Handout - Porter's 5 forces model

Handout for Business 189 undergraduate course in Strategic Management
Industry Level Strategic Analysis
Cournot, Porter and the Five Forces Model
Simon Rodan
Associate Professor
Department of Organization and Management
College of Business
San José State University
One Washington Square
San José, CA 95192-0070
e-mail: [email protected]
Please do not quote or reproduce without the author’s prior agreement
The implications of industry structure
To begin a strategic analysis, we begin with the industry. Question – does
the structure of the industry explain performance?
Industry concentration
Concentrated industries are ones in which a few firms account for the
majority of the total industry output. For example in the tire industry,
four firms (Goodyear, Michelin, Bridgestone and Cooper) account for 67%
of the total worldwide industry output. A popular measure of industry
concentration is the four-firm concentration ratio (often referred to as
CR4). It is the proportion of the industry’s total output produced by the
industries four largest firms. The eight-firm concentration ratio is (fairly
logically) the proportion of the industry’s total output produced by the
industries eight largest firms. The four firm concentration ratio of the tire
industry is therefore 67%.
As Cournot showed, the more fragmented (i.e. less concentrated) the less
money firms are likely to make. The more concentrated the industry, the
more likely it is that firm will be able to make money. Don’t be confused by
the notion of interdependence. While it might seem as though the more
interdependent firms are, the less money they will make, there is no
reason this should be true. In fact there is a logical relationship between
interdependence and profitability but it works the other way – the more
interdependent firms are, the more likely it is they will make above
normal returns. Signaling in support of tacit collusion is less effective the
more firms there are in the industry.
Next question – do firms compete on the basis of price or on non-price
factors? If they compete on non-price factors, there is a good chance they
will make money. Non-price based competition essentially means
competing by product differentiation – there are two aspects to a
successful differentiation strategy.
The two main questions here are:
Do the firms in the industry sell to different market segments?
Do they compete though innovation or brand development?
Market Segmentation
Segmentation means partitioning customers into groups with similar
preferences and producing a product for each group that closely meets
those preferences. Take the case of Brithinee Electric Ltd. There are two
principal segments to the rewinding business; large motors (over 100 hp)
and small motors. When X gets an enquiry about rewinding a small motor,
it refers it to Y. Conversely when Y gets an enquiry about a large motor it
-2refers the caller to X. X and Y have specialized and targeted their
operations towards different segments of the motor rewinding market,
hence they do not compete directly. In effect, each has a quazi-monolopy,
the only player providing services to that market segment. The more
concentrated the industry the fewer firms there are competing in it. The
fewer the number of firms, the more likely it is that given a certain
number of segments each will have a segment to itself (or at least
relatively few competitors in that segment.
Appropriating value
This on its own is not enough. We have to be able to appropriate this
value. By this I mean we need to find a way of getting the highest possible
price. Take the case of ATL, the ultra sound imaging company. Suppose
that their real time imaging system allows cardiologists to perform an
angioplasty procedure that makes invasive open-heart by-pass surgery
unnecessary. Imagine, for the purposes of this illustration, that the
cardiologists can charge exactly the same for an angioplasty as they would
for a by-pass operation (the patient get exactly the same value from both –
say 15 years of additional life expectancy), but that for the cardiologist,
she can now perform 3 procedures a day instead of one. Immediately we
can see what value ATL’s scanner has for the cardiologist – it’s the
additional revenues brought in by a 200% increase in patients treated and
thus a two fold increase in revenues. Now we have an idea of how much
ATL might be able to extract from the cardiologist for their scanner. The
exact numbers don’t matter but the idea is that the ATL scanner creates
value for the doctor increasing her potential willingness to pay.
However, whether she is required to pay this or not will depend on
whether there are competitors with machines on the market that offer the
same functionality as ATL. If not, then ATL can raise prices to quasimonopoly levels. If there are competitors, ATL will find itself in a more
difficult spot – more on this later.
Another way to jack up prices is to induce switching costs. If customers
have to incur costs when they switch a firm can raise prices to the point
where the difference between their price and their cheaper competitor’s is
just lower than the customer’s cost of moving to that competitor. Say I use
a Mac that costs more than a Dell PC. If I estimate it will cost me three
days lost time or three days of someone else’s time to migrate my
applications from the Mac to the PC, (which would entail a real or
opportunity cost of say $500) then Apple can maintain its prices $500
above the prices Dell charges without risking loosing existing customers.
Some credit card companies do this by awarding redeemable points,
airlines do it with air miles, and stores of all sorts with their store cards.
So to review, if barriers to entry are high, there will be few players in the
industry. If these firms can compete on non-prices factors, then they will
-3at least stand a chance of making some money. Non-price competition
boils down fundamentally to one of two "sub-strategies". First, you can
exploit transient rents, for example by continually bringing innovative
new products to market ahead of the competition. Second, you can try to
prevent customers from switching away new-product to a competitor's by
designing elements to your product offering to increase switching costs.
A point to note here is that fewer players make it more likely that you will
be able to do consistently better than the competition. The more firms
there are in the market, the more innovation begins to look like a game
involving the role of the dice. More precisely, you might think of this as a
game played in two stages. In the first stage, newly created firms reach
into a large urn and pull out 10 dice. In the second stage, firms roll the
dice repeatedly and the firm that end up rolling the highest scores, wins.
If all dice in the can identical and unbiased, then in the long run no one
firm will ever be able to consistently roll higher numbers than any other
firm. However, if some of the dice were biased, meaning that they may be
slightly biased towards, for example, sixes or ones, then the particularly
lucky firm would be one that by chance drew from the urn all 10 dice,
which biased to towards six. This firm would be likely to roll consistently
relatively high numbers, more specifically numbers that will consistently
be above the mean for all the firms.
Now imagine for the sake of argument that this firm faces only a handful
of competitors it seems a relatively improbable that any one of this firm's
competitors would also have been as lucky in its initial resource
endowment. Thus, in a concentrated market a firm fortunate enough to
have received an advantageous initial resource endowment might enjoy a
relatively long-lived advantage even as new firms entered (in other words
to dip their hands into the turn and draw 10 dice at random).
In contrast, in a highly fragmented industry with many firms, and by
implication many more firm's entering and leaving than in at the more
consolidated industry, it should not be long before one of these entering
firm's matches, initial firm's good fortune in drawing 10 biased dice. Now
our initial lucky firm faces an equally well equipped competitor. Facing a
competitor who is as likely to bring new innovative products to market
before us as we are likely to bring new products to market before them, at
best the high returns we previously enjoyed on now likely to be cut in half.
Hence, in a highly fragmented market in which firms are entering and
exiting relatively frequently, it is statistically improbable that one firm
would be likely to continue to consistently out-innovate all its competitors
in the long run. In contrast, in a concentrated market of a few players
where entry and exit is relatively infrequent, the advantage conferred by
the firm's initial fortunate resource endowment is likely to endure for
This is rivalry, the first of Michael Porter’s five forces (1980); it deals with
the degree to which firms manage to avoid (or not) costly price based
-4competition. The more firms there are in the industry, the harder that is.
Competing on non-price factors such as innovation or market
segmentation also helps avoid rivalrous competition. By building a loyal
customer base that believes your product is better than your competitor’s
means you can raise prices without a mass defection of customers to the
competition. The more loyal your customers, the closer you are to having,
in essence, a quasi monopoly.
A quick review is in order. High barriers to entry are typically associated
with concentrated industries. Concentrated industries reduce the
likelihood that existing competitors will try to occupy the same niches that
we do, or that new competitors entering the industry will be equally
fortunate in their initial resource endowments to enable them to threaten
our ability to consistently outperform the rest of the industry. The
concentration of the industry we are in is, however, not in and of itself
sufficient to guarantee above normal returns (by above normal returns we
refer to returns in excess of the cost production, the firm’s fixed costs and
the cost of capital required in the production process – in other words the
profit you earn on your investment in for example in plant and equipment,
exceeds the cost of the money you borrowed to buy that plant and
equipment and its depreciation).
To this point we have not talked at all about buyers. The logic has focused
exclusively on the focal firm's relationship to other firms in the industry
and seems that the only factor affecting prices is the behavior and by
implication the number of other firms in the industry. Buyers, although
we have not explicitly said so to this point, are assumed to be what
economists term ‘price-takers’. In this situation, individual buyers have
no influence on the price. The only thing they can do is to decide whether
the prices charged by firms in the industry a sufficiently attractive for
them to make the purchase or not.
The Bargaining Power of Buyers
This is where the second of Michael Porter's five forces comes into play.
When the buyer market is also concentrated buyers are no longer price
takers. Here, individual buyers can exert influence over individual
suppliers (us). Because a single buyer’s decision to purchase or not has an
appreciable effect on the focal firm, the focal firm could no longer take a
take-it-or-leave-it attitude towards customers. Although this may seem
somewhat strange, this is exactly what happens in a competitive market
prices are set in essence only with respect to the aggregate properties of
customer markets and with specific reference to other competing firms.
However, with a concentrated buyer’s market it is no longer possible for
the focal firm to treat customers as an aggregate group but must deal with
individual buyers and come to a negotiated agreement about products and
services rendered and the price to be paid.
-5The starting point for these negotiations is the upper limit set by the
structure of the industry. This is the oligopolistic price that the focal firm
would have charged in a price-taking, fragmented buyers market – but
since we are negotiating, the only place to go is down. In extremis, we may
face a single buyer – a monopsony. A monopsonist will reduce the amount
of product it purchases in order to depress the price it pays. When one firm
faces a single buyer, there is no analytic solution that tells us what price
will be set. However, intuition suggests that the two parties to the
negotiation will be most likely to split the surplus equally between them.
This means that the most probable outcome is one in which the price we
as the focal firm agree with the buyer will be exactly half the difference
between the buyers maximum valuation and our costs. To sum up, as the
concentration of buyers increases, so does their power and their ability to
influence (depress) prices. The more concentrated the buyers the further
below the oligopolistic supply, fragmented market price the outcome of our
negotiation with a powerful buyer is likely to be.
The Bargaining Power of suppliers
Clearly, a symmetrical argument can be made on the input side.
Previously we considered the effect of increasing concentration on the
output side. In other words the more concentrated and thus the more
powerful buyers become the more they push prices away from the
oligopolistic price we might like to charge. On the input side the
argument runs in an exactly analogous manner. Here the price we as the
focal firm would like to pay for ought inputs is the monopsony or
oligopsony price (depending on or whether there are one or a few firms in
the industry). As supplies become more powerful than any direction of
input costs are likely to move is up. As our suppliers consider restricting
output as a means of raising their profits, and by implication increasing
the price of the goods and services they are selling to us, our input costs
Returning to rivalry
Although we have not talked about rivalry explicitly, we have done so by
implication. By rivalry, we are really talking about the extent to which
competition is fought on the basis of price alone. If we can avoid price
based competition we should be able to keep prices above long run average
costs. Even when it differentiation is impossible and there is little or no
scope to impose switching costs on customers, Cournot suggests that by
anticipating the actions of competitors and their anticipation of our
anticipation of their actions, a tacit understanding can be arrived at with
by the output is restricted and oligopolistic quantities and prices ensue.
-6However, the Cournot solution is not always stable1. What does this
mean? Given sufficiently strong incentives to defect from this mutually
advantageous cooperative outcome, individual firms are likely to produce
more than the optimal quantity that would constitute the best outcome for
the industry as a whole, in an attempt to secure a larger slice of the pie for
themselves. This is in essence a prisoner’s dilemma game in which the
best solution would be corporate-cooperate but the outcome typically
arrived at (the equilibrium solution) is defect-defect. What turns a
potentially cozy situation of tacit collusion into a bloodbath of excess
capacity and price war is an industry that has the characteristics of
“winner takes all”. Two examples of winner takes all situations might help
illustrate this.
The first is an industry with considerable economies of scale, more
specifically where minimum efficient scale is reached at higher quantities
than the oligopolistic profit maximizing quantity. In this situation each
firm can derive small but important cost advantages compared to its
competitors by slightly increasing its output. The intuition here is that for
a single firm the reduction in the price caused by a small increase in an
output is more than compensated for by the reduction in costs associated
with that increase in output that derive from the economies of scale in the
production process.
A second example in which firms are again subject to strong incentives to
defect from cooperation is one in which there are considerable network
externalities. In fact this works it in a rather similar fashion to economies
of scale except that it acts on the value side of the equation rather than on
costs. Here increases in market share have the effect of increasing the
value to customers of the product or service you are offering. To the extent
that your firm is the only one to benefits in this way from the increase in
the installed base of your product (in other words, the more of your
product is sold in the market, the more viable of your product becomes for
customers while at the same time this increase in your product's use has
no impact on the usefulness of your competitor's product), your firm will
try to put itself in the position where it has the largest installed base of
any firm in the industry. The larger it’s installed base, the greater the
values of its products to customers, and the higher the price it will
ultimately be able to charge. However, the first goal is to achieve this
large installed base, something Microsoft for example understood very
well. One way to get there is to reduce prices initially in the order to
Stability means the price collusion will persist even when there are slight disturbances
that might knock firms off balance such as a minor down-turn in demand. When the
Courno’t predicted outcome is not stable, small perturbations may head to a cascade of
price-cutting as one firm tries to grab market share from its competitors, and red ink all
over the profit and loss statement.
-7capture the largest proportion of the market when a disproportionately
large market share has been achieved then prices can be raised.
In summary, economies of scale and network externalities, acting through
costs and value respectively, act as strong incentives for individual firms
to defect from the oligopolistic tacit collusion from which they would
collectively benefit the most. When firms defect and produce more than
the optimal oligopolistic quantities, prices fall and so typically do profits.
Exit barriers
The last factor that is likely to make competition particularly unpleasant
is exit barriers. When exit barriers are minimal firms seeing prices drop
below the long run average cost of capital will certainly exit the market.
After all, if there is nothing to prevent them from leaving, why should they
stay if the money they earn is insufficient to cover their long run costs?
However, easy exit implies that fixed assets can be disposed of pretty close
to cost. In other words by selling off your plant and equipment you could
repay the capital you have borrowed to set up in business. If you can exit
is relatively costless. On the other hand, if your assets are specific to the
industry it is unlikely you will be able to unload them on anybody because
the only firms who would have a use for them are your competitors. There
is no reason for them to bail you out by buying your plant and equipment
for anything like as much as you paid for it. Indeed, if they are
economically rational actors they will collectively reason that since you
have no alternative means of recouping your investment, as an equally
rational economic actor, you will accept even a single cent for your entire
productive capacity. In other words your likelihood of recouping any of the
investment in plant and equipment you have made to participate in this
industry is effectively zero.
If exiting the industry is not an option, the only decision you are left with
is a “produce or not”. Since your fixed costs are fixed, in other words you
will have to pay rent on the building whether you produce a single widget
or no widgets at all you are left with the following simple choice if the
price you can get for a single widget exceeds the variable costs of that
widgets, in other words the cost of materials that go into it, you are better
off producing a single widget that producing none. In other words, we will
produce widgets at any price above marginal cost. If other firms in the
industry face the same predicament, as indeed they are likely to, intuition
suggests that the likely outcome will be a market price equal to marginal
cost (which is below long run average costs) and all firms loose money in
the long run because they are not covering their fixed costs. This is the
worst possible situation imaginable.
It is exactly this situation in which many firms in the airline industry
currently find themselves. Commercial airplanes have few uses outside of
passenger air transportation. These specialized assets cannot therefore be
-8easily disposed of and constitute a significant exit barrier for an airline.
Moreover, given the high fixed costs associated with this industry
compared to the marginal costs associated with operating the fleet (the
marginal cost of a single passenger seat on the plane is practically zero)
firms have a very high incentive to defect from a collusive restriction of
capacity. Finally, one airline seat is to all intents and purposes
indistinguishable from one offered by a competing airline; in other words
differentiation between airlines is extremely difficult to achieve. Given
these three factors, a commodity product, high barriers to exit caused by
the specificity of fixed assets, and the enormous economies of scale that
arise from the high fixed costs compared to the very low variable costs
which lead to increase the likelihood of defection from a collusive
arrangements, it is little wonder that making money in the airline
industry is extremely difficult.
Threat of substitution
The threat of substitution has a somewhat similar affect on our ability to
maintain prices in excess of our long run average costs. You could think of
substitutes has in effect increasing the number of competitors in the
industry (even though they're not in the industry) because they give
buyers more options from which to choose. If there are five firms in our
industry and 25 firms in an industry that produces products that are in
effect perfect substitutes for ours, the outcome is likely to be little different
in terms of the prices we can charge that if our industry have had 30 firms
rather than only five.
Competing against new foreign competitors is not substitution. If you
make cars and your new competitors also make care they are in your
industry; cars, envy if they are made outside the US are not substitutes
for cars; they are still cars and the firms that make them are still in the
same industry. A new transit system (the Altermont Commuter Express
for example), which provides commuters with an alternative to driving, is
a substitute.
Porter, M. E. 1980. Competitive Strategy: Free Press.