A Guide for Industry Study and the Analysis of Firms and Competitive Strategy

This page is a guide to applying the principles of Economics to researching and understanding a market andthe industries and firms that make up the market.

An excellent source for the information needed to conduct an industry study or an analysis of a firm'scompetitive strategy is the Babson College Horn Library at http://www.babson.edu/library/. The Horn Libraryprovides a research guide and sources for researching a company and an industry.

There are two distinct yet related models for studying markets. One method of analysis is the "Structure-Conduct-Performance" paradigm from the Industrial Organization field of Economics. Another is Porter'sFive Forces. As we will see shortly, Porter's Five Forces and the "Structure-Conduct-Performance" paradigmoverlap in many ways. This page combines both methods into a unified guide for industry studies and theanalysis of firms and competitive strategy.

"The Structural Analysis of Industries" is covered quite well in Chapter 1 of Porter, Michael E., CompetitiveStrategy: Techniques for Analyzing Industries and Competitors, 1980 and new introduction in 1998, The FreePress, New York, NY.

Figure 1 is a graphical representation of Porter's Five Forces.

Figure 1: Porter's Five Forces

Porter details the factors that impact each force and develops an analytical model to study industries. Thepurpose of this analysis is to assess the profitability potential of industries. The analytical tools of Porter'sbook will not be reproduced here. However, Porter's framework incorporates the analysis of market structureand vertical supply chains and each of these concepts will be addressed from the perspective of an economist.

The real genius of Porter's Five Forces is that it builds on and combines two tools from microeconomics,namely the analysis of market structure and vertical boundaries. The analysis of market structure is the firstelement of the "Structure-Conduct-Performance" paradigm.

I. A. 2. a. Market Structure

The vertical elements of Porter's Five Forces are shown in Figure 2.

Figure 2: The Vertical Elements of Porter's Five Forces

Each of these elements corresponds to a determinant of market structure as detailed in Table 1 below.

Table 1: Porter's Five Forces and Market Structure

Element of Porter's Five Forces Determinant of Market StructurePotential Entrants Barriers to EntryIndustry Competitors(Direct Substitutes)

Number of SellersProduct Characteristics

Indirect Substitutes Product Characteristics

I. A. 2. b. Vertical Supply Chain

The horizontal elements of Porter's Five Forces are shown in Figure 3.

Figure 3: The Horizontal Elements of Porter's Five Forces

If one were to show these elements vertically, they would appear as:

Figure 4: The Vertical Supply Chain

This representation now shows the vertical supply chain. The important issue for firms in the industry is howthey position themselves in the supply chain. The firms essentially must choose their vertical boundaries.

The "Structure-Conduct-Performance" paradigm is a road map for identifying the factors that determine thecompetitiveness of a market, analyzing the behavior of firms, and assessing the success of an industry inproducing benefits for consumers.

"Structure" refers to the market structure of an industry which is indicative of the degree of competition in theindustry. "Conduct" refers to business practices adopted by firms in the industry to implement their

competitive strategies and to create competitive advantage (the ability to outperform competitors in theindustry). "Performance" refers to measurements by which the industry or firms in the industry can be judgedas to whether they have achieved their stated goals.

The methodology of our unified guide for understanding markets begins with an industry study and continueswith an examination of the competitive strategies of firms in the industry. The framework we will use foranalyzing industries and firms is:

Evaluate the industry's potential for profitability (with an industry analysis).

Identify the firm's strategic positioning within the industry and analyze its business practices.

Assess the firm's potential for competitive advantage (the firm's ability to outperform competitors in theindustry).

The purpose of an industry analysis is to assess the profitability potential of the industry.

The steps in an industry analysis are:

Identify the industry and describe its market.

Classify the market structure of the industry.

Characterize relationships between links in the vertical supply chain.

Evaluate the future profitability potential of the industry.

II. A. 1. a. Definition and Specific Description

The first task is to define the industry. Industry definition is important to determining the competitive set. Ineconomics, defining the competitive set is equivalent to defining a firm's horizontal boundaries. A firm'shorizontal boundaries are its competitors who supply direct substitutes.

The U.S. Census Bureau classifies industries with the North American Industrial Classification System(NAICS). NAICS can be accessed at the web page www.census.gov/naics. A researcher can navigate and/orsearch the site and find a description and definition of most industries in the US. Industry descriptions varyfrom very broad (two-digit NAICS codes) to very narrow (six-digit NAICS codes). Usually, a researcher willchoose the narrowest description of an industry. This allows the researcher to most closely identify thecompanies that compete with each other in an industry. The narrower the description of an industry, the more

likely the competitive set will be based on products that are direct substitutes. The broader the description onan industry, the more likely the competitive set will be based on products that are indirect substitutes.

For each six-digit NAICS code, there is a short description of the industry. Additionally, the U.S. CensusBureau provides a short definition of the industry. The researcher must determine if the description anddefinition of the industry fit with the intended companies targeted for study.

II. A. 1. b. General Description

An industry analysis often starts with a brief introduction to the industry. Sources for general information onan industry are:

Company provided information (web pages and information packages)Industry reviews (See "Introductory Reviews" under the subheading "INDUSTRY SOURCES" on thechecklist provided on the Babson College Horn Library web site "Library Research Guide: UnitedStates Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.)Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRYSOURCES" on the above checklist.)Corporate reports of publicly-held corporations. Companies often provide this information on their websites. Another alternative is the SEC Edgar Database of corporate information available athttp://www.sec.gov/edgarhp.htm. (See "Corporate Reports of Publicly-Held Companies" under thesubheading "COMPANY SOURCES" on the above checklist.)Periodical articles and news. (See "Index to Periodical Articles and Current News" under thesubheading "INDUSTRY SOURCES" on the above checklist.)Trade associations. A listing of trade associations is available at http://www.associationcentral.com/.(Other sources are provided on the Babson College Horn Library web site "Researching an Industry:Trade Association Material" at http://www.babson.edu/library/indtrade.htm.)

General market conditions faced by an industry are often important factors in the choice of conduct by firmsand for the ability of firms to generate profits and meet expected performance goals. Identifying relevantgeneral market conditions requires an analysis of:

Supply and demand conditions that define the market.The overall market environment. Environmental factors are often identified with a PEST methodology.The PEST acronym stands for Political/Legal, Economic, Sociocultural, and Technological factors.

II. A. 2. a. Supply and Demand Conditions

The factors driving the supply of and demand for a product of an industry are detailed in Table 2 below. Thesefactors determine the defining characteristics, position and slope, of supply and demand curves in aneconomist's representation of a market.

Table 2: Basic Market Conditions, Determinants of Supply and Demand

Determinants of Demand Determinants of Supply

Position of demand curve:

Change in number of buyers (market growth)Change in buyer tastes and preferencesChange in income (income elasticity of demand)Change in the prices of related goods, substitutes andcomplements (cross-price elasticity of demand)Change in expectations

Position of supply curve:

Change in number of suppliers (moreor less competition in the industry)Change in resource prices (rawmaterials and labor)Change in technologyChanges in taxes and subsidiesChange in prices of other goodsChange in expectations

Slope of demand curve:

Buyer price sensitivity (price elasticity of demand)- Degree of substitutability- Proportion of buyer income- Type of product (inferior versus normal good, normalgood further classified as necessity versus luxury)- Buyer time to purchase product

Slope of supply curve:

Firm time to respond to a change in theprice of the product

The interaction of supply and demand determine production levels and product price in the market. In aperfectly competitive market, equilibrium price and output in a market are determined where quantitysupplied equals quantity demanded. Determination of output and price in other market structures is a bit morecomplex. For additional information, see a standard Principles of Microeconomics textbook such asEconomics: Principles, Problems, and Policies, by Campbell R. McConnell and Stanley L. Brue, TheMcGraw-Hill Companies, Inc.

The analysis of supply and demand conditions are closely related to two aspects of Porter's Five Forces. Thedeterminants of demand parallel Porter's analysis of buyer bargaining power and the determinants of supplyare important factors in studying the intensity of rivalry between existing industry competitors.

II. A. 2. b. PEST

In addition to market forces within the industry, it is critical to monitor external forces that may impact theindustry on an ongoing basis. A manager may have a very good understanding of what is happening within anindustry, and yet be blindsided by external events that change the nature of competition and revenue within anindustry. A marketing framework commonly used to examine these factors that impact business decisions isreferred to as PEST. PEST is an acronym for the political/legal, economic, sociocultural, and technologicalfactors that shape the environment of an industry or a business.

Political/Legal

An industry must remain abreast of political forces that may influence the viability and profitability of theoverall industry, as well as specific firms. Political and legal issues that have impacted businesses andindustries over the past decade include: environmental legislation, regulation of the Internet, antitrust rulings,to name a few. For a multinational business, these factors become much more complicated. The business mustcontinually monitor the stability of governments, understand differences in governmental practices, know therules in terms of importing and exporting goods, and be knowledgeable about the laws that impact the

industry and the business in each country. These factors can impact the structure and profitability of thebusiness and industry in each country. Sources of information that can be used to monitor this factor include:government agency web sites and publications, embassies, lawyers and legal journals, and, of course,newspapers.

Economic

The economy can have a serious impact on sales and profitability within an industry and firm. Unemploymentrates, the value of the dollar, inflations, growth, and productivity are factors that impact the health of theeconomy and consumer confidence. These factors provide indicators to potential concerns on recession andinflation. The economy may lead to reduced spending by consumers that have a rebound effect throughoutcompanies and industries. A firm must monitor these factors to forecast sales and profits appropriately anddevise appropriate strategies to ride out an unfavorable economic environment. Firms may even be able totake advantage of an economic downturn to gain share and customers from competitors. Potential sources ofinformation to evaluate the current and projected state of the economy include the New York Stock Exchangeand NASDAQ (as well as world exchanges), Wall Street Journal, and analyst reports.

Sociocultural

Trends may occur within the social and/or cultural structure of society. Examples in the past decade includethe increase in working women, the health and fitness craze, and the growth in discretionary spending byyouths. These trends can have a serious impact on entire industries, as well as individual companies. Abusiness must monitor these trends to make sure that its product will continue to meet the needs of theconsumers it serves. New attributes may emerge and the importance of existing attributes may change as aresult of changes in society. Similarly, as the business enters new markets or countries, expectations may bevery different based on the social structure and societal expectations of the specific culture or cultures.Sources of information on these trends include newspapers and magazines, television and other masscommunication media, and specific monitoring publications or companies as American Demographics and theYankelovich Monitor.

Technology

In the past century, the world has seen a technological revolution. Today, we can travel faster, receivecommunications instantly, and produce more per capita. As a result of this change, many industries haveemerged (e.g., cellular phones and dot-coms) and many industries have all but disappeared (e.g., typewriters).Business that have survived have succeeded in staying ahead (or only slightly behind) the technologicaladvances. These businesses have taken advantage of the emerging technology in other industries to improvetheir product and/or service. These firms are always looking for technology that will help serve customersbetter and/or cheaper. In that way, technology may provide a competitive advantage. Sources of informationon technology include journals in potential areas such as computers or genetics, scientific journals, and othernewspapers and magazines.

The critical element in environmental scanning is to continually monitor the media relevant to yourcustomers, your industry, your market(s), and overall technological development. As changes occur forelements within PEST, a company (and industry) must ask:

Is this likely to grow and continue in acceptance?Is it likely to influence my industry?How can I use it to differentiate my product or service? Or should I offer a new product or service?

How can I use it to gain a competitive advantage?

A good resource for further information on environmental scanning (or PEST) is . [UNDERCONSTRUCTION - Professor Carol Gwin]

Market structure refers to the number and relative size of sellers and buyers in a particular market. There arefour definitions of a market structure: Perfect Competition, Monopolistic Competition, Oligopoly, andMonopoly. The market structure of an industry can be classified with three criteria: number of sellers, productcharacteristics, and barriers to entry. Market structure classification according to these three criteria issummarized in Table 3 below.

Table 3: Classifications of Market Structure

Criteria Market Structure

PerfectCompetitionMonopolisticCompetition Oligopoly Monopoly

Number of Sellers Many Many Few OneProductCharacteristics Homogenous Differentiated

Homogeneous (Pure Oligopoly) orDifferentiated (Impure Oligopoly) Unique

Barriers to Entry None None High Very High

The Department of Justice (DOJ) and the Federal Trade Commission publish horizontal merger guidelinesthat are an excellent reference source for market definition and defining the relevant market for classifying themarket structure of an industry. The publication Horizontal Merger Guidelines can be accessed from the webpage of the Antitrust Division of the DOJ at http://www.usdoj.gov/atr or of the Federal Trade Commission athttp://www.ftc.gov.

The guidelines state: "A market is defined as a product or group of products and a geographic area in which itis produced or sold such that a hypothetical profit-maximizing firm, not subject to price regulation, that wasthe only present and future producer or seller of those products in that area likely would impose at least a'small but significant and nontransitory' increase in price, assuming the terms of sale of all other products areheld constant." This statement is equivalent to the question: What firms would have to be included in a cartelfor the cartel to have market power?

The guidelines continue with: "A relevant market is a group of products and a geographic area that is nobigger than necessary to satisfy this test." Thus, the relevant market that we should consider in our analysis ofmarket structure is only those firms that must be included in a cartel for the cartel to have market power. Insome cases, only one firm need be included in the cartel because the geographic area in which a product issold is very small. These are called local monopolies. For example, many towns in the western U.S. have onlyone gas station or one grocery store. Consumers who live in these small towns may have to pay a "monopoly"price for gas or groceries because it is too costly for them to drive to the next town (these costs are calledsearch costs).

For most industries in the U.S., the relevant market is the entire nation (and possibly the entire world).However, a researcher must take care to consider issues such as the geographical span of market power.

How many sellers are there? This question can be answered in two ways. First, we can literally count thenumber of sellers. Second, we can measure the concentration of the industry.

For a definition of sellers and buyers, see Guides for Advertising Allowances and Other MerchandisingPayments and Services 16 CFR 240.1 available from the Federal Trade Commission web page athttp://www.ftc.gov.

U. S. Census Bureau

Data to determine the number of sellers in an industry is available from the web page of the U.S. CensusBureau at www.census.gov. The 1997 Economic Census provides data on Establishment and Firm Size in aSubject Series based on 20 NAICS sectors (two-digit NAICS codes). The 20 NAICS sectors are furthersubdivided into 96 subsectors (three-digit NAICS codes), 313 industry groups (four-digit NAICS codes), and1170 industries (five- and six-digit NAICS codes).

Most sector Subject Series provide information on the number of "Single Unit and Multiunit Firms Subject toFederal Income Tax: 1997" in Table 3 and "Concentration by Largest Firms Subject to Federal Income Tax:1997" in Table 6. Table 6 identifies concentration ratios based on revenue market share for each industry.

Concentration measures for mining, construction, and manufacturing are not available on the Census Bureauweb site.

The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) is available from the U.S.Census Bureau and reports concentration measures for manufacturing. Similar reports are also available formining and construction. (For Babson personnel, the 1992 Census of Manufactures is available on CD-ROMin Horn Library.) An excel spreadsheet containing concentration measures for manufacturing can be accessedat http://faculty.babson.edu/gwin/cr&hhi.xls.

II. B. 2. a. Concentration Measures

Market concentration measures are used to classify how competitive an industry is. Concentration measureshelp us to understand how much market share is concentrated in the hands of a small number of firms. Anindustry characterized by low concentration will have a large number of firms with small market shares. Anindustry characterized by high concentration will have a small number of firms with relatively high marketshares. Industries with high concentrations are more likely to have market power, i.e. the ability to set price.

Two commonly used concentration measures are the concentration ratio and the Herfindahl-Hirschman Index.

Concentration Ratio

A concentration ratio (CR) is the percentage of industry output that a specific number of the largest firmshave. The concentration ratio for the k largest firms in an industry is calculated simply by adding up themarket shares of these k firms. This can be represented as CRk = S1 + S2 + S3 + S4 + S5 + ... +Sk, where Si is

the market share of the ith firm. A very commonly used concentration ratio is the four-firm concentration ratioor CR4. The CR4 is the total market share held by the top four firms in an industry, and it is calculated as CR4= S1 + S2 + S3 + S4.

The 1997 Economic Census shows the total market share (based on revenues) for the largest 4, 8, 20, and 50firms. These concentration ratios would be the CR4, CR8, CR20, and CR50 respectively. Census Bureauconcentration measures are based on data on domestic sales from domestic production.

An alternative to using the Census data is for the researcher to calculate the concentration ratio with actualmarket share data. Market share data is available from many on-line resources such as

Gale Business Resources at http://www.galegroup.comABI/Inform at http://www.umi.comThe Market Share Reporter (Lexis-Nexis) at http://www.cispubs.com/

The Babson College Horn Library has information on all of these resources starting at their home page athttp://www.babson.edu/library/.

If market share data is not available, a researcher may have to calculate market shares for the firms in anindustry. An individual firm's market share is calculated as:

Market Share = Individual Firm Revenue / Total Industry Revenue.

Individual firm revenue data is available from sources such as

Dun & Bradstreet's Million Dollar Database at http://www.dnbmdd.com/mddi/ (Babson College usersshould refer to the Horn Library web pages.)Company provided information (web pages and information packages)Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRYSOURCES" on the checklist provided on the Babson College Horn Library web site "Library ResearchGuide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.)Corporate reports of publicly-held corporations. Companies often provide this information on their websites. Another alternative is the SEC Edgar Database of corporate information available athttp://www.sec.gov/edgarhp.htm. (See "Corporate Reports of Publicly-Held Companies" under thesubheading "COMPANY SOURCES" on the above checklist.)Periodical articles and news. (See "Index to Periodical Articles and Current News" under thesubheading "INDUSTRY SOURCES" on the above checklist.)

One problem with the concentration ratio is that it does not tell us the degree to which a single firm dominatesthe market.

Herfindahl-Hirschman Index (HHI)

The HHI is calculated by summing the squares of the individual market shares of all the firms in an industry.This is represented as HHI = S1

2 + S22 + S3

2 + S42 + S5

2 + ... +Sn2, where Si is the market share of the ith

firm.

Two advantages of the HHI over the four-firm concentration ratio are

The HHI reflects both the distribution of the market shares of the top four firms and the composition ofthe market outside the top four firms.The HHI gives proportionately greater weight to the market shares of the larger firms. This recognizesthe larger firms' relative importance in competitive interactions.

The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) referenced above showsboth the CR4 and HHI for manufacturing industries (NAICS Sectors 31-33).

The 1997 (and 1992) Economic Census does not show the HHI for non-manufacturing industries.

Limitations of Concentration Measures

Concentration measures are limited by how the researcher defines the relevant market. For example,concentration measures may be misleading if:

Import competition is important. Census Bureau concentration measures overstate the relativeimportance of leading domestic firms.Market span is important. Census Bureau concentration measures are based on national trends, marketpower due to dominance in a local geography are not considered.Competitors can enter a market. Census Bureau concentration measures only include firms that wereactive at the time of the census.Competitiveness has more than one dimension. Very often, inter-industry competition (indirectsubstitutes) is just as important is intra-industry competition (direct substitutes).

II. B. 2. b. Classifying Industries

It is important to classify industries as to market structure because the greater the number of sellers, the morelikely the industry is competitive. Figure 5 shows the general relationship between market structure,concentration, and profitability.

Figure 5: Market Structure, Concentration, and Profitability

As we move from left (perfect competition) to right (monopoly) in Figure 5, industry concentration increases.

As industry concentration increases, the market power (the ability to affect price) of firms in the industryincreases. Typically, profit margins increase as market power increases.

Another important reason to classify industries as to market structure is that the number of firms in anindustry plays a role in determining whether firms explicitly take other firms' actions into account.

In monopolistic competition, the multitude of firms makes it unlikely that they explicitly take intoaccount rival firms' responses to their decisions.

1.

In oligopoly, with fewer firms, each firm explicitly engages in strategic decision making - takingexplicit account of a rival's expected response to a decision being made.

2.

Classifying Industries with the CR4

Table 4 below is a general guide for classifying industries by CR4. The table is only a rule of thumb, there isno consensus among economists on using the CR4. Additionally, concentration is only one objective factor inclassifying market structure. There are many more factors, both objective and subjective, that a researchermust take into account before choosing a market structure that best describes an industry.

Table 4: Classifying Industries with the CR4

CR4 Interpretation of Market StructureCR4 = 0 Perfect Competition0 < CR4 < 40 Effective Competition or Monopolistic Competition40

The number of sellers in an industry is important because a small number of sellers with relatively largemarket shares may have market power. However, this market power may be offset if the number of buyers aresmall compared to the number of sellers. A small number of buyers may be able to demand lower prices.

The first question in analyzing buyers is: Who are the buyers? Do firms in the industry sell their productsthrough a distribution channel or directly to end users? The second question is: How many buyers are there?A small number of end users may be able to bargain over price with sellers in the industry. Or, there may be alarge number of end users but only a small number of distributing firms (such as wholesalers or retailers). Asmall number of distributing firms may also be able to bargain on price.

Identifying buyers (or segments of buyers) for an industry is probably best accomplished by identifyingbuyers for individual firms in the industry. Some possible resources are:

Company provided information (web pages and information packages)Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRYSOURCES" on the checklist provided on the Babson College Horn Library web site "Library ResearchGuide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.)Corporate reports of publicly-held corporations. Companies often provide this information on their websites. Another alternative is the SEC Edgar Database of corporate information available athttp://www.sec.gov/edgarhp.htm. (See "Corporate Reports of Publicly-Held Companies" under thesubheading "COMPANY SOURCES" on the above checklist.)Periodical articles and news. (See "Index to Periodical Articles and Current News" under thesubheading "INDUSTRY SOURCES" on the above checklist.)Trade associations. A listing of trade associations is available at http://www.associationcentral.com/.(Other sources are provided on the Babson College Horn Library web site "Researching an Industry:Trade Association Material" at http://www.babson.edu/library/indtrade.htm.)

As shown in Table 2, an important criteria for classifying market structure is whether the product ishomogeneous, differentiated, or unique.

A product is homogeneous if every firm in the industry sells exactly the same product. Homogeneousproducts can be found in perfect competition and pure oligopoly. In perfect competition, a homogeneousproduct means that no individual firm has any control over the price of its product. Price is set in the marketand each individual firm in the industry takes that price as given, hence perfectly competitive firms arereferred to as price-takers. A perfectly competitive firms can sell as much as it wants at the given marketprice, thus each individual firm in a perfectly competitive industry faces a horizontal demand curve.Generally, firms in an industry selling homogeneous products do not brand their products. An industryconsisting of many firms with small market shares and no branded products is likely very close to a perfectlycompetitive market structure. An industry with a few firms with large market shares and no branded productsis likely a pure oligopoly.

A product is differentiated if a firm in a competitive industry can increase price without losing all of its sales(which means the individual firm faces a downward sloping demand curve). This implies there is somedifferentiating feature of a product that some segment of consumers is willing to pay more for. Products canbe differentiated on any element of the marketing mix (the 4 P's) which consists of price, product, promotion,

and place. A product is differentiated only if the consumer perceives and values the differentiating feature ofthe product. The degree of differentiation, and thus the individual firm's market power, depends upon thedegree of substitutability for the product. Many close substitutes implies little differentiation and little marketpower. Few and distant substitutes implies high differentiation and relatively high market power. Generally,firms in an industry selling differentiated products brand their products. An industry consisting of many firmswith small market shares and branded products is likely very close to a monopolistically competitive marketstructure. An industry with few firms and large market shares and branded products is likely an impureoligopoly.

A unique product has no close substitutes. A firm with a unique product is a monopoly (at least in the shortrun). A monopoly firm faces the downward sloping market demand curve which allows the monopolist tohave market power.

Sources for identifying product characteristics are company provided information (web pages and informationpackages); company advertising and promotional materials, corporate reports of publicly-held corporations,periodical articles and news, and trade associations.

The final criteria for classifying market structure is the level of barriers to entry. This criteria does not apply inthe short run. By definition, the short run excludes entry. A researcher must be careful when looking at a"snapshot" of an industry at any point in time to classify market structure. At any point in time, marketstructure can be classified with knowing the number of sellers and product characteristics. However, theimportance of studying market structure is understanding the implications of the market structure for thecompetitive strategies of firms in the market. Competitive strategies are chosen to maximize the long-runprofits of firms. Thus, an important question is whether the market structure will change over time. Oligopolyand monopoly market structures can be sustained over time only if there are barriers to entry. Firms inoligopolistic industries or a monopoly firm can sustain market power only if they can prevent other firmsfrom entering the industry.

There are three types of barriers to entry:

Natural Barriers (economies of scale, economies of scope, absolute cost advantages, capital costs, etc.)Strategic Barriers (actions taken by firms such as product differentiation and increasing the cost ofentry)Legal Barriers (patents, licenses, laws and regulations, etc.)

Porter provides an excellent model for evaluating barriers to entry in Chapter 1 of his previously referencedbook Competitive Strategy: Techniques for Analyzing Industries and Competitors.

Identifying barriers to entry is a little tricky. A monopolist or firms in an oligopoly are unlikely to "advertise"barriers to entry given possible antitrust ramifications. However, there are some guideposts we can use.

II. B. 4. a. Identifying BTE in Monopoly

Identifying natural, legal, and strategic barriers to entry in monopoly first requires the researcher tounderstand the nature of the monopoly.

BTE in natural monopolies are relatively easy to identify. A natural monopoly occurs when long-run

average cost always decrease as output increases. This means that the most cost effective number offirms is one firm. The classic example is utility companies. It would be prohibitively costly for morethan one utility company to build the plants and transmission equipment necessary to deliver power tocustomers. Often, natural monopolies are regulated by government.Legal BTE in a monopoly are also easy to identify. A good example is a firm in the pharmaceuticalindustry that obtains a patent to protect future profits from a new drug.Strategic BTE in a monopoly are more difficult to analyze. Deliberate strategies that firms use to obtainor maintain a monopoly are often anticompetitive and can be illegal under antitrust law. A legitimatestrategic BTE may be investing in R&D to maintain product superiority.

II. B. 4. b. Identifying BTE in Oligopoly

The most common barriers to entry in an oligopoly are:

Economies of scale are reductions in the average cost of producing a product as the firm expands the size of itsplant (its output) in the long run. [Long-run average cost falls as quantity of output increases.]Economies of scope are savings that are acquired through simultaneous production of many different productswith the same plant & equipment.Absolute cost advantage: The long-run average cost of an entrant is higher than that of incumbents.Capital costs: The larger the Minimum Efficient Scale (MES), the larger the financing needed to enter theindustry at the MES. If entrants must pay a higher interest rate on financing than incumbents, then there is abarrier to entry.Product differentiation: Consumer may view products as imperfect substitutes based on quality, performance,or reputation. What really matters is whether consumers perceive a product is different in some way that benefitsthem. Differentiation can be achieved with advertising and promotion, service contracts and warranties, style, andmany more ways. Advertising itself can be a barrier to entry. Incumbents may have an advantage over an entrantin:- Absolute Cost Advantage- Economies of Scale in Advertising- Effect on Capital Cost of Entry

II. B. 4. c. Finding Evidence of BTE

Evidence of BTE can often be found by using resources provided by the monopolist or the firms in anoligopoly. Public companies provide investors with annual reports, quarterly earnings reports, dividendannouncements, and more. SEC filings are also good sources. Many companies, both public and private,provide information packages or make information available on their web sites.

Investment analysts are in the business of predicting what will happen to a firm's stock price. Stock priceshould reflect the net present value of future cash flows or profit. The ability to sustain economic profit oftendepends upon an industry's ability to keep new competitors out of the industry. Investment analysts areparticularly aware of the importance of BTE to future profits. Thus, investment analyst reports often identifythe BTE that are the foundation of their opinions for future profits of a firm and the direction of the firm'sstock price. (See "Investment Analyst Reports" under the subheading "INDUSTRY SOURCES" on thechecklist provided on the Babson College Horn Library web site "Library Research Guide: United StatesCompany & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.)

Given answers to the number of sellers, product characteristics, and barriers to entry, a researcher can identifythe market structure of an industry using Table 3. The objective data must be tempered with the subjectiveopinion of the researcher. Changing market conditions and industry dynamics often require a researcher topredict the evolution of market structure over time. An analysis of future competition in an industry willdepend upon the assumptions and analytical models employed by the researcher.

Hybrid Market Structures

Many industries may not clearly fit the criteria for any single market structure. Classification of marketstructure often depends upon the level of competition viewed by the researcher. Competition can be viewedfrom the company level, a product category level (with possible multiple categories), or an individual productlevel.

Many U.S. industries are characterized by a small number of companies that produce several brands ofproducts that are relatively close substitutes. At the company level of competition, the market structureappears to be an oligopoly. On the other hand, brand competition seems to be monopolistic competition. Forexample, 1997 market shares for cookie makers were Nabisco - 29%, Keebler - 13%, McKee Baking Co. -12%, and President Baking - 6%. The CR4 at the company level would be 60 which corresponds to anoligopoly market structure. 1998 best-selling cookies were Nabisco - 10.1%, Nabisco Chips Ahoy! - 8.5%,Archway - 4.2%, and Keebler Chips Deluxe - 4.2%. The CR4 at the brand level would be 27 whichcorresponds to a monopolistic competition market structure. In the cookie category, actual competition hascharacteristics of both market structures.

The vertical supply chain of Figure 4 can be viewed as a series of sellers who add value to a product before itis finally sold to an end user. For each seller there is an associated buyer who is simply the next seller in thevertical supply chain, except for the last seller who sells to the end user. There is a vertical relationshipbetween each successive link of the supply chain. The nature of these vertical relationships is an importantfactor in the ability of an industry to sustain economic profitability. In determining the number of sellers andbuyers in our previous study of market structure, we have already started an analysis of the bargaining powerof buyers. How effective are buyers in negotiating price and terms of sale with firms in the industry? Buyerbargaining power can reduce industry profitability. Similarly, each seller is also a buyer in the sense that eachseller must obtain input to its production process. Another important question is: How effective are suppliersin negotiating price and terms of sale with firms in the industry? Supplier bargaining power may also reduceindustry profitability.

Porter provides an excellent basis for evaluating the bargaining power of suppliers and buyers in Chapter 1 ofhis previously referenced book Competitive Strategy: Techniques for Analyzing Industries and Competitors.

Each of Porter's Five Forces shown in Figure 1 must be weighed together for an overall picture of the futureprofitability potential of the industry.

An evaluation of the fives forces must consider:

The relative importance of the force to the specific industry

How each force can potentially impact industry profitabilityWhether some forces dominate others or are counteracted by othersHow the interaction of the forces affects current and future profits in the industry

Once again, Chapter 1 in Porter's previously referenced book Competitive Strategy: Techniques for AnalyzingIndustries and Competitors provides more detail on the assessment of the future profitability potential of anindustry.

Each firm in an industry chooses its own positioning within the industry and its own strategy to compete.

Firms must choose their strategic positioning and product positioning. A firm's strategic positioning delineatesits boundaries, both vertical and horizontal. A firm's product positioning delineates the attributes that itsproduct will offer. Which comes first: strategic positioning or product positioning? Table 6 below should helpa researcher to choose which type of positioning to study first.

Table 6: Positioning Analysis

Order of study is For an Existing Firm if For a New Entrant if1. Strategic Positioning2. Product Positioning

New product in anexisting industry

Existing product in anexisting industry

1. Product Positioning2. Strategic Positioning

New product in a newindustry

New product in anexisting industry

A firm chooses its boundaries based on its ability to create value within a positioning. It is important to notethat boundaries are not barriers. Boundaries define a firm's competitors and the functions performed inside thefirm. Boundaries do not prevent entry or mergers and acquisitions.

III. A. 1. a. Horizontal Boundaries

A firm's horizontal boundaries are essentially defined by its direct competitors. A competitor is "direct" if itproduces a similar product. The important question to consider is: How many firms are in the industry?Slicing a pie is a good analogy for understanding horizontal boundaries. The pie represents the market for theindustry's product. The number of slices of the pie is equivalent to the number of firms in the industry. Thesize of a slice represents the market share of a firm. Horizontal boundaries define how many slices of pie thereare and how big each slice is. Wider slices (boundaries) mean there are relatively fewer firms with largermarket shares (the characteristics of an industry with high concentration). Narrower slices mean there arerelatively more firms with smaller market shares (the characteristics of an industry with low concentration).

There are two steps to determining horizontal boundaries. First, the industry itself and its product must beclearly defined (see Section II. B. 1.). Second, the number, identity, and market shares of each firm in the

industry must be determined (see Section II. B. 2.).

Identifying horizontal boundaries at any given moment is easy. A researcher need only obtain a list ofcompetitors in the industry. (See "Company Directories" under the subheading "COMPANY SOURCES"listed on the checklist provided on the Babson College Horn Library web site "Library Research Guide:United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.Another possible source is Hoover's Online at http://www.hoovers.com.)

The more difficult analysis is to predict how horizontal boundaries may change over time. Horizontalboundaries can change with:

Entry and exit of competitorsMergers of firms in the industry

A "widening" of horizontal boundaries takes place if some firms exit the industry or if firms merge. Theimplication of a widening of horizontal boundaries is an increase in industry concentration which usuallytranslates into higher profitability.

A "narrowing" of horizontal boundaries takes place if firms enter the industry. The implication of a narrowingof horizontal boundaries is a decrease in industry concentration which usually translates into lowerprofitability. Thus, existing firms in an industry have a vested interest in keeping horizontal boundaries aswide as possible. Barriers to entry are key to this effort (as discussed in Section II. B. 4.) The businesspractices firms can adopt to maintain horizontal boundaries at "wide" levels are discussed in Section III. C. 2.a. below.

III. A. 1. b. Vertical Boundaries

A firm's choice of vertical boundaries sets its relative position in the supply chain. Figure 6 shows theupstream and downstream vertical boundaries of a firm.

Figure 6: Vertical Boundaries

By definition, firms within the same industry must share at least one link of the vertical supply chain in

common. However, firms can differ as to how many links they occupy in the supply chain. A firm's decisionas to what links of the supply chain will be owned by the firm is call "The Make or Buy Decision." Table 7below specifies the benefits and costs of "buying" from market firms (buying inputs from suppliers and/ordistributing outputs through distribution channels) rather than "making" the activity within the firm. Ifbenefits of using the market outweigh the costs, then the firm should buy from the market firms. If benefits ofusing the market are less than the costs, then the firm should perform the activity in-house.

Table 7: The Make or Buy Decision

Benefits and Costs of Using the MarketBenefits Costs

Market firms may be able to achieve economiesof scale as suppliers selling to many buyers (oras distributors buying from many sellers)whereas in-house production may not achievescale economies if an individual firm's demandfor the activity is relatively small.Market firms are subject to the disciplines ofthe market. A market firm must be efficient andinnovative in order to survive in a competitiveenvironment.

Reliance on suppliers or distributors carries therisk of compromise to the vertical supply chainif the market firm cannot supply the necessaryactivityProprietary information of the firm may beleaked to market suppliers/distributors whocould use the information to help the firm'scompetitors or may even allow the marketsupplier/distributor to bypass the firm.Dealing with market firms usually requirestransaction costs

III. A. 1. c. Core Competency

Closely related to the "Make or Buy Decision" is the concept of core competency. A firm must first identifyits own set of complementary skills and technologies embedded in a group or team that allows a firm to createvalue in the market be executing one or more critical activities to a world-class standard. This set ofcomplementary skills and technologies is called a core competency. The subsequent consideration for a firm iswhether its value proposition will allow it to outperform its competitors in the industry. This is called acompetitive advantage. In other words, a core competency is what a firm does better than the rest. Acompetitive advantage is what a firm does better than the rest that allows it to make profits.

Identifying and Analyzing Core Competency

A core competency must create one of the following:

Customer valueCompetitor differentiationA gateway to new markets

The types of core competencies are:

Market-access competencies (from the firm to buyers)Integrity-related competencies (activities and activity systems)Functionally-related competencies (product attributes)

Firms evaluate their core competency by asking:

Are our skills and technologies truly superior?Is the superiority sustainable?Does the core competence create more value than other economic factors?Is the core competence integral to the firm's value proposition?

Product positioning refers to how customers think about proposed and/or present brands in a market(Perreault and McCarthy 1999). Through a brands positioning, a company tries to build a sustainablecompetitive advantage on product attribute(s) tangible or intangible in the mind of the consumer. Thisadvantage is designed to appeal to one or more segments in that product category.

III. A. 2. a. Types of Product Positionings

Products are positioned to create value for the consumer. If a firm can create more value for the consumerthan its next best competitor then the firm can earn higher profits than that competitor.

There are two types of positions that a firm can take to create more value relative to competition: adifferentiation position and a cost position.

Differentiation Position

Figure 7 below demonstrates a differentiation position. B represents benefit to the consumer, P representsprice, can C represents the company's cost. With a differentiation position, the company creates more benefitfor the consumer relative to its competitor.

Figure 7: A Differentiation Position

Cost Position

Figure 8 below demonstrates a cost position. With a cost position, the company creates the same benefit forthe consumer as does its competitor, but it does so at a lower cost.

Figure 8: A Cost Position

III. A. 2. b. Brand Positioning

To determine how to position a brand (or brands) in a market, the firm must understand the following.

The target market for the brand. If the target market is a new market for the product, the firm mustdefine and communicate effectively the advantage offered by this product to the new market. If thetarget market already buys brands within this industry or category, the firm must determine what, if any,advantage this brand will offer the target market. If there is no substantial differentiation that isimportant to this target market, the firm will have trouble getting customers to switch to this brand.The area of differentiation for the brand. Differentiation relates to differences in the brand relative tocompetition that are important to the target market. The firm may differentiate the brand based on anyone or some combination of the four Ps.- Product: The differentiation may result from a new attribute, improved performance on an existingattribute (perhaps through a technological advantage), a strong brand name, a new or enhanced serviceoffering, guarantees or warranties, etc.- Promotion: The differentiation may be real or perceived. Promotion creates perceptions about thebrand in consumers minds. For intangible attributes such as status or image, promotion may be used tomake a product seem cool or hot. As a result, we buy specific brands of clothing and yearn forspecific brands of automobiles. Further, companies may use promotion as a barrier to entry by usingheavy marketing spending to build a strong brand and keep the brand in the forefront of consumersminds.- Place: The differentiation may result from a new distribution channel or innovations in an existingchannel. Recently, we have seen the emergence of the Internet as a channel of distribution. Thischannel, in some ways, leveled the playing field by removing the investment required to build or enteran existing distribution channel. For business-to-business, the Internet appears to offer a more efficientway to manage the supply chain and facilitate re-orders. For business-to-consumer, the Internetprovides greater convenience and variety for many products. Note the importance of considering

differentiation in all factors (and the sustainability of this differentiation) in recent trends with theInternet. For business-to-consumer, the importance of branding and driving consumers to the site hasprevented profitability, enabling many of the existing companies in other channels to catch up to andovertake businesses that pioneered this new channel.- Price: This area of differentiation is usually the last way that a company wants to pursue. To besuccessful in differentiating based on a lower price, the firm must have a sustainable cost advantage. Agood example of such a company is Southwest Airlines. A high price point may also be a source ofdifferentiation; however, the firm must have the product quality and/or brand image and perceptions toreaffirm to the consumer that indeed the product is worth the premium price.

Perceptual mapping is a commonly used tool to evaluate the real and perceived differentiation of a brand. Forthis tool, a firm must plot its brands and competitors on key attributes for the industry and/or category. Theplot may be based on technical specifications, but a firm should also develop plots on consumer perceptionsobtained through surveys. The maps also provide information on potential opportunities for introducing newproducts, repositioning an existing brand, and/or segments thatare underserved by existing brands in thecategory. These plots give the firm a realistic picture on whether or not it has points of differentiation andwhether this differentiation is important to consumers. The Product Attributes Model is another way to look atdifferentiation and customer segments.

To turn a point of differentiation into a competitive advantage, a firm must be able to sustain this area ofdifferentiation relative to competitors and obtain the value of this differentiation from the consumer in theform of profits. These areas are discussed in the next section.

Perreault, William D., Jr. and E. Jerome McCarthy (1999), Basic Marketing: A Global-Managerial Approach,Boston, MA: Irwin McGraw-Hill.

[UNDER CONSTRUCTION - Professor Carol Gwin]

A strategy is a set of objectives, policies, and plans that, taken together, define the scope of the enterprise andits approach to survival and success.

See A Guide for Strategy Evaluation.

Figure 9 below shows the most basic implications of each market structure for a firm's competitive strategy.

Figure 9: Implication of Market Structure for a Firm's Competitive Strategy

III. B. 2. a. Perfect Competition

Individual firms in perfect competition face a horizontal demand curve, i.e. they take price from the marketwhere price is determined by the interaction of supply and demand. Marketing by an individual firm isineffective because the firm can already sell as much as it wants at the given market price. Thus, there areusually no brands associated with perfectly competitive firms. Improvements in operations that lower costsare ineffective in the long run because other firms can quickly copy innovations. The lack of a role formarketing and/or operations results in long-run zero economic profit for firms in perfect competition.However, firms that join together in perfectly competitive industries can form associations to improve marketdemand conditions. Associations can conduct R&D and promotions to increase demand for the industryproduct, which can shift the demand curve to the right and/or make demand less elastic. A listing of tradeassociations is available at http://www.associationcentral.com/. (Other sources are provided on the BabsonCollege Horn Library web site "Researching an Industry: Trade Association Material" athttp://www.babson.edu/library/indtrade.htm.)

III. B. 2. b. Monopolistic Competition

Individual firms in monopolistic competition face a downward sloping demand curve based on productdifferentiation. Thus, each firm has some market power. Firms position brands with specific perceivedfeatures or attributes to appeal to specific segments of consumers (or target markets). A segment of consumersloyal to a particular brand may be willing to pay more for some feature or attribute of the brand. The firm'sbrand may have added value for this segment because these consumers perceive and value the differentiatingcharacteristics. A firm's competitive strategy will be to price the brand based on the consumers' value fordifferentiation. This may allow the firm to earn short-run economic profits. However, there is no guarantee oflong-run economic profits due to free entry of new competition. Thus, each firm must maintain the value ofperceived differentiation to sustain a competitive advantage.

Marketing has a significant role in industries characterized as monopolistic competition. Productdifferentiation is accomplished through a firm's choice of its marketing mix or 4 P's (price, product,promotion, and place). The goal of marketing is to increase demand (shift the demand curve to the right) andto reduce the elasticity of demand (rotate the demand curve clockwise).

The role of marketing is covered in the Conduct/Behavior section of this guide.

III. B. 2. c. Oligopoly

The competitive strategies of firms in an oligopoly are mutually interdependent. When a firm in an oligopolychooses its strategy, it must take the potential reactions of its competitors into account. The outcome of adecision for one firm depends upon the decisions of its competitors. Thus, firms in an oligopoly arestrategically interdependent.

III. B. 2. d. Monopoly

The monopolist faces the downward sloping market demand curve for its unique product. Thus, themonopolist has market power.

The strategy of a monopolist is relatively clear: Price the unique product to maximize profit.

The role of operations to support this strategy is clear: Create and sustain the barriers to entry necessary toprotect monopoly profits. Sustaining barriers to entry is paramount (and can be evaluated as per section II. B.4. above). Creating new barriers can be quite interesting.

New barriers to entry can be beneficial to society.- New product development can provide goods and services that are wanted or needed by the public.However, some barriers to entry carry costs for society.- A monopolist may be "lazy" and not operate efficiently because its position is protected.- Such "lazy" behavior may also stagnate technological development as the protected monopolist has noincentive to invest in R&D.- Companies often lobby for a monopoly position. Such rent-seeking behavior is an inefficient cost tosociety.

The role of marketing depends on the nature of the product. Promotion can still be needed to stimulatedemand for the product. Consumers need to be aware of the product and its benefits in order for them toconsider a purchase. Sometimes, exclusive distribution supports the perception of the uniqueness of theproduct. As in monopolistic competition, the goal of marketing is still to increase demand (shift the demandcurve to the right) and to reduce the elasticity of demand (rotate the demand curve clockwise).

Firms develop and adopt business practices (operations, marketing, finance, etc.) that support their positioningand competitive strategy. Activities and activity systems conducted within the scope of the firm must becarefully selected and nurtured if the firm is to successfully implement its value proposition. A completestudy of business practice is too broad of a subject for this guide. Each industry is likely to have very differentmethods of conduct. However, three considerations are generally applicable to all industries. These are:

Porter's Value ChainConduct to support Strategic PositioningConduct to support Product Positioning

[UNDER CONSTRUCTION - Professor Carl Gwin]

Figure 10: The Value Chain

A firm that changes its (or adopts a new) strategic positioning must change its (or adopt new) boundaries.

III. C. 2. a. Sustaining Horizontal Boundaries (Preventing Entry by New Competitors)

Economic profits can be sustained in an oligopoly or a monopoly only if firms sustain their horizontalboundaries, i.e. they prevent entry of new firms into the industry.

Oligopolies and monopolies can try to create or sustain barriers to entry as discussed in Section III. B.2. d. above.Firms in an oligopoly may be able to take strategic actions that are intended to discourage entry.Strategic behavior in an oligopoly can either be cooperative or noncooperative.

Noncooperative Strategic Behavior in an Oligopoly

Noncooperative strategic behavior are those actions that a firm takes to maximize its profit by improving itsposition relative to its competitors.

To be successful, a noncooperative strategy requires the firm to have:

Advantage: Firm must have an advantage over competitors.1.Commitment: Firm must commit to the action regardless of actions by competitors.2.

Common noncooperative strategies are the threat of predatory pricing (see Section III. C. 2. b. below), limitpricing, investments to lower production costs, raising rivals' costs, and raising all firms' costs.

An incumbent firm uses limit pricing when it sets price and output so that there is not enough demand left for

another firm to profitably enter the market. Maximizing short-run profit can lead to entry of new firms,capacity expansion of smaller existing firms, and loss of sales to substitutes. Limit pricing starts with theassumption that firms maximize long-run, and not short-run, profits.

An incumbent firm may discourage entry by making investments to lower production costs in ways such asinvesting in R&D and learning by doing.

An incumbent firm may try to make entry difficult by raising rivals' costs. An incumbent firm may be able toraise the entrant's relative costs through direct methods, legal tactics, interference through governmentregulation, production of complements, raising switching costs, or raising wages or other input prices. Often,an incumbent firm discourages entry by raising all firms' costs through excessive promotion or governmentregulation.

Cooperative Strategic Behavior in an Oligopoly

Cooperative strategic behavior are those actions that competitors take together in order to reassure each otherthat they are not cheating on a cooperatively agreed-to price. Cooperatively agreed-to prices can take the formof price fixing, preventing price discounts, and eliminating price discounts.

The extreme of cooperative strategic behavior is a cartel. In a cartel, firms explicitly coordinate theirdecisions.

Cooperative strategies that facilitate cartels include most-favored-nation clauses, meeting-competitionclauses, trade associations, dividing the market, trigger prices, uniform prices, penalty for price discounts,advance notice of price changes, information exchanges, delivered pricing, and swaps and exchanges.

The ideal cartel would make decisions as if all firms where joined together as a monopoly. In the U.S., suchcooperative behavior is illegal.

Implicit cooperative behavior is usually not illegal. In this case, a firm simply observes the actions of itscompetitors and makes its own decisions accordingly. Thus, a researcher can often observe that thecompetitive strategies of firms in an oligopoly will be remarkably similar. In particular, the elements of eachfirms marketing mix will look very much the same. Products will be priced similarly, promotionalexpenditures will be similar, product development will appear to be on a parallel track between firms, andfirms will distribute their products through similar channels.

In an oligopoly, the elements of the marketing mix that can be observed in company provided information(web pages and information packages); company advertising and promotional materials, corporate reports ofpublicly-held corporations, periodical articles and news, and trade associations will all look roughly the same.[See the checklist provided on the Babson College Horn Library web site "Library Research Guide: UnitedStates Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.]

III. C. 2. b. Changing Horizontal Boundaries (Reducing the Number of Competitors inan Industry, Reducing the Effective Competition in the Industry, Forming StrategicAlliances)

As discussed in Section III. A. 1. a., firms in an industry have a vested interest in maintaining or evenwidening horizontal boundaries. Wider boundaries mean larger market shares (or larger slices of the marketpie) for firms in the industry which usually leads to higher profitability.

Reducing the Number of Competitors in an Industry

Firms can try to force competitors to exit the market by developing superior marketing or operations.

Marketing:- Predatory pricing is when a firm lowers its price in order to drive rivals out of business and scare offpotential entrants and then raises its price when its rivals exit the market (in most definitions, the firmlowers price below some measure of cost). The tactic is intended to increase market share at theexpense of absorbing short-term losses. Competitors must match the below-cost pricing in order tomaintain their own market share. The strategic objective of predatory pricing is to force competitors,who may not be able to absorb short-term losses, to exit the market. Once competitors exit the market,the remaining firm becomes a monopoly with market power. The remaining firm accepts the short-termlosses given the potential for increased long-term profitability. Of course, the risk is that new firms mayenter the market when prices return to profitable levels. However, the predatory firm will likely threatenpotential entrants with new rounds of price reductions to discourage entry.- New product development that offers consumers a superior benefit to price ratio may make oldproducts obsolete. If competitors cannot copy the new technology, then they may be forced to exit theindustry.- Superior promotions may convince consumer that one firm's brand offers a superior benefit to priceratio to competitive brands (even if it does not in reality). A shift in consumer tastes and preferencestowards the firm with superior promotions will increase its market share at the expense of competitors.A severe shift may even put some of the competitive brands out of business.- Superior access to distribution channels, which may involve foreclosing the channels to competitors,may give a firm the opportunity to distribute its product while competitors have no route to themarketplace.Operations: Superior operations generally means superior cost. With a cost advantage, firms may beable to price at a lower level than its competitors and force them out of business.

Mergers and acquisitions clearly reduce the number of competitors in an industry. A merger will occur only ifthe acquiring company expects to receive a greater return on the assets of the target firm than the target firmcan generate by itself. The motivations for mergers and acquisitions are:

Market powerEntry into a new marketEntry into a foreign marketProvide a missed attributeAids in diversificationIndustry capacity issuesAcquire undervalued assets (stock is undervalued)Tax considerations

Reducing the Effective Competition in the Industry

Collusion between competitors in an industry reduces effective competition. As discussed in Section II. B. 3.,explicit collusion is illegal in the US. Implicit collusion such as the simple observation of strategic and tacticalmoves is usually legal and allows firms to coordinate their behavior. As competitors better understand theinteractions of their strategies, they are more likely to choose strategies that improve profitability for all firmsin the industry.

Strategic Alliances

In a strategic alliances, two or more firms combine resources outside of the market to accomplish a particulartask or set of tasks. There are two general types of strategic alliances:

Joint venture: Equity sharingLicensing agreements: Contractual relationship

The key factors driving strategic alliances are globalization and new technologies.

Finding Evidence of Changing Horizontal Boundaries

Evidence of business practices that maintain or widen horizontal boundaries can be found in companyprovided information (web pages and information packages), corporate reports of publicly-held corporations,investment analysis reports, and periodical articles and news. See the checklist provided on the BabsonCollege Horn Library web site "Library Research Guide: United States Company & Industry Checklist" athttp://www.babson.edu/library/companyindustrycklist.htm.

III. C. 2. c. Changing Vertical Boundaries

Vertical Integration

A single firm is vertically integrated if it controls various links in the vertical supply chain from basic inputsto final output.

Vertical integration can be backwards or forwards.

A firm may vertically integrate backward or upstream in the supply chain by buying a supplier.Backward integration allow a firm to produce its own inputs.A firm may vertically integrate forward or downstream in the supply chain by buying another firm inthe distribution channel or the buyer. Forward integration allow a firm to market its own inputs.

The reasons for and against vertical integration are:

Lowering transaction costs: Four types of transactions that make vertical integration desirable are:1. Specialized assets that are characterized by:- Site specificity (an asset is in particular area that is useful to a small number of buyers or suppliers)- Physical-asset specificity (product design makes it useful to a small number of buyers)- Human-asset specificity (specialized knowledge)- Dedicated assets (investment only meets the requirements of one or few buyers)2. Uncertainty that makes monitoring difficult3. Asymmetric information (firm gains access to information)4. Extensive coordinationBackward integration to assure input supplyForward integration to correct market failures due to externalities (such as controlling quality in thedistribution channel)Avoiding taxes, government regulationCreating market power for the firmEliminating market power of suppliers or buyers

Integrated Supply Chains

The principal idea behind an integrated supply chain is that competition will be across supply chains, notindividual companies.

Companies in integrated supply chains:

Share and coordination information within the supply chain for maximum benefit to the companies inthe chainLink product design to supply chain considerationsCreate performance measures to assess supply chain effectivenessDesign their organizational structure to fit with supply chain management

Desired outcomes of integrated supply chains are:

Improvements in customer serviceReductions in inventories throughout the chainBetter product development and design plans lead to gains in economic and competitive advantagethroughout the entire product life cycle

The Choice of Vertical Relationship

The nature of the relationship between a firm and its suppliers/buyers is governed by the frequency andcomplexity of transactions between the two parties. Figure 11 below is a general guide for the choice ofvertical relationship.

Figure 11: The Choice of Vertical Relationship

Vertical Restraints

A vertical restraint is a contractual limitation on conduct that one nonintegrated firm imposes on another firmin the supply chain (an upstream supplier or a downstream buyer). Vertical restraints are intended to solve

distribution problems that arise from asymmetric information or free riding. In a relationship between amanufacturer and distributor, asymmetric information can lead to a principal-agent problem. Free ridingmeans one firm benefits from the actions of another firm without paying for it. Table 8 below lists a numberof distribution problems and the vertical restraints that manufacturers often adopt to solve the problems.

Table 8: Distribution Problems and Vertical Restraints Manufacturers Use to Solve Them

Distribution Problem Vertical Restraints Manufacturers Use to Solvethe Distribution ProblemDouble Marginalization - Double monopoly markup Maximum retail price (illegal in US since

1976)Quantity forcing (establish sales quotas)Franchise fee (fixed fee for the right to sell aproduct or use a brand name) and sell atmarginal costEncourage competition at distributor level

Free Riding Among Distributors - One distributor maybenefit from another distributors actions (conduct) in:

AdvertisingShowroomsSalesperson trainingTraining purchasing agentsCertifying quality

Establish exclusive territoriesLimit the number of distributorsResale price maintenanceTake over the conduct of marketing (e.g.advertise on behalf of distributors)Monitoring

Free Riding Among Manufacturers - One manufacturermay benefit from another manufacturers actions(conduct) in:

Having a common distributorTraining distributorsProviding customer lists to distributors

Exclusive dealing

Lack of Distributor Coordination the Leads toExternalities

Combinations of the above practices

Vertical restraints can have both positive and negative effects on consumers.

Positive effects may be:

Lower price- when there is increased output of existing firms- if there is encouragement of entry of new brands (competition among manufacturers/distributors maybe restrained, but competition among brands is encouraged)Better service- when the relevant product is both the good and the service provided with it

Negative effects may be:

Anticompetitive practices such as- Cartelization of an industry- Prevention of entry into an industry- Harm to rivals by raising rivals' costs

A firm's choice of marketing mix (or 4 P's) must support its product positioning.

III. C. 3. a. Pricing

One Price for all Consumers, Short-Run Profit Maximization

If a firm must charge one price to all consumers, the firm maximizes short-run profit by choosing output(which in turn determines price through its interaction with demand) where the additional revenue generatedfrom selling one more unit of its product is just equal to the additional cost of producing that unit (wheremarginal revenue equals marginal cost).

Perfect Competition: As shown in Figure 9, firms in a perfectly competitive industry are price-takers. Price isdetermined in the market. This means that the additional revenue generated from selling one more unit of itsproduct will be equal to the market price. A perfectly competitive firm maximizes short-run profit bychoosing output where price is just equal to the additional cost of producing that unit (where price equalsmarginal cost).

Firms in monopolistic competition, oligopoly, and monopoly choose output where marginal revenue equalsmarginal cost.

Price Discrimination: Different Prices for Different Consumers

Firms may be able to increase profits with price discrimination. A firm price discriminates if it chargesdifferent prices to different segments of its consumers.

There are three conditions for a firm to be able to price discriminate:

The firm must have market power

The firm must be able to identify consumer segments

The firm must be able to prevent or limit resale (or it must be inherently difficult for the product to beresold)

There are three types of price discrimination:

First-Degree Price Discrimination: The firm prices at the maximum that each consumer is willing topay for each unit of the product.

Second-Degree Price Discrimination (or non-linear pricing): Price differs with the number of units

purchased by the consumer.

Third-Degree Price Discrimination: Price differs between consumer segments.

With first- and third-degree price discrimination, the firm targets price to a specific consumer or consumersegment.

With second-degree price discrimination, the firm's pricing strategy maximizes profit based upon somecharacteristic of the product. Example of second-degree price discrimination are:

Nonlinear pricing methods such as a quantity discount, a single two-part tariff, and a two two-part tariff

Pricing based on bundling of products

Pricing based on quality choice

Premium for priority

Pricing for Long-Run Profit Maximization


III. C. 3. b. Product

Product Choice


Research & Development


Packaging


III. C. 3. c. Promotion

The purposes of promotion include

Shifting consumers' tastes and preferences in favor of a particular product or brandProviding information

Advertising


Advertising to Sales Ratio

Studies have found that an industry's advertising as a percentage of sales (advertising to sales ratio) is oftenclosely related to the industry's concentration ratio. In perfect competition, there is relatively little advertisinggiven a homogeneous product. In monopoly, there may be some advertising to support the monopoly position.Monopolistic competition and oligopoly market structures are likely to have significant advertisingexpenditures. Promotion is a key differentiator in monopolistic competition and strategic interdependence inoligopoly is likely to lead to excessive expenditures on advertising to protect market share. An impureoligopoly is likely to have a very high advertising to sales ratio for both of these reasons.

The advertising to sales ratio is calculated as:

Advertising to sales ratio = Advertising Expenditures / Revenue

An industry advertising to sales ratio will likely have to be calculated as a composite of individual firmadvertising to sales ratios.

Data on individual firm advertising expenditures is available from:

Advertising Age at http://adage.com/dataplace/.

Data on individual firm revenue can be found using the resources shown in Section II. B. 2. a.

A graphical representation of the relationship between advertising to sales ratio and concentration ratio isprovided in Figure 12 below.

NOTE: The graphical representation is approximate at best and the range of advertising to sales ratio shownon the figure is not representative of every industry. The graph shows the relative relationship betweenadvertising to sales ratio and concentration ratio for an industry in general. The decision as to whether aspecific value of an advertising to sales ratio is indicative of the strategic implications of a particular marketstructure must be based upon the analysis of the researcher and other relevant objective and subjectivecriteria.

Figure 12: The Relationship of Advertising to Sales Ratio and Concentration Ratio

III. C. 3. d. Place



Entrepreneurs exploit opportunities for creating profitable positions that other firms ignore or are unable to.Competitive advantage may originate in:

Creative destruction: Entrepreneurs exploit fundamental economic shocks (or strategic inflectionpoints) and go on the achieve profits during quieter times.Innovation: Invention (discovery), innovation (commercialization), and diffusion.Evolution: Firm's decisions are determined by routines, innovation is path dependent.Environment: See Figure 13 below. [UNDER CONSTRUCTION - Professor Carl Gwin]

Figure 13: Porter's Diamond


Figure 14: Identifying Competitive Advantage


Figure 15: Analyzing Competitive Advantage

Industry performance is measured by its success in creating value for consumers. Firm performance ismeasured by it success in value-creation relative to its competitors in the industry. The ideal measure of firmperformance is a comparison to its next best competitor. In practice, a firm is usually compared to somemeasure of average industry performance.

Common market performance measures are:

Rates of return: A ratio of some measure of earnings to some measure of investment.Price-cost margin (or Lerner Index): The difference between price (p) and marginal cost (MC) as afraction of price. This is represented as [(p - MC) / p].Gross margin (GM) (or contribution margin): Data on marginal cost is rarely available. In practice,researchers often assume that marginal cost can be approximated by average variable cost (AVC). Grossmargin is calculated as GM = [(p - AVC) / p]. If an industry or firm sells one product at a single price,then this measure of gross margin is equivalent to GM = [(Revenues - Cost of Goods Sold) / Revenues].

An evaluation of industry performance depends upon whether performance is being judged by return to aninvestor or value-created for a consumer. In general, high returns to an investor are the result of the extractionof value from the consumer. In other words, the firms in the industry have market power and can charge aprice higher than marginal cost and earn economic profits (profits in excess of a normal return). Firms in theindustry are better off as they earn higher profits, consumer are worse off because they buy less in quantityand pay more in price.

IV. E. 2. a. Evaluating Industry Performance

Evaluating industry performance from the perspective of an investor is simple. The researcher need only makea cross-sectional comparison of industry performance measures. Investment dollars will go to the industrywhere industry performance measures are the highest.

Evaluating industry performance from the perspective of a consumer is tricky. Performance must be weighedbetween value-creation and market power. Superior performance based on value-creation generally benefitsconsumers, superior performance based on market power generally hurts consumers.

Value-Creation

Value-creation can be based upon superior differentiation or superior cost.

Superior differentiation may be evidenced by

High product quality and/or serviceRapid technological advance

Superior cost may be evidenced by price competition in the industry that

Arises from entry of firms with lower cost structures into the industryResults in exit of firms with higher cost structures from the industry

Market Power

Market power depends on market structure. In general, market power increases as market concentration

increases. Thus, industry performance measures generally increase as market concentration increases.

Efficiency and Social Welfare

Productive efficiency is attained if products are produced at minimum average cost. Allocative efficiency isattained if products are produced using the optimal mix of inputs. Firms in perfect competition achieveefficiency because price is equal to marginal cost and, in the long run, price is equal to minimum average cost.Firms in other market structures have market power, they can choose output such that price is greater thanmarginal cost. Production by firms with market power (with no government regulation) always choose toproduce at an inefficient level. At this less than efficient output level, average cost is not minimized and toofew resources are allocated to production of the product.

The total benefit to society (social welfare) of the production of a good or service considers both the profits ofthe industry and the value created for consumers. Thus, a researcher evaluating the performance of an industrymust take care to consider both members of society. An industry's total contribution to society's welfare ismore than its own profits, measuring industry performance should also include the benefits created forconsumers.

IV. E. 2. b. Finding Industry Performance Measures

Good sources for industry performance measures are:

The Wall Street Journal (See "The Wall Street Journal Shareholder Scoreboard: The Best & WorstPerforming Companies," The Wall Street Journal, February 26, 2001. Available athttp://interactive.wsj.com/documents/scoreboard2001.htm.)Existing studies of industry performance (See "Industry Ratios for Comparing Your Company" underthe subheading "INDUSTRY SOURCES" on the checklist provided on the Babson College HornLibrary web site "Library Research Guide: United States Company & Industry Checklist" athttp://www.babson.edu/library/companyindustrycklist.htm.)Industry reviews (See "Introductory Reviews" under the subheading "INDUSTRY SOURCES" on theabove checklist.)Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRYSOURCES" on the above checklist.)Corporate reports of publicly-held corporations may contain performance measures that are comparedto industry measures. Companies often provide this information on their web sites. Another alternativeis the SEC Edgar Database of corporate information available at http://www.sec.gov/edgarhp.htm. (See"Corporate Reports of Publicly-Held Companies" under the subheading "COMPANY SOURCES" onthe above checklist.)Periodical articles and news. (See "Index to Periodical Articles and Current News" under thesubheading "INDUSTRY SOURCES" on the above checklist.)Trade associations. A listing of trade associations is available at http://www.associationcentral.com/.(Other sources are provided on the Babson College Horn Library web site "Researching an Industry:Trade Association Material" at http://www.babson.edu/library/indtrade.htm.)


[Professor Carl R. Gwin, 2001]

An important step in the formulation and execution of strategy is strategy evaluation.

Strategy Evaluation

Testing and probing the strategy for critical flaws.

Are the objectives appropriate?Are major policies and plans appropriate?Do results to date confirm or refute critical assumptions underpinning the strategy?

(This procedure is in contrast to ...)

Performance Evaluation

Has the business been creating or destroying wealth for its owners?

Economic profitability (returns in excess of cost of capital?).Accounting measures of performance (e.g., ROS, ROA).Market measures of performance (e.g., sales growth, market share).

Tests for a Sound Strategy

Consistency - Goals and policies are mutually consistent.Consonance - Adaptive to changes in the environment.Advantage - Provides a competitive advantage.Feasibility - It is possible with available resources.

The strategy must not entail mutually inconsistent goals and policies.

To evaluate the consistency of a strategy, you should ask ...

Are the business's internal operations (e.g., purchasing, operations, marketing and sales, service) andresource allocation processes consistent with each other?Are the business's internal operations consistent with business objectives and market economics?

The strategy must match and adapt the business to its environment (both its market and the broadernon-market environment).

To evaluate the current consonance of a strategy with its market environment, you should ask ...

Why does the business exist in its current form?Who and where are our customers and potential customers? How many customers are there?Are the boundaries of the business appropriate?What are the fundamental economic forces at work in our market?How does the business unit create economic value, i.e., what is its value-creation proposition?What are the drivers of consumer willingness to pay (benefit drivers)?What are the drivers of costs (cost drivers)?What are the different customer segments we serve and what are the benefit and cost drivers withineach segment?Which activities make money for the business?

To assess whether consonance with the market environment is likely to persist into the future you should ask...

What are likely trends in demand and technology that might affect the viability of our value-creationproposition?Are we vulnerable to "discontinuities?" Can we exploit "discontinuities?"- Significant redefinition of the served market.- "Outside-the-box" value-creation propositions.

Consonance is critical, but often overlooked because companies typically focus on their key competitors.Threats to an established way of doing business often come from outside the business's immediate circle ofriva

A Guide for Industry Study and the Analysis of Firms and Competitive Strategy

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