tMA2u962EeilxxL_ZeRz_A_b4dff370deb611e88608d7ffb3ca0099_Week-2-Slides

Analyzing Industry
Structure
By Laurent ERRERA from L'Union, France [CC BY‐SA 2.0 (http://creativecommons.org/licenses/by‐

sa/2.0)], via Wikimedia Commons
This slide handout was created by the University of Virginia Darden School of Business and is provided to support your learning while taking this course.
Please do not share or distribute it. 1
The Fundamental Principle
of Business Strategy
“If everyone can do it, it’s difficult to
create and capture value from it.”
or, alternatively
“In a perfectly competitive market, no
firm realizes economic profits (rents).”
Two Perspectives on Rents

Monopoly Rents Ricardian Rents
(Industrial Organization View) (Resource Based View)
S
MC1 MC2 AC2
S’
P P
AC1
Q q1 q2
•Barriers to entry •Barriers to imitation

•Industry structure matters •Firm structure matters
The Role of Industry
Structure
• The Industrial Organization
Perspective: S
 Premise that industry structure
matters most S’
 Economic rents due to barriers to
P
competition
(i.e., monopoly rents)
D
 Some industries are more profitable
than others Q
Medical Products and Equipment
Network and Other Communications…
Pharmaceuticals
Aerospace and Defense

Industry Averages in 2008
Chemicals
Computers, Office Equipment
Construction and Farm Machinery
Utilities: Gas and Electric
Health Care: Medical Facilities
Beverages
Financial Data Services
Telecommunications
Semiconductors and Other Electronic…
Commercial Banks
Entertainment
Forest and Paper Products
Real Estate
Airlines
‐15 ‐10 ‐5 0 5 10 15
Return on Assets (%)

Source: Fortune 500 2009, money.cnn.com
The Strategist’s Toolkit:
Five Forces Analysis
Threat of
Entry
Bargaining Bargaining
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
Threat of Entry, Part 1
Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
Threat of Entry
• Entry is less likely when...
 Entrant faces high sunk costs
− Sunk costs are investments that cannot
be recovered
 Incumbents have a competitive advantage
− Potential entrants are at a competitive
disadvantage compared to existing
players, simply not profitable to enter
 Entrant faces retaliation
− Potential entrants are likely to be forced
out of business by strategic (pricing)
behavior of incumbents
Competitive Advantages
• Patents & licenses

• Pioneering brands
• Pre-commitment contracts
(e.g., distribution)
• Large economies of scale
(relative to demand)
• Steep learning (experience) curves
• Others
Economies of Scale
$
AC
MES Output
Competitive Advantages
• Patents & licenses

• Pioneering brands
• Pre-commitment contracts
(e.g., distribution)
• Large economies of scale
(relative to demand)
• Steep learning (experience) curves
• Others
Learning Curves
Unit Cost
Cumulative Output Over Time
Learning Curve for
Semiconductor Memories
Price Per Bit
(millicents)
Cumulated Output
(bits x 1012)
Threat of Entry, Part 2
Threat of Entry
• Entry is less likely when...
 Entrant faces high sunk costs
− Sunk costs are investments that cannot
be recovered
 Incumbents have a competitive advantage
− Potential entrants are at a competitive
disadvantage compared to existing
players, simply not profitable to enter
 Entrant faces retaliation
− Potential entrants are likely to be forced
out of business by strategic (pricing)
behavior of incumbents
Likelihood of Retaliation
• Excess capacity of incumbents
• Economies of scale or other cost
advantage
• Substantial exit costs
 Exit costs are payments that must be
made upon exit
 Exit costs provide an incentive to fight
• Aggressive reputation of incumbents
 Must be credible
 Suffers from free-riding problem
Threat of Substitutes

Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
• Substitute products are less of a threat

when…
 Cross-price elasticity of demand is low
 Switching costs are high
− One-time costs customers incur when
switching to a new product or service
Cross-Price Elasticity
The ratio of the % change in demand for one good given a 1% increase
in price of another good.
P1 P1 P1
Q2 Q2 Q2
Perfectly /Infinitely “Moderately” Perfectly

Elastic Demand Elastic Demand Inelastic Demand
Cross-Price Elasticity
The ratio of the % change in demand for one good given a 1% increase
in price of another good.
P1 P1 P1
Q2 Q2 Q2
Perfectly /Infinitely “Moderately” Perfectly

Elastic Demand Elastic Demand Inelastic Demand
• Substitute products are less of a threat

when…
 Cross-price elasticity of demand is low
 Switching costs are high
− One-time costs customers incur when
switching to a new product or service
Bargaining Power of
Buyers, Part 1

Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
Bargaining Power of Buyers
• Buyers have less power when…

 Buyers are not concentrated
(no monopsony)
− Many potential buyers
− Each accounts for a small fraction of
sales
Relative Concentration
Monopoly
Many Competitive
Power
Buyer
Mutual Monopsony
Few
Dependence Power
Few Many
Supplier

 Buyers have few options
− Products are differentiated (low intra-
industry CPE)
− High switching costs (relationship-
specific assets)
− Buyer cannot backward integrate
Bargaining Power of
Buyers, Part 2

 Buyers are not concentrated
 Buyers have few options
 Buyers are segmented
− Price information is not widely
available
− Price discrimination possible
− Bundling possible
Price Discrimination
P
S
Consumer
Surplus
pc
Producer
Surplus
D
qc Q
P
S
pc
Producer
Surplus
D
qc Q
Self-Sorting
2nd Degree Price Discrimination
Price $60 Profits = $60M
$40
$20
1 2 3
Demand (Millions)
Self-Sorting
Price $60
$40
$20 Profits = $60M
1 2 3
Demand (Millions)
Self-Sorting
Price $60
$40
Profits = $100M
$20
1 2 3
Demand (Millions)
Sorting by Groups
3rd Degree Price Discrimination
Willingness to Pay for Product
Type
Consumer Type A B C D Total
HR $100 $90 $70 $20 $280
Engineers $60 $120 $70 $70 $290
Sales $100 $80 $140 $60 $380
Consultants $70 $100 $60 $80 $310
Min. Willingness
$60 $80 $60 $20 $220
to Pay for Product
Bargaining Power of
Suppliers
Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
Bargaining Power of Suppliers

• Suppliers are less of a threat when…
 Sellers are not concentrated
(no monopoly)
 Firms have many alternatives
− Many substitutes for supplier’s products
− Firms face low switching costs
− Supplier cannot forward integrate
 Sellers may not treat segments differently
− Price information is widely available
− Price discrimination not possible
P
S
pc
Producer
Surplus
D
qc Q
Intensity of Rivalry
Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes
• Rivalry is less intense when…

 The number of competitors is small!
 Incentives to “fight” are low
− Substantial market growth
▫ Especially if capacity constrained
− Opportunities to differentiate
− Low exit costs
− Little excess capacity
▫ Demand is not cyclical
• Rivalry is less intense when…

 Coordination is feasible
− Explicit price / market fixing
▫ Antitrust violation!
− Tacit coordination
▫ Implicitly holding prices high,
differentiating
Module Lessons
Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Role of Threat of Role of

Complements Substitutes Institutions
Module Lessons
• A key task in a strategic analysis is to
identify and address the competitive
forces that limit economic rents:
 Entry is less likely when incumbent firms
have a competitive advantage and can
credibly retaliate against new entrants.
 Substitution is less likely when switching
costs are high and cross-price elasticity is
low.
Module Lessons
• A key task in a strategic analysis is to
identify and address the competitive
forces that limit economic rents:
 Buyer and supplier power depend on
relative concentration, the viability of
alternatives, and information availability.
 Rivalry is more intense when there are
more competitors, incentives to fight are
large, and tacit coordination is difficult.
Strategist’s Toolkit:
Threat of
Entry
Intensity of
Power of Power of
Rivalry
Suppliers Buyers
Threat of
Substitutes

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Analyzing Industry

By Laurent ERRERA from L'Union, France [CC BY‐SA 2.0 (http://creativecommons.org/licenses/by‐

Two Perspectives on Rents

•Barriers to entry •Barriers to imitation

Medical Products and Equipment

Network and Other Communications…

Aerospace and Defense

Computers, Office Equipment

Construction and Farm Machinery

Utilities: Gas and Electric

Health Care: Medical Facilities

Financial Data Services

Semiconductors and Other Electronic…

Forest and Paper Products

Return on Assets (%)

Threat of Entry, Part 1

• Patents & licenses

• Patents & licenses

Cumulative Output Over Time

Threat of Entry, Part 2

The Strategist’s Toolkit:

• Substitute products are less of a threat

Perfectly /Infinitely “Moderately” Perfectly

Perfectly /Infinitely “Moderately” Perfectly

• Substitute products are less of a threat

The Strategist’s Toolkit:

• Buyers have less power when…

• Buyers have less power when…

• Buyers have less power when…

Price $60 Profits = $60M

$20 Profits = $60M

Bargaining Power of Suppliers

• Rivalry is less intense when…

• Rivalry is less intense when…

Role of Threat of Role of

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