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The five forces that shape industry competition

The five forces that shape industry competition.
© Coventry University. CC BY-NC 4.0
Understanding the economic forces of an industry is essential to making good, strategic decisions that will help your company to sustain competitive advantage.
The attractiveness of an industry or sector is determined by its industry structure. The five forces framework has become widely used because it is a straightforward tool to analyse an industry structure.
Porter claims that the attractiveness of an industry is determined by the following forces:
  1. Rivalry amongst existing competitors
  2. Threat of new entrants
  3. Bargaining power of suppliers
  4. Bargaining power of buyers
  5. Threats of substitute products or services
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Adapted from: Porter (2008) Harvard Business Review.
By applying the above model, managers are able to evaluate the attractiveness of an industry.

Rivalry amongst existing competitors

According to Porter (1990), for most industries, the major determinant of profitability is competition among incumbent firms. This happens because, under intense competition, companies tend to offer price discounts, introduce new products and spend more money on advertising.
Competition rivalry is high when:
  • Entry is likely
  • There are substitutes
  • Competitors are in balance
  • There is slow market growth
  • There are high fixed costs
  • Markets are undifferentiated
  • There are high exit barriers

Threat of new entrants

New entrants to an industry are bad news for incumbent firms. They will increase supply, put pressure on prices and intensify competition. Newcomers can disrupt the sector by adopting different business models.
The threat of new entrants in an industry will depend on the following entry barriers:
  • Economies of scale
  • Capital requirements of entry
  • Access to distribution channels
  • Cost advantages independent of size
  • Expected retaliation
  • Legislation or government action
  • Differentiation

Bargaining power of suppliers

Powerful suppliers can have a negative effect on profitability, as they can charge higher prices. Microsoft is a typical example of a powerful supplier that has exercised its power of negotiation, by increasing prices and squeezing profitability out of an industry unable to pass on cost increases to its customers.
Supplier power is high when:
  • There is a concentration of suppliers
  • Switching costs are high
  • The supplier brand is powerful
  • Integration forward by the supplier is possible
  • Customers are fragmented and bargaining power is low

Bargaining power of buyers

Powerful buyers make an industry more competitive and affect the company’s ability to achieve profitability. Industries with strong buyers are forced to lower prices, improve product quality and offer better services.
Buyer power is likely to be high when:
  • There is a concentration of buyers
  • Components or materials are a high percentage of cost to the buyer, leading to “shopping around”
  • Switching costs are low
  • There is a threat of backward integration
  • There are many small operators in the supplying industry
  • There are alternative sources of supply

Threats of substitute products or services

A substitute is a product or service from another industry that satisfies the same buyer need. For instance, telecommunications applications such as Skype or Zoom are replacing landline phones.
Industries that have several substitutes suffer. For example, the entertainment industry has a lot of substitutes making it difficult for companies operating in this industry to remain profitable.
Substitutes take different forms:
  • Product substitution
  • Substitution of a need (e.g. better toothpaste reduces the need for dentists)
  • Generic substitution (e.g. something identical with different brand)
  • Doing without (e.g. cigarettes)

The above model helps companies to understand the industry structure, and to develop strategies that minimise Porter’s Five Forces.
This is not an easy task for a company that operates in one market. However, it is even more complex for companies operating in different markets, as economic forces will differ among the markets and are not static.
Also, when you operate only in one market you can predict the responses of your direct competitors to your strategic decisions. This is very difficult when competing in different countries with companies that have different cultures and adopt different business models.
Multinational corporations must assess growth rates, unemployment, political stability, government policies and regulations, restrictions on foreign investment, protection of intellectual property, foreign exchange rates, factors of production and infrastructure.

Your task

How do you think managers can use Porter’s Five Forces to develop a competitive advantage?

References

Porter, M. E. (2008). The five competitive forces that shape strategy. Harvard Business Review.
Porter, M. E. (1990). The competitive advantage of nations. Harvard Business Review.
© Coventry University. CC BY-NC 4.0
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