ECON 696: Managerial Economics and Strategy
Lecture Notes 10: Industry Analysis
Introduction
This chapter provides a practical framework for analyzing a market and determining the long-term prospects for profitability. Once this framework is established, it is applied to three industries: hospital care in Chicago, commercial airframe manufacturing, and Hawaiian coffee, which must have been fun to research.
The Five-Forces Analysis Framework
The book provides a framework for market analysis that looks at five aspects of a market and the implications of each for long term profitability in a market.
Use of this framework presumes an appropriate definition of the market in question. In considering exactly what to include in the market you're analyzing, any geographical borders and the scope of substitutes should be clearly and appropriately determined.
1. Internal rivalry
Internal rivalry refers to the level of competition between firms in an industry at both strategic and tactical levels. The aggressiveness of this competition helps determine the level of prices and profits.
This competition may be price competition (in which firms compete by offering lower prices than their competitors) or non-price competition (offering higher quality at the same price). Either form of competition can erode profits.
The capacity of either type of competition to erode profits is demonstrated quite effectively by the market for air travel in the U.S. Prior to deregulation, regulatory boards set prices well above marginal cost, only to see airlines reduce their profits by competing to provide the highest level of service possible given the high prices. Since deregulation, airlines have competed primarily by trying to offer the lowest prices on any route. However, in situations where firms choose both price and quality levels, drawing a fine line between the two types of competition is a bit artificial.
The following factors generally reduce the potential for profitability in an industry. These are also factors that make collusion or a cooperative pricing arrangement more difficult to sustain.
1. Many sellers
2. Stagnant or declining demand
If an industry is declining, some firms will be pushed to the brink of bankruptcy, even if there are collusive agreements within the industry. Firms facing bankruptcy will have no incentive to continue cooperating and will cheat. Anticipating this cheating, other firms may defect first, causing agreements to break down far in advance of the threat of bankruptcy.
3. A wide range of cost functions
If firms face a wide range of costs, it will be more difficult for them to agree on what an appropriate (combined profit maximizing) price will be. Lower cost firms might want a lower price and greater quantity than higher cost firms would choose.
4. Excess capacity
Excess capacity makes it possible for firms to increase the quantity they supply very quickly. While this can make markets more competitive (because a price increase can be taken advantage of by any one firm), excess capacity can also be a weapon with which a firm can punish new entrants or other firms which produce too much or set prices too low. Depending on how it is used, excess capacity is a weapon that can either make a market more competitive or can be used to enforce a collusive agreement.
5. Homogeneous products
When products are homogeneous, firms may be very tempted to steal customers from each other by lowering prices. This is equivalent to a product being a commodity, or the type of product for which consumers are unconcerned about which seller they buy from. In an effort to keep this from happening, airlines have used frequent flyer programs to differentiate their products and make it costly for consumers to switch from one supplier to another, particularly when travelling for business.
6. Unobservable prices
When prices are unobservable, one firm can undercut its competitors without them knowing about it directly. This softens the threat of any retaliation.
7. Inflexible prices
Again, this reduces the ability of firms in an industry to punish one firm for cutting prices or producing too large a quantity.
8. Large or infrequent sales orders
9. No history of cooperative pricing
Often, the hardest part of a collusive or cooperative agreement is getting it started. If there is no pattern of cooperation, it may never get started, even if it would be sustainable once it was going.
10. Strong exit barriers
Strong exit barriers make it costly for firms to leave an industry and make it more difficult to drive new entrants or cheaters out of business.
2. Entry
Entry erodes incumbents' profits. Here are some factors that influence the potential for entry and, in turn, can affect the number of firms in an industry.
1. Economies of scale in production
As mentioned at the beginning of the chapter on entry and exit, entrants tend to be smaller than incumbent firms. If there are sufficient economies of scale in the industry, it will be nearly impossible for smaller new entrants to compete with existing firms.
2. Consumer brand loyalty
3. Access of entrants to key resources and technology
4. Difficulty of mastering production distribution
A steep learning curve is similar to the existence of economies of scale in an industry. If learning the little tricks of a business is difficult and costly, incumbent firms will have a near insurmountable advantage.
5. Network externalities
Again, this is related to the economies of scale issue. A good example is that people will be hesitant to buy a car unless there is a good service and dealer network in their area that can support the car through assistance and maintenance. For this reason, a new automobile company may have a difficult time establishing itself without a broad dealer network, something that won't exist until the company sells a lot of cars.
6. Government enforced barriers to entry
Governments will often restrict entry to markets through laws such as patents. In the absence of government, firms in some industries turn to organized crime to achieve largely the same effect. This was an effective barrier to entry in the trash hauling business in New York City for many years.
7. Expectations about post-entry competition
If potential entrants know that new firms in an industry are typically met with brutal price competition, they may look for other markets to enter.
3. Substitutes and complements
No product exists in a vacuum. Other products will affect the demand for a product, even if those other products are technically in other markets. The following factors may be important.
1. Availability of close substitutes
If something is a close substitute for the good offered in the industry you are examining, it should perhaps be included in the industry you are looking at. If this would be in some way inappropriate (perhaps because you are looking at the poultry market and pork, while a substitute, is supplied through a very different supply system) you should at least recognize the existence of this substitute and the fact that is will make demand more elastic.
2. Availability of good complements
Complements enhance demand for a product. Changes in the market for a product's complements can dramatically affect demand. One very good example is the effect that changes in computer software have had on the demand for computer hardware. As software has become easier to use, demand for computer hardware has increased.
4. Supplier and buyer power
Firms purchase their inputs and sell their products in markets. The structure of these markets will influence the potential for profitability.
Ideally, firms would be able to purchase their inputs in perfectly competitive markets so that the price is very close to minimum average cost and there is no danger of facing any sort of collusive pricing. As the market in which a firm purchases its inputs becomes more concentrated, the price it pays for those inputs is likely to rise and its profits will fall.
Similarly, a firm would like to sell its output in a market where it is a monopolist. As the market in which it is selling becomes more competitive, profits will erode.
In looking at the conditions under which a firm purchases inputs and sells outputs, all of the above considerations are relevant, as is consideration of how these conditions are likely to change over time.
Case Studies
The book offers three case studies of examining markets using the framework established here. They are definitely worth reading.
Summary
The chapter presents a framework for analyzing markets and determining their capacity for extra-normal profits in the long run.
The most important aspects for maintaining high profit levels are a high level of concentration in the market in which a firm is selling its output and a low level of concentration in the markets in which it buys its inputs. Beyond this, anything that will make it easier for a firm to maintain a cooperative relationship with its competitors will help to assure larger profits, even in the long run.