Why are certain industries always fragmented?

No business ever gets more than a few points of market share. Growth seems impossible.

And…

Being bigger as a business doesn’t make you any stronger.

It’s like all the advantages of scale don’t seem to work. Economies of scale, specialization, superior management, etc.

If scale is the superpower of business, fragmented industries are kryptonite.

In Part 1, I wrote about hypercompetitive industries. And the two drivers for them are:

• A greater number of players. Which relates to barriers to entry.
• Increased ferocity.

Well fragmented industries are a sub-type of hypercompetitive industries. By definition (i.e., they are fragmented), they have lots of players on the field. Which tends to mean increased competition, lower margins and a more difficult existence.

Here’s how I view fragmented and other hyper-competitive industries:

How to Measure Industry Fragmentation vs. Concentration

Well known investor and analyst Michael Mauboussin writes about industry concentration. He says it is a key driver in the degree of competition. In his Measuring the Moat paper, he talks about using the Herfindahl-Hirschman Index (HHI) as a measurement for market concentration. And therefore, market competitiveness.

HHI is the sum of the squares of every competitor’s market share.

Which gives you a range of 0 to 10,000.

• For example, a monopoly would have a 10,000 HHI score based on 100% market share squared (you don’t use the percentage).
• At the other extreme, perfect competition would be a score of zero. Tons of firms would have 0% market share squared. And the sum is still zero.

According to Wikipedia, the U.S. Department of Justice considers a market with an HHI of less than 1,500 to be a competitive marketplace. An HHI of 1,500 to 2,500 means a moderately concentrated marketplace. And an HHI of 2,500 or greater means a highly concentrated marketplace.

Here’s how I view consolidated industries.

So Why Are Some Industries Always Fragmented?

Only about half of industries consolidate. The rest are fragmented. And many / most don’t really consolidate over time. They just kind of exist that way forever. Regardless of individual business performance.

Why does this happen?

According to Michael Porter, it’s due to:

• Industry structure
• Diseconomies of scale

In his book Competitive Advantage, Porter lists some factors within this explanation. I have grouped them into four general reasons.

Reason 1: The Market Demands Are Too Complex and Dynamic for Standardization. Which is a Prerequisite for Growth and Scale.

This is about industry structure. The industry is just too complicated on the demand side and requires lots of complicated solutions on the supply side. Porter cites two factors related to this.

1a. Diverse market needs.

Some markets need lots of different products. And maybe in small batches. There is just a big diversity in market needs. So, you really can’t standardize and scale up to a few big businesses. You need lots and lots of businesses. Some examples are:

• Restaurants and food service. Customer preferences vary widely based on cuisine, dietary restrictions, ambiance, price, and location. So, you need lots of different, mostly small, restaurants.
• Craft beer and microbreweries offer enthusiasts unique flavors, styles, and brews. This means a lot of small-scale producers.

Customization adds another layer of diversity to this. Businesses and individuals want tailored software for specific industries, tasks, or workflows.

1b. Changing and unpredictable sales.

This is when buyers frequently change what they want. Or how often they buy.

And they do this unpredictably.

This makes efficiency and standardization difficult.

Fashion is an example of this. Consumer tastes in clothing shift rapidly due to trends, seasons, influencers, and cultural events. And some buyers purchase frequently (e.g., fast fashion enthusiasts), while others buy sporadically for special occasions.

The toy industry is similar. Demand spikes with holidays and fads driven by movies, TV shows, or viral trends (e.g., fidget spinners). So, we see lots of small toy companies producing niche products like collectible figurines. The unpredictable popularity of specific toys (e.g., Pokémon cards vs. slime) supports a fragmented market with many specialized producers.

You might have noticed that this last point really relates to classical strategy vs. adaptive strategy, which I have talked about a lot. There is an inherent tradeoff between optimizing a business for efficiency vs. adaptability. Classical strategy is about finding a good industry location, standardizing and then scaling up. Adaptive strategy is about being rapid at learning and adaptation to changing market demands. You can’t really do both. And one way to be adaptive is to have lots of smaller businesses.

Reason 2: Scale Doesn’t Give Big Advantages

In traditional business (physical products, services), increasing scale comes with advantages and disadvantages. But sometimes the advantages don’t materialize and all you really get are the disadvantages (bureaucracy, self-interest, complexity). That’s one of reasons you really don’t want to try to scale up many businesses in fragmented industries.

Porter cites two factors related to this.

2a. There can be diseconomies of scale in an important activity.

Boutique retailers are a good example of this. In trendy boutiques, inventory curation is a key activity. Especially when they are targeting trends and niche markets. But this type of inventory curation can start to be a problem when you scale it up to centralized buying decisions. It can lead to overstocking unpopular items or missing local trends. This means increasing costs for storage, markdowns, or returns.

Diseconomies of scale can be a problem. A big retailer like Macy’s would definitely struggle to stock niche fashion items (e.g., vintage streetwear) across all its stores due to the high costs of predicting and sourcing diverse inventory.

Another example is project management as a key activity in home renovation and contracting.

Large contracting firms struggle and become inefficient when they try to manage lots of customized, location-specific projects. Scaling up project management requires more supervisors, complex scheduling, and standardized processes. These increase overhead and reduce flexibility to meet unique client needs and to handle local regulations.

• Home Depot’s contractor services will likely face higher costs when coordinating subcontractors and materials across regions, leading to delays or mismatched client expectations.
• However, a local contractor, with direct oversight and fewer projects, can manage custom renovations more efficiently, adapting to specific client demands and local building codes.

2b. High transportation costs limit your market.

I talk about this all the time. It’s on my list of competitive advantages.

When shipping or logistics costs are a significant percentage of product’s value, it limits how far you can ship it profitable. That limits your effective market. In these cases, smaller, local firms can compete effectively against larger companies. They are better at serving nearby customers with lower transportation expenses. Transportation and location costs naturally limit markets.

We can see this in fresh produce (fruits and vegetables) where there is a low value-to-weight ratio. Plus, they are perishable and require refrigerated transport (cold chain logistics). All this significantly increases shipping costs as transporting produce over long distances means expenses for fuel, specialized trucks, and spoilage losses. This makes it less cost-effective for large firms to centralize distribution and serve distant markets.

Another example is construction aggregates (the gravel used for roads and office and housing developments). Aggregates are very heavy relative to their price. So, the transportation cost is a big percentage of the value. Additionally, aggregates can only be sourced from certain locations. So, there are two big factors that limit how far you can actually transport them profitable. Value investors like Thomas Russo like to invest is this particular business given its protection from distant competitors.

2c. Economies of scale don’t work if the buyer or seller is just too big.

You may be bigger than a rival retailer. That is usually how we talk about scale advantages.

But that doesn’t help you if you are still much smaller than your supplier (or buyer). You don’t get better supply terms (i.e., purchasing economies of scale). You may be a big YouTuber, but you have no sway over YouTube. You get the same terms as everyone else.

So superior scale than a rival doesn’t always mean a scale advantage. Sometimes you are just too exposed to big buyer or seller whims.

Reason 3: Smaller firms can achieve higher operating performance in many situations.

This reason is a lot more positive. It turns out smaller firms are better at some things. That’s why they dominate certain industries. And it’s usually about operating performance.

If an industry is naturally fragmented (i.e., not consolidated), there are fewer opportunities for structural advantages. Because scale is off the table. So, the emphasis shifts more to operating performance.

And smaller firms can be better operators in a couple of areas.

3a. When there is lots of personal service required.

These are your dentists. Consolidating dental practices has never worked. Partly because of the rarity of the skills and the importance of the individual dentists.

But also, because these are local services that require lots of interactions with the customer. You need the dentist nearby. You need lots of ongoing discussion and back and forth. You need someone to call when your tooth hurts at 2am.

When there is lots of personal service and interaction required, smaller local firms are better.

3b. When there is lots of creativity required.

Creativity doesn’t really standardize and scale up. Spending 10x the money doesn’t get you 10x the number of hit songs. Hollywood studios, music publishers and gaming studios usually work with lots of small creative teams. Usually as financiers and distributors.

3c. When it’s about “lean and mean” operations. Something small firms achieve with owner managers and low overhead costs.

This is really common.

In many industries, you want to keep things cheap, fast and flexible. You want to be “lean and mean”. That means minimizing overhead costs. It means avoiding bureaucracy.

Small firms are outstanding at minimizing overhead costs. And they often have owner-managers, which means even lower costs (the owner gets their return as their management salary).

You see these businesses everywhere. Some examples are:

• Boutique fitness studios (e.g., yoga, Pilates, or spin) – which operate with a single rented space, minimal equipment, and an owner who doubles as the instructor or manager.
• Specialty coffee shops. They also keep overhead low by operating in small spaces, using minimal staff (often family or owner-managed), and sourcing local or niche products. The owner-managers personally oversee operations, ensuring tight cost control and quick adaptation to customer preferences.
• Artisanal food producers. Small food businesses (e.g., bakeries, jam makers) often operate out of home kitchens or small facilities, with owners managing production and sales. They target niche markets (e.g., organic, gluten-free) and keep overhead low by selling direct-to-consumer or at farmers’ markets.

3d. When you need close local supervision for high operating performance.

This is pretty similar to the last point. But is less about cost and more about delivering the right type of service.

Certain businesses require close supervision. Such as with nightclubs and bars where you need to create a local vibe. You need to curate music and ambiance and respond to local tastes. Plus, you need to do crowd management and ensure safety. So, you have owner-managers or hired staff on-site. They adjust drink specials, DJ playlists, security measures and so on.

These types of businesses often involve complex, customer-facing operations where quality, atmosphere, or responsiveness require direct, on-site control.

Other examples are boutique hotels, live music venues, and specialty retail (like vintage record stores). Hair salons are a good example of this. They work better with direct oversight to ensure consistent service quality, manage stylists, and cater to local client preferences. The owner-operators often work as stylists themselves, maintaining standards and personal connections.

All of this close supervision makes it hard for large firms to standardize and scale. When you pull supervision and management up to a higher level, performance degrades.

Reason 4: Local Regulations

Government regulations can naturally fragment a market. Such as:

• Liquor licenses in the liquor retail business.
• Building permits and licenses in construction and contracting.
• Taxi medallions in the taxi industry.
• Local licensing requirements in childcare and day care centers. These can include staff-to-child ratios, safety certifications, and facility inspections, which can vary by state or county.

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Ok. That’s a pretty decent list (mostly from Michael Porter).

Also, keep in mind that emerging industries are naturally fragmented. Consolidation usually happens after the rapid growth phase of a new industry has passed. Then things boil down to a few large players.

Let’s talk about what you do in such industries.

What Should You Do in a Fragmented Industry?

How do you deal with lots of competition and possibly low margins?

Where getting bigger is likely not an option.

And where getting bigger doesn’t actually make you stronger?

I think you do two things.

• First, build competitive advantages besides scale. You can go for switching costs. You can go for standardization network effects. Scale is a big one. But there are others. Lots of small firms make tons of profits.
• Second, go for above average margin by superior operating performance. And this is really the default strategy for fragmented industries. In most industries, the default strategy is growth and scale. In fragmented industries, it’s superior operating performance.

Michael Porter talks about several approaches to fragmented industries. I think they are all basically operating strategies. He cites:

1. Build a lean and mean, no-frills operation. Keep your overhead and other costs very, very low. Hire cheap employees. Use owner managers, if possible.
2. Try for tightly controlled decentralization. You can add more businesses by being highly decentralized and very tightly controlled.
3. Do “formula factories”. This is similar. As much as possible, try to standardize a low-cost business, like a restaurant or factory. Try to standardize what you can. And then repeat that with tightly controlled decentralization.
4. Do a franchise hybrid. These are formula factories with some centralized functions. That’s how restaurant franchises work (mostly). They have local operations with empowered owner managers. And they get economies of scale by centralized purchasing and marketing.
5. Do backwards integration. If you can’t get big in your space, move upstream.

Final Point: What Not to Do in a Fragmented Industry

A common problem is managers who don’t know they are in fragmented industries. And they do what every manager does. They try to grow.

First, that is usually a losing strategy in a fragmented industry. It can’t be done.

Second, it can actually be harmful. It can decrease your value to customers. And it can waste a lot of cash.

So, according to Porter, here is what you don’t want to do in fragmented industries:

• Don’t seek dominance. As mentioned, it usually doesn’t work. And it will make you inefficient and inflexible. Attempts to standardize can make you lose differentiation.
• Don’t over centralize. Competition in fragmented industries usually requires personal service, close contacts, tight control of operations, and the ability to read customer changes. Centralization can hurt all of this.
• Don’t assume competitors have same overhead or objectives. Fragmented industries are usually a confusing mess of SMEs, family businesses and small private firms. This means lots of different objectives. This is not like larger corporations, which tend to have similar approaches and goals. SMEs will often accept low margins. They can have different cost structures. People often work out of their homes. And so on. Don’t assume your competitors are like you.
• Don’t get too excited about new products. This is an interesting point by Porter. He wrote that firms struggling in fragmented industries often get over-excited when a new, high-growth product emerges. They start to make larger margins than before. They think this will finally get them some relief from hyper competition. So, they invest aggressively in the new product. But over time, it gets copied and the standard dynamic will return. Jump on new products but don’t get over excited or invested.

***

Ok. That’s it for this topic. A bit long but fun.

Cheers, Jeff

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Related articles:

• The Characteristics of Unattractive Industries with Cutthroat Competition (1 of 3) (Tech Strategy)
• 5 Misconceptions About Barriers to Entry (Tech Strategy)

From the Concept Library, concepts for this article are:

• Industry Structure: Fragmented Industries
• Industry Structure: Highly Competitive Industries

From the Company Library, companies for this article are:

• n/a

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I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

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