Exploring industry dynamics: markets, competition and creative destruction. Lecture 3

Transcription

1 Exploring industry dynamics: markets, competition and creative destruction Lecture 3 1

2 Outline Traditional models of industry: structure > conduct > performance Industries as arenas of strategic competition: game theory Regularities and taxonomies of technological change and industry dynamics Models of industry evolution Stylized facts on industry dynamics. 2

3 Market structure is description of the behavior of buyers and sellers in that market INDUSTRY AS A MARKET STRUCTURE Market structure Number of firms Entry conditions Substitutes Nature of product Perfect competition Large number Easy entry Perfect Homogenous (undifferentiated) Monopolistic Large number Easy entry Imperfect Differentiated competition Oligopoly models Small Difficult Either 1. Undifferentiated or 2. Differentiated Monopoly One Blocked Distant Unique 3

4 STRUCTURE - CONDUCT PERFORMANCE (SCP) MODEL The basic SCP model and the chain of causation Structure Perfect competition Monopoly Conduct Prices are set equal to marginal costs of production Prices exceed the marginal costs of production Performance Good performance (allocative efficiency with normal profits) Poor performance (allocative inefficiency with the possibility of supernormal profits) 4

5 The structure conduct performance model Source: Simonetti et al, 2003, Firms, Open University Course, adapted from Scherer and Ross, 190, p.5) 5

6 Structure > Conduct > Performance A fundamental determinant of the firm s ability to create and sustain profits is the firm s competitive environment and buyer/supplier power Industry performance (economic profitability) is determined by firm conduct which in turn is determined by industry structure Industry structure is determined by exogenous factors (technology, demand) Porter: competitive strategy is about what makes industries attractive so that you can avoid unattractive industries and endeavour to keep your own industry attractive In short term: attractiveness is function of profitability In the long-term: profitability is a function of attractiveness 6

7 Industry as five forces model The Five Forces Model Risk of entry by potential competitors Bargaining Rivalry among Bargaining power of established power of suppliers firms buyers Threat of substitute products 7

8 The evidence on Porter Estimate relation: Industry level profit = f (industry structure/ conduct variables) Many econometric studies of this relationship suggest that structure does influence performance but that variations in structure do not explain all of the variation in industry performance. So structure matters but is not the determining factor. Measurement problems and method problems probably make it difficult to get the true picture. Industries are very complex and it is hard to describe their structures in simple terms. 8

9 A critique of five-forces model I Model is concerned with the profitability of industries, not firms There is not role for individual firm differences ( S > C > P) Porter s focus on industry determinants of profit is misguided. It is the FIRM alone that matters, because industry structure is a consequence of how firms compete not vice versa. Market structure is an outcome of competition between firms not a determinant (C>P>S). It is endogenous not exogenous. Firm actions and relative success determines both market structure and average profitability. The idea that market structure drives profits is thus spurious. Interdependence: The two views are not mutually exclusive. Firm actions can obviously affect market structure outcomes, and market structures can influence firm actions. There is interdependence between the two rather than the one way causation of the S-C-P model. 9

10 A critique of five-forces model II Product/market positioning vs. resource based/capability positioning There is not role for innovation > innovation can reshape industry structure Solution: punctuated equilibrium > critique: hyper competitive industries 10

11 Punctutated equilibrium and competitive structure Oligopoly (consolidated) Period of disequilibrium Degree of consolidation Fragmented T0 T1 T2 Time 11

12 INDUSTRY AND FIRM DYNAMICS CO- EVOLVE Firms and markets evolve together to shape industrial outcomes. A perspective that relies on market only as the lens through which to understand industrial development is likely to be seriously flawed. Rather then strategic and organizational choices made by managers choices not necessarily dictated by markets and technologies shape if not determine both firm and national economic performance Firms are not simply agents of the market. Markets simply cannot be understood without an understanding of firm s strategy and structures (cf. Chandler) 12

13 Industries as arenas of strategic competition: the Cola Wars Why Pepsi has invested in 1996, $500m in advertising campaign although the drink remained the same? How do we explain a dual market structure of colas market? 13

14 RELATIONSHIP BETWEEN CONCENTRATION AND MARKET SIZE: SELLER CONCENTRATION AND ENDOGENOUS SUNK COSTS Concentration ratio CN = 1/n CNd CNx Market size CNx concentration ratio of homogenous products CNd concentration ratio of endogenous products Endogenous sunk costs are the sunk costs which are incurred to increase consumer s willingness to pay (ex. R&D, advertising). 14

15 Regularities and taxonomies of technological change and industry dynamics A relationship between the dynamics of an industry to the rate of technological change Pavitt s taxonomy Science based industries: R&D and learning by searching are key elements in firms innovative activities. Examples: electronics; electrical; chemicals, pharmaceuticals Scale intensive industries: scale economies and productive features play a relevant role in competition among firms and in shaping industry structure. Bulk materials (steel, glass); assembly (consumer durables and autos) Specialized supplier industries: firm competencies are in development, engineering and design, and the ability to adapting and tailoring products to user needs. Machinery and instruments Supplier dominated industries: in which innovative activity is limited to learning by using and doing type, centered on incremental improvements and adaptations of new capital equipment, which have been developed and produced by upstream suppliers. Agriculture; housing; private services, traditional manufacture (clothing, shoes) Source: Pavitt, K (1984) Sectoral patterns of technological change: Towards a taxonomy and theory, Research Policy, vol. 13, no. 6, pp

16 The main building blocks of a sectoral system of innovation and production Knowledge base and learning processes Different degrees of accessibility, opportunities, cumulativeness and different knowledge bases > technological regime > see slides Basic technologies, inputs and demand, with key links and dynamic complementarities Filiere (development blocs) Type and structure of interactions among firms and non-firms organizations Firms, users, suppliers, non-firm organizations such as universities, financial institutions, government agencies, local authorities, individuals, firms sub-units (such as the R&D or the production department) and groups of firms (such as industry consortia Institutions Processes of generation of variety and of selection Variety: new firms; Selection: reduces heterogeneity via market and non-market selection (public services) Source: F. Malerba / Research Policy 31 (2002)

17 TECHNOLOGICAL REGIMES The specific pattern of innovative activities in an industry can be explained as the outcome of different technological regimes. TR is the specific combination of technological opportunities, appropriability of innovations, cumulativeness of technical advances and the properties of the knowledge base underpinning firms innovative activities. Opportunity Appropriability Cumulativeness Knowledge Base Level Level Technology Generic/Specific Pervasivenes Means Firm Tacit/Codified Variety Sector Simple/Complex Source Area Independent/System Source: Breschi S., F. Malerba and L. Orsenigo (2000) Technological regimes and Schumpeterian patterns of innovation, The Economic Journal 110 (April),

18 Why is technological regime useful? The notion of technological regimes provides a synthetic way of representing some of the most important economic properties of technologies and of the characteristics of the learning processes that are involved in innovative activities. Source: Breschi S., F. Malerba and L. Orsenigo (2000) Technological regimes and Schumpeterian patterns of innovation, The Economic Journal 110 (April),

19 Dimensions of technological regime Technological opportunities reflect the likelihood of innovating for any given amount of money invested in search. High opportunities provide a powerful incentives to the undertaking of innovative activities and denote an economic environment that is not functionally constrained by scarcity/ Appropriability of innovations summarized the possibilities of protecting innovations from imitation and of reaping product from innovative activities. High appropriability means the existence of ways to successfully protect innovation from innovation. Cumulativeness of technical advance is related to the fact that today knowledge and innovative activities form the base and the building blocks of tomorrow innovations : an innovation generates a stream of subsequent innovations, which are a gradual improvement on the original pone, or creates new knowledge which is used for other innovations in related areas. The properties of the knowledge base relate to the nature of knowledge underpinning firms innovative activities. Technological knowledge involves various degrees of specificity, tacitness, complexity and independence and may greatly differ across technologies. Source: ibid 19

20 Models of industry evolution 20

21 Stages of the industry life cycle Demand Embryonic Growth Shakeout Mature Declining Time ILC: a useful tool for analyzing the effects of an industry evolution on competitive forces. 21

22 Klepper s model of industry life cycle I I: the number of producers in the market remains relatively small (usually between one and three). II: the interval from the 'take-off' point of net entry to the time that net entry decelerates drastically. III: the ensuing period of low or zero net entry, IV: the subsequent period of negative net entry. V: the new equilibrium in the number of producers that coincides with the maturity of the product market and continues until some new fundamental disturbance generates a change in market structure. 22

23 Klepper s model of industry life cycle II: selected propositions Initially the number of entrants may rise or decline, but eventually it will decline to zero Initially the number of firms may rise over time, but eventually it will decline steadily. As each firm grows large, eventually the change in its market share will decline over time After entry ceases, the expected number of product innovations of all firms declines over time. Over time every firm that remains in the market increases its effort on process relative to product R&D On average the expected number of innovations per firm in each entry cohort will be determined by the average innovative expertise of firms in the cohort > entrants will be more innovative on average than incumbents, The larger the firm then the greater the returns from process R&D, hence the greater the effort devoted to R&D in general and process in particular > R&D and contemporaneous firm size are closely related, with firm size explaining over 50 percent of the variation in firm R&D in more R&D-intensive industries The largest and most profitable firms will come from the first cohort of entrants. These firms will increase their market shares over time and consistently earn supernormal profits. 23

24 Industry dynamics: stylized facts Microeconomic heterogeneity associated to unobserved firm or business units specific factor (cf. resources vs. capabilities) Persistence of microeconomic diversity Turbulence: high entry and exit, but small net entry Mechanism of productivity growth is entry, exit and expansion/contraction of incumbents Invariant structural patterns. Example: persistence of skewed distribution of both firms and plant size Industry specific features: capital intensity, advertising intensity, R&D and innovation activities, concentration, profitability Patterns of technical change and industry dynamics are similar across countries in the same technology classes (technological regimes and sectoral systems of innovation) 24

25 Descriptive statistics on entry and exit, 183 German manufacturing industries, Minimum Mean Maximum Standard Deviation Number of entrants Entry rate Entrant's market share Entrant's relative size (sales) Number of exiters Exit rate Exiter's market share Exiter's relative size Source: Scwalbach (1991) quoted in Martin (2001) Empirical evidence suggest that entry is a risky proposition, most likely to result in exit, and that entry and exit act more as a screening mechanisms selecting firms efficient enough to survive in an industry s oligopolistic core than an automatic adjustment mechanism that drives the economic product of incumbent firms to zero 25

26 TURBULENCE: ENTRY AND EXIT Theory: in the long run the number of firms adjust until equilibrium profit per firm is zero If entry occurs automatically when profits are above normal, and exit occurs automatically when products are below normal, then one would expect to see either entry or exit taking place at any point in time for a single industry, but not simultaneously entry and exit Empirical evidence suggest that entry and exits do not automatically drive economic profit to zero, even in the long run Most entrants, it appears, do not pass the test and withdraw from the market after a relatively short period of time Established incumbents compete oligopolistically among themselves, while an ever-changing group of small firms circle precariously on the edge of the market A far as established firms are concerned, the nature of the fringe group as a whole does not change very often The cost of moving from the fringe to the inner core of established oligopolistic firms depends on barriers to mobility Source: Stephen Martin Industrial Organization: a European perspective, Oxford University Press,

27 GIBRAT S LAW I: the law of proportionate growth In most industries, there are substantial inequalities in firm size (see next figure) Gibrat s law is one of invariant structural patterns in industry. It states that the probability of a given percentage change in the size of a firm over a given time period for firms in an industry is independent of the firms initial size. For example, if a company with sales of 10m doubles in size over a period of time, it is likely the same will happen for a company beginning with sales of only 1m. This type of firm growth has attractive property that over time it produces a highly skewed distribution of firms sizes which are commonly observed in a wide variety of industries. GL is a good approximation to the way firm sizes change over time for large, established firms Entrants tend to exit more frequently than would be predicted by Gibrat s Law 27

28 GIBRAT S LAW II 100 Cumulative share (%) of firms 0 0 Cumulative market share (%)

29 Entry and exit in Polish manufacturing, ; descriptive statistics (averaged across 152 industries Source: Barbara M. Roberts and Steve Thompson (2003) Entry and Exit in a Transition Economy: The Case of Poland, Review of Industrial Organization 22:

30 Conclusions Traditionally economics has not taken into analysis industry in its own right but mainly through market structure analysis. Industrial economics is focused on static aspects of industry through structure - conduct performance (Porter) and conduct (game theory) approaches (C>P>S). The two views are not mutually exclusive. Firm actions can obviously affect market structure outcomes, and market structures can influence firm actions. There is interdependence between the two rather than the one way causation of the S-C-P model. The SCP model predicts that the ultimate explanation for performance differences across industries is market structure. The SCP model has been questioned from efficiency and from innovation point of view. Klepper s model of industry life cycle represents a realistic stylization of industry change. Creative destruction is important for promoting productivity growth. Stylized facts of industry dynamics provide a more realistic view of industry 30

31 Internet based activity Please, visit DRUID 2005 conference website and watch video streamed discussion: Does industry affiliation or firm strategy matter? (June ) Motion: Let it be resolved that this conference believes that industry structure is a central determinant of firm performance, and that the scope for firm strategy is limited accordingly 31

32 Issues for discussion I Porter s five forces framework of industry analysis has been criticized for its static nature and the lack of appreciation of firms capability to reshape industry structure. Could you find few examples that support this argument? Strategic management models traditionally have defined firm in terms of products and markets positioning. What are the objections of resource based approach to this view? Porter s five forces model belongs to so called structure conduct performance approach to industrial economics. Could you explain structure conduct performance direction of reasoning, which lays behind this model by using examples of fragmented and highly, concentrated industries? 32

33 Issues for discussion II Industry dynamics during the socialism was rather stagnant. Also, industry dynamics was determined neither by five-competitive forces nor by individual firm strategies but by political decisions. Discuss how five competition forces have affected Estonian exporters? In the socialist period industry structure lacked small firms. This situation was described as the socialist black hole. With the post-socialism, the industry structures have changed in many sectors in CEE. Could you explain how small firms have changed industry structure and what are effects of this change on competition in industry? 33

34 Sources used in this lecture II Porter, Michael (1980) Competitive strategy: techniques for analysing industries and competitors, Free Press, New York, chapter 1 The structural analysis of industry, p Eric Bartelsman, John Haltiwanger and Stefano Scarpetta (2004), Microeconomic Evidence of Creative Destruction in Industrial and Developing Countries, IZA Discussion Paper No. 1374, October 2004, Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor Bonn. Available at: Klepper (1996) Entry, Exit, Growth, and Innovation over the Product Life Cycle American Economic Review, 86: 3 pages , Dosi, Giovanni (2005) Statistical Regularities in the Evolution of Industries. A Guide through some Evidence and Challenges for the Theory. LEM Working Paper Series, June 2005/17, St Anna School of Advanced Studies, Pisa. Available at (The most recent and excellent comprehensive overview evidence on the distribution of sizes amid performance of incumbents) 34

35 Sources used in this lecture II Steven Klepper and Kenneth L. Simons (2000) The Making of an Oligopoly: Firm Survival and Technological Change in the Evolution of the U.S. Tire Industry, Journal of Political Economy, 2000, vol. 108, no. 4 Stephen Martin Industrial Organization: a European perspective, Oxford University Press, 2001 Sutton, John (1991) Sunk Costs and Market Structure: Price Competition, Advertising and the Evolution of Concentration, MIT, Cam Himmelwelt, S., R. Simonetti, and A. Trigg (2001) Microeconomics: Neoclassical and Institutionalist Perspectives on Economic Behavior, Thomson/Open University. 35