Definition Of Industry And Porter Economics Essay

This chapter presents a basic explanation of how the pharmaceutical industry will be defined and which models will be used to analyse it.

2.1 Definition of Industry

The most important definition of industry was given by Michael Porter in 1979: a “group of competitors producing substitutes that are close enough that the behavior of any firm affects each of the others either directly or indirectly.” [1] Later, Porter defined the term more precisely as “a group of companies offering products or services that are close substitutes for each other, that is, products or services that satisfy the same basic customers’ needs.” [2] This new definition emphasizes the importance of industry borders and industry’s role as a market supplier or producer of goods and services, as distinguished from a market, defined as a consumer of goods and services.

Furthermore, inside every industry there are groups of companies that follow similar strategies, defined by Michael S. Hunt in his unpublished 1972 Ph.D. dissertation as strategic groups. [3] Between these groups there are differences in entry barriers, bargaining power with buyers and suppliers and skills and resources [4] . Strategic groups compete against each other within the industry as a result of these differences.

2.2 Models to Analyze the Industry and Its Environment

The literature agrees that comprehension of the industry structure is essential to developing a firm’s strategy and has a greater effect on the firm’s performance than whether it is business-specific or corporate-parent. [5] The comprehension of the structure requires analyses of the industry’s life cycle. It also requires step-by-step political, legal, technological, social and economic analyses as well as the five driving forces of business, provided by Michael Porter. By utilizing these analysis techniques, it is also possible to anticipate changes in industry competition and profitability over time.

2.2.1 Industry Life Cycle Analysis

During its development an industry passes through different phases, each characterized by a different environment that obliges competition to assume different forms. Through studying the life cycle, the industry realizes its stake in the market and its influence on consumers. The industry life cycle model includes four different phases: introduction, growth, maturity and decline. [6] 

The introductory phase is characterized by low demand, resulting in higher prices as a consequence of the firm’s inability to realize economies of scale. This situation gives rise to low profit margins and losses are expected due to substantial investments in new categories. Market penetration may be obstructed by a lack of technologies and competencies. Strategy is focused mainly on R&D and production, with the goal of enhancing novelty and quality. Competitors, attracted by the rising demand, attempt to replicate the new product. [7] 

In the second phase, growth, the use of the product is extended, demand grows, prices decline due to economies of scale, barriers to entry are lower and the threat of new entry is high. At this phase the technology is usually not exclusive property of one or more firms, and the primary reaction to competition is marketing expenditure and initiatives; profits are not very high because prices decline as competitors enter the market. There is a transition period, or shakeout, between the second and the third phases. The shakeout involves finding and using all investment opportunities, because the market is near saturation and demand grows more slowly. [8] 

In the third phase, maturity, market growth is low or nonexistent, and the focus shifts to gaining market share; demand is represented only by the substitution of products, investment in R&D decreases and there is little innovation. In this phase firms seek cost reductions, and competition is based primarily on advertising and quality because of the low differentiation between products. Big firms acquire smaller players, while others are forced to exit. As a conseguence of high barrier to entry, the threat of new entrants are low. [9] 

The last phase is decline, so called because of the continued decline in demand. Industries arrive at this stage for a variety of reasons. These include a change in social behaviors, demographic changes, international competition, technological innovations and increased customer knowledge. The buying process is based primarily on price rather than innovation. As a result, profit and revenues decline, and the industry as a whole may be supplanted. [10] 

2.2.2 PEST Analysis

The term “PEST” is an acronym of several factors – Political, Economic, Social and Technological – that influence business activities at any given moment. Due to the fact that each aspect may have an independent impact on the industry, it is essential that each be individually identified and analyzed through the PEST Analysis. [11] 

The political aspect of analysis encompasses various factors that influence business activities in a given country at several levels: national, subnational and supranational levels. [12] These include trade policies control imports, exports and international business partners, government ownership of industry, attitude toward monopolies and competition and trade policies. Hence, failure to consider these policies may result in loss of revenue due to taxes or penalty fees. Government stability is also very important, because it eradicates the risks associated with wars and conflicts. For an industry to thrive, political stability must be uncompromised; otherwise, sales and business activities will be uncertain, and investors will lose interest. The internal political issues in any country influence the running of industries. Politics based on race or religion may define the course for certain industries, especially if an industry falls short of political expectations. Elections and changes in leadership also influence an industry’s strengths and opportunities and thus should be considered during the analysis. In addition to internal issues, international pressures and influences may affect some industries, such as environmental degradation or product safety. Another factor is terrorism. Though uncommon in many countries, poor or unstable governance may attract terrorist activities, vengeful or otherwise, which can have adverse effects on the industries operating in that country. All these issues may stunt industrial growth and discourage stakeholders from making significant investments. [13] 

The economic aspect of analysis includes many factors. The first factor to consider is the current economic situation and trends in the country in which the industry is based. Companies should note inflation and economic decline so that when it comes to investing, they can avoid being financially affected. Failure to do this results in an economically blind platform that may cause the industry’s sudden collapse. Another factor to consider in analysis is taxation rates. When there are high taxation rates in a given country, price-based competition may affect a given industry in the international market. International economic trends are also very important, because they define currency exchange rates, imports and exports. Other factors to consider are consumer expenditure and disposable income and, finally, legal issues, including all trade legislation in a given country and other legal regulations that inhibit or encourage expansion of business activities. Also to be considered are consumer protection laws, employment laws, environmental protection laws and quality standardization regulations. Law regulating industrial competition, market policies and guidelines also have a significant impact on the stability of industry and future expansion opportunity. [14] 

When considering the social aspect, factors including demographic changes, shifts in values and culture and changes in lifestyle are important to note so as to strategize on expansion and growth [15] . Certain factors, such as media and communities, influence an industry’s growth and returns. Brand name and corporate image are also very important in influencing growth and returns since they shape customer loyalty and shareholder investment. The media’s views on certain industrial products should be incorporated into the analysis, as should consumer attitudes and sensibility to “green” issues, that is, issues that affect the environment, energy consumption and waste and its disposal. A company’s information systems and internal and external communications should also be analyzed to ensure that it keeps pace with its competitors. Other factors are the policies regulating education, health and distribution of income, all of which, in the long run, influence consumer use of products [16] .

The technological aspect of analysis encompasses a variety of factors. In addition to developing technologies, all associated technologies, along with their innovation potentials, speed of change and adoption of new technology, should be analyzed for a proper evaluation of the industry. Other technological factors are transportation, waste management and online business. The level of expenditure on R&D should also be considered in order to secure the industry’s competitive position to prevent losses and collapse [17] .

2.2.3 Porter’s Five Competitive Forces Analysis

Porter’s model, as described by Kay, is an evolution of the Structure-Conduct-Performance paradigm conceived by Edward Mason at Harvard University in the 1930s and detailed by Scherer in the 1980s. [18] , [19] The model aims to determine the intensity of industry competition, major issues in determining strategy and whether an industry is attractive or not. [20] Porter identified five competitive forces that act on an industry and its environment: threat of entry, intensity of rivalry among existing competitors, threat of substitutes, bargaining power of buyers and bargaining power of suppliers. [21] 

The first competitive force, threat of entry, refers to the threat of new entrants in an established industry or acquisition to gain market share. Reactions of participants and barriers to entry are the main factors used to establish whether the threat is high or low. Six major entry barriers have been identified:

capital required to compete in the industry (especially in risky industry, such as advertising or R&D)

switching costs

access to distribution channels

economies of scale

cost disadvantages independent of scale, such as patents, access to know-how, access to limited resources, favorable locations, government subsidies or policies and learning or experience curves

product differentiation

expected retaliation from existing firms against the new entrants

Strong barriers to the entry of new firms enable a few firms to dominate the market and thereby influence prices.

The second force is intensity of rivalry among existing competitors. Rivalry takes place when one or more firms inside an industry try to improve their position using tactics such as price competition, new product introduction or new services. Rivalry depends on several factors: number and size of competitors, industry growth, product characteristics (which determine whether the rivalry is based on price or differentiation), cost structure, exit barriers, diverse competitors, operative capacity and high strategic stakes. If an industry is inhibited, then firms will experience difficulties when trying to expand. The growth of foreign competition and the corporate stakes should also be included in the analysis.

Threat of substitutes is the third forces. Substitutes are those products manufactured by other industries but serving the same purposes as the initial product. These substitute products cause the demand to decline. The implications are reduced profits and reduced market command by the original capital investor. This is of particular importance when the buyer has no switching costs and can easily compare products in terms of price and efficiency.

Bargaining power of buyers is the fourth force. High bargaining power positions weak firms inside the industry, forcing price down, enhancing competition between industry players and resulting in bargaining for higher quality or services. This power is particularly high under certain conditions, such as few and specific buyers, undifferentiated products, low switching costs, the possibility of backward integration and information about demand and the availability of market price to the buyers. Furthermore, bargaining power is high if product quality is not a crucial factor of decision-making and if what the buyer is acquiring is a modest fraction of his total costs. Bargaining power is even higher when the buyer is a retailer or a wholesaler able to influence the consumer’s purchasing decision.

The fifth and last force is the bargaining power of suppliers. This can act on the industry in several ways: raising prices, lowering quality or privileging some buyers. Supplier power can be divided into several elements. One of these elements is supplier concentration. Suppliers are in a stronger position when there are few suppliers, switching costs are high, the industry they are serving account for a small fraction of their business or their products are an important part of the buyer’s business. The bargaining power of suppliers is low or nonexistent when there are substitute products. Lastly, purchase volume and the supplier’s influence on cost are very important.