Vinod Jain is an expert in global and digital business, former business professor, consultant, speaker, and author of Global Meets Digital.
Michael Porter’s Five Forces model is a widely accepted framework for understanding industry competition. The model identifies five critical forces that shape an industry’s competitive landscape: the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitutes and rivalry among existing competitors.
By studying these forces, business leaders can gauge the intensity of competition in their industry and assess the company’s profitability potential and, hence, its attractiveness to incumbents or prospective entrants.
While the Five Forces model has been extensively discussed in thousands of articles and books, including several articles on Forbes.com, I propose “industry structure” as an alternative method for understanding competition, which also has regulatory implications.
Industry Structure
Industry structure refers to the characteristics and organization of an industry that influence competitive dynamics and have regulatory implications. But first, let us define what industry is and what industry structure is.
An industry is a collection of firms offering goods or services that are close substitutes for each other. It can be defined narrowly, e.g., home furniture, or even more narrowly as bedroom furniture, or broadly to include all kinds of furniture. Alternatively, an industry can be defined as firms competing directly with each other.
Industry structure refers to the number and size distribution of firms in an industry. It encompasses a broader range of factors than the Five Forces model.
The number of firms in an industry can be hundreds, thousands or even more. Generally speaking, the level of competition in an industry rises with the number of firms. In addition to the number and size distribution of firms in the industry, an in-depth analysis of industry structure can include factors such as product differentiation, cost structure, pricing, technology and innovation, and the regulatory environment.
If all firms in an industry are small relative to its size, it is a fragmented industry. If a few firms control a large share of the industry’s output or sales, it is a concentrated (consolidated) industry, also called an oligopoly. An oligopoly is an industry where a very small number of firms—say, two, three or four—account for a large share of the industry’s output.
Competition
By looking at the structure of an industry, leaders can often learn a great deal about competition, rivalry, entry barriers and other aspects of competitive dynamics in that industry.
Fragmented industries sometimes have commodity-type products (e.g., raw materials, services and mass-manufactured products of everyday use) and exhibit low entry barriers. The existence of low entry barriers encourages the entry of new competitors into the industry whenever profits are high. Such entries lead to excess capacity, and industry members may begin competing on price. As a result, fragmented industries often experience price wars and boom-and-bust cycles.
Concentrated industries tend to exhibit high entry barriers and have differentiated products, established brand names and relatively high profitability. From the perspective of incumbents, a concentrated industry has a more attractive structure. Firms in concentrated industries often compete on non-price factors, such as advertising, product features and customer service, rather than disrupt industry structure through price competition.
Measuring Industry Concentration
The concentration ratio is a good, intuitive measure of the number and relative power of firms in an industry. The four-firm concentration ratio, denoted by CR4, is the combined market share of the four largest firms in the industry. The U.S. Census Bureau does a census of all industries every five years. From this data, we can determine industry concentration ratios for the United States.
A CR4 of 80% or more represents a highly concentrated industry, and a CR4 of 90% or more represents a very highly concentrated industry. As of 2017, three of the highly concentrated industries were deep sea passenger transportation (CR4 = 97%), warehouse clubs and super centers (94%), and armored car services (91%).
Consider the value of CR4 in selected industries.
Industries with a rising value of CR4:
• Newsprint mills rose from 53.9% in 2002 to 90.4% in 2017.
• Radio networks rose from 53.8% in 2002 to 83% in 2017.
• Taxi services rose from 17.6% in 2002 to 77.2% in 2017.
Industries with a declining value of CR4:
• Breweries fell from 90.8% in 2002 to 68.6% in 2017.
• Software publishers fell from 39.5% in 2002 to 32.4% in 2017.
• Commercial banking fell from 29.5% in 2002 to 24.6% in 2017.
Just looking at the value of CR4 gives a fairly good idea of industry structure and the type of competition in the industries above. A high level of concentration in an industry can represent the market power of dominant firms, high entry barriers and decreased competition. In contrast, fragmented industries, like software publishing and commercial banking, have numerous small firms promoting diverse product offerings and price-based competition.
Industry Concentration And Antitrust
Antitrust laws are designed to promote fair competition in the marketplace and prevent anticompetitive practices. In the U.S., antitrust laws are enforced by the Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ).
Antitrust laws help prevent the formation of monopolies and prohibit anticompetitive practices like collusion, price fixing and exclusive agreements that restrict competition—thus promoting market competition. Another key function of antitrust laws is to review merger and acquisition applications to ensure that an approved merger will not lessen market competition.
The FTC uses the Herfindahl-Hirschman Index (HHI) to measure concentration rather than CR4. Markets with HHI greater than 1,800 are considered highly concentrated by the agencies. A change of more than 100 points post-merger is presumed to substantially lessen market competition or tend to create a monopoly. In such a situation, the FTC may not allow a merger.
Drawing Conclusions
Based on the above analysis, some broad conclusions can be drawn. Companies in fragmented industries should focus on cost reduction and efficiency to survive price wars. They should expect new competitive entry into their industries and maintain strategic flexibility.
In oligopolies, use non-price competition, like innovation, brand building, advertising and superior customer service. While high industry concentration can confer significant market power on a few firms, potentially limiting consumer choice, antitrust regulations are essential in curbing anti-competitive practices and fostering healthy competition.
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