Porter's Five Forces Model of Industry Competiton
- Levels: AS, A Level
- Exam boards: AQA, Edexcel, OCR, IB
The Five Forces Model was devised by Professor Michael Porter. The model is a framework for analysing the nature of competition within an industry.
The short video below provides an overview of Porter's Five Forces model and there are some additional study notes below the video.
Introduction & Background - the Nature of Industry Competition
Every market or industry is different. Take any selection of industries and you should be able to find differences between them in terms of:
- Size (e.g. sales revenue, volumes, numbers of customers)
- Structure (e.g. the number of brands and competitors)
- Distribution channels (how the product gets from producer to final consumer)
- Customer needs and wants (the basis of marketing segmentation)
- Growth (the rate of growth and which businesses are growing faster or slower than the market)
- Product life cycle (the stage of the life cycle for the industry as a whole and for products and brands within it)
- Alternatives for the consumer (e.g. substitute products)
The result of the above differences is that industries vary in terms of how much profit they make. To take two examples:
Why do airlines make so little profit (and such big losses)? There are several factors, including:
- Very intensive competitor rivalry – mainly on price
- Low barriers to entry – lots of new airlines who want to set up
- Suppliers of aircraft & equipment are powerful – can charge high margins
- Customers have lots of substitute options – e.g. rail, car
- High fixed costs – airline losses rise significantly if revenues fall only slightly since it costs roughly the same to fly half-empty planes as full ones
By contrast, why are profits so high in the soft drinks market? The answer is mainly that:
- Customers and suppliers have little power – Pepsi has many millions of individual consumers, and thousands of retail distributors none of whom has much influence over the business
- There is high brand awareness & loyalty = less consumer desire for substitutes
- High barriers to entry – how do you enter a market dominated by Coca-Cola and Pepsi?
What we have illustrated above is some analysis that you would obtain by considering the Five Forces Model.
Porter identified five factors that act together to determine the nature of competition within an industry. These are the:
- Threat of new entrants to a market
- Bargaining power of suppliers
- Bargaining power of customers ("buyers")
- Threat of substitute products
- Degree of competitive rivalry
He identified that high or low industry profits (e.g. soft drinks v airlines) are associated with the following characteristics:
Let's look at each one of the five forces in a little more detail to explain how they work.
Threat of New Entrants
If new entrants move into an industry they will gain market share & rivalry will intensify
The position of existing firms is stronger if there are barriers to entering the market
If barriers to entry are low then the threat of new entrants will be high, and vice versa
Barriers to entry are, therefore, very important in determining the threat of new entrants. An industry can have one or more barriers. The following are common examples of successful barriers:
What makes an industry easy or difficult to enter? The following table helps summarise the issues you should consider:
Bargaining Power of Suppliers
If a firm's suppliers have bargaining power they will:
- Exercise that power
- Sell their products at a higher price
- Squeeze industry profits
If the supplier forces up the price paid for inputs, profits will be reduced. It follows that the more powerful the customer (buyer), the lower the price that can be achieved by buying from them.
Suppliers find themselves in a powerful position when:
- There are only a few large suppliers
- The resource they supply is scarce
- The cost of switching to an alternative supplier is high
- The product is easy to distinguish and loyal customers are reluctant to switch
- The supplier can threaten to integrate vertically
- The customer is small and unimportant
- There are no or few substitute resources available
Just how much power the supplier has is determined by factors such as:
Bargaining Power of Customers
Powerful customers are able to exert pressure to drive down prices, or increase the required quality for the same price, and therefore reduce profits in an industry.
A great example in the UK currently is the dominant grocery supermarkets which exert great power over supplier firms.
Several factors determine the bargaining power of customers, including:
Customers tend to enjoy strong bargaining power when:
- There are only a few of them
- The customer purchases a significant proportion of output of an industry
- They possess a credible backward integration threat – that is they threaten to buy the producing firm or its rivals
- They can choose from a wide range of supply firms
- They find it easy and inexpensive to switch to alternative suppliers
Threat of Substitute Products
A substitute product can be regarded as something that meets the same need
Substitute products are produced in a different industry –but crucially satisfy the same customer need. If there are many credible substitutes to a firm's product, they will limit the price that can be charged and will reduce industry profits.
The extent of the threat depends upon
- The extent to which the price and performance of the substitute can match the industry's product
- The willingness of customers to switch
- Customer loyalty and switching costs
If there is a threat from a rival product the firm will have to improve the performance of their products by reducing costs and therefore prices and by differentiation.
Overall Degree of Competitive Rivalry
If there is intense rivalry in an industry, it will encourage businesses to engage in
- Price wars (competitive price reductions),
- Investment in innovation & new products
- Intensive promotion (sales promotion and higher spending on advertising)
All these activities are likely to increase costs and lower profits.
Several factors determine the degree of competitive rivalry; the main ones are:
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