Competitive Strategies and Industry Profitability*

The first formative analysis of competitive strategy appeared in the Harvard Business Review, in 1979. This was put forward by Michael Porter. Porter argued that there are 5 forces that shape competitive strategy.

  • Rivalry among existing competitors
  • Threat of new entrants
  • Threat of substitute products or services
  • Bargaining power of suppliers
  • Bargaining power of customers

If the forces are intense, almost no company earns attractive returns on investment. For example, airlines, textiles, hotels.

Thus, industry structure drives competition and profitability.

Thereby, understanding the competitive forces and their causes, indicates the roots of an industry’s current profitability and provides a framework for future profits too.

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Forces that shape competition

The strongest competitive force(s) determine the profitability of an industry. Thereby, they become the most important in strategy formulation. For instance, in the photographic film industry, low returns are the result of Kodak and Fuji, the world’s leading producers of photographic film being superior substitutes. In this case, coping with the substitute becomes the first strategic priority.

The structure of an industry is shaped by

  • Threat of entry
    • New entrants bring in new capacity and desire to gain market share.
    • This puts pressure on prices, costs and the rate of investment necessary to compete.
    • When new entrants are diversifying from other markets, they can leverage existing capabilities and cash flows in order to disturb the competition. For instance, Pepsi did this when it entered the bottled water industry, Microsoft did this when it entered the internet browsers industry, Apple did it when it entered the music distribution business.
    • Hence, the threat of entry puts a cap into the profit potential of an industry. Thereby, the firms in the industry must hold low prices or increase investments.

For example, Starbucks must invest in modernizing its stores and menus due to low barriers to entry in the coffee industry

  • This is why barriers to entry are advantageous to the existing firms in an industry.
    • Sources of barriers to entry
      • Supply side economies of scale
        • This is when firms produce at larger volume and enjoy lower costs per unit. Therefore, this deters entry by forcing the entrant to come into the industry in a large scale.
      • Demand side benefits of scale (network effects)
        • This is when a buyer’s willingness to pay for a company’s products increase with the number of other buyers who also patronize the company. For example, online auction participants are attracted to Ebay since it offers the most potential trading partners.
        • Hence, demand side benefits of scale discourage the entry by limiting the willingness of customers to buy from newcomers.
  • Customer switching costs
    • These are the fixed costs that buyers will face when they change suppliers. For example, ERP software is a product with high switching costs.
    • Capital requirements
      • This barrier is particularly great if the capital requirement is for unrecoverable and harder to finance expenditures like upfront advertising or R &D.
    • Incumbency advantages
      • These are the cost or quality advantages for firms irrespective of their size, which is not available to its potential rivals. For example, proprietary technology, preferential access to the best raw material sources, brand identity.
  • For example, Target and Walmart have located stores in freestanding sites rather than regional shopping centres.
  • Unequal access to distribution channels
    • Sometimes, new entrants must bypass distribution channels altogether or create their own.
    • Restrictive government policy
      • Government directly limits entry into industries such as licensing requirements and restrictions on foreign investment.
      • For example, regulated industries are like liquor retailing, taxi services.
  • Power of suppliers
    • Powerful suppliers have the following characteristics
      • Greater concentration in the industry. For example, Microsoft’s near monopoly in operating systems coupled with the fragmentation of PC assemblers.
      • Not being dependent heavily on the industry for revenues.
      • Industry participants face switching costs in changing suppliers.
      • Differentiated products. For example, pharmaceutical companies that offer patented drugs.
      • Absence of substitutes
      • Threat of integrating forward into the industry.
  • Power of buyers
    • Powerful buyers will be present in the following cases
      • Existence of few buyers or each buyer purchases in large volumes.
      • Standardized products.
      • Few switching costs
      • Ability to threaten to integrate backward
    • On the other hand, buyers can be price sensitive in the following conditions:
      • If the product purchased represents a significant fraction of its procurement budget
      • IF they earn low profits or strapped for cash
      • Quality of the products is little affected by the industry’s product.
  • Threat of substitutes
    • Substitutes limit profit potential
    • Threat of substitutes will be high in the following situations:
      • It offers an attractive price performance trade off to the industry’s product. For example, telephone service providers suffered from the advent of inexpensive internet based phone services such as Vonage and Skype
      • The cost of switching to buyers is low
  • Rivalry among existing competitors
    • This can be in the form of price discounting, new product introductions, advertising campaigns and service improvements.
    • The level of rivalry will be high in the following cases:
      • Numerous competitors roughly equal in size and power
      • Slow industry growth
      • High exit barriers
      • Rivals are highly committed to the business
      • Lack of familiarity of the different firms in the industry
    • The strength of the rivalry indicates the intensity and basis of competition.
    • Profitability is affected by
      • The dimensions on which competition takes place
      • Whether rivals converge to compete on the same dimensions
      • Sustained price competition trains people to pay less attention to products’ features.
    • Price completion will occur in the following instances:
      • Identical products
      • High fixed costs and low marginal costs
      • Capacity must be expanded in large increments to achieve efficiency
      • Perishable products
    • Competition on dimensions other than price such as product features, support services, delivery time, brand image is less likely to reduce profitability.  This is because they improve customer value and therefore, can support higher prices.

In this way, the Porter’s five forces determine the industry’s long run profit potential.

However, other visible attributes of an industry also should be considered.

  • Industry growth rate
    • Fast growing industries are not always attractive. An expanding industry offers opportunities for all competitors. However, suppliers can become powerful in a fast growing industry.
    • Without new entrants, a high industry growth rate does not guarantee profitability if the customers are and substitutes are attractive.
  • Technology and innovation
    • Advanced technology alone cannot make an industry attractive or not.
  • Government
    • The government policies and their ways of involvement will affect industry in various ways
  •  Complementary products and services
    • Complements affect profitability via their influence of the five forces outlined above. For example, in application software, barriers to entry were lowered when producers of complementary operating system software like Microsoft provided tool sets making it easier to write applications.

The above discussion was based on a constant industry state. But, practically, industries keep on changing.

Shifts in industry structure can emanate from outside of an industry. These can boost industry’s potential profit or reduce it.

Porter’s five competitive forces provide a framework to identify the most important industry developments and for anticipation of their impact on industry attractiveness.

Shifting threat of new entry

Ex: When Merck’s patent for the cholesterol reducer Zocor expired, 3 pharmaceutical makers entered the market for the drug.

Ex: In 1970s, retailers like Walmart, Kmart, Toys R Us began to adopt new procurement, distribution and inventory control technologies with large fixed costs. These investments increased the economies of scale and made it more difficult for small retailers to enter the business.

Changing supplier or buyer power

Ex: In the global appliance industry, competitors including Electrolux, General Electric and Whirlpool have been squeezed by the consolidation of retail channels.

Shifting threat of substitution

Ex: The earliest microwave ovens were large and priced above $2000, making them poor substitutes for conventional ovens. With technological advances, they became serious substitutes.

Ex: Flash computer memory has become a good substitute for low capacity hard drives.

New bases of rivalry

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