The Effects of the Economic

Environment on Strategy

By Fathi Salem Mohammed, MBA

2009
Introduction:
Strategy is the direction and scope of an organization over the long term, which achieves
advantage in a changing environment through its configuration of resources and competences
with the aim of fulfilling stockholder expectations. An organization's objectives are the overall
plans for the firm as defined by management. Management attempts to achieve these objectives
by developing strategies. Achieving management's objectives is always subject to business risks
faced by the firm. Business risk is the risk that the organization will fail to achieve its objectives,
these risks can arias from any of the factors affecting the organization and its environment, such
as new technology eroding an organization's competitive advantage, or an organization failing to
execute its strategies as well as its competitors. A comprehensive understanding of the
organization’s internal and external environments is necessary for management to
understand the organization’s present condition and its business risks. This
understanding includes comprehension of the macro-environment and industry
environments.

Layers of the business environment:

1. The Macro-Environment is the highest-level layer. This consist of broad
environment factors that impact to greater or lesser extent on almost all organizations. Here,
the PESTEL framework can be used to identify how future trends in political, economic,
social, technological, environment (green) and legal environments might impinge on
organizations.
1.1. PESTEL analysis (see Illustration 1) is a useful tool for understanding the “big picture”
of the environment, in which you are operating, and the opportunities and threats that lie within
it. By understanding the environment in which you operate (external to your company or
department), you can take advantage of the opportunities and minimize the threats. Specifically
the PEST or PESTLE analysis is a useful tool for understanding risks associated with market
growth or decline, and as such the position, potential and direction for a business or
organization.
2. The Industry Environment
Economic theory defines an industry as ‘a group of firms producing the same principal
product’ or, more broadly, ‘a group of firms producing products that are close substitutes for
each other’. This concept of an industry can be extended into the public services through the
idea of a sector. This section looks at Michael Porter’s five forces framework for industry
analysis.
2.1. Porter’s five forces framework (Competitive forces) was originally developed as a
way of assessing the attractiveness (profit potential) of different industries. The five forces
constitute an industry’s ‘structure’ (see Illustration 2). The five forces are: the threat of entry
into an industry; the threat of substitutes to the industry’s products or services; the power of
buyers of the industry’s products or services; the power of suppliers into the industry; and the
extent of rivalry between competitors in the industry. Porter’s essential message is that where
these five forces are high, then industries are not attractive to compete in. There will be too
much competition, and too much pressure, to allow reasonable profits.

• The industry environment directly affects the firm and the types of strategies it
must develop to compete. It is most relevant to the firm’s profit potential. Management
attempts to position the firm where it can influence the industry factors and successfully
defend against their influence. Remember, management has little or no control over the
general environment factors but through its actions may have significant influence over
industry factors. Generally, the larger the firm’s market share the more influence it can
have on its industry environment.
 • Since firms must make strategic decisions that involve long-term commitments
(e.g., investments in technology, plant, etc.), management must not only deal with the
current environment, it must forecast the future. Effective management must analyze and
forecast the general environment to identify opportunities and threats to the firm. In doing
so, the following techniques are used:
a. Scanning—A study of all segments in the general environment. The objective is to
predict the effects of the general environment on the firm’s industry. Management can use
this information to modify its strategies and operating plans. Scanning of the general
environment is critical to firms in volatile industries. Sources of information for scanning
include trade publications, newspapers, business publications, public polls, government
publications, etc.

b. Monitoring—A study of environmental changes identified by scanning to spot

important trends. As an example, the trend in aging of the population in this country
would definitely be important to firms that provide services to retired individuals.
Effective monitoring involves identifying the firm’s major stakeholders (e.g., customers,
investors, employees, etc.).

c. Forecasting—Developing probable projections of what might happen and its timing.

As an example, management might attempt to forecast changes in personal disposable
income or the timing of introduction of a major technological development.

d. Assessing—Determining changes in the firm’s strategy that are necessary as a result of

the information obtained from scanning, monitoring, and forecasting. It is the process of
evaluating the implications of changes in the general environment on the firm.

2.1.1 Implications of five forces analysis

The five forces framework provides useful insights into the forces at work in the
industry or sector environment of an organisation. It is important, however, to use
the framework for more than simply listing the forces. The bottom-line is an
assessment of the attractiveness of the industry. The analysis should conclude with a
judgment about whether the industry is a good one to compete in or not.
The analysis should next prompt investigation of the implications of these forces,
for example:
● Which industries to enter (or leave)? The fundamental purpose of the five
forces model is to identify the relative attractiveness of different industries:
industries are attractive when the forces are weak. Managers should invest
in industries where the five forces work in their favour and avoid or disinvest
from markets where they are strongly against.
● What influence can be exerted? Industry structures are not necessarily fixed,
but can be influenced by deliberate managerial strategies. For example,
organizations can build barriers to entry by increasing advertising spend to
improve customer loyalty. They can buy up competitors to reduce rivalry
and increase power over suppliers or buyers. Influencing industry structure
involves many issues relating to competitive strategy.

2.1.2 Key issues in using the five forces framework

The five forces framework has to be used carefully and is not necessarily complete,
even at the industry level. When using this framework, it is important to
bear the following three issues in mind:
● Defining the ’right’ industry. Most industries can be analysed at different levels.
For example, the airline industry has several different segments such as domestic
and long haul and different customer groups such as leisure, business and freight.
 The competitive forces are likely to be different for each of these segments and can
be analysed separately. It is often useful to conduct industry analysis at a
disaggregated level, for each distinct segment. The overall picture for the industry
as a whole can then be assembled.
● Converging industries. Industry definition is often difficult too because industry
boundaries are continuously changing. For example, many industries, especially in
high-tech arenas, are undergoing convergence, where previously separate industries
begin to overlap or merge in terms of activities, technologies, products and
customers. Technological change has brought convergence between the telephone
and photographic industries, for example, as mobile phones increasingly include
camera and video functions. For a camera company like Kodak, phones are
increasingly a substitute and the prospect of facing Nokia or Samsung as direct
competitors is not remote.
● Complementary products. Some analysts argue for a ‘sixth force’, organizations
supplying complementary products or services. These complementors are players
from whom customers buy complementary products that are worth more together
than separately. Thus Dell and Microsoft are complementors in so far as computers
and software are complementary products for buyers. Microsoft needs Dell to
produce powerful machines to run its latest generation software. Dell needs
Microsoft to work its machines. Likewise, television programme makers and
television guide producers are complements. Complementors raise two issues. The
first is that complementors have opportunities for cooperation. It makes sense for
Dell and Microsoft to keep each other in touch with their technological
developments, for example. This implies a significant shift in perspective. While
Porter’s five forces sees organisations as battling against each other for share of
industry value, complementors may cooperate to increase the value of the whole
cake. The second issue, however, is the potential for some complementors to
demand a high share of the available value for themselves. Microsoft has been much
more profitable than the manufacturers of complementary computer products and its
high margins may have depressed the sales and margins available to companies like
Dell. The potential for cooperation or antagonism with such a complementary ‘sixth
force’ needs to be included in industry analyses.

2.2 The industry life cycle

The power of the five forces typically varies with the stages of the industry life cycle. The
industry life cycle concept proposes that industries start small in their development stage,
then go through period of rapid growth (the equivalent to ‘adolescence’ in the human life
cycle), culminating in a period of ‘shakeout’.
The final two stages are first a period of slow or even zero growth (‘maturity’), before the
final stage of decline (‘old age’). Each of these stages has implications for the five forces.
The development stage is an experimental one, typically with few players exercising little
direct rivalry and highly differentiated products. The five forces are likely to be weak,
therefore, though profits may actually be scarce because of high investment requirements.
The next stage is one of high growth, with rivalry low as there is plenty of market
opportunity for everybody.
Buyers may be keen to secure supplies and lack sophistication about what they are
buying, so diminishing their power. One downside of the growth stage is that barriers to
entry may be low, as existing competitors have not built up much scale, experience or
customer loyalty. Another potential downside is the power of suppliers if there is a
shortage of components or materials that fast growing businesses need for expansion. The
shake-out stage begins as the growth rate starts to decline, so that increased rivalry forces
the weakest of the new entrants out of the business. In the maturity stage, barriers to entry
tend to increase, as control over distribution is established and economies of scale and
 experience curve benefits come into play. Products or service tend to standardise. Buyers
may become more powerful as they become less avid for the industry’s products or
services and more confident in switching between suppliers.
For major players, market share is typically key to survival, providing leverage against
buyers and competitive advantage in terms of cost. Finally, the decline stage can be a
period of extreme rivalry, especially where there are high exit barriers, as falling sales
force remaining competitors into dog-eat-dog competition. Exhibit 1 summarises some of
the conditions that can be expected at different stages in the life cycle.

2.3 Comparative industry structure analyses

The industry life cycle notion underlines the need to make industry structure analysis
dynamic. One effective means of doing this is to compare the five forces over time in a
simple ‘radar plot’.
Exhibit 2 provides a framework for summarising the power of each of the five forces on five
axes. Power diminishes as the axes go outwards. Where the forces are low, the total area
enclosed by the lines between the axes is large; where the forces are high, the total area
enclosed by the lines is small. The larger the enclosed area, therefore, the greater is the
profit potential. In Exhibit 2.4, the industry at Time 0 (represented by the bright blue lines)
has relatively low rivalry (just a few competitors) and faces low substitution threats.
The threat of entry is moderate, but both buyer power and supplier power are relatively
high. Overall, this looks only a moderately attractive industry to invest in. However, given
the dynamic nature of industries, managers need to look forward, here five years
represented by the dark blue lines in Exhibit 2.4.11Managers are predicting in this case some
rise in the threat of substitutes (perhaps new technologies will be developed). On the other
hand, they predict a falling entry threat, while both buyer power and supplier power will be
easing.
Rivalry will still further reduce. This looks like a classic case of an industry in which a few
players emerge with overall dominance. The area enclosed by the dark blue lines is large,
suggesting a relatively attractive industry. For a firm confident of becoming one of the
dominant players, this might be an industry well worth investing in.
2.4 Techniques for industry analysis.
Firms use a variety of techniques to analyze their industries. In this section we will describe
three of those techniques, competitor analysis, price elasticity analysis, and target market
analysis.
2.4.1 Competitor analysis.
In formulating strategy, management must consider the strategies of the firm’s competitors.
Competitor analysis is of vital importance to devising strategies in concentrated industries.
Competitor analysis involves two major activities:
(1) gathering information about competitors’ capabilities, objectives, strategies, and
assumptions (competitor intelligence), and
(2) using the information to understand the competitors’ behavior. Management uses a
number of sources of information for competitor analysis including the competitor’s
• Annual reports and SEC filings
• Interviews with analysts
• Press releases

However, management must also consider information derived from the actions of the
competitor such as the following:
• Research and development projects
• Capital investments
• Promotional campaigns
• Strategic partnerships
• Mergers and acquisitions
• Hiring practices

In a competitor analysis, management seeks to understand

• What are the competitor’s objectives?
• What can and is the competitor doing based on its current strategy?
• What does the competitor assume about the industry?
 • What are the competitor’s strengths and weaknesses?

Information from the analysis of the competitor’s objectives, assumptions, strategy and
capabilities can be developed into a response profile of possible actions that may be taken
by the competitor under varying circumstances. This will allow management to anticipate
or influence the competitor’s actions to the firm’s advantage.

2.4.2 Price elasticity analysis

Price elasticity is measured as the percentage change in demand given a percentage change in
price and is described as follows:

Example:

Let’s assume you have been watching a product for a few months and have been counting the
number of the product sold at different prices. You find that when the price is $3.00, 75 units are
sold. When the price is raised to $3.25, only 60 units are sold. Calculate the product’s price
elasticity of demand.

Answer:

There are two important implications of this calculation:

1. Notice that the elasticity is negative. This means that prices and quantity demanded move
in opposite directions. As price increases, demand decreases, and as price decreases, demand
increases.
2. The percentage change in quantity demanded is 2.8 times the percentage change in
price. This product is fairly elastic, meaning the demand for the good is strongly affected by its
price. There are other goods, for example gasoline for your car, that are much less sensitive to
price changes. Another example is food. Since people must eat, the amount consumed might be
virtually unaffected by price changes. Note, however, that consumers will begin to substitute lower
cost foods for the ones with the greatest increases (e.g., chicken for beef).

When elasticity is greater than 1, demand is said to be elastic.

When elasticity is less than 1, demand is inelastic.
In order to develop a pricing strategy, management may perform price elasticity
analysis of product or service. By observing the effects of price changes
management can obtain a better understanding of the relationship. Regression
analysis may be used to perform a more sophisticated analysis.
 2.4.3 Target market analysis.
(1) A firm’s target market is the market in which the firm actually sells or plans to sell its
product or services. A thorough understanding of the market is key to accurate sales
forecasts. Just defining the market in geographic terms is not enough. Management
should perform target market analysis to understand exactly who the firm’s customers
are. Management needs to understand why customers purchase the firm’s product or
service. For an individual customer the purpose might be to satisfy a basic need, to make
things easier, or for entertainment. Target market analysis generally involves market
segmentation, which involves breaking the market into groups that have different levels
of demand for the firm’s product or service. For example, a clothing store like the GAP,
that sells clothing primarily for teens, is interested in the size of the segment of the market
—the number of teens in the geographical area that the store serves. Segmentation may be
performed along any dimension that defines the firm’s market, including
(a) Demographics (e.g., sex, education, income, etc.)
(b) Psychographics (e.g., lifestyle, social class, opinions, activities, attitudes, etc.)

(2) If the firm’s customers are businesses, segmentation might be performed in terms of
other relevant dimensions including
(a) Industry
(b) Size (in terms of sales, total employees, etc.)
(c) Location
(d) How they purchase (e.g., seasonality, volume, who makes the purchasing decision)
Unlike individuals, businesses purchase products to increase revenue, decrease costs, or
maintain status quo.

(3) Target market analysis may be essential to the firm’s success. The greater the
understanding management has of the firm’s market, the more effective it can be at
making marketing decisions.
Advertising, for example, can be tailored to particular market segments. The firm may
even be able to use differential pricing in which they charge different prices to different
market segments. As an example, airlines have long attempted to develop fare schedules
and restrictions that segment the business traveler from the vacation traveler because the
business traveler will generally pay more for a ticket.

3. Developing and Implementing Strategies

In developing business strategies, management will often begin with a SWOT (strengths,
weaknesses, opportunities and threats) analysis that evaluates the strengths and weaknesses of
the firm as well as its opportunities and threats. This evaluation is then used to develop
strategies to minimize risks and take advantage of major opportunities. This analysis is
usually displayed in a SWOT matrix.
SWOT analysis summarises the key issues from the business environment and the strategic
capability of an organisation that are most likely to impact on strategy development. This can
also be useful as a basis against which to judge future courses of action. The aim is to identify
the extent to which the current strengths and weaknesses are relevant to, and capable of,
dealing with the changes taking place in the business environment. It can also be used to
assess whether there are opportunities to exploit further the unique resources or core
competences of the organisation. Overall a SWOT analysis should help focus discussion on
future choices and the extent to which an organisation is capable of supporting these
strategies.
The SWOT matrix (TWOS matrix) is used to generate strategic options by building directly
on the information about the strategic position that is summarised in a SWOT analysis. In this
sense the TOWS matrix not only helps generate strategic options it also addresses their
suitability. Each box of the TOWS matrix is used to identify options that address a different
combination of the internal factors (strengths and weaknesses) and the external factors
(opportunities and threats). For example, the top left-hand box should list options that use the
strengths of the organisation to take advantage of opportunities in the business environment.
In contrast the bottom right-hand box should list options that minimise weaknesses and also
avoid threats.

Business strategies are generally classified as being product differentiation or

cost leadership.
1. Product differentiation. Product differentiation involves modification of a
product to make it more attractive to the target market or to differentiate it from
competitors’ products. Products may be differentiated in the following ways:
• Physical characteristics (e.g., aesthetics, durability, reliability,
performance, serviceability, features,
etc.)
• Perceived differences (e.g., advertising, brand name, etc.)
• Support service differences (e.g., exchange policies, assistance, after-
sale support, etc.)

By differentiating its products, the firm may be able to charge higher prices than
its competitors or higher prices for the same products sold in different market
segments.

2. Cost leadership. Striving for cost leadership fundamentally involves focusing

on reducing the costs and time to produce, sell, and distribute a product or
service. A number of techniques are used to attempt to reduce costs and time,
including process reengineering, lean manufacturing (production), supply chain
management, strategic alliances, and outsourcing.
• Process reengineering involves a critical evaluation and major
redesign of existing processes to achieve breakthrough improvements in
performance. Process reengineering differs from total quality management
(TQM) in that TQM involves gradual improvement of processes, while
reengineering often involves radical redesign and drastic improvement in
 processes. Many of the significant improvements in processes over the
last few years have been facilitated with innovations in information
technology.

• Lean manufacturing is a management technique that involves the

identification and elimination of all types of waste in the production
function. Operations are reviewed for those components, processes, or
products that add cost rather than value. A basic premise underlying lean
manufacturing is by focusing on improving design, increasing flexibility,
and reducing time, defects, and inventory, costs can be minimized.
• Supply chain management. (1) The term supply chain describes the
flow of goods, services, and information from basic raw materials through
the manufacturing and distribution process to delivery of the product to
the consumer, regardless of whether those activities occur in one or many
firms. Supply chain also called value delivery network.

EXAMPLE: A supply chain is illustrated below.

As shown, the firm’s operations include only the assembly and distribution
processes.
Other firms supply raw materials, perform subassembly, and are the resellers
of the final product. In viewing the supply chain, it is critical to go beyond the
firm’s immediate suppliers and customers to encompass the entire chain
.
(2) To improve operations and manage the relationships with their suppliers
many firms use a process known as supply chain management. A key
aspect of supply chain management is the sharing of key information from
the point of sale to the final consumer back to the manufacturer, the
manufacturer’s suppliers, and the suppliers’ suppliers. As an example, if a
manufacturer/distributor shares its sales forecasts with its suppliers and they
in turn share their sales forecasts with their suppliers, the need for
inventories for all firms is significantly decreased.
The manufacturer/distributor, for example, needs far less raw materials
inventory than normally would be the case because its suppliers are aware of
the manufacture’s projected needs and is prepared to have the materials
available when needed. Specialized software facilitates this process of
information sharing along the supply chain network.
(3) Supply chain management also focuses on improving processes to reduce
time, defects, and costs all along the supply chain. By focusing on the entire
supply chain, management may evaluate the full cost of inefficient processes,
defective materials, and inaccurate forecasts of sales.

(4) However, supply chain management presents the company with a number
of problems and risks including those arising from
(a) Incompatible information systems
(b) Refusal of some companies to share information
(c) Failure of suppliers or customers to meet their obligations.

3.1 Methods of Pursuing Strategies

A Strategic method is the means by which a strategy can be pursued. These
methods can be divided into three types:

3.1.1 Organic Development is where strategies are developed by building on and

developing an organisation's own capabilities. For many organisations, internal
development (sometimes known as 'internal development') has been the primary method
of strategy development for several reasons:

• For products that are highly technical in design or method of manufacture,

businesses may choose to develop new products themselves, since the process of
development is seen as the best way of acquiring the necessary capabilities to compete
successfully in the marketplace.
• A similar argument may apply to the development of new markets by direct
involvement. Market knowledge may be a core competence creating competitive
advantage over other organisations that are more distant from their customers.
• Although the final cost of developing new activities internally may be greater than
that of acquiring other companies, the spread of cost over time may be more favourable
and realistic. Also the slower rate of change which internal development brings may also
minimise the disruption to other activities.
• An organisation may have no choice about how new ventures are developed. In
many instances those breaking new ground may not be in a position to develop by
acquisition or joint development, since they are the only ones in the field.
• Internal development also may avoid the often traumatic political and cultural
problems arising from post-acquisition integration and coping with the different traditions
and incompatible expectations of two organisations.

3.1.2 Mergers and Acquisitions

Acquisition is where strategies are developed by taking over ownership of another
organisation. There are many different motives for developing through acquisition or
merger:

• The speed with which it allows the company to enter new product or market areas.
• The competitive situation may influence a company to prefer acquisition. In
markets that are static and where market shares of companies are reasonably steady, it can
be a difficult proposition for a new company to enter the market, since its presence may
 create excess capacity. If, however, the new company enters by acquisition, the risk of
competitive reaction is reduced.
• Deregulation was a major driving force behind merger and acquisition activities
where regulation had created a level of fragmentation that was regarded as sub-optimal.
• There may be financial motives for acquisitions. If the share value or
price/earnings (P/E) ratio of a company is high, the motive may be to spot and acquire a
firm with a low share value or P/E ratio.

• An acquisition may provide the opportunity to exploit an organisation's core

competences in a new arena.
• Cost efficiency is a commonly stated a reason for acquisitions (by cutting out
duplication or by gaining scale advantages).
• Learning can be an important motive.
• Institutional shareholders may expect to see continuing growth and acquisitions
may be a quick way to deliver this growth.
• Growth through acquisitions can also be very attractive to ambitious senior
managers as it speeds the growth of the company.
• There are some stakeholders whose motives are speculative rather than strategic.
They favour acquisitions that might bring a short-term boost to share value.

A strategic alliance is where two or more organisations share resources and activities to
pursue a strategy. Strategic alliances involve collaborative agreements between
two or more firms. They may be organized as joint ventures, equity ventures,
equity investments, or simple agreements (such as comarketing or
codevelopment agreements). Firms enter into strategic alliances for a number
of reasons, including to
(1) Refocus the firm’s efforts on its core competencies and value creation
activities
(2) Speed innovation
(3) Compensate for limited resources
(4) Reduce risk.

4. Estimating the Effects of Economic Changes

Successful management involves being able to anticipate changes in economic conditions and
competitor actions and devising strategies and plans to react to those changes. To begin with,
management must thoroughly understand the effects of economic changes on the firm. “How will
demand for the firm’s products or services be affected?” and “How will the change affect the firm’s
costs?” are key questions. In order to estimate the effects, management will collect and analyze
historical data. Quantitative techniques such as regression analysis may be used. Management will also
examine the effects of any competitor analysis that has been performed. The following table illustrates
the process.
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