March 20th, 2012 Five Forces of Competition
Michael Porter's 5 forces analysis is a framework for industry analysis and business strategy development developed by Michael Porter of Harvard Business School in 1979 . It uses concepts developed in Industrial Organization (IO) economics to derive 5 forces that determine the competitive intensity and therefore attractiveness of a market. Porter referred to these forces as the microenvironment, to contrast it with the more general term macroenvironment. They consist of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of the forces normally requires a company to re-assess the marketplace.
Strategy consultants use Porter's five forces framework when making a qualitative evaluation of a firm's strategic position. The framework is textbook material for modern business studies and therefore widely known.
Porter's Five Forces include three forces from 'horizontal' competition: threat of substitute products, the threat of established rivals, and the threat of new entrants; and two forces from 'vertical' competition: the bargaining power of suppliers, bargaining power of customers.
Each of these forces has several determinants:
The threat of substitute products
The existence of close substitute products increases the propensity of customers to switch to alternatives in response to price increases (high elasticity of demand).
- buyer propensity to substitute
- relative price performance of substitutes
- buyer switching costs
- perceived level of product differentiation
The threat of the entry of new competitors
Profitable markets that yield high returns will draw firms. The results is many new entrants, which will effectively decrease profitability. Unless the entry of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level (perfect competition).
- the existence of barriers to entry (patents, rights, etc.)
- economies of product differences
- brand equity
- switching costs or sunk costs
- capital requirements
- access to distribution
- absolute cost advantages
- learning curve advantages
- expected retaliation by incumbents
- government policies
The intensity of competitive rivalry
For most industries, this is the major determinant of the competitiveness of the industry. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.
- number of competitors
- rate of industry growth
- intermittent industry overcapacity
- exit barriers
- diversity of competitors
- informational complexity and asymmetry
- fixed cost allocation per value added
- level of advertising expense
The bargaining power of customers
Also described as the market of outputs. The ability of customers to put the firm under pressure and it also affects the customer's sensitivity to price changes.
- buyer concentration to firm concentration ratio
- bargaining leverage
- buyer volume
- buyer switching costs relative to firm switching costs
- buyer information availability
- ability to backward integrate
- availability of existing substitute products
- buyer price sensitivity
- price of total purchase
- RFM Analysis
The bargaining power of suppliers
Also described as market of inputs. Suppliers of raw materials, components, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers may refuse to work with the firm, or e.g. charge excessively high prices for unique resources.
- supplier switching costs relative to firm switching costs
- degree of differentiation of inputs
- presence of substitute inputs
- supplier concentration to firm concentration ratio
- threat of forward integration by suppliers relative to the threat of backward integration by firms
- cost of inputs relative to selling price of the product
This 5 forces analysis is just one part of the complete Porter strategic models. The other elements are the value chain and the generic strategies.