five forces of competition
Robert M. Grant
ORIGINS AND SIGNIFICANCE OF THE FIVE
FORCES FRAMEWORK
Introduced by Michael Porter in 1979, the
Five Forces of Competition framework has
become the best known and most widely applied
analytical framework in strategic management.
This framework shows how the structure of
an industry determines both the intensity of
competition within the industry and the level
of profitability within that industry (see
INDUSTRY ANALYSIS). It is used to guide decisions concerning the most attractive industries
and markets for a firm to enter, the allocation of
resources among a firm’s different businesses,
strategies to influence industry structure, and
the competitive positioning of a firm within
its industry. Hence, this framework is relevant
to both corporate strategy (deciding which
industries to be in and allocating resources
among them) and business strategy (positioning
the firm for competitive advantage).
The framework has its basis in industrial
economics, which itself is founded in the microeconomics of markets – the theories of monopoly,
oligopoly, and perfect competitions predict how
industry structure determines competition and
profit margins. Porter’s contribution was to take
the ‘‘structure-conduct-performance’’ model of
industrial economics previously applied to the
analysis of antitrust policies and to transform it
into a practical framework for identifying profit
opportunities.
THE STRUCUTRAL DETERMINANTS OF THE
FIVE COMPETITIVE FORCES
Porter’s Five Forces of Competition framework
identifies five sources of competitive pressure,
each of which depend upon features of industry
structure (Figure 1).
1.
Competition from substitutes. The price that
customers are willing to pay for a product
is impacted by the availability and price
of substitute products (see SUBSTITUTE
PRODUCTS). The absence of close substitutes for a product, as in the case of gasoline
2.
or cigarettes, means that consumers are
comparatively insensitive to price (demand
is inelastic). The existence of close substitutes means that customers will switch to
substitutes in response to price increases
for the product (demand is elastic). The
internet has provided a new source of
substitute competition that has proved
devastating for a number of established
industries. Travel agencies, newspapers,
and telecommunication providers have
all experienced severe competition from
internet-based substitutes.
Threat of entry. Profitable industries attract
new entrants. In the absence of barriers to
entry – impediments to new firms or firms
diversifying from other industries – new
entry will depress prices and profits. The
introduction of the Google’s Android
operating system has greatly facilitated
entry into smartphones causing profit
margins to drop precipitously. Entry
barriers are disadvantages that entrants face
as compared with established firms. Major
sources of barriers to entry are
– Capital requirements. The capital costs
of becoming established in an industry
can be so large as to discourage all but
the largest companies. The duopoly of
Boeing and Airbus in large passenger
jets is protected by the huge capital
costs of establishing R&D, production,
testing, and service facilities for big
airliners.
– Economies of scale. In industries that
require large, indivisible investments
in production facilities or technology or
research or marketing, cost efficiency
requires amortizing these indivisible
costs over a large volume of output.
The problem for new entrants is that
they typically enter with a low market
share and, hence, are forced to accept
high unit costs.
– Product differentiation. Where products
are differentiated, established firms
possess the advantages of brand
recognition and customer loyalty. New
entrants to such markets must spend
disproportionately heavily on advertising and promotion to gain levels of
2 five forces of competition
3.
brand awareness and brand goodwill
similar to those of established companies. The massive investments by
Coca-Cola and PepsiCo, in their brands
have made it very difficult for other
companies to compete in cola drinks.
– Access to channels of distribution. For
many new suppliers of consumer goods,
the principal barrier to entry is likely
to be gaining distribution. Limited
capacity within distribution channels
(e.g., shelf space), risk aversion by
retailers and the fixed costs associated
with carrying an additional product
result in retailers being reluctant to
carry a new manufacturer’s product.
– Governmental and legal barriers. In taxi
cabs, banking, telecommunications, and
broadcasting, entry usually requires
a license from a public authority;
in knowledge-intensive industries,
patents, copyrights, and other legally
protected forms of intellectual property are major barriers to entry (see
BARRIERS TO ENTRY AND EXIT).
Rivalry between established competitors. In
most industries, the major determinant of
the overall state of competition and the
general level of profitability is competition
among the firms within the industry. In
some industries, firms compete aggressively – sometimes to the extent that prices
are pushed below the level of costs and
industry-wide losses are incurred. In other
industries, price competition is muted and
rivalry focuses on advertising, innovation,
and other non-price dimensions. The intensity of competition between established
firms is the result of interactions between
six factors. Let us look at each of them.
– Concentration. Concentration ratio
(CR) measures the extent to which an
industry is dominated by a few large
firms, CR4 measures the percentage of
industry sales held by the four biggest
firms. Industries dominated by one
or two firms (P&G’s Gillette in razor
blades, Altria and R.J. Reynolds in US
tobacco; P&G and L’Oreal in hair care
products), tend to earn above-average
returns on capital. In industries where
–
–
–
–
there are many competitors (automobiles personal computers), competition
can be intense and profits very low.
Diversity of competitors. The extent to
which a group of firms can avoid price
competition in favor of collusive pricing
practices depends on how similar they
are in their origins, objectives, costs, and
strategies. The greater the differences
among competitors, the more likely that
they will compete aggressively.
Product differentiation. The more
similar the offerings among rival firms,
the more willing are customers to
switch between them and the greater is
the inducement for firms to cut prices to
boost sales. Where the products of rival
firms are virtually indistinguishable,
the product is a commodity and price
is the sole basis for competition. By
contrast, in industries where products
are highly differentiated (perfumes,
pharmaceuticals, restaurants, management consulting services), price competition tends to be weak, even though
there may be many firms competing.
Excess capacity and exit barriers. Why
does industry profitability tend to fall so
drastically during periods of recession?
The key is the balance between demand
and capacity. Unused capacity encourages firms to offer price cuts to attract
new business (see EXCESS CAPACITY).
Where demand is insufficient to fill
capacity, a key issue is whether excess
capacity will leave the industry. Barriers
to exit are costs associated with capacity
leaving an industry. Where resources
are durable and specialized, and where
employees are entitled to job protection,
barriers to exit may be substantial.
Cost conditions. When excess capacity
causes price competition, how low
will prices go? The key factor is cost
structure. Where fixed costs are high
relative to variable costs, firms will
take on marginal business at any price
that covers variable costs (see COST
ANALYSIS). The incredible volatility of
bulk shipping rates reflects the fact that
almost all the costs of operating bulk
five forces of competition
carriers are fixed. Similarly in airlines
where the emergence of excess capacity
almost invariably leads to price wars
and industry-wide losses.
4. Bargaining power of buyers. Powerful buyers
will exert downward pressure on prices and
profits. The strength of buying power that
firms face from their customers depends on
how big they are, how few their number
is, and how price-sensitive they are. Large
retail chains are able to force large discounts
from their suppliers because of the volume
of their prices and their cost of bought in
goods is critical to their ability to compete
with one another.
5. Bargaining power of suppliers. The impact
of suppliers on prices and profits is analogous to that of buyers. Where an industry
faces a large monopoly supplier of a critical input that supplier can appropriate a
major part of the industry’s profitability.
The dismal profitability of the personal
computer industry may be attributed to
the power exercised by the suppliers of key
components (processors, disk drives, LCD
screens) and the dominant supplier of operating systems (Microsoft). Labor unions are
important sources of supplier power.
APPLICATIONS OF THE FIVE FORCES
FRAMEWORK
The analysis of industry structure has several
applications:
•
•
Understanding the drivers of competition
and profitability in an industry. Some
industries consistently earn high profits
(pharmaceuticals, personal care products,
legal services). Other industries struggle
to cover their costs (airlines, newspapers,
private health clubs).
Forecasting industry profitability. Once we
know the structural features of an industry
that determine the intensity of competition
and the level of profitability then we can
identify structural trends in an industry to
predict likely changes in how competition
and profitability. In the wireless handset
industry, structural changes include saturation in most of the world’s major markets
3
resulting in increasing excess capacity, new
entry (especially from Taiwan and China),
which increases the number of competitors
in the industry and rising buyer power as
consolidation among service providers takes
place.
• Formulating strategy. Once we understand
how industry structure influences competition which in turn determined industry
profitability, then we can use this knowledge
to help formulate strategy. In the steel
industry, Mittal’s merger with Arcelor
triggered a wave of industry consolidation
that contributed to improving industry
profitability. In the US airline industry, the
airlines have used frequent-flier schemes
to create product differentiation, they have
enhanced market power by dominating
particular airports (American at Dallas-Fort
Worth, US Airways at Charlotte NC, Delta
at Atlanta) and used mergers and alliances to
reduce the numbers of competitors on many
routes.
The idea of firms reshaping their industries
to their own advantage has been developed by
Michael Jacobides. Given that industries are in
a state of continual evolution, each firm has
the potential to influence the development of
its industry structure to suit its own interests – thereby achieving ‘‘architectural advantage.’’
Even if a firm is unable to reshape its industry
structure by understanding how industry structure drives competition, it can position itself
where competitive forces are the weakest. The
record industry, once reliant on sales of CDs,
has been devastated by the substitute competition – digital downloads, piracy, and file sharing.
Yet not all segments of the recorded music
business have been equally affected. The old
are less inclined to turn to digital downloading
than younger listeners with the result that classical music, country, and golden oldies have
become comparatively more attractive than pop
and hip-hop genres. Porter describes the success
of US truck-maker, Paccar, in sheltering itself
from the bargaining power of fleet buyers. By
focusing on the preferences of independent
owner-operators – for example, by providing
superior sleeping cabins, higher specification
4 five forces of competition
Suppliers
Bargaining power of suppliers
Industry
competitors
Potential
entrants
Threat of
new entrants
Threat of
substitutes
Substitutes
Rivalry among
existing firms
Bargaining power of buyers
Buyers
Figure 1 Porter’s Five Forces of Competition framework.
seats, a roadside assistance program – Paccar
has consistently been able to earn the higher rate
of return in the industry.
Bibliography
Grant, R.M. (2010) Contemporary Strategy Analysis,
Chapter 3, 7th edn, John Wiley & Sons, Inc.,
Hoboken, NJ.
Porter, M.E. (2008) The five competitive forces that shape
strategy. Harvard Business Review, 57 (1), 57–71.