Strategies for Competing in Industries & Markets PDF

Strategies for Competing in Industries & Markets Session 4 Industry analysis and industry structure Prof. Joe Ploog [email protected] J.Ploog Strateg...

Strategies for Competing in Industries & Markets Session 4 Industry analysis and industry structure Prof. Joe Ploog [email protected] J.Ploog Strategy  Focus of today‘s session ▪ Relevant for: − Corporate strategy: Understand the attractiveness of industries − Business strategy: Identify key factors to establish a competitive advantage 2 J.Ploog Strategy  Agenda for today ▪ Roots and objectives of industry analysis ▪ Porter‘s five forces ▪ Limitations of industry analysis 3 J.Ploog Strategy Which external factors and actors influence a firm‘s success? 4 J.Ploog Strategy  Roots and assumptions of industry analysis ▪ Roots of sector and industry analysis: Economics, specifically Industrial Organization ▪ Key paradigm: SCP paradigm The structure of the industry (competitors, suppliers, buyers) determines the conduct of the firms within the industry and, as a consequence, the industry’s performance in terms of profitability ▪ Main purpose: − Industry structure → level of competition → profitability − Understand the industry structure → identify best position for a firm → accrue profits ▪ Industry structure is assumed to be fairly stable ▪ The performance of the firm is assumed to essentially depend on the structure of the industry 5 J.Ploog Strategy  Objectives of industry analysis ▪ Assess industry attractiveness ▪ Identify key success factors ▪ Use evidence of changes in industry structure to forecast future profitability ▪ Formulate strategies based on the industry structure to improve firms’ profitability 6 J.Ploog Strategy Which industries from the ones below are the most profitable ones? Why? 7 J.Ploog Strategy Which industries from the ones below are the most profitable ones? Why? Table shows median ROE (%), 2000-2010 for the US market 8 J.Ploog Strategy  9 J.Ploog Strategy A tool that allows us to dig deeper and understand industry attractiveness: 10 J.Ploog Strategy Porter‘s Five Forces 11 J.Ploog Strategy  Assumptions of P5F Fight for profits: ▪ Who gets what slice of the pie? ▪ Stronger horizontal competition divides profit over a larger number of companies (same slice, more eaters) ▪ Stronger vertical competition shifts value away from competitors (smaller slice). Either in the form of value captured by suppliers or customer surplus ▪ What about the size of the pie? Assumed to be fixed 12 J.Ploog Strategy Main steps for analyzing an industry with Porter‘s 5 Forces 1. Identification of the industry (e.g., car manufacturing) 2. Identification of the players in the industry (e.g., VW, Mercedes, Ford, Toyota...) 3. Sequential analysis of the structural determinants of each force 4. Develop a strategy: Cost advantage vs. differentiation advantage 13 J.Ploog Strategy  First step for industry analysis: Identify the industry and market ▪ Business sectors are classified according to the standard industrial classification (SIC) code. − The SIC code classifies industries into progressively broader groups: industry (4 digit), industry group (3 digit), and major group (2 digit). − Examples SIC 73: Business Services SIC 737: Computer Programming SIC 7372: Software Packages ▪ Key principle to define industries or markets: Substitutability ▪ Industry vs. Market: − Market is the segmentation of an industry − Geographic criteria, target criteria (age, tastes … ) 14 J.Ploog Strategy Once you know the industry and its key players, analyze the level of threat posed by each force 15 J.Ploog Strategy  Porter‘s 5F: Industry rivalry (1/4) ▪ Industry rivalry = competition ▪ Firms can compete on both price and nonprice dimensions Nonprice competition: Price competition: − Erodes profits by driving up fixed − Firms make price reductions in costs (e.g., new product the hope of gaining market development) and marginal costs share, while the success (e.g., adding product features) depends on price sensitivity of − However, firms can pass demand and rivals’ reaction additional costs along to − Typically erodes industry consumers by charging higher profits more significantly → prices (if price elasticity of demand “race to the bottom” allows this) − Difficult to reduce costs to the − Examples: haute couture fashion, necessary extent → margins pharma, online video games… decrease 16 J.Ploog Strategy  Important takeaway: Price wars are risky for firms and often decrease industry profits (lose-lose) If you want to read more about this you can look at: Rao et al. 17 J.Ploog (2000), How to Fight a Price War, Havard Business Review Strategy  Porter‘s 5F: Industry rivalry (2/4) How can we measure the intensity of rivalry? 3 Measures ▪ Market/industry concentration = number of firms competing in a market/industry ▪ Concentration rate: − CR = Sum of market share of the ‘x’ largest firms − CR4 = market share of the 4 largest firms ▪ Herfindahl index: − HHI = Sum of squares of all market shares − Spans 0-1 (the higher the index, the lower the competition) − Herfindahl is better when there are many large firms Let‘s apply this … 18 J.Ploog Strategy  Firm 1 Firm 2 Firm 3 Firm 4 Firm 5 Firm 6 Market 0.1 0.5 0.2 0.05 0.1 0.05 share 19 J.Ploog Strategy  Porter‘s 5F: Industry rivalry (3/4) How does the intensity of rivalry relate to profitability? ▪ Generally, negative correlation between the level of competition and profitability − Few firms = high profitability (Price increases possible due to tacit collusion) − Many firms = low profitability (Collusion and coordination more difficult) − However, it also depends on the Elasticity of Demand and other factors. 20 J.Ploog Strategy  Porter‘s 5F: Industry rivalry (4/4) Determinants of the intensity of competition next to industry concentration: ▪ Diversity of competitors (vertical differentiation): − Competition on quality − Typically, the more important the quality of a product/service the lower the competition on price ▪ Product differentiation (horizontal differentiation): − Customization of products/services important → lower competition on price (Consumers incur switching costs) ▪ Excess capacity & exit barriers: − Examples: Under-utilized production plant, sunk costs for product development − Both increase price competition ▪ Cost conditions (scale economies): − High fixed costs → even business with a marginal margin is attractive → high price competition 21 J.Ploog Strategy Porter‘s 5F: Threat of entry 22 J.Ploog Strategy  Porter‘s 5F: Threat of entry ▪ Forms of Entry − Entrant is a new firm (de novo) − Entrant is an established firm that is diversifying in a new market (de alio) − Entrant is an established firm that is entering a new geographical market (de alio) ▪ Different Forms of Exit − Firm cease to exist / bankruptcy (e.g., Air Berlin) − Firm discontinues a particular product or product group (e.g., Sega left the video game hardware market) − Firm leaves a particular geographic market segment (e.g., Peugeot left the U.S. market) 23 J.Ploog Strategy  Porter‘s 5F: Threat of entry Barriers to entry = factors that … 1) allow the incumbents to earn economic profit while 2) making it unprofitable for new firms to enter the industry. What determines the strengths of entry barriers? 24 J.Ploog Strategy  Porter‘s 5F: Threat of entry What determines the strengths of entry barriers? − Capital requirements − Economies of scale − Absolute cost advantages (e.g. access to inputs) − Product differentiation − Access to distribution channels − Legal barriers (e.g. patents) − Retaliation risk (e.g. post-entry price wars of incumbents) 25 J.Ploog Strategy  Porter‘s 5F: Threat of entry ▪ Classification of entry barriers ENTRY BARRIERS EX-ANTE EX-POST ENDOGENOUS EXOGENOUS ▪ Ex-ante: Costs of entry − E.g.: Investments in R&D or marketing ▪ Ex-post: Incumbents’ behaviors in response to new entrants − E.g.: Retaliation, aggressive pricing, control of distribution channels 26 J.Ploog Strategy Porter‘s 5F: Threat of entry ▪ Exogenous or structural barriers: − Natural advantages − High set-up costs, economies of scale, network effects, legal barriers ▪ Endogenous or strategic barriers: − Incumbents’ actions to deter entry − Product differentiation, R&D and marketing expenses, access to distribution channels, tacit knowledge 27 J.Ploog Strategy Porter’s 5F: Substitutes 28 J.Ploog Strategy  Porter’s 5F: Substitutes ▪ Risk of substitution = Buyers’ propensity to substitute a firm’s product/service with other products/services (incl. those from other industries!) ▪ Determinants: − Similarity of substitutes in terms of price and performance (and price sensitivity of consumers) − Switching costs (e.g. due to network effects, lock in effects) What are industries with high switching costs? 29 J.Ploog Strategy Porter’s 5F: Buyer and supplier power 30 J.Ploog Strategy  Porter’s 5F: Buyer and supplier power ▪ Buyer Power: − Refers to the price sensitivity and relative bargaining power of buyers (B2B and B2C) − Determinants: − Importance of an item price − Product differentiation sensitivity − Competition among buyers − Size and concentration of buyers bargaining − Buyers’ information power − Possibilities for backward integration ▪ Supplier power: − Refers to the price sensitivity and relative bargaining power of suppliers − Analogous to buyer power, but “side” changes (upstream) 31 J.Ploog Strategy  Limitations of industry analysis 1. Static perspective − Industries that are more dynamic and continuously changing are not well represented − Zero sum competition (no account for value creation, Session 2) 2. No interaction among competitors − Actions and success of one industry player may depend on the actions of other players in the industry − Session 13 & 14: Game theory 3. Reverse causal − Industry structure influences competition − But: Competition also influences industry structure 32 J.Ploog Strategy  Limitations of industry analysis 4. Difficulty of defining industry boundaries − Assumption that industry boundaries are given and well-defined − Industry boundaries vary depending on our objectives − Session 6: Segmentation 5. Excessive emphasis on industry structure − Assumes that industry structure is the main determinant of firms’ profits − Firms’ success also depends on firm-level factors (e.g., resources and capabilities) − Session 7 & 8: Resource-based view 6. Neglects complementors and legal institutions 33 J.Ploog Strategy  How Much Does Industry Matter? ▪ Industry accounts for ≈ 20% of aggregate variance in profitability ▪ Business strategy accounts for ≈ 30% of aggregate variance in profitability ▪ Corporate strategy accounts for ≈ 4% of aggregate variance in profitability ▪ Industry effects matter more in some sectors than others ▪ In some industries there is more/less room for strategizing ▪ Industry effects on profitability are more persistent than firm effects 34 J.Ploog Strategy Next session: Case study session 35 J.Ploog Strategy  Next session: Case Session ▪ Please read the case about US Airlines in the Grant Textbook (Case 4 in the 10th edition) ▪ Be prepared to answer questions on the case in Session 5 ▪ Focus on understanding the influence of one force of Porter’s framework on the profitability of the airline industry ▪ Workgroups 1 and 2: Focus on rivalry ▪ Workgroups 3 and 4: Focus on supplier power ▪ Workgroup 5: Focus on buyer power ▪ Workgroup 6: Focus on the threat of entry ▪ Workgroups 7 and 8: Focus on substitutes J.Ploog Strategy