit for their owners. – Firms use owners’ resources. Their contribution is to provide a return above what the owner could get from another use. Key Question: What are the determinants of a firm’s economic profitability? Industry profitability: – Depends on the economic structure of an industry and how that structure affects competition The firm and its position in the market – Firm’s resources and capabilities – Do these lead to a competitive advantage or disadvantage in an industry? Determinants of Economic Profitability

Industry Analysis

Industry analysis is useful: – Understand the context of firm decisions so we can make decisions within context - building blocks of strategy formulation Essential to making effective decisions about entry, exit, expansion, product positioning, cost reduction, etc. It helps identify potentially attractive/unattractive areas for growth. Understanding the current “rules of the game” in the industry is a precondition for eventually changing them. To outperform your industry, you need to understand its structural conditions and the key competitive forces that operate in it now (and to forecast future conditions). Why Analyze Structure of Industry?

Porter’s five forces model Professor Michael Porter of Harvard Business School applies microeconomic theory, focusing on power, prices, and profits. The stronger a force, the more it limits the industry firms’ ability to set prices. Strong forces are thus threats because they reduce profits. Weak forces are opportunities because they give firms chances to earn greater profits. The pattern of forces both define the industry power relations and constrain firms actions.

Porter’s five forces model Threat from Substitutes Suppliers’ Power Threat from New Entrants Buyers’ Power Rivalry of Firms Power of other Stakeholders

The question: To what extent does the threat of entry cut the profitability of a typical firm in the industry? Factors that restrict entry into an industry: – Economies of Scale – Large Up-Front Expenditures that are Sunk – Difficult access to key resources (raw materials, distribution channels, favorable locations) – Incumbent advantages: Learning curve effects, patents and licenses, switching costs, reputation, brand loyalty – Expectation of aggressive response to entry I. Barriers to Entry

Production economies due to lumpy capital, specialization of labor/capital, technological factors. – Large economies of scale can arise when minimum efficient scale is large relative to market size (Market Size/Minimum Efficient Scale) approximates number of efficient scaled firms that can be sustained – Limits number of firms that can be in the industry – Creates “lumpiness” - incumbents can make profits but any additional entry would “spoil the market”. Economies of Scale

If investment made is specific to this opportunity, cannot recover it. – To the extent that investment made is irreversible, hit and run entry impossible Extent and specificity of capital is a barrier to entry, since if exit is costly, more unlikely to enter under uncertainty. Some investments create barriers to entry by increasing the amount of sunk investments required to enter industry – Investments in brand building (advertising) - all sunk, so is a barrier to entry – Investments in R&D Sunk Costs

Exogenous Sunk Costs: – These are the sunk costs that firms must pay to be in business. The costs (and resale value) of factories, plant and equipment are often fixed in the market. Hence, the level of sunk costs is "given" — firms must pay them to operate. – More important when the minimum efficient scale of production in an industry is large — this is often determined by technological or market forces operating outside the industry. Endogenous Sunk Costs: – These are the sunk costs that firms choose the level of. For example, firms decide whether to promote their products and how much to spend on marketing. – Important in industries where sunk expenditures (like advertising) effectively increase consumers' willingness to pay for its product. Sunk Costs

The key question: – To what extent do the input prices facing a typical firm in an industry deviate from those that would prevail in highly competitive input markets because of the bargaining power of input suppliers? The power of suppliers increases if: – Input is a critical component of production – Supplier industry more concentrated than the industry it services Relative concentration is what matters – Firms in the analyzed industry purchase relatively small volumes relative to other customers of the supplier. The more important an industry to its suppliers, the more effort the suppliers may spend trying to get as much as they can out of this industry – Switching costs are high – Threat of forward integration by suppliers II. Bargaining Power of Suppliers

The key question – To what extent do purchase prices in this market differ from what would prevail in a market with a large number of fragmented buyers in which buyers are price takers? The power of buyers increases if: – input is a not a critical component of production – buyers are large and few in numbers – input is relatively standardized – switching costs for buyers are low – lots of substitutes – buyers can credibly threaten to backward integrate III. Bargaining Power of Buyers

Substitutes Question: – To what extent does competition from substitutes outside the current boundaries of industry erode the profitability of a typical firm in the industry? Identifying substitutes depends on how “finely” you draw the boundaries of the analyzed industry – Are railroads a competitor to airlines or a substitute product? – Either way: you have a substitute or a rival you must consider Substitutes limit profits by placing a ceiling on industry prices. – The more attractive the price-performance tradeoff offered by substitutes, the more important the substitute product – What can matter are customers’ PERCEPTIONS of substitutes e.g. tap water and bottled water: chemically very close, maybe not perceived as such close substitutes IV. Substitutes and Complements

Complements Question: – How is demand for a product affected by the availability/ price of the complementary product? Two aspects: – Market for complementary product affects demand for own product – Need for complementary products limits own ability to capture value – market must be shared Examples: – Intel/Microsoft - DVDs/DVD Players IV. Substitutes and Complements

Two basic questions: 1. How do firms compete? price strategy product differences technological innovations marketing 2. To what extent does price competition or non-price competition (advertising) cut the profitability of a typical firm in the industry? Intense rivalry cuts profitability by – reducing price-cost margins (price competition) – increasing programmed costs (non-price competition) Advertising, R&D, improvement in product quality Price rivalry is often most costly and important for profitability: If price is an effective competitive weapon, no quicker way to make a profitable industry unprofitable V. Threats from Competitors: Rivalry

Higher switching costs decrease responsiveness to price – Done by price differentiation/switching costs: Ex.: Frequent Flyer Program, Credit cards offering % back – Brand Loyalty plays a similar role: Decreases rivalry by creating a switching cost from consumer perspective Conditions for tacit coordination/collusion: – Concentrated market – Facilitating practices used (ex.: advanced announcement of price changes) – Public sales terms; firms have good info about competitors – Small, frequent orders – Strong capacity utilization – Rapidly growing demand Factors that Limit Pricing Rivalry

1) Is this, and will it continue to be, a profitable industry? 2) How does competition work in the industry? 3) How is competition likely to evolve? 4) What are the characteristics of successful companies and how will this evolve? Summary: Outcome of Analysis – Qualitative more than quantitative – Little attention to factors that affect demand beyond availability and price of substitutes and complements (strategies to boost demand, demographics, etc…) – Industry is the unit of analysis -- not individual companies – Ignores many strategic interactions – Does not address how a firm can affect ‘forces’ to its advantage Limitations: