CHAPTER 2

Analyzing the
External Environment
of the Firm:
Creating Competitive
Advantages

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 Learning Objectives

After reading this chapter, you should have a good understanding of:
2-1 The importance of developing forecasts of the business
environment.
2-2 Why environmental scanning, environmental monitoring, and
collecting competitive intelligence are critical inputs to
forecasting.
2-3 Why scenario planning is a useful technique for firms competing
in industries characterized by unpredictability and change.
2-4 The impact of the general environment on a firm’s strategies
and performance.
2-5 How forces in the competitive environment can affect
profitability, and how a firm can improve its competitive
position by increasing its power vis-à-vis these forces.
2-6 The concept of strategic groups and their strategy and
performance implications.

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 The Importance of External Environment

Consider. . .

The best CEOs are always aware of what’s going

on outside their company. Their perceptual
acuity allows them to sense what’s coming.
Detecting early warning signals, keeping pace with
changes in the external environment can sustain a
competitive advantage.

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 Enhancing Awareness of the External
Environment

Exhibit 2.1 Inputs to Forecasting

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 Environmental Scanning & Monitoring

Environmental scanning involves surveillance of

a firm’s external environment.
• Predicts environmental changes to come
• Detects changes already under way
• Allows firm to be proactive
Environmental monitoring tracks evolution of
environmental trends.
• Sequences of measurable facts/events
• Streams of activities or trends from outside the
organization

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 Competitive Intelligence

Competitive intelligence
• Helps firms define & understand their industry
• Identifies rivals’ strengths & weaknesses
• Collect data on competitors
• Interpret intelligence data
• Helps firms avoid surprises
• Anticipate competitors’ moves
• Decrease response time
• Potential for unethical behavior while gathering
intelligence

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 Environmental Forecasting

Environmental forecasting predicts change.

• Plausible projections about
• Direction of environmental change?
• Scope of environmental change?
• Speed of environmental change?
• Intensity of environmental change?
Scenario analysis involves detailed assessments
of the ways trends may affect an issue &
development of alternative futures based on these
assessments.

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 Question
(1 of 2)

A danger of forecasting discussed in the text is

that
A. in most cases, the expense of collecting the
necessary data exceeds the benefit.
B. forecasting’s retrospective nature provides little
information about the future.
C. managers may view uncertainty as “black and
white” while ignoring important “gray areas.”
D. it can create legal problems for the firm if
regulators discover the company is making
forecasts.

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 SWOT Analysis

SWOT analysis is a basic technique for analyzing

firm and industry conditions.
• Firm or internal conditions = Strengths &
Weaknesses
• Where the firm excels or where it may be lacking
• Environmental or external conditions =
Opportunities & Threats
• Developments that exist in the general environment
• Activities among firms competing for the same
customers
• Must consider both internal & external factors
simultaneously

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 The General Environment

The general environment is composed of factors

that are both hard to predict and difficult to
control.
• Demographic
• Sociocultural
• Political/Legal
• Technological
• Economic
• Global

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 The Demographic Segment

Demographics are easily understandable &

quantifiable.
• Aging population
• Rising affluence
• Changes in ethnic composition
• Geographic distribution of population
• Greater disparities in income levels

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 The Sociocultural Segment

Sociocultural forces influence the values, beliefs,

and lifestyles of a society.
• More women in the workforce
• Increase in temporary workers
• Greater concern for healthy diets & physical fitness
(increasing levels of obesity)
• Greater concern for the environment
• Postponement of marriage & family formation,
having children

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 The Political/Legal Segment

Political/Legal processes & legislation influence

environmental regulations with which industries
must comply.
• Tort reform
• Americans with Disabilities Act (ADA)
• Deregulation of utilities & other industries
• Increases in minimum wages
• Taxation
• Legislation on corporate governance reforms
• Affordable Health Care Act, Medicare
reimbursements

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 The Technological Segment

Technological developments lead to new products &

services. They can create new industries & alter
existing ones.
• Genetic engineering
• Three-dimensional (3D) printing
• Computer-aided design/computer-aided manufacturing
systems (CAD/CAM)
• Research in synthetic & exotic materials
• Pollution/global warming
• Miniaturization of computing technologies
• Wireless communications
• Nanotechnology
• Big data/data analysis

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 The Economic Segment

Economic forces affect all industries.

• Interest rates
• Unemployment
• Consumer Price Index
• Trends in GDP & net disposable income
• Changes in stock market valuations

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 The Global Segment

Global forces offer both opportunities & risks.

• Increasing global trade
• Currency exchange rates
• Emergence of the Indian & Chinese economies
• Trade agreements among regional blocs (NAFTA,
EU, ASEAN)
• Creation of the WTO (leading to decreasing
tariffs/free trade in services)
• Increased risks associated with terrorism

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 General Environment:
Relationships among Elements

Elements of the general environment interact with

each other.
• Demographic trends have implications for
economics.
• Greater access to information technology affects
both economics and global relationships.
• Political/legal trends can have very different effects
on different industries.
• Digital technology has altered the way business is
conducted in nearly every business domain.
• Data analytics

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 The Competitive Environment

The competitive environment consists of

factors in the task or industry environment that
are particularly relevant to a firm’s strategy.
• Competitors (existing or potential)
• Including those considering entry into an entirely
new industry
• Customers (or buyers)
• Suppliers
• Including those considering forward integration

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 Porter’s Five Forces Model of Industry
Competition

Exhibit 2.4 Porter’s Five Forces Model of Industry Competition

Source: From Michael E. Porter, “The Five Competitive Forces That Shape Strategy,” Special Issue on HBS Centennial.. Harvard Business
Review 86, No. 1 (January 2008), 78-93. Reprinted with permission of Michael E. Porter.
Jump to Appendix 1 for long description.
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 The Threat of New Entrants

The threat of new entrants – possibility that the

profits of established firms in the industry may be
eroded by new competitors.
Depends on existing barriers to entry:
• Economies of scale
• Product differentiation
• Capital requirements
• Switching costs
• Access to distribution channels
• Cost disadvantages independent of scale

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 Question
(2 of 2)

If you are considering opening a new pizza

restaurant in your community, what would be the
threat of new entrants? How would you evaluate
Porter’s other forces for this industry? Explain.

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 The Bargaining Power of Buyers

Buyers have bargaining power.

Buyers can force down prices, bargain for higher
quality or more services, or play competitors
against each other.
Buyer groups are powerful.
• Purchasing standard products are in large
volumes.
• Profits are low & switching costs are few.
• Backward integration is possible.
• Buyer’s product quality is not affected by industry
product.

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 The Bargaining Power of Suppliers

Suppliers can exert bargaining power by

threatening to raise prices or reduce the quality of
purchased goods and services.
Supplier groups are powerful.
• Only a few firms dominate the industry.
• There is no competition from substitute products.
• Suppliers sell to several industries.
• Buyer quality is affected by industry product.
• Products are differentiated & have switching costs.
• Forward integration is possible.

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 The Threat of Substitute Products &
Services

Substitute products & services limit the

potential returns of an industry.
Substitutes come from another industry.
Substitutes can perform the same function as the
industry’s offerings.
Substitutes place a ceiling on prices that firms in
an industry can profitably charge.
• The more attractive the price/performance ratio,
the more the substitute erodes industry profits.

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 The Intensity of Rivalry among
Competitors in an Industry

Rivalry tactics include price competition,

advertising battles, new product introductions,
increased customer service or warranties.
Interacting factors lead to intense rivalry.
• Numerous or equally balanced competitors
• Slow industry growth
• High fixed or shortage costs
• Lack of differentiation or switching costs
• Capacity augmented in large increments
• High exit barriers

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 How the Internet and Digital Technologies
Affect Competitive Forces

Competitive Forces Benefits to Industry Disadvantages to Industry

Threat of New Entrants • Lower barriers to entry increases

number of new entrants.
• Many Internet-based capabilities can
be easily imitated.
Bargaining Power of Buyers Reduces the power of buyer • Switching costs decrease.
intermediaries in many distribution • Information availability online
channels. empowers and users.
Bargaining Power of Suppliers Online procurement methods can • The Internet gives suppliers access
increase bargaining power over to more customers and makes it
suppliers. easier to reach end users.
• Online procurement practices deter
competition and reduce
differentiating features.
Threat of Substitutes Internet-based increases in overall • Internet-based capabilities create
efficiency can expand industry sales. more opportunities for substitution.
Intensity of Rivalry • Since location is less important, the
number of competitors increases.
• Differences among competitors are
harder to perceive online.
• Rivalry tends to focus on price and
differentiating features are
minimized.

Sources: Bodily, S., & Venkataraman, S. 2004. Not walls, windows: Capturing value in the digital age. Journal of Business Strategy. 25(3): 15-25; Lumpkin, G.T.
Droege, S.B., & Dess, G.G. 2002. E-commerce strategies: Achieving sustainable competitive advantage and avoiding pitfalls. Organizational Dynamics, 30 (Spring):
1-17.

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 Using Industry Analysis:
A Few Caveats

Managers must not always avoid low profit

industries; these can still yield high returns for
players who pursue sound strategies.
Five forces analysis implicitly assumes a zero-
sum game. Yet mutually beneficial relationships
can still be established with buyers & suppliers.
Five forces analysis is essentially a static analysis,
yet external forces can still change the structure
of all industries.
• See the value net extension of five forces analysis.
• Vertical dimension = suppliers & customers
• Horizontal dimension = substitutes & complements

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 The Value Net

Exhibit 2.6 The Value Net

Source: Adapted from “The Right Game: Use Game Theory Shape Strategy,” by A. Brandenburger and B.J. Nalebuff,
July-August 1995 Harvard Business Review.

Jump to Appendix 2 for long description.

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 Doing a Good Industry Analysis

Good industry analysis looks rigorously at the

structural underpinnings & root causes of
profitability.
• Must choose the appropriate time frame
• Consider the industry business life cycle
• Average profitability over 3-5 years or longer
• Must consider quantitative factors as well as
qualitative
• Get numbers to quantify five forces factors
• Percentages of total cost or sales accounted for by the
industry, actual switching costs

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 Strategic Groups within Industries

Two unassailable assumptions in industry

analysis:
• No two firms are totally different.
• No two firms are exactly the same.
Strategic groups – clusters of firms that share
similar strategies:
• Breadth of product & geographic scope
• Price/quality
• Degree of vertical integration
• Type of distribution

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 Strategic Groups as an Analytic Tool

Strategic groups can be analytical tools.

• Helps identify barriers to mobility that protect a
group from attacks by other groups
• Helps identify groups whose competitive position
may be marginal or tenuous
• Helps chart the future direction of firms’ strategies
• Helps to think through the implications of each
industry trend for the strategic group as a whole

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 Example: Strategic Groups within
Industries

Exhibit 2.7 The

World Automobile
Industry: Strategic
Groups
Note: Members of each
strategic group are not
exhaustive, only
illustrative.

©McGraw-Hill Education. Jump to Appendix 3 for long description.