The Elements Of Industries Structure
Industry structure can be analyzed by using Porter's framework competition in an industry. Professor Michael E. Porter of Harvard University is the nation's leading authority on industry analysis.
Porter identifies five basic competitive forces, which determine the state of competition an its underlying economic structure:
- The threat of new competitors entering the industry
- The intensity of rivalry among existing competitors
- The threat of substitute products or services
- The bargaining power of buyers
- The bargaining power of suppliers
These five forces of competition determine the rate of return on invested capital (ROI) in industry, relative to the industry's cost of capital. The strength of each of the competitive forces is determined by a number of key structural variables.
Threat Of New Entrants
A major force shaping competition within an industry is the threat of new entrants. The threat of new entrants is a function of both barriers to entry and the reaction from existing competitors. There are several types of entry barriers:
Economies of scale. Economies of scale act as barrier to entry by requiring the entrant to come on large scale, risking strong reaction from existing competitors, or alternatively to come in on a small scale accepting a cost disadvantage. Economies of scale refer to the decline in unit costs of a product or service (or an operation, or a function that goes into producing a product or service).
Product differentiation. Product differentiation creates a barrier to entry by forcing entrants to incur expenditure to overcome existing customer loyalties. New entrants must spend a great deal of money and time to overcome this barrier.
Capital requirements. The capital costs of getting established in an industry can be so large as to discourage all but the largest companies.
Cost advantages independent of scale. Existing firms may have cost advantages not available to potential entrants regardless of the entrant's size. These advantages can include access to the best and cheapest raw materials, possession of patents and proprietary technological know-how, the benefits of learning and experience curve effects, having built and equipped plants years earlier at lower costs, favourable locations, and lower borrowing costs.
Switching costs. Switching costs refer to the one-time costs that buyers of the industry's outputs incur if they switch from one company's products to another's. To overcome the switching cost barrier, new entrants may have to offer buyers a bigger price cut or extra quality or service. All this can mean lower profit margins for new entrants.
Access to distribution channels. Access to distribution channels can be a barrier to entry because of the new entrants's need to obtain distribution for its product. A new entrant may have to persuade the distribution channels to accept its product by providing extra incentives which reduce profits.
Governmental and legal barriers. Government agencies can limit or even bar entry by requiring licenses and permits. National governments commonly use tariffs and trade restrictions (antidumping rules, local content requirements, and quotas) to raise entry barriers for foreign firms.
The effectiveness of all these barriers to entry in excluding potential entrants depends upon the entrants' expectation as to possible retaliation by established firms. Retaliation against a new entrant may take the form of aggressive price-cutting, increased advertising, or a variety of legal manoeuvres.