Porter's five forces analysis is a framework that attempts to analyze the level of competition within an industry and business strategy development. It draws upon industrial organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of an Industry. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit. This analysis is associated with its principal innovator Michael E. Porter of Harvard University. Components of Poter’s Five Forces Model Threat of new entrants Threat of substitutes Bargaining power of buyers Bargaining power of suppliers Rivalry inside the industry 1. Threat of new entrants The market is full of competition. Not only the existing firms pose threat to the business, but the arrival of new entrants is also a challenge. As per the ideal scenario, the market is always open for entry and exits, resulting in comparable profits to all the firms. But, this is not applicable in the real picture market. In reality, all industries have some traits that protect their high profits and help them in warding off potential new entrants by erecting barriers 2. Threat of substitutes The substitutes can be defined as the products of other industries that have the ability to satisfy similar needs. Example: Coffee can be a substitute for tea, as it can be also used as a caffeine drink in the morning. When price of a substitute product changes, the demand of a related product also gets affected. When the number of substitute product increases, the competition also increases as the customers have more alternatives to select from. This forces the companies to raise or lower down the prices. Hence, it can be concluded that the competition created by the substitute firms is ‘price competition’. 3. Bargaining power of buyers This has an important effect on the manufacturing industry. When there many producers and there is a single customer in the market, then that situation is called as ‘monopsony’. In these markets, the position of the buyer is very strong and he sets the price. In reality, only a few monopsony markets exists. The bargaining power of the buyers compels the firms to reduce the prices and may also demand a product or service of higher quality at low price. 4. Bargaining power of suppliers Since the company needs raw material for producing, therefore the producers have to build a relationship with its suppliers. When suppliers have the power in their hands, they can exert influence on the producing firms by selling them raw materials at higher prices. Example: Wal-Mart as an organization thrives on the basis of its relationship with its suppliers. 5. Rivalry inside the industry For most industries the intensity of competitive rivalry is the major determinant of the competitiveness of the industry. Potential factors: • • • • • • Sustainable competitive advantage through innovation Competition between online and offline companies Level of advertising expense Powerful competitive strategy Firm concentration ratio Degree of transparency Strategic Management Life-cycle Strategies Industry Life-cycle Analysis A useful tool for analysing the effects of industry evolution on competitive forces is the “Industry life cycle” model, which identifies five sequential stages in the evolution of an industry, viz., embryonic, growth, shakeout, maturity and decline. The strength and nature of each of Porter’s five competitive forces (particularly, those of ‘risk of entry by potential competitors’ and ‘rivalry among existing firms’) change as an industry evolves and managers have to anticipate these changes and formulate appropriate strategies. Shakeout Growth Sales & Profits Embryonic Time Maturity Note: This discussion is regarding Industry Life-cycle analysis, SALES In the light of Porter’s Five-forces model. It is not to be confused with Product Life-Cycle PROFITS strategies. Decline Dr. B. K. Mukherjee 2 Stage v/s Strategy EMBRYONIC STATE: Industry is just beginning to develop (eg., personal computers in 1976). Growth at this stage is slow due to factors such as: Buyers’ unfamiliarity with the industry’s products, High prices due to poor economies of scale, and Poorly developed distribution channels. Barriers to entry tend to be based on access to key technological know-how. Higher the complexity, higher the barrier for new entrants. Rivalry is based not so much on price as on educating customers, opening up distribution channels, and perfecting the design of the product. The company that is first to solve design problems or employ innovative efforts is often able to build up a significant market share, eg. Personal computers (Apple), vacuum cleaners (Hoover) and photocopiers (Xerox – the ultimate proof of the success of a brand). The company has major opportunity to capitalize on the lack of rivalry and build up a strong market presence. Dr. B. K. Mukherjee 3 Growth stage In this stage, demand is expanding rapidly and the industry’s products take off because Customers have become familiar with the product, Prices fall because experience and economies of scale have been attained, and Distribution channels have developed. The U.S. cell-phone industry was in the growth stage most of the 1990s. In 1990 there were only 5 million cellular subscribers in the nation. By 2002, this figure had increased to 88 million and demand was growing @ more than 25% per year. Entry barriers: Control over technological knowledge has diminished by this time, also few companies have yet achieved significant scale of economies or built brand loyalty. Thus, threat from potential competitors is generally highest at this point. Rivalry: High growth rate usually means new entrants can be absorbed into an industry without marked increase in intensity of rivalry. Thus, rivalry tends to relatively low. A strategically aware company takes advantage of this relatively benign environment to prepare itself for the forthcoming intense competition in the shakeout stage. Dr. B. K. Mukherjee 4 Industry Shakeout Explosive growth cannot be maintained indefinitely. Sooner or later, rate of growth slows, demand approaches saturation levels and most of the demand is limited to replacement because there are few potential first-time buyers left (eg., U.S. personal computer industry – Dell Computers case). As an industry enters the shakeout stage, rivalry between companies become intense. Companies accustomed to rapid growth had in the past installed large production facilities. However, demand is no longer growing at historical rates, resulting today in excess capacity. Rivalry: In an attempt to utilize this capacity, companies often cut prices. The result can be a price war, which drives many of the most inefficient companies to bankruptcy. New entrants: Not a significant factor at this stage. It is now a case of “survival of the fittest” which is enough to deter any new entry. Dr. B. K. Mukherjee 5 Mature stage The companies that survive the shakeout enter the mature stage of the industry: the market is totally saturated, demand is limited to replacement demand, and growth is low or zero. Whatever growth there is comes from population expansion or from increase in replacement demand. Barriers to entry increase and the threat of entry from potential competitors decrease. Competition for market share drives down prices, often resulting in a price war (eg. Airline and PC industries). To survive the shakeout, companies begin to focus on cost minimization and building brand loyalty (eg, low-cost airlines and ‘frequent flyer’ programs, excellent after-sales service by PC companies). Only those with brand loyalty and low-cost operations will survive. At the same time, high entry barriers in mature industries give companies the opportunity to increase prices and profits. The end result will be a more consolidated industry structure. Rivalry: In mature industries, companies tend to recognize their interdependence. They try to avoid price wars and enter into cartels/price leadership/market segment agreements (eg, the domestic pressure cooker industry), thereby allowing greater profitability. However, an economic slump can depress industry demand, reduce profits, break down agreements, increase rivalry and result in renewed price wars. Dr. B. K. Mukherjee 6 Decline stage Eventually, most industries enter a decline stage: growth becomes negative for a variety of reasons, including Technological substitution (eg, air travel for rail travel); Social changes (eg, greater health consciousness hitting tobacco sales); Demographics (declining birthrate hurting the babycare and child products market); and International competition (cheap Chinese imports flooding many world markets). The main problem is once again that of excess capacity and, in such a scenario, rivalry among established companies usually increases. Exit barriers play a part in adjusting excess capacity. The greater the exit barriers, the harder it is for companies to reduce capacity and greater is the threat of severe price competition. (However, there is always the scope for ‘end-game strategy’ at this stage). In summary, Strategic managers have to tailor their strategies to changing industry conditions. They have to learn to recognize the crucial points in an industry’s development so that they can forecast when the shakeout stage might begin or when the industry might move into decline. Dr. B. K. Mukherjee 7
