Handout for Business 189 undergraduate course in Strategic Management Industry Level Strategic Analysis Cournot, Porter and the Five Forces Model Simon Rodan Associate Professor Department of Organization and Management College of Business San José State University One Washington Square San José, CA 95192-0070 e-mail: [email protected] Please do not quote or reproduce without the author’s prior agreement -1- The implications of industry structure To begin a strategic analysis, we begin with the industry. Question – does the structure of the industry explain performance? Industry concentration Concentrated industries are ones in which a few firms account for the majority of the total industry output. For example in the tire industry, four firms (Goodyear, Michelin, Bridgestone and Cooper) account for 67% of the total worldwide industry output. A popular measure of industry concentration is the four-firm concentration ratio (often referred to as CR4). It is the proportion 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 produced by the industries eight largest firms. The four firm concentration ratio of the tire industry is therefore 67%. As Cournot showed, the more fragmented (i.e. less concentrated) the less money firms are likely to make. The more concentrated the industry, the more likely it is that firm will be able to make money. Don’t be confused by the notion of interdependence. While it might seem as though the more interdependent firms are, the less money they will make, there is no reason this should be true. In fact there is a logical relationship between interdependence and profitability but it works the other way – the more interdependent firms are, the more likely it is they will make above normal returns. Signaling in support of tacit collusion is less effective the more firms there are in the industry. Next question – do firms compete on the basis of price or on non-price factors? If they compete on non-price factors, there is a good chance they will make money. Non-price based competition essentially means competing by product differentiation – there are two aspects to a successful differentiation 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 Segmentation Segmentation means partitioning customers into groups with similar preferences and producing a product for each group that closely meets those preferences. Take the case of Brithinee Electric Ltd. There are two principal segments to the rewinding business; large motors (over 100 hp) and small 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 -2refers the caller to X. X and Y have specialized and targeted their operations towards different segments of the motor rewinding market, hence they do not compete directly. In effect, each has a quazi-monolopy, the only player providing services to that market segment. The more concentrated the industry the fewer firms there are competing in it. The fewer the number of firms, the more likely it is that given a certain number of segments each will have a segment to itself (or at least relatively few competitors in that segment. Appropriating value This on its own is not enough. We have to be able to appropriate this value. By this I mean we need to find a way of getting the highest possible price. Take the case of ATL, the ultra sound imaging company. Suppose that their real time imaging system allows cardiologists to perform an 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 an angioplasty as they would for a by-pass operation (the patient get exactly the same value from both – say 15 years of additional life expectancy), but that for the cardiologist, she can now perform 3 procedures a day instead of one. Immediately we can see what value ATL’s scanner has for the cardiologist – it’s the additional revenues brought in by a 200% increase in patients treated and thus a two fold increase in revenues. Now we have an idea of how much ATL might be able to extract from the cardiologist for their scanner. The exact numbers don’t matter but the idea is that the ATL scanner creates value for the doctor increasing her potential willingness to pay. However, whether she is required to pay this or not will depend on whether there are competitors with machines on the market that offer the same functionality as ATL. If not, then ATL can raise prices to quasimonopoly levels. If there are competitors, ATL will find itself in a more difficult spot – more on this later. Another way to jack up prices is to induce switching costs. If customers have to incur costs when they switch a firm can raise prices to the point where the difference between their price and their cheaper competitor’s is just lower than the customer’s cost of moving to that competitor. Say I use a Mac that costs more than a Dell PC. If I estimate it will cost me three days lost time or three days of someone else’s time to migrate my applications from the Mac to the PC, (which would entail a real or opportunity cost of say $500) then Apple can maintain its prices $500 above the prices Dell charges without risking loosing existing customers. Some credit card companies do this by awarding redeemable points, airlines do it with air miles, and stores of all sorts with their store cards. So to review, if barriers to entry are high, there will be few players in the industry. If these firms can compete on non-prices factors, then they will -3at least stand a chance of making some money. Non-price competition boils down fundamentally to one of two "sub-strategies". First, you can exploit transient rents, for example by continually bringing innovative new products to market ahead of the competition. Second, you can try to prevent customers from switching away new-product to a competitor's by designing elements to your product offering to increase switching costs. A point to note here is that fewer players make it more likely that you will be able to do consistently better than the competition. The more firms there are in the market, the more innovation begins to look like a game involving the role of the dice. More precisely, you might think of this as a game played in two stages. In the first stage, newly created firms reach into a large urn and pull out 10 dice. In the second stage, firms roll the dice repeatedly and the firm that end up rolling the highest scores, wins. If all dice in the can identical and unbiased, then in the long run no one firm will ever be able to consistently roll higher numbers than any other firm. However, if some of the dice were biased, meaning that they may be slightly biased towards, for example, sixes or ones, then the particularly lucky firm would be one that by chance drew from the urn all 10 dice, which biased to towards six. This firm would be likely to roll consistently relatively high numbers, more specifically numbers that will consistently be above the mean for all the firms. Now imagine for the sake of argument that this firm faces only a handful of competitors it seems a relatively improbable that any one of this firm's competitors would also have been as lucky in its initial resource endowment. Thus, in a concentrated market a firm fortunate enough to have received an advantageous initial resource endowment might enjoy a relatively long-lived advantage even as new firms entered (in other words to dip their hands into the turn and draw 10 dice at random). In contrast, in a highly fragmented industry with many firms, and by implication many more firm's entering and leaving than in at the more consolidated industry, it should not be long before one of these entering firm's matches, initial firm's good fortune in drawing 10 biased dice. Now our initial lucky firm faces an equally well equipped competitor. Facing a competitor who is as likely to bring new innovative products to market before us as we are likely to bring new products to market before them, at best the high returns we previously enjoyed on now likely to be cut in half. Hence, in a highly fragmented market in which firms are entering and exiting relatively frequently, it is statistically improbable that one firm would be likely to continue to consistently out-innovate all its competitors in the long run. In contrast, in a concentrated market of a few players where entry and exit is relatively infrequent, the advantage conferred by the firm's 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 which firms manage to avoid (or not) costly price based -4competition. The more firms there are in the industry, the harder that is. Competing on non-price factors such as innovation or market segmentation also helps avoid rivalrous competition. By building a loyal customer base that believes your product is better than your competitor’s means you can raise prices without a mass defection of customers to the competition. The more loyal your customers, the closer you are to having, in essence, a quasi monopoly. A quick review is in order. High barriers to entry are typically associated with concentrated industries. Concentrated industries reduce the likelihood that existing competitors will try to occupy the same niches that we do, or that new competitors entering the industry will be equally fortunate in their initial resource endowments to enable them to threaten our ability to consistently 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 normal returns we refer to returns in excess of the cost production, the firm’s fixed costs and the cost of capital required in the production process – in other words the profit you earn on your investment in for example in plant and equipment, exceeds the cost of the money you borrowed to buy that plant and equipment and its depreciation). To this point we have not talked at all about buyers. The logic has focused exclusively on the focal firm's relationship to other firms in the industry and seems that the only factor affecting prices 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 thing they can do is to decide whether the prices charged by firms in the industry a sufficiently attractive for them to make the purchase or not. The Bargaining Power of Buyers This is where the second of Michael Porter's five forces comes into play. When the buyer market is also concentrated buyers are no longer price takers. Here, individual buyers can exert influence over individual suppliers (us). Because a single buyer’s decision to purchase or not has an appreciable effect on the focal firm, the focal firm could no longer take a take-it-or-leave-it attitude towards customers. Although this may seem somewhat strange, this is exactly what happens in a competitive market prices are set in essence only with respect to the aggregate properties 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 as an aggregate group but must deal with individual buyers and come to a negotiated agreement about products and services rendered and the price to be paid. -5The 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. In extremis, we may face a single buyer – a monopsony. A monopsonist will reduce the amount of product 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 that the 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 agree with the buyer will be exactly half the difference between the buyers maximum valuation and our costs. To sum up, as the concentration of buyers increases, so does their power and their ability to influence (depress) prices. The more concentrated the buyers the further below the oligopolistic supply, fragmented market price the outcome of our negotiation with a powerful buyer is likely to be. The Bargaining Power of suppliers Clearly, a symmetrical argument can be made on the input side. Previously we considered the effect of increasing concentration on the output side. In other words the more concentrated and thus the more powerful buyers become the more they push prices away from the oligopolistic price we might like to charge. On the input side the argument runs in an exactly analogous manner. Here the price we as the focal firm would like to pay for ought inputs is the monopsony or oligopsony price (depending on or whether there are one or a few firms in the industry). As supplies become more powerful than any direction of input costs are likely to move is up. As our suppliers consider restricting output as a means of raising their profits, and by implication increasing the price of the goods and services they are selling to us, our input costs increase. Returning to rivalry Although we have not talked about rivalry explicitly, we have done so by implication. By rivalry, we are really talking about the extent to which competition is fought on the basis of price alone. If we can avoid price based competition we should be able to keep prices above long run average costs. Even when it differentiation is impossible and there is little or no scope to impose switching costs on customers, Cournot suggests that by anticipating the actions of competitors and their anticipation of our anticipation of their actions, a tacit understanding can be arrived at with by the output is restricted and oligopolistic quantities and prices ensue. -6However, the Cournot solution is not always stable1. What does this mean? Given sufficiently strong incentives to defect from this mutually advantageous cooperative outcome, individual firms are likely to produce more than the optimal quantity that would constitute the best outcome for the industry as a whole, in an attempt to secure a larger slice of the pie for themselves. This is in essence a prisoner’s dilemma game in which the best solution would be corporate-cooperate but the outcome typically arrived at (the equilibrium solution) is defect-defect. What turns a potentially cozy situation of tacit collusion into a bloodbath of excess capacity and price war is an industry that has the characteristics of “winner takes all”. Two examples of winner takes all situations might help illustrate this. The first is an industry with considerable economies of scale, more specifically where minimum efficient scale is reached at higher quantities than the oligopolistic profit maximizing quantity. In this situation each firm can derive small but important cost advantages compared to its competitors by slightly increasing its output. The intuition here is that for a single firm the reduction in the price caused by a small increase in an output is more than compensated for by the reduction in costs associated with that increase in output that derive from the economies of scale in the production process. A second example in which firms are again subject to strong incentives to defect from cooperation is one in which there are considerable network externalities. In fact this works it in a rather similar fashion to economies of scale except that it acts on the value side of the equation rather than on costs. Here increases in market share have the effect of increasing the value to customers of the product or service you are offering. To the extent that your firm is the only one to benefits in this way from the increase in the installed base of your product (in other words, the more of your product is sold in the market, the more viable of your product becomes for customers while at the same time this increase in your product's use has no impact on the usefulness of your competitor's product), your firm will try to put itself in the position where it has the largest installed base of any firm in the industry. The larger it’s installed base, the greater the values of its products to customers, and the higher the price it will ultimately be able to charge. However, the first goal is to achieve this large installed base, something Microsoft for example understood very well. One way to get there is to reduce prices initially in the order to Stability means the price collusion will persist even when there are slight disturbances that might knock firms off balance such as a minor down-turn in demand. When the Courno’t predicted outcome is not stable, small perturbations may head to a cascade of price-cutting as one firm tries to grab market share from its competitors, and red ink all over the profit and loss statement. 1 -7capture the largest proportion of the market when a disproportionately large market share has been achieved then prices can be raised. In summary, economies of scale and network externalities, acting through costs and value respectively, act as strong incentives for individual firms to defect from the oligopolistic tacit collusion from which they would collectively benefit the most. When firms defect and produce more than the optimal oligopolistic quantities, prices fall and so typically do profits. Exit barriers The last factor that is likely to make competition particularly unpleasant is exit barriers. When exit barriers are minimal firms seeing prices drop below the long run average cost of capital will certainly exit the market. After all, if there is nothing to prevent them from leaving, why should they stay if the money they earn is insufficient to cover their long run costs? However, easy exit implies that fixed assets can be disposed of pretty close to cost. In other words by selling off your 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 industry it is unlikely you will be able to unload them on anybody because the only firms who would have a use for them are your competitors. There is no reason for them to bail you out by buying your plant and equipment for anything like as much as you paid for it. Indeed, if they are economically rational actors they will collectively reason that since you have no alternative means of recouping your investment, as an equally rational economic actor, you will accept even a single cent for your entire productive capacity. In other words your likelihood of recouping any of the investment in plant and equipment you have made to participate in this industry is effectively 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 whether you produce a single widget or no widgets at all you are left with the following simple choice if the price you can get for a single widget exceeds the variable costs of that widgets, in other words the cost of materials that go into it, you are better off producing a single widget that producing none. In other words, we will produce widgets at any price above marginal cost. If other firms in the industry face the same predicament, as indeed they are likely to, intuition suggests that the likely outcome will be a market price equal to marginal cost (which is below long run average costs) and all firms loose money in the long run because they are not covering their fixed costs. This is the worst possible situation imaginable. 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 specialized assets cannot therefore be -8easily disposed of and constitute a significant exit barrier for an airline. Moreover, given the high fixed costs associated with this industry compared to the marginal costs associated with operating the fleet (the marginal cost of a single passenger seat on the plane is practically zero) firms have a very high incentive to defect from a collusive restriction of capacity. Finally, one airline seat is to all intents and purposes indistinguishable from one offered by a competing airline; in other words differentiation between airlines is extremely difficult to achieve. Given these three factors, a commodity product, high barriers to exit caused by the specificity of fixed assets, and the enormous economies of scale that arise from the high fixed costs compared to the very low variable costs which lead to increase the likelihood of defection from a collusive arrangements, it is little wonder that making money in the airline industry is extremely difficult. Threat of substitution The threat of substitution has a somewhat similar affect on our ability to maintain prices in excess of our long run average costs. You could think of substitutes has in effect increasing the number of competitors in the industry (even though they're not in the industry) because they give buyers more options from which to choose. If there are five firms in our industry and 25 firms in an industry that produces products that are in effect perfect substitutes for ours, the outcome is likely to be little different in terms of the prices we can charge that if our industry have had 30 firms rather than only five. Competing against new foreign competitors is not substitution. If you make cars and your new competitors also make care they are in your industry; cars, envy if they are made outside the US are not substitutes for cars; they are still cars and the firms that make them are still in the same industry. A new transit system (the Altermont Commuter Express for example), which provides commuters with an alternative to driving, is a substitute. Porter, M. E. 1980. Competitive Strategy: Free Press.