Five-Forces Framework

The strategic approach extends the single-firm point of view by recognizing that a firm’s profit depends not only on the firm’s own actions but also on the actions of competitors. Thus, to determine its own optimal action, the firm must correctly anticipate the actions and reactions of its rivals. Roughly speaking, a manager must look at the competitive situation not only from his or her own point of view but also from rivals’ perspectives. The manager should put himself or herself in the competitor’s place to analyze what that person’s optimal decision might be. This approach is central to game theory and is often called interactive or strategic thinking.

The outline of this chapter is as follows. In the first section, we describe how to analyze different types of oligopolies, beginning with Michael Porter’s Five-Forces model. Next, we introduce the concept of market concentration, as well as the link between concentration and industry prices. In the following section, we consider two kinds of quantity competition: when a market leader faces a number of smaller competitors and when competition is between equally positioned rivals. In the third section, we examine price competition, ranging from a model of stable prices based on kinked demand to a description of price wars. Finally, in the fourth section, we explore two other important dimensions of competition within oligopolies: the effects of advertising and of strategic precommitments.

OLIGOPOLY

An oligopoly is a market dominated by a small number of firms, whose actions directly affect one another’s profits. In this sense, the fates of oligopoly firms are interdependent. To begin, it is useful to size up an oligopolistic industry along a number of important economic dimensions.

Five-Forces Framework

For 25 years, Michael Porter’s Five-Forces model has provided a powerful synthesis for describing the structures of different industries and guiding competitive strategy.1 Figure 9.1 provides a summary of the Five-Forces framework. The core of Porter’s analysis centers on internal industry rivalry: the set of major firms competing in the market and how they compete. Naturally, the number of close rivals, their relative size, position, and power, are crucial. (The following section looks closely at the notion of industry concentration to measurethe number and sizes of firms.) Entry into the market is the second most important factor in sizing up the industry. We have already seen that free

1The Five-Forces model is examined at length in M. E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Simon & Schuster, 1998).

FIGURE 9.1

The Five-Forces Framework

Supplier Power Entry

Internal Rivalry

Substitutes and Complements Buyer Power

entry predisposes a perfectly competitive market to zero economic profits in the long run. Conversely, significant barriers to entry (as listed and described in Chapter 8) are a precondition for monopoly. Ease of entry is also crucial for analyzing oligopoly. Boeing and Airbus compete vigorously to sell new aircraft, but barriers to entry due to economies of scale protect them from new competitors. By contrast, numerous new discount airlines in the United States and Europe have dramatically changed the competitive landscape in the air travel market. Similarly, a small independent studio (putting together a good script, directing talent, and up-and-coming actors) can produce a well-reviewed and profitable hit movie despite the formidable clout of the major studios.

The impacts of substitutes and complements directly affect industry demand, profitability, and competitive strategy. In a host of industries, this impact is ongoing, even relentless. For instance, trucking and railways are substitutes, competing modes of transport in the long-haul market. Soft-drink consumption suffers at the hands of bottled water, sports drinks, and new-age beverages. In other cases, the emerging threat of new substitutes is crucial. Cable companies have long challenged network television (with satellite TV a third option) and now vigorously compete for local telephone customers. Since the millennium, online commerce has steadily increased its sales, often at the expense of “brick-and-mortar” stores. The fast growth of hybrid automobiles poses a long-term threat to traditional gasoline-powered vehicles.

More recently, new attention and analysis has been paid to the industry impact of complementary goods and activities. Computer hardware and software are crucial complements. Steady growth in one market requires (and is fueled by) steady growth in the other. Although Barnes & Noble superstores compete with online seller Amazon, its sales are enhanced by its own online arm, barnesandnoble.com. Coined by Adam Brandenberger and Barry Nalebuff, the term coopetition denotes cooperative behavior among industry “competitors.” Thus, firms in the same industry often work together to set