This page is a guide to applying the principles of Economics to researching and understanding a market and the industries and firms that make up the market.
An excellent source for the information needed to conduct an industry study or an analysis of a firm's competitive strategy is the Babson College Horn Library at http://www.babson.edu/library/. The Horn Library provides a research guide and sources for researching a company and an industry.
There are two distinct yet related models for studying markets. One method of analysis is the "Structure-Conduct-Performance" paradigm from the Industrial Organization field of Economics. Another is Porter's Five Forces. As we will see shortly, Porter's Five Forces and the "Structure-Conduct-Performance" paradigm overlap in many ways. This page combines both methods into a unified guide for industry studies and the analysis of firms and competitive strategy.
"The Structural Analysis of Industries" is covered quite well in Chapter 1 of Porter, Michael E., Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1980 and new introduction in 1998, The Free Press, New York, NY.
Figure 1 is a graphical representation of Porter's Five Forces.
Figure 1: Porter's Five Forces
Porter details the factors that impact each force and develops an analytical model to study industries. The purpose of this analysis is to assess the profitability potential of industries. The analytical tools of Porter's book will not be reproduced here. However, Porter's framework incorporates the analysis of market structure and vertical supply chains and each of these concepts will be addressed from the perspective of an economist.
The real genius of Porter's Five Forces is that it builds on and combines two tools from microeconomics, namely the analysis of market structure and vertical boundaries. The analysis of market structure is the first element of the "Structure-Conduct-Performance" paradigm.
The vertical elements of Porter's Five Forces are shown in Figure 2.
Figure 2: The Vertical Elements of Porter's Five Forces
Each of these elements corresponds to a determinant of market structure as detailed in Table 1 below.
Table 1: Porter's Five Forces and Market Structure
|Element of Porter's Five Forces||Determinant of Market Structure|
|Potential Entrants||Barriers to Entry|
|Number of Sellers
|Indirect Substitutes||Product Characteristics|
The horizontal elements of Porter's Five Forces are shown in Figure 3.
Figure 3: The Horizontal Elements of Porter's Five Forces
If one were to show these elements vertically, they would appear as:
Figure 4: The Vertical Supply Chain
This representation now shows the vertical supply chain. The important issue for firms in the industry is how they position themselves in the supply chain. The firms essentially must choose their vertical boundaries.
The "Structure-Conduct-Performance" paradigm is a road map for identifying the factors that determine the competitiveness of a market, analyzing the behavior of firms, and assessing the success of an industry in producing benefits for consumers.
"Structure" refers to the market structure of an industry which is indicative of the degree of competition in the industry. "Conduct" refers to business practices adopted by firms in the industry to implement their competitive strategies and to create competitive advantage (the ability to outperform competitors in the industry). "Performance" refers to measurements by which the industry or firms in the industry can be judged as to whether they have achieved their stated goals.
The methodology of our unified guide for understanding markets begins with an industry study and continues with an examination of the competitive strategies of firms in the industry. The framework we will use for analyzing industries and firms is:
Evaluate the industry's potential for profitability (with an industry analysis).
Identify the firm's strategic positioning within the industry and analyze its business practices.
Assess the firm's potential for competitive advantage (the firm's ability to outperform competitors in the industry).
The purpose of an industry analysis is to assess the profitability potential of the industry.
The steps in an industry analysis are:
Identify the industry and describe its market.
Classify the market structure of the industry.
Characterize relationships between links in the vertical supply chain.
Evaluate the future profitability potential of the industry.
The first task is to define the industry. Industry definition is important to determining the competitive set. In economics, defining the competitive set is equivalent to defining a firm's horizontal boundaries. A firm's horizontal boundaries are its competitors who supply direct substitutes.
The U.S. Census Bureau classifies industries with the North American Industrial Classification System (NAICS). NAICS can be accessed at the web page www.census.gov/naics. A researcher can navigate and/or search the site and find a description and definition of most industries in the US. Industry descriptions vary from very broad (two-digit NAICS codes) to very narrow (six-digit NAICS codes). Usually, a researcher will choose the narrowest description of an industry. This allows the researcher to most closely identify the companies that compete with each other in an industry. The narrower the description of an industry, the more likely the competitive set will be based on products that are direct substitutes. The broader the description on an industry, the more likely the competitive set will be based on products that are indirect substitutes.
For each six-digit NAICS code, there is a short description of the industry. Additionally, the U.S. Census Bureau provides a short definition of the industry. The researcher must determine if the description and definition of the industry fit with the intended companies targeted for study.
An industry analysis often starts with a brief introduction to the industry. Sources for general information on an industry are:
General market conditions faced by an industry are often important factors in the choice of conduct by firms and for the ability of firms to generate profits and meet expected performance goals. Identifying relevant general market conditions requires an analysis of:
The factors driving the supply of and demand for a product of an industry are detailed in Table 2 below. These factors determine the defining characteristics, position and slope, of supply and demand curves in an economist's representation of a market.
Table 2: Basic Market Conditions, Determinants of Supply and Demand
|Determinants of Demand||Determinants of Supply|
|Position of demand curve:
||Position of supply curve:
|Slope of demand curve:
||Slope of supply curve:
The interaction of supply and demand determine production levels and product price in the market. In a perfectly competitive market, equilibrium price and output in a market are determined where quantity supplied equals quantity demanded. Determination of output and price in other market structures is a bit more complex. For additional information, see a standard Principles of Microeconomics textbook such as Economics: Principles, Problems, and Policies, by Campbell R. McConnell and Stanley L. Brue, The McGraw-Hill Companies, Inc.
The analysis of supply and demand conditions are closely related to two aspects of Porter's Five Forces. The determinants of demand parallel Porter's analysis of buyer bargaining power and the determinants of supply are important factors in studying the intensity of rivalry between existing industry competitors.
In addition to market forces within the industry, it is critical to monitor
external forces that may impact the industry on an ongoing basis. A manager may
have a very good understanding of what is happening within an industry, and yet
be blindsided by external events that change the nature of competition and
revenue within an industry. A marketing framework commonly used to examine these
factors that impact business decisions is referred to as PEST. PEST is an
acronym for the political/legal, economic, sociocultural, and technological
factors that shape the environment of an industry or a business.
An industry must remain abreast of political forces that may influence the viability and profitability of the overall industry, as well as specific firms. Political and legal issues that have impacted businesses and industries over the past decade include: environmental legislation, regulation of the Internet, antitrust rulings, to name a few. For a multinational business, these factors become much more complicated. The business must continually monitor the stability of governments, understand differences in governmental practices, know the rules in terms of importing and exporting goods, and be knowledgeable about the laws that impact the industry and the business in each country. These factors can impact the structure and profitability of the business and industry in each country. Sources of information that can be used to monitor this factor include: government agency web sites and publications, embassies, lawyers and legal journals, and, of course, newspapers.
The economy can have a serious impact on sales and profitability within an industry and firm. Unemployment rates, the value of the dollar, inflations, growth, and productivity are factors that impact the health of the economy and consumer confidence. These factors provide indicators to potential concerns on recession and inflation. The economy may lead to reduced spending by consumers that have a rebound effect throughout companies and industries. A firm must monitor these factors to forecast sales and profits appropriately and devise appropriate strategies to ride out an unfavorable economic environment. Firms may even be able to take advantage of an economic downturn to gain share and customers from competitors. Potential sources of information to evaluate the current and projected state of the economy include the New York Stock Exchange and NASDAQ (as well as world exchanges), Wall Street Journal, and analyst reports.
Trends may occur within the social and/or cultural structure of society. Examples in the past decade include the increase in working women, the health and fitness craze, and the growth in discretionary spending by youths. These trends can have a serious impact on entire industries, as well as individual companies. A business must monitor these trends to make sure that its product will continue to meet the needs of the consumers it serves. New attributes may emerge and the importance of existing attributes may change as a result of changes in society. Similarly, as the business enters new markets or countries, expectations may be very different based on the social structure and societal expectations of the specific culture or cultures. Sources of information on these trends include newspapers and magazines, television and other mass communication media, and specific monitoring publications or companies as American Demographics and the Yankelovich Monitor.
In the past century, the world has seen a technological revolution. Today, we can travel faster, receive communications instantly, and produce more per capita. As a result of this change, many industries have emerged (e.g., cellular phones and dot-coms) and many industries have all but disappeared (e.g., typewriters). Business that have survived have succeeded in staying ahead (or only slightly behind) the technological advances. These businesses have taken advantage of the emerging technology in other industries to improve their product and/or service. These firms are always looking for technology that will help serve customers better and/or cheaper. In that way, technology may provide a competitive advantage. Sources of information on technology include journals in potential areas such as computers or genetics, scientific journals, and other newspapers and magazines.
The critical element in environmental scanning is to continually monitor the media relevant to your customers, your industry, your market(s), and overall technological development. As changes occur for elements within PEST, a company (and industry) must ask:
A good resource for further information on environmental scanning (or PEST) is …. [UNDER CONSTRUCTION - Professor Carol Gwin]
Market structure refers to the number and relative size of sellers and buyers in a particular market. There are four definitions of a market structure: Perfect Competition, Monopolistic Competition, Oligopoly, and Monopoly. The market structure of an industry can be classified with three criteria: number of sellers, product characteristics, and barriers to entry. Market structure classification according to these three criteria is summarized in Table 3 below.
Table 3: Classifications of Market Structure
|Perfect Competition||Monopolistic Competition||Oligopoly||Monopoly|
|Number of Sellers||Many||Many||Few||One|
|Product Characteristics||Homogenous||Differentiated||Homogeneous (Pure Oligopoly) or Differentiated (Impure Oligopoly)||Unique|
|Barriers to Entry||None||None||High||Very High|
The Department of Justice (DOJ) and the Federal Trade Commission publish horizontal merger guidelines that are an excellent reference source for market definition and defining the relevant market for classifying the market structure of an industry. The publication Horizontal Merger Guidelines can be accessed from the web page of the Antitrust Division of the DOJ at http://www.usdoj.gov/atr or of the Federal Trade Commission at http://www.ftc.gov.
The guidelines state: "A market is defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profit-maximizing firm, not subject to price regulation, that was the only present and future producer or seller of those products in that area likely would impose at least a 'small but significant and nontransitory' increase in price, assuming the terms of sale of all other products are held constant." This statement is equivalent to the question: What firms would have to be included in a cartel for the cartel to have market power?
The guidelines continue with: "A relevant market is a group of products and a geographic area that is no bigger than necessary to satisfy this test." Thus, the relevant market that we should consider in our analysis of market structure is only those firms that must be included in a cartel for the cartel to have market power. In some cases, only one firm need be included in the cartel because the geographic area in which a product is sold is very small. These are called local monopolies. For example, many towns in the western U.S. have only one gas station or one grocery store. Consumers who live in these small towns may have to pay a "monopoly" price for gas or groceries because it is too costly for them to drive to the next town (these costs are called search costs).
For most industries in the U.S., the relevant market is the entire nation (and possibly the entire world). However, a researcher must take care to consider issues such as the geographical span of market power.
How many sellers are there? This question can be answered in two ways. First, we can literally count the number of sellers. Second, we can measure the concentration of the industry.
For a definition of sellers and buyers, see Guides for Advertising Allowances and Other Merchandising Payments and Services 16 CFR 240.1 available from the Federal Trade Commission web page at http://www.ftc.gov.
Data to determine the number of sellers in an industry is available from the web page of the U.S. Census Bureau at www.census.gov. The 1997 Economic Census provides data on Establishment and Firm Size in a Subject Series based on 20 NAICS sectors (two-digit NAICS codes). The 20 NAICS sectors are further subdivided into 96 subsectors (three-digit NAICS codes), 313 industry groups (four-digit NAICS codes), and 1170 industries (five- and six-digit NAICS codes).
Most sector Subject Series provide information on the number of "Single Unit and Multiunit Firms Subject to Federal Income Tax: 1997" in Table 3 and "Concentration by Largest Firms Subject to Federal Income Tax: 1997" in Table 6. Table 6 identifies concentration ratios based on revenue market share for each industry.
Concentration measures for mining, construction, and manufacturing are not available on the Census Bureau web site.
The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) is available from the U.S. Census Bureau and reports concentration measures for manufacturing. Similar reports are also available for mining and construction. (For Babson personnel, the 1992 Census of Manufactures is available on CD-ROM in Horn Library.) An excel spreadsheet containing concentration measures for manufacturing can be accessed at http://faculty.babson.edu/gwin/cr&hhi.xls.
Market concentration measures are used to classify how competitive an industry is. Concentration measures help us to understand how much market share is concentrated in the hands of a small number of firms. An industry characterized by low concentration will have a large number of firms with small market shares. An industry characterized by high concentration will have a small number of firms with relatively high market shares. Industries with high concentrations are more likely to have market power, i.e. the ability to set price.
Two commonly used concentration measures are the concentration ratio and the Herfindahl-Hirschman Index.
A concentration ratio (CR) is the percentage of industry output that a specific number of the largest firms have. The concentration ratio for the k largest firms in an industry is calculated simply by adding up the market shares of these k firms. This can be represented as CRk = S1 + S2 + S3 + S4 + S5 + ... +Sk, where Si is the market share of the ith firm. A very commonly used concentration ratio is the four-firm concentration ratio or CR4. The CR4 is the total market share held by the top four firms in an industry, and it is calculated as CR4 = S1 + S2 + S3 + S4.
The 1997 Economic Census shows the total market share (based on revenues) for the largest 4, 8, 20, and 50 firms. These concentration ratios would be the CR4, CR8, CR20, and CR50 respectively. Census Bureau concentration measures are based on data on domestic sales from domestic production.
An alternative to using the Census data is for the researcher to calculate the concentration ratio with actual market share data. Market share data is available from many on-line resources such as
The Babson College Horn Library has information on all of these resources starting at their home page at http://www.babson.edu/library/.
If market share data is not available, a researcher may have to calculate market shares for the firms in an industry. An individual firm's market share is calculated as:
Market Share = Individual Firm Revenue / Total Industry Revenue.
Individual firm revenue data is available from sources such as
One problem with the concentration ratio is that it does not tell us the degree to which a single firm dominates the market.
The HHI is calculated by summing the squares of the individual market shares of all the firms in an industry. This is represented as HHI = S12 + S22 + S32 + S42 + S52 + ... +Sn2, where Si is the market share of the ith firm.
Two advantages of the HHI over the four-firm concentration ratio are
The 1992 Census of Manufactures: Concentration Ratios by Industry (MC92-S-1) referenced above shows both the CR4 and HHI for manufacturing industries (NAICS Sectors 31-33).
The 1997 (and 1992) Economic Census does not show the HHI for non-manufacturing industries.
Limitations of Concentration Measures
Concentration measures are limited by how the researcher defines the relevant market. For example, concentration measures may be misleading if:
It is important to classify industries as to market structure because the greater the number of sellers, the more likely the industry is competitive. Figure 5 shows the general relationship between market structure, concentration, and profitability.
Figure 5: Market Structure, Concentration, and Profitability
As we move from left (perfect competition) to right (monopoly) in Figure 5, industry concentration increases. As industry concentration increases, the market power (the ability to affect price) of firms in the industry increases. Typically, profit margins increase as market power increases.
Another important reason to classify industries as to market structure is that the number of firms in an industry plays a role in determining whether firms explicitly take other firms' actions into account.
Table 4 below is a general guide for classifying industries by CR4. The table is only a rule of thumb, there is no consensus among economists on using the CR4. Additionally, concentration is only one objective factor in classifying market structure. There are many more factors, both objective and subjective, that a researcher must take into account before choosing a market structure that best describes an industry.
Table 4: Classifying Industries with the CR4
|CR4||Interpretation of Market Structure|
|CR4 = 0||Perfect Competition|
|0 < CR4 < 40||Effective Competition or Monopolistic Competition|
|40 <= CR4 < 60||Loose Oligopoly or Monopolistic Competition|
|60 <= CR4||Tight Oligopoly or Dominant Firm with a Competitive Fringe|
|90 <= CR1||Effective Monopoly (near monopoly) or Dominant Firm with a Competitive Fringe|
The DOJ and the Federal Trade Commission Horizontal Merger Guidelines (available at http://www.usdoj.gov/atr or http://www.ftc.gov) states that: "The Agency divides the spectrum of market concentration as measured by the HHI into three regions that can be broadly characterized as unconcentrated (HHI below 1000), moderately concentrated (HHI between 1000 and 1800), and highly concentrated (HHI above 1800)." The guidelines also state the conditions under which a merger can be challenged.
One interpretation of these guidelines for classifying market structure with the HHI is summarized in Table 5 below.
Table 5: Classifying Industries with the HHI
|HHI||Interpretation of Market Structure|
|HHI < 1000||Effective Competition or Monopolistic Competition|
|1000 < HHI < 1800||Monopolistic Competition or Oligopoly|
|1800 < HHI||Oligopoly, Dominant Firm with a Competitive Fringe, or Monopoly|
The number of sellers in an industry is important because a small number of sellers with relatively large market shares may have market power. However, this market power may be offset if the number of buyers are small compared to the number of sellers. A small number of buyers may be able to demand lower prices.
The first question in analyzing buyers is: Who are the buyers? Do firms in the industry sell their products through a distribution channel or directly to end users? The second question is: How many buyers are there? A small number of end users may be able to bargain over price with sellers in the industry. Or, there may be a large number of end users but only a small number of distributing firms (such as wholesalers or retailers). A small number of distributing firms may also be able to bargain on price.
Identifying buyers (or segments of buyers) for an industry is probably best accomplished by identifying buyers for individual firms in the industry. Some possible resources are:
As shown in Table 2, an important criteria for classifying market structure is whether the product is homogeneous, differentiated, or unique.
A product is homogeneous if every firm in the industry sells exactly the same product. Homogeneous products can be found in perfect competition and pure oligopoly. In perfect competition, a homogeneous product means that no individual firm has any control over the price of its product. Price is set in the market and each individual firm in the industry takes that price as given, hence perfectly competitive firms are referred to as price-takers. A perfectly competitive firms can sell as much as it wants at the given market price, thus each individual firm in a perfectly competitive industry faces a horizontal demand curve. Generally, firms in an industry selling homogeneous products do not brand their products. An industry consisting of many firms with small market shares and no branded products is likely very close to a perfectly competitive market structure. An industry with a few firms with large market shares and no branded products is likely a pure oligopoly.
A product is differentiated if a firm in a competitive industry can increase price without losing all of its sales (which means the individual firm faces a downward sloping demand curve). This implies there is some differentiating feature of a product that some segment of consumers is willing to pay more for. Products can be differentiated on any element of the marketing mix (the 4 P's) which consists of price, product, promotion, and place. A product is differentiated only if the consumer perceives and values the differentiating feature of the product. The degree of differentiation, and thus the individual firm's market power, depends upon the degree of substitutability for the product. Many close substitutes implies little differentiation and little market power. Few and distant substitutes implies high differentiation and relatively high market power. Generally, firms in an industry selling differentiated products brand their products. An industry consisting of many firms with small market shares and branded products is likely very close to a monopolistically competitive market structure. An industry with few firms and large market shares and branded products is likely an impure oligopoly.
A unique product has no close substitutes. A firm with a unique product is a monopoly (at least in the short run). A monopoly firm faces the downward sloping market demand curve which allows the monopolist to have market power.
Sources for identifying product characteristics are company provided information (web pages and information packages); company advertising and promotional materials, corporate reports of publicly-held corporations, periodical articles and news, and trade associations.
The final criteria for classifying market structure is the level of barriers to entry. This criteria does not apply in the short run. By definition, the short run excludes entry. A researcher must be careful when looking at a "snapshot" of an industry at any point in time to classify market structure. At any point in time, market structure can be classified with knowing the number of sellers and product characteristics. However, the importance of studying market structure is understanding the implications of the market structure for the competitive strategies of firms in the market. Competitive strategies are chosen to maximize the long-run profits of firms. Thus, an important question is whether the market structure will change over time. Oligopoly and monopoly market structures can be sustained over time only if there are barriers to entry. Firms in oligopolistic industries or a monopoly firm can sustain market power only if they can prevent other firms from entering the industry.
There are three types of barriers to entry:
Porter provides an excellent model for evaluating barriers to entry in Chapter 1 of his previously referenced book Competitive Strategy: Techniques for Analyzing Industries and Competitors.
Identifying barriers to entry is a little tricky. A monopolist or firms in an oligopoly are unlikely to "advertise" barriers to entry given possible antitrust ramifications. However, there are some guideposts we can use.
Identifying natural, legal, and strategic barriers to entry in monopoly first requires the researcher to understand the nature of the monopoly.
The most common barriers to entry in an oligopoly are:
Evidence of BTE can often be found by using resources provided by the monopolist or the firms in an oligopoly. Public companies provide investors with annual reports, quarterly earnings reports, dividend announcements, and more. SEC filings are also good sources. Many companies, both public and private, provide information packages or make information available on their web sites.
Investment analysts are in the business of predicting what will happen to a firm's stock price. Stock price should reflect the net present value of future cash flows or profit. The ability to sustain economic profit often depends upon an industry's ability to keep new competitors out of the industry. Investment analysts are particularly aware of the importance of BTE to future profits. Thus, investment analyst reports often identify the BTE that are the foundation of their opinions for future profits of a firm and the direction of the firm's stock price. (See "Investment Analyst Reports" under the subheading "INDUSTRY SOURCES" on the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.)
Given answers to the number of sellers, product characteristics, and barriers to entry, a researcher can identify the market structure of an industry using Table 3. The objective data must be tempered with the subjective opinion of the researcher. Changing market conditions and industry dynamics often require a researcher to predict the evolution of market structure over time. An analysis of future competition in an industry will depend upon the assumptions and analytical models employed by the researcher.
Many industries may not clearly fit the criteria for any single market structure. Classification of market structure often depends upon the level of competition viewed by the researcher. Competition can be viewed from the company level, a product category level (with possible multiple categories), or an individual product level.
Many U.S. industries are characterized by a small number of companies that produce several brands of products that are relatively close substitutes. At the company level of competition, the market structure appears to be an oligopoly. On the other hand, brand competition seems to be monopolistic competition. For example, 1997 market shares for cookie makers were Nabisco - 29%, Keebler - 13%, McKee Baking Co. - 12%, and President Baking - 6%. The CR4 at the company level would be 60 which corresponds to an oligopoly market structure. 1998 best-selling cookies were Nabisco - 10.1%, Nabisco Chips Ahoy! - 8.5%, Archway - 4.2%, and Keebler Chips Deluxe - 4.2%. The CR4 at the brand level would be 27 which corresponds to a monopolistic competition market structure. In the cookie category, actual competition has characteristics of both market structures.
The vertical supply chain of Figure 4 can be viewed as a series of sellers who add value to a product before it is finally sold to an end user. For each seller there is an associated buyer who is simply the next seller in the vertical supply chain, except for the last seller who sells to the end user. There is a vertical relationship between each successive link of the supply chain. The nature of these vertical relationships is an important factor in the ability of an industry to sustain economic profitability. In determining the number of sellers and buyers in our previous study of market structure, we have already started an analysis of the bargaining power of buyers. How effective are buyers in negotiating price and terms of sale with firms in the industry? Buyer bargaining power can reduce industry profitability. Similarly, each seller is also a buyer in the sense that each seller must obtain input to its production process. Another important question is: How effective are suppliers in negotiating price and terms of sale with firms in the industry? Supplier bargaining power may also reduce industry profitability.
Porter provides an excellent basis for evaluating the bargaining power of suppliers and buyers in Chapter 1 of his previously referenced book Competitive Strategy: Techniques for Analyzing Industries and Competitors.
Each of Porter's Five Forces shown in Figure 1 must be weighed together for an overall picture of the future profitability potential of the industry.
An evaluation of the fives forces must consider:
Once again, Chapter 1 in Porter's previously referenced book Competitive Strategy: Techniques for Analyzing Industries and Competitors provides more detail on the assessment of the future profitability potential of an industry.
Each firm in an industry chooses its own positioning within the industry and its own strategy to compete.
Firms must choose their strategic positioning and product positioning. A firm's strategic positioning delineates its boundaries, both vertical and horizontal. A firm's product positioning delineates the attributes that its product will offer. Which comes first: strategic positioning or product positioning? Table 6 below should help a researcher to choose which type of positioning to study first.
Table 6: Positioning Analysis
|Order of study is||For an Existing Firm if||For a New Entrant if|
|1. Strategic Positioning
2. Product Positioning
|New product in an existing industry||Existing product in an existing industry|
|1. Product Positioning
2. Strategic Positioning
|New product in a new industry||New product in an existing industry|
A firm chooses its boundaries based on its ability to create value within a positioning. It is important to note that boundaries are not barriers. Boundaries define a firm's competitors and the functions performed inside the firm. Boundaries do not prevent entry or mergers and acquisitions.
A firm's horizontal boundaries are essentially defined by its direct competitors. A competitor is "direct" if it produces a similar product. The important question to consider is: How many firms are in the industry? Slicing a pie is a good analogy for understanding horizontal boundaries. The pie represents the market for the industry's product. The number of slices of the pie is equivalent to the number of firms in the industry. The size of a slice represents the market share of a firm. Horizontal boundaries define how many slices of pie there are and how big each slice is. Wider slices (boundaries) mean there are relatively fewer firms with larger market shares (the characteristics of an industry with high concentration). Narrower slices mean there are relatively more firms with smaller market shares (the characteristics of an industry with low concentration).
There are two steps to determining horizontal boundaries. First, the industry itself and its product must be clearly defined (see Section II. B. 1.). Second, the number, identity, and market shares of each firm in the industry must be determined (see Section II. B. 2.).
Identifying horizontal boundaries at any given moment is easy. A researcher need only obtain a list of competitors in the industry. (See "Company Directories" under the subheading "COMPANY SOURCES" listed on the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm. Another possible source is Hoover's Online at http://www.hoovers.com.)
The more difficult analysis is to predict how horizontal boundaries may change over time. Horizontal boundaries can change with:
A "widening" of horizontal boundaries takes place if some firms exit the industry or if firms merge. The implication of a widening of horizontal boundaries is an increase in industry concentration which usually translates into higher profitability.
A "narrowing" of horizontal boundaries takes place if firms enter the industry. The implication of a narrowing of horizontal boundaries is a decrease in industry concentration which usually translates into lower profitability. Thus, existing firms in an industry have a vested interest in keeping horizontal boundaries as wide as possible. Barriers to entry are key to this effort (as discussed in Section II. B. 4.) The business practices firms can adopt to maintain horizontal boundaries at "wide" levels are discussed in Section III. C. 2. a. below.
A firm's choice of vertical boundaries sets its relative position in the supply chain. Figure 6 shows the upstream and downstream vertical boundaries of a firm.
Figure 6: Vertical Boundaries
By definition, firms within the same industry must share at least one link of the vertical supply chain in common. However, firms can differ as to how many links they occupy in the supply chain. A firm's decision as to what links of the supply chain will be owned by the firm is call "The Make or Buy Decision." Table 7 below specifies the benefits and costs of "buying" from market firms (buying inputs from suppliers and/or distributing outputs through distribution channels) rather than "making" the activity within the firm. If benefits of using the market outweigh the costs, then the firm should buy from the market firms. If benefits of using the market are less than the costs, then the firm should perform the activity in-house.
Table 7: The Make or Buy Decision
Benefits and Costs of Using the Market
Closely related to the "Make or Buy Decision" is the concept of core competency. A firm must first identify its own set of complementary skills and technologies embedded in a group or team that allows a firm to create value in the market be executing one or more critical activities to a world-class standard. This set of complementary skills and technologies is called a core competency. The subsequent consideration for a firm is whether its value proposition will allow it to outperform its competitors in the industry. This is called a competitive advantage. In other words, a core competency is what a firm does better than the rest. A competitive advantage is what a firm does better than the rest that allows it to make profits.
A core competency must create one of the following:
The types of core competencies are:
Firms evaluate their core competency by asking:
Product positioning “refers to how customers think about proposed and/or present brands in a market (Perreault and McCarthy 1999).” Through a brand’s positioning, a company tries to build a sustainable competitive advantage on product attribute(s) – tangible or intangible – in the mind of the consumer. This advantage is designed to appeal to one or more segments in that product category.
Products are positioned to create value for the consumer. If a firm can create more value for the consumer than its next best competitor then the firm can earn higher profits than that competitor.
There are two types of positions that a firm can take to create more value relative to competition: a differentiation position and a cost position.
Figure 7 below demonstrates a differentiation position. B represents benefit to the consumer, P represents price, can C represents the company's cost. With a differentiation position, the company creates more benefit for the consumer relative to its competitor.
Figure 7: A Differentiation Position
Figure 8 below demonstrates a cost position. With a cost position, the company creates the same benefit for the consumer as does its competitor, but it does so at a lower cost.
Figure 8: A Cost Position
To determine how to position a brand (or brands) in a market, the firm must understand the following.
Perceptual mapping is a commonly used tool to evaluate the real and perceived differentiation of a brand. For this tool, a firm must plot its brands and competitors on key attributes for the industry and/or category. The plot may be based on technical specifications, but a firm should also develop plots on consumer perceptions obtained through surveys. The maps also provide information on potential opportunities for introducing new products, repositioning an existing brand, and/or segments thatare underserved by existing brands in the category. These plots give the firm a realistic picture on whether or not it has points of differentiation and whether this differentiation is important to consumers. The Product Attributes Model is another way to look at differentiation and customer segments.
To turn a point of differentiation into a competitive advantage, a firm must be able to sustain this area of differentiation relative to competitors and obtain the value of this differentiation from the consumer in the form of profits. These areas are discussed in the next section.
Perreault, William D., Jr. and E. Jerome McCarthy (1999), Basic Marketing: A Global-Managerial Approach, Boston, MA: Irwin McGraw-Hill.
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A strategy is a set of objectives, policies, and plans that, taken together, define the scope of the enterprise and its approach to survival and success.
See A Guide for Strategy Evaluation.
Figure 9 below shows the most basic implications of each market structure for a firm's competitive strategy.
Figure 9: Implication of Market Structure for a Firm's Competitive Strategy
Individual firms in perfect competition face a horizontal demand curve, i.e. they take price from the market where price is determined by the interaction of supply and demand. Marketing by an individual firm is ineffective because the firm can already sell as much as it wants at the given market price. Thus, there are usually no brands associated with perfectly competitive firms. Improvements in operations that lower costs are ineffective in the long run because other firms can quickly copy innovations. The lack of a role for marketing and/or operations results in long-run zero economic profit for firms in perfect competition. However, firms that join together in perfectly competitive industries can form associations to improve market demand conditions. Associations can conduct R&D and promotions to increase demand for the industry product, which can shift the demand curve to the right and/or make demand less elastic. A listing of trade associations is available at http://www.associationcentral.com/. (Other sources are provided on the Babson College Horn Library web site "Researching an Industry: Trade Association Material" at http://www.babson.edu/library/indtrade.htm.)
Individual firms in monopolistic competition face a downward sloping demand curve based on product differentiation. Thus, each firm has some market power. Firms position brands with specific perceived features or attributes to appeal to specific segments of consumers (or target markets). A segment of consumers loyal to a particular brand may be willing to pay more for some feature or attribute of the brand. The firm's brand may have added value for this segment because these consumers perceive and value the differentiating characteristics. A firm's competitive strategy will be to price the brand based on the consumers' value for differentiation. This may allow the firm to earn short-run economic profits. However, there is no guarantee of long-run economic profits due to free entry of new competition. Thus, each firm must maintain the value of perceived differentiation to sustain a competitive advantage.
Marketing has a significant role in industries characterized as monopolistic competition. Product differentiation is accomplished through a firm's choice of its marketing mix or 4 P's (price, product, promotion, and place). The goal of marketing is to increase demand (shift the demand curve to the right) and to reduce the elasticity of demand (rotate the demand curve clockwise).
The role of marketing is covered in the Conduct/Behavior section of this guide.
The competitive strategies of firms in an oligopoly are mutually interdependent. When a firm in an oligopoly chooses its strategy, it must take the potential reactions of its competitors into account. The outcome of a decision for one firm depends upon the decisions of its competitors. Thus, firms in an oligopoly are strategically interdependent.
The monopolist faces the downward sloping market demand curve for its unique product. Thus, the monopolist has market power.
The strategy of a monopolist is relatively clear: Price the unique product to maximize profit.
The role of operations to support this strategy is clear: Create and sustain the barriers to entry necessary to protect monopoly profits. Sustaining barriers to entry is paramount (and can be evaluated as per section II. B. 4. above). Creating new barriers can be quite interesting.
The role of marketing depends on the nature of the product. Promotion can still be needed to stimulate demand for the product. Consumers need to be aware of the product and its benefits in order for them to consider a purchase. Sometimes, exclusive distribution supports the perception of the uniqueness of the product. As in monopolistic competition, the goal of marketing is still to increase demand (shift the demand curve to the right) and to reduce the elasticity of demand (rotate the demand curve clockwise).
Firms develop and adopt business practices (operations, marketing, finance, etc.) that support their positioning and competitive strategy. Activities and activity systems conducted within the scope of the firm must be carefully selected and nurtured if the firm is to successfully implement its value proposition. A complete study of business practice is too broad of a subject for this guide. Each industry is likely to have very different methods of conduct. However, three considerations are generally applicable to all industries. These are:
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Figure 10: The Value Chain
A firm that changes its (or adopts a new) strategic positioning must change its (or adopt new) boundaries.
Economic profits can be sustained in an oligopoly or a monopoly only if firms sustain their horizontal boundaries, i.e. they prevent entry of new firms into the industry.
Noncooperative strategic behavior are those actions that a firm takes to maximize its profit by improving its position relative to its competitors.
To be successful, a noncooperative strategy requires the firm to have:
Common noncooperative strategies are the threat of predatory pricing (see Section III. C. 2. b. below), limit pricing, investments to lower production costs, raising rivals' costs, and raising all firms' costs.
An incumbent firm uses limit pricing when it sets price and output so that there is not enough demand left for another firm to profitably enter the market. Maximizing short-run profit can lead to entry of new firms, capacity expansion of smaller existing firms, and loss of sales to substitutes. Limit pricing starts with the assumption that firms maximize long-run, and not short-run, profits.
An incumbent firm may discourage entry by making investments to lower production costs in ways such as investing in R&D and learning by doing.
An incumbent firm may try to make entry difficult by raising rivals' costs. An incumbent firm may be able to raise the entrant's relative costs through direct methods, legal tactics, interference through government regulation, production of complements, raising switching costs, or raising wages or other input prices. Often, an incumbent firm discourages entry by raising all firms' costs through excessive promotion or government regulation.
Cooperative strategic behavior are those actions that competitors take together in order to reassure each other that they are not cheating on a cooperatively agreed-to price. Cooperatively agreed-to prices can take the form of price fixing, preventing price discounts, and eliminating price discounts.
The extreme of cooperative strategic behavior is a cartel. In a cartel, firms explicitly coordinate their decisions.
Cooperative strategies that facilitate cartels include most-favored-nation clauses, meeting-competition clauses, trade associations, dividing the market, trigger prices, uniform prices, penalty for price discounts, advance notice of price changes, information exchanges, delivered pricing, and swaps and exchanges.
The ideal cartel would make decisions as if all firms where joined together as a monopoly. In the U.S., such cooperative behavior is illegal.
Implicit cooperative behavior is usually not illegal. In this case, a firm simply observes the actions of its competitors and makes its own decisions accordingly. Thus, a researcher can often observe that the competitive strategies of firms in an oligopoly will be remarkably similar. In particular, the elements of each firms marketing mix will look very much the same. Products will be priced similarly, promotional expenditures will be similar, product development will appear to be on a parallel track between firms, and firms will distribute their products through similar channels.
In an oligopoly, the elements of the marketing mix that can be observed in company provided information (web pages and information packages); company advertising and promotional materials, corporate reports of publicly-held corporations, periodical articles and news, and trade associations will all look roughly the same. [See the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.]
As discussed in Section III. A. 1. a., firms in an industry have a vested interest in maintaining or even widening horizontal boundaries. Wider boundaries mean larger market shares (or larger slices of the market pie) for firms in the industry which usually leads to higher profitability.
Firms can try to force competitors to exit the market by developing superior marketing or operations.
Mergers and acquisitions clearly reduce the number of competitors in an industry. A merger will occur only if the acquiring company expects to receive a greater return on the assets of the target firm than the target firm can generate by itself. The motivations for mergers and acquisitions are:
Collusion between competitors in an industry reduces effective competition. As discussed in Section II. B. 3., explicit collusion is illegal in the US. Implicit collusion such as the simple observation of strategic and tactical moves is usually legal and allows firms to coordinate their behavior. As competitors better understand the interactions of their strategies, they are more likely to choose strategies that improve profitability for all firms in the industry.
In a strategic alliances, two or more firms combine resources outside of the market to accomplish a particular task or set of tasks. There are two general types of strategic alliances:
The key factors driving strategic alliances are globalization and new technologies.
Evidence of business practices that maintain or widen horizontal boundaries can be found in company provided information (web pages and information packages), corporate reports of publicly-held corporations, investment analysis reports, and periodical articles and news. See the checklist provided on the Babson College Horn Library web site "Library Research Guide: United States Company & Industry Checklist" at http://www.babson.edu/library/companyindustrycklist.htm.
A single firm is vertically integrated if it controls various links in the vertical supply chain from basic inputs to final output.
Vertical integration can be backwards or forwards.
The reasons for and against vertical integration are:
The principal idea behind an integrated supply chain is that competition will be across supply chains, not individual companies.
Companies in integrated supply chains:
Desired outcomes of integrated supply chains are:
The nature of the relationship between a firm and its suppliers/buyers is governed by the frequency and complexity of transactions between the two parties. Figure 11 below is a general guide for the choice of vertical relationship.
Figure 11: The Choice of Vertical Relationship
A vertical restraint is a contractual limitation on conduct that one nonintegrated firm imposes on another firm in the supply chain (an upstream supplier or a downstream buyer). Vertical restraints are intended to solve distribution problems that arise from asymmetric information or free riding. In a relationship between a manufacturer and distributor, asymmetric information can lead to a principal-agent problem. Free riding means one firm benefits from the actions of another firm without paying for it. Table 8 below lists a number of distribution problems and the vertical restraints that manufacturers often adopt to solve the problems.
Table 8: Distribution Problems and Vertical Restraints Manufacturers Use to Solve Them
|Distribution Problem||Vertical Restraints Manufacturers Use to Solve the Distribution Problem|
|Double Marginalization - Double monopoly markup||
|Free Riding Among Distributors - One distributor may
benefit from another distributors actions (conduct) in:
|Free Riding Among Manufacturers - One manufacturer may
benefit from another manufacturers actions (conduct) in:
|Lack of Distributor Coordination the Leads to Externalities||
Vertical restraints can have both positive and negative effects on consumers.
Positive effects may be:
Negative effects may be:
A firm's choice of marketing mix (or 4 P's) must support its product positioning.
If a firm must charge one price to all consumers, the firm maximizes short-run profit by choosing output (which in turn determines price through its interaction with demand) where the additional revenue generated from selling one more unit of its product is just equal to the additional cost of producing that unit (where marginal revenue equals marginal cost).
Perfect Competition: As shown in Figure 9, firms in a perfectly competitive industry are price-takers. Price is determined in the market. This means that the additional revenue generated from selling one more unit of its product will be equal to the market price. A perfectly competitive firm maximizes short-run profit by choosing output where price is just equal to the additional cost of producing that unit (where price equals marginal cost).
Firms in monopolistic competition, oligopoly, and monopoly choose output where marginal revenue equals marginal cost.
Firms may be able to increase profits with price discrimination. A firm price discriminates if it charges different prices to different segments of its consumers.
There are three conditions for a firm to be able to price discriminate:
The firm must have market power
The firm must be able to identify consumer segments
The firm must be able to prevent or limit resale (or it must be inherently difficult for the product to be resold)
There are three types of price discrimination:
First-Degree Price Discrimination: The firm prices at the maximum that each consumer is willing to pay for each unit of the product.
Second-Degree Price Discrimination (or non-linear pricing): Price differs with the number of units purchased by the consumer.
Third-Degree Price Discrimination: Price differs between consumer segments.
With first- and third-degree price discrimination, the firm targets price to a specific consumer or consumer segment.
With second-degree price discrimination, the firm's pricing strategy maximizes profit based upon some characteristic of the product. Example of second-degree price discrimination are:
Nonlinear pricing methods such as a quantity discount, a single two-part tariff, and a two two-part tariff
Pricing based on bundling of products
Pricing based on quality choice
Premium for priority
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The purposes of promotion include
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Studies have found that an industry's advertising as a percentage of sales (advertising to sales ratio) is often closely related to the industry's concentration ratio. In perfect competition, there is relatively little advertising given a homogeneous product. In monopoly, there may be some advertising to support the monopoly position. Monopolistic competition and oligopoly market structures are likely to have significant advertising expenditures. Promotion is a key differentiator in monopolistic competition and strategic interdependence in oligopoly is likely to lead to excessive expenditures on advertising to protect market share. An impure oligopoly is likely to have a very high advertising to sales ratio for both of these reasons.
The advertising to sales ratio is calculated as:
Advertising to sales ratio = Advertising Expenditures / Revenue
An industry advertising to sales ratio will likely have to be calculated as a composite of individual firm advertising to sales ratios.
Data on individual firm advertising expenditures is available from:
Data on individual firm revenue can be found using the resources shown in Section II. B. 2. a.
A graphical representation of the relationship between advertising to sales ratio and concentration ratio is provided in Figure 12 below.
NOTE: The graphical representation is approximate at best and the range of advertising to sales ratio shown on the figure is not representative of every industry. The graph shows the relative relationship between advertising to sales ratio and concentration ratio for an industry in general. The decision as to whether a specific value of an advertising to sales ratio is indicative of the strategic implications of a particular market structure must be based upon the analysis of the researcher and other relevant objective and subjective criteria.
Figure 12: The Relationship of Advertising to Sales Ratio and Concentration
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Entrepreneurs exploit opportunities for creating profitable positions that other firms ignore or are unable to. Competitive advantage may originate in:
Figure 13: Porter's Diamond
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Figure 14: Identifying Competitive Advantage
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Figure 15: Analyzing Competitive Advantage
Industry performance is measured by its success in creating value for consumers. Firm performance is measured by it success in value-creation relative to its competitors in the industry. The ideal measure of firm performance is a comparison to its next best competitor. In practice, a firm is usually compared to some measure of average industry performance.
Common market performance measures are:
An evaluation of industry performance depends upon whether performance is being judged by return to an investor or value-created for a consumer. In general, high returns to an investor are the result of the extraction of value from the consumer. In other words, the firms in the industry have market power and can charge a price higher than marginal cost and earn economic profits (profits in excess of a normal return). Firms in the industry are better off as they earn higher profits, consumer are worse off because they buy less in quantity and pay more in price.
Evaluating industry performance from the perspective of an investor is simple. The researcher need only make a cross-sectional comparison of industry performance measures. Investment dollars will go to the industry where industry performance measures are the highest.
Evaluating industry performance from the perspective of a consumer is tricky. Performance must be weighed between value-creation and market power. Superior performance based on value-creation generally benefits consumers, superior performance based on market power generally hurts consumers.
Value-creation can be based upon superior differentiation or superior cost.
Superior differentiation may be evidenced by
Superior cost may be evidenced by price competition in the industry that
Market power depends on market structure. In general, market power increases as market concentration increases. Thus, industry performance measures generally increase as market concentration increases.
Productive efficiency is attained if products are produced at minimum average cost. Allocative efficiency is attained if products are produced using the optimal mix of inputs. Firms in perfect competition achieve efficiency because price is equal to marginal cost and, in the long run, price is equal to minimum average cost. Firms in other market structures have market power, they can choose output such that price is greater than marginal cost. Production by firms with market power (with no government regulation) always choose to produce at an inefficient level. At this less than efficient output level, average cost is not minimized and too few resources are allocated to production of the product.
The total benefit to society (social welfare) of the production of a good or service considers both the profits of the industry and the value created for consumers. Thus, a researcher evaluating the performance of an industry must take care to consider both members of society. An industry's total contribution to society's welfare is more than its own profits, measuring industry performance should also include the benefits created for consumers.
Good sources for industry performance measures are:
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