Another important dimension of industry is called “demand conditions” and refers to the nature of customer preferences. For instance, more consumers may feel they need a new computer that is faster and has more memory than they need, say, a device that locates the “studs” in a house's walls. Three aspects of demand conditions in an industry are important for entrepreneurs to understand: the magnitude of customer demand for products or services, the rate growth of that demand, and the heterogeneity of that demand across customer segments.
These aspects of demand conditions are important for entrepreneurs because they influence the performance of new firms. The magnitude of customer demand has a positive effect on new firm performance, leading new firms to perform better in larger markets. For example, new biotechnology firms tend to perform better when developing cures to major medical problems than when they pursue the development of orphan drugs. Why? New firms must incur a fixed cost to organize and produce a product to meet demand in an industry. As a result, the new firm's average cost of meeting demand is smaller in a larger market than in a smaller market. Because established firms have already incurred the fixed cost of organizing, they can meet demand at marginal cost, which is lower than average cost. The cost gap between new and established firm efforts to meet demand is smaller in larger markets than in smaller ones, making larger markets more favorable to new companies than smaller markets. Most venture capitalists understand this logic, which is why they often focus their attention on backing those start-ups pursuing the largest markets.
The performance of new firms is also higher in rapidly growing markets than in slowly growing markets. Why? Because the more rapidly a market grows, the less a new firm needs to serve the customers of existing firms.(5) Serving new customers, rather than the customers of existing firms, is advantageous because established companies compete more fiercely to protect their existing customers than they do to gain new customers, making the level of competition for new firms lower in rapidly growing industries.
Finally, the degree of segmentation of the market affects the favorability of an industry to new firms. Market segmentation refers to the degree to which the customer base of an industry wants different features in the products or services it demands. Some industries are composed of customers with very different combinations of preferences than others. That is, some markets are more segmented than others. Clothing is a good example of a highly segmented industry. Not only are there differences between men's, women's, and children's fashions, but there are large differences in quality, color, and other preferences. In contrast, water purification is an industry with very little segmentation. Basically, everyone wants clean water, and there is limited variation in preferences across customers in the features of purified water.
New firms benefit from segmented markets. Given the small scale at which most new firms are founded, they cannot service the entire market immediately upon entry. Segmented markets provide an opportunity for new firms to enter with small-scale production and serve the underserved niches. Usually, new firms face less competition from established firms when they enter markets in this way. Because established firms focus on their mainstream customers, they often retaliate when new firms enter unsegmented markets. In these markets, new firms are targeting their main customers. In contrast, when new firms enter underserved niches, established firms do not feel that their customer base is under attack and are more likely accommodate entry. Take, for example, the efforts by Nucor to enter the steel industry. Because Nucor initially targeted the segment of the steel market where the profit margins were the slimmest, the major steel makers accommodated its entry. Had Nucor first entered the highest margin segment of the market first, the major steel makers would likely have retaliated.
Stop! Don't Do It!
Don't start a business is a small market; you can just as easily start one in a large market.
Don't start a business in a slow growth market; your competitors will respond viciously.
Don't start a business in an unsegmented market; the competition from established firms will kill your business.