Performing a Five-Forces Analysis  Internal Rivalry

 Entry

 Substitutes and Complements  Supplier and Buyer Power

 Strategies for Coping with the Five Forces 3) Coopetition and the Value Net

4) Applying the Five Forces: Some Industry Analyses  Hospital Markets Then and Now

 Commercial Airframe Manufacturing  Hawaiian Coffee

 Conclusion

5) Chapter Summary 6) Questions

Chapter Summary

The roots of the field of industry economics and market competition can be traced to the 1930s or earlier. However, they had little impact on business strategy until Michael Porter published a series of articles in the 1970s that culminated in his pathbreaking book Competitive Strategy. In his book, Porter presented a convenient framework for exploring the economic factors that affect the profits of an industry and classified these factors into five major forces. This chapter reviews the five-forces framework in the context of the economics of firms and industries. One assesses each force by asking “Is it sufficiently strong to reduce or eliminate industry profits?” Because the framework is comprehensive, the process of working through each of the five forces requires the systematic evaluation of all the significant economics factors affecting an industry. The five-forces framework does have several limitations: (1) it is not concerned with the magnitude or growth in demand, (2) it focuses on the entire industry, rather than on that industry’s individual firms, (3) it does not explicitly account for the role of the

government, and (4) it is only qualitative. The chapter further uses the five-forces framework to analyse three specific industries: hospitals, tobacco, and Hawaiian Coffee.

Approaches to Teaching this Chapter Purposes of the Framework

 Provides for assessment of industry profitability

 Identifies opportunities for success and threats to success  Provides basis for generating strategic choices

 Applies equally well to industrial and service sectors Internal Rivalry

Internal rivalry refers to the jockeying for share by firms in the market. As was discussed in Chapters 7-9, firms may compete on a number of price and nonprice dimensions. Do firm interactions erode profits? Fierce competition between firms within an industry can force prices downward toward costs, thereby eroding profits. Internal rivalry is likely to be a problem when:

 there are numerous or equally balanced competitors  slow industry growth

 high fixed costs or storage costs

 lack of differentiation or switching costs  capacity augmented in large increments  diverse competitors

 high strategic stakes-- how important is this industry?  high exit barriers

Barriers to Entry

Does the threat of entry erode profits? If entrants are not substantially differentiated from incumbents, then entry has two deleterious effects: 1)-market shares of incumbent firms fall and 2) competition to protect share leads to lower prices and therefore to lower profit margins. Entry is a key threat to the stability of markets in which there has been low internal rivalry. For example, an entrant may lower prices below “collusive” levels in order to penetrate the market. Earlier chapters discussed factors that affect the likelihood of entry and the ability of firms to deter entry. Entrants can be ignored if they are small, but failure to retaliate may invite more entry. Anything that makes it difficult for entry to occur is called an entry barrier. Barriers to entry are high when:  there are economies of scale

 product differentiation  capital requirements are high  there are switching costs

 access to distribution channels (for example, channel crowding)  cost disadvantages independent of scale

 proprietary product technology  favorable access to raw materials  favorable locations

 government subsidies  learning or experience curve  government policies

Substitutes and Complements

Do substitute/complement products threaten to erode profits? Substitute products have similar “product performance characteristics”, that is, they perform a similar function, at least to a certain extent. Substitute products have the same effect as entry, the distinction is more a matter of degree. Close substitutes lead to greater price rivalry and theft of market share than do weak substitutes. Substitute products pose the greatest threat when they represent new technologies that will benefit from a learning curve and may eventually prove superior to the technologies they substitute for. Complements boost demand for the product in question, thereby enhancing profit opportunities for the industry.

One must be wary of:

 trends which improve the price-performance of substitutes for the industry’s product

 substitutes produced by industries with higher profits than the industry under consideration

 trends which reduce the price-performance of complements to the industry’s product

Ask students for ideas on how to qualitatively describe a market. Some ideas include: 1) products have similar product performance characteristics (what the product does for the consumer), 2) products have similar occasions of use, and 3) products are sold in the same geographic market.

Ask students to give examples of substitute and complement products, i.e., What is a substitute for airline travel? Answers may include train, car, fax, depending on the distance of travel, relative prices and purpose of travel. What is a complement to airline travel? Answers may include hotels, taxis, and rental cars.

Buyer Power

Do buyers have sufficient power to threaten industry profits? High buyer power leads to intense internal rivalry since small price reductions can generate large gains in market share. Buyer power is high when:

 Buyer purchases a large volume relative to sellers’ sales

 Buyer’s purchases represent a significant fraction of the buyers’ total costs  Products purchased are standard or undifferentiated

 Buyer faces few switching costs

 Buyers pose a threat of backward integration

 Industry’s product is unimportant to the quality of the buyers’ output  Buyer has full information

Supplier Power

Do suppliers have sufficient power to threaten industry profits? Again, this is related to concentration and the ability to shop around. Supplier power is high when;

 Suppliers’ industry is dominated by few companies and is more concentrated than the industry it is selling to

industry

 The industry is not an important customer of the supplier industry

 The suppliers’ products are differentiated or it has built up switching costs  The supplier group poses threat of forward integration

The Value Net

The Value Net framework (attributed to Brandenberger and Nalebuff) addresses weaknesses of Porter’s five forces analysis. While Porter’s five forces framework focuses on the negative spillovers of a firm’s actions with respect to other firms, the Value Net captures the notion that some actions firms take have positive spillover effects on other firms in the industry. The Value Net, which consists of suppliers, customers, competitors, and complementors, assesses both threats and opportunities to the industry. The Value Net is, therefore, a complement to a five forces analysis. The chapter contains several excellent examples.

Students should be able to make the connection of buyer and supplier power to some of the concepts discussed in Chapter 3 and 4, for example:

 Contracting costs: Chapters 3 and 4 address why vertical integration might be a good alternative to market contacting. Indeed the degree to which vertical

integration reduces transactions costs and improves dispute resolution, adaptability, and repeated exchanges, it is often preferable to using market specialists. When market specialists are used, however, relative buyer/supplier power affects these issues and may raise the cost of exchange.

 Hold-up: As discussed in Chapter 4, the holdup problem raises the costs of exchange by increasing the amount of time and money parties spend in

negotiations, reducing trust in the relationship, encouraging “overinvestment”, or leading one party to threaten to refrain from making relationship-specific

investments. All of these behaviors affect the relative level of either buyer or supplier power.

 Switching costs: Can buyers/sellers switch to other firms? When a relationship involves relationship-specific assets, parties cannot switch trading partners costlessly. If you buyers have no options, then, you have supplier power. If the supplier has no options, then the buyer owns the power. This is discussed in Chapter 4.

 Forward or backward integration: The ability of a buyer to backward integrate or a supplier to forward integrate can reduce the power of their contracting party. Vertical integration is discussed primarily in Chapters 3 and 4.

Ask students to prepare thoughts on the following questions before the lecture:  Consider the industry you worked in before returning to (graduate) school. What

were the key forces shaping the nature of competition and the opportunities for making profit in that industry? What, if anything, did firms do to insulate themselves from these forces?

 A business consultant once argued that it is undesirable to enter industries that are easy to enter. Is there any wisdom in this advice? Why or why not?

Suggested Harvard Case Studies

Caterpillar HBS 9-385-276 (see earlier chapters)

Crown Cork and Seal, HBS 9-378-024, rev. 3/84. Describes the technical, economic, and competitive trends in the metal container industry. The strategy of Crown Cork and Seal is then described in relation to these trends. Potential threats to Crown’s future are outlined. This case could be used to introduce students to Porter’s five forces model, and as the case describes the production process a discussion about optimal scale is appropriate. You may want to ask students to think of the following questions in preparation for the case:

a) Perform a five forces analysis of the can manufacturing industry as of 1977. When possible, back up your analysis with information from the case.

b) Identify viable strategic positions in this industry. How important are economies of scale in this industry?

c) Identify the current strengths and weaknesses of CCS. What opportunities and threats does the current environment pose?

d) Does CSS have a strategic position? What is it? What do you think it should be? Prepare a mission statement for CCS based on the position you think it should adopt.

e) Identify concrete steps that Connelly should take to improve Crown’s position. Be sure to discuss the move to aluminum, the growth of environmentalism, and opportunities overseas. Try to develop as cohesive a plan as possible. Does your plan address the opportunities and threats identified by your economic analysis? Hudepohl Brewing Company HBS 9-381-092 (see earlier chapters)

Ingvar Komprad and IKEA HBS 9-390-132 (see earlier chapters)

Tombow Pencil Co., Ltd. (HBS # 9-692-011 and Teaching Note # 5-693-027): This case illustrates how another firm (in another country!) struggles with a similar make-or- buy problem. While the most prominent issues in the case are the "boundaries of the firm" questions, the case also raises issues related to product market competition and the role of product variety, marketing channels, and organizational issues involving the coordination of marketing, sales, and production inside Tombow. The case also presents the differences between Keiretsu (networks of long-term relationships) and arms-length market contracting. It introduces students to the idea that assignment of ownership rights can solve problems that arise due to physical asset specificity (hold-up, human asset specificity). As with Nucleon (see chapter 3), it shows that there are strong relationships between production strategy, product market strategy, and the make-or- buy decision. This case can be taught with some combination of the following chapters: 3, 4, 5, 11, 12, 15, and 16. You may want to ask students to think of the following questions in preparation for the case:

a) What is Tombow Pencil’s current financial position? Look at Tombow’s financial statement, and compare their financial ratios to Mitsubishi’s. In particular what would the impact be on Tombow’s profits if they could reduce their inventory/sales ratio to Mitubishi’s level?

b) Is the Japanese pencil industry profitable? Are there some segments that are more profitable than others?

c) Compare the vertical chains for wooden pencils and the Object EO pencil (which will be our metaphor for mechanical pencils in general). Are the differences in the vertical scope/vertical boundaries in these two chains consistent with the

underlying economics of make or buy decisions? Why does Ogawa feel the need to reexamine the production system for the EO pencil, given that Tombow’s vertical relationship have served them well for so long?

d) What recommendations would you make for Tombow? Consider both the market position (product line, quality, price point, etc.) the horizontal and vertical scope, and the organization of the company.

Extra Readings

It may be useful to distribute the following to students:

McGahan, A. “Selected Profitability Data on U.S. Industries and Companies”.

Porter, Michael, “How Competitive Forces Shape Strategy”, Harvard Business Review, March-April 1979.

Porter, Michael, A Note on the Structural Analysis of Industries, Boston: Harvard Business School, 1975.

Grant, R.M. “Notes on Key Success Factors”, excerpts from Contemporary Strategy

Analysis: Concepts, Techniques, Applications, Cambridge, MA: Blackwell Business,

Answers to End of Chapter Questions

1. It has been said that Porter’s five forces analysis turns antitrust law—law