in Managing Complex Environments
Robert S. Atkin Katz Graduate School of Business University of Pittsburgh Pittsburgh, PA 15260 [e-mail]
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Chapter 3 "Markets as the Interface between the Firm and Its Environment" Revised, January 2008 2007 Robert S. Atkin
1. Written by the author for use in the course BUSSPP0020 "Managing in Complex Environments" at the University of Pittsburgh. Use for other purposes or by other instructors without the author's written permission is prohibited under copyright laws.
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Managing in Complex Environments
Lecture Notes 3: Industries
Professor X: "So, who is our competition? Every bloody MBA school in the world?" Professor Y: "No, only ...you know...only those we compete with..." Professor Z: "Well whoever they are, why is it so difficult to be successful these days?" Professor Y: "I dunno...maybe the industry just stinks." (Edited from a heated Faculty meeting. I won't say where or when)
Some facts about a real industry...see if you can guess which one... At least 500 US players and 100+ international ones, none with more than a fraction of a percent of market share; Little or no growth in domestic demand; Overcapacity in the US for more than 2 decades largely filled by importing international customers who now shop locally; Significant new capacity in Europe and Asia, with Europe probably at overcapacity relative to local buyers; Massive exit costs; Likely continued erosion of entry barriers by on-line providers; A more or less generic product with fewer than 2 dozen internationally recognized brands; Huge costs required to build new internationally visible brand; No intellectual property constraints, so successful product innovation is rapidly copied Most customers make only one purchase in a lifetime.... (From a presentation by the author to colleagues at University College Dublin, Ireland in 2001.) >>> Any idea what industry? Do you think this is a great industry in which to compete? Why or why not?
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Teaser A. Imagine the following: 1. You've just graduated from college. Your parents throw a big party. A family friend, knowing you're looking for a job, comes up to you and whispers: "Wireless." "Huh?" you say. "It's the future...everything will be wireless" is the reply. 2. (The above is a paraphrase of a scene from the movie "The Graduate," a popular movie of maybe 30 years ago but the whisper was "plastics." You may know the song "Mrs. Robinson," who was one of the characters.) B. What's going on? 1. The family friend is saying "look for a job in an attractive industry." 2. Make sense? Sure. Why? Lots of opportunity. C. So the obvious question is: is there a method to identify attractive industries? D. That question and some implications are the focus of this chapter.
II. Thinking about industries. A. We all know what an industry is, right? Somehow, we know that PNC is in the banking industry, and Heinz is in the food industry. Right? Well, sort of... 1. Let's take a closer look at a Pittsburgh-based firm, then called USX, as it was in the early 1990s. USX consisted of three major units: a. USS (US Steel), which made and distributed basic steel products; b. Marathon, which explored for petroleum, refined it into gasoline and other products, and distributed and sold these products; and c. Delphi, which distributed natural gas. 2. So, would it be accurate to say that USX was in the steel industry? Not exactly. It was "in" at least three industries: steel, petroleum, and natural gas distribution. 3. But even this is not exactly accurate, since the USS unit was also involved in coal mining, iron ore mining, shipping (via barges and railroads it owned) as well as steel-making and distribution. And their involvement was not trivial: in many of these areas, the USS unit was either the largest or one of the largest players in the US. 4. At that time, would you say that the USS unit was in the steel industry, the coal mining and iron ore mining industries (or maybe just the mining industry), or the shipping industry? 2008 Robert S. Atkin Page 83
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Or maybe, in all of these industries? Or maybe, since USS was (and still is) the largest US domestic steel producer, we should just keep it simple and go with the "obvious" -- it's primarily in the steel industry and everything else is secondary.
B. Important idea: Many firms simultaneously participate in multiple industries. III. Classifying industries A. General concept of an industry. 1. An industry is a set of players that sell more or less the same thing. 2. "Player" could refer to an entire firm or to a division of a firm. For example, in the USX example, Marathon was the "player" in the petroleum industry as a division of USX. 3. For another example, think about the non-alcoholic beverage industry. a. The largest US player is Coca Cola, selling such products as carbonated beverages, juice, water, and other drinks. b. Another important player is PepsiCo. PepsiCo is in several industries, including non-alcoholic beverages (again, carbonated, juice, water, and other drinks) and snack foods (things like Frito Lay chips). c. So, when we think about the major players in this industry, one is an entire firm (Coca Cola) while the other is not the entire firm, but just the division that makes and sells beverages (actually, two Divisions in this particular case, PepsiCo Beverages North America and PepsiCo International). B. Formal classification systems: The federal perspective 1. For various reasons, the Federal government has developed systems to classify firms into one or more industries. a. The standard system for many years was called the Standard Industrial Classification (SIC) system. In 1997, the North American Industrial Classification System (NAICS) officially replaced the SIC system. b. However, the Security and Exchange Commission (and probably other Federal agencies also) still uses the SIC system, so it hasn't vanished.1 2. For many purposes, the SIC/NAICS codes are useful. For example, you may want to visit www.census.gov/epcd/www/sic.html for a listing of useful data sets available on-line from the US Census Bureau. 3. However, the term tends to be used differently in practice. C. The substitutability approach to identifying industries. 2008 Robert S. Atkin Page 84
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The idea here is that firms in the same industry are likely to demonstrate demand-side substitutability or supply-side substitutability or both. What's that mean? a. Demand-side substitutability refers to the possibility of customers switching between suppliers. (1) For example, a buyer of a retail checking account could buy from National City, or Citibank, or a large number of other banks. (2) Similarly, you may prefer Burger King, but very similar products are also offered by McDonald's and Wendy's, among others. b. Supply-side substitutability refers the similarity of technologies used by producers. (1) For example, currently, Campbell's is a firm with lots of knowledge and experience turning tomatoes into prepared food. I don't think they make catsup. Heinz does. Customers looking for catsup won't find it at Campbell's. By the demand-side definition, Heinz is "in" the catsup industry and Campbell's is not. (2) However, does Campbell's have the technology to make catsup? Offhand, I don't know. But if they did, then under a supply-side definition, we would consider both firms in the same industry. (3) The technologies do not have to be identical for this to occur. (4) Also, obviously, just because the firm has the technology does not imply they actually make the product. OK, we have two possible definitions based on "substitutability." Let's make sure we understand how these differ (please refer to Table 3-1).
Table 3 - 1 Comparison of Demand- and Supply-Side
Demand-side Substitutability Perspective From buyer's perspective Supply-side Substitutability From seller's perspective What other firms make OR have the ability to make the same product I (as a producer) make and sell? Usually relatively difficult to determine which firms have the technology to make product that they currently are not making. Page 85
Implications What alternative firms exist from whom I (as a buyer) may purchase the product? Availability of critical information Usually relatively easy to determine which producers make substitutable products.
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Which definition is better? It depends on the question being asked. a. From a producer's perspective, the supply-side approach considers not only those players currently making the product (obviously they have the technology), but also potential new players. This may be important when the player tries to estimate their future demand. b. From a customer's perspective, the supply-side approach may not help much if you want the product today. (1) If you can delay your purchase, it may be useful because you believe that in, say a year, new producers may emerge. (a) If so, you may have more choice of suppliers. (b) If the new player's product is more or less the same as the current one, then, prices may tend down. (c) If the new product has some new set of attributes, then you may find a product better suited to your interests. (2) However, if you cannot or will not delay your purchase (assume you're hungry right now and unwilling to wait a year for a new restaurant), then from the customer's perspective, the demand-side approach has more appeal. c. Notice, demand-side substitutability generally provides a "narrower" definition of industry than does the supply-side approach. Let's try an example. The product is an MBA degree. From the demand side definition, the "MBA industry" consists of those players you know to offer such a degree. But from the point of view of a graduate business school, the industry consists of those currently offering such a degree plus those likely to enter the market in the next year or two.
D. Personally I prefer the supply-side approach. 1. However, as noted in Table 3-1, the general public usually has more information about the demand-side than about the supply-side. That is, outsiders to the firm usually have more and better information about the firm's products than about its technologies. 2. In this course, we will use both approaches. a. Hence, if two firms are demand-side substitutable, we will consider them to be in the same industry. This is particularly useful from the customer's perspective. b. If two firms are supply-side substitutable, we will also consider them to be in the same industry. This is particularly useful from the producer's perspective. c. Please realize this will produce some inconsistencies.
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IV. Industry boundaries and related topics A. Industry boundaries. 1. Industries don't have exact boundaries, and hence they can often be defined at different "levels" depending on the question we wish to ask. 2. For example, think about the entertainment industry. a. While we could certainly consider this an important industry for some kinds of questions, a little thinking suggests that it consists of wildly different kinds of entertainment, from professional sports to movies to ballet to rock concerts. b. Indeed, each one of these could be thought of as an industry, for example, professional sports. But professional sport consists of wildly different sports from NASCAR to basketball to snow boarding to bull fighting. And any one of these could be thought of as an industry. 3. You get the idea. You have to make the call where to draw the boundaries and usually this depends on the questions you want to address. 2 B. Rivals 1. Earlier, we defined competitors as other players on the same side of the transaction space as you in any particular market in which you participate. 2. Rivals are a special type of competitor, namely, those competitors that sell what you sell. a. As just discussed, these rivals may "look" different depending on how the industry is defined. b. These rivals could be entire firms or divisions of firms. c. And linking all this to another idea from earlier in this chapter, firms that participate in multiple industries may do this by having one division in one industry and a second division in a different industry. C. Which leads to an interesting question, namely, why would a firm ever participate in more than one industry? Or, maybe to ask the same question a different way, is there any upper limit to the number of industries in which a firm could participate? 1. First observation: This is a very complex topic, and the discussion here is simply introductory. 2. Second observation: We know that some firms participate in only one business area, while other participate in more than one (remember Coca Cola and PepsiCo?). a. If one approach were uniformly better than the other, we may expect to see all firms "do something similar," that is, all be in just one business or all be in more than one business.
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b. However, in practice some firms are in just one or two businesses, while others are in dozens (or more). c. This suggests that there must be some underlying tradeoff. For our purposes, this tradeoff is between the benefits of focus (doing one business exceedingly well) and the avoidance of risk. a. Quick idea If your firm is in one business, then you may do that very well, but something outside of your control may occur to completely disrupt that business and then the firm has no "fall back." b. One way to think of a fall back is to be in a second business. But if your firm does two things, it is difficult to do both equally well, so you loss some of the benefit of focus. Firms that are in more than one business area are called diversified. c. Which raises the next question the second business could be in same or a closely related industry to the first. If that's true, then there may be some "spill-over" effects of focus that is, knowledge of how to do business #1 well also helps you do business #2 well. However, when the businesses are related, than the risk of failure in business #1 may be similar (or identical) to risks that affect business #2. d. If a firm is diversified into related businesses, we use the phrase related diversification. If the multiple businesses are not related, we call it unrelated diversification. If in a single business we call it focused. e. Which suggests what? A firm in one business gets the maximum impact of focus, but also the greatest level of risk. A firm in many unrelated areas reduces its risk exposure, but loses the benefits of focus. An intermediate position occurs when firms are in multiple related businesses. In practice, then, all firms need decide to "where" on this tradeoff frontier they believe best balances focus and risk.
V. Industry analysis basic ideas A. Industry analysis is the process of systematically analyzing an industry. B. Porter's 5-forces model 1. In his 1980 book, Michael Porter presented what has become the standard approach to industry analysis.3 While his model has many flaws, it's an excellent framework for us to consider here, as it is the best known system of industry analysis. Other methods are also available. 2. The general question Porter was trying to answer was "what are the basic factors that affect the profitability (or attractiveness) of an industry?" a. His immediate answer was "The competitive situation in the industry."
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b. Which leads to the question: "What affects the competitive situation in an industry?" (Assuming that greater competition usually lowers prices and hence reduces industry profitability). c. He then identifies five forces that affect the competitive situation: (1) Competition among the rivals currently selling more or less similar products (what Porter calls competition from rivals) (2) Competition from other players that could sell a more or less similar products (competition from new entrants) (3) Competition from players that sell possible substitute products (what Porter calls competition from substitutes) (4) The relative power of customers (5) The relative power of suppliers d. These are usually organized into a diagram provided in Figure 3 - 1. Thinking about how each of the 5 forces affects industry competition. a. Competition from rivals: (1) All other things equal, when there are many rivals and each is small (similar to what we see in perfect competition), the greater the degree of competition we would expect among these rivals. (2) This is exacerbated if... (a) Demand in the industry were shrinking or flat or only growing very slowly (say, only 1-2% a year) (b) The industry has excess capacity (this occurs when total industry capacity exceeds total industry demand), especially when shutting down the excess capacity is expensive. (c) There are high exit costs (exit costs are the unrecoverable costs of completely leaving the industry). (3) Bottom line: We expect competition among rivals is greater when... (a) There are many small producers, (b) There is weak or negative growth in demand, (c) There is excess capacity that is expensive to shut down, and (d) There are high exit costs. All things equal, greater competition would be expected to reduce the profitability (or attractiveness) of the industry. b. Competition from new entrants: (1) At issue here is the relative ease of entering the industry. (2) Various entry barriers can be identified, which tend to inhibit the ease of entering the industry, including: (a) Can the firm obtain the needed technology? (b) How much does it cost to enter? (c) Are there economies of scale? (That is, are there major unit cost advantages to a big entry rather than a small entry which will raise the entry costs?) Page 89
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(d) Do existing current customers exhibit substantial brand loyalty to the existing products? (3) For example, if it is expensive to enter and there are substantial economies of scale and existing customers are brand loyal and it is difficult to obtain the needed technologies, then we say entry barriers are very high. Conversely, if entry is not expensive, there are no scale economies, current customers seem willing to try new direct substitutes, and the needed technology is readily available, then we say entry barriers are very low. (4) Other things equal, if entry barriers are low, than we would expect lower levels of profitability in the industry. (a) Why? (b) All things equal, low entry barriers tend to induce new players to enter with products virtually identical to yours. (You may have seen this in micro-economics as the assumption of "no costs to enter" when you discussed perfect competition.) For example, new pizza shops open every day. (c) If there are many new entrants, rivalry among players existing and new - tends to increase as the customers now have more choices. To the degree to which industry competition is on price, price will tend downward, decreasing industry profitability. Also, existing players may try to reduce price as a means of reducing the incentives for yet more players to enter, again reducing industry profitability. Competition from substitutes: (1) Let's try an example first. Let's say you drive to school. Possible substitute forms of transportation include buses, walking, biking, skateboards, and so on. (2) You are likely to substitute one of the other transportation modes... (a) To the degree to which you are predisposed to switch and (b) To the degree to which price-performance characteristics of the alternative modes of travel are advantageous. (3) Example: You are a Pitt student. If you travel in Allegheny County, you pay nothing incremental over student fees to take the bus. If it's too far to walk and you have no car (or bike, etc.), then this is a nobrainer. Indeed, even if you have a car, the sheer cost of driving and parking and tickets may tilt you to take the bus. (4) Other things equal, if competition from substitutes is high, then we would expect lower levels of profitability in the industry. (a) Why?
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(b) One way to decrease the attractiveness of substitutes is decrease to the price of your product. (c) The result is lower industry profitability. d. Relative customer power: (1) In general, buyers are price sensitive, suggesting they shop, in part, on price. The greater the price sensitivity, the greater the pressure on the rivals to reduce price to attract buyers, and the lower the profitability of the industry. (2) However, at least two things work "in the other direction." The first is brand loyalty. If buyers are brand loyal, then they tend to restrict their purchases to those of a particular brand. If so, then at least some of the rivals can increase price, increasing the profitability of the industry. (3) The second are switching costs. The idea here is if there are significant costs to the buyer of switching from one of the rivals to another, then we say switching costs are high. If switching costs are high, the buyer is essentially stuck, and cannot switch to another seller without incurring additional costs. These costs could be monetary (cancellation fees with cell phone providers) or in nonmonetary form (e.g., you transfer from one school to another and you lose a semester). (4) If the buyers have lots of information about prices and products of the suppliers, and if buyer can switch between suppliers at little or no cost, and if buyers are not brand loyal, then customer power is high. If buyers have little information, have high switching costs, and are brand loyal, then customer power is low. (5) All things equal, if customer power is low, then we would expect higher levels of industry profitability. Conversely, if customer power is high, we expect lower levels of industry profitability. e. Relative supplier power: (1) Good example here: Assume you are a PC manufacturer. How many suppliers can provide high quality CPUs or operating systems? Very few. How much power do Intel and Microsoft have over PC makers? A lot. This is particularly true if switching to alternative suppliers is difficult or very costly. (2) All things equal, if supplier power is low, then we would expect higher levels of industry profitability. Conversely, if supplier power is high, we expect lower levels of industry profitability. VI. Industry analysis -- a comprehensive example A. Remember, what we are trying to do with an industry analysis 2008 Robert S. Atkin Page 91
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Our main interest is to understand those elements of the environment that may affect industry profitability. Please note carefully a. If industry profitability is high, that industry is a more attractive arena for the all rivals, on average. b. However, whether a particular firm in the industry is profitable or not is only partly dependent on industry attractiveness. By itself, industry analysis tells us nothing about the profitability of a particular rival. We'll address that shortly.
B. This example considers the airline industry as it existed more or less in 2002. 1. We start by determining the industry boundaries. 2. We know from material above that setting industries boundaries is a judgment call that depends on the question we want to address. Let's say our specific interest is: "How attractive is the regularly scheduled, mid- and long haul domestic airline passenger industry?" 3. Right away, this excludes charter flights (not regularly scheduled), non-US airlines (not domestic), private planes (not regularly scheduled), and so on. 4. Given these boundaries, our next task is to identify the rivals. a. The largest three players in 2002 were American, Delta, and United. b. Others included Continental, US Airways, Southwest, Northwest, etc. c. Exactly how many players to include is often an issue. In general you want to include all players if the total number is small, or if the number is large, all of the largest players. We'll use the latter approach here, including the above named lines. C. Next we consider the competition among rivals 1. First issue is the number and size of players. Some homework suggests a relatively small number of players and some serious differences in size. This looks more like an oligopoly than say a perfect competition. Hence, our initial sense is there is at least some theoretical reason to believe that industry profitability could be significant. 2. The next issue is demand. Again some homework would suggest that demand was decreasing due to a shrinking economy (think dot com melt down) even before 9/11, and then the tragedy caused demand to shrink more quickly. Combining this with issue one above suggests that while some opportunity may exist in theory for nice industry profitability, sluggish demand may reduce it. 3. The third issue is capacity. The industry had some excess capacity even before demand started sliding, but after the slide began, it had increasing amounts of overcapacity (i.e., many more seats than could be filled). Again, the original rosier picture is getting bleaker. 2008 Robert S. Atkin Page 92
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The next issue is the cost of shutting down demand. Some homework would suggest this was very expensive, as the firms were committed to the aircraft they had (either because they were owned and being paid off or because they were leased and the firms couldn't easily get out of the leases). Finally, complete exit from the industry would be massively expensive. Bottom line: Putting all these things together suggests significant competition among rivals, probably depressing price and industry attractiveness.
D. Next we consider competition from new entrants. 1. While the costs of entry are significant and there are many entry barriers, we certainly have seen some new entrants in the recent past (e.g. Jet Blue). 2. Most, however, fail except in specialized markets. Moreover, with serious demand erosion, we didn't see much new entry during this period. E. Next is competition from substitutes. 1. Some homework would convince you that auto travel (and to some degree, train and bus travel) became more attractive during this period of time. 2. This tended to exacerbated demand and contributed to lower profitability. F. Relative power of suppliers. 1. Suppliers to this industry include those providing fuel, the labor market, plane manufacturers, and gates (the landing slots at airports). 2. Since overcapacity existed, the plane manufacturers had relatively low power over the airlines. Similarly, the relative power of labor was decreasing. Fuel, though less expensive than now, still had reasonable power. 3. Bottom line: Not much erosion of attractiveness from supplier power.
G. Relative power of customers. 1. The combination of excess capacity and reduced demand provided lots of opportunity for those who were flying to shop on price. Another issue here was the increasing use of the web as a means to buy tickets and comparison shop, which also shifted power to customers. 2. Also brand loyalty rapidly vaporized, and switching costs are negligent. 3. Another tick toward unattractive. H. Bottom line: Putting all of this together suggests a seriously unattractive industry. Note, this would not have been the outcome of the analysis even 3-4 years earlier. Any wonder why we saw several bankruptcies by 2005? I. Also, given all this, we may expect that things hit the traditionally priced firms hardest, and that the discount guys may have even benefited. And this was exactly true Southwest, for example, did quite well, while the traditional guys Page 93
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didn't. There is a lot more that can do with this. There are also many weaknesses in this type of analysis. But it's still a useful way to think about an industry. J. Before we leave this conversation, let's recall Professor Porter's basic question: "what are the factors that affect the competitiveness (and hence, the profitability) of an industry?" 1. Five such factors were identified and then applied to the domestic airline industry 2. We concluded that, in 2002, it's not an attractive industry. The importance of the analysis emerges from the implications (e.g., how attractive is the industry), not from the sheer description of the various forces. 3. Important point: Saying industry profitability is low does not imply that all firms in the industry will suffer. Indeed, in the airline industry, a few firms, such as Southwest, have been quite successful. 4. Why this is so is our next topic.
VII. Industry attractiveness, unique competitive advantages, and the firm's economic performance A. A quick summary before we begin the new ideas. 1. Firms conduct transactions with players in the environment. The environment is complex and, in theory, firms must monitor the environment extensively in an attempt to understand "what's happening out there." Markets are the specific arenas within which transactions occur. In theory, monitoring the environment implies monitoring all aspects of the environment that may affect all these various markets. 2. Exhaustive monitoring is expensive, time-consuming, difficult, and probably impossible. Hence, we can view the Porter model as focusing our attention on the relevant environment as defined by the industry in which the firm participates. This led us to consider rivals, suppliers, customers, potential new entrants, and substitutes. 3. While useful, this approach has many problems. a. It often misses important issues. For example, it does not directly concern itself directly with macro-economic phenomena or technology. b. Other problems (not discussed above) include (1) little or no concern with the dynamics of industry (it really doesn't tell us how an industry "got" to it's current level of attractiveness or where it may be going in this sense the model is cross-sectional) (2) little or no direct concern with what I earlier called regulatory mechanisms
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(3) the entire system doesn't work well with newly developing industries (because it is very difficult to identify various players) c. Also, as it turns out, some of the model's propositions have found scant empirical support. 4 Nevertheless, for our purposes at this point in these readings, it's quite useful. Kinda' like a Bohr model of the atom you may have seen in high school.
B. OK, now the new stuff. Basically, what I'll do in this section is to sketch out an approach to why firms like Wal-Mart and Southwest Airlines can be highly profitable even though their industries are not very attractive. I'll start with two propositions: 1. A firm's potential economic performance is dependent on industry attractiveness and the firm's unique competitive advantages to exploit the industry situation it finds. 2. A firm's unique competitive advantages are dependent on its resources, its history, and the past choices made by its dominant coalition. C. Proposition 1 allows us to simplify the world as noted in Table 3-2. 1. If the industry is attractive and the firm possesses unique competitive advantages capable of exploiting the industry situation, it has the potential for a high level of economic performance. 2. If the industry is attractive but the firm does not possess unique competitive advantages, it has a lower potential. a. Note, however, that in particularly attractive industries such a firm may still "be successful" (in terms of being able to make reasonable profits). It may also fail. b. Often we see such firms make investments to build unique competitive advantages (why?). c. However, sometimes we observe all such firms reduce investments in seeking unique competitive advantages and substitute explicit or implicit collusion (why?). 3. If the industry is unattractive, but the firm has unique competitive advantages, then it should have higher potential economic performance than those in the industry without these advantages. However, if the industry is particularly unattractive, even this firm may fail. a. There may be significant incentives in this kind of industry for those firms that have unique competitive advantages to continue to improve these advantages, if industry unattractiveness is not too severe. b. Given our analysis of the airline industry, this is the situation faced by Southwest.
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In general, if find a weak industry with a strong rival (e.g., Southwest in the airline industry), you should expect that there is something quite special about how the firm does business. If the industry is unattractive and the firm has no unique competitive advantages, then we would expect one of several possible outcomes: a. Exit from the industry (most likely), b. Or failure c. Or maybe investment to attempt to build unique competitive advantages perhaps accompanied by focus on a narrow slice of products and customers (perhaps the Apple strategy in the PC industry).
D. The above are some general relationships. Obviously, a lot rests on building unique competitive advantages, which leads to proposition 2 above. 1. Resources are anything the firm owns, controls, or can access including financial resources, human capital, sheer information, brand names, and so on. a. Many resource taxonomies have been proposed.5 b. For now, let's just think of resources as the building blocks available to the firm that enhance (or limit) it's ability to construct unique competitive advantages. 2. Today's resources are dependent on those the firm has developed in the past. a. In most cases, one type of resource is developed or acquired over time by "spending" other resources. b. Sometimes resources emerge by chance or dumb luck. c. All firms start with some set of unique resources, if only the skills of the entrepreneur. A key issue for the entrepreneur is how to build other needed resources from his or her initial endowment. 3. The decision to spend one resource ("invest") to produce another resource is likely to be made by the dominant coalition as is attempts to pursue it goal set. E. All this will be amplified, expanded, and reorganized somewhat over the remainder of these notes. For now, let's just note that we've covered much ground. More important is that we have begun to work with concepts and issues central to managing in complex environments. To this point, things have been rather theoretical. All that will change very soon. VIII. Back to the idea of complex environments. A. In Chapter 1, we developed the idea of complex environments, with the level of complexity dependent on the rate, magnitude, and uncertainty of change and the number and dynamics of drivers. There we also said that, to be successful, the 2008 Robert S. Atkin Page 96
firm had to attend to all possible competitors and environmental drivers. Now we see a somewhat different picture perhaps the firm needs attend to just the industry in which it participates. 1. Tangent: You may ask, "Isn't the finished goods market the only market in which the firm sells stuff? In what other market could the firm be a seller?" a. The answer to the first question is no. The second question is many. b. For example, the firm may also sell in the intellectual property market. (1) A firm may have developed a technology or a brand that they decide to sell or license.6 (2) As a specific example, think of the brand name "Ralph Lauren." It appears on many products, from women's clothing to paint. (3) Many of these products are not made by the original company, but by other firms which have licensed the right to use the brand name. That is, the original firm has sold or leased the rights to the brand name to other firms. (Please note: Selling the use of the right to use the brand name is not the same a selling the brand name. Of course, the latter could also occur.) 7 2. In the discussion that follows, we'll make two simplifying assumptions: a. The firm participates in only one industry. b. The firm only sells in the finished goods market. B. Given these two assumptions, a demand-side definition of industry helps us to define the firm's relevant environment. 1. The immediately relevant environment is likely to consist of at least five elements: a. The customers interested in buying some product. b. Rivals currently selling similar, even if not identical, products. c. Other firms selling substitute products. d. Suppliers to all the firms in our industry. 2. However, many decisions a firm makes today will not take effect for months or even years. a. For example, as we saw in Lecture Notes 2, product differentiation involves a set of activities and investments that require time to play out. b. Therefore, a more complete picture requires that we re-introduce supplyside substitutability, so we can include firms not currently rivals could "enter" the market in the near future with direct substitutes (we'll call them possible new entrants). 3. Putting all this together, I'll define the relevant environment of the firm as consisting of a total of five elements: a. Customers of the firm, b. Suppliers to the firm, c. Rival firms that are currently providing more or less direct substitutes, 2008 Robert S. Atkin Page 97
d. Firms that are currently providing possible substitutes, and e. Firms that may be possible new entrants (i.e., firms not currently making the product which posses the technology to provide direct substitutes) C. Does this imply that other issues, such as the macro-economy or regulatory mechanisms, are unimportant because they are not part of our "relevant" environment? 1. No. Certainly such things as the generally booming Chinese economy or continued threats of terrorism or rapidly developing wireless technology are important. 2. We will assume that such factors as the macro-economy, global geopolitics, or fundamental changes in technology are important as they influence one of the above five factors.
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Figure 3 1 Porter's 5 Forces Model
Customer Power
Competition from New Entrants
Rivals
Competition from Substitutes
Supplier Power
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Table 3-2 Industry Attractiveness, The Firm's Unique Competitive Advantages to Exploit the Industry Situation, and Potential Economic Performance
Does the Firm have unique competitive advantages with which to exploit the industry situation ? Yes Yes Is the industry attractive? High economic performance potential No Hard call; An attractive industry offers some economic potential even if no unique competitive advantages for many players; higher chance of failure than in Yes/Yes; strong incentive to make investments to build unique competitive advantages; some incentive for these players to collude explicitly or implicitly Low economic performance potential; high likelihood of failure or exit from industry; some incentive to invest in focus on a narrow slice of customers and products
No
Hard call; unique competitive advantages should produce higher potential economic performance than otherwise; if the industry is particularly unattractive, even this may fail; depending on level of unattractiveness incentives may exist for these firms to improve current advantages.
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END NOTES
1. 2.
For a basic listing of the SIC codes go to www.sec.gov/info/edgar/siccodes.htm. A concordance of NAICS and SIC codes is at http://www.bls.gov/ppi/ppinaics.htm. Sometimes setting boundaries is relatively easy and sometimes not. Clearly, important here is how much you know about the industry. For example, most students can make fine discriminations when drawing borders at various points within entertainment, but are much less generally knowledgeable about, say pharmaceuticals. Another important issue is whether the industry is "new" or not. Michael Porter, Competitive strategy: Techniques for analyzing industries and competitors, NY: Free Press, 1980. See chapter 3 in Robert Grant, Contemporary strategy analysis (5th ed), Oxford, England: Blackwell. 2004. See Jay Barney, Gaining and sustaining competitive advantage, Reading, MA: AddisonWesley, 1997, pp 142 for a succinct discussion. "License" is an agreement between the owner of the intellectual property and some other firm(s), allowing the other firm(s) to use the property under certain conditions for a certain period of time. For example, in mid-July, 2002, Heinz announced a deal with the Del Monte Company in which Heinz agreed to sell a number of brands (and manufacturing facilities) to Del Monte. One of these is Star-Kist Tuna.
3. 4. 5. 6.
7.
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