Then I realized - invert. The question is really “what makes an industry fragmented?” There’s literally a whole chapter in Michael Porter’s “competitive strategy” that answers this question.
Porter’s Causes of Fragmentation
Here’s Porter’s list of causes for fragmentation:
Simplified List
- Low entry barrier
- Absence of economies of scale or experience curve
- High transportation cost
- High inventory cost or erratic sales fluctuations
- So scale is less of an advantage because your plants can’t operate production continuously. Scale may and down
- No advantages of size in dealing with buyers or suppliers
- Perhaps because buyers or suppliers are even bigger
- Dis-economies of scale in some important aspects
- Rapid product/style changes
- Low overhead important
- Diverse product line that requires customization
- Heavy creative content
- Close local control
- Personal services important
- Local image and local contacts are important
- Diverse market needs
- High product differentiation, particularly if based on image
- Exit barriers. This reinforces low entry barrier, as too many competitors can come into the industry and not exit.
- Local regulation
- Government prohibition or concentration
- Newness. This bears a lengthier discussion. If fragmentation is caused by newness, then it may be a temporary condition. The industry may actually be ripe for consolidation.
We can consolidate this list into a few big buckets: 1) low entry barrier (a pre-requisite to be combined with other attributes according Porter), 2) no advantage to size, 3) diverse buyer segments/needs, and 4) distribution friction (high transport cost, local regulation). Of course, regulation is an ever present force.
Invert back. The reverse of the above properties enables winner-take-all dynamics: 1) high entry barrier/low exit barriers, 2) big advantages to size, 3) homogeneous buyer segments, and 4) low distribution friction.
Invert back. The reverse of the above properties enables winner-take-all dynamics: 1) high entry barrier/low exit barriers, 2) big advantages to size, 3) homogeneous buyer segments, and 4) low distribution friction.
It’s the “advantage to size” that made me say “duh ! Why didn’t I think of that?” Of course there has to be advantages to size! Otherwise what’s the point of getting bigger? The two most prominent types are:
Ideally there’s a positive feedback loop of increasing return to scale: a company grows in size, which gives it some competitive advantages over rivals, this allows the company to gain more market share, and the increased size yields even more competitive advantages. This feedback loop continues as long as the advantage to size overwhelms any advantages to smallness. This is as opposed to the reverse dynamic where a firm’s growth gets constrained by dis-economy of scale (negative feedback loop).
Porter also talked about how to overcome fragmentation and achieve consolidation. His approaches mirror the 4 buckets I gave, with emphasis on increasing scale and using standardization to overcome diverse market needs.
Growth Industries
The last point in Porter's list is "newness". Where the industry is in its life cycle also matters. Winner-take-all games are more likely to happen in fast growing industries facing disruptive innovation. This is because the industry has to create a whole new value chain, and that value chain needs a leader. Ideally the leader pushes forward with standardization schemes, which helps 1) various parts of the chain to interface with each other, 2) customer adoption.
How About Switching Cost and Differentiation?
- Network effect: Better value proposition for the customer as you add nodes to the network
- Economy of scale: Unit cost declines as volume increases.
As a firm gets bigger, the former increases customer benefits (“B”) while the latter decrease cost of production (“C”). Both creates a widening gap between B minus C that leads to increasing returns on capital.
Ideally there’s a positive feedback loop of increasing return to scale: a company grows in size, which gives it some competitive advantages over rivals, this allows the company to gain more market share, and the increased size yields even more competitive advantages. This feedback loop continues as long as the advantage to size overwhelms any advantages to smallness. This is as opposed to the reverse dynamic where a firm’s growth gets constrained by dis-economy of scale (negative feedback loop).
Porter also talked about how to overcome fragmentation and achieve consolidation. His approaches mirror the 4 buckets I gave, with emphasis on increasing scale and using standardization to overcome diverse market needs.
Growth Industries
The last point in Porter's list is "newness". Where the industry is in its life cycle also matters. Winner-take-all games are more likely to happen in fast growing industries facing disruptive innovation. This is because the industry has to create a whole new value chain, and that value chain needs a leader. Ideally the leader pushes forward with standardization schemes, which helps 1) various parts of the chain to interface with each other, 2) customer adoption.
How About Switching Cost and Differentiation?
That’s all great, but how about switching cost and differentiation?
Remember, the above are industry properties that encourage winner-take-all games. They apply to all companies in the industry. But I think switching cost and differentiation are best discussed in terms of how a specific firm can become that “winner”.
Differentiation is obviously a firm specific factor, while switching cost can be both industry-wide and firm specific.
In the industry context, switching cost appears under multiple categories. It is cited as a barrier to entry by Porter and is related to network effect (which I categorize as a form of “advantage to scale”).
Ultimately though, a customer switching from Firm A to Firm B is good for one and bad for another. In this sense the discussion of switching cost requires a company specific perspective. Switching costs can also vary according to company strategy. For example one can increase stickiness by having multiple touch points with its customers.
Naturally, the next question is “how does a company win in a winner-take-all-game”. I’m still thinking through that, so any inputs/comments would be appreciated. Thanks!
Remember, the above are industry properties that encourage winner-take-all games. They apply to all companies in the industry. But I think switching cost and differentiation are best discussed in terms of how a specific firm can become that “winner”.
Differentiation is obviously a firm specific factor, while switching cost can be both industry-wide and firm specific.
In the industry context, switching cost appears under multiple categories. It is cited as a barrier to entry by Porter and is related to network effect (which I categorize as a form of “advantage to scale”).
Ultimately though, a customer switching from Firm A to Firm B is good for one and bad for another. In this sense the discussion of switching cost requires a company specific perspective. Switching costs can also vary according to company strategy. For example one can increase stickiness by having multiple touch points with its customers.
Naturally, the next question is “how does a company win in a winner-take-all-game”. I’m still thinking through that, so any inputs/comments would be appreciated. Thanks!
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