- Looking at the Evidence
- Knowledge Conditions
- Demand Conditions
- Industry Life Cycles
- Industry Structure
- Summary
This chapter is from the book
This chapter is from the book
This chapter is from the book
Industry Structure
A final dimension of industry that is important to the performance of new firms is industry structure. The structure of the industry refers to the nature of barriers to entry and competitive dynamics in the industry. Four characteristics of industry structure are particularly important to the performance of new firms in the industry: capital intensity, advertising intensity, concentration, and average firm size.
Capital intensity measures the importance of capital as opposed to labor in the production process. Some industries, such as aerospace, involve a great deal of capital and relatively little labor. Other industries, such as textiles, involve relatively little capital and a great deal of labor.
New firms perform better in labor intensive industries (ones where work matters more than money) than in capital intensive ones.(10) Why? At the time that they are founded, new firms lack cash flow from existing operations. Yet new firms need to expend capital to establish the organization and create production and distribution assets. Because new firms must expend capital before they have cash flow from operations, they must obtain capital from external capital markets. Capital obtained from financial markets is more expensive than internally generated capital. Investors demand a premium for bearing the risk that comes from the gap of information between investors and entrepreneurs. The magnitude of this premium is related to the size of the capital requirement necessary to create the business. The larger the capital requirement, the greater the disadvantage faced by new firms in the industry.
New firms are disadvantaged relative to established firms in more advertising intensive industries. Advertising is a mechanism through which companies develop the reputations that help them sell their products and services. To build a brand name reputation through advertising, two conditions need to be met. First, the advertising has to be repeated over time. The capacities of human beings are such that they can only absorb so much information at a time. Therefore, it takes time for new firms to build their brand names, during which time they have lesser reputations than existing firms. Second, economies of scale exist in advertising. The cost of advertising is largely fixed, regardless of the number of units of a product sold. As a result, the cost per unit of advertising decreases with the volume of sales. New firms tend to produce fewer units than established firms because they begin operations at a small scale, making their per unit advertising costs higher than those of established firms.(11) Of course, this advertising disadvantage is more problematic the more important advertising is for an industry, making new firms less competitive with established firms in more advertising intensive industries than in less advertising intensive ones.
New firms are disadvantaged relative to established firms in more concentrated industries.(12) Concentration is a measure of the market share that is held by the largest companies in an industry. For instance, in some industries, such as pharmaceuticals (think of how few drugs you use are made by firms other than the big pharmaceutical companies like Merck, Pfizer, and Eli Lilly), the largest companies account for almost all of the market. In contrast, in more fragmented industries, like dry cleaning, virtually no firm has even 1 percent of the total market.
New firms perform relatively poorly in concentrated industries because industry concentration provides large, established firms with market power. In concentrated industries, such as telecommunications firms offering local phone service, established firms have the resources to keep new firms from establishing a beachhead in the industry. As a result, they use their monopoly or oligopoly profits to deter entry. Moreover, entry can be deterred more easily in concentrated industries than in fragmented industries for two reasons. First, in fragmented industries, there are small, vulnerable firms that can be challenged more successfully than the large, powerful firms that are the only competitors in concentrated industries. Second, in concentrated industries, established firms can collude to keep other firms from entering. For instance, they can collectively cut prices when a new entrant comes into the industry until that entrant is driven out of business and then raise prices again. Because collusion only works if all of the colluders participate, it is much easier to pull off when there are few players in an industry than when there are many.
New firms perform better in industries in which the average size of firms is small.(13) New firms tend to begin small as a way to minimize the risk of entrepreneurial miscalculation. That is, if entrepreneurs begin small, they have a lower downside loss if they are incorrect. In industries in which most firms are small, starting a new firm at a small scale does not create much of a disadvantage relative to the established firms in the industry.(14) In contrast, in industries where the average firm size is large, starting small creates a number of disadvantages, such as the inability to purchase in volume and higher average manufacturing and distribution costs due to the absence of economies of scale. As an example, think of the difference between Web site developers and steel mills. Because the average Web site developer is small, a new small Web site developer is able to operate at almost the same scale, if not the same scale, as the established players. However, the average steel mill is quite large. So, if a new steel mill is started small, it is initially at a great disadvantage relative to the established firms with which it needs to compete.
Stop! Don't Do It!
Don't start a business in a capital intensive industry.
Don't start a business in an advertising intensive industry.
Don't start a business in an industry in which the average sized firms are large.
Don't start a business in a concentrated market.
Questions to Ask Yourself
Is the industry that I am planning to enter a good one for starting a new company?
Are the knowledge conditions in the industry favorable to a start-up?
Are demand conditions in the industry favorable to a start-up?
Is the industry at the right stage of the life cycle for a start-up?
Is the industry structure favorable for a start-up?