Determinants of Competitive Intensity Editorial
(i) Threat of Entry
1. Barriers to Entry
There are seven main sources of barriers to entry
(1) Economies of scale.
Economies of scale mean that the unit cost of a product (or the cost of the operational or functional aspects of producing a product) declines as absolute output increases in each period. Economies of scale discourage entry by forcing entrants to enter on a large scale and willingly take the risk that the industry's incumbents will react strongly, or to enter on a small scale and face a cost disadvantage, both of which are unpleasant ways of doing business. Economies of scale may exist in virtually every function of a given firm, including manufacturing, purchasing, research and development, marketing, service outlets, sales capacity utilization and distribution. For example, Xerox and General Electric regrettably found that economies of scale in the manufacturing, research, marketing, and service sectors of the mainframe computer industry could be a major obstacle to the entry of new manufacturers into the industry.
Operations of scale may be associated with a complete functional area, as is the case in sales capacity, or they may arise from specific operations or activities that are integral to a functional area. For example, in television manufacturing, economies of scale are large in the production of color picture tubes and less significant in case joinery and complete assembly work. Therefore, in view of its special relationship between unit cost and scale of production, it is important to examine the components of cost separately.
(2) Product differences.
Product differentiation refers to the fact that established manufacturers have a recognized brand name and customer loyalty, which arise from past advertising, customer service, product diversification, etc., or simply as a result of the activities of the first to enter the industry. Product differentiation forces the entrant to spend a great deal of money to conquer existing customer loyalty, thus creating some kind of barrier to entry. This effort usually involves a loss of production and is experienced over a longer period of time. The investment in breaking out a certain brand is particularly risky because it has little residual value once entry fails.
Product differentiation is perhaps the most important barrier to entry in children's health care products, door-to-door retailing of pharmaceuticals, cosmetics, bank investments, and public accounting. In the brewing industry, product differentiation is often combined with economies of scale in production, marketing and distribution to produce high barriers.
(3) Capital requirements.
The large investment that competition requires to be consumed creates some barrier to entry, especially where that capital is required for risky or uncompensated, up-front advertising or research and development. Capital is needed not only for production facilities, but also for things like customer credit, inventory, or to cover start-up losses. In the copier industry, for example, when Xerox chose to lease copiers rather than sell them quickly, this practice greatly increased the amount of working capital required, thus creating somewhat of a greater capital barrier to entry into the copier industry. While some of today's large corporations are financially strong enough to enter almost any industry, the large capital requirements of fields such as computers and mining limit the potential for partnerships among entrants. Even when capital is available in the capital markets, the use of funds for entry remains risky because the prospective entrant must assume the risk of paying interest. These circumstances work in favor of the incumbent manufacturer.
(4) Pass-through costs.
The presence of pass-through costs creates some sort of barrier to entry, which is a one-time cost faced by a given buyer when transferring a product from one supplying vendor to another. Pass-through costs may include the cost of retraining employees, the cost of new auxiliary equipment, the cost of testing or qualifying a new source and the time it takes, the cost of technical assistance due to reliance on the seller's engineering assistance, the cost of redesigning the product, or even the psychological cost of severing the relationship. If these types of pass-through costs are high, then the new entrant must make large improvements in cost or product performance in order for the buyer to move away from the vendors within an industry. For example, in the case of intravenous fluids and their sets of appliances used in hospitals, the way in which patients are injected differs between competing fluids, and the appliances used to suspend injection bottles are not interchangeable. In such cases, product switching can be met with strenuous resistance from nurses responsible for care, and requires new investments in hanging apparatus.
(5) Access to distribution channels.
The need for new entrants to obtain distribution channels for their products creates some sort of barrier to entry. When the situation develops to the point where the established manufacturer's product offerings have been extended to those logical distribution channels, the new manufacturer must persuade those distribution channels to accept its product through price breaks, allowances for joint advertising, and so on, a practice that reduces profits. For example, the manufacturer of a new food product must persuade retailers to give it a place on the shelves of a highly competitive supermarket through a marketing pact, an aggressive sales effort by the retailer, or some other means.
The more restricted the wholesale or retail channels for a product are, and the more existing competitors block those channels, the more difficult it will obviously be to enter the industry. The existing competitor's connection to these channels may be based on a long-term relationship, high quality service, or even a specialized relationship with a particular manufacturer's channel. Sometimes this barrier to entry is so high that a new manufacturer will have to carve out an entirely new distribution channel to get past it, a maneuver used by Timix in the watch industry.
(6) Cost disadvantages not governed by size.
Regardless of the size of the potential entrants and whether or not they achieve economies of scale, they will not be able to arrive at a cost advantage similar to that which an established player might have. The crucial advantages are factors such as:
Experience is merely a conceptual name for certain technological changes that may apply not only to production but also to distribution, logistics, and other functions. As in the case of economies of scale, the decline in costs with experience is not related to the manufacturer as a whole, but arises from individual operations or the individual functions that make up the manufacturer. Experience can reduce costs in marketing, distribution, and other areas, as well as reducing production costs or the cost of operations in the production process. Each component of cost must be examined in order for experience to be effective.
(7) Government policy.
The last major source of barriers to entry is government policy. Through controls on applications for licenses and restrictions on access to raw materials (e.g., ski slopes to be built on coal fields or mountains), governments are able to limit or even prevent entry into an industry or industries. More obvious examples are the control of trucking, railroads, liquor retailing, air, land and water freight forwarding, and the like. More subtly, governments can also limit entry through controls such as air and water pollution standards and product safety and efficacy regulations. Pollution control requirements, for example, can increase the capital required for entry and technical difficulty, and even the size of the most desirable facilities. Product testing standards prevalent in industries such as the food industry and other health-related products can impose much longer lead times, which not only raises the basic investment for entry, but also allows established players to be fully aware of impending entry, and thus sometimes to develop retaliatory strategies based on a comprehensive understanding of the new competitor's products. Government policies in these areas are bound to have immediate social benefits, but they can also have some side effects on entry with insufficient prior knowledge.
2. Anticipated retaliation
The expectations that a potential entrant has about the reaction of an existing competitor can also affect the threatening effect of entry. If the existing competitors are expected to react so strongly that the entrant's stay in the industry becomes an unpleasant event, there is every likelihood that entry will be prevented. The conditions that signal a high probability of retaliation against entry and therefore deter entry are as follows:
(ii) Strength of resistance among existing competitors
1. A large number of competitors or evenly matched competitors.
When there are a large number of vendors, the likelihood of each vendor acting on its own is high, and some vendors take it for granted that they can act at will without being noticed. Even on occasions when there are relatively few vendors, if they are relatively balanced in terms of size and sizable financial resources, instability arises because they can easily take on each other and have sufficient financial resources to retaliate consistently and aggressively. On the other hand, when the industry is highly concentrated or controlled by one or a few manufacturers, then there is no misleading relative strength, and the industry leader imposes discipline and a coordinating role within the industry by means of something like a pricing leadership system.
In many industries, foreign competitors, either foreign exporters to the industry or direct participants through foreign investment, play an important role in industry competition. Although there are some differences between foreign and domestic competitors, which will be pointed out later, foreign competitors should be treated in exactly the same way as domestic competitors for the purposes of structural analysis.
2. High fixed or storage costs.
High fixed costs put strong pressure on all firms to fill their production capacity, and often lead to a rapid escalation of price cuts when there is excess capacity. For example, many basic materials like paper and aluminum suffer from this problem. The important characteristic of costs is that they are fixed costs related to value added, rather than fixed costs as a proportional relationship to total costs. Despite the fact that the absolute proportion of fixed costs is low, manufacturers with a high proportion of incoming costs in externally imported materials (low value-added)
will feel enormous pressure to fill their production capacity in order to break even.
Somewhat related to high fixed costs is the fact that once a product has been produced, it is very difficult or expensive to store it. In such cases, manufacturers will also be vulnerable to the temptation to cut prices in order to secure sales. In some industries, such as shrimping, hazardous chemicals manufacturing and some service industries, such pressures can keep profits low.
3. Lack of product differentiation or pass-through costs.
On occasions when a product or service is understood to be a commodity or quasi-commodity of some kind, the buyer's choice is based primarily on price and service, resulting in pressures for intense price and service competition. As already discussed, such forms of competition are particularly capricious. On the other hand, product differentiation creates some layers of isolation from conflict, as buyers have preferences and loyalties to particular sellers. Resale costs, described earlier, play the same role.
4. Massively expanded production capacity.
Where economies of scale dictate a large increase in production capacity, the increase in production capacity often disrupts the industry's supply-demand balance, especially at the risk of stringing together additional production capacity. Industries can face periods of renewed overcapacity and price reductions, as those manufacturing chlorine, ethyl chloride and ammonia fertilizers have faced.
5. Competitors of all shapes and sizes.
Competitors who differ in strategy, origin, personality and relationship with their parent company will have a variety of goals, different strategies for how to compete, and will likely continue to kill each other as they interact. It may be a difficult time for them to understand each other's intentions accurately and to agree on a set of "rules of the game" for the industry. Strategic choices that are right for one competitor may be wrong for another.
Foreign competitors often add a great deal of diversity to the industry because of their different environments and often changing goals. The same can be said of small, independently owned manufacturers or service companies, who are content to maintain their independence of private ownership by generally earning less than the normal rate of return on investment, whereas such low returns are unacceptable and clearly unreasonable to a recognized large competitor. Within such an industry, the posture of such small players might limit the profitability of large firms. Similarly, those who see the market as some outlet for surplus production capacity (in the case of dumping) will adopt policies diametrically opposed to those who see the market as a primary outlet. Finally, differences in the relationship between competing business units and their parent firms are also an important source of diversity in an industry. For example, if a business unit is part of a vertically organized chain of firms, it is quite possible for it to adopt different or even conflicting objectives than a small, autonomous manufacturer competing in the same industry. Or, if a business unit is a "golden calf" in its parent company's line of business, it will act differently than the kind of unit in that parent company that is being developed for long-term growth in the absence of other opportunities.
6. Highly strategic bets.
If a large number of players place high stakes on success in an industry, the trade-offs within that industry can become more erratic. For example, a manufacturer that is engaged in a variety of businesses will place a great deal of emphasis on its success in a particular industry in order to promote the formation of a comprehensive strategy for its company. Or, a foreign manufacturer, such as Bosch, Sony, or Phillips, may feel a strong need to establish a strong position in the U.S. market in order to build global prestige or technical credibility. In this case, the goals of such manufacturers may not only take a different form, but are more volatile, since they are expansive and contain an underlying desire to sacrifice profitability.
7. Higher barriers to exit.
Barriers to exit are economic, strategic, and emotional factors that keep a company competitive among firms, even if they yield a low or even negative return on investment. The main sources of barriers to exit are as follows:
When barriers to exit are high, excess capacity does not leave the industry, and firms that have lost the competitive battle do not concede defeat. Instead, they will remain resilient and, because of their weaknesses, will have to resort to extreme tactics. As a result, the profitability of the industry as a whole will only continue to remain low.
While exit barriers are conceptually distinct from entry barriers, their level of ****similarity is an important aspect of industry analysis. Barriers to exit and barriers to entry are often related to each other. For example, considerable economies of scale in production are usually associated with specialized assets, as is the case with the existence of proprietary technology.
Take the simplified case where barriers to exit and entry can be both high and low.
From the point of view of industry profitability, the best case scenario is one in which the barriers to entry are high and the barriers to exit are low. In this case, entry will be blocked and failed competitors will exit the industry. When both barriers to entry and barriers to exit are at high levels, potential profits are high, but are usually accompanied by greater risk. Although entry is blocked, the failed vendor will remain in the industry and continue to struggle.
It is not exciting enough to have both barriers to entry and barriers to exit low, but the worst case scenario is when the barriers to entry are low and the barriers to exit are high. In this case, entry will be lured by improved economic conditions or other temporary windfalls and will be easy to accomplish. However, it is not unlikely that production capacity will exit the industry when outcomes worsen, resulting in a backlog of production capacity in the industry and a prolonged loss of profitability. For example, an industry may be in the unlucky position where a supplier or lender will happily agree to finance an entry, but once the entry is successful, the manufacturer will be faced with a large fixed financing cost.
(iii) Pressure from substitutes
Broadly speaking, all vendors within a given industry are competing with an industry that produces substitutes. Substitute products limit the potential gains of an industry by setting a maximum price at which manufacturers within that industry may profit. The more attractive the alternative price targets offered by the substitute product, the more restrictive the limits on industry profits.
Just as acetylene and rayon manufacturers have faced stiff competition from alternative, low-cost feedstocks in many of their respective applications, sugar producers facing the challenge of commercializing large-scale, highly concentrated fructose corn syrup, a sugar substitute, are learning that lesson today. Substitute products not only limit profits in normal times, but also reduce the financial resources available to an industry during boom times. in 1978, manufacturers of insulating fiberglass were able to enjoy unprecedented demand due to high energy costs and cold winters, but the industry's ability to raise prices was tempered by the onslaught of a plethora of insulating substitutes including cellulose, asbestos and polystyrene foam. foam, among others. Such substitutes will inevitably limit profitability even more strongly once production capacity is increased by a flurry of plant expansions to meet the momentary demand.
Identifying substitutes is a matter of seeking out other products that fulfill the same function as the industry's products. Sometimes doing so can be a delicate exercise, and one that leads analysts into matters that seem completely unrelated to the industry. For example, stockbrokers are constantly encountering such alternatives as real estate, insurance, financial market funds, and other methods of personal investing.
In contrast to alternatives, status may be a matter entirely involving collective action by the industry. For example, an advertising campaign by one manufacturer may not be sufficient to support the industry's position against an alternative product, but a substantial and sustained advertising campaign by all industry participants may well improve the industry's collective position. The same argument applies to collective responses in areas such as product quality improvement, marketing efforts, and providing greater product effectiveness.
The substitutes most worthy of attention are
(1) those which are susceptible to the tendency to be dominated by products which improve their price indications and which can be exchanged for the products of the industry.
(2) It is a product produced by an industry which obtains high profits. In the latter case, if a development increases competition within its industry and causes price reductions or performance improvements, substitute products tend to come into play quickly. It is important to analyze such trends when deciding whether to strategically seek to discourage a substitution or to develop a strategy as an unavoidable and critical factor. For example, in the security and defense industry, electronic alarm systems represent a strong substitute. Moreover, as the labor-intensive defense services industry is facing inevitable cost escalation, they can only become more and more important, while electronic systems are likely to improve their defense performance and reduce their costs. In this case, based on a reinterpretation of the security guard as a skilled operator, the right response for security defense companies may lie in providing complete guard installations and electronic systems, without wanting to make electronic alarm systems fail to compete in the sector as a whole.
(iv) The bargaining power of the buyer
Buyers compete with the industry by forcing prices down, counting on higher quality or more service, and setting competitors against each other at the complete detriment of the industry's profitability. The bargaining power of the major group of buyers in each industry depends on many characteristics of its market conditions and the relative importance of buying from an industry in comparison with its total business activity. A buyer group is strong if the following applies.
1. Buyers are concentrated or buy in large quantities relative to the seller's sales.
If a particular buyer's purchases are a large proportion of sales, the result will be to increase the importance of that buyer's business. If the industry is characterized by large fixed costs, buyers who buy in large quantities become particularly powerful forces - as they do, for example, in refined grains and bulk chemicals - and raise the stakes for making full use of production capacity. of the bet to bring production capacity into full play.
2. The products that buyers purchase from the industry represent an important component of their cost or purchasing activity.
In this case, it is easy for the buyer to spend the necessary financial resources in order to purchase products at favorable prices and to be selective in its purchases. Buyers are usually less price sensitive when the industry sells products that represent only a small portion of the buyer's cost.
3. The products that the buyer purchases from the industry are standard or undifferentiated.
Buyers will swing one company against another, as they did in the aluminum industry, if they are confident that they can always find a choice of suppliers.
4. Buyers face little in the way of switching costs.
It has long been clear that pass-through costs can tie a buyer to a particular seller. Conversely, if the seller faces resale costs it increases the bargaining power of the buyer.
5. Buyers earn low profits.
Low profits create a great incentive for lower costs of entry. For example, Chrysler's suppliers have been complaining that they are being pressured for favorable terms. However, buyers with high profitability are generally less price sensitive (that is, of course, if the price does not account for a significant portion of their costs) and will help protect the prosperity of their supply side in the longer term.
6. The buyer creates a credible threat of backward integration.
If buyers are already partially integrated or form a credible threat of backward integration, they will be able to demand price reductions. Large automobile manufacturers, such as General Motors and Ford Motor Company, are famous for using this "self-created" threat as a bargaining tool. They engage in the practice of so-called creeping integration, i.e., they produce a particular part they need in-house and source the rest from outside suppliers. Not only is the threat of further integration particularly credible, but doing some of the manufacturing in-house gives them a detailed picture of the costs that will help them negotiate. A buyer's bargaining power is partially offset when manufacturers within the industry threaten forward integration in the buyer's industry.
7. The products of the industry are irrelevant to the quality of the buyer's product or service.
When the industry's products have a significant impact on the quality of the buyer's product, the buyer is generally less sensitive to price. Industries in this situation include the oilfield equipment industry, where the failure of a particular product can lead to significant losses (as exemplified by the recent huge losses sustained by a blowout preventer failure in an offshore oil well in Mexico), and the manufacturing of electronic medical and test equipment packaging, where the quality of the packaging can greatly affect the user's impression of the quality of the equipment inside the package.
8. The buyer has comprehensive information.
If the buyer has comprehensive information about the demand, the actual market price, and even the cost of supplying the manufacturer, this situation usually makes the buyer to produce greater bargaining power than in the information-poor. With comprehensive information, the buyer is in a better position to ensure that it accepts the most advantageous price offered to other buyers and is able to deal with appeals from suppliers when their right to exist is threatened.
The vast majority of the above sources of buyer bargaining power can be attributed to the consumer as well as to the industrial and commercial buyer, but it is only necessary to modify their norms. For example, consumers tend to be more price-sensitive if they are buying products that make no difference, are still expensive in relation to their income, or whose quality is not particularly important to them.
The buyer bargaining power of wholesalers and retailers depends on the same regulations as above, but with one important addition:
Retailers get more effective bargaining power than manufacturers when they are able to influence consumers' purchasing decisions, as they do with audio components, jewelry, appliances, sporting goods, and other products; and when wholesalers are able to influence the buying decisions of retailers or other wholesale targets, then they can similarly gain bargaining power.
9. Changing buyers' bargaining power
Buyers' bargaining power naturally rises or falls when the factors mentioned above change over time or as a result of a company's strategic decisions. For example, in the apparel industry, when buyers (department stores and apparel stores) have become more concentrated and their control has shifted to large chain stores, the industry is under increasing pressure and suffers from declining gross margins, and the industry is unable to differentiate its products or incur pass-through costs that can trap its buyers and mitigate this trend, even as imports pour into its market.
A company's choice of a buyer group to sell to should be viewed as a critical strategic decision. A company can improve its strategic posture - in other words, buyer selection - by finding buyers with minimal capacity to counteract it. It is rare that all of a firm's buyer groups enjoy equal bargaining power. Even if a firm sells its products to a separate industry, the sectors that exist within that industry usually have less bargaining power (and are therefore less price-sensitive) than other sectors. For example, the market for the vast majority of product updates is less price sensitive than the original equipment market.
(v) Supply-side bargaining power
Suppliers can use their bargaining power with participants in an industry by threatening to raise prices or reduce the quality of goods and services purchased. As a result, powerful suppliers are able to extract profits from an industry that is unable to cover cost increases with its own prices. For example, by raising prices, chemical companies undermine the profitability of aerosol packagers, who face stiff competition from buyers of their own products, thus limiting their freedom to raise prices.
The conditions that make the buyer powerful also mirror those that make the supplier powerful. A group of suppliers is strong if:
1. The supply side is controlled by several firms and is more concentrated than the industry to which it sells.
Suppliers that sell to more decentralized buyers are usually able to exert considerable influence over price, quality, and terms of trade.
2. The supplier does not have to compete with other substitute products sold to the industry
. Even larger and more powerful suppliers are constrained in their bargaining power if they compete with substitutes. For example, suppliers of sweetener substitutes compete fiercely for more applications even though individual manufacturers are relatively large for individual buyers.
3. The industry is not a significant customer for the group of supplying manufacturers.
When a supply vendor sells to many industries and a particular industry does not represent a significant portion of its sales, the supply side prefers to utilize bargaining power. If the industry is an important customer, then the supplier's fortunes will be tied to that industry, and those suppliers will protect the industry by pricing well and assisting in activities like research and development and lobbying.
4. The supplier's product is an important input into the buyer's business. This input is important to the success of the buyer in terms of manufacturing process or product quality. This practice increases the bargaining power of the supplying manufacturer. This is particularly true when the input is not storable, allowing the buyer to gradually expand its inventory.
5. The supplier group's products are differentiated or have established pass-through costs.
Buyer-oriented product differentiation or pass-through costs prevent a buyer from arbitrarily pitting one supplier against another. This is counterproductive if the supplier faces pass-through costs.
6. Groups of suppliers form a credible threat of forward integration.
This threat inhibits the industry's ability to improve its sourcing conditions.
We usually think of the supply side as a number of other vendors, but the labor force must also be thought of as a supply vendor, i.e., one that exerts great bargaining power in many industries. A great deal of experience has shown that a labor force that lacks highly skilled employees and is closely unionized will sell off a potentially lucrative and important component of an industry cheaply. The principles for determining the potential bargaining power of labor as a supplier are similar to those just discussed. Some important principles that need to be added to the assessment of the bargaining power of labor are the degree of organization of labor and the ability to expand the sources of supply of the various types of labor that are lacking. The bargaining power of labor is likely to be higher when labor is closely organized or when the sources of supply of the labor that is lacking are inhibited.
The conditions for determining supply-side capacity are not only susceptible to change, but are often beyond the control of the manufacturer. However, when a vendor has buyer bargaining power, it can sometimes strategize to improve its position. Such a vendor can enhance its threat of backward integration in order to preclude pass-through costs or similar disadvantages.