42001: Competitive Strategy

Industry Analysis and the Five Forces

Thomas R. Covert
thomas.covert@chicagobooth.edu
Week 2 Agenda: Industry Analysis

• Announcements / reminders

• Moneyball recap

• What is industry analysis? Why do we care?

• The “Five Forces” of Competitive Strategy

• Break

• Case – Cola Wars

Moneyball recap (1)
• Baseball is seemingly complicated, but 80+% of variation in wins
can be explained by OBP and SLG. OBP generates more wins
than SLG, but it costs less to buy in players (back then, anyway)

• Why is SLG is more costly to acquire than OBP?

− Hitting ability is (at least somewhat) about physique: scarce
− Hitting discipline can be learned: not so scarce

• Case/discussion about wins but not all wins are the same
− Fans might prefer flashy SLG-based wins to boring OBP-wins
− Because fans like SLG, TV stations and owners do too
Moneyball recap (2)
• What did the A’s have that was valuable and/or scarce?
− An idea: value players using the “win production function”
− An asset: a manager willing to learn it and ignore a sensible
revealed preference argument

• Were they really valuable? Yes. Were they scarce? No.

• Good reasons why the A’s learned the baseball production

function early and the Yankee’s (for example) didn’t

• The way baseball teams are managed today much closer to

what the A’s did than the Yankees (or anyone else) did
What industries do we think are profitable? (1/2)
• Guess a few at the top

• Guess a few at the bottom

Ghemawat & Rivkin (2014)
What industries do we think are profitable? (2/2)
• Some highly profitable industries
− Tobacco
− Pharmaceuticals
− Software
− Soft drinks

• Less profitable industries

− Oil and gas exploration
− Financial services
− Steel
− Entertainment
Industry Analysis
• Last week: profits and scarcity are tightly linked
• Today: why do some industries have more or less scarcity, and
in the right vs. “wrong” places?

• Divide our answers into two pieces:

1. Structural features (“a model”)
- “exogenous” facts about how the industry works
- observable reasons that match our economic intuitions
about the world

2. Everything else (“errors in the model”)

- Why is software more profitable than entertainment?
- Why is pharma more profitable than biotech?
Some uses for industry analysis

• Evaluate new markets to enter, old markets to leave

- If you were to become an “average” firm in an industry, how
well would you expect to perform?
- If you are a poor performer, is it you or is it them?

• Predict how “structural changes” might affect profits

- New technologies make entry less costly
- New customers with different preferences arrive
- Consolidation amongst your suppliers
Perspective (1): Five Forces are great!
• Industry analysis and the five forces are the “first sign” of
economics in a strategy classroom
- Alfred Chandler argued that “correct” business organization
structure was the cause of high profits
- mostly about successful examples in large scale
industries
- chemicals manufacturing (Dupont)
- autos (GM)
- oil exploration (Standard Oil)
- retail (Sears)

- Michael Porter argued that industrial organization ideas,

used in industry analysis, could explain industry profitability
Perspective (2): Five Forces don’t explain
everything, and are coarse simplifications of real
managerial decision making

• Industry analysis is not exactly a science, even by (low)

economics standards
- Limited rigorously defined theory
- Practically nonexistent believable empirical validation

• Why are there five forces?

Perspective (3)

• My opinion: explains a lot of variation in industry level profits

across industries, a lot of the time (i.e., there are obviously
counterexamples), even if the R2 isn’t 100%

• Plenty of useful intuition, driven by basic microeconomic ideas,

which we value in this course

• Five forces are definitely phrases and ideas that your boss,
investors, and colleagues will recognize

• Lets learn and appreciate them, but keep a healthy dose of

skepticism nearby
Porter’s “Five Forces”

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Force 1: Competitors and rivalry
• Within an industry, how “hard” do rivals compete?

• Typically we think about pricing (“Bertrand” competition)

• How else can you compete?

− “Cournot” competition (set quantities instead of prices)
− Product offerings (do we offer similar products? different?)
− Advertising (intensity, channels, type of message, etc)
− Recruiting
− R&D

• If competition is “stronger”, why are accounting profits smaller?

• How can / should you measure “competition”?

Ways of measuring competition: there are many,
but one is “best”
• Number of firms that sell the same good or service
• Ability of one firm to serve some/all of the customers of another
− Capacities of competitors, relative to demand
− Similarity of products across rivals
• Willingness of customers to forgo consumption (within industry)

• Ability to profitably charge more than (accounting) costs

− Possible if customers don’t have (within-industry) alternatives
− Possible if alternatives are “worse” or capacity constrained
− How to measure this? Demand elasticity
Demand elasticity and profits
• Quick reminder about calculus of price setting:
− D(p) is demand: how many units you sell if your price is p
− c is your variable cost (assume no capacity constraints)
− Then your (variable) profits are D(p) * (p – c)
− Take derivative with respect to p and set to 0 (why?)
0 = D’(p) * (p – c) + D(p)
− Divide through by p and rearrange to get an expression for
your markup
(p – c) / p = -(D(p) / p) / D’(p)
= - 1 / demand elasticity
• If you earn a large markup, you probably face inelastic demand
− i.e., your customers don’t have attractive options besides you
Demand elasticity and measures of competition
• Price elasticity of demand: an “all-in” measure of competition
− Cournot quantities + lots of competitors = high elasticity
− Bertrand prices + just 2 competitors = high elasticity
− Monopolist + very attractive outside option = high elasticity

• Encapsulates # of competitors, form of game, non-consumption

• More competitive = more elastic demand = less accounting profit

• Low demand elasticity means you have market power

What elasticity matters?
• Two kinds of demand elasticity we might care about:
− Firm elasticity: how much your q falls when you raise p
− Industry elasticity: how much aggregate Q falls when all
prices go up
− Why are they different?

• We are talking about industry profitability, so we want the

industry elasticity, right?

• Wrong. It depends on what force we are thinking about

− Now (competitors and rivalry): firm elasticity
− Later (substitutes and complements): industry elasticity
Soften competition/avoid rivalry => lower elasticity
• Rivalry avoidance 1: be differentiated
− Coke vs. Pepsi, Reebok vs. Nike, Marvel vs. DC (comics)
− iPhone vs. Android

• Rivalry avoidance 2: “capture” customers

− Airline loyalty programs, old wireless plans (switching costs)
− Amazon vs retail (search costs)

• Rivalry avoidance 3: control capacity

− Play constrained Cournot instead of Bertrand
− If rivals can’t serve your customers AND their customers, are
they really competing with you?
Force 2: Threat of entry and potential entrants
• Industries with “few” competitors – what’s going on?
− Boeing vs. Airbus
− Google vs. Bing
− Eli Lilly vs. Novo-Nordisk (insulin manufacturers)

• Are economic profits in these industries actually high?

− Hugely expensive assets generating accounting profits
− Conjecture: NPV of accounting profits – value of assets ~= 0

• Why are these assets so expensive / valuable? Entry barriers:

− Economies of scale
− Physical or legal constraints on access to “scale”
Economies of scale
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Scale, entry and threat of entry
• Why is scale important?
− ZEP tells us that size of market / MES sets a floor on the
number of competitors, in the long run
− Examples:
§ Taco shop – ratio is large
§ Commercial aircraft – ratio is small

• Strategic implication: incumbents have incentive to raise

entry costs of potential competitors
− Is MES a fact or a choice by incumbents?
− Do incumbents want to “over-serve” their markets?
Economies of scale: commercial aircraft
• Just 2 wide-body jet companies, 2 “new” designs in last decade*
− Boeing 787: $32 billion to design (also the 777X)
− Airbus A380: €11-14 billion to design (also the A350 XWB)
− Even the A380 cost several times the combined profits of the
next two biggest companies (Embraer and Bombardier) over
the last 3 years

• Boeing and Airbus sell new planes at a loss for several years
− Learning by doing: the empirically valid hope you figure out
how to make planes less expensively

• Barriers to entry: enormous fixed costs, learning

Legal constraints: out-of-patent biologic drugs
• Patents for many insulin molecules expired in the 2000s
− Essentially no generics in the US, $8 billion in annual sales
− Just two competitors: Eli Lilly and Novo Nordisk
− See also Epi-Pen, many cancer drugs, etc.

• Why? Limited legal institutions for “biosimilars”

− To sell a generic “small molecule,” need only prove that you
are making the right molecule
− To sell a generic “biologic,” burden of proof is much higher.
So far, just 20 “biosimilar” products approved in US to date
(Europe has 6X that…)

• Barriers to entry: regulation / intellectual property

Scale AND constraints: internet search engines
• Search engine market shares in July 2021 (comScore)
− Google: 62%
− Bing and Yahoo (both basically Microsoft): 37%

• Bing launched in 2009, not profitable until October 2015

− Losses of $1 billion/quarter in 2011!

• Complementarities “problem” for search engines

− More market share = more searches = better results
− Return to complementarities in next two weeks…

• Barriers to entry: consumer switching costs, “network effects”

Non-scale constraints on entry
• Real constraints (laws of nature?)
− Learning-by-doing (all advanced manufacturing)
− Network effects / complementarities (search engines)
− Physical limitations (wireless bandwidth, mineral rights)

• Artificial constraints (sometimes imposed by governments)

− Intellectual property
− Liquor licenses
− Taxi medallions
− Exclusive long-term contracts
Force 3: Substitutes and complements
• How should you think about competition from firms outside
of the industry?
− What are things customers could do with their money
instead of buying and still be happy?
− “Substitutes”

• How should you think about help from firms outside of the
industry?
− What are other things customers also buy that make
them more happy when they buy from the industry?
− “Complements”
Micro 101 of substitutes and complements
• A and B are substitutes if an increase in the price of A
increases the demand for B
− Cross price elasticity of A and B is positive
− Wine and beer, airplane travel and Amtrak, electric cars
and gasoline, bars and studying

• A and B are complements if an increase in the price of A

decreases the demand for B
− Cross price elasticity of A and B is negative
− Coke and rum, wine and steak, SUVs and gasoline, bars
and taxi rides
Micro 102 of substitutes and complements
• Let VA and VB be the value you get out of A, B individually
• Let VAB be the value you get out of A, B together

• A and B are substitutes if VAB < VA + VB

• A and B are complements if VAB > VA + VB

• These definitions will be helpful for our discussion of

competitive advantage next week, and network effects in
the second half of the course
Substitutes, complements and industry profits
• If an industry has lots of substitutable products, should we
expect profits to be high?

• What about lots of complementary products?

• Industry demand elasticity depends on substitutes,

complements
Force 4: Buyer power
• Would you rather have 1000 customers with single unit
demand or 2 customers each with 500-unit demand?

• When your customers are few in number and large in size,

you are the one who whose alternatives are poor.
− Setting your price a smidge too high could lead to a loss
in half of your sales!
− Your customers have buyer power

• Just as market power allows you to earn accounting

profits, buyer power allows your customers to earn
accounting profits (or “utility”) for themselves
Bargaining and buyer power
• Suppose you don’t get to just set a price, you have to
bargain with your customer

• Your customer gets VB from buying

• Your “walk away” value is WS, theirs is WB. What prices

are possible?
P > WS, VB - P > WB, so

WS < P < VB – WB
• Note that this is possible prices, not actual prices
Bargaining and buyer power (2)
• In reality, you might not know VB or WB (and your customer
won’t know WS) but for now lets assume its all public

• How should “buyer power” affect industry profits?

− Buyer is a big % of your sales?
§ Decrease WS
− Product is sold by other firms, low switching costs?
§ Increase WB
− Your product of minimal importance to buyers profits?
§ Decrease VB
• Note: movement in WB, WS, VB need not move P…
Force 5: Supplier power
• Exact same idea as buyer power: if your supplier is
irreplaceable in your production process, they have some
supplier power

• Supplier power increases when

− their walk-away value increases
§ i.e., you gain a competitor they can sell to
− your walk-away value decreases
§ i.e., they lose a competitor you can buy from
− your value of buying increases
§ i.e., their product makes yours more desirable
Five Forces Wrap-up
• Five Forces provide intuition about sources of industry profits

• We have bad data to test whether they really do work

− i.e., limited empirical evidence that industries with more
supplier power are less profitable, on average
− We usually can’t even cleanly measure barriers to entry or
relative levels of buyer/supplier power

• Five Forces as a “sniff test” – questions a manager should ask

him/herself before entering a new industry, exiting an old one, or
responding to “changes” in the marketplace