Saturday, October 3, 2015

A New Theory of Competitive Economic Forces: Supplementing Porter’s Aging Theory of Competitive Strategy

There is no doubt that Michael Porter’s Theory of Competitive Strategy (1980) is a landmark thesis in the domain of strategy, expressing the relationships between the firm and the environment as well as between the firms in an industry in a unique manner. Professor Porter identified five forces of competition, namely the threat of new entrants, threat of substitute products or services, bargaining power of buyers, bargaining power of suppliers and intensity of industry rivalry. Porter’s Five Forces theory draws largely on the structure-conduct-performance theories of industrial economics. Porter held that the five competitive forces vary based on the nature of the industry, the state of the industry and the state of the firm. He advocated that firms could deploy three generic strategies, namely cost leadership, differentiation and niche, for them to derive sustainable competitive advantage over the competitor firms.

Michael Porter also held that definition of the industry in which a firm operates in, and the levels of entry and mobility barriers within and across the defined industries, also influence the competitive strategy of a firm. Strategies of integration and diversification within an industry are proposed to influence, and be influenced by, the five forces. In a manner of saying, Porter’s theory of competitive strategy represents a domain that is at the intersection of industrial structure and business performance. Pathbreaking though Porter’s theory has been, there are certain critical shortcomings, especially with reference to contemporary industrial development. The first shortcoming is in viewing buyers, suppliers and competitors as distinct unrelated entities. The second is in the proposition that the higher the entry barrier the higher is the value or profit potential. The third is that industry or environmental volatility is low and predictable enabling firms plan their competitive strategies based on structural designs. More importantly, it is not calibrated to address the contemporary economic realities.

New realities

The new realities are that buyers, suppliers and competitors have multiple overlaps. Firms in the same industry competing at the product level tend to compete at component or materials level. While they may look for sourcing advantages or cost savings, brand premiums or sales discounts and design dependencies or independencies, they also tend to be aligned to maximize overall throughput individually and collectively. The smart device industry is an example with multiple layers of collaboration at component level amidst competition at product level.  Secondly, entry barriers need not necessarily represent value building opportunity. Steel industry may have the highest investment intensity and hence the highest entry barriers but typically offers meagre returns relative to low investment industries such as FMCG. The third is that industry structures are becoming increasingly impacted by economic trends, even as economic trends are getting increasingly governed by commodity and liquidity cycles as well as cross-border investments and exchange rate regimes are becoming increasingly volatile, impacting stability of strategies.  

The new realities could also combine two or more competitive forces into one and accentuate their combined impact. For example, new firms could enter the industry with substitute products or services (not just imitator products) thus increasing the competitive intensity more than proportionately. Buyers may start dumping their products in the exchange or used product schemes thus making firms more of substitutional sellers rather than incremental sellers. The intensity of industry rivalry could be more due to exit barriers (absence of bankruptcy provisions) rather than due to low entry barriers. Commodity and other economic cycles may mean that strategies such as cost leadership at design or manufacturing level may be differently impacted from time to time. An automotive design strategy developed at great cost for maximal fuel economy may become less powerful in a protracted phase of extremely cheap oil prices.

Macro versus micro

For Porter, industry-specific and firm mediated micro-environment provided for sharper articulation of corporate and business strategies, compared to woolly SWOT analyses that were in fashion in the 1960’s and 1970’s.  The issue, therefore, is whether industry level micro-environment as proposed by Porter in the 1980s or economy level macro-environment as is now emerging in the 2010s is more appropriate for formulating competitive strategy. The way the global economy is anticipative of US Fed rate hike or the entire Indian industry is exultant about RBI rate cut does indicate that macroeconomic factors do have an increasingly overarching influence these days. Similarly, the way the slowdown in China causes global demand tremors and stock market blues or how a taxation issue can fray or calm the nerves of portfolio investors in India are also proofs of global economic and industrial interconnectivity.

Industries and firms are impacted not merely by firm and industry specific competitive forces but also national and international economic forces. IPOs as well as follow-on offerings and stake sales by Public Sector Undertakings (PSUs) in India, for example, are affected by dips in Indian stock market sentiments which are, in turn, caused by dips in global stock markets.  Economic liberalization may have freed industrial development from public policy (notwithstanding residual macro regulations) but industrial development is impacted more than ever by national and international economic factors. There is probably no way to decouple Indian economy and industry from such vagaries but at least there must be a model that focuses the attention of firms and industries on such competitive economic forces. This blog post proposes a theory of five competitive economic forces as an adjunct to Porter’s theory of competitive strategy. 

Five Economic forces

Five economic forces impact industrial structure and performance. The first is the threat of inflation. The second is the risk of global capital flows. The third is the bargaining power of national technologies. The fourth is the bargaining power of national markets. The fifth is the intensity of national rivalry. Each of these has an impact on industry level competitive strategy. They also dictate a preferred drift in the generic competitive strategies. Competitive threat of inflation, for example, impacts the bargaining power of suppliers as well as that of buyers. It also supports cost leadership as a preferred generic competitive strategy. The competitive force of global flows influences market capitalization levels on bourses, and brings in or drives out more risk capital for expansion and diversification. Unlimited capital flows take the focus away from efficiency and promote differentiation and niche as generic competitive strategies.

Nations play a major role in licensing technologies, and generate major bargaining power over these. This is countered in part by the bargaining power of national markets. This interplay is evident usually in military technologies (eg., Rafale aircraft deal between France and India) but has extended to high end civilian technologies too (eg., China’s high speed rail technology for US to connect Los Angeles and Los Vegas). The latter at industry level was evident when major technology firms of US vied each with each other during Prime Minister Narendra Modi’s visit to US West Coast to invest and supply technologies for Indian markets. When nations compete to participate in emerging markets, rivalry is heightened, but to the benefit of the local industry. Governments can leverage such rivalry for national benefit. India, for example, can benefit from generating international interest and rivalry for building bullet train infrastructure or new capital cities. A firm, before applying Porter’s Five Forces Theory, must, therefore, apply the Five Economic Forces Theory to establish the correct perspectives for firm level competitive strategic analysis.   

Model within model

This blog post has proposed, probably for the first time in the history of strategic management, a theory of competitive economic forces as an overarching umbrella under which Porter’s theory of competitive strategy needs to be recalibrated. The big difference between the national economic forces and the industrial competitive forces is that the former are more volatile and unpredictable, and are additionally susceptible to public policy and governmental actions. While industrial competitive forces are more predictable they are swayed by how the economic policy framework changes. Some research is clearly needed to understand if and how the economic forces model can be linked to the industrial forces model. One way could be to choose a time horizon that starts with a major economic inflexion point and model the industrial forces until the expected next inflection point, and develop a calibrated industry and firm level model for the target timeframe. The author suggests that academia and practitioners of management, as well as economists and strategists must collaborate to assess the relevance and coupling of both these models; the new economic and the established industrial!   

For India, at this point a combination of competitive economic forces sets up the five force economic model, the forces being decelerating inflation (as is presently evident), declining portfolio investments (due to the much anticipated Fed rate hike), dependence foreign technologies (for next generation infrastructure), consumerisation of markets (with increased purchasing power) and increasing national rivalry to enter or expand in India (virtually every developed country desiring to have a share of India). Such an analytical framework sets the tone for recalibrating the basic Porter model. In the ultimate analysis, the issue is not one of choosing between a micro or macro model. Macro model is the missing piece in current strategy framework and must be provided for, as suggested herein. In addition, Porter’s micro model continues to be relevant but with two caveats. Firstly, industrial play is not only about forces of completion; it should be equally about forces of collaboration. Secondly, the five forces, and the entities causing them, are not independent of each other but could have overlaps, and be accentuated or attenuated based on overlaps.

Posted by Dr CB Rao on October 3, 2015

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