MBA 814
The Structural Analysis of Industries
The essence of developing a business strategy is ``relating the company to its
environment.'' The long-term profitability of a business depends on variety of factors each of
which determines the competitiveness of the industry. Because competition among firms in an
industry drives down the rate of return on capital, the better off shareholders are, the better the
firm is shielded from competition. The problem is that high returns a hallmark of a
non-competitive industry encourages additional investment This additional investment in
physical and human capital serves to drive down rates of return to competitive levels.
A goal of a business strategy is to develop a plan for defending the firm's position from
competitive forces or to reposition the firm to a position where it can better defend itself from
competition. To this end, and before such a strategy can be devised, the firm must analyze the
underlying economic structure of its industry. This lecture presents a check list that a firm could
consider when performing such an analysis of industrial structure.
o Premise: extent of competition among rivals derived from underlying economic
structure. Knowledge of this structure essential for developing a successful strategy
o Forces external to the industry have similar effects on all rivals
What is an industry?
o identify firms that produce products that are close substitutes. Must look beyond the
product's physical characteristics to function when defining industry. Eg. A garden store
that sells grass seeds, turf, shrubs, is really in the business of ``delivering'' beautiful
lawns and gardens to households.
- Increasingly a dynamic concept (eg. HMR in retail grocery stores)
What determines the state of competition in an industry?
1. Threat of entry
o Barriers to entry by new or existing firms
- Economies of scale (production, research, marketing, service network)
 Breakdown economies on a component basis. Eg. When making television sets large
scale economies in color tube production but not in cabinet making and set
assembly. May be difficult to achieve if products are customized instead
of standardized.
- Economies of scope (sharing of operations or functions)
 Brand names: expensive to establish and maintain. Once established additional cost of
applying it to other related products is low. Ready to eat breakfast cereal
companies. Automobile companies.
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 Air travel and air cargo services: Technological considerations make it impossible to fill
plane up with people. Space for cargo. Incremental cost of expanding into
cargo business is very low.
- Capital requirements
 Often sunk capital required. Eg. Mineral extraction companies.
- Product Differentiation
 ``Customer loyalties.'' Investment made through advertising, customer
services, and product design differences. Entrant faces large start up
costs to overcome this advantage. These costs are sunk and have no
``salvage value'' if they fail. Eg. baby care products, baby food, over the
counter drugs.
- Switching costs for buyers
 Does buyer have to incur costs when buying entrant's products? Eg. kits used for
medical diagnoses, heavy machinery, computer operating systems.
- Access to Distribution Channels
 Cost associated with forming new relationships with wholesalers and retailers. Does
entrant have create its own distribution channel? Eg. food processing
firms, mail order catalogue companies.
- Incumbent cost advantages
 Proprietary knowledge or technology. Patents, secret formulas (Coca Cola, American
Home Products).
 Location is a scarce resource!
 Experience or position on the ``learning curve.'' A type of technological change that
occurs only as a result of producing and selling. Eg. Firms with skilled
labor, universities, investment banks, accounting firms etc.; also complex
assembly requirements. This barrier is not the same as economies of scale!
- Government policy
 Licensing requirements; pollution controls and standards for product testing
increase fixed cost of entry. Some regulations may delay entry providing
incumbents with time to adjust strategies.
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 Expiration of Patents. Eg. Established drug faces competition from ``generic'' drugs;
Kodak enters to compete with Polaroid's instant camera.
o Expected retaliation
- Do firms in the industry have a history of engaging in price cutting when encountering
new rivals? Do they have the resources to engage in a prolonged period of price
discounting? Eg. major airlines with new carrier begins service on one of their
routes.
o Entry Deterring Price
- Do firms price at a point where short run marginal revenue is less than short run
marginal cost. This means output is larger and price lower as a way of deterring
entrants. If economies of scale a factor as output expands this would be a further
deterrent.
2. Intensity of Rivalry Among Incumbents
o Competition occurs because a rival sees an opportunity of improve its position (ie.
profitability).
However, rivals ``moves'' have effects on the firm as well as other
competitors. The pattern of reaction among competitors may or may not leave the
producer better off.
- Price competition especially dynamic. Price reductions easily met by rivals. Competition
occurs not only with price, but with product quality, service, warranties,
advertising etc. Industry may derive more benefits from some forms of non-price
competition.
o Factors contributing to intensity of rivalry.
- High exit barriers: Specialized assets with low salvage values often associated with
substantial economies of scale (see next tick) ; interrelationships between business
unit and other units in the firm; especially common outside the United States,
government restrictions. Eg. In India, legal environment makes closing a plant
with 50 + employee difficult.
- High fixed costs production methods: When ``excess capacity'' is present (ie. very low
marginal costs) price cutting occurs. Eg. In paper products industry, production
process often most efficient when let to run 24 hours a day 7 days a week.
Storage or inventory costs associated with bulky items becomes important
consideration in pricing. Fishing industry faces similar challenges.
- Inability to differentiate product: Successful product differentiation makes producers’
product a poorer substitute for other products in the industry. This differentiation
makes the demand for the producer's product less sensitive to price changes. Low
consumer ``switching'' cost intensifies competition in a similar manner.
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- Many equally balanced competitors (including foreign competitors): Industry with
many firms and little concentration likely will experience more intense
competition than one with a similar number of firms, but greater concentration of
output among a few firms. (Corresponds to View #2 in lecture on Industries
With Few Sellers.)
- Slow industry growth: Competition over the size of producer's market share appears to
be more important part of its strategy.
3. Competition From Substitute Products
o Industries selling substitute products limit profit potential because their product prices
create a ``ceiling'' on the producer's prices. Identify such products by finding those that
while different perform the same function. ( Eg. ``Low end'' chain restaurants and HMR
programs in grocery stores; Sugar producers compete with corn syrup industry; fiberglass
insulation and rock wool and styrofoam; security guards and electronic alarm and
surveillance systems.)
4. Bargaining Power of Buyers
o Buyers affect industry profitability by their ability to hold out for lower price, higher
quality, better service. An important determinant is the number of buyers (consumers)
in the industry. Eg. ready to wear clothing producers and retail department stores. In the
extreme case, there may be only one or a few buyers of a service. Eg. tank gunners may
find employment only with the military or as a mercenary. An even better example is the
NCAA. The buyers do not take price (wage) as given and instead realize that their
decisions about the employment of factors affect price. When there also are few sellers,
prices determined as a result of bargaining (although more advanced economic analyses
suggests the range of ``rational'' price and output outcomes is limited.
o Other factors affecting buyer power.
- Product is a significant fraction of buyer's (consumer's) total cost
- Products purchased from an industry producing standardized (as opposed to
customized) products
- Buyer (Consumer) encounters low switching costs.
- Buyers could integrate backwards and produce the product themselves: Historically true
in the U.S. automobile industry.
- Buyer (consumer) is well informed
5. Bargaining Power of Suppliers
o Similar analysis as with buyers, but here very important to analyze the state of labor
relations. Implications of unionization differs substantially among countries.
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6. Government Policy
o Producer faces an ``alphabet soup'' of regulations at the national, state, and local level. If
the firm does business internationally, the regulatory environment is even more complex.
Important to understand the unique impact that the public sector has on competition
(rivalry) in the industry.