Market Power
The intersection of microeconomics and competitive strategy
In the early 2000’s the state of California experienced an energy crisis. During this crisis it was found that companies like Enron had taken advantage of their scale to raise prices. The market looked to be a very competitive market with low margins, but given the design of the market, Enron and others were able to bid up the prices. This is because they knew the Utilities had no choice but to provide electricity to their customers (due to regulations). This created a perfect storm that helped Enron’s stock price more than double, before their precipitous fall.
This is all to say that by understanding your market you can identify areas of opportunity for growth. This post is about tearing apart a market to understand the competitive dynamics.
Competitive Strategy
To understand Market Power there are a few frameworks that we’ll discuss in this post, Porter’s 5 Forces and Microeconomics Supply-Demand Equilibrium curves.
Let’s start with Michael Porter’s 5 Forces model. As the model describes there are 5 forces that are useful to evaluate a market. Each of these factors are assessed to determine the attractiveness of a market. Whether that be to launch a new app, a new smartphone, or provide a new service.
For this post we won’t spend much time on the threats of new entry as we are looking at this from a market expansion / go-to-market perspective:
- The current market concentration of firms (Rivalry)
- The amount of power that suppliers have in the market
- The nature of the demand that exists
- How likely is a homeowner to hire a pro vs. DIY a service (substitutes)
To complement Porter’s model we’ll leverage a basic framework from microeconomics supply and demand curves. For those that need a refresher of microeconomics I have an image below that should spark some memories or you can visit the Khan Academy.
Rivalry — Using market concentration
Rivalry describes the nature of the market between firms competing for customers and suppliers attention. While all companies would prefer less competitors to have more influence on setting price, this is often not the case for many firms. If you are a startup or entering a new market one way to limit the competitors is to define a niche strategy where you can build up share of a market and influence some market power.
One of the methods I use to calculate market concentration is call the Herfindahl–Hirschman Index (HHI for short). This index is a simple calculation where you sum the squares of each companies market share. Take for example a market with 3 companies that each have 30% and the remaining 1000 companies each have 0.01% of the market. The formula looks like this:
HHI = (30)² + (30)² + (30)² + 1000*(0.01)² = 2700
An HHI below 100 indicates a highly competitive industry.
An HHI below 1,500 indicates an unconcentrated industry.
An HHI between 1,500 to 2,500 indicates moderate concentration.
An HHI above 2,500 indicates high concentration.
Based on the example below this would represent a highly concentrated market. This is just one data point I look at when evaluating rivalry, but is a helpful place to start to baseline the dynamics.
Here are a few other questions I look at:
- Is price the biggest driver of differentiation?
- Do competitors have advantaged channels to market?
- Do competitors have proprietary and/or protected products (e.g. patents)?
- Do competitors have power over supplier relationships to set standards?
Microeconomics — Where supplier power meets buyer power
Let’s start with a definition from Investopedia on Microeconomics:
Microeconomics is the social science that studies the implications of individual human action, specifically about how those decisions affect the utilization and distribution of scarce resources. Microeconomics shows how and why different goods have different values, how individuals make more efficient or more productive decisions, and how individuals best coordinate and cooperate with one another. Generally speaking, microeconomics is considered a more complete, advanced and settled science than macroeconomics.
So what does this mean and how does this relate to Porter’s 5 Forces?
One of the key statements is “how those decisions affect the utilization and distribution of scarce resources”. In this post I’ll look at access to people to complete home services. These individuals, especially in licensed trades like electricians, are a scarce resource. Now let’s unpack the other components of the sentence:
- Utilization — A challenge that faces services industries is how to maximize utilization. At Accenture we had specific targets that we were looking to hit based on your level in the company. For the gig economy, where home services is a great example, this is the key to success. For many home services categories the jobs don’t take a full day to complete, which adds an added level of complexity to manage. For services companies you have to manage the full lifecycle from marketing to sales to delivery and support. The image below shows the variability in the on-demand driver market.
Example — Finding a home pro
Recently I have been working on a market analysis of the home improvement industry for Porch. One of the key elements of a market analysis is determining your market. It sounds easy, but in practice can be quite challenging as there are many ways to cut it.
In the home improvement industry there is a market of providers like Porch.com that are a facilitating projects between pros and homeowners across the US. There are also distinct verticals, like electricians, plumbers, and roofers. The challenge I ran into here is that while we may be looking to be a national provider of the service, the reality is that “the market” is really much more narrow, probably down to the specific service requested and the neighborhood / city you live. For example, an electrician company in Denver is not going to help me in Seattle. In fact, a friend in one part of the Seattle area may recommend a pro that isn’t willing to travel to my house that is 20 miles away.
Given this context, how do you evaluate the market dynamics?
If we took painters and electricians as examples, there are ~30,000 and 40,000 companies in the US respectively, with no single company having more than 1% share. Thus the HHI would be <100 and you would expect a highly competitive industry.
The reality is that you have to take a look at a regional level. I used data at a county level and found that the HHI for the Seattle area, Orange County, CA and Denver, CO was around 1200–1500. While this doesn’t dramatically change the competitive profile it is an order of magnitude different than the national view. In a local market there may be 100’s of companies that cover a region vs. the tens of thousands that cover the US. From a rivalry perspective it is relatively competitive and thus you will have to charge a market rate to win work.
Evaluating the market growth and drivers
There are a number of reasons why a market could expand in size, with a few primary drivers including change in demand for services, change in supply for services and increase in costs of service.
Let’s extend the look above for Painters and break down the market growth:
- Total Revenues are 4% a year according to IBIS World, though online searches have risen 15% per year
- Labor wages have been rising ~2% per year since 2004 with only a slight slow down during the recession based on BLS data
- Labor supply peaked in 2007 and shed 75k jobs during the recession or 30% of the labor force and has risen 20% over the past 5 years to be at 85% of the 2007 high based on BLS wage data
- Material prices have been rising 4% per year since 2004, largely driven by increases in oil prices based on Producer Price Index
My interpretation of the above is that thus at least a quarter of the growth is due to increase in service requests given that materials often account for 40% of the total revenues and wages for 35% of revenue. Painting is clearly a nice to have service based on the large dip in labor during the recession and that 69% of people will paint a room on their own based on a 2016 Zillow survey.
Given these factors painting would not rank highly on my list of services to target, without knowing more about the buyer dynamics or having access to homeowner demand. For Porch.com to enter this beyond a referral service I would be looking at the number of requests for painting projects and how well we are able to fulfill with our existing supply strategy. If there is a large demand-supply gap this could be a market to target, but would be concerned over tightening of the market to spend on these services.
Electricians is a different story.
Here are the details for electricians market.
- Revenues rising at 4% per year, with online searches rising 24% per year
- Material prices have risen 2% per year and account for 40% of revenues
- Labor wages have risen 2% per year and account for 35% of revenues
- Labor supply is at 95% to the 2007 peak levels and only dropped 20% during the recession.
- Substitutes: Only 24% of homeowners will DIY electrical work
For this market the biggest question is how to acquire electricians given license constraints in various markets. This segment is clearly more recession proof as homeowners that have to make electrical repairs / improvements will look to hire a pro. One of the first tests I would run is around how difficult electrician acquisition would be and whether there is any margin that can be captured.
Summary
Market analysis tools are helpful to get a base understanding from which to build out a strategy. While two markets may look very similar, like painters and electricians, it requires going deeper to understand the true drivers. In addition, your core business capabilities are a key element of evaluating market expansion opportunities. These frameworks we have discussed are helpful to build out a strong decision making framework so that you can move quickly on a market opportunity.
Many of the forces we discussed are long-term structural forces that are unlikely to change in the near-term, like home ownership rates, whether DIY is a substitute and market concentration. Understanding this is helpful to determine where to focus your efforts. One factor that is moving fast is online search, which is why the industry today is heavily focused on digital solutions.
In Closing
A dynamic strategy requires building out a system to monitor these market changes and inserting into your decision making framework. Personally, one of my goals is to find a way to build a tool that can automatically pull in the various data sources I used in this model to have an updated market framework. If you have thoughts on how to do this please reach out directly.
References
Porter’s Five Forces
Microeconomics
Zillow Report
Bureau of Labor Statistics
Producer Price Index
