industry is one in which firms are able to generate
or appropriate profit
Some scholas believe that threats to profitability arise from the structural characteristics of an industry. This concept is most closely associated with the work of Prof. Michael Porter of Harvard Business School. Porter, an industrial organization economist by training, argued that industry profitability was the outcome of an ongoing struggle between incumbents who wished to retain it, and others who wished to take it. Those others included:
- Buyers (end user customers or distribution channels)
- Suppliers (providers of skill and material inputs)
- New entrants (firms that seek to do the same thing as those in an industry, and whose entry adds production capacity)
- Substitutes (firms who create the same benefits for customers as a focal industry, but do so in an advantageous way)
In addition, the behaviour of industry incumbent
s towards each other, defined as rivalry
, could either reduce or increase industry profitability.
Porter's thinking was summarized in his famous Five Forces model which is well-described on elsewhere on E2. This model also explains why, in some industries such as commercial aviation, profits are negative (and the industry is consequently unattractive). That makes the achievements of consistently profitable enterprises such as Southwest Airlines that much more remarkable.
As attractive industries are profitable and as that profit is desired by other firms, one of the main activities of incumbents is erecting barriers to entry. Barriers include seeking regulation, patenting, requiring special credentials or permissions, guarding access to distribution channels, and developing economies of scale.
Attractiveness is a useful concept because it enables an analyst or investor to determine the array of factors with which a company's management must contend to drive corporate performance. It also enables management to make decisions about acquisitions as well as their corporate strategy.
While investors don't invest in industries per se (other than through index funds), understanding the underlying forces that make an industry attractive or enables a more accurate identification of sources of risk. For example, in the airline industry, the biggest driver of profitabilty is the high variation in fuel prices. As few airlines hedge their fuel cost, suppliers of fuel are considered to be powerful vis-a-vis the airline industry, as those suppliers are able to obtain the price they seek for their input. Since airlines cannot substitute another input to replace fuel, they and their customers are exposed to changes in oil prices. Since demand for travel is not perfectly inelastic, some portion of airline industry profitability is will move to jet fuel suppliers when oil prices rise.