BM 499 Ghemawat, Chapter 2

1. BM 499Ghemawat, Chapter 2 Darral G. Clarke Professor of Management Darral G. Clarke for BM 499

2. Average Economic Profits of U.S. Industry Groups, 1978-1996 Value Line Industry Groups Darral G. Clarke for BM 499 Source: Compustat, Value Line, Marakon Associates Analysis

3. Distribution of Industry Returns Average Return on Equity in US Industries, 1982-1993 11.7% 13.8% 16.5% First Quartile Average 22.2% Fourth Quartile Average 9.3% Number of Industries Average = 14.7% Median = 13.8% Return on Equity (Percent) Note: Return on Equity = Net Income / Year End Shareholders’ Equity; Analysis based on sample of 593 industries Source: Jan W. Rivkin’s Analysis Based on Dun and Bradstreet Data

4. Pharmaceuticals Prepackaged software Semiconductors Women's clothing stores Dental equipment Eating places Drug stores Petroleum / natural gas Race track operations Trucking except local Engineering services Cable TV service Motor vehicles Scheduled airlines 0 5 10 15 20 25 Operating Income / Assets, 1988-95 (%) Profitability Differences Across Selected Industries Computer system design Source: Jan W. Rivkin based on Compustat

5. A Three-Dimensional Business Landscape

6. Monetary Units Supply Equilibrium Price Demand Equilibrium Physical Quantity Units Supply-Demand Analysis

7. 900 800 Malden 700 Faulkner 600 500 400 300 200 NE Medical Center Newton-Wellesley Leonard Morse NNE Memorial Mount Auburn 100 St. Elizabeth's Atlanticare Framingham South Shore Winchester University Lawrence Waltham Norwood St. Johns Goddard Lowell Beverly Lahey Salem HMC 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Supply Curve for Boston Hospitals Case mix adjusted expense per adjusted day ($) Beds (% of total market 8,270 beds) Source: Partners HealthCare System, Inc. (A), Case #696-062

8. From Supply / Demand to the Five Forces • What determines the long-run supply / demand balance? • Entry barriers and intensity of rivalry affect whether firms will add capacity in response to excess demand • Exit barriers affect whether firms will retire capacity in response to excess supply • What determines the effect of a supply / demand imbalance on profitability? • In industries with intense rivalry or powerful buyers, small amounts of excess capacity tend to lead to big price wars • In industries with powerful suppliers, the benefits of excess demand may accrue to the suppliers • Supply / demand analyses say little about what determines the position and shape of the two curves Darral G. Clarke for BM 499

9. Threat of New Entry Rivalry Among Existing Competitors Bargaining Power of Suppliers Bargaining Power of Customers Threat of Substitutes Industry Analysis: The Five Forces Darral G. Clarke for BM 499

10. P Profit Q Theory of the Firm: The link to the Five Forces • Five forces identifies the factors that determine differences in firm profitability • Five forces tells us how profitability responds to changes in a large variety of factors Darral G. Clarke for BM 499

11. P Profit Q Theory of the Firm:The link between the Five Forces and profitability • Consider a sequence of market entry and decreasing differentiation P D D Q Darral G. Clarke for BM 499

12. Rivalry among Current Competitors • Concentration and balance • Industry growth • Fixed (or storage costs)/Value added • Product differences • Brand identity • Switching costs • Intermittent over-capacity • Diverse stakes • Exit barriers Darral G. Clarke for BM 499

13. Economies of scale Product differences Brand identity Switching costs Capital requirements Access to distribution Absolute cost advantages Learning curve Access to necessary inputs Low cost product design Government policy Expected retaliation Entry Barriers Darral G. Clarke for BM 499

14. Intrinsic Strength Buyer concentration Buyer volume Switching costs Buyer information Ability to backward integrate Substitute products Pull through Price Sensitivity Price/Total purchase Product differences Brand identity Impact on quality/performance Buyer profits Decision maker’s incentives Power of Buyers Darral G. Clarke for BM 499

15. Power of Suppliers • Supplier concentration • Substitute suppliers • Supplier volume • Product differences • Brand identity • Switching costs • Low buyer information • Threat of forward integration • Pull through Darral G. Clarke for BM 499

16. Threat of Substitution • Product function not form • Entire value added chain • Thread depends on • Relative price/performance • Switching costs • Often an S-curve process Darral G. Clarke for BM 499

17. The Value Net Customers Firm Suppliers A player is your competitorwith respect to customers if customers value your productlesswhen they have the other player’s product as well A player is your complementor with respect to customers if customers value your product more when they have the other player’s product as well Competitors Complementors A player is your competitor with respect to suppliers if it is less attractive for a supplier to provide resources to you when it is also supplying the other player A player is your complementor with respect to suppliers if it is more attractive for a supplier to provide resources to you when it is also supplying the other player Source: Adam Brandenburger and Barry Nalebuff, Co-opetition (New York: Currency Doubleday, 1996)

18. Threat of New Entry Rivalry Among Existing Competitors Bargaining Power of Suppliers Bargaining Power of Customers Threat of Substitutes Availability of Complements Expanded Industry Analysis Darral G. Clarke for BM 499

19. The Power of Complementors • Relative concentration • Relative buyer or supplier switching costs • Ease of unbundling • Differences in pull-through • Asymmetric integration threats • Rate of growth of the pie

20. Landscapes • Landscape is broader than industry • Landscape includes firms, institutions, and other players which often are not viewed as part of an industry • Landscape includes networks of firms (from different industries) whose profits may be interdependent (e.g. Microsoft-Intel)

21. Commitment Opportunities and Structure • Production scale economies set a lower bound on concentration • Many settings are more concentrated than production scale economies would imply • Opportunities to commit resources to advertising and R & D in ways that enhance willingness-to-pay to some minimal degree are what lead to “excess” concentration

22. Steps in Landscape Analysis • Define the landscape: what is in, what is out • Identify the players • e.g., who are the customers, really? Who are the competitors? • Assess the relationships among players • See Porter (1979, 1980) for some factors to consider • Sniff-test • Is assessment in line with actual profitability? • Are more profitable players better positioned vis-a-vis competitive forces? • Assess recent and future changes

23. Identify forces that must be countered in order to achieve superior profitability Test decision to enter Test decision to exit Assess effects of a major change Identify ways to alter structure Pinpoint most threatening force and seek ways to counter (e.g., build switching costs, find new sources of supply) Consider effect of entry on structure; choose relative position; select entry vehicle; compare costs of entry to benefits Identify options for improving structure or relative position; select exit vehicle; compare costs of exit to benefits Consider how change will affect each force Assess consolidation, backward integration, forward integration, investments that raise entry costs, entry into substitute market, etc. Steps in Landscape Analysis (cont.) Purpose Common steps

24. Common Pitfalls in Landscape Analysis • Failing to define the landscape clearly • A clear definition is more important that the “right” definition • Confusing transient effects with structural forces • Ignoring changes in structural forces • Assuming that competitive forces cannot be altered • Confusing evidence of a force with its underlying cause • e.g., blaming customer power on customer price sensitivity rather than exploring root causes of price sensitivity • Ignoring the full range of substitutes • Paying equal attention to all the forces Darral G. Clarke for BM 499

25. Lessons • Industries or landscapes are neither created equal nor stay equal • The concept of “extended competition” provides a comprehensive framework for assessing structural attractiveness • A firm’s strategy can increase or decrease its exposure to competitive forces • Other things being equal, a firm should seek to trigger actions that improve structural attractiveness • But it isn’t enough to look at just structural attractiveness: competitive position must also be considered

26. Conclusion • Envisioning the business landscape • Adapting to the business landscape • Shaping the business landscape