The Effect of Changing External Environment on Industry Structure, Competition, and Profitability

During the 1970s, a more turbulent and unpredictable business environment started emerging. Before this, the external environment of businesses used to be stable, which ensured stable industry structures. As today’s business environment has become more unstable, it has moderately, or severely affected the industry structures of many industries, resulting in the unsustainability of the built competitive advantages.

The external environment of a business comprises the societal and task environment. The societal environment comprises political, sociocultural, economic, social, and technological forces and other external influences that rarely affect the short-term activities of the firm but often affect its long-run decisions. And the task environment comprises elements or groups such as customers, competitors, suppliers, employees, distributors, creditors, and others that affect the firm and, in turn, are affected by it. Industry structure is a subset of the industry’s task environment, which comprises five basic competitive elements: buyers, suppliers, new entrants, substitutes, and competitors. The resultant intensity of these elements’ forces determines the profit potential in the industry, where the profit potential is defined as a long-run return on invested capital (ROIC).

The external environment of a business can be characterized as stable or unstable. The external environmental forces, such as technology and consumer preferences, and the firm’s strategies, can affect the industry structure. These forces can change the industry structure moderately or severely or can also render the structure obsolete, which in turn, can affect the industry competition and profitability. The industry structure can also change from within. A stable external environment, in most situations, maintains a stable industry structure. Therefore, changes in the industry structure can enhance the industry’s future profit potential or reduce it. Based on this characterization, I will describe how the changing external environment affects the industry structure.

A two-dimensional chart as shown in figure 1.0 is constructed to describe the impact of the changing external environment on industry structure and consequently the effect of structure on competition and profitability. In figure 1.0, the “external environmental change” is shown on the horizontal (X) axis—described as stable and unstable. The “industry structure” is shown on the vertical (Y) axis—described as stable and unstable. 

 Figure 1.0

Stable Business Environment/Stable Industry Structure (Q1)

Quadrant 1 (Q1) in Figure 1.0 refers to firms operating in a stable external environment and having a stable industry structure. In this environment, firms follow similar strategies with similar resources and capabilities and have fewer opportunities for generating competitive advantage than in industries in which external change is rapid and firms largely differ from each other. Examples of industries that operate in a relatively stable external environment and stable industry structure are beer brewing, food processing, can manufacturing, and soft drinks. Because the industry structure is stable, the five forces that drive competition will determine the profitability of the industry. In these industries, the five forces of competition are weak, therefore many firms are profitable, and interfirm differences in profitability within strategic groups tend to remain small and stable over the long run.

Stable External Environment/Changing Industry Structure (Q2)

In quadrant (Q2) of figure 1.0, the firm’s external environment is stable, but the industry structure experiences a gradual change to one or all of the five forces. Some activities, such as building new capabilities, acquiring, or losing a patent, and mergers and acquisitions, can alter the magnitude of the five forces and change the industry structure. This change can positively or negatively affect the industry’s profit potential. For example, if the threat from new entrants is changing (if any of the seven barriers to new entry are changing), it can raise or lower or eliminate the threat of new entrants. When Merck’s patent for its cholesterol reduction drug Zocor expired, three similar drug makers entered the market.

Changing External Environment/Stable Industry Structure (Q3)

Quadrant Q3 in figure 1.0 refers to firms when their external environment is changing but their industry structure is stable. The changing external environment depicted in quadrant Q3 can generate different competitive advantages among companies because of their differences in resources and capabilities or strategic positioning. For example, in 2017, the US Congress passed a tax bill that reduced the subsidies for renewable energy. This enhanced the competitive advantage for fossil fuel power producers, such as AEP and Duke Energy, compared to Terra-Gen and Caithness Energy, the wind and solar power producers. In this situation, the external environment forces a modest change to an otherwise stable industry structure.

The potential to generate competitive advantage depends proportionately on the magnitude of external change and differences in firms’ strategic positioning. The changing external environment can alter the industry structure in a way that can increase or decrease industry profitability. Some toy companies, such as Hasbro, Mattel, and MGA Entertainment, have experienced sudden changes in consumer preferences in the recent past that resulted in unusual variances in profitability.

Changing External Environment/Changing Industry Structure (Q4)

Quadrant Q4 in figure 1.0 refers to firms when both their external environment and industry structure are changing. The rapid change in today’s new business environment is driven by political, economic, and technological forces and many other external interventions. These environmental forces, particularly the impact of disruptive digital technologies and international competition, have slowly or abruptly destabilized the industry structure of many industries. According to Rich D’Aveni, the general feature of industries today is hypercompetition: “intense and rapid competitive moves, in which competitors must move quickly to build (new) advantages and erode the advantages of their rivals.” If industries are hypercompetitive, their structures are unstable and competitive advantage is temporary. However, research indicates that disruptions with rapid structural changes are not limited to the high-technology sector, but the oil and gas, financial, and taxi services have also experienced the same disruptions in the recent past.

Because the structural change is rapid, the five-force framework is not adequate for predicting competitive behavior and profitability. However, in practice, hypercompetitive firms do not reduce the importance of the five-force framework. For example, in analyzing the structural changes that have taken place in the solar panel industry, pharmaceutical industries, and retailing, the five-force framework shows us how changes in the industry structure will affect the competitive forces and profitability.

In some industries, the differences in profitability between firms are exceptionally large, which causes us to believe that industry attractiveness is not so important in accepting it as a source of superior profitability. For example, during the years 2015-2017, Apple earned a return on equity (ROE) of approximately 30% on mobile devices, but its competitors incurred huge losses. In the video game industry, the console maker, Nintendo, and Sony have captured a major portion of the industry’s profit. In most situations, a firm with market share leadership takes resources away from its competitors. This condition is known as the winner-take-all industries. In these industries, the firm that captures a large market share achieves the privilege of generating a large amount of competitive advantage. This huge competitive advantage is generated through positive feedback loops (network effects) and not through usual scale economies and stable industry structures. Therefore, in analyzing these winner-take-all industries, we first analyze network externalities before we conduct an industry analysis, to identify the sources of competitive advantage. Complementary products play a significant role in generating network externalities.

References and Further Reading

1. M. Grant, Contemporary Strategy Analysis (United Kingdom: John Wiley & Sons, Ltd., 2018), Chapters 3, 4, 6, 7, 8, 9, and 10.
2. L. Wheelen, J. D. Hunger, Alan N. Hoffman, and Charles E. Bamford, Strategic Management & Business Policy (United Kingdom: Pearson Education Ltd., 2018), Chapter 4.
3. E. Porter, “The Five Competitive Forces That Shape Strategy,” Harvard Business Review 57 (January 2008): 57-71.
4. Daft, Organizational Theory and Design, 12^th edition, p. 151.
5. Ashok N., Important Elements of Value Creation in an Ecosystem, A& N Strategy Consulting (May 29, 2021).
6. A. D’Aveni, Hyper-competition: Managing the Dynamics of Strategic Maneuvering (New York: Free Press, 1994): 217-218.
7. A. D’Aveni, G.B. Dagnino, and K.G. Smith, “The Age of Temporary Advantage,” Strategic management Journal 31 (2010): 1371-1385.
8. Ashok N., A New Business Model Structure, Innovation Strategy, and Competitive Advantage, A& N Strategy Consulting (April 8, 2018).