Michael Porter’s Five forces of the Industry Competition

Michael Porter’s work in Strategy
Profitability(Returns on Invested Capital ROIC) of selected US Industries (1992-2006)

Michael Porter made an attempt to analyze why the industries are varying between minimum of 6% and maximum of 41%. And the outcome of his analysis is the FIVE FORCES ANALYSIS.

Five forces of the Industry Competition

#1 Threat of New Entrants (aka Barriers to Entry)
All the below factors would likely push up the barriers to the entry, we will see one by one

  • High Economies of Scale: MES(Minimum Efficient Scale) is pointed in the below graph. If the industry is characterized by high MES, individual players in that particular industry cannot afford to play at that cost and if they choose somewhere less than the MES point then the cost-per-unit would me more and hence subsequently they would be thrown out of markets.

So whenever economies of scale is high which is followed by high MES, it restricts more number of players entering into the market.

  • High Product Differentiation/ Brand Equity: example Audi brand
  • High Capital Requirements: example Airline industry
  • High Switching Costs: It refers to the willingness of the customers to switch from the existing products to the new entrant products in the market. The more this cost is, the lower customers would be willing to switch.
  • High cost of accessing Distribution Channels: example FMCG dist channels
  • Absolute Advantages: like Experience, Technology, IPR, etc. These are irrespective of the scale of what we are operating on. ?? what is experience curve effect? first movers affect?
  • High Expected Retaliation: If the industry is characterized with the behavior associated to the players fighting whenever they essentially have a threat of a new entrant coming in(sth which is seen in the past), like Airline industry because of low levels of profits
  • High Level of Government Protection

Looking from an incumbents perspective, it is always good to have high barriers to entry.

Higher Barriers to Entry -> High Industry Attractiveness -> Higher Levels of Profitability

This is the only force which we need to keep up in order to have the Industry Attractiveness high. In current markets even this force is going down and business is becoming more and more difficult.

#2 Bargaining Power of Suppliers
Suppliers are likely to be powerful if:

  • Few Firms Dominate Supplier Industry: for example there are only two major suppliers in Airline Industry whereas there are 100s of airlines operating on them.
  • Few substitutes for Supplier Products (SP)
  • Buyer(industry player) not an important customer for supplier
  • Supplier is important from a (price/quality) ratio as far as the buyer is concerned
  • Supplier is Highly Differentiated
  • Supplier is able to induce high Switching Costs: The costs the market player in the industry has to bear in switching between the suppliers.
  • High Threat of Forward Integration by Supplier: Boeing(a manufacturing company) starting an airlines
  • Low Threat of Backward Integration by Buyer: Indigo(airline players) starting to manufacture airplanes
  • Rivalry among Competing Firms

Lower the suppliers are fragmented, the higher power they exhibit, so make sure the suppliers are fragmented.

Higher Bargaining Power of Suppliers -> Lower Industry Attractiveness -> Lower Levels of Profitability

#3 Bargaining Power of Buyers
Buyer groups are likely to be powerful if:

  • Buyer concentration is high (buyers of the industry product)
  • Buyer purchase accounts for a significant fraction of supplier’s sales
  • Products are undifferentiated
  • Buyers face few switching costs: between two products in the same industry
  • Buyer’s industry earns low profits? like walmart
  • Buyer presents a credible threat of backward integration

Higher Bargaining Power of Buyers -> Low Industry Attractiveness -> Lower Levels of Profitability

#4 Threat of Substitute Products
Threat of Substitute Products is high when

  • Close substitutes available
  • Low Switching Cost: between the substitutes (which may not be in the same industry)
  • High Price Value Performance of Substitutes
  • High Profitability of Producers of substitutes

For example: A substitute in an airline industry can be video conferencing. It is very important to analyze this force keeping in mind who all can be substituted for your industry products. This is one of the reasons airline industry is declining.

Higher Threat of Substitute Products -> Low Industry Attractiveness -> Lower Levels of Profitability

#5 Rivalry Among Existing Competitors
Rivalry among competition is high when:

  • Large number of competitors (aka Low Concentration Ratios)
  • Many equally balanced competitors
  • Slow growth industry: When the growth rate is very slow one player will try to get into another player’s market which increases rivalry among them.

Note: There should never be cost rivalry in any industry. When there is a rivalry with respect to the costs then most likely the entire industry will get commoditized and will become no longer attractive industry.

  • High fixed costs & high storage costs: When these costs are high every player would like sell of his products as soon as possible and thus creating rivalry.
  • Changing conditions of demand and supply
  • Capacity added in large increments: Since exact demand capacity cannot be calculated every big player add their capacities in big increments and when it turns out that there is glut in the market as every individual did the same thing, it creates rivalry.
  • Lack of product differentiation
  • Low switching costs between rivals products: between rival incumbent players in a particular industry
  • High strategic stakes: in which you not only bring the focal industry but also other industries. For example, Kingfisher survived so long even while accumulating so heavy losses is not because of the economics associated with airline industry but because of economics of other industries he had (liquor business)
  • High exit barriers: Companies which cannot compete based on the economics should go out of the industry. For example, AirIndia is being supported by Indian Govt even though it is operated under huge losses in which case it might create rivalry with other players as AirIndia itself is not sensitive to economics whereas other players are.
  • High exit barriers are always bad.

Exit barriers are high when
· Highly specialized assets?? number of buyers
· High Fixed Cost of exit (e.g., labor agreements)
· High Strategic interrelationships
· High Emotional barriers
· High Government and social restrictions
Higher Rivalry Among Existing Competitors -> Low Industry Attractiveness -> Lower Levels of Profitability

There are two more additions to these five forces but Porter still didn’t acknowledge them into this framework.
#6 Government Actions
#7 Power of Complimentors

Industry Analysis: Putting it all together

In practical situations it would neither be on the lowest side not on the highest side but some what like this:

Note: This analysis has to be done at several stages of life cycle of a product as it varies over a period of time based on the industry.

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