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Implications of Industry Structure

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Implications of Industry Structure

  1. 1. Implications of industry structureTo begin a strategic analysis, we begin with the industry. Question – does the structure of theindustry explain performance?Industry concentrationConcentrated industries are ones in which a few firms account for the majority of the totalindustry output. For example in the tire industry, four firms (Goodyear, Michelin, Bridgestoneand Cooper) account for 67% of the total worldwide industry output. A popular measure ofindustry concentration is the four-firm concentration ratio (often referred to as CR4). It is theproportion of the industry‟s total output produced by the industries four largest firms. The eight-firm concentration ratio is (fairly logically) the proportion of the industry‟s total output producedby the industries eight largest firms. The four firm concentration ratio of the tire industry istherefore 67%.As Cournot showed, the more fragmented (i.e. less concentrated) the less money firms are likelyto make. The more concentrated the industry, the more likely it is that firm will be able to makemoney. Don‟t be confused by the notion of interdependence. While it might seem as though themore interdependent firms are, the less money they will make, there is no reason this should betrue. In fact there is a logical relationship between interdependence and profitability but it worksthe other way – the more interdependent firms are, the more likely it is they will make abovenormal returns. Signaling in support of tacit collusion is less effective the more firms there are inthe industry.Next question – do firms compete on the basis of price or on non-price factors? If they competeon non-price factors, there is a good chance they will make money. Non-price based competitionessentially means competing by product differentiation – there are two aspects to a successfuldifferentiation strategy.The two main questions here are: Do the firms in the industry sell to different market segments? Do they compete though innovation or brand development?Market SegmentationSegmentation means partitioning customers into groups with similar preferences and producing aproduct for each group that closely meets those preferences. Take the case of Brithinee ElectricLtd. There are two principal segments to the rewinding business; large motors (over 100 hp) andsmall motors. When X gets an enquiry about rewinding a small motor, it refers it to Y.Conversely when Y gets an enquiry about a large motor it refers the caller to X. X and Y havespecialized and targeted their operations towards different segments of the motor rewindingmarket, hence they do not compete directly. In effect, each has a quazi-monolopy, the onlyplayer providing services to that market segment. The more concentrated the industry the fewerfirms there are competing in it. The fewer the number of firms, the more likely it is that given acertain number of segments each will have a segment to itself (or at least relatively fewcompetitors in that segment.
  2. 2. Appropriating valueThis on its own is not enough. We have to be able to appropriate this value. By this I mean weneed to find a way of getting the highest possible price. Take the case of ATL, the ultra soundimaging company. Suppose that their real time imaging system allows cardiologists to performan angioplasty procedure that makes invasive open-heart by-pass surgery unnecessary. Imagine,for the purposes of this illustration, that the cardiologists can charge exactly the same for anangioplasty as they would for a by-pass operation (the patient get exactly the same value fromboth – say 15 years of additional life expectancy), but that for the cardiologist, she can nowperform 3 procedures a day instead of one. Immediately we can see what value ATL‟s scannerhas for the cardiologist – it‟s the additional revenues brought in by a 200% increase in patientstreated and thus a two fold increase in revenues. Now we have an idea of how much ATL mightbe able to extract from the cardiologist for their scanner. The exact numbers don‟t matter but theidea is that the ATL scanner creates value for the doctor increasing her potential willingness topay.However, whether she is required to pay this or not will depend on whether there are competitorswith machines on the market that offer the same functionality as ATL. If not, then ATL can raiseprices to quasi-monopoly levels. If there are competitors, ATL will find itself in a more difficultspot – more on this later.Another way to jack up prices is to induce switching costs. If customers have to incur costs whenthey switch a firm can raise prices to the point where the difference between their price and theircheaper competitor‟s is just lower than the customer‟s cost of moving to that competitor. Say Iuse a Mac that costs more than a Dell PC. If I estimate it will cost me three days lost time orthree days of someone else‟s time to migrate my applications from the Mac to the PC, (whichwould entail a real or opportunity cost of say $500) then Apple can maintain its prices $500above the prices Dell charges without risking loosing existing customers. Some credit cardcompanies do this by awarding redeemable points, airlines do it with air miles, and stores of allsorts with their store cards.So to review, if barriers to entry are high, there will be few players in the industry. If these firmscan compete on non-prices factors, then they will at least stand a chance of making some money.Non-price competition boils down fundamentally to one of two "sub-strategies". First, you canexploit transient rents, for example by continually bringing innovative new products to marketahead of the competition. Second, you can try to prevent customers from switching away new-product to a competitors by designing elements to your product offering to increase switchingcosts.A point to note here is that fewer players make it more likely that you will be able to doconsistently better than the competition. The more firms there are in the market, the moreinnovation begins to look like a game involving the role of the dice. More precisely, you mightthink of this as a game played in two stages. In the first stage, newly created firms reach into alarge urn and pull out 10 dice. In the second stage, firms roll the dice repeatedly and the firmthat end up rolling the highest scores, wins. If all dice in the can identical and unbiased, then inthe long run no one firm will ever be able to consistently roll higher numbers than any otherfirm. However, if some of the dice were biased, meaning that they may be slightly biasedtowards, for example, sixes or ones, then the particularly lucky firm would be one that by chancedrew from the urn all 10 dice, which biased to towards six. This firm would be likely to roll
  3. 3. consistently relatively high numbers, more specifically numbers that will consistently be abovethe mean for all the firms.Now imagine for the sake of argument that this firm faces only a handful of competitors it seemsa relatively improbable that any one of this firms competitors would also have been as lucky inits initial resource endowment. Thus, in a concentrated market a firm fortunate enough to havereceived an advantageous initial resource endowment might enjoy a relatively long-livedadvantage even as new firms entered (in other words to dip their hands into the turn and draw 10dice at random).In contrast, in a highly fragmented industry with many firms, and by implication many morefirms entering and leaving than in at the more consolidated industry, it should not be long beforeone of these entering firms matches, initial firms good fortune in drawing 10 biased dice. Nowour initial lucky firm faces an equally well equipped competitor. Facing a competitor who is aslikely to bring new innovative products to market before us as we are likely to bring newproducts to market before them, at best the high returns we previously enjoyed on now likely tobe cut in half. Hence, in a highly fragmented market in which firms are entering and exitingrelatively frequently, it is statistically improbable that one firm would be likely to continue toconsistently out-innovate all its competitors in the long run. In contrast, in a concentrated marketof a few players where entry and exit is relatively infrequent, the advantage conferred by thefirms initial fortunate resource endowment is likely to endure for longer.This is rivalry, the first of Michael Porter‟s five forces (1980); it deals with the degree to whichfirms manage to avoid (or not) costly price based competition. The more firms there are in theindustry, the harder that is. Competing on non-price factors such as innovation or marketsegmentation also helps avoid rivalrous competition. By building a loyal customer base thatbelieves your product is better than your competitor‟s means you can raise prices without a massdefection of customers to the competition. The more loyal your customers, the closer you are tohaving, in essence, a quasi monopoly.A quick review is in order. High barriers to entry are typically associated with concentratedindustries. Concentrated industries reduce the likelihood that existing competitors will try tooccupy the same niches that we do, or that new competitors entering the industry will be equallyfortunate in their initial resource endowments to enable them to threaten our ability toconsistently outperform the rest of the industry. The concentration of the industry we are in is,however, not in and of itself sufficient to guarantee above normal returns (by above normalreturns we refer to returns in excess of the cost production, the firm‟s fixed costs and the cost ofcapital required in the production process – in other words the profit you earn on your investmentin for example in plant and equipment, exceeds the cost of the money you borrowed to buy thatplant and equipment and its depreciation).To this point we have not talked at all about buyers. The logic has focused exclusively on thefocal firms relationship to other firms in the industry and seems that the only factor affectingprices is the behavior and by implication the number of other firms in the industry. Buyers,although we have not explicitly said so to this point, are assumed to be what economists term„price-takers‟. In this situation, individual buyers have no influence on the price. The only thingthey can do is to decide whether the prices charged by firms in the industry a sufficientlyattractive for them to make the purchase or not.
  4. 4. The Bargaining Power of BuyersThis is where the second of Michael Porters five forces comes into play. When the buyermarket is also concentrated buyers are no longer price takers. Here, individual buyers can exertinfluence over individual suppliers (us). Because a single buyer‟s decision to purchase or not hasan appreciable effect on the focal firm, the focal firm could no longer take a take-it-or-leave-itattitude towards customers. Although this may seem somewhat strange, this is exactly whathappens in a competitive market prices are set in essence only with respect to the aggregateproperties of customer markets and with specific reference to other competing firms. However,with a concentrated buyer‟s market it is no longer possible for the focal firm to treat customers asan aggregate group but must deal with individual buyers and come to a negotiated agreementabout products and services rendered and the price to be paid.The starting point for these negotiations is the upper limit set by the structure of the industry.This is the oligopolistic price that the focal firm would have charged in a price-taking,fragmented buyers market – but since we are negotiating, the only place to go is down. Inextremis, we may face a single buyer – a monopsony. A monopsonist will reduce the amount ofproduct it purchases in order to depress the price it pays. When one firm faces a single buyer,there is no analytic solution that tells us what price will be set. However, intuition suggests thatthe two parties to the negotiation will be most likely to split the surplus equally between them.This means that the most probable outcome is one in which the price we as the focal firm agreewith the buyer will be exactly half the difference between the buyers maximum valuation andour costs. To sum up, as the concentration of buyers increases, so does their power and theirability to influence (depress) prices. The more concentrated the buyers the further below theoligopolistic supply, fragmented market price the outcome of our negotiation with a powerfulbuyer is likely to be.The Bargaining Power of suppliersClearly, a symmetrical argument can be made on the input side. Previously we considered theeffect of increasing concentration on the output side. In other words the more concentrated andthus the more powerful buyers become the more they push prices away from the oligopolisticprice we might like to charge. On the input side the argument runs in an exactly analogousmanner. Here the price we as the focal firm would like to pay for ought inputs is the monopsonyor oligopsony price (depending on or whether there are one or a few firms in the industry). Assupplies become more powerful than any direction of input costs are likely to move is up. Asour suppliers consider restricting output as a means of raising their profits, and by implicationincreasing the price of the goods and services they are selling to us, our input costs increase.Returning to rivalryAlthough we have not talked about rivalry explicitly, we have done so by implication. Byrivalry, we are really talking about the extent to which competition is fought on the basis of pricealone. If we can avoid price based competition we should be able to keep prices above long runaverage costs. Even when it differentiation is impossible and there is little or no scope to imposeswitching costs on customers, Cournot suggests that by anticipating the actions of competitorsand their anticipation of our anticipation of their actions, a tacit understanding can be arrived atwith by the output is restricted and oligopolistic quantities and prices ensue. However, the
  5. 5. Cournot solution is not always stable1. What does this mean? Given sufficiently strongincentives to defect from this mutually advantageous cooperative outcome, individual firms arelikely to produce more than the optimal quantity that would constitute the best outcome for theindustry as a whole, in an attempt to secure a larger slice of the pie for themselves. This is inessence a prisoner‟s dilemma game in which the best solution would be corporate-cooperate butthe outcome typically arrived at (the equilibrium solution) is defect-defect. What turns apotentially cozy situation of tacit collusion into a bloodbath of excess capacity and price war isan industry that has the characteristics of “winner takes all”. Two examples of winner takes allsituations might help illustrate this.The first is an industry with considerable economies of scale, more specifically where minimumefficient scale is reached at higher quantities than the oligopolistic profit maximizing quantity. Inthis situation each firm can derive small but important cost advantages compared to itscompetitors by slightly increasing its output. The intuition here is that for a single firm thereduction in the price caused by a small increase in an output is more than compensated for bythe reduction in costs associated with that increase in output that derive from the economies ofscale in the production process.Exit barriersThe last factor that is likely to make competition particularly unpleasant is exit barriers. Whenexit barriers are minimal firms seeing prices drop below the long run average cost of capital willcertainly exit the market. After all, if there is nothing to prevent them from leaving, why shouldthey stay if the money they earn is insufficient to cover their long run costs? However, easy exitimplies that fixed assets can be disposed of pretty close to cost. In other words by selling offyour plant and equipment you could repay the capital you have borrowed to set up in business.If you can exit is relatively costless. On the other hand, if your assets are specific to the industryit is unlikely you will be able to unload them on anybody because the only firms who would havea use for them are your competitors. There is no reason for them to bail you out by buying yourplant and equipment for anything like as much as you paid for it. Indeed, if they areeconomically rational actors they will collectively reason that since you have no alternativemeans of recouping your investment, as an equally rational economic actor, you will accept evena single cent for your entire productive capacity. In other words your likelihood of recouping anyof the investment in plant and equipment you have made to participate in this industry iseffectively zero.If exiting the industry is not an option, the only decision you are left with is a “produce or not”.Since your fixed costs are fixed, in other words you will have to pay rent on the building whetheryou produce a single widget or no widgets at all you are left with the following simple choice ifthe price you can get for a single widget exceeds the variable costs of that widgets, in otherwords the cost of materials that go into it, you are better off producing a single widget thatproducing none. In other words, we will produce widgets at any price above marginal cost. Ifother firms in the industry face the same predicament, as indeed they are likely to, intuitionsuggests that the likely outcome will be a market price equal to marginal cost (which is belowlong run average costs) and all firms loose money in the long run because they are not coveringtheir fixed costs. This is the worst possible situation imaginable.
  6. 6. It is exactly this situation in which many firms in the airline industry currently find themselves.Commercial airplanes have few uses outside of passenger air transportation. These specializedassets cannot therefore be easily disposed of and constitute a significant exit barrier for anairline. Moreover, given the high fixed costs associated with this industry compared to themarginal costs associated with operating the fleet (the marginal cost of a single passenger seat onthe plane is practically zero) firms have a very high incentive to defect from a collusiverestriction of capacity. Finally, one airline seat is to all intents and purposes indistinguishablefrom one offered by a competing airline; in other words differentiation between airlines isextremely difficult to achieve. Given these three factors, a commodity product, high barriers toexit caused by the specificity of fixed assets, and the enormous economies of scale that arisefrom the high fixed costs compared to the very low variable costs which lead to increase thelikelihood of defection from a collusive arrangements, it is little wonder that making money inthe airline industry is extremely difficult.Threat of substitutionThe threat of substitution has a somewhat similar affect on our ability to maintain prices inexcess of our long run average costs. You could think of substitutes has in effect increasing thenumber of competitors in the industry (even though theyre not in the industry) because they givebuyers more options from which to choose. If there are five firms in our industry and 25 firms inan industry that produces products that are in effect perfect substitutes for ours, the outcome islikely to be little different in terms of the prices we can charge that if our industry have had 30firms rather than only five.Competing against new foreign competitors is not substitution. If you make cars and your newcompetitors also make care they are in your industry; cars, envy if they are made outside the USare not substitutes for cars; they are still cars and the firms that make them are still in the sameindustry. A new transit system (the Altermont Commuter Express for example), which providescommuters with an alternative to driving, is a substitute.

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