Analysis of the External Environment

LEARNING OBJECTIVES

Studying this chapter should provide you with the knowledge to:

1. Explain the importance of correctly identifying and choosing a firm’s industries and markets.
2. Identify and measure the five major forces that shape average firm profitability within industries to evaluate the overall attractiveness of an industry.
3. Discuss how understanding the five forces that shape industry competition is useful as a starting point for developing strategy.
4. Discuss situations in which entry into both attractive and unattractive industries follows “new thinking” rather than conventional wisdom.
5. Identify the factors in the general environment that affect firm and industry profitability.

George Jacob “G. J.” Mecherle founded the State Farm Mutual Automobile Insurance company in 1922. Mecherle’s company targeted small-town and rural farmers as policy hold- ers with a new value proposition: lower premiums. Insurers of the automobiles (still a rela- tively new innovation in the 1920s) based their policy premiums on payouts and accident claims by urban drivers. Mecherle realized that rural customers, his target, had a far different driving profile than auto owners in larger cities: They had far fewer opportunities for acci- dents and thefts. State Farm based its premiums on this lower incidence of risk.1 The com- pany expanded into the life insurance market in 1929 and opened a homeowners line in 1935. By 1942 the company had become the nation’s largest auto insurer, a title it still holds today.2 The Good Neighbor (taken from State Farm’s famous jingle written by Barry Manilow) wrote just shy of $42 billion worth of premiums in 2016, gobbling up 18 percent of the US market.
Importantly, State Farm’s $42 billion in the auto market represented 65 percent of its total Property and Casualty (P&C) revenue of almost $65 billion. The company’s 65,000 employees and 19,000 agents collected over $17 billion in homeowners premiums.3 The

17

company’s auto line is almost 8 times its life insurance revenue, and 60 times its sales of health insurance products.4 State Farm is the market leader in the auto and homeowner lines of business with over 81 million US policy holders and commands just over 10 percent of the market, 40 percent greater than Berkshire Hatha- way’s 6 percent and more than double Allstate’s 4.9 percent. For State Farm, P&C is the 800 lb. gorilla.
You might think of P&C insurance as a sleepy business with known risks and very slow growth. You’d be wrong. P&C insurers have seen, and continue to see, changes in their industry that require innovation and new business models. The rise of the “gig” economy and ridesharing companies like Uber or Lyft present one challenge. Most of these drivers carry passengers in their personal vehicles; when they pick up a rider, their car is no longer a “per- sonal” vehicle, it becomes a “livery” or commercial-use vehicle. Personal auto policies don’t cover livery uses, and drivers lose their coverage. Rideshare companies established bare-bones, low-cost policies to insure drivers, and State Farm created flexible insurance to provide better coverage. When a driver engages the App, State Farm’s policy (called a rider) continues their personal coverage while their vehicle is in “livery” mode. State Farm sur- vived, and profited from, the advent of ride sharing.
Services like Airbnb or Vacation Rental by Owner create simi- lar problems for State Farm policy holders. When an Airbnb guest arrives, the home ceases to be a personal dwelling and becomes a “short-term rental” used to make a profit. State Farm, like most other insurers, won’t cover most claims when a private dwelling gets used for most business activities. Homeowners insurance provides two types of coverage: property and liability. Coverage remains in force for most weather related property damage, but policies don’t cover damage caused by short-term renters (e.g., if guests host a party at the house that ruins furniture or floors). Personal liability—say a guest slips on the stairs, breaks a leg, and sues the homeowner for medical costs—also falls outside most policies, leaving the renter, or host, on the hook for costs. To date, State Farm has not developed a short-term rental policy to respond to these changes.5
The rise of the gig or sharing economy signaled changes in how policy holders (customers) behave. Climate change repre- sents another challenge for P&C insurers. Rising oceans mean that waterfront properties, and coastal cities in general, face greater risk of weather-related damage. In humid climates, ris- ing average temperatures spawn more powerful hurricanes,

tornadoes, and typhoons. In dry climates, warmer air increases the risk of brush and forest fires. The net result for State Farm: greater risk of property damage, both in the number of prop- erties damaged and higher claim amounts. State Farm, and all property insurers, continue to struggle with how to respond. For example, in 2018 California experienced the worst fire in the state’s history—the Mendocino Complex Fire—and 16 other fires that caused extensive property damage and loss of life.6 For 2017 and 2018, loss claims for these wildfires exceeded $23 billion. Some insurers refuse to cover at-risk homes, while others have seen the claims rise by 20 percent.7 Strategy makers at State Farm have to decide more than just prices for coverage; they have to determine whether or not to compete in an increasingly risky homeowners market.
As described in Chapter 1, strategy involves crafting a plan to create competitive advantage—and superior profitability—in par- ticular markets. This plan, however, is shaped by the landscape in which the firm competes. A firm’s external environment provides both opportunities—ways of taking advantage of conditions in the environment to become more profitable—and threats—con- ditions in the competitive environment that endanger the profit- ability of the firm.8 Successful firms have a deep understanding of their environment and constantly scan the horizon to see oppor- tunities and threats as they emerge.9
One of the key threats a strategist must understand and cope with is the environment in which their firm operates. In this chapter you’ll learn about the forces that shape that envi- ronment, from the specific industry the firm competes in to the larger, macroeconomic environment of competition. State Farm competes in what has traditionally been a very stable industry; however, changes among its customers, suppliers, competitors, potential entrants, and substitute products all combine to cre- ate turbulence in its markets. Together, all five forces define an industry’s structure and shape the competitive interactions—and profitability—of companies within that industry. Even though industries might appear to differ significantly, the principles that determine the underlying drivers of profitability are often the same. Outside forces, like a changing climate, help determine the ultimate attractiveness of industries such as homeowners insur- ance. This chapter will help you to recognize the major threats and opportunities that make up the competitive landscape, both the industry forces and general macroeconomic forces that drive industry attractiveness—and profitability.

As described in Chapter 1, strategy involves crafting a plan to create competitive advantage— and superior profitability—in particular markets. This plan, however, is shaped by the landscape in which the firm competes. A firm’s external environment provides both opportunities—ways of taking advantage of conditions in the environment to become more profitable—and threats— conditions in the competitive environment that endanger the profitability of the firm.10 Suc- cessful firms have a deep understanding of their environment and constantly scan the horizon to see opportunities and threats as they emerge.11
One of the key threats a strategist must understand and cope with is competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s direct

competitors. Nokia was so focused on Microsoft as its key competitor in the 3G operating system industry, and Motorola and Ericsson as its cell phone competitors, that it failed to effectively prepare for Apple’s entry into the industry. Competition for profits goes beyond established industry competitors to include four other forces that shape industry attractiveness and profit- ability: customers, suppliers, potential entrants, and substitute products. Together, all five forces define an industry’s structure and shape the competitive interactions—and profitability—of companies within that industry. Even though industries might appear to differ significantly, the principles that determine the underlying drivers of profitability are often the same. The global cell phone industry, for instance, appears to have nothing in common with the highly-profitable soft drink industry or the low-cost airline industry (i.e., Southwest and JetBlue). But to under- stand industry competition and profitability in these and other industries we must analyze the same five forces.
This chapter will help you to recognize the major threats and opportunities that make up the competitive landscape, both the industry forces and general macroeconomic forces that drive industry attractiveness—and profitability.

Determining the Right Landscape: Defining a Firm’s Industry
The first strategic decision that most firms must make is to select the industry, and markets, in which it will compete. The Strategy in Practice feature discusses the US government’s clas- sification of industries.
A firm’s industry also determines which customers and which competitors will be part of the firm’s landscape. The landscape is typically defined by: (1) the industry (or indus- tries) in which a firm competes, and (2) the product and geographic markets within that industry that the firm targets. For example, Nokia competes primarily in the cellular tele- phone manufacturing and operating system industries. Within the cellular telephone man- ufacturing industry, Nokia targets multiple product markets by selling a range of handsets, from high-end smartphones to inexpensive basic phones. The company also targets multiple geographic markets, focusing mainly on Europe and developing economies in the Middle East and Africa.
Be careful about assuming that it is obvious which industry a company competes in. For example, it seems obvious that Barnes & Noble competes in the book retailing industry and Microsoft competes in the computer software industry. However, it may be less obvious that those aren’t their only industries. In addition to operating systems, Microsoft also makes the X-Box gaming system, so it competes in the gaming console industry as well as the PC operating system industry. Barnes & Noble sells an e-reader, the Nook, that combines electronic books with computer hardware. Amazon.com, Barnes & Nobles’ main book retailing competitor, not only sells books and the Kindle e-Reader, but also sells web services competing with Microsoft and a wide range of products online as a discount retailer competing with Walmart. Firms must choose which markets to compete in, with many large firms choosing to compete in several at the same time.
If managers do not properly define and understand their industry, they may be vulner- able to unseen competitors. For example, Nokia defined itself primarily as a mobile handset manufacturer. As a result, managers failed to see computer hardware companies like Apple and web search companies like Google becoming potential competitors—or potential partners. (Nokia now uses Google’s Android operating system on its smartphones.) Their focus on pre- venting Microsoft from creating a dominant position in the mobile operating system industry caused them to overlook Apple, a company that has consistently been the leader in innovative,

Strategy in Practice
How the US Government Defines Industries
One tool that helps to define industries is the North American Industry Classification System (NAICS), a series of codes generated by the US government.12 These codes (formerly referred to as SIC codes, for Standard Industrial Classification) vary from two to seven digits, becoming more narrow with increasing numbers of digits.
Table 2.1 provides the NAICS codes for State Farm. At the high- est level the company competes in the Finance and Insurance sec- tor, which includes banking, investment, and insurance companies. It’s a broad industry, but the three-digit code narrows State Farm’s industry to insurance. The four-digit level describes the extent of State Farm’s business model. The five-digit level captures the com- pany’s different product lines and the six-digit level provides more detail about its casualty and property lines.

NAICS codes can be useful not just for helping to define an industry but also for determining who the primary competitors and stakeholders are, although in fast-changing industries, the NAICS can sometimes lag behind changing technologies or changing cus- tomer demands. As we’ve seen, State Farm has to figure out a new segment of buyers, people sharing their cars and homes with oth- ers, which is not yet reflected in the NAICS lines of business.
The choice of industries is important because not all industries are created equal. The profits of an average firm in some industries are substantially higher than profits of an average firm in other indus- tries. Figure 2.1 shows the return on equity for a variety of industries over a ten-year period. As you can see, the industry in which a firm competes has a direct bearing on the profits earned by that firm.

NAICS Codes for State Farm

Code Classification
52 Finance and Insurance
524 Insurance Carriers and Related Activities
5241 Insurance Carriers
52411 Direct Life, Health, and Medical Insurance Carriers
52412 Direct Insurance (except Life, Health, and Medical) Carriers
524126 Direct Property and Casualty Insurance
5242 Agencies, Brokerages and Other Insurance Activities
52421 Insurance Agencies and Brokerages

Varying Profitabilty of US Industries, 2018
60%

50%

40%

30%

20%

10%

0%

–10%

FIGURE 2.1 Varying Attractiveness of US Industries, 2018
Source: Data from various sources, compiled by Aswan Damodoran, NYU Stern School of Business. Available at http:// pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html.

user-friendly operating systems for a variety of platforms.13 At the time Apple didn’t make phones, while Microsoft had announced plans to start making them. Because of how Nokia defined their industry, it was easy for them to overlook Apple, a non-phone manufacturer.
Truly understanding an industry often begins by taking a customer-oriented view. Rather than identifying the industry based on the product or service they produce (such as cell phone handsets), firms should think carefully about the job that products do for customers. What need does a product fill? Understanding customer needs can be very helpful in defining the boundaries of an industry. If two firms have products that do the same job for customers— that meet similar customer needs—then those two firms can be considered part of the same industry. For instance, companies that meet the need for communication by manufacturing mobile handsets, as opposed to mobile ham radios (long-range walkie talkies), compete in the same industry.14 In the case of cell phones, changing customer needs broadened the bound- aries of the industry, from primarily manufacturing hardware to including mobile operating sys- tems and applications that allowed phones to do far more jobs for customers than just place a phone call. This led to new competitors for Nokia, including Apple and Google.

Five Forces that Shape Average Profitability Within Industries

Michael Porter, a well-known strategy professor at Harvard, identified five forces that shape the profit-making potential of the average firm in an industry. As shown in Figure 2.2, those five forces are (1) rivalry, (2) buyer power, (3) supplier power, (4) threat of new entrants, and
(5) threat of substitute products. The strength of each of these five forces (known as Porter’s five forces15) varies widely from industry to industry. For instance, in the semiconductor industry, the threat of substitutes is almost nonexistent, while in the carbonated soft drink industry it is a significant threat. A careful analysis of the five forces is a powerful way for firms to discover the threats and opportunities in their environments. We provide a tool at the end of this chap- ter to help you conduct a careful analysis of an industry’s five forces.
There are three basic steps involved in using the five forces analysis tool:
• Step 1: Identify the specific factors relevant to each of the five major forces. We describe the factors that contribute to each of the five forces in the next five sections of this chapter.
• Step 2: Analyze the strength of each force. To what extent is it shaping the industry’s attractiveness? The appendix at the end of the book lists several sources where you might find the data you need to analyze each of the five forces.
• Step 3: Estimate the overall strength of the combined five forces to determine the general
attractiveness of the industry, the profit potential for an average firm in the industry.
Instructions for steps 2 and 3 are at the end of the chapter. Step 1, the factors relevant to each of the five forces, is discussed next.

Rivalry: Competition Among Established Companies
Competition in an industry is sometimes referred to as war, with each company deploying as many weapons in its arsenal as possible to gain greater profits. Because there are typically a lim- ited number of buyers, each firm’s profits often come at the expense of other firms in the industry. Each move by a firm provokes countermoves among competitors, resulting in a constantly shift- ing competitive landscape populated by winners and losers. (Chapter 11 explores how successful firms manage that shifting landscape by planning for the countermoves of their rivals.)
Firms’ moves and countermoves can take many forms, including sales and promotions, better quality or service, a wider variety of products, or lower prices. Not surprisingly, these types of moves increase rivalry—the intensity with which companies compete with each other

rivalry Competition among firms within an industry. Typically this involves firms putting pressure on each other and limiting
each other’s profit potential by attempting to gain profits and/or market share.
substitute A product that is fundamentally different yet serves the same function or purpose as another product.
threats Conditions in the competitive environment that endanger the profitability
of a firm.
opportunities Ways of taking advantage of conditions in the environment to become more profitable.
attractiveness of an industry The degree to which an average firm in the industry can earn good profits.

FIGURE 2.2 Analyzing Major Threats and Opportunities: The Five Forces Industry Analysis Tool
Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 86, 1 (January 2008), pp. 80–86.

for customers—which tends to squeeze the profit margins of most firms in an industry. Rivalry among firms in an industry—for either rational or irrational reasons—is such an important determinant of profitability that it is shown at the center of Figure 2.2.
The following seven factors are critical to understanding the intensity of rivalry in an industry:

1. The number and size of competitors
2. Standardization of products
3. Costs to buyers of switching to another product
4. Growth in demand for products
5. Levels of unused production capacity
6. High fixed costs and highly perishable products
7. The difficulty for firms of leaving the industry

The Number and Relative Size of Competitors The more competitors there are in an industry, the more likely that one or more of them will take action to gain profits at the expense of others. Economists call an industry with a lot of competitors a fragmented industry. In a fragmented industry, it is difficult to keep track of the pricing and competitive moves of multiple players. The large number of firms responding to one another tend to create intense rivalry. The same is true of the relative sizes of competitors. If firms are approximately the same size, they tend to be able to respond, or retaliate, strongly to moves by rival firms.
Industries that are concentrated, as opposed to fragmented, have far fewer competitors and tend to be dominated by a few large firms. In these industries, rivalry is typically much less intense. Smaller competitors do not have the capability to respond to actions taken by large firms, and the few large competitors are more aware of each other and less likely to risk actions that may result in price wars.

Relatively Standardized Products Differentiated products, ones that boast dif- ferent features or better quality, tend to engender loyalty in customers because they meet

customer needs in unique ways. When products are standardized, or commodity-like, buyers are less loyal to a particular brand and it is easier to convince them to switch brands. A rider may be fiercely loyal to his or her Harley-Davidson motorcycle, for example, but willing to buy several different brands of gas for the Harley. Firms that sell standardized products—manufactured prod- ucts or materials that are interchangeable regardless of who makes them, like bolts and nuts, rubber, plastics, or commodities such as coal, crude oil, salt, or sugar—often have to compete by offering sales, rebates, or lowering prices. Price wars increase rivalry and decrease profits.

Low Switching Costs for Buyers Switching costs include any cost to the customer for changing brands. Switching costs for buyers are related to the degree of product standardi- zation. For a computer user, changing operating system or word processing software would entail considerable switching costs because the user would need to (1) convert files to the new software, and (2) learn how to use the new software. Switching from an iPod to another MP3 player might require music lovers to move all of their music files from iTunes to a different music software. In contrast, most of us can change our brand of gum or candy bar without any switching costs. The lower the switching costs, the easier it is for competitors to poach cus- tomers, thereby increasing industry rivalry.
Switching costs are a fundamental part of not just rivalry but also the other four forces:

1. Buyer power: If customers, or buyers, can easily switch firms, then buyers have increased power.
2. Supplier power: If firms can’t switch suppliers easily, then suppliers have increased power.
3. New entrants: If buyers can easily switch to new companies attempting to enter the industry, there is a greater threat of new entrants.
4. Substitutes: If buyers can switch to substitute products without much difficulty, firms face an increased threat from those substitutes.

Slow Growth in Demand for Products or Services When demand is increasing rapidly, most firms can grow without taking existing customers from competitors. When growth slows, however, firms can become desperate. They may try to increase their sales volume by attracting customers from their competitors through sales promotions, price discounts, or other tactics.16 Of course, competitors then respond with their own sales promotions and price cuts, thereby increasing industry rivalry. Consider the flat-screen television industry. When large, flat-panel displays were first introduced, prices were high. They remained that way for years while industry growth exploded. As flat-panel manufacturers anticipated slower growth, from 18 percent in 2010 to 4 percent in the first half of 2011, they dropped prices by more than 25 percent in the last quarter of 2010 in a bid to gain what market share they could from their competitors.17

High Levels of Unused Production Capacity Unused production capacity is expensive. Firms typically try to produce at or near their full production capacity so that they can spread the fixed cost of factories, machinery, and other means of production across more units. In fact, they may try to produce more product than the market demands, in order to use their capacity completely. However, when more is produced than is demanded in the market, firms often have to drop their price or risk having unsold product. This has frequently been the case in the automobile industry. During an economic downturn, automakers offer price cuts, rebates, and special sales incentives to buyers so that they don’t have significant unused pro- duction capacity or lots of older-model cars left to sell when new ones are produced.

High Fixed Costs, Highly Perishable Products, High Storage Costs Indus- tries that produce or serve products in these three categories sometimes find themselves with a supply of products that they have to sell quickly or take large losses on. For example, airlines operate with high fixed costs. Most of the cost of a flight is in the airplane, the fuel, and the pilot and flight attendants. It is not in the cost of serving an additional passenger. The marginal

switching costs Barriers that help keep buyers using the same supplier by imposing extra costs for switching suppliers.

cost of adding an additional passenger is truly only peanuts (and a drink). If it appears that a scheduled flight is going to have few passengers, an airline may be tempted to discount steeply in order to fill as many seats as possible. The variable cost of an additional passenger is very little, so selling a seat for less would not cost the airline money, but leaving it empty would mean the airline has fewer passengers over whom to spread its fixed costs.
Firms that sell highly perishable products, such as fruits or vegetables, face similar prob- lems. As food nears the date when produce will spoil, grocery chains often steeply discount it rather than lose the sale completely. Products with high storage costs exhibit the same charac- teristics. If firms have an oversupply and are forced to store the product, they may discount the price to avoid storage costs. In all three cases, steep discounting leads to increased rivalry as competitors are forced to respond with discounts of their own or be left with losses while others recoup their production costs.

High Exit Barriers In some industries, companies don’t exit even when they aren’t making a lot of money. Most often, they stay because they have made investments in special- ized equipment that can’t be used in any other industry. For example, steel blast furnaces are very expensive and cannot be used in any industry other than steelmaking. If the firm exits the steel industry, its blast furnaces lose most of their value. Another barrier to exit is labor or government agreements that make it difficult to close a plant. Emotional ties to employees or a business can also lead to less than rational decisions by top management to stay in business.

supplier A firm that provides products that are inputs to another firm’s production process.

backward integration A firm purchases one or more of its suppliers in order to make a product itself rather than buying it from another firm.

Buyer Power: Bargaining Power and Price Sensitivity
When buyers have sufficient power, they can demand either lower prices or better products from their suppliers, thereby hurting average profitability of firms in the supplier industry. The two primary situations in which buyers have high power are when buyers hold a stronger bar- gaining position than sellers and when buyers are price-sensitive. The strength of a buyer’s bargaining power or price sensitivity can be affected by a number of factors. When firms under- stand what causes buyers to have power over their industry, they have a better chance of coun- tering that power.

Buyer Bargaining Power Four key factors influence the degree to which buyers have bargaining power over their suppliers. We already discussed two of these factors—buyers’ switching costs and demand—because they are also factors in rivalry among firms. The two remaining factors are the concentration and size of buyers and the threat that buyers can backward integrate:
• Number, or concentration, and size of buyers: Buyer concentration reflects the law of supply and demand. If there are few buyers but many sellers, then the sellers must compete more strongly for buyer business. Sellers in this situation are likely to give concessions to make the sale. Likewise, the larger the number of buyers, compared to sellers, the more likely sellers are to increase the level of competition in order to gain buyers’ business. For example, farmers, as suppliers to the frozen-food industry, are not very concentrated. The three largest farmers account for only about 1 percent of all food produced and sold. Frozen- food makers, however, are concentrated. The top four (Nestlé, Schwan, ConAgra, and H.J. Heinz) accounted for nearly half (48.6 percent) of total market share in their industry in 2010.18 This means that frozen-food manufacturers, as buyers, have a great deal of power over farmers. A farmer who needs the business of the big four frozen-food makers in order to sell this year’s crop may be willing to accept a lower price in order to secure their business.
• Credible threat of backward integration: In some cases, a buyer can exert pressure over suppliers by threatening them with backward integration, meaning they will make the product themselves. For example, one way Walmart keeps prices low for consumers is by threatening to expand its Sam’s Choice store brand products into additional categories if manufacturers of other branded products don’t meet Walmart’s pricing demands.

Buyer Price Sensitivity In general, when buyers are more price-sensitive, they are more likely to exert pressure on suppliers to keep prices low. Buyers exert pressure not just through price negotiation but also through more comparison shopping and a greater willing- ness to switch suppliers. Buyer price sensitivity tends to increase in the following situations:
• Buyers are struggling financially: When companies, or consumers, are struggling finan- cially, they are more likely to be price-conscious and to look for less expensive sources of supply. If many of an industry’s buyers are in the same situation, there is a cap on what suppliers can charge.
• Product is significant proportion of buyer’s costs: Buyers tend to care more about getting a good price when the product they are buying creates a large part of the costs of their own production (or their budget, if the buyers are the end consumers). If the product is only a small part of their cost structure, buyers are less likely to bother negotiating or comparison shopping. For instance, end consumers are less likely to do extensive comparison shopping for a gallon of milk than they are for a home or car. Likewise, auto manufacturers are less likely to pressure suppliers of electrical wiring for price cuts than suppliers of steel or engine components.
• Buyers purchase in large volumes: When buyers purchase in large volumes, they typically expect to get breaks in price. In essence, the buyer is taking a risk by being willing to buy large amounts at once rather than smaller amounts over time.
• Product doesn’t affect buyers’ performance very much: If a product is very important to the quality of the buyers’ end product, then buyers tend not to be very price conscious. For instance, when Nokia had the most innovative handsets on the market, many cellular phone carriers, like Verizon and T-Mobile, were willing to pay whatever Nokia charged in order to be able to offer Nokia phones to their customers. However, if suppliers’ prod- ucts don’t affect buyers’ quality or performance very much, then buyers are much more likely to be price conscious. For instance, the plastic casing on tablet or laptop computers doesn’t enhance the performance of the computers very much; it doesn’t drive sales to the end consumer. As a consequence, PC manufacturers are likely to shop around for price discounts on plastic casings in ways that they might not for the microprocessors that run the computers.
• Product doesn’t save buyers money: If a product saves buyers money, they tend not to be very price-conscious when purchasing it. These types of products can be anything from machinery in manufacturing industries that replaces highly skilled, costly labor to inexpensive, overseas labor that replaces more expensive labor or machinery in countries such as the United States. If a product does not save buyers money, however, buyers are as likely to be price conscious as they are with other types of products they buy.

Supplier Bargaining Power
The factors that increase the bargaining power of suppliers are very similar to those that increase the bargaining power of buyers. In this case, however, the firms are not customers but suppliers, those from whom your industry purchases inputs. When supplier industries have strong bargaining power, they can charge higher prices, which tends to decrease average profit- ability in a buyer’s industry. As firms understand the factors that give suppliers power, they may be able to make decisions that decrease that power.

Number, or Concentration, and Size of Suppliers As with buyer concentration, supplier concentration also follows the law of supply and demand. If there are few sellers but lots of buyers in an industry, then the buyers have to compete to get the products that they want, often paying higher prices to get sufficient supply. Likewise, the larger the number of sellers compared to the buyers, the less likely buyers are to pay the price that sellers are demanding.

forward integration A firm goes into the business of its former buyers, rather than continuing to sell to them.

barriers to entry The way organizations make it more difficult for potential entrants to get a foothold in the industry.

For instance, ARM, a designer of semiconductor chips for smartphones, has, for years, controlled upwards of 95 percent of the market for its product,19 resulting in a highly concen- trated supplier industry dominated by one large firm. As a consequence, Nokia, or any other smartphone handset manufacturer that wants a sufficient supply of chips, and wants the high- quality chips that won ARM its market share in the first place, has to buy from chip manufac- turers who license from ARM. ARM has sufficient power that it can, to a large degree, set the price for its product. Suppliers who charge more often squeeze the profits of buyers, who may not be able to pass additional costs through to their customers. In fact, ARM’s rise to power in the mobile semiconductor chip industry is a major contributor to Nokia’s current difficulties. Nokia cannot charge enough for its low-cost handsets to make a good profit after paying for expensive ARM chips.

Credible Threat of Forward Integration In some cases, a supplier can exert pressure over its buyers by threatening them with forward integration, doing what its buyers do, if the buyers don’t offer price concessions. A good example of this is Google and its decision to forward integrate into the smartphone handset industry by manufacturing its own phones.20 Google also licenses its Android operating system to other handset makers, such as HTC and Samsung. Google’s ability to forward integrate, even if they don’t sell many phones, gives Google power over those handset makers. When there is a credible threat of forward integration, buyers are often willing to take a cut in profit by paying higher prices, rather than risk losing the supply altogether and creating a new rival (if the supplier hasn’t already forward integrated).

Threat of New Entrants
As previously shown in Figure 2.1, not all industries are created equal. Industries in which the average firm is making good profits can often be targets, enticing firms from outside those industries to enter. Likewise, quickly growing industries are often attractive, which increases the incentive for outside firms to enter those industries. One of the important tasks for strate- gists is to identify firms that might enter their industries. New entrants pose a double hazard. First, they typically are anxious to gain market share.21 Unless the industry is growing quickly, that market share must come at the expense of existing firms. Second, new entrants bring new production capacity, which tends to drive prices down unless demand is growing faster than the increase in supply.
New entrants mean greater rivalry, so existing firms often try to discourage new entrants by building barriers to entry. The higher the barriers to entry, the more difficult it is for poten- tial entrants to get a foothold in the industry, and the more likely that they are to quit or choose to not enter in the first place. Likewise, incumbent firms, those already in the industry, often signal new entrants that they are likely to retaliate by slashing prices, increasing advertising, or other competitive moves that help the established firms hold on to their market share. If the threats of retaliation are perceived as credible, potential entrants might decide to stay away.
It is essential for firms to understand the barriers to entry that already exist in their industry and to consider ways of increasing them. Existing firms may also want to build new barriers. Firms that are considering going into an industry can use an analysis of the barriers to entry in the target industry to help them determine how likely they are to succeed if they attempt to enter.

Economies of Scale, Experience, or Learning These types of economies occur when the cost per unit of production (the cost for producing each individual product or service) decreases as a firm produces more. Typically, these economies come from mass manufacturing methods, discounts through purchasing in high volumes, employees becoming quicker and better at production, and being able to spread the fixed costs of production machinery, R&D, advertising, and marketing across more units.22 Chapter 4 will explore these three types of cost advantages in greater detail. In essence, lower costs allow the firm either to lower its price, perhaps in retaliation for a new firm entering the market, or to maintain its price while earning more profits than competitors.

When economies of scale, experience, or learning exist in an industry, new firms will be at a cost disadvantage. New firms are not likely to have as much market share as existing firms, so they will not produce as much and can’t achieve the same economies as existing firms. Some firms may not be able to lower their prices sufficiently to match incumbent firms’ prices. Other new entrants may match incumbent prices, but earn smaller profit margins than the incum- bents. The higher the economies of scale, the greater the barrier to entry and the easier it is for the larger incumbent to pose a credible threat of retaliation.
If conditions change so that cost savings from these economies become smaller, the barrier diminishes. For example, from the late 1980s until the early 2000s, the cell phone handset manufacturing industry possessed high economies of scale. Nokia produced millions of handsets per year during this time and had the lowest costs of its competitors. Conse- quently, the number of firms in the industry was relatively stable during this period. However, the invention of flexible manufacturing processes, coupled with the rise of low-cost, highly- skilled labor in China in the mid-2000s, lowered the cost savings that could be achieved from high levels of production and allowed thousands of new Shanzhai manufacturers to success- fully enter the industry.

Other Cost Advantages Not Related to Scale Incumbent firms might have cost advantages relative to new entrants for a variety of reasons besides economies of scale. These include the following:

1. Patents or proprietary technology, such as those that exist in the pharmaceutical industry
2. Better locations, a deterrent to firms wishing to enter markets where Starbucks is domi- nant, for example
3. Economies of scope, less expensive costs per unit created by bundling different types of products. For example, Procter & Gamble has low-cost marketing and distribution costs, compared to firms that manufacture only one type of product, because P&G ships dozens of different types of products to the same retailers. (See Chapter 4 for a more detailed explanation of economies of scope.)
4. Preferential access to critical resources, such as raw materials or access to distribution net- works. For example, Chinese makers of lithium ion batteries have government-protected access to sources of rare earth elements, raw materials that are necessary for battery pro- duction. In many industries, new entrants face high barriers in the cost of building a dealer network or recruiting retailers to sell their products. With a limited number of potential dealers and retailers, new entrants often find themselves having to cut prices, and profit margins as well, to secure access to distribution.
   As with economies of scale, it is important for firms to track whether barriers are rising or falling. An expiring patent or the advent of an innovative distribution channel, such as the Inter- net, has the potential to radically change the strength of barriers related to cost advantages.

Capital Requirements It costs money to enter a new industry. Not only do potential entrants often need capital to build a factory or store, but they may also have to invest in R&D to generate viable products, build inventory, undertake sufficient advertising and marketing to take market share from incumbent firms, and have sufficient cash on hand to cover customer credit. Anything that increases the start-up costs will reduce the pool of possible entrants. For instance, the computer semiconductor chip industry, dominated by Intel, makes a very com- plex product. New entrants would need to spend years of R&D before they had a viable prod- uct and could make their first sale. The high capital requirements needed for long periods of R&D limit the number of entrants to those with enough financial or other resources to enter. However, firms that already have made R&D investments in similar products, such as semi- conductor chips for mobile phones, could lower the capital costs associated with entering the computer semiconductor industry. It is likely no coincidence that ARM, the maker of mobile semiconductor chips, is one of only a few successful entrants into Intel’s industry in the last 30 or more years.

network effects Growth in demand for a firm’s product that results from a growth in the number of existing customers.

Network Effects In some industries, network effects increase the switching costs for cus- tomers, making it more difficult for new entrants to take business from incumbent firms. When network effects are in operation, the greater the number of people using products from a given firm, the greater the demand grows for that firm’s product. For example, the more people who use a particular social networking site, the more customers want to continue to use the site, and the more new customers are likely to try it. A new entrant wanting to compete with Facebook is at a distinct disadvantage, because most of their potential customers’ “friends” are likely to be on Facebook, making it less likely that they will be willing to switch to a new social media site. For new entrants to compete with a firm like Facebook they have to be innovative enough to attract large numbers of users quickly, creating their own network effect.

Government Policy Restrictions Finally, government policies may make it more difficult to enter a market or even restrict a market completely to new entrants. For instance, governments often raise the costs of entry by requiring bonding, licenses, insurance, or envi- ronmental studies before a firm can enter an industry. New entrants will have to use capital that might have been used for R&D, production, or advertising to meet those requirements. When competing across international borders, additional regulations, such as trade restric- tions and local content requirements, may be applied to try to limit foreign competition. In some industries, such as hairstyling, the requirements might be fairly minimal, but in others, such as oil refining, they can become so onerous that most new firms cannot overcome the barrier.

Threat of Substitute Products
A substitute is a product that is fundamentally different yet serves the same basic function or purpose as another product. One of the primary problems for the strategist in assessing substitutes is determining what is a substitute and what isn’t. It involves determining the boundaries of an industry, as we addressed earlier in the chapter, and then scanning other industries to find products that might serve the same basic functions. For instance, e-mail is a substitute for telephone messages, faxed documents, or documents delivered via the post office. All four are ways of delivering messages. Similarly, fruit juice is a substitute for any number of other drink products, including coffee, wine, and soda. Generally, something can be considered a substitute if it serves the same function, such as quenching thirst, but does so with a different set of characteristics. If the product has the same basic characteris- tics and is made using the same general set of inputs, it would be considered part of rivalry, rather than a substitute. For instance, competitor brands serving the same basic need, such as Apple’s iPhones and Samsung’s smartphones running Google’s Android operating system, are rivals, not substitutes.
In general, substitutes put downward pressure on the price that firms in an industry can charge. For instance, streaming video across the Internet is a substitute for watching movies in the theater. Even if you had the only movie theater in an area, you could not charge whatever price you wanted to. As your price rose, more customers would switch to streaming video. If the price difference is enough, customers will stream even though the quality is lower and they have to wait weeks or months before the movie leaves the theater and is available online. For some industries, such as newspapers, the low price of the substitute—in this case, free news on the Internet—can be disastrous, creating such a low cap on the prices they can charge that many firms go out of business. The factors that determine the intensity of a threat of substitutes include the awareness and availability of substitutes and their price and performance com- pared to an industry’s products.

Awareness and Availability Sometimes customers aren’t readily aware that substi- tutes exist. The threat increases when substitute products are well known. This is particularly true if there are strong brands among the substitute products. Likewise, if the substitute prod- uct is just as easy for customers to obtain as the industry’s products are, it is more of a threat. If the substitute is difficult to find or acquire, the threat is diminished.

Price and Performance A significant part of the customer decision to switch to substi- tutes will concern the price and performance trade-offs. As we discussed earlier in the chapter, customers are more likely to switch to a substitute if the costs of switching are low. The price of the substitute itself also factors into customers’ decisions. If substitutes are cheaper than products from another industry, the threat is higher. Likewise, if the performance of substitutes is similar or better, the threat is higher. The closer the substitute is in performance, the less flexible a seller can be with price. For instance, many newspapers have seen steep declines in circulation as Internet news has gained in quality. The Wall Street Journal, however, has not declined in circulation over the same time period because online substitutes for serious business news have not increased in quality nearly as fast as for other types of news.

Overall Industry Attractiveness
Understanding the five forces that shape industry competition is useful as a starting point for developing strategy. Indeed, managers often define competition too narrowly, as if it occurred only among direct competitors. Yet competition for profits goes beyond direct rivals to include buyers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interac- tion within an industry. Every company should know what the average profitability of its industry is and how that has been changing over time. The five forces help explain why industry profitabil- ity is what it is—and why it might be changing. Attractive (profitable) industries are those where firms have created power over buyers and suppliers, created barriers to entry to reduce the threat of new entrants, and minimized the threat of substitutes while keeping rivalry to a minimum. Even inefficient, relatively poorly run companies can earn superior profits under such conditions. At the other extreme are unattractive industries. Firms in these industries are consistently pressured by buyers and suppliers alike. They face high rivalry, easy entrance for new compet- itors, and many well-positioned substitute products. Under these conditions, only the most efficient, well-run companies are able to turn a profit. Each of the five forces can be analyzed to
determine how, and the degree to which, it contributes to industry attractiveness.
We provide a strategy tool at the end of this chapter for analyzing each force. After doing an analysis of each force, these can be combined to develop a detailed picture of what is driving the overall profitability—the attractiveness—of the industry.
Few industries will rate high (attractive) or low (unattractive) on all forces. A significant threat from just one or two of the five forces is often sufficient to destroy the attractiveness of an industry. For example, many firms in the auto industry have struggled to be profitable over the last decade. This industry, however, has relatively low buyer and supplier power, no real threat of substitutes, and a moderate threat of new entrants. Rivalry, however, has been fierce, with constant excess production capacity and price discounting. Sometimes, it only takes one of the five forces to be unattractive to make an industry struggle. When many of the five forces are unattractive, firms face great challenges maintaining profitability. However, under- standing each force and how it is influencing profitability helps managers know where to focus in dealing with those challenges. Moreover, a company strategist who understands that compe- tition extends well beyond existing rivals will perceive wider competitive threats and be better prepared to address them. At the same time, thinking comprehensively about an industry’s structure can uncover opportunities to improve performance on each of the five forces, thereby becoming the basis for distinct strategies that yield superior performance.
One thing to keep in mind is that the five forces are subject to change. Each of the five forces can be altered by actions taken by firms inside or outside the industry. For instance, Google built the Android operating system, even though it gives it away for free, to increase the number of suppliers for its search engine, thus decreasing the supplier power that Apple might have earned had it been able to dominate the smartphone industry. A good strategist always has her eye on actions and trends that might change any of the five forces in her industry. Not all of those trends come from actions taken by firms close to the industry. Some come from the general environment. These are discussed in the next section.

Where Should We Compete? New Thinking About the Five Forces and Industry Attractiveness
Strategists have long argued that where you compete is the starting point for strategic analysis. The traditional answer to this question has been to use the five forces model we just studied to compete in attractive (i.e., profitable) industries or markets characterized by high bargaining power over suppliers and buyers, low threats of substitutes or new entry, and low rivalry. This traditional argument is reflected in the recent best seller Playing to Win, by prominent strate- gists A. G. Lafley and Roger Martin, who argue, “Porter’s five forces help define the fundamental attractiveness of an industry and its individual segments.”23 We agree that the five forces model describes the kind of industry or market you’d like to create or compete in, and it remains an excellent model that firms all over the world use to keep tabs on the industry and markets they compete in and to get guidance about what tactical moves they can make to increase profit- ability in their industry.
Executives, however, have to choose markets to compete in before they enter. This is where new thinking turns the five forces a bit upside down. Traditionally, you would give executives the advice to enter industries or markets that are rated “attractive” by the five forces. But the success of their choice to enter is determined almost completely by the unique value the firm hopes to offer and the resources and capabilities (these concepts will be covered extensively in Chapter 3) it has to deliver that unique value. Thus, whether a market is attractive may depend more on what the entrant can offer to that market rather than the structural characteristics of the market. To use a popular idiom: “Beauty is in the eye of the beholder.” Or, in other words, unattractive markets according to traditional industry analysis may be quite attractive to the right kind of entrant.
By almost any measure of attractiveness, the automobile industry is not an attractive industry to enter. Entry barriers are enormous, bargaining power over customers is minimal, rivalry is high, and average profitability is quite low. No wonder there hasn’t been a success- ful US-based company entrant since Chrysler in 1925. Yet in 2008, during the Great Recession while the US government was bailing out GM and Chrysler to the tune of $80 billion24 Tesla, a California-based firm, entered anyway. They entered an unattractive industry at the depths of its unattractiveness—typically, a foolhardy strategic decision. Tesla entered the automo- bile market with the Roadster, a pricy, beautifully designed, battery electric (BEV) sports car. They followed with the Model S and Model X—both targeted at wealthy individuals with a pen- chant for fast cars and a desire to reduce carbon emissions and US dependence on foreign oil.25 Within nine years of entry, by February 2017, Tesla had generated a market value of more than
$44.6 billion—double that of Chrysler and closing in on the 114-year-old Ford26—all in an “unat- tractive” industry.
Where successful companies choose to compete doesn’t depend so much on the histor- ical profitability or structural attractiveness of the market. Rather, it is fundamentally tied to what unique value they can offer, what capabilities they have, and whether they can prevent imitation (all concepts covered more fully in Chapter 3). For industries that are not attractive from a five-forces perspective, successful entry requires offering a unique value proposition with unique resources and capabilities. If you use an approach that mimics what incumbents are doing, your profits will be poor—just like incumbents. Nucor entered the unattractive steel industry, but did so in a radically different way. It used Mini-Mill technology and sourced scrap steel, rather than the traditional enormous steel production plants using iron and coke as their raw materials. Nucor was, and is still, able to produce steel at a much lower cost and to be highly profitable at a time when many US steel manufacturers have gone out of business.27 Markets that are unattractive from a five-forces perspective can still be attractive to new entrants—but only when they offer unique value.

On the flip side, it is also important to understand that attractive markets from a five-forces perspective are typically unattractive for new entrants. In an article for Harvard Business Review (see “Strategies to Crack Well Guarded Markets”), we reported that, on average, new entrants into highly profitable (attractive) markets were 30 percent less profitable than new entrants into unattractive markets (i.e., in general, it is easier for new entrants to make money in unattractive industries than attractive ones).28 The reason? Barriers to entry made it difficult for the new entrant to establish itself. So, on average, an attractive market (from a five-forces perspective) is actually the least attractive market for a new entrant. But wait. We also found that when new entrants did achieve profitability in the most attractive markets, they were four times as profitable as the average profitable entrant elsewhere. For example, the beverage industry has historically been a high-profit industry (indeed one of the most profitable)—but one with high barriers to entry. So according to the logic we’ve been discussing, it should be an unattractive market for new entrants. Walmart, however, decided to enter anyway—offering consistently low prices with its Sam’s Choice brand. We won’t spell out exactly how Walmart did it because those barriers to entry are part of the Coca-Cola and Pepsi case that is a companion to this chapter. Suffice it to say that Walmart was able to overcome each element of the barriers to entry that Coca-Cola and Pepsi had painstakingly erected over decades. By figuring out how to circumvent the entry bar- riers, Walmart was able to grab almost 5 percent share in an attractive market, indeed in one of the most attractive markets from a five-forces perspective. The point is that if firms figure out how to circumvent the barriers to entry into an attractive market, it can be profitable even if they aren’t able to enter with a particularly unique value proposition (Sam’s Choice Cola isn’t all that unique). Finally, we’ve learned that industries as we’ve historically defined them (e.g., automobiles, medical equipment, computers, cell phones, etc.—think about the NAICS codes we covered at the beginning of this chapter) are becoming somewhat irrelevant as it relates to finding attrac- tive markets to compete in (it is not irrelevant to understanding the dynamics of an industry you are already in). In deciding where to compete (i.e., which markets to enter), it is helpful to be as specific as possible rather than using broad generalities such as industries as they have histor- ically been defined. In fact, as Harvard business professor Clayton Christensen has suggested, you compete at the “job to be done” level (if you truly understand the functional, emotional, and social needs of your customer segment, the task of offering unique value becomes much easier).29 Tesla started in the automobile industry by targeting wealthy individuals who loved fast cars but also had a desire to be green. Customers purchased a Tesla not just because it solved a functional need (transportation, rapid acceleration/speed) but also an emotional need (“I want a green world”) and a social need (“I want to be part of the Tesla community and want others to know about my social consciousness”). Now Tesla has added in-home battery charg- ing stations and roof-mounted solar panels for homes. So from a historical perspective, Tesla is now in the roofing segment of the home construction industry as well as being in the auto- mobile industry. One could say that Tesla is in the energy industry at a very high level—which is true. But it has expanded into roof tiles and battery-charging stations to do a particular job for a very specific segment of customers: provide a convenient one-stop shop for clean energy at home and on the road for individuals who want a green world.30 When the industry is defined at the “job to be done” level, it then makes it easier to identify what other companies are also
trying to do at that specific job (competitors) and what substitutes exist for that job.

How the General Environment Shapes Firm and Industry Profitability
To determine the landscape that a firm competes in, it isn’t enough to only understand the five forces that directly affect an industry. The general environment also needs to be understood, as it can affect firms in a variety of ways,31 including affecting the shape of each of the five indus- try forces. A simple way to think about the general environment is to break it down into eight

categories. Strategic managers in the best companies are focused on each of these categories, looking for trends that might lead to new opportunities or threats. This is illustrated in Figure 2.3:
• Complementary products or services
• Technological change
• General economic conditions
• Population demographics
• Ecological/natural environment
• Global competitive forces
• Political, legal, and regulatory forces
• Social/cultural forces
Developments in each of the eight categories shown in the outer ring have the potential to shape and change the general landscape for any specific industry. Each category can affect an industry’s dynamics, which are shown by the area within the center circle, altering any or all of the five forces. You should always keep in mind that an industry’s five forces are not static. The five forces are subject to change and may change, even radically, if elements of the general environment change. When you are examining the general environment, it is important, then, to not just get a picture of what things look like today but to analyze trends and the direction each category is headed toward tomorrow. Remember, as well, that this analysis is industry specific. You want to know how each of the eight categories is going to affect the industry you are studying, rather than how it might affect a single firm. Both levels of analysis can be useful. But at this stage you want to know how the general environment might affect the five forces, potentially giving you advance notice of what is going to change in your industry and a chance to plan accordingly.

THE GENERAL ENVIRONMENT

FIGURE 2.3 Trends in Opportunities and Threats in the General Environment

The relative importance of each of the general environmental factors differs from industry to industry. In the fast-food industry, social forces, such as a shift toward healthier eating, are likely to significantly alter the threat of substitutes, but technological change doesn’t play as large a role. In the motorcycle manufacturing industry, demographics play a key role, as many industrialized nations experience an upward trend in the average age of the population, but changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting in fewer people riding because of their age rather than a societal shift in the perception of motor- cycles. Managers need to develop a deep sense of which environmental factors are strategically relevant to their own industries.32 Managers need to understand not only which factors have the largest impact on their industry right now, but also which factors are likely to change in the future, so that they can adapt their firms’ strategies to changing conditions.

Complementary Products or Services
Complementary products or services are those that can be used in tandem with those in another industry. For example, video gaming hardware and software, or smartphone operating systems and Apps, are complementary sets of products. When two complements are used together, they are worth more than when they are used apart. Complementary pairs or groups (also called ecosystems) of products can be found in many places, not just in the technology sector.33 Gas stations and roads are complements to automobiles, and piping is a complemen- tary product to natural gas. Trends in complementary industries have the potential to radically alter—for better or worse—the landscape in which firms compete.
Take the rise of application software (Apps), for instance. In the 1990s, Microsoft created tools for software designers. By doing so, Microsoft lowered the barriers to entry in the appli- cation software industry, a complementary industry to operating systems. Apple made it even easier to enter the App industry by releasing segments of its operating system code, creating even more new entrants and sparking the rise of single-purpose, inexpensive Apps for mobile computing devices. Now, customers at Apple’s App store can choose from hundreds of thou- sands of Apps for their iPhones.
The number of new entrants in the App industry is actually increasing the barriers to entry in the smartphone operating system industry. It would be difficult for a new mobile operating system to come on the scene and compete with Apple or Android. Even powerful Microsoft has experienced challenges entering the mobile operating system business even though it had a head start over Apple and Google.34 For many industries, changes in complementary products are one of the most important trends to keep an eye on. Some consider them significant enough that they even refer to them as a sixth force among the five industry forces.35

Technological Change
Technological change within an industry has the potential to radically reshape a firm’s land- scape, and sometimes society with it. Technological changes can include new products, such as smartphones; new processes, such as hydraulic fracturing (fracking), which has dramatically increased the output of the natural gas industry; or new materials, such as lithium batteries, which make electric automobiles possible. In many industries, the pace of technological change has accelerated over the last couple of decades.36 Managers find it increasingly important to consistently scan the environment to locate potential new technologies that might affect their industries.37 Early adopters are often able to gain greater market share and earn higher profit margins than those who are late to adopt, suggesting the importance of incorporating new technologies early.
Not only can technology change the nature of rivalry in an industry by giving some firms an upper hand in gaining market share, but it can sometimes lower barriers to entry. For in- stance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such as steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new tech- nology for smelting steel called the electric arc oven allowed new firms, such as Nucor, to enter

complementary products or services Products or services that can be used in tandem with those from another industry.

the industry with only one-tenth the capital investment that would have been needed to start a traditional steel firm. Perhaps the technological change that has affected the threat of new entrants in the greatest number of industries in the last 20 years is the Internet. Some have sug- gested that the next giant wave of technology change, one we are in the middle of experiencing, is wireless communication, like smartphones, which allow individuals to connect to and from anywhere and anyone at any time; and the coming 5G wireless revolution, which promises to allow those connections to occur at speeds that truly allow connection to and from anything and anyone, at anytime, and from anywhere no matter how much data is being transmitted.38

General Economic Conditions
Changing macroeconomic forces can also have a large impact on industries. The state of an economy can affect a region or nation and, subsequently, the ability of the average firm in an industry to be profitable. Analyzing the economic environment typically involves measuring the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or deflation. The appendix provides a list of sources where you can find information on these eco- nomic indicators.

Economic Growth How quickly, or slowly, an economy is growing has a direct impact on most firms’ bottom line. Economic expansion tends to improve customer balance sheets, lower price sensitivity, and increase the growth rate in an industry, as customers purchase more, eas- ing rivalry. For example, a number of African nations, such as Nigeria and Kenya, have expe- rienced solid levels of economic growth in the last few years.39 As a consequence, a growing percentage of the population has sufficient disposable income to afford products like automo- biles and cell phones. Companies providing products like these in Africa have experienced a boom in customer demand.40 The reverse is also true. When an economy slows down, industry growth rates slow, customers are more price sensitive, and suppliers are also likely to be strug- gling and pursuing ways of increasing profits—at the expense of firms in your industry, if they have the power to do so.

Interest Rates Interest rates particularly affect rivalry by increasing or decreasing the demand for an industry’s products. This is particularly true for expensive items like housing, cars, and even education, which often require customers to take out loans to purchase. For example, the housing boom experienced in the United States and Europe in the early 2000s was fueled by low-interest-rate loans, sometimes below 4 percent, when the average mortgage interest rate in the previous decade had been above 6 percent. When interest rates are low, industry growth rates increase and rivalry decreases. When interest rates are high, the opposite can occur. In addition, interest rates affect the cost of capital. When interest rates are low, many firms can afford to invest in new assets. As interest rates increase, new investments become more difficult. As a result, firms sometimes engage in price wars as a strategy for gaining market share when rates are high, rather than investing in R&D and new product development.

Currency Exchange Rates Currency exchange rates reflect the value of one country’s currency in relation to the currency from another country. Exchange rates can have a large impact on the prices that customers pay for products from firms in other countries, directly affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss franc appreciated 65 percent against the US dollar, making Swiss products 65 percent more costly in the United States, even though the cost of production hadn’t changed at all. Nestlé, a Swiss firm, was particularly hard hit. It either had to decrease its profit margin to cover the extra cost or increase its prices substantially, risking fewer customers buying its products.

Inflation A significant, consistent rise in prices, known as inflation, can create many problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year (low

inflation), then next year that product will cost $1.02. If it is higher, though, say 30 percent, which is not unheard of around the world, the product would cost $1.30 next year and $1.63 the year after that, doubling the cost in three years. Inflation or deflation, if they are high enough, can make it hard for firms to plan investments. Inflation tends to decrease overall economic growth, increasing rivalry and possibly buyer and supplier power and the threat of substitutes. When firms can’t predict what price they will be able to get for a particular prod- uct, investments in new product development become riskier. When inflation is high, many industries experience increases in price competition, rather than development, as a means of gaining market share.

Demographic Forces
Demographic forces involve changes in the basic characteristics of a population, including changes in the overall number of people, the average age, the number of each gender or eth- nicity, or the income distribution of the population.41 Because demographic changes involve basic shifts in the product and geographic markets that firms target, demographic changes are always accompanied by opportunities and threats. Even though demographics often change slowly, they fundamentally reshape the landscape, so good strategic managers have a firm understanding of demographic trends. The appendix contains a list of readily available sources for demographic information. Some sources, such as the World Bank, contain hundreds of dif- ferent demographic indicators.
Over the last 50 years, the size of the world’s population has more than doubled, from around 3 billion to more than 7 billion people. Projections suggest that the Earth’s population could reach 9 billion by 2040.42 Each new individual is a potential new consumer, suggesting that growth rates of many industries will increase over time. However, increases in consump- tion resulting from population growth also mean that supplies of raw materials (such as the rare-earth metals terbium and europium currently used in flat-panel displays43) are likely to decrease. Furthermore, the world population isn’t spread evenly over all nations. The enor- mous populations of China and India account, to a large degree, for the number of firms that have set up operations in those countries.
The average age of the population within a nation can also have a tremendous effect on some industries. In Japan, for instance, more than 20 percent of the population is over age 65. In the United States, this won’t occur until around 2040.44 The robotics industry has already felt this shift. Japanese companies like Honda have invested tens of millions of dollars in robots for home use, including walk-assist robots that help seniors with weakened muscles remain ambulatory when they would otherwise need to use a wheelchair.45

Ecological/Natural Environment
The natural environment can also be a source of change for many industries. In some cases, this involves changes to the physical environment such as increasing shortages of key inputs like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas). More often, though, current trends in the natural environment involve changes in the public’s per- ception of how business affects the environment. From global warming to clean air and water, the public in many countries—including developing economies like China—are demanding that firms be more proactive in protecting the environment. Many firms have responded by implementing green initiatives. Although some of these may be for public relations purposes only many firms have established serious goals. For instance, Procter & Gamble has goals to use 30 percent renewable energy to power its plants by 2020. By 2014, 7.5 percent of its energy needs were already met by renewable energy. They have also promised to reduce their energy consumption, water usage, greenhouse gas emissions, and waste by 20 percent by 2020. They have already reduced them by 8 percent by 2014.46 If consumers truly care about the environment, then actions like these increase rivalry as competitors are forced to respond in kind.

Global Forces
Global forces also play a large role in shaping many industries. Over the last 50 years, as com- munications and transportation technologies have undergone a revolution, trade barriers among nations have fallen dramatically. Many countries, from South Korea and Taiwan, to China and India, to Brazil and South Africa, have enjoyed remarkable economic growth and a rising standard of living. These changes have caused firms from many countries to expand operations and begin producing and selling across national borders. We will examine global forces and strategies for capitalizing on them in greater detail in Chapter 9.

Political, Legal, and Regulatory Forces
Political, legal, and regulatory forces are those that arise from the use of government. When new laws are passed, they may alter the shape of an industry and influence the strategic actions that firms might take.47 For example, the federal Affordable Health Care Act, enacted in 2009, mandated that health insurance companies insure everyone, including those with preex- isting conditions. This changed the cost structure of the insurance and healthcare industries, resulting in consolidation and less rivalry, as inefficient firms either went out of business or were acquired by more viable firms. In the United States, following the Great Recession of 2008– 2009, the Federal Reserve required banks to keep larger amounts of cash on hand to cover potential mortgage-related losses. One consequence of this regulation was less lending to small businesses, erecting entry barriers in many industries and changing the nature of rivalry in industries with many small firms.
Because political processes, laws, and regulations have the potential to shape and con- strain industries, managers should analyze and understand the impact of new laws and regu- lations and decide how to respond. The Affordable Health Care Act, for example, required firms with over 50 employees to provide health insurance for their workers, or face fines. Because the law also provided for health insurance exchanges through which uninsured people could buy their own insurance, some firms dropped employee health insurance as a benefit. Their man- agers have determined that the fines their companies face would be cheaper than the current premiums for health insurance.
Of course, laws can provide opportunities as well as threats. For instance, laws in many countries and states in the United States that require electricity providers to obtain a percentage of their electricity from renewable sources have resulted in a boom in demand for wind tur- bines and solar panels. Because of the potentially far-ranging effect of laws and regulations, many firms and industries strategically lobby government in an attempt to influence the law- makers to enact legislation favorable to their industries.

Social/Cultural Forces
Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes are so fundamental that they often affect the other six general environmental forces, shaping the overall landscape in which firms compete. For instance, changing cultural norms about health have resulted in laws against sodas being sold in schools and lawsuits against fast-food retailers such as McDonald’s for marketing “unhealthy” food to children.
Like the other environmental forces, however, social forces can create opportunities if a firm happens to be among the first to act on changes in values and attitudes. For instance, Facebook helped to change social norms about connecting to friends and family. It reaped enormous profits for being among the first to capitalize on the change in social networking.
Social forces are different, sometimes radically so, in different countries. Firms that com- pete in a global industry must understand differences among consumers in each country they serve. For example, the collectivist orientation of many people in China results in a general belief that the well-being of the group is more important than that of the individual and a related norm of open information sharing.48 This open-sharing norm allows a greater acceptance of product knockoffs and software pirating than many people are comfortable with in countries that tend to have individualist orientations, such as the United States.

Summary
• One of the primary decisions that firms need to make is which industry, or environment, they are going to compete in. Defining a firm’s industry correctly is important because it helps managers to identify their competition. One tool for helping to define an industry is the NAICS codes produced by the US government.
• Not all industries are equally attractive. Five major forces determine the attractiveness of an industry, defined as the profitability of the average firm in the industry. These forces are rivalry, buyer power, sup- plier power, threat of new entrants, and threat of substitute products.
• Good managers develop a deep understanding of the effect of each of the Five Forces on industry attractiveness. Such an understanding allows them to take strategic action to influence the five forces in a positive way for their firm and industry. Misunderstanding the nature of the five forces can lead to decisions that destroy industry profitability.

• New thinking suggests that for potential entrants the conventional wisdom needs to be re-examined. Rather than suggesting that new entrants should always look for industries that are attractive, for new entrants who possess unique value, entering an unattractive industry can be much more profitable than entering an attractive industry. But if you don’t possess that unique value you can still enter attractive industries if you completely understand the barriers to entry and can overcome each one.
• Eight general environmental factors can affect the profit potential of a firm: complementary products or services; technological change; general economic conditions; demographic forces; the ecological/ natural environment; global forces; political, legal, and regulatory forces; and social/cultural forces. Changes in any of these eight factors can create additional opportunities and threats and often shape the five industry-specific forces.

Key Terms
attractiveness of an industry 21 backward integration 24 barriers to entry 26
complementary products or services 33

forward integration 26
network effects 28
opportunities 21
rivalry 21

substitute 21
supplier 24
switching costs 23
threats 21

Review Questions

1. Why is it important for a firm to accurately determine what indus- try it is in?
2. How should a firm decide what industry it is in?
3. What are the five major industry forces? How do they shape average profitability in an industry?
4. What factors determine the intensity of rivalry?
5. Which type of industry has more rivalry, fragmented or concen- trated, and why?
6. Explain what happens to buyer power when buyers have increased price sensitivity.
7. Explain what it means for suppliers to have a credible threat of for- ward integration.
8. What factors determine the intensity of the threat of new entrants?
9. What are substitutes? Can you name any substitutes for the laptop most of your classmates are using? What about substitutes for watch- ing your university play football on Saturdays?
10. Under what conditions does the traditional advice concerning entering attractive markets and staying away from unattractive ones

not hold? Besides the examples used in the book, can you think of any other examples?

11. Can you identify some of the eight general environmental factors that might be important for the personal care industries that Procter & Gamble participates in, such as shampoo, dish and laundry deter- gents, toothpaste, and cough medicine, to name a few? Please feel free to use the Internet to get more information about Procter & Gamble. The appendix also has a guide about how to gather information about the eight general environmental trends. If your professor assigns this question as part of a larger project, you may find the appendix to be very useful as a starting point.
12. How does each of the eight general environmental factors influ- ence industry profitability? Take your time in answering this one and examine how at least one general environmental factors affects each of the five forces (you can use a different environmental factor for each of the five forces).
13. What are the elements of a complete external analysis?

Application Exercises
Exercise 1: Practice evaluating the industry five forces using the strategy tools presented in this chapter and using the cola industry case included in your textbook.
Read the case, Coca-Cola, Pepsi, and the Shiking Landscape of the Carbonated Sok Drink Industry.

1. Use the strategy tool presented in this chapter, along with data from the case, to evaluate:
   a. The intensity of rivalry within the cola manufacturing industry (where Coca-Cola and Pepsi are prominent firms). Is rivalry high, medium, or low?
   b. The intensity of supplier power within the cola bottling industry (where Coca-Cola and Pepsi are prominent suppliers). Is supplier power high, medium, or low?
2. Where sufficient data aren’t available, use qualitative evidence to evaluate the strength of a particular factor. Whether there is sufficient data or not, fill in the explanation/data line of each strategy tool where the data can be found and/or a summary of your logic.
3. Which industry is likely to be more attractive: cola manufacturing or bottling? Why? Use your analysis to back up your claim.
   Exercise 2: Practice evaluating the five forces, using the strategy tools presented in this chapter.
4. Use either an industry that your professor assigns to you or pick an industry of your choice.
5. Use a five-forces tool that your professor assigns to you (or one of your choice) to evaluate that force within the industry you are

analyzing. Be prepared to either hand in your completed analysis, using the tools from Figures 2.3–2.9, or show and explain it in class.
Exercise 3: Analyze the effects of the general environment on an industry of your choice.

1. Identify an industry you would like to learn more about. Ideally, you should be able to gather sufficient information on this industry to thor- oughly analyze the impact of the general environment on industry profit- ability. Although information is available for a wide variety of industries, this exercise will be easier if you choose an industry that has been writ- ten about consistently in the business press. In order to manage the volume of data required for a thorough analysis, your instructor might want you to focus solely on the home country of the largest firms in the industry (unless most firms earn a majority of their profits from abroad).
2. Use data from a variety of sources, including those listed in the appendix, in your analysis.
3. Try to identify the major effects of each of the eight factors (com- plementary products; technological change; general economic con- ditions; demographic forces; ecological/natural environment forces; global forces; political, legal, and regulatory forces; and social/cultural forces) on industry profitability.
4. Identify and predict any short-term to medium-term changes in any of the eight factors that might alter average profitability in the industry. Address how those changes will affect industry profitability in the future.
5. As part of the analysis, consider how the general environmental factors may affect each of the five industry forces (rivalry, buyer power, supplier power, threat of new entrants, and threat of substitutes).

Strategy Tool
Evaluating Industry Attractiveness Using Porter’s Five Forces Model
Understanding the five forces and their effect on the landscape that a firm competes in is a cornerstone of successful strategic analysis. Figures 2.4 through 2.9 are general analytical tools used by a number of Fortune 500 firms to evaluate the intensity of the five forces in an industry, either their own or one they are thinking about entering.48 These tools essentially help to quantify the ideas that we have already discussed in this chapter. In practice, top management often implicitly understands the dynamics of the five forces and might not personally use the tools presented here to map out the strength of each force and its overall effect on industry profitability. However, a number of For- tune 500 firms use these tools in their strategic planning departments to provide rigor to the strategic analyses and recommendations they present to top management. Although the tools might appear compli- cated, they distill the concepts from this chapter, allowing a relatively simple, yet comprehensive and detailed analysis of the five forces.
You can look for the data to complete these analysis tools in the sources listed in the appendix at the end of the book. Many of the

indicators in these analysis tools are objective numbers that you can obtain from various data sources. Others are more subjective; they require a logical argument for the level—low, medium, or high—that you choose. Even for more subjective indicators, however, data from various sources, for instance, articles in the business press, can take the guesswork out of doing a five-forces analysis.
To use the tools, for each separate item, put an X in the box that most accurately reflects the data you have gathered on your industry. For some boxes this is a range of data, for instance, 60 to 70 percent combined market share in the rivalry tool. If the correct number is anywhere within the range, put an X in the appropriate box. Cite your data source and/or explain the logic of your placement underneath each item. Your answer for some rows of boxes will be an average of more than one item. For instance, in the rivalry tool, the degree of industry standardization is the average of the four items below it.
After filling out each item, you will use the columns. Each column is assigned a number, 1 through 5. The columns will help you to find the correct answer for elements that have subsets to them. For instance, in the rivalry worksheet, you need to determine whether the degree of industry product standardization is low, medium, or high. The low,

medium, and high are encased in boxes, letting you know that this is a major concept, while the rows that are not in boxes will help determine the answer to the major concept. You also should notice that each row of boxes lines up with a number to the left. Each number is a major concept that you will use to determine the overall level of whichever force you are measuring, in this case, rivalry.
So, to determine the degree of standardization, you will use data and/or logic to put an X on the right answer (according to your data) for each of the four rows underneath Product Standardization. Now the columns come into play. Notice that each X that you placed falls under one of the columns. Each column has a number 1 through 5. Add up the placement of your Xs and then divide by the number of rows you were using (in this case there were four) to determine whether Product Standardization is high, medium, or low.
For example, if the answer, according to your data and/or logic, for the four rows under Product Standardization was (1) 5%–10%, (2) 50%, (3) Med, and (4) Med (each of these four items was in column 3), you would add these together (3+3+3+3), getting the number 12. You would then divide by the number of rows you were using (4) and end up with the number 3. That tells you to put an X in the row of boxes for Product Standardization that is in column 3, which would be medium. If the sum for the four rows doesn’t divide evenly by 4, round the decimal to the nearest whole number to see which column your X should go in. So, if instead of 12 our total was 15, we still would

divide by 4 rows, returning the number 3.75. This means we would put our X under column 4, meaning that Product Standardization is between medium and low.
To get the value for the overall intensity of each force, you will first add the values from the boxes with Xs in them (the major concepts, i.e., that have a row of boxes and a number next to them on the left side of the worksheet). The values come from the columns. So you would look down each column and see if a box has an X in it. If all the boxes are in Column 1, we would get a 6 for the rivalry worksheet because there are six major concepts. If all of the boxes were in column 5, we would get a 30 (6 x 5 = 30). After you have a total from adding the numbers of each box, which you obtained from the column it is in, you divide that num- ber into the number of major concepts (6 for rivalry) times the number of columns (5). For the rivalry worksheet, the total number possible is

30. Suppose the sum of all of the major concepts (found in the boxes, each one under a numbered column) for your analysis is 15. Using those two numbers, you have 30 divided by 15 = 2. You would then place your answer for the Overall Intensity of Rivalry (the row at the very bottom) under column 2, resulting in Rivalry that is relatively competitive (half- way between fiercely competitive and neutral). As with the subcon- cepts, always round your answer to the nearest whole number. If you got a 1.6 or a 2.4, you still would put your final X under column 2.
    And now that you know how to use the worksheets, go and do great work! FIGURE 2.4 Strategy Tool—Evaluating the Intensity of Rivalry (mark an × in the appropriate box for each factor)
31. Number and Relative Size of Competitors
    • Top 4 competitors’ combined industry market share
    Explanation/Source of Data:
32. Degree of Industry Product Standardization
    (take the average of the bullet points below)
    • Difference between competitors in price of similar products
    Explanation/Source of Data:
    • What % of industry’s products are sold at discount?
    Explanation/Source of Data:
    • Customers’ ability to recognize brands from industry
    Explanation/Source of Data:
    • Degree of switching costs
    Explanation/Source of Data:
33. Industry Growth Rate
    Explanation/Source of Data:
34. Unused Industry Production Capacity
    • % of industry wide production capacity currently in use
    Explanation/Source of Data:
35. Degree to which firms have high fixed costs or products have high storage costs or are perishable
    Explanation/Source of Data:
36. Extent of Exit Barriers
    Explanation/Source of Data:

1 2 3 4 5

<40% 40–50% 50–60% 60–70% >70%

High Med. Low

<2% 2–5% 5–10% 10–15% >15%

100% 75% 50% 25% 0%

Low Med. High

Low Med. High

<0% 0–1% 1–3% 3–5% >5%

<70% 70–80% 80–90% 90–100% >100%

High Med. Low

High Med. Low

Overall Intensity of Rivalry
(take the average of the major factors, items numbered 1 through 6)

Fiercely Competitive

Neutral

Mildly Competitive

FIGURE 2.5 Strategy Tool—Evaluating the Intensity of Buyer Power (mark an × in the appropriate box for each factor)

1. Buyer Industry Bargaining Power
   (take the average of the bullet points below)

1 2 3 4 5

• Buyer concentration (top 4 buyers as a % of total industry
volume sold to buyers)
Explanation/Source of Data: >70% 60–70% 50–60% 40–50% <40% • Buyer switching costs Explanation/Source of Data: Low Med. High • Demand (supplier industry growth rate) Explanation/Source of Data: <0% 0–1% 1–3% 3–5% >5%
• Possibility of buyer backward integration
Explanation/Source of Data: High Med. Low

2. Buyer Industry Price Sensitivity
   (take the average of the bullet points below)

• Profitability of average buyer
Explanation/Source of Data: <0% 0–5% 5–10% 10–15% >15%
• % of suppliers’ products which are sold at a discount
Explanation/Source of Data: >50% 30–50% 20–30% 5–20% <5% • Cost of supplier industry products as a % of total buyer costs Explanation/Source of Data: >50% 30–50% 15–30% 5–15% <5%
• Number of high volume purchases
Explanation/Source of Data: Most Half Few
• Impact of suppliers’ products on buyer quality/performance
Explanation/Source of Data: Low Med. High
• Degree to which supplier products save buyers money
Explanation/Source of Data: Low Med. High

Overall Intensity of Buyer Power
(take the average of the major factors, items 1 and 2, above)

High Power

Neutral

Low Power

FIGURE 2.6 Strategy Tool—Evaluating the Intensity of Supplier Power (mark an × in the appropriate box for each factor)

1. Number and Relative Size of Suppliers
   • Top 4 suppliers combined volume of total supplier industry sales to buyer industry
   Explanation/Source of Data:
2. Difficulty of Switching Suppliers
   (take the average of the bullet points below)

1 2 3 4 5

70% 60–70% 50–60% 40–50% <40%

High Med. Low

• Cost of switching suppliers as a % of total input costs (costs
include not just higher prices but all switching costs)
Explanation/Source of Data: >30% 20–30% 10–20% 5–10% >5%
• Difference between suppliers in price of similar products
Explanation/Source of Data: <2% 2–5% 5–10% 10–15% >5%
• Importance of suppliers’ brands to the end consumer
Explanation/Source of Data: High Med. Low

3. Possibility of Supplier Forward Integration
   Explanation/Source of Data:

Overall Intensity of Supplier Power
(take the average of the major factors, items 1 through 3, above)

High Power

Neutral

Low Power

FIGURE 2.7 Strategy Tool—Evaluating the Intensity Threat of New Entrants (mark an × in the appropriate box for each factor)

1. Incumbent Firms’ Cost Advantages
   (take the average of the bullet points below)

1 2 3 4 5

• Size of scales economies: measured as the slope of the scale
curve (see Chapter 4 for how to calculate this) >95% 85–95% 80–85% 70–80% >70%
Explanation/Source of Data:
• Size of investment in plant and machinery required to enter industry Small Med. Large
Explanation/Source of Data:
• Size of investment in marketing needed to match incumbent Small Med. Large
brand awareness
Explanation/Source of Data:
• Degree to which incumbents employ property rights, like Low Med. High
patents, to protect their market share
Explanation/Source of Data:
• Market share required to break even <5% 5–15% 15–30% 30–40% >40%
Explanation/Source of Data:

2. Other Incumbent Firm Advantages
   (take the average of the bullet points below)
   • Strength of incumbents’ brands (how influential in
   customer purchase decision?) Weak Neutral Strong
   Explanation/Source of Data:
   • Size of switching cost for incumbents’ customers Low Med. High
   Explanation/Source of Data:
   • Degree to which network effects affect buying decision
   Explanation/Source of Data: Low Med. High
   • Cost for entrants to comply with government regulations Low Med. High
   Explanation/Source of Data:
3. Additional Considerations
   (take the average of the bullet points below)
   • Profitability of average incumbent
   Explanation/Source of Data:
   • Incumbent industry growth rate
   Explanation/Source of Data:

Overall Threat of New Entrants

Low Med. High

15% 10–15% 5–10% 0–5% <0%

5% 3–5% 1–3% 0–1% <0%

(take the average of the major factors, items 1 through 3, above) High
Threat

Neutral Low
Threat

FIGURE 2.8 Strategy Tool—Evaluating the Intensity of the Threat of Substitutes (mark an × in the appropriate box of each factor)

1. Customer Awareness of Substitutes
   • Customers’ ability to recognize brands from substitute industry
   Explanation/Source of Data:
2. Availability of substitutes (compared to focal industry)
   Explanation/Source of Data:
3. Price of substitutes (compared to focal industry)
   Explanation/Source of Data:
4. Performance of substitutes (compared to focal industry)
   Explanation/Source of Data:
5. Customer switching costs
   Explanation/Source of Data:

Overall Threat of Substitutes

1 2 3 4 5

High Med. Low

Better Same Worse

Lower Same Higher

Better Same Worse

Low Med. High

(take the average of factors, items 1–5 above) High Power

Neutral Low
Power

FIGURE 2.9 Strategy Tool—Evaluating the Overall Attractiveness of an Industry (highlight the appropriate box for each factor)

1. Competitor Rivalry
2. Buyer Power
3. Supplier Power
4. Threat of New Entrants
5. Threat of Substitutes

1 2 3 4 5

High Med. Low

High Med. Low

High Med. Low

High Med. Low

High Med. Low

Overall Industry Attractiveness
(take the average of boxes, 1–5)

Low Avg. Profits

Med. Avg. Profits

High Avg.
Profits

References
1“State Farm Mutual Automobile Insurance Company History,” Funding Universe, 2002, http://www.fundinguniverse.com/company-histories
/state-farm-mutual-automobile-insurance-company-history/, accessed February 18, 2019.
2“Which Is the Biggest Car Insurance Company?” Online Auto Insurance, https://www.onlineautoinsurance.com/companies/which-biggest/, accessed January 24, 2019.
3A. Glenn, “Largest Homeowners Insurance Companies in the US,” Nerd Wallet (April 7, 2016), https://www.nerdwallet.com/blog/insurance
/top-home-insurance-companies/, accessed February 18, 2019.
4Financial and operating data taken from the company’s release of 2017 earnings, March 1, 2018, https://newsroom.statefarm.com/2017-
state-farm-financial-results/, accessed January 24, 2019.

5“Never Mind the Discount. Double Check Your State Farm Policy if You’re Hosting on Airbnb,” Sharing My Home, https://www.sharingmy home.com/state-farm-insurance-for-airbnb-hosts/, accessed February 18, 2019. As of this writing, we could not find evidence that State Farm offers any dedicated home sharing policy.
6R. Meyer, “Why the Wildfires of 2018 Have Been So Ferocious,” The Atlantic (August 10, 2018), https://www.theatlantic.com/ science/archive/2018/08/why-this-years-wildfires-have-been-so- ferocious/567215/, accessed February 18, 2019.
7N. Friedman, “California Homeowners Face Higher Prices for a Scarce Commodity: Wildfire Insurance,” The Wall Street Journal (February 10, 2019), https://www.wsj.com/articles/california-homeowners-face-higher- prices-for-a-scarce-commodity-wildfire-insurance-11549803600, accessed February 18, 2019.