Six components of macro environment

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chapter 3

Evaluating a Company’s External Environment

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Learning Objectives

This chapter will help you

LO 3-1 Recognize the factors in a company’s broad macro- environment that may have strategic significance.

LO 3-2 Use analytic tools to diagnose the competitive conditions in a company’s industry.

LO 3-3 Map the market positions of key groups of industry rivals.

LO 3-4 Determine whether an industry’s outlook presents a company with sufficiently attractive opportunities for growth and profitability.

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a basis for deciding on a long-term direction and developing a strategic vision). It then moves toward an evaluation of the most promising alternative strategies and business models, and finally culmi- nates in choosing a specific strategy.

This chapter presents the concepts and analytic tools for zeroing in on those aspects of a compa- ny’s external environment that should be consid- ered in making strategic choices. Attention centers on the broad environmental context, the specific market arena in which a company operates, the drivers of change, the positions and likely actions of rival companies, and key success factors. In Chapter 4, we explore the methods of evaluating a company’s internal circumstances and competitive capabilities.

In order to chart a company’s strategic course wisely, managers must first develop a deep under- standing of the company’s present situation. Two facets of a company’s situation are especially per- tinent: (1) its external environment—most nota- bly, the competitive conditions of the industry in which the company operates; and (2) its internal environment— particularly the company’s resources and organizational capabilities.

Insightful diagnosis of a company’s external and internal environments is a prerequisite for man- agers to succeed in crafting a strategy that is an excellent fit with the company’s situation—the first test of a winning strategy. As depicted in Figure 3.1, strategic thinking begins with an appraisal of the company’s external and internal environments (as

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Continued innovation is the best way to beat the competition.

Thomas A Edison—Inventor and Businessman

No matter what it takes, the goal of strategy is to beat the competition.

Kenichi Ohmae—Consultant and author

Sometimes by losing a battle you find a new way to win the war.

Donald Trump—President of the United States and founder of

Trump Entertainment Resorts

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50

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ANALYZING THE COMPANY’S MACRO-ENVIRONMENT

• LO 3-1 Recognize the factors in a company’s broad macro- environment that may have strate- gic significance.

FIGURE 3.1 From Analyzing the Company’s Situation to Choosing a Strategy

Identify promising strategic options for the

company

Select the best

strategy and

business model for the

company

Form a strategic vision of where the company needs to

head

Analyzing the company’s

external environment

Analyzing the company’s

internal environment

CORE CONCEPT The macro-environment encompasses the broad environmental context in which a company’s industry is situated.

Every company operates in a broad “macro-environment” that comprises six princi- pal components: political factors; economic conditions in the firm’s general environ- ment (local, country, regional, worldwide); sociocultural forces; technological factors; environmental factors (concerning the natural environment); and legal/regulatory con- ditions. Each of these components has the potential to affect the firm’s more immedi- ate industry and competitive environment, although some are likely to have a more important effect than others (see Figure 3.2). An analysis of the impact of these fac- tors is often referred to as PESTEL analysis, an acronym that serves as a reminder of the six components involved (Political, Economic, Sociocultural, Technological, Environmental, Legal/regulatory).

Since macro-economic factors affect different industries in different ways and to different degrees, it is important for managers to determine which of these represent the most strategically relevant factors outside the firm’s industry boundaries. By strategically relevant, we mean important enough to have a bearing on the decisions the company ultimately makes about its long-term direction, objectives, strategy, and business model. The impact of the outer-ring factors depicted in Figure 3.2 on a company’s choice of strategy can range from big to small. Those factors that are likely to a bigger impact deserve the closest attention. But even factors that have a low impact on the company’s business situation merit a watchful eye since their level of impact may change.

For example, when stringent new federal banking regulations are announced, banks must rapidly adapt their strategies and lending practices to be in compliance. Cigarette producers must adapt to new antismoking ordinances, the decisions of governments

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CHAPTER 3 Evaluating a Company’s External Environment 51

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CORE CONCEPT PESTEL analysis can be used to assess the stra- tegic relevance of the six principal components of the macro-environment: Political, Economic, Social, Technological, Environmental, and Legal/ Regulatory forces.

FIGURE 3.2 The Components of a Company’s Macro-Environment

Political Factors

MACRO-EN VIRONMENT

Economic Conditions

Legal/ Regulatory

Factors

Environmental Forces

Technological Factors

Sociocultural Forces

COMPANY

Producers of Substitute ProductsSuppliers

Rival Firms

New Entrants

Buyers

Imm edia

te In dustry an

d Competitive Environment

to impose higher cigarette taxes, the growing cultural stigma attached to smoking and newlyemerging e-cigarette technology. The homebuilding industry is affected by such macro-influences as trends in household incomes and buying power, rules and regulations that make it easier or harder for homebuyers to obtain mortgages, changes in mortgage interest rates, shifting preferences of families for renting versus owning a home, and shifts in buyer preferences for homes of various sizes, styles, and price ranges. Companies in the food processing, restaurant, sports, and fitness indus- tries have to pay special attention to changes in lifestyles, eating habits, leisure-time preferences, and attitudes toward nutrition and fitness in fashioning their strategies. Table 3.1 provides a brief description of the components of the macro-environment and some examples of the industries or business situations that they might affect.

As company managers scan the external environment, they must be alert for potentially important outer-ring developments, assess their impact and influence, and adapt the company’s direction and strategy as needed. However, the factors in a

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Component Description

Political factors Pertinent political factors include matters such as tax policy, fiscal policy, tariffs, the political climate, and the strength of institutions such as the federal banking system. Some political policies affect certain types of industries more than others. An example is energy policy, which clearly affects energy producers and heavy users of energy more than other types of businesses.

Economic conditions Economic conditions include the general economic climate and specific factors such as interest rates, exchange rates, the inflation rate, the unemployment rate, the rate of economic growth, trade deficits or surpluses, savings rates, and per-capita domestic product. Some industries, such as construction, are particularly vulnerable to economic downturns but are positively affected by factors such as low interest rates. Others, such as discount retailing, benefit when general economic conditions weaken, as consumers become more price-conscious.

Sociocultural forces Sociocultural forces include the societal values, attitudes, cultural influences, and lifestyles that impact demand for particular goods and services, as well as demographic factors such as the population size, growth rate, and age distribution. Sociocultural forces vary by locale and change over time. An example is the trend toward healthier lifestyles, which can shift spending toward exercise equipment and health clubs and away from alcohol and snack foods. The demographic effect of people living longer is having a huge impact on the health care, nursing homes, travel, hospitality, and entertainment industries.

Technological factors Technological factors include the pace of technological change and technical developments that have the potential for wide-ranging effects on society, such as genetic engineering, nanotechnology, and solar energy technology. They include institutions involved in creating new knowledge and controlling the use of technology, such as R&D consortia, university- sponsored technology incubators, patent and copyright laws, and government control over the Internet. Technological change can encourage the birth of new industries, such as drones, virtual reality technology, and connected wearable devices. They can disrupt others, as cloud computing, 3-D printing, and big data solution have done, and they can render other industries obsolete (film cameras, music CDs).

Environmental forces These include ecological and environmental forces such as weather, climate, climate change, and associated factors like flooding, fire, and water shortages. These factors can directly impact industries such as insurance, farming, energy production, and tourism. They may have an indirect but substantial effect on other industries such as transportation and utilities. The relevance of environmental considerations stems from the fact that some industries contribute more significantly than others to air and water pollution or to the depletion of irreplaceable natural resources, or to inefficient energy/resource usage, or are closely associated with other types of environmentally damaging activities (unsustainable agricultural practices, the creation of waste products that are not recyclable or biodegradable). Growing numbers of companies worldwide, in response to stricter environmental regulations and also to mounting public concerns about the environment, are implementing actions to operate in a more environmentally and ecologically responsible manner.

Legal and regulatory factors

These factors include the regulations and laws with which companies must comply, such as consumer laws, labor laws, antitrust laws, and occupational health and safety regulation. Some factors, such as financial services regulation, are industry-specific. Others affect certain types of industries more than others. For example, minimum wage legislation largely impacts low-wage industries (such as nursing homes and fast food restaurants) that employ substantial numbers of relatively unskilled workers. Companies in coal-mining, meat-packing, and steel-making, where many jobs are hazardous or carry high risk of injury, are much more impacted by occupational safety regulations than are companies in industries such as retailing or software programming.

TABLE 3.1 The Six Components of the Macro-Environment

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company’s environment having the greatest strategy-shaping impact typically pertain to the company’s immediate industry and competitive environment. Consequently, it is on a company’s industry and competitive environment (depicted in the center of Figure 3.2) that we concentrate the bulk of our attention in this chapter.

ASSESSING THE COMPANY’S INDUSTRY AND COMPETITIVE ENVIRONMENT Thinking strategically about a company’s industry and competitive environment entails using some well-validated concepts and analytic tools. These include the five forces framework, the value net, driving forces, strategic groups, competitor analy- sis, and key success factors. Proper use of these analytic tools can provide managers with the understanding needed to craft a strategy that fits the company’s situa- tion within their industry environment. The remainder of this chapter is devoted to describing how managers can use these tools to inform and improve their strategic choices.

• LO 3-2 Use analytic tools to diagnose the competitive conditions in a company’s industry.

The character and strength of the competitive forces operating in an industry are never the same from one industry to another. The most powerful and widely used tool for diagnosing the principal competitive pressures in a market is the five forces framework.1 This framework, depicted in Figure 3.3, holds that competitive pressures on compa- nies within an industry come from five sources. These include (1) competition from rival sellers, (2) competition from potential new entrants to the industry, (3) competition from producers of substitute products, (4) supplier bargaining power, and (5) customer bargaining power.

Using the five forces model to determine the nature and strength of competitive pressures in a given industry involves three steps:

• Step 1: For each of the five forces, identify the different parties involved, along with the specific factors that bring about competitive pressures.

• Step 2: Evaluate how strong the pressures stemming from each of the five forces are (strong, moderate, or weak).

• Step 3: Determine whether the five forces, overall, are supportive of high industry profitability.

Competitive Pressures Created by the Rivalry among Competing Sellers The strongest of the five competitive forces is often the rivalry for buyer patronage among competing sellers of a product or service. The intensity of rivalry among com- peting sellers within an industry depends on a number of identifiable factors. Figure 3.4 summarizes these factors, identifying those that intensify or weaken rivalry among direct competitors in an industry. A brief explanation of why these factors affect the degree of rivalry is in order:

THE FIVE FORCES FRAMEWORK

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FIGURE 3.3 The Five Forces Model of Competition: A Key Analytic Tool

Buyers

Competitive pressures stemming

from supplier bargaining

power

Competitive pressures coming from other firms in

the industry

Competitive pressures coming from the threat of entry of new rivals

Competitive pressures stemming from buyer bargaining

power

Potential New Entrants

Firms in Other Industries O�ering Substitute Products

Rivalry among Competing

Sellers

Competitive pressures coming from the producers of substitute

products

Suppliers

Sources: Adapted from M. E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (1979), pp. 137–145; M. E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no. 1 (2008), pp. 80–86.

• Rivalry increases when buyer demand is growing slowly or declining. Rapidly expand- ing buyer demand produces enough new business for all industry members to grow without having to draw customers away from rival enterprises. But in markets where buyer demand is slow-growing or shrinking, companies eager to gain more business are likely to engage in aggressive price discounting, sales promotions, and other tactics to increase their sales volumes at the expense of rivals, sometimes to the point of igniting a fierce battle for market share.

• Rivalry increases as it becomes less costly for buyers to switch brands. The less costly (or easier) it is for buyers to switch their purchases from one seller to another, the easier it is for sellers to steal customers away from rivals. When the cost of

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FIGURE 3.4 Factors Affecting the Strength of Rivalry

Suppliers

Rivalry among Competing Sellers

Rivalry increases and becomes a stronger force when:

Rivalry decreases and becomes a weaker force under the opposite conditions.

Substitutes

New Entrants

Buyers

• Buyer demand is growing slowly or declining. • Buyer costs to switch brands are low. • The products of industry members are commodities or else weakly di�erentiated. • The firms in the industry have excess production capacity and/or inventory. • The firms in the industry have high fixed costs or high storage costs. • Competitors are numerous or are of roughly equal size and competitive strength. • Rivals have diverse objectives, strategies, and/or countries of origin. • Rivals have emotional stakes in the business or face high exit barriers.

switching brands is higher, buyers are less prone to brand switching and sellers have protection from rivalrous moves. Switching costs include not only monetary costs but also the time, inconvenience, and psychological costs involved in switch- ing brands. For example, retailers may not switch to the brands of rival manufactur- ers because they are hesitant to sever long-standing supplier relationships or incur the additional expense of retraining employees, accessing technical support, or test- ing the quality and reliability of the new brand. Consumers may not switch brands because they become emotionally attached to a particular brand (e.g. if you identify with the Harley motorcycle brand and lifestyle).

• Rivalry increases as the products of rival sellers become less strongly differentiated. When the offerings of rivals are identical or weakly differentiated, buyers have less reason to be brand-loyal—a condition that makes it easier for rivals to convince buyers to switch to their offerings. Moreover, when the products of different sellers are virtu- ally identical, shoppers will choose on the basis of price, which can result in fierce price competition among sellers. On the other hand, strongly differentiated product offerings among rivals breed high brand loyalty on the part of buyers who view the attributes of certain brands as more appealing or better suited to their needs.

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• Rivalry is more intense when industry members have too much inventory or sig- nificant amounts of idle production capacity, especially if the industry’s product entails high fixed costs or high storage costs. Whenever a market has excess sup- ply (overproduction relative to demand), rivalry intensifies as sellers cut prices in a desperate effort to cope with the unsold inventory. A similar effect occurs when a product is perishable or seasonal, since firms often engage in aggressive price cutting to ensure that everything is sold. Likewise, whenever fixed costs account for a large fraction of total cost so that unit costs are significantly lower at full capacity, firms come under significant pressure to cut prices whenever they are operating below full capacity. Unused capacity imposes a significant cost-increasing penalty because there are fewer units over which to spread fixed costs. The pressure of high fixed or high storage costs can push rival firms into offering price concessions, special discounts, and rebates and employing other volume-boosting competitive tactics.

• Rivalry intensifies as the number of competitors increases and they become more equal in size and capability. When there are many competitors in a market, companies eager to increase their meager market share often engage in price-cutting activities to drive sales, leading to intense rivalry. When there are only a few competitors, companies are more wary of how their rivals may react to their attempts to take market share away from them. Fear of retaliation and a descent into a damaging price war leads to restrained competitive moves. Moreover, when rivals are of com- parable size and competitive strength, they can usually compete on a fairly equal footing—an evenly matched contest tends to be fiercer than a contest in which one or more industry members have commanding market shares and substantially greater resources than their much smaller rivals.

• Rivalry becomes more intense as the diversity of competitors increases in terms of long-term directions, objectives, strategies, and countries of origin. A diverse group of sellers often contains one or more mavericks willing to try novel or rule-breaking market approaches, thus generating a more volatile and less predictable competi- tive environment. Globally competitive markets are often more rivalrous, especially when aggressors have lower costs and are intent on gaining a strong foothold in new country markets.

• Rivalry is stronger when high exit barriers keep unprofitable firms from leaving the industry. In industries where the assets cannot easily be sold or transferred to other uses, where workers are entitled to job protection, or where owners are commit- ted to remaining in business for personal reasons, failing firms tend to hold on longer than they might otherwise—even when they are bleeding red ink. Deep price discounting typically ensues, in a desperate effort to cover costs and remain in busi- ness. This sort of rivalry can destabilize an otherwise attractive industry.

The previous factors, taken as whole, determine whether the rivalry in an industry is relatively strong, moderate, or weak. When rivalry is strong, the battle for market share is generally so vigorous that the profit margins of most industry members are squeezed to bare-bones levels. When rivalry is moderate, a more normal state, the maneuvering among industry members, while lively and healthy, still allows most industry members to earn acceptable profits. When rivalry is weak, most companies in the industry are relatively well satisfied with their sales growth and market shares and rarely undertake offensives to steal customers away from one another. Weak rivalry means that there is no downward pressure on industry profitability due to this particular competitive force.

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The Choice of Competitive Weapons Competitive battles among rival sellers can assume many forms that extend well beyond lively price competition. For example, competitors may resort to such marketing tactics as special sales promotions, heavy advertising, rebates, or low-interest-rate financing to drum up additional sales. Rivals may race one another to differentiate their products by offering better performance features or higher quality or improved customer service or a wider product selection. They may also compete through the rapid introduction of next-generation products, the frequent introduction of new or improved products, and efforts to build stronger dealer networks, establish positions in foreign markets, or otherwise expand distribution capabilities and market presence. Table 3.2 displays the competitive weapons that firms often employ in battling rivals, along with their primary effects with respect to price (P), cost (C), and value (V)—the elements of an effective business model and the value-price-cost framework, discussed in Chapter 1.

Competitive Pressures Associated with the Threat of New Entrants New entrants into an industry threaten the position of rival firms since they will com- pete fiercely for market share, add to the number of industry rivals, and add to the industry’s production capacity in the process. But even the threat of new entry puts added competitive pressure on current industry members and thus functions as an important competitive force. This is because credible threat of entry often prompts industry members to lower their prices and initiate defensive actions in an attempt

Types of Competitive Weapons Primary Effects

Discounting prices, holding clearance sales

Lowers price (P), increases total sales volume and market share, lowers profits if price cuts are not offset by large increases in sales volume

Offering coupons, advertising items on sale

Increases sales volume and total revenues, lowers price (P), increases unit costs (C), may lower profit margins per unit sold (P – C)

Advertising product or service characteristics, using ads to enhance a company’s image

Boosts buyer demand, increases product differentiation and perceived value (V), increases total sales volume and market share, but may increase unit costs (C) and lower profit margins per unit sold

Innovating to improve product performance and quality

Increases product differentiation and value (V), boosts buyer demand, boosts total sales volume, likely to increase unit costs (C)

Introducing new or improved features, increasing the number of styles to provide greater product selection

Increases product differentiation and value (V), strengthens buyer demand, boosts total sales volume and market share, likely to increase unit costs (C)

Increasing customization of product or service

Increases product differentiation and value (V), increases buyer switching costs, boosts total sales volume, often increases unit costs (C)

Building a bigger, better dealer network

Broadens access to buyers, boosts total sales volume and market share, may increase unit costs (C)

Improving warranties, offering low- interest financing

Increases product differentiation and value (V), increases unit costs (C), increases buyer switching costs, boosts total sales volume and market share

TABLE 3.2 Common “Weapons” for Competing with Rivals

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to deter new entrants. Just how serious the threat of entry is in a particular market depends on (1) whether entry barriers are high or low, and (2) the expected reaction of existing industry members to the entry of newcomers.

Whether Entry Barriers Are High or Low The strength of the threat of entry is governed to a large degree by the height of the industry’s entry barriers. High barriers reduce the threat of potential entry, whereas low barriers enable easier entry. Entry bar- riers are high under the following conditions:2

• There are sizable economies of scale in production, distribution, advertising, or other activities. When incumbent companies enjoy cost advantages associated with large- scale operations, outsiders must either enter on a large scale (a costly and perhaps risky move) or accept a cost disadvantage and consequently lower profitability.

• Incumbents have other hard to replicate cost advantages over new entrants. Aside from enjoying economies of scale, industry incumbents can have cost advantages that stem from the possession of patents or proprietary technology, exclusive partner- ships with the best and cheapest suppliers, favorable locations, and low fixed costs (because they have older facilities that have been mostly depreciated). Learning- based cost savings can also accrue from experience in performing certain activi- ties such as manufacturing or new product development or inventory management. The extent of such savings can be measured with learning/experience curves. The steeper the learning/experience curve, the bigger the cost advantage of the com- pany with the largest cumulative production volume. The microprocessor industry provides an excellent example of this:

Manufacturing unit costs for microprocessors tend to decline about 20 percent each time cumu- lative production volume doubles. With a 20 percent experience curve effect, if the first 1 million chips cost $100 each, once production volume reaches 2 million, the unit cost would fall to $80 (80 percent of $100), and by a production volume of 4 million, the unit cost would be $64 (80 percent of $80).3

• Customers have strong brand preferences and high degrees of loyalty to seller. The stronger the attachment of buyers to established brands, the harder it is for a new- comer to break into the marketplace. In such cases, a new entrant must have the financial resources to spend enough on advertising and sales promotion to over- come customer loyalties and build its own clientele. Establishing brand recognition and building customer loyalty can be a slow and costly process. In addition, if it is difficult or costly for a customer to switch to a new brand, a new entrant may have to offer a discounted price or otherwise persuade buyers that its brand is worth the switching costs. Such barriers discourage new entry because they act to boost financial requirements and lower expected profit margins for new entrants.

• Patents and other forms of intellectual property protection are in place. In a number of industries, entry is prevented due to the existence of intellectual property protec- tion laws that remain in place for a given number of years. Often, companies have a “wall of patents” in place to prevent other companies from entering with a “me too” strategy that replicates a key piece of technology.

• There are strong “network effects” in customer demand. In industries where buyers are more attracted to a product when there are many other users of the product, there are said to be “network effects,” since demand is higher the larger the net- work of users. Video game systems are an example because users prefer to have the same systems as their friends so that they can play together on systems they all

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know and can share games. When incumbents have a large existing base of users, new entrants with otherwise comparable products face a serious disadvantage in attracting buyers.

• Capital requirements are high. The larger the total dollar investment needed to enter the market successfully, the more limited the pool of potential entrants. The most obvious capital requirements for new entrants relate to manufacturing facilities and equipment, introductory advertising and sales promotion campaigns, working capital to finance inventories and customer credit, and sufficient cash to cover startup costs.

• There are difficulties in building a network of distributors/dealers or in securing adequate space on retailers’ shelves. A potential entrant can face numerous distribution-channel challenges. Wholesale distributors may be reluctant to take on a product that lacks buyer recognition. Retailers must be recruited and convinced to give a new brand ample display space and an adequate trial period. When existing sellers have strong, well-functioning distributor–dealer networks, a newcomer has an uphill struggle in squeezing its way into existing distribution channels. Potential entrants sometimes have to “buy” their way into wholesale or retail channels by cutting their prices to provide dealers and distributors with higher markups and profit margins or by giv- ing them big advertising and promotional allowances. As a consequence, a potential entrant’s own profits may be squeezed unless and until its product gains enough con- sumer acceptance that distributors and retailers are willing to carry it.

• There are restrictive regulatory policies. Regulated industries like cable TV, tele- communications, electric and gas utilities, radio and television broadcasting, liquor retailing, nuclear power, and railroads entail government-controlled entry. Government agencies can also limit or even bar entry by requiring licenses and permits, such as the medallion required to drive a taxicab in New York City. Government-mandated safety regulations and environmental pollution standards also create entry barriers because they raise entry costs. Recently enacted banking regulations in many countries have made entry particularly difficult for small new bank startups—complying with all the new regulations along with the rigors of com- peting against existing banks requires very deep pockets.

• There are restrictive trade policies. In international markets, host governments com- monly limit foreign entry and must approve all foreign investment applications. National governments commonly use tariffs and trade restrictions (antidumping rules, local content requirements, quotas, etc.) to raise entry barriers for foreign firms and protect domestic producers from outside competition.

The Expected Reaction of Industry Members in Defending against New Entry  A second factor affecting the threat of entry relates to the ability and willingness of indus- try incumbents to launch strong defensive maneuvers to maintain their positions and make it harder for a newcomer to compete successfully and profitably. Entry candidates may have second thoughts about attempting entry if they conclude that existing firms will mount well-funded campaigns to hamper (or even defeat) a newcomer’s attempt to gain a market foothold big enough to compete successfully. Such campaigns can include any of the “competitive weapons” listed in Table 3.2, such as ramping up advertising expenditures, offering special price discounts to the very customers a newcomer is seek- ing to attract, or adding attractive new product features (to match or beat the newcomer’s product offering). Such actions can raise a newcomer’s cost of entry along with the risk of failing, making the prospect of entry less appealing. The result is that even the expectation on the part of new entrants that industry incumbents will contest a newcomer’s entry may

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be enough to dissuade entry candidates from going forward. Microsoft can be counted on to fiercely defend the position that Windows enjoys in computer operating systems and that Microsoft Office has in office productivity software. This may well have contributed to Microsoft’s ability to continuously dominate this market space.

However, there are occasions when industry incumbents have nothing in their com- petitive arsenal that is formidable enough to either discourage entry or put obstacles in a newcomer’s path that will defeat its strategic efforts to become a viable competitor. In the restaurant industry, for example, existing restaurants in a given geographic market have few actions they can take to discourage a new restaurant from opening or to block it from attracting enough patrons to be profitable. A fierce competitor like Nike was unable to prevent newcomer Under Armour from rapidly growing its sales and market share in sports apparel. Furthermore, there are occasions when industry incumbents can be expected to refrain from taking or initiating any actions specifically aimed at contesting a newcomer’s entry. In large industries, entry by small startup enterprises normally poses no immediate or direct competitive threat to industry incumbents and their entry is not likely to provoke defensive actions. For instance, a new online retailer with sales prospects of maybe $5 to $10 million annually can reasonably expect to escape competitive retaliation from much larger online retailers selling similar goods. The less that a newcomer’s entry will adversely impact the sales and profitability of industry incumbents, the more reasonable it is for potential entrants to expect industry

incumbents to refrain from reacting defensively. Figure 3.5 summarizes the factors that cause the overall competitive pressure

from potential entrants to be strong or weak. An analysis of these factors can help managers determine whether the threat of entry into their industry is high or low, in general. But certain kinds of companies—those with sizable financial resources, proven competitive capabilities, and a respected brand name—may be able to hurdle an industry’s entry barriers even when they are high.4 For example, when Honda opted to enter the U.S. lawn-mower market in competition against Toro, Snapper, Craftsman, John Deere, and others, it was easily able to hurdle entry barriers that would have been formidable to other newcomers because it had long-standing

expertise in gasoline engines and a reputation for quality and durability in automobiles that gave it instant credibility with homeowners. As a result, Honda had to spend rela- tively little on inducing dealers to handle the Honda lawn-mower line or attracting cus- tomers. Similarly, Samsung’s brand reputation in televisions, DVD players, and other electronics products gave it strong credibility in entering the market for smartphones—

Samsung’s Galaxy smartphones are now a formidable rival of Apple’s iPhone. It is also important to recognize that the barriers to entering an industry can

become stronger or weaker over time. For example, once key patents preventing new entry in the market for functional 3-D printers expired, the way was open for new competition to enter this industry. On the other hand, new strategic actions by incumbent firms to increase advertising, strengthen distributor–dealer relations, step up R&D, or improve product quality can erect higher roadblocks to entry.

Competitive Pressures from the Sellers of Substitute Products Companies in one industry are vulnerable to competitive pressure from the actions of companies in a closely adjoining industry whenever buyers view the products of the two industries as good substitutes. Substitutes do not include other brands within your

Even high entry barriers may not suffice to keep out certain kinds of entrants: those with resources and capabilities that enable them to leap over or bypass the barriers.

High entry barriers and weak entry threats today do not always translate into high entry barriers and weak entry threats tomorrow.

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FIGURE 3.5 Factors Affecting the Threat of Entry

Rivalry among

Competing Sellers

Buyers

Substitutes

Suppliers

Competitive Pressures from Potential Entrants

Threat of entry is a stronger force when (1) incumbents are unlikely to make retaliatory moves against new entrants and (2) entry barriers are low. Entry barriers are high (and threat of entry is low) when • Incumbents have large cost advantages over potential entrants due to − High economies of scale − Significant experience-based cost advantages or learning curve e�ects − Other cost advantages (e.g., favorable access to inputs, technology, location, or low fixed costs) • Customers with strong brand preferences and/or loyalty to incumbent sellers • Patents and other forms of intellectual property protection • Strong network e�ects • High capital requirements • Limited new access to distribution channels and shelf space • Restrictive government policies • Restrictive trade policies

industry; this type of pressure comes from outside the industry. Substitute products from outside the industry are those that can perform the same or similar functions for the consumer as products within your industry. For instance, the producers of eye- glasses and contact lenses face competitive pressures from the doctors who do correc- tive laser surgery. Similarly, the producers of sugar experience competitive pressures from the producers of sugar substitutes (high-fructose corn syrup, agave syrup, and artificial sweeteners). Internet providers of news-related information have put brutal competitive pressure on the publishers of newspapers. The makers of smartphones, by building ever better cameras into their cell phones, have cut deeply into the sales of producers of handheld digital cameras—most smartphone owners now use their phone to take pictures rather than carrying a digital camera for picture-taking purposes.

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As depicted in Figure 3.6, three factors determine whether the competitive pressures from substitute products are strong or weak. Competitive pressures are stronger when

1. Good substitutes are readily available and attractively priced. The presence of readily available and attractively priced substitutes creates competitive pressure by placing a ceiling on the prices industry members can charge without risking sales erosion. This price ceiling, at the same time, puts a lid on the profits that industry members can earn unless they find ways to cut costs.

2. Buyers view the substitutes as comparable or better in terms of quality, performance, and other relevant attributes. The availability of substitutes inevitably invites custom- ers to compare performance, features, ease of use, and other attributes besides price. The users of paper cartons constantly weigh the price-performance trade-offs

FIGURE 3.6 Factors Affecting Competition from Substitute Products

Firms in Other Industries O�ering Substitute Products

Competitive pressures from substitutes are stronger when

• Good substitutes are readily available and attractively priced. • Substitutes have comparable or better performance features. • Buyers have low costs in switching to substitutes.

Competitive pressures from substitutes are weaker under the opposite conditions.

Suppliers Buyers

Rivalry among

Competing Sellers

New Entrants

Indicators of increasing competitive strength among substitutes

• Sales of substitutes are growing faster than sales of the industry being analyzed.

• Producers of substitutes are moving to add new capacity.

• Profits of the producers of substitutes are on the rise.

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with plastic containers and metal cans, for example. Movie enthusiasts are increas- ingly weighing whether to go to movie theaters to watch newly released movies or wait until they can watch the same movies streamed to their home TV by Netflix, Amazon Prime, cable providers, and other on-demand sources.

3. The costs that buyers incur in switching to the substitutes are low. Low switching costs make it easier for the sellers of attractive substitutes to lure buyers to their offer- ings; high switching costs deter buyers from purchasing substitute products.

Some signs that the competitive strength of substitute products is increasing include (1) whether the sales of substitutes are growing faster than the sales of the industry being analyzed, (2) whether the producers of substitutes are investing in added capacity, and (3) whether the producers of substitutes are earning progressively higher profits.

But before assessing the competitive pressures coming from substitutes, com- pany managers must identify the substitutes, which is less easy than it sounds since it involves (1) determining where the industry boundaries lie and (2) figuring out which other products or services can address the same basic customer needs as those pro- duced by industry members. Deciding on the industry boundaries is necessary for determining which firms are direct rivals and which produce substitutes. This is a mat- ter of perspective—there are no hard-and-fast rules, other than to say that other brands of the same basic product constitute rival products and not substitutes. Ultimately, it’s simply the buyer who decides what can serve as a good substitute.

Competitive Pressures Stemming from Supplier Bargaining Power Whether the suppliers of industry members represent a weak or strong competitive force depends on the degree to which suppliers have sufficient bargaining power to influence the terms and conditions of supply in their favor. Suppliers with strong bargaining power are a source of competitive pressure because of their ability to charge industry members higher prices, pass costs on to them, and limit their opportunities to find better deals. For instance, Microsoft and Intel, both of which supply PC makers with essential com- ponents, have been known to use their dominant market status not only to charge PC makers premium prices but also to leverage their power over PC makers in other ways. The bargaining power of these two companies over their customers is so great that both companies have faced antitrust charges on numerous occasions. Prior to a legal agree- ment ending the practice, Microsoft pressured PC makers to load only Microsoft prod- ucts on the PCs they shipped. Intel has defended itself against similar antitrust charges, but in filling orders for newly introduced Intel chips, it continues to give top priority to PC makers that use the biggest percentages of Intel chips in their PC models. Being on Intel’s list of preferred customers helps a PC maker get an early allocation of Intel’s latest chips and thus allows the PC maker to get new models to market ahead of rivals.

Small-scale retailers often must contend with the power of manufacturers whose products enjoy well-known brand names, since consumers expect to find these prod- ucts on the shelves of the retail stores where they shop. This provides the manufacturer with a degree of pricing power and often the ability to push hard for favorable shelf dis- plays. Supplier bargaining power is also a competitive factor in industries where unions have been able to organize the workforce (which supplies labor). Air pilot unions, for example, have employed their bargaining power to increase pilots’ wages and benefits in the air transport industry. The growing clout of the largest healthcare union in the United States has led to better wages and working conditions in nursing homes.

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As shown in Figure 3.7, a variety of factors determine the strength of suppliers’ bargaining power. Supplier power is stronger when

• Demand for suppliers’ products is high and the products are in short supply. A surge in the demand for particular items shifts the bargaining power to the suppliers of those products; suppliers of items in short supply have pricing power.

• Suppliers provide differentiated inputs that enhance the performance of the industry’s product. The more valuable a particular input is in terms of enhancing the per- formance or quality of the products of industry members, the more bargaining leverage suppliers have. In contrast, the suppliers of commodities are in a weak bargaining position, since industry members have no reason other than price to prefer one supplier over another.

• It is difficult or costly for industry members to switch their purchases from one supplier to another. Low switching costs limit supplier bargaining power by enabling indus- try members to change suppliers if any one supplier attempts to raise prices by more than the costs of switching. Thus, the higher the switching costs of industry members, the stronger the bargaining power of their suppliers.

• The supplier industry is dominated by a few large companies and it is more concen- trated than the industry it sells to. Suppliers with sizable market shares and strong demand for the items they supply generally have sufficient bargaining power to charge high prices and deny requests from industry members for lower prices or other concessions.

FIGURE 3.7 Factors Affecting the Bargaining Power of Suppliers

Suppliers

Supplier bargaining power is stronger when • Suppliers’ products and/or services are in short supply. • Suppliers’ products and/or services are di�erentiated. • Industry members incur high costs in switching their purchases to alternative suppliers. • The supplier industry is more concentrated than the industry it sells to and is dominated by a few large companies. • Industry members do not have the potential to integrate backward in order to self-manufacture their own inputs. • Suppliers’ products do not account for more than a small fraction of the total costs of the industry‘s products. • There are no good substitutes for what the suppliers provide. • Industry members do not account for a big fraction of suppliers’ sales.

Supplier bargaining power is weaker under the opposite conditions.

Buyers

Rivalry among

Competing Sellers

New Entrants

Substitutes

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• Industry members are incapable of integrating backward to self-manufacture items they have been buying from suppliers. As a rule, suppliers are safe from the threat of self-manufacture by their customers until the volume of parts a customer needs becomes large enough for the customer to justify backward integration into self- manufacture of the component. When industry members can threaten credibly to self-manufacture suppliers’ goods, their bargaining power over suppliers increases proportionately.

• Suppliers provide an item that accounts for no more than a small fraction of the costs of the industry’s product. The more that the cost of a particular part or component affects the final product’s cost, the more that industry members will be sensitive to the actions of suppliers to raise or lower their prices. When an input accounts for only a small proportion of total input costs, buyers will be less sensitive to price increases. Thus, suppliers’ power increases when the inputs they provide do not make up a large proportion of the cost of the final product.

• Good substitutes are not available for the suppliers’ products. The lack of readily avail- able substitute inputs increases the bargaining power of suppliers by increasing the dependence of industry members on the suppliers.

• Industry members are not major customers of suppliers. As a rule, suppliers have less bargaining leverage when their sales to members of the industry constitute a big percentage of their total sales. In such cases, the well-being of suppliers is closely tied to the well-being of their major customers, and their dependence upon them increases. The bargaining power of suppliers is stronger, then, when they are not bargaining with major customers.

In identifying the degree of supplier power in an industry, it is important to recog- nize that different types of suppliers are likely to have different amounts of bargaining power. Thus, the first step is for managers to identify the different types of suppliers, paying particular attention to those that provide the industry with important inputs. The next step is to assess the bargaining power of each type of supplier separately.

Competitive Pressures Stemming from Buyer Bargaining Power and Price Sensitivity Whether buyers are able to exert strong competitive pressures on industry members depends on (1) the degree to which buyers have bargaining power and (2) the extent to which buyers are price-sensitive. Buyers with strong bargaining power can limit indus- try profitability by demanding price concessions, better payment terms, or additional features and services that increase industry members’ costs. Buyer price sensitivity limits the profit potential of industry members by restricting the ability of sellers to raise prices without losing revenue due to lost sales.

As with suppliers, the leverage that buyers have in negotiating favorable terms of sale can range from weak to strong. Individual consumers seldom have much bar- gaining power in negotiating price concessions or other favorable terms with sell- ers. However, their price sensitivity varies by individual and by the type of product they are buying (whether it’s a necessity or a discretionary purchase, for example). Similarly, small businesses usually have weak bargaining power because of the small- size orders they place with sellers. Many relatively small wholesalers and retailers join buying groups to pool their purchasing power and approach manufacturers for better terms than could be gotten individually. Large business buyers, in con- trast, can have considerable bargaining power. For example, large retail chains like

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Walmart, Best Buy, Staples, and Home Depot typically have considerable bargaining power in purchasing products from manufacturers, not only because they buy in large quantities, but also because of manufacturers’ need for access to their broad base of customers. Major supermarket chains like Kroger, Albertsons, Hannaford, and Aldi have sufficient bargaining power to demand promotional allowances and lump-sum payments (called slotting fees) from food products manufacturers in return for stock- ing certain brands or putting them in the best shelf locations. Motor vehicle manu- facturers have strong bargaining power in negotiating to buy original-equipment tires from tire makers such as Bridgestone, Goodyear, Michelin, Continental, and Pirelli, partly because they buy in large quantities and partly because consumers are more likely to buy replacement tires that match the tire brand on their vehicle at the time of its purchase. The starting point for the analysis of buyers as a competitive force is to identify the different types of buyers along the value chain—then proceed to analyzing the bargaining power and price sensitivity of each type separately. It is important to recognize that not all buyers of an industry’s product have equal degrees of bargaining power with sellers, and some may be less sensitive than others to price, quality, or service differences.

Figure 3.8 summarizes the factors determining the strength of buyer power in an industry. The top of this chart lists the factors that increase buyers’ bargaining power,

FIGURE 3.8 Factors Affecting the Power of Buyers

Buyers

Competitive pressures from buyers increase when they have strong bargaining power and are price- sensitive.

Buyer bargaining power is stronger when

• Buyer demand is weak in relation to industry supply. • The industry’s products are standardized or undi�erentiated. • Buyer costs of switching to competing products are low. • Buyers are large and few in number relative to the number of industry sellers. • Buyers pose a credible threat of integrating backward into the business of sellers. • Buyers are well informed about the quality, prices, and costs of sellers. • Buyers have the ability to postpone purchases.

Buyers are price-sensitive when

• Buyers earn low profits or low income. • The product represents a significant fraction of their purchases. • The product is undi�erentiated or quality is not an important factor.

Competitive pressures from buyers decrease under the opposite conditions.

Rivalry among

Competing Sellers

Suppliers

Substitutes

New Entrants

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which we discuss next. Note that the first five factors are the mirror image of those determining the bargaining power of suppliers.

Buyer bargaining power is stronger when

• Buyer demand is weak in relation to the available supply. Weak or declining demand and the resulting excess supply create a “buyers’ market,” in which bargain-hunting buyers have leverage in pressing industry members for better deals and special treatment. Conversely, strong or rapidly growing market demand creates a “sellers’ market” characterized by tight supplies or shortages—conditions that put buyers in a weak position to wring concessions from industry members.

• Industry goods are standardized or differentiation is weak. In such circumstances, buyers make their selections on the basis of price, which increases price competi- tion among vendors.

• Buyers’ costs of switching to competing brands or substitutes are relatively low. Switching costs put a cap on how much industry producers can raise prices or reduce quality before they will lose the buyer’s business.

• Buyers are large and few in number relative to the number of sellers. The larger the buyers, the more important their business is to the seller and the more sellers will be willing to grant concessions.

• Buyers pose a credible threat of integrating backward into the business of sellers. Beer producers like Anheuser Busch InBev SA/NV (whose brands include Budweiser, Molson Coors, and Heineken) have partially integrated backward into metal-can manufacturing to gain bargaining power in obtaining the balance of their can requirements from otherwise powerful metal-can manufacturers.

• Buyers are well informed about the product offerings of sellers (product features and quality, prices, buyer reviews) and the cost of production (an indicator of markup). The more information buyers have, the better bargaining position they are in. The mushrooming availability of product information on the Internet (and its ready access on smartphones) is giving added bargaining power to consumers, since they can use this to find or negotiate better deals. Apps such as ShopSavvy and BuyVia are now making comparison shopping even easier.

• Buyers have discretion to delay their purchases or perhaps even not make a purchase at all. Consumers often have the option to delay purchases of durable goods (cars, major appliances), or decline to buy discretionary goods (massages, concert tick- ets) if they are not happy with the prices offered. Business customers may also be able to defer their purchases of certain items, such as plant equipment or mainte- nance services. This puts pressure on sellers to provide concessions to buyers so that the sellers can keep their sales numbers from dropping off.

Whether Buyers Are More or Less Price Sensitive Low-income and budget- constrained consumers are almost always price sensitive; bargain-hunting consumers are highly price sensitive by nature. Most consumers grow more price sensitive as the price tag of an item becomes a bigger fraction of their spending budget. Similarly, busi- ness buyers besieged by weak sales, intense competition, and other factors squeezing their profit margins are price sensitive. Price sensitivity also grows among businesses as the cost of an item becomes a bigger fraction of their cost structure. Rising prices of frequently purchased items heightens the price sensitivity of all types of buyers. On the other hand, the price sensitivity of all types of buyers decreases the more that the quality of the product matters.

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The following factors increase buyer price sensitivity and result in greater competi- tive pressures on the industry as a result:

• Buyer price sensitivity increases when buyers are earning low profits or have low income. Price is a critical factor in the purchase decisions of low-income consumers and companies that are barely scraping by. In such cases, their high price sensitiv- ity limits the ability of sellers to charge high prices.

• Buyers are more price-sensitive if the product represents a large fraction of their total purchases. When a purchase eats up a large portion of a buyer’s budget or repre- sents a significant part of his or her cost structure, the buyer cares more about price than might otherwise be the case.

• Buyers are more price-sensitive when the quality of the product is not uppermost in their considerations. Quality matters little when products are relatively undifferentiated, leading buyers to focus more on price. But when quality affects performance, or can reduce a business buyer’s other costs (by saving on labor, materials, etc.), price will matter less.

Is the Collective Strength of the Five Competitive Forces Conducive to Good Profitability? Assessing whether each of the five competitive forces gives rise to strong, moderate, or weak competitive pressures sets the stage for evaluating whether, overall, the strength of the five forces is conducive to good profitability. Is any of the competitive forces suf- ficiently powerful to undermine industry profitability? Can companies in this industry reasonably expect to earn decent profits in light of the prevailing competitive forces?

The most extreme case of a “competitively unattractive” industry occurs when all five forces are producing strong competitive pressures: Rivalry among sellers is vigor- ous, low entry barriers allow new rivals to gain a market foothold, competition from substitutes is intense, and both suppliers and buyers are able to exercise considerable leverage. Strong competitive pressures coming from all five directions drive industry profitability to unacceptably low levels, frequently producing losses for many industry members and forcing some out of business. But an industry can be competitively unat- tractive without all five competitive forces being strong. In fact, intense competitive pressures from just one of the five forces may suffice to destroy the conditions for good

profitability and prompt some companies to exit the business. As a rule, the strongest competitive forces determine the extent of the competitive

pressure on industry profitability. Thus, in evaluating the strength of the five forces overall and their effect on industry profitability, managers should look to the stron- gest forces. Having more than one strong force will not worsen the effect on industry profitability, but it does mean that the industry has multiple competitive challenges with which to cope. In that sense, an industry with three to five strong forces is even more “unattractive” as a place to compete. Especially intense competitive conditions due to multiple strong forces seem to be the norm in tire manufacturing, apparel, and

commercial airlines, three industries where profit margins have historically been thin. In contrast, when the overall impact of the five competitive forces is moderate to

weak, an industry is “attractive” in the sense that the average industry member can reasonably expect to earn good profits and a nice return on investment. The ideal competitive environment for earning superior profits is one in which both suppliers and customers have limited power, there are no good substitutes, high barriers block further entry, and rivalry among present sellers is muted. Weak competition is the best

CORE CONCEPT The strongest of the five forces determines the extent of the downward pressure on an industry’s profitability.

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of all possible worlds for also-ran companies because even they can usually eke out a decent profit—if a company can’t make a decent profit when competition is weak, then its business outlook is indeed grim.

Matching Company Strategy to Competitive Conditions Working through the five forces model step by step not only aids strategy makers in assessing whether the intensity of competition allows good profitability but also promotes sound strategic thinking about how to better match company strategy to the specific competitive character of the marketplace. Effectively matching a company’s business strategy to prevailing competitive conditions has two aspects:

1. Pursuing avenues that shield the firm from as many of the different competitive pressures as possible.

2. Initiating actions calculated to shift the competitive forces in the company’s favor by altering the underlying factors driving the five forces.

But making headway on these two fronts first requires identifying competitive pressures, gauging the relative strength of each of the five competitive forces, and gain- ing a deep enough understanding of the state of competition in the industry to know which strategy buttons to push.

A company’s strategy is strengthened the more it provides insulation from competitive pressures, shifts the competitive battle in the company’s favor, and posi- tions the firm to take advan- tage of attractive growth opportunities.

COMPLEMENTORS AND THE VALUE NET Not all interactions among industry participants are necessarily competitive in nature. Some have the potential to be cooperative, as the value net framework demonstrates. Like the five forces framework, the value net includes an analysis of buyers, suppliers, and substitutors (see Figure 3.9). But it differs from the five forces framework in sev- eral important ways.

First, the analysis focuses on the interactions of industry participants with a particular company. Thus it places that firm in the center of the framework, as Figure 3.9 shows. Second, the category of “competitors” is defined to include not only the focal firm’s direct competitors or industry rivals but also the sellers of sub- stitute products and potential entrants. Third, the value net framework introduces a new category of industry participant that is not found in the five forces framework— that of “complementors.” Complementors are the producers of complementary prod- ucts, which are products that enhance the value of the focal firm’s products when they are used together. Some examples include snorkels and swim fins or shoes and shoelaces.

The inclusion of complementors draws particular attention to the fact that suc- cess in the marketplace need not come at the expense of other industry participants. Interactions among industry participants may be cooperative in nature rather than competitive. In the case of complementors, an increase in sales for them is likely to increase the sales of the focal firm as well. But the value net framework also encour- ages managers to consider other forms of cooperative interactions and realize that value is created jointly by all industry participants. For example, a company’s suc- cess in the marketplace depends on establishing a reliable supply chain for its inputs, which implies the need for cooperative relations with its suppliers. Often a firm works

CORE CONCEPT Complementors are the producers of complemen- tary products, which are products that enhance the value of the focal firm’s products when they are used together.

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hand in hand with its suppliers to ensure a smoother, more efficient operation for both parties. Newell-Rubbermaid, and Procter & Gamble for example, work cooperatively as suppliers to companies such as Walmart, Target, and Kohl’s. Even direct rivals may work cooperatively if they participate in industry trade associations or engage in joint lobbying efforts. Value net analysis can help managers discover the potential to improve their position through cooperative as well as competitive interactions.

FIGURE 3.9 The Value Net

Customers

Suppliers

The FirmCompetitors Complementors

(Includes substitutors and

potential entrants)

INDUSTRY DYNAMICS AND THE FORCES DRIVING CHANGE

While it is critical to understand the nature and intensity of competitive and coopera- tive forces in an industry, it is equally critical to understand that the intensity of these forces is fluid and subject to change. All industries are affected by new developments and ongoing trends that alter industry conditions, some more speedily than others. The popular hypothesis that industries go through a life cycle of takeoff, rapid growth, maturity, market saturation and slowing growth, followed by stagnation or decline is but one aspect of industry change—many other new developments and emerging trends cause industry change.5 Any strategies devised by management will therefore play out in a dynamic industry environment, so it’s imperative that managers consider the factors driving industry change and how they might affect the industry environment. Moreover, with early notice, managers may be able to influence the direction or scope of environmental change and improve the outlook.

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CORE CONCEPT Driving forces are the major underlying causes of change in industry and competitive conditions.

Industry and competitive conditions change because forces are enticing or pres- suring certain industry participants (competitors, customers, suppliers, complemen- tors) to alter their actions in important ways. The most powerful of the change agents are called driving forces because they have the biggest influences in reshap- ing the industry landscape and altering competitive conditions. Some driving forces originate in the outer ring of the company’s macro-environment (see Figure 3.2), but most originate in the company’s more immediate industry and competitive environment.

Driving-forces analysis has three steps: (1) identifying what the driving forces are; (2) assessing whether the drivers of change are, on the whole, acting to make the indus- try more or less attractive; and (3) determining what strategy changes are needed to prepare for the impact of the driving forces. All three steps merit further discussion.

Identifying the Forces Driving Industry Change Many developments can affect an industry powerfully enough to qualify as driving forces. Some drivers of change are unique and specific to a particular industry situa- tion, but most drivers of industry and competitive change fall into one of the following categories:

• Changes in an industry’s long-term growth rate. Shifts in industry growth up or down have the potential to affect the balance between industry supply and buyer demand, entry and exit, and the character and strength of competition. Whether demand is growing or declining is one of the key factors influencing the intensity of rivalry in an industry, as explained earlier. But the strength of this effect will depend on how changes in the industry growth rate affect entry and exit in the industry. If entry barriers are low, then growth in demand will attract new entrants, increasing the number of industry rivals and changing the competitive landscape.

• Increasing globalization. Globalization can be precipitated by such factors as the blossoming of consumer demand in developing countries, the availability of lower-cost foreign inputs, and the reduction of trade barriers, as has occurred recently in many parts of Latin America and Asia. Significant differences in labor costs among countries give manufacturers a strong incentive to locate plants for labor-intensive products in low-wage countries and use these plants to supply market demand across the world. Wages in China, India, Vietnam, Mexico, and Brazil, for example, are much lower than those in the United States, Germany, and Japan. The forces of globalization are sometimes such a strong driver that companies find it highly advantageous, if not necessary, to spread their oper- ating reach into more and more country markets. Globalization is very much a driver of industry change in such industries as energy, mobile phones, steel, social media, public accounting, commercial aircraft, electric power generation equipment, and pharmaceuticals.

• Emerging new Internet capabilities and applications. Mushrooming use of high-speed Internet service and Voice-over-Internet-Protocol (VoIP) technology, growing acceptance of online shopping, and the exploding popularity of Internet applica- tions (“apps”) have been major drivers of change in industry after industry. The Internet has allowed online discount stock brokers, such as E*TRADE, and TD Ameritrade to mount a strong challenge against full-service firms such as Edward Jones and Merrill Lynch. The newspaper industry has yet to figure out a strategy for surviving the advent of online news.

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Massive open online courses (MOOCs) facilitated by organizations such as Coursera, edX, and Udacity are profoundly affecting higher education. The “Internet of things” will feature faster speeds, dazzling applications, and billions of connected gadgets performing an array of functions, thus driving further industry and competitive changes. But Internet-related impacts vary from industry to industry. The challenges are to assess precisely how emerging Internet developments are altering a particular industry’s landscape and to factor these impacts into the strategy-making equation. • Shifts in who buys the products and how the products are used. Shifts in buyer demo-

graphics and the ways products are used can greatly alter competitive conditions. Longer life expectancies and growing percentages of relatively well-to-do retirees, for example, are driving demand growth in such industries as cosmetic surgery, assisted living residences, and vacation travel. The burgeoning popularity of streaming video has affected broadband providers, wireless phone carriers, and television broadcasters, and created opportunities for such new entertainment businesses as Hulu and Netflix.

• Technological change and manufacturing process innovation. Advances in technology can cause disruptive change in an industry by introducing substitutes or can alter the industry landscape by opening up whole new industry frontiers. For instance, revolutionary change in autonomous system technology has put Google, Tesla, Apple, and every major automobile manufacturer into a race to develop viable self- driving vehicles.

• Product innovation. An ongoing stream of product innovations tends to alter the pattern of competition in an industry by attracting more first-time buyers, rejuve- nating industry growth, and/or increasing product differentiation, with concomi- tant effects on rivalry, entry threat, and buyer power. Product innovation has been a key driving force in the smartphone industry, which in an ever more connected world is driving change in other industries. Philips Lighting Hue bulbs now allow homeowners to use a smartphone app to remotely turn lights on and off, blink if an intruder is detected, and create a wide range of white and color ambiances. Wearable action-capture cameras and unmanned aerial view drones are rapidly becoming a disruptive force in the digital camera industry by enabling photography shots and videos not feasible with handheld digital cameras.

• Marketing innovation. When firms are successful in introducing new ways to market their products, they can spark a burst of buyer interest, widen industry demand, increase product differentiation, and lower unit costs—any or all of which can alter the competitive positions of rival firms and force strategy revisions. Consider, for example, the growing propensity of advertisers to place a bigger percentage of their ads on social media sites like Facebook and Twitter.

• Entry or exit of major firms. Entry by a major firm thus often produces a new ball game, not only with new key players but also with new rules for competing. Similarly, exit of a major firm changes the competitive structure by reducing the number of market leaders and increasing the dominance of the leaders who remain.

• Diffusion of technical know-how across companies and countries. As knowledge about how to perform a particular activity or execute a particular manufacturing technol- ogy spreads, products tend to become more commodity-like. Knowledge diffusion can occur through scientific journals, trade publications, onsite plant tours, word of mouth among suppliers and customers, employee migration, and Internet sources.

• Changes in cost and efficiency. Widening or shrinking differences in the costs among key competitors tend to dramatically alter the state of competition. Declining costs of producing tablets have enabled price cuts and spurred tablet sales (especially

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lower-priced models) by making them more affordable to lower-income households worldwide. Lower cost e-books are cutting into sales of costlier hardcover books as increasing numbers of consumers have laptops, iPads, Kindles, and other brands of tablets.

• Reductions in uncertainty and business risk. Many companies are hesitant to enter industries with uncertain futures or high levels of business risk because it is unclear how much time and money it will take to overcome various technological hurdles and achieve acceptable production costs (as is the case in the solar power indus- try). Over time, however, diminishing risk levels and uncertainty tend to stimulate new entry and capital investments on the part of growth-minded companies seeking new opportunities, thus dramatically altering industry and competitive conditions.

• Regulatory influences and government policy changes. Government regulatory actions can often mandate significant changes in industry practices and strategic approaches—as has recently occurred in the world’s banking industry. New rules and regulations pertaining to government-sponsored health insurance programs are driving changes in the health care industry. In international markets, host gov- ernments can drive competitive changes by opening their domestic markets to for- eign participation or closing them to protect domestic companies.

• Changing societal concerns, attitudes, and lifestyles. Emerging social issues as well as changing attitudes and lifestyles can be powerful instigators of industry change. Growing concern about the effects of climate change has emerged as a major driver of change in the energy industry. Concerns about the use of chemi- cal additives and the nutritional content of food products have been driving changes in the restaurant and food industries. Shifting societal concerns, atti- tudes, and lifestyles alter the pattern of competition, favoring those players that respond with products targeted to the new trends and conditions.

While many forces of change may be at work in a given industry, no more than three or four are likely to be true driving forces powerful enough to qualify as the major determinants of why and how the industry is changing. Thus, company strate- gists must resist the temptation to label every change they see as a driving force. Table 3.3 lists the most common driving forces.

The most important part of driving-forces analysis is to determine whether the collective impact of the driv- ing forces will increase or decrease market demand, make competition more or less intense, and lead to higher or lower industry profitability.

• Changes in the long-term industry growth rate • Increasing globalization • Emerging new Internet capabilities and applications • Shifts in buyer demographics • Technological change and manufacturing process innovation • Product and marketing innovation • Entry or exit of major firms • Diffusion of technical know-how across companies and countries • Changes in cost and efficiency • Reductions in uncertainty and business risk • Regulatory influences and government policy changes • Changing societal concerns, attitudes, and lifestyles

TABLE 3.3 The Most Common Drivers of Industry Change

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Assessing the Impact of the Forces Driving Industry Change The second step in driving-forces analysis is to determine whether the prevailing change drivers, on the whole, are acting to make the industry environment more or less attractive. Three questions need to be answered:

The real payoff of driving- forces analysis is to help managers understand what strategy changes are needed to prepare for the impacts of the driving forces.

• LO 3-3 Map the market positions of key groups of industry rivals.

STRATEGIC GROUP ANALYSIS Within an industry, companies commonly sell in different price/quality ranges, appeal to different types of buyers, have different geographic coverage, and so on. Some are more attractively positioned than others. Understanding which companies are strongly positioned and which are weakly positioned is an integral part of analyzing an indus- try’s competitive structure. The best technique for revealing the market positions of industry competitors is strategic group mapping.

Using Strategic Group Maps to Assess the Market Positions of Key Competitors A strategic group consists of those industry members with similar competitive approaches and positions in the market. Companies in the same strategic group can

1. Are the driving forces, on balance, acting to cause demand for the industry’s product to increase or decrease?

2. Is the collective impact of the driving forces making competition more or less intense?

3. Will the combined impacts of the driving forces lead to higher or lower industry profitability?

Getting a handle on the collective impact of the driving forces requires looking at the likely effects of each factor separately, since the driving forces may not all be

pushing change in the same direction. For example, one driving force may be acting to spur demand for the industry’s product while another is working to curtail demand. Whether the net effect on industry demand is up or down hinges on which change driver is the most powerful.

Adjusting the Strategy to Prepare for the Impacts of Driving Forces The third step in the strategic analysis of industry dynamics—where the real payoff for strategy making comes—is for managers to draw some conclusions about what strat- egy adjustments will be needed to deal with the impacts of the driving forces. But taking the “right” kinds of actions to prepare for the industry and competitive changes being wrought by the driving forces first requires accurate diagnosis of the forces driving industry change and the impacts these forces will have on both the industry environ- ment and the company’s business. To the extent that managers are unclear about the drivers of industry change and their impacts, or if their views are off-base, the chances of making astute and timely strategy adjustments are slim. So driving-forces analysis is not something to take lightly; it has practical value and is basic to the task of thinking stra- tegically about where the industry is headed and how to prepare for the changes ahead.

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resemble one another in a variety of ways. They may have comparable product-line breadth, sell in the same price/quality range, employ the same distribution channels, depend on identical technological approaches, compete in much the same geographic areas, or offer buyers essentially the same product attributes or similar services and technical assistance.6 Evaluating strategy options entails examining what strategic groups exist, identifying the companies within each group, and determining if a com- petitive “white space” exists where industry competitors are able to create and cap- ture altogether new demand. As part of this process, the number of strategic groups in an industry and their respective market positions can be displayed on a strategic group map.

The procedure for constructing a strategic group map is straightforward:

• Identify the competitive characteristics that delineate strategic approaches used in the industry. Typical variables used in creating strategic group maps are price/quality range (high, medium, low), geographic coverage (local, regional, national, global), product-line breadth (wide, narrow), degree of service offered (no frills, limited, full), use of distribution channels (retail, wholesale, Internet, multiple), degree of vertical integration (none, partial, full), and degree of diver- sification into other industries (none, some, considerable).

• Plot the firms on a two-variable map using pairs of these variables. • Assign firms occupying about the same map location to the same strategic group. • Draw circles around each strategic group, making the circles proportional to the

size of the group’s share of total industry sales revenues. This produces a two-dimensional diagram like the one for the U.S. casual dining

industry in Illustration Capsule 3.1. Several guidelines need to be observed in creating strategic group maps. First, the

two variables selected as axes for the map should not be highly correlated; if they are, the circles on the map will fall along a diagonal and reveal nothing more about the relative positions of competitors than would be revealed by comparing the rivals on just one of the variables. For instance, if companies with broad product lines use mul- tiple distribution channels while companies with narrow lines use a single distribution channel, then looking at the differences in distribution-channel approaches adds no new information about positioning.

Second, the variables chosen as axes for the map should reflect important differences among rival approaches—when rivals differ on both variables, the locations of the rivals will be scattered, thus showing how they are positioned differently. Third, the variables used as axes don’t have to be either quantitative or continuous; rather, they can be discrete variables, defined in terms of distinct classes and combinations. Fourth, drawing the sizes of the circles on the map proportional to the combined sales of the firms in each strategic group allows the map to reflect the relative sizes of each strategic group. Fifth, if more than two good variables can be used as axes for the map, then it is wise to draw several maps to give different exposures to the competitive positioning relationships present in the industry’s structure—there is not necessarily one best map for portraying how competing firms are positioned.

The Value of Strategic Group Maps Strategic group maps are revealing in several respects. The most important has to do with identifying which industry members are close rivals and which are distant rivals. Firms in the same strategic group are the closest rivals; the next closest rivals

CORE CONCEPT Strategic group mapping is a technique for displaying the different market or com- petitive positions that rival firms occupy in the industry.

CORE CONCEPT A strategic group is a clus- ter of industry rivals that have similar competitive approaches and market positions.

Strategic group maps reveal which companies are close competitors and which are distant competitors.

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ILLUSTRATION CAPSULE 3.1

Note: Circles are drawn roughly proportional to the sizes of the chains, based on revenues.

Comparative Market Positions of Selected Companies in the Casual Dining Industry: A Strategic Group Map Example

Few U.S. Locations

Low

Moderate

High

Many U.S. Locations

Geographic Coverage

P ri

ce /S

er vi

ce /R

es ta

ur an

t A m

bi an

ce

International

Maggiano’s Little Italy, P.F.

Chang’s

Olive Garden, Longhorn

Steakhouse

Hard Rock Café, Outback

Steakhouse

Applebee’s, Chili’s, On the Border,

TGI Friday’s

Cracker Barrel, Red Lobster, Golden

Corral

Five Guys, Bu�alo Wild Wings, Firehouse

Subs, Moe’s Southwest Grill

Jason’s Deli, McAlister’s Deli, Fazoli’s

BJ’s Restaurant & Brewery, The

Cheesecake Factory, Carrabba’s Italian

Grille

Corner Bakery Café, Atlanta Bread

Company

Panera Bread

Company

California Pizza

Kitchen

are in the immediately adjacent groups. Often, firms in strategic groups that are far apart on the map hardly compete at all. For instance, Walmart’s clientele, merchandise selection, and pricing points are much too different to justify calling Walmart a close competitor of Neiman Marcus or Saks Fifth Avenue. For the same reason, the beers produced by Yuengling are really not in competition with the beers produced by Pabst.

The second thing to be gleaned from strategic group mapping is that not all posi- tions on the map are equally attractive.7 Two reasons account for why some positions can be more attractive than others:

1. Prevailing competitive pressures from the industry’s five forces may cause the profit potential of different strategic groups to vary. The profit prospects of firms in dif- ferent strategic groups can vary from good to poor because of differing degrees

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of competitive rivalry within strategic groups, differing pressures from potential entrants to each group, differing degrees of exposure to competition from substi- tute products outside the industry, and differing degrees of supplier or customer bargaining power from group to group. For instance, in the ready-to-eat cereal industry, there are significantly higher entry barriers (capital requirements, brand loyalty, etc.) for the strategic group comprising the large branded-cereal makers than for the group of generic-cereal makers or the group of small natural-cereal producers. Differences among the branded rivals versus the generic cereal mak- ers make rivalry stronger within the generic-cereal strategic group. Among apparel retailers, the competitive battle between Marshall’s and TJ MAXX is more intense (with consequently