Industry Structure Supplement by Dennis Hanlon 2000 Industry Structure Industries vary in overall profitability or attractiveness due to differences

in their structures. According to Michael Porter of Harvard University, five forces determine the overall structure of an industry. These are: entry barriers, buyer power, supplier power, threat of substitutes, and competitive rivalry. One goal of industry analysis is to understand how these forces operate in your chosen industry. Entry Barriers Interestingly, most start-ups occur in industries associated with high rates of failure. In contrast, industries with the lowest rates of failure are characterized by fewer start-ups. On the surface this seems puzzling. Why would entrepreneurs choose to start their firms in industries where their chances of success are significantly lower? The answer lies in understanding entry barriers. High entry barriers serve to keep competitors out of an industry. Veterinary clinics have a high survival rate, for example, but many years of specialized training are required in order to become a veterinarian. In contrast, the residential construction industry is notorious for a high rate of start-ups and failures. Here we would say the barriers to entry are low. Many of these firms operate from the home, require only a few inexpensive tools (which are usually already owned) and a minimum of capital. In Newfoundland this industry became especially competitive due to the presence of displaced fishers and other workers who operated construction businesses on a part-time basis (e.g. teachers, police officers, firefighters). Entry barriers consist of structural barriers and retaliatory barriers. Structural barriers Economies of scale: Per-unit reductions in cost that result from high volume. The presence of economies of scale forces competitors to enter on a large scale or accept a cost disadvantage. Excess capacity: In industries with excess capacity existing firms will be under pressure to produce more product to spread out their fixed costs. This will usually result in lowering prices - an effective deterrent to new firms. Product differentiation: When products are perceived as unique by the consumer new entrants will have to spend heavily on advertising in order to overcome existing loyalties. Specific assets: When existing firms have a high investment in assets that cannot be redeployed, they will fight vigorously to protect their market share.

Capital requirements: High capital requirements can serve as a barrier to individual entrepreneurs, but are less important in the case of large firms. Switching costs: If it costs customers extra to switch to a new provider, new firms will be at a disadvantage. An example might be the training required to learn new software. Smart firms may seek to create switching costs. Access to distribution channels: When distribution channels are owned or controlled by a few firms, new entrants may find it difficult to get their products to market. Supermarkets, for example, charge high fees for stocking new products. Cost disadvantages unrelated to size: These include proprietary technology (e.g. patents), government subsidies and long-term contracts. Retaliatory Barriers The threat of retaliation can be an effective deterrent to entry in an industry. Large, established firms are likely to retaliate when: a) they have a reputation and history of retaliation b) the attack is at their core business. Firms are likely to retaliate when the product being threatened represents the majority of their sales volume. c) the industry is characterized by slow growth. In this case, new entrants must steal market share from existing firms. Retaliation often takes the form of price-cutting or legal challenges. Price cutting is especially prevalent where the product has the characteristics of a commodity (i.e. competing brands are viewed as equivalent so price becomes all-important). Buyer Power When buyer power is high a firm may be forced to lower its prices or increase product quality, resulting in a lower profit margin. Buyer power is determined by the following factors: Buyer concentration: where there are only a few buyers, the buyer is in a stronger bargaining position. Automobile manufacturers, for example, possess considerable power in comparison to their suppliers. Buyers costs: if the product represents a high proportion of the buyers total costs, the buyer will be more price-sensitive. Homogeneous products: where the product is viewed as a commodity, buyers will purchase on the basis of price.

Switching costs: if the buyer faces few switching costs s/he will be more likely to shop around. Buyer income: buyers with low income or profits will be price-sensitive. Threat of integration: If the buyer is a firm and is capable of making the product themselves, this will increase its bargaining power. Full information: the more information the buyer has manufacturing costs, etc., the greater their bargaining power. Supplier Power When supplier power is high they should be in a better position to charge you higher prices or decrease their product quality. You should assess the bargaining power of your suppliers in terms of the following factors: Supplier concentration: where only a few suppliers exist, their power is greater. Role of substitutes: where few substitutes for the product exist, supplier power is increased. Purchasing power: where sales volume only represents a small proportion of the suppliers sales volume, suppliers tend to have greater power. Importance of quality: if the product being purchased is crucial to your success, the power of suppliers increases. Switching costs: the presence of switching costs will make it more difficult for you to switch suppliers, thus increasing supplier power. Threat of integration: if suppliers have the capability to forward-integrate and carry out your firms function themselves, their power is increased. Threat of Substitutes The threat of substitutes does not refer to offerings of direct competitors. It represents instead the threat of a product being replaced by an indirect competitor. An example would be the potential for steel to be replaced by aluminum or ceramics. To the extent that substitutes represent a viable alternative, this places a ceiling on the potential for profits in an industry. Competitive Rivalry Rivalry among firms is increased under the following conditions: about

Numerous and balanced competitors: when there are many firms of relatively equal size and power, competitive rivalry tends to be increased. In contrast, the presence of a few dominant firms can often stabilize an industry and decrease competitive pressure. Slow industry growth: slow industry (or market) growth makes it difficult for firms to grow without stealing market share from other firms by lowering prices or increasing quality. Commodity--type products: places pressure on price.