Teaching Note 5

The Structure of Industry

Intensity of Firm Rivalry

Competition is the nature of business. To an economist, the competitive market is inhabited by firms that react to changes in an impersonal way. Business people view what rivals do as very personal! So, when a rival contests the market, such as by manipulating prices, changing product differentiation, using manufacturing and product innovation, controlling or creatively using channels of distribution, or exploiting relationships with suppliers, this action can precipitate counter moves by others in the industry. How intense rivalry among firms is in an industry depends on the number of firms in the market, on the distribution of market share, and the industry's history of rivalry. Depending on how aggressive the moves and counter-moves of rivals appear to be and how much of the market is gained and lost by rivals, we characterize the rivalry as being "cutthroat", "intense", "moderate", or "weak". In many industries, rivalry is "disciplined". Firms tend not to make aggressive moves to capture market share. Disciplined markets tend to be characterized by a history of fierce competition that has been resolved, by the role of a leading firm whose market power dominates smaller rivals, or by informal compliance among rivals with a generally "understood" code of conduct. This is more akin to a "collective memory" than "collusion", which is illegal.

The number of firms competing for customers is a traditional view of rivalry that provides a convenient, as often valid, estimation of an industry's potential for profits. An industry with many rivals tends to evidence low profits; an industry with few rivals tends to evidence high profits. Unfortunately, most "real" industries lie somewhere in the middle of "many" and "few" rivals. So, just counting the number of firms is often not helpful.

Market share distribution is also a important for assessing rivalry. Market share is the percentage of industry sales captured by a firm [MS = a firm's Sales ÷ Total Industry Sales]. We equate market share with market power of a firm because a firm that has captured most of the customers has more latitude in what it can do than a small firm.  

To analyze market rivalry the convention is to consider both the number of firms and each firm's market share. Economists use the Concentration Ratio measure for this purpose. In a market of 100 firms with a CR(4) = 80  the four largest firms hold 80% of the industry's sales - a concentrated market because the remaining 96 firms only have 20% of all sales. In business we are more apt to simply examine rivalry more causally. For example, what profit expectation would you have about this market?

Industry organizational characteristics that tend to intensify rivalry are:

1. Increased number of firms and/or equal sized firms increase rivalry because more firms must compete for customers and resources and equality of size leads to struggle for dominance.
2. Slow market growth causes firms to fight for market share. In a growing market, firms are able to improve revenues simply by virtue of an expanding market.
3. High fixed costs impose an economy of scale effect. When total costs are mostly fixed costs, the firm must produce near capacity to attain efficiency (lowest unit costs). High production levels means that a high volume of product must be sold - leading to a fight for market share.
4. High storage costs or highly perishable products cause a producer to sell goods as soon as possible. If other producers are attempting to unload at the same time, competition for customers intensifies.
5. Low switching costs increases rivalry. When a customer can freely switch from one product to another there is a greater struggle to capture customers.
6. Product differentiation is low in more competitive industries. Brand identification, on the other hand, tends to constrain rivalry.
7. Strategic stakes are high when a firm is losing market position or has potential for great gains. This intensifies rivalry.
8. High exit barriers place a high cost on abandoning the product. The firm must compete.
9. A diversity of rivals with different cultures, histories, and philosophies make an industry unstable. There is greater possibility for mavericks and for misjudging rival's moves. Rivalry can be intense and volatile.