Industrial Strategies and Policies:
Porter’s five forces model.
Porter’s five forces model
POTENTIAL
ENTRANTS
Threat of
New entry
SUPPLIERS
INDUSTRY
COMPETITORS
Bargaining power
of suppliers
BUYERS
Bargaining power
of buyers
Rivalry among
existing firms
Threat of substitute goods
or services
SUBSTITUTES
The model of the Five Competitive Forces was developed by Michael E. Porter in 1980. Since that
time it has become an important tool for analyzing an organization’s industry structure in strategic
processes. Porter’s model is based on the insight that a corporate strategy should meet the
opportunities and threats in the organization’s external environment. The competitive strategy
should base on an understanding of industry structures and the way they change. Porter has
identified five competitive forces that shape every industry and every market. These forces
determine the intensity of competition and hence the profitability and attractiveness of an industry.
The objective of corporate strategy should be to modify these competitive forces in a way that
improves the position of the organization. Porters model supports analysis of the driving forces in an
industry. Based on the information derived from the Five Forces Analysis, management can decide
how to influence or to exploit particular characteristics of their industry.
The five competitive forces in Porter’s model are typically described as follows:
1. Bargaining Power of Suppliers
Suppliers have a great deal of influence over an industry as they affect price increases and product
quality. A supplier group exerts even more power over an industry if it is dominated by a few
companies, there are no substitute products, the industry is not an important consumer for the
suppliers, their product is essential to the industry, the supplier differs costs, and forward
integration potential of the supplier group exists. Labour supply can also influence the position of
the suppliers. These factors are generally out of the control of the industry or company but strategy
can alter the power of suppliers. The term 'suppliers' comprises all sources for inputs that are
needed in order to provide goods or services. Supplier bargaining power is likely to be high when:
 The market is dominated by a few large suppliers rather than a fragmented source of supply,
 There are no substitutes for the particular input,
 The suppliers customers are fragmented, so their bargaining power is low,
 The switching costs from one supplier to another are high,
 There is the possibility of the supplier integrating forwards in order to obtain higher prices
and margins. This threat is especially high when:
 The buying industry has a higher profitability than the supplying industry,
 Forward integration provides economies of scale for the supplier,
 The buying industry hinders the supplying industry in their development (e.g.
reluctance to accept new releases of products).
 The buying industry has low barriers to entry.
In such situations, the buying industry often faces a high pressure on margins from their suppliers.
The relationship to powerful suppliers can potentially reduce strategic options for the organization.
2. Bargaining Power of Buyers
The buyer's power is significant in that buyers can force prices down, demand higher quality
products or services, and, in essence, play competitors against one another, all resulting in potential
loss of industry profits. Buyers exercise more power when they are large-volume buyers, the product
is a significant aspect of the buyer's costs or purchases, the products are standard within an industry,
there are few changing or switching costs, the buyers earn low profits, potential for backward
integration of the buyer group exists, the product is not essential to the buyer's product, and the
buyer has full disclosure about supply, demand, prices, and costs. The bargaining position of buyers
changes with time and a company's (and industry's) competitive strategy. The bargaining power of
buyers determines how much buyers can impose pressure on margins and volumes. Buyers
bargaining power is likely to be high when
 they buy large volumes, there is a concentration of buyers,
 the supplying industry comprises a large number of small operators
 The supplying industry operates with high fixed costs,
 The product is undifferentiated and can be replaces by substitutes,
 Switching to an alternative product is relatively simple and is not related to high costs,
 Buyers have low margins and are price sensitive,
 Buyers could produce the product themselves,
 The product is not of strategic importance for the customer,
 The buyer knows about the production costs of the product
 There is the possibility for the buyer integrating backwards.
3 Threat of New Entrants
The higher the competition in an industry is, the easier it is for other companies to enter this
industry. In such a situation, new entrants could change major determinants of the market
environment (e.g. market shares, prices, customer loyalty) at any time. There is always a latent
pressure for reaction and adjustment for existing players in this industry.
Threats of new entrants into an industry depends largely on the extent to which there are barriers to
entry. Porter identifies a number of major barriers to entry:
 Economies of scale (minimum size requirements for profitable operations), Economies of
scale, or decline in unit costs of the product, which force the entrant to enter on a large
scale and risk a strong reaction from firms already in the industry, or accepting a
disadvantage of costs if entering on a small scale.
 High initial investments and fixed costs. Capital requirements for entry; the investment of
large capital, after all, presents a significant risk.
 Cost advantages of existing players due to experience curve effects of operation with fully
depreciated assets. Established companies already have product technology, access to raw
materials, favourable sites, advantages in the form of government subsidies, and experience.
This implies cost disadvantages for the new entrant independent of scale.
 Brand loyalty of customers. Product differentiation, or brand identification and customer
loyalty.
Protected intellectual property like patents, licenses etc, (i.e. Legislation and government
action).
 Scarcity of important resources, e.g. qualified expert staff
 Access to raw materials is controlled by existing players,
 Distribution channels are controlled by existing players. New entrants have to establish their
distribution in a market with established distribution channels to secure a space for their
product.
 Existing players have close customer relations, e.g. from long-term service contracts,
 High switching costs for buyers (Switching costs are the costs the buyer has to absorb to
switch from one supplier to another).
New entrants can also expect a barrier in the form of government policy through state regulations
and licensing. New firms can expect retaliation from existing companies and also face changing
barriers related to technology, strategic planning within the industry, and manpower and expertise
problems. The entry deterring price or the existence of a prevailing price structure presents an
additional challenge to a firm entering an established industry.
4 Threat of Substitutes
Substitute products are the natural result of industry competition, but they place a limit on
profitability within the industry. A substitute product involves the search for a product that can do
the same function as the product the industry already produces. Porter uses the example of security
brokers, who increasingly face substitutes in the form of real estate, money-market funds, and
insurance. Substitute products take on added importance as their availability increases.
A threat from substitutes exists if there are alternative products with lower prices of better
performance parameters for the same purpose. They could potentially attract a significant
proportion of market volume and hence reduce the potential sales volume for existing players. This
category also relates to complementary products. Similarly to the threat of new entrants, the threat
of substitutes is determined by factors like:
 Brand loyalty of customers,
 Close customer relationships,
 Switching costs for customers,
 The relative price for performance of substitutes,
 Current trends.
5 Competitive Rivalry between Existing Players
This force describes the intensity of competition between existing players (companies) in an
industry. High competitive pressure results in pressure on prices, margins, and hence, on profitability
for every single company in the industry. Rivalries naturally develop between companies competing
in the same market. Competitors use means such as advertising, introducing new products, more
attractive customer service and warranties, and price competition to enhance their standing and
market share in a specific industry. To Porter, the intensity of this rivalry is the result of factors like
equally balanced companies, slow growth within an industry, high fixed costs, lack of product
differentiation, overcapacity and price-cutting, diverse competitors, high-stakes investment, and the
high risk of industry exit. There are also market entry barriers.
Porter argues that the business unit must find a position in its industry where it can best defend
itself from competitive forces or seek to influence those forces to its own advantage. This structural
analysis is the fundamental underpinning for formulating competitive strategy. The elements are:
 Rivalry among existing firms. How many competitors are there and how powerful?
 Threat of new entrants. How easy is it for new competition to spring up?
 Bargaining power of buyers. If , for example, the firm is relying on just one customer for its
sales it is in a weak position compared with many customers.
 Bargaining power of suppliers. The firm can more easily secure added value if it is in a strong
position to negotiate terms with the suppliers of its inputs.
 Threat of substitute products or services. Clearly the firm has more monopoly power if there
is no threat of a close substitute for its product.
Competition between existing players is likely to be high when:
 There are many players of about the same size,
 Players have similar strategies
 There is not much differentiation between players and their products, hence, there
is much price competition.
 Low market growth rates (growth of a particular company is possible only at the
expense of a competitor),
 Barriers for exit are high (e.g. expensive and highly specialized equipment).
In summary, Porter's five-forces models concentrates on five structural industry features that
comprise the competitive environment, and hence profitability, of an industry. Applying the model
means, to be profitable, the firm has to find and establish itself in an industry so that the company
can react to the forces of competition in a favourable manner.
Use of the Information from Five Forces Analysis
Five Forces Analysis can provide valuable information for three aspects of corporate planning:
Statical Analysis:
The Five Forces Analysis allows determining the attractiveness of an industry. It provides insights on
profitability. Thus, it supports decisions about entry to or exit from and industry or a market
segment. Moreover, the model can be used to compare the impact of competitive forces on the own
organization with their impact on competitors. Competitors may have different options to react to
changes in competitive forces from their different resources and competences. This may influence
the structure of the whole industry.
Dynamical Analysis:
In combination with a PEST-Analysis, which reveals drivers for change in an industry, Five Forces
Analysis can reveal insights about the potential future attractiveness of the industry. Expected
Political, Economical, Sociodemographical and Technological(PEST) changes can influence the five
competitive forces and thus have impact on industry structures. Useful tools to determine potential
changes of competitive forces are scenarios.
Analysis of Options:
With the knowledge about intensity and power of competitive forces, organizations can develop
options to influence them in a way that improves their own competitive position. The result could be
a new strategic direction, e.g. a new positioning, differentiation for competitive products of strategic
partnerships.
Thus, Porters model of Five Competitive Forces allows a systematic and structured analysis of
market structure and competitive situation. The model can be applied to particular companies,
market segments, industries or regions. Therefore, it is necessary to determine the scope of the
market to be analyzed in a first step. Following, all relevant forces for this market are identified and
analyzed. Hence, it is not necessary to analyze all elements of all competitive forces with the same
depth. The Five Forces Model is based on microeconomics. It takes into account supply and demand,
complementary products and substitutes, the relationship between volume of production and cost
of production, and market structures like monopoly, oligopoly or perfect competition.
Influencing the Power of Five Forces.
After the analysis of current and potential future state of the five competitive forces, managers can
search for options to influence these forces in their organization’s interest. Although industryspecific business models will limit options, the own strategy can change the impact of competitive
forces on the organization. The objective is to reduce the power of competitive forces. The options
of an organization are determined not only by the external market environment, but also by its own
internal resources, competences and objectives.
The power of the Five forces can be influenced by
 Reducing the Bargaining Power of Suppliers
 Reducing the Bargaining Power of customers
 Reducing the Threat of New Entrants
 Reducing the Threat of Substitutes
 Reducing the Competitive Rivalry between Existing Players
Bargaining power of suppliers can be reduced by: Partnering, Supply chain management, Supply
chain training, Increase dependency, Build knowledge of supplier costs and methods and also take
over a supplier
Bargaining power of customers can be reduced by: Partnering, Supply chain management, Increase
loyalty, Increase incentives and value added, Move purchase decision away from price and also by
cutting powerful intermediaries (go directly to customer).
Threat of New Entrants can be reduced by: Increasing minimum efficient scales of
Operations, Creating a marketing / brand image (loyalty as a barrier), Patents, protection of
intellectual property, forming alliances with linked products / services, tying up with suppliers, tying
up with distributors and developing own retaliation tactics.
Threat of Substitutes can be reduced by: taking legal actions, Increasing switching costs, forming
alliances, carrying out Consumer surveys to learn about their preferences, entering substitute
market and influence from within and accentuating differences (real or perceived)
Competitive Rivalry between existing players can be reduced by: Avoiding price competition,
Differentiating your product, Buying out competition, Reducing industry over-capacity, Focusing on
different segments, Communicating with competitors.
Critique of Model
Porter’s model of Five Competitive Forces has been subject of much critique. Its main weakness
results from the historical context in which it was developed. In the early eighties, cyclical growth
characterized the global economy. Thus, primary corporate objectives consisted of profitability and
survival. A major prerequisite for achieving these objectives has been optimization of strategy in
relation to the external environment. At that time, development in most industries has been fairly
stable and predictable, compared with today’s dynamics. In general, the meaningfulness of this
model is reduced by the following factors:
In the economic sense, the model assumes a classic perfect market. The more an industry is
regulated, the less meaningful insights the model can deliver.
The model is best applicable for analysis of simple market structures. A comprehensive description
and analysis of all five forces gets very difficult in complex industries with multiple interrelations,
product groups, by-products and segments. A too narrow focus on particular segments of such
industries, however, bears the risk of missing important elements.
The model assumes relatively static market structures. This is hardly the case in today’s dynamic
markets. Technological breakthroughs and dynamic market entrants from start-ups or other
industries may completely change business models, entry barriers and relationships along the supply
chain within short times. The Five Forces model may have some use for later analysis of the new
situation; but it will hardly provide much meaningful advice for preventive actions.
The model is based on the idea of competition. It assumes that companies try to achieve competitive
advantages over other players in the markets as well as over suppliers or customers. With this focus,
it does not really take into consideration strategies like strategic alliances, electronic linking of
information systems of all companies along a value chain, virtual enterprise-networks or others.
Overall, Porters Five Forces Model has some major limitations in today’s market environment. It is
not able to take into account new business models and the dynamics of markets. The value of
Porters model is more that it enables managers to think about the current situation of their industry
in a structured, easy-to-understand way – as a starting point for further analysis.
Porter’s model has been criticised as being essentially static. It tells a firm how things are at a
moment of time. It does not say much about how things may alter in future. As a result, some firms
use such an approach in conjunction with an industry S- curve.
Although Porter uses numerous industry examples to illustrate his theory, since those examples are
now over twenty years old, changes in technology and other industrial shifts and trends have made
them somewhat obsolete. Porter's model does not, for example, consider nonmarket changes, such
as events in the political arena that impact an industry. Furthermore, Porter's model has come under
fire for what critics see as his under-evaluation of government regulation and antitrust violations.
Overall, criticisms of the model find their nexus in the lack of consideration by Porter of rapidly
changing industry dynamics. In virtually all instances, critics also present alternatives to Porter's
model.
The S curve shows how a typical industry evolves over time. When the product is new and relatively
unknown, sales are growing slowly. The growth phase shows the period when industry sales grow
rapidly. The market is still young. Maturity and the likely appearance of new products leads to a
negative growth in sales. The S-curve enables the company to make planning decisions according to
where it is on the curve. Even the S-curve approach is open to criticism. For example McGahan
(2000) has pointed out that life cycle phases are difficult to see, and that industry boundaries are not
as precise as implied here. She has also argued that there are substantial differences in the way that
industries evolve. Thus the S-curve has limited value as a tool for decision making.
An Industry S- curve
Growth
Introduction
Maturity
Decline
Industry sales
Time
The five forces are competitive factors which determine industry competition and include: suppliers,
rivalry within an industry, substitute products, customers or buyers, and new entrants
Although the strength of each force can vary from industry to industry, the forces, when considered
together, determine long-term profitability within the specific industrial sector. The strength of each
force is a separate function of the industry structure, which Porter defines as "the underlying
economic and technical characteristics of an industry." Collectively, the five forces affect prices,
necessary investment for competitiveness, market share, potential profits, profit margins, and
industry volume. The key to the success of an industry, and thus the key to the model, is analyzing
the changing dynamics and continuous flux between and within the five forces. Porter's model
depends on the concept of power within the relationships of the five forces.
Industrial Policy
Industrial Policy (Defined)
- relates to the policies whose main direct effect is upon individual firms and industries, or
an industry as a whole.
- Political actions designed to affect either the general mechanisms of production and
resource allocation or the actual allocation of resources among sectors of production by
means other than general monetary and fiscal policies.
- Effective and coherent implementation of all those policies which impinge on the
structural adjustment of industry with a view to promoting competitiveness.
- It covers competition policy intended to affect markets with certain characteristics or
firms; regional policy to influence the spatial location of industry- innovation policy
- Trade policies designed to protect specific firms and industries predominantly directed
at the industrial or secondary sector.
The theoretical case for industrial policy
-
Welfare enhancement (improved employment, increased output, favourable balance of
trade).
Govt intervention improves welfare in cases where markets fail to provide an efficient
utilization of resources- monopoly, public goods (eg. defence ), externalities, common
property rights.- monopoly leads to an inferior allocation of resources by restricting
output (should be increased until marginal benefit derived by consumers, the demand
curve equals the marginal cost of production).- Externalities arise when social costs and
benefits do not coincide with private costs and benefits, for example on pollution.
Property rights may not be clearly assigned. It is also noted that govt intervention is not
necessarily welfare enhancing because politicians may intervene just to ensure reelection e.g. import controls to protect workers- these benefit identified groups.
Approaches to industrial policy intervention
1. Laissez –faire- approach aims at strengthening and promoting a competitive environment
through control of monopoly, or measures to remove ambiguities in the assignment of
property rights.
2. Supportive- like laissez faire but argues for intervention to improve allocation and
enforcement of property rights, to encourage education and entrepreneurship in order to
foster the process of economic change
3. Active approach- argues for wider and more direct govt involvement in the industrial sector.
Govt agencies more involved. Selected industries would typically be given financial support
to promote restructuring and be protected from external competition by tariff and nontariff barriers. Although protected from external competition, measures would again be
taken to promote competition domestically.
4. Planning approach-extreme version of active approach- argues that welfare can be improved
through central planning. The rationale is central planners are in a better position (because
of their superior, economy-wide information- to make welfare enhancing decisions than
individual firms. This advantage is greater where info flows are imperfect and where the
economy is changing rapidly.
The accelerative industry policy is to speed up the innovation process by providing financial support
to the most promising firm, markets or technologies. The premise behind such a policy is that an
economy benefits from adopting innovations ahead of its trading rivals. Govt encourages and aids
emergence of particular sectors of the economy and emerging technologies. –aids and encourages
emergence through support of R & D programs. –assistance for R&D, aid for industrial restructuring.
Advocates of selective intervention may argue that uncertainty can be reduced by supporting firms
with a proven record, but past success is not an infallible guide to future performance. However
policy means development of other sectors is hampered. Extra taxes or higher interest rates are
imposed on firms and their customers to finance industry policy resulting in an overall reduction in
the demand for goods and services. These other sectors, although not apparently promising, may
turn out to be real winners.
Decelerative industry policy- if an essentially viable concern is facing temporary financial difficulties,
bankruptcy or liquidation may be avoided by providing assistance to help it rationalize production
methods or to improve its product range e.g. Rolls-Royce, British Leyland. If rescue is not viable then
help can be given to phase the closure, giving time for restraining and for new firms to set up in the
area. Most frequent justification for support to ‘failing’ firms is that their collapse will lead to
adverse effects on economic welfare. Externalities may arise from the closure of a major employer in
a particular locality, causing a large proportion of the population to become unemployed with
consequent ill effects on the rest of the community leading to the domino effects on other
companies. However if a firm cannot convince lenders of its basic soundness, then govt resources
should not be advanced to try to improve its operation. Furthermore, financial support from the
government may fail to promote efficiency , for it enables management, which has demonstrated its
incompetence, to retain control of the company. This is compounded by the reduced pressure on
management and unions to adapt and change. Financial support required for a short period
otherwise over a long period the financing of decelerative policy generates its own domino effects
leading to the contraction, reduced growth or even accelerated failure of companies in the
unsupported sector.
Neutral industry policy- seeks to improve the market framework within which economic agents
operate. Specific examples of neutral policy include attempts to ensure that property rights are
closely assigned. The more certain it is that the legal system will enforce such rights, the greater the
incentive for citizens to acquire private property. Typical measures include the prevention of
monopoly, enforcement of property rights, improving access to information and training and
improving the infrastructure. In order to minimise opportunity costs , programs should be designed
for ease of administration and for effectiveness in implementation. A rules-based programme may
score over one based upon discretion. Rules clearly define the way the programme operates, and so
monitoring is facilitated.
Competition Policy
According to the structure-conduct-performance (SCP) approach, competition policy should be
directed towards modifying market structures and imposing constraints on firms’ behaviour.
Competition policy encompasses measures designed either to promote a more competitive
environment or to prevent a reduction in competition. Competition policy should seek to break up
or to regulate existing monopolies. It should also control firms’ attempts to acquire such positions by
merger. More generally, competition policy should try to prevent firms undertaking practices which
adversely affect competition.
Trade Policy
Historically trade policy was the principal method of supporting domestic industries, with tariffs and
quotas the main instruments. There has been a reduction in the use of these traditional measures,
particularly in manufacturing. This is a result of the formation of the GATT and emergence of free
trade areas and customs unions (eg. EU, NAFTA). Despite the benefits of free trade, advanced
economies continue to rely heavily on trade policy. Unlike other industrial policy instruments, such
policies are frequently used to protect firms in the agricultural and service sectors, as well as in
manufacturing. Within manufacturing they tend to be concentrated on a narrow range of products
including textiles, footwear, steel, automobiles, electronic products and components.