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22/03/2015 Porter's Five Forces Model: analysing industry structure
http://www.tutor2u.net/business/strategy/porter_five_forces.htm 1/9
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Porter's Five Forces Model: analysing industrystructureAuthor: Jim Riley Last updated: Sunday 23 September, 2012
Overview of the Five Forces Model
Porter identified five factors that act together to determine the nature of competition within an industry. These are the:
Threat of new entrants to a marketBargaining power of suppliersBargaining power of customers (“buyers”)Threat of substitute productsDegree of competitive rivalry
He identified that high or low industry profits (e.g. soft drinks v airlines) are associated with the followingcharacteristics:
Let’s look at each one of the five forces in a little more detail to explain how they work.
Threat of new entrants to an industry
If new entrants move into an industry they will gain market share & rivalry will intensifyThe position of existing firms is stronger if there are barriers to entering the marketIf barriers to entry are low then the threat of new entrants will be high, and vice versa
Barriers to entry are, therefore, very important in determining the threat of new entrants. An industry canhave one or more barriers. The following are common examples of successful barriers:
BarrierNotes
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22/03/2015 Porter's Five Forces Model: analysing industry structure
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Investment cost High cost will deter entryHigh capital requirements might mean that only large businessescan compete
Economies of scale availableto existing firms
Lower unit costs make it difficult for smaller newcomers to breakinto the market and compete effectively
Regulatory and legalrestrictions
Each restriction can act as a barrier to entryE.g. patents provide the patent holder with protection, at least inthe short run
Product differentiation(including branding)
Existing products with strong USPs and/or brand increasecustomer loyalty and make it difficult for newcomers to gainmarket share
Access to suppliers anddistribution channels
A lack of access will make it difficult for newcomers to enter themarket
Retaliation by establishedproducts
E.g. the threat of price war will act to discourage new entrantsBut note that competition law outlaws actions like predatorypricing
What makes an industry easy or difficult to enter? The following table helps summarise the issues youshould consider:
Easy to EnterDifficult to Enter
Common technologyAccess to distribution channelsLow capital requirementsNo need to have high capacity and outputAbsence of strong brands and customer loyalty
Patented or proprietary know-howWell-established brandsRestricted distribution channelsHigh capital requirementsNeed to achieve economies of scale foracceptable unit costs
Bargaining power of suppliers
If a firm’s suppliers have bargaining power they will:
Exercise that powerSell their products at a higher priceSqueeze industry profits
If the supplier forces up the price paid for inputs, profits will be reduced. It follows that the more powerfulthe customer (buyer), the lower the price that can be achieved by buying from them.Suppliers find themselves in a powerful position when:
There are only a few large suppliersThe resource they supply is scarceThe cost of switching to an alternative supplier is high The product is easy to distinguish and loyal customers are reluctant to switchThe supplier can threaten to integrate verticallyThe customer is small and unimportantThere are no or few substitute resources available
Just how much power the supplier has is determined by factors such as:
FactorNote
Uniqueness of the inputsupplied
If the resource is essential to the buying firm and no closesubstitutes are available, suppliers are in a powerful position
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22/03/2015 Porter's Five Forces Model: analysing industry structure
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supplied substitutes are available, suppliers are in a powerful position
Number and size of firmssupplying the resources
A few large suppliers can exert more power over market pricesthat many smaller suppliers each with a small market share
Competition for the input fromother industries
If there is great competition, the supplier will be in a strongerposition
Cost of switching to alternativesources
A business may be “locked in” to using inputs from particularsuppliers – e.g. if certain components or raw materials aredesigned into their production processes. To change thesupplier may mean changing a significant part of production
Bargaining power of customers
Powerful customers are able to exert pressure to drive down prices, or increase the required quality forthe same price, and therefore reduce profits in an industry.
A great example in the UK currently is the dominant grocery supermarkets which are able exert greatpower over supply firms. You can see a great video about this issue here.
Several factors determine the bargaining power of customers, including:
FactorNote
Number of customers The smaller the number of customers, the greater their power
Their size of their orders The larger the volume, the greater the bargaining power ofcustomers
Number of firms supplying theproduct
The smaller the number of alternative suppliers, the lessopportunity customers have for shopping around
The threat of integratingbackwards
If customers pose a threat of integrating backwards they willenjoy increased power
The cost of switching Customers that are tied into using a supplier’s products (e.g. keycomponents) are less likely to switch because there would becosts involved
Customers tend to enjoy strong bargaining power when:
There are only a few of themThe customer purchases a significant proportion of output of an industryThey possess a credible backward integration threat – that is they threaten to buy the producing firmor its rivalsThey can choose from a wide range of supply firmsThey find it easy and inexpensive to switch to alternative suppliers
Threat of substitute products
A substitute product can be regarded as something that meets the same need
Substitute products are produced in a different industry –but crucially satisfy the same customer need. Ifthere are many credible substitutes to a firm’s product, they will limit the price that can be charged andwill reduce industry profits.
As an example, consider the many substitutes that consumers now have to buying a newspaper for theirnews:
22/03/2015 Porter's Five Forces Model: analysing industry structure
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The extent of the threat depends upon
The extent to which the price and performance of the substitute can match the industry’s productThe willingness of customers to switchCustomer loyalty and switching costs
If there is a threat from a rival product the firm will have to improve the performance of their products byreducing costs and therefore prices and by differentiation.
Degree of competitive rivalry
If there is intense rivalry in an industry, it will encourage businesses to engage in
Price wars (competitive price reductions),Investment in innovation & new productsIntensive promotion (sales promotion and higher spending on advertising)
All these activities are likely to increase costs and lower profits.
Several factors determine the degree of competitive rivalry; the main ones are:
FactorNote
Number of competitors in themarket
Competitive rivalry will be higher in an industry withmany current and potential competitors
Market size and growth prospects Competition is always most intense in stagnatingmarkets
Product differentiation and brandloyalty
The greater the customer loyalty the less intense thecompetitionThe lower the degree of product differentiation thegreater the intensity of price competition
The power of buyers and theavailability of substitutes
If buyers are strong and/or if close substitutes areavailable, there will be more intense competitive rivalry
Capacity utilisation The existence of spare capacity will increase theintensity of competition
The cost structure of the industry Where fixed costs are a high percentage of costs thenprofits will be very dependent on volumeAs a result there will be intense competition over marketshares
Exit barriers If it is difficult or expensive to exit an industry, firms willremain thus adding to the intensity of competition
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