INDUSTRY ANALYSIS

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Cases for Industry Analysis

Cola Wars 7-up Case The Personal Computer Industry (Apple Inc)

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Warren Buffett: When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.

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A firms profits depend on its industry and its position within its industry.
INDUSTRY PROFITS Industries differ in their average profitability Some differences stem from risk or business cycle fluctuations A significant portion of the variation, however, derives from the fundamental differences in the economic characteristics of different industries To help understand and explain these differences, we will develop a framework to conduct an industry-level analysis - specifically, The Five Forces FIRM-LEVEL PROFITS Firms that face the same basic economic characteristics can nevertheless vary considerably in regards to their profit margins This variation can be explained by differences in firms strategic choices In later sessions, we will develop a framework to analyze firm-level variation in 29 profits - notably, competitive advantage

Why a firms industry matters

The right strategy depends on the firms environment Understanding the industry structure is crucial for developing strategies Competitive advantage is not a generic characteristic A strategy only confers competitive advantage if it is specifically suited to the firms environment In considering entry, diversification, or expansion along the supply chain, it is useful to assess the attractiveness of the industry into which a firm may move.
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Five Forces Analysis

Define industry boundaries Identify the participants Highlight each of the five forces Identify the factors that drive each force Assess the threat to profits from each force Assess industry profitability potential Conclusion: for incumbents/ for potential entrants
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What is an industry?
Collection of firms whose products (or services) are perfect or near perfect substitutes In practice: Anyone who produces a substitute product is a competitor. Two products tend to be close substitutes when: they have similar performance characteristics they have similar occasion for use they are sold in the same geographic area

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Performance Characteristics
Performance characteristics describe what the product does to the customer Example from automobiles
Seating capacity Curb appeal Power and handling Reliability

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Occasion for Use

Products may share characteristics but may differ in the way they are used Orange juice and cola are beverages but used in different occasions Another example: Hiking shoes versus court shoes

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Geographic Area
Identical products in two different geographic markets will not be substitutes due to transportation costs Bulky products like cement cannot be transported over long distances to benefit from geographic price difference

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Empirical Approaches to Competitor Identification

Cross price elasticity of demand

Px / Px If yx is positive, consumers purchase more of Y when the price of X increases. Goods X and Y would then be close substitutes. Firms selling these goods would be in the same industry. Example: % change in demand for Dells Alienware caused by a 1% increase in the price of Apple MacBook. If high and positive, then Alienware and MacBook are close substitutes. Dell and Apple are competitors in the same industry. Example: % change in demand for eReaders caused by a 1% increase in the price of laptops. If positive, then eReaders and laptops are substitute products. Are firms selling these products in the same industry? Or are firms selling eReaders in a different industry than firms selling laptops, and thus we should rather 36 consider firms selling eReaders in the Force of Substitutes?

yx

Q y / Q y

Empirical Approaches to Competitor Identification Firms in the same Standard Industrial Classification Products and services are identified by a seven digit code Each digit represents a finer degree of classification

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Industry Boundaries
Challenges of industry definition industries evolve structure and firms change over time at what level of aggregation? e.g., beer vs. craft beer segment domestic vs. global? an industry may split into strategic groups

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Strategic Groups in the U.S. Airline Industry

High Mobility Barrier

Prices Charged

Delta Jet Blue Alaska Airlines Southwest Airlines American Airlines

United Airlines

U.S. Airways

Low Low

Routes Serviced

High
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Industries and Market Structure from the Economics

perspective

Industries are often described by the degree of market concentration Monopoly is one extreme with the highest concentration - one seller Perfect competition is the other extreme with innumerable sellers

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Measures of Market Structure

The N-firm concentration ratio (the combined market share of the largest N firms) Herfindahl index (the sum of squared market shares) When the relative size of the largest firms is important Herfindahl is likely to be more informative
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Four Classes of Market Structure

Nature of Competition Perfect Competition Monopolistic Competition Oligopoly Monopoly Range of Herfindahls Usually < 0.2 Usually < 0.2 Intensity of Price Competition Fierce Maybe fierce or light, depending on the degree of product differentiation Depends on inter-firm rivalry Light unless there is threat of entry

0.2 to 0.6 > 0.6

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Perfect Competition
Many sellers who sell a homogenous good Many well informed buyers Consumers can costlessly shop around Sellers can enter and exit costlessly Each firm faces infinitely elastic demand

With perfect competition economic profits go to zero

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Five Forces Analysis: The Logic = (P-C)*Q

RIVALRY : When price competition is fierce, prices will approach marginal costs, which decrease ENTRY : As entry occurs, Q and/or P decline (or C rises) which decreases SUBSTITUTES: The existence of good substitutes for an industrys product implies a flat/elastic demand curve, which results in a lower market price, which decreases SUPPLIERs: Supplier power results in high input costs for firms, increasing C, which decreases BUYERS: Buyer power results in low prices for firms, decreasing P, which decreases
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What is the threat to profits from.?

Threat of
Rate each threat High, Moderate, or Low Threat of New New Entrants Entrants

Complementors

Bargaining Power of Suppliers

Rivalry Among Competing Firms in Industry

Bargaining Power of Buyers

Government?

Threat of Substitute Products

to determine: 1) (for incumbents) how to compete 2) (for entrants) if this is an attractive industry to enter, and how
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Force 1: Internal Rivalry

Internal rivalry is the competition for market share among the firms in the industry Competition could be on price or some non-price dimension Competition on non-price dimension can drive up costs (e.g. new product development; adding product features; advertisement)
Non-price competition is less likely to erode profits if customers are willing to pay a higher price for the improvements

Price Competition erodes the price cost margin and profitability

Why would any firm reduce its prices?
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Force 1: Rivalry with competitors dissipates profits through price competition.

Economics When price competition is fierce, prices will approach marginal costs, which decreases = (P-C)*Q Examples Strong price rivalry: Airlines Weak price rivalry: Perfume
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Force 1: Rivalry with competitors dissipates profits through price competition

Characteristics of the market that threaten profits through fierce price rivalry Many sellers Homogeneous products Low buyer switching costs Buyers motivated to search, willing to shop for price Large and infrequent (lumpy) sales Excess industry capacity and/or declining demand Cost structure with high fixed costs, low marginal costs Strong exit barriers
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Distribution of Market Shares and Intensity of Competition

Business A
A1 = 10% A2 = 10% A3 = 10% A4 = 10% A5 = 10% A6 = 10% A7 = 10% A8 = 10% A9 = 10% A10 = 10%

Business B
B1 = 60% B2 = 30% B3 = 10% Bigger players are less likely to lower prices and go after B3. B3 can aim for being a niche player with potentially high profits.

In an industry with many sellers: Small players will be tempted to lower prices in order to gain market share. If all think the same (and they will because collusive agreements are less likely) then 49 price competition is more likely to be intense in industry A than B.

Homogeneous Products
There are three sources of increased revenue when price is lowered
Customers buying more New customers buying Customers switching from the competitors

If products are homogeneous:

For firms that cut prices, customers switching from a competitor are likely to be the largest source of revenue gain Customers will be less loyal to the sellers and sellers are more likely to compete on price
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Excess Capacity
If industry has excess capacity, then in the long run, prices fall below average cost
Some firms may choose to exit rather than sustain long-run economic losses

However, if exit is not an option (because capacity is industry specific- that is, it can only be used to produce in this industry) then excess capacity and losses (caused by prices being below average costs) will persist for a while Firms with excess capacity might be under pressure to boost sales and often can rapidly expand output to steal business from rivals, leading to price competition Example: During economic downturns, the airlines have substantial excess capacity on many routes. Because consumers perceive airlines as selling undifferentiated products, each airline can fill empty seats by undercutting rivals prices and stealing their 51 customers.

Force 2: Entry both lowers market share and affects rivalry

Economics As entry occurs, Q and/or P decline (or C rises) which decreases = (P-C)*Q Examples Easy Entry: Restaurants Difficult entry: Auditing/accounting; Commercial Aircraft Manufacturing
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Force 2: Entry both lowers market share and affects rivalry

Characteristics of the market that threaten profits by making entry easier Few economies of scale, low minimum efficient scale relative to the size of the market Flat learning or experience curve Easy access to inputs and distribution, few government regulations Necessary technology is readily available to entrants (patents, trade secrets, and intellectual property are not important) No strong brand identity or reputation for incumbents Low exit costs
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Economies of Scale & Minimum Efficient Scale

Diseconomies of Scale- Examples: Physical limits to efficient size Managerial diseconomies Worker motivation
Cost per unit of output

Minimum Efficient Plant Size

Units of output per period

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Learning curve Total Costs Decrease with Additional Production Experience

The Law of Experience

1988

1990 Cost per unit of output (in real $)

The cost per unit of output declines by a constant % (typically 5-30%) each time cumulative output doubles

1992 1994 1996 1998 2000

55 Cumulative Output

Force 3: Substitutes are analogous to entry, but with a different product instead of a different producer.

Characteristics of a product that threaten profits through substitutability

Fulfills the same customer need Similar performance characteristics, availability, ease of use, etc. Similar cost per unit of usage

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Force 3: Substitutes are analogous to entry, but with a different product instead of a different producer.
Economics Substitutes affect the slope of an industrys demand curve The existence of good substitutes for an industrys product implies a flat/elastic demand curve, which results in a lower market price, which decreases Examples Industrieswithgoodsubstitutes:Departmentstoresfaced bycategorykillers Industrieswithpoorsubstitutes:Disposablediapers 57

Force 4: Supplier power is the ability of suppliers to extract profits by obtaining high prices Characteristics ofthemarketthatthreatenprofits throughsupplierpower
Relativelyfewsuppliers Inputsaredifficulttosubstitute Firmsmakespecificinvestmentsinordertouse inputspurchasedfromsupplier Supplierhasabilitytointegrateforward Note:Evenifaninputisvitalforproduction,supplier powerwillnotnecessarilybehighinanindustry
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Force 4: Supplier power is the ability of suppliers to extract profits by obtaining high prices Economics
Supplierpowerresultsinhighinputcostsforfirms, increasingC, whichdecreases =(PC)*Q

Examples
Highsupplierpower:Automotivefirmsfacehigh supplierpowerfromunionizedworkers Highsupplierpower:PCmanufacturersfacehigh supplierspowerfromMicrosoftandIntel Lowsupplierpower:Cigarettemanufacturersface lowsupplierpowerfromtobaccofarmers 59

Force 5: Buyer power is the ability of buyers to extract profits by obtaining low prices
Characteristics ofthemarketthatthreatenprofits throughbuyerpower
Relativelyfewbuyers,eachaccountingforalarge fractionofsales Firmsmustmakespecificinvestmentsinordertoserve theneedsofbuyers Buyershavetheabilitytointegratebackwardsinto supplyingtheirowninputs Note:Buyerpowerisrelatedtorivalrywithcompetitors; lumpysales,lowswitchingcost,etc.tendtoincrease buyerpower.
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Force 5: Buyer power is the ability of buyers to extract profits by obtaining low prices Economics
Buyerpowerresultsinlowpricesforfirms, decreasingP,whichdecreases =(PC)*Q

Examples
Highbuyerpower:Procter&Gamblefacehigh buyerpowerwhensellingtoWalMart Lowbuyerpower:CableTVprovidersfacelowbuyer powerwhenprovidingcableservicetolocal 61 customers(households)

Dynamic Five Forces Analysis

Industries Evolve Over Time as the Relationships Between The Five Forces Change

demand

time

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A SIXTH FORCE? COMPLEMENTORS

Definition
Industry Participants whose businesses enhance the value of yours Opposite of Substitutes Emergence of Networks of Organizations Make the pie bigger

Examples
Computer Manufacturers & Software Makers

The Central Issue

How to get complementors to make strategic investments which mutually benefit both companies
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Example: Complements in the Personal Computer Industry

What are they? How have they influenced the industrys profitability between 1980s and today? Applications: Software prices dropped, functionality increased, the number of applications increased Peripherals: Prices dropped, functionality increased Internet- Complement? Or substitute?

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Weaknesses of Industry Analysis

Focuses on an industry, and less on why particular firms are doing well/poorly The role of the government is important in some industries More, better, and cheaper complements (the mirror image of substitutes) can increase industry profits. Not well accommodated (at least not in the original framework proposed by Porter)

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Lessons from Industry Analysis

One force can be a fatal flaw for overall profitability At the same time, the strength of any individual force, independently, is neither necessary nor sufficient as an explanation of an industrys profitability The relevance of each of the forces will necessarily depend on the industry being analyzed If we can forecast changes in industry structure we can predict likely impact on competition and profitability
Industry analysis is a good start to understand the effect of changes in the business environment on performance
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Lessons from Industry Analysis

Ask: What structural variables are depressing profitability? How can they be changed by individual or collective action? Collective action- Remember Cola Wars Individual action- What can firms do in an industry that a Five Forces analysis indicates is unattractive? Develop an effective strategy to outperform competitors (competitive advantage) Find an industry segment or niche market with more favorable conditions Firms ca try to change the forces
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Remember two assumptions about competition

It is not enough to succeed; others must fail (Gore Vidal) You dont have to blow out the other fellows light to let your own shine (Bernard Barruch)

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Example of Five Forces Analysis

SOFT DRINKS INDUSTRY BOTTLING INDUSTRY

Force
Entry Substitutes Supplier Power Buyer Power Rivalry

What is the threat to profits from?

Low High Low Low to Moderate Low Low High for CP. Low for others Low to Moderate

Low (except for Fountains) Moderate to High (Varies by channel)

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