Industry Analysis Lecture Notes

8/12/2019 Industry Analysis Lecture Notes

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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 areputation for brilliance tackles a business witha reputation for poor fundamental economics , itis the reputation of the business that remainsintact.

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A firms profits depend on its industry andits 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

profits - notably, competitive advantage 29

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 theindustry 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 beclose 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 theproduct 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 maydiffer in the way they are used

Orange juice and cola are beverages but usedin different occasions

Another example: Hiking shoes versus courtshoes

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Geographic Area

Identical products in two different geographicmarkets will not be substitutes due totransportation costs

Bulky products like cement cannot betransported over long distances to benefit fromgeographic price difference

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Empirical Approaches to Competitor Identification

Cross pric e elasticity of d emand

If yx is positive, consumers purchase more of Y when the price ofX 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 Appleare 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 andlaptops are substitute products . Are firms selling these products inthe same industry? Or are firms selling eReaders in a differentindustry than firms selling laptops, and thus we should ratherconsider firms selling eReaders in the Force of Substitutes?

x x

y y yx PP

QQ/

/

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Empirical Approaches to Competitor Identification

Firms in the same Standard IndustrialClassification

Products and services are identified by aseven digit code

Each digit represents a finer degree ofclassification

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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

P r i c e s

C h a r g e d

Routes ServicedLow

Low

High

High

Alaska Airlines

JetBlue

Southwest Airlines

United AirlinesDelta

American Airlines

U.S. Airways

MobilityBarrier

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Industries and Market Structure from the Economicsperspective

Industries are often described by the degree ofmarket concentration

Monopoly is one extreme with the highestconcentration - one seller

Perfect competition is the other extreme withinnumerable sellers

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Measures of Market Structure

The N-firm concentration ratio(the combined market share of the largest Nfirms)

Herfindahl index (the sum of squared marketshares)

When the relative size of the largest firms isimportant Herfindahl is likely to be moreinformative

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Four Classes of Market Structure

Nature ofCompetition

Range ofHerfindahls

Intensity of PriceCompetition

PerfectCompetition

Usually < 0.2 Fierce

MonopolisticCompetition

Usually < 0.2 Maybe fierc e or ligh t,depending on the degreeof product differentiation

Oligo poly 0.2 to 0.6 Depends on inter -firmrivalry

Monopoly > 0.6 Light unless there isthreat of entry

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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 tozero

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

RIVALRY : When price competition is fierce, prices willapproach marginal costs, which decrease

ENTRY : As entry occurs, Q and/or P decline (or C rises) whichdecreases

SUBSTITUTES: The existence of good substitutes for anindustrys product implies a flat/elastic demand curve, whichresults in a lower market price, which decreases

SUPPLIERs : Supplier power results in high input costs forfirms, increasing C, which decreases

BUYERS : Buyer power results in low prices for firms,

decreasing P , which decreases44

Threat ofSubstituteProducts

Threat ofNew

EntrantsThreat of New

Entrants

Rivalry AmongCompeting Firms in

Industry

BargainingPower ofBuyers

BargainingPower ofSuppliers

Rate each threatHigh, Moderate,or Low

to determine: 1) (forincumbents) how tocompete 2) (for entrants) ifthis is an attractiveindustry t o enter, and how

Complementors

Government?

What is the threat to profits from.?

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Force 1: Internal Rivalry

Internal rivalry is the competition for market shareamong 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 productfeatures; advertisement) Non-price competition is less likely to erode profits if

customers are willing to pay a higher price for theimprovements

Price Competition erodes the price cost margin andprofitability Why would any firm reduce its prices?

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Force 1: Rivalry with competitors dissipates profitsthrough 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 dissipatesprofits through price competition

Characteristics of the market that threaten profits throughfierce 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 ofCompetition

Business AA1 = 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%

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

Bigger players are less likely tolower prices and go after B3.B3 can aim for being a nicheplayer with potentially high profits.

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Homogeneous Products

There are three sources of increased revenuewhen 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 ofrevenue gain

Customers will be less loyal to the sellers andsellers 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) thenexcess capacity and losses (caused by prices being below averagecosts) will persist for a while

Firms with excess capacity might be under pressure to boost salesand often can rapidly expand output to steal business from rivals,leading to price competition

Example: During economic downturns, the airlines have substantialexcess capacity on many routes. Because consumers perceiveairlines as selling undifferentiated products, each airline can fillempty seats by undercutting rivals prices and stealing theircustomers.

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Force 2: Entry both lowers market share andaffects rivalry

Economics As entry occurs, Q and/or P decline (or C

rises) which decreases = (P-C)*QExamples

Easy Entry: Restaurants Difficult entry: Auditing/accounting;

Commercial Aircraft Manufacturing52

Force 2: Entry both lowers market share and affectsrivalry

Characteristics of the market that threaten profits bymaking 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 arenot important)

No strong brand identity or reputation for incumbents Low exit costs

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Units of outputper period

MinimumEfficientPlant Size

Cost per unit of output

Economies of Scale & Minimum Efficient Scale

Diseconomies of Scale- Examples:

Physical limits to efficient size Managerial diseconomies Worker motivation

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Cost per unitof output (inreal $)

Cumulative Output

1988

1990

1992

19941996

1998 2000

Learning curveTotal Costs Decrease with Additional Production Experience

The Law of Experience

The cost per unit of output declines by a co nstant% (typically 5-30%) each time cumulative outputdoubles

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

Characteristics of a product that threatenprofits 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 witha 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, whichresults in a lower market price, which decreases

Examples

Industries with good substitutes: Department stores faced by category killers

Industries with poor substitutes: Disposable diapers 57


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Force 4: Supplier power is the ability of suppliersto extract profits by obtaining high prices

Characteristics of the market that threaten profits through supplier power Relatively few suppliers Inputs are difficult to substitute Firms make specific investments in order to use

inputs purchased from supplier Supplier has ability to integrate forward Note: Even if an input is vital for production, supplier

power will not necessarily be high in an industry58

Force 4: Supplier power is the ability of suppliersto extract profits by obtaining high prices

Economics Supplier power results in high input costs for firms,

increasing C, which decreases = (PC)*Q Examples

High supplier power: Automotive firms face high supplier power from unionized workers

High supplier power: PC manufacturers face high suppliers power from Microsoft and Intel

Low supplier power: Cigarette manufacturers face low supplier power from tobacco farmers 59

Force 5: Buyer power is the ability of buyers toextract profits by obtaining low prices

Characteristics of the market that threaten profits through buyer power

Relatively few

buyers,

each

accounting

for

a large

fraction of sales

Firms must make specific investments in order to serve the needs of buyers

Buyers have the ability to integrate backwards into supplying their own inputs

Note: Buyer power is related to rivalry with competitors; lumpy sales, low switching cost, etc. tend to increase buyer power.

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Force 5: Buyer power is the ability of buyers toextract profits by obtaining low prices

Economics Buyer power results in low prices for firms,

decreasing P , which decreases = (PC)*Q

Examples High buyer power: Procter & Gamble face high

buyer power when selling to Wal Mart Low buyer power: Cable TV providers face low buyer

power when providing cable service to local customers (households) 61

Dynamic Five Forces Analysis

Industries Evolve Over Time as theRelationships Between The Five Forces Change

time

d e m a n

d

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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 ComputerIndustry

What are they? How have they influenced theindustrys profitability between 1980s and today?

Applications: Software prices dropped, functionalityincreased, 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 particularfirms are doing well/poorly

The role of the government is important in someindustries

More, better, and cheaper complements (the mirrorimage of substitutes) can increase industry profits.Not well accommodated (at least not in the originalframework 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 anexplanation of an industrys profitability

The relevance of each of the forces will necessarilydepend on the industry being analyzed

If we can forecast changes in industry structure we canpredict 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 FiveForces analysis indicates is unattractive?

Develop an effective strategy to outperform competitors(competitive advantage)Find an industry segment or niche market with morefavorable conditionsFirms ca try to change the forces

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Remember two assumptions aboutcompetition

It is not enough to succeed; others must fail(Gore Vidal)

You dont have to blow out the other fellows light tolet your own shine

(Bernard Barruch)

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Example of Five Forces Analysis

SOFT DRINK S INDUSTRY B OTTL ING I NDUSTRY

Force What is the threat to profits from?Entry Low LowSubstitutes High LowSupplier Power Low High for CP. Low for othersBuyer Power Low (except for Fountains) Moderate to High (Varies by channel)Rivalry Low to Moderate Low to Moderate

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Documents

Industry Analysis Lecture Notes