Understanding industry structure and profitability - Michael Porter - Video 1
Transcript
Hi folks and welcome back to understanding business strategy. In the last video we have explore different reasons that gave birth to a new soup field in economics IO (industrial organization). Industrial organization economists try to explain what are the structural reasons under why some industries are more profitable than others. Industrial organization economist face huge troubles in trying to find an acceptable answer to this question, not because finding an answer was complicated, or because the answer was hidden but because of the framing of the problem.
There were two main roadblocks in the way of industrial economy to define why an industry is more profitable than the other. The first one is because industrial economist are generally speaking, economists are much more interested in public policies rather than business policies. Well, what does this mean? This means that economists always try to find a way to minimize the excess of profit rather than embracing the point of view of private organization companies which is trying to maximize the return of profit. And the second problem is that industrial economists try to define only few dimensions in order to explain industry profitability. He took the work of at that time PhD student at Harvard who will become professor Michael Porter to reframe the perception of the problem. In his note on structural analysis of industry, professor Porter explained that industrial economists are looking at the problem from the wrong side. They are looking at the problem from a public policy aspect, which is minimizing the the extra profit in an industry. Michael Porter argues that actually we needed to look at the problem from the opposite perspective which is the perspective of businesses and obviously their job of maximizing profit rather than profit minimization.
In 1880 professor porter will publiship competitive strategy a groundbreaking book in which elaborated is not on structural analysis of industry and in which introduces the concept of the five forces framework in order to understand industry profitability, but before letting you go we need to answer a very important question: how come that was a PhD student in not an economist working in industrial organization to be able to reframe the question on industry attractiveness? And I suppose the answer is fascinating. The answer is that Michael Porter was working on his PhD on two different departments in Harvard. He was working in Harvard business school, therefore, was able to see the problem from the point of view of business, of profit maximization, but at the same time he was in the economics department which actually were framing the problem from the other side that is minimizing extra profit in an industry, and I think is this double and the standing of the same problem that gave Michael Porter the right tools to unbundle industry attractiveness. Again, this is a classical example how many time innovation is about being able to see the same problem from different points of view. It is not that the answer is hidden but actually is that the framing of the problem is wrong and perhaps even more fascinating is how, it is not that the answer is difficult to find, that is not the problem, the problem is the way that we perceive the problem itself, and it's our ability to look at the problem in different points of view, in different lights, in different perspectives that we actually will become able to find a different answer. Stay tuned!
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Industry Structure Overview - Video 2
Transcript
So, I'm gonna take a little different tact for this lesson and give you some information before you read the chapter because I think it may be helpful as you go through the industry analysis stuff. When we are looking at industry analysis, the book will talk about abroad set of stuff that we are doing but at the heart of it is understanding the nature of the industry and really that comes down to the industry structures as there is pretty significant evidence to suggest that industry structure makes a big difference in determining the average level of profits for and industry.
So, we need to understand it and then once we understand it we can also begin to ask some questions about forecasting likely future profitability, identifying key success factors, and identifying potential strategies. Well, maybe at the heart of all this is answering a question that says why do some industries perform better than others? If you look at almost any measures of industry profitability and we are talking not any particular firm but the average level of profitability across an industry, you will find that some industries like pharmaceuticals regularly are at or near the top of the list, whereas other industries for example airlines are regularly near the bottom of the list. The question is: why? Are there factors that we can look at that can predict on average how profitable an industry is likely to be? Well it turns out that there are, but to get there we have to go back to the basics of microeconomics and I know that can be a little scary but I'm not going to ask for a lot of detail, just gonna ask you to remember a couple of pretty simple things. One is supply and demand, and the other is information on the nature of industries. You probably will recall talking about monopolistic industries, oligopolistic industries, and perfect competition. And because when we look at industries, perfect competition is kind of the idealized state. In perfect competition there's lots of firms, no barriers to entry or exit, products are relatively homogeneous, think about bales of wheat barrels of oil and firms are assumed to have perfect information about the ideal production function, the nature of supply and demand, etc, but turns out that that's no really the reality for most industries and instead what we get are oligopolistic do off believe where there's really only two major player and monopolies. Well, monopolies in the U.S at least are typically regulated out of existence. So what we are really interested in is oligopolistic industries where are some major players and then a variety of smaller players and in those kinds of industries there may well be some barriers to entry or exit. The potential for products to be differentiated, that is, they are not all exactly the same and the reality of business where there is imperfect information.
So, we think about our microeconomics. We are really asking kind of what are the forces that are going to work to balance supply and demand to push industries towards perfect competition? And remembering that imperfect competition firms are only supposed to earn a normal return on their investment. If you want the picture here it is where supply and demand intersect that's our equilibrium, quantity and equilibrium price for the industry, and so we need to think about what are the forces that work the supply and demand back to equilibrium? Well it turns out there are a variety of these.
First one and probably the one best remember is this notion of entry. The idea is that if there is not enough supply in the industry and firms are able to earn above average, or above normal return it's going to attract other firms to the industry. Well, when those firms come in they are going to add supply, they are going to push us back down towards that equilibrium point of perfect competition, but it turns out that sometimes there are barriers to entry that is firms cannot always easily enter. So that's once force that we need to think about.
The second is the power of buyers. Buyers are generally not thrilled to know that the price they are paying is making the people they are buying it from rich. So they are going to try to appropriate some of that value, whether they can or not, we’ll see as we go through the book and the rest the lesson there is a variety of factors that help us determine whether or not firm buyer are going to be able to do that, but it's certainly a force that all else equal we will push for an industry back towards perfect competition.
Similarly is the power of suppliers. They are also going to want to capture some of the value of an industry that they are supplying is earning above normal return, so they are gonna try to find a way to capture a piece of that value to get the firms in the industry to pay more for the things that are being supplied. Again whether or not suppliers have that power it has been a very industry to industry depending on a variety of factors.
Substitute products. This is one you got to make sure you get clear in your head these are products from other industry. One that's mentioned in your book is probably the best example is a short haul airline to fly from New York to Boston. There are alternatives: you can drive, you can take the train, you could take a bus. Those are alternative products if you will from other industries that serve essentially the same purpose and when there are substitute products available that are really viable, it puts a cap on the profits and the prices that firms in the industry can charge. When there are substitute products it pushes an industry towards perfect competition. When there are not they way may be able to actually earn above normal returns.
And then finally there's rivalry among firms in the industry. Even when these other factors we have just talked about aren't working, firms sometimes get greedy, that is, they will want a little bit more even though everyone is earning money, each individual firm may want a little bit more. So for example, in OPEC they agree on output levels to try to set price at a level, but individual countries are tempted to cheat and grap a little bit more. We will see that there are various factors that may encourage rivalry or may work against it.
So, those Five Forces turn out to be Porter’s Five Forces of competition. It's nothing magical about them they come straight out of the basics of economics. The threat of potential entrants, buyer and supplier power, threat or presence of substitute products, and then rivalry amongst existing firms.
So the question we are really asking is for any given industry: is it attractive? Is it likely to earn above average returns? Now turns out that in the attractive industries, pharmaceuticals for example, there are many the five forces that are working in favor of the firm is that already in the industry. In unattractive industries like airlines many of the forces are working against the industry and pushing it back more towards perfect competition. Sello differently, in an attractive industry, many maybe not all. Not sure there are many industries for all of them really are in favor, but in many industries, in an attractive industry many of these will work in the favored event of the industry. That is, there will be barriers to entry. Suppliers to the industry are going to have limited power. Buyers are also going to have limited power. There will be limited or no viable substitutes, and there will be limits to rivalry. If those things are in those directions an industry is likely to be more attractive. So, what we need to try to do with industry analysis is understand the forces and what drives them. Or we need to determine which forces are most important in any given industry, that is our barriers to entry an issue here by our supplier power etc, and what are the underlying factors that drives these forces. In the chapter you will see a number of things that help determine whether a force is likely to have an influence on an industry or not, and what it is that's going on with it. Also, when you get towards the end of the lesson I brought a little worksheet that you can look at that will talk about those same things try to help you understand.
Once we have made that determination we can then use it to determine a variety of things. It becomes a very helpful information. We can use it determine likely current profitability of an industry, and also to forecast where we think and industry is going to be in the future. We can use it to determine key success factors for an industry that is what is it that driving profitability and that firms need to be aware of and find way to cope with, and finally we can use it to identify potential strategies not necessarily the strategy that any particular firm ought to use, but we ought to be able to speculate given the nature of the industry structure, given the nature of the five forces and the factors that are underlying them, what strategies might work in this industry. So well that is a basis, now can go read the chapter hopefully that's helpful in helping you understand it. Come back, do the quiz, and then work through the rest of the lesson.
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Industry Structure and Concentration - Video 3
Transcript
Okay so now I want to do is talk about industry structure and kind of put together some of the numbers that I talked about with the actual structures, the industry structures that we see. So, I have three levels here: CR4, HHI and the name that I will give to each industry structure. CR4 is the concentration ratio of the top four firms, how much of the market did the top four firms owned? the Herfindahl level is the market share squared and then add it and so you can see other videos on how to actually determine what a Herfindahl level is, but we know that the Herfindahl level goes from 0 to 10,000 and then, finally we have the name that we are gonna give the industry structure. These are all rules of thumb or estimates, so don't take too much stock in any one specific number that you see here, this is a continuum and so you can interpret things slightly differently than what I say here okay.
What we know is that at the left end of the continuum we have what we call perfect competition or high fragmentation and at the absolute left of the continuum we have a CR4 level of 0 and a Herfindahl level of 0 and you might ask why can we have CR4 level of 0. Imagine that we have a million firms in the industry and each of them are equal. The market share of any one firm is one over a million which is basically 0 and so we are gonna call that 0, same thing with the Herfindahl level. High fragmentation industries include things like pizza restaurants that's an example I usually go over, or home builders, there are 35,000 home builders in the United States and so there are only 12 that have one percent market share or greater and so although the Herfindahl level of home builders won't be 0, it will be very close to 0 might be about 200. We keep going to the right of the number line and we start to get to concentrate it relatively soon on the number line which is another thing that I have tried to bring up in class which is “don't think this is an equal number line between 0 and 10.000”. Well, notice that between 5,000 and 10,000 almost nothing happens. At 10,000 all the way to the right we have a monopoly which is the most concentrated an industry could be, with one firm owning the entire industry and halfway at 5,000 we have a duopoly which is the next most concentrated industry. So between 5,000 and 10,000 we only have two different types of market structures and so what we know is that most action is going to happen to the left of the 5,000 and even further to the left. Now 1800 is an important number because it's where there department of justice signifies a moderately concentrated industry and it’s where they will start to regulate things like collusion and things like merger activity, so 1800 is a very key number to remember and we will just call that concentrated or moderately concentrated, it is where oligopolies tend to begin.
We have a general CR4 level of about 60 and a Herfindahl about 1800 at that concentrated level. As we move further to the right we start to get into a deeper oligopoly and again the deeper oligopoly will be where fewer firms own more market share. So for example cellular phone service providers. We have four in the country that control almost the entire market. We have AT&T Mobile Sprint and Verizon, the four firms own about 90% market share and so we would say the CR4 level would be about 90%. This is of course a four firm oligopoly and the Herfindahl index will be around 3.000 in that industry. So again you see my rules of thumb I put 80 in 3.000 but in some it might be 70 and in some it might be 90 okay. An oligopoly again is very very concentrated market share, we go from oligopoly to duopoly and we see it goes from about 3000 to 5000 clearly of duopoly with 5000 the Herfindahl would be a split market duopoly where two firms, each own 50% of the market, 50 squared is 2,500, 50 squared is 2500 that's why we get a Herfindahl level of 5,000 and the CR4 level will actually be just a CR2 level although we will still call it CR4 and it will be at 100 because both companies own the entire market combined.
We can have a duopoly above 5,000. If we had a duopoly of say 70% and 30%, we would get 70 squared is 4900, 30 squared is 900 so that duopoly would be about 5,800. No that a duopoly cannot be, mathematically cannot be less than 5,000 and it can be higher than 5,000 and of course as we start to get towards monopoly of 10,000, we start to get different types of industry structures and you can have things between 5,000 and 10,000 but they are not really all interesting for a class about competition because in that case there really isn’t any competition. So, just know that most of these things that we are going to study you are going to happen between 0 and 3,000 and in fact, really towards the left of 3,000.
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Industry Structure and Profitability - Video 4
Transcript
Let's talk just a minute in very general terms of industry structure and profitability right and we kind of look at it more variety perspectives right. You can say what about firms that have perfect competition? Does the industry have perfect competition? The perfect competition is exactly what your learn about in your macro and micro economics classes right? Of course then it zooms individuals can invest their money or buy any goods or services that they wish. You have an industry in this industry concentration where there are many firms and all the firms are roughly the same and they are offering products that are roughly the same. Furthermore all customers have access to perfect information at all times. Now what that means by the way when, when customers have perfect information available to them all times. Think about this, you go to, I don't know, Walmart and you look at the milk right? and you can take your milk and say well you know what I know it’s ten cents cheaper at target so I'm going to leave here and go to Target. The customer can examine a product and they know all about the quality and the price of the product just like that. Now some of you are thinking “well, is that really true, right?” Well, when Adam Smith assumed that customers had perfect information flow, people thought that was absurd right? Adam Smith writing a Glasgow would say you know that a bushel of grain in Glasgow was one shilling and you know Edinburgh was a pound, so the customers would know they didn't need to go to Edinburgh because it was cheaper in Glasgow. Well, that was an absurd situation, assumption at that time because it would take a couple days by carriage to get to Edinburgh. But today I think this assumption is beginning to hold because of the fact that we have customers always on their smartphones right? You know if you don't like the restaurant you can yelp it, talk about how bad it was so customers have that information they don’t want to go there. If you are not sure how much your milk should really costs you could look it up on Google while you are at the grocery store. So I think this is actually becoming more and more relevant that we are having perfect information flow.
Now we talked about many firms offering homogenous or similar products. Now, this is particularly true when we start talking about the dealing of commodities. Commodities are products that are relatively similar. Think about milk, milk I mean there are some differences: there's lactose free milk, almond milk, 2% scale, whatever, but within those specific categories you know your 2% milk from one store in one vendor is pretty much the same as 2% milk from a different store or a different vendor. If you are buying bricks of gold, bars of gold, or bushels of grain, things of that nature it's probably gonna be about the same. That's a very different kind of logic than all the bells and whistles that people try to add on things like smartphone, technologies, or pharmaceutical drugs that are different, things like that, right? Now again, perfect competition there's no entry or exit barriers it means that you can go and participate in that industry with no startup costs, no special fees, and when you decide you don't want to be in that industry anymore you can leave without any sort of exit costs.
Do we also have an oligopoly. Now that’s when there's a handful of firms that are the dominant players in that industry, so you have just a few firms not many many firms, and there's significant barriers to entry and exit. Think about it again, I will use the trucking example that I have talked about in some of my previous modules right? Trucking is a good example of an oligopoly. There's a few trucking firms that kind of dominate the industry and if you want to get into trucking you have go to buy a lot of trucks and a lot of Memphis structures just to get off the ground, so that's a significant entry barrier but in oligopoly there's also a significant exit barrier. Let’s say it's like, okay I don't want to be a trucker anymore. Well that's fine but you have got to sell off all those trucks, you have got sell off all the infrastructure, fire(4:09) all those people and it's gonna take time to sell those trucks, and if you are in a hurry you are gonna have to take a significant loss in the price with which you were selling the truck. Yes, that’s an exit barrier, and of course an oligopoly there is potential for differentiation. Again, we’ll use the trucking example, short haul trucking from city to city within a couple hundred mile radius versus long haul trucking you know taking goods across the country, or maybe you have refrigerated trucking you like a cold truck to take milk from point A to point B will be very different than like a moving company’s trucking business right? So that would be a some degree of differentiation and of course it would be less perfect availability of information, right? Meaning that it can be difficult for a consumer who is uninformed to compare the trucking services of one company to that of another because they may not fully understand the dynamics of the trucking industry.
Additionally, as we start getting ino older godleys evolution for perfect competition you start finding more profitability, right? Because you have had to overcome certain entry barriers and there's fewer firms against what you compete directly, and you have differentiation. This increases your amount of profitability, I mean think about it on all four fronts, right? If you know exactly who your competitors are, you know there's only a dozen of them you can plan on how to get some sort of competitive advantage against them, versus having you know possibly limit these numbers of competitors in under perfect competition. I forgot to write all the gobbly (5:45) on my board but sorry about that. I'm kind of excited.
Ok you have had to overcome certain entry barriers which other firms were not able to overcome, right? So that gives you a competitive advantage. When you have products that are different that further reduces the number of competition that you have, and when customers aren't really able to understand the nature of your product, you can charge a higher price than you would normally and the customers won’t know any better, it’s that increases your potential profitability. Now a little bit more on the extreme side of an oligopoly would be a duopoly. So, when you talk about a duopoly that means two firms basically control the industry and monopoly be that one firm and again the duopoly two firms, monopoly one firm. The barriers getting into a dual duopoly are even higher than they are in oligopoly with a monopoly they are extremely high. The product differentiation is even more important in a duopoly than it is a monopoly, versus and oligopoly and the availability of information gets even more scarce in duopoly, in a monopoly versus an oligopoly.
So, we have given you a kind of a macroeconomic birds-eye view of industry structure and profitability. I hope you have enjoyed this video and we are going to move on to next is “Porter’s Five Forces Analysis” which is another way to help you understand whether you should enter a given industry or not, or whether a firm should enter a given industry or not. So, I’m looking forward to see you then.
Retrived from: https://www.youtube.com/watch?v=s8JDFflXkMI
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