Porters 5 Forces


Michael Porter provided a framework that models an industry as being influenced by five forces. The strategic business manager seeking to develop an edge over rival firms can use this model to better understand the industry context in which the firm operates.

I. Rivalry

Firms strive for a competitive advantage over their rivals.  The intensity of rivalry among firms varies across industries, and strategic analysts are interested in these differences.

With only a few firms holding a large market share, the competitive landscape is less competitive. 

In pursuing an advantage over its rivals, a firm can choose from several competitive moves:

1. Changing prices - raising or lowering prices to gain a temporary advantage.

2. Improving product differentiation - improving features, implementing innovations in the manufacturing process an din the product itself. 

3. Creatively using channels of distributions - using vertical integration or using a distribution channel that is novel to the industry. For example with high-end jewelry stores reluctant to carry its watches, Timex moved into drugstores and other non-traditional outlets and cornered the low to mid-price watch market. 

4. Exploiting relationships with suppliers - for example, from the 1950's to the 1970's Sears Roebuck and Co. dominated the retail household appliance market. Sears set high quality standard sand required suppliers to meet its demands for product specification and price. 

The intensity of rivalry is influenced by the following industry characteristics:

1.    A large number of firms increases rivalry because more firms must compete for the same customers and resources. The rivalry intensifies if the firms have similar market share, leading to a struggle for market leadership. 

2.    Slow market growth causes firms to fight for market share. In a growing market firms are able to improve revenues simply because of the expanding market.

3.    High fixed costs result in an economy of scale effect that increases rivalry. When total costs are mostly fixed costs, the firm must produce near capacity to attain the lowest unit costs. Since the firm must sell this large quantity of product, high levels of production lead to a fight for a market share and results in increased rivalry. 

4.    High storage costs or highly perishable products cause a producer to sell goods as soon as possible. If other producers are attempting to unload at the same time, competition for customers intensifies. 

5.    Low switching costs increases rivalry. When a customer can freely switch from one product to another there is a greater struggle to capture customers. 

6.    Low levels of production differentiation is associated with higher levels of rivalry. Brand identification, on the other hand, tends to constrain rivalry.

7.    Strategic stakes are high when a firm is losing market position or has potential for great gains. This intensifies rivalry. 

8.    High exit barriers place a high cost on abandoning the product. The firm must compete. High exit barriers cause a firm to remain in an industry, even when the venture is no profitable. A common exit barrier is asset specificity. When the plant and equipment required for manufacturing a product is highly specialized, these assets cannot easily be sold to other buyers in another industry.

9.    A diversity of rivals with different cultures, histories, and philosophies make an industry unstable. There is greater possibility for mavericks and for misjudging rival’s moves. Rivalry is volatile and can be intense. 

10.    Industry shakeout. A growing market and the potential for high profits induces new firms to enter a market and incumbent firms to increase production. A point is reached where the industry becomes crowded with competitors and demand cannot support the new entrants and the resulting increased supply. The industry may become crowded if its growth rate slows and the market becomes saturated, creating a situation of excess capacity with too many goods chasing too few buyers. A shakeout ensues, with intense competition, price wars and companies failures. 

II Threat of substitutes

In Porter’s model, substitute products, refer to products in other industries. To the economist a threat of substitutes exists when a product’s demand is affected by the price change of a substitute product. As more substitutes become available, the demand becomes more elastic since customers have more alternatives. A close substitute product constrains the ability of firms in an industry to raise prices. The price of aluminum beverage cans is constrained by the price of glass bottles, steel cans, and plastic containers. These containers are substitutes, yet they are not rivals in the aluminum can industry.  

III Buyer Power

The power of buyers is the impact that customers have on a producing industry. In general, when buyer power is strong the relationship to the producing industry is near to what an economist terms a monopsony – a market in which there are many suppliers and one buyer. Under such market conditions, the buyer sets the price. In reality few pure monophonies’ exist, but frequently there is isome asymmetry between a producing industry and buyers. 

Buyers are powerful if:

1.    Buyers are concentrated – there are a few buyers with significant market share. 
a.    DOD purchases from defense contractors
2.    Buyers purchase a significant proportion of output – distribution of purchases or if the product is standardized. 
a.    Circuit City and Sears large retail market provides power over appliance manufacturers. 
3.    Buyers possess a credible backward integration threat – can threaten to buy producing firm or rival
a.    Large auto manufacturers purchases of tires

Buyers are weak if:

1.    Producers threaten forward integration – producer can take over own distribution/retailing
a.    Movie-producing companies have integrated forward to acquire theaters
2.    Significant buyer switching costs – products not standardized and buyer cannot easily switch to another product
a.    IBM’s 360 system strategy in the 1960’s
3.    Buyers are fragmented (many, different) – no buyer has any particular influence on product or price 
a.    Most consumer products
4.    Producers supply critical portions of buyers’ input – distribution of purchases
a.    Intel’s relationship from PC manufacturers

IV. Supplier Power

A producing industry requires raw materials – labor, components, and other supplies. This requirement leads to buyer-supplier relationships between the industry and the firms that provide it raw materials used to create products. Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry’s profits. 

Suppliers are powerful if:

1.    Credible forward integration threat by suppliers
a.    Baxter international, manufacturer of hospital supplies, acquired American Hospital Supply, a distributor.
2.    Suppliers concentrated 
a.    Drug industry’s relationship to hospitals
3.    Significant cost to switch suppliers
a.    Microsoft’s relationship with PC manufacturers
4.    Customers Powerful
a.    Boycott of grocery stores selling non-union picked grapes

Suppliers are weak if:

1.    Many competitive supplies – product is standardized
a.    Tire industry relationship to automobile manufacturers 
2.    Purchase commodity products
a.    Grocery store brand label products
3.    Credible backward integration threat by purchasers
a.    Timber producers relationship to paper companies
4.    Concentrated purchasers    
a.    Garment industries relationship to major department stores
5.    Customers weak
a.    Travel agent’s relationship to airlines

V. Threat of New Entrants and Entry Barriers

It is not only incumbent rivals that pose a threat to firms in an industry: the possibility that new firms may enter the industry also affects competition. In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry.

When profits decrease, we would expect some firms to exit the market thus restoring market equilibrium. Falling prices, or the expectation that future prices will fall, deters rivals from entering a market. Firms also may be reluctant to enter markets that are extremely uncertain, especially if entering involves expensive start-up costs. These are normal accommodations to market conditions. But if firms individually (collective action would be illegal collusion) keep prices artificially low as a strategy to prevent potential entrants from entering the market, such entry deterring pricing establishes a barrier. 

Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm’s competitive advantage. Barriers to entry arise from several sources:

1.    Government creates barriers. 
2.    Patents and proprietary knowledge serve to restrict entry into an industry
3.    Asset specificity inhibits entry into an industry
4.    Organizational (Internal) Economies of Scale

Barriers to Exit – see referenced page below

Generic Strategies to counter the five forces

1.    Corporate Level
2.    Business unit level
3.    Functional or departmental level

Generic Strategies

1.    Cost Leadership
2.    Differentiation
3.    Focus

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