Porter’s Five Forces model is a tool created by Michael Porter to understand the level of competition in a business environment. To do this, the model analyzes the five competitive forces that exist in every industry. It then tries to determine the strengths and weaknesses in that industry.
The forces help you determine if your strategy has potential for future profitability. Let’s look at each of the five forces in detail.
1. The Potential Threat of New Entrants to the Industry
How easy is it for new businesses and competitors to enter and exit the market? If it’s relatively easy, it tends to lead to established businesses losing market share. As new entrants come into the market, businesses charge lower prices to try and keep or increase their market share.
Established companies enjoying above-average profits will likely have to suddenly decrease their prices and face squeezed profit margins because of the competition from the new entrants. The increase in supply also puts downward pressure on prices.
Therefore, this force depends on the barriers to entry that exist in the industry to determine how businesses will function. In this case, the barriers refer to the obstacles and costs new businesses face when entering a market. These barriers include:
a. Economies of scale can decide whether you’ll be successful.
This concept explains how the cost of production will go down once production efficiency increases. As more goods are produced, the cost is spread over a larger number of goods, thus resulting in lower costs overall. Businesses that have already been established in an industry will most likely experience economies of scale. This makes it hard for new, smaller businesses to enter into the industry and immediately start competing.
b. Some industries may struggle to meet the required capital.
Certain industries require a much higher amount of capital to set up a business. For example, a business may need a large initial investment to set up its infrastructure. An example would be the telecommunications industry. If potential entrants are unable to match the capital required, they will not be able to enter the industry.
c. Brand loyalty of local consumers may hinder new players.
Most consumers tend to have specific brands and specific products that they buy, which decreases the threat of substitutes. For example, though there are many soft drinks available in the market, you will rarely find a Coca-Cola drinker buying Pepsi, or vice versa. New players will find it difficult to break into markets that have established businesses with entrenched brand loyalty among consumers.
d. Retaliation methods can play a role.
If an industry already has established businesses, it can force a new competitor out of the market with strategies like price reductions. The established businesses realize that their economies of scale are better than those of a new entrant, and they are also more likely to have balance sheets that can withstand price reductions while the established businesses fight off new entrants.
This leads the established businesses to reduce their prices to the point where the new competitor is not able to compete in the market anymore. Undercutting competition through price reductions is an effective competitive strategy, even though there are laws protecting new entrants in most countries.
e. Supply chain connections inside the market make it tougher for new entrants.
Established businesses will already have supplier connections and distribution channels. Most of these businesses will have exclusive contracts with the various vendors in their supply chains in order to ensure low-cost supplies. This will be tough to beat for new entrants as they struggle to find suppliers in the market at competitive rates.
Let’s take one of the biggest giants in the e-commerce industry: Amazon. It has been in business since July 5, 1994, enjoying a competitive advantage of economies of scale, supplier relationships, and brand loyalty. Certain businesses can compete with them, like Walmart, which has an established presence, lower costs, and a good customer base. However, any new business trying to enter into the many different industries in which Amazon operates will face an uphill battle, if not certain death.
2. The Power of Suppliers
This force analyzes how much control a supplier has over the prices of its products in the market. When dealing with powerful suppliers, businesses are likely to face increases in input costs as suppliers try to take advantage of their control in the market. The key factors of supplier power are as follows:
a. The number of suppliers in the industry.
This will depend on the industry, but fewer suppliers means higher barriers to entry. If the market is run by a monopoly (one supplier) or an oligopoly (a small group of suppliers), then they are most likely going to control the prices in the market. Because there is very little competition, buyer power is low because buyers must either accept the prices that have been offered or not receive their supplies at all.
b. The difficulty of producing/acquiring supplies.
Sometimes, supplies are difficult to find or manufacture. In those cases, suppliers are going to have most of the power. For example, if a mobile chip is produced by only one company, for example, due to patents or difficulties finding the necessary raw materials, then pricing will be determined by that company.
c. The cost of switching to an alternate supplier.
In any industry, if switching costs are low, then it is relatively easy for a business to buy from a cheaper alternative and reduce unit costs. As a result of this, suppliers will keep their prices competitive and on par with industry prices to maintain their customer base. For example, the fast-food industry faces fierce competition, so restaurants must keep prices in line with other fast-food restaurants or risk losing some of their customers to cheaper alternatives.
d. The brand name of the supplier.
There are big brand names in almost every industry that are able to act independently from industry standards because of the brand name and reputation they have built for themselves. They have brand loyalty from their customers and are known for their higher quality, so they are in a better position to charge higher prices with less repercussion.
Let’s take Apple, for example. Apple has few potential competitors because of its business strategy to constantly innovate, resulting in a loyal following of consumers hungry for the next cutting-edge product. Apple has built its brand to such an extent that it can charge higher prices than its competitors and still have a relatively large market share.
The power of suppliers is high when:
The number of suppliers is low
The difficulty of production/acquisition is great
The cost of switching is high
The power of suppliers is low when:
The number of suppliers is high
The difficulty of production/acquisition is low
The cost of switching is low
Looking at the airline industry, for example, we can see that it has low supplier bargaining power. The two factors to analyze are as follows:
- The number of suppliers. Suppliers in the airline industry are vendors that supply catering services, jet fuel, media equipment, etc. Because of the large number of vendors supplying various goods and services to airlines, airlines are able to switch suppliers at any moment without much negative impact.
- The difficulty of acquisition. Supplies needed by airlines are general items that any company can provide to the airline industry. Also, airlines need very large quantities of most goods and services, and so suppliers will lose a large volume of orders if an airline shifts to a competitor. This means that suppliers will typically go to great lengths to keep their business with an airline.
3. The Power of Buyers
This force looks at consumers in any given industry and how much power they have over the prices and quality of products. Everything else being equal, consumers would universally want lower prices, and they would have the power to do this depending on the following:
a. The number of buyers in the industry compared to sellers.
If there are more buyers in the market than sellers, then the demand for certain products is going to surpass the supply. When this is the case, suppliers can charge a higher price for the product because consumers would be willing to buy the product even at higher prices.
b. Whether the buyer is dependent on the supplier.
If a certain product from a supplier can be easily purchased from another supplier, then the buyer’s bargaining power is high. However, some suppliers are able to create a dependency on their product which makes moving to another brand a tougher transition. For example, moving from a Microsoft Windows system to a macOS system can be a big change for a consumer.
c. How difficult or costly it is to switch to a competitor.
If there are no other alternatives and buyers are forced to purchase from one or a few suppliers, then their bargaining power is low. For example, there are only a few airlines that operate in most countries. As a result, the bargaining power of customers is low and they are not able to affect the prices of flights.
d. Whether the product is differentiated or not.
When a supplier is able to distinguish itself from other competitors showing what it does differently, it is likely to have a good brand name, brand loyalty, and more chance for growth. This gives the buyers lower bargaining power because they are attracted to this product/brand.
The general idea as a business is that if you have a small but powerful set of clients, then they have more individual power and are able to leverage this against you to get lower prices and higher quality. However, the more customers a business has, the more the power is distributed until the overall customer bargaining power is low.
Let’s take the telecommunications industry and put it to the test to see who has the higher power: the buyer or the seller.
- Buyers versus suppliers in the market. There are a lot more consumers than suppliers of telecommunications services in the market. In fact, the market is usually controlled by a small group of providers. Therefore, the bargaining or buying power of customers is low.
- Dependence on the supplier. The service is mostly the same across all the providers. There are only differences in packages, pricing, coverage, and customer service. However, most consumers like to stick with the same phone number or the same carrier because it’s “what they are used to.” As such, the buying power here would be medium.
- The cost of switching. In order to switch to another service, there isn’t too much of a cost to the consumer, and they are able to do it quickly and easily. Again, the buying power here would be medium.
Examining these three factors together, we see that the buyer has medium to low bargaining power in the telecommunications industry.
4. The Threat of Substitute Products or Services
With this force, we look at how simple it is for buyers to switch from using one business’s products to another. To clarify what a substitute is, here’s an example. Sliced cheese that you buy from a supermarket will have multiple brands selling the same product. This is not a substitute. A substitute is when you decide to use a laptop instead of a desktop.
In essence, a substitute will fulfill the same needs but using different techniques/methods. As a business, an ideal situation would be to have no close substitutes for their product. This way, the business will have full control over the market.
These are the important factors that help determine how much of a threat substitutes are in any market:
a. The total number of substitutes available.
In any market where there are many substitutes available for a business’s products, that business has less control over the market. Consumers can switch to another substitute with little cost or negative effect. Businesses need to be careful with their pricing, promotions, strategies, and customer service.
b. The cost of switching to a substitute.
Some markets may have substitutes available, but the cost of switching to one of them may not be worth the effort. For example, you may have a vehicle, and as a substitute, there may be commuting options such as a train, Uber, Lyft, etc. However, switching to this mode of travel is less convenient or more expensive than driving a car.
c. Whether the product is differentiated or not.
If a business’s products have unique properties that other products don’t, or if the whole product simply cannot be substituted, then the business has all or most of the power. For example, let’s again take Apple and its whole ecosystem. There are no other brands that offer the same ecosystem and connectivity as Apple, making it difficult to substitute completely.
d. Whether the price justifies the performance.
There may be multiple substitutes for a product or service, but the substitutes need to provide equal or more satisfaction for the price it demands. Consumers will switch to the substitute only once they have determined that they are getting a better overall deal from the substitute.
For example, consumers who want to take high-quality videos don’t need an expensive camera anymore. There are smartphone options at much lower prices that also film high-quality videos.
Let’s again take the airline industry as an example. Depending on the location, consumers will be able to get from point A to point B using multiple travel modes: plane, cruise, car, taxi, or public transportation.
The total number of substitutes.
There are quite a few options available. But this will depend on the consumer’s needs such as distance, timing, and comfort.
- The cost of switching. Depending on the location, the cost of switching modes of travel can be either high or low. In some areas, flights are cheap, but in others, they are not. If there are cheaper substitutes for flights, consumers are more likely to take them.
- Whether it is differentiated. Airlines don’t have much differentiation, and so it mostly just comes down to the service they offer.
- Price justifies the performance. There are new substitutes coming out or being announced in the world, such as Tesla with its electric vehicles or the new HyperLoop concept that it is working on. With more additions like this, there is a definite threat to the airline industry in the future.
5. Rivalry among the Competition
This force analyzes the existing competition in the market to identify how many competitors there are, what each of them specifically does, and how intense the competition is. If there are only a few businesses in the market, the competitive rivalry between them is going to be high. This means that each of them is likely to become engaged in price wars and aggressive promotional tactics.
If you are a new entrant in a high competition market, you will have to watch for prices being undercut, high-quality products, and keeping up with the promotional tactics of your competitors. If you are not able to compete, they will capture a larger share of the overall market.
Below are the factors used to determine a market’s competition levels:
a. The total number and size of competitors.
For markets with many competitors, if these competitors are of the same size or growing at a steady rate, the competition is going to be really intense. The competition can also go on for extended periods of time, resulting in favorable prices and high quality of products for the consumers.
b. How quickly the industry is growing.
If the market is just emerging and starting to grow, there will be more market share to capture, meaning that the competition levels will be high as all the businesses try to get a foothold in the market. If the market is stagnant, then the competition will be focused on the top players as they fight for the remaining market share.
c. Whether fixed costs are high.
For a business where manufacturing costs are high, the cost of being idle is huge. These businesses will want to sell their products/services even at loss to earn revenue. Therefore, competition will be high as these businesses lower their prices to compete with each other.
d. Whether there are high barriers to exit.
If there is a huge cost to leaving the market, then businesses would instead choose to remain in the market and try to capture more market share. This will increase the competition level.
Let’s look at the grocery or retail industries in countries like the United States. There are tens of thousands of these stores across the country. Brands fight among each other to offer the same products at lower prices to consumers.
- Number and size of competitors. There are many big grocery and retail chains across the country that are around the same size, such as Target and Walmart. They will constantly compete against each other to get more market share.
- Industry growth. The whole industry is still growing as consumers will use these stores for their daily purchases. Taking into account online shopping as well, there is a lot of space for growth in the industry meaning more intense competition in the future.
- Fixed costs. There is a lot of costs tied up in running physical stores, carrying inventory, maintaining employees, etc. Simply trying to give up and leave the market is going to end up with significant winding-up costs. Competition in this space has likely already considered this issue and is likely to just stay in the market and try to win more customers.
With the addition of online store options, this industry will most certainly continue to face intense competition over the coming years.
Michael Porter’s Five Forces model states there are many other factors that affect the level of competition in an industry. These include government intervention and technological improvements. However, these factors are situationally based. They are not key factors in the overall competitive environment but true permanent competitive factors. Nevertheless, his five competitive forces are key tools in helping to determine business strategy.
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