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Industry Evolution and Strategic Change

LECTURE OUTLINE
I. Overview A. This module examines the development of a firms strategy to manage its industry environment. B. Firms have to manage competitive relations with other firms, and these relationships differ depending on the nature of the competitive industry environment. First, strategies to compete in fragmented industries are described. Next, strategies that are appropriate for embryonic, growth, mature, and declining industry environments are discussed. Strategies in Fragmented Industries A. A fragmented industry comprises a large number of small- and medium-sized companies, such as the dry cleaning or restaurant industries. B. An industry may be fragmented for several reasons. 1. It may be fragmented because of lack of economies of scale leading to low barriers to entry. For example, customers prefer to deal with local real estate agents. 2. Some industries are fragmented due to diseconomies of scale, such as occurs when customers prefer the taste of local restaurant food to the standardized offerings of chain restaurants. 3. Low barriers to entry allow a constant influx of entrepreneurs in some specialized industries. 4. High transportation costs, such that local production is the only efficient method, can contribute to fragmentation. 5. Specialized customer needs mean that companies cannot take advantage of mass production and encourage fragmentation. C. A focused strategy is an appropriate competitive choice in a fragmented industry. Examples are small specialty or custom-made companies and service organizations. D. However, if a way can be found to overcome the factors that cause industry fragmentation and to let the industry consolidate, the potential returns are high. This is what firms like Wal-Mart and McDonalds and chains of health clubs, lawyers, and accountants have done. 1. Chaining involves establishing a network of linked merchandise outlets to obtain the advantages of a cost-leadership or differentiation strategy. It allows bulk purchasing, economies of scale in advertising, increased ability to serve customers, and so on. Examples include restaurant chains, discount store chains, and supermarket chains. 2. In franchising, the local outlets of a chain are owned and managed by the same person. Thus there is a strong motivation for the owner-manager to control costs and maintain quality. The personal service they offer is especially helpful for differentiators. Franchising also permits quick expansion and thus growth. The franchisers operations can be small and local, while still taking advantage of the same opportunities that larger firms enjoy.

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Lecture Notes: Rushi Anandan. Please do not reproduce without permission.

Page 2 of 6 When one firm in an industry takes over and merges with another firm, a horizontal merger has occurred. The result of horizontal mergers is less competition and greater ability to influence price and output decisions, which increases industry profitability. 4. The Internet is the latest means by which companies have been able to consolidate a fragmented industry. Good examples of this approach are eBay in the auction industry and amazon.com in the bookstore industry. III. Strategies in Embryonic and Growth Industries A. Embryonic and growth industries pose special challenges for strategists because customer attributes change as markets develop. Also, the rate of market growth exercises a significant influence over the success of the chosen strategy. B. Embryonic industries typically arise through innovations by pioneering companies. C. Customer demand in embryonic industries is typically limited, due to the limited performance and poor quality of the first products, customer unfamiliarity with what the new product can do for them, poorly developed distribution channels to get the product to customers, a lack of complementary products to increase the value of the product for customer, and high production costs because of small volumes of production. D. Embryonic industries become growth industries as a mass market develops for the firms products. This occurs when technological progress increases the value of the product to the customer, key complementary products are developed, and companies reduce production costs and set a low price, stimulating demand. E. Understanding changes in market demand is critical for firms in the embryonic and growth stages. 1. Growth follows an S-curve, with demand first accelerating and then decelerating. a. The first customers to enter a market are innovators, who enjoy tinkering with new products and are willing to pay high prices. b. Early adopters follow the innovators. They are visionaries, and see the possibility of using the new product in diverse and ingenious ways. c. These are followed by the early majority, who constitute the leading edge and signal of the arrival of the mass market. They are practical, weighing product benefits against costs. They arrive in large numbers. d. After about 30 percent of potential customers have entered the market, the late majority enters. This is a more cautious group of customers, but it is as large as the early majority. e. Finally, the laggards, who tend to be very conservative and perhaps even techno-phobic, arrive. 2. Pioneering companies that fail often attract innovators and early adopters, but fail to attract the majority, leading to few sales and ultimately, the firms failure. Companies that attract the majority, on the other hand, are likely to experience very high sales and high profits. Geoffrey Moore argues that innovators and early adopters have very different needs than the early majority, and thus firms need a different set of competencies to serve them effectively. a. Innovators tolerate technical problems, but the early majority favors ease of use and reliability. b. Innovators can be reached through specialty retailers, but the early majority uses mass distribution channels. c. Innovators are few and are not price sensitive, so skills in mass production are not required. When the early majority arrives, mass production is necessary to insure quality at a lower cost. 3.

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Lecture Notes: Rushi Anandan. Please do not reproduce without permission.

Page 3 of 6 Moving from an embryonic market to a mass market is not easy and smooth; instead, it represents a competitive chasm. Thus, embryonic markets consist of many small firms, but most fall into the chasm and disappear, leaving only a few firms in a mass market. 4. Managers in embryonic and growth industries must learn how to compete for the mass market. a. One important focus for these managers is to correctly identify the needs of the first members of the early majority very early on, while the growth is still primarily being driven by innovators and early adopters. b. Managers must then alter their business model and their value chain activities so as to effectively reach the early majority. c. Managers must also not become too focused on meeting the needs of innovators and early adopters, who dont contribute significant sales. d. Managers must be aware of and respond effectively to their competitors actions. Game theory is useful here. e. Managers must understand the S-curve of growth, and realize that industries develop at different rates. By their strategic choices and actions, managers can change their industrys growth rate, and thus, its profitability. (1) A factor that accelerates customer demand is a new products relative advantage, that is, the degree to which a new product is perceived as better at satisfying customer needs than the product it supersedes. (2) Another factor is compatibility, which refers to the degree to which a new product is perceived as being consistent with the current needs or values of potential adopters. (3) Complexity, the degree to which a new product is perceived as difficult to understand and use, is another factor. (4) A fourth factor is trialability, which is the degree to which a new product can be experimented with on a hands-on trial basis. (5) A fifth factor is observability, which refers to the degree to which the results of adopting a new product can be clearly seen and appreciated by other people. (6) A final factor that is very important in the growth of many new products is the availability of complementary products. f. Therefore, one way for managers to help their industries grow rapidly is to use these six factors to their advantage. For example, increase the products compatibility, reduce its complexity, and so on. g. Another concept that can be helpful to managers is to think of the spread of demand for a new product as analogous to a viral infection. Thus, companies can identify and court community opinion leaders. IV. Strategy in Mature Industries A. A mature industry becomes consolidated so that it comprises a small number of large companies that are interdependent; they recognize that their actions affect one another. B. Thus, the main issue facing a company in a mature industry is to adopt a competitive strategy that simultaneously enables it to maximize its profitability given the strategies that all other companies in the industry are likely to pursue. C. Firms in a mature industry can pursue strategies based on game theory principles to increase the profitability of all competitors in the industry. 1. One important goal of firms in mature industries is to deter potential entrants. a. One method for deterring potential entrants is product proliferation, which occurs when a company tries to broaden its product line and provide products Lecture Notes: Rushi Anandan. Please do not reproduce without permission. d.

Page 4 of 6 for all market segments in order to make it very hard for a potential competitor to enter the market. Such an effort is also called filling the niches. When the niches are filled, it is hard to enter except at a disadvantage. b. Another way to deter potential entrants is through the use of pricing games. (1) Companies can deter entry by cutting prices every time a potential entrant contemplates entering, sending a strong signal. However, firms must be careful to avoid illegal predatory pricing, in which a large company uses revenue generated in one market to support pricing below the cost of production in another market. (2) Another pricing game is the use of limit pricing, in which existing companies with scale economies can set prices above their cost of production, but under the new entrants cost of production, which will be higher due to their smaller size and lack of experience. However, firms that plan to enter and use a new, lower-cost technology will not be deterred by limit pricing. (3) Both of these strategies will be unsuccessful against a powerful new entrant, for example, a firm that is already successful in another industry and now wishes to enter other industries. c. A third way to deter potential entrants is by maintaining excess capacity. Existing firms threaten potential entrants on notice with the possibility that they will increase production and drive down prices to a level at which new entry would be unprofitable. Another important goal of firms in mature industries is to reduce industry rivalry. a. Price signaling is the process by which firms convey their intentions to rivals concerning pricing strategy and how they will compete in the future or how they will react to the competitive moves of their rivals. (1) For example, firms can announce that they will follow along with other firms price cuts or increases. This is called a tit-for-tat strategy. b. Price leadership, in which one company takes the responsibility of setting industry prices, is another way of using price signaling to enhance industry profitability. By setting prices, the leader creates a model that other firms can follow. (1) The price leader is generally the strongest firm in the industry, so it can best threaten other companies that might cut prices. (2) Such price setting is illegal, so the process is often very subtle. For example, frequently, the weakest firmsthose with the highest cost structures, are used as a price model for the other competitors. (3) Price leadership stabilizes industry relationships, giving weaker firms more time to strengthen. However, it can lead to complacency and makes existing firms vulnerable to competitors with new, lower-cost technologies. c. A third way that companies try to reduce industry rivalry is by the use of nonprice competition, such as product differentiation. Nonprice competition reduces rivalry because it keeps a competitor from gaining access to its customers and from attacking its market share. Product differentiation also reduces rivalry because it minimizes the risk that companies will compete by price, which hurts everybody.

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Page 5 of 6 Market penetration is one type of nonprice competition. It occurs when a company expands into more segments of its existing market. This strategy uses heavy advertising to promote and build product differentiation. (2) Product development involves consistently creating new or improved products to replace existing ones. This strategy relies on extensive R&D and can be expensive. In some industries, preemptive signaling, or announcing a product development that is not yet ready for sale, is widely used. (3) Market development involves finding new market segments to exploit a companys products. The firm is seeking to capitalize on its brand name in new markets, as the Japanese did in entering the luxury segment of the car market. (4) Product proliferation can also be used to reduce rivalry. Here each firm in the industry makes sure that it is in every niche to prevent any firm from gaining a competitive advantage, and if a new niche develops, it rushes to provide a product to fill the niche and reestablish industry stability. d. Although firms prefer nonprice competition, price competition is likely to break out when industry overcapacity exists, due to overbuilding, falling demand, technological advancements, or entry into the industry. e. Firms control industry capacity preemptively, when one first-mover rapidly increases capacity and deters others from doing so. (1) This strategy is risky because it involves committing to investment before the market demand is clear. (2) It is also risky because it may fail to deter competitors. f. Firms may instead choose to control capacity through a coordination strategy in which firms signal to one another their intentions concerning their future capacity. By indirectly informing one another of their plans, they seek to ensure jointly that capacity does not become so large that it promotes a price war. However, they must avoid overt signaling, which is considered to be illegal tacit collusion under antitrust law. Another important goal of firms in mature industries is to effectively manage its relationships with buyers and suppliers. a. Companies in mature industries tend to have high power over buyers and suppliers. Both buyers and suppliers tend to become dependent on the firm in a consolidate industry. b. One common strategy is for companies to own their supply or distribution operations, vertical integration. c. Another common strategy is for the firm to outsource some of its functions in order to lower costs. d. There are important reasons to control supplier-distributor relationships. The firm can safeguard its ability to dispose of its outputs or acquire inputs in a timely, reliable manner, thereby reducing costs and improving product quality. (1) One type of relationship between a firm and its buyers or suppliers is the anonymous approach, in which the two parties have an arms-length, shortterm relationship. This type of relationship has been the norm in American business for years. (2) Another type of relationship is the relational approach, in which the two parties develop a long-term, mutually supportive relationship built on (1)

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Lecture Notes: Rushi Anandan. Please do not reproduce without permission.

Page 6 of 6 trust. This type of relationship offers benefits to both parties and is becoming more common in the U.S. e. There are several ways to distribute products. The company can sell to an independent distributor that sells to retailers, or the firm may sell directly to retailers or even directly to the customer. (3) The complexity of the product and the amount of information it requires will determine which method a company will use to distribute its products. The more complex the product, the more likely a company is to try to control the way its products are sold and serviced. (4) However, large firms that sell nationwide usually sell directly to the retailer because they save the profit that would otherwise have gone to the wholesaler or distributor. Strategy in Declining Industries A. Once demand starts to fall, an industry is in decline, and competitive pressures become even more intense. Industries usually decline due to changes in technology, social trends, or demographics. B. Four critical factors determine the intensity of competition in a declining industry. Rapid decline, high exit barriers, high fixed costs, and commodity products generate more competition. Also, segments within an industry may decline at different rates. C. Companies have different strategies available to deal with decline. 1. One strategy for dealing with decline is the leadership strategy, which is an attempt to pick up the market share of companies leaving an industry. This makes most sense when a company has distinctive strengths that give it a competitive advantage and the rate of decline is moderate. a. The tactical steps companies might use to achieve a leadership position include aggressive pricing and marketing to build market share, acquiring established competitors to consolidate the industry, and raising the stakes for other competitors. b. The leadership strategy signals to competitors that a firm is willing to stay and compete, and may speed up exit of competitors from the industry. 2. Another strategy for decline is the niche strategy, which focuses on pockets of demand where demand is stable or declining less slowly than in the industry as a whole. This strategy makes sense when the company has distinctive competencies in that particular segment of the market. 3. A third decline strategy is the harvest strategy, which involves a company optimizing its cash flow as it exits an industry. This strategy makes sense when the firm anticipates a very steep decline or when it lacks distinctive competencies. a. Tactical steps for achieving a harvest strategy include cutting all investment in the business, then continuing to produce until sales decline, after which divestiture follows. b. In practice, this strategy may be difficult to implement because employee morale suffers, and if customers realize what is happening, they may defect rapidly and hasten the decline. 4. A fourth strategy is the divestment strategy. Once a company has recognized that an industry is in decline, it moves early to sell the business to maximize the value that it can get for it. Often it might sell to the leadership company, which is best positioned to weather the storms ahead.

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Lecture Notes: Rushi Anandan. Please do not reproduce without permission.