Evaluating a Firm's External Environment - Illinois State University

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M02_BARN4586_03_SE_C02.qxd 7/1/09 7:34 AM Page 39 Chapter 2: Evaluating a Firm’s External Environment 39 the line in Figure 2.4. This curve suggests that any deviation, positive or negative, from an optimal level of production (point X in Figure 2.4) will lead a firm to experience much higher costs of production. To see how economies of scale can act as a barrier to entry, consider the following scenario. Imagine an industry with the following attributes: The industry has five incumbent firms (each firm has only one plant); the optimal level of production in each of these plants is 4,000 units (X = 4,000 units); total demand for the output of this industry is fixed at 22,000 units; the economies-of-scale curve is as depicted in Figure 2.4; and products in this industry are very homogeneous. Total demand in this industry (22,000 units) is greater than total supply (5 4,000 units = 20,000). Everyone knows that, when demand is greater than supply, prices go up. This means that the five incumbent firms in this industry will have high levels of profit. The S-C-P model suggests that, absent barriers, these superior profits should motivate entry. However, look at the entry decision from the point of view of potential entrants. Certainly, incumbent firms are earning superior profits, but potential entrants face an unsavory choice. On the one hand, new entrants could enter the industry with an optimally efficient plant and produce 4,000 units. However, this form of entry will lead industry supply to rise to 24,000 units (20,000 + 4,000). Suddenly, supply will be greater than demand (24,000 > 22,000), and all the firms in the industry, including the new entrant, will earn negative profits. On the other hand, the new entrant might enter the industry with a plant of smaller-than-optimal size (e.g., 1,000 units). This kind of entry leaves total industry demand larger than industry supply (22,000 > 21,000). However, the new entrant faces a serious cost disadvantage in this case because it does not produce at the low-cost position on the economies-of-scale curve. Faced with these bleak alternatives, the potential entrant simply does not enter even though incumbent firms are earning positive profits. Of course, potential entrants have other options besides entering at the efficient scale and losing money or entering at an inefficient scale and losing money. For example, potential entrants can attempt to expand the total size of the market (i.e., increase total demand from 22,000 to 24,000 units or more) and enter at the optimal size. Potential entrants can also attempt to develop new production technology, shift the economies-of-scale curve to the left (thereby reducing the optimal plant size), and enter. Or, potential entrants may try to make their products seem very special to their customers, enabling them to charge higher prices to offset higher production costs associated with a smaller-than-optimal plant. 15 Any of these actions may enable a firm to enter an industry. However, these actions are costly. If the cost of engaging in these “barrier-busting” activities is greater than the return from entry, entry will not occur, even if incumbent firms are earning positive profits. Historically, economies of scale acted as a barrier to entry into the worldwide steel market. To fully exploit economies of scale, traditional steel plants had to be very large. If new entrants into the steel market had built these efficient and large steel-manufacturing plants, they would have had the effect of increasing the steel supply over the demand for steel, and the outcome would have been reduced profits for both new entrants and incumbent firms. This discouraged new entry. However, in the 1970s, the development of alternative mini-mill technology shifted the economies-of-scale curve to the left by making smaller plants very efficient in addressing some segments of the steel market. This shift had the effect of decreasing barriers to entry into the steel industry. Recent entrants, including Nucor Steel and Chaparral Steel, now have significant cost advantages over firms still using outdated, less efficient production technology. 16
M02_BARN4586_03_SE_C02.qxd 7/1/09 7:34 AM Page 40 40 Part 1: The Tools of Strategic Analysis Product Differentiation as a Barrier to Entry Product differentiation means that incumbent firms possess brand identification and customer loyalty that potential entrants do not. Brand identification and customer loyalty serve as entry barriers because new entrants not only have to absorb the standard costs associated with starting production in a new industry; they also have to absorb the costs associated with overcoming incumbent firms’ differentiation advantages. If the cost of overcoming these advantages is greater than the potential return from entering an industry, entry will not occur, even if incumbent firms are earning positive profits. Numerous examples exist of industries in which product differentiation tends to act as a barrier to entry. In the brewing industry, for example, substantial investments by Budweiser, Miller, and Coors (among other incumbent firms) in advertising (will we ever forget the Budweiser frogs?) and brand recognition have made large-scale entry into the U.S. brewing industry very costly. 17 Indeed, rather than attempting to enter the U.S. market, InBev, a large brewer headquartered in Belgium, decided to purchase Anheuser Busch. 18 E. & J. Gallo Winery, a U.S. winemaker, faced product differentiation barriers to entry in its efforts to sell Gallo wine in the French market. The market for wine in France is huge—the French consume 16.1 gallons of wine per person per year, for a total consumption of over 400 million cases of wine, whereas U.S. consumers drink only 1.8 gallons of wine per person per year, for a total consumption of less than 200 million cases. Despite this difference, intense loyalties to local French vineyards have made it very difficult for Gallo to break into the huge French market—a market where American wines are still given as “gag gifts” and only American theme restaurants carry U.S. wines on their menus. Gallo is attempting to overcome this product differentiation advantage of French wineries by emphasizing its California roots—roots that many French consider to be exotic—and downplaying the fact that it is a U.S. company, corporate origins that are less attractive to many French consumers. 19 Cost Advantages Independent of Scale as Barriers to Entry In addition to the barriers that have been cited, incumbent firms may have a whole range of cost advantages, independent of economies of scale, compared to new entrants. These cost advantages can act to deter entry, because new entrants will find themselves at a cost disadvantage vis-à-vis incumbent firms with these cost advantages. New entrants can engage in activities to overcome the cost advantages of incumbent firms, but as the cost of overcoming them increases, the economic profit potential from entry is reduced. In some settings, incumbent firms enjoying cost advantages, independent of scale, can earn superior profits and still not be threatened by new entry because the cost of overcoming those advantages can be prohibitive. Examples of these cost advantages, independent of scale, are presented in Table 2.2; they include (1) proprietary technology, (2) managerial know-how, (3) favorable access to raw materials, and (4) learning-curve cost advantages. Proprietary Technology. In some industries, proprietary (i.e., secret or patented) technology gives incumbent firms important cost advantages over potential entrants. To enter these industries, potential entrants must develop their own substitute technologies or run the risks of copying another firm’s patented technologies. Both of these activities can be costly. Numerous firms in a wide variety of industries have discovered the sometimes substantial economic costs associated with violating another firm’s patented proprietary technology. For
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Evaluating a Firm's External Environment - Illinois State University

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