Description

Contemporary Strategy Analysis
Eleventh Edition
Robert M. Grant

Chapter 6
Organizational Structure and Management Systems: The
Fundamentals of Strategy Implementation

Organization Structure and Management Systems: The
Fundamentals of Strategy Implementation
Outline
• Strategy Formulation and Strategy Implementation.
• The Fundamentals of Organizing.
• Developing Organizational Capability.
• Organizational Design.

6-2

Learning Objectives
Learning Objectives
• To understand the relationship between strategy formulation and strategy
implementation and the role of strategic planning systems in linking the
two.
• To recognize the role of cooperation and coordination within
organizations.
• To appreciate the role of resources, processes, motivation, and structure in
developing organizational capabilities.
• To select organizational structures best suited to particular business
contexts.
6-3

Strategy Formulation and Strategy Implementation (1 of 2)
Strategy Formulation and Strategy Implementation
• Strategic management cannot be segmented into self-contained
formulation and implementation stages.
• Intended strategy is always incomplete—it is during implementation that
strategy becomes fully specified.
• Equally, strategy formulation has to take account of the circumstances of
implementation.
• However, action needs to be preceded by intention: hence, the starting
point for most strategy is the cognitive processes of managers.
6-4

Strategy Formulation and Strategy Implementation (2 of 2)
The Strategic Planning Cycle

6-5

The Fundamentals of Organizing (1 of 3)
Basic Tasks of Organizing: Cooperation and Coordination

6-6

The Fundamentals of Organizing (2 of 3)
Key drivers:
1. Technological and economic developments.
o
o

2.

Developments in transportation (e.g. railroads) enabled firms to serve wider markets.
Developments in communication (e.g. telegraph, telephone) allowed firms to organize across a wider geographical area.

Legal developments
o

o

The corporation as a legal entity.
Limited liability.

3. Organizational innovations
o
o

o

Line and staff structure—the creation of corporate headquarters that administered multiple operating units
The holding company—financial group of companies linked by parent-subsidiary relationships
The multidivisional structure—integrated companies with corporate headquarters responsible for financial and strategic control
and divisions operating the individual businesses.
6-7

The Fundamentals of Organizing (3 of 3)
Hierarchy as Coordination: [2] Loosely-Coupled Modular Systems Allow Decentralized
Adaptation

Tightly-coupled, integrated system:
Change in any part of the system requires
system-wide adaptation.

Loose-coupled, modular hierarchy:
partially-autonomous modules linked by
standardized interfaces permits
decentralized adaptation and innovation.
6-8

Developing Organizational Capability (1 of 3)
Integrating Resources to Create Organizational Capability

6-9

Developing Organizational Capability (2 of 3)
Resources & capabilities in professional soccer

6-10

Developing Organizational Capability (3 of 3)
Reorganizing for Capability Development: Booz Allen Hamilton (Worldwide Commercial
Business), 1992-1998

6-11

Organizational Design (1 of 8)
Hierarchy as Control: Weber’s Principles of Bureaucracy
• Rational-legal authority.
• Specialization of labor.
• Hierarchical structure.
• Coordination and control through rules and standard operating procedures.
• Standardization of employment practices.
• Separation of positions and people: authority assigned to a position, not a
person.
• Formalization of administrative acts, decisions, and rules.
6-12

Organizational Design (2 of 8)
Hierarchy as Coordination: [1] Hierarchy Economizes on Coordination Costs

But what about effectiveness of coordination?
–Depends upon the organization’s task
6-13

Organizational Design (3 of 8)
Ryanair Holdings plc: Organizational structure

6-14

Organizational Design (4 of 8)
General Electric: Organizational Structure, January 2018

6-15

Organizational Design (5 of 8)
Sony Group: Organizational Structure, April 2020

6-16

Organizational Design (6 of 8)
Royal Dutch/Shell Group, 1994: A Matrix Structure

6-17

Organizational Design (7 of 8)
Mechanistic versus Organic Organizational Forms
Feature

Mechanistic forms

Organic forms

Task definition

Rigid and highly specialized

Flexible and broadly defined

Coordination and control

Rules and directives vertically imposed

Mutual adjustment, common culture

Communication

Vertical

Vertical and horizontal

Knowledge

Centralized

Dispersed

Commitment and loyalty

To immediate superior

To the organization and its goals

Environmental context

Stable with low technological uncertainty Dynamic with significant technological
uncertainty and ambiguity

6-18

Organizational Design (8 of 8)
New Approaches to Business Organization
• Adhocracy—team-based organization where shared values, employee participation,
flexible communication, and spontaneous coordination substitute for hierarchy,
authority, and control.
• Project-based organizations—dynamic structures with time-limited project teams.
• Network structures—organizations where coordination is based upon informal social
linkages rather than by hierarchy. Effective in creating and disseminating knowledge.
• Humanistic organization—dedicated to the dignity, liberty, integrity, and well-being of
members. To promote the flourishing of its people commitment to ethics and selfdetermination is essential.
6-19

DB -Module 05: Organizational Structure, Systems, and Implementation
Read Case 6: BP: Organizational Structure and Management Systems (R.M. Grant,
Contemporary Strategy Analysis, 11th ed. Wiley, 2022).
Remember that a case study is a puzzle to be solved, so before reading and discussing the
specific case questions below, develop your proposed solution by following these steps:
1. Read the case study to identify the key issues and underlying issues. These issues
are the principles and concepts of the course module which apply to the situation
described in the case study.
2. Record the facts from the case study which are relevant to the principles and
concepts of the module. The case may have extraneous information not relevant to
the current course module. Your ability to differentiate between relevant and
irrelevant information is an important aspect of case analysis, as it will inform the
focus of your answers.
3. Describe in some detail the actions that would address or correct the situation.
4. Complete this initial analysis and then read the discussion questions. Typically, you
will already have the answers to the questions but with a broader consideration. At
this point, you can add the details and/or analytical tools required to solve the case.
The disastrous explosions at BP’s Texas City refinery and its Macondo oil well in the Gulf of
Mexico have drawn attention to the organizational structure and management system
created at BP by former CEO John Browne.
• Discuss the role that specialization with coordination and cooperation played in the
BP disaster? Provide examples of organizational capabilities that could have
facilitated this process.
• What structure is used in your organization and is this model appropriate to the
industry in which you work? Why or Why not?
Directions:
• Discuss the concepts, principles, and theories from your textbook. Cite your
textbooks and cite any other sources if appropriate.
• Your initial post should address all components of the question with a 500 word
limit.
In this module, we explore strategy execution and learn that strategy formulation and
strategy implementation cannot be separated. Strategy implementation considers broad
organizational concepts such as organizational design and behavior as well as human
resource management. We will also utilize a strategic viewpoint to focus on strategy
implementation from a front-line perspective, particularly considering organizational
structure and management systems. We will continue to learn about organizational
resources and capabilities because they form the foundation from which strategy can be
implemented.
Learning Outcomes
1. Understand the processes of strategy execution.
2. Reconcile specialization with coordination and cooperation.

3. Identify organizational capabilities needed to implement strategy.
4. Examine types of structures and systems and how they are suited to particular
contexts.
Readings
Required:
• Chapter 6 Organization Structure and Management Systems: The Fundamentals of
Strategy Implementation in Contemporary Strategy Analysis
• Chapter 6 PowerPoint slides in Contemporary Strategy Analysis
• Kulović, D., Husaković, D., & Husetović, E. (2022). Relationship between
organizational configurations and competing values culture model. BH Economics
Forum / BH Ekonomski Forum, 16(1), 63–78.
• Wade, J. (2014). Reinventing organizations: A guide to creating organizations
inspired by the next stage of human consciousness. Journal of Transpersonal
Psychology, 46(2), 255–256.
Recommended:
• Di Muro, P., Lecoeuvre, L., & Turner, R. (2021). Ambidextrous strategy and execution
in entrepreneurial project-oriented organizations: The case of Pagani
supercars. International Journal of Project Management, 39(1), 45.

3

Industry Analysis:
The Fundanientals
When a management with a reputation for bri lliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that
remains intact.
– WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY

The reinsurance business has the defect of being too attractive-looking to new
entrants for its own good and will therefore always tend to be the opposite of, say,
the o ld business of gathering and rendering dead horses that always tended to
contain few and prosperous participants.
– CHARLES T MUNGER, CHAIRMAN, WESCO FINANCIAL CORP

OUTLINE
♦

•

Introduction and Objectives

•

From Environmental Analysis to Industry Analysis

•

Strategies to Alter Industry Structure

•

Analyzing Industry Attractiveness

•

Positioning the Company

•

♦

Using Industry Analysis to Develop Strategy

Defining Industries: Where to Draw the Boundaries

•

Porter’s Five Forces of Competition Framework

•

Competit ion from Substit utes

•

Industries and Markets

•

Threat of Entry

•

•

Riva lry between Establi shed Com petitors

Defining Industries and Market s: Substitution in
Demand and Supply

•

Bargaining Power of Buyers

•

Bargaining Power of Suppliers

♦

From Industry Attractiveness to Competitive
Advantage: Identifying Key Success Factors
Summary
♦

Self-Study Questions
♦

Notes

Applying Industry Analysis to Forecasting Industry

♦

Profita bi Iity
•

Identifying Industry Structure

•

Forecast ing Indust ry Profitability

CHAPTER 3 INDUSTRY ANALYSIS : THE FUNDAMENTALS

Introduction and Objectives
In this chapter and the next, we explore the external environment of the firm. In Chapter 1, we observed
that profound understanding of the competitive environment is a critical ingredient of a successful
strategy. We also noted that business strategy is essentially a quest for profit. The primary task for this
chapter is to identify the sources of profit in the external environment. The firm’s proximate environment
is its industry; hence, indu stry analysis w ill be our focus.
Industry analysis is relevant both to corporate- and business-level strategies.
•

Corporate strategy is concerned w ith decid ing which industries the firm should be engaged in and
how it should allocat e its resources among them. Such decisions require assessment of the attractiveness of different industries in terms of their profit potential. The main objective of th is chapter is

♦

to understand how the competitive structure of an industry determines its profitability.
Business strategy is concerned w ith establish ing competitive advantage. By analyzing customer
needs and preferences and the ways in which firms compete to serve customers, we identify the
general sources of competitive advantage in an industry- w hat we call key success factors.

By the time you have completed this chapter, you w ill be able to:
•

Appreciate that the firm’s industry form s the core of its external environment.

♦

Identify the main structural features of an industry and understand how they impact the
intensity of competition and overall level of profitability in the industry.
App ly industry analysis to predict how an ind ustry’s profitability is likely to change in the
♦

future.
♦

Develop strategies that (a) position the firm most favorably in relation to competition and
(b) influence industry structure in order to enhance industry attractiveness.

•

Define the boundaries of th e industry within w hich a firm is located.

♦

Identify opportunities for competitive advantage w ithin an industry (key success factors) .

From Environmental Analysis to Industry Analysis
The business environment of the firm consists of all the external influences that
impact its decisions and its performance. Given the vast number of external influences, how can managers hope to monitor, let alone analyze, environmental conditions1 The starting point is some kind of system or framework for organizing
information. Environmental influences can be classified by source, for example,
PEST analysis considers the political, economic, social, and technological factors that
impact a firm . PEST analysis and similar approaches to macrolevel environmental
scanning can help keep a firm alert to what is happening in the world but may result
in information overload.

55

56 PART II THE TOOLS OF STRATEGY ANALYSIS

The prerequisite for effective environmental analysis is to distinguish the vital from
the merely important. Hence, we need to establish what features of a firm’s external
environment are critical to its decisions. For the firm to make a profit, it must create
value for customers. Hence, it must understand its customers. Second, in creating
value, the firm acquires inputs from suppliers. Hence, it must understand its suppliers and manage relationships with them. Third, the ability to generate profitability
depends on the intensity of competition among firms that vie for the same valuecreating opportunities. Hence, the firm must understand competition. Thus, the core of
the.firm’s business environment is formed by its relationships with three sets of p layers:
customers, suppliers, and comp etitors. This is its industry environment.
This is not to say that macrolevel factors such as general economic trends, changes
in demographic structure, political events, and new technologies are unimportant
for strategy analysis. They may be critical sources of the threats and opportunities a
company will fa ce in the future. The key issue, however, is how these factors affect
the firm’s industry environment (Figure 3.1). Consider the threat of global warming.
For many companies, this is not a core strategic issue (at least, not within their normal
planning horizons). However, for those businesses most directly affected by changing
weather patterns- fa rmers and ski resorts- and those subject to carbon taxes and
environmental regulations- electricity generators and automobile producers-global
warming is a vital issue. For these businesses, the key is to analyze the implications
of global warming for customers, suppliers, and competition within their particular
industry. For the auto makers, will consumers switch to electric cars? Will governme nts mandate zero-emission vehicles or increase spending on public transportation?
Will there be new entrants into the auto industry?
If strategy is about identifying and exploiting sources of profit, then the starting
point for industry analysis is the simple question “What determines the level of profit
in an industry?”
In the last chapter, we learned that, for a firm to make profit, it must create value
for the customer. Value is created when the price the customer is willing to pay for
a product exceeds the costs incurred by the firm. Whether creating customer value
yields profit dep ends upon the intensity of competition. The stronger competition
is among producers, the more value is received by customers as consumer surplus
(the difference between the price they actually pay and the maximum price they
would have been w illing to pay) and the less is received by producers as profit. A
single supplier of umbrellas outside the Gare de Lyon on a wet Parisian morning
can charge a price that fully exploits commuters’ desire to keep dry. As more and

FIGURE 3.1

From environmental analysis to industry analysis
The nat ional/
international
economy

THE INDUSTRY
ENVIRONMENT
• Suppliers
• Competitors
• Cust omers
Government

and political
fo rces

Social forces

CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

more umbrella sellers arrive, so the price of umbrellas will be pushed closer to the
wholesale cost.
However, the profit earned by Parisian umbrella sellers, or any other industry, does
not just depend on the competition between them. It also depends upon their suppliers. If an indust1y has a powerful supplier- a single wholesaler of cheap, imported
umbrellas- that supplier may be able to capture a major part of the value created in
the local umbrella market.
Hence, the profits earned by the firms in an indust1y are determined by three factors:
• the value of the product to customers
• the intensity of competition
• the bargaining power of industry members relative to their suppliers and buyers.
Industry analysis brings all three factors into a single framework.

Analyzing Industry Attractiveness
Table 3.1 shows the profitability of different US industries. Some earn consistently high
rates of profit; others fail to cover their cost of capital. The basic premise that underlies industry analysis is that the level of industry profitability is neither random nor the
result of entirely industry-specific influences: it is determined by the systematic influences of the industry’s structure.
TABLE 3.1

The profitability of US industries, 2008- 2018

Industry

ROCE (%)

Tobacco

645

Alt ria, Reynolds America n, Philip Morris Int.

Computers and Peripherals

53.0

Apple, Dell, HP, NCR

Aerospace, Defense

50.2

Boeing, Lockheed Martin, United Technologies

Househo ld Products

38.6

Procter & Gamble, Kimberley-Clark,
Colgate-Palmolive

Pharmaceut icals

36.2

Pfizer, Johnson & Johnson, Merck

Beverages (soft drinks)

33.4

Coca-Cola, PepsiCo

Information Services

29.1

Visa, Western Union, Sa bre

Semiconductors

26.6

Intel, Qua lcomm, Texas Instruments

Software

26.6

Microsoft, Oracle, Salesforce

Food Processing

21.1

Kraft Foods, General Mills, ConAg ra

Metals & Mining

21. 1

Alcoa, Freeport-McMoRan, Newmont Mining

Restaurants

20.8

McDonalds, Darden Restaurants, Starbucks

Engineering/Constru ction

20.6

Flour, AECOM, Jacobs Engineering

Medical Devices

19.6

Becton Dickinson, Stryker, Boston Scientific

Leading Companies

(continued)

57

58

PART II THE TOOLS OF STRATEGY ANALYSIS

TABLE 3.1

( Continued)

Industry

ROCE (%)

Apparel

19.5

VF, Hanesbrands, Ralph Lauren

Chemicals (specialty)

18.0

Du Pont, PPG Industries, WR Grace

Railroads

16.8

Union Pacific, CSX, Norfolk Southern

Packaging, Containers

16.7

WestRock, Ball, Crown Holdings

Furniture, Home Furnishings

16.6

Mohawk Industries, Masco, Herman Miller

Chemicals (basic)

7.2

Dow Chemical, Olin, Huntsman

Entertainment

17.2

Walt Disney, Time Warner, CBS

Airlines

15.5

American Airlin es, Delta Air Lines, United Continental

Hospitals, Healthcare Facilities

14.7

United Health Group, HCA Holdings, Tenet
Healthcare

Oil and Gas (integrated)

14.3

ExxonMobil, Chevron

Publishing, Newspapers

13.6

News Corp, R.R. Donnelley & Sons, Gannett

Telecom Services

13.5

AT&T, Verizon Communications, Comcast

Food Retailing

11.1

Kroger, Albertsons, Publix Super Markets

Steel

11.0

Nucor, US Steel, Steel Dynamics

Paper, Forest Prod ucts

10.0

Weyerhaeuser, International Paper, Boise Cascade

Insurance

8.7

State Farm Insurance, MetLife, Prudential Fina ncial

Electrical Power

8.2

Exelon, Duke Energy, PG&E Corp.

Hotels, Casinos

8.1

Marriott International, Las Vegas Sands, MGM Resorts

Invest ment, Asset Management

7.5

BlackRock, Charles Schwab, Franklin Resources

Home Bui lding

7.1

Lennar, Horton, PulteGroup

Trucking

6.7

XPO Logistics, C.H. Robinson Worldwide, J.B. Hu nt

Motor Vehides

5.3

Genera l Motors, Ford Motor, Paccar

Telecom (wireless)

34

Sprint, T-Mobile, US Cellu lar

Leading Companies

Note:
ROCE = Earnings before interest and tax/ (Equity+ Lo ng-term debt )
Source: Data fro m Aswath Damodaran, Damodaran on li ne,

The underlying theory of how industry structure drives competitive behavior and
determines industry profitability is provided by industrial organization (IO) economics.
The two reference points are the the01y of monopoly and the theo1y of perfect competition. In a monopoly, a single firm is protected by high barriers to entry. In perfect competition, many firms supply a homogeneous product and there are no entry
barriers. Monopoly and perfect competition form end points of a spectrum of industry
structures. While a monopolist can appropriate as profit the full amount of the value
it creates, under perfect competition, the rate of profit falls to a level that just covers

CHAPTER 3 INDUSTRY ANALYSIS: THE F UNDAMENTALS

Chewing Tobacco, Sausage Skins, and Sports Cards: The Joys
of Niche Markets
US Smokeless Tobacco Company earned an operating

to t he South American Chorizo, Devro has a casing to

margin of 62% during 2014- 2017, making a major con-

suit all product types:’ Its overal l world market share is

t ribution to t he 122% ret urn on equity earned by its par-

around 60%. During 20 14-2017, Devro’s return on eq uity

ent, Altria Inc., over the same period. What’s the secret

exceeded 20%- about three t imes its cost of equ ity.

of USSTC’s profitability? It accounts for 57% of t he US

Panini Group, based in Modena, Ita ly, is the world

market for smokeless tobacco, and its long-established

leader in sport s t rading cards and col lectable stickers.

brands (including Skoal, Copenhagen, and Red Seal), its

With an exclusive licence wit h FIFA, it dominates

dist ribution through t housands of sma ll retail outlets, and

soccer cards and, w ith licences to supp ly NBA, NFL,

government restrictions on advertising tobacco prod-

and NHL trading cards. It has become market leader

ucts create form idable ba rriers to would-be competitors.

in t he United States. It is believed to have earned an

Devro pie, based

in t he Scottish

vi llage of

operat ing margin of over 20% on it s 2018 revenues of

Moodiesburn, is the world’s leading supplier of col-

$1 bill ion.

lagen sausage skins (“casi ngs”). “From t he British Banger

Sources: www.altria.com, www.devro.com, and

to the Chinese Lap Cheong, from t he French Merguez

www.paninigroup.com/corporate/.

firms’ cost of capital. Some real-world industries are near monopolies. At the root of
Alphabet’s 34% return on equity is Google’s 92% share of internet search. Niche markets may be sufficiently small that they can be dominated by a single firm (see Strategy
Capsule 3.1). Other industries are close to being perfectly competitive. The US farm
sector earns a long-run return on equity of about 3%- well below its cost of capital.
However, most industries are somewhere in between: many are oligopolies-industries
dominated by a few major companies.

Porter’s Five Forces of Competition Framework
Michael Porter’s five forces of competition framework is the most widely used tool for
1
analyzing competition within industries. It regards the profitability of an industry (as
indicated by its rate of return on capital relative to its cost of capital) as determined
by five sources of competitive pressure. These five forces of competition include three
sources of “horizontal” competition: competition from substitutes, competition from
entrants, and competition fro m established rivals; and two sources of “vertical” competition: the power of suppliers and the power of buyers (Figure 3.2).
The strength of each of these competitive forces is determined by a number of key
structural variables, as shown in Figure 3.3.

Competition from Substitutes
The price that customers are willing to pay for a product depends, in part, on the availability of substitute products. The absence of close substitutes for a product, as in the

59

60 PART II THE TOOLS OF STRATEGY ANALYSIS

FIGURE 3.2

Porter’s five forces of competition framework
SUPPLIERS

Bargaining power of suppliers

INDUSTRY
COMPETITORS
POTENTIAL
ENTRANTS

Threat of

Threat of

new entrants

substitutes

SUBSTITUTES

Rivalry among
existing firms

Bargaining power of buyers

BUYERS

FIGURE 3.3

The structural determinants of the five forces of competition
SUPPLIER POWER
• Buyers’ price sensitivity
• Relative bargaining power
(see Buyer Power for detail)

INDUSTRY RIVALRY

THREAT OF ENTRY
• Capital requirements
~

• Concentration

• Economies of scale

• Diversity of competitors

• Absolute cost
advantages

• Product differentiat ion

• Product differentiation

• Excess capacity and
exit barriers

• Access to distribution

• Cost conditions

SUBSTITUTE
COMPETITION
~

• Buyers’ propensity t o
substitute
• Relative prices and
performance of
substitutes

• Legal barriers
• Ret aliation

BUYER POWER
Price sensitivity

Bargaining power

• Cost of product
relative t o t ot al cost

• Size and concent ration
of buyers relative t o producers

• Product
differentiation

• Buyers’ swit ching cost s
• Buyers’ information

• Competition
between buyers

• Buyers’ ability t o
backward int eg rat e

CHAPTER 3 INDUSTRY ANALYSIS : THE FUNDAMENTALS

case of gasoline or cigarettes, means that consumers are comparatively insensitive to
price (demand is inelastic with respect to price). With close substitutes, customers will
switch to substitutes in response to price increases for the product (demand is elastic
with respect to price). The internet has provided a new source of substitute competition that has proved devastating for the profitability of several industries, including
travel agencies, newspapers, and bookstores.
The extent to which substitutes depress prices and profits depends on the propensity of buyers to substitute between alternatives. This, in turn, depends on their priceperformance characteristics. The advent of high-speed rail services between London
and Paris, Madrid and Barcelona, and Beijing and Shanghai have devastated the profitability of these routes for airlines.

Threat of Entry
If an industry earns a return on capital in excess of its cost of capital, it will attract
entry from new firms and established firms diversifying from other industries. If entry
is unrestricted, profitability will fall toward its competitive level. In some industries, it
is easy to establish a new company. Beer brewing has seen a flood of new entrants in
recent years. Between 1990 and 2017, the number of breweries increased from 284 to
4269 in the United States and from 241 to 892 in the United Kingdom, despite declining
2
beer consumption in both countries. Wage differences between occupations are also
influenced by entry barriers. Why is it that my wife, a psychotherapist, earns much less
than our niece, a recently qualified medical doctor? Psychotherapy, with its multiple
accrediting bodies and less restrictive licensing, has much lower barriers to entry than
medical practice.
Threat of entry rather than actual entry may be sufficient to ensure competitive
price levels. An industry where no barriers to entry or exit exist is contestable: prices
and profits tend toward the competitive level, regardless of the number of firms within
the industry. 3 Contestability depends on the absence of sunk costs, hence making an
industry is vulnerable to “hit and nm” entry whenever established firms raise their
prices above the competitive level.
In most industries, however, new entrants must surmount barriers to entry: disadvantages that new entrants face relative to established firms . The size of this disadvantage determines the height of a barrier to entry. The principal sources of barriers to
entry are as follows:

Capital Requirements

Set-up costs can be so large as to discourage all but the
largest companies. The duopoly of Boeing and Airbus in large passenger jets is
protected by the huge investments needed to develop, build, and service big jet
planes. Conversely, start-up costs for take-away catering businesses tend to be low:
the cost of a franchised pizza outlet starts at $119,950 for Domino’s and $130,120 for
4
Papa John’s.

Economies of Scale Industries with high capital requirements are also subject to economies of scale. If large, indivisible investments in production, product
development, distribution or marketing are required, efficiency requires amortizing
these costs over a large volume of output. According to Fiat Chrysler’s late-CEO, Sergio
Marchionne, financial viability in automobiles requires producing at least six million
vehicles a year. New automobile producers must either enter with suboptimal capacity
or with scale-efficient capacity that is massively undemtilized while the entrant builds
market share.

61

62

PART II THE TOOLS OF STRATEGY ANALYSIS

Absolute Cost Advantages Established firms may have a cost advantage over
entrants, irrespective of scale. Absolute cost advantages often result from the ownership
of low-cost sources of raw materials. Established oil and gas producers, such as Saudi
Aramco and Gazprom, which have access to the world’s biggest and most accessible
reserves, have an unassailable cost advantage over more recent entrants such as Cairn
Energy and EOG Resources. Absolute cost advantages also result from learning. Intel’s
efficiency in producing advanced microprocessors derives from its wealth of experience.

Product Differentiation In an indust1y where products are differentiated, established
firms possess the advantages of brand recognition and customer loyalty. 5 New entrants
to such markets must spend disproportionately heavily on advertising and promotion
to establish brand awareness.

Access to Channels of Distribution For many new suppliers of consumer goods,
the principal barrier to entry is gaining distribution. Limited shelf space, risk aversion,
and the costs of carrying an additional product cause retailers to be reluctant to carry a
new manufacturer’s product. An important consequence of the internet has been allowing new businesses to circumvent barriers to distribution.

Governmental and Legal Barriers Some of the most effective barriers to entry are
those created by government. In taxicabs, banking, telecommunications, and broadcasting, entty usually requires a license from a public authority. Patent and copyright law
creates formidable barriers to entry for many technology-based and cultural industries.

Retaliation Potential entrants may also be deterred by expectations of retaliation
by established firms. Such retaliation may take the form of aggressive price-cutting,
increased advertising, sales promotion, or litigation. The budget airlines frequently
allege predato1y price cuts by the major airlines designed to deter them from
6
new routes .

The Effectiveness of Barriers to Entry Industries protected by entry barriers tend
to earn above-average rates of profit.7 However, the effectiveness of barriers to entry
depends on the resources and capabilities that potential entrants possess. Barriers that
are effective against new companies may be ineffective against established firms that
8
are diversifying from other industries. Google’s massive web presence allowed it to
challenge the seemingly impregnable market positions of Microsoft in web browsers
and Apple in smartphones.

Rivalry between Established Competitors
In most industries, the major determinant of competition and profitability is rivalry
among the firms within the industry. In some industries, firms compete aggressively,
resulting in industry-wide losses. In other industries, price competition is muted. The
intensity of price competition between established firms is the result of five main factors.

Concentration Seller concentration refers to the number and size distribution of
firms competing within a market. It is measured by the concentration ratio: the combined
market share of the leading producers. For example, the four-firm concentration ratio
(CR4) is the market share of the four largest producers. In markets dominated by a
single firm (e.g., Gillette in razor blades, or FICO in consumer credit scoring), or by a

CHAPTER 3 INDUSTRY ANALYSIS : THE FUNDAMENTALS

small group of companies (Coca-Cola and Pepsi in soft drinks; Bloomberg and Reuters
in financial information), price competition tends to be restrained , and competition
focuses on advertising, promotion, and new product development. As the number of
firms supplying a market increases, self-restraint in price competition is eroded. In
wireless telecommunications, regulators in the United States and Europe have favored
four operators in each market and opposed mergers in the belief that three competitors
are too few for effective price competition. 9 However, research finds that the relationship “between seller concentration and profitability is weak statistically and the estimated effect is usually small.”10

Diversity of Competitors The ability of rival firms to avoid price competition by
coordinating their prices depends on how similar they are in their origins, objectives,
costs, and strategies. The lack of robust price competition in professional serviceslawyers, accountants, medical doctors-reflects the social and cultural homogeneity
of these tightly knit communities. Conversely, the difficulties that OPEC experiences
in agreeing and enforcing output quotas among its member countries are exace rbated by their differences in te rms of o bjectives, production costs, politics, and
religion.11

Product Differentiation The more similar the offerings among rival firms , the more
willing are customers to switch between them and the greater is the inducement for
firms to cut prices to boost sales. For commodities, price tends to be the sole basis for
competition. By contrast, in industries where products are highly differentiated (perfumes, pharmaceuticals, restaurants, management consulting), competition tends to
focus on quality, brand promotion, and customer service rather than price.

Excess Capacity and Exit Barriers Why, especially in commodity industries,
does industry profitability tend to fall so drastically during periods of recession? The
key is the balance between demand and capacity. Unused capacity encourages firms
to offer price cuts to attract new business. Excess capacity may be cyclical (e.g.,
the boom- bust cycles experie nced in semiconductors and shipping); it may also
be a structural problem resulting from overinvestment and declining demand. In
this latter situation, the key issue is whether excess capacity w ill leave the industry.
Barriers to exit are impediments to capacity leaving an industry. Where assets
are durable and specialized, and where employees are entitled to job protection,
barriers to exit may be substantial. 12 In the European auto industry, excess capacity
together w ith high exit barriers have depressed profitability. Conversely, demand
growth creates capacity shortages that boost margins. During 2021, a shortage of
production capacity for semicondu ctors boosted the profit margins of semiconductor fabricators.

Cost Conditions: Scale Economies and the Ratio of Fixed to Variable Costs
When excess capacity causes price competition, how low will prices go? The key factor
is cost structure. Where fixed costs are high relative to variable costs, firms will take
on marginal business at any price that covers variable costs. The incredible volatility
of bulk shipping rates reflects the fact that almost all the costs of operating bulk carriers are fixed. During the COVID-19 pandemic, daily charter rates for “capesize” bulk
carriers collapsed before rising over 900% in the 12 months to May 2021. Similarly,
in airlines, the low additional costs of filling empty seats mean that the emergence
of excess capacity often leads to price wars and industry-wide losses. In “cyclical”

63

64

PART II THE TOOLS OF STRATEGY ANALYSIS

industries, high fixed costs cause fluctuations in revenues to be amplified into much
bigger fluctuations in profits.
Scale economies may also induce aggressive price competition as companies seek
the cost benefits of greater volume.

Bargaining Power of Buyers
The profit margin earned by the firms in an indust1y depends on the prices they
can charge their customers. These customers will do all they can to exert downward
pressure on these prices. The ability of buyers to drive down the prices they pay
depends upon two factors: their price sensitivity and their bargaining power relative to
the firms within the industry.

Buyers’ Price Sensitivity The extent to which buyers are sensitive to the prices they
are charged depends primarily upon the proportion of buyers’ total cost that the product accounts for. Soft drink companies are highly sensitive to the price of aluminum
cans because this is one of their largest cost items. Conversely, most companies are not
sensitive to the fees charged by their auditors, since auditing costs are a tiny fraction of total
expenses. Price sensitivity also depends upon buyers’ access to information on prices. By
increasing price transparency, the internet has greatly increased consumers’ price sensitivity.

Relative Bargaining Power Bargaining power rests, ultimately, on the refusal to
deal with the other party. The balance of power between the two parties to a transaction depends on the credibility and effectiveness with which each makes this threat.
The key issue is the relative cost that each party would incur in the event of a holdout by the counterparty, together with the relative bargaining skills of each party. The
bargaining power of buyers relative to that of sellers depends primarily upon relative
concentration. If an industry faces few buyers, each with large purchases, firms will be
very reluctant to lose a large buyer. Buyers’ power is enhanced when they backward
integrate into their suppliers’ industry. By manufacturing its own batteries, Tesla is
reducing its dependence upon Panasonic.

Bargaining Power of Suppliers
Analysis of supplier power is precisely analogous to the analysis of buyer power. The
only difference is that it is now the firms in the industty that are the buyers and the
producers of inputs that are the suppliers. Again, the relevant factors are the ease with
which the firms in the industry can switch between different input suppliers and the
relative bargaining power of each party.
The suppliers of commodities tend to lack bargaining power relative to their customers; hence, they may use cartels to boost their influence over prices (e.g., OPEC, the
International Coffee Organization, and farmers’ marketing cooperatives). Conversely,
the suppliers of complex, technically sophisticated components may be able to exert
considerable bargaining power. The dismal profitability of the personal computer
industry during the past 30 years may be attributed to the power exercised by the
suppliers of key components (processors, disk drives, LCD screens) and the dominant
supplier of operating systems (Microsoft) . Wireless telecom carriers are pressured
by monopoly suppliers of spectrum: auctions of 3G licenses raised $127 billion for
the governments of OECD countries, while US 4G auctions raised $65 billion during
2014- 2017 .13 Labor unions possess significant supplier power: in automobiles, steel,
and airlines, powerful unions depress industry profitability.

CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

Applying Industry Analysis to Forecasting Industry Profitability
Once we understand how industry structure determines current levels of industry profitability, we can use this analysis to forecast industry profitability in the future.

Identifying Industry Structure
The first stage of any industry analysis is to identify the key elements of the industry’s
structure. In principle, this is a simple task. It requires identifying who are the main
players-the producers, the buyers, the suppliers of inputs, and the producers of substitute goods-then distinguishing the key structural characteristics of each that will
impact competition and bargaining power.
In most manufacturing industries, identifying the main groups of players is straightforward; in other industries, particularly in service industries, mapping the industry
can be more difficult. Figure 3.4 depicts the increased complexity of the recorded
music industry.

Forecasting Industry Profitability
We can use industry analysis to understand why profitability has been low in some
industries and high in others but, ultimately, our interest is not to explain the past
but to predict the future. Investment decisions made today will commit resources
to an industry for years- often for a decade or more-hence, it is critical that we
are able to predict what level of returns the industry is likely to offer in the future .
Current profitability is a poor indicator of future profitability: industries such as newspapers, solar panels, and petroleum have suffered massive declines in profitability.
However, if an industry’s profitability is determined by the structure of that industry,
then we can use observations of the structural trends in an industry to forecast likely
changes in competition and profitability. Changes in industry structure typically result
from fundamental shifts in customer buying behavior, technology, and firm strategies
which can be anticipated well in advance of their impacts on competition and profitability.

FIGURE 3.4

Industries are becoming more complex: Recorded music
1990

2021

SUPPLIERS

Recording artists, songwriters

Recording artists, songwriters

PRODUCERS

Record Companies

Record Companies (Sony Music,

EMI, CBS, BMG, Polygram

Universal Music, Warner Music)

DISTRIBUTORS

Wholesalers

Retailers

Ret ailers

Download

(Amazon, HMV,
Shimamura)

(Apple iTunes,
Amazon MP3)

Streaming
(Spotify, Apple Music,
Amazon, YouTube,
Tencent)

Platform s (Apple iOS,
Android, MS Windows)

CONSUMERS

Consumers

Consumers

Advertisers

65

66

PART II THE TOOLS OF STRATEGY ANALYSIS

To predict the future profitability of an industry, our analysis proceeds in three stages:
Examine how the industry’s current and recent levels of competition and profitability are a consequence of its present structure.
2 Identify the trends that are changing the indust1y’s structure. Is the industry consolidating? Are new players seeking to enter? Are the industry’s products becoming
more differentiated or more commoditized? Will additions to industry capacity
outstrip growth of demand? Is technological innovation causing new substitutes
to appear?
3 Identify how these structural changes will affect the five forces of competition
and resulting profitability of the industry. Will the changes in industry structure
cause competition to intensify or to weaken? Rarely, do all the structural changes
move competition in a consistent direction; typically some will exacerbate competitive intensity, others will cause it to abate. Hence, determining the overall
impact on profitability is a matter of judgment.
1

Strategy Capsule 3.2 discusses the outlook for profitability in the world automobile indust1y.

Using Industry Analysis to Develop Strategy
Once we understand how industry structure influences competition, which in turn
determines industry profitability, we can use this knowledge to develop firm strategies.
First, we can develop strategies that influence industry structure in order to moderate
competition; second, we can position the firm to shelter it from competition.

Strategies to Alter Industry Structure
Understanding how the structure of an industry determines competition and the level
of profitability, we can identify how to change indust1y structure in order to alleviate
competitive pressures. For example:
• Between 2000 and 2006, a wave of mergers and acquisitions among the
world’s iron ore miners resulted in three companies-Vale, Rio Tinto, and BHP
Billiton- controlling 75% of global iron ore exports. The growing power of the
iron ore producers relative to their customers, the steel makers, contributed to
the 400% rise in iron ore prices between 2004 and 201014
• In chemicals, increased competition from Asian and Middle East producers
encouraged a wave of mergers among US and European producers during
2016-2017 as they sought to gain market power and shift from commodity to
specialty products. Major deals included Dow and DuPont, Bayer and Mon15
santo, Clariant and Huntsman, and Sherwin-Williams, and Valspar.
• US airlines have changed an unfavorable industry structure by (a) using
frequent-flyer schemes to build customer loyalty; Cb) creating dominant positions at hub airports; (c) using mergers and alliances to reduce the numbers of
16
competitors on most routes.
• Building entry barriers is a vital strategy for preserving high profitability. A
primary goal of the American Medical Association has been to maintain the
incomes of its members by controlling the numbers of doctors trained in the
United States and limiting the entry of doctors from overseas.

CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

The Future of the World Automobile Industry
During 2016- 2020, t he top eight producers (Toyota,

t rends wi ll impact the five forces of competition in the

VW, General Motors, Ford, Nissan, Hyundai, Honda, and

future. In the table, the direction of t he arrow shows the

Fiat Chrysler) have earned an average return on capita l

predicted impact of each competitive force on industry

employed of 5.1 % (barely covering their weighted

profitabi lity.

average cost of capital). Applying the five forces of com-

Even with potential new revenue sources (e.g., online

petition framework to the industry reveals why profit-

services for car occupants), it wou ld appear t hat struc-

ability has been low. We can then identify t he current

t ural cha nges in t he industry w ill depress t he profit-

t rends that are reshaping the industry-the switch to

ability of t he car manufacturers. Th is negative outlook is

electric veh icles (EVs), autonomous drivi ng, increased

reflected in com panies’ stock market capitalization: the

shared ownership and ride sharing, internationaliza-

top eight auto makers had an average P/E ratio of 10.6 on

tion by Chinese auto producers- and show how these

May 20, 2021 compared to 44.1 for the S&P 500.

Relevant
structural features
of the industry

Impact on
profitability

Changes in
industry structure

Impact on
profitability

2016-2020

2021-2025

2021-2025

Subst itutes

Alternative modes of
t ransportat ion (bicycles,
public transport). Al so
telecommuting.

Weak _j}.

Congestion and
environmental concerns
w il l increase substitute
competition

Increasing _j}.

New entry

•

Internationalization by
domest ic producers

Moderate _j}.

Increased competition
from bot h sources.

Increasing _j}.

•
•

New producers of EVs
St rong _j}.

•

M&A to reduce no.
of producers

•

Continuing excess
capacity due to exit
barriers (especially
government support)
and fa lling demand
due to lower personal
ownership of ca rs

Competitive
force

Internal
rival ry

22 companies w ith
annual output of
>1 million cars

•

Massive excess capacity
(g lobal capacity utilizat ion approx. 72%)

•

High fixed costs and
large-sca le economies
encourage quest for
market share

1J

Buyer power

Distribution through
franchi sed dealers

Weak

Supplier
power

•

Consolidation among
component suppliers

Moderate _j}.

•

Suppliers control key
technologies

Positive impact
of M&A offset by
negative impact
of new entry
and of declining
demand _j}.

No sig nificant change
Emergence of powerful
new suppliers, especially
software companies and
suppliers of batteries

Increasing _j}.

67

68

PART II THE TOOLS OF STRATEGY ANALYSIS

The fact that industries are in a state of continual evolution means that all firms , not
just the market leaders, have the potential to influence changes in industry structure to
17
own
interests.
suit their

Positioning the Company
Recognizing and understanding the competitive forces that a firm faces within its
industry allows managers to position the firm where competitive forces are weakest.
• The recorded music industry, once reliant on sales of CDs, has been devastated
by substitute competition in the form of digital downloads, piracy, file sharing,
and streaming. Yet, not all segments of the recorded music business have been
equally affected. The old are less inclined to new technology than younger
listeners are; hence, classical music, country, and golden oldies have become
comparatively more attractive for the sale of CDs than pop and hip-hop genres.
Prominent in the resurgence of vinyl have been albums by David Bowie, the
Beatles, and Pink Floyd.
• The traditional brokerage industly has been devastated by competition from
online brokerage companies such as E*Trade and TD Ameritrade. Edward
Jones has prospered by positioning itself as a full-service wealth management
18
company offering personalized service through local offices.
Effective positioning requires the firm to anticipate changes in the competitive
forces likely to affect the industry. Department stores are being decimated by online
retailing. To adapt to the new competitive reality, the British department store chain,
John Lewis, is shifting floor space from products to services-restaurants, spas, roof
gardens, and shared-use office services- and adopting new approaches to integrating
19
“clicks-and-bricks.”

Defining Industries: Where to Draw the Boundaries
A key challenge in industly analysis is defining the relevant industry. The Standard
Industrial Classification (SIC) is of limited use in identifying groups of firms that compete with one another.

Industries and Markets
We must clarify what we mean by the term industry. Economists define an indust1y as
a group of firms that supplies a market. So is there any difference between analyzing
industry structure and analyzing market structure? One major difference is that industry
analysis, notably five forces analysis, views industry profitability as determined by competition in two markets: product markets and input markets .
In everyday usage, the term industry tends to refer to firms within a broad sector,
whereas a market refers to the buyers and sellers of a specific product. Thus, the packaging industry comprises several distinct product markets- glass containers, steel cans,
aluminum cans, paper cartons, plastic containers, and so on.
To define an indust1y, it makes sense to start by identifying the firms that compete
with one another. At the outset, this approach may lead us to question conventional
concepts of industry boundaries. For example, what is the industry commonly referred

CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

to as banking? Institutions called banks supply a number of different products and services, each comprising different sets of competitors. A basic distinction is between retail
banking, corporate/wholesale banking, and investment banking. Each of these can be
disaggregated into several different product markets. Retail banking comprises deposit
taking, transaction services, credit cards, and mortgage lending. Investment banking
includes corporate finance and underwriting, trading, and advisory services (such as
mergers and acquisitions).

Defining Industries and Markets: Substitution in Demand
and Supply
The basic issue in defining a firm’s industry is to establish who is competing with
whom. To do this, we need to draw upon the principle of substitutability, both on the
demand side and on the supply side.
Let us consider once more the industry within which Ferrari competes. Starting with
the demand side, if customers are willing to substitute only between Ferraris and other
sports car brands on the basis of price differentials, then Ferrari is part of the performance
car industly. If, on the other hand, customers are willing to substitute Ferraris for other
mass-market brands, then Ferrari is part of the broader automobile industry.
But this fails to take account of substitutability on the supply side. If volume car producers such as Ford and Hyundai are able to apply their production facilities and distribution networks to supply sports cars, then, on the basis of supply-side substitutability,
we could regard Ferrari as part of the broader automobile industiy. The same logic can
be used to define the major domestic appliances as an industly. Although consumers
are unwilling to substitute between refrigerators and dishwashers, manufacturers can
use the same plants and distribution channels for different appliances-hence we view
Electrolux, Whirlpool, and Haier as competing in the domestic appliance industry.
Similar considerations apply to geographical boundaries. Should Ferrari view itself
as competing in a single global market or in a series of separate national or regional
markets? The criterion here again is substitutability. If customers are willing and able to
substitute cars available on different national markets, or if manufacturers are willing
and able to divert their output among different countries to take account of differences
in margins, then a market is global. The key test of the geographical boundaries of a
market is price: if price differences (net of taxes) for the same product between different locations tend to be eroded by demand-side and supply-side substitution , then
these locations lie within a single market.
In practice, drawing the boundaries of markets and industries is a matter of judgment
that depends on the purposes and context of the analysis. Decisions regarding pricing
and market positioning require a microlevel approach. Decisions over investments in
technology, new plants, and new products require a wider view of the relevant market.
The boundaries of a market or industry are seldom clear-cut. A firm’s competitive
environment is a continuum rather than a bounded space. Thus, we may view the competitive market of Disneyland, Hong Kong as a set of concentric circles. The closest
competitors are nearby theme parks Ocean Park and Ma Wan Park. Slightly more distant are Shenzhen Happy Valley, Shenzhen Window of the World, and Splendid China.
Further still are Disneyland parks in Tokyo and Shanghai and alternative forms of entertainment, for example, a trip to Macau or to a Lantau Island beach resort.
For the purposes of applying the five forces framework, where we draw industry
boundaries is seldom critical. For example, if we define Hong Kong Disneyland narrowly to include only Hong Kong theme parks, we still consider competition form
more distant theme parks- but these are substitutes rather than industry rivals. 20

69

70

PART II THE TOOLS OF STRATEGY ANALYSIS

From Industry Attractiveness to Competitive Advantage: Identifying
Key Success Factors
The five forces framework allows us to determine an industry’s potential for profit. But
how is industry profit shared between the different firms competing in that industry?
Let us look explicitly at the sources of competitive advantage within an industry. In
subsequent chapters we will examine competitive advantage more comprehensively. My
goal in this chapter is simply to explore the external sources of competitive advantagewhat I refer to as an industry’s key success factors: those factors within an industry that
influence a firm’s ability to outperform rivals. 21 In Strategy Capsule 3.3, Kenichi Ohmae,
former head of McKinsey’s Tokyo office, discusses key success factors in forestry.

Probing for Key Success Factors

As a consultant faced with an unfamiliar business or

He repl ied:”The rate of tree growth is the key variable.

industry, I make a point of first asking the special ists in t he

As a rule, two factors promote growth: the amount of

business, “What is the secret of success in this industry?”

sunsh ine and the amount of water. Our company doesn’t

Needless to say, I seldom get an immediate answer and

have many forests w ith enough of both. In Arizona and

so I pursue the inquiry by asking other questions from a

Utah, for example, we get more than enoug h sunshine

variety of angles in order to establish as quickly as possible

but too little water and so tree growth is very low. Now,

some reasonable hypotheses as to key factors for success.

if we cou ld give t he trees in those states enough water,

In t he course of these interviews, it usually becomes quite

they’d be ready in less than 15 years instead of the 30 it

obvious what analyses w ill be required in order to prove

takes now. The most important project we have in hand

or disprove these hypotheses. By first identifyi ng t he

at the moment is aimed at finding out how to do t his:·

probable key factors for success and then screen ing them

Impressed that t hi s director knew how to work out

by proof or disproof, it is often possible for the strateg ist to

a key factor strategy for his business, I offered my own

penetrate very quickly to the core of a problem.

contribution: “Then under t he opposite cond itions,

Traveling in the United States last year, I found myself

where t here is plenty of water but too little sunshine-

on one occasion sitting in a plane next to a director of one

for example, arou nd the lower reaches of the Columbia

of the biggest lumber com panies in the country. Thinking

River- the key factors shou ld be fertilizers to speed up

I might lea rn something useful in the course of the five-

the growth and the choice of tree varieties that don’t

hour fl ight, I asked him, “What are the key factors for suc-

need so much sunshine:·

cess in the lumber industry?”To my surprise, his reply was

Having established in a few m inutes the general

immediate: “Owning large forests and maximizing t he

framework of what we were going to talk about, I spent

yield from them:’The first of these key factors is a relatively

the rest of the long flight very profitably hearing from him

simpl e matter: purchase of forestland. But his second

in detail how each of these factors was being applied.

point required further explanation. Accordingly, my next
question was: “What variable or variables do you contro l

Source: Kenichi Ohmae, The Mind of the Strategist (New York:
McGraw-Hill, 1982): 85 © The McGraw-Hill Companies Inc.,

in order to maximize the yield from a given t ract7”

reproduced with permiss ion.

CHAPTER 3 INDUSTRY ANALYSIS: THE FUNDAMENTALS

Like Ohmae, our approach to identifying key success factors is straightforward and
commonsense. To survive and prosper in an industry, a firm must meet two criteria:
first, it must attract customers; second, it must survive competition. Hence, we may start
by asking two questions:
• What do our customers want?
• What does the firm need to do to survive competition?
To answer the first question, we need to look more closely at the customers of the
industry and to view them, not as a source of buying power and a threat to profitability, but as the raison d ‘etre of the industry and its underlying source of profit. This
requires that we inquire the following: Who are our customers? What are their needs?
How do they choose between competing offerings? Once we recognize the basis upon
which customers choose between rival offerings, we can identify the factors that confer
success upon the individual firm. For example, if travelers choose airlines primarily on
price, then cost efficiency is the prima1y basis for competitive advantage in the airline
industry and the key success factors are the determinants of relative cost.
The second question requires that we examine the nature of competition in the
indust1y. How intense is competition and what are its key dimensions? Thus, in airlines,
it is not enough to offer low fares. To survive intense competition during recessionary
periods an airline requires financial strength; it may also require good relations with
regulators and suppliers.
A basic framework for identifying key success factors is presented in Figure 3.5.
Application of the framework to identify key success factors in three industries is outlined in Table 3.2.
Key success factors can also be identified through the direct modeling of profitability, thereby identifying the drivers of a firm’s profitability relative to rivals. Using
the same approach as in Chapter 2 (Figure 2.2), we can disaggregate return on capital
employed into component ratios, which then point to the main drivers of superior profitability. In some industries, there are well-known formulae that link operating ratios
to overall profitability. Strategy Capsule 3.4 disaggregates profit margin in the airline
industry to identify key success factors.
FIGURE 3.5

Identifying key success factors
Prerequisites for success

What do customers
want?

How does the firm
survive competition?

Analysis ofdemand

Analysis of competition

• Who are our customers?

• What drives competition?

• What do they want?

• What are the main
dimensions of competition?
• How intense is competition?
• How can we obtain a superior
competitive position?

71

72 PART II THE TOOLS OF STRATEGY ANALYSIS

Identifying key success factors: Steel, fashion clothing, and supermarkets

TABLE 3.2

What do customers want?
(Analysis of demand}

How do firms survive
competition? (Analysis
of competition}

Cloud computing

Reliability
Securit y
Custom ized services
Ad vanced data analytics/Al

Advanced software and data
analytics capabilit ies
Critica l mass, global scope, and
financial st rength

Globa l scale
Compre hensive array of
software products and advanced
technical services
Cust om ization of offerings to meet
customer needs

Fashion clothing

Diversity o f customer
preferences
Custom ers wi ll pay premium
for brand, style, exclusivity,
and quality
Mass market is highly
price sensitive

Low barriers to ent ry and many
competitors imply intense
competition
Differentiation offers price
premium, but imitation is rapid

Combining differentiation
with low cost s
Different iation involves style,
brand appeal, quality, and market
responsiveness
Cost efficiency requires manufacture
where wages are low

Superm arket s

Low prices
Convenient location
Wide prod uct range
Quality produce, good
service, ease of parking,
p leasant ambience

Intensely price competitive
Buying power essential
for low costs

Low costs requ ire operational
efficiency, large-sca le
purchases, low wages
Differentiation requ ires large stores,
convenient location, meticulo us
in-store m anagement

Key success factors

Identifying Key Success Factors by Profitability Modeling: Airlines

Profitability, as measured by profit per available seat-mile
♦

Load factor (RPMs/ASMs)

(ASM), is determined by th ree factors: yield, wh ich is tota l

•

competitiveness and flexibility of prices

operating revenues divided by the number of revenue

•

efficiency of route planning and scheduling

•

customer loyalty

•

matching airplane size to demand for individual

passenger miles (RPMs); load factor, which is the ratio
of RPMs to ASMs; and unit cost, which is total operati ng
expenses divided by ASMs. Thus:

flights.
Profit
ASMs

Revenue RPMs Expenses
—x— –RPMs
ASMs
ASMs

Some of the main det erminants of each of these

•

Expenses/ASMs
•

wage rates and benefit levels

•

fuel efficiency of aircraft

•

productivity of employees (determined partly by

component ratios are t he following:
♦

their job flexibility)

Reven ue/RPMs
•

intensity of competition on routes flown

•

load factors

•

effective yield management to permit rapid price

•

level of administrative cost.

adjustment to changing market conditions
•

ability to attract business customers

•

customer service quality.

CHAPTER 3 INDUSTRY ANALYSIS: THE F UNDAMENTALS

The usefulness of industry-level success factors in formulating strategy has been
scorned by some strategy scholars for encouraging the firms in an industry to deploy
similar strategies.22 However, common success factors do not imply that firms need to
adopt similar strategies in order to exploit them. In fashion clothing we identified several key success factors (Table 3.2), yet each leading company-Inditex (Zara), H&M,
Diesel, and Mango- adopts a unique strategy to exploit them.

Summary
In Chapter 1, we established t hat a profound understandi ng of t he competitive environment is a critical ingred ient of a successful strategy. Despite t he vast number of external infl uences t hat affect every
business enterprise, our focus is t he fi rm’s industry environment that we analyze in order to evaluate t he
ind ust ry’s profit potential and t o identify the sources of competitive advantage.
The centerpiece of our approach is Porter’s five fo rces of co m petition framework, w hich lin ks
t he st ructure of an indust ry to t he competit ive intensity w ithi n it and to the profitabi lity t hat it
rea lizes. The Porter framework offers a simple yet powerful org anizing framework fo r identifying
t he relevant features of an ind ust ry’s st ru ct ure and predicting th eir implications for com petit ive
behavior.
The pri mary application fo r t he Porter five forces framework is in predicting how changes in an
ind ustry’s struct ure are likely to affect it s profitabi lity. Once we understand t he drivers of industry profitability, we can identify strateg ies through w hich a firm can improve industry attractiveness and position
itself in relation to these d ifferent competitive forces.
As w ith most of th e t ools for st rategy ana lysis that we shall con sider in t his book, th e Porter
five forces framework is easy t o comprehend. How ever, rea l learnin g about ind ustry analysis and
about t he Po rter framework in parti cular derives fro m its applicat io n. It is only w hen we apply t he
Port er fra mework t o ana lyzing competition and d iag nosing t he cau ses of high or low profit ability
in an indu stry th at we are forced t o confro nt the com plexities and subt leties of t he mod el. A key
issue is identifying the indust ry w ithin w hich a firm compet es and recogn izing its boundari es. By
employing t he principl es of substitutability and relevance, we ca n delineate meaningful industry
boundari es.
Finally, our ind ustry analysis allows us to make a first approach at ident ifying th e sources of competit ive advantage through recognizing key success factors in an industry.
I urge you to put the tools of industry analysis to work- not just in your strategic management
coursework but also in interpreting everyday business events. The Porter framework is a practica l
tool- it allows us to underst and the disparities in profitability between indust ries, to predict w hether
an industry w ill sustain its profita bility into the future, and t o recog nize w hich strategies have t he best
potential for making money. Throug h pract ical applicati ons, you w ill also become aware of the limitations of t he Porter framework. In t he next chapter, we w ill see how we can extend our analysis of
industry and competition.

73

74 PART II THE TOOLS OF STRATEGY ANALYSIS

Self-Study Questions
1.

From Table 3.1 , select a high-profit industry and a low-profit industry. From what you know
of the structure of your selected industries, use the five forces framework to explain why profitability has been high in one industry and low in the other.

2. With reference to Strategy Capsule 3.1 , use the five forces framework to explain why profit-

ability has been so high in the US market for smokeless tobacco.
3. The major forces shaping the business environment of the fixed-line telecom industry are
technology and government policy. The industry has been influenced by fiber optics (greatly
increasing transmission capacity), new modes of telecommunication (wireless and internet
telephony), the convergence of telecom and cable TV, and regulatory change (including the
opening of fixed-line infrastructures to “virtual operators”). Using the five forces of competition framework, predict how each of these developments has influenced competition and
profitability in the fixed-line telecom indust1y.
4. By 2021, the online travel agency indust1y had consolidated around two leaders: Expedia (which had acquired Travelocity, Lastminute.com, Hotels.com, Trivago , and Orbitz)
and Booking Holdings (which owned Priceline, booking.com, Kayak, Rentalcars.com, and
OpenTable). These two market leaders competed with numerous smaller online travel agents,
with traditional travel agencies (e.g., Carlson Wagonlit, TUI, and American Express), and with
direct online sales by airlines, hotel chains, and car rental companies. Amazon and Google
were both potential entrants to the market. The online travel agents are dependent upon computerized airline reservation systems such as Sabre, Amadeus, and Travelport. Use Porter’s five
forces framework to predict the likely profitability of the online travel agency industry over
the next ten years.
5. Walmart (like Carrefour, Ahold, and Tesco) competes in several countries of the world, yet
most shoppers choose between retailers within a radius of a few miles. For the purposes of
analyzing profitability and competitive strategy, should Walmart consider the discount retailing
industry to be global, national, or local?
6. What do you think are key success factors in:

a.
b.

the pizza delivery indust1y
the credit card industty (where the world’s biggest issuers are: Bank of America, JPMorgan
Chase, Citibank, American Express, Capital One, HSBC, and ICBC)?

Notes
1. M. E. Porte r, “The Five Com pe titive Forces That Shape

Strategy,” Harvard Business Review 57 (Janua ry
2008): 57- 71.
2. Brewers Association, “Historical U.S. Brewery Count,”
http ://www.brewersassociatio n.org/statistics/n umberofbreweries/; “Good Beer Guide 201 5 Shows UK Has
Most Breweries ,” Guardian (Se ptember 11, 2014) .

3. W. J. Baumol, J. C. Panzar, and R. D. Willig , Contestable
Ma rkets and the Theory ofl ndusfly Structu re (New Yo rk:
Ha rcourt Brace Jovanovich , 1982). See also M. Spe nce,
“Co ntestable Markets and the Theo ry of Industry Sm 1cture: A Review Article,” Journal of Economic Litera ture 21
(1983): 981- 990 .
4. “Annual Franchise 500,” En trepreneur (January 2017) .

CHAPTER 3 INDUSTRY ANALYSIS: THE F UNDAMENTALS

5. Products where b rand loyalty is particularly strong
include: online search , online reta iling , smartphones,
video streaming, coffee, cosmetics, and cars. See: https://
brandkeys.com/ po rtfolio/custo mer-loyalty-engageme ntindex/, accessed September 2, 2017.
6. C. V. Oster and J. S. Strong Predatory Practices in the US
Airline Industry (Washingto n DC, 2001).
gov/lib/ 17000/17600/ 17602/PB2001102478.pdf, accessed
Septe mber 5, 2017.
7. J. L. Siegfried and L. B. Evans, “Empirical Studies of Entry
and Exit: A Survey o f the Evide nce,” Review of Industrial
Organization 9 (1994): 121- 155; D. Heger and K. Kraft,
“Barriers to Entry and Profitability,” ZEW-Centre for
European Economic Research Discussion Paper
No. 08-071 (2008).
8. G. S. Yip, “Gateways to Entry,” Harvard Business Review
60 (Septembe r/ October 1982): 85-93.
9. “Four Is a Magic Number,” Economist (March 15, 2014):
64; “Three’s a Crowd.” Economist (February 4, 2016).
10. “OPEC Has a Deal, But Will Its Members Cheat?” Wall
Street fournal (December 11, 2016).
11. R. Schmalensee, “Inter-Industry Studies of Structure and
Performance,” in R. Schmale nsee and R. D. Willig (eds.),
Handbook of Industrial Organization, 2nd edn
(Amsterdam: orth Ho lla nd , 1988): 976.
12. C. Baden-Fuller (ed.), Strategic Management c!f Excess
Capacity (Oxford: Basil Blackwell, 1990).

13. “Afte r the Te lecommunicatio ns Bubble ,” OECD Economics
Departme nt Working Pap ers (2003); “America’s Latest
Spectrum Auction ,” Economist (Februa1y 16, 2017).
14. “Iron O re Companies Consolidated ,” International
Resource Journal (October 2014).
15. “Hunt for Earnings Growth Reshapes Chemicals Sector,”
Financial Times (May 30, 2017).
16. https:// www.businessinsider.com/airline-mergers-andacquisitions-in-the-us-since-2000-2020-3, accessed
March 3, 2021.
17. M. G . Jacobides and J. P. MacDuffie , “How to Drive Value
Yo ur Way,” Harvard Business Review, 91 (July/ August
2013): 92-100.
18. “Edward Jones,” Case 9-700-009, Harvard Business
School (1999).
19. ‘J o hn Lewis’ Paula ickolds on Re inventing the Business,”
Retail Week, March 30, 2017.
20. Fo r a concise discussio n o f market definition , see: O ffice
of Fair Trading, Market Definition (London: December
2004), especially pp . 7- 17. k/
governme nt/publications/ market-definition , accessed
September 5, 2017.
21. The term was coined by Chuck Hofer and Dan Schendel
(Strategy Formulation: Analytical Concepts, St Paul : West
Pub lishing , 1977: 77).
22. P. G hemawat, Commitment: The Dynamic of Strategy
(New York : Free Press, 1991): 11.

75

4

Further Topics
in Industry and
Competitive Analysis
Economic progress, in capita list society, means turmoil.
– JOSEPH A SCHUMPETER, AUSTRIAN ECONOMIST, 1883- 1950

OUTLINE
♦

♦

♦

Introduction and Objectives

Competitive Interaction: Game Theory
and Competitor Analysis

The Limits of Industry Analysis
•
•
•

Does Industry Matter7
Hypercompetitio n
Winner-Ta ke-All Industries

+ Beyond the Five-Forces: Complements, Ecosystems,
and Business Models

♦

•

Gam e Theory

•

Competitor Analysis

Segmentation and Strategic Groups
•

Segmentation Analysis

•

Strategic Groups

•

Complements: A Missing Force in the Porter Model?

+ Summary

•

Value Creation and Val ue Capture w it hin Business
Ecosystem s

+ Self-Study Questions

•

Using Business Models to Manage t he Business
Ecosystem

+ Notes

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS

Introduction and Objectives
The previous chapter out li ned Porter’s five fo rces framework and demonst rated its application to
analyzing competition, predicting industry profitabil ity, and developing strategy. The Porter fram ework is one of the most useful and widely applied tools of st rategic analysi s. It also has its limitations.
In this ch apter, we sha ll extend our analysis of industry and competition beyond t he limits of the Port er
framework.

By t he time you have com pleted t his chapter, you w ill be able to:

+ Recognize the limits of the Porter five forces framework.

+ Extend industry analysis to include the role of complements, business ecosystems, and
business models.

+ Understand competitive interactio n, applying insights from game t heory and th e tools of
competitor analysis.

+ App ly seg mentation analysis and st rategic group analysis in order to analyze industries at
a more disaggregated level.

The Limits of Industry Analysis
Does Industry Matter?
Porter’s five forces of competition framework has been criticized both for its flimsy
theoretical foundations and for its lack of robust empirical support- a firm’s industry
environment is a relatively minor determinant of its profitability. Studies of differences
in profitability among firms show that industry factors account for less than 20% of the
variation in return on assets. 1
Do these findings imply that industry doesn’t matter and we relegate the analysis of
industry and competition to a minor role in our strategic analysis? Certainly not!
It is true that profitability differences within industries are greater than profitability differences between industries: McKinsey & Company provide clear evidence
ofth is .2
However, the usefulness of industry analysis is not conditional upon the relative
importance of inter and intra-industry profitability differences. Industry analysis is
important because, without a deep understanding of their competitive environment,
firms cannot make sound strategic decisions. Industry analysis is not just about choosing which industr·ies to locate within, it is also important for identifying competitive
threats, attractive segments, and the sources of competitive advantage. Nevertheless, it

77

78 PART II THE TOOLS OF STRATEGY ANALYSIS

is important that we acknowledge the limitations of the Porter framework and, where
possible, augment our industry analysis.

Hypercompetition
The Porter’s five forces framework is based upon the assumption that industry structure
determines competitive behavior, which in turn determines industry profitability. But
competition also unleashes the forces of innovation and entrepreneurship that transform industry structures. Joseph Schumpeter viewed competition as a “perennial gale
of creative destruction” in which market-dominating incumbents are challenged, and
often unseated, by rivals’ innovations. 3
Schumpeter’s view of competition as a dynamic process in which industry structure
is in constant change raises the issue of whether competitive behavior should be seen
4
as an outcome of industry structure or a determinant of industry structure. The issue
here is the speed of structural change in the industry: if structural transformation is
rapid, then the five forces framework does not offer a stable basis for predicting competition and profitability.
In most industries, Schumpeter’s process of “creative destruction” tends to be more
of a breeze than a gale. In established industries, new entty tends to be infrequent and
changes in industrial concentt·ation are slow. 5 One survey observed: “the picture of the
6
competitive process . . . is, to say the least, sluggish in the extreme.” As a result, both
at firm and industry levels, profits tend to be highly persistent in the long run. 7
However, this stability of industry structures is being eroded by the disruptive
impact of digital technologies. Rich D’Aveni argues that a general feature of industries
today is hypercompetition: “intense and rapid competitive moves, in which competitors must move quickly to build [new] advantages and erode the advantages of their
8
rivals.” If industries are hypercompetitive, their structures are unstable and competitive advantage is temporary.9 According to Rita McGrath, “Transient advantage is the
10
new normal.”
Despite a lack of consistent empirical evidence of growing instability of industry
11
structure and accelerating erosion of competitive advantage, casual observation
suggest that the rapid structural change is not restricted to the hi-tech sectorfinancial services, oil and gas, and taxi services have all experienced disruptive
change in recent years. Yet, hypercompetition does not necessarily obviate Porter’s
five forces framework. For example, in analyzing the dramatic structural changes
that have occurred in the solar panel industry, in pharmaceuticals, in retailing, and
in telecom services, the five forces framework allows us to forecast how changes
in industry structure will affect the forces of competition, and what their impact on
profitability is likely to be.

Winner-Take-All Industries
In some industries, the disparities in profitability between firms are so great as to render
irrelevant the whole notion of industry attractiveness. During 2020, Apple accounted
for over 85% of the total net profits made in the smartphone industry. In 2020,
Alibaba accounted for 58% of online sales in China and an even bigger share of profits.
In these industries, market share confers massive competitive advantage. Typically, this
advantage is the result, not of conventional scale economies, but of positive feedback

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS

loops-the most important of which are network externalities. In online auctions
(dominated by eBay) and social media (dominated by Facebook), users gravitate to the
firm that has the greatest market presence. More generally, a firm with market share
leadership attracts resources away from competitors. Netflix’s global leadership in video
streaming has allowed it to vastly outspend rivals in producing movies and TV shows.
In these “winner-take-all” industries, analyzing the dynamics of competitive advantagenetwork externalities in particular-takes precedent over conventional industry analysis. Let us look more closely at these dynamics.

Beyond the Five Forces: Complements, Ecosystems,
and Business Models
If our industty analysis is to fulfill its potential, it needs to go beyond the confines of
the Porter five forces framework. To understand competitive behavior and the determinants of profitability, we need to look more broadly at industries to include complements, extended value chains, and other participants that form part of the “business
ecosystem.” We also need to look more narrowly: disaggregating broad industry sectors
to examine competition within particular segments and among particular groups of
firms. Let’s begin by considering extensions to the Porter framework.

Complements: A Missing Force in the Porter Model?
The Porter framework considers the suppliers of substitutes as one of the forces of
competition that reduces the profit available to firms within an industry. But what about
complements? While the presence of substitutes reduces the value of a product, complements increase its value: without ink cartridges my printer is useless, as is my car
without gasoline . Given the importance of complements to most products, our analysis
of the competitive environment needs to take them into account. The simplest way is
12
to add a sixth force to Porter’s framework (Figure 4.1).
If complements have the opposite effect to substitutes- they increase rather than
reduce the value of an industry’s product-the key question is: how is this value shared
between the producers of the different complementary products?
To use a smartphone, users require several complementary products: the phone,
an operating system, applications, wireless service, and electricity. The greatest
shares of the profits generated by smartphones are the owners of the dominant
operating systems: Apple (owner of iOS) and Google (owner of Android). The
power of the operating system owners over the suppliers of hardware and applications derives, first, from the intellectual property protecting these operating syste ms and, second, from network effects that e nsure the dominance of just two
operating systems.
Whenever two or more companies offer complementary products that are part
of a single system, profit is captured by the company that is able to monopolize its own product, while ensuring competition and commoditization within the
13
other components of the system. In the case of Android, Google’s sole ownership
contrasts w ith the more than 1000 suppliers of Android phones and the 2.6 million
apps . Such dominance requires intellectual property. Nestle’s inability to enforce
its patents over its Nespresso coffee system prevented it from controlling the

79

80

PART II THE TOOLS OF STRATEGY ANALYSIS

FIGURE 4.1

Five forces, or six?
SUPPLIERS

Bargaining power of suppliers

The suppliers of
complements create
value for the industry
and can exercise
bargaining power

INDUSTRY
COMPETITORS
COMPLEMENTS
POTENTIAL
ENTRANTS

Threat of
new entrants

Threat of
Rivalry among
existing firms

substitutes

SUBSTITUTES

Bargaining power of buyers

BUYERS

supply of coffee capsules and permitting the entry of many suppliers of Nespressocompatible capsules.14
As the above examples suggest, systems of complementary products are a common
feature of markets based on digital technologies. In these markets, competition tends to
be among rival platforms- the interfaces that link the component parts of the system.
These platforms tend to be either operating systems such as Android and Windows
or they are marketplaces such as eBay or Amazon. In both cases, the power of the
platform is its ability to draw, on one side, complementors and, on the other, users. In
doing so, the platform creates a powerful network externality: complementors favor the
platform with the most users; users favor the platform with the most complements. We
shall revisit network externalities and platform-based competition in Chapter 9.

Value Creation and Value Capture within Business
Ecosystems
Incorporating the suppliers of complementary products is a first step in broadening
industry analysis beyond Porter’s five forces- but we can go further. Recognition that
a firm’s business environment extends beyond conventional industry boundaries has
given rise to the term business ecosystem to describe the “community of organi15
zations, institutions, and individuals that impact the enterprise.” This notion of an
ecosystem recognizes the co-dependencies among its members and their continual
evolution. The most prominent business ecosystems are those built around digital
platforms: the Android ecosystem, the Amazon ecosystem, and the Uber ecosystem.
However, ecosystems are also associated with more traditional business models:
Toyota’s multi-tiered supplier network, or localized industry clusters such as the Danish
wind power ecosystem.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS

The viability of any business ecosystem depends upon its ability to create value for
its members. In the case of business ecosystems built upon technological platforms,
Boston Consulting Group found that successful ecosystems were those that:
• Seized the opportunity through rapid market penetration to build critical mass
• Evolved the model through broadening the scope of the platform and increasing
engagement with ecosystem members
• Locked in leadership through building relations with stakeholders such as regulators and customers, shaping industry standards, and preempting competitors
by embracing new technologies and product features. 16
In platform-based ecosystems, the platform owner typically appropriates the
major share of value created. In more traditional business ecosystems, the different
players maneuver for advantage. Value capture within ecosystems depends critically
upon identifying and occupying “bottlenecks”: components of the ecosystem that
constrain its performance due to poor quality, poor performance , or short supply. 17
In home solar power systems in the United States, the principal bottleneck was
initially consumer finance; subseque ntly, it was installation capability, and then supplying the racking systems. The firms that best managed these bottlenecks were the
most successful. 18
Efforts to apply greater rigor to the analysis of value capture in business ecosystems
have involved the application of game theory. The result has been the formulation of
what have become known as “biform” or “value capture models.”19
The value that the firm can appropriate lies between two limits. The upper limit
is the amount of value that the firm creates within its ecosystem-w hich is the
amount by which the total value created would diminish if the firm left the network.
The lower limit is determined by the amount of value that the firm could add to an
alternative network.
Strategies to influence the value a firm can capture comprise competitive initiatives
that increase the maximum value the firm adds to its existing network or to an alternative
network and persuasive initiatives that influence how much value the members of the
network are willing to give up to the firm.20

Using Business Models to Manage the Business Ecosystem
Business model is a widely used but poorly understood concept-which is hardly
surprising given the variety of ways in which it has been used. A model is a simplified
description of a real thing. Hence, a business model is a simplified description of a
21
business-it specifies the “core logic for creating value” or, as David Teece explains:
“the manner by which the business enterprise delivers value to customers, entices cus22
tomers to pay for value, and converts those payments to profit.”
There is a long-running debate over whether there is anything distinctive about
the concept of a business model, or whether it is simply anothe r name for a business
strategy. We will not resolve that debate here. Instead, let us focus on situations
where the concept of a business model can extend our strategy analysis. Business
models are especially useful in formulating novel strategies to exploit relationships
w ithin a firm’s business ecosystem. We will return to the topic of strategic innovation
in Chapter 7.

81

82

PART II THE TOOLS OF STRATEGY ANALYSIS

FIGURE 4.2

The Business Model Canvas
Infrastructure

I Partners ~

Offer

Value
Proposition

Customer

I Segments ~
I Relationships ~

Financial viability

~

Profit ~

The reason that business models are useful is because strategy is often viewed too
narrowly. Business models allow us to consider more complex business situations that
offer a broader range of business opportunities.
Most approaches to the design and selection of business models identify the
components of business models and alternative ways to configure them. One widely
used framework, the Business Model Canvas, views the firm as an infrastructure
(comprising resources , activities, and partners) that is applied to customers
(comprising segments, channels, and relationships) through a value proposition that
generates revenue at a cost that permits a pro.fit (see Figure 4.2). The firm’s business
model represents an integrated set of choices in relation to these components. By
mapping the firm’s business model on this canvas, it is possible to experiment with
alternatives: How can the firm change the components of its business model to
create new configurations?23
Traditionally, most enterprises are operated with fairly simple business models. For
example, the typical business model for a consumer goods producer involves adding
value to bought-in materials and components, then supplying the finished product to
distributors. More elaborate business models involve complementary products (e.g.,
the “razors-and-blades” model favored by Gillette and suppliers of inkjet printers) or
supplying inputs rather than outputs (e.g., franchising).
Digital technologies have caused the emergence of more complex business ecosystems that offer opportunities for more diverse business models. As established
industries are disrupted by digital technologies, the challenge for traditional firms
is to find business models to replace those rendered obsolete by new competition.
Travel agents have transitioned from being commission-based retailers to providing
customized, fee-based services to travelers; newspapers have experimented with
differe nt online revenue models: free content/ paid advertising, “freemium” (free
access to basic content; charges for premium content), metered access, or variants on these.
The more elaborate business models that exploit the opportunities available in
more complex digital ecosystems are illustrated by Google (see Strategy Capsule 4.1).
However, as Strategy Capsule 4.1. shows in relation to Ryanair, many mature industries
also have complex business ecosystems that offer opportunities for business models
that exploit relationships among diverse partner organizations.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS

Business Models for Complex Business Ecosystems:
Google and Ryanair
Google: At t he heart of Google’s st rategy is a

model has been extended by Rya nair to exploit m ul-

business model w hereby free search supports paid

t iple sources of revenue generated by a range of part-

advertising- over two-th irds of the revenues of

ners. Elements of t he Rya nair business model include

Google’s parent, Alphabet, are generated by adver-

t he fol lowing:

t ising p laced on Google’s own websites and applica-

Extreme unbundling. In add it ion to paying for
♦

t ions. However, Google’s fu ll business model is more

flight tickets, passengers are encouraged to pay

extensive. It includes t he following:
♦

Using its advertising management capabilities

baggage, priority boarding, credit card fees, and

and relationships with advertisers to manage

infl ight refreshments.

advertising placements on other content pro-

♦

♦

♦

Payments from airports and local government

viders’ websites (AdSense).

authorities (incent ives to Ryanair to initiate and

Gathering huge q uant ities of user data that allow

maintain specific routes).

more precise targeting of advertising.
♦

for services such as seat assignments, checked

•

Commission on sales of partners’ complementary

Protect ing t he availabi lity and data-gathering

products and services such as car hire, t rain and

capabilities of Google’s search products by

bus services, insurance, hotels, theater, and sports

provid ing its own web browser (Chrome) and

tickets- also ticket sales for other airlines (e.g.,

operating systems (Android, Chrome OS).

Air Europa).

Sustaining

dominance of online advertising

through launch ing compet ing products against

•

Advert ising on Ryanair website, travel magazine,
and seat backs.

rivals such as Apple, Facebook, and Microsoft.

Ryanair: Ryanair’s strategy is based upon the lowcost carrier business model developed by Southwest

Sources: Allan Afuah, Business Model Innovation: Concepts,
Analysis, and Cases (Routledge, 2014); Ryanair Holdings pie,
Annual Report, 2017.

Airlines (see Figure 1.3 in Chapter 1). However, this

Competitive Interaction: Game Theory and Competitor Analysis
Game Theory
Central to the criticisms of Porter’s five forces framework is its failure to address
competitive interaction among firms. A fundamental feature of strategic situations is
interdependence- the decisions made by any one player are dependent on the actual
and anticipated decisions of the other players. By relegating competition to a mediating
variable that links industry structure w ith profitability, the five forces analysis offers

83

84

PART II THE TOOLS OF STRATEGY ANALYSIS

little insight into competition as a process of interactive decision-making by rival firms.
Game the01y allows us to model this competitive interaction. In doing so, it permits:
• The framing of strategic interaction by providing a structure, a set of concepts, and a terminology that allows us to characterize a competitive situation
in terms of:
o Who are the players?
o What are each player’s options?
o What are the payoffs from every combination of options?
o What is the sequence of decisions?
• Predicting the outcome of competitive situations and identifying optimal strategic choices in situations of rivalry and bargaining. In doing so, game theory
offers penetrating insights into central issues of strategy that go well beyond
pure intuition. Simple models (e.g. , the prisoners’ dilemma) predict whether
outcomes will be competitive or cooperative, whereas more complex games
permit analysis of the effects of reputation,24 deterrence,2 5 information,26 and
commitment,27 especially within the context of multi-period games. Particularly important for practicing managers, game theory can indicate strategies for
improving the outcome of the game through manipulating the payoffs to the
28
different players.
Game theory has been applied to a wide variety of competitive situations: the Cuban
missile crisis of 1962,29 rivalry between Boeing and Airbus, 30 NASCAR race tactics, 31
auctions of airwave spectrum,32 the 2008 financial crisis, 33 and the evolutiona1y determinants of male bird plumage. 34 In terms of business competition, game theory points
to five types of strategic behavior for influencing competitive outcomes: cooperation,
deterrence, commitment, changing the structure of the game, and signaling.

Cooperation Game theory encompasses both competition and cooperation. The
concept of coopetition recognizes that most business relationships combine both competition and cooperation. 35 Samsung Electronics and Apple are fierce rivals in the
market for smartphones and in the courts over patent rights. Yet, Samsung is Apple’s
biggest component supplier and the firms are linked by a network of cross-licensing
deals. The desire of competitors to cluster together-movie studios in Hollywood;
race car constructors in Britain’s Motorsport Valley- points to the common interests of
competing firms in sharing know-how and developing infrastructure. Although cooperation usually results in better outcomes for rival firms , the communication and trust
needed to avoid competition are difficult to establish. The prisoners’ dilemma game not
only analyzes this predicament, it also points to the strategic initiatives through which
a player can transform the game in order to reach a cooperative outcome (Strategy
Capsule 4.2).

Deterrence As we see in Strategy Capsule 4.2, one way of changing a game’s
equilibrium is through deterrence. The principle behind deterrence is to impose costs
on the other players for actions deemed to be undesirable. By establishing the certainty
that deserters would be shot, the British army provided a strong incentive to its troops
to participate in advances on heavily fortified German trenches during World War I.
To be effective, a deterrent must be credible . A deterrent that is costly to the threatening party will lack credibility. Threatening a potential new entrant with a price war

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS

The Prisoners’ Dilemma
The classic prisoners’ dilemma game involves a pair of

w here the member countries agree quotas but then

crime suspects w ho are arrested and interrogated sep-

cheat on them.

arately. The dilemma is that each w ill rat on the other

How can a firm escape from such prisoners’ dilemmas?

w ith the result t hat both end up in jail despite the fact

One answer is to chan ge a one-period game (si ngl e

that, if both had remained silent, t hey would have been

transaction) into a repeated game. In the above example

released for lack of evidence.

of competition in advert ising, a multiperiod perspective

The dilemma arises in most competitive situations-

allows the compa nies to recognize t he futi lity of adver-

everyone could be better off w ith collusion. Consider

tising ca mpaigns that merely cancel one another out.

compet ition between Coca-Cola and Pepsi in Ecuador,

In the case of supplier- buyer relations, w here the typ-

where each has t he choice of setting a big or small adver-

ical equilibrium is a low-quality product at a low price,

ti sing budget. Figure 4.3 shows t he payoffs to each firm.

moving from a spot-transaction to a long-term vendor

Clearly, the best solution for both firms is for each

relationsh ip gives the suppl ier the incentive to offer a

to restrain their advertising expenditure (the upper-left

better-quality product and the buyer to offer a price that

cell). However, in the absence of cooperation, both firms

reflects the preferred quality.

adopt big budgets (the lower-right cell). The reason is

A second solution is to change the payoffs through

that each fea rs that any restraint…
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