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.