Leg Zero: Porter´s five forces model explained: Force number One: Industry Rivalry (part I)
Even with the limitations of Porter Five Forces model, I always start my industry analysis with it because it is quite a good starting point. Believe me. I do use it because it helps me to see the whole competitive map of the industry, and that’s OK.
Today I will start explaining the first force of Porter or the force called Degree of Rivalry: Industry Rivalry between established competitors.
This first force of Porter has several key determinant factors. These major factors determining the nature and intensity of competition between established firms are:
Diversity of Competitors
Excess capacity and exit barriers
Scale economies and the ratio of fixed to variable costs
I will start with CONCENTRATION. The first question for Starbucks El Salvador should be: How many competitors does Starbucks have in this country which are similar in size and scope?
The word to explain this question is the variable called concentration. Concentration measures the degree of competition in an industry. The concentration is measured by a ratio. Each coffee shop has a market share. And the concentration ratio is the combined market share of the leading coffee shops competitors.
In economics, the concentration ratio indicates the size of the firms in relation to their industry as a whole. The concentration ratio is calculated as the sum of the market share percentages held by the largest specified number of firms.The concentration ratio ranges from 0% to 100%. If the Concentration ratio is from 0% to 50% it may indicate the industry is perfectly competitive and is considered low concentration. If ranges from 50% to 80% it indicates a medium concentration and the industry is an oligopoly. If the concentration ratio for only one company is equal to 100%, it indicates we are in the case of a monopoly.
For example, the top four firm concentration ratio (CR4) measures the combined market share of the four largest coffee shops companies in El Salvador.
2. The Coffee Cup
4. San Martin
The big universe of all coffee shops in El Salvador is ample. As I explained previously there are many more competitors. To calculate the CR4, I have used only the four largest market share companies. I do not add the company Viva Espresso (with three stores) neither Juan Valdez (with three stores), because of two reasons: they do not have a leading dominant position yet, neither in number of stores nationally nor with the relevant sales. In addition, these two firms are relatively new. Moreover, I don’t add McDonald’s with their “in store” adjacency format McCafe because they started recently too and still McDonald’s strategic core business is hamburgers. There are other coffee shops retail chains which compete in other coffee segments of price and format, such as Florence’s, Mister Donut, Cafe Macchiato, Panaderia Santa Eduviges and many good quality pastries shops such as Le Croissant, Elsy’s Cakes, Panaderia Tecleña, Sweets, etc. The competitive map for coffee shops suffers a problem of Industry Definition. Do we have to consider cake shops, or pastry shops which serve coffee? And this is one of the most difficult problems in industry analysis. No industry has clear boundaries. It is a matter of experience and good judgment. For those who are not familiar with these Salvadoran retail names, do not worry, we will have enough topics and examples globally in the near future. A friend of mine told me to provide my examples with several industries in different regions or countries or cities. I consider her feedback as valid.
Now let’s go finally to calculate the concentration CR4 ratio, we must take into account only the top 4 leading firms, based on market share percentages. For illustrative purposes and in order to protect the privacy of the numbers owners, I will use invented amounts (from my imagination) of the % market share. If you don’t know how to calculate market share I can help you later on. Each market share is shown next to the name of the company.
1. Starbucks – 12%
2. The Coffee Cup – 14%
3. Shaws – 10%
4. San Martin – 18%
The CR4 for the coffee shops concentration ratio is 54 %. To calculate it just add the four percentages. This tells us the coffee shops industry is an oligopoly. Where an industry is comprised of a small group of leading companies (an oligopoly), price competition may also be restrained, either by outright collusion or parallelism (prices set at similar levels). there is another methodology to calculate concentration called the Herfindahl Index, but I will not dig into it today.
Why is it important to understand the concentration ratio? Because your Pricing depends on it. Your competitive strategy depends on it. Your decisions for profit depend on it.
Tomorrow I will continue writing about the second-factor of the Industry Rivalry force, Diversity of Competitors.
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