Strategic Management - Concepts and Cases (Frank T. Rothaermel, 3e, 2016)

1. Chapter 3
External Analysis: Industry Structure, Competitive Forces,
and Strategic Groups

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The AFI Strategy Framework
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Chapter 3 Outline (1 of 2)
3.1 The PESTEL Framework
– Political Factors
– Economic Factors
– Sociocultural Factors
– Technological Factors
– Ecological Factors
– Legal Factors
3.2 Industry Structure and Firm Strategy: The Five Forces
Model
– Competition in the Five Forces Model
– The Threat of Entry
– The Power of Suppliers
– The Power of Buyers
– The Threat of Substitutes

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Chapter 3 Outline (2 of 2)
3.2 Industry Structure and Firm Strategy: The Five Forces
Model
– Rivalry among Existing Competitors
– A Sixth Force: The Strategic Role of Complements
3.3 Changes over Time: Industry Dynamics
3.4 Performance Differences within the Same Industry:
Strategic Groups
– The Strategic Group Model
– Mobility Barriers
3.5 Implications for the Strategist

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Learning Objectives
LO 3-1 Generate a PESTEL analysis to evaluate the impact of external factors
on the firm.
LO 3-2 Apply Porter’s five competitive forces to explain the profit potential
of different industries.
LO 3-3 Explain how competitive industry structure shapes rivalry among
competitors.
LO 3-4 Describe the strategic role of complements in creating positive-sum
co-opetition.
LO 3-5 Appraise the role of industry dynamics and industry convergence in
shaping the firm’s external environment.
LO 3-6 Generate a strategic group model to reveal performance differences
between clusters of firms in the same industry.

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The PESTEL Framework

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Importance of Analyzing the External Environment
• Managers can mitigate threats.
• Managers can leverage opportunities.
• Gain understanding of potential impacts.
• Understand the source / proximity of factors.

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The PESTEL Model
• Groups environmental factors into six segments:
– Political
– Economic
– Sociocultural
– Technological
– Ecological
– Legal
• These factors can create:
– Opportunities
– Threats

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Exhibit 3.1 The Firm within Its External Environment, Industry, and
Strategic Group, Subject to PESTEL Factors
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Political Factors
• Processes & actions of government bodies
• Firms can shape this factor through:
– Lobbying
– Public Relations
– Contributions
– Litigation
• Example: Tesla
– Has a build-to-order sales model
– Cuts out dealers
– Dealers are lobbying for new legislation

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Economic Factors
• Largely macro-economic
• Examples include:
– Growth rates
– Levels of employment
– Interest rates
– Price stability
– Currency exchange rates

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In Periods of Economic Expansion…
• Growth rates:
– Businesses expand, are more profitable.
• Levels of employment
– Unemployment is low.
• Interest rates
– Credit is cheap because interest rates are low.
• Price stability
– Rising prices result in inflation.
• Currency exchange rates
– The dollar can appreciate.

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In Periods of Economic Contraction…
• Growth rates:
– Businesses retract, are less profitable.
• Levels of employment
– Unemployment is high.
• Interest rates
– Credit is expensive because interest rates are high.
• Price stability
– Falling prices result in deflation.
• Currency exchange rates
– The dollar can depreciate.

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Sociocultural Factors
• Society’s cultures, norms, and values
– Are constantly in flux
– Differ across groups
• Demographic trends
– Present opportunities and threats
– Population characteristics related to age, gender, family
size, ethnicity, sexual orientation, religion, and
socioeconomic class

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Technological Factors
• Application of knowledge
– To create new processes
– To create new products
• Innovations in process technology:
– Lean manufacturing, Six Sigma quality, and biotechnology
• Innovations in product technology:
– Smartphones, computer tablets, and high-performing
electric cars such as the Tesla Model S

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Ecological Factors
• Involve environmental issues, such as:
– Natural environment
– Global warming
– Sustainable economic growth
• Also provide business opportunities

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Legal Factors
• Official outcomes of political processes:
– Laws
– Mandates
– Regulations
– Court decisions
• Industry deregulations affect multiple industries:
– Airlines, telecom, energy, and trucking
• Governments can achieve desired outcomes:
– To buy zero-emission vehicles, the U.S. government offers
a $7,500 federal tax credit

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Strategy Highlight 3.1 (1 of 2)
• Blackberry
– Pioneer in smartphones
– Increased productivity
– A status symbol
• Market cap of Blackberry:
– In 2008: $75 Billion
– In 2015: $8 Billion

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Strategy Highlight 3.1 (2 of 2)
• Lacked awareness of Sociocultural Factors
– People began to use their own phones at work for
communication.
– IT departments had to incorporate other devices.
• Lacked awareness of Technological Factors
– Apple’s release in ‘07 included a camera, touch-screen,
and had Wi-Fi.
– Was dismissed as a toy with low security features

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Industry Structure and Firm Strategy:
The Five Forces Model

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Industry & Industry Analysis
• Industry:
– Group of incumbent companies
– Relatively the same set of suppliers and buyers
– Tend to offer similar products and services
• Industry Analysis, a method to:
– Identify an industry’s profit potential
– Derive implications for a firm’s strategic position

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Strategic Positioning
• A firm’s strategic profile
• Based on value creation and cost
• The goal
– Generate a large gap between
• The value the firm’s product or service creates
• The cost required to produce it

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Exhibit 3.2 The Five Forces Model
The following five forces determine the profit potential of an industry and
shape a firm’s competitive strategy:
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SOURCE: Michael E. Porter, “The five
competitive forces that shape
strategy,” Harvard Business Review,
January 2008.

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Strategy Highlight 3.2(1 of 2)
Five Forces in the Airline Industry
• Competitive rivalry: intense
– Consumers make decisions based on price.
– Price comparisons are easy.
• Power of buyers: high
– Switching costs are low.
– Large corporate contracts
• Entry barriers: low
– Example: Virgin America entered in 2007

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Strategy Highlight 3.2(2 of 2)
Five Forces in the Airline Industry
• Power of suppliers: strong
– Providers are highly specialized
• Power of substitutes: high
– Substitutes are readily available.
– Alternatives: train, bus, car
• Result:
– Mega airline carriers struggle.
– Service providers are quite profitable (catering, etc.).
– Customers pay low prices.

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Threat of Entry
• The risk that potential competitors will enter an
industry
• Lowers industry profit potential:
– Incumbents lower prices
• Incumbents spend more to satisfy existing
customers.
• Entry barriers:
– Obstacles blocking others from entering
– A significant predictor of industry profit potential

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Types of Entry Barriers
• Economies of scale
• Network effects
• Customer switching costs
• Capital requirements
• Advantages independent of size
• Government policy
• Credible threat of retaliation

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Power of Suppliers
• Pressures that industry suppliers can exert on an
industry’s profit potential
• Lowers industry profit potential if:
– Suppliers demand higher prices for their inputs
– Suppliers reduce quality

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Bargaining Power of Suppliers Is High When:
• Concentrated (or limited) supplier industry
• Suppliers not dependent on industry for majority of
revenue
• Incumbent firms face supplier switching costs
• Suppliers offer differentiated products
• There are no supplier substitutes.
• Suppliers can forward-integrate into the industry.

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Bargaining Power of Buyers Is High When:
• There are a few buyers & each buyer purchases large
quantities.
• The industry’s products are standardized or
undifferentiated commodities.
• Buyers face low or no switching costs.
• Buyers can backwardly integrate into the industry.

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Power of Buyers (Customers)
• Pressure customers put on an industry by
demanding:
– A lower price or
– Higher product quality

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Threat of Substitutes
• Products or services outside an industry meeting the
needs of current customers
• Examples:
– H&R Block vs. TurboTax
– Energy drinks vs. coffee
– E-mail vs. express mail
– Wireless telephone vs. VOIP
– Videoconferencing vs. business travel

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Threat of Substitutes is High When:
• The substitute offers an attractive price-performance
trade-off.
• The buyer’s cost of switching to the substitute is low.

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Rivalry Among Competitors
• The intensity with which companies in the same
industry jockey for market share and profitability
• Other 4 forces put pressure on this rivalry
– The stronger the forces, the higher the intensity.
• Intensity determined by (covered next):
1. Competitive industry structure
2. Industry growth
3. Strategic commitments
4. Exit barriers

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Competitive Industry Structure
• The number and size of its competitors
• The firms’ degree of pricing power
• The type of product or service (commodity or
differentiated product)
• The height of entry barriers

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4 Main Competitive Industry Structures
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

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Exhibit 3.3 Industry Competitive Structures
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Perfect Competition
• Many small firms
• Firms are price-takers
• Offer commodity products
• Low entry barriers
• Resulting industry: profitability is typically low

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Monopolistic Competition
• Many firms
• Some pricing power
• Differentiated product
• Medium entry barriers
• Resulting industry: niches are established

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Oligopoly
• Few (large) firms
• Some pricing power
• Differentiated product
• High entry barriers
• Firms are interdependent
• Resulting industry: firm actions often coordinated

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Monopoly
• One firm
• Considerable pricing power
• Unique product
• Very high entry barriers
• Resulting industry: profit extracted

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Industry Growth
• Affects intensity of rivalry among competitors
• During periods of high growth:
– Consumer demand rises
– Price competition among firms decreases
• They focus on capturing new customers
• They are not focused on taking profitability away from each other
• During periods of negative growth:
– Rivalry is fierce
– Rivals can only gain at the expense of one another

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Strategic Commitments
• Affects intensity of rivalry among competitors
• Firm actions that are:
– Costly
– Long-term oriented
– Difficult to reverse
• Example: airline industry
– Hub and spoke model requires significant investment

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Exit Barriers
• Affects intensity of rivalry among competitors
• Obstacles that determine how easily a firm can leave
that industry
• Examples:
– Contractual obligations
– Emotional attachments

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A Sixth Force: Complements
• A product, service, or competency
• Adds value when used with the original product
• Complementor:
– A company that provides a good or service that leads
customers to value your firm’s offering more when the two
are combined

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Changes over Time: Industry Dynamics

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Industry Dynamics
• Models discussed are only a snapshot.
• Leaders need information about:
– Changing speed of an industry
– Rate of innovation
• Industries aren’t stable over time.

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Industry Consolidation
• Consolidated industries are more profitable.
• Mergers and acquisitions make this possible.
– Results in higher industry profitability
• Example: U.S. Airline Industry mergers
– Delta and Northwest
– United and Continental
– Southwest and AirTran
– American and U.S. Airways

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Industry Convergence
• When unrelated industries satisfy the same need
• Example: Media Industries
– Progress in IT, telecommunications, digital media
– Has united computing, communications, content
• Content providers are adapting:
– Newspapers, magazines, TV, movies, radio, music
• New forms of content media:
– Amazon’s Kindle
– Apple’s iPad
– Google’s Chromebook

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Performance Differences within the Same
Industry: Strategic Groups

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Strategic Groups
• Strategic groups are:
– A set of companies
– That pursue a similar strategy
– In a specific industry
• The strategic group model (framework):
– Clusters different firms into groups
– Is based on key strategic dimensions

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Strategic Groups Differ From Other
Strategic Groups In Terms Of…
• R&D expenditures
• Technology
• Product differentiation
• Product and service offerings
• Pricing
• Market segments
• Distribution channels
• Customer service

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How to Create a Strategic Group Map
1. Identify important strategic dimensions.
2. Choose two key dimensions
– For horizontal and vertical axes
– Not highly correlated
3. Graph the firms in the strategic group.
– Each firm’s market share indicated by the size of the
bubble

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Exhibit 3.5 Example of a Strategic Group:
The Airline Industry
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Insights from Strategic Group Mapping
1. Competitive rivalry:
– Strongest between firms in the same strategic group
2. External environment:
– Affects strategic groups differently
3. Five competitive forces:
– Affect strategic groups differently
4. Profitability:
– Some strategic groups are more profitable than others

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What Is a Mobility Barrier?
• Industry-specific factors
• Separate one strategic group from another

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Implications for the Strategist

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Analysis of the External Environment Is
Key to Strategic Management
• First step: PESTEL Analysis
– How external factors affect the industry
• Next step: Porter’s Five Forces
– The overall industry environment
• Final step: Draw a Strategic Group Map
– Explains performance differences in an industry

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How to Apply the Five Forces Model
• Define the relevant industry.
• Identify the key forces – group them.
• Identify the drivers of each force.
– Are they strong or weak?
• Assess overall industry structure.
– Profit potential

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Shortcomings of Models Discussed
• They are static
– Just a snapshot
– But black swan events happen suddenly
– Information can become obsolete
• Models don’t explain why performance differences
occur in an industry.
– Internal analysis is required (next chapter.)

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Chapter 3 Summary

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Take Away Concepts (1 of 6)
LO 3-1 Generate a PESTEL analysis to evaluate the impact of external
factors on the firm.
•A firm’s macroenvironment consists of a wide range of political, economic, sociocultural,
technological, ecological, and legal (PESTEL) factors that can affect industry and firm
performance. These external factors have both domestic and global aspects.
•Political factors describe the influence government bodies can have on firms.
•Economic factors to be considered are: growth rates, interest rates, levels of employment, price
stability (inflation and deflation), and currency exchange rates.
•Sociocultural factors capture a society’s cultures, norms, and values.
•Technological factors capture the application of knowledge to create new processes and
products.
•Ecological factors concern a firm’s regard for environmental issues such as the natural
environment, global warming, and sustainable economic growth.
•Legal factors capture the official outcomes of the political processes that manifest themselves in
laws, mandates, regulations, and court decisions.

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Take Away Concepts (2 of 6)
LO 3-2 Apply Porter’s five competitive forces to explain the profit potential
of different industries.
•Competition must be viewed more broadly to encompass not only direct rivals but
also a set of other forces in an industry: buyers, suppliers, the potential new entry of
other firms, and the threat of substitutes.
•The profit potential of an industry is a function of the five forces that shape
competition: (1) threat of entry, (2) power of suppliers, (3) power of buyers, (4) threat
of substitutes, and (5) rivalry among existing competitors.
•The stronger a competitive force, the greater the threat it represents. The weaker the
competitive force, the greater the opportunity it presents.
•A firm can shape an industry’s structure in its favor through its strategy.

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Take Away Concepts (3 of 6)
LO 3-3 Explain how competitive industry structure shapes rivalry among
competitors.
•The competitive structure of an industry is largely captured by the number and size of
competitors in an industry, whether the firms possess some degree of pricing power, the type of
product or service the industry offers (commodity or differentiated product), and the height of
entry barriers.
•A perfectly competitive industry is characterized by many small firms, a commodity product, low
entry barriers, and no pricing power for individual firms.
•A monopolistic industry is characterized by many firms, a differentiated product, medium entry
barriers, and some pricing power.
•An oligopolistic industry is characterized by few (large) firms, a differentiated product, high entry
barriers, and some degree of pricing power.
•A monopoly exists when there is only one (large) firm supplying the market. In such instances,
the firm may offer a unique product, the barriers to entry may be high, and the monopolist
usually has considerable pricing power.

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Take Away Concepts (4 of 6)
LO 3-4 Describe the strategic role of complements in creating
positive-sum co-opetition.
• Co-opetition (co-operation among competitors) can create a positive-
sum game, resulting in a larger pie for everyone involved.
• Complements increase demand for the primary product, enhancing
the profit potential for the industry and the firm.
• Attractive industries for co-opetition are characterized by high entry
barriers, low exit barriers, low buyer and supplier power, a low threat
of substitutes, and the availability of complements.

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Take Away Concepts (5 of 6)
LO 3-5 Appraise the role of industry dynamics and industry convergence in
shaping the firm’s external environment.
•Industries are dynamic—they change over time.
•Different conditions prevail in different industries, directly affecting the firms
competing in these industries and their profitability.
•In industry convergence, formerly unrelated industries begin to satisfy the
same customer need. Such convergence is often brought on by technological
advances.

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Take Away Concepts (6 of 6)
LO 3-6 Generate a strategic group model to reveal performance
differences between clusters of firms in the same industry.
•A strategic group is a set of firms within a specific industry that pursue a similar strategy in their
quest for competitive advantage.
•Generally, there are two strategic groups in an industry based on two different business
strategies: one that pursues a low-cost strategy and a second that pursues a differentiation
strategy.
•Rivalry among firms of the same strategic group is more intense than the rivalry between
strategic groups: intra-group rivalry exceeds inter-group rivalry.
•Strategic groups are affected differently by the external environment and the five competitive
forces.
•Some strategic groups are more profitable than others.
•Movement between strategic groups is restricted by mobility barriers—industry-specific factors
that separate one strategic group from another.

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Key Terms
• Competitive industry
structure
• Complement
• Complementor
• Co-opetition
• Entry barriers
• Exit barriers
• Five forces model
• Industry
• Industry analysis
• Industry convergence
• Mobility barriers
• Network effects
• PESTEL model
• Strategic group
• Strategic group model
• Strategic position
• Threat of entry

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Chapter 3 Cases & Exercises

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Chapter Case 3: Consider This… (1 of 3)
• Tesla Motors:
– Successfully entered U.S. automotive market
– Uses innovative new technology
• Future success will depend on industry forces
– Lowered profit potential
– Reduced attractiveness
• Other non-traditional competitors
– Google and Apple

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Chapter Case 3: Consider This… (2 of 3)
• Factor 1: price for crude oil dropped steeply
• Factor 2: tax credits for alternative vehicles being
phased out
• Factor 3: Lithium-ion battery packs
– Are in short supply
– Are very expensive
– Tesla initiating a lithium-ion battery production facility

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Chapter Case 3: Consider This… (3 of 3)
• Which PESTEL factors are the most salient?
• What is the profit potential of the U.S. car industry?
– Use Porter’s Five Forces
• How should Tesla Motors compete in the U.S. car
industry?
• Strategic group map – draw & discuss
• Discuss Tesla’s market cap vs. GM’s revenue

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My Strategy Exercise (1 of 2)
Is My Job the Next One Being Outsourced?
• Which aspects of accounting are less susceptible to
out-shoring?
• What are the best domestic/global job
opportunities?
• How do industry trends affect your job search?

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My Strategy Exercise (2 of 2)
Is My Job the Next One Being Outsourced?
• Some accounting jobs moving to India
– Specifically, tax returns
• Accountants in Bangalore, India:
– Are much cheaper
– Work longer hours

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Small Group Exercise #1
• This work is for Kraft Heinz Company
• Your group is a team of marketing interns
• Your goal:
– Create guidelines to promote food to children
– Use a socially responsible approach
• Focus on: Lunchables product

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Small Group Exercise #2
• Textbook publishing
• Textbook publishing is challenged by:
– Self-publishing firms
– The need to offer digital resources
• Use the five forces model to think through impacts
– How to respond to change
– How technology shifts impact textbook industry profits

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End of Chapter 3

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Strategy Smart Videos

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Strategy Smart Videos (1 of 5)
• Wired Magazine Video Feature
• How the Tesla Model S is Made
• Link:
– https://www.youtube.com/watch?v=8_lfxPI5ObM
• 4:54 Minutes

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Strategy Smart Videos (2 of 5)
• Professor Michael E. Porter
• The Five Competitive Forces That Shape Strategy
• Link:
– https://www.youtube.com/watch?v=mYF2_FBCvXw
• 13:11 Minutes

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Strategy Smart Videos (3 of 5)
• Professor Jim Hazy
• Overview of Strategic Group Mapping
• Link:
– https://www.youtube.com/watch?v=YHl37IYdSSI
• 7:49 Minutes

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Strategy Smart Videos (4 of 5)
• PESTLE Analysis Overview
• Link:
– https://www.youtube.com/watch?v=X4m53nPlxr4
• 3:13 Minutes

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Strategy Smart Videos (5 of 5)
• How to Create a Strategic Group Map in Excel
• Link:
– https://www.youtube.com/watch?v=FQ2XGgbNXWY
• 8:46 minutes

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Chapter Case 3

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Chapter Case 3: Tesla (1 of 2)
• GM, Ford, and Chrysler – “The Big Three”
– Ruled the U.S. car market for the 20th century
– Protected by high entry barriers
• 1980’s: foreign entrants intensified competition
– U.S. Congressed passed import restrictions.
• No new car manufacturers have emerged.
– Cars are complex to build.
– Large scale production is necessary to be cost competitive.

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Chapter Case 3: Tesla (2 of 2)
• Elon Musk
– Designed early version of Google maps & PayPal
– Sale of these was $2B
• Enabled him to pursue his passions
• One of his largest ventures: Tesla Motors
– Produces electric cars with small motors
– Sold 2,500 Roadster Sports Coupes ($110,000 each)
– Model S: $71,000 but also eligible for tax credits
• Appeals to larger market
• 2013 Motor Trend Car of the Year
• Highest score of any car: Consumer Reports

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Appendix 1 The AFI Strategy Framework
The important inside circle is titled "Gaining and Sustaining a Competitive Advantage" that is at the very center of the image, with
five different circles on on the outside of it. Arrows go back and forth from the center circle to each of the five outer circles. The
five outer circles are labeled: (1) Getting Started, (2) External and Internal Analysis, (3) Formulation: Business Strategy, (4)
Formulation, Corporate Strategy, and (5) Implementation.
Each of these outer five circles have a brief description beside them to explain what the circle means:
Under the first outer circle titled "Getting Started", it says: Part 1, Strategy Analysis, "What is Strategy (Chapter 1)" and "Strategic
Leadership: Managing the Strategy Process (Chapter 2)".
Under the second outer circle titled "External and Internal Analysis", it says: Part 1, Strategy Analysis, "External Analysis: Industry
Structure, Competitive Forces and Strategic Groups (Chapter 3)", "Internal Analysis: Resources, Capabilities and Core
Competencies (Chapter 4)", and "Competitive Advantage, Firm Performance, and Business Models (Chapter 5)".
Under the third outer circle titled "Formulation: Business Strategy", it says: Part 2, Strategy Formulation, "Business Strategy:
Differentiation, Cost Leadership and Integration (Chapter 6)" and "Business Strategy, Innovation and Entrepreneurship (Chapter
7)".
Under the fourth outer circle titled "Formulation: Corporate Strategy", it says: Part 2, Strategy Formulation, "Corporate Strategy:
Vertical Integration and Diversification (Chapter 8)", "Corporate Strategy: Strategic Alliances, Mergers and Acquisitions (Chapter
9)", and "Global Strategy: Competing Around the World (Chapter 10)".
Under the fifth outer circle titled "Implementation", it says: Part 3, Strategy Implementation, "Organizational Design: Structure,
Culture and Control (Chapter 11)", and "Corporate Governance and Business Ethics (Chapter 12)".
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Appendix 2 Exhibit 3.1 The Firm within Its External Environment,
Industry, and Strategic Group, Subject to PESTEL Factors
This image shows circles within several circles. The center-most
circle is titled "Firm." That circle is contained within another
circle titled, "Strategic Group." That circle is contained within
another circle titled, "Industry." That circle is contained within
another circle titled, "External Environment." The External
Environment circle contains six arrows pointing inward, and they
are titled: Economic, Sociocultural, Technological, Ecological,
Legal and Political.
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Appendix 3 Exhibit 3.2 The Five Forces Model
This image shows an inner circle titled "Rivalry among Existing
Competitors." There are four boxes on the outside of the inner
circle, with arrows coming out from the box and pointing
towards the circle. These boxes say: Threat of New Entrants,
Bargaining Power of Buyers, Threat of Substitute Products or
Services, Bargaining Power of Suppliers.
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Appendix 4 Exhibit 3.3 Industry Competitive Structures
The most fragmented industry form is perfect competition, and
is made up of many small firms, firms are price takers, they offer
commodity products, and there are low entry barriers. The next
somewhat fragmented industry form is monopolistic
competition, which consists of many firms with some pricing
power, they offer a differentiated product and there are medium
entry barriers. The next somewhat consolidated industry form is
an oligopoly which features few (large) firms, some pricing
power, a differentiated product, and high entry barriers. The
next consolidated industry form is a monopoly, which consists of
one firm, with considerable pricing power, a unique product and
very high entry barriers.
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Appendix 5 Exhibit 3.5 Example of a Strategic Group:
The Airline Industry
The two strategic dimensions on the axes are prices and routes. As a result of
this mapping, two strategic groups become apparent, as indicated by the
dashed lines: Group A, low-cost, point-to-point airlines (Virgin Atlantic, Alaska
Airlines, JetBlue, and Southwest Airlines) and Group B, differentiated airlines
using a hub-and-spoke system (American, Delta, and United). The low-cost,
point-to-point airlines are clustered in the lower-left corner because they
tend to offer lower ticket prices but generally serve fewer routes due to their
point-to-point operating system.
The differentiated airlines in Group B, offering full services using a hub-and-
spoke route system, are clustered in the upper-right corner because their
frequently higher ticket prices reflect frequently higher cost structures. They
usually offer many more routes than the point-to-point low-cost carriers,
made possible by use of the hub-and-spoke system, and thus offer many
different destinations.
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