External analysis

Industry structure
Session 3
Most profitable industries
• In most years, there is a clear difference in profitability between
industries- on most criterion-
• Return on shareholders equity
• Return on revenues
• Return on Assets
• Some industry groups are clearly more profitable than others
• Studies show variability of 10-20% of profits as accounted for by the
industry to which it belongs

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Three factors determining company
performance
• Industry context
• National context
• Company capabilities and strategies
Industry analysis and competitive analysis
• An industry is a collection of firms that offer similar products or
services.
• Structural attributes are the enduring characteristics that give an
industry its distinctive character.
• Concentration refers to the extent to which industry sales are
dominated by only a few firms.
• Barriers to entry are the obstacles that a firm must overcome to
enter an industry.

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Applying the structure-conduct-performance model
Structural attributes: concentration
• N-firm concentration ratio: Combined market share of
the N largest firms in the market
• Herfindahl index (better indicator): Sum of squared
market share of all the firms in the market
• Perfect competition- H index usually below .2
• Monopolistic competition- H usually below .2, competition
may be heavy or light based on level of product
differentiation
• Oligopoly- H index from .2 to. 6
• Monopoly- H index of .6 and above

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Judging whether two products are from the
same industry
• Are inputs and product technologies similar?
• Are competitors mostly the same?
• Do firms look to the same resources as the basis of competitive
advantage, and have broadly similar value chains?
• Is there significant overlap between the different products’ customers
and end-users?
Firms in an industry also share a ‘recipe’:
• Shared mental model; ‘rules of the game’
• Common routines

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Structure-conduct-performace
The feedback critique of SCP
• There is no one way causal link
• Conduct can affect market structure
• Market performance can affect conduct as well as market structure
The competitive forces- the five forces
• Threat of entry/barriers to entry- high barriers to entry means threat
of entry is low
• Power of suppliers
• Power of buyers
• Threat of substitutes
• Rivalry among existing competitors
Different barriers to entry
• 1. Economies of scale
• Product specific economies of scale
• Low set up costs as a percentage of total costs
• More specialised machining and tooling
• Plant specific economies of scale
• Engineers 2/3 rule: since the area of a sphere or cylinder varies as two thirds power of
volume, the cost of constructing process engineering plants can be expected to rise as
two thirds power of their output capacity (this rule applies to petroleum refining,
cement making, iron ore reductions and steel conversion)
• Also economies of massed reserves
Multiproduct economies of scale
• Example – cost of (iron, steel) < cost (Iron) + cost (steel)
• Key idea- shareable input – in this case, thermal economies in the production
of iron and steel
• Other examples- aircraft, automobiles, consumer electronics, household
appliances, personal computers, software, power tools
Multi plant economies of scale
• Economies of multi plant production, investment and physical
distribution
Supply side economies of scale
• Firms that produce at large volumes enjoy lower costs per unit
• Spread fixed costs over more units
• Employ more efficient technology
• Command better terms from suppliers
• New entrants have to accept a cost disadvantage
Demand side benefits of scale
• Network effects due to which a buyer's willingness to buy a product
increases with the number of buyers
Barriers to entry: intended excess capacity
• Building extra capacity for the intended purpose of deterring entrants
from entering the industry
• Excess capacity deters entry by increasing the credibility of price
cutting as an entry response by the incumbents
• E.g Dupont in the production of Titanium dioxide for paint
Barriers to entry: product differentiation
• Brand identification and customer loyalty to incumbent products may
be a barrier to potential entrants (e.g Coca Cola)
Examples of economies of scope
• Aircraft- common wing, nose, and tail components allow several
models to be leveraged using different numbers of fuselage modules
to create aircraft of different lengths and passenger capacities by
Boeing and Airbus
• Automobiles- the Taurus platform was leveraged to provide the basis
for Taurus Sedans and Mini vans
• Consumer electronics: over 160 variations of the Sony Walkman were
leveraged by mixing and matching modular components in a few basic
system designs (Legos)
Barriers to entry- experience curve
advantages
• E.g. in chemical industry it is found that each doubling of plant scale
over time was accomplished by an 11% reduction in unit costs
Barriers to entry- capital requirements/
switching costs
• Capital requirements – eg electronics, processors
• High switching costs of buyers-
• E.g. changing my require employee retraining, for example in computer
software
Barriers to entry- access
• Access to distribution channels- e.g. self space
• Favourable access to raw materials and to markets- e.g. through
exclusive dealing arrangements or favourable geographic locations
Barriers to entry- proprietary technology
• Product know how
• Low cost product design
• Patents and other government restrictiosn
Barriers to entry- high exit costs
• Exit barriers of incumbents can be entry barriers to potential entrants
• High exogenous and endogenous sunk costs- not just high fixed costs
• High asset specificity
• High illiquid assets
• Low salvage value if exit occurs
• High switching costs
• Low mobility of assets
• Credible commitments
• Irreversible investment (e.g. pipelines)
High power of suppliers - if
• Dominated by a few companies
• No substitutes for supplier products
• Supplier products are differentiated
• Incumbents face high switching costs
• Product is important input to the buyer
• Forward integration is a threat
• Suppliers exert power by threatening to raise prices or reduce
quality, and powerful suppliers can squeeze industry profitability
Power of buyers is high if
• A few large buyers (potential collusion)
• Large buyers relative to a seller
• Products are standardized and undifferentiated
• Buyers face few switching costs
• High switching costs for sellers
• Backward integration is credible buyer has full information)
• Buyers compete with the supplying industry by – bargaining down
prices, forcing higher quality and by playing firms off each other
Threat of substitutes is high if
• Substitute is good price-performance trade off
• Buyers switching costs to substitute is low
• Products with similar functions limit the prices that firms can charge
Incumbent rivalry is high if
• Many competitors in the industry- if industry concentration is low
• Firms are of equal size
• Industry growth is slow or shrinking – overcapacity is high
• Exit barriers are high
• Du to contractual obligations
• Geographies or historical attachments
• Products and services are direct substitutes (or product
differentiation is low)
Degree of rivalry
• Advertising battles may well expland or enhance the level fo product
differentiation in the industry for the benefit of all firms
The uses of industry analysis
• Static analysis- how do we explain current rivalry and profitability?
• Dynamic analysis- where is the industry likely to be in the future?
Industries evolve over time as the
relationships between the five forces change
Five forces or six: complements?
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Typical phases within the industry life cycle

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Industry KSF

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