Week 3 / Chapters 2, 11, 13 Flashcards
Chapter 2: Analysis of the External
Environment: Opportunities
and Threats
Chapter 2: Analysis of the External
Environment: Opportunities
and Threats
A firm’s external environment provides both
1) opportunities—ways of
taking advantage of conditions in the environment to become more profitable
2) threats— conditions in the competitive environment that endanger the profitability of the firm
Competition for profits goes beyond established
industry competitors to include four other forces that shape industry attractiveness and profitability:
1) customers,
2) suppliers,
3) potential entrants,
4) and substitute products
LO 1 Determining the Right Landscape: Defining a
Firm’s Industry
LO 1 Determining the Right Landscape: Defining a
Firm’s Industry
The first strategic decision that most firms must make is to
select the industry, and markets,
in which it will compete (the sandbox)
The firm’s landscape is typically defined by:
(1) the industry (or industries)
in which a firm competes, and
(2) the product and geographic markets within that
industry that the firm targets
How the US Government Defines Industries
- North American Industry Classification System (NAICS)
- vary from two to seven digits, becoming more narrow with increasing numbers of digits
- Used to be SIC codes
LO 2 Five Forces that Shape Average Profitability
Within Industries
LO 2 Five Forces that Shape Average Profitability
Within Industries
Michael Porter’s 5 Forces
1) Rivalry
2) Buyer power
3) Supplier power
4) Threat of new entrants
5) Threat of substitutes products
There are three basic steps involved in using the five forces analysis tool:
Step 1: Identify the specific factors relevant to each of the five major forces. We describe
the factors that contribute to each of the five forces in the next five sections of this chapter.
• Step 2: Analyze the strength of each force. To what extent is it shaping the industry’s
attractiveness? The appendix at the end of the book lists several sources where you might
find the data you need to analyze each of the five forces.
• Step 3: Estimate the overall strength of the combined five forces to determine the general
attractiveness of the industry, the profit potential for an average firm in the industry.
Rivalry
Competition among firms within an industry. Typically this involves firms putting pressure on each other and limiting each other’s profit potential by attempting to gain profits and/or market share.
Substitute
A product that is
fundamentally different yet serves
the same function or purpose as
another product.
Threats
Conditions in the
competitive environment that
endanger the profitability
of a firm.
Opportunities
Ways of taking
advantage of conditions in the
environment to become more
profitable.
Attractiveness of an industry
The degree to which an average
firm in the industry can earn
good profits.
The following seven factors are critical to understanding the intensity of rivalry in
an industry:
- The number and size of competitors
- Standardization of products
- Costs to buyers of switching to another product
- Growth in demand for products
- Levels of unused production capacity
- High fixed costs and highly perishable products
- The difficulty for firms of leaving the industry
Competitor rivalry as per Figure 2.2
In the middle is Competitor Rivalry, around it is:
Buyer power, New entrants, Supplier Power, Substitutes
The Number and Relative Size of Competitors
The more competitors there
are in an industry, the more likely that one or more of them will take action to gain profits at the
expense of others.
Fragmented Industry
What Economists call an industry with a lot of competitors
-it is difficult to keep track of the pricing and competitive moves of multiple players. The large number of firms responding to one another tend to create intense
rivalry
Concentrated Industry
-have far fewer competitors
and tend to be dominated by a few large firms
-rivalry is typically much less
intense
Relatively Standardized Products
Differentiated products, ones that boast different
features or better quality, tend to engender loyalty in customers because they meet customer needs in unique ways.
When products are standardized, or commodity-like
buyers are
less loyal to a particular brand and it is easier to convince them to switch brands
Standardized products
manufactured products or materials that are interchangeable regardless of who makes them, like bolts and nuts, rubber, plastics, or commodities such as coal, crude oil, salt, or sugar
Switching costs
Barriers that help keep buyers using the same
supplier by imposing extra costs
for switching suppliers.
Low Switching Costs for Buyers
The lower the switching costs, the easier it is for competitors to poach customers,
thereby increasing industry rivalry
Buying a different type of gum vs going from Windows to MacOS
Switching costs are a fundamental part of not just rivalry but also the other four forces:
- Buyer power: If customers, or buyers, can easily switch firms, then buyers have increased
power. - Supplier power: If firms can’t switch suppliers easily, then suppliers have increased power.
- New entrants: If buyers can easily switch to new companies attempting to enter the industry, there is a greater threat of new entrants.
- Substitutes: If buyers can switch to substitute products without much difficulty, firms face
an increased threat from those substitutes.
Slow Growth in Demand for Products or Services
-When demand is increasing
rapidly, most firms can grow without taking existing customers from competitors
-When sales decline competitors may try to increase their sales volume by attracting customers from their competitors through sales promotions, price discounts, or other tactics
Examples: TV prices dropping by 25% in 2010 as sales dropped tremendously
High Levels of Unused Production Capacity
Firms typically try to produce at or near their full production capacity so that they can spread the fixed cost of factories, machinery, and other means of production across more units
However, when more is produced than is demanded in the market, firms often have to drop their price or risk having unsold product
Examples: Automobile industry when economic downturns hit and they have too many cars
High Fixed Costs, Highly Perishable Products, High Storage Costs
Industries that produce or serve products in these three categories sometimes find themselves with
a supply of products that they have to sell quickly or take large losses on
Example: Airline seats that don’t sell, produce in a grocery store that is approaching its expiration date, manufacturing firms that produce too much and need to pay for storage
High Exit Barriers
In some industries, companies don’t exit even when they aren’t making a lot of money. Most often, they stay because they have made investments in specialized
equipment that can’t be used in any other industry
Example: Steel blast furnaces
Buyer Power: Bargaining Power and Price Sensitivity
When buyers have sufficient power, they can demand either lower prices or better products
from their suppliers, thereby hurting average profitability of firms in the supplier industry
The two primary situations in which buyers have high power are when
1) Buyers hold a stronger bargaining
position than sellers
2) When buyers are price-sensitive
Buyer Bargaining Power
-Four key factors influence the degree to which buyers have bargaining power over their suppliers
Four key factors of Buyer Bargaining Power
1 + 2) Buyers switching costs and demand
3) Number, or concentration, and size of buyers:
4) Credible threat of backward integration:
Supplier
A firm that provides products that are inputs to
another firm’s production process.
Number, or concentration, and size of buyers:
Buyer concentration reflects the law of supply
and demand
If there are few buyers but many sellers,
hen the sellers must compete
more strongly for buyer business.
Sellers in this situation are likely to give concessions to
make the sale
If there are lots of buyers but few sellers,
many buyers
The more likely sellers are to increase the level of competition in order to gain buyers’ business
Credible threat of backward integration:
In some cases, a buyer can exert pressure over
suppliers by threatening them with backward integration, meaning they will make the
product themselves.
Backward integration
A firm purchases one or more of its
suppliers in order to make a product itself rather than buying it from another firm.
Buyer Price Sensitivity
In general, when buyers are more price-sensitive, they are more likely to exert pressure on suppliers to keep prices low.
Buyers exert pressure not just through price negotiation but also through more comparison shopping and a greater willingness to switch suppliers
Buyer price sensitivity tends to increase in the following situations:
Buyers are struggling financially
Product is significant proportion of buyer’s costs
Buyers purchase in large volumes
Product doesn’t affect buyers’ performance very much
Product doesn’t save buyers money
Supplier Bargaining Power
The factors that increase the bargaining power of suppliers are very similar to those that
increase the bargaining power of buyers.
When supplier industries have strong bargaining power, they can charge higher prices, which tends to decrease average profitability in a buyer’s industry
Number, or Concentration, and Size of Suppliers
As with buyer concentration,
supplier concentration also follows the law of supply and demand.
If there are few sellers but lots of buyers in an industry, then the buyers have to compete to get the products that they want, often paying higher prices to get sufficient supply
Credible Threat of Forward Integration
In some cases, a supplier can exert
pressure over its buyers by threatening them with forward integration, doing what its buyers
do, if the buyers don’t offer price concessions
Forward integration
A firm goes into the business of its former
buyers, rather than continuing to sell to them.
Barriers to entry
The way organizations make it more difficult for potential entrants to get a foothold in the industry.
Incumbent firms might have cost
advantages relative to new entrants for a variety of reasons besides economies of scale. These
include the following:
- Patents or proprietary technology, such as those that exist in the pharmaceutical industry
- Better locations, a deterrent to firms wishing to enter markets where Starbucks is dominant,
for example - Economies of scope, less expensive costs per unit created by bundling different types of
products. - Preferential access to critical resources, such as raw materials or access to distribution networks.
Capital Requirements
Not only do potential entrants often need capital to build a factory or store, but they may also have to invest in R&D to generate viable products, build inventory, undertake sufficient advertising and marketing to take market share from incumbent firms, and have sufficient cash on hand to cover customer
credit.
Network Effects
Growth in demand for a firm’s product that results from a growth in the number of existing customers.
Government Policy Restrictions
Finally, government policies may make it more
difficult to enter a market or even restrict a market completely to new entrants
Example: governments often raise the costs of entry by requiring bonding, licenses, insurance, or environmental studies before a firm can enter an industry
Threat of Substitute Products
A substitute is a product that is fundamentally different yet serves the same basic function
or purpose as another product.
Example: Coffee vs Energy Drink, e-mail instead of text, phone calls, fax
Difference between a rival and a substitute
If the product has the same basic characteristics
and is made using the same general set of inputs, it would be considered part of rivalry, rather than a substitute.
For instance, competitor brands serving the same basic need, such as Apple’s iPhones and Samsung’s smartphones running Google’s Android operating system, are rivals, not substitutes
Awareness and Availability
Sometimes customers aren’t readily aware that substitutes exist.
The threat increases when substitute products are well known
Likewise, if the substitute product is just as easy for customers to obtain as the industry’s products are, it is more of a threat. If the substitute is difficult to find or acquire, the threat is diminished.
Price and Performance
The price of the substitute itself also factors into customers’ decisions. If substitutes are cheaper than
products from another industry, the threat is higher.
Likewise, if the performance of substitutes
is similar or better, the threat is higher. The closer the substitute is in performance, the less flexible a seller can be with price
LO 2.3 Overall Industry Attractiveness
LO 2.3 Overall Industry Attractiveness`
Attractive (profitable) industries
Are those where firms have created power over buyers and suppliers, created barriers to entry to reduce the threat of new entrants, and minimized the threat of substitutes while keeping rivalry to a minimum.
Unattractive industries
Firms in these industries are consistently
pressured by buyers and suppliers alike. They face high rivalry, easy entrance for new competitors,
and many well-positioned substitute products
Do industries often show up at unattractive or attractive after doing the Porter’s test?
A significant threat from just one or two of the five forces is often sufficient to destroy the attractiveness of
an industry
LO 2.4 Where Should We Compete? New Thinking
About the Five Forces and Industry Attractiveness
LO 2.4 Where Should We Compete? New Thinking
About the Five Forces and Industry Attractiveness
Popular idiom for this assessment tool
“Beauty is in the eye of the beholder.”
Or, in other words, unattractive markets according to traditional industry analysis may be quite attractive to the right kind of entrant.
Should you enter an attractive market or an unattractive market to make money?
On average, new entrants into highly profitable (attractive) markets were 30 percent less profitable than new entrants into unattractive markets (i.e., in general, it is easier for new entrants to make money in unattractive industries than attractive ones)
The reason? Barriers to entry made it difficult for the new entrant to establish itself. So, on average, an attractive market (from a five-forces perspective)
is actually the least attractive market for a new entrant
LO 2.5 How the General Environment Shapes Firm
and Industry Profitability
LO 2.5 How the General Environment Shapes Firm
and Industry Profitability
A simple way to think about the general environment is to break it down into eight categories.
- Complementary products or services
- Technological change
- General economic conditions
- Population demographics
- Ecological/natural environment
- Global competitive forces
- Political, legal, and regulatory forces
- Social/cultural forces
Complementary Products or Services
AKA Ecosystems
Products or services that
can be used in tandem with those
from another industry.
Examples: Burgers and buns, Gas stations and roads are complements to automobiles, piping is a complementary product to natural gas
For example, video gaming hardware and software, or smartphone operating systems and Apps, are complementary sets of products
For many industries, changes in complementary products are one of the most important trends to keep an eye on. Some consider them significant enough that they even refer to them as a ______ force among the five industry forces
sixth
6th
Technological Change
can include new products, such
as smartphones; new processes, such as hydraulic fracturing (fracking), which has dramatically
increased the output of the natural gas industry; or new materials, such as lithium batteries,
which make electric automobiles possible
General Economic Conditions
Economic growth
Interest Rates
Currency exchange rates
Inflation
Analyzing the economic environment typically involves
Measuring the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or
deflation
Economic Growth
How quickly, or slowly, an economy is growing has a direct impact on most firms’ bottom line.
Economic expansion tends to improve customer balance sheets, lower price sensitivity, and increase the growth rate in an industry, as customers purchase more, easing rivalry.
Example: Africa now having more money so people can buy cars and automobiles
Interest Rates
Interest rates particularly affect rivalry by increasing or decreasing the demand for an industry’s products.
This is particularly true for expensive items like housing, cars, and even education, which often require customers to take out loans to purchase
Currency Exchange Rates
Currency exchange rates reflect the value of one country’s currency in relation to the currency from another country.
Exchange rates can have a large
impact on the prices that customers pay for products from firms in other countries, directly
affecting profitability for those firms
Inflation
significant, consistent rise in prices, known as inflation, can create many problems for firms.
Inflation, or the opposite, deflation, means that the value of the dollar doesn’t stay constant. Today, a product may cost $1.
If inflation is at 2 percent a year (low inflation), then next year that product will cost $1.02.
Demographic Forces
Involve changes in the basic characteristics of a population, including changes in the overall number of people, the average age, the number of each gender or ethnicity, or the income distribution of the population
Ecological/Natural Environment
The natural environment can also be a source of change for many industries. In some cases,
this involves changes to the physical environment such as increasing shortages of key inputs
like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas).
Current trends in the natural environment involve changes in the public’s perception
of how business affects the environment
Global Forces
Another factor
Political, Legal, and Regulatory Forces
Those that arise from the use of government
When new laws are passed, they may alter the shape of an industry and influence the strategic
actions that firms might take
Social/Cultural Forces
refer to society’s cultural values and norms, or attitudes
Values and attitudes are
so fundamental that they often affect the other six general environmental forces, shaping the
overall landscape in which firms compete
