Porter’s five forces refer to the five elements that determine a market or industry’s competition and profits. Michael Porter first described it in the Harvard Business Review article in 1979.
Those forces include the threat of new entrants, competition among existing companies, the threat of substitute products, buyers’ bargaining power, and suppliers’ bargaining power.
Those five things are essential to explain why one industry’s profitability is higher than in other industries. If all five are strong, the industry offers a low return on investment.
This model provides an important framework for analyzing the competition. Management may use it as input in strategy development. Capital market analysts or banks use it to select an attractive industry for investment allocation or lending.
This model offers guidance and makes it easier for you to analyze the industry. You gain more in-depth insight into the key variables that determine industry competition and profits.
The threat of new entrants
New entrants erode profitability. They bring new capacities to the market and seek to gain market share. They have the potential to put pressure on prices, costs, and the level of investment needed to compete.
Additional capacity increases supply in the market and pushes down market prices. To stay competitive and maintain market share, incumbents must rethink their competitive strategy
The high level of threat of entry limits the profit potential of an industry. Incumbents must ensure their prices and products remain competitive. New entrants will often adopt aggressive strategies to build a customer base and gain market share, for example, through a penetration pricing strategy. They sell low prices to attract as many and as fast customers as possible.
The threat of entry increases investment to deter new competitors and maintain current market positions.
The significance of threats of new entrants depends on two things:
- Entry barrier
- Incumbents’ competitive reactions
The high barrier of entry reduces the threat of entry. Likewise, if incumbents are likely to retaliate and launch a powerful attack, new entrants might hesitate to step in.
New entrants will weigh the long-term costs and profit. If the costs of overcoming the two things are lower than the long-term profit, they may choose to step in, even if they struggle.
Furthermore, several factors that influence barriers to entry to the industry are:
Production economies of scale. If an industry requires significant sales volumes to achieve economies of scale, entry barriers are likely high. It is unlikely the new entrants will reach economies of scale, break-even, and operate profitably soon.
Customer switching costs. High switching costs discourage consumers from switching to new products. Thus, it increases the barriers to entry because it is less likely to acquire new customers. One of the factors that influence switching costs is differentiation. Product differentiation allows customers to be loyal to existing products and reluctant to switch to new products.
Capital requirements for entry. When capital requirements are significant, barriers to entry are high. Only large companies are likely to enter and compete. This usually applies to industries that have complex and expensive production facilities such as oil refineries.
Government policy. The government may restrict access to the industry. Policies such as patents and protection of intellectual property rights also contribute to barriers to entry. They prevent anyone other than the owner from using or copying it.
Access to distribution channels. When new entrants can access multiple distribution channels, barriers to entry are likely low. New entrants do not need to invest expensively to build their own network.
Rivalry among existing companies
The great rivalry between existing players reduces the potential for industry profits. Rivalry depends on the intensity of competition and the basis of competition.
In general, the rivalry between companies is intense when:
There are a large number of players. Thus, each company only gets a small share of the market profits.
Companies are relatively similar in size and resources. No company dominates and tries to get competitors out of the market. If anyone does, it invites a competitor’s competitive reaction. And, competitors can do so credibly because their resources are relatively equal.
Industrial growth is slow. The potential demand is lower. Therefore, each of the companies will try to maximize sales by seizing the competitors’ market share.
Homogeneous product. It keeps switching costs low. Consumers can easily switch to competing products when a company increases its price. Long story short, a homogeneous product does not create customer loyalty.
Companies can’t read each other’s signals. On the other hand, if they can read each other’s signals, they are likely to engage in tacit collusion. They will use these signals to coordinate to reduce the intensity of competition.
Industry has high fixed costs. As a result, the company must achieve high sales to achieve economies of scale and break even. The intensity of competition is higher if, at the same time, industrial growth slows down.
There is idle capacity. The company strives to drive sales to produce at optimal capacity. They may lower the selling price to boost sales. That can lead to a price war.
High exit barriers. So, the number of competitors does not decrease, and each will compete fiercely to survive in the market.
Threats of substitution
Substitute products have functions and fulfill the same or similar needs as industrial products. If the threat of substitution is high, industry profitability suffers.
The threat of substitution is high when:
The performance and price of substituted products are almost similar to industrial products. In other words, the product acts as a close substitute.
Homogeneous industrial products. So that consumers buy only because of price reasons. If the price rises, they turn to substitute products. They tend to be disloyal to industrial products.
The variety of substitution products is many. It increases buyer choice, allowing them to turn to substitutes when industrial products are no longer attractive.
Substitutions are available in abundance. Consumers can find them anywhere without incurring high costs (such as transportation costs).
Low switching costs. Consumers do not bear the costs when they switch to replacement products. For example, tea is a substitute for coffee. When the tea price rises, you may switch to coffee without having to bear the extra cost.
Bargaining power of buyers
Buyers can threaten profitability by forcing prices down. Or, they demand higher quality and demand more service.
A fall in price reduces revenue. Meanwhile, high quality increases costs. Both ultimately reduce profitability.
The stronger the bargaining power of the buyers, the more significant the impact on profitability.
Buyers have high bargaining power if:
The number of buyers is less than the number of companies in the industry. An extreme case is a monopsony market, where there are only one buyer and many sellers. In this situation, the buyer may demand lower prices and higher quality. The pressure may be looser in the duopsony or oligopsony market.
Industrial products are relatively homogeneous. Buyers can easily switch to alternatives when prices go up.
Substitutions are available in abundance. It increases buyer choice, allowing them to turn to substitutes when products are no longer attractive.
Low switching costs. On the other hand, when buyers have to bear high switching costs, they are reluctant to switch. So, their bargaining power is weaker.
Buyers have the ability to threaten back. They have credible capabilities and resources to develop backward integration, produce their own products, and compete directly with companies in the industry.
Purchases represent a large proportion of industry sales. That way, they can use their position to negotiate a discount or more lenient purchase terms.
Bargaining power of suppliers
Strong suppliers suppress industry profitability by charging higher prices and limiting quality. They may also set strict sales terms.
The bargaining power of suppliers is high when:
The input has no substitutions. Thus, companies in the industry are forced to buy from suppliers because there is no alternative.
High switching costs. That may outweigh the cost savings when they switch to other suppliers. So, changing suppliers is not a better choice.
The number of suppliers is less than the number of companies in the industry. An example is a monopoly market where there is only one supplier. In this case, the supplier has absolute market power over the quantity, price, and quality of products.
Supplier profits do not depend on purchases by firms in the industry. They can cut off the supply at any time without weighing on profits.
Differentiated input. When suppliers offer unique inputs, firms in the industry are less likely to switch because they tend to be loyal.
Credible suppliers to carry out a forward integration strategy. They can cut supply, produce industrial products, and compete directly with today’s companies.
