Industry Analysis
Economic Profits
• Key Concept of Business: Economic Profit
Economic profit is the revenue earned by a firm above the
economic cost required to generate that revenue.
– Economic Cost = Accounting Cost + Opportunity Cost
– Opportunity cost is the return available from the next
best use of the resources used in the venture
– Economic Profit = Accounting Profit–Opportunity Cost
Why do we include opportunity cost? Because a key cost of
using resources in one way is not being able to use them in
another way.
Economic Profits: Measuring Opportunity Cost
• Firms use invested capital to purchase resources
– Investors will require the best available estimated
return, accounting for the risk of the venture
– So, the cost of capital provides a measure of the
opportunity cost
• A convenient definition for economic profits that we use:
Economic Profit = Revenue – Accounting Cost –
Capital Cost
Determinants of Economic Profitability
• Firms exist to generate economic profit for their owners.
– Firms use owners’ resources. Their contribution is to provide a
return above what the owner could get from another use.
• Key Question:
What are the determinants of a firm’s economic profitability?
• Industry profitability:
– Depends on the economic structure of an industry and how
that structure affects competition
• The firm and its position in the market
– Firm’s resources and capabilities
– Do these lead to a competitive advantage or
disadvantage in an industry?
Industry Analysis
Why Analyze Structure of Industry?
• Industry analysis is useful:
– Understand the context of firm decisions so we can make
decisions within context - building blocks of strategy formulation
• Essential to making effective decisions about entry, exit, expansion,
product positioning, cost reduction, etc.
• It helps identify potentially attractive/unattractive areas for growth.
• Understanding the current “rules of the game” in the industry is a
precondition for eventually changing them.
• To outperform your industry, you need to understand its structural
conditions and the key competitive forces that operate in it now (and to
forecast future conditions).
Porter’s five forces model
• Professor Michael Porter of Harvard Business
School applies microeconomic theory, focusing
on power, prices, and profits.
• The stronger a force, the more it limits the
industry firms’ ability to set prices. Strong forces
are thus threats because they reduce profits.
• Weak forces are opportunities because they give
firms chances to earn greater profits.
• The pattern of forces both define the industry
power relations and constrain firms actions.
Porter’s five forces model
Threat from
New Entrants
Suppliers’
Power
Rivalry
of
Firms
Threat from
Substitutes
Buyers’
Power
Power of other
Stakeholders
I. Barriers to Entry
• The question:
To what extent does the threat of entry cut the
profitability of a typical firm in the industry?
• Factors that restrict entry into an industry:
– Economies of Scale
– Large Up-Front Expenditures that are Sunk
– Difficult access to key resources (raw materials,
distribution channels, favorable locations)
– Incumbent advantages:
• Learning curve effects, patents and licenses,
switching costs, reputation, brand loyalty
– Expectation of aggressive response to entry
Economies of Scale
• Production economies due to lumpy capital, specialization
of labor/capital, technological factors.
– Large economies of scale can arise when minimum
efficient scale is large relative to market size
• (Market Size/Minimum Efficient Scale) approximates
number of efficient scaled firms that can be sustained
– Limits number of firms that can be in the industry
– Creates “lumpiness” - incumbents can make profits
but any additional entry would “spoil the market”.
Sunk Costs
• If investment made is specific to this opportunity, cannot
recover it.
– To the extent that investment made is irreversible,
hit and run entry impossible
• Extent and specificity of capital is a barrier to entry, since if
exit is costly, more unlikely to enter under uncertainty.
• Some investments create barriers to entry by increasing the
amount of sunk investments required to enter industry
– Investments in brand building (advertising) - all
sunk, so is a barrier to entry
– Investments in R&D
Sunk Costs
• Exogenous
Sunk Costs:
– These are the sunk costs that firms must pay to be in business. The
costs (and resale value) of factories, plant and equipment are often fixed
in the market. Hence, the level of sunk costs is "given" — firms must pay
them to operate.
– More important when the minimum efficient scale of production in an
industry is large — this is often determined by technological or market
forces operating outside the industry.
• Endogenous
Sunk Costs:
– These are the sunk costs that firms choose the level of. For example,
firms decide whether to promote their products and how much to spend
on marketing.
– Important in industries where sunk expenditures (like advertising)
effectively increase consumers' willingness to pay for its product.
II. Bargaining Power of Suppliers
• The key question:
– To what extent do the input prices facing a typical firm in an industry
deviate from those that would prevail in highly competitive input markets
because of the bargaining power of input suppliers?
• The power of suppliers increases if:
– Input is a critical component of production
– Supplier industry more concentrated than the industry it services
• Relative concentration is what matters
– Firms in the analyzed industry purchase relatively small volumes
relative to other customers of the supplier.
• The more important an industry to its suppliers, the more effort the
suppliers may spend trying to get as much as they can out of this industry
– Switching costs are high
– Threat of forward integration by suppliers
III. Bargaining Power of Buyers
• The key question
– To what extent do purchase prices in this market differ
from what would prevail in a market with a large number
of fragmented buyers in which buyers are price takers?
• The power of buyers increases if:
– input is a not a critical component of production
– buyers are large and few in numbers
– input is relatively standardized
– switching costs for buyers are low
– lots of substitutes
– buyers can credibly threaten to backward integrate
IV. Substitutes and Complements
Substitutes
• Question:
– To what extent does competition from substitutes outside the current
boundaries of industry erode the profitability of a typical firm in the industry?
• Identifying substitutes depends on how “finely” you draw the
boundaries of the analyzed industry
– Are railroads a competitor to airlines or a substitute product?
– Either way: you have a substitute or a rival you must consider
• Substitutes limit profits by placing a ceiling on industry prices.
– The more attractive the price-performance tradeoff offered by substitutes,
the more important the substitute product
– What can matter are customers’ PERCEPTIONS of substitutes
• e.g. tap water and bottled water: chemically very close, maybe not
perceived as such close substitutes
IV. Substitutes and Complements
Complements
• Question:
– How is demand for a product affected by the
availability/ price of the complementary product?
• Two aspects:
– Market for complementary product affects demand for
own product
– Need for complementary products limits own ability to
capture value – market must be shared
• Examples:
– Intel/Microsoft
- DVDs/DVD Players
V. Threats from Competitors: Rivalry
• Two basic questions:
1. How do firms compete?
• price strategy
• product differences
• technological innovations
• marketing
2. To what extent does price competition or non-price competition
(advertising) cut the profitability of a typical firm in the industry?
• Intense rivalry cuts profitability by
– reducing price-cost margins (price competition)
– increasing programmed costs (non-price competition)
• Advertising, R&D, improvement in product quality
• Price rivalry is often most costly and important for profitability:
If price is an effective competitive weapon, no quicker way to
make a profitable industry unprofitable
Factors that Limit Pricing Rivalry
• Higher switching costs decrease responsiveness to price
– Done by price differentiation/switching costs:
• Ex.: Frequent Flyer Program, Credit cards offering % back
– Brand Loyalty plays a similar role:
• Decreases rivalry by creating a switching cost from consumer
perspective
• Conditions for tacit coordination/collusion:
– Concentrated market
– Facilitating practices used
(ex.: advanced announcement of price changes)
– Public sales terms; firms have good info about competitors
– Small, frequent orders
– Strong capacity utilization
– Rapidly growing demand
Summary: Outcome of Analysis
1) Is this, and will it continue to be, a profitable industry?
2) How does competition work in the industry?
3) How is competition likely to evolve?
4) What are the characteristics of successful companies and how will
this evolve?
Limitations:
– Qualitative more than quantitative
– Little attention to factors that affect demand beyond availability
and price of substitutes and complements (strategies to boost
demand, demographics, etc…)
– Industry is the unit of analysis -- not individual companies
– Ignores many strategic interactions
– Does not address how a firm can affect ‘forces’ to its advantage