Principles of

Management
Nova SBE – Fall 2020
Lecture 10 thru. to 14 – Strategic Analysis
Industry Evolution Over
Time
Determinants of
Industry Profitability
Michael Porter’s five forces
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Porter’s five forces for overall profitability in an industry

Porter explains that there are five forces that determine industry
attractiveness and long-run industry profitability. These five
"competitive forces" are
- The threat of entry of new competitors (new entrants)
- The threat of substitutes
- The bargaining power of buyers
- The bargaining power of suppliers
- The degree of rivalry between existing competitors

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Market structure and
competitive pressure
Determinants of industry profitability
The intensity of rivalry between competitors in an industry will
depend on

The structure of competition

• Rivalry is more intense where there are many small or equally sized competitors
• Rivalry is less when an industry has a clear market leader

The structure of industry costs

• Industries with high fixed costs encourage competitors to fill unused capacity by price cutting

Degree of differentiation

• Industries where products are commodities (e.g. steel, coal) have greater rivalry
• Industries where competitors can differentiate their products have less rivalry

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Intensity is the degree to which
firms depreciate each others’
profits
Switching costs
Rivalry is reduced where buyers have high switching costs
If there is a significant cost associated with the decision to buy a product from an
alternative supplier
Strategic objectives
When competitors are pursuing aggressive growth strategies, rivalry is more intense
Where competitors are "milking" profits in a mature industry, the degree of rivalry is
lower
Exit barriers
When barriers to leaving an industry are high, competitors tend to exhibit greater
rivalry

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Entry Barriers
Determinants of industry profitability
Entry barriers are rents derived from incumbency

New entrants to an industry can raise the level of competition, thereby

reducing its attractiveness

The threat of new entrants largely depends on the barriers to entry

High entry barriers exist in some industries (e.g. shipbuilding) whereas

other industries are very easy to enter (e.g. estate agency, restaurants)

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Entry barriers can go beyond
fixed costs
Key barriers to entry include
Economies of scale
(e.g. Paper and pulp, refineries, chemicals, etc.)
Capital / investment requirements
(e.g. Xerox copiers)
Customer switching costs (SAP)
Access to industry distribution channels
(Japan 1980s)
The likelihood of retaliation from existing industry
players.

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Network externalities are the critical mass that some goods
exhibit

There are network externalities when the benefit of being connected

to a certain system (telecommunications network, electricity network,
network system users that is incompatible with third parties) depends
on the number of users
Requires the existence of a minimum number of users that can
assure the auto-sustainability of the network’s growth (critical mass)
When the number of users is lower than the critical mass, the
network tends to ‘’disappear’”
Reason for the interconnection imposed between networks.

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Network diffusion

Time

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Competition between standards
Matsushita vs. Sony
Matsushita licensed the VHS system and charged royalties
Sony tried to impose the Betamax system (better technology, better own distribution
network)
Established in the market those who knew how to take advantage of the existence of network
externalities
Incompatible systems
Larger benefit of connection to a larger network
More recently, a similar war occurred between the HD-DVD and the BluRay formats

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Vertical relationships:
suppliers and clients
Determinants of industry profitability
Bargaining power of buyers

Buyers are the people / organisations who create

demand in an industry
The bargaining power of buyers is greater when
There are few dominant buyers and many sellers in the industry
Products are standardised
Buyers threaten to integrate backward into the industry
Suppliers do not threaten to integrate forward into the buyer's industry
The industry is not a key supplying group for buyers

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Bargaining power of suppliers

Suppliers are the businesses that The cost of items bought from If suppliers have high bargaining
supply materials & other products suppliers (e.g. raw materials, power over a company, then in
into the industry. components) can have a significant theory the company's industry is less
impact on a company's profitability attractive

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High bargaining power of supplier is bad for downstream
profitability

The bargaining power of suppliers will be high when

There are many buyers and few dominant suppliers
There are undifferentiated, highly valued products
Suppliers threaten to integrate forward into the industry
(e.g. brand manufacturers threatening to set up their own
retail outlets)
Buyers do not threaten to integrate backwards into supply
The industry is not a key customer group to the suppliers

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Market segmentation
Determinants of industry profitability
Substitutes and
complements
Things to consider:
The existence of close substitutes/complements
Price-value of substitutes and complements (e.g.,
close substitutes will be a weak threat if their price is
very high)
Price elasticity at the industry level (if high, the
industry is very limited in term of potential price
increases)

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Other third party constraints

Financing Regulatory Environmental

constraints constraints regulations
• Underdeveloped • Differences in • e.g. Chlorine
financial markets missions and production
• Investor network objectives (mercury cells vs
• Technical vs. • e.g. Welfare membranes)
managerial project maximization vis-à-
emphasis vis value creation

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But what is missing?

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 FSD by
Age
Cohort in
Portugal

≤1, 2-4, 5-9, 10-19, 20-29, >30

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Internal Analysis
Strengths, Weaknesses, Opportunities, & Threats
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Generic Competitive
Strategies
The basis for firm heterogeneity
Types of generic strategies

A firm's relative position within its industry determines whether a firm's profitability is above or
below the industry average

The fundamental basis of above average profitability in the long run is sustainable competitive
advantage

Firms compete on product the superiority of product characteristics

There are two basic sources for this superiority are: low-cost or differentiation

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Series of five tests for a superior resource:

Inimitability - how hard is it for competitors to copy the resource? A company can
stall imitation if the resource is:
• physically unique
• a consequence of path dependent development activities
• causally ambiguous (competitors don't know what to imitate)
• a costly asset investment for a limited market, resulting in economic deterrence.
Durability - how quickly does the resource depreciate?
Appropriability - who captures the value that the resource creates: company,
customers, distributors, suppliers, or employees?
Substitutability - can a unique resource be trumped by a different resource?
Competitive Superiority - is the resource really better relative to competitors?

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Types of strategies
The two basic types of competitive advantage combined with
the scope of activities for which a firm seeks to achieve them,
lead to three generic strategies for achieving above average
performance in an industry
Cost Leadership
Differentiation
Focus
The focus strategy has two variants, cost focus and
differentiation focus

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Types of
strategies

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Cost leadership
In cost leadership, a firm sets out to become the low cost producer in its
industry
The sources of cost advantage are varied and depend on the structure of
the industry. They may include
The pursuit of economies of scale
Proprietary technology
Preferential access to raw materials and other factors
A low-cost producer must find and exploit all sources of cost advantage.
if a firm can achieve and sustain overall cost leadership, then it will be an
above average performer in its industry, provided it can command prices
at or near the industry average

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Cost leadership
Competitive Strategy Required Skills & Organizational Elements Associated Risks
Resources
Overall Cost Leadership Sustained capital Tight cost control Technological change
investment and Frequent, detailed reports that nullifies past
access to capital Structured organization investments or
and responsibilities learning
Process engineering Incentives based on Low-cost learning by
skills meeting strict industry newcomers
quantitative targets or followers through
Intensive supervision of imitation, or through
labor their ability to invest
in state-of-the-art
Products designed for facilities
ease of Inability to see required
manufacture product or
marketing change
Low-cost distribution because of the
system attention placed on
cost
Inflation in costs that
narrow the firm’s
ability to maintain
enough of a price
differential to offset
competitors’ brand
images or other
approaches to
differentiation

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Ex: Samsung vs competitors in the entry-level smartphone market
Differentiation
Differentiation Strong marketing abilities
Product engineering
Creative flair
Strong capability in basic research
Corporate reputation for quality or
technological leadership
Long tradition in the industry or
unique combination of skills
drawn from other businesses
Strong cooperation from channels
Strong coordination among functions in
R&D, product development, and
marketing
Subjective measurement and
incentives instead of quantitative
measures
Amenities to attract highly skilled labor,
scientists, or creative people
The cost differential between low-cost
competitors and the
differentiated firm becomes too
great for differentiation to hold
brand loyalty. Buyers thus
sacrifice some of the features,
services, or image possessed by
the differentiated firm for large
cost savings.
Buyers’ need for the differentiating
factor falls. This can occur as
buyers become more
sophisticated.
Imitation narrows perceived
differentiation, a common
occurrence as industries mature.
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Focus

The generic strategy of focus rests on the choice of a narrow competitive scope within an industry

The focuser selects a segment or group of segments in the industry and tailors its strategy to
serving them to the exclusion of others

The focus strategy has two variants

In cost focus a firm seeks a cost advantage in its target segment

Differentiation focus a firm seeks differentiation in its target segment

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Focus
Both variants of the focus
strategy rest on differences
between a focuser's target
segment and other segments in
the industry
The target segments must
either have buyers with unusual
needs or else the production Cost focus exploits differences
and delivery system that best in cost behaviour in some
serves the target segment must segments
differ from that of other industry
segments
Differentiation focus exploits the
special needs of buyers in
certain segments
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Focus

Focus Combination of the above policies
directed at the particular
strategic target
Combination of the above policies
directed at the particular
strategic target
The cost differential between broad-
range competitors and the
focused firm widens to eliminate
the cost advantages of serving a
narrow target or to offset the
differentiation achieved by focus.
The differences in desired products or
services between the strategic
target and the market as a whole
narrows.
Competitors find submarkets within
the strategic target and outfocus
the focuser.

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Strategic Analysis – Part II
Competencies, resources, sustainability. Technology.
Contents

1 2 3
Capabilities and Unique resources Technology,
competences and sustainability innovation and
of the competitive competitive
advantages positioning

38
Core Competencies and
Capabilities

And the role of economies of scope

Economies of scope are savings from producing different
goods

Economies of scope exist if the firm achieves savings as it increases the variety of goods and
services it produces
TC(Qx,Qy) < TC(Qx,0) + TC (0,Qy)
That is, the total cost of independent production of the two goods is higher than the total cost
of joint production
Economies of scope benefit the expansion of vertical and corporate boundaries
We can rearrange the previous formula to obtain another interpretation
TC(Qx,Qy) – TC (0,Qy) < TC(Qx,0)
This says that the incremental cost of producing Qx units of good X, as opposed to none at
all, is lower when the firm is producing a positive quantity Qy of good Y.

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Economies of Scope
Apple’s core competency in engineering allows it to make popular cell phones,
laptops, and tablet computers

Ikea’s skills in product design extends to an enormous range of home furnishing

products

Economies of scale and scope may arise at any point in the production process, from
acquisition and use of raw inputs to distribution and retailing

Although business managers often cite scale and scope economies as justifications for
growth activities and mergers, they do not always exist.

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Core Competencies and
Capabilities
Competencies are a harmonized combination of multiple
resources and skills that distinguish a firm in the marketplace
Core competencies fulfill three criteria:
Provides potential access to a wide variety of markets.
Should make a significant contribution to the perceived customer
benefits of the end merchandise.
Difficult to imitate by competitors
Capabilities present a method to evaluate different product
architectures with respect to their contribution to the
development of core competencies

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What are Core Competencies and
Capabilities?
Prahalad and Hamel (1990) speak of core competencies
as the collective learning in the organization, especially
how to coordinate diverse production skills and integrate
multiple streams of technology
These skills underlie a company's various product lines,
and explain the ease with which successful competitors
are able to enter new and seemingly unrelated businesses

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Core Competency Skills

Interpersonal skills Business skills Personal skills

Leader Accounting Motivated
Motivator Economics Initiative
Negotiator Legal & Compliance Experience
Team builder Technology Communicative
Consultive

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Resource-Based View of the Firm

resources are the key for superior performance

The link
between
RBV and
competitive
advantage
RESOURCE DISTINCTIONS
AND CHARACTERISTICS
MATTERS

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RBV uses internal resources in an external competitive
environment

The RBV framework combines the internal (core competency)

and external (industry structure) perspectives on strategy
Like the frameworks of core competence and capabilities,
firms have very different collections of physical and
intangible assets and capabilities, which RBV calls
resources
Competitive advantage is ultimately attributed to the
ownership and control of a valuable resource

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RBV theory implies path dependency of firm histories

Resources are more broadly defined to be physical (e.g. No two companies have the same resources because no
property rights, capital), intangible (e.g. brand names, two companies have had the same set of experience,
technological know how), or organizational (e.g. routines acquired the same assets and skills, or built the same
or processes like lean manufacturing) organizational culture

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The VRIO framework
Unique resources and sustainability of
the competitive advantages
Series of five tests for a valuable resource:

Inimitability - how hard is it for competitors to copy the resource? A company can
stall imitation if the resource is (1) physically unique, (2) a consequence of path
dependent development activities, (3) causally ambiguous (competitors don't know
what to imitate), or (4) a costly asset investment for a limited market, resulting in
economic deterrence.
Durability - how quickly does the resource depreciate?
Appropriability - who captures the value that the resource creates: company,
customers, distributors, suppliers, or employees?
Substitutability - can a unique resource be trumped by a different resource?
Competitive Superiority - is the resource really better relative to competitors?

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Resources of a Corporation

SO, WHAT ARE THESE RESOURCES THAT BUSINESS RESOURCES CAN USEFULLY
A BUSINESS NEEDS TO PUT IN PLACE TO BE GROUPED UNDER SEVERAL
PURSUE ITS CHOSEN STRATEGY? CATEGORIES

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Resources, capabilities and
competitive advantage

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Financial Resources

FINANCIAL RESOURCES CONCERN AN AUDIT OF FINANCIAL RESOURCES

THE ABILITY OF THE BUSINESS TO WOULD INCLUDE ASSESSMENT OF
"FINANCE" ITS CHOSEN STRATEGY THE FOLLOWING FACTORS

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Examples: Financial
Resources
Existing finance funds
Cash balances
Bank overdraft
Bank and other loans
Shareholders' capital
Working capital (e.g. stocks, debtors) already invested in the business
Creditors, suppliers, &government
Ability to raise new funds
Strength and reputation of the management team and the overall business
Strength of relationships with existing investors and lenders

Attractiveness of the market in which the business operates (i.e. is it a market that is
attracting investment generally?)
Listing on a quoted Stock Exchange? If not, is this a realistic possibility?

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 Examples: Human Resources
The heart of the issue with Human Resources is the
skills-base of the business. What skills does the
business already possess? Are they sufficient to meet
the needs of the chosen strategy? Could the skills-
base be flexed / stretched to meet the new
requirements?
An audit of human resources would include
assessment of the following factors:

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 Human Resources
Existing - Numbers of staff by function, location, grade, experience, qualification,
staffing remuneration
resources
- Existing rate of staff loss ("natural wastage")
- Overall standard of training and specific training standards in key roles
- Assessment of key "intangibles" - e.g. morale, business culture

Changes - What changes to the organisation of the business are included in the
required to strategy (e.g. change of location, new locations, new products)?
resources
- What incremental human resources are required?
- How should they be sourced? (alternatives include employment,
outsourcing, joint ventures etc.)

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 Physical Resources
The category of physical resources covers wide range of operational resources concerned
with the physical capability to deliver a strategy. These include:

Production - Location of existing production facilities; capacity; investment and

facilities maintenance requirements
- Current production processes - quality; method & organisation
- Extent to which production requirements of the strategy can be delivered
by existing facilities

Marketing - Marketing management process

facilities
- Distribution channels

Information - IT systems
technology
- Integration with customers and suppliers

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 Examples of Intangible
Resources
It is easy to ignore the intangible resources of a business when assessing how to deliver a
strategy - but they can be crucial. Intangibles include:

Goodwill - The difference between the value of the tangible assets of the business
and the actual value of the business (what someone would be prepared to
pay for it)

Reputation - Does the business have a track record of delivering on its strategic
objectives? If so, this could help gather the necessary support from
employees and suppliers

Brands - Strong brands are often the key factor in whether a growth strategy is a
success or failure

Intellectual - Key commercial rights protected by patents and trademarks may be an

Property important factor in the strategy.

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Sustainable Competitive
Advantage

Achievable? A tautology?
Evidence on the Persistence of
Profitability

Dennis Mueller’s study of U. S. manufacturing firms finds

that
Firms with abnormally high ROA will experience a decline over
time

Firms with abnormally low ROA will experience an improvement

over time and

high ROA firms and low ROA firms do not converge to a common
mean

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Evidence on the Persistence of
Profitability
Mueller’s results indicate that there are some
forces that push markets towards the competitive
rate of return and other forces that impede that
dynamic
The net result is a persistent ROA gap between
firms that start out as high ROA firms and firms
that start out as low ROA firms

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The
Persistence
of
Profitability
in Mueller’s
Sample

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Sustainability

Differences in profitability persistent in time point to the existence of specific

factors explaining the dispersion of the performances

An RBV emphasizes the role of the asymmetries in resources and capabilities

between firms as a sources of sustainable advantages

The resources and capabilities must be scarce and immobile (not appropriable
by a third party) so that they can serve as a basis for sustainable advantages

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Sustainability
For the advantages to be sustainable, they must be
associated with isolating mechanisms preventing its
duplication by a third party. These mechanisms are
essentially

Imitation Barriers

First-Mover’s Advantage

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Sustainability

Cases of barriers • Legal restrictions (patents)

• Privileged access to scarce inputs or clients

to imitation
• Economies of scale in ‘’small markets’’
• Intangible barriers to imitation such as causal ambiguity, etc.

Sources of First • Learning economies

• Network externalities
• Brand loyalty (brand name reputation) when consumers reveal uncertainty regarding the quality of the products

mover's advantage and

• Switching costs between products

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 Steps in the Process of
Formulating a Strategy

Identification and classification of the firm’s resources

Assessment of the capabilities of the firm

Assessment of the potential of the resources

Formulation of the strategy

Identification of the resource gaps

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Technology, innovation
and competitive
positioning
First, a book recommendation
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There are different ways to think about
innovation

Sustaining
Evolutionary
An innovation that improves a product in an
existing market in ways that customers are
expecting (e.g., fuel injection for gasoline
engines, which displaced carburetors.)
Revolutionary (discontinuous, radical)
An innovation that is unexpected, but
nevertheless does not affect existing
markets (e.g., the first automobiles in the
late 19th century, which were expensive
luxury items, and as such very few were
sold)

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Everybody’s heard of disruptive innovation, but what is it?

An innovation that creates a

new market by providing a
Disruptive There are things to be
different set of values, which Should originate on
innovation ultimately (and
gained, but also to be lost
unexpectedly) overtakes an
existing market

low-end of the new-market

market footholds

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Everybody’s heard of
disruptive innovation, but
what is it?
Disruptive innovation
An innovation that creates a new market by providing
a different set of values, which ultimately (and
unexpectedly) overtakes an existing market → things
to be gained, but also to be lost
Should originate on
a) low-end or
b) new-market footholds

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Community fact checking and quality
73
Fact
checking
in fiction

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Innovation
Innovation versus invention
Types of innovation
Innovation of product
Innovation of process
Structure of the market and innovation
Schumpeter for entrepreneurial ventures
K. Arrow replacement effect in monopolies
Patents and free riding

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Schumpeter on Innovation
Schumpeter Mark I (1934): creative destruction
Entrepreneurship “replaces today's Pareto optimum with
tomorrow’s different new thing. (...) Carrying out innovations
[a process of creative destruction] is the only function which
is fundamental in history.“

1942

1934

Schumpeter Mark II (1942): large firms and innovation

“As soon as we go into the details and inquire into the
individual items in which progress was most conspicuous, the
trail leads not to the doors of those firms that work under
conditions of comparatively free competition but precisely to
the doors of the large concerns.”

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Innovation and Imitation

Some innovations are more easily imitated than others

In many high-tech industries, every so often a drastic innovation takes place

Everyone else tries to imitate – normally imperfectly and with a time lag

There is a leader and there is a laggard – until the next drastic innovation comes
around

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Differentiation

In a differentiation strategy a firm seeks to be unique in its industry along some dimensions
that are widely valued by buyers

It selects one or more attributes that many buyers in an industry perceive as important, and
uniquely positions itself to meet those needs

It is rewarded for its uniqueness with a premium price

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Vertical and horizontal differentiation

Vertically differentiated products differ in quality and all consumers

agree on the preference ordering for their purchase

In horizontally differentiated products, consumers do not agree on the

preference ordering
• If all products are sold at the same price, the optimal choice varies from consumer to
consumer
• For the same price, some will choose flat or sparkling water; vanilla or strawberry ice-
cream (or peanut butter, I mean, why not?)
• This also applies for location: for two identical pharmacies I will prefer the closest

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Branding is a further example of horizontal differentiation

Each consumer will have a specific product

version that she prefers, that is closest to her
preferences (if priced equally)
We will use distance and location as a metaphor for how close a given
product is to a consumer’s own preferences
Think of cocoa-level in chocolate
A consequence of the difference in preferences (distance) will be that
consumers will be unlikely to buy from a different, far-away producer
Firms will therefore have some degree of market power

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81
Address/location models
Def.: Address models are models in which
consumers view each the product of each firms
as having a particular address/location in a
product space and where consumers also differ
in their location

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The address of a consumer defines her
most preferred product

Competition tends to be localized:

• An increase in the price for one product does not impact on the
demand for products that are far away (i.e. very different) but
will impact on the demand for products in its neighborhood (i.e.
very similar)
• Conversely, the demand for a given product is only affected by
the prices of goods in its neighborhood, not by the prices of
remote products

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Address models

Address models also require us to specify how consumers are

distributed in the product space
• Are consumers particularly keen on some product type or are they more evenly
spread in their preferences?

We also need to specify how willing the consumers are to trade

off characteristics for price
• How much utility does a consumer lose from buying a product that does not
match her ideal?

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Questions for address models

Does product differentiation create market power?

How much will firms choose to differentiate their products?

Is there under- of over-variety?

What determines prices in a differentiated market?

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Hotelling location model
Horizontal product differentiation
Two firms at different locations in a product space (no
entry)
Consumers also have locations and lose utility from
choosing from a different address – transportation
costs
Consumers are uniformly distributed across space

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Hotelling location model
Product space: a continuum between 0 and 1
Two firms: i = 1,2 located at yi
y1 = a (a is the distance from the left city boundary)
y2 = b (1-b is the distance from the right city boundary)
a ≤ 1 – b (firm 1 is closer to the boundary)
each firm has constant marginal cost c

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Location

Preferences: V – p – k (|x – y|)

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Segmentation
Strategies

Demand effect: There is an incentive for both

to locate at the center in order to increase their
market share
Strategic effect: There is also an incentive for
both players to locate at opposite extremes

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