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A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
This page is a guide to applying the principles of Economics to researching and understanding a market and the industries and firms that make up the market. An excellent source for the information needed to conduct an industry study or an analysis of a firm's competitive strategy is the Babson College Horn Library at http://www.babson.edu/library/. The Horn Library provides a research guide and sources for researching a company and an industry.
I. Introduction
There are two distinct yet related models for studying markets. One method of analysis is the "StructureConduct-Performance" paradigm from the Industrial Organization field of Economics. Another is Porter's Five Forces. As we will see shortly, Porter's Five Forces and the "Structure-Conduct-Performance" paradigm overlap in many ways. This page combines both methods into a unified guide for industry studies and the analysis of firms and competitive strategy.
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Porter details the factors that impact each force and develops an analytical model to study industries. The purpose of this analysis is to assess the profitability potential of industries. The analytical tools of Porter's book will not be reproduced here. However, Porter's framework incorporates the analysis of market structure and vertical supply chains and each of these concepts will be addressed from the perspective of an economist.
I. A. 2. a. Market Structure
The vertical elements of Porter's Five Forces are shown in Figure 2. Figure 2: The Vertical Elements of Porter's Five Forces
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Each of these elements corresponds to a determinant of market structure as detailed in Table 1 below. Table 1: Porter's Five Forces and Market Structure Element of Porter's Five Forces Determinant of Market Structure Potential Entrants Industry Competitors (Direct Substitutes) Indirect Substitutes Barriers to Entry Number of Sellers Product Characteristics Product Characteristics
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If one were to show these elements vertically, they would appear as: Figure 4: The Vertical Supply Chain
This representation now shows the vertical supply chain. The important issue for firms in the industry is how they position themselves in the supply chain. The firms essentially must choose their vertical boundaries.
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"Structure" refers to the market structure of an industry which is indicative of the degree of competition in the industry. "Conduct" refers to business practices adopted by firms in the industry to implement their competitive strategies and to create competitive advantage (the ability to outperform competitors in the industry). "Performance" refers to measurements by which the industry or firms in the industry can be judged as to whether they have achieved their stated goals.
II. A. Introduction to the Industry and its Market II. A. 1. Industry Definition and Description
II. A. 1. a. Definition and Specific Description
The first task is to define the industry. Industry definition is important to determining the competitive set. In economics, defining the competitive set is equivalent to defining a firm's horizontal boundaries. A firm's horizontal boundaries are its competitors who supply direct substitutes. The U.S. Census Bureau classifies industries with the North American Industrial Classification System (NAICS). NAICS can be accessed at the web page www.census.gov/naics. A researcher can navigate and/or search the
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site and find a description and definition of most industries in the US. Industry descriptions vary from very broad (two-digit NAICS codes) to very narrow (six-digit NAICS codes). Usually, a researcher will choose the narrowest description of an industry. This allows the researcher to most closely identify the companies that compete with each other in an industry. The narrower the description of an industry, the more likely the competitive set will be based on products that are direct substitutes. The broader the description on an industry, the more likely the competitive set will be based on products that are indirect substitutes. For each six-digit NAICS code, there is a short description of the industry. Additionally, the U.S. Census Bureau provides a short definition of the industry. The researcher must determine if the description and definition of the industry fit with the intended companies targeted for study.
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factors determine the defining characteristics, position and slope, of supply and demand curves in an economist's representation of a market. Table 2: Basic Market Conditions, Determinants of Supply and Demand Determinants of Demand Position of demand curve: Change in number of buyers (market growth) Change in buyer tastes and preferences Change in income (income elasticity of demand) Change in the prices of related goods, substitutes and complements (cross-price elasticity of demand) Change in expectations Determinants of Supply Position of supply curve: Change in number of suppliers (more or less competition in the industry) Change in resource prices (raw materials and labor) Change in technology Changes in taxes and subsidies Change in prices of other goods Change in expectations Slope of supply curve: Firm time to respond to a change in the price of the product
Slope of demand curve: Buyer price sensitivity (price elasticity of demand) - Degree of substitutability - Proportion of buyer income - Type of product (inferior versus normal good, normal good further classified as necessity versus luxury) - Buyer time to purchase product
The interaction of supply and demand determine production levels and product price in the market. In a perfectly competitive market, equilibrium price and output in a market are determined where quantity supplied equals quantity demanded. Determination of output and price in other market structures is a bit more complex. For additional information, see a standard Principles of Microeconomics textbook such as Economics: Principles, Problems, and Policies, by Campbell R. McConnell and Stanley L. Brue, The McGraw-Hill Companies, Inc. The analysis of supply and demand conditions are closely related to two aspects of Porter's Five Forces. The determinants of demand parallel Porter's analysis of buyer bargaining power and the determinants of supply are important factors in studying the intensity of rivalry between existing industry competitors.
II. A. 2. b. PEST
In addition to market forces within the industry, it is critical to monitor external forces that may impact the industry on an ongoing basis. A manager may have a very good understanding of what is happening within an industry, and yet be blindsided by external events that change the nature of competition and revenue within an industry. A marketing framework commonly used to examine these factors that impact business decisions is referred to as PEST. PEST is an acronym for the political/legal, economic, sociocultural, and technological factors that shape the environment of an industry or a business.
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Political/Legal An industry must remain abreast of political forces that may influence the viability and profitability of the overall industry, as well as specific firms. Political and legal issues that have impacted businesses and industries over the past decade include: environmental legislation, regulation of the Internet, antitrust rulings, to name a few. For a multinational business, these factors become much more complicated. The business must continually monitor the stability of governments, understand differences in governmental practices, know the rules in terms of importing and exporting goods, and be knowledgeable about the laws that impact the industry and the business in each country. These factors can impact the structure and profitability of the business and industry in each country. Sources of information that can be used to monitor this factor include: government agency web sites and publications, embassies, lawyers and legal journals, and, of course, newspapers. Economic The economy can have a serious impact on sales and profitability within an industry and firm. Unemployment rates, the value of the dollar, inflations, growth, and productivity are factors that impact the health of the economy and consumer confidence. These factors provide indicators to potential concerns on recession and inflation. The economy may lead to reduced spending by consumers that have a rebound effect throughout companies and industries. A firm must monitor these factors to forecast sales and profits appropriately and devise appropriate strategies to ride out an unfavorable economic environment. Firms may even be able to take advantage of an economic downturn to gain share and customers from competitors. Potential sources of information to evaluate the current and projected state of the economy include the New York Stock Exchange and NASDAQ (as well as world exchanges), Wall Street Journal, and analyst reports. Sociocultural Trends may occur within the social and/or cultural structure of society. Examples in the past decade include the increase in working women, the health and fitness craze, and the growth in discretionary spending by youths. These trends can have a serious impact on entire industries, as well as individual companies. A business must monitor these trends to make sure that its product will continue to meet the needs of the consumers it serves. New attributes may emerge and the importance of existing attributes may change as a result of changes in society. Similarly, as the business enters new markets or countries, expectations may be very different based on the social structure and societal expectations of the specific culture or cultures. Sources of information on these trends include newspapers and magazines, television and other mass communication media, and specific monitoring publications or companies as American Demographics and the Yankelovich Monitor. Technology In the past century, the world has seen a technological revolution. Today, we can travel faster, receive communications instantly, and produce more per capita. As a result of this change, many industries have emerged (e.g., cellular phones and dot-coms) and many industries have all but disappeared (e.g., typewriters). Business that have survived have succeeded in staying ahead (or only slightly behind) the technological advances. These businesses have taken advantage of the emerging technology in other industries to improve their product and/or service. These firms are always looking for technology that will help serve customers better and/or cheaper. In that way, technology may provide a competitive advantage. Sources of information on technology include journals in potential areas such as computers or genetics, scientific journals, and other newspapers and magazines.
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The critical element in environmental scanning is to continually monitor the media relevant to your customers, your industry, your market(s), and overall technological development. As changes occur for elements within PEST, a company (and industry) must ask: Is this likely to grow and continue in acceptance? Is it likely to influence my industry? How can I use it to differentiate my product or service? Or should I offer a new product or service? How can I use it to gain a competitive advantage? A good resource for further information on environmental scanning (or PEST) is . [UNDER CONSTRUCTION - Professor Carol Gwin]
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have market power? The guidelines continue with: "A relevant market is a group of products and a geographic area that is no bigger than necessary to satisfy this test." Thus, the relevant market that we should consider in our analysis of market structure is only those firms that must be included in a cartel for the cartel to have market power. In some cases, only one firm need be included in the cartel because the geographic area in which a product is sold is very small. These are called local monopolies. For example, many towns in the western U.S. have only one gas station or one grocery store. Consumers who live in these small towns may have to pay a "monopoly" price for gas or groceries because it is too costly for them to drive to the next town (these costs are called search costs). For most industries in the U.S., the relevant market is the entire nation (and possibly the entire world). However, a researcher must take care to consider issues such as the geographical span of market power.
U. S. Census Bureau
Data to determine the number of sellers in an industry is available from the web page of the U.S. Census Bureau at www.census.gov. The 1997 Economic Census provides data on Establishment and Firm Size in a Subject Series based on 20 NAICS sectors (two-digit NAICS codes). The 20 NAICS sectors are further subdivided into 96 subsectors (three-digit NAICS codes), 313 industry groups (four-digit NAICS codes), and 1170 industries (five- and six-digit NAICS codes). Most sector Subject Series provide information on the number of "Single Unit and Multiunit Firms Subject to Federal Income Tax: 1997" in Table 3 and "Concentration by Largest Firms Subject to Federal Income Tax: 1997" in Table 6. Table 6 identifies concentration ratios based on revenue market share for each industry. Concentration measures for mining, construction, and manufacturing are not available on the Census Bureau web site. The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) is available from the U.S. Census Bureau and reports concentration measures for manufacturing. Similar reports are also available for mining and construction. (For Babson personnel, the 1992 Census of Manufactures is available on CD-ROM in Horn Library.) An excel spreadsheet containing concentration measures for manufacturing can be accessed at http://faculty.babson.edu/gwin/cr&hhi.xls.
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us to understand how much market share is concentrated in the hands of a small number of firms. An industry characterized by low concentration will have a large number of firms with small market shares. An industry characterized by high concentration will have a small number of firms with relatively high market shares. Industries with high concentrations are more likely to have market power, i.e. the ability to set price. Two commonly used concentration measures are the concentration ratio and the Herfindahl-Hirschman Index. Concentration Ratio A concentration ratio (CR) is the percentage of industry output that a specific number of the largest firms have. The concentration ratio for the k largest firms in an industry is calculated simply by adding up the market shares of these k firms. This can be represented as CRk = S1 + S2 + S3 + S4 + S5 + ... +Sk, where Si is the market share of the ith firm. A very commonly used concentration ratio is the four-firm concentration ratio or CR4. The CR4 is the total market share held by the top four firms in an industry, and it is calculated as CR4 = S1 + S2 + S3 + S4. The 1997 Economic Census shows the total market share (based on revenues) for the largest 4, 8, 20, and 50 firms. These concentration ratios would be the CR4, CR8, CR20, and CR50 respectively. Census Bureau concentration measures are based on data on domestic sales from domestic production. An alternative to using the Census data is for the researcher to calculate the concentration ratio with actual market share data. Market share data is available from many on-line resources such as Gale Business Resources at http://www.galegroup.com ABI/Inform at http://www.umi.com The Market Share Reporter (Lexis-Nexis) at http://www.cispubs.com/ The Babson College Horn Library has information on all of these resources starting at their home page at http://www.babson.edu/library/. If market share data is not available, a researcher may have to calculate market shares for the firms in an industry. An individual firm's market share is calculated as: Market Share = Individual Firm Revenue / Total Industry Revenue. Individual firm revenue data is available from sources such as Dun & Bradstreet's Million Dollar Database at http://www.dnbmdd.com/mddi/ (Babson College users should refer to the Horn Library web pages.) Company provided information (web pages and information packages) Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRY SOURCES" on the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.) Corporate reports of publicly-held corporations. Companies often provide this information on their web sites. Another alternative is the SEC Edgar Database of corporate information available at http://www.sec.gov/edgarhp.htm. (See "Corporate Reports of Publicly-Held Companies" under the
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subheading "COMPANY SOURCES" on the above checklist.) Periodical articles and news. (See "Index to Periodical Articles and Current News" under the subheading "INDUSTRY SOURCES" on the above checklist.) One problem with the concentration ratio is that it does not tell us the degree to which a single firm dominates the market. Herfindahl-Hirschman Index (HHI) The HHI is calculated by summing the squares of the individual market shares of all the firms in an industry. This is represented as HHI = S12 + S22 + S32 + S42 + S52 + ... +Sn 2, where Si is the market share of the ith firm. Two advantages of the HHI over the four-firm concentration ratio are The HHI reflects both the distribution of the market shares of the top four firms and the composition of the market outside the top four firms. The HHI gives proportionately greater weight to the market shares of the larger firms. This recognizes the larger firms' relative importance in competitive interactions. The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) referenced above shows both the CR4 and HHI for manufacturing industries (NAICS Sectors 31-33). The 1997 (and 1992) Economic Census does not show the HHI for non-manufacturing industries. Limitations of Concentration Measures Concentration measures are limited by how the researcher defines the relevant market. For example, concentration measures may be misleading if: Import competition is important. Census Bureau concentration measures overstate the relative importance of leading domestic firms. Market span is important. Census Bureau concentration measures are based on national trends, market power due to dominance in a local geography are not considered. Competitors can enter a market. Census Bureau concentration measures only include firms that were active at the time of the census. Competitiveness has more than one dimension. Very often, inter-industry competition (indirect substitutes) is just as important is intra-industry competition (direct substitutes).
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As we move from left (perfect competition) to right (monopoly) in Figure 5, industry concentration increases. As industry concentration increases, the market power (the ability to affect price) of firms in the industry increases. Typically, profit margins increase as market power increases. Another important reason to classify industries as to market structure is that the number of firms in an industry plays a role in determining whether firms explicitly take other firms' actions into account. 1. In monopolistic competition, the multitude of firms makes it unlikely that they explicitly take into account rival firms' responses to their decisions. 2. In oligopoly, with fewer firms, each firm explicitly engages in strategic decision making - taking explicit account of a rival's expected response to a decision being made. Classifying Industries with the CR4 Table 4 below is a general guide for classifying industries by CR4. The table is only a rule of thumb, there is no consensus among economists on using the CR4. Additionally, concentration is only one objective factor in classifying market structure. There are many more factors, both objective and subjective, that a researcher must take into account before choosing a market structure that best describes an industry. Table 4: Classifying Industries with the CR4 CR4 CR4 = 0 0 < CR4 < 40 60 <= CR4 90 <= CR1 Perfect Competition Effective Competition or Monopolistic Competition Tight Oligopoly or Dominant Firm with a Competitive Fringe Effective Monopoly (near monopoly) or Dominant Firm with a Competitive Fringe
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Classifying Industries with the HHI and The Antitrust Division of the Department of Justice (DOJ) The DOJ and the Federal Trade Commission Horizontal Merger Guidelines (available at http://www.usdoj.gov/atr or http://www.ftc.gov) states that: "The Agency divides the spectrum of market concentration as measured by the HHI into three regions that can be broadly characterized as unconcentrated (HHI below 1000), moderately concentrated (HHI between 1000 and 1800), and highly concentrated (HHI above 1800)." The guidelines also state the conditions under which a merger can be challenged. One interpretation of these guidelines for classifying market structure with the HHI is summarized in Table 5 below. Table 5: Classifying Industries with the HHI HHI HHI < 1000 1800 < HHI Interpretation of Market Structure Effective Competition or Monopolistic Competition Oligopoly, Dominant Firm with a Competitive Fringe, or Monopoly
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Trade associations. A listing of trade associations is available at http://www.associationcentral.com/. (Other sources are provided on the Babson College Horn Library web site "Researching an Industry: Trade Association Material" at http://www.babson.edu/library/indtrade.htm.)
II B. 3. Product Characteristics
As shown in Table 2, an important criteria for classifying market structure is whether the product is homogeneous, differentiated, or unique. A product is homogeneous if every firm in the industry sells exactly the same product. Homogeneous products can be found in perfect competition and pure oligopoly. In perfect competition, a homogeneous product means that no individual firm has any control over the price of its product. Price is set in the market and each individual firm in the industry takes that price as given, hence perfectly competitive firms are referred to as price-takers. A perfectly competitive firms can sell as much as it wants at the given market price, thus each individual firm in a perfectly competitive industry faces a horizontal demand curve. Generally, firms in an industry selling homogeneous products do not brand their products. An industry consisting of many firms with small market shares and no branded products is likely very close to a perfectly competitive market structure. An industry with a few firms with large market shares and no branded products is likely a pure oligopoly. A product is differentiated if a firm in a competitive industry can increase price without losing all of its sales (which means the individual firm faces a downward sloping demand curve). This implies there is some differentiating feature of a product that some segment of consumers is willing to pay more for. Products can be differentiated on any element of the marketing mix (the 4 P's) which consists of price, product, promotion, and place. A product is differentiated only if the consumer perceives and values the differentiating feature of the product. The degree of differentiation, and thus the individual firm's market power, depends upon the degree of substitutability for the product. Many close substitutes implies little differentiation and little market power. Few and distant substitutes implies high differentiation and relatively high market power. Generally, firms in an industry selling differentiated products brand their products. An industry consisting of many firms with small market shares and branded products is likely very close to a monopolistically competitive market structure. An industry with few firms and large market shares and branded products is likely an impure oligopoly. A unique product has no close substitutes. A firm with a unique product is a monopoly (at least in the short run). A monopoly firm faces the downward sloping market demand curve which allows the monopolist to have market power. Sources for identifying product characteristics are company provided information (web pages and information packages); company advertising and promotional materials, corporate reports of publicly-held corporations, periodical articles and news, and trade associations.
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market structure is understanding the implications of the market structure for the competitive strategies of firms in the market. Competitive strategies are chosen to maximize the long-run profits of firms. Thus, an important question is whether the market structure will change over time. Oligopoly and monopoly market structures can be sustained over time only if there are barriers to entry. Firms in oligopolistic industries or a monopoly firm can sustain market power only if they can prevent other firms from entering the industry. There are three types of barriers to entry: Natural Barriers (economies of scale, economies of scope, absolute cost advantages, capital costs, etc.) Strategic Barriers (actions taken by firms such as product differentiation and increasing the cost of entry) Legal Barriers (patents, licenses, laws and regulations, etc.) Porter provides an excellent model for evaluating barriers to entry in Chapter 1 of his previously referenced book Competitive Strategy: Techniques for Analyzing Industries and Competitors. Identifying barriers to entry is a little tricky. A monopolist or firms in an oligopoly are unlikely to "advertise" barriers to entry given possible antitrust ramifications. However, there are some guideposts we can use.
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performance, or reputation. What really matters is whether consumers perceive a product is different in some way that benefits them. Differentiation can be achieved with advertising and promotion, service contracts and warranties, style, and many more ways. Advertising itself can be a barrier to entry. Incumbents may have an advantage over an entrant in: - Absolute Cost Advantage - Economies of Scale in Advertising - Effect on Capital Cost of Entry
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monopolistic competition market structure. In the cookie category, actual competition has characteristics of both market structures.
III. A. Positioning
Firms must choose their strategic positioning and product positioning. A firm's strategic positioning delineates its boundaries, both vertical and horizontal. A firm's product positioning delineates the attributes that its product will offer. Which comes first: strategic positioning or product positioning? Table 6 below should help a researcher to
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choose which type of positioning to study first. Table 6: Positioning Analysis Order of study is 1. Strategic Positioning 2. Product Positioning 1. Product Positioning 2. Strategic Positioning For an Existing Firm if For a New Entrant if
New product in an existing Existing product in an industry existing industry New product in a new industry New product in an existing industry
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profitability. A "narrowing" of horizontal boundaries takes place if firms enter the industry. The implication of a narrowing of horizontal boundaries is a decrease in industry concentration which usually translates into lower profitability. Thus, existing firms in an industry have a vested interest in keeping horizontal boundaries as wide as possible. Barriers to entry are key to this effort (as discussed in Section II. B. 4.) The business practices firms can adopt to maintain horizontal boundaries at "wide" levels are discussed in Section III. C. 2. a. below.
By definition, firms within the same industry must share at least one link of the vertical supply chain in common. However, firms can differ as to how many links they occupy in the supply chain. A firm's decision as to what links of the supply chain will be owned by the firm is call "The Make or Buy Decision." Table 7 below specifies the benefits and costs of "buying" from market firms (buying inputs from suppliers and/or distributing outputs through distribution channels) rather than "making" the activity within the firm. If benefits of using the market outweigh the costs, then the firm should buy from the market firms. If benefits of using the market are less than the costs, then the firm should perform the activity in-house. Table 7: The Make or Buy Decision Benefits and Costs of Using the Market Benefits Market firms may be able to achieve economies of scale as suppliers selling to many buyers (or as
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distributors buying from many sellers) whereas inhouse production may not achieve scale economies if an individual firm's demand for the activity is relatively small. Market firms are subject to the disciplines of the market. A market firm must be efficient and innovative in order to survive in a competitive environment.
vertical supply chain if the market firm cannot supply the necessary activity Proprietary information of the firm may be leaked to market suppliers/distributors who could use the information to help the firm's competitors or may even allow the market supplier/distributor to bypass the firm. Dealing with market firms usually requires transaction costs
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and McCarthy 1999). Through a brands positioning, a company tries to build a sustainable competitive advantage on product attribute(s) tangible or intangible in the mind of the consumer. This advantage is designed to appeal to one or more segments in that product category.
Cost Position Figure 8 below demonstrates a cost position. With a cost position, the company creates the same benefit for the consumer as does its competitor, but it does so at a lower cost. Figure 8: A Cost Position
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existing companies in other channels to catch up to and overtake businesses that pioneered this new channel. - Price: This area of differentiation is usually the last way that a company wants to pursue. To be successful in differentiating based on a lower price, the firm must have a sustainable cost advantage. A good example of such a company is Southwest Airlines. A high price point may also be a source of differentiation; however, the firm must have the product quality and/or brand image and perceptions to reaffirm to the consumer that indeed the product is worth the premium price. Perceptual mapping is a commonly used tool to evaluate the real and perceived differentiation of a brand. For this tool, a firm must plot its brands and competitors on key attributes for the industry and/or category. The plot may be based on technical specifications, but a firm should also develop plots on consumer perceptions obtained through surveys. The maps also provide information on potential opportunities for introducing new products, repositioning an existing brand, and/or segments thatare underserved by existing brands in the category. These plots give the firm a realistic picture on whether or not it has points of differentiation and whether this differentiation is important to consumers. The Product Attributes Model is another way to look at differentiation and customer segments. To turn a point of differentiation into a competitive advantage, a firm must be able to sustain this area of differentiation relative to competitors and obtain the value of this differentiation from the consumer in the form of profits. These areas are discussed in the next section. Perreault, William D., Jr. and E. Jerome McCarthy (1999), Basic Marketing: A Global-Managerial Approach, Boston, MA: Irwin McGraw-Hill. [UNDER CONSTRUCTION - Professor Carol Gwin]
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goal of marketing is to increase demand (shift the demand curve to the right) and to reduce the elasticity of demand (rotate the demand curve clockwise). The role of marketing is covered in the Conduct/Behavior section of this guide.
III. B. 2. c. Oligopoly
The competitive strategies of firms in an oligopoly are mutually interdependent. When a firm in an oligopoly chooses its strategy, it must take the potential reactions of its competitors into account. The outcome of a decision for one firm depends upon the decisions of its competitors. Thus, firms in an oligopoly are strategically interdependent.
III. B. 2. d. Monopoly
The monopolist faces the downward sloping market demand curve for its unique product. Thus, the monopolist has market power. The strategy of a monopolist is relatively clear: Price the unique product to maximize profit. The role of operations to support this strategy is clear: Create and sustain the barriers to entry necessary to protect monopoly profits. Sustaining barriers to entry is paramount (and can be evaluated as per section II. B. 4. above). Creating new barriers can be quite interesting. New barriers to entry can be beneficial to society. - New product development can provide goods and services that are wanted or needed by the public. However, some barriers to entry carry costs for society. - A monopolist may be "lazy" and not operate efficiently because its position is protected. - Such "lazy" behavior may also stagnate technological development as the protected monopolist has no incentive to invest in R&D. - Companies often lobby for a monopoly position. Such rent-seeking behavior is an inefficient cost to society. The role of marketing depends on the nature of the product. Promotion can still be needed to stimulate demand for the product. Consumers need to be aware of the product and its benefits in order for them to consider a purchase. Sometimes, exclusive distribution supports the perception of the uniqueness of the product. As in monopolistic competition, the goal of marketing is still to increase demand (shift the demand curve to the right) and to reduce the elasticity of demand (rotate the demand curve clockwise).
III. C. Conduct
Firms develop and adopt business practices (operations, marketing, finance, etc.) that support their positioning and competitive strategy. Activities and activity systems conducted within the scope of the firm must be carefully selected and nurtured if the firm is to successfully implement its value proposition. A complete study of business practice is too broad of a subject for this guide. Each industry is likely to have very different methods of conduct. However, three considerations are generally applicable to all industries. These are:
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Porter's Value Chain Conduct to support Strategic Positioning Conduct to support Product Positioning
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position relative to its competitors. To be successful, a noncooperative strategy requires the firm to have: 1. Advantage: Firm must have an advantage over competitors. 2. Commitment: Firm must commit to the action regardless of actions by competitors. Common noncooperative strategies are the threat of predatory pricing (see Section III. C. 2. b. below), limit pricing, investments to lower production costs, raising rivals' costs, and raising all firms' costs. An incumbent firm uses limit pricing when it sets price and output so that there is not enough demand left for another firm to profitably enter the market. Maximizing short-run profit can lead to entry of new firms, capacity expansion of smaller existing firms, and loss of sales to substitutes. Limit pricing starts with the assumption that firms maximize long-run, and not short-run, profits. An incumbent firm may discourage entry by making investments to lower production costs in ways such as investing in R&D and learning by doing. An incumbent firm may try to make entry difficult by raising rivals' costs. An incumbent firm may be able to raise the entrant's relative costs through direct methods, legal tactics, interference through government regulation, production of complements, raising switching costs, or raising wages or other input prices. Often, an incumbent firm discourages entry by raising all firms' costs through excessive promotion or government regulation. Cooperative Strategic Behavior in an Oligopoly Cooperative strategic behavior are those actions that competitors take together in order to reassure each other that they are not cheating on a cooperatively agreed-to price. Cooperatively agreed-to prices can take the form of price fixing, preventing price discounts, and eliminating price discounts. The extreme of cooperative strategic behavior is a cartel. In a cartel, firms explicitly coordinate their decisions. Cooperative strategies that facilitate cartels include most-favored-nation clauses, meeting-competition clauses, trade associations, dividing the market, trigger prices, uniform prices, penalty for price discounts, advance notice of price changes, information exchanges, delivered pricing, and swaps and exchanges. The ideal cartel would make decisions as if all firms where joined together as a monopoly. In the U.S., such cooperative behavior is illegal. Implicit cooperative behavior is usually not illegal. In this case, a firm simply observes the actions of its competitors and makes its own decisions accordingly. Thus, a researcher can often observe that the competitive strategies of firms in an oligopoly will be remarkably similar. In particular, the elements of each firms marketing mix will look very much the same. Products will be priced similarly, promotional expenditures will be similar, product development will appear to be on a parallel track between firms, and firms will distribute their products through similar channels. In an oligopoly, the elements of the marketing mix that can be observed in company provided information (web pages and information packages); company advertising and promotional materials, corporate reports of publiclyfaculty.babson.edu/gwin/indstudy/ 28/40
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held corporations, periodical articles and news, and trade associations will all look roughly the same. [See the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.]
III. C. 2. b. Changing Horizontal Boundaries (Reducing the Number of Competitors in an Industry, Reducing the Effective Competition in the Industry, Forming Strategic Alliances)
As discussed in Section III. A. 1. a., firms in an industry have a vested interest in maintaining or even widening horizontal boundaries. Wider boundaries mean larger market shares (or larger slices of the market pie) for firms in the industry which usually leads to higher profitability. Reducing the Number of Competitors in an Industry Firms can try to force competitors to exit the market by developing superior marketing or operations. Marketing: - Predatory pricing is when a firm lowers its price in order to drive rivals out of business and scare off potential entrants and then raises its price when its rivals exit the market (in most definitions, the firm lowers price below some measure of cost). The tactic is intended to increase market share at the expense of absorbing short-term losses. Competitors must match the below-cost pricing in order to maintain their own market share. The strategic objective of predatory pricing is to force competitors, who may not be able to absorb short-term losses, to exit the market. Once competitors exit the market, the remaining firm becomes a monopoly with market power. The remaining firm accepts the short-term losses given the potential for increased long-term profitability. Of course, the risk is that new firms may enter the market when prices return to profitable levels. However, the predatory firm will likely threaten potential entrants with new rounds of price reductions to discourage entry. - New product development that offers consumers a superior benefit to price ratio may make old products obsolete. If competitors cannot copy the new technology, then they may be forced to exit the industry. - Superior promotions may convince consumer that one firm's brand offers a superior benefit to price ratio to competitive brands (even if it does not in reality). A shift in consumer tastes and preferences towards the firm with superior promotions will increase its market share at the expense of competitors. A severe shift may even put some of the competitive brands out of business. - Superior access to distribution channels, which may involve foreclosing the channels to competitors, may give a firm the opportunity to distribute its product while competitors have no route to the marketplace. Operations: Superior operations generally means superior cost. With a cost advantage, firms may be able to price at a lower level than its competitors and force them out of business. Mergers and acquisitions clearly reduce the number of competitors in an industry. A merger will occur only if the acquiring company expects to receive a greater return on the assets of the target firm than the target firm can generate by itself. The motivations for mergers and acquisitions are: Market power Entry into a new market Entry into a foreign market
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A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
Provide a missed attribute Aids in diversification Industry capacity issues Acquire undervalued assets (stock is undervalued) Tax considerations Reducing the Effective Competition in the Industry Collusion between competitors in an industry reduces effective competition. As discussed in Section II. B. 3., explicit collusion is illegal in the US. Implicit collusion such as the simple observation of strategic and tactical moves is usually legal and allows firms to coordinate their behavior. As competitors better understand the interactions of their strategies, they are more likely to choose strategies that improve profitability for all firms in the industry. Strategic Alliances In a strategic alliances, two or more firms combine resources outside of the market to accomplish a particular task or set of tasks. There are two general types of strategic alliances: Joint venture: Equity sharing Licensing agreements: Contractual relationship The key factors driving strategic alliances are globalization and new technologies. Finding Evidence of Changing Horizontal Boundaries Evidence of business practices that maintain or widen horizontal boundaries can be found in company provided information (web pages and information packages), corporate reports of publicly-held corporations, investment analysis reports, and periodical articles and news. See the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.
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A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
The reasons for and against vertical integration are: Lowering transaction costs: Four types of transactions that make vertical integration desirable are: 1. Specialized assets that are characterized by: - Site specificity (an asset is in particular area that is useful to a small number of buyers or suppliers) - Physical-asset specificity (product design makes it useful to a small number of buyers) - Human-asset specificity (specialized knowledge) - Dedicated assets (investment only meets the requirements of one or few buyers) 2. Uncertainty that makes monitoring difficult 3. Asymmetric information (firm gains access to information) 4. Extensive coordination Backward integration to assure input supply Forward integration to correct market failures due to externalities (such as controlling quality in the distribution channel) Avoiding taxes, government regulation Creating market power for the firm Eliminating market power of suppliers or buyers Integrated Supply Chains The principal idea behind an integrated supply chain is that competition will be across supply chains, not individual companies. Companies in integrated supply chains: Share and coordination information within the supply chain for maximum benefit to the companies in the chain Link product design to supply chain considerations Create performance measures to assess supply chain effectiveness Design their organizational structure to fit with supply chain management Desired outcomes of integrated supply chains are: Improvements in customer service Reductions in inventories throughout the chain Better product development and design plans lead to gains in economic and competitive advantage throughout the entire product life cycle The Choice of Vertical Relationship The nature of the relationship between a firm and its suppliers/buyers is governed by the frequency and complexity of transactions between the two parties. Figure 11 below is a general guide for the choice of vertical relationship. Figure 11: The Choice of Vertical Relationship
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Vertical Restraints A vertical restraint is a contractual limitation on conduct that one nonintegrated firm imposes on another firm in the supply chain (an upstream supplier or a downstream buyer). Vertical restraints are intended to solve distribution problems that arise from asymmetric information or free riding. In a relationship between a manufacturer and distributor, asymmetric information can lead to a principal-agent problem. Free riding means one firm benefits from the actions of another firm without paying for it. Table 8 below lists a number of distribution problems and the vertical restraints that manufacturers often adopt to solve the problems. Table 8: Distribution Problems and Vertical Restraints Manufacturers Use to Solve Them Distribution Problem Double Marginalization - Double monopoly markup Vertical Restraints Manufacturers Use to Solve the Distribution Problem Maximum retail price (illegal in US since 1976) Quantity forcing (establish sales quotas) Franchise fee (fixed fee for the right to sell a product or use a brand name) and sell at marginal cost Encourage competition at distributor level Establish exclusive territories Limit the number of distributors Resale price maintenance Take over the conduct of marketing (e.g. advertise on behalf of distributors) Monitoring
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Free Riding Among Distributors - One distributor may benefit from another distributors actions (conduct) in: Advertising Showrooms Salesperson training Training purchasing agents
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A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
Certifying quality Free Riding Among Manufacturers - One manufacturer may benefit from another manufacturers actions (conduct) in: Having a common distributor Training distributors Providing customer lists to distributors Lack of Distributor Coordination the Leads to Externalities Combinations of the above practices Exclusive dealing
Vertical restraints can have both positive and negative effects on consumers. Positive effects may be: Lower price - when there is increased output of existing firms - if there is encouragement of entry of new brands (competition among manufacturers/distributors may be restrained, but competition among brands is encouraged) Better service - when the relevant product is both the good and the service provided with it Negative effects may be: Anticompetitive practices such as - Cartelization of an industry - Prevention of entry into an industry - Harm to rivals by raising rivals' costs
III. C. 3. a. Pricing
One Price for all Consumers, Short-Run Profit Maximization If a firm must charge one price to all consumers, the firm maximizes short-run profit by choosing output (which in turn determines price through its interaction with demand) where the additional revenue generated from selling one more unit of its product is just equal to the additional cost of producing that unit (where marginal revenue equals marginal cost). Perfect Competition: As shown in Figure 9, firms in a perfectly competitive industry are price-takers. Price is determined in the market. This means that the additional revenue generated from selling one more unit of its
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product will be equal to the market price. A perfectly competitive firm maximizes short-run profit by choosing output where price is just equal to the additional cost of producing that unit (where price equals marginal cost). Firms in monopolistic competition, oligopoly, and monopoly choose output where marginal revenue equals marginal cost. Price Discrimination: Different Prices for Different Consumers Firms may be able to increase profits with price discrimination. A firm price discriminates if it charges different prices to different segments of its consumers. There are three conditions for a firm to be able to price discriminate: The firm must have market power The firm must be able to identify consumer segments The firm must be able to prevent or limit resale (or it must be inherently difficult for the product to be resold) There are three types of price discrimination: First-Degree Price Discrimination: The firm prices at the maximum that each consumer is willing to pay for each unit of the product. Second-Degree Price Discrimination (or non-linear pricing): Price differs with the number of units purchased by the consumer. Third-Degree Price Discrimination: Price differs between consumer segments. With first- and third-degree price discrimination, the firm targets price to a specific consumer or consumer segment. With second-degree price discrimination, the firm's pricing strategy maximizes profit based upon some characteristic of the product. Example of second-degree price discrimination are: Nonlinear pricing methods such as a quantity discount, a single two-part tariff, and a two two-part tariff Pricing based on bundling of products Pricing based on quality choice Premium for priority Pricing for Long-Run Profit Maximization [UNDER CONSTRUCTION - Professor Carol Gwin]
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III. C. 3. b. Product
Product Choice [UNDER CONSTRUCTION - Professor Carol Gwin] Research & Development [UNDER CONSTRUCTION - Professor Carol Gwin] Packaging [UNDER CONSTRUCTION - Professor Carol Gwin]
III. C. 3. c. Promotion
The purposes of promotion include Shifting consumers' tastes and preferences in favor of a particular product or brand Providing information Advertising [UNDER CONSTRUCTION - Professor Carol Gwin] Advertising to Sales Ratio Studies have found that an industry's advertising as a percentage of sales (advertising to sales ratio) is often closely related to the industry's concentration ratio. In perfect competition, there is relatively little advertising given a homogeneous product. In monopoly, there may be some advertising to support the monopoly position. Monopolistic competition and oligopoly market structures are likely to have significant advertising expenditures. Promotion is a key differentiator in monopolistic competition and strategic interdependence in oligopoly is likely to lead to excessive expenditures on advertising to protect market share. An impure oligopoly is likely to have a very high advertising to sales ratio for both of these reasons. The advertising to sales ratio is calculated as: Advertising to sales ratio = Advertising Expenditures / Revenue An industry advertising to sales ratio will likely have to be calculated as a composite of individual firm advertising to sales ratios. Data on individual firm advertising expenditures is available from: Advertising Age at http://adage.com/dataplace/.
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Data on individual firm revenue can be found using the resources shown in Section II. B. 2. a. A graphical representation of the relationship between advertising to sales ratio and concentration ratio is provided in Figure 12 below. NOTE: The graphical representation is approximate at best and the range of advertising to sales ratio shown on the figure is not representative of every industry. The graph shows the relative relationship between advertising to sales ratio and concentration ratio for an industry in general. The decision as to whether a specific value of an advertising to sales ratio is indicative of the strategic implications of a particular market structure must be based upon the analysis of the researcher and other relevant objective and subjective criteria. Figure 12: The Relationship of Advertising to Sales Ratio and Concentration Ratio
III. C. 3. d. Place
[UNDER CONSTRUCTION - Professor Carol Gwin]
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A Guide for Industry Study and the Analysis of Firms and Competitive Strategy
Creative destruction: Entrepreneurs exploit fundamental economic shocks (or strategic inflection points) and go on the achieve profits during quieter times. Innovation: Invention (discovery), innovation (commercialization), and diffusion. Evolution: Firm's decisions are determined by routines, innovation is path dependent. Environment: See Figure 13 below. [UNDER CONSTRUCTION - Professor Carl Gwin] Figure 13: Porter's Diamond
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investor or value-created for a consumer. In general, high returns to an investor are the result of the extraction of value from the consumer. In other words, the firms in the industry have market power and can charge a price higher than marginal cost and earn economic profits (profits in excess of a normal return). Firms in the industry are better off as they earn higher profits, consumer are worse off because they buy less in quantity and pay more in price.
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the industry and the value created for consumers. Thus, a researcher evaluating the performance of an industry must take care to consider both members of society. An industry's total contribution to society's welfare is more than its own profits, measuring industry performance should also include the benefits created for consumers.
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