Economics of Strategy

Economics of Strategy
Industry Analysis
Five-Forces Analysis
• A systematic analysis of major economic
forces affecting the industry
Internal Rivalry
Buyer Power
Seller Power
Substitute Products
• Assess each force by asking
– “Is it sufficiently strong to reduce or eliminate
industry profits?”
Supplier Power
Internal Rivalry
Substitute Products
Buyer Power
Internal Rivalry
• What is the intensity of competition within
the market?
– Types of Competition
• Price Competition
• Non-price Competition
Price Competition
• Firms within the industry competing for
consumers with price
• Price competition is more fierce with
numerous sellers
homogeneous products
switching costs that are low for consumers
transaction conditions that are not transparent to
other firms
– sales orders that are large, received
infrequently, and at irregular intervals
– excess capacity exists in the industry
Non-Price Competition
• firms within the industry are competing for
consumers on non-price factors
– product delivery conditions and scheduling
– conditions of contract
• warranties, return policies, customer service
– terms of payment/financing
– tie-in sales
– relationship selling (“Best BBQ Clause”)
Levels of Rivalry
• Depend upon
– relative size and success of peer firms
• large numbers of firms tend to reduce rivalry
• wide ranges of success tend to increase rivalry
– industry growth rates
• rapid growth rates tend to increase rivalry
Levels of Rivalry
• Tend to increase with
high fixed costs
high storage costs
low switching costs
diversity among firm paths to profitability
technological change
lumpy capacity investment
• Entry erodes profit margins
– Entry from existing firms
• with existing capacity, change in quantity supplied
• with new capacity, change in supply
– Entry from interloper firms
Barriers to Entry
– Economies of Scale
– Economies of Scope
– Ownership of a required input
• intellectual property rights, patents, copyrights,
crucial resource
– Favorable access to distribution channels
– High financial capital requirements
– Product differentiation/ strong brand identity
Other Potential Incumbent
– Learning curves/ accumulated experience in the
– Favorable access or terms with input suppliers’
– Geographical/Location advantages
– Regulatory Environment
• Experience with
• Influence within
• Captured and used to block entry
– Slow growth in the industry can create time
Threat of Retaliation
• Existing firms may have an established
pattern of deterring new entrants
• Existing firms may have financial resources
to ride out the retaliatory period
• Existing firms may have ties to suppliers,
distributors, or customers which can be
leveraged to deter new entrants
• What are the available substitutes for
– Think about all available and potential substitutes
• Changes in technology
• Changes in consumer tastes and preferences
• Firm-level price elasticity within the industry or industrylevel price elasticity across substitute industries?
• Look forward… but not too forward!
Identifying Substitutes
• Identify products which provide the same
functional use
• Focus on substitutes
– which are relatively good substitutes but have
been historically excluded because of
production costs
– which are produced by an industry enjoying
high profits
Supplier Power
• input suppliers have market power
– due to relationship specific assets
• exploiting the gap between rents and quasi-rents
– due to monopoly power
• allows flexibility in extracting rents
– when buyer is doing well -- raise input prices
– when buyer is doing poorly -- lower input prices
Supplier Power increases if
• Suppliers have market power
– monopoly
– oligopoly
• your purchases are unimportant to firm
• they have built in high switching costs for
• they can, or threaten to, integrate upstream
Buyer Power
• buyers may have market power
– monopsony - single buyer
– oligopsony - small number of buyers
– can be due to relationship specific assets
• exploiting the gap between rents and quasi-rents
Buyer Power increases if
• they are price sensitive
– because the product they are purchasing
represents a high proportion of their costs
– because they are acclimated to competitive
pricing in the input market
• they earn low profits
• they face low switching costs
• they can, or threaten to, integrate
• the input is not critical to the quality of the
final product
Five-Forces Analysis
• Inherent Weaknesses
– Assumes sufficient demand exists in industry
– Focuses on the industry as a whole
– Ignores government (the gorilla in the living
• Regulatory Environment
– Industry-specific regulation
– Health, Safety, Environmental regulation
– Property Rights policies
• Taxation Policies
• Social Welfare Policies
– Qualitative analysis