What Makes an Industry Fragmented?

Industries are fragmented for a wide variety of reasons, with greatly differing implications for competing in them. Some indus-tries are fragmented for historical reasons—because of the resources or abilities of the firms historically in them—and there is no funda-mental economic basis for fragmentation. However, in many indus-tries there are underlying economic causes, and the principal ones seem to be as follows:

Low Overall Entry Barriers. Nearly all fragmented industries have low overall entry barriers. Otherwise they could not be popu-lated by so many small firms. However, although a prerequisite to fragmentation, low entry barriers are usually not sufficient to ex-plain it. Fragmentation is nearly always accompanied by one or more of the other causes discussed below.

Absence of Economies of Scale or Experience Curve. Most fragmented industries are characterized by the absence of significant scale economies or learning curves in any major aspect of the busi-ness, whether it be manufacturing, marketing, distribution, or re-search. Many fragmented industries have manufacturing processes characterized by few if any economies of scale or experience cost de-clines, because the process is a simple fabrication or assembly opera-tion (fiberglass and polyurethane molding), is a straightforward warehousing operation (electronic component distribution), has an inherently high labor content (security guards), has a high personal service content, or is intrinsically hard to mechanize or routinize. In an industry like lobster fishing, for example, the unit of production is the individual boat. Having multiple boats does little to lower fish-ing costs because all boats are essentially fishing in the same waters with the same chance of a good catch. Thus there are many, many small operators with roughly equal costs. Until recently, mushroom farming has been similarly resistant to cost savings through scale or learning. Finicky mushrooms have been grown in caves by many small operators who know the “black art” required. Recently this situation has started to change, however, as will be discussed fur-ther.

High Transportation Costs. High transportation costs limit the size of an efficient plant or production location despite the pres-ence of economies of scale. Transportation costs balanced against economies of scale determine the radius a plant can economically service. Transportation costs are high in such industries as cement, fluid milk, and highly caustic chemicals. They are effectively high in many service industries because the service is “produced” at the cus-tomer’s premises or the customer must come to where the service is produced.

High Inventory Costs or Erratic Sales Fluctuations. Although there may be intrinsic economies of scale in the production process, they may not be reaped if inventory carrying costs are high and sales fluctuate. Here production has to be built up and down, which works against the construction of large-scale, capitalintensive facil-ities and operating them continuously. Similarly, if sales are very er-ratic and fluctuate over a wide range, then the firm with large-scale facilities may not have advantages over the smaller, more nimble firm, even if the large firm‘s production operations are more effi-cient in a fully loaded state. Small-scale, less specialized facilities or distribution systems are usually more flexible in absorbing output shifts than large, more specialized ones, even though they may have higher operating costs at a steady operating rate.

No Advantages of Size in Dealing with Buyers or Suppliers. The structure of the buyer groups and supplier industries is such that a firm gains no significant bargaining power in dealing with these adjacent businesses from being large. Buyers, for example, might be so large that even a large firm in the industry would only be marginally better off in bargaining with them than a smaller firm. Sometimes powerful buyers or suppliers will be powerful enough to actually keep companies in the industry small, through intentionally spreading their business or encouraging entry.

Diseconomies of Scale in Some Important Aspect. Diseconomies of scale can stem from a variety of factors. Rapid product changes or style changes demand quick response and intense coordination among functions. Where frequent new product intro-ductions and style changes are essential to competition, allowing only short lead times, a large firm may be less efficient than a smaller one—which seems to be true in women’s clothing and other industries in which style plays a major role in competition.

If maintaining a low overhead is crucial to success, this factor can favor the small firm under the iron hand of an owner-manager, unencumbered by pension plans and other corporate trappings and less subject to scrutiny by government regulators than the larger firm.

A highly diverse product line requiring customization to indi-vidual users requires a great deal of user-manufacturer interface on small volumes of product and can favor the small firm over the larger one. The business forms industry may be an example of one in which such product diversity has led to fragmentation. The top two North American business form producers hold only about a 35 per-cent share of the market.

Although there are exceptions, if heavy creative content is re-quired, it is often difficult to maintain the productivity of creative personnel in a very large company. One sees no dominant firms in industries such as advertising and interior design.

If close local control and supervision of operations is essential to success the small firm may have an edge. In some industries, par-ticularly services like nightclubs and eating places, an intense amount of close, personal supervision seems to be required. Absen-tee management works less effectively in such businesses, as a gen-eral rule, than an owner-manager who maintains close control over a relatively small operation. ‘

Smaller firms are often more efficient where personal service is the key to the business. The quality of personal service and the cus-tomer’s perception that individualized, responsive service is being provided often seem to decline with the size of the firm once a thres-hold is reached. This factor seems to lead to fragmentation in such industries as beauty care and consulting.

Where a local image and local contacts often are keys to the business the large firm can be at a disadvantage. In some industries like aluminum fabricating, building supply, and many distribution businesses, a local presence is essential to success. Intense business development, contact building, and sales effort on a local level are necessary to compete. In such industries a local or regional firm can often outperform a larger firm provided it faces no significant cost disadvantages.

Diverse Market Needs. In some industries buyers’ tastes are fragmented, with different buyers each desiring special varieties of a product and willing (and able) to pay a premium for it rather than accept a more standardized version. Thus the demand for any partic-ular product variety is small, and adequate volume is not present to support production, distribution, or marketing strategies that would yield advantages to the large firm. Sometimes fragmented buyers’ tastes stem from regional or local differences in market needs, for example, in the fire engine industry. Every local fire department wants its own customized fire engine with many expensive bells, whistles, and other options. Thus nearly every fire engine sold is unique. Production is job shop and almost purely assembly, and there are literally dozens of fire engine manufacturers, none of whom has a major market share.

High Product Differentiation, Particularly if Based on Image. If product differentiation is very high and based on image, it can place limits on a firm‘s size and provide an umbrella that allows inef-ficient firms to survive. Large size may be inconsistent with an image of exclusivity or with the buyer’s desire to have a brand all his or her own. Closely related to this situation is one in which key suppliers to the industry value exclusivity or a particular image in the channel for their products or services. Performing artists, for example, may pre-fer dealing with a small booking agency or record label that carries the image they desire to cultivate.

Exit Barriers. If there are exit barriers, marginal firms will tend to stay in the industry and thereby hold back consolidation. Aside from economic exit barriers, managerial exit barriers appear to be common in fragmented industries. There may be competitors with goals that are not necessarily profitoriented. Certain busi-nesses may have a romantic appeal or excitement that attracts com-petitors who want to be in the industry despite low or even nonexist-ent profitability. This factor seems to be common in such industries as fishing and talent agencies.

Local Regulation. Local regulation, by forcing the firm to comply with standards that may be particularistic, or to be attuned to a local political scene, can be a major source of fragmentation in an industry, even where the other conditions do not hold. Local regula-tion has probably been a contributing factor to fragmentation in in-dustries like liquor retailing and personal services such as dry clean-ing and fitting eyeglasses.

Government Prohibition of Concentration. Legal restrictions prohibit consolidation in industries such as electric power and televi-sion and radio stations, and McFadden Act restrictions on branch banking across state lines are impeding consolidation in electronic funds transfer systems.

Newness. An industry can be fragmented because it is new and no firm or firms have yet developed the skills and resources to com-mand a significant market share, even though there are no other im-pediments to consolidation. Solar heating and fiber optics may well have been in this state in 1979.

It takes the presence of only one of these characteristics to block the consolidation of an industry. If none of them are present in a fragmented industry, then this is an important conclusion, as will be discussed below.

Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.

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