External Analysis:

The Identification of
Opportunities and Threats
3
C H A P T E R O U T L I N E

Analyzing Industry Structure Industry Life Cycle Analysis

Risk of Entry by Potential Embryonic Industries
Competitors Growth Industries
Rivalry Among Established Industry Shakeout
Companies Mature Industries
The Bargaining Power Declining Industries
of Buyers Summary
The Bargaining Power
The Macroenvironment
of Suppliers
Substitute Products Macroeconomic Forces
Porter’s Model Summarized Global Forces
Technological Forces
Strategic Groups within Industries Demographic Forces
Implications of Strategic Groups Social Forces
The Role of Mobility Barriers Political and Legal Forces

L E A R N I N G O B J E C T I V E S

After reading this chapter you should be • Discuss how industries evolve over
able to: time, with reference to the industry life
• Review the main technique used to ana- cycle model.
lyze competition in an industry environ- • Show how trends in the macro-
ment, the five forces model. environment can shape the nature
• Explore the concept of strategic groups of competition in an industry.
and illustrate its implications for industry
analysis.
56 Part 2 The Nature of Competitive Advantage

OVERVIEW
The starting point of strategy formulation is an analysis of the forces that shape
competition in the industry in which a company is based. The goal of such an analy-
sis is to gain an understanding of the opportunities and threats confronting the firm
and to use this understanding to identify strategies that will enable the company to
outperform its rivals. Opportunities arise when a company can take advantage of
conditions in its environment to formulate and implement strategies that enable it to
become more profitable. Threats arise when conditions in the external environment
endanger the integrity and profitability of the company’s business.
This chapter begins with an analysis of the industry environment. First, it exam-
ines concepts and tools for analyzing the competitive structure of an industry and
identifying industry opportunities and threats. Second, it analyzes the competitive
implications that arise when groups of companies within an industry pursue similar
and different kinds of competitive strategies. Third, it explores the way an industry
evolves over time and the accompanying changes in competitive conditions. Fourth,
it looks at the way in which forces in the macroenvironment affect industry struc-
Opportunities ture and influence opportunities and threats. By the end of the chapter, you will
Opportunities arise understand that to succeed, a company must either fit its strategy to the external
when a company environment in which it operates or must be able to reshape the environment to its
can take advantage advantage through its chosen strategy.
of conditions in
its environment
to formulate and
implement strategies
that enable it to
Analyzing Industry Structure
become more An industry can be defined as a group of companies offering products or services
profitable. that are close substitutes for each other, that is, products or services that satisfy the
Threats same basic customer needs. A company’s closest competitors, its rivals, are those that
serve the same basic customer needs. For example, carbonated drinks, fruit punches,
Threats arise when
and bottled water can be viewed as close substitutes for each other because they
conditions in the
serve the same basic customer needs for refreshing and cold nonalcoholic beverages.
external environment
Thus, we can talk about the soft drink industry, whose major players are Coca-Cola,
endanger the integrity
PepsiCo, and Cadbury Schweppes. Similarly, desktop computers and notebook com-
and profitability of the
puters satisfy the same basic need that customers have for computer hardware on
company’s business.
which to run personal productivity software; browse the Internet; send e-mail; play
Industry games; and store, display, and manipulate digital images. Thus, we can talk about the
A group of companies personal computer industry, whose major players are Dell, HP, Lenovo (the Chinese
offering products or company that purchased IBM’s personal computer business), and Apple Computer.
services that are close The starting point of external analysis is to identify the industry that a company
substitutes for each competes in. To do this, managers must begin by looking at the basic customer needs
other—that is, products their company is serving—that is, they must take a customer-oriented view of their
or services that business as opposed to a product-oriented view (see Chapter 2). The basic customer
satisfy the same basic needs that are served by a market define an industry’s boundary. It is important for
customer needs. managers to realize this, for if they define industry boundaries incorrectly, they may
be caught flat-footed by the rise of competitors that serve the same basic customer
Competitors needs with different product offerings. For example, Coca-Cola long saw itself as
Enterprises that being in the carbonated soft drink industry, whereas in fact it was in the soft drink
serve the same basic industry, which includes noncarbonated soft drinks. In the mid-1990s, Coca-Cola
customer needs. was caught by surprise by the rise of customer demand for bottled water and fruit
 Chapter 3 External Analysis: The Identification of Opportunities and Threats 57

Figure 3.1 Porter’s Five Forces Model

Risk of entry
by potential
competitors

Intensity of
Bargaining Bargaining
rivalry among
power of power of
established
suppliers buyers
firms

Threat of
substitutes

Data Source: Adapted and reprinted by permission of Harvard Business Review. From Michael
E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review, March/April 1979.
© 1979 by the President and Fellows of Harvard College. All rights reserved.

drinks, which began to cut into the demand for sodas. Coca-Cola moved quickly to
respond to these threats, introducing its own brand of water, Dasani, and acquiring
orange juice maker Minute Maid. By defining its industry boundaries too narrowly,
Coca-Cola almost missed the rapid rise of the noncarbonated soft drinks segment of
the soft drinks market.
Once the boundaries of an industry have been identified, the task facing manag-
ers is to analyze competitive forces in the industry environment to identify oppor-
tunities and threats. Michael E. Porter’s well-known framework, known as the five
forces model, helps managers with this analysis.1 His model, shown in Figure 3.1,
focuses on five forces that shape competition within an industry: (1) the risk of entry
by potential competitors, (2) the intensity of rivalry among established companies
within an industry, (3) the bargaining power of buyers, (4) the bargaining power of
suppliers, and (5) the closeness of substitutes to an industry’s products.
Porter argues that the stronger each of these forces, the more limited the ability
of established companies to raise prices and earn greater profits. Within Porter’s
framework, a strong competitive force can be regarded as a threat because it de-
presses profits. A weak competitive force can be viewed as an opportunity because it
allows a company to earn greater profits. The strength of the five forces may change
through time as industry conditions change. The task facing managers is to recog-
nize how changes in the five forces give rise to new opportunities and threats and to
formulate appropriate strategic responses. In addition, it is possible for a company,
through its choice of strategy, to alter the strength of one or more of the five forces
to its advantage.
58 Part 2 The Nature of Competitive Advantage

Risk of Entry by Potential Competitors

Potential competitors are companies that are not currently competing in an industry
but have the capability to do so if they choose. For example, cable TV companies
have recently emerged as potential competitors to traditional phone companies. This
is because new digital technologies have allowed cable companies to offer consumers
telephone service over the same cables that are used to transmit TV shows.
Established companies already operating in an industry often attempt to discour-
age potential competitors from entering the industry because the more companies
that enter, the more difficult it becomes for established companies to protect their
share of the market and generate profits. A high risk of entry by potential competi-
tors represents a threat to the profitability of established companies. If the risk of
new entry is low, established companies can take advantage of this opportunity to
raise prices and earn greater returns.
The risk of entry by potential competitors is a function of the height of barriers
to entry, that is, factors that make it costly for companies to enter an industry. The
greater the costs that potential competitors must bear to enter an industry, the greater
are the barriers to entry and the weaker this competitive force. High entry barriers
may keep potential competitors out of an industry even when industry profits are
high. Important barriers to entry include economies of scale, brand loyalty, absolute
cost advantages, strategic preemption, customer switching costs, and government
regulation.2 It should be noted that a significant aspect of strategy is about build-
ing barriers to entry (in the case of incumbent firms), or finding ways to circumvent
those barriers (in the case of new entrants). We shall discuss this in more detail in
subsequent chapters.

Economies of Scale Economies of scale arise when unit costs fall as a firm ex-
pands its output. Sources of scale economies include (1) cost reductions gained
through mass-producing a standardized output, (2) discounts on bulk purchases of
Potential Competitors raw material inputs and component parts, (3) the advantages gained by spreading
Companies that are not fixed production costs over a large production volume, and (4) the cost savings asso-
currently competing in ciated with spreading marketing and advertising costs over a large volume of output.
an industry but have If the cost advantages from economies of scale are significant, a new company that
the capability to do so enters the industry and produces on a small scale suffers a significant cost disad-
if they choose. vantage relative to established companies. If the new company decides to enter on a
large scale in an attempt to obtain these economies of scale, it has to raise the capital
Barriers to Entry
required to build large scale production facilities and bear the high risks associated
Factors that make it with such an investment. A further risk of large-scale entry is that the increased sup-
costly for companies ply of products will depress prices and result in vigorous retaliation by established
to enter an industry. companies. For these reasons, the threat of entry is reduced when established com-
Economies of Scale panies have economies of scale.
Reductions in unit costs
attributed to a larger Brand Loyalty Brand loyalty exists when consumers have a preference for the
output. products of established companies. A company can create brand loyalty through
continuous advertising of its brand-name products and company name, patent pro-
Brand Loyalty tection of products, product innovation achieved through company research and
Preference of development programs, an emphasis on high product quality, and good after-sales
consumers for the service. Significant brand loyalty makes it difficult for new entrants to take market
products of established share away from established companies. Thus, it reduces the threat of entry by po-
companies. tential competitors since they may see the task of breaking down well-established
 Chapter 3 External Analysis: The Identification of Opportunities and Threats 59

3.1 STRATEGY IN ACTION

Circumventing Entry Barriers into the Soft Drink Industry
The soft drink industry has long been dominated by two cost savings, which it passed onto retailers in the form of
companies, Coca-Cola and PepsiCo. Both companies lower prices. For their part, the retailers found that they
have historically spent large sums of money on advertis- could significantly undercut the price of Coke and Pepsi
ing and promotion, which has created significant brand colas, and still make better profit margins on private label
loyalty and made it very difficult for prospective new brands than on branded colas.
competitors to enter the industry and take market share Cott’s breakthrough came in 1992 when it signed a
away from these two giants. When new competitors do deal with Walmart to supply the retailing giant with a pri-
try and enter, both companies have shown themselves vate label cola, called “Sam’s Choice.” Walmart proved to
capable of responding by cutting prices, forcing the new be the perfect distribution channel for Cott. The retailer
entrant to curtail expansion plans. was just starting to get into the grocery business, and
However, in the early 1990s, the Cott Corporation, consumers went to the stores not to buy branded mer-
then a small Canadian bottling company, worked out a chandise, but to get low prices.
strategy for entering the soft drink market. Cott’s strat- As Walmart’s grocery business grew, so did Cott’s
egy was deceptively simple. The company initially fo- sales. Cott soon added other flavors to its offering, such
cused on the cola segment of the soft drink market. Cott as lemon lime soda that would compete with Seven
signed a deal with Royal Crown Cola for exclusive global Up and Sprite. Moreover, pressured by Walmart, by the
rights to its cola concentrate. RC Cola was a small player late 1990s, other U.S. grocers also started to introduce
in the U.S. cola market. Its products were recognized as private label sodas, often turning to Cott to supply their
having a high quality, but RC Cola had never been able needs. By 2006, Cott had grown to become a $1.8 billion
to effectively challenge Coke or Pepsi. Next, Cott signed company. Its volume growth in an otherwise stagnant
a deal with a Canadian grocery retailer, Loblaw’s, to pro- U.S. market for sodas has averaged around 12.5% be-
vide the retailer with its own private label brand of cola. tween 2001 and 2006. Cott captured over 5% of the U.S.
Priced low, the Loblaw’s private label brand, known as soda market in 2005, up from almost nothing a decade
President’s Choice, was very successful, taking share earlier, and held onto a 16% share of sodas in grocery
from both Coke and Pepsi. stores, its core channel. The losers in this process have
Emboldened by this success, Cott decided to try been Coca-Cola and PepsiCo, who are now facing the
and convince other retailers to carry private label cola. steady erosion of their brand loyalty and market share as
To retailers, the value proposition was simple—unlike consumers increasingly came to recognize the high qual-
its major rivals, Cott spent almost nothing on advertis- ity and low price of private-label sodas.3
ing and promotion. This constituted a major source of

customer preferences as too costly. In the market for colas, for example, consumers
have a strong preference for the products of Coca-Cola and PepsiCo which makes it
difficult for other enterprises to enter this market (despite this, the Cott Corporation
has succeeded in entering the soft drink market—see the Strategy in Action).

Absolute Cost Advantages Sometimes established companies have an absolute

cost advantage relative to potential entrants, meaning that entrants cannot expect Absolute Cost
to match the established companies’ lower cost structure. Absolute cost advantages Advantage
arise from three main sources (1) superior production operations and processes due A cost advantage that is
to accumulated experience in an industry, patents, or secret processes; (2) control enjoyed by incumbents
of particular inputs required for production, such as labor, materials, equipment, or in an industry and that
management skills, that are limited in their supply; and (3) access to cheaper funds new entrants cannot
because existing companies represent lower risks than new entrants, and therefore expect to match.
60 Part 2 The Nature of Competitive Advantage

face a lower cost of capital.4 If established companies have an absolute cost advan-
tage, the threat of entry as a competitive force is weaker.

Customer Switching Costs Switching costs arise when it costs a customer time,
energy, and money to switch from the products offered by one established company
to the products offered by a new entrant. When switching costs are high, custom-
ers can be locked in to the product offerings of established companies, even if new
entrants offer better products.5 A familiar example of switching costs concerns the
costs associated with switching from one computer operating system to another. If a
person currently uses Microsoft’s Windows operating system and has a library of re-
lated software applications (e.g., word processing software, spreadsheet, games) and
document files, it is expensive for that person to switch to another computer operat-
ing system. To effect the change, this person would have to buy a new set of software
applications and convert all existing document files to run with the new system.
Faced with such an expense of money and time, most people are unwilling to make
the switch unless the competing operating system offers a substantial leap forward
in performance. Thus, the higher the switching costs are, the higher is the barrier to
entry for a company attempting to promote a new computer operating system.

Government Regulation Historically, government regulation has constituted a

major entry barrier into many industries. For example, until the mid-1990s, U.S.
government regulation prohibited providers of long-distance telephone service
from competing for local telephone service and vice versa. Other potential provid-
ers of telephone service, including cable television service companies such as Time
Warner and Comcast (which could in theory use their cables to carry telephone
traffic as well as TV signals), were prohibited from entering the market altogether.
These regulatory barriers to entry significantly reduced the level of competition in
both the local and long-distance telephone markets, enabling telephone companies
to earn higher profits than might otherwise have been the case. All this changed in
1996 when the government deregulated the industry significantly. In the months
that followed this announcement, local, long-distance, and cable TV companies all
announced their intention to enter each other’s markets, and a host of new players
entered the market. The five forces model predicts that falling entry barrier due to
government deregulation would result in significant new entry, an increase in the
intensity of industry competition, and lower industry profit rates. And, indeed, that
is what occurred.
In summary, if established companies have built brand loyalty for their products,
have an absolute cost advantage with respect to potential competitors, have signifi-
cant economies of scale, are the beneficiaries of high switching costs, or enjoy regu-
latory protection, the risk of entry by potential competitors is greatly diminished; it
is a weak competitive force. Consequently, established companies can charge higher
prices, and industry profits are higher. Evidence from academic research suggests
Switching Costs that the height of barriers to entry is one of the most important determinants of
Costs that consumers profit rates in an industry.6 Clearly, it is in the interest of established companies to
must bear to switch pursue strategies consistent with raising entry barriers to secure these profits. By
from the products the same token, potential new entrants have to find strategies that allow them to
offered by one circumvent barriers to entry. Research suggests that the best way to do this is not to
established company compete head-to-head with incumbents, but to look for customers who are poorly
to the products offered served by incumbents, and to go after those customers using new distribution chan-
by a new entrant. nels and new business models.7
 Chapter 3 External Analysis: The Identification of Opportunities and Threats 61

Rivalry among Established Companies

The second of Porter’s five competitive forces is the intensity of rivalry among es-
tablished companies within an industry. Rivalry refers to the competitive struggle
between companies in an industry to gain market share from each other. The com-
petitive struggle can be fought using price, product design, advertising and promo-
tion spending, direct selling efforts, and after-sales service and support. More intense
rivalry implies lower prices or more spending on non–price-competitive weapons, or
both. Because intense rivalry lowers prices and raises costs, it squeezes profits out of
an industry. Thus, intense rivalry among established companies constitutes a strong
threat to profitability. Alternatively, if rivalry is less intense, companies may have the
opportunity to raise prices or reduce spending on non–price-competitive weapons,
which leads to a higher level of industry profits. The intensity of rivalry among estab-
lished companies within an industry is largely a function of four factors: (1) industry
competitive structure, (2) demand conditions, (3) cost conditions, and (4) the height
of exit barriers in the industry.

Industry Competitive Structure The competitive structure of an industry refers

to the number and size distribution of companies in it, something that strategic man-
agers determine at the beginning of an industry analysis. Industry structures vary,
and different structures have different implications for the intensity of rivalry. A
fragmented industry consists of a large number of small- or medium-sized com-
panies, none of which is in a position to determine industry price. A consolidated
industry is dominated by a small number of large companies (an oligopoly), or in
extreme cases, by just one company (a monopoly) in which companies often are in Rivalry
a position to determine industry prices. Examples of fragmented industries are agri-
The competitive
culture, dry cleaning, video rental, health clubs, real estate brokerage, and sun tan-
struggle between
ning parlors. Consolidated industries include the aerospace, soft drink, automobile,
companies in an
pharmaceutical, and stockbrokerage industries.
industry to gain market
Many fragmented industries are characterized by low entry barriers and
share from each other.
commodity-type products that are hard to differentiate. The combination of these
traits tends to result in boom-and-bust cycles as industry profits rise and fall. Low Fragmented Industry
entry barriers imply that whenever demand is strong and profits are high, new en- An industry that
trants will flood the market, hoping to profit from the boom. The explosion in the consists of a large
number of video stores, health clubs, and tanning parlors during the 1980s and number of small-
1990s exemplifies this situation. or medium-sized
Often the flood of new entrants into a booming fragmented industry creates ex- companies, none of
cess capacity, so companies start to cut prices in order to use their spare capacity. The which is in a position
difficulty companies face when trying to differentiate their products from those of to determine industry
competitors can exacerbate this tendency. The result is a price war, which depresses prices.
industry profits, forces some companies out of business, and deters potential new en-
trants. For example, after a decade of expansion and booming profits, many health Consolidated Industry
clubs are now finding that they have to offer large discounts in order to hold onto An industry dominated
their membership. In general, the more commodity-like an industry’s product is, the by a small number of
more vicious will be the price war. This bust part of the cycle continues until overall large companies or,
industry capacity is brought into line with demand (through bankruptcies), at which in extreme cases, by
point prices may stabilize again. just one company,
A fragmented industry structure, then, constitutes a threat rather than an op- which are in a position
portunity. Most booms are relatively short-lived because of the ease of new entry to determine industry
and will be followed by price wars and bankruptcies. Because it is often difficult to prices.
62 Part 2 The Nature of Competitive Advantage

differentiate products in these industries, the best strategy for a company is to try to
minimize its costs so it will be profitable in a boom and survive any subsequent bust.
Alternatively, companies might try to adopt strategies that change the underlying
structure of fragmented industries and lead to a consolidated industry structure in
which the level of industry profitability is increased. How companies can do this is
something we shall consider in later chapters.
In consolidated industries, companies are interdependent, because one company’s
competitive actions or moves (with regard to price, quality, and so on) directly affect
the market share of its rivals, and thus their profitability. When one company makes
a move, this generally “forces” a response from its rivals, and the consequence of such
competitive interdependence can be a dangerous competitive spiral. Rivalry increases as
companies attempt to undercut each other’s prices or offer customers more value in their
products, pushing industry profits down in the process. The fare wars that have periodi-
cally created havoc in the airline industry provide a good illustration of this process.
Companies in consolidated industries sometimes seek to reduce this threat by
following the prices set by the dominant company in the industry.8 However, com-
panies must be careful, for explicit face-to-face price-fixing agreements are illegal.
(Tacit, indirect agreements, arrived at without direct or intentional communication,
are legal). Instead, companies set prices by watching, interpreting, anticipating, and
responding to each other’s behavior.

Industry Demand The level of industry demand is a second determinant of the

intensity of rivalry among established companies. Growing demand from new cus-
tomers or additional purchases by existing customers tend to moderate competi-
tion by providing greater scope for companies to compete for customers. Growing
demand tends to reduce rivalry because all companies can sell more without taking
market share away from other companies. High industry profits are often the result.
Conversely, declining demand results in more rivalry as companies fight to maintain
market share and revenues. Demand declines when customers are leaving the mar-
ketplace or each customer is buying less. Now a company can grow only by taking
market share away from other companies. Thus, declining demand constitutes a
major threat for it increases the extent of rivalry between established companies.

Cost Conditions The cost structure of firms in an industry is a third determinant

of rivalry. In industries where fixed costs are high, profitability tends to be highly lev-
eraged to sales volume, and the desire to grow volume can spark off intense rivalry.
Fixed costs refer to the costs that must be born before the firm makes a single sale.
For example, before they can offer service, cable TV companies have to lay cable in
the ground—the costs of doing so is a fixed cost. Similarly, in order to offer air ex-
press service a company like FedEx has to invest in planes, package sorting facilities,
and delivery trucks. These all represent fixed costs that require significant capital in-
vestments. In industries where the fixed costs of production are high, if sales volume
is low firms cannot cover their fixed costs and they will not be profitable. This creates
an incentive for firms to cut their prices and/or increase promotion spending in order
to drive up sales volume, thereby covering fixed costs. In situations where demand is
not growing fast enough and too many companies are engaged in the same actions,
Fixed Costs cutting prices and/or raising promotion spending in an attempt to cover fixed costs,
Costs that must be the result can be intense rivalry and lower profits. Research suggests that often the
borne before the firm weakest firms in an industry initiate such actions precisely because they are the ones
makes a single sale. struggling to cover their fixed costs.9
 Chapter 3 External Analysis: The Identification of Opportunities and Threats 63

Exit Barriers Exit barriers are economic, strategic, and emotional factors that
prevent companies from leaving an industry.10 If exit barriers are high, companies
become locked into an unprofitable industry where overall demand is static or de-
clining. The result is often excess productive capacity, which leads to even more in-
tense rivalry and price competition as companies cut prices in the attempt to obtain
the customer orders needed to use their idle capacity and cover their fixed costs.11
Common exit barriers include the following:
• Investments in assets such as specific machines, equipment, and operating facili-
ties that are of little or no value in alternative uses or cannot be sold off. If a
company wishes to leave the industry, it has to write off the book value of these
assets.
• High fixed costs of exit, such as the severance pay, health benefits, and pensions
that have to be paid to workers who are being made redundant when a company
ceases to operate.
• Emotional attachments to an industry, as when a company’s owners or employees
are unwilling to exit from an industry for sentimental reasons or because of pride.
• Economic dependence on an industry because a company relies on a single indus-
try for its revenue and profit.
• The need to maintain an expensive collection of assets at or above some mini-
mum level in order to participate effectively in the industry.
• Bankruptcy regulations, particularly in the United States, where Chapter 11
bankruptcy provisions allow insolvent enterprises to continue operating and re-
organize themselves under bankruptcy protection. These regulations can keep un-
profitable assets in the industry, result in persistent excess capacity, and lengthen
the time required to bring industry supply in line with demand.
As an example of the effect of exit barriers in practice, consider the express mail and
parcel delivery industry. The key players in this industry such as FedEx and UPS rely
on the delivery business entirely for their revenues and profits. They have to be able
to guarantee their customers that they will deliver packages to all major localities in
the United States, and much of their investment is specific to this purpose. To meet
this guarantee, they need a nationwide network of air routes and ground routes, an
asset that is required in order to participate in the industry. If excess capacity devel-
ops in this industry, as it does from time to time, FedEx cannot incrementally reduce
or minimize its excess capacity by deciding not to fly to and deliver packages in, say,
Miami because that proportion of its network is underused. If it did that, it would
no longer be able to guarantee that it would be able to deliver packages to all major
locations in the United States, and its customers would switch to some other carrier.
Thus, the need to maintain a nationwide network is an exit barrier that can result in
persistent excess capacity in the air express industry during periods of weak demand.
Finally, both UPS and FedEx managers and employees are emotionally tied to this
industry because they both were first movers in the ground and air segments of the
industry, respectively; their employees are also major owners of their companies’
stock; and, they are financially dependent on the fortunes of the delivery business.
Exit Barriers
The economic,
The Bargaining Power of Buyers
strategic, and emotional
The third of Porter’s five competitive forces is the bargaining power of buyers. An factors that prevent
industry’s buyers may be the individual customers who ultimately consume its prod- companies from leaving
ucts (its end users) or the companies that distribute an industry’s products to end an industry.
64 Part 2 The Nature of Competitive Advantage

users, such as retailers and wholesalers. For example, while soap powder made by
Procter & Gamble and Unilever is consumed by end users, the principal buyers of
soap powder are supermarket chains and discount stores, which resell the product to
end users. The bargaining power of buyers refers to the ability of buyers to bargain
down prices charged by companies in the industry or to raise the costs of companies
in the industry by demanding better product quality and service. By lowering prices
and raising costs, powerful buyers can squeeze profits out of an industry. Thus, pow-
erful buyers should be viewed as a threat. Alternatively, when buyers are in a weak
bargaining position, companies in an industry can raise prices, and perhaps reduce
their costs by lowering product quality and service, and increase the level of industry
profits. Buyers are most powerful in the following circumstances:
• When the industry that is supplying a particular product or service is composed
of many small companies and the buyers are large and few in number. These
circumstances allow the buyers to dominate supplying companies.
• When the buyers purchase in large quantities. In such circumstances, buyers can
use their purchasing power as leverage to bargain for price reductions.
• When the supply industry depends on the buyers for a large percentage of its
total orders.
• When switching costs are low so that buyers can play off the supplying compa-
nies against each other to force down prices.
• When it is economically feasible for buyers to purchase an input from several
companies at once so that buyers can play off one company in the industry
against another.
• When buyers can threaten to enter the industry and produce the product them-
selves and thus supply their own needs, also a tactic for forcing down industry
prices.
The auto component supply industry, whose buyers are large automobile manufac-
turers such as GM, Ford, and Toyota, has historically been a good example of an
industry in which buyers have had a strong bargaining power and thus constituted
a strong competitive threat. Why? The suppliers of auto component are numerous
and typically small in scale; their buyers, the auto manufacturers, are large in size
and few in number. Additionally, to keep component prices down, both Ford and
GM have used the threat of manufacturing a component themselves rather than
buying it from auto component suppliers. The automakers have used their powerful
position to play off suppliers against each other, forcing down the price they have
to pay for component parts and demanding better quality. If a component supplier
objects, the automaker can use the threat of switching to another supplier as a bar-
gaining tool.
Bargaining Power Another issue is that the relative power of buyers and suppliers tends to change
of Buyers in response to changing industry conditions. For example, because of changes now
The ability of buyers to taking place in the pharmaceutical and health care industries, major buyers of phar-
bargain down prices maceuticals (hospitals and health maintenance organizations) are gaining power
charged by companies over the suppliers of pharmaceuticals and have been able to demand lower prices.
in the industry or to
raise the costs of
The Bargaining Power of Suppliers
companies in the
industry by demanding The fourth of Porter’s five competitive forces is the bargaining power of suppliers—
better product quality the organizations that provide inputs into the industry, such as materials, services, and
and service. labor (which may be individuals, organizations such as labor unions, or companies
 Chapter 3 External Analysis: The Identification of Opportunities and Threats 65

that supply contract labor). The bargaining power of suppliers refers to the ability
of suppliers to raise input prices, or to raise the costs of the industry in other ways—
for example, by providing poor-quality inputs or poor service. Powerful suppliers
squeeze profits out of an industry by raising the costs of companies in the industry.
Thus, powerful suppliers are a threat. Alternatively, if suppliers are weak, companies
in the industry have the opportunity to force down input prices and demand higher-
quality inputs (e.g., more productive labor). As with buyers, the ability of suppliers
to make demands on a company depends on their power relative to that of the com-
pany. Suppliers are most powerful in the following situations:
• The product that suppliers sell has few substitutes and is vital to the companies
in an industry.
• The profitability of suppliers is not significantly affected by the purchases of
companies in a particular industry, in other words, when the industry is not an
important customer to the suppliers.
• Companies in an industry would experience significant switching costs if they
moved to the product of a different supplier because a particular supplier’s prod-
ucts are unique or different. In such cases, the company depends on a particular
supplier and cannot play suppliers off against each other to reduce price.
• Suppliers can threaten to enter their customers’ industry and use their inputs to
produce products that would compete directly with those of companies already
in the industry.
• Companies in the industry cannot threaten to enter their suppliers’ industry and
make their own inputs as a tactic for lowering the price of inputs.
An example of an industry in which companies are dependent on a powerful sup-
plier is the personal computer industry. Personal computer firms are heavily depen-
dent on Intel, the world’s largest supplier of microprocessors for PCs. The industry
standard for personal computers runs on Intel’s microprocessor chips. Intel’s com-
petitors, such as Advanced Micro Devices (AMD), must develop and supply chips
that are compatible with Intel’s standard. Although AMD has developed competing
chips, Intel still supplies about 85% of the chips used in PCs primarily because only
Intel has the manufacturing capacity required to serve a large share of the market.
It is beyond the financial resources of Intel’s competitors, such as AMD, to match
the scale and efficiency of Intel’s manufacturing systems. This means that while
PC manufacturers can buy some microprocessors from Intel’s rivals, most notably
AMD, they still have to turn to Intel for the bulk of their supply. Because Intel is in
a powerful bargaining position, it can charge higher prices for its microprocessors Bargaining Power
than would be the case if its competitors were more numerous and stronger (i.e., if of Suppliers
the microprocessor industry were fragmented). The ability of suppliers
to raise the price of
Substitute Products inputs or to raise the
costs of the industry in
The final force in Porter’s model is the threat of substitute products: the products other ways.
of different businesses or industries that can satisfy similar customer needs. For ex-
ample, companies in the coffee industry compete indirectly with those in the tea and Substitute Products
soft drink industries because all three serve customer needs for nonalcoholic drinks. The products of
The existence of close substitutes is a strong competitive threat because this limits different businesses
the price that companies in one industry can charge for their product, and thus in- or industries that can
dustry profitability. If the price of coffee rises too much relative to that of tea or soft satisfy similar customer
drinks, coffee drinkers may switch to those substitutes. needs.
66 Part 2 The Nature of Competitive Advantage

If an industry’s products have few close substitutes, so that substitutes are a weak
Ethical Dilemma competitive force, then, other things being equal, companies in the industry have
You are a strategic analyst the opportunity to raise prices and earn additional profits. For example, there is no
at a successful hotel enter- close substitute for microprocessors, which gives companies like Intel and AMD the
prise that has been gener-
ability to charge higher.
ating substantial excess
cash flow. Your CEO in-
structed you to analyze the
competitive structure of Porter’s Model Summarized
closely related industries to
find one that the company
The systematic analysis of forces in the industry environment using the Porter frame-
could enter, using its cash work is a powerful tool that helps managers to think strategically. It is important to
reserve to build a sustain- recognize that one competitive force often affects the others, so that all forces need
able position. Your analysis, to be considered and thought about when performing industry analysis. Indeed, in-
using Porter’s five forces
model, suggests that the
dustry analysis leads managers to think systematically about the way their strategic
highest profit opportunities choices will both be affected by the forces of industry competition and how their
are to be found in the gam- choices will affect the five forces and change conditions in the industry. For an ex-
bling industry. You realize ample of industry analysis using Porter’s framework, see the Running Case.
that it might be possible to
add casinos to existing ho-
tels, lowering entry costs
into this industry. However,
you personally have strong
moral objections to gam-
bling. Should your own Strategic Groups within Industries
personal beliefs influence
your recommendations to Companies in an industry often differ significantly from each other with respect to
the CEO? the way they strategically position their products in the market in terms of such fac-
tors as the distribution channels they use, the market segments they serve, the quality
of their products, technological leadership, customer service, pricing policy, advertis-
ing policy, and promotions. As a result of these differences, within most industries, it
is possible to observe groups of companies in which each company follows a strategy
that is similar to that pursued by other companies in the group, but different from
the strategies followed by companies in other groups. These different groups of com-
panies are known as strategic groups.12
Normally, the basic differences between the strategies that companies in different
strategic groups use can be captured by a relatively small number of strategic fac-
tors. For example, in the pharmaceutical industry, two main strategic groups stand
out (see Figure 3.2).13 One group, which includes such companies as Merck, Eli Lilly,
and Pfizer, is characterized by a business model based on heavy R&D spending and
a focus on developing new, proprietary, blockbuster drugs. The companies in this
proprietary strategic group are pursuing a high-risk, high-return strategy. It is a high-
risk strategy because basic drug research is difficult and expensive. Bringing a new
Strategic Groups drug to market can cost up to $800 million in R&D money and a decade of research
Groups of companies and clinical trials. The risks are high because the failure rate in new drug develop-
in which each company ment is very high: only one out of every five drugs entering clinical trials is ultimately
follows a strategy approved by the U.S. Food and Drug Administration. However, the strategy is also
that is similar to that a high-return one because a single successful drug can be patented, giving the in-
pursued by other novator a 20-year monopoly on its production and sale. This lets these proprietary
companies in the companies charge a high price for the patented drug, allowing them to earn millions,
group, but different if not billions, of dollars over the lifetime of the patent.
from the strategies The second strategic group might be characterized as the generic drug strate-
followed by companies gic group. This group of companies, which includes Forest Labs, Mylan Labs and
in other groups. Watson Pharmaceuticals focuses on the manufacture of generic drugs: low-cost