Since its introduction in 1979, Porter’s Five Forces has become the de facto framework for industry analysis. The five forces measure the competitiveness of the market deriving its attractiveness. The analyst uses conclusions derived from the analysis to determine the company’s risk from in its industry (current or potential). The five forces are (1) Threat of New Entrants, (2) Threat of Substitute Products or Services, (3) Bargaining Power of Buyers, (4) Bargaining Power of Suppliers, (5) Competitive Rivalry Among Existing Firms. Don’t forget to check out an example of a Porter’s Five Forces analysis of the Coca-Cola company.
1. Threat of New Entrants: Microeconomics teaches that profitable industries attract new competition until the downward pressure on prices has squeezed all the economic profit from the firms. New firms in an industry put downward pressure on prices, upward pressure on costs and an increased necessity for capital expenditures in order to compete. The less threat there is from firms entering the industry, the more stable a firm’s profits are. An attractive, low-risk industry, is one in which there are significant barriers to entry such as:
Economies of Scale: The theory behind supply side economies of scale state is that the most efficient level of production in an industry is at the point in which the average total costs are at a minimum. In some industries, this takes a significant market share to attain and if a firm cannot attain this level of efficiency, than the firm’s cost structure is too high and the firm will not be competitive.
Demand side economies of scale, or “network effects,” is the theory that the value of a product is dependent on the others using the same product. For example, a competitor to Microsoft’s Excel is highly unlikely to emerge because of the huge network of business consumers that currently utilize the program. Any spreadsheet software that aspires to compete with Excel must be widely adopted by the business community in order to be effective.
Consumer Switching Costs: Any additional cost the consumer bears to switch to a new product increases the effective price of the new product. This creates an additional barrier to entry for the entering firm. This effect may be two-fold for some products such as business enterprise software; the business may incur costs to implement and customize the software in addition to incurring costs through employee retraining and initial unproductivity.
Product Differentiation: In industries in which there is high product differentiation, there is more consumer loyalty to the product. This creates difficulty for an entering firm; marketing expenses must be sufficient enough to lure customers away from the product of their choice.
Government Barriers: In certain industries, the government will erect barriers to protect the industry from competition or to protect consumers from the industry. Certain industries are called “natural monopolies,” in that it is more efficient for a monopoly to exist than to allow competition. In this instance the government will protect the natural monopoly and ban competition (e.g. cable or electricity). In other industries, the government protects consumers from the negative industry effects by introducing barriers. For example, pharmaceutical companies must get product approval before it is available for sale.
Capital Requirements: Some industries require a large financial outlay in order to enter the industry (before even reaching economies of scale). For example: A new pharmaceutical or biotech firm must spend millions in research and development costs to develop a product. On the other hand, a new accounting or investment banking firm has little capital requirement outlays to compete within their industry.
Access to Distribution Channels: Competition for space on a grocery store shelf is a zero-sum game, if one product wins access to the shelf, another product lost. Large providers such as Nabisco and Keebler have strong relationships with the major grocery store chains and a new firm in the cookie market may have difficulty finding a place to sell the product.
2. Threat of Substitute Products or Services: A substitute is a product that performs the same or similar function as another product. Microeconomics teaches that the more substitutes a product has, the demand for the product becomes more elastic. Elastic demand means increased consumer price sensitivity which equates to less certainty of profits. For example, public-transportation is a substitute for driving a car, and e-mail is a substitute for writing letters. Conditions that increase the threat of substitutes are:
An attractive price of substitutes: The price of substitutes acts as a ceiling to the price of the subject product. An attractive price of a substitute acts inhibits an industry from reaching its profit potential.
Increased quality of substitutes: If the quality of a substitute is high, there is increased pressure to increase the quality of the subject product. For example, products such as Netflix and Hulu have introduced video on demand services offered through the internet. Cable and internet companies have answered back by introducing fiber optic networks to not only compete in the video on demand space, but offer incredible picture quality not yet available to the new technologies.
Low switching costs to consumers: Switching costs to consumers can come in the form of monetary costs (transferring cell phone service: termination and initiation fees) or lifestyle switching costs (switching from driving a car to public transportation). Monetary costs effectively increase the price of the substitute products whereas lifestyle costs are more subjective and difficult to identify. In either case, the easier and less costly it is to switch to a substitute, the higher threat of that substitute.
3. Bargaining Power of Buyers: The more powerful a buyer is relative to the seller, the more influence the buyer has. This influence can be used reduce the profits of the seller through a reduction of prices, increased favor in customer service or order delivery, or influence over who the seller supplies to. Customers are powerful if:
Customers are concentrated: If there are only a few customers (or one) in the market, the customers will have more leverage because of the increased reliance on the income stream. A diversified customer base allows more leeway for a supplier to ignore a difficult customer requests.
One customer consumes a significant amount of output: If one customer buys a significant amount of the output from a seller, the seller will do more for the buyer to keep them as a customer. Because of Wal-Mart’s buying power, it holds the upper hand over suppliers and is able to influence the suppliers’ prices. A fragmented customer base allows more leeway for a supplier to ignore difficult customer requests.
Customers possess the power to buy seller or rival- If a customer is so large that it may choose backward integrate, the seller loses influence.
4. Bargaining Power of Suppliers: The more powerful a seller is relative to the buyer, the more influence the seller has. This influence can be used to reduce the profits of the buyer through more advantageous pricing, limiting quality of the product or service, or shifting some costs onto the buyer (e.g. shipping costs). Suppliers are powerful if:
Suppliers are concentrated or differentiated: If there are only a few suppliers (or one) in the market, the suppliers will have more leverage because of the lack of available alternatives.
Significant costs involved in switching suppliers: Customers are less likely to switch suppliers if there are large costs associated with switching. For example, professional video editors are less likely switch from one system (Final Cut Pro) to another (Adobe Premier Pro) because of the costs associated with purchasing new hardware.
Suppliers can forward integrate: If a supplier has the power to or threatens to forward integrate, the buyer may be forced to accept influencefrom the supplier.
5. Competitive Rivalry Among Existing Firms: Rivalry among industry players can affect industry profits through (a) downward pressure on prices, (b) increased innovation, (c) increased advertising, (d) increased service/product improvements, among others. In economics, a monopoly industry structure earns the most profit while the “perfect competition” industry structure earns the least. An increase in competitive rivalry among existing firms brings an industry closer to the theoretical “perfect competition” state. Factors that increase competitive rivalry among existing firms include:
Large Number of Firms: If there are more firms within an industry, there is an increased competition for the same customers and product resources. There is even greater competition if industry players are equal in size and power, as rivals compete for market dominance.
Slowed Industry Growth: When an industry is growing rapidly, firms are able to increase profits because of the expanding industry. When growth slows and industries reach the maturity stage of the industry lifecycle, competition increases to gain market share (and continue the profit growth that investors require).
High Fixed Costs or High Storage Costs: In industries where the fixed costs are high, firms will compete to gain the largest amount of market share possible to cover the fixed costs.
High Exit Barriers: When high exit barriers exist, firms will stay and compete in an industry longer than they would if no exit barriers existed
In addition, price competition is more likely to exist when:
Products or services are identical and/or low switching costs: This encourages price competition to gain market share. Fixed costs high and/or marginal costs low: This encourages competitors to cut prices belowtheir average costs (but not below marginal costs) to recoup some of their fixed costs. Capacity must be expanded in large increments to be efficient: The products are perishable: When a product is perishable, at a certain time it loses its value completely. This creates pressure on a competing firm to sell its product at a price while it still has value. This is true not only for food but for many industries where technology is consistently being improved (e.g. cars, computers, etc).