Using an industry with which you are familiar, apply 2 elements of Porters Five Forces model (Porter, 2008) that you think profoundly affect the industry, b

To determine the landscape that a firm competes in, it isn’t enough to only understand the five forces that directly affect an industry. The general environment also needs to be understood, as it can affect firms in a variety of ways,31 including affecting the shape of each of the five industry forces. A simple way to think about the general environment is to break it down into eight categories. Strategic managers in the best companies are focused on each of these categories, looking for trends that might lead to new opportunities or threats. This is illustrated in Figure 2.3:

Complementary products or services

Technological change

General economic conditions

Population demographics

Ecological/natural environment

Global competitive forces

Political, legal, and regulatory forces

Social/cultural forces

Complementary products or services

Technological change

General economic conditions

Population demographics

Ecological/natural environment

Global competitive forces

Political, legal, and regulatory forces

Social/cultural forces

FIGURE 2.3 Trends in Opportunities and Threats in the General Environment

Developments in each of the eight categories shown in the outer ring have the potential to shape and change the general landscape for any specific industry. Each category can affect an industry’s dynamics, which are shown by the area within the center circle, altering any or all of the five forces. You should always keep in mind that an industry’s five forces are not static. The five forces are subject to change and may change, even radically, if elements of the general environment change. When you are examining the general environment, it is important, then, to not just get a picture of what things look like today but to analyze trends and the direction each category is headed toward tomorrow. Remember, as well, that this analysis is industry specific. You want to know how each of the eight categories is going to affect the industry you are studying, rather than how it might affect a single firm. Both levels of analysis can be useful. But at this stage you want to know how the general environment might affect the five forces, potentially giving you advance notice of what is going to change in your industry and a chance to plan accordingly.

The relative importance of each of the general environmental factors differs from industry to industry. In the fast-food industry, social forces, such as a shift toward healthier eating, are likely to significantly alter the threat of substitutes, but technological change doesn’t play as large a role. In the motorcycle manufacturing industry, demographics play a key role, as many industrialized nations experience an upward trend in the average age of the population, but changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting in fewer people riding because of their age rather than a societal shift in the perception of motorcycles. Managers need to develop a deep sense of which environmental factors are strategically relevant to their own industries.32 Managers need to understand not only which factors have the largest impact on their industry right now, but also which factors are likely to change in the future, so that they can adapt their firms’ strategies to changing conditions.

Complementary Products or Services

Complementary products or services are those that can be used in tandem with those in another industry. For example, video gaming hardware and software, or smartphone operating systems and Apps, are complementary sets of products. When two complements are used together, they are worth more than when they are used apart. Complementary pairs or groups (also called ecosystems) of products can be found in many places, not just in the technology sector.33 Gas stations and roads are complements to automobiles, and piping is a complementary product to natural gas. Trends in complementary industries have the potential to radically alter—for better or worse—the landscape in which firms compete.

“complementary products or services Products or services that can be used in tandem with those from another industry.”

Take the rise of application software (Apps), for instance. In the 1990s, Microsoft created tools for software designers. By doing so, Microsoft lowered the barriers to entry in the application software industry, a complementary industry to operating systems. Apple made it even easier to enter the App industry by releasing segments of its operating system code, creating even more new entrants and sparking the rise of single-purpose, inexpensive Apps for mobile computing devices. Now, customers at Apple’s App store can choose from hundreds of thousands of Apps for their iPhones.

The number of new entrants in the App industry is actually increasing the barriers to entry in the smartphone operating system industry. It would be difficult for a new mobile operating system to come on the scene and compete with Apple or Android. Even powerful Microsoft has experienced challenges entering the mobile operating system business even though it had a head start over Apple and Google.34 For many industries, changes in complementary products are one of the most important trends to keep an eye on. Some consider them significant enough that they even refer to them as a sixth force among the five industry forces.35

Technological Change

Technological change within an industry has the potential to radically reshape a firm’s landscape, and sometimes society with it. Technological changes can include new products, such as smartphones; new processes, such as hydraulic fracturing (fracking), which has dramatically increased the output of the natural gas industry; or new materials, such as lithium batteries, which make electric automobiles possible. In many industries, the pace of technological change has accelerated over the last couple of decades.36 Managers find it increasingly important to consistently scan the environment to locate potential new technologies that might affect their industries.37 Early adopters are often able to gain greater market share and earn higher profit margins than those who are late to adopt, suggesting the importance of incorporating new technologies early.

Not only can technology change the nature of rivalry in an industry by giving some firms an upper hand in gaining market share, but it can sometimes lower barriers to entry. For instance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such as steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new technology for smelting steel called the electric arc oven allowed new firms, such as Nucor, to enter the industry with only one-tenth the capital investment that would have been needed to start a traditional steel firm. Perhaps the technological change that has affected the threat of new entrants in the greatest number of industries in the last 20 years is the Internet. Some have suggested that the next giant wave of technology change, one we are in the middle of experiencing, is wireless communication, like smartphones, which allow individuals to connect to and from anywhere and anyone at any time; and the coming 5G wireless revolution, which promises to allow those connections to occur at speeds that truly allow connection to and from anything and anyone, at anytime, and from anywhere no matter how much data is being transmitted.38

General Economic Conditions

Changing macroeconomic forces can also have a large impact on industries. The state of an economy can affect a region or nation and, subsequently, the ability of the average firm in an industry to be profitable. Analyzing the economic environment typically involves measuring the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or deflation. The appendix provides a list of sources where you can find information on these economic indicators.

Economic Growth

How quickly, or slowly, an economy is growing has a direct impact on most firms’ bottom line. Economic expansion tends to improve customer balance sheets, lower price sensitivity, and increase the growth rate in an industry, as customers purchase more, easing rivalry. For example, a number of African nations, such as Nigeria and Kenya, have experienced solid levels of economic growth in the last few years.39 As a consequence, a growing percentage of the population has sufficient disposable income to afford products like automobiles and cell phones. Companies providing products like these in Africa have experienced a boom in customer demand.40 The reverse is also true. When an economy slows down, industry growth rates slow, customers are more price sensitive, and suppliers are also likely to be struggling and pursuing ways of increasing profits—at the expense of firms in your industry, if they have the power to do so.

Interest Rates

Interest rates particularly affect rivalry by increasing or decreasing the demand for an industry’s products. This is particularly true for expensive items like housing, cars, and even education, which often require customers to take out loans to purchase. For example, the housing boom experienced in the United States and Europe in the early 2000s was fueled by low-interest-rate loans, sometimes below 4 percent, when the average mortgage interest rate in the previous decade had been above 6 percent. When interest rates are low, industry growth rates increase and rivalry decreases. When interest rates are high, the opposite can occur. In addition, interest rates affect the cost of capital. When interest rates are low, many firms can afford to invest in new assets. As interest rates increase, new investments become more difficult. As a result, firms sometimes engage in price wars as a strategy for gaining market share when rates are high, rather than investing in R&D and new product development.

Currency Exchange Rates

Currency exchange rates reflect the value of one country’s currency in relation to the currency from another country. Exchange rates can have a large impact on the prices that customers pay for products from firms in other countries, directly affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss franc appreciated 65 percent against the US dollar, making Swiss products 65 percent more costly in the United States, even though the cost of production hadn’t changed at all. Nestlé, a Swiss firm, was particularly hard hit. It either had to decrease its profit margin to cover the extra cost or increase its prices substantially, risking fewer customers buying its products.

Inflation

A significant, consistent rise in prices, known as inflation, can create many problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year (low inflation), then next year that product will cost $1.02. If it is higher, though, say 30 percent, which is not unheard of around the world, the product would cost $1.30 next year and $1.63 the year after that, doubling the cost in three years. Inflation or deflation, if they are high enough, can make it hard for firms to plan investments. Inflation tends to decrease overall economic growth, increasing rivalry and possibly buyer and supplier power and the threat of substitutes. When firms can’t predict what price they will be able to get for a particular product, investments in new product development become riskier. When inflation is high, many industries experience increases in price competition, rather than development, as a means of gaining market share.

Demographic Forces

Demographic forces involve changes in the basic characteristics of a population, including changes in the overall number of people, the average age, the number of each gender or ethnicity, or the income distribution of the population.41 Because demographic changes involve basic shifts in the product and geographic markets that firms target, demographic changes are always accompanied by opportunities and threats. Even though demographics often change slowly, they fundamentally reshape the landscape, so good strategic managers have a firm understanding of demographic trends. The appendix contains a list of readily available sources for demographic information. Some sources, such as the World Bank, contain hundreds of different demographic indicators.

Over the last 50 years, the size of the world’s population has more than doubled, from around 3 billion to more than 7 billion people. Projections suggest that the Earth’s population could reach 9 billion by 2040.42 Each new individual is a potential new consumer, suggesting that growth rates of many industries will increase over time. However, increases in consumption resulting from population growth also mean that supplies of raw materials (such as the rare-earth metals terbium and europium currently used in flat-panel displays43) are likely to decrease. Furthermore, the world population isn’t spread evenly over all nations. The enormous populations of China and India account, to a large degree, for the number of firms that have set up operations in those countries.

The average age of the population within a nation can also have a tremendous effect on some industries. In Japan, for instance, more than 20 percent of the population is over age 65. In the United States, this won’t occur until around 2040.44 The robotics industry has already felt this shift. Japanese companies like Honda have invested tens of millions of dollars in robots for home use, including walk-assist robots that help seniors with weakened muscles remain ambulatory when they would otherwise need to use a wheelchair.45

Ecological/Natural Environment

The natural environment can also be a source of change for many industries. In some cases, this involves changes to the physical environment such as increasing shortages of key inputs like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas). More often, though, current trends in the natural environment involve changes in the public’s perception of how business affects the environment. From global warming to clean air and water, the public in many countries—including developing economies like China—are demanding that firms be more proactive in protecting the environment. Many firms have responded by implementing green initiatives. Although some of these may be for public relations purposes only many firms have established serious goals. For instance, Procter & Gamble has goals to use 30 percent renewable energy to power its plants by 2020. By 2014, 7.5 percent of its energy needs were already met by renewable energy. They have also promised to reduce their energy consumption, water usage, greenhouse gas emissions, and waste by 20 percent by 2020. They have already reduced them by 8 percent by 2014.46 If consumers truly care about the environment, then actions like these increase rivalry as competitors are forced to respond in kind.

Global Forces

Global forces also play a large role in shaping many industries. Over the last 50 years, as communications and transportation technologies have undergone a revolution, trade barriers among nations have fallen dramatically. Many countries, from South Korea and Taiwan, to China and India, to Brazil and South Africa, have enjoyed remarkable economic growth and a rising standard of living. These changes have caused firms from many countries to expand operations and begin producing and selling across national borders. We will examine global forces and strategies for capitalizing on them in greater detail in Chapter 9.

Political, Legal, and Regulatory Forces

Political, legal, and regulatory forces are those that arise from the use of government. When new laws are passed, they may alter the shape of an industry and influence the strategic actions that firms might take.47 For example, the federal Affordable Health Care Act, enacted in 2009, mandated that health insurance companies insure everyone, including those with preexisting conditions. This changed the cost structure of the insurance and healthcare industries, resulting in consolidation and less rivalry, as inefficient firms either went out of business or were acquired by more viable firms. In the United States, following the Great Recession of 2008–2009, the Federal Reserve required banks to keep larger amounts of cash on hand to cover potential mortgage-related losses. One consequence of this regulation was less lending to small businesses, erecting entry barriers in many industries and changing the nature of rivalry in industries with many small firms.

Because political processes, laws, and regulations have the potential to shape and constrain industries, managers should analyze and understand the impact of new laws and regulations and decide how to respond. The Affordable Health Care Act, for example, required firms with over 50 employees to provide health insurance for their workers, or face fines. Because the law also provided for health insurance exchanges through which uninsured people could buy their own insurance, some firms dropped employee health insurance as a benefit. Their managers have determined that the fines their companies face would be cheaper than the current premiums for health insurance.

Of course, laws can provide opportunities as well as threats. For instance, laws in many countries and states in the United States that require electricity providers to obtain a percentage of their electricity from renewable sources have resulted in a boom in demand for wind turbines and solar panels. Because of the potentially far-ranging effect of laws and regulations, many firms and industries strategically lobby government in an attempt to influence the lawmakers to enact legislation favorable to their industries.

Social/Cultural Forces

Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes are so fundamental that they often affect the other six general environmental forces, shaping the overall landscape in which firms compete. For instance, changing cultural norms about health have resulted in laws against sodas being sold in schools and lawsuits against fast-food retailers such as McDonald’s for marketing “unhealthy” food to children.

Like the other environmental forces, however, social forces can create opportunities if a firm happens to be among the first to act on changes in values and attitudes. For instance, Facebook helped to change social norms about connecting to friends and family. It reaped enormous profits for being among the first to capitalize on the change in social networking.

Social forces are different, sometimes radically so, in different countries. Firms that compete in a global industry must understand differences among consumers in each country they serve. For example, the collectivist orientation of many people in China results in a general belief that the well-being of the group is more important than that of the individual and a related norm of open information sharing.48 This open-sharing norm allows a greater acceptance of product knockoffs and software pirating than many people are comfortable with in countries that tend to have individualist orientations, such as the United States.

Summary

One of the primary decisions that firms need to make is which industry, or environment, they are going to compete in. Defining a firm’s industry correctly is important because it helps managers to identify their competition. One tool for helping to define an industry is the NAICS codes produced by the US government.

Not all industries are equally attractive. Five major forces determine the attractiveness of an industry, defined as the profitability of the average firm in the industry. These forces are rivalry, buyer power, supplier power, threat of new entrants, and threat of substitute products.

Good managers develop a deep understanding of the effect of each of the Five Forces on industry attractiveness. Such an understanding allows them to take strategic action to influence the five forces in a positive way for their firm and industry. Misunderstanding the nature of the five forces can lead to decisions that destroy industry profitability.

New thinking suggests that for potential entrants the conventional wisdom needs to be re-examined. Rather than suggesting that new entrants should always look for industries that are attractive, for new entrants who possess unique value, entering an unattractive industry can be much more profitable than entering an attractive industry. But if you don’t possess that unique value you can still enter attractive industries if you completely understand the barriers to entry and can overcome each one.

Eight general environmental factors can affect the profit potential of a firm: complementary products or services; technological change; general economic conditions; demographic forces; the ecological/natural environment; global forces; political, legal, and regulatory forces; and social/cultural forces. Changes in any of these eight factors can create additional opportunities and threats and often shape the five industry-specific forces.

Key Terms

attractiveness of an industry

backward integration

barriers to entry

complementary products or services

forward integration

network effects

opportunities

rivalry

substitute

supplier

switching costs

threats