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CHAPTER 2
Analyzing the External
Environment of the Firm:
Creating Competitive
Advantages

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Learning Objectives
After reading this chapter, you should be able to:
1. Understand the importance of developing forecasts of the business
environment.
2. Explain why environmental scanning, environmental monitoring, and
collecting competitive intelligence are critical inputs to forecasting.
3. Explain why scenario planning is a useful technique for firms
competing in industries characterized by unpredictability and
change.
4. Recognize the impact of the general environment on a firm’s
strategies and performance.
5. Explain 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.
6. Understand the concept of strategic groups and their strategy and
performance implications.

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 Looking Ahead

Enhancing Awareness of the External

Environment.
The General Environment.
The Competitive Environment.

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 The Important of External Environment

Consider …
Successful managers 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 and 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 and 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 is an in-depth approach.
• What are some of the ways trends may affect an issue?
• Can we project alternative futures based on these
assessments?

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 Question 1

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.
• A firm’s internal conditions = Strengths and
Weaknesses.
• Where the firm excels or where it may be lacking.

• Any environmental or external conditions =

Opportunities and Threats.
• Developments that exist in the general environment.
• Activities among firms competing for the same
customers in an industry.

• Must consider both internal and 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 Social Segment

Sociocultural forces influence the values,

beliefs, and lifestyles of a society.
• More women in the workforce.
• Increase in temporary workers.
• Greater concern for fitness.
• Greater concern for the environment.
• Postponement of family formation.

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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) of 1990.
• Deregulation of utilities & other industries.
• Increases in federally mandated minimum wages.
• Taxation at local, state, federal levels.

• Legislation on corporate governance reforms in

bookkeeping, sock options, and so forth (Sarbanes-Oxley
act of 2002).
• Affordable Care Act (Obamacare)
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 The Technological Segment
Technological developments lead to new products
and services. They can create new industries and
alter existing ones.
• Genetic engineering.
• Three-dimensional (3D) printing.
• Research in synthetic & exotic materials.
• Miniaturization of computing technologies.
• Wireless communications.
• Nanotechnology.
• Big Data Analytics

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 The Economic Segment

Economic forces affect all industries.

• Interest rates.
• Unemployment.
• Consumer Price Index.
• Trends in GDP.
• Changes in stock market valuations.
• National debt.

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 The Global Segment

Global forces offer both opportunities & risks.

• Changes in global trade.
• Currency exchange rates.
• Emergence of the Indian and 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.
• Political/legal trends can have very different effects
on different industries.
• Greater access to information technology affects
both economics and global relationships.
• The digital economy and the use of data
analytics has altered the way business is
conducted in nearly every business domain.

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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.
Access the text alternative for slide images.

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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

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 and
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
Threat of New Entrants
Bargaining Power of Buyers
Bargaining Power of Suppliers
Threat of Substitutes
Intensity of Rivalry
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Benefits to Industry
• Can offer premium services.
• Gain access to previously closed
distribution channels or
manufacturers.
• Reduces the power of buyer
intermediaries in many
distribution channels.
• Online procurement methods
can increase bargaining power
over suppliers.
• Reintermediation creates
opportunities for new suppliers.
• Internet-based increases in
overall efficiency can expand
industry sales.
• If capable, can use digital
technologies to create a distinct
image, unique offerings,
smarter service delivery options
to differentiate themselves.
Disadvantages to
Industry
• Lower barriers to entry increased
number of entrants.
• Many Internet-based capabilities
can be easily imitated.
• Switching costs decrease.
• Information availability online
empowers and users.
• The Internet gives suppliers access
to more customers and makes it
easier to reach end users.
• Online procurement practices deter
competition and reduce
differentiating features.
• Internet-based storage capabilities
create more opportunities for
substitution.
• 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 via infomediaries.
 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.
Access the text alternative for slide images

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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.
• i.e. percentages of total cost or sales accounted for by the
industry, actual switching costs

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 Strategy 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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 Strategy 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.
Access the text alternative for slide images.

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