Library research is required in the COMPLETE assignment of each unit. At least three of your citations must be from scholarly

Industry Competition

Chapter Outline 3-1 Industry Life Cycle Stages

3-2 Industry Structure

3-3 Intensity of Rivalry among Incumbent Firms

3-3a Concentration of Competitors

3-3b High Fixed or Storage Costs

3-3c Slow Industry Growth

3-3d Lack of Differentiation or Low Switching Costs

3-3e Capacity Augmented in Large Increments

3-3f Diversity of Competitors

3-3g High Strategic Stakes

3-3h High Exit Barriers

3-4 Threat of Entry

3-4a Economies of Scale

3-4b Brand Identity and Product Differentiation

3-4c Capital Requirements

3-4d Switching Costs

3-4e Access to Distribution Channels

3-4f Cost Advantages Independent of Size

3-4g Government Policy

3-5 Pressure from Substitute Products

3-6 Bargaining Power of Buyers

3-7 Bargaining Power of Suppliers

3-8 Limitations of Porter’s Five Forces Model

3-9 Summary

Key Terms

Review Questions and Exercises

Practice Quiz

Notes

Reading 3-1

3

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T his chapter marks the beginning of the strategic management pro- cess and is one of two that considers the external environment. At this point it is appropriate to focus on factors external to the organiza- tion and to view fi rm performance from an industrial organization

perspective. Internal factors are considered later in the process and in future chapters.

Each business operates among a group of companies that produces compet- ing products or services known as an industry. The concept of an industry is a simple one, but it is often confused in everyday conversations. The term industry does not refer to a single company or specifi c fi rms in general. For example, in the statement, “A new industry is moving to the community,” the word industry should be replaced by company or fi rm.

Although usually differences exist among competitors, each industry has its own set of combat rules governing such issues as product quality, pricing, and distribution. This is especially true for industries that contain a large number of fi rms offering standardized products and services. Most competitors—but not all—follow the rules. For example, most service stations in the United States generally offer regular unleaded, midgrade, and premium unleaded gasoline at prices that do not differ substantially from those at nearby stations. Breaking the so-called rules and charting a different strategic course might be possible, but may not be desirable. As such, it is important for strategic managers to under- stand the structure of the industry(s) in which their fi rms operate before decid- ing how to compete successfully.

Defi ning a fi rm’s industry is not always an easy task. In a perfect world, each fi rm would operate in one clearly defi ned industry; however, many fi rms compete in multiple industries, and strategic managers in similar fi rms often differ in their conceptualizations of the industry environment. In addition, some companies have utilized the Internet to redefi ne industries or even invent new ones, such as eBay’s online auction or Priceline’s travel businesses. As a result, the process of industry defi nition and analysis can be especially challenging when Internet competition is considered.1

Numerous outside sources can assist a strategic manager in determining “where to draw the industry lines” (i.e., determining which competitors are in the industry, which are not, and why). Government classifi cation systems, such as the Standardized Industrial Classifi cation (SIC), as well as distinctions made by trade journals and business analysts may be helpful. In 1997, the U.S. Census Bureau replaced the SIC system with the North American Industry Classifi cation System (NAICS), an alternative system designed to facilitate comparisons of busi- ness activities across North America. Astute managers assess all of these sources, however, and add their own rigorous and systematic analysis of the competition when defi ning the industry.

Numerous descriptive factors can be used when drawing the industry lines. In the case of McDonald’s, for example, attributes such as speed of service, types of products, prices of products, and level of service may be useful. Hence, one might defi ne McDonald’s industry as consisting of restaurants offering easy to consume, moderately priced food products rapidly and in a limited service environment. Broad terms such as “fast food” are often used to describe such industries, but doing so does not eliminate the need for a clear, tight defi nition.

Some factors are usually not helpful when defi ning an industry, however, such as those directly associated with strategy and fi rm size. For example, it is not a good idea to exclude a “fast-food” restaurant in McDonald’s industry because it is not part of a large chain or because it emphasizes low-priced food. Rather, these

Industry

A group of competitors that produce similar

products or services.

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Industry Competition 39

factors explain how such a restaurant might be positioned vis-à-vis to McDonald’s, a concept discussed in greater detail in Chapter 7.

The concept of primary and secondary industries may also be a useful tool in defi ning an industry. A primary industry may be conceptualized as a group of close competitors, whereas a secondary industry includes less direct competition. When one analyzes a fi rm’s competition, the primary industry is loosely considered to be “the industry,” whereas the secondary industry is presented as a means of adding clarity to the analysis. For example, McDonald’s primary industry includes such competitors as Burger King and Wendy’s, whereas its secondary industry might also include restaurants that do not emphasize hamburgers and offer more traditional restaurant seating such as Pizza Hut and Denny’s. The distinction between primary and secondary industry may be based on objective criteria such as price, similarity of products, or location, but is ultimately a subjective call.

Once the industry is defi ned, it is important to identify the market share, which is a competitor’s share of the total industry sales, for the fi rm and its key rivals. Unless stated otherwise, market share calculations are usually based on total sales revenues of the fi rms in an industry rather than units produced or sold by the individual fi rms. This information is often available from public sources, especially when there is a high level of agreement as to how an industry should be defi ned.

When market share is not available or substantial differences exist in industry defi nitions, however, relative market share, or a fi rm’s share of industry sales when only the fi rm and its key competitors are considered, can serve as a useful substitute. Consider low-end discount retailer Dollar Tree as an example and assume that the only available market share data considers Dollar Tree to be part of the broadly defi ned discount department store industry. If a more narrow industry defi nition is proposed—perhaps one limited to deep discount retailers— new market share calculations will be necessary. In addition, it becomes quite complicated when one attempts to include the multitude of mom-and-pop dis- counters in the calculations. In this situation, computing relative market shares that consider Dollar Tree and its major competitors can be useful. Assume for the sake of this example that four major competitors are identifi ed in this industry— Dollar General, Family Dollar, Dollar Tree, and Fred’s—with annual sales of $6 billion, $5 billion, $2 billion, and $1 billion, respectively. Relative market share would be calculated on the basis of a total market size of $14 billion (i.e., 6 + 5 + 2 + 1). In this example, relative market shares for the competitors are 43 percent, 36 percent, 14 percent, and 7 percent, respectively. From a practical standpoint, calculating relative market share can be appropriate when external data sources are limited.

A fi rm’s market share can also become quite complex as various industry or market restrictions are added. Unfortunately, the precise market share informa- tion most useful to a fi rm may be based on a set of industry factors so com- plex that computing it becomes an arduous task. In a recent analysis, the Mintel International Group set out to identify the size of the “healthy snack” market in the United States, a task complicated by the fact that many products such as cheese, yogurt, and cereal are eaten as snacks in some but not all instances.2 To overcome this barrier, analysts computed a total for the healthy snack market by adding only the proportion of each food category consumed as a healthy snack. In other words, 100 percent of the total sales of products such as popcorn and trail mix—foods consumed as “healthy snacks” 100 percent of the time—were included in the total. In contrast, only 40 percent of cheese consumption, 61 per- cent of yogurt consumption, and 21 percent of cereal consumption were included

Market Share

The percentage of total market sales attributed to one competitor (i.e., fi rm sales divided by total market sales).

Relative Market Share

A fi rm’s share of industry sales when only the fi rm and its key competitors are considered (i.e., fi rm sales divided by total sales of a select group fi rms in the industry).

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in the total. Although this approach is reasonable and can be quite useful, it can only be calculated when one has access to data that may not be readily available. Hence, analysts must use the best data available to describe the relative market positions of the competitors in a given industry (see Case Analysis 3-1).

3-1 Industry Life Cycle Stages Like fi rms, industries develop and evolve over time. Not only might the group of competitors within a fi rm’s industry change constantly, but also the nature and structure of the industry can change as it matures and its markets become better defi ned. An industry’s developmental stage infl uences the nature of competition and potential profi tability among competitors.3 In theory, each industry passes through fi ve distinct phases of an industry life cycle (see Figure 3-1).

A young industry that is beginning to form is considered to be in the introduc- tion stage. Demand for the industry’s outputs is low at this time because product and/or service awareness is still developing. Virtually all purchasers are fi rst-time buyers and tend to be affl uent, risk tolerant, and innovative. Technology is a key concern in this stage because businesses often seek ways to improve production and distribution effi ciencies as they learn more about their markets.

Normally, after key technological issues are addressed and customer demand begins to rise, the industry enters the growth stage. Growth continues but tends to slow as the market demand approaches saturation. Fewer fi rst-time buyers remain, and most purchases tend to be upgrades or replacements. Many competitors are

Case Analysis 3-1

Step 2: Identifi cation of the Industry and the Competitors After the organization has been introduced, its industry must be specifi cally identifi ed. This process can be either relatively simple or diffi cult. For example, most would agree that Kroger is in the “grocery store industry,” and its competition comes primarily from other grocery stores. However, not all decisions are simple. For example, should Wal- Mart be classifi ed in the department store industry (competing with upscale mall- oriented stores) or in the discount retail industry (competing with low-end retailers such as Family Dollar)? Is Taco Bell in the fast-food industry or in the broader restaurant industry? To further complicate matters, many corporations are diversifi ed and compete in a number of different industries. For example, Anheuser Busch operates breweries and theme parks. In cases in which multiple business units are competing in different industries, one needs to identify multiple industries. Market shares or relative market shares for the fi rm and its key competitors—based on the best available data—should also be identifi ed. It is important to clarify industry defi nition at the outset so that the macroenvironmental forces that affect it can be realistically assessed. In addition, a fi rm’s relative strengths and weaknesses can be classifi ed as such only when compared to other companies in the industry.

F I G U R E Th e I n d u s t r y L i f e C y c l e3-1

Industry Life Cycle

The stages (introduc- tion, growth, shakeout,

maturity, and decline) through which indus-

tries often pass.

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profi table, but available funds may be heavily invested into new facilities or tech- nologies. Some of the industry’s weaker competitors may go out of business in this stage.

Shakeout occurs when industry growth is no longer rapid enough to support the increasing number of competitors in the industry. As a result, a fi rm’s growth is contingent on its resources and competitive positioning instead of a high growth rate within the industry. Marginal competitors are forced out, and a small number of industry leaders may emerge.

Maturity is reached when the market demand for the industry’s outputs is com- pletely saturated. Virtually all purchases are upgrades or replacements, and indus- try growth may be low, nonexistent, or even negative. Industry standards for quality and service have been established, and customer expectations tend to be more consistent than in previous stages. The U.S. automobile industry is a classic exam- ple of a mature industry. Firms in mature industries often seek new uses for their products or services or pursue new markets, often through global expansion.

The decline stage occurs when demand for an industry’s products and services decreases and often begins when consumers turn to more convenient, safer, or higher quality offerings from fi rms in substitute industries. Some fi rms may divest their business units in this stage, whereas others may seek to “reinvent themselves” and pursue a new wave of growth associated with a similar product or service.

A number of external factors can facilitate movement along the industry life cycle. When oil prices spiked in 2005, for example, fi rms in oil-intensive indus- tries such as airlines and carmakers began to feel the squeeze.4 When an industry is mature, however, fi rms are often better able to withstand such pressures and survive.

Although the life cycle model is useful for analysis, identifying an industry’s precise position is often diffi cult, and not all industries follow these exact stages or at predictable intervals.5 For example, the U.S. railroad industry did not reach maturity for many decades and extended over a hundred years before entering decline, whereas the personal computer industry began to show signs of maturity after only seven years. In addition, following an industry’s decline, changes in the macroenvironment may revitalize new growth. For example, the bicycle industry fell into decline some years ago when the automobile gained popularity but has now been rejuvenated by society’s interest in health and physical fi tness.

3-2 Industry Structure Factors associated with industry structure have been found to play a dominant role in the performance of many companies, with the exception of those that are its notable leaders or failures.6 As such, one needs to understand these factors at the outset before delving into the characteristics of a specifi c fi rm. Michael Porter, a leading authority on industry analysis, proposed a systematic means of analyzing the potential profi tability of fi rms in an industry known as Porter’s “fi ve forces” model. According to Porter, an industry’s overall profi tability, which is the combined profi ts of all competitors, depends on fi ve basic competitive forces, the relative weights of which vary by industry (see Figure 3-2).

1. Intensity of rivalry among incumbent fi rms 2. Threat of new competitors entering the industry 3. Threat of substitute products or services 4. Bargaining power of buyers 5. Bargaining power of suppliers

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These fi ve factors combine to form the industry structure and suggest (but do not guarantee) profi tability prospects for fi rms that operate in the industry. Each of the factors is discussed in greater detail in sections 3-3 through 3-7.

3-3 Intensity of Rivalry among Incumbent Firms

Competition intensifi es when a fi rm identifi es the opportunity to improve its position or senses competitive pressure from other businesses in its industry, which can result in price wars, advertising battles, new product introductions or modifi cations, and even increased customer service or warranties.7 Rivalry can be intense in some industries. For example, a battle wages in the U.S. real-estate industry, where traditional brokers who earn a commission of 5 to 6 percent are being challenged by discount brokers who charge sellers substantially lower fees. Agents for the buyer and seller typically split commissions, which usually fall in the $7,000 range for both agents when a home sells for $250,000. Discount bro- kers argue that the primary service provided by the seller’s agent is listing the home in a multiple listing service (MLS) database, the primary tool used by most buyers and their agents to peruse available properties. Discount brokers provide sellers with a MLS listing for a fl at fee in a number of markets, sometimes less than $1,000. Traditional brokers are angry, however, and argue that discount brokers simply do not provide the full array of services available at a so-called full-service broker. Traditional brokers dominate the industry, accounting for 98 percent of all sales in 2005. They often control the local MLS databases, and many discount brokers charge that they are not provided equal access to list their properties.8 Hence, rivalry in this industry—especially between full-service and discount brokers—remains quite intense.

Competitive intensity often evolves over time and depends on a number of interacting factors, as discussed in sections 3-3a through 3-3h. Factors should be assessed independently and then integrated into an overall perspective.

F I G U R E Po r t e r ’ s F i v e Fo rc e s M o d e l3-2

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3-3a Concentration of Competitors The number of companies in the industry and their relative sizes or power levels infl uence an industry’s intensity of rivalry. Industries with few fi rms tend to be less competitive, but those with many fi rms that are roughly equivalent in size and power tend to be more competitive, as each fi rm fi ghts for dominance. Competition is also likely to be intense in industries with large numbers of fi rms because some of those companies may believe that they can make competitive moves without being noticed.9

3-3b High Fixed or Storage Costs When fi rms have unused productive capacity, they often cut prices in an effort to increase production and move toward full capacity. The degree to which prices (and profi ts) can fall under such conditions is a function of the fi rms’ cost struc- tures. Those with high fi xed costs are most likely to cut prices when excess capac- ity exists, because they must operate near capacity to be able to spread their overhead over more units of production.

The U.S. airline industry experiences this problem periodically, as losses gen- erally result from planes that are fl ying substantially less than full or those that are not fl ying at all. This dynamic often results in last-minute fare specials in an effort to fi ll seats that would otherwise fl y vacant. During the diffi cult times for U.S. airlines immediately following the 9/11 terrorist attacks, frequent price wars were often initiated by low-cost airlines such as JetBlue, Southwest, and AirTran.10 Interestingly, airlines fi lled 73.4 percent of their seats in 2003 compared to only 63.5 percent a decade earlier.11

3-3c Slow Industry Growth Firms in industries that grow slowly are more likely to be highly competitive than companies in fast growing industries. In slow-growth industries, one fi rm’s increase in market share must come primarily at the expense of other fi rms’

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shares. Competitors often attend more to the actions of their rivals than to con- sumer tastes and trends when formulating strategies.

Slow industry growth can be caused by a sluggish economy, as was the case for vehicles during the early 2000s. As a result, manufacturers began to emphasize value by enhancing features and cutting costs. Ford, DaimlerChrysler, Nissan, Toyota, and others began to produce slightly larger trucks with additional fea- tures, while trimming prices. Producers also began to develop lower priced luxury cars in a fi erce battle for sales.12

Slow industry growth—and even declines—are frequently caused by shifts in consumer demand patterns. For example, per capita consumption of carbonated soft drinks in the United States fell from its peak of fi fty-four gallons in 1997 to approximately fi fty-two gallons by 2004. During this same period, annual world growth declined from 9 percent to 4 percent as consumption of fruit juices, energy drinks, bottled water, and other noncarbonated beverages continued to rise. Coca-Cola and PepsiCo acquired or developed a number of noncarbonated brands during this time in efforts to counter the sluggish growth prospects in soft drinks. Interestingly, these rivals now appear to have modifi ed their industry defi nitions from a narrow “soft drink” focus to a broader perspective including noncarbonated beverages.13

3-3d Lack of Differentiation or Low Switching Costs The more similar the offerings among competitors, the more likely customers are to shift from one to another. As a result, such fi rms tend to engage in price com- petition. Switching costs are one-time costs that buyers incur when they switch from one company’s products or services to another. When switching costs are low, fi rms are under considerable pressure to satisfy customers who can easily switch competitors at any time. When products or services are less differentiated, purchase decisions are based on price and service considerations, resulting in greater competition.

Interestingly, fi rms often seek to create switching costs in efforts to encourage customer loyalty. Internet Service Provider (ISP) America Online, for example, encourages users to obtain and use AOL e-mail accounts. Historically, these accounts were eliminated if the AOL customer switched to another ISP. Free e-mail accounts with Yahoo and other providers proliferated in the mid-2000s, however. As a result, AOL loosened this restriction in 2006, suggesting that most consumers no longer see the loss of an e-mail account as a major factor when considering a switch to another ISP (see Strategy at Work 3-1). Frequent fl ier programs also reward fl iers who fl y with one or a limited number of airlines. The Southwest Airlines generous program rewards only customers who complete a given number of fl ights within a twelve-month period, thereby effectively raising the costs of switching to another airline.

The cellular telephone industry in the United States benefi ted from key switch- ing costs for a number of years. Until regulations changed in late 2003, consumers who switched providers were not able to keep their telephone numbers. Hence, many consumers were reluctant to change due to the hassle associated with alert- ing friends and business associates of the new number. Today, however, “number portability” greatly reduces switching costs, allowing consumers to retain their original telephone number when they switch providers.14

3-3e Capacity Augmented in Large Increments When production can be easily added one increment at a time, overcapac- ity is not a major concern. If economies of scale or other factors dictate that

Switching Costs

One-time costs that buyers of an industry’s

outputs incur as they switch from one com-

pany’s products or serv- ices to another’s.

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production be augmented in large blocks, however, then capacity additions may lead to temporary overcapacity in the industry, and fi rms may cut prices to clear inventories. Airlines and hotels, for example, usually must acquire additional capacity in large increments because it is not feasible to add a few airline seats or hotel rooms as demand warrants. When additional blocks of seats or rooms become available, fi rms are under intense pressure to cover the additional costs by fi lling them.

3-3f Diversity of Competitors Companies that are diverse in their origins, cultures, and strategies often have different goals and means of competition. Such fi rms may have a diffi cult time agreeing on a set of combat rules. As such, industries with global competitors or with entrepreneurial owner-operators tend to be diverse and particularly com- petitive. Internet businesses often change the rules for competition by emphasiz- ing alternative sources of revenue, different channels of distribution, or a new business model. This diversity can sharply increase rivalry.

3-3g High Strategic Stakes Competitive rivalry is likely to be high if fi rms also have high stakes in achieving success in a particular industry. For instance, many strong, traditional compa- nies cannot afford to fail in their Web-based ventures if their strategic managers believe a Web presence is necessary even if it is not profi table. These desires can often lead a fi rm to sacrifi ce profi tability.

3-3h High Exit Barriers Exit barriers are economic, strategic, or emotional factors that keep companies from leaving an industry even though they are not profi table or may even be losing money. Examples of exit barriers include fi xed assets that have no alterna- tive uses, labor agreements that cannot be renegotiated, strategic partnerships among business units within the same fi rm, management’s unwillingness to leave an industry because of pride, and governmental pressure to continue operations

S T R A T E G Y A T W O R K 3 – 1

Rivalry and Cooperation in Internet Services

Amidst a fl urry of copromotion agreements between retailers and Internet brands, Microsoft and Best Buy embarked on a strategic alliance that includes Internet, broadcasting, and in-store promotional projects. Microsoft utilizes the new agreement to expand its dis- tribution and increase subscribers to its Internet serv- ices. The agreement also displays and promotes the Best Buy logo and BestBuy.com links at Microsoft’s Web sites and broadcasting properties, including the Expedia.com travel service, Microsoft’s e-mail serv- ices, Hotmail, WebTV Network, the new MSN eShop online, and MSNBC. In return, Best Buy became a major advertiser with Microsoft’s Internet and broad- cast properties.

Wal-Mart and America Online (AOL) have also teamed up to drive traffi c to Wal-Mart’s Web site and introduce millions of customers to the AOL brand. AOL is most interested in the in-store …