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Analyzing the External Environment of the Firm: Creating Competitive Advantages

chapter 2

Learning Objectives


After reading this chapter, you should have a good understanding of:

LO1.1 The importance of developing forecasts of the business environment.

LO1.2 Why environmental scanning, environmental monitoring, and collecting competitive intelligence are critical inputs to forecasting.

LO1.3 Why scenario planning is a useful technique for firms competing in industries characterized by unpredictability and change.

Learning Objectives

After reading this chapter, you should have a good understanding of:

LO1.4 How forces in the competitive environment can affect profitability, and how a firm can improve its competitive position by increasing its power vis-à-vis these forces.

LO1.5 How the Internet and digitally based capabilities are affecting the five competitive forces and industry profitability.

LO1.6 The concept of strategic groups and their strategy and performance implications.


The Importance of External Environment


If a company does not keep pace with changes in the external environment, it becomes difficult to sustain competitive advantages and deliver strong financial results.


Recall the story of Borders’ demise in Chapter 1.


Creating the Environmentally Aware Organization

Exhibit 2.1 Inputs to Forecasting


So how do managers become environmentally aware? By doing scanning, monitoring, and gathering competitive intelligence, and using these inputs to develop forecasts. Then scenario planning and SWOT analysis can be used to help anticipate major future changes in the external environment, preparing the firm to do more extensive analysis of the forces in the general environment and the industry or competitive environment.


Environmental Scanning & Monitoring

Environmental scanning involves surveillance of a firm’s external environment

Predicts environmental changes to come

Detects changes already under way

Allows firm to be proactive

Environmental monitoring tracks evolution of environmental trends

Hard trends – measurable facts/events

Soft trends – estimated, probable events


Environmental scanning = surveillance of a firm’s external environment to predict environmental changes and detect changes already under way. Is a BIG PICTURE viewpoint of the industry/competition, looking for key indicators of emerging trends – what catches your eye? Alerts the firm to critical trends before changes have developed a discernible pattern and before competitors recognize them. Environmental monitoring = a firm’s analysis of the external environment that tracks the evolution of environmental trends, sequences of events, or streams of activities. Monitor the trends that have the potential to change the competitive landscape – what do you want to track? Firms need to CHOOSE the trends identified via the scanning activity, and regularly monitor or track these specific trends to evaluate the impact of these trends on their strategy process, i.e. Johnson & Johnson tracking % of GDP spent on health care, or # of active hospital beds. Hard trends = a projection based on measurable facts, events, or objects. It is something that WILL happen. Soft trends = something that MIGHT happen; and the probability with which it might happen can be estimated.


Competitive Intelligence

Competitive intelligence

Helps firms define & understand their industry

Identify rivals’ strengths & weaknesses

Collect data on competitors

Interpret intelligence data

Helps firms avoid surprises

Anticipate competitors’ moves

Decrease response time

Beware of the potential for unethical behavior while gathering intelligence


Competitive intelligence = a firm’s activities of collecting and interpreting data on competitors, defining and understanding the industry, and identifying competitors’ strengths and weaknesses. Be careful – aggressive efforts to gather competitive intelligence may lead to unethical or illegal behaviors. Note Strategy Spotlight on Ethical Guidelines on Competitive Intelligence: United Technologies.


Example: Using Competitive intelligence

Startups have a disadvantage – it takes a lot of time to be ready for the market – someone else can get there first.

How to find out if your competitor will beat you to launch?

Do competitive intelligence:

Monitor the competitor’s blog posts, e-mail blasts, the CEO's Twitter messages, changes to the LinkedIn profile

Track the dates of each dispatch on a spreadsheet and look for patterns

When the company’s chatter becomes more frequent, broadcasting more and more positive messages about its new product, "It led me to believe they were entering launch mode” so “we put together a limited version of our software and released it to get the Qworky name out first.”


This story illustrates how a startup company can try to beat the competition with a new product launch. Seattle entrepreneur Mikal Lewis has an M.B.A. from Florida A&M and spent four years at Microsoft working in product planning and strategy. In 2011 he tried launch a company selling software – a Web application designed to improve company meetings. Although he was able to get the name, Qworky, in the press, the company never really got any traction. This demonstrates that competitive intelligence is important, but not sufficient for competitive success. See the story at http://www.inc.com/magazine/20110401/how-to-use-competitive-intelligence-to-gain-an-advantage.html – “How to use competitive intelligence to gain an advantage” by Burt Helm, April 2011, Inc. Magazine.


Environmental Forecasting

Environmental forecasting predicts change

Plausible projections about

Direction of environmental change?

Scope of environmental change?

Speed of environmental change?

Intensity of environmental change?

Scenario analysis involves detailed assessments of the ways trends may affect an issue & development of alternative futures based on these assessments


Environmental forecasting = the development of plausible projections about the direction, scope, speed, and intensity of environmental change. Scenario analysis = an in-depth approach to environmental forecasting that involves experts’ detailed assessments of societal trends, economics, politics. technology, or other dimensions of the external environment. Asks what would happen if the environment should change dramatically? Addresses the need to consider a wider context than the narrow, traditional markets, laying down guidelines for at least 10 years in the future to anticipate rapid change.



A danger of forecasting discussed in the text is that

in most cases, the expense of collecting the necessary data exceeds the benefit.

forecasting’s retrospective nature provides little information about the future.

managers may view uncertainty as “black and white” while ignoring important “gray areas”.

it can create legal problems for the firm if regulators discover the company is making forecasts.


Answer: C. Some forecasting issues are much more specific to a particular firm and the industry in which it competes. Consider how important it is for Motel 6 to predict future indicators, such as the number of rooms, in the budget segment of the industry. If its predictions are low, it will build too many units, creating a surplus of room capacity that would drive down room rates. A danger of forecasting is that managers may view uncertainty as black and white and ignore important gray areas. The problem is that underestimating uncertainty can lead to strategies that neither defend against threats nor take advantage of opportunities.


SWOT Analysis

SWOT analysis is a basic technique for analyzing firm and industry conditions

Firm or internal conditions = Strengths & Weaknesses

Where the firm excels or where it may be lacking

Environmental or external conditions = Opportunities & Threats

Developments that exist in the general environment

Activities among firms competing for the same customers


Once environmental scanning, monitoring, intelligence gathering, and forecasting have been done, the firm must do a more in-depth analysis to see how all this affects its strategy. SWOT analysis = a framework for analyzing a company’s internal and external environment and that stands for strengths, weaknesses, opportunities, and threats. The firm’s strengths come from within, and are where your firm excels; while the weaknesses are where your firm is lacking relative to competitors. The opportunities and threats can come from the general environment and/or from the specific industry’s competitive environment.


SWOT Analysis

SWOT analysis

Forces managers to consider both internal & external factors simultaneously

Makes firms act proactively

Raises awareness about role of strategy

A firm’s strategy must build on its strengths,

Remedy the weaknesses or work around them,

Take advantage of the opportunities presented by the environment, and

Protect the firm from the threats.


SWOT’s conceptual simplicity is achieved without sacrificing analytical rigor. (However, see limitations of a SWOT in Chapter 3)


Example: SWOT Analysis

Southwest Airlines SWOT


Strong culture, employee relationships


Lack of cultural fit with new AirTran employees


Consolidation in the airline industry means more routes or acquisition targets might be available


Economic conditions/jet fuel prices might affect profitability in the future


For more information, see Case 21 on Southwest Airlines.


The General Environment







The general environment is composed of factors that are both hard to predict and difficult to control:


General environment = factors external to an industry, and usually beyond a firm’s control, that affect a firm’s strategy. Although the effects of these factors can vary across industries, EVERY industry has to anticipate the affect of each factor on its firm’s long-term strategies. See Exhibit 2.3 for effects of these various trends on certain industries. In addition, there are many reciprocal relationships among the various elements. For instance, the aging of the U.S. population has important implications for the economic segment.


The Demographic Segment

Demographics are easily understandable & quantifiable:

Aging population

Rising affluence

Changes in ethnic composition

Geographic distribution of population

Greater disparities in income levels


Demographic segment of the general environment = genetic and observable characteristics of a population, including the levels and growth of age, density, sex, race, ethnicity, education, geographic region, and income.


The Sociocultural Segment

Sociocultural forces influence the values, beliefs, and lifestyles of a society:

More women in the workforce

Dual-income families

Increase in temporary workers

Greater concern for healthy diets & physical fitness (increasing levels of obesity)

Greater concern for the environment

Postponement of marriage & family formation, having children


Sociocultural segment of the general environment = the values, beliefs, and lifestyles of a society. These forces might enhance the sales of products and services in many industries but depress sales in others. For instance, increase of women in the workforce enhances the sale of women’s business attire (see Case 9: Ann Taylor) but reduces demand for backing products and cooking staples (see Case 33: Campbell Soup).


The Political/Legal Segment

Political/Legal processes & legislation influence environmental regulations with which industries must comply:

Tort reform

Americans with Disabilities Act (ADA)

Deregulation of utilities & other industries

Increases in minimum wages

Taxation at local, state, federal levels

Legislation on corporate governance reforms

Affordable Health Care Act


Political/legal segment of the general environment = how a society creates and exercises power, including rules, laws, and taxation policies. Federal legislation such as Sarbanes-Oxley and Dodd-Frank not only affected how corporations managed their corporate governance processes, but helped create new businesses such as professional accounting services. The Affordable Care Act (Obama-care) will have the same effect on health care delivery mechanisms. Any immigration reform will affect how businesses find and keep needed employees.


The Technological Segment

Technological developments lead to new products & services; can create new industries & alter existing ones:

Genetic engineering

Computer-aided design/computer-aided manufacturing systems (CAD/CAM)

Research in synthetic & exotic materials

Pollution/global warming

Wireless communications



Technological segment of the general environment = innovation and state of knowledge in industrial arts, engineering, applied sciences, and pure science; and their interaction with society.


The Economic Segment

Economic forces affect all industries:

Interest rates


Consumer Price Index

Trends in GDP & net disposable income

Changes in stock market valuations


Economic segment of the general environment = characteristics of the economy, including national income and monetary conditions.


The Global Segment

Global forces offer both opportunities & risks:

Increasing global trade

Currency exchange rates

Emergence of the Indian & Chinese economies

Trade agreements among regional blocs (NAFTA, EU, ASEAN)

Creation of WTO (leading to decreasing tariffs/free trade in services)

Increased risks associated with terrorism


Global segment of the general environment = influences from foreign countries, including foreign market opportunities, foreign-based competition, and expanded capital markets. Globalization provides both opportunities to access larger potential markets and a broad base of production factors such as raw materials, labor, skilled managers, and technical professionals. (See Heineken Case 10, or Case 13, eBay’s challenges in China.) However, such endeavors also carry many political, social, and economic risks.


The Competitive Environment

The competitive environment consists of factors in the task or industry environment that are particularly relevant to a firm’s strategy:

Competitors (existing or potential)

Including those considering entry into an entirely new industry

Customers (or buyers)


Including those considering forward integration


Competitive environment = factors that pertain to an industry and affect a firm’s strategies. Industry = a group of firms that produce similar goods or services. Forward integration = a form of vertical integration whereby a firm expands activities to include control of the direct distribution of its products, e.g. a farmer sells his/her crops at the local market rather than to a distribution center for eventual sale to a supermarket (This definition is not in the textbook, but comes from http://www.investopedia.com/terms/f/forwardintegration.asp See more about vertical integration in Chapter 6. )


Porter’s Five-Forces Model of Industry Competition

Exhibit 2.4 Porter’s Five-Forces Model of Industry Competition

Source: Adapted and reprinted with permission of The Free Press, a division of Simon & Schuster Adult Publishing Group, from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980, 1998 by The Free Press. All rights reserved.


Porter’s five-forces model of industry competition = a tool for examining the industry-level competitive environment, especially the ability of firms in that industry to set prices and minimize costs. Includes the threat of new entrants; the bargaining power of buyers; the bargaining power of suppliers; the threat of substitute products and services; the intensity of rivalry among competitors in an industry. Each of these forces affects a firm’s ability to compete in a given market. Together they determine the profit potential for a particular industry.


The Threat of New Entrants

The threat of new entrants – possibility that the profits of established firms in the industry may be eroded by new competitors.

Depends on existing barriers to entry:

Economies of scale

Product differentiation

Capital requirements

Switching costs

Access to distribution channels

Cost disadvantages independent of scale


Threat of new entrants = the possibility that the profits of established firms in the industry may be eroded by new competitors. Economies of scale = decreases in cost per unit as absolute output per period increases. Forces the new entrant to come in at a large scale and risk strong reaction from existing firms, or come in at a small scale and accept a cost disadvantage. Product differentiation = the degree that a product has strong brand loyalty or customer loyalty. New entrants must spend heavily to overcome existing customer loyalties. Switching cost = one-time costs that a buyer/supplier faces when switching from one supplier/buyer to another. In some industries, large financial resources or access to distribution channels are required in order to set up operations. Other advantages that existing competitors might have include proprietary products; favorable access to raw materials; government subsidies; or favorable government policies.



If you are considering opening a new pizza restaurant in your community, what would be the threat of new entrants? How would you evaluate Porter’s other forces for this industry? Explain.


Answer: The threat of new entrants in the food industry is very high, which is why a majority of new food restaurants fail within their first year. The minimum requirements to open a pizza shop are an oven and a small amount of capital. The potential number of competitors is unlimited due to these factors. Based on other forces also, this industry is not very attractive: for instance there is no industry growth, and a lack of differentiation among competitor’s products, so competition is based on cost or service, and the industry has low profit margins as it is.


The Bargaining Power of Buyers

Buyers have bargaining power:

Buyers can force down prices, bargain for higher quality or more services, play competitors against each other.

Buyer groups are powerful when:

Purchasing standard products in large volumes

Profits are low & switching costs are few

Backward integration is possible

Quality is not affected by industry product


Bargaining power of buyers = the threat that buyers may force down prices, bargain for higher quality or more services, and play competitors against each other. Backward integration = A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it will result in improved efficiency and cost savings. For example, backward integration might cut transportation costs, improve profit margins and make the firm more competitive. An example of backward integration would be if a bakery business bought a wheat processor and a wheat farm. An example of backward integration would be if a bakery business bought a wheat processor and a wheat farm. (Definition is not in the textbook. Comes from http://www.investopedia.com/terms/b/backwardintegration.asp) NOTE there’s a difference between customers/buyers, and CONSUMERS. Consumers rarely have any “buyer power” – can you negotiate the price of a movie ticket? Yet the chain of “buyers” in the movie industry is multi-layered – from production studio to distributor to theater owner., with each buyer group having different degrees of power. See Case 16, the Movie Exhibition Industry.


The Bargaining Power of Suppliers

Suppliers can exert bargaining power by threatening to raise prices or reduce the quality of purchased goods and services.

Supplier groups are powerful when:

Only a few firms dominate the industry

No competition from substitute products

Suppliers sell to several industries

Buyer quality is affected by industry product

Products are differentiated & have switching costs

Forward integration is possible


Bargaining power of suppliers = the threat that suppliers may raise prices or reduce the quality of purchased goods and services. See Case 16, the Movie Exhibition Industry. Forward integration = a form of vertical integration whereby a firm expands activities to include control of the direct distribution of its products, e.g. a farmer sells his/her crops at the local market rather than to a distribution center for eventual sale to a supermarket (This definition is not in the textbook, but comes from http://www.investopedia.com/terms/f/forwardintegration.asp )


The Threat of Substitute Products & Services

Substitute products & services limit the potential returns of an industry by placing a ceiling on the prices that firms can profitably charge.

Substitutes come from another industry

Can perform the same function as the industry’s offerings

The more attractive the price/performance ratio, the more the substitute erodes industry profits.


Threat of substitute products and services = the threat of limiting the potential returns of an industry by placing a ceiling on the prices that firms in that industry can profitably charge without losing too many customers to substitute products. Substitute products and services = products and services outside the industry that serve the same customer needs as the industry’s products and services. Example is ice cream – an expensive summer time treat. Frozen fruit smoothies are a substitute. See Case 17 Dippin’ Dots vs. Case 8 Jamba Juice.


The Intensity of Rivalry Among Competitors in an Industry

Rivalry tactics include price competition, advertising battles, new product introductions, increased customer service or warranties

Interacting factors lead to intense rivalry:

Numerous or equally balanced competitors

Slow industry growth

High fixed or shortage costs

Lack of differentiation or switching costs

Capacity augmented in large increments

High exit barriers


Intensity of rivalry among competitors in an industry = the threat that customers will switch their business to competitors within the industry. Rivalry occurs when competitors sense the pressure or act on an opportunity to improve their position. Rivalry differs across industries. See Case 5 the Casino Industry for cutthroat tactics.


How the Internet and Digital Technologies Affect Competitive Forces


The Internet = a global network of linked computers that use a common transmission format, exchange information and store date. The Internet and other digital technologies have fundamentally changed the ways businesses interact with each other and with consumers. These changes have affected industry forces in ways that have created many new strategic challenges.


Using Industry Analysis: A Few Caveats

Managers must not always avoid low profit industries – these can still yield high returns for players who pursue sound strategies

Five forces analysis implicitly assumes a zero-sum game – yet mutually beneficial relationships can still be established with buyers & suppliers

Five forces analysis is essentially a static analysis – yet external forces can still change the structure of all industries

See the value net

Vertical dimension = suppliers & customers

Horizontal dimension = substitutes & complements


Industry analysis helps a firm evaluate the profit potential of an industry and consider various ways to strengthen its competitive position. However, strategists must be wary – it’s not always simple. Zero-sum game = a situation in which multiple players interact, and winners win only by taking from other players. Complements = products or services that have an impact on the value of a firm’s products or services. For instance, Apple’s iTunes was software that made the iPod hardware such a popular product. See Case 6: Apple.


The Value Net

Exhibit 2.6 The Value Net

Source: reprinted by permission of Harvard Business Review. Exhibit from “The Right Game: Use Game Theory to Shape Strategy,” by A. Brandenburger and B.J. Nalebuff, July-August 1995. Copyright © 1995 by the Harvard Business School Publishing Corporation. All rights reserved.


The value net is based on game-theory, and represents all the players in the game, analyzing how their interactions affect a firm’s ability to generate and appropriate value. The vertical dimension of the net includes suppliers and customers. The firm has direct transactions with them. On the horizontal dimension are substitutes and complements, players with whom a firm interacts but may not necessarily transact. Yet complements are products or services that have a potential impact on the value of a firm’s own products or services. A firm must acknowledge its potential partnerships here. See the Strategy Spotlight 2.8 on Apple and the iPod.


Doing a Good Industry Analysis

Good industry analysis looks rigorously at the structural underpinnings & root causes of profitability

Must choose the appropriate time frame

Consider the industry business life cycle

Average profitability over 3-5 years or longer

Must consider quantitative factors as well as qualitative

Get numbers to quantify five forces factors

Percentages of cost or sales, actual switching costs


Michael Porter cautions that good industry analysis needs to yield an understanding of the structural underpinnings and root causes of profitability within the industry by choosing the appropriate time frame and doing a rigorous quantification of the five forces.


Strategic Groups Within Industries

Two unassailable assumptions in industry analysis:

No two firms are totally different

No two firms are exactly the same

Strategic groups – clusters of firms that share similar strategies:

Breadth of product & geographic scope


Degree of vertical integration

Type of distribution


Some groups of firms are more similar to each other than other firms. Rivalry will be greater in firms that are alike. Strategic groups = clusters of firms that share similar strategies. Dimensions should be considered that reflect the variety of strategic combinations in an industry.


Strategic Groups Within Industries

Exhibit 2.7 The World Automobile Industry: Strategic Groups

Note: Members of each strategic group are not exhaustive, only illustrative.


Here is a strategic grouping of the worldwide auto industry. Note not all firms are included, only the four major groups: high-end luxury (those with exclusive clientele, and little rivalry from other groups), low-price/quality (those with a narrow market of bargain shoppers who aren’t that concerned with quality), high-price/quality (with some product-line breadth), and firms with a broad range of products/multiple price points (products that compete at both the lower end and higher end of the market). Consider how Ford (Case 32) and General Motors (Case 31) must monitor trends in this industry. The movement of the various strategic groups can help predict the future volatility and intensity of competition. Members of a strategic group can consider overcoming mobility barriers and migrate to other groups that they find attractive if they are willing to commit time and resources. (Also consider the Boston Beer Company Case 20 – which strategic group does Sam Adams belong to these days?!)


Strategic Groups Within Industries

Strategic groups as an analytical tool

Helps identify barriers to mobility that protect a group from attacks by other groups

Helps identify groups whose competitive position may be marginal or tenuous

Helps chart the future direction of firms’ strategies

Helps to think through the implications of each industry trend for the strategic group as a whole


The question is how to group firms in an industry on the basis of similarities in their resources and strategies. Identifying the strategic group your organization is in helps to decide where threats or opportunities may lie.


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