e: The Accountant's

(1976): 447
\ccounting Rates of
'ategies Create Value
g and Managing the
k," Harvard Business
I Review 50 (1943):
Ie highest being that
at potential that goes
3
Analyzing the Industry
Environm.ent
The reinsurance business has the defect of being too attractive-looking to
new entrants for its own good and will therefore always tend to be the
opposite of, say, the old business of gathering and rendering dead horses
that always tended to contain few and prosperous participants.
-Charles T. Munger, Chairman, Wesco Financial Corp.
(extract from the 1986 Annual Report)
OUTLINE
INTRODUCTION AND OBJECTIVES
FROM ENVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSIS
THE DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION
ANALYZING ATTRACTIVENESS
Porter's Five Forces of Competition Framework
Competition from Substitutes
Threat of Entry
Rivalry Between Established Competitors
Bargaining Power of Buyers
Bargaining Power of Suppliers
ApPLYING INDUSTRY ANALYSIS
Forecasting Industry Profitability
Strategies to Alter Industry Structure
DEFINING INDUSTRIES: IDENTIFYING THE RELEVANT MARKET
BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, AND
COOPERATION
Schumpeterian Competition
Hypercompetition
The Contribution of Game Theory
OPPORTUNITIES FOR COMPETITIVE AnvANTAGE: IDENTIFYING KEy SUCCESS
FACTORS
SUMMARY
51
52 A N A L Y Z I ~ G THE INDUSTRY ENVIRONMENT
~ I INTRODUCTION AND OBJECTIVES
In this chapter and the next we turn our attention to analyzing the external environ
ment of the firm. In Chapter 1 we observed that profound understanding of the
competitive environment is a critical ingredient of a successful strategy. We further
noted that for business enterprises, strategy is essentially a quest for profit. Our pri
mary task in this chapter is to identifY the sources of profit in the business environ
ment.
The distinction between corporate-level and business-level strategy is relevant
here. Corporate strategy is concerned with deciding which industries the firm
should be engaged in and with the allocation ofcorporate resonrces among them. To
make such decisions, it is vital that the firm evaluate the attractiveness of different
industries in terms of their potential to yield profit in the future. The primary objec
tive of this chapter is to analyze how competition determines industry profitability.
Once the determinants of industry profitability are understood, it is possible to fore
cast the future profit potential of an industry.
Business strategy is concerned with establishing competitive advantage. Identi
fYing the basis of and opportunities for competitive advantage requires an understand
ing of competition within the industry. It also requires that we understand customers,
their needs and motivations, and the means by which these needs are satisfied.
By the time you have completed this chapter you will be able to:
IdentifY the main structural features of an industry that influence competi
tion and profitability.
Apply this analysis and explain why some industries are more profitable than
others.
Use evidence on structural trends within industries to forecast changes in
industry profitability in the future.
IdentifY the opportunities available to influence industry structure in order to
alleviate the pressures of competition and improve industry profitability.
Appreciate the roles of both competitive and cooperative behavior in seeking
profit within an industry. FI
Analyze competition and customer requirements in order to identifY oppor
tunities for competitive advantage within an industry.
FROM E1\TVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSIS
The business environment of the firm consists of all the external influences that
impact a firm's decisions and performance. The problem here is that, given the vast
number and range of external influences, how can managers hope to monitor, let
alone analyze, environmental conditions? The starting point is some kind of system
or framework for organizing information. For example, environmental influences can
be classified by source into economic, technological, demographic, social, and gov
ernmental factors; or by proximity: the "micro-environment" or "task environment"
can be distinguished from the wider influences that form the "macro-environment."
Though systematic, continuous scanning of the whole range of external influ
ences might seem desirable, such extensive environmental analysis is unlikely to be
cost effective and creates information overload. The Royal Dutch/Shell Group, one
53 FROM ENVIRONMENTAL ANALYSIS TO INDUSTRY ANALYSIS , ENVIRONMENT
external environ
:rstanding of the
ltegy. We further
r profit. Our pri
>usiness environ
rategy is relevant
lustries the firm
among them. To
:ness of different
Ie primary objec
stry profitability.
possible to fore
:lvantage. Identi
:s an understand
:stand customers,
satisfied.
I:
iuence competi
e profitable than
~ c a s t changes in
I
ture in order to
rofitability.
avior in seeking
identifY oppor
influences that
given the vast
to monitor, let
kind of system
influences can
cial, and gov
environment"
nvironment."
external influ
unlikely to be
11 Group, one
FIGURE 3.1
The Business Environ
ment
of the world's largest and most international enterprises, invests more heavily in the
systematic monitoring and analysis of its business environment than most other
companies. Its scenario analysis (which we look at in detail in Chapter 10) is excep
tionally far-sighted and wide-ranging in assessing its business environment. Never
theless, the group's environmental scanning and analysis focuses on factors that are
directly relevant to its strategic planning: in particular, those factors that influence
the demand and supply of oil and refined products.
1
The prerequisite for effective environmental analysis is to distinguish the vital
from the merely important. Let's return to first principles. For the firm to make
profit it must create value for customers. Hence, the firm must understand its cus
tomers. Second, in creating value, the firm acquires goods and services from suppli
ers. Hence, the firm must understand its suppliers and how to form business
relationships with them. Third, the ability to generate profitability from value-creat
ing activity depends on the intensity of competition among the firms that vie for the
same value-creating opportunities. Hence, the firm must understand competition.
Thus, the core of the firm's business environment is formed by its relationships with
customers, suppliers, and competitors. This is the firm's industry environment.
This is not to say that macro-level factors such as general economic trends,
changes in demographic structure, or social and political trends are unimportant to
strategy analysis. These factors may be critical determinants of the threats and
opportunities a company will face in the future. The key issue is how these more
general environmental factors impact the firm's industry environment (Figure 3.1).
For most firms, global warming is not a crtical issue. For the producers of automo
biles, oil, and electricity, it is important since government measures to restrict the
production of carbon dioxide and other greenhouse gases will directly affect the
demand for their products and their costs of doing business. By focusing on the
industry environment, we can determine which of the macro-level influences are
important for the firm and which are not.'
54 ANALYZING THE INDUSTRY ENVIRONMENT
THE DETERMINANTS OF INDUSTRY PROFIT: DEMAND AND COMPETITION
If the purpose of strategy is to help the firm to survive and make money, the starting
point for industry analysis is: What determines the level of profit in an industry?
As already noted, business is about the creation of value for the customer. Firms
create value by production (transforming inputs into outputs) or arbitrage (transfer
ring products across time and space). Value creation requires that the price the cus
tomer is willing to pay the firm exceed the costs incurred by the firm. But value
creation does not translate directly into profit. The surplus of value over cost is dis
tributed between customers and producers by the forces of competition. The stron
ger the competition among producers, the lower the price actually paid by customers
compared with the maximum price they would have been willing to pay. In other
words, the greater the proportion of the surplus gained by customers (consumer sur
plus), the less is earned by producers (producer surplus or economic rent). A single sup
plier of bottled water at an all-night rave can charge a price that fully exploits the
dancers' thirst. If there are many suppliers of bottled water, then, in the absence of
collusion, competition causes the price of bottled water to fall toward the cost of
supplying it.
The surplus earned by producers over and above the minimum costs of produc
tion is not entirely captured in profits. Where an industry has powerful suppliers
monopolistic suppliers of components or employees united by a strong labor
union-then a substantial part of the surplus may be appropriated by these suppliers
(the profits of suppliers or premium wages of union members).
The profits earned by the firms in an industry are thus determined by three
factors:
The value of the product or service to customers
The intensity of competition
The relative bargaining power at different levels in the production chain.
Our industry analysis brings all three factors into a single analytic framework.
-1 ANALYZING INDUSTRY ATTRACTIVENESS
Table 3.1 shows the average rate of profit earned in different U.S. industries. Some
industries (such as tobacco and pharmaceuticals) consistently cam high rates of
profit; others (such as iron and steel, nonferrous metals, airlines, and basic building
materials) have failed to cover their cost of capital. The basic premise that underlies
industry analysis is that the level of industry profitability is neither random nor the
result of entirely industry-specific influences, but is determined, in part at least, by
the systematic influence of industry structure. As an example of how an attractively
structured industry can support a superior profitability, consider the cases of the sau
sage skin manufacturer, Devro, and tobacco products supplier, UST (see Exhibit 3.1).
The underlying theory of how industry structure drives competitive behavior
and determines industry profitability is provided by industrial organization (10)
economics. The two reference points are the theory of monopoly and the theory of
perfect competition, which represent the two ends of a spectrum of industry struc
tures. A single firm protected by barriers to the entry of new firms forms a monop
oly in which it can appropriate in profit the full amount of the value it creates. By
contrast, many firms supplying an identical product with no restrictions on entry or
STRY ENVIRONMENT
AiYZING INDUSTRY ATTRACTIVENESS 55
IMPETITION
Industry Return on Equity (1985-95)
te money, the starting
,fit in an industry?
r the customer. Firms
Jr arbitrage (transfer
hat the price the cus
{ the firm. But value
value over cost is dis
npetition. The stron
tlly paid by customers
!ling to pay. In other
tomers (consumer Jur
ic rent). A single sup
hat fully exploits the
en, in the absence of
11 toward the cost of
Ilum costs of produc
powerful suppliers
[ by a strong labor
:ed by these suppliers
determined by three
Drugs
Food and kindred products
-of which Tobacco products
Instruments and related products
Printing and publishing
Electrical and electronic equipment
Aircraft, guided missiles, and parts
Fabricated metal products
Rubber and misc. plastics products
Paper and allied products
Retail trade corporations
Petroleum and coal products
Textile mill products
Wholesale trade corporations
Stone, glass and clay products
Machinery, exc. electrical
Nonferrous metals
Motor vehicles and equipment
Iron and steel
Mining corporations
Airlines
19.39%
13.85%
18.60%
11.24%
10.16%
10.00%
.8.36%
8.15%
9.95%
8.47%
8.37%
7.88%
7.25%
5.72%
5.28%
4.29%
4.21%
2.61%
1.30%
1.24%
(2.84%)
lroduction chain.
I
ralytic framework.
.S. industries. Some
earn high rates of
and basic building
mise that underlies
er random nor the
in part at least, by
how an attractively
e cases of the sau
(see Exhibit 3.1).
petitive behavior
organization (10)
and the theory of
of industry struc
s forms a monop
alue it creates. By
'ctions on entry or
Source: Federal Trade Commission
exit constitutes perfect competition: the rate of profit falls to a level that just cov
ers firms' cost of capital. In the real world, industries fall between these two
extremes. The U.S. market for smokeless tobacco is close to being a monopoly, the
Chicago grain markets are close to being perfectly competitive. Most manufactur
ing industries and many service industries tend to be oligopolies: they are domi
nated by a small number of major companies. Figure 3.2 identifies some key points
on the spectrum. By examining the principal structural features and their interac
tions for any particular industry, it is possible to predict the type of competitive
behavior likely to emerge and the resulting level of profitability.
Porter's Five Forces of Cmnpetition Framework
Figure 3.2 identifies four structural variables influencing competition and profitabil
ity. In practice, there are many features of an industry that determine the intensity of
competition and the level of profitability. A helpful, widely used framework for clas
sifYing and analyzing these fators is the one developed by Michael Porter of Har
vard Business School.
2
Porter's Five Forces of Competition framework views the
profitability of an industry (as indicated by its rate of return on capital relative to its
00 ANALYZING THE INDUSTRY
EXHIBIT 3.1
Sausage Skins and Chewing Tobacco: The Joys of Dominating Niche Markets
Devro International pte is a Scottish company
with headquarters in the village of Moodiesburn
near Glasgow. With 930 employees and plants in
Scotland, Australia, and the United States, Devro
holds 56 percent of the world market for col
lagen sausage skins. The company was listed on
the London Stock Exchange in 1993, two years
after a management buyout from its parent,
Johnson & Johnson. During 1991 and 1992, oper
ating profits averaged 25 percent of sales reve
nue. Devro holds 94 percent of the UK market,
83 percent of the Australian market, and 40 per
cent of the U.S. market. Although collagen cas
ings are a substitute for natural gut sausage
casings, collagen possesses some clear advan
tages that have resulted in the steady displace
ment of natural gut. Scale economies.,
technology, and Devro's absolute cost advan
tages pose substantial barriers to would-be
entrants. Because casings account for only a
small proportion of the sausag.e manufacturers'
total costs, they are relatively insensitive to the
price of casing and do not exert substantial bar
gaining power.
UST Inc. (Formerly U.s. Tobacco) has the dis
tinction of earning the highest return on equity
FIGURE 3.2
The Spectrum
of Industry
Structures
of any company in Fortune's listings (165 percent
in 1996, 146 percent in 1995). UST dominates the
U.S. market for "smokeless tobacco" (chewing
tobacco and snuff) with a market share of 78
percent (in a range of brands including Skoal,
Copenhagen, Long Cut, and Red Seal). Despite its
association with a bygone era of cowboys and
rural poverty, chewing tobacco has been a
growth market over the past two decades with a
surprisingly large number of young consumers.
usn brands, its distribution
through tenS of thousands of small retail outlets,
and the unwillingness of major tobacco compa
nies to enter thiS market (due to the poor image
and social unacceptability of the product), have
supPorted UST's unassailable market position.
Federal controls on the advertising of smokeless
tobacco products introduced in 1986 have but
tressed UST's market position by limiting the
opportunities for would-be entrants to market
their products.
Source: James Buxton, "A Leaner Business That
Has More Bite," Financial Times, April 16, 1993,
p. 33; Standard & Poor's Stock Reports.
.. i
"

rRY ENVIRONMENT
ANALYZI,\lG INDUSTRY ATTRACTIVENESS 57
(165 percent
tdomihates the
(chewing
share of 78
Skoal,
ie.tl). Despite its
colNboys and
!t. has been a

Img consumers.
... distribution
outlets.
rpbacco compa
Pt.e pOor image
ltproduct), have
position.

but
It..d,.ulimiting the
riMs to ma rkat
r
P"
80slness That
rll 16. 1993,
cost of capital) as determined by five sources of competitive pressure. These five
forces of competition include three sources of"horizontal" competition: competition
from substitutes, competition from entrants, and competition from established
rivals; and two sources of "vertical" competition: the bargaining power of suppliers
and buyers (see Figure 3.3).
The strength of each of these competitive forces is determined by a number of
key structural variables as shown in Figure 3.4.
Competition from Substitutes
.
The price customers are willing to pay for a product depends, in part, on the avail
ability of substitute products. The absence of close substitutes for a product, as in
the case ofgasoline or cigarettes, means that consumers are comparatively insensi
tive to price, i.e., demand is inelastic with respect to price. The existence of close
substitutes means that customers will switch to substitutes in response to price
increases for the product, i.e., demand is elastic with respect to price. The intro
duction of digital personal communication services (peS) in the United States by
Sprint Spectrum and Nextel and in the UK by Hutchinson Orange has increased
the substitute competition faced by traditional cellular companies and lowered
their margins.
FIGURE 3.3
Porter's Five Forces of
Competition Frame
work
58
FIGURE 3.4
The Structural Deter
minants of Competi
tion and Profitability
within the Porter
Framework
ANALYZING THE INDUSTRY ENVIRONMENT ANAl
SUPPLIER POWER
Factors determining power of suppliers
relative to producers; same as those
determining power of producers relative
to buyers see "Buyer Power" box.
Economies of scale
Absolute cost advantages
Capital requirements
Product differentiation
Access to distribution
channels
Government and legal
barriers
Retaliation by established
producers
The extent to which substitutes limit prices and profits depends on the pro
pensity of buyers to substitute between alternatives. This, in turn, is dependent on
their price-performance characteristics. If city-center to city-center travel
between Washington and New York is two hours quicker by air than by train and
the average traveler values time at $25 an hour, the implication is that the train
will be competitive with air at fares of $50 below those charged by the airlines.
The more complex the needs being fulfilled by the product and the more difficult
it is to discern performance differences, the lower the extent of substitution by
customers on the basis of price differences. The failure oflow-priced imitations of
leading perfumes to establish significant market share reflects, in part, consumers'
difficulty in discerning the performance characteristics of different fragrances.
I
ITRY ENVIRONMENT
i
TOF SUBSTITUTES
opensity to substitute
price performance of
es
ends on the pro
, is dependent on
ity-center travel
than by train and
is that the train
d by the airlines.
the more difficult
f substitution by
iced imitations of
part, consumers'
nt fragrances.
nING INDUSTRY ATTRACTIVENESS 59
Threat of Entry
If an industry earns a return on capital in excess of its cost of capital, that industry
acts a magnet to firms outside the industry. Unless the entry of new firms is barred,
the rate of profit will fall toward its competitive level. The U.S. bagel industry, for
example, faced a flood of new entrants in 1996, which caused a sharp diminution of
profit prospects. The threat of entry rather than actual entry may be sufficient to
ensure that established firms constrain their prices to the competitive level. Only
American Airlines offers a direct service between Dallas/Fort Worth and Santa
Barbara, California. Yet American may be unwilling to exploit its monopoly posi
tion if other airlines can easily extend their routes to cover the same two cities. An
industry where no barriers to entry or exit exist is prices and profits
remain at the fully competitive level, regardless of the number of firms within the
industry.3 Contestability depends on the absence of sunk costs. Sunk costs exist
where entry requires investment in industry-specific assets whose value cannot be
recovered on exit. An absence of sunk costs makes an industry vulnerable to "hit
and-run" entry whenever established firms raise their prices above the competitive
level.
In most industries, however, new entrants cannot enter on equal terms with
those of established firms. The size of the advantage of established over entrant firm
(in terms of unit costs) measures the height of barriers to entry. which determines
the extent to which the industry can, in the long run, enjoy profit above the compet
itive level. The principal sources of barriers to entry are: capital requirements, econ
omies of scale, cost advantages, product differentiation, access to channels of
distribution, governmental and legal barriers, and retaliation.
Capital Requirements. The capital costs of getting established in an industry
can be so large as to discourage all but the largest companies. The duopoly of Boeing
and Airbus in large passenger jets is protected by the prohibitive costs of establishing
such a venture. In satellite television broadcasting in Britain, Rupert Murdoch's Sky
TV incurred almost $1 billion in capital costs and operating losses and Robert Max
well's British Satellite Broadcasting spent some $1.8 billion before the two merged
in 1991. In other industries, entry costs can be modest. Start-up costs for franchised
fast-food restaurants are around $280,000 for a Wendy's and $800,000 for a Burger
King.
4
Economics of Scale. In industries that are capital or research or advertising
intensive, efficiency requires large-scale operation. The problem for new entrants is
that they are faced with the choice of either entering on a small scale and accepting
high unit costs, or entering on a large scale and running the risk of drastic underuti
lization of capacity while they build up sales volume. Thus, in large jet engines,
economies of scale in R&D and manufacturing have caused consolidation into just
three producers (General Electric, Pratt & Whitney, and Rolls-Royce), which are
protected by very high barriers to entry. Economies of scale in automobiles have
deterred entry into that industry: recent entrants such as Ssangyong of Korea and
Proton of Malaysia have incurred huge losses trying to establish themselves.
Absolute Cost Advantages. Apart from economies of scale, established firms
may have a cost advantage over entrants simply because they entered earlier.
-
60 ANALYZING THE INDUSTRY ENVIRONMENT
ANA
Absolute cost advantages tend to be associated with the acquisition of low cost
sources of raw materials or economies of learning.
Product Differentiation. In an industry where products are differentiated,
established firms possess the advantages of brand recognition and customer loyalty.
The percentage of U.S. consumers loyal to a single brand varies from under 30 per
cent in batteries, canned vegetables, and garbage bags, up to 61 percent in tooth
paste, 65 percent in mayonnaise, and 71 percent in cigarettes.
5
New entrants to such
markets must spend disproportionately heavily on advertising and promotion to gain
levels of brand awareness and brand goodwill similar to that of,established compa
nies. One study found that, compared to early entrants, late entrants into consumer
goods markets incurred additional advertising and promotional costs amounting to
2.12 percent of sales revenue.
6
Alternatively, the new entrant can accept a niche
position in the market or can seek to compete by cutting price. In producer goods
too, reputation and close customer-supplier relationships impose similar problems
for new entrants. Despite their huge financial resources, most U.S. commercial
banks have chosen to enter investment banking by means of acquiring existing
investment banks.
Access to Channels of Distribution. Whereas lack of brand awareness
among consumers acts as a barrier to entry to new suppliers of consumer goods, a
more immediate barrier for the new company is likely to be gaining distribution.
Limited capacity within distribution channels (e.g., shelf space), risk aversion by
retailers, and the fixed costs associated with carrying an additional product result in
distributors'reluctance to carry a new manufacturer's product. In the United States
and Britain, food and drink processors are increasingly required to make lump-sum
payments to the leading supermarket chains in order to gain shelf space for a new
product.
Governmental and Legal Barriers. Some economists claim that the only
effective barriers to entry are those created by government. In taxicabs, banking,
telecommunications, and broadcasting, entry usually requires the granting of a
license by a public authority. In knowledge-intensive industries, patents, copyrights,
and trade secrets are major barriers to entry. Xerox Corporation's near monopoly
position in the world plain-paper copier business until the mid-1970s was protected
by a wall of over 2,000 patents relating to its xerography process. In industries sub
ject to regulation and environmental and safety standards, new entrants may be at a
disadvantage to established firms because compliance costs weigh more heavily on
newcomers.
Retaliation. The effectiveness of the barriers to entry also depends on the
entrants' expectations as to possible retaliation by established firms. Retaliation
against a new entrant may take the form of aggressive price cutting, increased adver
tising, sales promotion, or litigation. British Airways' retaliation against competition
from Virgin Atlantic on its North Atlantic routes included not only promotional
price cuts and advertising, but also a variety of"dirty tricks" such as accessing Virgin's
computer system, poaching its cus!omers, and attacking Virgin's reputation. South
west and other low-cost airlines have alleged that selective price cuts by American
and other major airlines amounted to predatory pricing designed to drive them out of
ENVIRONMENT
ANALYZING INDUSTRY ATTRACTIVENESS 61
differentiated,
ustomer loyalty.
under 30 per
rcent in tooth
entrants to such
omotion to gain
blished compa
s into consumer
ts amounting to
accept a niche
producer goods
imilar problems
.5. commercial
quiring existing
rand awareness
nsumer goods, a
.ng distribution.
risk aversion by
product result in
e United States
make lump-sum
space for a new
that the only
.cabs, banking,
e granting of a
tents, copyrights,
near monopoly
Os was protected
n industries sub
ants may be at a
more heavily on
depends on the
ms. Retaliation
, increased adver
.nst competition
Ionly promotional
Iaccessing Virgin's
South
cuts by American
drive them out of
business. The likelihood of retaliation is influenced by the scale of entry. When Japa
nese firms first entered the U.S. car and consumer electronics markets, they sought to
avoid retaliation by introducing small products in segments that were deemed
unprofitable by U.S. producers. A successful retaliatory strategy is one that deters
entry by using a threat that is credible enough to intimidate would-be entrants.
7
The Effect;veness of Barriers to Entry. Studies by Bain
8
and Mann
9
found
profitability was higher in industries with "very high entry barriers" than in those
with "substantial" or "moderate to low" barriers. Capital intensity and advertising are
key variables that increase entry barriers and raise industry profitability. 10
Whether barriers to entry are effective in deterring potential entrants depends
on the resources of the potential entrants. Barriers that are effective for new compa
nies may be ineffective for firms that are diversifying from other industries. George
Yip found no evidence that entry barriers deterred new entry.ll Entrants were able
to successfully overcome entry barriers for one of two reasons. Some possessed
resources and capabilities that permitted them to surmount barriers and compete
against incumbent firms using similar strategies. American Express, for example,
used its brand name to enter a broad range of financial service markets, and Mars
used its strong position in confectionery to enter the ice cream market.
12
Others
successfully circumvented entry barriers by adopting different strategies from those
of incumbent firms. Southwest Airlines used a low-cost, "no-frills" strategy to chal
lenge the major U.S. airlines. Dell Computer used direct-mail distribution and tele
phone-based customer service to bypass established distribution channels.
Rivalry Between Established COlllpetitors
For most industries, the major determinant of the overall state of competition and the
general level of profitability is competition among the firms within the industry. In
some industries, firms compete aggressively-sometimes to the extent that prices are
pushed below the level of costs and industry-wide losses are incurred. In others, price
competition is muted and rivalry focuses on advertising, innovation, and other non
price dimensions. Six factors play an important role in determining the nature and
intensity of competition between established firms: concentration, the diversity of
competitors, product differentiation, excess capacity, exit barriers, and cost conditions.
ConcentraNon. Seller concentration refers to the number and size-distribution
of firms competing within a market. Seller concentration is most commonly mea
sured by the concentration ratio: the combined market share of the leading pro
ducers. For example, the four-firm concentration ratio (conventionally denoted
"CR4") is the market share of the four largest producers. A market dominated by
a single firm, e.g., Xerox in the U.S. plain-paper copier market during the early
1970s, or UST in the U.S. smokeless tobacco market, displays little competition
and the dominant firm can exercise considerable discretion over the prices it
charges. Where a market is dominated by a small group ofleading companies (an
oligopoly), price competition may also be restrained, either by outright collusion,
or more commonly through "parallelism" of pricing decisions.
13
Thus, in markets
dominated by two companies, such as alkaline batteries (Duracell and Eveready),
color film (Kodak and Fuji), and soft drinks (Coke and Pepsi), prices tend to be
similar and competition focuks on advertising, promotion, and product develop
ment. As the number of firms supplying a market increases, coordination of prices
62 ANALYZING THE INDUSTRY ENVIRONMl:iNT
TABLE 3.2
The Relationship
Between Real
Market Growth
and Profitability
becomes more difficult, and the likelihood that one firm will initiate price cutting
increases. Despite the strong theoretical arguments, the effect of seller concentra
tion on profitability has been hard to pin down empirically. Richard Schmalensee
concludes that: "The relation, if any, between seller concentration and profitabil
ity is weak statistically and the estimated effect is usually small.,,14
Diversity of Competitors. The ability of firms in an industry to avoid price
competition also depends on their similarities in terms of origins, objectives, costs,
and strategies. The cozy atmosphere of the U.S. steel industry prior to the advent of
import competition and the new mini-mills was possible because of the similarities of
the companies and the outlooks of their senior managers. By contrast, the inability of
OPEC to maintain prices and output quotas is a consequence of differences in objec
tives, production costs, language, politics and religion among member countries.
Product Differentiation. The more similar the offerings among rival firms, the
more willing customers are to substitute and the greater the incentive for firms to cut
prices to increase sales. Where the products of rival firms are virtually indistinguishable,
the product is a commodity and price is the sole basis for competition. Commodity
industries such as agriculture, mining, and basic materials tend to be plagued by price
wars and low profits. By contrast, in industries where products are higWy differentiated
(perfumes, pharmaceuticals, restaurants, management consulting services), price com
petition tends to be weak, even though there may be many firms competing.
Excess Capacity and Exit Barriers. Why does industry profitability tend to
fall so drastically during periods of recession? The key is the balance between demand
and capacity. Unused capacity encourages firms to offer price cuts to attract new busi
ness in order to spread fixed costs over a greater sales volume. Excess capacity may
not be just cyclical, but part of a structural problem due to over-investment and stag
nant or declining demand. In such situations, the issue is whether excess capacity will
leave the industry. Barriers to exit are costs associated with capacity leaving an indus
try. Where resources are durable and specialized, and where employees are entitled to
job protection, barriers to exit may be substantial.
15
Depressed profits in the Euro
pean oil refining industry are the result oflow demand, over-investment, and barriers
to exit in the form of refinery dismantling, environmental cleanup, and employee
redundancy. Conversely, growth industries tend to be subject to capacity shortages,
which boost profitability, although cash flow in rapidly growing industries can be
negative due to high rates of investment (see Table 3.2).
REAL ANNUAL RATE OF MARKET GROWTH
Less than -5% -5% to 0 Oto 5% 5% to 10% Over 10%
Gross margin on sales 23.5 25.6 26.9 25.7 29.7
Return on sales 7.8 8.3 9.1 8.3 9.4
Return on investment 20.6 23.0 23.2 22.2 26.6
Cash flow/Investment 6.0 4.9 3.5 2.4 -0.1
Source: R. D. Buzzell and B. T. Gale. The PIMS Principles (New York: Free Press, 1987) pp. 56-57.
63
I
ANALYZING INDUSTRY ATTRACTIVENESS Y ENVIRONMENT
price cutting
seller concentra
t:hard Schmalensee
and profitabil

to avoid price
objectives, costs,
to the advent of
pf the similarities of
the inability of
in objec
rber countries.
ong rival firms, the
tive for firms to cut
y indistinguishable,
tition. Commodity
be plagued by price
'ghly differentiated
rvices), price com
mpeting.
rofitability tend to
ce between demand
to attract new busi
cess capacity may
vestment and stag
excess capacity will
ty leaving an indus
yees are entitled to
rofits in the Euro
tment, and barriers
up, and employee
capacity shortages,
g industries can be
,to 10% Over 10%
25.7 29.7
8.3 9.4
22.2 26.6
2.4 -0.1
)ress, 1987) pp. 56-57.
Cost Conditions: Scale Economies and the Ratio ofFixed to variable Costs.
When excess capacity causes price competition, how low will prices go? The key factor is
cost structure. Where fixed costs are high relative to variable costs, firms will take on
marginal business at any price that covers variable cost. The consequences for profitabil
ity can be disastrous. From 1990 to 1995, the total losses of the U.S. airline industry
exceeded total profits during the previous three decades. The willingness of airlines to
offer heavily discounted tickets on flights with low bookings reflects the fact that the
variable costs associated with filling empty seats on a scheduled flight are close to zero.
The devastating impact of excess capacity on profitability in petrochemicals, tires, steel,
and memory chips is a result ofhigh fixed costs in these busif\esses and the willingness of
firms to accept additional business at any price that covers variable cost.
Scale economies may also encourage companies to compete aggressively on
price in order to gain the cost benefits of greater volume. In consumer electronics,
automobiles, and semi-conductors, the cost benefits of market leadership are power
ful drivers of inter-firm competition.
Bargaining Power of Buyers
The firms in an industry operate in two types of markets: in the markets for inputs
they purchase raw materials, components, and financial and labor services from the
suppliers of these factors of production; in the markets for outputs they sell their
goods and services to customers (who may be distributors, consumers, or other
manufacturers). In both markets, the relative profitability of the two parties in a
transaction depends on relative economic power. Dealing first with the sales to cus
tomers, two sets of factors are important in determining the strength of buying
power: buyers' price sensitivity and relative bargaining power.
Buyers 1 Price Sensitivity. The extent to which buyers are senSItIve to the
prices charged by the firms in an industry depends upon four major factors.
The greater the importance of an item as a proportion of total cost, the more
sensitive buyers will be about the price they pay. Beverage manufacturers are
highly sensitive to the costs of metal cans because this is one of their largest
single cost items. Conversely, most companies are not sensitive to the fees
charged by their auditors, since auditing costs are such a small proportion of
overall company expenses.
The less differentiated the products of the supplying industry, the more will
ing the buyer is to switch suppliers on the basis of price. The manufacturers
ofT-shirts, light bulbs, and blank videotapes have much more to fear from
Wal-Mart's buying power than do the suppliers of perfumes.
The more intense the competition among buyers, the greater their eagerness
for price reductions from their sellers. As competition in the world automo
bile industry has intensified, so component suppliers are subject to greater
pressures for lower prices, higher quality, and faster delivery.
The greater the importance of the industry's product to the quality of the
buyer's product or service, the less sensitive are buyers to the prices they are
charged. The buying power of personal computer manufacturers relative to
the manufacturers or microprocessors (Intel, Motorola, Advanced Micro
Devices) is limited by the critical importance of these components to the
functionality of their product.
64 ANALYZING THE INDUSTRY ENVIRONMENT
Relative Bargaining Power. Bargaining power rests, ultimately, on refusal to
deal with the other party. The balance of power between the two parties to a trans
action depends on the credibility and effectiveness with that each makes this threat.
The key issue is the relative cost that each party sustains as a result of the transaction
not being consummated. A second issue is each party's expertise in leveraging its
position through gamesmanship. Several factors influence the bargaining power of
buyers relative to that of sellers.
Size andconcentration ofbuyers relative to suppliers. The smaller the number ofbuy
ers and the bigger their purchases, the greater the cost of losing one. Because of
their size, health maintenance organizations (HMOs) can purchase health care
from hospitals and doctors at much lower cost than caIi 6individual patients.
Buyers' information. The better informed buyers are about suppliers and their
prices and costs, the better they are able to bargain. Doctors and lawyers do
not normally display the prices they charge, nor do traders in the bazaars of
Tangier and Istanbul. Keeping customers ignorant of relative prices is an
effective constraint on their buying power. But knowing prices is of little
value if the quality of the product is unknown. In the markets for haircuts,
interior design, and management consulting, the ability of buyers to bargain
over price is limited by uncertainty over the precise attributes of the product
they are buying.
Ability to integrate vertically. In refusing to deal with the other party, the
alternative to finding another supplier or buyer is to do-it-yourself Large
food processors such as Heinz and Campbell's Soup have reduced their
dependence on the oligopolistic suppliers of metal cans by manufacturing
their own. The leading retail chains have increasingly displaced their suppli
ers' brands with their own brand products. Backward integration need not
necessarily occur-a credible threat may suffice.
Empirical evidence points to the tendency for buyer concentration to depress
prices and profits in supplying industries.
16
PIMS data show that the larger the aver
age size of customers' purchases and the larger the proportion of customers' total pur
chases the item represents, the lower the profitability of supplying firms.
17
Bargaining Power of Suppliers
Analysis of the determinants of relative power between the producers in an industry
and their suppliers is precisely analogous to the analysis of the relationship between
producers and their buyers. Since the factors that determine the effectiveness of sup
plier power against the buying power of the industry are the same as those that
determine the power of the industry against that of its customers, they do not
require a separate analysis.
Because raw materials, semi-finished products, and components tend to be com
modities supplied by small companies to large manufacturing companies, their suppli
ers usually lack bargaining power. Hence, commodity suppliers often seek to boost their
bargaining power through cartelization---e.g., OPEC, the International Coffee Orga
nization, and farmers' marketiog cooperatives. A similar logic explains labor unions.
PIMS studies of the impact of suppliers' bargaining power on firms' profitability
is complex. Increasing concentration of a firm's purchases is initially beneficial since it
permits certain economies of purchasing. Thereafter, increasing concentration among
65
19
7.9
Over 75%
18
7.9
23
9.0
24
9.0
PERCENTAGE OF EMPLOYEES UNIONIZED
1% TO 35% 35% TO 60% 60% TO 75%
25
10.8
None
Forecasting Industry Profitability
Decisions to commit resources to a particular industry must be based on anticipated
returns five to ten years in the future. Over these periods, profitability cannot be
accurately forecast by projecting current industry profitability. However, we can pre
dict changes in the underlying structure of an industry with some accuracy. Struc
tural changes are driven by current changes in product and process technology, the
current strategies of the leading players, the changes occurring in infrastructure and
in related industries, and by government policies. If we understand how industry
structure affects competition and profitability, we can use our projections of struc
tural change to forecast the likely changes in industry profitability.
The first stage is to understand how past changes in industry structure have
influenced competition and profitability. Exhibit 3.2 explains deteriorating profit
ability of the world automobile industry in terms of the structural changes that have
affected the five forces of competition. The next stage is to identify current structural
trends and determine how these will impact the five forces of competition and
resulting industry profitability. Consider the U.S. casino gambling industry (see
Exhibit 3.3). The current strategies of the companies and actions by regulatory
authorities have clear implications for structural changes in the industry. These
structural trends directly influence competition and profitability.
While it is not possible to predict with any confidence the quantitative impact
of structuraL changes, their qualitative impact is easier to assess. The main problem
is the difficulty of appraising the aggregate effect of multiple structural changes
where some are beneficial to profitability, others are detrimental. Thus, a key issue in
the casino industry is wheth.er the current merger wave will offset the tendency for
increasing excess capacity to depress profitability.
Once we understand how industry structure drives competition which, in turn, deter
mines industry profitability, then we can apply this analysis, first, to forecasting industry
profitability in the future and, second, to devising strategies to change industry structure.
purchasers results in decreased profitability due to increased supplier power. Supplier
power is significantly increased by forward integration into its customer's own indus
try. When a firm faces its suppliers as competitors within its own industry, its ROI is
reduced by two percentage points. Unionization is unambiguously associated with
decreasing profitability (see Table 3.3).
Source: R.D. Buzzell and B.T. Gale. The PIMS Principles: Linking Strategy to Performance
(New York: Free Press. 1987). p.67.
ROI(%)
ROS(%)
APPLYING INDUSTRY ANALYSIS
alier the number ofbuy
oflosing one. Because of
can purchase health care
6individual patients.
out suppliers and their
octors and lawyers do
aders in the bazaars of
of relative prices is an
.ng prices is of little
e markets for haircuts
,
ty of buyers to bargain
ibutes of the product
the other party, the
do-it-yourself Large
p have reduced their
~ s by manufacturing
Isplaced their suppli
integration need not
centration to depress
t the larger the aver
customers' total pur
g firms. 17
nts tend to be com
panies, their suppli
n seek to boost their
tional Coffee Orga
'ns labor unions.
n firms' profitability
y beneficial since it
ncentration among
ucers in an industry
relationship between
effectiveness of sup
same as those that
omers, they do not
IDUSTRY ENVIRONMENT
ultimately, on refusal to
~ e two parties to a trans
It each makes this threat.
~ result of the transaction
~ e r t i s e in leveraging its
~ h e bargaining power of
i
I
66 ANALYZING THE INDUSTRY ENVIRONMENT
EXHIBIT 3.2
Competition and Profitability in the World Automobile Industry
Despite record profits earned by the U.S. Big
Three (GM, Ford, and Chrysler) from 1994t6 1997
and recovery of Japanese and German car makers
in 1996-1997, the overall profitability of the
world auto industry during the 1990s was dismal.
During the six year period from 1990 to 1995, the
average return on equity earned by the world's
10 largest car makers Was 3.4 percent'""""'Substan
tially below thE!ir cost of equity capital. Profit
ability was far below the levels earned during the
1960s. What factors can explain the deterioration
in industry profitabilitY?
Substitute competition remained modest.
Despite dire warnings over the imminent demise
of private motoring, the automobile increased its
position as the dominant mode of personal trans
portation in the industrialized countdes.Despite
growing congestion, little shift to public transpor
tation occurred while telecommuting remained in
its infancy.
New entry was also limited, due maihly to
the huge costs of establishing manufacturing
and distribution facilities and the large scale
economies in the business. New entrants during
the 1980s and 1990s included Proton (Malaysia),
Ssangyong and Samsung (Korea), and some
small companies producing for their domestic
markets.
The major force of increased competition
was increased rivalry among existing car makers.
At the global level, industry .concentration
increased as many small and medium-sized pro
ducers were merged or acquired: in France, Peu
geot and Citroen merged; Chrysler acquired
AMC; VW acquired Seat .. and Skoda; BMW
acquired Rover; Ford acquired Jaguar. Yet,loo.k
ingat national markets, the picture was quite
different. During the 1960s, national car makers
dominated their domestic markets. The process
of internationalization resulted itl increased
import competition and building of foreign
plants with the result that every national market
featured more companies and lower concentra
tion than three decades earlier. The U.S. market
share of the Big Three dropped!rom 85 to 64
percent, Fiat's share of the Italian market feU
from 66 to 40 percent, Rover (formerly Btitish
Leyland) saw its UK market share decline from 40
to 11percen1; in Germany, the market share of
VW and Mercedes declined from 50 to 28 per-
cent. The leading motor vehicle manufactures in
1994 in terms of number of cars and trucks pro
duced were as follows (figures in thousands):
GM u.s. 8,619
Ford U.S. 6,462
Toyota Japan 4,465
Volkswagen Ge.rmany 3,299
Nissan 2,839
Chrysler U.S 2,808

Peugeot France 1,890
Renault France 1.761
Honda Japan 1,765
Mitsubishi Japan 1,529
Hyundai S. Korea 1,255
Mazda Japan 974

Daimler-Benz German 930
Kia S. Korea 691
Daihatsu Japan 606
BMW Germany 563
VAl Russia 585
DaeWoo S. Korea 523
Isuzu Japan 456
Volvo Sweden 448
Fuji Japan 419
Not only were there more competitors, but
their products were becoming increasingly simi
lar. Increasing standardization of designs, tech
nologies, and features resulted in different
manufacturers' vehicles In each product category
becoming increasingly sjmHar. Competitioh was
further enhanced by exceSs capacity. Although a
strong U.S. economy kept capacity utilization
high in North America during 1995 to 1997, else
Where, the picture was less satisfactory. In
Europe, glpacity utilization remained low, and
union agreements and political pressures pre
sented major barriers to exit. Substantial excess
capacity also existed in Japan and Korea..
wide, heavy investment in new plants and new
process technologies was causing production
capacity to grow faster than demand.
The manufacturers were also pressured by
increased vertical bargaining power. The power
of suppliers had increased greatly. Suppliers of
components and sub-assemblies such as Bosch,
TRW, Verity, Aisln Seikl, Dana, and Eaton rivaled
the auto manufacturers in terms of size and mul
tlnationality. Increa:singly, technology develop
ment was led by the component manufacturers,
67
SNVIRONMENT
APPLYING INDUSTRY ANALYSIS
EXHIBIT 3.2
(Continued)
, trucks pro
Jsands}:
8,619
6,462
4,465
3,299
2,839
2.808
2,143
1,890
1,761
1,765
1,529
1,255
974
940
930
691
606
563
585
523
456
448
419
not the auto companies. At the buyer level,
there were signs the auto manufacturers might
be losing control over their distribution chan
nels. In the United States, the traditional dealer
system was being challenged by new "automo
bile supermarkets" including Automax (owned
EXHIBIT 3.3
by Circuit City) and AutoNation (owned by
Republic Industries), as well as by Internet sales.
Source: R. M. Grant, "The World Automobile
Industry," Georgetown School of Business, 1997.
How Will Structural Change Affect the Profitability of U.S. Casinos?
The 1990s were a period of rapid development
for the U.S. casino gambling industry. Increas
ingly, the industry was viewed, not just by the
existing casino operators, but also by municipali
ties, states, and entertainment companies as
offering huge economic potential. The result was
expansion on multiple fronts.
In terms of new entry, casino gambling
expanded well beyond its traditional locations in
Nevada and Atlantic City, NJ. The potential for
gambling to offer new revenue sources to gov
ernments and opportunities for economic devel
opment encouraged the licensing of casinos in
Mississippi and the introduction of riverboat casi
nos. By 1996, 10 states had licensed casinos. The
1988 Indian Gaming Regulatory Act opened the
way for some 70 casInos on Indian reservations in
17 states. One of the biggest reservation casinos
is Foxwood's, owned by the Mashantucket
Pequot tribe in Ledyard, CT.
Additional sources of new capacity have
been expansion by existing casino companies in
Las Vegas and Atlantic City. In Las Vegas, compe
tition to build the "biggest and best" has
resulted in the demolition and rebuilding of a
number of leading casinos. Between 1996 and
2000, the number of hotel rooms at Las Vegas
casinos will double. New "megacasinos" include
the $390 million Luxor, the $450 million Treasure
Island, the $1 billion MGM Grand resort, and the
$2.5 billion Bellagio (by Mirage Resorts). Rivalry
between Donald Trump and Mirage Resorts'
Steve Wynn has also expanded capacity in Atlan
tic City. where excess capacity is already causIng
several casinos to lose money. Mirage will own
5,500 rooms by 1998. The problems of excess
capacity are exacerbated by the high fixed costs
of operating casinos.
Increasingly. the Las Vegas casinos are com
peting through ever more ambitious differentia
tion. New casinos such as New York, Bellagio, and
Monte Carlo are breakIng new ground in specta
cle, entertainment, theming, and sheer scale.
However, the geographical proximity of these
casinos means despite differentiation, the casinos
will still be battling forthe same pool of gamblers.
At the substitute level, Americans' dreams of
quick riches were also being met by an expanding
number of state lotterIes, and an increasing use of
games of chance as vehicles for marketing maga
zines, soft drinks, and credit cards. Traditional
forms of gambling such as horse and greyhound
racing were attempting to revitalize their appeal
through the addition of slot-machine gambling.
The expansion of cruIse-ship vacations provIded
new opportunities for offshore gambling.
Whether the pressures of new entry and
excess capacity will cause industry margins to col
lapse depends on the extent to new supply will
create its own demand. If new gambling oppor
tunities attract a new breed of gamblers and if
the themed megacasinos attract vacationing
families, it may be possible for the market to
absorb the new capacity. Certainly, gambling in
the UnIted States is a growth industry with total
revenues rising from $124 billion in 1982 and
$304 billion in 1991, to over $500 billion in 1996.
B,!Jt, if the new casinos are simply increasing com
petition for the narrow group of "high rollers,"
then the prospects look gloomy.
68 ANALYZING THE INDUSTRY ENVIRONMENT
Resorts, Circus Circus,
a big. players seeking
players. A battle for m
n asmall number of
term s ut resulting
a more favorable long-term structure.
In other industries, there may be little ambiguity about the impact of structural
changes on profitability since the main structural changes are pulling in the same
direction. For example:
It seems likely that the profitability of U.S. network broadcasting will
decline over the next ten years (1998-2007) in response to an increased
number of broadcast networks (the big three-ABC, CBS, and NBC
were joined first by Fox, then by Time Warner); increased competition
from substitutes such as direct satellite TV, the Internet, and video
games; and increased bargaining power of production studios and local
TV stations.
The situation is similar with the issuers of bank credit cards. More competi
tion due to increasing numbers of competitors (including non-bank issuers
such as GM, GE, and AT&T), entry from various co-branders (ranging
from universities and churches to clubs and airlines), lower demand due to
increased consumer indebtedness, and increased substitute competition from
ATM cards and electronic transactions through the Internet and other
media may affect profitability.
Strategies to Alter Industry Structure
Understanding how the structural characteristics of an industry determine the
intensity of competition and the level of profitability provides a basis for identifYing
opportunities for changing industry structure in order to alleviate competitive preas
sures. The first issue is to identifY the key structural features of an industry that are
responsible for depressing profitability. The second is to consider which of these
structural features are amenable to change through appropriate strategic initiatives.
For example:
In consumer electronics, suppliers of leading brands (such as Sony and Pio
neer) have sought to limit the buying power of discount chains by refusing to
supply those chains that advertise cut prices or that do not display their
products within "an appropriate retailing environment."
In the European and North American oil refining industry, most firms
have earned returns well below their cost of capital due to many competi
tors, excess capacity, and commodity products. Efforts to improve industry
DEI
69
TRY ENVIRONMENT
NING INDUSTRIES: IDENTIFYING THE RELEVANT MARKET
impact of structural
pulling in the same
: broadcasting will
lse to an increased
CBS, and NBC
eased competition
Iternet, and video
Istudios and local
s. More competi
non-bank issuers
branders (ranging
er demand due to
competition from
ternet and other
determine the
is for identifYing
ompetitive preas
industry that are
r which of these
ategic initiatives.
as Sony and Pio
'ns by refusing to
not display their
stry, most firms
many competi
prove industry
profitability include mergers between BP and Mobil in Europe, between
Shell and Texaco in the United States (aimed at facilitating capacity reduc
tion), and attempts at product differentiation through performance
enhancing additives to gasoline.
Excess capacity has also been a major problem in the European petrochemi
cals industry. Through a series of bilateral plant exchanges, the number of
companies producing each product group has been reduced and capacity
rationalization has been facilitated.
1S
During 1993, ICI initiated a program
of plant swaps with BASF, Bayer, and Dow to reduce excess capacity in
European polyurethane production.
19

Building entry barriers is a vital strategy for preserving high profitability in
the long run. A primary goal of the American Medical Association has been
to maintain the incomes of its members by controlling the numbers of doc
tors trained in the United States and imposing barriers to the entry of doc
tors from overseas.
DEFINING INDUSTRIES: IDENTIFYING THE RELEVANT MARKET
One of the most difficult problems in industry analysis is defining the relevant
industry. Suppose Jaguar, a division ofFord Motor Company, is assessing its outlook
over the next ten years. In forecasting the profitability of its industry, should Jaguar
consider itself part of the "motor vehicles and equipment" industry (SIC 371), the
automobile industry (SIC 3712), or the luxury car industry? Should it view its
industry as national (UK), regional (Europe), or global?
The first issue is clarifYing what we mean by the term "industry"? Economists
define an industry as a group of firms that supplies a market.
20
Hence, the key to
defining industry boundaries is identifYing the relevant market. By focusing on the
relevant market, we do not lose sight of the critical relationship among firms within
an industry: competition.
A market's boundaries are defined by substitutability, both on the demand side
and the supply side. Thus, in determining the appropriate range of products to be
included in BMW's market, we should look first at substitutability on the demand
side. If customers are unwilling to substitute trucks for cars on the basis of price dif
ferences, then Jaguar's market should be viewed as automobiles rather than all motor
vehicles. Again if customers are willing to substitute among different types of auto
mobiles-luxury cars, sports cars, family sedans, sport utility vehicles and station
wagons-on the basis of relative price, then Jaguar's relevant market is the automo
bile market rather than just the luxury car market.
Even if there is limited substitution by customers between different types of
automobile, if manufacturers find it easy to switch their production from luxury
cars to family sedans to sports cars and the like, then such supply-side substitut
ability would suggest that Jaguar is competing within the broader automobile
market. The ability of Toyota, Nissan, and Honda to penetrate the luxury car
market suggests that supply-side substitutability between mass-market autos and
specialty autos is moderately high. Similarly, the automobile industry is fre
quently defined to include vans and light trucks, since these can be manufactured
at the same plants as automo}:liles (often using the same platforms and engines).
So too with "major appliance" manufacturers. They tend to be classified as a sin
gle industry, not because consumers are willing to substitute between refrigerators
70 ANALYZING THE INDUSTRY ENVIRONMENT
and dishwashers, but because the manufacturers can easily substitute among dif
ferent appliances.
The same considerations apply to the geographical boundaries of markets.
Should Jaguar view itself as competing in a single global market or in a series of sepa
rate national or regional markets? The criterion here again is substitutability. If cus
tomers are willing and able to substitute cars available on different national markets,
and/or if manufacturers are willing and able to divert their output among different
countries to take account differences in margins, then a market is global. Whereas the
market for jet aircraft is clearly global and the market for dairy products clearly
national (or local), automobiles are an especially difficult case. To the extent that most
auto manufacturers are multinational corporations, there is considerable supply-side
substitutability. However, to the extent that national markets are separated by trade
restrictions, regulations, and the manufacturers' tightly controlled distribution chan
nels, the international auto market may be seen as a conglomeration of many national
markets with imperfect demand and supply-side substitutability among them.
Ultimately, drawing boundaries around industries and markets is a matter ofjudg
ment that must account for the purposes and context of the analysis. Substitutability
tends to be higher in the long run than in the short term. Hence, ifJaguar is planning
its strategy over a ten year period, its relevant business environment is the global auto
mobile industry. If it is considering its competitive strategy over the next three years, it
makes sense to focus on specific national and regional markets--the United States,
Japan, the EU, and Mercosur--and on the luxury car market rather than the automo
bile market as a whole.
Fortunately, the precise delineation of an industry's boundaries is seldom critical
to the outcome of industry analysis so long as we remain wary of external influences.
Because the five forces framework includes influences from outside the industry
entrants and substitutes-the risks of defining the industry too narrowly are miti
gated. For example, if we choose to identify Jaguar's industry as comprising the
manufacturers ofluxury cars, then we can view substitute competition as sports cars,
family sedans, and sport utility vehicles, and view the manufacturers of these vehi
cles as potential entrants into the luxury car market.
BEYOND THE FIVE FORCES MODEL: DYNAMICS,
GAME THEORY, AND COOPERATION
Despite being widely used as a framework for analyzing competition and predicting
profitability, Porter's Five Forces of Competition framework is not without its crit
ics. Economists criticize its theoretical foundations. Its basis is the structure-con
duct-performance approach to industrial organization economics, which has been
largely displaced by game theory approaches. Researchers at McKinsey & Company
have identified a number of assumptions in the structure-conduct-performances
approach which do not hold in practice. For example, business relationships are not
always arms-length. Many relationships are characterized by privilege through affec
tion or trust; others are co-dependent systems formed by webs of companies, where
competition exists between webs and within webs. Thus the "Wintel" web competes
with the A p ~ l e web, while within the Wintel web, Compaq and Dell compete with
one another. 1 Apart from unease over its dubious theoretical foundations, the Five
Forces model is also limited by its static nature: it views industry structure as stable
and externally determined. This determines the intensity of competition, which in
~ Y ENVIRONMENT
BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, AND COOPERATION 71
ltitute among dif
daries of markets.
in a series ofsepa
Ititutability. If cus
t national markets,
It among different
lobal. Whereas the
rproducts clearly
Ie extent that most
erable supply-side
separated by trade
distribution chan
I of many national
long them.
~ a matter ofjudg
~ s . Substitutability
~ a g u a r is planning
Is the global auto
pext three years, it
e United States,
an the automo
is seldom critical
ernal influences.
e the industry
rowlyare miti
comprising the
fn as sports cars,
rrs of these vehi
and predicting
without its crit
structure-con
hich has been
ey & Company
t-performances
.onships are not
through affec
panies, where
"web competes
compete with
tions, the Five
cture as stable
ition, which in
turn influences the level of industry profitability. But competition is not some con
strained process that determines prices and profits and leaves industry structure
unchanged. Competition is a dynamic process through which industry structure
itself changes through evolution and transformation. Thus, a model that does not
take these features into account fails to recognize that competition changes industry
structure both consciously by firms' strategic decisions and as an outcome of the
resulting competitive interaction.
The essence of competition, then, is a dynamic process in which equilib
rium is never reached and in the course of which industry structures are contin
ually reformed. This is evident in the structural transformation of deregulated
industries.
By the mid-1990s, the U.S. airline industry had developed a structure that
few of the architects of deregulation had predicted. The economists of the
Civil Aeronautics Board had predicted that, in the absence of government
regulation of routes and fares, entry would be easy, concentration would fall,
and fares would drop to their competitive levels. In practice, the industry has
been shaped by the strategies of the leading players: mergers and acquisitions
have increased concentration; the hub-and-spoke system has given rise to
several local near-monopolies; selective price competition has driven a num
ber oflow-cost entrants into bankruptcy; and barriers to entry have been cre
ated through control of airport gates and landing slots, computer
reservations systems, and frequent flyer programs.
The privatization of British Telecom and the deregulation of the British
telecommunications industry heralded a new era of intense competition and
rapid and radical structural change. Competition from Mercury was soon
followed by cellular phone competitors such as Vodaphone, PCS competitors
such as Orange, and cable TV companies offering telephone service.
SchUlllpeterian COlllpetition
Joseph Schumpeter was the first to recognize and analyze the dynamic interaction
between competition and industry structure. Schumpeter focused on innovation as
the central component of competition and the driving force behind industry evolu
tion. Innovation represents a "perennial gale of creative destruction" through which
favorable industry structures-monopoly in particular-contain the seeds of their
own destruction by providing incentives for firms to attack established positions
through new approaches to competing. Although identified here with Schumpeter,
this view of competition as dynamic process of rivalry is associated more widely with
the Austrian school of economics.
22
The key issue raised by Schumpeter is whether we can use current industry
structures as a reliable guide to the nature of competition and industry performance
in the future. The relevant consideration is the speed of structural change in indus
try. If the pace of transformation is rapid, if entry rapidly undermines the market
power of dominant firms, if innovation speedily transforms industry structure by
changing process technology, by creating new substitutes, and by shifting the basis
on which firms compete, then there is little merit in using industry structure as a
basis for analyzing competition and profit.
Most empirical studies e>f changes over time in industry structure and profit
ability show Schumpeter's process of "creative destruction" to be more of a breeze
72 ANALYZING THE INDUSTRY ENVIRONMENT
than a gale. Studies of United States and Canadian industrr3 have found that
entry occurs so slowly that profits are undermined only slowly. One survey com
mented: "... the picture of the competitive process ... is, to say the least, sluggish
in the extreme.,,24 Overall, the studies show a fairly consistent picture of the rate
of change of profitability and structure. Both at the firm and the industry level,
profits tend to be highly persistent in the long run.
25
Structural change-notably
concentration, entry, and the identity of leading firms-also appears to be, on
average, slow.
26
Some industries, however, conform closely to Schumpeter's model. Jeffrey Wil
liams identifies "Schumpeterian industries" as those subject to rapid product innova
tion with relatively steep experience curves. In these industries, structure tends to be
unstable. In computers, telecommunication services, Internet access, and electronic
games, using current trends in industry structure to forecast profitability several
years ahead is unreliable for two reasons: the relationship between competition and
industry structure is unstable, and changes in industry structure are rapid and diffi
cult to predict. We return to the issues of industry evolution and forecasting industry
structure in Chapter 10.
H ypercOInpetition
Schumpeter's ideas of competition as a process of creative destruction have been
developed and extended in Rich D'Aveni's concept of hypercompetition.
Hypercompetition is an environment characterized by intense and rapid
competitive moves, in that competitors must .move quickly to build advan
tages and erode the advantages of their rivals. This speeds up the dynamic
strategic interactions among competitors.
Hypercompetitive behavior is the process of continuously generating new
competitive advantages and destroying, obsoleting, or neutralizing the
opponent's competitive advantage, thereby creating disequilibrium,
destroying perfect competition, and disrupting the status quo of the market
place. This is done by firms moving up their escalation ladders faster than
competitors, restarting the cycles, or jumping to new arenas.
27
The driving force of competition is the quest for profit through establishing
competitive advantage. However, rivalry for competitive advantage means that com
petitive advantage is transitory. Only by continually recreating and renewing com
petitive advantage can firms sustain market dominance and superior performance
over the long haul.
The Contribution of GaIlle Theory
Central to the criticisms of Porter's Five Forces as a static framework is its failure to
take full account of competitive interactions among firms. In Chapter 1, we noted
that the essence of strategic competition is the interaction among players such that
the decisions made by anyone player are dependent on the actual and anticipated
decisions of the other players. By relegating competition to a mediating variable that
links industry structure with profitability, the Five Forces analysis offers little insight
into firms' choices of whether to compete or to cooperate; sequential competitive
!
73
( ENVIRONMENT
i have found that
Jne survey com
he least, sluggish
icture of the rate
1e industry level,
change-notably
ppears to be, on
odel. Jeffrey Wil
i product innova
llcture tends to be
iSs, and electronic
klfitability several
Icompetition and
rapid and diffi
recasting industry
i
,
have been
ftlOn.
e and rapid
build advan
the dynamic
f.
erating new
tralizing the
quilibrium,
f the market
s faster than
establishing
Imeans com
renewmg com
performance
Irk is its failure to
lpter 1, we noted
players such that
1and anticipated
:tingvariable that
fers little insight
ntial competitive
BEYOND THE FIVE FORCES MODEL: DYNAMICS, GAME THEORY, AND COOPERATION
moves; and the role of threats, promises, and commitments. Game theory has two
especially valuable contributions to make to strategic management.
1. It permits the framing of strategic decisions. Apart from any theoretical
value of the theory ofgames, the description of the game in terms of:
Identitying the players,
Specitying each player's options,
Establishing the payoffs from every combination of options,
Defining sequences of decisions using game trees,
permits us to understand the structure of the competitive situation and
facilitates a systematic, rational approach to decision making.
2. Through the insight it offers into situations of competition and bargaining,
game theory can predict the equilibrium outcomes of competitive situations
and the consequences of strategic moves by anyone player. Game theory
provides penetrating insight into central issues of strategy that go well
beyond pure intuition. Simple game models (e.g., "prisoner's dilemma") pre
dict cooperative versus competitive outcomes, whereas more complex games
permit analysis of the effects of reputation,28 deterrence,29 information,30
and commitment
31
-especially within the context of multiperiod games.
Particularly important for practicing managers, game theory can indicate
strategies for improving the structure and outcome of the game through
manipulating the payoffs to the different players.
32
Despite the explosion of interest in game theory during the 1980s, practical appli
cations, especially in the area of strategic management, remained limited until the
1990s. Interest in game theory has grown recently as a result of a number of practical
guides to the application of the game theory's tools and insights.
33
Game theory has
provided illuminating insights into a wide variety of situations, including the Cuban
missile crisis of 1962,34 President Reagan's 1981 tax cut,35 subsidies for Airbus Indus
trie, the problems of OPEC in agreeing to production cuts, the competitive impact of
Philip Morris's cutting cigarette prices on 'Marlboro Monday' in 1993,36 and the auc
tioning of licenses of wavelengths for telecommunications by the U.S. and New
Zealand governments.
3
?
One of the greatest benefits of game theory is its ability to view business inter
actions as comprising both competition and cooperation. A key deficiency of the
Five Forces framework is in viewing rivalry and bargaining as competitive in nature.
The central message of Adam Brandenburger and Barry Nalebuff's book, Co-opeti
tion, is recognizing the competitive/cooperative duality of business relationships.
Whereas Coca-Cola's relationship with Pepsi-Cola is essentially competitive, that
between Intel and Microsoft is primarily complementary. Thus,
A player is your complementor if customers value your product more when
they have the other player's product than when they have your product alone.
A player is your competitor if customers value your product less when they
have the other player's product than when they have your product alone.
The Value Net recognizes these two types of relationship (see Figure 3.5). It is impor
tant to recognize that a player may occupy multiple roles. Microsoft and Netscape com
pete fiercely to dominate the Rlarket for Internet browsers. At the same time, the two
companies cooperate in establishing security protocols for protecting privacy and guard
74 OPI ANALYZING THE INDUSTRY ENVIRONMENT
FIGURE 3.5
The Value Net
ing against credit card fraud on the Internet. Similarly, with customers and suppliers,
though these players are essentially partners in creating value, they are also bargaining
over sharing that value. The desire of competitors to cluster together--antique dealers in
London's Bermondsey Market and advertising agencies on Madison Avenue--points to
the complementary relations among competitors in growing the size of their market and
developing its infrastructure.
The most important insights that game theory provides are its ability to identify
opportunities for a player to change the structure ofa game in order to improve payoffs.
Consider the following examples:
The benefits ofrepeated games. A classic case of"prisoners,dilemmd' is purchas
ing a product where the quality cannot be easily discerned prior to purchase (e.g.,
a used car). The seller has an incentive to offer low quality, the buyer has an
incentive to offer a low price in the likelihood that quality will be poor (see
Chapter 9 for a fuller analysis). Both parties would benefit from ensuring that
the product was high quality. How can this dilemma be resolved? One answer is
to change a one period game (single transaction) into a repeatedgame (long-term
vendor relationship). Faced with the possibility of a long-term business relation
ship, the seller has the incentive to offer a quality product, the buyer has the
incentive to offer a price that offers the seller a satisfactory return.
Deterrence. The payoffs in a game can be changed through increasing the
costs to other players of choices that are undesirable to the firm. By estab
lishing the certainty that deserters would be shot, the British army made
desertion a less attractive alternative for troops than advancing over no
man's-land to attack German trenches during World War I. Similarly, estab
lished airlines have sought to deter Southwest from expanding its route net
work by the threat of matching Southwest's fares on the new routes.
Bringing in competitors. "Establishing alliances and agreements with competi
tors can increase the value of the game by increasing the size of the market and
75
RY ENVIRONMENT OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KEY SUCCESS FACTORS
lers and suppliers,
lI"e also bargaining
'1l11tique dealers in
,"venue-points to
,f their market and
ability to identify
~ improve payofft.
~ m m d ' is purchas
to purchase (e.g.,
the buyer has an
r
lwill be poor (see
pm ensuring that
?One answer is
game (long-term
usiness relation
e buyer has the
increasing the
firm. By estab
.sh army made
cing over no
imilarly, estab
g its route net
routes.
building strength against other competitors. The key is converting win-lose (or
even lose-lose) games into win-win games. When Intel developed its 8086
microprocessor, it gave up its monopoly by offering second-sourcing licenses
to AMD and IBM. Although Intel was creating competition for itself, it was
also encouraging the adoption of the 8086 chip by computer manufacturers
(including IBM) who were concerned about overdependence on Intel. Once
Intel had established its technology as the industry standard, it developed its
family of 286, 386, 486, and Pentium processors and became much more
restrictive over licensing. A cooperative solution was also found to Norfolk
Southern's competition with CSX for control of Conrail. The 1997 bidding
war was terminated when CSX and Norfolk Southern agreed to dismember
and share Conrail.
Game theory permits considerable insight into the nature of situations involving
interactions among multiple players. It clarifies the structure of relationships and
nature of interactions among players, and it identifies the alternative actions available
to different players and related these to possible outcomes. Game theory has provided
valuable decision support in negotiations and in simulating competitive patterns of
action and reaction. War gaming, based on game theory principles, is a popular tech
nique both among military planners and management consultants such as Booz Allen
and Coopers & Lybrand. The weaknesses are in the ability to apply game theory to
specific business situations and generate unambiguous, meaningful, and accurate pre
dictions. Game theory is excellent in providing insights and understanding; it has
been less valuable in predicting outcomes and designing strategies. The cost of game
theory's mathematical rigor has been narrowness of application. Game theory pro
vides clear prediction in highly stylized situations involving few external variables and
highly restrictive assumptions. The result is a mathematically sophisticated body of
theory that suffers from unrealistic assumptions, lack of generality, and an analysis of
dynamic situations through a sequence of static equilibria.
38
When applied to more
complex (and more realistic) situations, game theory frequently results in either no
equilibrium or multiple equilibria, and outcomes that are highly sensitive to small
changes in the assumptions. Experience in applying game theory has been mostly
disappointing. The game theory-designed FCC auctions for PCS licenses are gener
ally viewed as being a disaster, both for the FCC and for the bidders who used game
theory to formulate their bidding strategies. Although game theory is in a phase of
rapid development, it is far from providing the theoretical foundations for strategic
management. Though we draw on game theory in several places in this book, the
emphasis of analysis is less on the analysis of action and response between rivals and
other approaches to "playing the game," and more about the transformation of com
petitive games through building sustainable competitive advantage.
39
OPPORTUNITIES FOR COMPETITIVE ADVANTAGE:
IDENTIFYING KEY SUCCESS FACTORS
Our discussion of hypercompetition and game theory has taken us well beyond the
confines of the Five Forces framework. Remember that the primary purpose of that
model is to analyze industry attractiveness in order to forecast industry profitability.
Hypercompetition explicitly recognizes that competition is a battle for competitive
advantage. Game theory also focuses on positioning and maneuvering for advantage.
I
76 ANALYZING THE INDUSTRY ENVIRONMENT
The purpose of this section is to look explicitly at the analysis of competitive advan
tage. In subsequent chapters, we develop a more comprehensive analysis of competi
tive advantage. The purpose here is to identifY the potential for competitive
advantage within an industry in terms of the factors that determine a firm's ability to
survive and prosper-its Key Success Faetors.
40
In Exhibit 3.4, Kenichi Ohmae of
McKinsey and Company in Tokyo discusses Key Success Factors in forestry and their
link with strategy.
Like Ohmae, our approach to identifYing key success factors is straightforward
and commonsense. To survive and prosper in an industry, a firm must meet two cri
teria: first, it must supply what customers want to buy, second, it must survive com
petition. Hence, we may start by asking two questions:
What do our customers want?
What does the firm need to do to survive competition?
EXHIBIT 3.4
Probi ng for Key Success Factors
As a consultant faced with an \4Mamiliar
or industry, I make a point of first Bsking the spe
ciaUsts in the business. "What secret of
cess in this industry?" Needless to my, I seldQrn get
an immediate inquiry
by asking other quemonsfrom a variety of
in order to establish as Cluickly. as possible some
reasonable hypotheses as to keyfaetors for sy<:cess.
In the course of these interviews it usually becomes
quite obvious what analyses will be required in
order to prove or disprove these hypotheses' . By
first identifying the probable key tor suc
cess and then screening them by proof or disproof,
it is often possible for the strategist to penetrate
very quickly to the core of a problem.
Traveling in the United States last year. I
found myself on one occasion sitting in a plane
next to a director of one of the biggest
companies in the count.ry. Thinking I might learn
something useful in the course ofthe five-hour
flight. I asked him, "What are the key factors for
success in the lumber .industry?" To my surpriSe.
his reply was immediate: "Owning large forests
and maximizing the yield from them."
The first of these key factors is a relatively
simple matter: purchase of forestland. But his
second point required further explanation.
Accordingly, my next question was: "What vari
able or variables do you control in orderto max
imize the yield from a given tract?"
we replied: "The rate 01 tree .9towth is the
keY variable. As a rule.twofae:tors promote
growth: ... the amount of SUnshine . and the
amodnt of. wat.er. have
many forests with enough of both. In Arizona
and, Utah, for example,. we .get. Il\ore than
enough sunshine but .too little water, and so
tre.egrowth is very low. NoW, if we could give
the trees in those states enough water, they'd
be ready in less than fifteen years instead of the
thirty it takes now. The. most important project
we have in hand at the momentls aimed at find
ing out how to do this."
Impressed that this direet()f knew how to
work out a key factor strategy for his business. I
offered my own contrit>ution: "Then under the
opposite conditions, where. there is plenty of
water but. too little sUnshipe-for example,
around the lower reaches of the Columbia River
-the key factors shoulc! be fertilizers to speed
up the growth and the choice of tree varieties
that don't need so much sUf'shine."
Having established .. in. a few minutes the
general framework of what we we[egoing to
talk: about, I spent the rest of the long flight
very profitably hearing from him in detail how
each of these factors was being applied.
Source:KenichiOhmae, The Mind ofthe Strate
gist (Harmondsworth. U.K.: Penguin, 1982): 85.
.j
77 YENVIRONMENT
ompetitive advan
lalysis of competi
I for competitive
~ a firm's ability to
~ e n i c h i Ohmae of
.forestry and their
is straightforward
lUst meet two cri
[lust survive com-
OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KEY SUCCESS FACTORS
To answer the first question we need to look more closely at customers of
the industry and to view them, not so much as a source of bargaining power
and hence as a threat to profitability, but more as the basic rationale for the
existence of the industry and as the underlying source of profit. This implies
that the firm must identify who its customers are, identify their needs, and
establish the basis on which they select the offerings of one supplier in prefer
ence to those of another. Once we have identified the basis of customers' pref
erence, this is just the starting point for a chain of analysis. As Table 3.4 shows,
if consumers select supermarkets primarily on the basis of price, and if low
prices depend on low costs, the interesting questions concern the determinants
of low costs.
TABLE 3.4
Identifying Key Success Factors: Some Examples
WHAT DO CUSTOMERS HOW DOES A FIRM
WANT? SURVIVE COMPETITION? KEY SUCCESS
(Analysis of demand) (Analysis of Competition) FACTORS
Steel Customers include auto,
engineering, and container
industries. Customers
acutely price sensitive. Cus
tomers require product con
sistency and reliability of
supply. Specific technical
specifications required for
special steels.
Competition primarily on
price.Competition intense
due to declining demand,
high fixed costs, excess
capacity, low-cost
imports, and exit barriers
high. Transport costs
high. Scale economies
important.
Cost efficiency through
scale-efficient plants, low
cost location, rapid adjust
ment of capacity to out
put, efficient use of labor.
Scope for differentiation
through quality service
and technical factors.
Fashion
Clothing
Demand fragmented by gar
ment, style, quality, color.
Customers' willingness to
pay price premium for fash
ion, exclusivity, and quality.
Mass market highly price
sensitive. Retailers seek reli
ability and speed of supply.
Low barriers to entry and
exit. Low seller concentra
tion. Few scale economies.
International competition
strong. Retail chains exer
cise strong buying power.
Need to combine effec
tive differentiation with
low-cost operation. Key
differentiation variables
are speed of response to
changing high fashions,
style, reputation and
quality.
Supermarkets Low prices. Convenient loca
tion. Wide range of prod
ucts. Product range adapted
to local customer prefer
ences. Freshness of produce.
Cleanliness, service, and
pleasant ambience.
Markets localized and
concentration normally
high. But customer price
sensitivity encourages vig
orous price competition.
Exercise of bargaining
power an important
influence on input cost.
Scale economies in opera
tioC1 and advertising.
Low cost operation
requires operational effi
ciency, scale efficient
stores, large aggregate
purchases to maximize
buying power, low wage
costs. Differentiation
requires large stores (to
allow wide product
range), convenient loca
tion, easy parking.
78 ANALYZING THE INDUSTRY ENVIRONMENT OPI
FIGURE 3.6
Identifying Key Suc
cess Factors
The second question requires that the firm examine the basis of competition
in the industry. How intense is competition and what are its key dimensions? If
competition in an industry is intense, then, even though the product may be
highly differentiated and customers may choose on the basis of design and qual
ity rather than price, low cost may be essential for survival. Retailers such as
Harrods, Nordstrom, and Tiffany's do not compete on low prices, but in a
fiercely competitive retailing sector, their prosperity depends on rigorous cost
control.
A basic framework for identifying Key Success Factors is presented in Figure
3.6. Application of the framework to identify Key Success Factors in three industries
is outlined in Table 3.4.
Key Success Factors can also be identified through the direct modeling of profit
ability. In the same way that our Five Forces analysis models the determinants of
industry-level profitability, we can also attempt to model firm-level profitability in
terms of identifying the key factors that drive a firm's relative profitability within an
industry. In Chapter 2, we made some progress on this front. By disaggregating a
firm's return on capital employed into individual operating factors and ratios, we can
pinpoint the most important determinants of firm success (see Figure 2.2). In many
industries, these primary drivers of firm-level profitability are well-known and widely
used as performance targets. Exhibit 3.5 gives a well-known profitability formula used
in the airline industry then identifies the factors that drive the profitability ratios.
fRY ENVIRONMENT OPPORTUNITIES FOR COMPETITIVE ADVANTAGE: IDENTIFYING KE'{ SUCCESS FACTORS 79
asis of competition
key dimensions? If
e product may be
of design and qual
. Retailers such as
w prices, but in a
s on rigorous cost
presented in Figure
rs in three industries
modeling of profit
the determinants of
level profitability in
ofitability within an
By disaggregating a
s and ratios, we can
igure 2.2). In many
-known and widely
ability formula used
profitability ratios.
EXHIBIT 3.5'
Identifying Key Success Factors Through Modeling Profitability: The Airline Business
Profitability, as measured by operating income per Matching airplaine size to demand
available seat-mile (ASM), is determined by three for individual flights.
factors: Yield, total operating revenues divided by
the number of revenue passenger miles (RPM);
Load factor, the ratio between RPMs and APMs;
and Cost total operating expenses divided by
ASMs. Where an ASM is one seat flown one mile
with a passenger in it or not, RPM is one seat
flown one mile with a passenger in it. Thus:
= X _
Some of the primary determinants of each of
these measures are the following:
Revenue/RPMs
Intensity of competition on routes
flown.
Ability to quickly adjust prices and
price structures to changing market
conditions through effective yield
management.
Ability to attract business customers.
Offering superior customer service.
load factors
Competitiveness of prices.
Efficiency of route planning (e.g.,
through hub-and-spoke systems)
Building customer loyalty through
quality of service. frequent-flyer
programs.
ExpenseslASMs
Wage rates and benefit levels.
Fuel efficiency of aircraft.
Productivity qf employees (deter
mined partly by their job flexibility).
load factors.
level of administrative cost.
In their quest for survival and competitive
advantage, the airlines have sought to opti
mize as many of these factors as possible in
order to improve their profitability. tn terms of
revenue enhancement, several airlines have
withdrawn from the most intensely competi
tive routes, others have sought to achieve a
fare premium over the cut-price airlines
through punctuality, convenience. comfort,
and services (e.g., inflight telephones. personal
video monitors with choice of movies). To
improve load factors, companies have sought
fleXibility in allocating plane capacity to
routes. and used their computer reservation
systems and Internet sales to achieve more
flexible pricing. Most notably, companies have
sought cost economies through increasing
employee productivity, reducing administra
tive overhead through outsourcing, investing
in fuel-efficient aircraft, and reducing wages
and benefits.
More generally, the approach introduced in Chapter 2 (see Figure 2.2) to disaggregate
return on capital into its component ratios can be extended to identifY the specific
operational and strategic drivers of superior profitability. Fig,ure 3.7 applies this analy
sis to identifY success factors in retailing.
The value of success factors in formulating strategy has been scorned by some
strategy scholars. Pankaj Ghemawat observes that the" ... whole idea of identifYing a
success factor and then chasing it seems to have something in common with the ill
considered medieval hunt for the,ghilosopher's stone, a substance that would transmute
everything it touched into gold." 1 The objective here in identifYing Key Success Fac
tors is less ambitious. There is no universal blueprint for a successful strategy, and even
in individual industries, there is no "generic strategy" that can guarantee superior profit
ability. However, each market.is different in terms of what motivates customers and
how competition works. Understanding these aspects of the industry environment is a
80 ANALYZING THE INDUSTRY ENVIRONMENT
FIGURE 3.7
Identifying Key Suc
cess Factors in Retail
ing Through
Analyzing Drivers of
Return on Capital
Employed
~ S U M M A R Y
prerequisite for an effective business strategy. This does not imply that firms within an
industry adopt common strategies. Since every firm comprises a unique set of resources
and capabilities, every firm must pursue unique key success factors.
In Chapter 1, we observed that understanding one's competitive environment is a
key ingredient of a successful strategy. In this chapter, we examined concepts and
frameworks to assist us in understanding the business environment of the firm. A
key assumption is that to understand competition and the determinants of profit
ability within an industry, we are not restricted to acquiring experience-based,
industry-specific learning over a long period of time. Instead, we can draw on con
cepts, principles, and theories that can be applied to any industry. Although every
industry is unique, the patterns of competitive behavior can be explained and using
common analytical frameworks.
The underlying premise of this chapter is that the structural characteristics of
an industry playa key role in determining the nature and intensity of the competi
tion within it and the rate of profit it earns. Our framework for linking industry
structure to competition and profitability is Porter's Five Forces of Competition
model. This provides a simple, yet powerful, organizing framework for classifYing
the relevant features of an industry's structure and predicting their implications for
competitive behavior. The framework is particularly useful for:
Predicting industry profitability
Indicating how the firriJ. can influence industry structure in order to moder
ate competition and improve profitability.
I
_I NOTES
~ a t firms within an
~ u e set of resources
environment is a
ed concepts and
t of the firm. A
.nants of profit-
erience-based,
an draw on con
Although every
lained and using
haracteristics of
of the competi
linking industry
of Competition
k for classifying
implications for
fRY ENVIRONMENT NOTES 81
The Porter framework suffers from some critical limitations. In particular, it
does not take adequate account of the dynamic character of competition. Competi
tion is a powerful force that changes industry structure. In hypercompetitive indus
tries, competing strategies create a process of "creative destruction" that continually
transforms industry structure. As for the theoretical weaknesses of the Porter frame
work, game theory provides a broader theoretical basis for analyzing both competi
tion and cooperation, but, in providing a basis for strategy formulation, its potential
has yet to be realized.
Though the Porter framework permits analysis of competition and profitability
at the industry level, our industry analysis is also directed toward understanding the
opportunities for competitive advantage. Our approach h'as been to show that by
understanding customer demand, the competitive process, and the determinants of
firm-level profitability, we can identify Key Success Factors: the prerequisites for
survival and success within an industry.
Subsequent chapters draw extensively on the frameworks, concepts, and tech
niques introduced here. In particular, we develop our industry analysis through con
sidering the evolution of industry structure (Chapter 10) and the characteristics of
technology-based industries (Chapter 11), mature industries (Chapter 12), and glo
bal industries (Chapter 14). Chapter 4 extends our industry analysis through exam
ining the internal complexity of industries in relation to segmentation, strategic
groups, and competitor behavior.
1 See, for example, J. P. Leemhuis, "Using Scenarios to Develop Strategies," Long Range
Planning (April 1985): 30-37; and Pierre Wack, "Scenarios: Shooting the Rapids," Har
vard Business Review (November-December 1985): 139-150.
2 Michael E. Porter, Competitive Strategy: Techniques fOr Analyzing Industries and Competi
tors (New York: Free Press, 1980), chapter 1. For a summary, see his article, "How Com
petitive Forces Shape Strategy," Harvard Business Review 57 (March-April 1979): 86-93.
3 W. J. Baumol, John C. Panzar, and Robert D. Willig, Contestable Markets and the Theory
ofIndustry Structure (New York: Harcourt Brace Jovanovitch, 1982).
4 "Annual Franchise 500," Entrepreneur (January 1996).
5 "Brand Loyalty Is Rarely Blind Loyalty," Wall Street journal, October 19, 1989: B1.
6 Robert D. Buzzell and Paul W. Farris, "Marketing Costs in Consumer Goods Indus
tries," in Strategy + Structure =Perftrmance, ed. Hans Thorelli (Bloomington, IN: Indiana
University Press, 1977): 128-129.
7 Martin B. Lieberman, "Excess Capacity as a Barrier to Entry,"journal ofIndustrial Eco
nomics 35 (June 1987): 607-627, argues that to be credible the threat of retaliation needs
to be supported by excess capacity.
8 J. S. Bain, Barriers to New Competition (Cambridge, MA: Harvard University Press, 1956).
9 H. Michael Mann, "Seller Concentration, Entry Barriers, and Rates of Return in Thirty
Industries," Review ofEconomics and Statistics 48 (1966): 296-307.
10 See, for example, the studies by W. S. Comanor and T. A. Wilson, Advertising and Mar
ket Power (Cambridge: Harvard University Press, 1974); and L. Weiss, "Q1Jantitative
Studies in Industrial Organization," in Frontiers of Quantitative Economics, ed. M. Intrili
gator (Amsterdam: North Holland, 1971).
11 George S. Yip, "Gateways to Entry," Harvard Business Review 60 (September-October
1982): 85-93.
12 Guy de Jonquieres, "Europe'saNew Cold Warriors," Financial Times, May 19,1993: 18.
13 See "U.S. Probes Whether Airlines Colluded on Fare Increases," Wall Street journal, Decem
ber 14, 1989: B1; and "A Tank Full ofTrouble," Economist, December 16-22, 1989: 57.
82
NOTm
ANALYZING THE INDUSTRY ENVIRONMENT
14 Richard Schmalensee, "Inter-Industry Studies of Structure and Performance," in Hand
book of Industrial Organization 2, ed. Richard Schmalensee and Robert D. Willig
(Amsterdam: North Holland, 1988): 976. For evidence on the impact of concentration
in banking, airlines, and railroads see D. W. Carlton and J. M. Perloff,Modern Industrial
Organization (Glenview, IL: Scott, Foresman, 1990): 383-385.
15 The problems caused by excess capacity and exit barriers are discussed in Strategic Man
agement ofExcess Capacity, ed. Charles Baden Fuller (Oxford: Basil Blackwell, 1990).
16 S. H. Lustgarten, "The Impact of Buyer Concentration in Manufacturing Industries,"
Review ofEconomics and Statistics 57 (1975): 125-132; and Robert M. Grant "Manufac
turer- Retailer Relations: The Shifting Balance of Power," in Business Strategy and Retail
ing, ed. G. Johnson (Chichester: John Wiley & Sons, 1987).
17 Robert D. Buzzell and Bradley T. Gale, The PIMS Principles: Linking Strategy to Perfor
mance (New York: Free Press, 1987): 64-65.
18 See Joe Bower, When Markets Quake (Boston: Harvard Business School Press, 1986).
19 Paul Abrahams, "ICI Seeks Restructure of Polyurethane Industry," Financial Times, July
1,1993: 28.
20 The economist's definition of an industry can differ from normal usage of the term. For
example, the U.S. automobile industry tends to be viewed either as comprising U.S.
owned car makers (GM, Ford, Chrysler) or U.S.-located car makers (the Big Three plus
the U.S. subsidiaries of foreign-owned auto companies such as Honda, Nissan, and
BMW). A market-based definition would focus on all auto companies that supply the
U.S. car market wherever their plants are located.
21 Kevin Coyne, "A Comprehensive Model for Strategy Development," paper presented at
the Strategic Management Society Conference, Barcelona, October 6, 1997.
22 See Robert Jacobson, "The Austrian School of Strategy,"Academy ofManagement Review
17 (1992): 782-807; and Greg Young, Ken Smith, and Curtis Grimm, "Austrian and
Industrial Organization Perspectives on Firm-Level Competitive Activity and Perfor
mance," Organization Science 7 (May-June 1996): 243-254.
23 R. T. Masson and J. Shaanan, "Stochastic Dynamic Limit Pricing: An Empirical Test,"
Review of Economics and Statistics 64 (1982): 413-422; R. T. Masson and J. Shaanan,
"Optimal Pricing and Threat of Entry: Canadian Evidence," International Journal of
Industrial Organization 5 (1987).
24 P. A. Geroski and R. T. Masson, "Dynamic Market Models in Industrial Organization,"
InternationalJournalofIndustrial Organization 5 (1987): 1-13.
25 Dennis C. Mueller, Prrifits in the Long Run (Cambridge: Cambridge University Press,
1986).
26 Richard Caves and Michael E. Porter, "The Dynamics of Changing Seller Concentra
tion," Journal ofIndustrial Economics 19 (1980): 1-15; P. Hart and R. Clarke, Concentra
tion in British Industry (Cambridge: Cambridge University Press, 1980).
27 Richard D'Aveni, Hypercompetition: Managing the Dynamics of Strategic Maneuvering
(New York: Free Press, 1994): 217-218.
28 Keith Weigelt and Colin F. Camerer, "Reputation and Corporate Strategy: A Review of
Recent Theory and Applications," Strategic Management Journal 9 (1988): 137-142.
29 A. K. Dixit, "The Role ofInvestment in Entry Deterrence," Economic Journal 90 (1980):
95-106.
30 P. Milgrom and J. Roberts, "Informational Asymmetries, Strategic Behavior and Indus
trial Organization," American Economic Review 77, no. 2 (May 1987): 184-189; J. Tirole,
The Theory ofIndustrial Organization (Cambridge, MA: MIT Press, 1990).
31 Pankaj Ghemawat, Commitment: The Dynamic ofStrategy (New York: Free Press, 1991).
32 The are two outstanding introductions to the principles of game theory and their practi
cal applications: Thomas C. Schelling, The Strategy of Conflict, 2nd edition (Cambridge:
Harvard University Press, 1980); and A. K. Dixit and B. J. Nalebuff, Thinking Strategi
cally: The Competitive Edge in Busillless, Politics, and Everyday Life (New York: W. W.
Norton, 1991).
ENVIRONMENT NOTES 83
rmance," in Hand
Robert D. Willig
;t of concentration
;Modern Industrial
I in Strategic Man
Ickwell, 1990).
turing Industries,"
:Grant "Manufac
'!rategy and Retail-
Strategy to Perftr
Press, 1986).
Times, July
re of the term. For
U.S.
BigThree plus
r,nda, Nissan, and
,that supply the
aper presented at
1997.
nagement Review
:Austrian and
.ty and Perfor-
Empirical Test,"
and J. Shaanan,
tional Journal of
aI Organization,"
University Press,
eiler Concentra
larke, Concentra
'gic Maneuvering
avior and Indus
4-189; J. Tirole,
0).
ree Press, 1991).
i and their practi
ion (Cambridge:
"binking Strategi
:w York: W. W.
33 Avinash K. Dixit and Barry Nalebuff, Thinking Strategically: The Competitive Edge in
Business, Politics, and Everyday Life (New York: W. W. Norton, 1991); John McMillan,
Games, Strategies, and Managers (New York: Oxford University Press, 1992); Adam
Brandenburger and Barty Nalebuff, Co-opetition (New York: Doubleday, 1996).
34 Graham Allison, lc-'ssence ofDecision: Explaining the Cuban Missile Crisis (Boston: Little,
Brown, 1971).
35 A. K. Dixit and B.J. Nalebuff,op cit.,131-135.
36 "Business War Games Attract Big Warriors," Wall Street Journal, December 22, 1994:
B1.
37 "Winning the Game of Business," Business Week, February 11, 1985: 28.
38 There are numerous critiques of the usefulness of game theory. F. M. Fisher, "The
Games Economists Play: A Noncooperative View," RAND Journal of Economics 20
(Spring 1989): 113-124, points to ability of game theory to predict almost any equilib
rium solution. Colin Camerer describes this as the "Pandora's Box Problem," see C. F.
Camerer, "Does Strategy Research Need Game Theory?" Strategic ManagementJournal,
special issue, 12 (Winter 1991): 137-152. Steve Postrel illustrates this problem by devel
oping a game theory model to explain the rationality of bank presidents setting fire to
their trousers. See S. Postrel, "Burning Your Britches Behind You: Can Policy Scholars
Bank on Game Theory," Strategic Management Journal, special issue, 12 (Winter 1991):
153-155. Michael E. Porter, "Toward a Dynamic Theory of Strategy," Strategic Manage
ment Journal, special issue 12 (Winter 1991): 95-117, notes that game theory"... stops
short of a dynamic theory of strategy ... these models explore the dynamics of a largely
static world."
39 In game theory terminology, we may regard the establishment of competitive advantage
through cost or differentiation advantage as a dominant strategy. If all players are pursuing
such dominant strategies then equilibrium in the game is simple and robust.
40 The term was coined by Chuck Hofer and Dan Schendel, Strategy Formulation: Ana
lytical Concepts (St. Paul: West Publishing, 1977): 77, who defined Key Success Factors
as "... those variables that management can influence through its decisions and that
can affect significantly the overall competitive positions of the firms in an industry ...
Within any particular industry they are derived from the interaction of two sets ofvari
ables, namely, the economic and technological characteristics of the industry ... and
the competitive weapons on which the various firms in the industry have built their
strategies."
41 Pankaj Ghemawat, Commitment: The Dynamic ofStrategy (New York: Free Press, 1991): 11.
IcEEsAi
BIBL/OTECA