Terry College of Business - ECON 7950

Lecture 10: Industry Analysis

Primary reference: Besanko et al, Economics of Strategy, Ch.12 (5th edition)

Using the Tools of Game Theory, Bargaining, Pricing,Rivalry, Etc.

I Industry analysis is the use of industrial organizationeconomics to assess industry and firm performance.

I We just covered game theory and some basic IO models, sonow you have the tools.

I Michael Porter’s Five Forces.I Pioneered the use of IO tools to analyze performance.I Somewhat incomplete in that it treats one’s related parties

(customers, suppliers, competitors, etc.) as universally harmingone’s own performance.

I Adam Brandenburger and Barry Nalebuff’s Value Net.I Co-opetition. Doubleday, New York, 1996.I Some related parties might actually enhance profits.

Porter’s Five Forces

I You have seen this before...what do you think of it?

Internal Rivalry

I How many firms are there in the market? More is usuallyworse.

I What is the market? Do firms compete in multiple markets?I Is a market geographical, like ready-mix concrete or hotels?I Include all firms that constrain each other’s strategic

decision-making. What is the level of strategicinterdependence?

I Is demand expanding or declining?I Is ”A” from the Cournot model growing or shrinking?I In declining industries, the only way to expand is to grab

market share.

I Is there excess capacity?I If so, expect price wars.

Internal Rivalry

I Are products close substitutes?I How are products differentiated?I Is ”c ,” from the Hotelling model, large?

I Are there switching costs?I Do firms have profitable strategies for locking in customers

that are available?

I Is there a history of price leadership or other “facilitatingpractices?”

I Is tacit cooperation possible?

I Are there strong barriers to exit?

Entry

I Entry divides up demand among more sellers.

I Entry intensifies internal rivalry.

I This is most evident in the Cournot model. With 2 firms, ifA = b = 1 and C = 0, the equilibrium price and output perfirm is 1

3 , so profit is 19 .

I With a third firm, if price stayed at 13 and the 3 firms split the

output, each firm would produce 29 and earn profit 2

27 . Butbecause they compete more fiercely, price falls to 1

4 and eachfirm earns profit of only 1

16 .

Are Entry Costs High?

I Are fixed costs of entry high?

I Are scale economies significant?

I Are incumbent firms protected by regulation?

I Do early entrants face less severe fixed costs than laterentrants?

I Are there network externalities?I How have incumbents historically responded to entry?

I This is very important if there are just 1-2 incumbents.

Substitutes and Complements

I Are products differentiated? How?I Differentiation is a good thing.

I Are substitutes priced high?I Infant formula? Yes.I High-priced substitutes are less of a threat.

I Are complements priced low?I Nintendo NES? Yes.I Entry as a game developer looks more promising.

Supplier Power

I How concentrated is the group of suppliers?I If supply is competitive, that’s good, though there’s still risk of

price fluctuation.I If supply is monopolistic, that’s bad. Hold-up problems are an

issue.

I Threats of forward integration by suppliers.I Recall the NBCU-Comcast discussion.I Forward integration could lead to a foreclosed market or higher

prices.

I Can suppliers price discriminate?I If so, more profitable firms might face higher prices.

Buyer Power

I How concentrated is the group of buyers?I If demand is competitive, that’s good, though there’s still risk

of price fluctuation.I If demand is monopolistic, that’s bad. Hold-up problems are

an issue.

I Threats of backward integration by customers.I Is it possible to price discriminate among consumers?

I If so, profits may be higher.

The Value Net

I This looks somewhat like a Porter analysis, but with theadded category of Complementors.

I It also reveals a certain amount of symmetry in relationships,how competitors compete with both customers and suppliers.

The Value Net

I Another firm is a complementor if customers have a highervalue for your product when they also have that player’sproduct.

I Oscar Mayer and Coleman’s.

I In contrast, another firm is a competitor if customers have alower value for your product when they also have that player’sproduct.

I Coke and Pepsi.

I These terms also apply to relationships with suppliers.I Firms can be both competitors and complementors, to some

extent. American and Delta compete for landing slots, butaircraft manufacturers like Boeing and Airbus are more inclinedto invest in new plane technology when there’s a second bigbuyer.

The Value Net

I Porter’s Five Forces includes an important weakness. It viewsall other firms as threats to profitability. This need not be thecase.

I Competitors who help set technology standards (3G or 4Gmobile broadband) may facilitate overall growth.

I Competitors who advocate for favorable regulatory changes,like lowered trade barriers, may also help growth.

I Complementary efforts to improve product quality, a laNintendo, stimulates overall demand for games and systems.

I The Value Net assesses opportunity as opposed to threats.

I My profit from the Value Net is approximately the surplus inthe Value Net with me there minus the surplus with me notthere.

DVD hardware in 1997-98: Five Forces

I Internal Rivalry: Fairly homogeneous products, somedifferentiation by brand.

I Entry: Modest technological and capital hurdles. Manyconsumer electronics producers had the required know-how.

I Substitutes and Complements: Satellite TV and streaminginternet video are emerging threats.

I Supplier Power: Movie studios and top producers were quitepowerful. Given Circuit City’s alternative DIVX format, theseplayers could demand high prices.

I Buyer Power: Best Buy and Circuit City were dominantdistributors, could have demanded high margins to promotethe DVD format.

I Given these threats, does it look promising?

DVD hardware in 1997-98: Five Forces

Force Threat to Profits

Internal Rivalry Medium to High

Entry High

Substitutes/Complements Medium to High

Buyer Power Medium to High

Supplier Power High

DVD hardware in 1997-98: Value Net

I The scope for adding value was huge. This was a new,superior technology for video of all kinds.

I Manufacturers of DVD players could have set low prices toboost demand. They did not do this at first, and insteadfocused on profiting from early adopters. They did do this inthe second year.

I Best Buy set rock-bottom prices to promote the technology.

I With lower hardware prices, movie studios cut prices on classicfilms and accelerated the release of new films.

I The size of the pie grew fast, even as some firms such as BestBuy took short-term losses.

Aspartame

I Aspartame (“Equal,” “NutraSweet”) was a breakthroughsweetener in the early 1980s.

I It is 180 times sweeter than sugar and did not carry the publichealth fear associated with saccharine.

I It was pioneered by G.D. Searle and Co. in the 1960s, and gotFDA approval in 1981 (packets) and 1983 (in soft drinks).

I Monsanto bought Searle in 1985 and had a monopolyposition, secured by patents through 1987 in Europe andthrough 1992 in the US.

Holland Sweetener in Europe

I In 1986, Holland Sweetener began constructing a plant in TheNetherlands, to compete with Monsanto.

I Making aspartame is complicated, so there are severelearning-curve effects and barriers to entry.

I When Monsanto’s European patent expired in 1987, Hollandentered. A price war followed. The price of aspartame fellfrom $70 per pound to $22-30 per pound.

I Holland operated at higher costs (due to the learning curve)and, to survive had to appeal to European courts to impose“antidumping” duties on Monsanto.

Holland Sweetener in the US

I Here, the value net illustrates how Coke and Pepsi might beable to play Nutrasweet vs. Holland Sweetener.

I How is Holland Sweetener adding value?

Holland Sweetener in the US

I In 1992, Holland Sweetener could enter the US market.

I Just prior to this, Coke and Pepsi both signed new long-termcontracts with Monsanto.

I The new contracts yielded Coke and Pepsi a combined savingsof $200 million per year.

I Holland Sweetener was shut out. Why?

Holland Sweetener and added value

I Holland Sweetener didn’t really add any value when it cameto selling aspartame.

I They did add value for Coke and Pepsi, however.

I They did this by reducing the added value of Nutrasweet.

Holland Sweetener’s US entry post-mortem

I Neither Coke nor Pepsi wanted to use generic aspartame.I The disastrous 1985 New Coke launch was a recent

event...why risk something like that by removing theNutrasweet logo from the can?

I If the other firm switched, would you use that against them?

I Monsanto invested heavily in the Nutrasweet brand.I They lowered prices to manufacturers using 100 percent

Nutrasweet and using the logo.

I Monsanto had reduced costs by 70 percent since it firstlaunched Nutrasweet.

I “Monsanto appears to have followed the biblical lesson: usethe seven years of plenty to prepare for the seven years offamine,” -Brandenburger and Nalebuff, Coopetition, p. 75