Market Structure Analysis Objectives of the Lecture

1. Market Structure Analysis Objectives of the Lecture 1)To give basic idea about Structure - Conduct - Performance (SCP) Framework. 2) To give basic idea about Porter’s Five Forces Model/Analysis. 3) To give basic knowledge about Various Market Structures a) Perfect Competition b) Monopoly/Monopsony c) Monopolistic Competition e) Oilgopoly

2. The Structure Conduct Performance (SCP) Framework Generally two approaches are used to characterize and to analyze markets. 1) SCP approach 2) Porter’s five forces analysis The importance of analysis of market structure: 1) Structure affects for the conduct and it affects for the performance of the firm. 2) To formulate strategic policies. SCP framework mainly developed by Mason and Bain and it is a neo-classical tool which assumes that firms maximize profits, consumers maximize utility and markets tend towards a position of equilibrium. This framework is useful to classify and to analyze industries. It is simple, easy to apply, easy to understand, not industry specific and therefore can use on different industries and for comparative purposes.

3. Structure Conduct Performance The Nature of SCP Basic Conditions

4. SCP Framework : Industry Structure • “the way in which the market is organised or the underlying factors which determine the competitive relations between sellers” • The nature of product • Cost conditions • Demand conditions • Existence of economies of scales and scope • number and size distribution of firms/sellers (concentration) • Number and size distribution of the buyers • Conditions of entry and exit • Product differentiation • Corporate integration • Diversification

5. SCP Framework : Industry Conduct • “the behaviour of firms as they interact with each other and customers or factors which are under control of firm” • Pricing policies • Marketing and advertising strategies • Financing policies • The degree of competition or cooperation • Output decisions • R & D and innovation • Growth and merger behaviour

6. SCP Framework : Industry Performance • “the level of efficiency achieved by firms in their use of scarce resources or indicators which measure the performance of the organization” • extent of profits - normal v. abnormal profits • allocative efficiency(Marginal social benefits = marginal social costs of production) • productive efficiency(Usage of resources more efficiently than before) • net economic welfare - deadweight losses • Size and growth of industry output • the development of product and technology

7. Criticisms and alternatives to SCP framework 1) Structure is determined exogenously in simple SCP framework. S C P. Here no answer for the question of what shapes the structure. 2) Most of these factors are overlapping and interrelated with respect to S, C and P. 3) Market or industry specific nature limit its application to multi-products or diversified firms. 4) Most of the empirical studies are concerned only about structure and performance. No place for conduct. 5) Actual market situation is not given a proper place in determination of conduct and performance specially in contestable markets (markets no barriers to entry or exist). Alternative to this is the Porter’s five forces analysis.

8. Measuring the Market Concentration “Market concentration refers to the extent to which the supply of a good or service is controlled by the leading suppliers of the product” Commonly used measures : • Concentration Ratio (market supplied by the given number of firms 1….8) • Market share (market share analyzes according to employment, value added, output and capital) • Profits rates (high profits in monopoly) • Lerner index (P-MC/P) • Herfindahl Index (HI) (measures the size distribution of the firm or level of market concentration. Index depends on the number of firms in the industry and their relative market share. Value closer to 1 says increased monopolization). • Lorenz curve (This shows relationship between cumulative % of firms in the industry and the cumulative % of market share) • Gini coefficient (measure of concentration in market)

9. Porter’s Five Forces Analysis This model also can be used to classify and analyze industries. It can be used to analyze the current market position and in formulation of strategic policies. This use same factors as SCP but characterize under different headings: 1) Current competition or the Extent of Competitive Rivalry 2) Potential competition or threat of Potential New Entrants 3) Threat of substitute products 4) The power of buyers 5) The power of suppliers

10. Porter’s Five Forces Analysis • What are the key forces influencing an organization? • Could these forces change: • Is there a case for changing strategic relationship with suppliers? • Is there a case for forming a new relationship with large buyers? • Are there any technical developments that rivals could use to dramatically alter the environment? • What can management do to influence these forces? • Are some industries more attractive than others?

11. Bargaining power of suppliers Suppliers Porter’s Five Forces Model Industry competitors

12. Bargaining Power of Suppliers Suppliers are more powerful when • there are few suppliers: difficult to switch • supplier’s customers are fragmented • there are no substitutes for the supplies • suppliers’ prices form a large part of the total costs • supplier could potentially undertake the value-added process • supplier brand is powerful • JIT production

13. Buyers Bargaining power of buyers Porter’s Five Forces Model Bargaining power of suppliers Industry competitors Suppliers

14. Bargaining Power of Buyers Buyers (or Customers) are more powerful when • they are concentrated and there are few of them (particularly true for high volume) • product is undifferentiated • backward integration (buyers collective actions or groupings) is possible • if the selling price is unimportant to the buyer’s total costs • supply industry comprises a large number of small operators

15. Potential entrants Threat of new entrants Porter’s Five Forces Model Bargaining power of suppliers Industry competitors Buyers Suppliers Bargaining power of buyers

16. Threat of Potential New Entrants • High when barriers to entry are low • Porter identifies 7 major BTEs: • Economies of scale • Product differentiation • Capital requirements • Access to distribution channels • Cost disadvantages independent of scale • Government policy • Retaliation

17. Entry barriers 1) Economies of scale (Internal or external) a) Technical - This come through an increased specialization and indivisibilities in fixed costs. b) Marketing - results from spreading the costs of marketing over higher output. c) Financial - Larger firms can easily access to capital for low rates. d) Risk -bearing - Diversification helps to face risks in markets. e) Natural monopoly situation - market can be supplied by one firm for the least costs. 2) Legal barriers such as patents and franchises. Patents are exclusive licences to exploit an invention for a given length of time and franchises are licences given to an individual or firm to manufacture or sell a named product in a certain area for a specific time. 3) Advertising and branding - Industries where brand names are well established then difficult to enter without heavy advertising expenditure. 4) High initial capital requirements (heavy initial capital requirement is a barrier). 5) Switching costs (In some sectors switching costs are high). 6) Lack of distribution channels. 7) Restrictive practices.

18. Barriers to Exist also important in porters model 1) Costs barriers - This depend on the industry-specific nature of the firm’s assets. More industry specific means low second hand value and higher exist costs. 2) Intangible assets barriers - knowledge of market and R and D can not be resale. 3) labour costs

19. Potential entrants Threat of substitute products and services Substitutes Porter’s Five Forces Model Threat of new entrants Bargaining power of suppliers Industry competitors Buyers Suppliers Bargaining power of buyers

20. Threat of Substitutes • Product for Product substitution • fax for post; e-mail for fax • Substitution of need • no-clean flux for cleaning solvents • Generic substitution • furniture purchases for holiday purchases • Doing without • no smoking for tobacco products … can be identified by looking at cross-price elasticities

21. Substitutes may not entirely replace existing products but • introduce new technology or reduce the costs of producing • the same products. • Substitutes may affect products in neighboring markets that • might not have originally been expected to provide competition. • Key Issues: • Possible threats of disappearance. • Ability of customers to switch to the substitute. • Costs of providing some extra aspects of the service that • will prevents switching • Likely reduction in profit margin if prices come down or are • Held.

22. Potential entrants Industry competitors Rivalry among existing firms Threat of substitute products and services Substitutes Porter’s Five Forces Model Threat of new entrants Bargaining power of suppliers Industry competitors Buyers Suppliers Bargaining power of buyers

23. The Extent of Competitive Rivalry • Different market structures have different degree of competition. • Highly competitive markets, companies have regular and • extensive monitoring of the competitors behaviour. • Ex: • Price changes and matching any significant move accordingly. • Product changes and new initiatives. • Investing in new plants and reducing costs. • Recruiting new staffs.

24. Factors affecting competitive rivalry • number of competitors • extent to which competitors are in balance • market growth rates (product lifecycle) • existence of global customers • high fixed costs (price wars, low margins) • extra capacity is in large increments • differentiation • acquisition of weaker companies • high exit barriers

25. Example: The Airline Industry • What is driving the current restructuring in the passenger airline industry? • Characterise the competitive forces in the airline industry • bargaining power of suppliers • bargaining power of buyers • threat of entrants • threat of substitutes • competitive rivalry

26. Potential entrants Industry competitors Rivalry among existing firms Threat of substitute products and services Substitutes Porter’s Five Forces Model Threat of new entrants • Suppliers • Slots & ATC : fierce competition for limited supply • Planes : oligopolistic suppliers • Labour : highly skilled operators for planes; service providers • Fuel : main variable cost, volatile • high ratio of fixed to variable costs Bargaining power of suppliers Industry competitors Buyers Suppliers Bargaining power of buyers

27. Potential entrants Industry competitors Rivalry among existing firms Threat of substitute products and services Substitutes Porter’s Five Forces Model Threat of new entrants • Buyers • Segments : business v. consumer • Many alternatives for buyers • Price sensitive • Elastic demand • Rise in web as selling channel means have more information • Suppliers • Slots & ATC : fierce competition for limited supply • Planes : oligopolistic suppliers • Labour : highly skilled operators for planes; service providers • Fuel : main variable cost, volatile • high ratio of fixed to variable costs High power of suppliers Industry competitors Buyers Bargaining power of buyers

28. Potential entrants Industry competitors Rivalry among existing firms Threat of substitute products and services Substitutes Porter’s Five Forces Model • Potential Entrants • BTEs decreasing over time through… • decreased regulation • freer competition for slots • decline in importance of agencies and exclusive booking systems • But… • still has high MES Threat of new entrants • Suppliers • Slots & ATC : fierce competition for limited supply • Planes : oligopolistic suppliers • Labour : highly skilled operators for planes; service providers • Fuel : main variable cost, volatile • high ratio of fixed to variable costs • Buyers • Segments : business v. consumer • Many alternatives for buyers • Price sensitive • Elastic demand • Rise in web as selling channel means have more information High power of suppliers Industry competitors Increasing power of buyers

29. Industry competitors Rivalry among existing firms Threat of substitute products and services Substitutes Porter’s Five Forces Model • Potential Entrants • BTEs decreasing over time through… • decreased regulation • freer competition for slots • decline in importance of agencies & exclusive booking systems • But… still has high MES Threat of existing firms into new segments • Substitutes • potential for substitution of need, generic substitution and doing without all high • also possible to have product for product substitution for short journeys • demand for air travel is elastic • Suppliers • Slots & ATC : fierce competition for limited supply • Planes : oligopolistic suppliers • Labour : highly skilled operators for planes; service providers • Fuel : main variable cost, volatile • high ratio of fixed to variable costs • Buyers • Segments : business v. consumer • Many alternatives for buyers • Price sensitive • Elastic demand • Rise in web as selling channel means have more information High power of suppliers Industry competitors Increasing power of buyers

30. Industry competitors Rivalry among existing firms Porter’s Five Forces Model • Potential Entrants • BTEs decreasing over time through… • decreased regulation • freer competition for slots • decline in importance of agencies & exclusive booking systems • But… still has high MES Threat of existing firms into new segments • Rivalry • many firms of similar size (but not big enough…) • simultaneous attempts to work together (share costs) and compete (branding) • move towards price-based competition • limited effectiveness of differentiation • Suppliers • Slots & ATC : fierce competition for limited supply • Planes : oligopolistic suppliers • Labour : highly skilled operators for planes; service providers • Fuel : main variable cost, volatile • high ratio of fixed to variable costs • Buyers • Segments : business v. consumer • Many alternatives for buyers • Price sensitive • Elastic demand • Rise in web as selling channel means have more information High power of suppliers Industry competitors Increasing power of buyers High threat from generics • Substitutes • potential for substitution of need, generic substitution and doing without all high • also possible to have product for product substitution for short journeys • demand for air travel is elastic

31. Criticisms of the Model 1) Assumption of organization’s own interests comes first: this is not applicable for public bodies and charitable organizations. 2) Assumption that buyers have no greater importance than any other aspect of the micro-environment. But customer is more important than other aspects of strategy development and is not to be treated as an equal aspects of such an analysis. 3) Consideration of suppliers and buyers as possible threats to organization. But most companies have good co-operation with these two parties. 4) Ignored the human resources aspects of strategy, country culture and management skills aspects of corporate strategy. 5) Analysis is predictive rather emergent.

32. Merits 1) Useful starting point in the analysis and development of corporate strategy. 2) A good logical and structured framework. 3) This analysis is complementary with analysis of industry evolution and strategic group. 4) A good framework to analyze the firm’s business environment.

33. Self-Study a) Apply Porter's Five Forces model to your organization (Moratuwa University or your Household) or any other firm/industry of your choice. What are the main drivers of competition in your chosen industry? • b) Apply Porter’s Five Forces model to analyze profitability of any industry of your choice. • Why Coke is very profitable compared to other soft drinks. • Why MTV is very profitable compared to other TV channel.

34. c) The costs of building a conventional hot-rolled steel mill have declined substantially as a result of the new mini-mill technology that requires only scarp metal, an electric furnace, and 300workers rather than iron ore raw materials, enormous blast furnaces, rolling mills, reheating furnaces, and 1000 of workers. 1) What effects on the potential industry profitability would Porter’s Five Forces framework suggest this new technology would be? 2) Why it is so?