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What determines Industry Profitability?
1. Value Creation: Is the project valuable?
2. Value Capture: Is the value being dissipated by competition? - Actual and potential rivalry
3. Value Capture: Is the value being captured somewhere else in supply chain?- Supplier and buyer power
1. Value Creation. PIE = difference between willingness to pay (Industry Demand) and opportunity costof Resources
Shifts in demand affect WTP
Substitutes: place a ceiling on industry prices; depends on price-performance trade-off; can only raise prices so high before people substitute
Complements: X and Y are complements if consumers WTP for X increases when the cost of Y decreases. Examples include:
a) Population growth: shifts demand to right
Income growth: shifts demand to right
Whataffects Opportunity cost? Cost reductions by suppliers and incumbents. Shift cost curve down. (or up….if cost increases)
2. Value Capture: Rivalry
Bertrand Model: individual incentive to cut prices by each participant in the industry leading to the prices that leave each participant collectively worse off. One shot competition with homogenous goods and constant unit costs.
Results inprices = unit costs
To get away from this need: capacity constraints, differentiated products/switching costs, repeated interaction – tacit coordination
Role of Capacity. Excess capacity is a key driver of price cuts; provides ability and motivation to reduce prices. Particularly relevant when the industry has high fixed costs/low marginal costs
Differentiation. Reduces price competition. Switchingcosts/search costs also decrease responsiveness to price, and thus to price competition. May create these costs on purpose (for strategic reasons!)
Tacit Coordination (repeated interaction). Facilitated by: concentrated market, public sales terms, good information about competitors, small, frequent orders, strong capacity utilization, rapidly growing demand
Exit Barriers increase rivalrybecause unprofitable firms stick around.
3. Value Capture: Barriers to Entry: To what extent does the threat or incidence of entry erode the profitability of a firm in the industry?
Factors that restrict entry into an industry:
Economies of Scale (EOS)
Capital expenditures as BTE: Large CapEx neither necessary or sufficient for there to be EOS. The key is MES relative to market size.
Largesunk (non-recoverable) expenditures
If investment made is specific to this opportunity, cannot recover it.
BTE, since if exit is costly, more unlikely to enter under uncertainty
Some firms create BTE by increasing amount of sunk investments required to enter the industry (e.g., in brand building, IT, R&D)
Incumbent advantage
Learning curve effects; patents and licenses; switching costsExpectation of aggressive response to entry
4. Value Capture: Supplier Power: To what extent do the input prices facing a typical firm in this industry deviate from those that would prevail in perfectly competitive input markets because of the bargaining power of input suppliers?
HIGH IF:
* Input critical component of production
* Supplier industry more concentrated than the industryit sells to
* Firms in the analysed industry purchase relatively small volumes relative to other customers of the supplier
* Suppliers can credibly threaten to forward integrate
* Switching costs are high
5. Value Capture: Buyer Power: To what extent do purchase prices in this market differ from those that would prevail in a market with a large number of fragmented buyers in whichbuyers act as price takers?
HIGH IF:
* Input is not a critical component of production
* Buyers are large and few in numbers
* Input is relatively standardized
* Switching costs for buyers are low
* Lots of substitutes
* Buyers can credibly threaten to backward integrate
INDUSTRY DEFINITION
Identifying substitutes depends on how “finely” you draw the boundaries of the...