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Economics of Strategy Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 12

Industry Analysis

Besanko, Dranove, Shanley, and Schaefer

Industry Analysis

Industry analysis facilitates

assessment of industry and firm performance

identification of factors that affect performance

determination of the effect of changes in the business environment on performance and

identification of opportunities and threats (SWOT analysis)

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Industry Analysis

Industry analysis helps with assessing generic business strategies

Porter’s five forces framework is rooted in microeconomics

Value net (Brandenburger and Nalebuff) supplements the five forces framework to analyze strategy

The Five-Forces Framework

Michael Porter’s Five-Forces framework identifies the economic forces that affect industry profits

The five forces are Internal rivalry

Entry

Substitutes and complements

Supplier power

Buyer power

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The Five-Forces Framework

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

Price Competition erodes the price cost margin and profitability

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Internal Rivalry

Competition on non-price dimension can drive up costs.

Non-price competition does not erode profits as severely as price competition if customers are willing to pay a higher price for the improvements.

Internal Rivalry

Price competition heats up when

There are many sellers

Some firms have cost advantage over others

There is excess capacity in the industry

Products are undifferentiated and switching costs are low

Prices and sale terms are easily observable

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Internal Rivalry

Other conditions that facilitate intense price competition

Large and infrequent sales orders

Absence of “facilitating practices”

Absence of a history of cooperative pricing

Strong exit barriers

Industry demand is elastic

Entry

Entry hurts the incumbents by by cutting into the incumbents’ market share and

by intensifying internal rivalry and leads to a decline in price cost margin

Barriers to entry can be exogenous (nature of the industry) or

endogenous (incumbents’ strategic choices)

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Factors that Affect the Threat of Entry

Minimum efficient scale relative to the size of the market

Government policies that favor the incumbents

Brand loyalty of consumers and value placed by consumers on reputation

Entrants’ access to critical resources such as raw material, technical know how and distribution network

Factors that Affect the Threat of Entry

Steepness of the learning curve

Network externalities that give the incumbents the benefit of a large installed base

Incumbents’ reputation regarding post-entry competitive behavior

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Substitutes and Complements

Availability of substitutes erode the demand for the industry’s output

Complements boost industry demand

When the price elasticity of demand is large, pressure from substitutes will be significant

Changes in demand can in turn affect internal rivalry and entry/exit

Supplier Power

Supplier has indirect power if upstream market is competitive. It sells to the highest bidder.

Supplier has direct power if

the upstream industry is concentrated or

the customers are locked into the relationship with suppliers due to relationship specific assets

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Buyer Power

Buyer power is analogous to supplier power

Buyers have indirect power in competitive markets

Buyer concentration or relationship specific assets can lead to direct power

Buyer power relative to upstream is analogous to supplier power relative to downstream

Supplier Power

The factors that determine supplier power are Competitiveness of the input market

Relative concentration the industry

Relative concentration of upstream and downstream firms

Purchase volume by downstream firms Availability of substitute inputs Extent of relationship specific investments Threat of forward integration by suppliers Suppliers’ ability to price discriminate

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Some Strategies to Cope with the Five Forces

To outperform its rivals firms can

develop a cost advantage or

a differentiation advantage

Firms can seek an industry segment where the five forces are less severe

Firms can try to change the forces

Some Strategies to Cope with the Five Forces

Facilitating strategies to reduce internal rivalries

Moves that increase switching costs for the customers

Pursuing entry deterring strategies

Tapered integration to reduce buyer/supplier power

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Five Forces and Value Net

The Five-Forces Framework tends to view other firms - competitors, suppliers or buyers - as threats to profitability

In the value net model (Coopetition) interactions between firms can be positive or negative

Cooperative Interactions Among Firms

Setting industry standards that facilitate industry growth

Lobbying for regulation or legislation that favors the industry

Cooperation with buyers/suppliers

to improve product quality

to improve productive efficiency

to improve inventory management

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The Value Net Concept

The value net consists of

Suppliers

Customers

Competitors and

Complementors (producers of complementary goods and services)

The value net complements the five forces approach by considering opportunities posed by each force.

The DVD Hardware Market: A Five-Forces Analysis

Internal rivalry was intense. Brand name was the main source of differentiation

It was easy for consumer electronics firms to enter.

Satellite TV could be a substitute. Streaming over the internet was another possibility.

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Movie studios (upstream) and big retailers (downstream) had power.

DVD hardware makers, according to this analysis, had reason to be pessimistic.

DVD format’s success can be attributed to firms working together (value net).

The DVD Hardware Market: A Five-Forces Analysis

The DVD Hardware Market: The Value Net

In the beginning DIVX was a major threat.

DVD manufacturers cut prices on some models and advertised heavily.

Other members of the value net chipped in to increase the size of the DVD “pie.” Movie studios released popular titles in DVD format and

priced them moderately

Retailers promoted the DVD hardware and software

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Five Forces Analysis of Chicago Hospitals

Product market is the market for acute medical services

Competition among hospitals is local

The geographic market for a hospital is the entire metropolitan area or a particular submarket.

Competitive dynamics could vary across submarkets

Chicago Hospitals: Internal Rivalry

In 1980 most hospitals were independent. Today many of them belong to systems.

Herfindahl index has gone up from 0.05 to 0.20 over this period.

Herfindahl index is slightly higher in submarkets.

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Chicago Hospitals: Internal Rivalry

With the arrival of managed care organizations (MCOs), price elasticity of demand increased

Insurers were less brand loyal than patients

Price negotiations were secret

Contracting was lumpy and price rivalry intensified

Chicago Hospitals: Internal Rivalry

Considerable variation in cost structures.

Excess capacity with stagnant demand (until recently) for admissions.

Managed care organizations (MCOs) increased the price elasticity of demand by seeking hospitals that offered the best value.

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Chicago Hospitals: Internal Rivalry

MCOs intensified internal rivalry by

treating all hospitals as identical,

negotiating with hospitals in secret and

negotiating large contracts for multiple years

Hospitals were unable to develop facilitating practices

Chicago Hospitals: Internal Rivalry

Recent trends towards softening of competition

Branding by hospitals with strong reputation

Patients demand to go outside the MCO networks

Consolidation in submarkets

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Chicago Hospitals: Entry

Structural barrier to entry

State regulatory restrictions on new hospital construction

Capital intensive nature of hospitals

Difficulties is making brand loyal customers switch

Difficulties in establishing a base of medical staff that admit patients

Chicago Hospitals: Entry

As the market grows suburbs could attract entrants

Technological changes could lower entry barriers

Small specialized hospitals may become feasible reducing the capital requirement and the size of medical staff needed

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Chicago Hospitals: Substitutes/Complements

Due to technological changes, substitutes for hospital services have emerged.

Surgeries performed outside hospitals

Home healthcare for recuperating patients and the chronically ill

Economies of scope have allowed hospitals to expand into outpatient services.

Chicago Hospitals: Supplier Power

The suppliers to an hospital are

specialized medical personnel (nurses, technicians and doctors)

Firms that supply equipment and supplies and drugs

Relationship specific investments are rare

Suppliers protected by patents can have direct power

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Chicago Hospitals: Buyer Power

The buyers are patients

admitting physicians and

insurance companies.

Patients and doctors did not wield buyer power in the 80s.

Insurers including Medicaid and Medicare were largely passive in the 80s.

Buyer power was low in the 80s.

Chicago Hospitals: Buyer Power

Current trends point to rising buyer power

Selective contracting has increased insurers’ buyer power

Government providers have lowered their rates

Employers are asking employees to bear a greater share of costs which increases price elasticity of demand

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Chicago Hospitals: Buyer Power

In wealthy communities, specialty hospitals could compete for the most profitable patients.

Buyers as well as regulators are demanding access to information about hospital quality

Anti trust ruling requires hospitals to negotiate individually (rather than as a group) with insurers.

Five-Forces Analysis of the Chicago Hospital Market

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Commercial Airframe Manufacturing

Boeing and Airbus compete globally.

Fringe players in aircraft with capacity less than 125 seats are excluded from the analysis.

The market share (by revenue) of the fringe players is small.

There are no meaningful submarkets.

Commercial Airframe Manufacturing: Internal Rivalry

Boeing delivered its first commercial aircraft in 1958.

Airbus is younger.

Boeing enjoys economies of scope due to its defense business.

Airbus gets government subsidies.

Stable market shares and reduced incentive for price wars

Historically there has been little product differentiation

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Commercial Airframe Manufacturing: Internal Rivalry

Airbus developed the double-decker mega plane.

Boeing abandoned competing with its Sonic Cruiser.

Airliners exhibit loyalty to suppliers

Economic slowdown has reduced the demand for aircraft.

Commercial Airframe Manufacturing: Entry

Major barriers to entry are:

Huge development costs

Experience-based advantages

Buyer reluctance to buy from startups

Customer loyalty to current suppliers

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Commercial Airframe Manufacturing: Substitutes

Small plane manufacturers cut into demand for Boeing and Airbus planes in regional routes.

As demand for air travel increases airlines switching back to larger planes in regional routes.

Other forms of transportation could be substitutes (High speed rail) for “regional jets.”

Commercial Airframe Manufacturing: Supplier Power

Parts market is competitive

Part suppliers deal directly with airlines. But Boeing’s Global Airlines Inventory Network (GAIN) gains leverage over suppliers.

Jet engine suppliers are not numerous and enjoy direct power.

Unionized labor has significant supplier power.

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Commercial Airframe Manufacturing: Buyer Power

Buyers for aircraft are either airlines or leasing companies. Neither have buyer power.

Each order could be of the order of 15% of annual sales revenue for the manufacturer.

Buyers may cancel orders during economic downturns.

Five-Forces Analysis of the Commercial Aviation Industry

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Professional Sports: Market Definition

Major sports leagues in the U. S.

MLB

NBA

NFL

NHL

Five force analysis is also applicable to major sports leagues elsewhere

Professional Sports: Internal Rivalry

Sports leagues require competitive balance to keep the contests interesting

Athletic competition does not imply business competition

Internal rivalry is low within leagues as teams follow rules and share revenue

Teams do not compete in the labor market

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Professional Sports: Entry

Each league has rules for admitting new teams.

Current owners need to be compensated when new teams are added.

Incumbent owners can veto new franchises in their geographic market.

Starting an entire new league is risky.

Professional Sports: Substitutes and Complements

Teams compete in the local markets with other forms of entertainment

Elasticity of substitution is quite low

Important complements

Television

Sports betting

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Professional Sports: Supplier Power

Unionized players

For new players NCAA has been a benign supplier

Cities spend tax dollars to build facilities to attract sports teams.

As municipal finances get tighter, subsidizing teams becomes more difficult.

Professional Sports: Buyer Power

Television networks and sports cable systems compete with each other for broadcasting rights

In negotiations regarding broadcast rights leagues have the upper hand against television networks

local television and

radio.

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Five-Forces Analysis of Professional Sports Leagues

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