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Strategy Ramon Casadesus-Masanell, Series Editor

Industry Analysis

RAMON CASADESUS-MASANELL HARVARD BUSINESS SCHOOL

8101 | Published: January 31, 2014

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8101 | Core Reading: INDUSTRY ANALYSIS 2

This reading contains links to online interactive illustrations, denoted by the icon above. To access these exercises, you will need a broadband Internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/list.tech-specs.

Ramon Casadesus-Masanell, Herman C. Krannert Professor of Business Administration, Harvard Business School, developed this Core Reading with the assistance of writer R. David Seabrook.

Copyright © 2014 Harvard Business School Publishing Corporation. All rights reserved. To order copies or request permission to reproduce materials (including posting on academic sites) call 1-800-545-7685 or go to http://www.hbsp.harvard.edu.

Table of Contents

1 Introduction ..................................................................................................................3

2 Essential Reading .........................................................................................................4 2.1 The Five Forces Framework ................................................................................4

2.2 The Methodology of Five Forces Analysis .......................................................9 The Threat of New Entrants................................................................................9 The Bargaining Power of Suppliers ............................................................... 11 The Bargaining Power of Buyers .................................................................... 13 The Threat of Substitutes ................................................................................ 14 Rivalry among Existing Competitors ............................................................. 15 Extending the Analysis to Address Cooperation and Complements ...... 17

2.3 Applying Industry Analysis .............................................................................. 19 Turn Threats into Opportunities ..................................................................... 19

2.4 An Example of Performing and Applying Industry Analysis ..................... 20 Define the Industry............................................................................................ 21 Identify the Players ........................................................................................... 23 Analyze the Players’ Influence on Profitability ........................................... 24 Test the Analysis................................................................................................ 26

2.5 Develop a Way to Deal with the Industry Environment ............................ 27 Exploit Industry Change ................................................................................... 29 Leveraging Industry Analysis to Compete Over Time ............................... 32 Explore Opportunities to Shape Industry Structure ................................... 32

2.6 Criticisms and Limitations ................................................................................ 33 Does the Five Forces Framework Adequately Analyze the Business Environment? ..................................................................................................... 33 Does Industry Analysis Explain Competitive Advantage? ........................ 34 Does Industry Analysis Help Companies Find Entirely New Opportunities? ................................................................................................... 34

2.7 Conclusion: The Business World Changes, but Industries Remain .......... 34

3 Supplemental Reading ............................................................................................. 35 3.1 How Much Does Industry Matter? ................................................................... 35

4 Key Terms ................................................................................................................... 37

5 For Further Reading ................................................................................................. 37

6 Endnotes ..................................................................................................................... 38

7 Index ............................................................................................................................ 40

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1 INTRODUCTION o some people, the word “industry” seems old-fashioned. It conjures up images of smokestacks and Dickensian textile mills. It feels out of place in the world of Google and Zynga. Yet any organization that

produces something for others is part of an industry. Google competes in the search advertising industry with Microsoft, Yahoo!, Ask, AOL, and Baidu. Zynga competes in the online game industry with Tencent Holdings Ltd., Electronic Arts, and Activision Blizzard. Greenpeace competes in the environmental protection industry with more than 40 other organizations.1

We define an industry as a group of firms producing products or services that are perceived by customers as meeting the same needs. Apple Inc. competes in the smartphone industry, as does Samsung.

Every industry exists in an industry environment, which comprises suppliers, customers, and other firms, including those that may enter the industry and those that may offer either substitute or complementary products. For example, the companies that manufacture multi- touch screens and other components of smartphones are not part of the smartphone industry; they are suppliers to the industry. The retail outlets that sell smartphones to end users are the industry’s customers. Potential entrants are firms that may be considering entering the smartphone industry. Firms offering a substitute product include the makers of simpler “dumb phones” and tablets. Firms offering complementary products include wireless carriers, whose service is used with smartphones. Collectively, we will refer to the firms in the industry and in the industry environment as market participants.

Industry analysis is a tool for understanding how profits are distributed among market participants. A firm’s profitability depends partly on the intensity of competition from rivals in the industry and partly on the influence of players in the industry environment. All those market participants engage in a continual struggle for a share of industry profits.a

Industry analysis is an essential tool in strategy development because it helps a company understand how its industry structure influences profits. As we discussed in the introductory reading of this Core Curriculum series, a strategy is an integrated set of choices that positions the firm in its industry in a way that generates superior financial returns over the long run. Strategists need to employ industry analysis so that they can understand the economic forces at work and defend the firm from negative developments in the industry and its environment while creating or exploiting the profit opportunities that the industry presents.

Industry analysis is based on a fundamental principle of economics: People (or, in our case, market participants) respond to incentives. If there are profits to be made, market participants will try to appropriate them. If an organization doesn’t have a plan for dealing with all the players scrambling to increase their share of the profits, it doesn’t have a strategy.

Managers, entrepreneurs, capital providers, investment bankers, financial analysts, consultants, and even those making a career choice can benefit from industry analysis. Managers can use it in the following ways:

• To identify opportunities to increase profits

• To discern threats to existing profits and develop ways to counter them

• To decide whether to enter a market

a As we will see, firms offering complementary products compete for profits across industries.

T

8101 | Core Reading: INDUSTRY ANALYSIS 3

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• To decide whether to exit a market

• To position their firm to succeed in a given industry

• To assess the effect of a major change (such as deregulation, new technology, complements, demographic shifts)

• To shape the industry environment2

Industry analysis applies to business, but also to any situation where organizations are competing. In the humanitarian aid industry, the “profits”— that is, the benefits from aid donations—are distributed on the basis of the industry’s structure. This distribution is affected by the relative bargaining power of suppliers, the aid agencies, and their customers. Should these customers be corrupt governments or powerful militias, such players could capture the value of the aid intended for the distressed population.

There are typically six steps in analyzing an industry and applying the results of the analysis:

1 Define the industry

2 Identify the players (the market participants)

3 Analyze the players’ influence on profitability

4 Test the analysis

5 Develop a way to deal with the industry environment

6 Analyze how the factors influencing profitability may change and the response required.

In this reading we present the most widely used framework for analyzing an industry: the Five Forces Framework developed by Harvard Business School Professor Michael Porter. We then describe the applications of industry analysis. Next, using several real-world examples, including Walmart, we work through the six steps listed above to demonstrate how to analyze an industry and how to use that analysis to position a company for strategic advantage—now and in the future. We also consider the Five Forces Framework relative to other strategy development tools, discuss some of its shortcomings, and, in the Supplemental Reading, address the question, “How much does industry matter?”

2 ESSENTIAL READING

2.1 The Five Forces Frameworkb

In a Harvard Business Review article published in 1979, “How Competitive Forces Shape Strategy,” Michael Porter coined the term “five forces” to refer to the market participants and their influence in determining who gets the profits in an industry.3 (See Figure 1.) As Porter points out, “Managers tend to view competition too narrowly.” Direct competitors, customers, suppliers, potential entrants to the industry, and producers of substitute products are all

b In his classic 1980 book on strategy, titled Competitive Strategy, Michael Porter referred to his framework on industry analysis as “the five basic competitive forces that determine the ultimate profit potential in an industry.” The original framework is therefore typically referred to as “The Five Forces Framework.” While the framework presented in this reading is modified from Porter’s original framework depicting the five forces, it will nevertheless be referred to as “The Five Forces Framework” in this reading.

8101 | Core Reading: INDUSTRY ANALYSIS 4

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8101 | Core Reading: INDUSTRY ANALYSIS 5

FIGURE 1 Forces Governing Competition in an Industry

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

competing for their share of the profits (later in this reading we augment the original Five Forces Framework to add complements). Managers who fail to consider all market participants put their firms at risk.

While many management fads have come and gone, the Five Forces Framework has endured, in large part because of its foundations in economics. It allows managers to rise above the details of economic modeling and avoid trawling though thousands of pages in economics textbooks. The framework identifies the important factors affecting industry profitability and helps strategists judge their relative influence.

The study of the economics of industries is called Industrial Organization (IO), sometimes called the “Harvard Tradition.” Early work in this field emphasized empirical analysis such as regression analysis and case studies. The results found relationships between structural factors, such as concentration ratio (the extent to which a small group of firms dominates an industry), barriers to entry, and measures of performance, such as profitability. Later work relied more on formal economic models, particularly using game theory. Unfortunately, the models are very sensitive to the specific assumptions used and therefore can be difficult to apply.4

Porter’s important contribution was to distill the key findings from industrial organization research into five forces that influence the profitability of an industry: the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitutes, and rivalry among existing competitors. The strength of each force depends on the economic characteristics of the industry.c, d

c The Five Forces Framework captures concepts both from classical microeconomic analysis and game theory.

The threat of substitutes, for example, derives from the influence of substitutes on the price elasticity of demand, which affects pricing power. Another finding from microeconomics is that rivalry among existing competitors is likely to be greater when fixed costs are high and marginal costs are low. When business is slow, such firms will be prepared to cut price below average total cost.

d Game theory shows that developing a reputation for retaliating against new market entrants by lowering price can help deter market entry. The Five Forces Framework represents such a reputation as a “barrier to entry” that reduces the strength of the force of “the threat of entry.” Another result from game theory concerns a situation where rivals have diverse approaches and “personalities.” This increases rivalry and reduces the probability of cooperation.

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8101 | Core Reading: INDUSTRY ANALYSIS 6

How do the five forces influence profitability? Put simply, profitability is influenced by willingness to pay, the price, and the cost. For example, powerful buyers can use their negotiating strength to force industry prices down. They may also demand that industry rivals increase the value of the products they sell, which will increase their costs. Similarly, powerful suppliers will be able to charge higher prices, increasing the industry’s costs and reducing its profits.5

Using the interactive diagram shown below, you can click on the “Up” and “Down” arrows to see how each force affects price, cost, and profit.

The Five Forces Framework is useful for many reasons. For one, it helps explain why profitability varies by industry. Figure 2A shows that while the median profitability of U.S. industries (measured by return on invested capital) was 14.3% from 1992 to 2006, the profitability of the top 10% of industries was more than 25%. Meanwhile, the profitability of the bottom 10% of industries was only 7%. Figure 2B shows that industries such as security brokering and dealing and soft drinks had far higher levels of profitability than the hotel and airline industries. Why? The Five Forces Framework implies that while the less-profitable industries are subject to powerful forces that make it difficult for industry participants to appropriate profits, such forces are muted in the more profitable industries.

Interactive Illustration 2 shows the forces at work in selected industries. It provides an alternative view of industry profitability that is based on economic profit, which is a measure of profit that includes all costs, including the opportunity cost of capital employed in the business. You can click on the vertical bars representing the profitability of some of the industries to see an illustration of how the five forces affect profitability in that industry.

In the next section, we explain how to evaluate the strength of the forces. But first, see the sidebar “Perils of Poor Industry Analysis: Global Crossing” to learn why analyzing the industry and its environment is so important.

INTERACTIVE ILLUSTRATION 1 Porter’s Forces Framework

Sources: Adapted and reprinted by permission of Harvard Business Review. Exhibit from "The Five Competitive Forces that Shape Strategy" by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved; adapted and reprinted by permission of Harvard Business School Press. From Understanding Michael Porter: The Essential Guide to Competition and Strategy by Joan Magretta. Boston, MA: 2012, p. 41. Copyright © 2012 by the Harvard Business School Publishing Corporation; all rights reserved.

Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHKWuJ

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8101 | Core Reading: INDUSTRY ANALYSIS 7

FIGURE 2A Average Return on Invested Capital in U.S. Industries, 1992–2006

Source: Reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

FIGURE 2B Profitability of Selected U.S. Industries

Source: Reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

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8101 | Core Reading: INDUSTRY ANALYSIS 8

Perils of Poor Industry Analysis: Global Crossing “When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial

brilliance.”6 –Warren Buffet

To see the importance of understanding the industry environment and economics, consider the case of Global Crossing, described by Richard P. Rumelt in Good Strategy Bad Strategy: The Difference and Why it Matters (Crown Business, 2011). The company was founded in 1997 to provide a trans-Atlantic cable to carry telephone and data traffic. Using high-bandwidth optical fiber, the company was able to sell capacity at less than half the price of existing competitors. As Rumelt explains, “After six months of operations, Global Crossing offered stock to the public, and the resulting price valued the firm at an astounding $19 billion. Six months later it was valued at $38 billion, more than the Ford Motor Company.”7

Unfortunately, the company (and its investors) failed to conduct a basic analysis of the industry environment. As Rumelt explains, the cable technology was not proprietary and data-carrying capacity was a commodity. That meant that customers could easily switch from one supplier to another, putting them in a powerful bargaining position. Furthermore, customers were price- sensitive. Even worse, the threat of entry was high, and other companies were entering the business, fueled by easy financing. High fixed costs but near-zero marginal costs (the cost to carry one more piece of data) led to fierce price competition within the industry. As Rumelt says, “One struggles to imagine a worse industry structure.”

As new entrants came into the market and industry competition increased, the price of fiber capacity collapsed. Rumelt declared that “the collapse of prices could have been foreseen by anyone doing a simple Five Forces analysis.”8

Global Crossing declared bankruptcy in January 2002.9

Sources: Ghemawat, Pankaj E., Strategy and the Business Landscape, 3rd, © 2010. Printed and Electronically reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey; adapted and reprinted by permission of Harvard Business Review. Exhibit from "The Five Competitive Forces that Shape Strategy" by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

INTERACTIVE ILLUSTRATION 2

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8101 | Core Reading: INDUSTRY ANALYSIS 9

2.2 The Methodology of Five Forces Analysis

In this section, we explain how to conduct a Five Forces analysis. The best way to use Porter’s framework is to focus not only on the forces, but also on the economic factors that underlie them and how these factors might change. The first part of this description is based on a teaching note Porter published in 2007.10 We then add an analysis of complements. Later, we will demonstrate how to apply the analysis.

The Threat of New Entrants

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

When the potential for profit in an industry is high, companies have a powerful incentive to enter. New entrants increase competition, driving down prices and profit. The impact of potential entrants on profit depends on how easy it is to enter the industry, which in turn depends on barriers to entry. Strategists need to evaluate the size of the barriers to entry, and how they may change, by evaluating the following factors:

• Supply-side economies of scale. Economies of scale exist when a company’s cost per unit decreases as the quantity supplied increases. These economies come from the ability to spread fixed costs over more units, greater efficiency, and a larger scale. They give high-volume incumbents a cost advantage over smaller entrants. Supply-side economies of scale present a barrier to entry because they force a potential entrant either to enter at scale (which is risky) or to accept a cost disadvantage. Logistics company DHL faced such a barrier when attempting to enter the U.S. logistics market against incumbents UPS and FedEx. Research and development, production, marketing, sales, and IT infrastructure can all exhibit economies of scale. Amazon.com was able to develop a strong cloud-computing services business because its large and early investment in IT infrastructure—coupled with a near zero marginal cost to serve each additional customer—created significant economies of scale, which made it difficult for others to compete. Economies of experience and economies of scope can also create barriers to entry. The sales of IT consulting projects exhibit economies of scope. Because one sales force can sell multiple projects to the same client, large incumbents have an advantage in sales cost per project over new entrants. Not surprisingly, the industry has a small number of very large, established competitors.

• Demand-side benefits of scale. Better known as network effects, demand-side benefits of scale exist when the value a buyer gets from a product increases as more people buy that product. A classic example is eBay. The potential value to a customer from buying or selling on eBay depends on the number of other buyers and sellers who use it. Similarly, Facebook has withstood a well-financed challenge from Google Plus because most users’ larger established networks make it more attractive to post on Facebook

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than on any competitor. The existence of network effects creates a barrier to entry, as customers prefer larger incumbents.

• Customer switching costs. When customers must incur costs to switch suppliers, their incentive to do so is reduced. This can present a formidable barrier to entry. Switching costs are not just monetary; they include the time required to learn how to use the new product. Users of Microsoft Windows, for example, must not only buy new software when they switch to a new operating system, they must also learn a new interface. Companies with major investments in software may be reluctant to switch for fear that new software may not work as advertised. Suppliers attempt to create switching costs by locking in customers. For example, computer printer manufacturers design printer cartridges that work only in their machines. Switching costs may be undermined by new technologies or new standards. Cloud-based applications such as Google Drive and Dropbox are platform-independent and so reduce or eliminate platform switching costs for their users.

• Capital requirements. A billion-dollar upfront investment requirement presents a larger barrier to entrants than a requirement of a few hundred thousand dollars. That’s why there are few entrants into the semiconductor manufacturing industry but many in the restaurant business. Unrecoverable and risky investments such as product development and advertising present the greatest barriers. Well-financed firms can enter any industry, however, as long as the returns are attractive.

• Incumbency advantages independent of size. Being first can be an advantage. Mining companies that secure access to deposits close to the surface have an advantage over latecomers who must dig deeper to extract resources. Technology inventors can use patents to deter entrants. Investments that produce cumulative benefits, such as branding or experience, present a barrier to companies that are just beginning to compete.

• Unequal access to distribution channels or supplier networks. Many people can make a movie, but few can get their movie distributed to cinemas across the country. Distribution channels with limited capacity present a barrier to entry because new entrants must displace incumbents that may have contractual or other forms of preferred access.

• Restrictive government policy. Governments can restrict or prohibit new entrants. Licensing requirements restrict entry by new liquor retailers. Patents provide legal barriers to imitators. Foreign investment barriers can protect local businesses. Regulations that are costly to comply with can deter new entrants. Governments’ influence over market entry provides an incentive for both incumbents and potential entrants to hire lobbyists to influence policy.

• High barriers to exit. When it is easy to get out of an industry, firms will be more willing to get in. Industries that require illiquid investments or commitment to long- term contracts make exiting more difficult and therefore decrease the incentive to enter. For example, pension cost liabilities in some labor-intensive industries make exiting expensive.

The barriers to entry described above are primarily exogenous to the industry; that is, they are due to the economic characteristics of the industry. Other barriers are endogenous, created by industry participants to deter entrants. Strategists must also consider this “game theory” aspect of market entry; that is, they must consider how an entrant’s decision may be influenced by the anticipated response of the industry incumbents.

8101 | Core Reading: INDUSTRY ANALYSIS 10

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8101 | Core Reading: INDUSTRY ANALYSIS 11

New entrants may face additional barriers to entry if:

• Incumbents have a reputation for responding vigorously against new entrants

• Incumbents possess substantial resources to fight back

• Incumbents are likely to cut prices to retain market share or because of excess capacity

• Industry growth is slow, so newcomers must take share from incumbents Incumbents with substantial resources can fight back by offering deep discounts or

launching expensive advertising campaigns. Potential entrants need to evaluate the probability of provoking a strong response and develop a plan to deal with it.

It is not unusual for industries to exhibit multiple barriers to entry. (See Table 1.) For example, eBay maintains an effective monopoly in its industry through not only network effects but also economies of scale and capital requirements. A new entrant would also require substantial capital to establish a brand that rivals that of eBay.

TABLE 1 Factors Affecting the Threat of New Entrants into an Industry

Barriers to Entry Example/Rationale Supply-side economies of scale, scope, or experience

FedEx has a lower cost per package than a potential new entrant because of its large scale.

Demand-side benefits of scale eBay is more attractive to buyers than smaller competitors because of its large number of sellers (and sellers then also benefit from more buyers).

Customer switching costs Microsoft Windows users who may want to switch to another operating system must buy new software and learn how to use a new operating system.

Capital costs A large required capital commitment can deter new entrants.

Incumbency advantages Incumbent mining companies may have locked up the best reserves.

Unequal access to distribution channels

Movie producers with a track record and established relationships have an advantage in getting cinema distribution.

Restrictive government policy Patents can deter market entry by imitators.

High barriers to exit High labor severance costs can deter market entry.

Anticipated vigorous incumbent response

The threat of price cuts or expensive advertising campaigns by deep-pocketed incumbents can deter entry.

Slow industry growth Newcomers must take share from incumbents.

The Bargaining Power of Suppliers

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

Every transaction is a tussle between a seller and a buyer. The more powerful one secures the larger portion of the available profit. Powerful suppliers can raise prices and shift costs downstream to industry participants.

Although we focus mostly on suppliers’ bargaining power, price sensitivity is another source of power for the suppliers. There is a subtle but important difference. Bargaining power influences price, while price sensitivity influences quantity. Suppliers with no direct ability to

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influence price may nevertheless be so sensitive to the market price that they substantially reduce the amount they are willing to supply.

Factors that affect the bargaining power of suppliers include:

• Supplier concentration. When suppliers are more concentrated than the industry they sell to, they have market power and can secure more of the profit from a transaction. The PC manufacturing industry, for example, has powerful suppliers—Microsoft and Intel—but is itself fragmented and produces largely undifferentiated products. Consequently, the margins of PC manufacturers are low, while those of suppliers Microsoft and Intel are relatively high.

• Industry switching costs. An established supplier is in a powerful position if it is costly for a customer to switch to a competing supplier. For example, customers who create documents in Adobe Photoshop face significant costs in time and effort if they shift their document libraries to another software vendor.

• Differentiated products. A differentiated product creates market power. If a particular brand of footwear is perceived as the most desirable, for example, a retailer serving the style-conscious teenage market must pay the price and stock the product.

• Few or no substitutes for supplier products. Some patent-protected pharmaceuticals offer unique medical benefits. Their manufacturers have substantial power in negotiations with health-care providers.

• Credible threat of forward integration. Soda manufacturers that see bottlers making large profits have an incentive to bottle their own soda. This is a special form of the “threat of new entry” that increases the negotiating power of the supplier.

• Low dependence on the industry. Aircraft engine manufacturers cannot set their prices so high that aircraft manufacturers and airlines go out of business. Such mutual dependence limits the power of suppliers. However, when a supplier sells to many industries and so does not depend heavily on any particular one, it is in a powerful negotiating position and has less incentive to moderate price demands.

When a small price reduction has a large impact on the quantity the supplier is willing to provide, customers have less room to negotiate. (See Table 2.) Crude oil is one such example: Suppliers will provide large quantities at the world price but zero quantity at discounted prices. Suppliers of specialized labor such as elite soccer players are also price sensitive. Many soccer clubs appear to fear that they cannot bargain players’ salaries down without causing those players to leave the clubs, severely affecting the clubs’ success.11

TABLE 2 Factors Affecting the Bargaining Power of Suppliers

Factor Example/Rationale

Suppliers are more concentrated than the industry rivals

Microsoft and Intel have bargaining power because of their dominant market shares and fragmented PC manufacturing customers.

Industry participants face switching costs

A supplier has more bargaining power if it is difficult for customers to switch to competing suppliers.

Suppliers offer differentiated products

If customers believe suppliers’ products differ significantly, competition is reduced and prices tend to increase.

Few substitutes for supplier products

Suppliers of patented pharmaceuticals with unique benefits have significant bargaining power.

Credible threat of forward integration

Suppliers who can credibly threaten to compete with their customers have more bargaining power than those who cannot.

Suppliers do not depend heavily on the industry

Suppliers who do not depend on the industry have less incentive to moderate price demands.

8101 | Core Reading: INDUSTRY ANALYSIS 12

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8101 | Core Reading: INDUSTRY ANALYSIS 13

The Bargaining Power of Buyers

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

Buyers’ power is the mirror image of suppliers’ power. The factors that affect the bargaining power of customers include:

• Customer concentration (monopsony power). When customers are more concentrated than the industry from which they are buying, or they are buying in volumes that are large compared with the size of a vendor, they have “monopsony” power. The warehouse club retailer Costco, for instance, often stocks only one brand in each product category. That maximizes purchasing volume and increases Costco’s bargaining power with suppliers.

• Low customer switching costs. Customers can easily play one supplier off against another if switching costs are low. Airline customers are powerful because they treat flights like commodities. Airlines try to increase switching costs with loyalty programs.

• Undifferentiated industry products. Food retailers have more bargaining power with suppliers of fresh produce than they do with branded products. Many consumers do not perceive important differences among various suppliers of apples, oranges, and eggs, for instance, giving retailers more bargaining power with these suppliers. Some companies, however, have invested heavily in branding produce. In the United States, Eggland’s Best eggs command a premium price from both consumers and retailers.

• Credible threat of backward integration. Many supermarket chains and pharmacies offer “store brands” that compete with their suppliers’ branded products. This threat of backward integration increases the stores’ bargaining power in negotiations with suppliers.

Factors that affect customers’ price sensitivity include:

• Concentration of purchases. Customers will be more sensitive to price when they’re making purchases that represent a significant fraction of their total expenditures. Steel manufacturers are more sensitive to the price of iron ore than they are to the price of the computers used by their office workers.

• Customers’ financial pressure. Customers that earn low profits or are otherwise under financial pressure will be sensitive to price. Local governments face public scrutiny of their expenditures and typically pay lower prices for similarly skilled staff than Wall Street firms do.

• Industry impact on product quality. A builder will be relatively more sensitive to the price of construction materials that customers cannot see than to the price of the materials used, for example, in a building’s facade.

For consumers, the channels through which they buy an industry’s products can have significant influence over what they buy. For companies that sell through distribution

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8101 | Core Reading: INDUSTRY ANALYSIS 14

channels, strategists need to consider not only their bargaining power with distributors but also the distributor’s bargaining power with consumers. Profits are shared between the industry participant, the distributor, and the end consumer on the basis of the relative power of each. (See Table 3.)

TABLE 3 Factors Affecting the Bargaining Power of Buyers

Factor Example/Rationale Customers are more concentrated than the industry they buy from

Retailers such as Walmart are more concentrated than their suppliers, and thus have significant bargaining power.

Customers face few switching costs Airline customers have substantial bargaining power because they have low switching costs.

Industry products are undifferentiated

If customers believe suppliers’ products do not differ significantly, the customer has more pricing power.

Credible threat of backward integration

Customers who can credibly threaten to manufacture their own inputs have more bargaining power than those who cannot.

Industry purchases represent a significant fraction of their cost

Customers will be more sensitive to the price of inputs that have a bigger impact on their bottom line.

Customers earn low profits Input costs have a proportionally greater impact on the profits of low-profit customers than they do on those of high-profit customers.

Customer’s quality is not substantially affected by the industry

Where quality is not affected, the customer has no incentive to accept a higher-priced, higher-quality input.

The Threat of Substitutes

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

Substitutes compete for industry profits, but from outside the industry. Videoconferencing competes for profits with business-class air travel. Digital downloads compete with DVDs. Online retailers compete for the same profits as brick-and-mortar stores. Search engines compete with telephone directories for advertising profits.

The concept of “substitutes” is an artifact of how economics defines industries. Although one could argue that search engines and telephone directories are both in the “information industry,” economists classify industries primarily by the technology they use. Automobiles and airplanes both provide transportation, but because they use vastly different technologies they are placed in different industry classifications. This scheme has the advantage of “comparing apples with apples,” but it obscures the reality that automobiles and airplanes are in some sense competitors. To deal with this issue, economists developed the concept of “substitutes.”

One product is a substitute for another if a price increase in one increases the quantity demanded of the other. To illustrate, if a 5% increase in the price of restaurant meals leads to a 10% increase in meals cooked at home, home cooking represents a significant threat of substitution for the restaurant industry. Automobile travel is a substitute for air travel because a price increase in air travel could very well increase the amount that people are willing to

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drive. But even very different products may be substitutes. To someone buying a gift, a shirt may be a substitute for a book.

Substitutes exist for almost every product. For a homeowner, fixing a leaky faucet is a substitute for calling a plumber. The more expensive the plumber, the more likely it is that the homeowner will attempt the repair. Even doing nothing is a substitute since the homeowner can choose to ignore the leak.

One way to analyze the threat of substitutes is to consider the customer’s perspective. For a salesperson, the benefit of visiting a potential customer in person may be winning a million- dollar deal. Using a videoconference instead might lose the deal to a competitor who—by choosing to fly to a meeting with the customer—develops a better customer relationship. In such a case, the expected benefit of visiting in person more than pays for the cost of the flight. Consequently, while a videoconference may not be a powerful threat to air travel for initial sales meetings, once the salesperson has established a relationship with the customer, a videoconference may provide the same level of customer support at much lower cost. In this case, videoconferencing threatens to substitute for air travel.

The most potent threats come from substitutes that offer the same benefits at lower cost. E- mail is an important substitute for “snail mail” because it offers nearly the same information as physical mail but is delivered much faster and nearly at zero cost. Strategists need to be creative in thinking about substitutes and should pay particular attention to substitutes whose performance/price ratio is improving rapidly. (See Table 4.)

TABLE 4 Factors Affecting the Threat of Substitutes

Factor Example/Rationale “Closeness” of substitute The closer the substitute, the easier it is to switch to it.

Performance / Price ratio of substitute

A substitute that offers slightly lower performance at a much lower price is more of a threat than one that offers slightly lower performance with only a small reduction in price.

Rivalry among Existing Competitors

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

The last of the five forces seems the most obvious. Rivalry among competitors threatens the profits of all of them, although industries can differ in the intensity and focus of their rivalry. Competition on dimensions other than price—product features, support services, delivery time, or brand image, for instance—is less likely to erode profitability because it improves customer value and can support higher prices. Real estate brokers in the United States, for example, compete on service rather than on price. Participants in this industry that offer excellent service can sustain good margins even in the face of competitors with practically undifferentiated products.

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Competition on price is the most threatening to profits. (See Table 5.) The following factors contribute to price-based competition:

• Undifferentiated products and low switching costs. Gasoline retailing and airline travel often exhibit intense price competition because of low differentiation and low switching costs. Real estate brokers try to reduce price competition by creating switching costs in the form of fixed-term contracts.

• High fixed costs and low marginal costs. Manufacturers with high fixed costs have an incentive to slash prices below average costs in order to generate some revenue to contribute toward fixed costs. The semiconductor memory manufacturing industry is characterized by periods of intense price competition for that reason.

• Need for capacity to expand in large increments. The natural gas industry expands or contracts in large increments. These large changes in industry supply create price volatility.

• Perishability. Producers of perishable products have a powerful incentive to cut prices to sell a product while it still has value. Airlines cut seat prices when they face unsold inventory close to departure time.

The following factors contribute to intense industry competition:

• Many competitors of roughly equal size and power. The dominant firm in an industry often acts as a price leader, setting a price from which smaller competitors have little incentive to deviate. Industries with a few large competitors can evolve into oligopolistic pricing, where tacit collusion can keep prices high. However, when there are many competitors of roughly equal size and power, rivals often cannot resist trying to steal each other’s customers. For example, satellite television companies offer significant incentives for new customers.

• Slow industry growth. When the industry “pie” is not growing, competitors can grow only by securing a larger slice. That creates intense competition.

• High exit barriers. When it is easy to exit an industry, low prices drive out the least profitable suppliers and industry prices rise. But when exit is costly, excess supply remains and pricing pressure persists.

• Diversity of rivals’ approaches. In the tablet computing market, Amazon.com follows a low-price strategy for the Kindle in order to secure distribution for its digital content. Apple and Samsung, on the other hand, seek higher hardware margins. The lack of a common approach to producing profit reduces the chances of tacit collusion and creates a more intensely competitive environment than would exist if all firms were pursuing the same approach.

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TABLE 5 Factors Affecting Rivalry among Competitors

Factor Example/Rationale Product lacks differentiation If products are not very different, rivals must compete on price.

Fixed costs are high and marginal costs are low Rivals have an incentive to price below average cost.

Capacity must expand in large increments Owners of unused capacity have an incentive to cut prices.

Product is perishable Rivals have an incentive to cut price as the product approaches the end of its saleable life.

Competitors are numerous and roughly equal in size

Numerous and equal competitors reduce the potential for tacit collusion.

Industry growth is slow Rivals must take others’ market share to grow.

Exit barriers are high High exit barriers tend to slow reduction of industry overcapacity, which then produces price competition.

Rivals have diverse approaches Diverse approaches reduce the potential for collusion.

Extending the Analysis to Address Cooperation and Complements

Source: Adapted and reprinted by permission of Harvard Business Review. Exhibit from “The Five Competitive Forces that Shape Strategy” by Michael E. Porter, January 2008. Copyright © 2008 by the Harvard Business School Publishing Corporation; all rights reserved.

The Five Forces Framework deals with competition. Existing competitors, potential entrants, suppliers, customers, and substitutes all compete for the largest slice of the pie, although sometimes a business will cooperate with customers or other businesses in order to grow a market. Rather than competing for the largest slice of the pie, they work together to make the pie bigger.

Complements—products that are typically consumed together, like computers and operating system software—provide an incentive to cooperate. Intel’s new processors allow Microsoft to develop attractive new features for Windows, which creates demand for Windows software upgrades, and demand for the upgraded Windows software creates demand for the latest Intel processors.

While a larger profit pie can benefit everyone, market participants still compete for the largest slice. As Adam Brandenburger and Barry Nalebuff write in their book Co-opetition, “Business is cooperation when it comes to creating a pie and competition when it comes to dividing it up.”12 They adopted the word “co-opetition” to describe this combination of cooperation and competition.

Complements can have such a powerful influence on an industry that they can be considered a “sixth force.” Consider their impact on the web browser industry. Netscape, the producer of the first widely used web browser, started out by charging users for its software.13 Microsoft quickly realized that a browser is an essential complement to web applications, which can compete with PC application software. To protect its power in the industry, Microsoft developed Internet Explorer, which it distributed at no cost. More recently, Google recognized that the browser is an essential complement to online search services and

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developed Google Chrome. Complementary goods promoted intense competition in the browser industry and left browser creators without even a crumb from the profit pie.

Complements are everywhere. Auto financing, auto insurance, and automobiles are complementary goods. Automakers have an incentive to make auto financing available. Tablet computers like Apple’s iPad, Samsung’s Galaxy Note, and Microsoft’s Surface all need applications to succeed. Those companies and their partners invest heavily in application programming interfaces (APIs), online tutorials, and developer conferences to promote application development for their platforms.

While it is often useful to think of complements as a sixth force, it is important to remember that complements can influence the other five forces. For example, Google’s Android operating system, a complement to the smartphone and tablet computing industries, increased the threat of new entrants into those industries by lowering the barriers to entry.

Strategists cannot afford to ignore the influence of complements on the industry environment. However, complements are more powerful in some industries than in others. Pankaj Ghemawat lists the factors influencing complements (See Table 6): 14

• Complement concentration. Google’s dominance of the online search industry helped give it the power to successfully introduce Google Chrome. Getting one browser widely adopted would have been much more difficult in an environment where three or four powerful search engines each attempted to promote their own browsers.

• Relative switching costs. If it is easier for users to switch across competitors than it is across complements, then complements will have significant power. For example, if switching your application software is more difficult than switching your Internet service provider, the software vendor is the more powerful actor.

• Ease of unbundling. Because it is difficult for Apple users to unbundle downloaded music and iTunes, Apple has a powerful influence in the music retailing industry. Users of the MP3 standard find it easier to switch music players and hardware providers.

• Influence on demand. Content providers such as the UK’s Premier League football have a powerful influence on the demand for cable channels.

• Asymmetric threats. It is more likely that an automobile manufacturer will enter the battery business than a battery maker will start making automobiles. That gives the automaker more power in the battery industry.

• Rate of growth of the profit opportunity. A fast-growing profit opportunity is likely to decrease the influence of complements on the industry.

TABLE 6 Factors Affecting Complements

Factor Example/Rationale

Complements are concentrated

A dominant complementor can exert more influence on an industry than many smaller complementors that compete with one another.

Relative switching costs If it is easier for users to switch across competitors than it is across complements, complements have significant power.

Ease of unbundling If a product and its complement are difficult to unbundle, the complement has more influence over the product’s customers.

Influence on demand Content providers such as the UK’s Premier League football have a powerful influence on the demand for complementary products such as cable channels.

Asymmetric threats A complementor that can easily enter the product-maker’s industry has more power than one that cannot.

Rate of growth of the profit opportunity

Industries with low-profit growth are more likely to be influenced by complements, as there are fewer alternatives to grow profits.

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2.3 Applying Industry Analysis

The principal application of industry analysis is in developing a way to profit within the industry environment. There are two ways to do this. The first is by finding or creating an attractive environment. The second is by developing a competitive advantage that enables the company to be more profitable than its competitors, despite the environment. These two approaches are not mutually exclusive. Even companies with a competitive advantage need to focus on the more profitable opportunities within their environment.

Positioning is the process by which a firm establishes a unique position in a market segment relative to competing firms. Companies can also seek to create an attractive environment by exploiting industry change, exploring strategies to compete over time, and reshaping the forces to their advantage.

The idea behind positioning is that firms should find market segments, or “positions,” where they can fend off threats from other players in the industry and exploit opportunities. As Porter explains, “Strategy can be viewed as building defenses against the competitive forces or as finding a position in an industry where the forces are weakest.”15

Harley-Davidson, for example, chooses not to compete in the high-volume, low-price segment of the motorcycle industry. By focusing instead on the premium, custom-made segment, the company mitigates the challenge from the economies of scale of high-volume manufacturers. Differentiating the product and developing a powerful brand mitigates rivalry from competitors, and a cohesive owner’s community creates switching costs for those considering alternatives.

When you start to think about what to do in response to your industry analysis, bear in mind the following points:

• It is possible to make good money in a tough industry. Companies like Ryanair, The Economist Group, and Apple are able to do so. The key is to find a way to deal effectively with the five forces.

• There are different ways to react to competitive forces. A strategist may be able to identify a profitable position that is not yet occupied.

• It is possible to profit by spotting changes in industry structure before others do.

• It is possible to influence industry structure.

• Innovators can use their understanding of how technology affects competitive forces to craft a strategy to protect their profits from imitators.

• Industry analysis is particularly important when moving to new geographic areas or going into new businesses.

Turn Threats into Opportunities One approach to positioning is to treat every threat as an opportunity. Erect barriers to entry and look for ways to increase customer switching costs. To increase your bargaining power with suppliers, either secure multiple sources or design products using standard components. Counter substitutes by producing your own substitutes (a practice known as cannibalization) or by exploiting complements. (See Table 7.)

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TABLE 7 Possible Responses to Threats to Profitability

Threat Possible Responses

New entrants Exploit network effects and economies of scale. Create customer switching costs. Invest to preempt entry. Lock in distribution channels. Develop a reputation for retaliation. Exploit patent protection.

Bargaining power of suppliers Use standard instead of proprietary products. Secure multiple sources. Encourage mutual dependence.

Bargaining power of buyers Build customer loyalty. Target small customers. “Lock in” customers to increase switching costs. Differentiate the product. Target customer segments that are less sensitive to price.

Substitutes Cannibalize the business before others do. Target consumers of substitutes with new product offerings. Exploit complements.

Rivalry among existing competitors

Target less-competitive market segments. Differentiate the product. Create switching costs. Seek to dominate a market segment.

Finding Opportunity in the Wine Industry16 Neither the budget nor the premium segment of the wine industry looks particularly attractive. The budget segment features powerful customers: strong distributors, consolidated supermar- kets, and price-sensitive consumers who have no switching costs. There are large barriers to entry in the form of competition for shelf space and the need for large-scale distribution and operations. The industry features intense rivalry—on price, advertising, and promotions. Substitutes such as beer, hard liquor, and other beverages represent a significant threat.

The premium segment features powerful distributors and retailers. Consumers are not price sensitive, but they like to switch for the sake of variety. It is easy for a boutique winemaker to enter the market. Although there is limited price competition, the market is fragmented and there are makers who are not so interested in profits.

Yet there’s an opportunity in this industry to target consumers of substitute products—people who are intimidated or confused by traditional wines. The Australian winemaker Yellow Tail, for instance, went after this underserved segment by eliminating the use of wine terminology; reducing the range, aging, and prestige of their wines; and creating ease of purchase, ease of drinking, and a sense of adventure and fun.

Creating a new position in an industry does not produce sustained profitability, however, unless there are barriers to imitation. Yellow Tail is now threatened by a host of imitators.

2.4 An Example of Performing and Applying Industry Analysis

We will use the example of Walmart to illustrate how to perform and apply industry analysis, drawing from the case study “Walmart Stores in 2003.”17 We will cite other industry examples where necessary to highlight specific points.

The most effective way to approach industry analysis—or any analysis—is by using the scientific method. Instead of collecting data and then “doing an industry analysis,” the strategic issue is identified, hypotheses about the answer are developed, and an analysis is conducted that tests the hypotheses. The analysis that must be conducted will determine the data that are needed.

For Walmart, we could specify two common strategic questions:

1 Where are the most attractive opportunities to increase the company’s profits?

2 What are the potential threats to existing profits and how should Walmart counter them?

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With these questions in mind, we could develop several hypotheses, which are potential answers to the questions. The hypotheses should suggest specific actions. For example:

• There are significant new profit opportunities in opening more stores in the United States.

• There are significant new profit opportunities in introducing new services in existing locations.

• The primary threat to existing profits comes from higher labor costs. It doesn’t matter if the hypotheses turn out to be disproved; the analysis will suggest new

hypotheses that can be supported by the evidence. Testing any of these hypotheses requires an understanding of the competitive forces and the economics underlying the industry.

We will now work through the six-step process outlined in the introduction.

Define the Industry

This first step may seem trivial, but it’s not. Let’s walk through the thought process that’s involved.

For example, in what industry does Walmart compete? The company sells household goods and groceries, but so do supermarkets, convenience stores, and specialty retailers. Are all these businesses in the same industry? What matters is not what industry analysts or business managers think, it’s what customers think.

Do customers see Walmart as equivalent to a local supermarket? There are likely to be at least two differences between Walmart and a local supermarket: The local supermarket is closer, and Walmart’s prices are lower. Consequently, for some consumers the two are not equivalent because these consumers feel that Walmart competes in a “lower price but less convenient” industry. From their point of view, Walmart’s direct competitors are not supermarkets but other stores that offer lower prices but less convenience.

The local supermarket is a substitute for Walmart, but how powerful a threat is that substitute? You would expect that for price-sensitive customers, the threat is not great. However, for those customers who value convenience more than low prices, the local supermarket is an attractive option.

So far we have segmented the market along two dimensions: price and convenience. So who are Walmart’s direct competitors? According to this segmentation, they are retailers that are more widely dispersed but offer lower prices than local supermarkets. Companies like Kmart (which merged with Sears in 200418) come to mind. Consumers may also see Target as a competitor to Walmart, even though it charges higher prices and sells a somewhat different range of products.

But warehouse clubs such as Costco also fit this classification. Are Costco and Walmart direct competitors? Costco offers a much smaller range of products than most Walmart stores, which suggests another dimension of segmentation: product range. Note, however, that Walmart also competes in the warehouse club segment with its Sam’s Club brand.

Amazon.com offers lower prices but, in the view of some customers, less convenience than local supermarkets since it is necessary to wait for delivery (for physical goods). Is Amazon.com in the same industry as Walmart? While Walmart.com does compete with Amazon.com, it also offers different retail formats.

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After considering the customers’ perspective, it’s sometimes helpful to look at industry statistics. The U.S. Department of Commerce maintains statistics on retail sales, and in a category labeled “general merchandise stores” includes a subcategory called “warehouse clubs and superstores.” 19 Superstores combine general merchandise and groceries. These government statistics distinguish such stores from food and beverage retailers, such as grocery stores, and nonstore retailers, such as e-commerce sites. These classifications don’t mention price but rather focus on what economists call “technology,” the way the business meets the consumer’s need.

As a final check on our thinking, we can define a business along the three dimensions developed by Derek Abell: customer groups, customer needs, and alternative technologies.20 Customer groups define “who” is being satisfied, customer needs define “what” is being satisfied, and alternative technologies define “how” the need is satisfied. Customer groups could be segmented into urban, suburban, and rural, or domestic and international, or by income level. For the customer need dimension, we have food and food preparation, clothing, personal hygiene, and entertainment. We could distinguish technologies by their price, product range, and delivery times: superstores, warehouse clubs, and online retailers represent different “technologies.”

So what’s the best way to define the industry? First, the definition should be unambiguous. Second, the definition should be useful in addressing the issue at hand: Where are the new profit opportunities? The industry analysis needs to be specific enough to be able to direct action. It’s not enough to say that the new profit opportunities are in “new store openings” (if indeed they are). The question is, “In which locations should Walmart open new stores, and in what formats?”

One approach would be to define Walmart’s industry as the “superstore” industry in the United States: large-format discount retailers selling both household goods and groceries to the U.S. market. That means that the industry rivals, at least on a U.S. national scale, are Walmart, Target, and Kmart.

With this definition, we would classify warehouse clubs such as Costco and Sam’s Club as substitutes for the superstore industry. Amazon.com and Walmart.com are also substitutes, as are local supermarkets such as Stop & Shop, A & P, Wegmans, and Kroger. Specialty markets such as Whole Foods, Balducci’s, and Fairway are substitutes, too, as are convenience stores, home food delivery services, restaurants, and diets. For some product categories, hardware and electronics stores are substitutes.

Thinking about the dimensions along which we define the industry starts to give us insights into positioning. One dimension of positioning is physical location. Other dimensions are product range, pricing, and technology (physical stores versus online stores). Walmart superstores, Costco warehouse clubs, local supermarkets, and Amazon.com occupy different positions.

Note that in this business, “industry” is regional. To say that a store in Boston is in the same industry as one in San Diego makes sense for economic statistics but not for competitive analysis. What matters for strategists is competition, and grocery competitors are either regional or local. To complete this analysis, we would need to list all the potential store locations in the United States and identify competitors and substitutes in each of those markets. Only then could we test the hypothesis about which market to enter.

Because Walmart participates in other industries, such as photo processing and banking services, we would also need to conduct separate analyses for those industries to identify profit opportunities and threats.

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Some Cautions on Defining an Industry Don’t confuse companies with industries. Many businesses compete in multiple industries. Apple competes in personal computers, smartphones, portable music players, recorded music and movie retailing, application software, and more.

Don’t rely on NAICS (North American Industry Classification System) or SIC (Standard Industry Classification) codes, either. These systems—used for government statistics—classify industries on the basis of production technology, not customer needs. Consequently, they often either lump together businesses with quite different characteristics or separate those that serve the same need. For example, fur jackets and men’s coats are in separate SIC classifications, yet most customers would consider them close substitutes.

Data Sources Performing and applying industry analysis requires research. Table 8 lists some public sources of industry information.

TABLE 8 Some Possible Sources of Industry Information

Type of Source Examples

Industry studies Book-length reports, investment analyst reports

Industry trade associations Newspaper Association of America, CTIA (wireless communications industry)

Business press General publications (e.g., Wall Street Journal, Fortune), specialized industry trade journals

Government sources Bodies responsible for industry oversight; antitrust, legal, or tax documents; census or IRS data

Industry and company directories Thomas Register, Dun & Bradstreet directories

Company sources Annual reports; SEC filings, especially Form 10-K, proxies, and prospectuses; public relations offices; Internet sites; investment analyst reports; online services (e.g., Bloomberg, OneSource, Compustat); company histories

Identify the Players

The next step is to identify the “players” in the industry: the companies and organizations that influence Walmart’s profitability. Start with Porter’s classification, dividing them into potential entrants, suppliers, customers, producers of substitutes, and industry competitors. Recognize that a single business may play multiple roles: Samsung makes smartphones as well as smartphone components, and is both a competitor and a supplier to Apple.

Substitutes can be particularly difficult to identify. Diets can be a substitute for Walmart because increased dieting can reduce the amount of food shopping done at Walmart.

Also identify the producers of complementary goods. Finally, consider whether “nonmarket actors” such as governments and interest groups have an influence on industry profitability.

Based on our conclusion that Walmart is in the U.S. superstore industry, we might identify the key players as follows:

• Industry rivals: Walmart, Kmart, and Target.

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• Suppliers: Walmart’s suppliers include manufacturers of groceries and household goods. These include not just manufacturers of branded consumer goods such as Procter & Gamble and Coca-Cola, but also manufacturers of Walmart’s Great Value and Sam’s Choice store-brand goods.

 Other key suppliers: Importantly, this category also includes suppliers of labor and of land. Suppliers of land include not only property owners but also local authorities that provide zoning and building permits. Where labor is organized, suppliers of labor include unions.

 Further suppliers: These include suppliers of IT hardware and services, transportation and logistics, marketing services, fixtures and fittings, as well as cleaning, electricity, communications, and other services.

• Customers: While most customers are individual or family consumers, Walmart also has corporate customers.

• Substitutes: Substitutes include local supermarkets, warehouse clubs, online retailers, and convenience stores. They also include home food delivery services, restaurants, and diets. For some product categories, hardware and electronics stores are substitutes.

• Potential entrants: Potential entrants into the U.S. superstore industry include major domestic and foreign supermarket chains, such as Tesco, Aldi, and Safeway.

• Complements: Superstores sell such a wide range of goods that there are thousands of complements, but two apply to all their products: transportation and financial services.

• Nonmarket actors: Labor unions, local government authorities, federal authorities, and special interest groups can all affect Walmart’s profit opportunities.

Analyze the Players’ Influence on Profitability

Porter’s framework provides specific guidelines for evaluating the relative strength of the forces influencing profitability. Those guidelines can be used as a checklist. For example, when evaluating the threat of entry, evaluate each factor: Are there significant economies of scale? Do customers face significant switching costs? And so on.

In the Walmart example, the analysis might look like this:

• Threat of new entrants: In markets not yet served by superstores, the threat of new entrants may be high. On the other hand, the threat of new superstore entrants in small markets dominated by an existing superstore seems low. There are barriers to entry in terms of distribution and economies of scale.

 Economies of scale and scope come from several sources: regional economies of scale and scope from distribution centers; store economies of scale and scope from fixed costs; and national or even global economies of scale in purchasing. Customer acquisition costs, parking for customers, and customer travel time all exhibit economies of scope. Information technology investments also exhibit economies of scale and scope. Economies of scope suggest an opportunity to broaden the product range.

 Network effects are not significant in this business.

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 Customer switching costs are influenced by driving distance and the opportunity cost of lost savings. Switching costs will be greatest in markets dominated by one large-scale store, because switching will involve driving a significant distance. Loyalty programs may also increase switching costs.

 Capital costs are not high enough to deter entry in this industry. A Walmart superstore required an initial investment of $15.5 million in 2003.

 Incumbency advantages independent of size include superior access to scarce large-format retail space, particularly in densely populated areas. First movers can develop relationships with local planning and zoning authorities.

 Restrictive government policy can be a barrier to entry. Nonmarket actors such as unions can influence planning and zoning authorities.

 Barriers to exit are not high. Store locations can be used by other stores or for other purposes.

 Fixed costs are not so high that incumbents are likely to cut prices significantly.

• Bargaining power of suppliers:  Product suppliers: Suppliers are important drivers of cost in this industry. From

Walmart’s income statement, we can calculate that the cost of goods sold (the amount the company pays suppliers for the products it sells) is 76% of its superstore sales. But how much bargaining power do suppliers have? Supplier concentration varies by category. Branded product suppliers like Coca-Cola and Procter & Gamble have more bargaining power than suppliers of unbranded commodity products. For example, the hair-care market in the United States is relatively concentrated. In 2011, Euromonitor reported that L’Oréal USA had 24% of the market, Procter & Gamble had 22%, and Unilever had 13%.21 The branded consumer goods market features continual product innovation and heavy marketing investment. Consequently, the bargaining power of branded product suppliers is generally high in this industry.

 Suppliers of labor: Labor costs are a critical factor in this low-margin industry. Supercenters have 220 to 550 employees, or associates. Payroll expenses are about 8% or 9% of sales. Because the majority of employees are low-skilled, they do not have much individual bargaining power, particularly in regions where there are few other low-skilled jobs. The bargaining power of labor will be greater in regions with established labor unions. Regulations such as minimum- wage laws will affect labor costs.

 Suppliers of land: The average size of a supercenter is 185,000 square feet. Suppliers of land will be less powerful in small towns surrounded by underdeveloped property. Suburban and urban markets will have fewer suitable locations, and that relative scarcity increases the bargaining power of property suppliers. Lease agreements often restrict leasing to industry rivals on the same property, further increasing the bargaining power of property owners. Nonmarket actors such as neighborhood groups and labor unions may pressure local governments to deny planning permission.

• Bargaining power of buyers: Customer bargaining power is high. Superstore customers are price-sensitive; purchases of groceries and household goods represent a substantial proportion of the expenditure of lower-income families.

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• Threat of substitutes: The threat of substitutes is high. As we discovered in defining the industry, substitutes for superstores are legion. Warehouse clubs, local supermarkets, specialty markets, “category killer” retailers such as Toys R Us and Home Depot, dollar stores, convenience stores, and online retailers are all substitutes. Many substitutes offer identical products, sometimes at higher prices but often with more convenience. In some categories, large online retailers such as Amazon.com have achieved significant economies of scale. The threat of less obvious substitutes, such as farmers’ markets, dieting, restaurants, and takeout food, is generally low.

• Rivalry among existing firms: Rivalry among existing firms is strong. Rivals compete on price to sell mostly undifferentiated products. The limited life of food encourages price discounting. New entrants may expand capacity in large increments within a neighborhood, providing yet another incentive to compete on price in order to capture market share. However, rivalry has been muted somewhat in the United States by Kmart’s bankruptcy and reorganization. Target aims for a more upscale market segment and prices at a 10% to 15% premium.

• Complements: Driving and payment are complementary to superstore shopping. That suggests an opportunity for gasoline sales, auto parts, and auto services. Payment services and basic banking transactions represent another opportunity. Complements, however, are not a powerful force in this industry.

This analysis suggests that profitability in this industry will generally be low. The U.S. superstore industry faces a powerful threat from substitutes: warehouse clubs, local supermar- kets, and “category killer” retailers. Suppliers and customers have significant bargaining power. Industry rivalry is often price-based.

Test the Analysis

The best way to test an industry analysis is to compare its predictions with observed levels of profitability. If an industry has generally low profitability, the analysis should have identified at least one powerful force that shrinks the profit pie. It should be possible to explain superior levels of profitability among some industry participants by how they deal with the competitive forces.

In the U.S. superstore industry, Kmart’s losses and its subsequent bankruptcy and reorganization suggest that this is indeed a tough industry. From our analysis, we would expect that some combination of hard-bargaining suppliers, price-sensitive customers, a potent threat of substitutes, and intense industry rivalry caused the company’s demise.

But that is not the whole story. Walmart’s return on equity has consistently been around 20%. Target’s ROE is about 17.5%. Walmart’s return on invested capital is around 16%, while—according to Porter—the average return on invested capital for industries in the United States from 1992 to 2006 was about 15%.

The financial performance of Walmart and Target suggests that it is possible to mitigate the threat of the competitive forces in this industry. Now we need to pivot from analyzing the industry and its environment to understanding how to succeed in that environment.

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2.5 Develop a Way to Deal with the Industry Environment

It’s at about this point that people trying to apply industry analysis for the first time begin to get frustrated. In the transition from “understanding the industry structure” to “figuring out what to do about it,” they start to question what the point of industry analysis actually is. The first caveat is to beware of declaring an industry “attractive” or “unattractive,” which tends to raise questions such as these:

• If the industry is not attractive, why should I even bother to analyze it?

• If the industry is attractive, it’s because there are barriers to entry. If I can’t enter the industry, what’s the point of analyzing it?

The point of industry analysis is not to declare an industry attractive or unattractive; it is, as we’ve noted, first to spot profit opportunities and develop a strategy to exploit them, and then to identify threats to profits and develop a strategy to counter those threats.

Instead of asking, “Is this industry attractive?” strategists should ask, “How do I find a profitable position?” and “How do I move from my current position to where I would like to be?” Identifying profitable positions requires understanding the economics of the industry and the factors that influence the profitability of industry participants.

We started the Walmart analysis with two strategic questions:

• Where are the most attractive opportunities to increase the company’s profits?

• What are the potential threats to existing profits and how should Walmart counter them?

To answer these questions, we need to understand Walmart’s current sources of profit. The company seems to have a competitive advantage. In 2003 Walmart’s superstore SG&A (sales, general, and administrative) costs were about 18% of sales, compared with 21% for Kmart and 26% for Target. Walmart’s greater scale (it was nearly six times the size of Target in 2003) suggests that the company may have an advantage in sourcing goods. And its supply chain outperformed those of rivals: Inventory turns were 7.6 in 2003, compared with 6.1 at Target and 5.4 at Kmart.22

But these advantages are only part of the explanation. By treating each of the five forces as an opportunity instead of a threat, we can identify potentially profitable positions.

Positioning for the Threat of New Entry

The superstore industry exhibits economies of scale and scope. Consequently, one profitable positioning should be large-scale stores offering a wide range of products.

It is important to be precise when considering economies of scale. Are they local, regional, national, or international? Store economies of scale are local, but distribution economies of scale are regional. By one estimate, a superstore needs a potential customer base of 76,000 people to be viable.23 Distribution centers serve approximately 150 stores within an average radius of 150 miles. This suggests that a profitable position for superstores will be in local markets with about 76,000 to 150,000 potential customers. These locations will be large enough to support one superstore but too small to support two. The most attractive regions

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will be those with many local markets of this size, situated no farther than about 150 miles from some central point that would serve as a potential site for a distribution center.

Even at this stage, the analysis is pointing to a positioning that looks like Walmart’s: large- scale stores with a wide range of products saturating regions with numerous small towns. In 2003 more than 80% of Walmart’s Supercenters were in regions classified by one analyst as “small-town living” or “rural America.”24

We now have a hypothesis about a profitable positioning—one that mitigates the threat of new entry. Now let’s examine if that positioning can exploit the opportunities of—and withstand the threats from—the other forces. This will develop other aspects of the strategy and should create an integrated set of choices. (For more on the importance of integrated choices in strategy, see Core Reading: Introduction to Strategy [HBP No. 8097].)

Positioning to Counter the Bargaining Power of Suppliers

The opportunity in bargaining with suppliers comes from being a bigger purchaser than your competitors. “Category killer” retailers like Home Depot achieve this by becoming the largest purchaser in one product category. And as mentioned before, companies can also weaken suppliers’ power by developing alternative sources. Walmart uses both tactics.

Walmart has substantial bargaining power with suppliers because so much of its suppliers’ business depends on it. Walmart typically represents a much larger share of the supplier’s business than the supplier represents for Walmart. For example, by 2003 Walmart was by far P&G’s largest customer, accounting for 17% of P&G’s total revenue, but P&G’s share of Walmart’s total revenue was less than 3%. Walmart commanded as much as 30% of the U.S. market in a number of household staples such as disposable diapers and shampoo.

Walmart increases competition in many product segments through selling store brands and buying directly from manufacturers. In 2003, private labels accounted for about 20% of store sales, reducing product differentiation and increasing the availability of substitutes for supplier products. Walmart does not face significant costs in switching suppliers. And in most categories, there is little danger of suppliers integrating forward into retailing. Taking all these factors together, product suppliers have relatively low bargaining power with Walmart.

Walmart’s “small town” positioning reduces the bargaining power of property owners. Suppliers of land have more power where land is scarce, but that threat is mitigated when Walmart locates in less-developed areas, such as small towns surrounded by open land.

Reducing the bargaining power of labor suppliers suggests positioning in states with weaker unions and lower minimum wages.

Positioning to Counter the Bargaining Power of Buyers

Where Walmart has entered an area early enough to be the dominant superstore, switching costs should provide the company with some pricing power, although it will be constrained by substitutes. Customers in rural locations face larger switching costs—in terms of driving distances—than those in suburban and urban areas.

Positioning to Counter the Threat of Substitutes

Locating in rural or small-town markets where it has a local monopoly mutes the threat of substitutes. Walmart has also entered industry substitutes: Sam’s Club competes in the warehouse club industry with Costco and others, and Walmart.com competes with online retailers such as Amazon.com.

Positioning to Counter Industry Rivalry

Walmart’s competitive advantage and willingness to compete on price have muted industry rivalry. Rivalry has been further weakened in the United States by Kmart’s bankruptcy and

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reorganization. Given Walmart’s position as the low-cost industry participant, rivals are unlikely to win a price war. Fixed costs are not so high that incumbents are likely to cut prices significantly. Rivals have avoided head-to-head competition. Target, for example, aims for a more upscale market segment and prices at a 10% to 15% premium.

Walmart’s Integrated Set of Positioning Choices

We can summarize Walmart’s positioning in the superstore industry: large-scale stores, large product range, rural and small-town locations, regional saturation, national scale, store brands, everyday low pricing, lowest cost in the industry.

This is an integrated set of choices, because the decisions are mutually reinforcing. Rural and small-town locations create local monopolies, which reduce the threat of entry, reduce competition for labor and land, and increase pricing power. But without regional saturation, economies of scale from distribution centers would be lost. Regional saturation allows the company to reduce the threat of entry by preempting neighboring markets. The regional and national economies of scale help to make the low-cost position possible, which mutes industry rivalry. The low-cost position makes the everyday low-pricing position possible. That increases customers’ switching costs.

Identifying New Profit Opportunities

Now that we understand how Walmart’s positioning creates profits, we can return to the hypotheses we developed earlier:

• There are significant new profit opportunities in opening more stores in the United States.

• There are significant new profit opportunities in introducing new services in existing locations.

To test the first hypothesis, we would need to analyze local markets and infrastructure, and target (in the first instance) regions with dispersed small towns with good transport infrastructure that are not already served by superstores. Walmart could continue to look to dominate regions and avoid competing head-to-head with warehouse stores in urban environments.

Exploiting economies of scope by introducing new products and services to existing customers seems likely to be a profitable opportunity. Walmart could exploit its dominance of local markets to good effect. To test this idea for specific products and services, we would need to analyze the industry environment, for example, to estimate how profitable banking services are likely to be.

Exploit Industry Change

The final step is to look at change in the industry and its environment. Companies can exploit change and even act to shape the industry and its environment in their favor.

Sometimes change can be influenced by market participants. But there are other changes over which market participants have little control. These can occur suddenly and dramatically, such as new regulations or the development of new technologies. Industry analysis helps companies analyze how such changes can affect profitability, develop a strategy to compete over time, and explore opportunities to change the industry structure.

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Analyze How Profitability May Change Over Time Typically, dramatic change is a result of new regulations or a change in technology. One example is the impact of the Internet on the newspaper industry.

Before the spread of the Internet, the newspaper industry was very profitable. The printing process featured significant economies of scale, which tended to create local monopolies. Powerful brands and proprietary distribution channels presented further barriers to entry. Entering a market also entailed significant capital expenditure, in the form of a local printing press and offices. There was even a network effect: The more people who bought the newspaper, the more advertisers would want to advertise in it, which encouraged yet more readers to choose that newspaper to search for jobs, automobiles, and other products. A typical newspaper earned 70% of its revenue from advertising and 30% from circulation.25 One of the biggest concerns for newspapers was not industry rivalry, the threat of new entrants, the threat of substitutes, or the power of customers; it was the power of the suppliers of newsprint.

The Internet changed almost everything about the newspaper industry. It did not cause a decline in the value created by the news industry, but it did lead to a decline in the value captured by written, edited news. This change in power was due to a dramatic increase in the number of alternatives that each reader had at his or her fingertips and a radical decline in switching costs (a mouse click). Barriers to entry crumbled, and bloggers repackaging content proliferated. For advertisers, the Internet produced a dramatic increase in the number of alternatives, including a glut of web pages vying for advertisers’ patronage. The power of suppliers (writers and advertisers) increased, as they could bypass the media and go directly to customers.26 One of the most striking effects of the Internet was the emergence of powerful new substitutes for print advertising. Job sites like Monster.com siphoned off employment advertising revenue. Sites like Cars.com took over classified advertising for used cars. Dating sites like Match.com and craigslist undermined “lonely hearts” columns. Search engines like Google displaced many other types of newspaper advertising.

Of course, strategists cannot anticipate every conceivable technology development. But they can use the Five Forces Framework to explore how changes in various factors can affect the five forces, thus influencing industry profitability.

Let’s return to the Walmart example to see how changes may create profit opportunities or threaten existing profits. That will allow us to test the hypothesis that “the primary threat to existing profits comes from higher labor costs.”

Changes in the Threat of Entry

The threat of new superstore entrants in small markets already served by Walmart Supercenters seems small given the barriers to entry presented by distribution and economies of scale. If Walmart Supercenters are at the minimum efficient scale in a local market and can serve the entire market, the company has no need to fear entry by a rival operating at larger scale. If necessary, Walmart can deter entry by initiating price cuts. The company has taken care to enter at the minimum efficient scale in many of its markets, particularly in small towns. As the low-cost incumbent, it is difficult to dislodge.

Changes in the Bargaining Power of Suppliers

As Walmart develops more store brands and increases its scale, the bargaining power of product suppliers is likely to decrease. On the other hand, the power of suppliers of labor and land is likely to increase.

The company, a frequent target of unionization efforts, is likely to face even more powerful labor suppliers as it expands into urban areas with higher living costs and into states with higher minimum-wage laws, stronger unions, and less flexible workforces. Laws mandating benefits such as health care also represent a risk.

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As Walmart seeks to expand beyond its traditional market of rural areas and small towns, it will face more competition for suitable locations. Nonmarket actors such as neighborhood groups and labor unions may pressure local governments to deny permission to develop stores. These are strategic issues that influence the relative attractiveness of growth opportunities.

Strategies to deal with those challenges could include experimenting with models requiring fewer employees, such as warehouse stores, and targeting regions with less stringent labor laws. Nonmarket strategies, such as lobbying and developing community relationships, are likely to be increasingly important in more densely populated markets.

Changes in the Bargaining Power of Buyers

Customers’ bargaining power is lower where Walmart dominates the local market. In 2003 Walmart Supercenters accounted for 94% of the superstores in rural America but only 44% in affluent or elite locations. As Walmart expands into such areas, price-sensitive customers will have more alternatives, and so their power will grow. While there is little prospect that the industry will consolidate enough to decrease customers’ bargaining power, traffic congestion may become more of an issue for customers. Walmart could attempt to increase switching costs by targeting locations that are relatively close to substitutes in distance but relatively far in terms of travel time.

The threat to growth is market entry at scale by other firms into markets not yet served by Walmart superstores. As Walmart’s model is well-known, others may move to preempt it in unserved markets.

As we’ve seen, nonmarket actors such as labor unions and other interest groups can increase barriers to entry for Walmart, particularly in states where unions are strong. They can influence planning and zoning authorities, and encourage restrictive government policies.

Changes in the Threat of Substitutes

The appeal of the Walmart brand may wane in markets where affluence is growing. Demographic shifts towards urbanization increase the threat of substitutes. Traffic congestion makes nearby substitutes relatively more attractive. Online competitors and home delivery may become increasingly important, especially in densely populated areas. Walmart could consider experimenting with new delivery models in those markets.

Changes in Industry Rivalry

Rivalry is likely to increase as Walmart attempts to expand into new markets. Competition is likely to take the form of a battle for dominance in specific local markets, rather than head-to- head competition between neighboring superstores.

Changes in the Influence of Complements

As population density increases, parking becomes more valuable, which suggests opportunities for partnerships with parking lot owners and operators.

Threats to Walmart’s Profitability

To return to our hypothesis, labor costs are likely to continue to be a threat, but perhaps not the most important one. The biggest threats are likely to come from increasing costs, increasing rivalry, and decreasing distribution efficiencies in urban markets. Walmart could continue to experiment with smaller formats in more densely populated environments and consider rebranding Sam’s Clubs for the more affluent urban and suburban markets.

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Leveraging Industry Analysis to Compete Over Time Industry analysis is a snapshot in time, but businesses compete through time. Developing a strategy to strengthen competitive position is necessary for all businesses but is particularly important for innovators. Amazon.com is one example.

Amazon.com famously expressed its strategy as “Get Big Fast!” The company explained its reasoning prior to its initial public offering:

The Company believes that its success will depend in large part on its ability to (i) extend its brand position, (ii) provide its customers with outstanding value and a superior shopping experience, and (iii) achieve sufficient sales volume to realize economies of scale. Accordingly, the Company intends to invest heavily in marketing and promotion, site development and technology and operating infrastructure development. The Company also intends to offer attractive pricing programs, which will reduce its gross margins. Because the Company has relatively low product gross margins, achieving profitability given planned investment levels depends upon the Company's ability to generate and sustain substantially increased revenue levels. As a result, the Company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred will increase significantly from current levels.27

Here Amazon.com announced its intention of building barriers to entry by developing economies of scale. The large capital requirement due to “substantial operating losses for the foreseeable future” formed a second barrier to entry. The commitment to “outstanding value” was a signal that Amazon.com would not be beaten on price. These barriers to entry were not fixed; they grew stronger over time. Branding and economies of scale can have cumulative value. Taken together, these barriers to entry explain why Amazon.com is the dominant pure- play Internet retailer.

Walmart started out in small towns, growing gradually at first, then accelerated its growth rate. The company operated in 8 states in 1975 and then in all 50 by 1996. Economies of scale and scope mean that one of the most attractive opportunities for Walmart is the same one it has had since its founding: entering a regional market at a larger scale than incumbents and achieving an effective local monopoly by serving the entire market.

Time is an important factor in market entry. Walmart achieved early success by entering rural markets at scale before competitors caught on to the idea. That timing and commitment created a barrier to entry for competitors and continues to be important. If Walmart can signal commitment by building a local distribution center and following up with store openings quickly enough, it can discourage competitors. Because barriers to exit are not high, Walmart could invest preemptively in locations where future growth is likely.

Competitors in markets where Walmart is not yet present have an incentive to enter markets at scale in an attempt to preempt entry by Walmart. That is likely to be one reason why Walmart has used acquisitions and joint ventures to expand internationally.

Explore Opportunities to Shape Industry Structure It is possible for companies to shape an industry to their advantage, but it can take many years. For decades, Boeing had a dominant position in the long-haul air transportation market in the Very Large Commercial Transport (VLCT) segment. That put it in a position to extract profits from its airline customers, which therefore had a powerful incentive to encourage entry by a competitor. Although barriers to entry were high, a combination of state support and the willingness of airlines to commit to large orders changed the industry structure. Now the

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aircraft industry features intense competition in every segment, including VLCT, and bargaining power has shifted to the airlines.

There are different ways to shape industry structure. Fragmented industries can be consolidated, as Wire and Plastic Products PLC (WPP) did with the marketing services industry by acquiring J. Walter Thompson, The Ogilvy Group, and many smaller companies.28 Emerging industries can be shaped by the preemption of valuable assets or the creation of customer switching costs.

Complementors can have a powerful incentive to shape industry structure. For Google, the transition to mobile computing and smartphones represented a potential threat to its search advertising business. If a dominant smartphone platform or operating system had emerged, the owner would have been in a powerful bargaining position with respect to the suppliers of web services such as search capability. By developing and distributing the Android operating system, Google ensured that no platform became too powerful.

As the market leader, Walmart has already shaped the industry environment in the United States, but customers and substitutes remain powerful. It does not seem likely that Walmart can mitigate customer power using techniques such as branding. Continuing to expand into substitute industries and leveraging operating efficiencies and purchasing economies seem more likely to succeed.

2.6 Criticisms and Limitations

The Five Forces Framework has attracted its share of criticism. Those critiques generally fall into three categories: The framework does not adequately analyze all relevant factors in the business environment; it says little about sources of competitive advantage; and it is not very helpful in finding new opportunities or in dealing with industries whose structures are evolving rapidly. Although some of these criticisms have merit, others do not. We discuss each criticism below.

Does the Five Forces Framework Adequately Analyze the Business Environment? Some critics argue that the Five Forces Framework omits important players, such as government, nonmarket actors (such as trade unions and lobbyists), and complementors. Others say that it is “static,” incapable of reflecting the evolution in industry structure. Still others charge that the framework does not model strategic interaction between market participants, such as collusion.

We agree that the Five Forces Framework needs to be augmented with an analysis of complements, as we have done here. Nonmarket actors, though, can be represented in the framework by their influence on the five forces.29 In discussing Walmart, we have seen that lobbyists and trade unions can change the power of suppliers by influencing the supply of labor and land.

Although industry analysis is sometimes criticized as “static,” the previous sections show that it is useful in developing a strategy over time. When industry analysis is treated as a snapshot, strategists can analyze the current forces and then plot how they would like them to look in the future. The strategy over time (or “dynamic strategy”) becomes the plan to move from the current environment to the desired future one, as the Amazon.com example shows. Industry analysis can also evaluate the impact of technological change.

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The Five Forces Framework provides a structured way of thinking about the factors affecting profitability. It does not, however, predict how specific competitors will respond to strategic moves. In some circumstances it is helpful to supplement industry analysis with game theory and to think more analytically about competitive response.

Does Industry Analysis Explain Competitive Advantage? The Five Forces Framework focuses on the economic characteristics of the industry and its environment. It recognizes that profit potential is affected by firm-specific factors such as “differentiation” and “incumbency advantages independent of size,” such as brands and proprietary technology. It does not, however, explain why some firms perform better than others in the same environment.

To understand performance differences, strategists use the term “competitive advantage.” For more details, see Core Reading: Competitive Advantage (HBP No. 8105). Competitive advantage comes from differences in the decisions firms make. Some theories about the sources of competitive advantage emphasize decisions about which activities to perform. Others focus on decisions about which resources to invest in and which capabilities to develop, an approach known as the “resource-based view” of the firm.30

Although they are sometimes presented as “competitors” to the Five Forces Framework, theories about competitive advantage do not really compete with it. Whatever the decisions of the firm—whether concerning activities or investments in resources and capabilities—they need to deal effectively with the environment in which the firm operates.

Does Industry Analysis Help Companies Find Entirely New Opportunities? Another criticism of the Five Forces Framework is that it examines the current and evolving state of competition among players who are following the established ways of competing, rather than illuminating altogether new ways of competing. That is the focus of the approach known as Blue Ocean Strategy, which advocates that instead of competing in overcrowded industries, companies should look for uncontested market spaces and create new demand.31

In Competing for the Future, Gary Hamel and C.K. Prahalad make a similar criticism. “Strategy, as taught in many business schools and practiced in most companies, seems to be more concerned with how to position products and businesses within the existing industry structure than how to create tomorrow’s industries.”32

Although these are fair points, criticizing the Five Forces Framework on these grounds is like criticizing a hammer for not being a saw. The Five Forces Framework, Blue Ocean Strategy, and other approaches are different tools that are used for different purposes. It is worth emphasizing, however, that competitive forces must be considered in any strategy. As Amazon.com clearly realized, even an innovator needs a strategy for protecting profits from the forces that try to appropriate them.

2.7 Conclusion: The Business World Changes, but Industries Remain

The study of management has its fads and fashions. One year, innovation may be the hot topic while a year later, organizational culture may be on everyone’s minds. But as Carl Shapiro and

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Hal Varian write in Information Rules, “Ignore basic economic principles at your own risk. Technology changes. Economic laws do not.”33

Industry analysis deals with fundamental economic principles. No organization can afford to ignore competitive forces. As strategists work to understand the competitive environment, they also need to think about how they can shape it, and how they can develop a firm that can survive and even thrive in it.

3 SUPPLEMENTAL READING

3.1 How Much Does Industry Matter?

This chapter is about industry analysis. But what if a firm’s industry doesn’t matter much? If the success of firms within an industry varies a lot, then success depends more on the firm than on the industry. Wouldn’t that imply that strategists should focus more on the factors that make individual firms successful and less on factors that affect all firms in the industry?

While this “firm versus industry” question seems important at first glance, a little thought shows that it’s a false dichotomy. The distinctive characteristics of a firm don’t matter if it can’t deal effectively with competitive forces. Any strategy must consider both the firm and the industry environment. As Michael Porter explains, “Strategy is the act of aligning a company and its environment.”34

Nevertheless, in the 1980s and 1990s several researchers set out to try to measure the importance of industry to a firm’s success. These empirical studies have been influential in the development of theories about strategy.

The first important study was by Richard Schmalensee.35 In a 1985 paper entitled “Do Markets Differ Much?” he framed the competing explanations of profitability differences among firms in a provocative way. The classical tradition, he wrote, assumed differences among firms were “transitory or unimportant.” In that tradition, industry profits depended primarily on the concentration of sellers (that is, the amount of dominance of the market by a small number of sellers) because that creates opportunities for collusion. An anticlassical, revisionist, view asserted that there are persistent efficiency differences among sellers and that the more efficient sellers tend to grow at the expense of their rivals. A third tradition, which Schmalensee called managerial, posits that “some firms are better managed than others.” He cited In Search of Excellence—a bestseller by Thomas Peters and Robert Waterman, Jr.—as espousing the managerial tradition.36 The managerial tradition is also represented in more recent bestsellers, such as Built to Last by Jim Collins and Jerry I. Porras.37 When framed like that, the stakes could hardly have been higher for strategy researchers. Who was right? Does management matter, or is it irrelevant?

Schmalensee’s conclusions were striking. In a study using the U.S. Federal Trade Commission’s 1975 Line of Business data for industrial companies, he found that firm effects did not exist (that is, the differences between firms did not explain variations in profitability) and that industry effects (differences between industries) accounted for at least 75% of the variance in industry rates of return on assets. Those results imply that industry is a very important determinant of profitability. He noted, however, that “80 percent of the variance in business unit profitability is unrelated to industry or [market] share effects.” He went on to say that “while industry effects matter, they are clearly not all that matters.”

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Richard Rumelt published an influential response to Schmalensee in 1991.38 Rumelt’s study—titled “How Much Does Industry Matter?”—reached dramatically different conclusions. Using four years of data instead of Schmalensee’s one, he concluded that stable industry effects accounted for only 8% of the variance in business-unit returns. Further, he found that 46% of the variance was due to stable business-unit effects. According to Rumelt, “Business-units differ from one another within industries a great deal more than industries differ from one another.”

Anita McGahan and Michael Porter published their own empirical study in 1997.39 While Schmalensee’s and Rumelt’s analyses were limited to manufacturing, McGahan and Porter’s study (entitled “How Much Does Industry Matter, Really?”) included all industries (except finance) and used 14 years of data. They found that nearly 19% of the variance in profitability was due to stable industry effects, and industry effects accounted for 36% of explained variation. McGahan and Porter also found substantial variation in the importance of industry effects across industries, which further suggested to them that industry structure was important. In their analysis, however, firm effects were still important: Business segment effects accounted for 32% of the variance in business-segment profitability.

These empirical studies continue. Although the results vary, the studies generally show that the proportion of variance in firms’ return on assets explained by industry effects is about 10% to 20%, while firm effects (within industries) account for 30% to 45%. In other words, profitability depends only in part on a firm’s industry. The firm’s decisions have a larger impact on profitability than its industry. So what are strategists to make of this?

Despite the article titles, it doesn’t follow that if companies’ profits vary within an industry, the competitive forces are irrelevant. Although competitive forces within an industry are the same, firms can respond to them differently. The Five Forces Framework points to many things that firms can do to mitigate competitive forces. Some of these—like branding—are firm-specific and so can produce profits that vary within the industry.

Nothing in industry analysis says that the choices a firm makes are irrelevant, nor does industry analysis say that firms don’t make different choices. What industry analysis says is that unless a firm’s decisions deal effectively with the industry environment, the firm is doomed to failure.

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4 KEY TERMS asymmetric threats A business that can enter the industry of another business while the second business is less able to enter the industry of the first business. A complementor in this position has a degree of power over the second business.

backward integration A strategy in which a business takes over functions once provided by its suppliers.

bargaining power of buyers The customer’s ability to influence the price, availability, or quality of the products of a business, which depends on the number of customers a business has, the importance of a customer to a business, switching costs, and a number of other factors.

bargaining power of suppliers A supplier’s ability to increase costs, reduce quality, or restrict availability to a customer.

barriers to entry Characteristics of an industry or market that make it more difficult for new entrants to compete.

barriers to exit Impediments that hinder a firm that wants to leave a market or industry.

competitive advantage A firm’s ability to perform activities more effectively or distinctively than its industry rivals.

complementary goods A product whose demand increases along with that of another good: As the price of the second good decreases the demand of the complementary good increases.

cost advantage A lower cost of production due to access to less expensive inputs, more efficient processes, more favorable locations, a more skilled workforce, more advanced technologies, or less waste.

customer concentration or monopsony power A market situation in which there are fewer customers than there are vendors, and thus the customers have greater bargaining power.

customer switching costs The additional cost a consumer incurs in moving from one vendor’s products or services to another vendor’s products or services.

demand-side benefits of scale or network effects The gain in the value of a product to a consumer as the number of consumers increases.

economies of scale The decline in the cost of production per unit as the volume grows.

forward integration A strategy by which a business takes over the functions located between it and its ultimate customers, such as distribution centers and retailers.

incumbency advantages The benefits a business enjoys from being the first to compete in an industry.

substitutes In economics, two products are considered substitutes when a rise in the price of one increases the demand for the other.

5 FOR FURTHER READING Brandenburger, Adam M., and Barry J. Nalebuff. Co-opetition. New York: Doubleday, 1996.

Porter, Michael E. Competitive Strategy. New York: Free Press, 1980.

Porter, Michael E. “The Five Competitive Forces That Shape Strategy.” Harvard Business Review 86, no.1 (January 2008): 78–93.

Porter, Michael E. “Understanding Industry Structure, Teaching Note.” HBS No. 707–493. Boston: Harvard Business School, 2006.

8101 | Core Reading: INDUSTRY ANALYSIS 37

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This document is authorized for use only by Erdong Wang in Spring 2020 Strategic Management-1 taught by Matt Fisher, San Francisco State University from Aug 2020 to Feb 2021.

6 ENDNOTES 1 Ramon Casadesus-Masanell and Jordan Mitchell, “Greenpeace,” HBS No. 708–418 (Boston: Harvard Business

School, 2009).

2 Jan W. Rivkin and Kevin Sharer, “Industry and Positioning,” unpublished teaching plan, March 2013.

3 Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (March–April 1979): 78–93.

4 Jean Tirole, The Theory of Industrial Organization (Cambridge, MA: MIT Press, 2006).

5 Joan Magretta, Understanding Michael Porter (Boston, MA: Harvard Business Press Books, 2012).

6 Peter Bevelin, A Few Lessons For Investors and Management from Warren E. Buffett (Glendale, CA: PCA Publications L.L.C., 2012), p.18.

7 Richard Rumelt, Good Strategy Bad Strategy: The Difference and Why It Matters (New York, NY: Crown Publishing Group, 2011), p. 278.

8 Richard Rumelt, Good Strategy Bad Strategy: The Difference and Why It Matters (New York, NY: Crown Publishing Group, 2011), p. 284.

9 Michael E. Porter, “Understanding Industry Structure, Teaching Note,” HBS No. 707–493 (Boston: Harvard Business School, August 2007).

10 Michael E. Porter, “Understanding Industry Structure, Teaching Note” HBS No. 707–493 (Boston: Harvard Business School, August 2007).

11 ESPN, “Revenue report warns English clubs over wages,” ESPN, June 6, 2013, http://www.espn.co.uk/football/sport/story/210681.html, accessed August 1, 2013.

12 Adam Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Doubleday, 1996).

13 Lance Ulanoff, “Goodbye Netscape Navigator,” PC Magazine, February 13, 2008, http://www.pcmag.com/article2/0,2817,2259414,00.asp, accessed March 11, 2013.

14 Pankaj Ghemawat, Strategy and the Business Landscape (Upper Saddle River, NJ: Prentice Hall, 2001).

15 Michael E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 86, no. 1 (January 2008): 78–93.

16 Jan W. Rivkin, “Yellow Tail,” unpublished teaching plan.

17 Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Walmart Stores in 2003,” HBS No. 704–430 (Boston: Harvard Business School, 2004).

18 Sears Holdings Corporation, “About Kmart,” http://www.searsholdings.com/about/kmart/, accessed April 8, 2013.

19 Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Walmart Stores in 2003,” HBS No. 704–430 (Boston: Harvard Business School, 2004), Exhibit 1.

20 Derek F. Abell, Defining the Business: The Starting Point of Strategic Planning (Upper Saddle River, NJ: Prentice Hall, 1980).

21 Euromonitor International, “Hair Care in the US,” June 2012, http://www.euromonitor.com/hair-care-in-the- us/report, accessed April 20, 2013.

22 Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Walmart Stores in 2003,” HBS No. 704–430 (Boston: Harvard Business School, 2004), p.8.

23 Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Walmart Stores in 2003,” HBS No. 704–430 (Boston: Harvard Business School, 2004), p. 5.

24 Calculated from Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Walmart Stores in 2003,” HBS No. 704–430 (Boston: Harvard Business School, 2004), Exhibit 8.

25 For example, New York Times advertising and circulation revenues accounted for approximately 70% and 23% respectively of 1997 revenues. The New York Times Company, 1997 Annual Form 10-K, http://www.nytco.com/pdf/annual_1997/1997_10-K_MDA.pdf, accessed April 12, 2013.

26 Adapted from Jan W. Rivkin, unpublished teaching plan for “The Economist” (HBS No. 710–441).

27 Amazon.com Inc., “Form S-1 Registration Statement,” March 24, 1997, p.5, http://www.sec.gov/Archives/edgar/data/1018724/0000891618-97-001309.txt, accessed April 15, 2013.

28 WPP Group, “Group History,” http://www.wpp.com/wpp/about/whoweare/history, accessed April 1, 2013.

8101 | Core Reading: INDUSTRY ANALYSIS 38

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This document is authorized for use only by Erdong Wang in Spring 2020 Strategic Management-1 taught by Matt Fisher, San Francisco State University from Aug 2020 to Feb 2021.

29 Michael E. Porter, “Understanding Industry Structure, Teaching Note,” HBS No. 707–493 (Boston: Harvard Business School, August 2007).

30 Birger Wernerfelt, “A Resource-Based View of the Firm,” Strategic Management Journal 5 (September–October 1984): 171–180.

31 W. Chan Kim and Renée A. Mauborgne, “Blue Ocean Strategy,” Harvard Business Review 82, no. 10 (October 2004): 76–84.

32 Gary Hamel and C.K. Prahalad, Competing for the Future (Boston, MA: Harvard Business School Press, 1984).

33 Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston, MA: Harvard Business School Press, 1999).

34 Michael E. Porter, “Towards a Dynamic Theory of Strategy,” Strategic Management Journal vol. 12 (Winter 1991): 95–117.

35 Richard Schmalensee, “Do Markets Differ Much?” The American Economic Review 75, no. 3 (June 1985): 341–351.

36 Thomas J. Peters and Robert H. Waterman, Jr., In Search of Excellence: Lessons from America’s Best-Run Companies (New York: Harper & Row, 1982).

37 Jim Collins and Jerry I. Porras, Built to Last: Successful Habits of Visionary Companies (New York: HarperBusiness, 2002).

38 Richard P. Rumelt, “How Much Does Industry Matter?” Strategic Management Journal 12, no. 3 (March 1991): 167–185.

39 Anita M. McGahan and Michael E. Porter, “How Much Does Industry Matter, Really?” Strategic Management Journal vol. 18, (Summer 1997): 15–30.

8101 | Core Reading: INDUSTRY ANALYSIS 39

For the exclusive use of E. Wang, 2020.

This document is authorized for use only by Erdong Wang in Spring 2020 Strategic Management-1 taught by Matt Fisher, San Francisco State University from Aug 2020 to Feb 2021.

7 INDEX airline industry, 6, 12, 13, 16, 32–33 Amazon.com, 9, 16, 21–22, 26, 28, 32, 33, 34 Apple Inc., 3, 16, 18, 19, 23 asymmetric threats, 18, 37 backward integration, 13, 37 bargaining power of buyers, 5, 13–14, 25, 28,

31, 37 bargaining power of suppliers, 4, 5, 11–12, 25,

28, 30–31, 37 barriers to entry, 5, 9–11, 30, 32, 37 barriers to exit, 10, 16, 25, 32, 37 Blue Ocean Strategy, 34 buyers, bargaining power of, 5, 13–14, 25, 28,

31, 37 buyers, power of, 13–14 capacity expansion, 16 capital requirements, 10, 25 change, exploiting, 4, 29–31 classical tradition, 35 competitive advantage, 19, 27, 34, 37 competitors, rivalry among, 3, 5, 6, 15–17, 19,

21, 23, 26, 28–29, 31 complementary goods (complements), 3, 9,

17–18, 19, 23, 24, 26, 31, 33, 37 complementors, 33, 37 cooperation, 17–18 cost advantage, 9, 37 Costco Wholesale Corporation, 13, 21, 22, 28 customer concentration, 13, 37 customer switching costs, 10, 12, 13, 18, 19, 25,

33, 37 data sources of industry information, 23 demand, influence on, 18 demand-side benefits of scale, 9–10, 37 DHL, 9 differentiated products, 12, 19, 28, 34 distribution channels, 10 diversity of competitors, 16 eBay, 9, 11 economies of scale, 9, 27–28, 32, 37 endogenous barriers to entry, 10–11 entry barriers, 5, 9–11, 30, 32, 37 exit barriers, 10, 16, 25, 32, 37 exogenous barriers to entry, 9–10 Facebook, 9–10 FedEx, 9 financial pressure of customers, 12 Five Forces Framework, 4–8, 9, 30–31, 33 fixed costs, 16, 25, 28 forward integration, 12, 37

game theory, 5, 10, 34 Global Crossing, 8 Google Inc., 9, 10, 17–18, 30, 33 government policy restrictions, 10, 25, 30–31 Harley-Davidson Inc., 19 hypotheses, in industry analysis, 20, 21 incumbency advantages, 10, 25, 34, 37 Industrial Organization (IO), 5 industry, 3, 35–36 industry, definition of, 4, 21–23 industry, profitability variations by, 6, 7, 8 industry analysis, 3 industry analysis, steps in, 4, 21 industry analysis, test of, 4, 26 industry data sources, 23 industry dependence, 12 industry environment, 3, 4, 8, 27–29 industry growth, 16 industry rivalry, 3, 5, 6, 15–17, 19, 21, 23, 26,

28–29, 31 industry structure, shaping, 32–33 integrated set of choices, in strategy, 28, 29 Intel Corporation, 12, 17 Kmart, 21, 22, 23, 26, 27, 28 managerial tradition, 35 marginal costs, 16 Microsoft Corporation, 12, 17, 18 Microsoft Windows operating system , 10, 17 monopsony power, 13, 37 network effects, 9–10, 37 new entrants, 5, 9–11, 24, 27–28, 30 nonmarket actors, 23, 24, 25, 31, 33 perishability of products, 16 players, identification of, 4, 23–24 positioning, 19, 22, 27–29 potential entrants, 5, 9–11, 24, 27–28, 30 product quality, 12 profitability, 5–6, 35–36 profitability, changes over time, 30–31 profitability, ‘‘firm versus industry’’ question

on, 35–36 profitability, industry variations in, 6, 7, 8 profitability, players’ influence on, 4, 24–26 profitability, threats to, 19–20, 31 profit opportunities, 18, 29 purchases, concentration of, 12

8101 | Core Reading: INDUSTRY ANALYSIS 40

For the exclusive use of E. Wang, 2020.

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resource-based view, of firm, 34 response to industry environment, 4, 27–29 return on invested capital, 6, 7 revisionist view, 35 rivalry, among competitors, 3, 5, 6, 15–17, 19,

21, 23, 26, 28–29, 31 Samsung Group, 3, 16, 18, 23 scientific method, 20–21 size of competitors, 16 strategic questions, 20, 27 strategy, 35 substitutes, 12, 21, 22, 23, 24, 37 substitutes, threat of, 5, 14–15, 26, 28, 31 superstores, 22, 23–24, 25, 26, 27–28, 29, 30, 31 supplier concentration, 12, 25 supplier network access, 10

suppliers, bargaining power of, 4, 5, 11–12, 25, 28, 30–31, 37

switching costs, 10, 12, 13, 18, 19, 25, 33, 37 Target Corporation, 21, 22, 23, 26, 27, 29 test of industry analysis, 4, 26 unbundling, 18 undifferentiated products, 12, 13, 16, 26 Walmart, 20, 21–22, 23–24, 25, 26, 27, 28, 29,

30–31, 32, 33 warehouse clubs, 13, 21, 22, 24, 26, 28, 29, 31 wine industry, 20 Yellow Tail brand, 20

8101 | Core Reading: INDUSTRY ANALYSIS 41

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