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Introduction

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External Analysis
Itai Ater
School of Management
Tel Aviv University

November 3, 2015

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When an industrys underlying economics are


crumbling, talented management may slow the
rate of decline. Eventually, though, eroding
fundamentals will overwhelm managerial
brilliance.
Warren Buffet
If you want to get a reputation of a good
businessman, be sure to get into a good
business.
Warren Buffet

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The Goal

Recall, our ultimate goal is to identify the firms


strategic positioning and its competitive advantage.
The first step is to get acquainted with the
environment in which the firm acts - External Analysis.

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Market/Industry Definition
The first step in the external analysis is identifying the
relevant markets that the firm operates in:
Products/services
Geography

A market is the set of close substitutes products and


geographic regions at which these products are sold
Often it is difficult to have a clear market definition (+
technology and regulatory changes tend to change
market boundaries).
Nevertheless, identifying which markets are central to
the firm and which arent is important

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Approaches to Identify Rivals

Correct classification is important because:


Too narrow: ignores threats by potential rivals
Too broad: distracted by perceived threats

Estimation of demand elasticity


Price correlation between competitors over time
Surveys
Comparison of product characteristics, occasions of
use, geographic market

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The Tool
Porters five forces.
Michael porter introduced this organizing scheme at
the end of the 1970s. Became one of the most,
applied frameworks in strategy.
Most ideas are based on the economics literature on
industrial organization. Therefore, we will mainly
emphasize economic principles.
The scheme is taken from the Newtonian world:
various forces work on the firm and determine its
position.
Pedagogical note: every topic includes a check list.
In class we will focus on a small subset and pass
quickly through others.

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Porters Five Forces

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General
We say that a force has a strong effect on the firm if it
reduces the firms current or future earnings.
Later we claim that the strategic positioning of the firm
should be characterized by low pressure from the
various forces.
We will discuss these forces sequentially.
The framework is supposed to address two main
questions:
1

What characteristics of my market context are


important determinants of profitability?
Given the market context, what strategic actions can I
take to improve performance?

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Competition

Probably the most important driver of firms profits.


Competition determines the level of profit that a firm
earns and therefore:
1

It is important to understand the determinants of


competition.
Firms will take actions to reduce the competition that
they face.

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The Communication Products Price Index

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The Israeli Cellular Market

Oct. 2009: Launching the search for a fifth operator.


Sep. 2010: Rami Levi communications is established.
Apr. 2011: An auction for frequencies takes place.
July 2011: Golan Telecom is the fifth operator.
Dec. 2011: Rami Levi begins its operation.
May 2012: Golan Telecom begins its operation.

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Average Revenue Per Subscriber

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Retail Food Market


2013 - 2014

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Market Structure

The nature of competition is mainly driven by the


number and size of firms in the market.
It is common to use the number and the size of firms
to classify the market structure. These include:
Monopoly - little or no competition (In Israel, more than
50 percent market share).
Oligopoly - few large firms operate in the market.
Fragmented industry - no market leader, many small
firms.
Competitive environment.

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Competition

Usually, competition is bad for firms as it reduces


profits.
The magnitude of the decrease depends on
Competition intensity.
The dimension on which firms compete.

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Competition Intensity
Competition is intense if
Many competitors or similar competitors.
Similar products and low switching costs.
Slow growth (cellular).
Price/product information is available.
High barriers to exit:
Different long-term goal (Ideology, commitment to
workers).
Liquidation problems (e.g. problematic re-renting,
obligations).
Biased view of the future.

Competitors wish to lead because of other reasons


(e.g. ego competition, Israel Hayom)

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Competition Dimension
Possible dimensions
Price.
Price transparency, easy to imitate.
The strongest effect is when the firms are involved in a
price competition.

Quality.
Technology.
Service, availability (e.g. flights to Europe)
Advertising.

Naturally, firms can compete on multiple dimensions.


Generally, the smaller the number of dimensions, the
stronger is the effect of competition on profits.

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Price Competition
Price competition happens frequently when:
Low differentiation, low switching costs, weak loyalty
(cellular, airlines).
Large fixed costs and small variable costs (freight
railroads, but not hotels).
Perishable goods (vegetables, one-shot events).

The solution is creating loyalty and switching costs:


Consumer club (e.g. frequent flier).
Long term contracts.

The solution is differentiation:


Within a firm (e.g. various versions).
Between firms (e.g. low-cost airlines, private label).

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Differentiation

Consumers often have different preferences over


products (e.g. beer, cereal, movies)
Competition is more intense when products are similar
Differentiation has two effects:
Getting away from from competing products (less price
competition)
Getting closer to customers that prefer the
differentiated product (better value proposition)

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Strategic Group Map


A technique for looking at your position in your market
Drawing the map: identify two competitive factors in
the market. For instance:
Brand image and dist. channels
Market penetration and price per quality

Rank the factors from high to low


Plot the results in a graph with each factor on one
axis, where each firm is a point
Draw a circle around each firm, making the circles
proportional to its market share

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Strategic Group Map - Example

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Strategic Group Map - Example

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It is not about the entry


Potential entrants include new firms, firms from nearby
markets and conglomerates:
Entry hurts the incumbents in two different ways:
Entry cuts into the incumbents market share
Entry intensifies competition and lowers prices.

It is not about the entry - it is about the threat.


The strength of the threat depends on the barriers to
entry and on the expected reaction of the incumbents.
Firms which are threatened by entry may decrease
prices and increase investment. Both bad for
business.
The analysis of entry models relies heavily on
game-theoretical models.

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Barriers to Entry
Barriers to Entry - the difficulties a firm expects to
encounter upon entering a new market.
Coffee shops:
Relatively low costs of entry
low-tech technology

Cellular operators in Israel:


Highly expensive and risky (infrastructure, service,
advertising).
The regulator has taken aggressive steps to enable
new carriers to enter (interconnection charges, number
portability).
Incumbents enjoyed strong brand names and good
distribution channels.

But also needs to take into account market size.

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Barriers to Entry - Returns to scale


Will be discussed in detail as part of the Internal
Analysis.
Bottom line: if there are returns to scale in the market,
it means that big firms produce at low cost per product.
Possible explanations:
Fixed costs.
Large scale technology.
Bargaining power.

The entrant should either be big or accept high


production costs.
More significant returns to scale imply lower threat of
entry.

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Barriers to Entry - Other Examples


Network effect
Reputation - Ill have what she is having (infant
formula, Remedia).
Compatibility - in particular in computer applications.

Customers switching costs.


Capital requirements
Capital is needed for facilities, equipment, credit,
inventory, low initial prices.
In some cases the capital is non-refundable
(advertising, R&D, low prices).

Incumbency advantages
Example: connections, reputation (repeated game).
Example: unequal access to distribution channels (first
mover advantage).

Regulation

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Incumbents Reaction
New entrants fear that the incumbents reaction will
make their entry unprofitable.
Such fear may be based on:
Past experience.
Multi-market contact.
The incumbents do not exhaust their resources.
Prices are high.
Slow growing sector.

Predatory pricing.
Generally defined as sales below cost by a dominant
firm over a long enough period of time for the purpose
of driving a competitor off the market.
Good for consumers?

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Is Entry Certain?

Often, outsiders have not yet decided about entry


Incumbents pre-entry behavior may affect entry
decisions.
If incumbents reduce they prices then potential
entrants may be deterred. Hence, we can expect to
see pre-entry price reductions.
However, if entry is surely going to take place - then
should the incumbent set lower prices?

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Incumbents Respond to the Threat of Entry Example


Evidence from the US Airline Industry

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Further Issues
The Role of Commitment

Assuming entry takes place - can the incumbent


maintain the low prices?
If not, then the low-prices are not effective in deterring
entry...
How can the incumbent commit to setting low prices
for a long-time period?
Long term contracts with low prices
Excess capacity or inventory - creates incentives to
sustain low prices

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Securing Suppliers or Customers


Yet, committing to low prices is potentially very costly
for the firm
Instead, a firm can sign long-term contracts with large
enough consumers or suppliers...
Consequently, making it less attractive for a rival to
enter a market
Google purchased Waze presumably to prevent
Facebook/Apple from entering the real-time mapping
application
Microsoft added free explorer to Windows to drive out
Netscape
Elevators firms set high prices from rivals for elevators
spare parts and thus control the downstream market
Large retail chains (e.g. McDonalds, SuperPharm,
Aminach) limit the competition they face by signing
exclusivity contracts with shopping malls

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Market Size and Entry Deterrence


Intermediate Size Markets Exhibit Most Action

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Summary

For external analysis we focus on the incumbents


point of view.
If Barriers to entry are high, incumbents are less
threatened by new entries.
If past experience is of aggressive reaction,
incumbents are less threatened by new entries.

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It is all about the Bargaining Power

The firm and the supplier have a cake to share.


The size of the cake is not always clear: what is the
share of the suppliers product in the selling price of the
firm?
Do firms always understand their bargaining power?
Do firms always use their bargaining power?

Generally, suppliers with bargaining power keep as


large a part as possible of the cake to themselves.

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The Practice of Using Bargaining Power

High Prices.
Limited service (as part of transferring expenses to the
firm).
Limited products or quality (exclusivity, premium).
Intervention in the firms policy (especially pricing
policy).

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The Israeli Food industry

Large suppliers (Osem, Tnuva, Strauss, Unilever,


Central Company)
Large retailers (Sufersol, Mega)
Who has the upper hand?

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Monopolies in the Food Industry

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More Monopolies in the Food Industry

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Operational profitability in the Food Industry

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How to maintain or enhance your bargaining


power

Suppliers often Use smaller chains (e.g Rami-Levy) to


reduce the dominance of strong retailers
Suppliers strengthen their brand name
Retailers develop private label to reduce the
dominance of large suppliers

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When do Suppliers have Bargaining Power

The firms market is more competitive than the


suppliers market.
No substitutes (e.g. suppliers are differentiated,
experts).
The firms market provides a small fraction of the
suppliers profits and activity.
High switching costs (e.g. software).
The suppliers can become players in the market.

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Again, it is all about the Bargaining Power

The customers can be consumers (final customers \


users) or other firms.
The analysis of the case where the customers are
firms bears a lot of resemblance to the suppliers
analysis.
Naturally, customers with more bargaining power get
better prices, better service and better products.

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When do Customers have Bargaining Power


The firms market is more competitive than the
customers market.
Few customers (or very big customers)
The products in the firms market are not differentiated.
There are low switching costs

The customers are price-sensitive.


The expenditure on the product is significant
(mortgage).
The product does not affect the quality of the
customers product or other expenditures (fuel).
However, customers can act irrationally.

The firm has large fixed costs and therefore must sell
(soccer tickets). However,
Repeated game.
Part of strategy (upgraded economy seats).

The customers can become players in the market

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Social Media as a Coordinating Device

The rise of Social Online Media (e.g. Facebook) could


help consumers act collectively.
The Cottage Cheese Boycott is a famous example
What constitutes a potential target for a consumer
boycott?

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Intermediate Customers
Example 1: Publisher, book store, readers.
Example 2: Seed company, farmers, wholesale
chains.
Example 3: Politician, votes supplier (e.g. head of
union), voters.
Complicated scenario:
The intermediate customers can affect the decisions of
the end customers.
Therefore, they have bargaining power with the initial
suppliers.
Therefore, the initial suppliers may try to bypass the
intermediate customers in marketing.

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Definition

Two products are substitutes if they serve similar


purpose with different means.
Economics: Two products are substitutes if an
increase in the price of one leads to an increase in the
demand for the other.
It is sometimes hard to distinguish between
substitutes and direct competition.

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Examples

Video conference vs. flight to meetings.


Ketchup vs. mayonnaise. Pulp Fiction
Coca cola vs. water.
New vs. old housing (zero VAT law)
Swimming pools vs. sea.
Electric cars vs. cars (suppose you are a fuel
supplier).

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Significant Threat of Substitute


The substitute exhibits a good quality-price
combination.
Skype vs. international calls providers.
SMS/Whatapp vs. phone calls.
VOD vs. video stores. But, Haozen Hashlishit or
cinemas.

Low switching costs (Teva).


Technology (Digital cameras).
The threat of substitutes in the consumers market also
matters.

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Complements
Definition:
Two products are complements if they serve
complementing purposes.
Economics: Two products are complements if an
increase in the price of one leads to a decrease in the
demand for the other.

Example: Fuel and cars.


Example: Applications and operating system.
Example: Gaming consuls and Video games.
Standardization.

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Summary - Porter

porter

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Various regulatory authorities


Market-specific regulatory bodies (e.g. ministries of
communication, finance, energy).
Quality supervision (Ministry of health, Machon
Hatkanim).

These agencies usually set the rules of the game.


The role of the antitrust/competition authority is to
enhance market competition. Often, the objectives of
the antitrust authority and the specific regulators clash.
Do regulators advance the public interest or specific
interests (regulatory capture)?

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PEST - Macro Level Analysis

PEST is used to analyze political, economic,


sociological and technological factors
Political - elections, government spending, minimum
wage laws, legal issues.
Economic - Inflation, unemployment, exchange rates,
business cycles.
Sociological - cultural attitudes, lifestyle changes,
ethical beliefs.
Technological - changes in process and managerial
innovation.

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Value Net
The five forces framework views other firms - entrants,
competitors, suppliers or buyers - as threats to
profitability
The Value Net model introduce the concept of
coopetition and emphasize potential
complementarities across players:
Firms cooperate in setting industry standards that
facilitate industry growth.
Firms cooperate in lobbying for favorable regulation or
legislation.
Firms cooperate with buyers/suppliers to improve
inventory management.

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The Uses of External Analysis

External analysis improves the prediction of reaction


to shocks (e.g. digitization of music).
External analysis allows for a more accurate definition
of the market (e.g. car oil and truck oil, local markets).
Mainly, external analysis provides the necessary tools
to identify strategic positioning

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