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Economics of Strategy Industry Analysis

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Presentation on theme: "Economics of Strategy Industry Analysis"— Presentation transcript:

1 Economics of Strategy Industry Analysis
Focus here is on the INDUSTRY

2 Five-Forces Analysis A systematic analysis of major economic forces affecting the industry Internal Rivalry Entry Buyer Power Seller Power Substitute Products Assess each force by asking “Is it sufficiently strong to reduce or eliminate industry profits?” Widely used tool for strategic decision-making. It has some weaknesses which we will cover later. It also has tremendous strengths. If you want to enter into an industry then you need to make a systematic survey of that industry from a host of perspectives. Five-Force analysis does this.

3 Entry Internal Rivalry Supplier Power Buyer Power Substitute Products

4 Internal Rivalry What is the intensity of competition within the market? Types of Competition Price Competition Non-price Competition Internal Rivalry sets in the middle of the model due to its pivotal role in the industry. Price and non-price competition both take a toll on industry profit margins. Price reductions directly erode TR in markets with elastic demand and non-price competition erodes the TC side.

5 Price Competition Firms within the industry competing for consumers with price Price competition is more fierce with numerous sellers homogeneous products switching costs that are low for consumers transaction conditions that are not transparent to other firms sales orders that are large, received infrequently, and at irregular intervals excess capacity exists in the industry Use the Profit Mountain Story with S&D Analysis Entry in the form of (1) Expansion of output levels by extant firms (2) actual entry into the market by new firms. Both have the same effect on the supply curve over time - S shifts out.

6 Non-Price Competition
firms within the industry are competing for consumers on non-price factors product delivery conditions and scheduling conditions of contract warranties, return policies, customer service provisions terms of payment/financing tie-in sales relationship selling (“Best BBQ Clause”)

7 Levels of Rivalry Depend upon relative size and success of peer firms
large numbers of firms tend to reduce rivalry wide ranges of success tend to increase rivalry industry growth rates rapid growth rates tend to increase rivalry

8 Levels of Rivalry Tend to increase with high fixed costs
high storage costs perishability low switching costs egos diversity among firm paths to profitability technological change lumpy capacity investment High fixed costs, high storage costs, and product perishability all tend to increase the downward pressure on price and competition among peer firms in general. When consumers can easily switch to your competitor rivalry increases. When management egos become involved rivalry can increase (Michael Eisner and Jeffrey Katzenberg) When a host of different strategies have produced good results rivalry increases Technological change speeds up the competitive process When additional capacity has to be added in large chunks/unit plants (”lumpy”) rivalry increases

9 Entry Entry erodes profit margins Entry from existing firms
with existing capacity, change in quantity supplied with new capacity, change in supply Entry from interloper firms The “IBM LOVES COMPETITION FALLACY”

10 Barriers to Entry Economies of Scale Economies of Scope
Ownership of a required input intellectual property rights, patents, copyrights, crucial resource Favorable access to distribution channels High financial capital requirements Product differentiation/ strong brand identity

11 Other Potential Incumbent Advantages
Learning curves/ accumulated experience in the industry Favorable access or terms with input suppliers’ Geographical/Location advantages Regulatory Environment Experience with Influence within Captured and used to block entry Slow growth in the industry can create time pressures

12 Threat of Retaliation Existing firms may have an established pattern of deterring new entrants Existing firms may have financial resources to ride out the retaliatory period Existing firms may have ties to suppliers, distributors, or customers which can be leveraged to deter new entrants

13 Substitutes What are the available substitutes for consumers?
Think about all available and potential substitutes Changes in technology Changes in consumer tastes and preferences Firm-level price elasticity within the industry or industry-level price elasticity across substitute industries? Look forward… but not too forward! Where are your strategic competitors of the future? Cable TV Companies as an example Telephone companies Satellite Dishes Electrical Companies Cellular Service? Could you use a decision tree? Rate each potential competitor on level of short-term, medium-term, and long-term threat. “Beware the ides of futurists” - they make great best-sellers but their predictions often don’t pan out.

14 Identifying Substitutes
Identify products which provide the same functional use Focus on substitutes which are relatively good substitutes but have been historically excluded because of production costs which are produced by an industry enjoying high profits Electricity has numerous substitutes in heating (e.g., oil, wood, active solar, passive solar, propane, kerosene, natural gas, geothermal) but few substitutes in lighting. Some potential substitutes that seem very weak, usually due to high relative costs, may become viable substitutes in very short time periods. Could be due to changes in technology (e.g., the development of viable electric cars is highly dependent upon battery technology and advances in battery technology could make electric cars viable substitutes quickly.) Also watch out for firms which have accumulated high levels of retained earnings. They may be laying low for a bushwhackin’ ! If they have a close substitute, but its costs are high, finding ways to reduce those costs provide an entry wedge and may also be a strategic move if their technology is likely to leap-frog yours.

15 Supplier Power input suppliers have market power
due to relationship specific assets exploiting the gap between rents and quasi-rents due to monopoly power allows flexibility in extracting rents when buyer is doing well -- raise input prices when buyer is doing poorly -- lower input prices

16 Supplier Power increases if
Suppliers have market power monopoly oligopoly your purchases are unimportant to firm revenues they have built in high switching costs for you they can, or threaten to, integrate upstream

17 Buyer Power buyers may have market power monopsony - single buyer
oligopsony - small number of buyers can be due to relationship specific assets exploiting the gap between rents and quasi-rents Monopsony or Oligopsony occur when a firm’s purchases of your product represent a large portion of your sales or their purchases are important to your needs such as a regular cash flow (RAM Photography and TRW.)

18 Buyer Power increases if
they are price sensitive because the product they are purchasing represents a high proportion of their costs because they are acclimated to competitive pricing in the input market they earn low profits they face low switching costs they can, or threaten to, integrate downstream the input is not critical to the quality of the final product

19 Five-Forces Analysis Inherent Weaknesses
Assumes sufficient demand exists in industry Focuses on the industry as a whole Ignores government (the gorilla in the living room…) Regulatory Environment Industry-specific regulation Health, Safety, Environmental regulation Property Rights policies Taxation Policies Social Welfare Policies Qualitative analysis

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