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

4/20/13

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

A Guide for Industry Study and the Analysis of Firms and Competitive StrategyThis page is a guide to applying the principles of Economics to researching and understanding a market and the 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's competitive strategy is the Babson College Horn Library at http://www.babson.edu/library/. The Horn Library provides a research guide and sources for researching a company and an industry.

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

I. A. Porter's Five Forces I. A. 1. Introduction"The Structural Analysis of Industries" is covered quite well in Chapter 1 of Porter, Michael E., Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1980 and new introduction in 1998, The Free Press, New York, NY. Figure 1 is a graphical representation of Porter's Five Forces. Figure 1: Porter's Five Forces

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

I. A. 2. The Microfoundations of Porter's Five ForcesThe 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 first element of the "Structure-Conduct-Performance" paradigm.

I. A. 2. a. Market StructureThe vertical elements of Porter's Five Forces are shown in Figure 2. Figure 2: The Vertical Elements of Porter's Five Forces


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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 Structure Potential Entrants Industry Competitors (Direct Substitutes) Indirect Substitutes Barriers to Entry Number of Sellers Product Characteristics Product Characteristics

I. A. 2. b. Vertical Supply ChainThe horizontal elements of Porter's Five Forces are shown in Figure 3. Figure 3: The Horizontal Elements of Porter's Five Forces


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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 how they position themselves in the supply chain. The firms essentially must choose their vertical boundaries.

I. B. The "Structure-Conduct-Performance" ParadigmThe "Structure-Conduct-Performance" paradigm is a road map for identifying the factors that determine the competitiveness of a market, analyzing the behavior of firms, and assessing the success of an industry in producing benefits for consumers.faculty.babson.edu/gwin/indstudy/ 4/40

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"Structure" refers to the market structure of an industry which is indicative of the degree of competition in the industry. "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 the industry). "Performance" refers to measurements by which the industry or firms in the industry can be judged as to whether they have achieved their stated goals.

I. C. A Unified Guide for Studying Industries and FirmsThe methodology of our unified guide for understanding markets begins with an industry study and continues with an examination of the competitive strategies of firms in the industry. The framework we will use for analyzing 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 the industry).

II. Industry AnalysisThe 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. Introduction to the Industry and its Market II. A. 1. Industry Definition and DescriptionII. A. 1. a. Definition and Specific DescriptionThe first task is to define the industry. Industry definition is important to determining the competitive set. In economics, defining the competitive set is equivalent to defining a firm's horizontal boundaries. A firm's horizontal 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/or search thefaculty.babson.edu/gwin/indstudy/ 5/40

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site and find a description and definition of most industries in the US. Industry descriptions vary from very broad (two-digit NAICS codes) to very narrow (six-digit NAICS codes). Usually, a researcher will choose the narrowest description of an industry. This allows the researcher to most closely identify the companies 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 on an 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. Census Bureau provides a short definition of the industry. The researcher must determine if the description and definition of the industry fit with the intended companies targeted for study.

II. A. 1. b. General DescriptionAn industry analysis often starts with a brief introduction to the industry. Sources for general information on an industry are: Company provided information (web pages and information packages) Industry reviews (See "Introductory Reviews" under the subheading "INDUSTRY SOURCES" 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.) Investment analyst reports. (See "Investment Analyst Reports" under the subheading "INDUSTRY SOURCES" on the above checklist.) Corporate reports of publicly-held corporations. Companies often provide this information on their web sites. Another alternative is 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" on the above checklist.) Periodical articles and news. (See "Index to Periodical Articles and Current News" under the subheading "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.)

II. A. 2. Market ConditionsGeneral market conditions faced by an industry are often important factors in the choice of conduct by firms and for the ability of firms to generate profits and meet expected performance goals. Identifying relevant general 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 ConditionsThe factors driving the supply of and demand for a product of an industry are detailed in Table 2 below. Thesefaculty.babson.edu/gwin/indstudy/ 6/40

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factors determine the defining characteristics, position and slope, of supply and demand curves in an economist's representation of a market. Table 2: Basic Market Conditions, Determinants of Supply and Demand Determinants of Demand Position of demand curve: Change in number of buyers (market growth) Change in buyer tastes and preferences Change in income (income elasticity of demand) Change in the prices of related goods, substitutes and complements (cross-price elasticity of demand) Change in expectations Determinants of Supply Position of supply curve: Change in number of suppliers (more or less competition in the industry) Change in resource prices (raw materials and labor) Change in technology Changes in taxes and subsidies Change in prices of other goods Change in expectations Slope of supply curve: Firm time to respond to a change in the price of the product

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, normal good further classified as necessity versus luxury) - Buyer time to purchase product

The interaction of supply and demand determine production levels and product price in the market. In a perfectly competitive market, equilibrium price and output in a market are determined where quantity supplied equals quantity demanded. Determination of output and price in other market structures is a bit more complex. For additional information, see a standard Principles of Microeconomics textbook such as Economics: Principles, Problems, and Policies, by Campbell R. McConnell and Stanley L. Brue, The McGraw-Hill Companies, Inc. The analysis of supply and demand conditions are closely related to two aspects of Porter's Five Forces. The determinants of demand parallel Porter's analysis of buyer bargaining power and the determinants of supply are important factors in studying the intensity of rivalry between existing industry competitors.

II. A. 2. b. PESTIn addition to market forces within the industry, it is critical to monitor external forces that may impact the industry on an ongoing basis. A manager may have a very good understanding of what is happening within an industry, and yet be blindsided by external events that change the nature of competition and revenue within an industry. A marketing framework commonly used to examine these factors that impact business decisions is referred to as PEST. PEST is an acronym for the political/legal, economic, sociocultural, and technological factors that shape the environment of an industry or a business.faculty.babson.edu/gwin/indstudy/ 7/40

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Political/Legal An industry must remain abreast of political forces that may influence the viability and profitability of the overall industry, as well as specific firms. Political and legal issues that have impacted businesses and industries 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 must continually monitor the stability of governments, understand differences in governmental practices, know the rules 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 the business 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. Unemployment rates, the value of the dollar, inflations, growth, and productivity are factors that impact the health of the economy and consumer confidence. These factors provide indicators to potential concerns on recession and inflation. The economy may lead to reduced spending by consumers that have a rebound effect throughout companies and industries. A firm must monitor these factors to forecast sales and profits appropriately and devise appropriate strategies to ride out an unfavorable economic environment. Firms may even be able to take advantage of an economic downturn to gain share and customers from competitors. Potential sources of information to evaluate the current and projected state of the economy include the New York Stock Exchange and 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 include the increase in working women, the health and fitness craze, and the growth in discretionary spending by youths. These trends can have a serious impact on entire industries, as well as individual companies. A business must monitor these trends to make sure that its product will continue to meet the needs of the consumers it serves. New attributes may emerge and the importance of existing attributes may change as a result of changes in society. Similarly, as the business enters new markets or countries, expectations may be very 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 mass communication media, and specific monitoring publications or companies as American Demographics and the Yankelovich Monitor. Technology In the past century, the world has seen a technological revolution. Today, we can travel faster, receive communications instantly, and produce more per capita. As a result of this change, many industries have emerged (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 technological advances. These businesses have taken advantage of the emerging technology in other industries to improve their product and/or service. These firms are always looking for technology that will help serve customers better and/or cheaper. In that way, technology may provide a competitive advantage. Sources of information on technology include journals in potential areas such as computers or genetics, scientific journals, and other newspapers and magazines.faculty.babson.edu/gwin/indstudy/ 8/40

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The critical element in environmental scanning is to continually monitor the media relevant to your customers, your industry, your market(s), and overall technological development. As changes occur for elements 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 . [UNDER CONSTRUCTION - Professor Carol Gwin]

II. B. Market StructureMarket structure refers to the number and relative size of sellers and buyers in a particular market. There are four definitions of a market structure: Perfect Competition, Monopolistic Competition, Oligopoly, and Monopoly. The market structure of an industry can be classified with three criteria: number of sellers, product characteristics, and barriers to entry. Market structure classification according to these three criteria is summarized in Table 3 below. Table 3: Classifications of Market Structure Criteria Perfect Competition Number of Sellers Product Characteristics Barriers to Entry Many Homogenous None Monopolistic Competition Many Differentiated None Market Structure Oligopoly Few Homogeneous (Pure Oligopoly) or Differentiated (Impure Oligopoly) High Monopoly One Unique Very High

II. B. 1. Market Definition and the Relevant MarketThe Department of Justice (DOJ) and the Federal Trade Commission publish horizontal merger guidelines that are an excellent reference source for market definition and defining the relevant market for classifying the market structure of an industry. The publication Horizontal Merger Guidelines can be accessed from the web page of the Antitrust Division of the DOJ at http://www.usdoj.gov/atr or of the Federal Trade Commission at http://www.ftc.gov. The guidelines state: "A market is defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profit-maximizing firm, not subject to price regulation, that was the 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 are held constant." This statement is equivalent to the question: What firms would have to be included in a cartel for the cartel tofaculty.babson.edu/gwin/indstudy/ 9/40

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have market power? The guidelines continue with: "A relevant market is a group of products and a geographic area that is no bigger than necessary to satisfy this test." Thus, the relevant market that we should consider in our analysis of market structure is only those firms that must be included in a cartel for the cartel to have market power. In some cases, only one firm need be included in the cartel because the geographic area in which a product is sold is very small. These are called local monopolies. For example, many towns in the western U.S. have only one 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 called search 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.

II. B. 2. Number of SellersHow many sellers are there? This question can be answered in two ways. First, we can literally count the number 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 Merchandising Payments and Services 16 CFR 240.1 available from the Federal Trade Commission web page at http://www.ftc.gov.

U. S. Census BureauData to determine the number of sellers in an industry is available from the web page of the U.S. Census Bureau at www.census.gov. The 1997 Economic Census provides data on Establishment and Firm Size in a Subject Series based on 20 NAICS sectors (two-digit NAICS codes). The 20 NAICS sectors are further subdivided into 96 subsectors (three-digit NAICS codes), 313 industry groups (four-digit NAICS codes), and 1170 industries (five- and six-digit NAICS codes). Most sector Subject Series provide information on the number of "Single Unit and Multiunit Firms Subject to Federal 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 Bureau web 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 for mining and construction. (For Babson personnel, the 1992 Census of Manufactures is available on CD-ROM in Horn Library.) An excel spreadsheet containing concentration measures for manufacturing can be accessed at http://faculty.babson.edu/gwin/cr&hhi.xls.

II. B. 2. a. Concentration MeasuresMarket concentration measures are used to classify how competitive an industry is. Concentration measures helpfaculty.babson.edu/gwin/indstudy/ 10/40

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us to understand how much market share is concentrated in the hands of a small number of firms. An industry characterized by low concentration will have a large number of firms with small market shares. An industry characterized by high concentration will have a small number of firms with relatively high market shares. 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 firms have. The concentration ratio for the k largest firms in an industry is calculated simply by adding up the market 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 ratio or 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 50 firms. These concentration ratios would be the CR4, CR8, CR20, and CR50 respectively. Census Bureau concentration 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 actual market share data. Market share data is available from many on-line resources such as Gale Business Resources at http://www.galegroup.com ABI/Inform at http://www.umi.com The 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 at http://www.babson.edu/library/. If market share data is not available, a researcher may have to calculate market shares for the firms in an industry. 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 users should 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 "INDUSTRY SOURCES" 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.) Corporate reports of publicly-held corporations. Companies often provide this information on their web sites. Another alternative is the SEC Edgar Database of corporate information available at http://www.sec.gov/edgarhp.htm. (See "Corporate Reports of Publicly-Held Companies" under thefaculty.babson.edu/gwin/indstudy/ 11/40

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subheading "COMPANY SOURCES" on the above checklist.) Periodical articles and news. (See "Index to Periodical Articles and Current News" under the subheading "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 dominates the 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 = S12 + S22 + S32 + S42 + S52 + ... +Sn 2, 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 of the market outside the top four firms. The HHI gives proportionately greater weight to the market shares of the larger firms. This recognizes the larger firms' relative importance in competitive interactions. The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) referenced above shows both 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 relative importance of leading domestic firms. Market span is important. Census Bureau concentration measures are based on national trends, market power due to dominance in a local geography are not considered. Competitors can enter a market. Census Bureau concentration measures only include firms that were active at the time of the census. Competitiveness has more than one dimension. Very often, inter-industry competition (indirect substitutes) is just as important is intra-industry competition (direct substitutes).

II. B. 2. b. Classifying IndustriesIt is important to classify industries as to market structure because the greater the number of sellers, the more likely the industry is competitive. Figure 5 shows the general relationship between market structure, concentration, and profitability. Figure 5: Market Structure, Concentration, and Profitability


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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 industry increases. 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 an industry plays a role in determining whether firms explicitly take other firms' actions into account. 1. In monopolistic competition, the multitude of firms makes it unlikely that they explicitly take into account rival firms' responses to their decisions. 2. In oligopoly, with fewer firms, each firm explicitly engages in strategic decision making - taking explicit account of a rival's expected response to a decision being made. 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 is no consensus among economists on using the CR4. Additionally, concentration is only one objective factor in classifying market structure. There are many more factors, both objective and subjective, that a researcher must take into account before choosing a market structure that best describes an industry. Table 4: Classifying Industries with the CR4 CR4 CR4 = 0 0 < CR4 < 40 60

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

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