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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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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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