Industry rivalry

The most destructive kind of competition for an industry is price competition. Several structural factors influence the likelihood that the industry will be characterised by price competition.

This is post six in a series on industry analysis.


Standard microeconomic theory focuses on three kinds of industry rivalry: perfect competition, oligopoly, and monopoly. The model only presents clear behavioural predictions for perfect competition and monopoly. Unfortunately, almost all real life industries belong to the oligopoly category, for which no clear predictions can be made. Some real life industries are very close to either perfect competition or monopoly, so those models can still be useful. However, this post will describe further how to analyse industries characterised as oligopolies.

Companies in the focal industry can compete in three different, mutually non-exclusive ways:

• Price competition. This involves anything related to the price of the product.The amount of rivalry is typically the highest with price competition because it forces all companies in the focal industry to compete on only one dimension. Any attempt to differentiate a company's products will only have a small effect in such industries.
• Product competition. This involves anything related to the products in the existing product category. The amount of rivalry is lowest with product competition. Product competition often take the form of advertising based competition. Advertising-based competition is the most benign type of competition since advertising creates differentiation, but also stability. Product-feature based competition is likely to have similar effect. Thus several competitors can co-exist and changes in market share will tend to be gradual.
• Product category competition. This involves anything related to the creation of new product categories. The new product category can be based on technical innovation or a new way to reach the  buyers. The smartphone is a good example of a technologically based new product category. The amount of rivalry is typically somewhere in the middle with product category competition. Innovation is needed to create a new product category so a lot of resources are devoted to technical as well as conceptual development. Winners and losers are created. The losers play a catch up game and often have to offer lower prices to get buyers to buy their product in the new product category.

Industry analysis is mostly about the structural factors listed below. These factors influence how the focal industry is likely to compete; price, product or product category. However, after analysing the structural factors it is also useful to directly measure the type of competition observed. If there is a discrepancy between the what the structural factors predict and the actual observation of behaviour, that is interesting.

Concentration ratio. A high concentration ratio leads to less focus on price competition. In concentrated industries there is a realisation of mutual interdependence. When companies are able to monitor each other they are less likely to engage in price competition as they will be found out quickly. Price competition is most severe when the industry companies are numerous. If one company lowers prices, the other companies will follow quickly and the whole industry is worse off. In a concentrated industry companies can use signalling to reduce the risk for price competition spiralling out of control. In less concentrated industries it is possible to lower prices without the competitors quickly finding out. In such an environment a desperate company might decide it is worth the risk of lowering prices. The company might gain some market share before the competitor respond.

Market leadership. The existence of a clear market leader leads to less focus on price competition. If the largest company is large enough to function like a leader, other companies will avoid head-to-head conflict. The market leader is thus able to reduce rivalry by not always acting aggressively to competitor action. It is hard to generalise what market share is necessary to be able to function as a market leader. It is unlikely that a company will be a strong market leader unless it has at least 20% market share and is at least 50% larger than the second largest company in the industry. However this can vary from industry to industry.

Diversity of companies' background. If the companies are all very similar in terms of background it is easier to engage in tacit coordination. All US car manufacturers used to be located in Detroit, Illinois and all US tyre manufacturer used to be located in Akron, Ohio. Their executives probably had the same background, some employees moved between the companies, and they engaged with the same suppliers. Even without a malign intent of coordinating activities, these companies would independently come up with very similar decisions. Today, the US automotive manufacturers have lost market share to Japanese and German manufacturers. It is very difficult to engage in tacit coordination if the head office of your competitors are located in Detroit in the US, Stuttgart in Germany, and Tokyo in Japan.

Capacity utilisation. If there is spare capacity in the industry it is very likely that some companies will try to increase capacity utilisation by lowering prices. The profit margin on filling up the capacity is generally very high. Spare capacity can generally be present in industries with high fixed costs or when products are perishable. The cost of running a nuclear power plant is likely to be quite similar irrespective of whether the capacity utilisation is 50% or 80%. The cost of flying a plane from A to B is largely going to be independent of whether the load factor is 50% or 80%. When fixed costs are a smaller portion of total costs there is generally very little spare capacity in the industry. A special case of this is when there are very large economies of scale warranting the building of a large capacity. Such lumpy investments can lead an industry to over-invest. This used to be the case in supply of industrial gases before the building of small plants became technically feasible.

Exit barriers leading to low capacity utilisation. In most industries there is no penalty to exiting the industry. However, if there are actual costs associated with exiting the industry, some companies will continue to operate even if they under normal circumstances would exit the industry. There might be environment regulations requiring a costly decontamination of the land if a chemical plant were to close. In the 1980s most European nations had their own national airline that often were the sort of some pride. These national airlines were often called flag carriers and the respective governments were subsiding them. Sometimes, companies gets emotional about their original business unit and subsidise their operation even though it might not be economically viable. Disney started out making animated films, but receives most of its profit from the ESPN sports channel.

Industry growth. If the industry is growing all firms can increase their sales at the same time, even if some firms actually lose market share. However, if the industry is not growing (or growing very slowly) some of the firms will also start to decline in sales. It is more noticeable for a company to experience declining sales as opposed to declining market share. When a company is faced with declining sales, it is likely to be more aggressive in its competitive positioning.

-note to self: wrong entry, update with the two stage competition. Buyer's relationship-specific assets. Such investments make it especially costly for a customer to change supplier. A corporation that uses Microsoft's Office suite will have invested in training, and IT support specific to that product. An airline that only buys Airbus airplanes will have invested in pilot training, and maintenance staff specific to that product.

Product differentiation. This factor is largely determined by the structural factors above, but it is can also be strongly influenced by the companies in the focal industry. If the products sold are differentiated from each other, they are less subject to head-to-head competition that can occur when the product is a commodity and the only distinguishing feature is price. Differentiation can be pursued on several dimensions; e.g. product quality, durability, design, brand, service level, warranty, innovation. If differentiation is limited to the product category, the rivalry will be low. However, if differentiation is also creating new product categories, rivalry is likely to be higher.

Entrepreneurial or new management. This factor is mostly behavioural. If a company in the industry is taken over by new management with a very different background a certain degree of uncertainty results. The same is the case with new entrants from a previous time period. These companies might decide to compete in a different and more aggressive way. This could result in product category innovation and/or price competition. Their private assumption would be that through a more aggressive competition they stand to gain market share before the competitors respond. If the new management decides to engage in both price competition as well as product category competition simultaneously, rivalry can become extremely destructive. The introduction of freely distributed tabloid newspapers in large cities in the late 1990s is an illustrative examples. The new product category was a fully advertising financed newspaper typically distributed to commuters.