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I wanted to share an interesting concept I’ve learned a few months ago that could help you better understand the external environment of any business.
Most of you may already be familiar with the Porter 5 Forces framework, which is a way to analyze an industry. The problem with this framework is that it only gives us a better understanding of the industry structure; not on how firms will operate and perform.
The SCP framework is a timeless model to understand how firms behave and perform in a market-based economy.
The basic idea is that, in any industry, the performance of companies will depend on how they behave in the industry, which in turn depends on the structural features of the industry.
Structure → Conduct → Performance
You can also view this as a dynamic model with a feedback loop, where the Performance will in turn impact the Structure.
Let’s dive into it!
External Shocks
External shocks are what happen entirely outside of the control of the industry. They are the events that set the structure in an industry.
External shocks are (non-exhaustive list):
Regulations
Credit markets
Exchange rates
Commodity prices
Technology
These elements can really change the whole playing field of an industry.
Structure
The structural features of an industry are the things that are slow to change over time.
To understand the structure of an industry, you can look at:
Growth in demand
Volatility / cyclicality
Differentiability of products
Barriers to entry & exit
Threat of substitute products
Intensity of competition
Power of suppliers & buyers
Understanding the structure of an industry is understanding the set of parameters companies in that market operate under.
Conduct
Firms will behave differently under different circumstances. Conduct refers to the specific actions taken by companies in an industry.
This includes actions like:
Pricing
Product differentiation
Collusion
Advertising & promotion
New product and R&D
Expansion / reduction in capacity
Entry / exit of a market
Acquisition / merger / divestiture
Cost control
Companies have a set actions they can take to respond to a certain market structure. Depending on the structural conditions, they will behave in a way that they believe will maximize their returns.
Most of these elements can change quickly, which leads to conduct changing more often than structure.
Performance
Performance is the outcome of the interplay between Structure and Conduct. We usually refer to financial performance.
Performance, however, is not only represented by financial metrics. It includes the following:
Profitability
Operational efficiency
Value creation
Brand equity
Innovation
Customer satisfaction
Performance outcomes will then feedback and affect the company’s conduct, which will in turn influence how it competes in the market, and therefore the market structure.
Think of performance as information that is being transmitted to the company. It is the reflection of how it conducted itself, represented through financial numbers.
Tying it all back together
Firms compete in a market that is impacted by external events. These events will set in place a structure for the market - a set of parameters under which firms will play under.
Once the structure is established, firms competing in the market will behave in such a way as to maximize their profits. Based on these actions, they will get feedback through financial performance.
Their performance will guide them as to how they should act - it creates a feedback loop. Their new actions will then change the structure of the industry itself.
Things are not static, they are dynamic. Think of industries as big complex systems that are constantly evolving, and impacted by external events.
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