Porter's Five Competition framework is one of the most widely used tools for business strategy, determining the industry profitability and determining the success factors. However, as any other methodologies it has been prone to attacks.
Some believe that the framework lacks robustness and rigour. And other believe that the industry structure has little to do with business profitability.
We need to acknowledge that profitability differences within industries are greater then profitability differences between industries. Returns on Equity (ROE) between most and least profitable industries vary at approx 45%. The usefulness of the industry analysis is not conditional upon relative importance of the differences between industries, but because without understanding of the industry competitive environment we cannot make sound strategic decisions. It is important for establishing the competitive advantage. If our analysis is full of promise, we need to go deeper into the analysis to understand the relationships within the market structures and market competition. We need to examine competitors within particular segments and even among particular group of firms.
The Porter's analysis recognise the suppliers of substitute products as a factor that reduces the profit of the firm in the industry. The presence of substitutes reduces the value of products. Complimentary products, however, increase their value. Compliments have the opposite effects to substitutes. Here, the bargaining power is the key. Where two products compliment one another, profit will accrue to the supplier that has built the stronger market position and reduces the value created by another. The key is to achieve monopolisation, differentiation and shortage of supply in one's own product, while encouraging competition, commoditisation and excess capacity in the production of the complimentary product.
The Porter's framework assumes that competition and profitability is driven by the industry structure, but we could turn it around and say that the quest for profit unlashes the competitive forces of innovation and shapes the industry structure. Innovative products and solutions can drive the competitors down. Therefore perhaps the competitive behaviour should be seen as an outcome of industry structure. But in established industries entries are very slow and profits tend to be persistent in a long term. Hyper-competition is the general feature of industries today. Competitors move quickly to establish advantage and structures are less stable. Increasing competitive advantage is the only way to assure profitability. Industry structures are destabilising and shift into hyper-competition is visible.
The game theory
Decisions of one player in the industry will shape the decisions of another player. Game theory allows us to closer evaluate the competitive interactions. It allows for framing the strategic decisions as it provides a set of concepts. It identifies the players, specify their options, the specification of the payoff from each option and sequencing of decisions. It can predict the outcome of competitive situations and identify the optimal strategic choices. Game theory provides penetrating insights into the central issue of the strategy. It can provide the strategy to improving the structure and outcome of the game through manipulating the payoffs to the different players.
The game theory points out the five aspects of strategic behaviour which can improve the competitive outcomes:
1. Cooperation - is is the ability to encompass the competition and cooperation. We can recognise the durability of business relationship. Some relationships are predominantly competitive and some cooperative. All business relationships combine both. Some competition result is similar decisions and strategies, even pricing and product introductions. There is a common interest of competing firms with growing the size of the market and developing its infrastructure.
2. Deterrence - in the context of game theory, deterrence refers to a strategic behaviour aimed at preventing or discouraging other players from taking further action. It typically arises where multiple firms competing with each other in the market. Each firm wants to maximise its own profits and gain competitive advantage over its rivals. Deterrence strategies are employed to dissuade other firms from pursuing certain actions that could harm the deterrence-seeking firm's interest. Price war in one of the most well-known concepts where firms aggressively lower their prices to gain market share and gain new customers. But this behaviour can decrease profits for all firms involved. Firms often want to match or undercut the price reductions. Another example to deterrence is use of strategic investment in research and development, production capacity or marketing to signal commitment and capabilities in the market. This can discourage potential entrants from trying to challenge the firm's position. Any attempt to compete will be met with strong resistance, making it less attractive or economically unviable to enter the challenge the market. Deterrence relies on credible threat of punishment or negative consequence. This requires a combination of resources, reputation and credible commitment to follow through the actions. It is a strategic behaviour preventing rivals from engaging in certain actions that could harm the firm's interest. By signalling a credible threat and demonstrating capability to respond the firm would seek influence and seek to maintain its competitive advantage. Deterrence strategies should be tailored to specific market conditions and competitive landscape. It is important to assess the impact and feasibility of each action and adapt the deterrence approach as the market evolves.
3. Commitment - for deterrence to be effective it must be backed by commitment and elimination the strategic options. There can be hard commitments for strict competition and soft commitments for moderate competition. How different types of commitment affect the firm's profitability depends on the game being played. Price may be matched then both firms will reduce their profits, but commitment to output may have different results. In the theory of game and competition, commitment to output refers to a strategic decision made by a firm to signal its determination and capability to produce a certain level of output in the market. It can take different forms, but the underlying idea is to influence the behaviour of other firms and shape market dynamic in favour of the committing firm. The actions aim to discourage rivals from entering and expanding in the market and to gain a favourable position in negotiations and strategic interactions. One example would be to making investment in production capacity or infrastructure where firm makes a commitment to produce large volumes of output. This can serve as a deterrent to potential entrants or existing competitors who may perceive the market as less attractive due to the firm's ability to flood the market with products.
Another example would be long term supply contracts or customer agreement. By securing agreements with customers or suppliers for a specific volume of output over an extended period a firm can signal commitment to maintaining a certain level of production which can deter the competitors to woo away the firms customers or suppliers as they will have difficulty in securing similar long-term commitments.
Commitment to output can also be achieved through public announcements or statements. A firm might publicly declare its intention to maintain a specific level of output, signalling its determination and resolve to competitors and stakeholders. Such announcements can influence market expectations, discourage rivals from attempting to challenge the firms position and shape the competitive landscape. The rationale of commitment lies in strategic advantage gained by shaping the expectations and behaviour of other players in the market. By making a credible commitment the firm alters the perception of the competitors from engaging in actions that may undermine their position. Commitment to output carries risks and requires careful consideration. The firm must have the resources, capabilities and market conditions that support the commitment. If the firm fails to deliver the commitment, it could suffer reputation damage and loss of credibility, potentially inviting aggressive actions from competitors or regulations.
3. Changing the structure of the game being played - a company may seek to change the structure of the industry to increase profit. Establishing alliances and agreements with competitors may increase the value of the game and increase the market through building a joint strength. This is a way to converting a win-loose situation to win-win situation.
A firm has the ability to change the structure of the game being played in the industry through various strategic actions:
- Innovation and technological advancements. By introducing innovate products, technologies and business models, a firm can disrupt the existing game structure and create new set of rules. Innovation can lead to differentiation, cost advantages or creating entirely new market and reshaping the competitive dynamics.
- Merges and acquisitions. A firm can change a game structure by acquiring or merging with other companies in the industry that can lead to changes in the market concentration, market share distribution and overall competitiveness. Merges and acquisitions can create larger, more powerful entities that have significant influence on the industry dynamics.
- Vertical integration. It is where firm expands its operations to encompass different stages of the value chain. Firm can gain greater control over inputs, distribution channels or customer relationships, reshaping the industry's competitive landscape.
- Strategic alliances and partnerships. A firm can alter the game's structure by forming alliances and partnerships with other companies that can enable resource sharing, knowledge exchange and combined market power. This can create competitive forces and challenge their existing dominant players.
- Pricing and Business Model innovations. A firm can introduce disruptive pricing strategies or business models that change the rules of the game. This can involve offering products or services at significantly lower prices, implementing subscription models or introducing new information sharing models. By doing so a firm can attract customers, gain market share and force competitors to adapt.
- Regulatory and policy influence - firms can actively engage with regulatory bodies and policy makers to shape the industry's structure. By advocating for favourable regulations, standards or market conditions a firm can influence the rules of the game in its favour. This can influence lobbying efforts, public advocacy or participation in industry association.
- Market expansion and diversification. A firm can change a game's structure by expanding into new markets or diversifying its products offerings. This can mean targeting new customer's segments, geographical expansion or entering adjacent industries. Such moves can create additional competitive advantage and reshape the overall industry landscape.
- Disruptive marketing and branding. By introducing innovate marketing strategies, a firm can change the perception of the game and disrupt the established norms. This can be achieve through establishing strong brand presence, utilising social media platforms, or leveraging influencer marketing to redefine customer preferences and behaviour.
Changing the game's structure is not without challenges and risks. It can provoke responses from competitors, regulatory bodies or other stakeholders. Firm needs to assess the potential impact, feasibility and long-term sustainability of their strategic actions to ensure that they achieve their desired actions.
4. Signalling. The competitive reactions will depend on how the rivals will perceive the initiative. Signalling includes choosing the type of the communication to competitors to provoke certain reactions. The use of misinformation is well established in military intelligence. The credibility of threat is highly dependant on the reputation. Even if this type of strategies may only result in short term profitability, it may built the reputation of aggressiveness that deters competition in the future and strength in other markets.
Some studies conclude that the theory of game is more practical in evaluating the past then trying to predict the future. However, it can certainly help to understand the business situations and structure our view on competitive interactions. By identifying the players in the game and their strategic choices as well as implications of decisions we have a systematic framework to exploring the dynamics of competition. We then have ways of suggesting the strategies of changing the game and gaining competitive advantage.
Competitor analysis and Competitive intelligence
In highly concentrated industries, the dominant feature of the company's competitive environment is likely to be the behaviour of its closest rivals. Game theory provides a theoretical apparatus for analysing competitive interactions by a small number of rivals. For everyday business situations a less formal tools might be useful.
Competitive intelligence involves a systematic collection and analysis of information about rivals for informed decision making. It has a purpose of forecasting their future strategies and decisions, predict their reactions and determine how their decisions can be influenced.
To understand competitors it is important to be informed about them. However, the distinction between public and private information is uncertain and the law relating to trade secrets is much less precise the copyright and patents law.
But, competitive intelligence is not simply about collecting information, we must make it clear to what information is required and for what purpose it is to be used. The main goal is to understand the competitor. There are several parts that are worth exploring.
* Competitor's current strategy - looking what they say and what they do.We are looking for linking to what the top management say with strategic actions, particularly in to where the resources are placed. Unfortunately for these, public information is often unreliable.
* Competitor's objectives - if a competitor is to change strategy, we should identify its goals. companies may be driven by financial goals or market goals. Those which are after marketshare will compromise on profitability. The most difficult competitors are those which are not prone to profit disciplines. The level of their current performance will determine their strategy changes. If the performance is falling short, radical changes including changes in top management are likely.
* Competitor's assumptions about the industry - these perceptions are guided by beliefs that senior management holds about the industry and the success factors within it. Often, industry can develop 'blind spots' that can limit the capacity of a firm to respond to an external threat. This also sometimes relates to the entire industry.
* Competitor's resources and capabilities - rivals can have a massive cash pile and it would be unwise to initiate price war. But if we direct the actions towards their weaknesses, it may be difficult for them to respond. Often businesses implement innovating forms of differentiation that are difficult to replicate.
Segmentation analysis
The process of disaggregating industry into specific markets is called segmentation. Competition may vary across different markets and some are more attractive then others. The purpose of segmentation is to identify attractive segments and select appropriate strategies for different segments. This analysis generally follow in five stages:
Identify key segmentation variables - these are the choices on which customers to serve and what to offer them as they relate to the characteristics of the customers. The most appropriate variables are those which partition the market in terms of limits to substitution to customers. For the analysis to be useful, we need to try to limit those variables to two or three. For example, for restaurants: price, service, cuisine and alcohol licence would be closely related. So we could use 3 variables: full-service restaurants, cafes and food outlets as a proxy for all of those variables.
Construct a segmentation matrix - in the context of the industry analysis, a segmentation matrix refers to a framework used to segment or divide the industry into different categories or segments based on the various criteria. It helps in understanding of the structure of the industry and identifying distinct groups of customers, competitors or products within that industry. The purpose of the matrix is to identify opportunities and make strategic decisions based on the characteristics and needs of different segments. Companies can tailor their marketing strategies, product offerings, pricing and distribution channels to better serve a specific need of each segment. For example the criteria could be factors such as customer demographics, purchasing behaviour or product attractiveness, depending on the specific industry being analysed. The matrix allows companies to visualise different segments and understand how they differ from another. This information can be used to allocate resources effectively, identify growth opportunities and gain competitive advantage in the industry. There are also matrixes created by geographical location and product type, for example.
Analyse segment attractiveness - the profitability across the segments can be analysed through Five Competitive Forces analysis. However, when analysing the pressure from substitute products, we need to be concerned with substitutes from other industries as well as other segments within the industry. In similar way, when evaluating the entries, these may be threats from other segments of the same industry as well. Differences in competitive conditions in the segments can be much profitable then others. This segmentation may be useful for identifying unexploited opportunities.
Identify the segment's key success factors - difference in competitive structure and in customer preferences in different segments result in different Key Success Factors (KSFs). We can identify those KSFs by analysing purchasing criteria.
Select segment scope - finally we need to decide on whether we want to be a specialist in a particular segment or across types. Shared costs and similarities across segments will give advantage to more broad selection. If KSFs are different among segments a firm will need to develop different strategies.
Profit pool analysis
Profit pool analysis is a strategic tool used by businesses to assess the profitability of an industry or market. It helps organisations to understand how value is distributed among various players within the industry and identify potential opportunities for capturing a largest share of a profit.
The concept of profit pool refers to the total profits generated within a specific market or industry. Profit pool analysis involves breaking down this total profit into its various components and examining how those profits are distributed among different participants such as suppliers, manufacturers, distributors and retailers.
Here are the key steps involved in conducting a profit pool analysis:
Define the industry or market scope. Determine the boundaries of the industry or market you want to analyse. This could be a specific product segment, region or customer segment.
Identify the players. Identify all the participants involved in the value chain of the industry, including suppliers, manufacturers, distributors, retailers and service providers. This step helps in understanding the value flow and the different stages where profits are generated.
Quantify the profit flows. Estimate the total profits within the industry or market and examine how those profits are distributed among the various players. This can be done by gathering financial data, market research and industry reports.
Analyse profitability drivers. Identify the factors that drive profitability within each segment of the industry. This includes factors such as pricing power, cost structure, market share, customer loyalty and economies of scale. Analysing these drives helps identify opportunities for improving profitability.
Identify opportunities or threats. Based on the analysis, identify areas where there may be untapped profit potential or where profits are being captured disproportionately. This could involve exploring underserved customer segments, developing innovate products or services or improving operational efficacy.
Develop strategic initiatives. Based on the identified opportunities and threats, develop strategic initiatives to capture a larger share of the profit pool. This may involve entering new markets, forming strategic alliances, acquiring new players, optimising the value chain or differentiating products or services.
Profit pool analysis provides valuable insights into the dynamics of the industry helping companies make informed strategic decisions. By understanding the distribution of profits and the factors influencing profitability, businesses can align their resources and capabilities to capture a larger proportion of the profit pool and drive sustainable growth.
Strategic groups
Strategic group analyses segments of industry based on the strategies of a member firms. It a a group of firms following similar strategy dimensions. This can include quality, product range, geographical range, choice of distribution channels, choice of technology and so on. In some industries these strategic groups are easily identifiable. Some groups are also are more profitable then other groups. Through group analysis we can understand strategic patterns of the players and identifying strategic niches.
In the context of industry analysis, strategic groups refer to clusters of companies within an industry that have similar business models, strategies and competitive positions. These groups are formed based on similarities in factors such as target markets, product offering, distributor channels, pricing strategy and geographic focus.
The concept of strategic groups helps to identify patterns and variations in the competitive landscape of an industry. By analysing strategic groups, companies can better understand their competitive position and dynamics within their specific groups.
To position themselves to the higher spectrum of the strategic groups and gain profits a company can consider the following strategies:
Differentiation. Differentiate your products or services to create a unique value proposition that sets your company apart from competitors in the same strategic group. This can involve offering superior quality, innovate features, exceptional customer service or customised solutions. By doing this company can command higher prices and capture a larger share of profits.
Niche market focus. Identify the niche markets within the industry where there may be less competition. By focusing on specific customer segments or specialised applications, a company can position itself as a leader in that niche and gain higher profitability. Serving niche markets often allows for better pricing power and higher margins.
Cost leadership. Strive to achieve cost leadership within your strategic group by optimising operations, improving efficacy and controlling costs. This can be achieved through economies of scale, effective supply chain management, process improvements and technological advancements. Cost leadership allows the company to offer competitive prices while managing healthy profit margins.
Market expansion. Explore opportunities to expand the market reach beyond your current strategic group. This could involve entering new markets, targeting different customer segments or diversifying into related product categories. By expanding the market, a company can tap into new sources of revenue and potentially position itself in a higher profit strategic groups.
Strategic partnerships. Form strategic partnerships or alliances with other companies in the industry to leverage complementary strength and resources. This can enable access to new markets, technologies, distribution channels or shared research and development efforts. Collaborative partnerships can enhance company's competitive position and profitability.
Continuous innovation. Foster a culture of continuous innovation to stay ahead of the competition and maintain a higher position within a strategic groups. Invest in research and development to develop new products, technologies or business models that address evolving customer needs and industry trends. Innovation can create barriers to entry for competitors and drive profit growth.
It is important for a business to assess its internal capabilities, market dynamics and competitive landscape to determine the most suitable positioning strategy within its strategic group. Regular monitoring of industry and adapting strategies accordingly is crucial to maintain an profitable position over time.
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