FoBS: Week 2: Analyzing Industry Structure

Question 1

FoBS: Discuss Five Forces analysis

Answer 1

Is used to analyze why a firm is profitable.
There are five primary forces that inhibit/prohibit firms to be profitable.
-Threat of Entry
-Bargaining power of suppliers
-Intensity of rivalry
-Bargaining power of buyers
-Threat of substitutes

Question 2

FoBS: What perspective on economic rents uses five forces analysis?

Answer 2

Monopoly rents, where it is argued that industry structure matters most. 5 forces analysis looks at this structure.

Question 3

FoBS: Discuss 5 forces: Threat of Entry.

Answer 3

One could argue it is the most important of the five forces.
An industry is more attractive, when entry is more difficult.

Question 4

FoBS: When is entry in an industry less likely?

Answer 4

There are the following barriers to entry:

1) Entrant faces high sunk costs
2) Incumbents have a competitive advantage.
3) Entrant faces retaliation. (potential entrants are likely to be forced out of business by strategic (pricing) behavior of incumbents.

Question 5

FoBS: What are sunk costs?

Answer 5

Investments that cannot be recovered. e.g. research & development, building a specified factory…

Question 6

FoBS: Give some competitive advantages that are barriers to entry.

Answer 6

• Patents & licenses
• Pioneering brands (e.g. google search) => be carefull, think netscape
• pre-commitment contracts (e.g. distribution that locks out other players, e.g. airlines that ‘lock up’ gates)
• Large economies of scale: as output increases, average costs go down. There is a minimum efficient scale, the amount of output necessary to be competitive within the industry. the existing firms have this scale, thus an advantage over firms that still have to reach it.
• Steep learning curves (e.g. intel processors)
• others…

Question 7

FoBS: Discuss Threat of substitutes.

Answer 7

One of the five forces that analyses industry structure.
Substitute products are less of a threat when:
- Cross-price elasticity of demand is low.
- Switching costs are high (one-time costs customers incur when switching to a new product or service)

Question 8

FoBS: How do you determine the likelihood of retaliation of incumbent firms when you enter a market?

Answer 8

• Look at the excess capacity of incumbents (e.g. your plant runs at 60% capacity, if you lower prices you create more demand, but you can handle this with the other 40%. If you didn’t have the excess cap, customers would still go to your competition because you cant supply to them)
• Are there economies of scale or other cost advantages. This way a firm can go in a price war and sustain this price war longer then you.
• Are there substantial exit costs? A firm can fight harder and longer because those exit costs are higher then the losses they would have by cutting their prices.
• Do the incumbents have an aggressive reputation? (watch out for potential free-riding problems, because firms can look at each other to start the price war and thus no price war starts)

Question 9

FoBS: What is the cross-price elasticity of demand.

Answer 9

e.G. margarine and butter. If we raise the price of butter, how many people will switch over to margarine.
=> The ratio of the % change in demand for one good, given a 1% increase in price of another good.

Question 10

FoBS: Discuss Bargaining power of buyers.

Answer 10

How much power do buyers of your product have to argue about the price.

Question 11

FoBS: When do buyers of your product have less power?

Answer 11

1) Buyers are not concentrated
- Many potential buyers
- each accounts for a small fraction of sales
2) Buyers have few options
- Products are differentiated
- High switching costs
- buyer cannot backward integrate (i.e. make the product themselves)
3) Buyers are segmented (you can ask different prices for different buyer preferences)
- Price information is not widely available
- price discrimination possible (charge more for people who are willing to pay more e.g. flights in weekdays are more expensive because businesses that mainly use the weekday flights can pay more.)
- bundling possible

Question 12

FoBS: When do suppliers of your product have less power?

Answer 12

1) When sellers are not concentrated (no monopoly)
2) When firms have many alternatives
- Many substitutes for supplier’s products
- Firms face low switching costs
- Supplier cannot forward integrate
3) Sellers may not treat segments differently
- Price information is widely available
- Price discrimination is not possible