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Strategy
Ramon Casadesus-Masanell, Series Editor
Industry Analysis
RAMON CASADESUS-MASANELL
HARVARD BUSINESS SCHOOL
8101 | Published: January 31, 2014
+ INTERACTIVE ILLUSTRATIONS
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8101 | Core Reading: INDUSTRY ANALYSIS 2
This reading contains links to online interactive illustrations, denoted by the icon above. To access
these exercises, you will need a broadband Internet connection. Verify that your browser meets the
minimum technical requirements by visiting http://hbsp.harvard.edu/list.tech-specs.
Ramon Casadesus-Masanell, Herman C. Krannert Professor of Business Administration, Harvard
Business School, developed this Core Reading with the assistance of writer R. David Seabrook.
Copyright 2014 Harvard Business School Publishing Corporation. All rights reserved. To order copies or request permission to reproduce
materials (including posting on academic sites) call 1-800-545-7685 or go to http://www.hbsp.harvard.edu.
Table of Contents
1 Introduction ……………………………………………………………………………………………………3
2 Essential Reading ……………………………………………………………………………………………4
2.1 The Five Forces Framework ……………………………………………………………………..4
2.2 The Methodology of Five Forces Analysis ……………………………………………….9
The Threat of New Entrants……………………………………………………………………..9
The Bargaining Power of Suppliers ……………………………………………………… 11
The Bargaining Power of Buyers ………………………………………………………….. 13
The Threat of Substitutes …………………………………………………………………….. 14
Rivalry among Existing Competitors ……………………………………………………. 15
Extending the Analysis to Address Cooperation and Complements …… 17
2.3 Applying Industry Analysis …………………………………………………………………… 19
Turn Threats into Opportunities …………………………………………………………… 19
2.4 An Example of Performing and Applying Industry Analysis ………………… 20
Define the Industry……………………………………………………………………………….. 21
Identify the Players ………………………………………………………………………………. 23
Analyze the Players Influence on Profitability ……………………………………. 24
Test the Analysis…………………………………………………………………………………… 26
2.5 Develop a Way to Deal with the Industry Environment ………………………. 27
Exploit Industry Change ……………………………………………………………………….. 29
Leveraging Industry Analysis to Compete Over Time …………………………. 32
Explore Opportunities to Shape Industry Structure …………………………….. 32
2.6 Criticisms and Limitations …………………………………………………………………….. 33
Does the Five Forces Framework Adequately Analyze the Business
Environment? ……………………………………………………………………………………….. 33
Does Industry Analysis Explain Competitive Advantage? …………………… 34
Does Industry Analysis Help Companies Find Entirely New
Opportunities? ……………………………………………………………………………………… 34
2.7 Conclusion: The Business World Changes, but Industries Remain ………. 34
3 Supplemental Reading ………………………………………………………………………………… 35
3.1 How Much Does Industry Matter? …………………………………………………………. 35
4 Key Terms ……………………………………………………………………………………………………. 37
5 For Further Reading ……………………………………………………………………………………. 37
6 Endnotes ……………………………………………………………………………………………………… 38
7 Index ……………………………………………………………………………………………………………. 40
For the exclusive use of E. Wang, 2020.
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1 INTRODUCTION
o some people, the word industry seems old-fashioned. It conjures
up images of smokestacks and Dickensian textile mills. It feels out of
place in the world of Google and Zynga. Yet any organization that
produces something for others is part of an industry. Google competes in
the search advertising industry with Microsoft, Yahoo!, Ask, AOL, and Baidu.
Zynga competes in the online game industry with Tencent Holdings Ltd.,
Electronic Arts, and Activision Blizzard. Greenpeace competes in the
environmental protection industry with more than 40 other organizations.1
We define an industry as a group of firms producing products or services that are
perceived by customers as meeting the same needs. Apple Inc. competes in the smartphone
industry, as does Samsung.
Every industry exists in an industry environment, which comprises suppliers, customers,
and other firms, including those that may enter the industry and those that may offer either
substitute or complementary products. For example, the companies that manufacture multi-
touch screens and other components of smartphones are not part of the smartphone industry;
they are suppliers to the industry. The retail outlets that sell smartphones to end users are the
industrys customers. Potential entrants are firms that may be considering entering the
smartphone industry. Firms offering a substitute product include the makers of simpler
dumb phones and tablets. Firms offering complementary products include wireless carriers,
whose service is used with smartphones. Collectively, we will refer to the firms in the industry
and in the industry environment as market participants.
Industry analysis is a tool for understanding how profits are distributed among market
participants. A firms profitability depends partly on the intensity of competition from rivals
in the industry and partly on the influence of players in the industry environment. All those
market participants engage in a continual struggle for a share of industry profits.a
Industry analysis is an essential tool in strategy development because it helps a company
understand how its industry structure influences profits. As we discussed in the introductory
reading of this Core Curriculum series, a strategy is an integrated set of choices that positions
the firm in its industry in a way that generates superior financial returns over the long run.
Strategists need to employ industry analysis so that they can understand the economic forces
at work and defend the firm from negative developments in the industry and its environment
while creating or exploiting the profit opportunities that the industry presents.
Industry analysis is based on a fundamental principle of economics: People (or, in our case,
market participants) respond to incentives. If there are profits to be made, market participants
will try to appropriate them. If an organization doesnt have a plan for dealing with all the
players scrambling to increase their share of the profits, it doesnt have a strategy.
Managers, entrepreneurs, capital providers, investment bankers, financial analysts,
consultants, and even those making a career choice can benefit from industry analysis.
Managers can use it in the following ways:
To identify opportunities to increase profits
To discern threats to existing profits and develop ways to counter them
To decide whether to enter a market
a As we will see, firms offering complementary products compete for profits across industries.
T
8101 | Core Reading: INDUSTRY ANALYSIS 3
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To decide whether to exit a market
To position their firm to succeed in a given industry
To assess the effect of a major change (such as deregulation, new technology,
complements, demographic shifts)
To shape the industry environment2
Industry analysis applies to business, but also to any situation where organizations are
competing. In the humanitarian aid industry, the profits that is, the benefits from aid
donationsare distributed on the basis of the industrys structure. This distribution is affected
by the relative bargaining power of suppliers, the aid agencies, and their customers. Should
these customers be corrupt governments or powerful militias, such players could capture the
value of the aid intended for the distressed population.
There are typically six steps in analyzing an industry and applying the results of the
analysis:
1 Define the industry
2 Identify the players (the market participants)
3 Analyze the players influence on profitability
4 Test the analysis
5 Develop a way to deal with the industry environment
6 Analyze how the factors influencing profitability may change and the response
required.
In this reading we present the most widely used framework for analyzing an industry: the
Five Forces Framework developed by Harvard Business School Professor Michael Porter. We
then describe the applications of industry analysis. Next, using several real-world examples,
including Walmart, we work through the six steps listed above to demonstrate how to analyze
an industry and how to use that analysis to position a company for strategic advantagenow
and in the future. We also consider the Five Forces Framework relative to other strategy
development tools, discuss some of its shortcomings, and, in the Supplemental Reading,
address the question, How much does industry matter?
2 ESSENTIAL READING
2.1 The Five Forces Framework
b
In a Harvard Business Review article published in 1979, How Competitive Forces Shape
Strategy, Michael Porter coined the term five forces to refer to the market participants and
their influence in determining who gets the profits in an industry.3 (See Figure 1.) As Porter
points out, Managers tend to view competition too narrowly. Direct competitors, customers,
suppliers, potential entrants to the industry, and producers of substitute products are all
b In his classic 1980 book on strategy, titled Competitive Strategy, Michael Porter referred to his framework on
industry analysis as the five basic competitive forces that determine the ultimate profit potential in an
industry. The original framework is therefore typically referred to as The Five Forces Framework. While the
framework presented in this reading is modified from Porters original framework depicting the five forces, it will
nevertheless be referred to as The Five Forces Framework in this reading.
8101 | Core Reading: INDUSTRY ANALYSIS 4
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8101 | Core Reading: INDUSTRY ANALYSIS 5
FIGURE 1 Forces Governing Competition in an Industry
Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from The Five Competitive Forces that Shape Strategy
by Michael E. Porter, January 2008. Copyright 2008 by the Harvard Business School Publishing Corporation; all rights reserved.
competing for their share of the profits (later in this reading we augment the original Five
Forces Framework to add complements). Managers who fail to consider all market
participants put their firms at risk.
While many management fads have come and gone, the Five Forces Framework has
endured, in large part because of its foundations in economics. It allows managers to rise
above the details of economic modeling and avoid trawling though thousands of pages in
economics textbooks. The framework identifies the important factors affecting industry
profitability and helps strategists judge their relative influence.
The study of the economics of industries is called Industrial Organization (IO), sometimes
called the Harvard Tradition. Early work in this field emphasized empirical analysis such as
regression analysis and case studies. The results found relationships between structural
factors, such as concentration ratio (the extent to which a small group of firms dominates an
industry), barriers to entry, and measures of performance, such as profitability. Later work
relied more on formal economic models, particularly using game theory. Unfortunately, the
models are very sensitive to the specific assumptions used and therefore can be difficult to
apply.4
Porters important contribution was to distill the key findings from industrial organization
research into five forces that influence the profitability of an industry: the threat of new
entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of
substitutes, and rivalry among existing competitors. The strength of each force depends on
the economic characteristics of the industry.c, d
c The Five Forces Framework captures concepts both from classical microeconomic analysis and game theory.
The threat of substitutes, for example, derives from the influence of substitutes on the price elasticity of demand,
which affects pricing power. Another finding from microeconomics is that rivalry among existing competitors is
likely to be greater when fixed costs are high and marginal costs are low. When business is slow, such firms will be
prepared to cut price below average total cost.
d Game theory shows that developing a reputation for retaliating against new market entrants by lowering price
can help deter market entry. The Five Forces Framework represents such a reputation as a barrier to entry
that reduces the strength of the force of the threat of entry. Another result from game theory concerns a situation
where rivals have diverse approaches and personalities. This increases rivalry and reduces the probability of
cooperation.
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8101 | Core Reading: INDUSTRY ANALYSIS 6
How do the five forces influence profitability? Put simply, profitability is influenced by
willingness to pay, the price, and the cost. For example, powerful buyers can use their
negotiating strength to force industry prices down. They may also demand that industry
rivals increase the value of the products they sell, which will increase their costs. Similarly,
powerful suppliers will be able to charge higher prices, increasing the industrys costs and
reducing its profits.5
Using the interactive diagram shown below, you can click on the Up and Down arrows
to see how each force affects price, cost, and profit.
The Five Forces Framework is useful for many reasons. For one, it helps explain why
profitability varies by industry. Figure 2A shows that while the median profitability of U.S.
industries (measured by return on invested capital) was 14.3% from 1992 to 2006, the
profitability of the top 10% of industries was more than 25%. Meanwhile, the profitability of
the bottom 10% of industries was only 7%. Figure 2B shows that industries such as security
brokering and dealing and soft drinks had far higher levels of profitability than the hotel and
airline industries. Why? The Five Forces Framework implies that while the less-profitable
industries are subject to powerful forces that make it difficult for industry participants to
appropriate profits, such forces are muted in the more profitable industries.
Interactive Illustration 2 shows the forces at work in selected industries. It provides an
alternative view of industry profitability that is based on economic profit, which is a measure
of profit that includes all costs, including the opportunity cost of capital employed in the
business. You can click on the vertical bars representing the profitability of some of the
industries to see an illustration of how the five forces affect profitability in that industry.
In the next section, we explain how to evaluate the strength of the forces. But first, see the
sidebar Perils of Poor Industry Analysis: Global Crossing to learn why analyzing the
industry and its environment is so important.
INTERACTIVE ILLUSTRATION 1 Porters Forces Framework
Sources: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy”
by Michael E. Porter, January 2008. Copyright 2008 by the Harvard Business School Publishing Corporation; all rights reserved; adapted
and reprinted by permission of Harvard Business School Press. From Understanding Michael Porter: The Essential Guide to Competition and
Strategy by Joan Magretta. Boston, MA: 2012, p. 41. Copyright 2012 by the Harvard Business School Publishing Corporation; all rights
reserved.
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHKWuJ
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8101 | Core Reading: INDUSTRY ANALYSIS 7
FIGURE 2A Average Return on Invested Capital in U.S. Industries, 19922006
Source: Reprinted by permission of Harvard Business Review. Exhibit from The Five Competitive Forces that Shape Strategy by Michael E.
Porter, January 2008. Copyright 2008 by the Harvard Business School Publishing Corporation; all rights reserved.
FIGURE 2B Profitability of Selected U.S. Industries
Source: Reprinted by permission of Harvard Business Review. Exhibit from The Five Competitive Forces that Shape Strategy by Michael E.
Porter, January 2008. Copyright 2008 by the Harvard Business School Publishing Corporation; all rights reserved.
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8101 | Core Reading: INDUSTRY ANALYSIS 8
Perils of Poor Industry Analysis: Global Crossing
When an industrys underlying economics are crumbling, talented management may slow
the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial
brilliance.6 Warren Buffet
To see the importance of understanding the industry environment and economics, consider the
case of Global Crossing, described by Richard P. Rumelt in Good Strategy Bad Strategy: The
Difference and Why it Matters (Crown Business, 2011). The company was founded in 1997 to
provide a trans-Atlantic cable to carry telephone and data traffic. Using high-bandwidth optical
fiber, the company was able to sell capacity at less than half the price of existing competitors.
As Rumelt explains, After six months of operations, Global Crossing offered stock to the public,
and the resulting price valued the firm at an astounding $19 billion. Six months later it was
valued at $38 billion, more than the Ford Motor Company.7
Unfortunately, the company (and its investors) failed to conduct a basic analysis of the industry
environment. As Rumelt explains, the cable technology was not proprietary and data-carrying
capacity was a commodity. That meant that customers could easily switch from one supplier to
another, putting them in a powerful bargaining position. Furthermore, customers were price-
sensitive. Even worse, the threat of entry was high, and other companies were entering the
business, fueled by easy financing. High fixed costs but near-zero marginal costs (the cost to
carry one more piece of data) led to fierce price competition within the industry. As Rumelt
says, One struggles to imagine a worse industry structure.
As new entrants came into the market and industry competition increased, the price of fiber
capacity collapsed. Rumelt declared that the collapse of prices could have been foreseen by
anyone doing a simple Five Forces analysis.8
Global Crossing declared bankruptcy in January 2002.9
Sources: Ghemawat, Pankaj E., Strategy and the Business Landscape, 3rd, 2010. Printed and Electronically reproduced by permission of
Pearson Education, Inc., Upper Saddle River, New Jersey; adapted and reprinted by permission of Harvard Business Review. Exhibit from
“The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright 2008 by the Harvard Business
School Publishing Corporation; all rights reserved.
INTERACTIVE ILLUSTRATION 2
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8101 | Core Reading: INDUSTRY ANALYSIS 9
2.2 The Methodology of Five Forces Analysis
In this section, we explain how to conduct a Five Forces analysis. The best way to use Porters
framework is to focus not only on the forces, but also on the economic factors that underlie
them and how these factors might change. The first part of this description is based on a
teaching note Porter published in 2007.10 We then add an analysis of complements. Later, we
will demonstrate how to apply the analysis.
The Threat of New Entrants
Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from The Five Competitive Forces that Shape Strategy
by Michael E. Porter, January 2008. Copyright 2008 by the Harvard Business School Publishing Corporation; all rights reserved.
When the potential for profit in an industry is high, companies have a powerful incentive to
enter. New entrants increase competition, driving down prices and profit. The impact of
potential entrants on profit depends on how easy it is to enter the industry, which in turn
depends on barriers to entry. Strategists need to evaluate the size of the barriers to entry, and
how they may change, by evaluating the following factors:
Supply-side economies of scale. Economies of scale exist when a companys cost per
unit decreases as the quantity supplied increases. These economies come from the
ability to spread fixed costs over more units, greater efficiency, and a larger scale. They
give high-volume incumbents a cost advantage over smaller entrants. Supply-side
economies of scale present a barrier to entry because they force a potential entrant
either to enter at scale (which is risky) or to accept a cost disadvantage. Logistics
company DHL faced such a barrier when attempting to enter the U.S. logistics market
against incumbents UPS and FedEx. Research and development, production,
marketing, sales, and IT infrastructure can all exhibit economies of scale. Amazon.com
was able to develop a strong cloud-computing services business because its large and
early investment in IT infrastructurecoupled with a near zero marginal cost to serve
each additional customercreated significant economies of scale, which made it
difficult for others to compete. Economies of experience and economies of scope can
also create barriers to entry. The sales of IT consulting projects exhibit economies of
scope. Because one sales force can sell multiple projects to the same client, large
incumbents have an advantage in sales cost per project over new entrants. Not
surprisingly, the industry has a small number of very large, established competitors.
Demand-side benefits of scale. Better known as network effects, demand-side benefits
of scale exist when the value a buyer gets from a product increases as more people buy
that product. A classic example is eBay. The potential value to a customer from buying
or selling on eBay depends on the number of other buyers and sellers who use it.
Similarly, Facebook has withstood a well-financed challenge from Google Plus because
most users larger established networks make it more attractive to post on Facebook
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than on any competitor. The existence of network effects creates a barrier to entry, as
customers prefer larger incumbents.
Customer switching costs. When customers must incur costs to switch suppliers, their
incentive to do so is reduced. This can present a formidable barrier to entry. Switching
costs are not just monetary; they include the time required to learn how to use the new
product. Users of Microsoft Windows, for example, must not only buy new software
when they switch to a new operating system, they must also learn a new interface.
Companies with major investments in software may be reluctant to switch for fear that
new software may not work as advertised. Suppliers attempt to create switching costs
by locking in customers. For example, computer printer manufacturers design printer
cartridges that work only in their machines. Switching costs may be undermined by
new technologies or new standards. Cloud-based applications such as Google Drive
and Dropbox are platform-independent and so reduce or eliminate platform switching
costs for their users.
Capital requirements. A billion-dollar upfront investment requirement presents a larger
barrier to entrants than a requirement of a few hundred thousand dollars. Thats why
there are few entrants into the semiconductor manufacturing industry but many in the
restaurant business. Unrecoverable and risky investments such as product development
and advertising present the greatest barriers. Well-financed firms can enter any
industry, however, as long as the returns are attractive.
Incumbency advantages independent of size. Being first can be an advantage. Mining
companies that secure access to deposits close to the surface have an advantage over
latecomers who must dig deeper to extract resources. Technology inventors can use
patents to deter entrants. Investments that produce cumulative benefits, such as
branding or experience, present a barrier to companies that are just beginning to
compete.
Unequal access to distribution channels or supplier networks. Many people can make a
movie, but few can get their movie distributed to cinemas across the country.
Distribution channels with limited capacity present a barrier to entry because new
entrants must displace incumbents that may have contractual or other forms of
preferred access.
Restrictive government policy. Governments can restrict or prohibit new entrants.
Licensing requirements restrict entry by new liquor retailers. Patents provide legal
barriers to imitators. Foreign investment barriers can protect local businesses.
Regulations that are costly to comply with can deter new entrants. Governments
influence over market entry provides an incentive for both incumbents and potential
entrants to hire lobbyists to influence policy.
High barriers to exit. When it is easy to get out of an industry, firms will be more
willing to get in. Industries that require illiquid investments or commitment to long-
term contracts make exiting more difficult and therefore decrease the incentive to
enter. For example, pension cost liabilities in some labor-intensive industries make
exiting expensive.
The barriers to entry described above are primarily exogenous to the industry; that is, they
are due to the economic characteristics of the industry. Other barriers are endogenous, created
by industry participants to deter entrants. Strategists must also consider this game theory
aspect of market entry; that is, they must consider how an entrants decision may be
influenced by the anticipated response of the industry incumbents.
8101 | Core Reading: INDUSTRY ANALYSIS 10
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8101 | Core Reading: INDUSTRY ANALYSIS 11
New entrants may face additional barriers to entry if:
Incumbents have a reputation for responding vigorously against new entrants
Incumbents possess substantial resources to fight back
Incumbents are likely to cut prices to retain market share or because of excess capacity
Industry growth is slow, so newcomers must take share from incumbents
Incumbents with substantial resources can fight back by offering deep discounts or
launching expensive advertising campaigns. Potential entrants need to evaluate the probability
of provoking a strong response and develop a plan to deal with it.
It is not unusual for industries to exhibit multiple barriers to entry. (See Table 1.) For
example, eBay maintains an effective monopoly in its industry through not only network
effects but also economies of scale and capital requirements. A new entrant would also require
substantial capital to establish a brand that rivals that of eBay.
TABLE 1 Factors Affecting the Threat of New Entrants into an Industry
Barriers to Entry Example/Rationale
Supply-side economies of
scale, scope, or experience
FedEx has a lower cost per package than a potential new entrant because of its
large scale.
Demand-side benefits of scale eBay is more attractive to buyers than smaller competitors because of its large number of sellers (and sellers then also benefit from more buyers).
Customer switching costs Microsoft Windows users who may want to switch to another operating system must buy new software and learn how to use a new operating system.
Capital costs A large required capital commitment can deter new entrants.
Incumbency advantages Incumbent mining companies may have locked up the best reserves.
Unequal access to distribution
channels
Movie producers with a track record and established relationships have an
advantage in getting cinema distribution.
Restrictive government policy Patents can deter market entry by imitators.
High barriers to exit High labor severance costs can deter market entry.
Anticipated vigorous
incumbent response
The threat of price cuts or expensive advertising campaigns by deep-pocketed
incumbents can deter entry.
Slow industry growth Newcomers must take share from incumbents.
The Bargaining Power of Suppliers
Source: Adapted and reprinted by permission of Harvard
