Chapter 5

Porter’s Five Forces Model, Part 2

The Power of Suppliers, Buyers, Substitutes, and Rivalry

Introduction

In the last chapter, you saw that low barriers to entry can allow entrants to attack and siphon off industry profits, according to Porter. There are, however, four other significant forces that can do the same. In this chapter, we’ll first assess how suppliers and buyers can extract profits from industry firms, as they have much in common. The first issue to keep in mind is that we are concerned with the power of suppliers to and buyers from the focal industry. Consider Figure 5.1; here we see that for the auto industry the suppliers include steel firms, electronics and integrated chip manufacturers, drive train and engine producers, and labor, among many others, while buyers include dealers, government agencies, and rental fleets. Focus on how each group applies power because you want to determine if each does or does not extract profits. You should not be concerned with how powerful the auto industry is as a supplier or as a buyer!

You will also learn how to analyze the ways in which substitutes for the product or service of the focal industry can erode profits for incumbents. Substitutes are other ways of solving the problem the firms in the focal industry solve; sometimes substitutes can be powerful enough to draw customers away. This can force industry firms to drop prices to retain customers—which cuts profits. Finally, you’ll develop some tools for determining how rivalry among industry firms can compete away profits.

It is important to remember that these four forces are not also barriers to entry as beginning analysts often assume. They are simply other ways in which profits can disappear.

Supplier Power

Suppliers are powerful if they can hike the prices of the goods or services sold to the focal industry firms. To the extent that the focal industry firms cannot pass price increases along, profits will be eroded (that is, the profits will flow to the suppliers). When we analyze supplier power, we need tests that show whether this happens.

To begin this, the first thing you need to do is identify the suppliers. The easiest way to do this is to make sure you understand the economics of the focal industry. What does it take to make the product or service? What are the tools, materials, assets, and so on that firms require to deliver the product to buyers? In other words, draw on the work you did in the definition of the industry to help you identify suppliers. Practically speaking, if you have access to the cost breakdown for the product or service, most of your identification problem is solved. Focus on the major industries as suppliers (e.g., those that contribute to 80% or thereabouts of the product or service cost). Further, make sure you focus on industries not firms; we are seeking a general statement about supplier power. For example, in the air carrier industry, major suppliers include steel, drive trains, labor, and so on. In the air carrier industry, the major cost factors are airplanes, fuel, labor, and the airports themselves.

As noted earlier, suppliers are powerful when they can increase prices to the focal industry firms. There are four ways that this can happen, and these will be the standards or tests by which you assess supplier power.

Suppliers are powerful when they are more concentrated than the focal industry. That is, suppliers are comparatively concentrated when there are fewer firms in the supplier industry than in the focal industry or when the suppliers are dominated by one or a few firms. This leads to pricing power because there are few competing firms to which focal industry firms can turn. An extreme example is that of a monopoly or a single seller/supplier. Monopolists are well known for setting very high prices. If there are a few firms, we call it oligopolistic competition, and as long as these are fewer than focal industry firms, prices still tend to be high. The opposite condition is that of pure competition where there are very many suppliers, each competing for focal industry firm business.

We should develop some measure of how concentrated the supplier industries are versus how concentrated the focal industry is. In the brewing industry, as an example, key inputs include malt barley and hops as well as other agricultural inputs, packaging, and labor. Malting involves wetting the barley to encourage germination and then stopping the process by heating the grain. Major U.S. brewers, like Anheuser-Busch and Coors, all do some malting and therefore purchase barley for the purpose. There are generally many farmers growing malt barley. For major brewers, then, such suppliers have little power because the brewers are broadly indifferent to the type of barley, making the concentration of suppliers vis à vis the industry very low. On the other hand, since not even the largest brewers do all, or even most, of their own malting, they need to purchase from maltsters. Table 5.1 lists the output of these firms¹ as of 1997, and Table 5.2 recaps the data, presented in chapter 2, about the U.S. brewing industry as of 2005. I am willing to entertain a few years difference in data because getting exactly commensurate information is difficult and because the structure of the brewing industry did not change much from 1997 to 2005. Microbrewers may be a great deal more exposed because of specific recipe requirements, thereby reducing the number of suppliers that can meet their needs. Still, since major brewers account for about 90% of the market, what would you conclude about the power of agricultural input suppliers for the industry as a whole?

Appendix 5.1 illustrates two measures you can use to assess concentration. One is a simple concentration measure called the C4 (or the sum of shares of the top four firms in the respective industries) and the other is the Herfindahl measure. No matter which you use, you must do the analysis for both the supplier industries and the focal industry so as to draw a comparison. If your analysis shows that supplier industries are less concentrated than the focal industry, then supplier power, on this measure, is low. In this case, the C4 for the brewing industry is 0.827 while for the maltster industry it is 0.584. The Herfindahl scores are 0.293 and 0.095, respectively (the method for deriving the scores is elaborated in the appendix). You should conclude that the brewing industry is more concentrated than this supplier industry. Therefore, this supplier group is less powerful. Obviously, you may get mixed results where some industries are more concentrated and some are less so. What conclusion would you reach about concentration and supplier power then?

Another issue to consider is the locus of supply. For example, in the U.S. air carrier industry, carriers negotiate with airports for landing rights, gates, and so on. There are certainly thousands of airports in the United States, but if a carrier wants to add Denver to its route system, threatening to go to Detroit or Dallas isn’t effective as a bargaining technique. In the scope of the Denver market, there is one good alternative and a few less effective ones—but observe how the number of suppliers has diminished! If supply is a local issue, measure concentration at that level.

Another caveat, especially with labor, is to be thoughtful about the real negotiating unit. If workers have individual employment contracts, you can consider that labor as a supplier is diffused. However, labor unions, because they are a bargaining unit, represent a significant concentration for that supply input. Just think about how powerful unions have been in the past at extracting wage and benefit concessions from firms.

Suppliers are also more powerful when there are no substitutes for their products or services. The lack of substitutes reduces the ability of focal industry firms to shop around for alternate ways of solving their own key economic problem. As a historical example, industries in heavy manufacturing were often quite dependent on labor as a vital input. As previously mentioned, labor unions came to exert considerable power because of it. Increasingly, however, industry firms have invested in computer-based automation of all sorts of functions—from robotic welders and computer numerically controlled (CNC) machines to office automation. These devices are a substitute for physical labor, and as they become available and cost effective, they diminish the power of labor as a supplier.

In another example, steel is a significant component in auto manufacturing but substitutes like plastic have emerged as body part materials. Some plastics may be more costly than steel now, but if steel suppliers hike the price of their product, plastics begin to look more attractive as an alternative. Put differently, substitutes put a cap on the price suppliers can ask. Labor cannot negotiate for wage increases as effectively (e.g., strikes) if the cost this would impose on focal industry firms is greater than that of a substitute for labor—because rational firm managers will quickly adopt the lower cost approach. If there are substitutes for what one group of suppliers provides, this weakens them. If there are no substitutes, suppliers are strong.

Suppliers are more powerful when they are a credible threat to integrate forward into the focal industry. Forward integration means that firms in one upstream supply industry enter the focal industry and become a new competitor. Referring again to Figure 5.1, we are interested in whether firms in the steel, electronics, drive train, or labor groups supplier industries can enter the auto manufacturing industry. Here is how the threat of forward integration works. Suppose focal industry firms can otherwise resist price increase demands from suppliers. This means that input costs are relatively low and profits high. Suppliers can threaten to enter the industry and, as another industry firm, share those high profits—which means that incumbents would become less profitable. So, suppliers can present focal industry firms with a choice: Pay us now, or pay us later.

What this depends on is the credibility or believability of the threat. There are two standards you might apply here. The first is based on the analysis you’ve done of the barriers to entry. The higher these barriers are the less believable a threat to enter becomes. The second standard is based on the economic problem of the focal industry and how closely the skills and resources of firms in the supplier industry match up with that task. As the task grows more complex, or the gap between task requirements and supplier knowledge and skills increases, threats to enter and do that task become less believable or credible. In the pharmaceutical industry, for example, biotech firms often play an important role as developers of new therapies that are then supplied to major pharma firms. Certainly pharmaceutical firms do a lot of drug development, but they have also developed assets in manufacturing drugs under strictly controlled processes subject to FDA oversight. They have also developed large sales forces of well-educated reps for the labor intensive process of face to face selling to physicians. Since most biotech firms are very small, technically oriented groups (i.e., mostly scientists and technicians with very small scale, developmental plants), would you consider a threat by a biotech firm to integrate forward into the pharmaceutical industry proper a credible threat? Why or why not?

Finally, suppliers are likely to be more powerful when the focal industry purchases are not a significant portion of overall supplier revenues. Porter argues that if supply industries serve a wide variety of industries and are not heavily exposed to any of them, then they will seek high prices from all.² However, if a supply industry is dependent on the focal industry for the bulk of revenues, supply firms will be wary of damaging the performance of focal industry firms because it would also damage them. The effect is to moderate the ability of suppliers to ask high prices. The standard you should apply here is a ratio of the share of supply industry revenues from the focal industry. The greater this ratio is, the less power suppliers are likely to have.

So, to assess supplier power, you need, first, to identify who the suppliers are. Base this on your understanding of the cost structure the focal industry faces, and make sure you are covering the inputs for at least 75% of the costs. Then, assess the suppliers in terms of the four criteria just described: concentration, substitution, forward integration, and share of supplier revenues. You can summarize your analysis by scoring each factor on the –1/0/1 scale described in chapter 4. If the test indicates higher supplier power, score that factor as a –1 and vice versa. Usually, you can expect that some factors will score high, some low, and some neutral. When you sum the scores, you will have a final value ranging from –4 to 4 where –4 indicates very high supplier power and 4 very low. Draw on the whole of your analysis and reach a reasoned, comprehensive conclusion. Finally, note that these are not the only sources of supplier power but the ones we will emphasize here.

Buyer Power

Buyer power is assessed in very much the same way as supplier power. If suppliers exert power by raising the prices on inputs to the industry, how, then, would buyers exert power and extract profits from the industry? In general, buyers are powerful when they can depress the prices paid to firms in the focal industry, thereby capturing profits as some variant of consumer surplus.

Again, the first step is to identify the buyers or the entities in the next step of the value chain. Most of the time, buyers are the immediate downstream businesses that continue to add value. So, as Figure 5.1 shows, for the automotive industry, dealers and rental fleet firms are buyers. So too are governments, although they are more like final consumers than intermediaries. The point is individuals or consumers are not always, or even often, the buyer we assess here. As with suppliers, make sure you identify the key buying groups (i.e., account for at least 75%–80% of purchases from the focal industry). Make sure you understand the steps of your value chain!

As with supplier power, we will employ four tests to assess buyer power. These tests are concentration of the buyers versus the focal industry, degree to which focal industry products are undifferentiated, the ability of buyers to backward integrate, and the portion of buyer costs attributable to the focal industry.

Buyers are more powerful when they are more concentrated than the focal industry. The meaning and application of concentration is precisely the same as it was when illustrated in supplier power; although, a single buyer is called a monopsony rather than a monopoly. If buyers are more concentrated, focal industry firms have to compete for a limited pool of business. This tends to cause competition based on price (i.e., industry firms cut prices to win the business). The test or standard here is identical to that developed for supplier power. Again, appendix 5.1 should provide some guidance in developing concentration measures.

Buyers tend to be more powerful if focal industry products are undifferentiated or commoditized. Recall our definition of differentiation from the last chapter—the willingness of buyers to pay more for a product or service and be loyal. If products are undifferentiated, then there is clearly no willingness to pay more, and if loyalty is not an issue, what basis will buyers use to decide? This is one of the reasons that grocery stores generally have such low margins. Whether it is potatoes or hamburger or shampoo, the products being sold are generally the same from store to store. Certainly, grocery chains have been pushing two strategies to offset this: Either a bare bones shopping experience like at Aldi’s or a more upscale experience such as Kroger Signature stores or Wegman’s. But, particularly in the current economic conditions, buyers have not recognized very much differentiation and are increasingly price driven.³ The standard here is to assess the degree to which buyers perceive and value differences among the goods or services offered by the focal industry firms. Why do buyers purchase what they do? To the extent that there are attributes in the product or service buyers value other than price, the less power they have to drive price down.

Buyers tend to be powerful when they are a credible threat to integrate backward into the focal industry. Clearly, this means buyers threaten to move upstream in the value chain and enter the focal industry as competitors. The standards for evaluation here are the same as those for supplier power. You need to consider your analysis of barriers to entry because if the barriers are high, then the threat is less credible. Also assess how well the skills and assets of the buyers match the processes of the focal industry. To the extent that they do not match, the threat is diminished and buyers are correspondingly weakened.

Finally, buyers tend to be more powerful when purchases from the focal industry comprise a significant portion of their costs. The logic here is not difficult to see: Consider your own shopping behavior when purchasing a car or home versus a magazine. The payoff to negotiating on high-price items promises to be very beneficial, so we tend to dedicate time to research and comparison shopping for big-ticket items. On the other hand, the gain from negotiating a lower price on incidentals versus the time we spend in the negotiation process is minimal. Therefore, the test for this criterion is to determine the portion of overall costs that purchases from the focal industry represent. For consumers, you may want to compare against annual income while for businesses, you should have a more detailed breakdown of cost centers.

In summary, assess buyer power by identifying who the buyers are. Base this on your understanding of the revenue streams the focal industry faces and make sure you are accounting for 75%–80% of the revenue streams. Then, assess buyers in terms of the four criteria already described: concentration, differentiation, backward integration, and portion of buyer costs. Again, it is likely some criteria will indicate high buyer power and others low or neutral. Draw a comprehensive conclusion.

Substitute Power

Defining substitutes requires going back to the industry definition process. There, we found that the firms in an industry solve the interesting economic problem (i.e., meeting the customer need) in more or less she same way. That is, they all use the same general processes to produce, essentially, the same product or service. A substitute solves that same problem but in a different way. The substitute solution will meet the need (more or less, as we’ll see) but with a different approach than the focal industry solution. For example, consider the aluminum canning industry, which is composed of firms producing two piece aluminum cans for food and beverages. You can undoubtedly identify some very popular substitutes for the aluminum can: plastic bottles or glass bottles or steel cans being three. How does the availability of such substitutes affect the price of aluminum cans? What happens if canners seek to raise prices to their customers? In general, strong substitutes siphon profits from the focal industry to those substitute industries.

Here are two important caveats for you. First, substitutes in this analysis are an industry level issue. If you are analyzing the auto industry, the substitutes for General Motors’ products are not Ford or Honda because these are inside the industry. What are the substitutes? Public transportation, bicycles, or walking work very well as local alternatives in some settings, such as major cities while air carriers are often very strong substitutes for long distance trips. Second, substitutes are rarely perfect, meeting the customer needs in exactly the same way and to the same degree that the industry solution does. This is why it is important to recall that customer needs are usually multidimensional. That is, a purchase satisfies a number of needs or utilities simultaneously. Substitution can be based on product/service quality specifications (will this do what I want or need), income (to what extent can I afford this), or time (is now better or can I defer). As Porter⁴ points out, neckties and power saws are substitutes if you are in hurry to buy a Father’s Day gift What you might perceive to be imperfect substitutes can work, though the less perfect they are, the less likely they will be able to meet needs effectively. In one of my graduate classes, for example, students debated in a rather hot fashion whether a salad is a substitute for a steak. What do you think? Go further: Is a book a substitute for a steak? The answer has to be yes, though the salad is a closer substitute than the book if consumers are choosing how best to spend that last few dollars.

The standards for assessing the power of substitutes begin with defining the substitutes are which means you must envision other ways of solving the customer problem. Once these have been identified, assess them with respect to their price relative to the focal industry product or service and their quality, or how well they meet the utility requirements—how perfect they are.

Substitutes tend to have power when customers have low switching costs. This means that there are no sunk investments in material or learning to overcome. With no to low switching costs, customers can more freely purchase the substitute. Your test is to determine if there are switching costs for the product or service from the focal industry.

Substitutes also have power when they are less costly, of higher quality, or some combination thereof. Quality here again refers to the specifications customers have for the product. You can likely imagine the sort of internal discussion a customer might have in weighing these factors. For example, consider the choice between a trip to Europe and saving for college. What are the tradeoffs? What would you ask yourself?

Assessing the effect substitutes have on the focal industry is usually one of the most difficult of these processes, mostly because we underestimate the range of potential substitutes. Be creative here! Once you’ve identified good candidates, be thoughtful in analyzing the cost/quality characteristics. If switching costs are low and the substitutes are attractively priced or offer high quality or both, customer money should flow toward them and away from the focal industry. What happens if there are switching costs? Does this automatically end the analysis? No—be sure to carry through and research an overall conclusion. For example, in the auto industry, tooling for plastic body parts differs from tooling for steel parts so the latter are an unusable investment if a switch to plastic is made. However, as the price of steel rises relative to plastic, this switching cist becomes less and less important to the decision. As always, be sure to draw a conclusion consistent with the evidence.

Rivalry

The last of Porter’s forces to be considered is that of rivalry, or the effect of competition among industry incumbents. In general, as rivalry increases, firms compete on the basis of price (i.e., by cutting prices), and falling prices are not good for overall industry profitability. We will use five tests to assess the extent if industry rivalry.

Rivalry is likely to be high if industry products or services are undifferentiated. We covered this problem in the discussion of buyer power, but to reiterate, if products are undifferentiated, buyers have no reason to prefer one firm’s products over another’s except on a price basis. How then do industry firms win customers? By cutting prices—and this is true of industry firms in general. Prices and profits fall. Draw on earlier analyses (in barriers to entry or buyer power) to determine if products are undifferentiated.

Rivalry tends to be high when industry growth is slow. The rationale is that in slow growth environments, strategic moves by one firm to grow or gain share are felt more strongly by competitors than those occurring in fast growing environments. In the latter, all firms likely experience increasing revenues and may even be stressed to keep up with their own orders. In slow growing markets, gains by one firm are experienced as share and revenue declines by others, stimulating rivalrous response, which often includes price-cutting (hence profit-cutting) to retain share. The issue here is deciding what constitutes slow growth. There are several approaches you can use to decide. The first is to contrast industry growth rates with some larger measure such as Gross Domestic Product (GDP). Industry sector growth rates can also be a useful yardstick—for example, assessing transportation sector growth as part of the air carrier or automotive industry analyses—but the elements of the larger sector data may be tightly internally correlated. That is, because they serve similar purposes, there may be trends specific to the sector that could distort your assessment. GDP gives us a sense of how fast the economy as a whole is growing. By contrasting the national and industry trends, we understand whether the focal industry is high-, average-, or low-growth relative to all industries. Additionally, it may be useful to assess the direction of change. We can estimate how current industry growth rates, which are usually measured as revenue growth, compare to industry cumulative average growth rates (CAGR). An even simpler way is to compare recent annual growth rates. If current rates are greater than historical (i.e., the industry is experiencing a growth surge), rivalry is decreasing. If rates are lower, rivalry increases. Interpreting your findings requires some judgment. Growth rates for industries can vary widely, but if we use GDP as a center point, the issue is deciding what constitutes a great enough difference to be considered fast or slow growth. If GDP is growing at 3%, is a rate of 2% or 4% necessarily low or high? Or, are these near-average results, which indicates a neutral effect on rivalry? There is no simple answer, and it would depend more on the spread of returns for all industries. You can find information on long term and recent GDP performance from the U.S. Bureau of Economic Analysis⁵ and, in a more global and comparative context, from the World Bank.⁶

Rivalry is likely to be high if fixed costs in the industry are high. Recall the cost equations from chapter 4 and the relationship between fixed costs, volume, and average cost. When fixed costs are high, firms need sales volume and the resulting production volume to absorb the fixed costs and keep the average cost in line. Therefore, you need to judge the extent to which industry firms face high fixed costs. This is not easy because there are few, if any, cross industry comparisons. However, if you recall that fixed costs are those the firms incur no matter the level of production and are usually related to investments in capital equipment, you can use industry descriptions to make the call. For example, if you’ve already determined that an industry exhibits economies of scale, you can reasonably conclude that fixed costs are higher than those industries that do not have economies of scale. Significant economies of scale can be a proxy for a measure of fixed costs. A valuable addition to this assessment is the information from sources like Hoover’s “First Research Industry Profiles” These provide summaries on production and sales processes for hundreds of industries. For example, an assessment of the architect’s offices industry indicates that economies of scale are low, that offices are often small, and that they are heavy users of computers.⁷ Legal services are very much the same.⁸ On the other hand, aircraft parts manufacturing is characterized by economies of scale and heavy investment in costly production equipment.⁹ What would you conclude about the fixed cost structures of these industries? What do you conclude, then, about the scope of rivalry?

Rivalry is also likely to be high when firms are more or less the same size. Appendix 5.1 compares two scenarios of industry structure where the top six firms have the same total market share of 90%. In one, each firm is the same size. In the other, one firm has 80% share and the rest have 2% share. Porter¹⁰ argues that such asymmetries in size, as seen in the last example, reduce rivalry because a single firm controls the vast majority of the market and really doesn’t regard the others as significant competitors. Thus, it is unlikely to respond much to rivalrous actions by the others because they simply can’t do much. On the other hand, firms that are closer in size will be more directly competitive and engage in responses like price-cutting. One way to assess this test is to develop a Herfindahl Index score, which is a variation on concentration measures as discussed earlier and as described in appendix 5.1. If the score is low, rivalry will increase. If the score is high, rivalry is decreased.

Finally, rivalry is increased if firms have high strategic stakes in the focal industry. The issue here is the extent to which they are committed to that industry versus other business opportunities. To illustrate, if a firm is engaged in only the focal industry, its survival is directly related to what happens in that industry. Conversely, a firm that sees the focal industry as only one of several or many in which it participates (a diversified firm) will not perceive industry conditions and performance in the same way: What happens in the focal industry is less significant to the diversified firm’s survival. Thus, the firms have different stakes in the industry. The issue is that with no other place to turn, firms with high stakes will fight desperately to survive while firms with other opportunities will be less willing to engage in low profit actions, choosing, rather, to exit and divert investment to where returns are higher. The test, then, is to determine the extent to which engagement in the focal industry comprises a key portion of overall firm revenues. The higher this is for industry firms in general, the higher rivalry is likely to be.

You can summarize your analysis of rivalry (as for all other forces) by scoring each factor on the –1/0/1 scale described in chapter 4. If the test indicates higher rivalry, score that factor as a –1 and vice versa. Usually, you can expect that some factors will score high, some low, and some neutral on rivalry. When you sum the scores, you will have a final value ranging from –5 to 5 where –5 indicates very high rivalry and 5 very low.

The last step of the industry analysis is to convert your force assessments to a common range for a summary judgment. In the last chapter, we ended with a simulated assessment of the widget industry. This is carried over in Table 5.1 where force scores are summarized. Now, for each, convert to the –1/0/1 metric. For example, barriers to entry score at 3/7. This certainly means that barriers are not low, but are they moderate (0) or high (1)? Generally, I would treat scores around the mean (i.e., from –3 to 3) as moderate and scores greater than 3 as high or strong. For four- and five-item tests, use a –2/2 range. When you do this, you weight each force equally and can summarize your assessment of the industry. We can summarize this chapter by closing with a discussion of what constitutes an attractive industry. Each of the forces we have analyzed illustrates how profits may be diverted from firms in the focal industry. The tests that accompany each force compel us to dig in detail into what really happens in production, sales, and competition. From our results and conclusions, we build a picture of the industry as a whole. So, if you were a manager in the widget industry, what scores would you most like to see, and why? I interpret the following results from Table 5.1: Barriers to entry are moderate; supplier power is quite high; buyer power is weak; substitutes are powerful; and rivalry is high. In other words, the effects on profits for the industry would be neutral, bad, good, bad, and bad respectively. Overall, the widget industry seems to have a lot going against it, and we should expect profits to be low.

A final note: Twenty years after Porter developed his five forces model, he introduced new work on the relations between firms in an extended value chain.¹¹ The perspective in the five forces is that transactions are zero-sum: If suppliers win, for instance, focal industry firms lose. In contrast, Porter later developed the idea of clusters of firms in particular fields where interactions are much more collaborative and less competitive. He illustrates this idea through the California wine cluster, which is composed not just of vintners or winemakers but also of universities; grape stock growers; equipment manufacturers; firms that produce bottles, barrels, and corks; as well as restaurant and tourism firms. The perspective here is that the cluster is collectively interested in the final goal of delivering wine to wine drinkers. Porter argues that clusters foster better coordination and higher trust due to repeated interaction and physical proximity (most clusters are in a specific area, like wine in the Napa and Sonoma valleys of California) and also improve productivity and innovation. We’ve already seen how Porter anticipated this in the point about how suppliers who are dependent on a particular focal industry will be less likely to be aggressive in pricing. Here, we see it can extend to an entire (though localized) value chain. Clusters are not necessarily indicative of an entire industry, but we do have to note them when they occur—and they do occur quite often. In his 1998 paper, Porter identified roughly thirty locale/industry groups in the United States such as insurance in Hartford, Connecticut; farm equipment production in the Quad Cities area of Iowa, Wisconsin, and Illinois; or pharmaceuticals in the Philadelphia/Northern New Jersey area. This is not just a U.S. phenomenon; clusters are found around the world in virtually every industry. The important takeaway is that if such clusters exist, the competitive dynamics for firms within the clusters will differ from those outside the cluster with commensurate effects on profitability.

Summary

In this chapter, you learned how to assess Porter’s other forces beyond barriers to entry. The systematic approach to doing this effectively is to first identify the relevant players in each force. Know which industries supply yours and which industries are buyers from yours. Then, apply the standard for assessment and draw a conclusion. Ultimately, you’ll want to consolidate all the conclusions you reach into an overall assessment of the industry—and then run a sanity check against your expectations about the industry. If they are different, what does this tell you? In the end, the most valuable result from this sort of analysis is a much more deeply developed sense of the rules of the game, or a good feel for how firms are likely to compete and a strong awareness of the opportunities for, and threats to, firms in your industry.

Appendix 5.1

Concentration Measures

1. C₄ or C₆ or C_x—a simple concentration measure.

Where si = market share of the ith firm. The idea here is to sum the market shares of the four or six or x largest firms. The result will be somewhere between 0 and 1 with lower values implying less concentrated industries and higher values implying more concentrated industries. Using the data from the brewing and maltster industries in chapter 5, calculate the C4 ratios for both scenarios.

Solution

• Brewing industry
  • C4 = sum of four largest firm shares = 0.495 + 0.187 + 0.111 +
  • 0.034 = 0.827
• Maltster industry
  • C4 = sum of four largest firm shares = 0.223 + 0.152 + 0.107 +
  • 0.102 = 0.584
• Note that the brewing industry is more concentrated because the top four firms control more share in their industry than is the case in the maltster industry.

2. The Herfindahl index corrects for variation in market shares.

Where si = market share of the ith firm. The Herfindahl Index (HI) gives more weight to larger firms.

Using the same data, calculate the HI scores.

Solution

• Brewing industry
  • H4 = (0.495)2 + (0.187)2 + (0.111)2 + (0.034)2
  • = 0.245 + 0.035 + 0.012 + 0.001 = 0.293
• Maltster industry
  • H4 = (0.223)2 + (0.152)2 + (0.107)2 + (0.102)2
  • = 0.050 + 0.023 + 0.011 + 0.010 = 0.095
• Herfindahl scores are useful in comparing the structures of industries that are very different in terms of how evenly the market shares are divided. The brewing industry has much more share concentrated in the hands of a single firm than does the maltster industry. Thus, the concentration score captured in the H4 is almost 3:1 for the brewing industry. It is the same result as, but much more emphatic than, the concentration ratio scores.
• Concentration ratio scores are easier to calculate and are fine if the respective industry structures are roughly the same. The more they differ in terms of share distribution, the more an H score evaluation would be useful.