How to measure the intensity of competitive rivalry?

Competitive rivalry is one of the important forces that drives economic profits for the market participants in an industry. It addresses how fiercely companies in the industry compete with one another on various dimensions like price, service, new product introduction and advertising

Market Share Analysis: One of the simplest ways to gauge competitive rivalry is by looking at the market shares of major competitors in the industry. A high number of competitors with relatively equal market shares often indicates intense rivalry.

Industry Concentration: In almost all industries, coordination among competitors improves the collective good. Coordination is difficult if there are lots of competitors. In this case, each firm considers itself a minor player and is more likely to think individualistically. A concentration ratio is a common way to measure the number and relative power of firms in an industry.

There are two simple & well-accepted methods to calculate industry concentration;

Relative concentration across Industries can be calculated by adding up the percentage of value shipments that the top four companies in an industry. A higher percentage implies higher concentration, like in India, the domestic pharma formulation market is fragmented relative to the passenger vehicles industry when the following concentration ratio were calculated at the end of Q1 of 23-24 ;

Passenger Vehicles: 81.7

Mobile Handsets: 63.0

Pharmaceuticals: 23.7

One of the disadvantages of using the industry concentration ratio as a measure of competitive rivalry is that it does not account for the degree of product differentiation among firms. For example, two industries may have the same concentration ratio, but one may have more differentiated products than the other, leading to different levels of competition and performance. Therefore, the industry concentration ratio alone may not be sufficient to evaluate competitive rivalry in an industry.

The Herfindahl-Hirschman Index (HHI) is a way of measuring how competitive an industry is. It is based on the market share of the firms in the industry. The market share is the percentage of sales or output that a firm produces in the industry. The HHI is calculated by squaring the market share of each firm and adding them up. The higher the HHI, the less competitive the industry is. The lower the HHI, the more competitive the industry is.

For example, suppose there are four firms in an industry, with market shares of 40%, 30%, 20%, and 10%. The HHI is:

HHI = 40^2 + 30^2 + 20^2 + 10^2

HHI = 1600 + 900 + 400 + 100

HHI = 3000

The HHI can range from 0 to 10,000. A value of 0 means that there are many small firms in the industry, and no firm has a dominant position. A value of 10,000 means that there is only one firm in the industry, which has a monopoly. According to the U.S. Department of Justice, an HHI below 1,500 indicates a competitive industry, an HHI between 1,500 and 2,500 indicates a moderately concentrated industry, and an HHI above 2,500 indicates a highly concentrated industry.

The HHI has some advantages and disadvantages as a measure of market concentration. Some advantages are that it is easy to calculate, it uses readily available data, and it gives more weight to larger firms. Some disadvantages are that it does not account for the differences between products, markets, or regions, it does not capture the dynamics of entry and exit, and it may overstate or understate the degree of competition.

Apart from the above quantitative measurements, there are other factors which, legendary economist Michael J. Mauboussin explained nicely in his famous article “Measuring the Moat”

1. Firm homogeneity: If companies within an industry are similar—say in incentives, ownership structure, and corporate philosophy—rivalry may be less intense. Homogeneity is a particularly important consideration for global industries where competing companies often have asymmetric objectives.

2. Asset specificity, which has a profound influence on entry barriers, also plays a role in rivalry. Specific assets encourage a company to stay in an industry even under difficult conditions because the company has no other use for the assets. In this context, assets include physical assets like railroad tracks as well as intangible assets like brands.

3. Demand variability: When demand variability is high, companies have a difficult time coordinating their internal activities and a very difficult time coordinating with competitors. Variable demand is a particularly important consideration in industries with high fixed costs. In these industries, companies often add too much capacity at points of peak demand. This capacity, while necessary at the peak, is massively excessive at the trough and spurs even more intense competition. The condition of variable demand and high fixed costs describes many commodity industries, which is why their rivalry is so bitter and consistent excess economic returns are so rare.

4. Industry Growth: A final consideration in rivalry is industry growth. When the pie of potential excess economic profits grows, companies can create shareholder value without undermining their competitors. The game is not zero-sum. In contrast, stagnant industries are zero-sum games, and the only way to increase value is to take it from others. So, a decelerating industry growth rate is often concomitant with a rise in rivalry.

I hope you enjoyed reading this concept and strengthen your industry analysis process.