The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry
The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry. Attractiveness in this context refers to the overall industry profitability. You can use this framework when introducing a new product, expanding into a new market, divesting a product line, acquiring a new business, or assessing the cause of declining sales or profitability.
In determining the competitive intensity of an industry, Porter’s Five Forces include three forces from ‘horizontal’ competition (1, 2 and 3), and two forces from ‘vertical’ competition (4 and 5):
- Existing competition: How strong is the rivalry posed by the present competition?
- Barriers to entry: What is the threat posed by new players entering the market?
- Substitutes: What is the threat posed by substitute products and services?
- Supplier bargaining power: How much bargaining power do suppliers have?
- Customer bargaining power: How much bargaining power do customers have?
The intensity of competition in an industry is affected by various factors, including:
- The number of firms in the industry, the more firms the stronger the competition because there are more firms competing for the same customers;
- Slow market growth leads to increased competition because there is only a small number of new customers entering the market each year, firms must compete to win existing customers;
- Where firms have economies of scale, that is they have relatively high fixed costs and low variable costs, the more they produce the lower their per unit costs become. This results in more intense rivalry between firms as they compete to gain market share;
- Where customers have low switching costs, this intensifies competition as firms compete to retain their current customers and steal customers from other firms;
- Low levels of product differentiation between firms leads to increased competition. Where a firm has a strong brand name or a highly differentiated product, this reduces the intensity of competition;
- Diversity of competition (for example, firms from different countries and cultures) reduces the predictability and stability in the market. Uncertainty in the market leads firms to compete more agressively, thereby driving down firm profits in the industry;
- High exit barriers increase competition because firms that might otherwise exit the industry are forced to stay and compete. A common exit barrier is where a firm has highly specialised equipment that it cannot sell or use for any other purpose; and
- An industry shakeout will result in a short period of intense competition. Where a growing market induces a large number of new firms to enter the market, a point is reached where the industry becomes crowded with competitors. When the market growth rate slows and the market becomes overcrowded, a period of intense competition, price wars and company failures ensues.
In theory, any firm should be able to enter a market, however, in reality industries often possess characteristics that prevent new players from entering the market (barriers to entry). Barriers to entry reduce the rate of entry of new firms, thus maintaining the level of profits for those firms already in the industry.
Barriers to entry may exist for various reasons, including:
- high capital costs of setting up a business in a particular industry;
- where an industry requires highly specialised equipment, potential entrants may be reluctant to commit to acquiring specialised assets that cannot be sold or converted into other uses if the venture fails;
- lack of the proprietary technology or patents that are needed to become a player in the industry;
- extensive scale and branding of existing competitors may prevent potential entrants from gaining market share and hence deter entry into the market;
- government regulations: Government may regulate to prevent new firms from entering an industry. It might do this because of the existence of a natural monopoly. A natural monopoly is an industry where one firm is able to produce the desired output at a lower social cost than could be achieved by two or more firms (social costs being the sum of private and external costs). Natural monopolies exist because of the existence of economies of scale, and examples include railways, water services, and electricity; and
- Individual firms may have economies of scale. The existence of such economies of scale creates a barrier to entry because an existing firm can produce at a much lower cost per unit than a new firm.
Economics defines substitute goods as goods for which an increase in demand for one leads to a fall in demand for the other. In the Porter’s Five Forces framework, a reference to a substitute good refers to a good in another industry. For example, natural gas is a substitute for petroleum.
Good A and good B are substitutes if they can be used in place of one another (at least in some circumstances). The existence of close substitutes constrains the ability of a firm to raise prices and, as the number of substitutes increase, the quantity demanded will become more and more sensitive to changes in the price level (i.e. price elasticity of demand for the product increases).
The threat posed by substitute goods is affected by various factors, including:
- the cost to customers of switching to a substitute product or service (switching costs). For example, the cost of switching between the Windows operating system and Apple operating system might be prohibitive because computer programs and accessories are built to work with one operating system or the other;
- buyer propensity to substitute;
- relative price-performance of substitutes; and
- perceived level of product differentiation.
Suppliers are providers of the inputs to the industry, for example, labour and raw materials. Factors that will effect the bargaining power of a supplier include:
- The number of possible suppliers and the strength of competition between suppliers;
- Whether suppliers produce homogenous or differentiated products;
- The importance of sales volume to the supplier;
- The cost to the firm of changing suppliers (switching cost);
- The presence of substitute inputs; and
- Vertical integration of the supplier or threat to become vertically integrated. Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers. For example, a car manufacturer may also own a tyre manufacturer.
Customers are the purchasers of the goods or services produced by the company. Factors that will effect the bargaining power of a customer include:
- The volume of goods or services purchased. If the customer purchases a significant proportion of output, then they will have a significant amount of bargaining power;
- The number of customers. The fewer customers there are, the more bargaining power they will have to negotiate price. For example, in America the market for defence equipment is a monopsony, a market in which there are many suppliers and only one buyer. As such, the Department of Defence has strong bargaining power to negotiate the terms of supply contracts;
- Brand name strength. A product that has a stronger brand name will be able to be sold for a higher price in the market;
- Products differentiation. A firm that produces a product or service that is unique in some way will have more bargaining power and will be able to charge a higher price in the market; and
- The availability of substitutes.
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