1. Modern Competitive Strategy 3 rd Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

2. Chapter 4 Industry Analysis 4-2

3. An industry is composed of: Firms whose products provide value in functionally equivalent ways (e.g., air conditioners – but not fans) Firms that compete directly through changes in product value and price Firms that face common economic (e.g., common suppliers and buyers) Producers of substitutes (outside the industry) are: Firms whose products are functionally different from the industry’s products but compete to provide value to the industry’s buyers (e.g., snowboards are substitutes for skis) What is an Industry? 4-3

4. Firms create industries, not the reverse Competing firms influence each other with shifts in product value and price Increasing strategic interaction establishes mutual dependence between firms Behavior and performance subject to emerging industry forces How Do Industries Emerge? 4-4

5. Market Segmentation Many industries have more than one market segment Segments are defined by the distribution of customer preferences Firms align their product lines with one or more segments, which could overlap Specialist firms Tailor their product to one segment Generalist firms Design their product for many segments 4-5

6. What Determines Firm Profitability? Macroeconomic factors Forces in the overall economy: e.g., regulation, interest rates, tax policy Industry factors Conditions specific to an industry, e.g., the level of competition, the presence of powerful buyers The firm’s market position as determined by its resources and capabilities The firm’s value and cost compared to competitors and its ability to defend this position 4-6

7. Manufacturing Sector Transportation Sector Services Sector Percentage Contribution of Business Segment, Industry and Other Factors to Business Return on Assets 1980–1994 (U.S. data). Relative Contributions of Industry and Business Unit to Economic Performance 4-7

8. Industry Forces Influencing Firm Performance Porter’s five industry forces: Strength of competition Potential for entry into the industry The power of buyers The power of suppliers The strength of substitutes for the industry’s products When forces are strong, profitability is low and when forces are weak, profitability is high Add complements – e.g., cars and gas stations Strong complements raise the product’s value 4-8

9. Figure 3.1 Source: Michael Porter, Competitive Strategy (New York: Free Press, 1980), p. 4. Porter’s Five Forces Framework 4-9

10. Competition May reduce prices, while holding value and cost constant, resulting in customers receiving higher buyer surplus May increase value without increasing the price of the product May increase cost if higher value is required to compete 4-10

11. Effect of Competition on Transaction with Customers Value to the Customer Price Cost Strong Competition Can Increase the Value Required to Compete Reduces Price Can Increase the Cost Required to Compete as Investment in Value Rises 4-11

12. Types of Competition Perfect competition Strong rivalry among many very similar firms No firm makes a profit above its cost of capital, since rivalry has driven the market price down Monopoly Absence of rivalry Monopolists produce less and charge more Not illegal, but illegal to exploit Oligopolistic competition Competition occurs among a few similar firms 4-12

13. Characteristics of Perfect Competition Many competitors A common set of buyers for all firms The same value offered by all firms The same cost structure in all firms Relatively costless entry Relatively costless exit 4-13

14. Oligopoly and Industry Concentration Oligopolies are found in concentrated industries Concentration is determined by: Low ratio of market size to the minimum setup costs necessary to compete High level of sunk costs investment made by incumbent companies Entrants are at a cost disadvantage to compete with the incumbents 4-14

15. Concentration-Profitability Relationship More concentrated industries tend to be a little more profitable Causes of the concentration-profitability relationship: Higher efficiency of large firms Non-cooperative strategic interaction to increase profits Collusion to increase profits 4-15

16. Efficiency Differences among Firms Higher profits are achieved from investing in scale-based innovations that reduce costs So interaction with competitors and knowledge of their practices is necessary for profitability 4-16

17. Noncooperative Strategic Interaction Firms act by observing and analyzing competitors’ moves – i.e. they play a game with each other Profits are possible in a noncooperative game Focus on a duopoly (two firms competing against each other – e.g., Coke and Pepsi) Price takers Value and price are the same across firms (e.g., oil companies) So compete on volume (see the cattle ranches on the next slide) Price makers Value, prices and costs differ across firms (e.g., GM, Ford, Toyota and Honda) So compete on value and price 4-17

18. Quantity Competition Between Two Cattle Ranches (best response for each combination is shown in bold) Number of Steers Delivered by Reata Number of Steers Delivered by the Ponderosa 102030405060708090100 10 19,1918,3617,5116,6415,7514,8413,9112,9611,99 10, 100 20 36,1834,3432,4830,6028,7026,7824,8422,88 20, 90 18,90 30 51,1748,3245,4542,5639,6536,7233,7730,80 27, 81 24,80 40 64,1660,3056,4252,5248,6044,6640,70 36, 72 32,7228,70 50 75,1570,2865,3960,4855,5550,6045,63 40, 64 35,63 30,60 60 84,1478,2672,3666,4460,5054,54 48, 5642,56 36,54 30,50 70 91,1384,2477,3370,4063,45 56, 48 49,49 42,4835,4538,40 80 96,1288,2280,30 72,36 64, 4056, 42 48,4240,4032,3624,30 90 99,11 90,20 81, 27 72,3263,35 54, 36 45,3536,3227,2718,20 100100,10 90,1880,2470,28 60, 30 50,3040,3830,2420,1810,10 Best Response for Both Ranches Jointly 4-18

19. Tacit Collusion Tacit collusion may occur to make profits above the competitive outcome Required conditions among firms Mutual familiarity Repeated interaction Consistent roles Strategic complementarity Information signaling A mechanism for coordinating decisions 4-19

20. Explicit Collusion Explicit collusion is the coordination of firms’ major decisions through direct communication Generally illegal Hard to integrate and sustain Extreme case of collusion leads to cartels Cartels are illegal in most of the developed world Cartels are often found in commodity industries Firms decide on cartel administration and policies 4-20

21. Forces Influencing Cartelization Reasons for cartel establishment Homogenous market positions Mutual familiarity through long-standing competition High industry concentration Lack of viable substitutes for the industry’s product Reasons for cartel failure Inability to prevent entry into the industry Uncontrolled cheating or defection Fluctuating demand Bargaining problems within the cartel 4-21

22. What Factors Raise Entry Barriers? Lower prices by firms in the industry Limit pricing High barriers to imitation Property rights Dedicated assets Causal ambiguity Learning curve and development costs High customer switching costs 4-22

23. Entry Barriers Affecting Transaction with Customers Figure 3.3 Value to the Customer Price Cost Low Barriers to Entry Force the Firm to Lower Price 4-23

24. Buyer Power Buyer power is increased by: Availability of competing products with the same value and price Buyer concentration (few buyers) Low market growth Percentage of product sold to the buyer Low importance of the product to the buyer High importance of selling product to buyer The firm’s need to fill capacity by selling to buyer Buyer’s credible threat of vertical (backward) integration 4-24

25. The Effect of Buyer Power Figure 3.4 Value Price Cost Strong Buyers Force the Firm to Increase Value Force the Firm to Lower Price 4-25

26. Supplier Power Supplier power is increased by: Supplier concentration (few suppliers) Growth in demand for the firm’s product Low percentage of supplier volume bought by customer (size of buyer relative to supplier) High strategic importance of supplier to buyer Low strategic importance of buyer to supplier 4-26

27. The Effect of Supplier Power Figure 3.5 Value to the Customer Price Cost Strong Suppliers Decrease the Value of Their Inputs Increase the Firm’s Cost by Raising Their Prices 4-27

28. Substitutes The threat of substitutes increases when: A firm has a low buyer surplus (value minus price) relative to the substitute A firm’s customers have low switching costs Defenses against substitutes: Increase the buyer surplus Raise switching costs 4-28

29. The Effect of Substitutes on Transaction with Customers Figure 3.6 Value to the Customer Price Cost Strong Substitutes Increase the Value Required to Compete Force Lower Prices 4-29

30. Forces Increasing Firm Performance The strength of complements of the industry’s products (Legal) cooperation between buyers and suppliers Coordination among competitors Strategic groups 4-30

31. Figure 3.7 Industry Forces that Increase Profitability: The Value Net Suppliers Customers Complementors Competitors The Firm 4-31

32. Coordination Among Competitors Cooperative pricing (not price-fixing) to avoid price competition Readily available pricing information Comparable value-cost profiles for competitors Interfirm partnerships For example, R & D consortia 4-32

33. Cooperative Pricing Often depends on the presence of a price leader Price leadership requires: Observable prices Common buyers Strategic discipline A small number of firms Common history of competition Comparable market positions Adherence to antitrust law Cooperative output levels 4-33

34. Cooperation Between Buyers and Suppliers Sharing information Operating decisions (e.g., logistics) Strategic decisions (e.g., technology development) Sharing resources and capabilities Quality management techniques 4-34

35. Complements Products in different industries whose patterns of demand are systematically positively correlated Skis and ski boots Sails and sailboats Tires and automobiles 4-35

36. Strategic Groups Strategic groups are a level of analysis between the firm and the industry. Characteristics of strategic groups: Firms within an industry that have similar cost and value drivers compared to firms in other groups Firms which compete in the same market segment Firms that take a similar approach to competing in an industry 4-36

37. Mobility Barriers Similar to barriers to entry to the industry – but between strategic groups Entry-deterring behavior of firms in a group Isolating mechanisms specific to the group Group limit pricing Actions taken by stronger and more profitable competitors to protect their groups from entry by rival firms in the industry Prevent the movement of firms from one strategic group to another 4-37

38. Figure 3.8 Strategic Groups in the U.S. Domestic Airline Industry 4-38

39. The Effect of Industry Forces on Value, Cost and Price Five Industry ForcesEffect on ValueEffect on CostEffect onPrice Stronger Rivalry May be based on higher customer value May increase cost associated with higher value Lowers the price required to compete in industry Stronger Buyers Raise the value required to compete in industry Lower the price required to compete in industry Stronger Suppliers Lower the value provided to firms in the industry Raise the costs of firms in industry Lower Entry Costs Lower the price to keep entrants out of industry More Powerful Substitutes Raise the value required to compete in industry Lower the price required to compete in industry 4-39

40. The Effect of Industry Force on Value, Cost and Price (cont’d) Value NetEffect on ValueEffect on CostEffect onPrice Cooperation Between Firm and Buyers Raises the value to buyers without comparable rise in firm costs Lowers firm costs without comparable drop in buyer value Cooperation Between Firm and Suppliers Raises the value to firm without a comparable rise in supplier costs Lowers supplier costs without comparable drop in firm value Cooperation Between Firm And Competitors Raises the value to industry buyers without a comparable rise in industry costs (shared innovation) Lowers the costs in industry without a comparable drop in value to industry buyers (shared innovation) Raises the potential price necessary to compete (cooperative Pricing) Effective Complements Raise the value to industry buyers without a comparable rise in industry costs 4-40