Understanding Strategic Groups and Their Role in Competitive Strategy, Study notes of Business

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UNIVERSITY OF ILLINOIS L'BR^ iris , AT URBANA-CHAWIPAIGN BOOKSTACKS 5 SI BEBR FACULTY WORKING PAPER NO. 1238 Exploring the Linkage Between Strategic Groups and Competitive Strategy Avi Fiegenbaum John McGee Howard Thomas College of Commerce and Business Administration Bureau of Economic and Business Research University of Illinois, Urbana-Champaign BEBR FACULTY WORKING PAPER MO. 1238 e g e of Commerce and Business Administration University of Illinois at Urbana-Charapaign April 1*86 Exploring the Linkage Between Strategi Grcups 3r. d Competitive Strategy A v i Fiegenbaum, Assistant Department of Business Administration John McGee Temple ton College, Oxford Howard Thomas, Professor Department of Business Administration INTRODUCTION In the last decade, the nature of a firm's competitive strategy has been realized by both practitioners and academicians as an impor- tant element in business success. Competitive strategy "... involves positioning a business to maximize the value of the capabilities that distinguish it from its competitors" (Porter (1980:47)). According to this definition, two major questions are raised in competitive stra- tegy analysis: 1. Who are the firm's competitors? 2. What kind of strategic decisions should an organization take in order to position itself relative to its competitors? In economics, an industry is often used to define competitive boundaries. Two criteria normally define the boundaries of the industry: markets and technologies. The market criterion (e.g., Caves (1977)) includes within a specific industry those firms that have products sufficiently similar as to be close substitutes. This similarity is tested by the cross-elasticity of demand. The tech- nological criterion (e.g., Andrews (1951)) focuses upon the classifi- cation of firms according to the similarity of their production proc- esses. In the United States, the Standard Industrial Classification, or S.I.C., follows the market criterion by defining industries in pro- duct terms. (See McGee and Thomas (1986) for a comprehensive dis- cussion. ) With the difficulties of satisfying both market and technological criteria, and with the increasing industrial complexity since World War II—diversification of products, participation in several "indus- tries" and multinational activity— the definition of the set of -2- competitors for a given firm (i.e., the industry) has become increas- ingly imprecise. To illustrate the problem, (Huff> Thomas, and Fiegenbaum (1985)) consider the response of Walter Wriston, the Chief Executive Officer of CITICORP, when asked to identify his competitors: Sometimes Wriston mentions Morgan Guaranty... other- wise, Wriston sees his competition as being Merrill Lynch, the American Telephone and Telegraph Company, Sears Roebuck and company, Prudential-Bache and the American Express company. (Bennett (1983:16)) These comments indicate that the problem of defining the firm's com- petitors (i.e., industry or competitive set) is an increasingly dif- ficult issue in formulating competitive strategy. In his doctoral dissertation on competitive processes in the "white goods" industry, Hunt (1972) coined the term "Strategic Group" (SG) for the finer classifications that exist within industries. He observed that different firms in the industry adopted different stra- tegies in order to achieve their organizational goals. Indeed, firms similar in their strategic behavior were clustered into a strategic group . The concept of strategic groups allows firms to make more sense of competition in analyzing complex industries (McGee and Thomas (1985)), in defining firms' competitors, and in illustrating the com- petitive positions available within an industry. Based on the concept of strategic groups, Caves and Porter (1977) generalized the theory of entry barriers (Bain (1956), Vernon (1972), Scherer (1980)) and devised the term "mobility barriers." The theory of Mobility barriers argues that barriers not only protect firms in a strategic group from entry by firms outside the industry but also provide barriers to firms -5- that will be taken by the firm in order to achieve its goals. The strategy of firms which fit this model is characterized by changing markets, products, and other activities. The writings of Chandler (1962), Cannon (1968), Andrews (1971), Drucker (1974), and Steiner and Miner (1977) rest on such a linear model. Second, adaptive strategy is concerned with the development of a viable match between the oppor- tunities and risks present in the external environment and the organi- zation's capabilities and resources for exploiting those opportunities' (Hofer (1973: 3)). Adaptive strategy tries to achieve a match between the firm and its environment. In contrast to the linear model the adaptive model considers a firm's action or reaction as a response to the nature and magnitude of environmental changes and pressures. Hofer (1973), Hofer and Schendel (1978), Mintzberg (1978), Quinn (1980), Gluck et. al (1982) employ this model. Finally, Chaffee calls the third model interpretive strategy , for it looks at strategy from the viewpoint of the organization's culture. In this model, strategy becomes the "orienting metaphors to motivate behavior expected to pro- duce favorable organizational results" (Chaffee (1985:83)). Different groups and stakeholders can affect the firm's strategy and, therefore, good strategy can be achieved by fostering sound communication and relationships between the various stakeholders. Such writers as Pettigrew (1977), Van Cauwenbergh and Cool (1982), Dirsmith and Covaleski (1983), and Chaffee (1985) emphasize the relevance of the interpretive model. In trying to find a workable guideline (rather than theoretical arguments) to identify strategy, the following statements should be considered: -6- (1) Strategy is "a pattern in a stream of decisions" (Mintzberg (1978: 934)). This view of strategy stresses the longitudinal nature of strategic development and its internal consistency. (2) "The decision must be important to the success of the enter- prise" (Shirley (1983: 265)). This statement emphasizes that only decisions that can affect the success (or failure) of the enterprise should be considered as strategic decisions. (3) It is important to relate strategy to organizational level. Hofer and Schendel (1978) emphasize four levels of an organi- zation that different strategic questions should be raised in each level. At the enterprise strategy level , strategy is concerned with the question of "how can we maintain the poli- tical legitimacy of the organizations?" (Hofer and Schendel (1978:15)). At the corporate strategy level , the question is "what set of businesses should we be in?" (Hofer and Schendel (1978: 27)). At the business strategy level , the question is "how to compete in a particular industry or product/market segment." (Hofer and Schendel (1982: 27)). And at the functional strategy level , the question is on the "Maximization of resource productivity" (Hofer and Schendel (1978:29)). (4) For each level of organizational strategy, four components of strategic decisions can be identified: 1. Scope , that is, the extent of the organization's present and planned interactions with its environment. 2. Resource Deployment , that is, the level and pattern of the organization's past and present resource and skill deployments. 3. Competitive Advantage , that is, the unique position an organization develops vis-a-vis its competitors. 4. Synergy , that is, the joint effects that are sought from the organization's resource deployments and/or scope decisions" (Hofer and Schendel (1978: 25)). (5) It is important, as noted by Mintzberg (1978), to distinguish between two major kinds of strategies, intended and realized. Intended strategy is an ex-ante concept whereas realized strat- egy is an ex-post result. Mintzberg suggests that these two strategies should be studied so that "...the interplay between intended and realized strategies may lead us to the heart of this complex organizational process" (Mintzberg (1978: 934)). In summary, the five perspectives above can serve as a guideline for the purpose of formulating strategic groups. More specifically, -7- iteras 1, 3 and 4 (longitudinal, level and component, respectively) define what may be called the Strategic Space (SSP). Either intended Insert Figure 1 About Here or realized strategy can be drawn on this space (item 5). Item (2) above emphasizes that strategic decisions are important to the success (or failure) of the organization. Therefore, the important dimensions which define strategic groups should reflect matters of salience and importance to the company. Strategic Groups: Review and Perspectives Since Hunt (1972) coined the term, both theoretical and empirical literature has used the concept of "strategic groups'" in different ways. Researchers in industrial organization economics, strategic management, marketing, among others, have all employed the concept. An extensive research review is available in McGee and Thomas (1986). In this paper the review of studies on strategic groups falls into the following categories. 1. Fundamentals of strategic groups theory. 2. The theory of strategic structure within an industry and firm performance. 3. Strategic group formation and the behavior of firms and groups over time. 4. Summary of the empirical studies on strategic groups. 5. The relevance of strategic groups for competitive strategy analysis. -10- between Che industry and the firm for analyzing the nature of com- petitive strategy. Based on the concept of strategic groups, Caves and Porter (1977) developed the concept of mobility barriers , a modification of the entry barrier (Bain (1956)) idea. Theories about entry barriers argue that existing firms are protected from new entrants into the industry by such elements as economies of scale, product differentiation, and the like. The mobility barriers theory argues that barriers impede not only newcomers but also firms in the same industry but with dif- ferent asset configurations who might wish to improve their relative strategic positioning by moving into another strategic group. In summary, it is argued here that the strategic groups concept is important. More specifically, the concept is important in examining the structure/conduct/performance paradigm, the nature of intra-industry structures and their effects on firm performance, and the duality of mobility barriers and strategic groups. Two topics are explored in the following sections, namely, the theory of the strategic structure within an industry and firm performance, and strategic groups for- mation and the behavior of firms and groups over time. The Theory of the Strategic Structure Within an Industry and Company's Performance Porter (1979, 1980) presents a theory of the determinants of firm profit performance based on the strategic structure within the industry. Based on the concepts of strategic groups and mobility barriers, the theoretical explanation is divided into the following steps : -11- a) The configuration of strategic groups within the industry has an impact on the overall performance of the industry. Porter (1979; 218) suggested that the number and size distribution of strategic groups, the strategic distance among strategic groups, and the market interdependence among groups are the major variables which define con- figuration. The greater the number of strategic groups, when most of the groups have equal size, then the greater is the rivalry among them or the greater is the chance of tacit collusion. On the other hand, when few strategic groups exist, and the size distribution of these groups is not equal, this structure gives advantage to the large stra- tegic groups; tacit collusion is not expected. It is also expected that the greater the distance among strategic groups, the more difficult will be any tacit collusion, and the more likely strong rivalry will exist within the industry. Market interdependence indicates the degree to which different strategic groups compete for the same customers. It is expected that with a high level of interdependency , competition will not only be intense but varied in form reflecting the diverse asset structures of competitors. Hergert (1983) developed statistical measures for the strategic groups configuration. He was able to show that some of the expected relationships between strategic groups configurations and industry Harrigan (1985) and Hergert (1985) have measured strategic distance in terms of the distance (difference) between the centroids of the strategic groups (defined in terms of the relevant and impor- tant strategic variables). -12- profits were in the expected direction (as were hypothesized by Porter (1979)). b) The location of the strategic group relative to other strate- gic groups may convey advantages or disadvantages to the group's members. There are several possible reasons. First , some types of strategies are more suited to market conditions than others, and can result in superior performance. Thus, firms which belong to better performing strategic groups will have the opportunity to achieve above industry average profit. Second , each strategic group has a different ability to protect itself from competitive firms in other strategic groups (Caves and Porter (1977)). Strategic groups with significantly superior mobility barriers are better able to exploit profit oppor- tunities. McGee (1985) and McGee and Thomas (1986) categorized the mobility barriers into three classes: market, supply and firm-specific strategic variables. In addition, mobility barriers may also arise from what Lippman and Rumelt (1981) called the concept of "uncertain iraitability , " meaning that even if a firm wants to replicate the stra- tegy of firms in a superior strategic group, it may fail because of its uncertainty about how to imitate and implement that strategy in practice. Third, the degree to which firms in the same strategic group compete amongst each other can also affect the average profit of the group relative to other groups. When firms in the same strategic group try to improve their position, other firms may retaliate, and the potential profit of the strategic group as a whole may decrease. c) The location of the firm within the strategic group affects the firm's performance. The rationale for this proposition is given by Porter (1979; 218-219): -15- Firm-level and Group-level Behavior Over Time: To understand Che dynamic characteristics of strategic groups requires two levels of investigation: the firm and group. Firm level : The theory of strategic groups argues that firms within an industry can be clustered into groups. Most studies in the area of strategic groups either specify current strategic groups or investigate the relationship between performance and strategy for dif- ferent strategic groups. However, it is argued here that strategic group studies can contribute to our understanding of the firm's strate- gic behavior. More specifically, once strategic groups are iden- tified, and firms make sense of the strategies of close competitors, it is likely that strategic group members (firms) will follow similar strategies over time. Several explanations can be offered to support this viewpoint. First, firms in the same strategic group have similar assumptions about the future potential of the industry (Porter (1980)). Secondly, strategic group members have similar goals and the skills that are required to achieve these goals. If there is either an external or an internal change in the industry, all strategic group members are expected to react in the same way (Caves and Porter (1977: 251)). This argument is consistent with the adaptive model of firm's strategy (Chaffee (1985)). Moreover, taking the adaptive model one step further, firms within the same strategic group have similar mechanisms for strategic adaptation, and these adaptation mechanisms differ across strategic groups. Even if a firm is not "happy" with its current strategy, it is not easy to move to a more successful strategic group. Such strategic barriers such as mobility barriers -16- (Caves and Porter (1977), McGee and Thomas (1986)), uncertain inst- ability (Rumelt (1981)) and inertia (Huff, Thomas and Fiegenbaum (1985)) may induce firms to remain in the same strategic group. Three empirical studies on firm movement among strategic groups support this proposition. Oster (1982) observed that few firms moved between the two strategic groups she defined (as below and above the industry average of advertising over last year sales). Fiegenbaum and Primeaux ((1983), (1985)) also found low level of firm movement among strate- gic groups when strategic groups were defined in terms of market share and several other strategic variables. In summary, strategic group members will probably follow similar strategies over time. Similarities involving strategic assumptions, goals, skills, and the strategic barriers that prevent firms from easily moving among strategic groups explain this phenomenon, and stu- dies, such as Oster (1982) and Fiegenbaum and Primeaux ((1983), (1985)) provide empirical support. Group level : In the previous section it is argued that strategic group members will follow similar strategies over time. Therefore, the composition of strategic group membership is most likely to be the same over time. However, another important aspect of strategic group behavior over time is whether or not the strategic group as an entity will move toward a new strategic position in the strategic space. Organization theories argue that the organization's environment is unstable (e.g., Dess and Beard (1984)) and that firms are trying to adapt their strategic behavior to environmental change (e.g., Miller and Friesen (1980), Hofer and Schendel (1978), Chaffee (1985)). The -17- final outcome may be that the strategic group as a whole will be located in a new position over time. This, however, depends on the strategic group members' ability to differentiate themselves viably from other strategic groups. In addition, the studies of Kumar, Thomas, and Fiegenbaum (1984a, 1984b) have looked at strategic groups from a different angle in order to identify the feasible strategic group positions within the strate- gic space. These studies are primarily deductive in nature and explore a fundamental theoretical issue; namely, whether there are limits to the numbers of strategic groups which may exist within a specific industry context. Using the notion of equilibrium as a benchmark, Kumar et al. (1984a) specified the strategic groups that may exist in equilibrium under "dominant strategy" assumptions. The concept of dominant strategy assumes that only firms which have the "right strategic mix" (strategy) will survive the competitive game. The weaker firms will be dominated by the more successful firms. Kumar et al. (1984b) also used a game theoretic approach to investi- gate some other properties of strategic groups in equilibrium. They concluded that in a monopolistic competitive market, the number of strategic groups that will exist in equilibrium depends on environmen- tal conditions "if there are K uncontrollable variables in the utility function, then there can be at most (K + 1) strategic groups in a "structurally stable "equilibrium" (p. 8). (The K structurally uncontrollable variables, represent the environmental variables of the model) . -20- investment strategy, advertising strategy). On the other hand, stud- ies such as Hatten (1974) and Patton (1976) exemplify strategic groups specified at the business level. This is because most of the firms in the brewing industry are not diversified in other industries and the product is relatively homogeneous. Finally, the studies of Frazier and Howell (1983) and Hawes and Crittenden (1984) defined strategic groups according to functional (marketing) level strategy. Second, the studies have identified strategic groups according to the components of the firm's strategy (Column 3). Most of the studies used either scope or resource deployment criteria (see Hofer and Schendel (1978)) but some of them used both these components (Ramsler (1982), Fiol (1984)). Third, the formation of strategic groups depends upon the strat- egy definition used (i.e., strategy as intentions (ex-ante strategy formulation) or realizations (ex-post inference of intended strategy) (Mintzberg (1978)) Column 4). Most studies have used the realized strategy definition to define strategic groups by inferring strategic intent from ex-post archival financial statement information. Only two stud-ies, Dess and Davis (1984), and Hawes and Crittenden (1984) appear to have defined strategic groups using strategy as intentions. They used a questionnaire to derive perceptual data which they then analyzed to form strategic groups. Fourth, many industries have been studied. They range from con- sumer goods industries to producer goods industries, and from single product industries to multi-product industries (see Column 5). -21- Fifth, few studies have analyzed the dynamic aspects of strategic groups. Only Oster (1982), Ryans and Wittink (1985), and Fiegenbaum and Primeaux ((1983), (1985)) have looked at some dynamic aspects of strategic groups (see Column 6). Sixth, different strategic dimensions have been used to cluster strategic groups (see Column 7). Some of the authors used such single criteria as market share (Porter (1979), Primeaux (1983, 1985), Fiegenbaum and Primeaux (1983)), advertising to sales ratio (Oster (1982)), and security prices (Ryans and Wittink (1985)). Other writers (e.g., Hatten (1974), Hergert (1983)) used multivariate criteria. Seventh, strategic groups have been identified using either sta- tistical or rule of thumb procedures (see Column 8). By rule of thumb we mean that the writer had information about the industries that, based with the information on the criterion variables, allowed them to sort the firms logically into strategic groups (e.g., Hunt (1972), Porter (1979), Harrigan (1981)). On the other hand, some writers who used multiple criteria to identify strategic groups have used such statistical packages as cluster analysis or three mode factor analysis (e.g., Harrigan (1985), Baird and Sudharshan (1983), respectively). Eighth, different strategic groups were identified in the various studies (see Column 9). In one case no single strategic group was identified in six out of fifty industries. (Hergert (1983: 111-28)) while in other studies many strategic groups were consistently iden- tified (e.g., Newman (1973, 1978), Baird and Sudharshan (1983)). Each -22- writer named the various strategic groups according to some properties that dominated the strategic group membership. Finally, the main conclusions and purposes of each study can be specified. The main conclusion of Hunt's (1972) study, which was the springboard for the whole field of research, was that strategic group structure can be identified in the home appliance industry. Other studies have reinforced Hunt's conclusions in different industries and at different levels of firm strategy. Some writers have investigated the structure/conduct/performance paradigm of industrial organization economics. Writers such as Newman (1973, 1978), Hatten (1974), Patton (1976), Hergert (1983), have focused on this aspect of strategic groups. Primeaux (1983, 1985) was able to show that different strategic groups occur at different stages of the investment life cycle. Oster (1982), and Fiegenbaum and Primeaux ((1983), (1985)) examined, movement among strategic groups. The low level of movement seen in these studies may have important implications for the dynamics of competitive strategy. Yet the main studies in the area of strategic groups are 'data-driven.' That is, they identify a number of key strategic dimensions drawn from Porter's (1980:127) or McGee and Thomas's (1986) listing of key strategic variables and typically use cluster analysis with data bases such as COMPUSTAT to form groups of firms who 'cluster' together in terms of their observed strategic behavior. Criticisms have been voiced (McGee and Thomas (1986) as to whether the observed groups made sense to managers within those industries or other interested parties such as investment analysts. What is clearly needed Is the adoption of -25- The Identification of Strategic Group Members An important rationale for forming strategic groups is to enable planners to identify and better understand the behavior of com- petitors. But, who are the competitors? In complex industries where firms compete on different strategic dimensions, the definition of the set of competitors for a given firm is not always clear. Porter (1980) suggested that firms in the same strategic group should recognize each other as close competitors while firms in different strategic groups are less closely competitive. Therefore, knowing strategic group membership (the competitors) can aid planners in understanding the bases of competition and in making more effective competitive strategy decisions. For planners it is important to compare groups defined on the basis of industry wisdom (e.g., analysts, managers insights, etc.) with those derived from empirical, quantitative studies. Differences in these groups may allow managers and analysts to review and reinterpret their notions of competition. The theorv of the strategic structure within an industry and i - -- - - -- - - - 2 interfirm performance difference s Porter (1979) presented a theory of the determinants of firm-level profit based on the strategic structure within the industry. According to this theory and the empirical findings that partially support it, firms following similiar strategies will tend to have similiar performance profiles. The underlying theory is explained in pages 10 and 11 of this paper. -26- For example, suppose that two strategic groups exist within an industry (SGI, SG2) and two performance measures, risk and return, are considered by the companies (see Figure 2). Insert Figure 2 About Here It can be seen that different performance levels can be associated with each strategic group. This information may help strategic plan- ners. For example, should firms stay in the same strategic group and benefit from the average level of performance, or to try and move to another more attractive strategic group requiring a different finan- cial and capital structure profile but which provides an improved potential average profit level. The causal relationship between structure, strategy and performance Some writers, among them Hatten (1974), Patton (1976), Hergert (1983), found that different relationships exist between performance measures and elements of industry structure and strategy for firms in different strategic groups. Thus, careful modelling of the strategy- structure relationship should highlight the important strategic factors (and variables) for each strategic group and indicate how they differ across groups. For example, in one of the Purdue brewing studies (Patton (1976)) the relationship between Debt (strategic element) and ROE (a performance measure), was examined for each strategic group. For the national brewer strategic group and for the small regional brewer strategic group positive relationships were found (regression coefficients of 0.15 and 0.33 respectively). On the other hand, for the large regional strategic group the relationship was found to be -27- negative (regression coefficients of -0.61). Clearly the relevance of debt and the influence of debt varies markedly across strategic groups. Similar patterns can be found for other key strategic dimen- sions in those and other studies. Therefore, the strategic importance of certain key dimensions can more clearly be assessed. Porter (1980: 138-140) also argued that the structure of strate- gic groups has implications in explaining industry rivalry, and hence, firm performance. Strategic groups characteristics, such as, the number of strategic groups, the extent to which different strategic groups are competing for the same customers, and the strategic distance among strategic groups were mentioned by Porter as important elements. Hergert (1983) showed empirically that the characteristics of strategic group structure affect the market performance of firms within industries. In summary, the strategic groups structure within an industry has an impact on firms performance. Therefore, when either existing or potential firms are trying to evaluate their future performance poten- tial, the strategic groups structure as well as the characteristics of the specific group should be considered. Understanding Strategic Group Dynamics Understanding dynamics in strategic management is crucial since the formulation of competitive strategy is an evolutionary process. Several writers have investigated dynamic aspects of strategic groups. Oster (1982), and Fiegenbaum and Primeaux (1983, 1985) found a low level of movement among strategic groups. Huff, Thomas, and Fiegenbaum (1985) have considered the role of grounded theories and -30- These three dimensions capture the nature of the strategic environment. Figure 1 defines the dimensions of the STRATEGIC SPACE (SSP). Thus, a firm's strategic decisions in each level of the organization and for each time period can be depicted in terms of the SSP. It can be seen immediately that strategic groups can be defined for each level of the organization, for each strategic component, and for each time period as well as for any combination of the three. Following Porter's (1981b) suggestion in an anti-trust symposium, and McGee and Thomas's (1985) paper, in-depth historical analysis of an industry can supplement strategic group analysis by enabling managers and extra-firm policy makers to make sense of complex industries. Further, the industry study of strategic groups obtained by quantitative approaches such as multivariate analysis should be validated by managers and industry analysts as they try to understand competition and close competitors in an industry. It should be noted that little follow-up with industry participants has been reported except in the case of the Purdue brewing industry studies (Hatten (1974) and others) and the more recent studies of Frazier and Howell (1983), Dess and Davis (1984) and Hawes and Crittenden (1984). This richer industry-study approach is also consistent with studies on strategic groups by Hunt (1972) on the home appliance industry and by Hatten (1974) and Patton (1976) on the brewing industry. CONCLUSIONS Studying strategic groups can highlight different aspects of competitive strategy. First, identifying the strategic dimensions -31- that define strategic groups is a key issue in understanding how competitors formulate their strategies. 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