Summary Industrial organization

FACILITATING PRACTICES

Firms can facilitate cooperative pricing through a number of practices, including:

 Price leadership

 Advance announcement of price changes

 Most favored customer clauses

 Uniform delivered prices

Price Leadership

Price leadership is a way to overcome the problem of coordinating on a focal equilibrium.

In price leadership, each firm gives up its pricing autonomy and cedes control over industry pricing to a single firm.

The price leader in the industry announces price changes ahead of others and others match the leader’s price. The

system of price leadership can break down if the leader does not retaliate if one of the follower firms defects.

Advance Announcement of Price Changes

In some markets, firms will publicly announce the prices they intend to charge in the future. These

preannouncements can benefit consumers, such as when cement makers announce prices weeks ahead of the

spring construction season, enabling contractors to bid on projects more intelligently. But advance announcements

can also facilitate price increases, much to the harm of consumers. Advance announcements of price changes

reduce the uncertainty that firms’ rivals will undercut them.

Advance announcement also allows the firms to roll back the changes if the rival deviates from cooperative pricing.

Most Favored Customer Clauses

A most favored customer clause is a provision in a sales contract that allows a buyer that it will pay the lowest price

the seller charges. While this clause appears to benefit the buyer (a price cut to any one customer lowers the price

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for the most favored customer) it also inhibits price competition. There are two basic types of most favored customer

clauses: contemporaneous and retroactive.

Uniform Delivered Prices

When transportation costs are significant, pricing could be either:

• Uniform FOB pricing or,

• Uniform delivered pricing

Under uniform FOB pricing, the seller quotes a price for pickup at the seller’s loading dock, and the buyer absorbs

the transportation charges for shipping from the seller’s plant to the buyer’s plant.

Whereas under uniform delivered pricing, the firm quotes a single delivered price for all buyers and absorbs any

transportation charges itself.

With uniform delivered pricing, the response to price cutting can be “local” and effective in deterring defection from

cooperative pricing.

Sutton’s Endogenous Sunk Costs

• Necessary to make sunk investments to acquire the necessary inputs from “outside”, but you also need to build a

brand with many positive associations from the “inside” (“endogenous sunk costs”)…

• You also decide “inside” how innovative you wish to be (R&D expenditures).

• Innovator dilemma: by innovating you destroy your current business, by not innovating you are vulnerable to

entrants with new ideas.

• Innovation usually deconcentrating (Geroski and Pomroy)

• Over time, a few big names and many niche players.

CHAPTER 8 INDUSTRY ANALYSIS

Industry analysis frameworks, such as Michael Porter’s five forces and Brandenberger and Nalebuff’s Value Net,

provide a structure that enables us to work through these complex economic issues.

An industry analysis based on such frameworks facilitates the following important tasks:

• Assessment of industry and firm performance.

• Identification of key factors affecting performance in vertical trading relationships and horizontal competitive

relationships.

• Determination of how changes in the business environment may affect performance.

• Identification of opportunities and threats in the business landscape(SWOT analysis).

Brandenberger and Nalebuff make a significant addition to the five-forces framework. They describe the firm’s

“Value Net,” which includes suppliers, distributors, and competitors.

Whereas Porter describes how suppliers, distributors, and competitors might destroy a firm’s profits, Brandenberger

and Nalebuff’s key insight is that these firms often enhance firm profits.

In other words, strategic analysis must account for both cooperation and competition.

There are 4 limits on the Porter’s analysis:

• The study ignore completely factors that could affect demand.

• Moreover it focuses on Industry instead on legal firms.

• It doesn’t include the government as a possible actor.

• It isn’t a qualitative analysis but is a quantitative.

PERFORMING A FIVE-FORCES ANALYSIS

Michael Porter’s Five-Forces framework identifies the economic forces that affect industry profits.

The five forces are:

• Internal rivalry

• Entry

• Substitute and complementary products

• Supplier power

• Buyer power

1. Internal Rivalry

Internal rivalry refers to the competition for market share among the firms in the industry. Thus, an analysis of internal

rivalry must begin by defining the market. That firms may compete on both price and nonprice dimensions, price

competition erodes the price cost margin and profitability.

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Each of the following conditions tends to heat up price competition:

• There are many sellers in the market. The theory of oligopoly predicts that prices are lower when there are

more firms in the market.

• The industry is stagnant or declining. Firms cannot easily expand their own output without stealing from

competitors.

• Some firms have cost-advantage over others. Firms with lower costs usually have lower profit-maximizing

prices. Low-cost firms may also reason that if they cut prices, their high-cost rivals may exit.

• Some firms have excess capacity. Firms with excess capacity may be under pressure to boost sales and

often can rapidly expand output to steal business from rivals.

• Products are undifferentiated/buyers have low switching costs, firms believe that price reductions will

generate substantial increases in market share.

• There are strong exit barriers. This condition can prolong price wars as firms struggle to survive instead of

exiting.

• There is high industry price elasticity of demand. If industry demand is very price sensitive, then price

cutting does not harm the industry nearly as much as when consumers have inelastic industry demand.

• Prices and terms of sales are unobservable/prices cannot be adjusted quickly

2. Entry

Entry erodes incumbents’ profits in two ways. First, entrants divide market demand among more sellers. Second,

entrants decrease market concentration and heat up internal rivalry. Some entry barriers are exogenous, whereas

others are endogenous.

Each of the following tends to affect the threat of entry:

• Production entails significant economies of sales. The entrant must achieve a substantial market share to

reach minimum efficient scale, and if it does not, it may be at a significant cost disadvantage.

• Government protection of incumbents. Laws may favor some firms over others.

• Consumers highly value reputation/consumers are brand loyal. Entrants must invest heavily to establish a

strong reputation and brand awareness.

• Access of entrants to key inputs. Patents, unique locations, know-how, raw material, distribution network, and

so forth can all be barriers to entry.

• Experience curve. A steep experience curve puts entrants at a cost disadvantage.

• Network externalities. This gives an advantage to incumbents with a large installed base.

• Expectations about post entry competition. Do incumbents have a reputation for predatory pricing in the

face of entry?

Substitutes and Complements

Substitutes erode profits in the same way as entrants by stealing business and intensifying internal rivalry, whereas

complements boost the demand for the product in question.

Factors to consider when assessing substitutes and complements include:

• Availability of close substitutes and/or complements. Consider product performance characteristics when

identifying substitutes and complements.

• Price-value characteristics of substitutes/complements. Many new products may be weak substitutes or

complements, but may gain strength.

• Price elasticity of industry demand. When the industry-level price elasticity is large, rising industry prices

tend to drive consumers to purchase substitute products.

Supplier Power and Buyer Power

We say that suppliers in a competitive upstream market have “indirect power” because they can sell their services to

the highest bidder. The price they charge depends on supply and demand in the upstream market. An input supplier

with direct power can raise prices when its target market is thriving, thereby extracting a share of its customers’

profits.

A powerful supplier may lower prices when its target market is struggling. Consistent application of both pricing

strategies will permit the supplier to extract much of its target market’s profits without destroying that market. Buyer

power is analogous to supplier power. It refers to the ability of individual customers to negotiate purchase prices that

extract profits from sellers. Buyers have indirect power in competitive markets, and the price they pay will depend on

the forces of supply and demand.

The following factors must be considered:

• Competitiveness of the input market.

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• The relative concentration of the industry in question. Firms in the more concentrated industry may have

greater bargaining power and may be able to achieve a cooperative price that puts firms in the less

concentrated industry at a disadvantage.

• Purchase volume of downstream firms. Suppliers may give better service and lower prices to larger

purchasers.

• Availability of substitute inputs. The availability of substitutes limits the price that suppliers can charge.

• Ability of suppliers to price discriminate. If suppliers can price discriminate, they can raise the prices they

charge more profitable firms.

• Extent of relationship specific investments

• Threat of forward integration by suppliers

Some Strategies to Cope with the Five Forces

• To outperform its rivals firms can

develop a cost advantage or

o a differentiation advantage

o

• Firms can seek an industry segment where the five forces are less severe

• Firms can try to change the forces

Strategies

• Facilitating strategies to reduce internal rivalries

• Moves that increase switching costs for the customers

• Pursuing entry deterring strategies

• Tapered integration to reduce buyer/supplier power

COOPETITION AND THE VALUE NET

Porter’s five forces is an enduring framework that remains widely used for industry Analysis. Brandenberger and

Nalebuff identify an important weakness of the framework.

From the viewpoint of any one firm, Porter tends to view all other firms, as