Evaluating a Firm’s External Environment Chapter 2

Objectives Understand the import role that the competitive environment plays on firms Gain an understanding of Porter’s Five Forces and how the tool is applied as part of an industry analysis. Have fun learning!

Questions Name some of the participants in a external environment. Name the external forces that managers must be aware of. What are the names Porter’s Forces (Hint: There are 5)?

Why External Analysis? External analysis allows firms to: Discover threats and opportunities. See if above normal profits are likely in an industry. Better understand the nature of competition in an industry. Make more informed strategic choices.

The Competitive Environment The competitive environment is also called the task or industry environment. The CE consists of competitors (existing or potential), customers, and suppliers.

General External Environment Focal Firm Buyers Suppliers Entry Rivalry Substitutes Complementors Demographic Trends Technological Change Cultural Economic Climate Legal/Political Conditions Specific International Events Industry

General External Environment Focal Firm Demographic Trends Technological Change Cultural Economic Climate Legal/Political Conditions Specific International Events PDA’s & Cell Phones Hispanic Population Growth Changing Image of SUV’s Rising Interest Rates Changing Policy toward Oil Exploration on Public Lands European Union Ban on Hormone-Treated U.S. Beef

Porter’s Five Forces Competition tends to be more intense among firms within a strategic group than between strategic groups. The competitive forces determine: The state of competition in an industry and The degree to which the firms in an industry are constrained in raising prices.

The Five Force’s Model Helps to analyze the firms competitive environment for a specific industry. Should the firm remain in or exit an industry? Provides rational for increasing/decreasing resource commitments. Helps to assess how to improve the firm’s competitive position.

Porter’s Five Forces The stronger the competitive force, the greater the threat. A weak force is an opportunity for the firms in the industry. The collective strength of these forces determines the ultimate profit potential of an industry. Strong competitive forces limit the profitability of the overall industry.

Porter’s Five Forces Model Focal Firm Buyers Suppliers Entry Rivalry Substitutes Industry Threat If all threats are high expect normal profits If all threats are low expect above normal profits Most industries are somewhere between the extremes

Threat of Entrants New competitors may enter the industry and erode profits for established firms. Existing barriers to entry and firms’ reactions determine the extent of the threat. Therefore: If barriers are low & the threat from existing competitors is low than the threat of new entrants is high.

Sources of Entry Barriers Economies of Scale – High production costs spread over a large number of units. Product Differentiation – Strong brand identification and customer loyalty. Capital Requirements – Need to make a large investment to compete.

Sources of Entry Barriers Switching Costs – One-time costs that the buyer faces when switching to a new manufacturer. Distribution Channels – Difficulty in securing distribution for product. Cost Disadvantages Independent of Scale – Advantages derived from having: a proprietary product, favorable access to raw materials, & gov’t subsidies/policies.

Buyer’s Bargaining Power Concentrated or Large Sales from Single Purchaser – As a buyer’s purchases a greater percent of a suppliers output the buyer’s power increases. Products are Standard / Undifferentiated – There are few differences in the product. Buyer Faces Few Switching Costs – No or little cost to switch from one supplier to another.

Buyer’s Bargaining Power Product Earns Low Profits – Low profits create incentives to lower purchasing costs. Buyer Can Produce Product – Buy has the capability to backward integrate it’s product. Quality is Unimportant to Buyer’s Product – Quality of the product does not greatly affect the buyer’s product.

Supplier’s Bargaining Power There are Few Suppliers There are Few Substitute Products The Industry is Not an Important Customer The Supplier’s Product is Important The Supplier’s Product Has Switching Costs The Supplier Group Poses a Threat of Forward Integration

Threat of Substitute Products Substitutes limit the potential returns of an Industry by placing a ceiling on prices. Identifying substitutes involves searching for other products/services that can perform the same function as the industry’s offering. May have to look outside the industry for a substitute.

Industry Rivalry Numerous or Equally Balanced Competitors Slow Industry Growth High Fixed or Storage Costs Lack of Differentiation/Switching Costs Capacity Augmented in Large Increments High Exit Barriers

High Rivalry What does high rivalry look like? Firms are jockeying for position via price and/or non-price competition through: Frequent Price Cutting Frequent Product Introductions Intense Advertising Rapid Competitive Actions & Reactions

Five Forces Weaknesses It assumes a zero sum game, i.e. one firm wins at the others expense. This analysis therefore down plays the potential for win-win relationships through partnering with customers/suppliers. An example of this is JIT inventory systems. It is static in that it looks at a dynamic environment at a single moment. Relationships can quickly change.

Exploiting Industry Structure Opportunities Generic Industry Structures: Most industries fits into one of four generic categories. Each industry structure presents opportunities that may be exploited. Firms can choose to exploit an industry structure, continue business as usual, or exit the industry.

Exploiting Industry Structure Opportunities Fragmented Industry Structure Industry Characteristics Large number of small firms. No dominant firms. No dominant technology. Commodity type products. Low barriers to entry. Few, if any, economies of scale. Opportunity Consolidation: buy competitors build market power exploit economies of scale

Exploiting Industry Structure Opportunities Emerging Industry Structure Industry Characteristics: New industry based on break through technology or product. No product standard has been reached. No dominant firm has emerged. New customers come from non-consumption not from competitors. Opportunity: First mover advantages Technology Locking-up assets Creating switching costs

Exploiting Industry Structure Opportunities Mature Industry Structure Industry Characteristics: Slowing growth in demand. Technology standard exists. Increasing international competition. Industry-wide profits declining. Industry exit is beginning. Opportunities: Refine current products Improve service Process innovation

Exploiting Industry Structure Opportunities Declining Industry Structure Industry Characteristics: Industry sales have sustained pattern of decline. Some well-established firms have exited. Firms have stopped investing in maintenance. Opportunities: Market leadership Niche Harvest Divest

Responding to Environmental Threats Neutralizing Threats Most firms cannot unilaterally change the threats in an industry. By altering relationships in an industry, firms may reduce threats and/or create opportunities, thereby increasing profits.

Strategic Groups Factors that might be relevant in identifying strategic groups: Leaders (innovators) and Followers Market Segments Served Pricing Quality Distribution Channels No two firms are totally different. No two firms are exactly the same.