Business Strategy: The Five Competitive Forces
In 1980 Harvard professor Michael Porter identified five forces in a market that determine the intensity of competition. These forces are still used today to perform what is known as structural analysis of an industry. The five forces are described below.
Rivalry Among Existing Firms
The first of the forces, the intensity of the rivalry among existing firms, is the most obvious of the forces affecting the intensity of competition. This rivalry is created because firms feel threatened or see an opportunity to improve position in the market. For example, firms might view slow growth in an industry as a threat and seek to change strategy to acquire more market share.
Another situation that intensifies rivalry among firms is lack of product differentiation. When the product or service provided in the industry is the same for all companies creating it, then competition rises between firms trying to differentiate themselves based on price and customers service. However, when there are significant differences between the same product produced by firms in the industry, rivalry might wane because each firm has it own little niche.
Another factor that could have an influence on rivalry is whether firms can easily leave the industry or not. Firms that can get out of a market easily do not feel threatened because these firms can exit and go somewhere else. But for a market that cannot be exited easily, firms must stay in and fight for survival. This survival instinct could intensify the rivalry, and consequently market competition greatly.
Threat of New Firms in the Market
Some markets are easy to get into. These markets do not require major investments and unit cost changes little as quantities go up. The firms that already exist in a market such as this might feel threatened by another company entering the market. As a result, the level of competition could go up dramatically to try to capture market share and maintain that market share before any new firms enter the market.
However, some industries require extensive investment to begin operations. Also, it is possible for unit prices to drop drastically as quantities go up. This gives an existing firm leverage in its pricing strategy to ward off start up firms. In these cases, it would be very difficult for a new firm to enter a market and keep up with the existing firms. Thus, in a market with these characteristics, existing firms do not fear as much the entrance of new competitors. This decreases the intensity of competition in an industry.
Threat of Substitute Products
A substitute product or service is another product or service that can do the same thing that the original product or service does. For example, the telegraph was the method of rapid communication -- until Alexander Graham Bell invented the telephone. Once that happened, the telegraph -- and the companies that made them -- became obsolete. The development of substitute products depends primarily on developments in technology. This is why industries need to be aware of what is transpiring in the technology realm.
Industries that do not have a threat of a substitute product taking over have the intensity of competition remain unchanged. However, once a substitute becomes available and affordable, these same firms feel threatened and the intensity of competition will increase. The firms originally in the market may begin to fight for their existence and attack the new firms that market the substitute.
Bargaining Power of Buyers
Buyers can play a huge part in affecting the competition level of an industry. If there are many buyers each purchasing insignificant amounts from the industry firms, the level of competition will remain unaffected by buyers. However, once a small number of buyers purchase large quantities of goods from the industry, then the buyers have substantial power over the firms in the industry. Buyers can demand lower prices from existing suppliers or the buyers will find another supplier. This raises the level of competition because the the firm supplying the goods will need to reduce costs to meet the demand of the buyers but the firm's competitors will also seek to grab the buyer's business.
Supplying firms in the industry in question can reduce some of the competition intensity by adequately differentiating themselves. The supplying firm would need to justify why its product is better and justify how it would make the buyer's product better, in turn differentiating the buyer's product as well. One example of this was in the processing chip industry where Intel and AMD were the major firms in the industry. Makers of computers (the buyers) wanted lower processor prices. However, Intel successfully convinced many computer manufacturers that the Intel chip was superior. As a result, many computer manufacturers still bought the Intel chip and then marketed their computers with the slogan "Intel Inside".
Bargaining Power of Suppliers
Sometimes the firms supplying materials to the industry can exert pressure and increase the intensity of competition. When there are only a few suppliers and there is no threat of substitutes for the supplied materials, firms in an industry might fight over keeping certain suppliers, particularly if the materials are highly differentiated. This naturally raises the competition intensity in an industry.
Porter describes one other supplier that can have tremendous power in an industry -- labor. If there is no union or the union does not have much power, then the workforce does not exert much power on the firms in the industry. However, if the workforce is unionized and highly organized, the workforce can exert significant pressure on an industry. When unions successfully bargain for higher wages or benefits, firms in the industry must find ways of cutting other costs or raise sales prices of its products. Competition increases over who can cut costs the most and raise sales prices the least.
This article has examined Michael Porter's five forces model. Each of the five forces has been examined and how these forces can increase competition in an industry. While developed in the 1980s, the five forces model is still cited and used today.
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