Porters 5 Forces

1           Introduction

The model of the Five Competitive Forces was developed by Michael E. Porter in his book
“Competitive Strategy: Techniques for Analyzing Industries and Competitors” in 1980. Since
that time it has become an important tool for analyzing an organizations industry structure in
strategic processes.
 
Porter’s model is based on the insight that a corporate strategy should meet the opportunities
and threats in the organizations external environment. Especially, competitive strategy should
base on and understanding of industry structures and the way they change.
Porter has identified five competitive forces that shape every industry and every market.
These forces determine the intensity of competition and hence the profitability and
attractiveness of an industry. The objective of corporate strategy should be to modify these
competitive forces in a way that improves the position of the organization. Porter’s model
supports analysis of the driving forces in an industry. Based on the information derived from
the Five Forces Analysis, management can decide how to influence or to exploit particular
characteristics of their industry.

2           The Five Competitive Forces

The Five Competitive Forces are typically described as follows:

 
2.1          Bargaining Power of Suppliers

The term 'suppliers' comprises all sources for inputs that are needed in order to provide goods
or services.
Supplier bargaining power is likely to be high when:
 
       The market is dominated by a few large suppliers rather than a fragmented source of
supply,
       There are no substitutes for the particular input,
       The suppliers customers are fragmented, so their bargaining power is low,
       The switching costs from one supplier to another are high,
       There is the possibility of the supplier integrating forwards in order to obtain higher
prices and margins. This threat is especially high when
       The buying industry has a higher profitability than the supplying industry,
       Forward integration provides economies of scale for the supplier,
       The buying industry hinders the supplying industry in their development (e.g.
reluctance to accept new releases of products),
       The buying industry has low barriers to entry.
 
In such situations, the buying industry often faces a high pressure on margins from their
suppliers. The relationship to powerful suppliers can potentially reduce strategic options for
the organization.

2.2          Bargaining Power of Customers

Similarly, the bargaining power of customers determines how much customers can impose
pressure on margins and volumes.
Customers bargaining power is likely to be high when
       They buy large volumes, there is a concentration of buyers,
       The supplying industry comprises a large number of small operators
       The supplying industry operates with high fixed costs,
       The product is undifferentiated and can be replaces by substitutes,
       Switching to an alternative product is relatively simple and is not related to high costs,
       Customers have low margins and are price-sensitive,
       Customers could produce the product themselves,
       The product is not of strategic importance for the customer,
       The customer knows about the production costs of the product
       There is the possibility for the customer integrating backwards.
 
2.3          Threat of New Entrants

The competition in an industry will be the higher, the easier it is for other companies to enter
this industry. In such a situation, new entrants could change major determinants of the market
environment (e.g. market shares, prices, customer loyalty) at any time. There is always a
latent pressure for reaction and adjustment for existing players in this industry.
The threat of new entries will depend on the extent to which there are barriers to entry. These
are typically
       Economies of scale (minimum size requirements for profitable operations),
       High initial investments and fixed costs,
       Cost advantages of existing players due to experience curve effects of operation with
fully depreciated assets,
       Brand loyalty of customers
       Protected intellectual property like patents, licenses etc,
       Scarcity of important resources, e.g. qualified expert staff
       Access to raw materials is controlled by existing players,
       Distribution channels are controlled by existing players,
       Existing players have close customer relations, e.g. from long-term service contracts,
       High switching costs for customers
       Legislation and government action
 

2.4          Threat of Substitutes

A threat from substitutes exists if there are alternative products with lower prices of better
performance parameters for the same purpose. They could potentially attract a significant
proportion of market volume and hence reduce the potential sales volume for existing players.
This category also relates to complementary products.
Similarly to the threat of new entrants, the treat of substitutes is determined by factors like
       Brand loyalty of customers,
       Close customer relationships,
       Switching costs for customers,
       The relative price for performance of substitutes,
       Current trends.
 

2.5          Competitive Rivalry between Existing Players

This force describes the intensity of competition between existing players (companies) in an
industry. High competitive pressure results in pressure on prices, margins, and hence, on
profitability for every single company in the industry.
Competition between existing players is likely to be high when
       There are many players of about the same size,
       Players have similar strategies
       There is not much differentiation between players and their products, hence, there is
much price competition
       Low market growth rates (growth of a particular company is possible only at the
expense of a competitor),
       Barriers for exit are high (e.g. expensive and highly specialized equipment).
 
 

3           Use of the Information form Five Forces Analysis

Five Forces Analysis can provide valuable information for three aspects of corporate
planning:
 
Static Analysis:
The Five Forces Analysis allows determining the attractiveness of an industry. It provides
insights on profitability. Thus, it supports decisions about entry to or exit from and industry or
a market segment. Moreover, the model can be used to compare the impact of competitive
forces on the own organization with their impact on competitors. Competitors may have
different options to react to changes in competitive forces from their different resources and
competences. This may influence the structure of the whole industry.
 
 
Dynamical Analysis:
In combination with a PEST-Analysis, which reveals drivers for change in an industry, Five
Forces Analysis can reveal insights about the potential future attractiveness of the industry.
Expected political, economical, socio-demographical and technological changes can influence
the five competitive forces and thus have impact on industry structures.
Useful tools to determine potential changes of competitive forces are scenarios.
 
 
Analysis of Options:
With the knowledge about intensity and power of competitive forces, organizations can
develop options to influence them in a way that improves their own competitive position. The
result could be a new strategic direction, e.g. a new positioning, differentiation for
competitive products of strategic partnerships (see section 4).
 
 
Thus, Porters model of Five Competitive Forces allows a systematic and structured analysis
of market structure and competitive situation. The model can be applied to particular
companies, market segments, industries or regions. Therefore, it is necessary to determine the
scope of the market to be analyzed in a first step. Following, all relevant forces for this market
are identified and analyzed. Hence, it is not necessary to analyze all elements of all
competitive forces with the same depth.
 
The Five Forces Model is based on microeconomics. It takes into account supply and demand,
complementary products and substitutes, the relationship between volume of production and
cost of production, and market structures like monopoly, oligopoly or perfect competition.
 
 
4           Influencing the Power of Five Forces

After the analysis of current and potential future state of the five competitive forces, managers
can search for options to influence these forces in their organization’s interest. Although
industry-specific business models will limit options, the own strategy can change the impact
of competitive forces on the organization. The objective is to reduce the power of competitive
forces.
 
The following figure provides some examples. They are of general nature. Hence, they have
to be adjusted to each organization’s specific situation. The options of an organization are
determined not only by the external market environment, but also by its own internal
resources, competences and objectives.
 

4.1          Reducing the Bargaining Power of 4.2          Reducing the Bargaining Power of
Suppliers Customers
          Partnering           Partnering
          Supply chain management           Supply chain management
          Supply chain training           Increase loyalty
          Increase dependency           Increase incentives and value added
          Build knowledge of supplier costs           Move purchase decision away from
and methods price
          Take over a supplier           Cut put powerful intermediaries (go
directly to customer)

4.3          Reducing the Treat of New Entrants 4.4          Reducing the Threat of Substitutes
          Increase minimum efficient scales of           Legal actions
operations           Increase switching costs
          Create a marketing / brand image           Alliances
(loyalty as a barrier)           Customer surveys to learn about their
          Patents, protection of intellectual preferences
property           Enter substitute market and influence
          Alliances with linked products / from within
services           Accentuate differences (real or
          Tie up with suppliers perceived)
          Tie up with distributors
          Retaliation tactics
 
4.5          Reducing the Competitive Rivalry
between Existing Players
          Avoid price competition
          Differentiate your product
          Buy out competition
          Reduce industry over-capacity
          Focus on different segments
          Communicate with competitors
 
 
 I. Rivalry

In the traditional economic model, competition among rival firms drives profits to zero. But
competition is not perfect and firms are not unsophisticated passive price takers. Rather, 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.

Economists measure rivalry by indicators of  industry concentration. The Concentration Ratio
(CR) is one such measure. The Bureau of Census periodically reports the CR for major
Standard Industrial Classifications (SIC's). The CR indicates the percent of market share held
by the four largest firms (CR's for the largest 8, 25, and 50 firms in an industry also are
available). A high concentration ratio indicates that a high concentration of market share is
held by the largest firms - the industry is concentrated. With only a few firms holding a large
market share, the competitive landscape is less competitive (closer to a monopoly). A low
concentration ratio indicates that the industry is characterized by many rivals, none of which
has a significant market share. These fragmented markets are said to be competitive. The
concentration ratio is not the only available measure; the trend is to define industries in terms
that convey more information than distribution of market share.

If rivalry among firms in an industry is low, the industry is considered to be disciplined. This
discipline may result from the industry's history of competition, the role of a leading firm, or
informal compliance with a generally understood code of conduct. Explicit collusion
generally is illegal and not an option; in low-rivalry industries competitive moves must be
constrained informally. However, a maverick firm seeking a competitive advantage can
displace the otherwise disciplined market.

When a rival acts in a way that elicits a counter-response by other firms, rivalry intensifies.
The intensity of rivalry commonly is referred to as being cutthroat, intense, moderate, or
weak, based on the firms' aggressiveness in attempting to gain an advantage.

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

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

 Improving product differentiation - improving features, implementing innovations in
the manufacturing process and in the product itself.

 Creatively using channels of distribution - 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.

 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 standards and required suppliers to meet its demands for product
specifications and price.

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

1. A larger 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 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 product 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 not 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. Litton Industries' acquisition
of Ingalls Shipbuilding facilities illustrates this concept. Litton was successful in the
1960's with its contracts to build Navy ships. But when the Vietnam war ended,
defense spending declined and Litton saw a sudden decline in its earnings. As the firm
restructured, divesting from the shipbuilding plant was not feasible since such a large
and highly specialized investment could not be sold easily, and Litton was forced to
stay in a declining shipbuilding market.

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. The hospital industry, for example, is
populated by hospitals that historically are community or charitable institutions, by
hospitals that are associated with religious organizations or universities, and by
hospitals that are for-profit enterprises. This mix of philosophies about mission has
lead occasionally to fierce local struggles by hospitals over who will get expensive
diagnostic and therapeutic services. At other times, local hospitals are highly
cooperative with one another on issues such as community disaster planning.

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 company failures.

BCG founder Bruce Henderson generalized this observation as the Rule of Three and
Four: a stable market will not have more than three significant competitors, and the
largest competitor will have no more than four times the market share of the smallest.
If this rule is true, it implies that:

o If there is a larger number of competitors, a shakeout is inevitable

o Surviving rivals will have to grow faster than the market
o Eventual losers will have a negative cash flow if they attempt to grow
o All except the two largest rivals will be losers
o The definition of what constitutes the "market" is strategically important.

Whatever the merits of this rule for stable markets, it is clear that market stability and
changes in supply and demand affect rivalry. Cyclical demand tends to create cutthroat
competition. This is true in the disposable diaper industry in which demand fluctuates
with birth rates, and in the greeting card industry in which there are more predictable
business cycles.
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. A product's price elasticity is affected by substitute products - 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 competition engendered by a Threat of Substitute comes from products outside the
industry. 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. To the manufacturer of automobile tires, tire retreads are a
substitute. Today, new tires are not so expensive that car owners give much consideration to
retreading old tires. But in the trucking industry new tires are expensive and tires must be
replaced often. In the truck tire market, retreading remains a viable substitute industry. In the
disposable diaper industry, cloth diapers are a substitute and their prices constrain the price of
disposables.

While the treat of substitutes typically impacts an industry through price competition, there
can be other concerns in assessing the threat of substitutes. Consider the substitutability of
different types of TV transmission: local station transmission to home TV antennas via the
airways versus transmission via cable, satellite, and telephone lines. The new technologies
available and the changing structure of the entertainment media are contributing to
competition among these substitute means of connecting the home to entertainment. Except in
remote areas it is unlikely that cable TV could compete with free TV from an aerial without
the greater diversity of entertainment that it affords the customer.
 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 monopsonies exist,
but frequently there is some asymmetry between a producing industry and buyers. The
following tables outline some factors that determine buyer power.

Buyers are Powerful if: Example

Buyers are concentrated - there are a few
DOD purchases from defense contractors
buyers with significant market share
Buyers purchase a significant proportion of
Circuit City and Sears' large retail market
output - distribution of purchases or if the
provides power over appliance manufacturers
product is standardized
Buyers possess a credible backward
integration threat - can threaten to buy Large auto manufacturers' purchases of tires
producing firm or rival
 
Buyers are Weak if: Example
Producers threaten forward integration -
Movie-producing companies have integrated
producer can take over own
forward to acquire theaters
distribution/retailing
Significant buyer switching costs - products
not standardized and buyer cannot easily IBM's 360 system strategy in the 1960's
switch to another product
Buyers are fragmented (many, different) - no
buyer has any particular influence on product Most consumer products
or price
Producers supply critical portions of buyers'
Intel's relationship with PC manufacturers
input - distribution of purchases
 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 the 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. The following tables outline some factors that determine
supplier power.

Suppliers are Powerful if: Example

Baxter International, manufacturer of hospital
Credible forward integration threat by
supplies, acquired American Hospital Supply,
suppliers
a distributor
Suppliers concentrated Drug industry's relationship to hospitals
Significant cost to switch suppliers Microsoft's relationship with PC manufacturers
Boycott of grocery stores selling non-union
Customers Powerful 
picked grapes
 
Suppliers are Weak if: Example
Many competitive suppliers - product is Tire industry relationship to automobile
standardized manufacturers
Purchase commodity products Grocery store brand label products
Credible backward integration threat by Timber producers relationship to paper
purchasers companies
Garment industry relationship to major
Concentrated purchasers
department stores
Customers Weak Travel agents' relationship to airlines
V. Barriers to Entry / Threat of Entry

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.

Barriers to entry are more than the normal equilibrium adjustments that markets typically
make. For example, when industry profits increase, we would expect additional firms to enter
the market to take advantage of the high profit levels, over time driving down profits for all
firms in the industry. When profits decrease, we would expect some firms to exit the market
thus restoring a 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. Although the principal role of the government in a

market is to preserve competition through anti-trust actions, government also restricts
competition through the granting of monopolies and through regulation. Industries
such as utilities are considered natural monopolies because it has been more efficient
to have one electric company provide power to a locality than to permit many electric
companies to compete in a local market. To restrain utilities from exploiting this
advantage, government permits a monopoly, but regulates the industry. Illustrative of
this kind of barrier to entry is the local cable company. The franchise to a cable
provider may be granted by competitive bidding, but once the franchise is awarded by
a community a monopoly is created. Local governments were not effective in
monitoring price gouging by cable operators, so the federal government has enacted
legislation to review and restrict prices.

The regulatory authority of the government in restricting competition is historically

evident in the banking industry. Until the 1970's, the markets that banks could enter
were limited by state governments. As a result, most banks were local commercial and
retail banking facilities. Banks competed through strategies that emphasized simple
marketing devices such as awarding toasters to new customers for opening a checking
account. When banks were deregulated, banks were permitted to cross state
boundaries and expand their markets. Deregulation of banks intensified rivalry and
created uncertainty for banks as they attempted to maintain market share. In the late
1970's, the strategy of banks shifted from simple marketing tactics to mergers and
geographic expansion as rivals attempted to expand markets.
 2. Patents and proprietary knowledge serve to restrict entry into an industry. Ideas
and knowledge that provide competitive advantages are treated as private property
when patented, preventing others from using the knowledge and thus creating a barrier
to entry. Edwin Land introduced the Polaroid camera in 1947 and held a monopoly in
the instant photography industry. In 1975, Kodak attempted to enter the instant camera
market and sold a comparable camera. Polaroid sued for patent infringement and won,
keeping Kodak out of the instant camera industry.
3. Asset specificity inhibits entry into an industry. Asset specificity is the extent to
which the firm's assets can be utilized to produce a different product. When an
industry requires highly specialized technology or plants and equipment, potential
entrants are reluctant to commit to acquiring specialized assets that cannot be sold or
converted into other uses if the venture fails. Asset specificity provides a barrier to
entry for two reasons: First, when firms already hold specialized assets they fiercely
resist efforts by others from taking their market share. New entrants can anticipate
aggressive rivalry. For example, Kodak had much capital invested in its photographic
equipment business and aggressively resisted efforts by Fuji to intrude in its market.
These assets are both large and industry specific. The second reason is that potential
entrants are reluctant to make investments in highly specialized assets.

4. Organizational (Internal) Economies of Scale. The most cost efficient level of

production is termed Minimum Efficient Scale (MES). This is the point at which unit
costs for production are at minimum - i.e., the most cost efficient level of production.
If MES for firms in an industry is known, then we can determine the amount of market
share necessary for low cost entry or cost parity with rivals. For example, in long
distance communications roughly 10% of the market is necessary for MES. If sales for
a long distance operator fail to reach 10% of the market, the firm is not competitive.

The existence of such an economy of scale creates a barrier to entry. The greater the
difference between industry MES and entry unit costs, the greater the barrier to entry.
So industries with high MES deter entry of small, start-up businesses. To operate at
less than MES there must be a consideration that permits the firm to sell at a premium
price - such as product differentiation or local monopoly.

Barriers to exit work similarly to barriers to entry. Exit barriers limit the ability of a firm to
leave the market and can exacerbate rivalry - unable to leave the industry, a firm must
compete. Some of an industry's entry and exit barriers can be summarized as follows:
Easy to Enter if there is: Difficult to Enter if there is:

 Common technology  Patented or proprietary know-how

 Little brand franchise  Difficulty in brand switching

 Access to distribution channels  Restricted distribution channels

 Low scale threshold  High scale threshold

Easy to Exit if there are: Difficult to Exit if there are:

 Salable assets  Specialized assets

 Low exit costs  High exit costs

 Independent businesses  Interrelated businesses