CHAPTER 2

EXTERNAL ENVIRONMENT OF THE FIRM

➢ THREE IMPORTANT PROCESSES TO DEVELOP FORECASTS:

1) ENVIRONMENTAL SCANNING: surveillance of a firm’s external environment to predict
environmental changes and detect changes already under way.
2) ENVIRONMENTAL MONITORING: a firm’s analysis of the external environment that tracks the
evolution of environmental trends, sequence of events, or streams of activities.
3) COMPETITIVE INTELLIGENCE: a firm’s activities of collecting and interpreting data on
competitors, defining and understanding the industry, and identifying competitors’ strengths and
weaknesses.

• ENVIRONMENTAL FORECASTING
- The development of plausible projections about the direction, scope, speed, and intensity of
environmental change. A danger of forecasting is that managers may view uncertainty as black
and white and ignore important grey areas.

• SCENARIO ANALYSIS
- An in-depth approach to environmental forecasting that involves experts’ detailed assessments
of societal trends, economics, politics, technology, or other dimensions of the external
environment.

• SWOT ANALYSIS
- A framework for analyzing a company’s internal and external environment and that stands for
strengths, weaknesses, opportunities and threats.
- The strengths and weaknesses portion of SWOT refers to the internal conditions of the firm.
opportunities and threats are environmental conditions external to the firm.
➢ Limitations of SWOT Analysis
- By listing the firm’s attributes, managers have the raw material needed to perform more in-depth
strategic analysis. However, SWOT cannot show them how to achieve a competitive advantage,
because of the following limitations:
❖ Strengths may not lead to an advantage;
❖ SWOT focus on the external environment is too narrow;
❖ SWOT gives a one-shot view of a moving target, because it is primarily a static assessment;
❖ SWOT overemphasizes a single dimension of strategy.

➢ THE GENERAL ENVIRONMENT

- Factors external to an industry, and usually beyond a firm’s control, that affect a firm’s strategy.
The general environment is divided into six segments:
1) Demographic: aging population, rising affluence, changes in ethnic composition, geographic
distribution of population etc;
2) Sociocultural: more women in the workforce, increase in temporary workers, greater concern
for fitness, concern for environment etc;
3) Political/Legal: tort reform, Americans with Disabilities Act, taxation of local, state and federal
levels, Sarbanes-Oxley Act of 2002 etc;
4) Technological: genetic engineering, emergence of Internet technology, pollution/global
warming, wireless communication etc;
5) Economic: interest rates, unemployment rates, consumer price index, trends in GDP, changes
in stock market valuations etc;
6) Global: increasing global trade, currency exchange rates, emergence of the Indian and Chinese
economies, creation of WTO etc.
• THE COMPETITIVE ENVIRONMENT
- Factors that pertain to an industry and affect a firm’s strategies. The nature of competition in an
industry as well as the profitability of a firm is often more directly influenced by developments in
the competitive environment.

• PORTER’S FIVE-FORCES MODEL

- The “five-forces” model has been the most commonly used analytical tool for examining the
competitive environment. It describes the competitive environment in terms of five basic
competitive forces (see the figure):
1) Potential Entrants
2) Buyers
3) Suppliers
4) Substitutes
5) Industry Competitors

1) THREAT OF NEW ENTRANTS: possibility that the profits of established firms in the industry
may be eroded by new competitors. There are six major sources of entry barriers:
❖ Economies of Scale;
❖ Product Differentiation;
❖ Capital Requirements;
❖ Switching Costs;
❖ Access to Distribution Channels;
❖ Cost Disadvantages Independent of Scale.
2) BARGAINING POWER OF BUYERS: buyers threaten an industry by forcing down prices,
bargaining for higher quality or more services, and playing competitors against each other. A
buyer group is powerful under the following circumstances:
❖ It is concentrated or purchases large volumes relative to seller sales;
❖ The products it purchases from the industry are standard or undifferentiated;
❖ The buyer faces few switching costs;
❖ The buyers pose a credible threat of backward integration;
❖ The industry’s product is unimportant to the quality of the buyer’s products or services.
3) BARGAINING POWER OF SUPPLIERS:
❖ The supplier group is dominated by a few companies and is more concentrated (few firms
dominate the industry) than the industry it sells to;
❖ The supplier group is not obliged to contend with substitute products for sale to the industry;
❖ The industry is not an important customer of the supplier group;
❖ The supplier group’s products are differentiated or it has built up switching costs for the buyer;
❖ The supplier group poses a credible threat of forward integration.
4) THREAT OF SUBSTITUTE PRODUCTS AND SERVICES: all firms within an industry compete
with industries producing substitute products and services. Substitutes limit the potential returns
 of an industry by placing a ceiling on prices that firms in that industry can profitably charge. The
more attractive the price/performance ratio of substitute products, the tighter the lid on an
industry’s profits.
5) INTENSITY OF RIVALRY AMONG COMPETITORS IN AN INDUSTRY: rivalry among existing
competitors takes the form of jockeying for position. Firms use tactics like price competition,
advertising battles, product introductions, and increased customer service or warranties. Intense
rivalry is the result of several interacting factors, including the following:
❖ Numerous or equally balanced competitors
❖ Slow industry growth
❖ High fixed or storage costs
❖ Lack of differentiation or switching costs
❖ Capacity augmented in large increments
❖ High exit barriers

• CAVEATS OF USING INDUSTRY ANALYSIS:

- Managers must not always avoid low profit industries (or low profit segments in profitable
industries). Such industries can still yield high returns;
- the five-forces analysis implicitly assumes a zero-sum game, determining how a firm can
enhance its position relative to the forces. Yet, such an approach can often be short-sighted;
- The five-forces analysis also has been criticized for being essentially a static analysis. External
forces as well as strategies of individual firms are continually changing the structure of all
industries.

• COMPLEMENTS
- Products or services that have an impact on the value of a firm’s products or services.

• STRATEGIC GROUPS
- Clusters of firms that share similar strategies. Competition tends to be more intense among firms
within a strategic group than between strategic groups.
- One can derive an analytical tool from the strategic groups concept:
o Strategic groupings help a firm to identify barriers to mobility that protect a group from attacks
by other groups;
o Strategic groupings help a firm identify groups whose competitive position may be marginal
or tenuous;
o Strategic groupings help chart the future directions of firms’ strategies;
o Strategic groups are helpful in thinking through the implications of each industry trend for the
strategic group as a whole.