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 41 Chapter 2: Evaluating a Firm’s External Environment 41 Proprietary technology. When incumbent firms have secret or patented technology that reduces their costs below the costs of potential entrants, potential entrants must develop substitute technologies to compete. The cost of developing this technology can act as a barrier to entry. Managerial know-how. When incumbent firms have taken-for-granted knowledge, skills, and information that take years to develop and that is not possessed by potential entrants. The cost of developing this know-how can act as a barrier to entry. Favorable access to raw materials. When incumbent firms have low-cost access to critical raw materials not enjoyed by potential entrants. The cost of gaining similar access can act as a barrier to entry. Learning-curve cost advantages. When the cumulative volume of production of incumbent firms gives them cost advantages not enjoyed by potential entrants. These cost disadvantages of potential entrants can act as a barrier to entry. TABLE 2.2 Sources of Cost Advantage, Independent of Scale,That Can Act as Barriers to Entry example, in the 1990s Eastman Kodak had to pay Polaroid $910 million and Intel had to pay Digital $700 million for violating patents. More recently, Roche Holding had to pay Igen International $505 million and Genentech had to pay City of Hope National Medical Center $500 million for violating patents. Eolas had to pay $521 million for infringing a Microsoft patent, and Gateway had to pay $250 million for violating an Intergraph patent. Indeed, in the United States at least 20 firms have had to pay some other firm over $100 million for violating the other firm’s patents. And this does not include the numerous patent infringement suits that are settled out of court, suits that involve literally billions of dollars exchanging hands. Obviously, if an industry has several firms with proprietary technologies, these technologies can substantially increase the cost of entry into that industry. 20 The number of patent infringement suits filed in the United States has increased every year for the past 15 years. The number of such suits in 1991 was 1,171; the number in 2004 (the last year for which complete data are available) was 3,075. Since 1994, the median damage award in a patent infringement suit has been $8 million. Currently, 60 percent of the patent infringement suits filed lead to financial compensation. Patent suits are distributed across numerous industries, including electronic equipment (14.6 percent), chemicals (14 percent), measuring instruments (13.4 percent), computer equipment (12.2 percent), and business services (9.8 percent). 21 Managerial Know-How. Even more important than technology per se as a barrier to entry is the managerial know-how built up by incumbent firms over their history. 22 Managerial know-how is the often-taken-for-granted knowledge and information that are needed to compete in an industry on a day-to-day basis. 23 Know-how includes information that it has taken years, sometimes decades, for a firm to accumulate that enables it to interact with customers and suppliers, to be innovative and creative, to manufacture quality products, and so forth. Typically, new entrants will not have access to this know-now, and it will often be costly for them to build it quickly. One industry where this kind of know-how is a very important barrier to entry is the pharmaceutical industry. Success in this industry depends on having
M02_BARN4586_03_SE_C02.qxd 7/1/09 7:34 AM Page 42 42 Part 1: The Tools of Strategic Analysis high-quality research and development skills. The development of world-class research and development skills—the know-how—takes decades to accumulate. New entrants face enormous cost disadvantages for decades as they attempt to develop these abilities, and thus entry into the pharmaceutical industry has been quite limited. 24 Favorable Access to Raw Materials. Incumbent firms may also have cost advantages, compared to new entrants, based on favorable access to raw materials. If, for example, only a few sources of high-quality iron ore are available in a specific geographic region, steel firms that have access to these sources may have a cost advantage over those that must ship their ore in from distant sources. 25 Learning-Curve Cost Advantages. It has been shown that in certain industries (such as airplane manufacturing) the cost of production falls with the cumulative volume of production. Over time, as incumbent firms gain experience in manufacturing, their costs fall below those of potential entrants. Potential entrants, in this context, must endure substantially higher costs while they gain experience, and thus they may not enter the industry despite the superior profits being earned by incumbent firms. These learning-curve economies are discussed in more detail in Chapter 4. Government Policy as a Barrier to Entry Governments, for their own reasons, may decide to increase the cost of entry into an industry. This occurs most frequently when a firm operates as a governmentregulated monopoly. In this setting, the government has concluded that it is in a better position to ensure that specific products or services are made available to the population at reasonable prices than competitive market forces. Industries such as electric power generation and elementary and secondary education have been (and to some extent, continue to be) protected from competitive entry by government restrictions on entry. Although the government has acted to restrict competitive entry in many industries in the past, the number of such industries and the level of this entry restriction have both fallen dramatically over the past several years. Indeed, in the United States, deregulation in the electric power generation industry has been occurring at a rapid pace. And although the bankruptcy of Enron may delay the relaxing of government-imposed barriers to entry into the power generation industry, most observers agree that these restrictions will continue to be less important in the future. Entry is even occurring in the primary and secondary school industry with the creation of “charter schools”—schools that provide educational alternatives to traditional public school systems. The Threat of Rivalry New entrants are an important threat to the ability of firms to maintain or improve their level of performance, but they are not the only threat in a firm’s environment. A second environmental threat in the five forces framework is rivalry—the intensity of competition among a firm’s direct competitors. Both Barnes & Noble.com and Borders.com have become rivals of Amazon.com. CBS, NBC, Fox, USA Networks, and TNN—to name a few—are all rivals of ESPN. Rivalry threatens firms by reducing their economic profits. High levels of rivalry are indicated by such actions as frequent price cutting by firms in an
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Evaluating a Firm's External Environment - Illinois State University

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