Definition of the Industrial Organization (I/O) Model
During strategy formulation, firms consider two primary factors: the external and internal environment. The external environment consists of the general environment and the industry environment.
In the I/O model, the industry environment has a dominant influence on strategies. It is most likely to determine the firms’ strategic conduct, and actions to deploy. The internal environment is only a minor factor in determining strategies. Thus resources and capabilities do not have a big impact on the firms’ strategic direction.
More on the Industrial Organization (I/O) Model
The I/O model suggests that above-average returns are earned when firms are able to effectively study the external environment as the foundation for identifying an attractive industry and implementing the appropriate strategy. The model specifies that the firm’s performance is determined primarily by a range of industry properties, including economies of scale, barriers to market entry, diversification, product differentiation, the degree of concentration of firms in the industry, and market frictions.
For example, in some industries, firms can reduce competitive rivalry and erect barriers to entry by forming joint ventures. Because of these outcomes, the joint ventures increase profitability in the industry. Companies that develop or acquire the internal skills needed to implement strategies required by the external environment are likely to succeed, while those that do not are likely to fail. Hence, this model suggests that returns are determined primarily by external characteristics rather than by the firm’s unique internal resources and capabilities.
Understanding Industrial Organization
Industrial organization is a field in economics. It studies the structure of firms and the markets where firms compete against one another. Understanding these concepts is vital for firms in setting the right strategic direction.
The industrial organization (I/O) model stems from the literature on monopolistic competition. This model is originally constructed to help us better understand the Industrial organization.
Note that there are four basic market types: (1) perfect competition, (2) monopolistic competition, (3) oligopoly, and (4) monopoly. The other three advanced types are (1) duopoly, (2) oligopsony, and (3) monopsony.
The First Implication of the I/O Model
To achieve strategic competitiveness, firms need to identify the industry that provides the best opportunities.
This is because the I/O model implies that the industry in which a firm operates has a much higher impact on its performance than internal resources, capabilities, and core competencies.
Managing strategically from the I/O model perspective would entail firms competing in attractive industries, avoiding weak or faltering industries. Firms should gain a full understanding of key external factor relationships within that attractive industry.
Characteristics of the industry would dictate the firms’ performance. Higher performance then leads to higher above-average (superior) returns.
These characteristics include (but are not limited to) barrier to entry, economies of scale, product differentiation, price discrimination, industry life cycle, measures of concentration, market power, and market frictions.
The Second Implication of the I/O Model
To increase their performance, firms can prepare internal resources and capabilities needed to implement necessary strategies.
The companies that can utilize their resources, capabilities, and core competencies might succeed in earning above-average returns. Those that do not are likely to fail.
Thus, firms must either find ways to imitate each other or try to develop strategically unique and valuable resources. Firms with imitation may perform poorly, especially in long term. Those that can obtain strategic resources and capabilities might, on the other hand, develop a foundation for superior products and services at a lower price.
How Company Can Earn Superior Returns (based on I/O Model)
To earn above-average returns, the I/O model suggests these five steps that firms should complete:
- Study the external environment, both general environment and industry environment.
- Locate the industry or industry segment with high above-average returns potential.
- Formulate strategy based on the industry or industry segment identified.
- Prepare resources (assets and capabilities) needed to implement the strategy.
- Deploy these resources (as the firms’ strengths) for actual implementation of the strategy.
Resources
Further Reading
- Industrial Organization (investopedia.com)
- Alternative Models of Developing Strategic Competitiveness (openlearningworld.com)
Related Concepts
- Business Strategy Formulation
- Business External Environment Components
- Industry Environment Analysis
References
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2016). Strategic Management: Concepts: Competitiveness and Globalization (12th ed.). Cengage Learning.
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2019). Strategic Management: Concepts and Cases: Competitiveness and Globalization (MindTap Course List) (13th ed.). Cengage Learning.