© Ram Mudambi, Temple University, Lecture 2 External Analysis: The Identification of Industry Opportunities and Threats BA 951 Policy Formulation and Administration

© Ram Mudambi, Temple University, Learning Outcomes  Methodologies for analyzing the external environment of the firm  Theories  Applications  European groceries  Competition in a digital age

© Ram Mudambi, Temple University, Lecture Outline  Components of External Analysis  Static models for examining external environment  The Industry - The Five Forces Model  Wide Focus – PEST Analysis  Narrow Focus – Strategic Groups  Dynamic models – industry evolution  Punctuated equilibrium  The life cycle model  The external environment and -  Network economies  Globalization  The competitive advantage of the Nation State

© Ram Mudambi, Temple University, Two Components of External Analysis Supplying a viable, saleable product Ability to survive its environment ANALYSIS OF PRODUCTANALYSIS OF ENVIRONMENT KEY SUCCESS FACTORS

© Ram Mudambi, Temple University, Analysis of Product: What are the industry’s dominant economic traits?  Market size and growth rate  Scope of competitive rivalry  Number of competitors and their relative sizes  Prevalence of backward/forward integration  Entry/exit barriers  Nature and pace of technological change  Product and customer characteristics  Scale economies and experience curve effects  Capacity utilization and resource requirements  Industry profitability

© Ram Mudambi, Temple University, Defining an Industry Industry Industry  A group of companies offering products or services that are close substitutes for each other and that satisfy the same basic customer needs  Industry boundaries may change as customer needs evolve and technology changes Sector Sector  A group of closely related industries Market Segments Market Segments  Distinct groups of customers within an industry  Can be differentiated from each other with distinct attributes and specific demands

© Ram Mudambi, Temple University, The Computer Sector: Industries and Market Segments

© Ram Mudambi, Temple University, Analyzing Industry Structure Opportunities and threats are competitive challenges arising for changes in industry conditions. The five forces model is an analytic tool that helps managers formulate appropriate strategic responses.

© Ram Mudambi, Temple University, Porter’s Five Forces Model Industry competitors Rivalry amongst existing firms Potential entrants Threat of new entrants Substitutes Threat of new substitute product or service Suppliers Bargaining power of suppliers Buyers Bargaining power of buyers Source: Adapted and reprinted by permission of Harvard Business Review. An exhibit from “How Competitive Forces Shape Strategy” by Michael E.. Porter (March-April 1979), Copyright © 1979 by the President and Fellows of Harvard College: all rights reserved

© Ram Mudambi, Temple University, Competitive Strategy Industry environment Five forces model The firm Distinctive competencies vis-à-vis competitors Strategic Choice Maximize competitive advantage

© Ram Mudambi, Temple University, Potential Entrants Joe Bain’s key insight – firm profitability is affected by extant competition as well as potential competition. Joe Bain’s key insight – firm profitability is affected by extant competition as well as potential competition. Firms limit their current Firms limit their current profits for fear of attracting entrants. Entry barriers reduce the threat of new and additional competition.Entry barriers reduce the threat of new and additional competition. FORCE 1

© Ram Mudambi, Temple University, Barriers to entry - Bain vs. Stigler  ‘Barriers to entry’ is a loaded term  Joe Bain (U.C.-Berkeley) - barriers to entry exist when entrant firms face obstacles  George Stigler (U.Chicago) - barriers to entry exist when entrant firms face obstacles not faced by incumbent firms

© Ram Mudambi, Temple University, “Barriers to entry” - Bain Economies of scale Economies of scale Existence of learning/experience curve effects Existence of learning/experience curve effects Strong brand preferences and customer loyalty Strong brand preferences and customer loyalty Capital requirements and/or other specialized resource requirements Capital requirements and/or other specialized resource requirements Cost disadvantages independent of size Cost disadvantages independent of size Access to distribution channels Access to distribution channels All these are barriers according to Bain, but not according to Stigler. Entrant firms just have to follow the same path of incumbents

© Ram Mudambi, Temple University, Barriers to entry - Stigler All of the above “barriers” would be called first-mover advantages by Stigler. However, Stigler does agree that there are barriers to entry. Some examples: Inability to gain access to specialized technology - patents are barriers Inability to gain access to specialized technology - patents are barriers Regulatory policies, tariffs, trade restrictions - legal restrictions are barriers Regulatory policies, tariffs, trade restrictions - legal restrictions are barriers

© Ram Mudambi, Temple University, Rivalry Among Established Companies The intensity of competitive rivalry in an industry arises from:  Industry’s competitive structure.  Demand (growth or decline) conditions in industry.  Height of industry exit barriers. FORCE 2

© Ram Mudambi, Temple University, Competitive Structure Continuum of Industry Structures Fragmented Many firms, no dominant firm Few firms, shared dominance (oligopoly) Consolidated One firm or one dominant firm (monopoly)

© Ram Mudambi, Temple University, The Market Spectrum Inter-dependence irrelevant Inter-dependence absent

© Ram Mudambi, Temple University, The Bargaining Power of Buyers Buyers are most powerful when:  There are many small sellers and few large buyers.  Buyers purchase in large quantities.  A single buyer is a large customer to a firm.  Buyers can switch suppliers at low cost.  Buyers purchase from multiple sellers at once.  Buyers can easily vertically integrate to compete with suppliers. FORCE 3

© Ram Mudambi, Temple University, The Bargaining Power of Suppliers Suppliers have bargaining power when:  Their products have few substitutes and are important to buyers.  The buyer’s industry is not an important customer to the supplier.  Differentiation makes it costly for buyers to switch suppliers.  Suppliers can vertically integrate forward to compete with buyers and buyers can’t integrate backward to supply their own needs. FORCE 4

© Ram Mudambi, Temple University, Substitute Products The competitive threat of substitute products increases as they come closer to serving similar customer needs. CloseFar FORCE 5

© Ram Mudambi, Temple University, A Sixth Force: Complementors Complementors:  Companies whose products are sold in tandem with another company’s products.  Increased supply of a complementary product collaterally increases demand for the primary product. Example:  Faster CPU chips fuel sales of personal computers.

© Ram Mudambi, Temple University, Who profits from falling transaction costs? Market Firm 1Firm 2 Innovator Complementor

© Ram Mudambi, Temple University, Example Nokia makes cell phone bodies Texas Instruments makes Digital Signal Processing chips (DSPs) that make it possible for cell phones to become web devices  Primary assets – Nokia’s cell phone technology  Complementary assets – TI’s DSP technology Which cell does this fall into? This is a generic example as more and more devices become web-enabled, e.g., TVs, fridges, etc.

© Ram Mudambi, Temple University, Generic Strategies Run Run: continuously changing key elements of the business model - continuous innovation Block Block: Erect barriers to entry around existing business model - making imitation costly (patents, brands, etc.)

© Ram Mudambi, Temple University, Collaborative Advantage – Burton’s 5 sources Industry collaborators Horizontal strategic alliances SuppliersBuyers Previously unrelated industries Substitutes and complements Prospective diversification alliances Related diversification alliances Relational contracting, quasi-integration Partnering w/ channels., buyers

© Ram Mudambi, Temple University, Collaborative Strategy Industry environment Five sources model The firm Distinctive competencies vis-à-vis collaborators Strategic Choice Maximize collaborative advantage

© Ram Mudambi, Temple University, Five forces of competition Five sources of collaboration Firm’s distinctive competencies Sustainable competitive advantage Sustainable collaborative advantage Composite strategy Maximize overall sustainable advantage PORTERBURTON

© Ram Mudambi, Temple University, The Role of the Macro-environment Polity Economy SocietyTechnology Demography Regulation BuyersSuppliers Rivals Substitutes INTERNAL Operations Finance HRM Marketing Entrants Complements

© Ram Mudambi, Temple University, Wide-focus: PEST ANALYSIS

© Ram Mudambi, Temple University, Strategic Groups Within Industries The concept of strategic groups  Within an industry, a competitor grouping using similar strategies that differ from other industry groups. Implications of strategic groups  The closest industry competitors are those in the group.  The various industry groups are differentially and competitively advantaged and positioned.  Mobility barriers inhibit the movement of competitors from one strategic group to another.

© Ram Mudambi, Temple University, Strategic Groups in the Pharmaceutical Industry

© Ram Mudambi, Temple University, Criticisms of the Five Forces and Strategic Group Models Both models are static and ignore innovation.Both models are static and ignore innovation. Their focus is on industry and group structures rather than individual companies.Their focus is on industry and group structures rather than individual companies.  Innovation creates change in industry structures, altering the competitive environment.  Industry structure cannot fully explain the performance differences between industry competitors.

© Ram Mudambi, Temple University, Punctuated Equilibrium and Competitive Structure Major Innovation Development & Diffusion Stasis

© Ram Mudambi, Temple University, The Industry Life Cycle Model Stages in the industry life cycle:

© Ram Mudambi, Temple University, Technology and the life cycle Development Competing standards Leaders – first movers Diffusion Emergence of an industry standard Network externalities Fast followers – second movers Imitation Parallel development Adoption Licensing & royalties Late followers – third movers

© Ram Mudambi, Temple University, Industry life cycle and industry structure TIME Many firms Competing techs/ standards Product is: Expensive User unfriendly Slow growth Mergers/Acquisitions/ Exits Development of single standard Product is: Much cheaper User friendly Product R&D Rapid growth Mature Oligopoly Intense rivalry Process R&D Slow growth, decline Nascent PhaseConsolidationMaturity

© Ram Mudambi, Temple University, Network Economics As a Determinant of Industry Conditions The demand for primary industry products depends on the size of the total market for complementary products.  Network economics result in positive feedback loops that foster rapid demand increases.  Market competitors are protected by switching cost entry barriers.

© Ram Mudambi, Temple University, Positive Feedback in the Computer Industry

© Ram Mudambi, Temple University, Globalization and Industry Structure Globalization  Globally dispersed production lowers costs and increases quality.  Global markets are replacing national markets. Trend implications  No isolated national markets  More competitors, more intense competition  More rapid innovation and shorter product life cycles

© Ram Mudambi, Temple University, The Internet – a powerful external stimulus Greater incentives for collaborative strategies Larger fixed costs Shorter product life-cycles More uncertainty INTERNET Globalizing customers Dispersed, changing technology

© Ram Mudambi, Temple University, The Nation-State and Competitive Advantage – Porter’s Diamond model The determinants of competitive advantage: Factor endowments

© Ram Mudambi, Temple University, Summary  Static models for analyzing the firm’s external environment  The industry – 5 forces  Beyond the industry – PEST  Within the industry – strategic groups  Dynamic models  Punctuated equilibria and the industry life cycle  Drivers of the external environment  Networks, globalization, location advantages