Porter'sFiveForces

AMODELFORINDUSTRYANALYSISThemodelofpurecompetitionimpliesthatrisk-adjustedratesofreturnshouldbeconstantacrossfirmsandindustries.However,numerouseconomicstudieshaveaffirmedthatdifferentindustriescansustaindifferentlevelsofprofitability;partofthisdifferenceisexplainedbyindustrystructure.MichaelPorterprovidedaframeworkthatmodelsanindustryasbeinginfluencedbyfiveforces.Thestrategicbusinessmanagerseekingtodevelopanedgeoverrivalfirmscanusethismodeltobetterunderstandtheindustrycontextinwhichthefirmoperates.DiagramofPorter's5Forces

SUPPLIERPOWER

Supplierconcentration

Importanceofvolumetosupplier

Differentiationofinputs

Impactofinputsoncostordifferentiation

Switchingcostsoffirmsintheindustry

Presenceofsubstituteinputs

Threatofforwardintegration

Costrelativetototalpurchasesinindustry

BARRIERS

TOENTRY

Absolutecostadvantages

Proprietarylearningcurve

Accesstoinputs

Governmentpolicy

Economiesofscale

Capitalrequirements

Brandidentity

Switchingcosts

Accesstodistribution

Expectedretaliation

ProprietaryproductsTHREATOF

SUBSTITUTES

-Switchingcosts

-Buyerinclinationto

substitute

-Price-performance

trade-offofsubstitutes

BUYERPOWER

Bargainingleverage

Buyervolume

Buyerinformation

Brandidentity

Pricesensitivity

Threatofbackwardintegration

Productdifferentiation

Buyerconcentrationvs.industry

Substitutesavailable

Buyers'incentivesDEGREEOFRIVALRY

-Exitbarriers

-Industryconcentration

-Fixedcosts/Valueadded

-Industrygrowth

-Intermittentovercapacity

-Productdifferences

-Switchingcosts

-Brandidentity

-Diversityofrivals

-Corporatestakes

I.

RivalryInthetraditionaleconomicmodel,competitionamongrivalfirmsdrivesprofitstozero.Butcompetitionisnotperfectandfirmsarenotunsophisticatedpassivepricetakers.Rather,firmsstriveforacompetitiveadvantageovertheirrivals.Theintensityofrivalryamongfirmsvariesacrossindustries,andstrategicanalystsareinterestedinthesedifferences.Economistsmeasurerivalrybyindicatorsof

industryconcentration.TheConcentrationRatio(CR)isonesuchmeasure.TheBureauofCensusperiodicallyreportstheCRformajorStandardIndustrialClassifications(SIC's).TheCRindicatesthepercentofmarketshareheldbythefourlargestfirms(CR'sforthelargest8,25,and50firmsinanindustryalsoareavailable).Ahighconcentrationratioindicatesthatahighconcentrationofmarketshareisheldbythelargestfirms-theindustryisconcentrated.Withonlyafewfirmsholdingalargemarketshare,thecompetitivelandscapeislesscompetitive(closertoamonopoly).Alowconcentrationratioindicatesthattheindustryischaracterizedbymanyrivals,noneofwhichhasasignificantmarketshare.Thesefragmentedmarketsaresaidtobecompetitive.Theconcentrationratioisnottheonlyavailablemeasure;thetrendistodefineindustriesintermsthatconveymoreinformationthandistributionofmarketshare.Ifrivalryamongfirmsinanindustryislow,theindustryisconsideredtobedisciplined.Thisdisciplinemayresultfromtheindustry'shistoryofcompetition,theroleofaleadingfirm,orinformalcompliancewithagenerallyunderstoodcodeofconduct.Explicitcollusiongenerallyisillegalandnotanoption;inlow-rivalryindustriescompetitivemovesmustbeconstrainedinformally.However,amaverickfirmseekingacompetitiveadvantagecandisplacetheotherwisedisciplinedmarket.Whenarivalactsinawaythatelicitsacounter-responsebyotherfirms,rivalryintensifies.Theintensityofrivalrycommonlyisreferredtoasbeingcutthroat,intense,moderate,orweak,basedonthefirms'aggressivenessinattemptingtogainanadvantage.Inpursuinganadvantageoveritsrivals,afirmcanchoosefromseveralcompetitivemoves:Changingprices-raisingorloweringpricestogainatemporaryadvantage.Improvingproductdifferentiation-improvingfeatures,implementinginnovationsinthemanufacturingprocessandintheproductitself.Creativelyusingchannelsofdistribution-usingverticalintegrationorusingadistributionchannelthatisnoveltotheindustry.Forexample,withhigh-endjewelrystoresreluctanttocarryitswatches,Timexmovedintodrugstoresandothernon-traditionaloutletsandcorneredthelowtomid-pricewatchmarket.Exploitingrelationshipswithsuppliers-forexample,fromthe1950'stothe1970'sSears,RoebuckandCo.dominatedtheretailhouseholdappliancemarket.Searssethighqualitystandardsandrequiredsupplierstomeetitsdemandsforproductspecificationsandprice.Theintensityofrivalryisinfluencedbythefollowingindustrycharacteristics:Alargernumberoffirmsincreasesrivalrybecausemorefirmsmustcompeteforthesamecustomersandresources.Therivalryintensifiesifthefirmshavesimilarmarketshare,leadingtoastruggleformarketleadership.Slowmarketgrowthcausesfirmstofightformarketshare.Inagrowingmarket,firmsareabletoimproverevenuessimplybecauseoftheexpandingmarket.Highfixedcostsresultinaneconomyofscaleeffectthatincreasesrivalry.Whentotalcostsaremostlyfixedcosts,thefirmmustproducenearcapacitytoattainthelowestunitcosts.Sincethefirmmustsellthislargequantityofproduct,highlevelsofproductionleadtoafightformarketshareandresultsinincreasedrivalry.Highstoragecostsorhighlyperishableproductscauseaproducertosellgoodsassoonaspossible.Ifotherproducersareattemptingtounloadatthesametime,competitionforcustomersintensifies.Lowswitchingcostsincreasesrivalry.Whenacustomercanfreelyswitchfromoneproducttoanotherthereisagreaterstruggletocapturecustomers.Lowlevelsofproductdifferentiationisassociatedwithhigherlevelsofrivalry.Brandidentification,ontheotherhand,tendstoconstrainrivalry.Strategicstakesarehighwhenafirmislosingmarketpositionorhaspotentialforgreatgains.Thisintensifiesrivalry.Highexitbarriersplaceahighcostonabandoningtheproduct.Thefirmmustcompete.Highexitbarrierscauseafirmtoremaininanindustry,evenwhentheventureisnotprofitable.Acommonexitbarrierisassetspecificity.Whentheplantandequipmentrequiredformanufacturingaproductishighlyspecialized,theseassetscannoteasilybesoldtootherbuyersinanotherindustry.LittonIndustries'acquisitionofIngallsShipbuildingfacilitiesillustratesthisconcept.Littonwassuccessfulinthe1960'swithitscontractstobuildNavyships.ButwhentheVietnamwarended,defensespendingdeclinedandLittonsawasuddendeclineinitsearnings.Asthefirmrestructured,divestingfromtheshipbuildingplantwasnotfeasiblesincesuchalargeandhighlyspecializedinvestmentcouldnotbesoldeasily,andLittonwasforcedtostayinadecliningshipbuildingmarket.Adiversityofrivalswithdifferentcultures,histories,andphilosophiesmakeanindustryunstable.Thereisgreaterpossibilityformavericksandformisjudgingrival'smoves.Rivalryisvolatileandcanbeintense.Thehospitalindustry,forexample,ispopulatedbyhospitalsthathistoricallyarecommunityorcharitableinstitutions,byhospitalsthatareassociatedwithreligiousorganizationsoruniversities,andbyhospitalsthatarefor-profitenterprises.Thismixofphilosophiesaboutmissionhasleadoccasionallytofiercelocalstrugglesbyhospitalsoverwhowillgetexpensivediagnosticandtherapeuticservices.Atothertimes,localhospitalsarehighlycooperativewithoneanotheronissuessuchascommunitydisasterplanning.IndustryShakeout.

Agrowingmarketandthepotentialforhighprofitsinducesnewfirmstoenteramarketandincumbentfirmstoincreaseproduction.Apointisreachedwheretheindustrybecomescrowdedwithcompetitors,anddemandcannotsupportthenewentrantsandtheresultingincreasedsupply.Theindustrymaybecomecrowdedifitsgrowthrateslowsandthemarketbecomessaturated,creatingasituationofexcesscapacitywithtoomanygoodschasingtoofewbuyers.Ashakeoutensues,withintensecompetition,pricewars,andcompanyfailures.BCGfounderBruceHendersongeneralizedthisobservationastheRuleofThreeandFour:astablemarketwillnothavemorethanthreesignificantcompetitors,andthelargestcompetitorwillhavenomorethanfourtimesthemarketshareofthesmallest.Ifthisruleistrue,itimpliesthat:Ifthereisalargernumberofcompetitors,ashakeoutisinevitableSurvivingrivalswillhavetogrowfasterthanthemarketEventualloserswillhaveanegativecashflowiftheyattempttogrowAllexceptthetwolargestrivalswillbelosersThedefinitionofwhatconstitutesthe"market"isstrategicallyimportant.Whateverthemeritsofthisruleforstablemarkets,itisclearthatmarketstabilityandchangesinsupplyanddemandaffectrivalry.Cyclicaldemandtendstocreatecutthroatcompetition.Thisistrueinthedisposablediaperindustryinwhichdemandfluctuateswithbirthrates,andinthegreetingcardindustryinwhichtherearemorepredictablebusinesscycles.

II.ThreatOfSubstitutesInPorter'smodel,substituteproductsrefertoproductsinotherindustries.Totheeconomist,athreatofsubstitutesexistswhenaproduct'sdemandisaffectedbythepricechangeofasubstituteproduct.Aproduct'spriceelasticityisaffectedbysubstituteproducts-asmoresubstitutesbecomeavailable,thedemandbecomesmoreelasticsincecustomershavemorealternatives.Aclosesubstituteproductconstrainstheabilityoffirmsinanindustrytoraiseprices.ThecompetitionengenderedbyaThreatofSubstitutecomesfromproductsoutsidetheindustry.Thepriceofaluminumbeveragecansisconstrainedbythepriceofglassbottles,steelcans,andplasticcontainers.Thesecontainersaresubstitutes,yettheyarenotrivalsinthealuminumcanindustry.Tothemanufacturerofautomobiletires,tireretreadsareasubstitute.Today,newtiresarenotsoexpensivethatcarownersgivemuchconsiderationtoretreadingoldtires.Butinthetruckingindustrynewtiresareexpensiveandtiresmustbereplacedoften.Inthetrucktiremarket,retreadingremainsaviablesubstituteindustry.Inthedisposablediaperindustry,clothdiapersareasubstituteandtheirpricesconstrainthepriceofdisposables.Whilethetreatofsubstitutestypicallyimpactsanindustrythroughpricecompetition,therecanbeotherconcernsinassessingthethreatofsubstitutes.ConsiderthesubstitutabilityofdifferenttypesofTVtransmission:localstationtransmissiontohomeTVantennasviatheairwaysversustransmissionviacable,satellite,andtelephonelines.Thenewtechnologiesavailableandthechangingstructureoftheentertainmentmediaarecontributingtocompetitionamongthesesubstitutemeansofconnectingthehometoentertainment.ExceptinremoteareasitisunlikelythatcableTVcouldcompetewithfreeTVfromanaerialwithoutthegreaterdiversityofentertainmentthatitaffordsthecustomer.III.BuyerPowerThepowerofbuyersistheimpactthatcustomershaveonaproducingindustry.Ingeneral,whenbuyerpowerisstrong,therelationshiptotheproducingindustryisneartowhataneconomisttermsamonopsony-amarketinwhichtherearemanysuppliersandonebuyer.Undersuchmarketconditions,thebuyersetstheprice.Inrealityfewpuremonopsoniesexist,butfrequentlythereissomeasymmetrybetweenaproducingindustryandbuyers.Thefollowingtablesoutlinesomefactorsthatdeterminebuyerpower.BuyersarePowerfulif:ExampleBuyersareconcentrated-thereareafewbuyerswithsignificantmarketshareDODpurchasesfromdefensecontractorsBuyerspurchaseasignificantproportionofoutput-distributionofpurchasesoriftheproductisstandardizedCircuitCityandSears'largeretailmarketprovidespoweroverappliancemanufacturersBuyerspossessacrediblebackwardintegrationthreat-canthreatentobuyproducingfirmorrivalLargeautomanufacturers'purchasesoftires

BuyersareWeakif:ExampleProducersthreatenforwardintegration-producercantakeoverowndistribution/retailingMovie-producingcompanieshaveintegratedforwardtoacquiretheatersSignificantbuyerswitchingcosts-productsnotstandardizedandbuyercannoteasilyswitchtoanotherproductIBM's360systemstrategyinthe1960'sBuyersarefragmented(many,different)-nobuyerhasanyparticularinfluenceonproductorpriceMostconsumerproductsProducerssupplycriticalportionsofbuyers'input-distributionofpurchasesIntel'srelationshipwithPCmanufacturers

IV.SupplierPowerAproducingindustryrequiresrawmaterials-labor,components,andothersupplies.Thisrequirementleadstobuyer-supplierrelationshipsbetweentheindustryandthefirmsthatprovideittherawmaterialsusedtocreateproducts.Suppliers,ifpowerful,canexertaninfluenceontheproducingindustry,suchassellingrawmaterialsatahighpricetocapturesomeoftheindustry'sprofits.Thefollowingtablesoutlinesomefactorsthatdeterminesupplierpower.SuppliersarePowerfulif:ExampleCredibleforwardintegrationthreatbysuppliersBaxterInternational,manufacturerofhospitalsupplies,acquiredAmericanHospitalSupply,adistributorSuppliersconcentratedDrugindustry'srelationshiptohospitalsSignificantcosttoswitchsuppliersMicrosoft'srelationshipwithPCmanufacturersCustomersPowerful

Boycottofgrocerystoressellingnon-unionpickedgrapes

SuppliersareWeakif:ExampleManycompetitivesuppliers-productisstandardizedTireindustryrelationshiptoautomobilemanufacturersPurchasecommodityproductsGrocerystorebrandlabelproductsCrediblebackwardintegrationthreatbypurchasersTimberproducersrelationshiptopapercompaniesConcentratedpurchasersGarmentindustryrelationshiptomajordepartmentstoresCustomersWeakTravelagents'relationshiptoairlines

V.BarrierstoEntry/ThreatofEntryItisnotonlyincumbentrivalsthatposeathreattofirmsinanindustry;thepossibilitythatnewfirmsmayentertheindustryalsoaffectscompetition.Intheory,anyfirmshouldbeabletoenterandexitamarket,andiffreeentryandexitexists,thenprofitsalwaysshouldbenominal.Inreality,however,industriespossesscharacteristicsthatprotectthehighprofitlevelsoffirmsinthemarketandinhibitadditionalrivalsfromenteringthemarket.Thesearebarrierstoentry.Barrierstoentryaremorethanthenormalequilibriumadjustmentsthatmarketstypicallymake.Forexample,whenindustryprofitsincrease,wewouldexpectadditionalfirmstoenterthemarkettotakeadvantageofthehighprofitlevels,overtimedrivingdownprofitsforallfirmsintheindustry.Whenprofitsdecrease,wewouldexpectsomefirmstoexitthemarketthusrestoringamarketequilibrium.Fallingprices,ortheexpectationthatfuturepriceswillfall,detersrivalsfromenteringamarket.Firmsalsomaybereluctanttoentermarketsthatareextremelyuncertain,especiallyifenteringinvolvesexpensivestart-upcosts.Thesearenormalaccommodationstomarketconditions.Butiffirmsindividually(collectiveactionwouldbeillegalcollusion)keeppricesartificiallylowasastrategytopreventpotentialentrantsfromenteringthemarket,suchentry-deterringpricingestablishesabarrier.Barrierstoentryareuniqueindustrycharacteristicsthatdefinetheindustry.Barriersreducetherateofentryofnewfirms,thusmaintainingalevelofprofitsforthosealreadyintheindustry.Fromastrategicperspective,barrierscanbecreatedorexploitedtoenhanceafirm'scompetitiveadvantage.Barrierstoentryarisefromseveralsources:Governmentcreatesbarriers.Althoughtheprincipalroleofthegovernmentinamarketistopreservecompetitionthroughanti-trustactions,governmentalsorestrictscompetitionthroughthegrantingofmonopoliesandthroughregulation.Industriessuchasutilitiesareconsiderednaturalmonopoliesbecauseithasbeenmoreefficienttohaveoneelectriccompanyprovidepowertoalocalitythantopermitmanyelectriccompaniestocompeteinalocalmarket.Torestrainutilitiesfromexploitingthisadvantage,governmentpermitsamonopoly,butregulatestheindustry.Illustrativeofthiskindofbarriertoentryisthelocalcablecompany.Thefranchisetoacableprovidermaybegrantedbycompetitivebidding,butoncethefranchiseisawardedbyacommunityamonopolyiscreated.Localgovernmentswerenoteffectiveinmonitoringpricegougingbycableoperators,sothefederalgovernmenthasenactedlegislationtoreviewandrestrictprices.Theregulatoryauthorityofthegovernmentinrestrictingcompetitionishistoricallyevidentinthebankingindustry.Untilthe1970's,themarketsthatbankscouldenterwerelimitedbystategovernments.Asaresult,mostbankswerelocalcommercialandretailbankingfacilities.Bankscompetedthroughstrategiesthatemphasizedsimplemarketingdevicessuchasawardingtoasterstonewcustomersforopeningacheckingaccount.Whenbankswerederegulated,bankswerepermittedtocrossstateboundariesandexpandtheirmarkets.Deregulationofbanksintensifiedrivalryandcreateduncertaintyforbanksastheyattemptedtomaintainmarketshare.Inthelate1970's,thestrategyofbanksshiftedfromsimplemarketingtacticstomergersandgeographicexpansionasrivalsattemptedtoexpandmarkets.Patentsandproprietaryknowledgeservetorestrictentryintoanindustry.Ideasandknowledgethatprovidecompetitiveadvantagesaretreatedasprivatepropertywhenpatented,preventingothersfromusingtheknowledgeandthuscreatingabarriertoentry.EdwinLandintroducedthePolaroidcamerain1947andheldamonopolyintheinstantphotographyindustry.In1975,Kodakattemptedtoentertheinstantcameramarketandsoldacomparablecamera.Polaroidsuedforpatentinfringementandwon,keepingKodakoutoftheinstantcameraindustry.Assetspecificityinhibitsentryintoanindustry.Assetspecificityistheextenttowhichthefirm'sassetscanbeutilizedtoproduceadifferentproduct.Whenanindustryrequireshighlyspecializedtechnologyorplantsandequipment,potentialentrantsarereluctanttocommittoacquiringspecializedassetsthatcannotbesoldorconvertedintootherusesiftheventurefails.Assetspecificityprovidesabarriertoentryfortworeasons:First,whenfirmsalreadyholdspecializedassetstheyfiercelyresisteffortsbyothersfromtakingtheirmarketshare.Newentrantscananticipateaggressiverivalry.Forexample,KodakhadmuchcapitalinvestedinitsphotographicequipmentbusinessandaggressivelyresistedeffortsbyFujitointrudeinitsmarket.Theseassetsarebothlargeandindustryspecific.Thesecondreasonisthatpotentialentrantsarereluctanttomakeinvestmentsinhighlyspecializedassets.Organizational(Internal)EconomiesofScale.ThemostcostefficientlevelofproductionistermedMinimumEfficientScale(MES).Thisisthepointatwhichunitcostsforproductionareatminimum-i.e.,themostcostefficientlevelofproduction.IfMESforfirmsinanindustryisknown,thenwecandeterminetheamountofmarketsharenecessaryforlowcostentryorcostparitywithrivals.Forexample,inlongdistancecommunicationsroughly10%ofthemarketisnecessaryforMES.Ifsalesforalongdistanceoperatorfailtoreach10%ofthemarket,thefirmisnotcompetitive.Theexistenceofsuchaneconomyofscalecreatesabarriertoentry.ThegreaterthedifferencebetweenindustryMESandentryunitcosts,thegreaterthebarriertoentry.SoindustrieswithhighMESdeterentryofsmall,start-upbusinesses.TooperateatlessthanMEStheremustbeaconsiderationthatpermitsthefirmtosellatapremiumprice-suchasproductdifferentiationorlocalmonopoly.Barrierstoexitworksimilarlytobarrierstoentry.Exitbarrierslimittheabilityofafirmtoleavethemarketandcanexacerbaterivalry-unabletoleavetheindustry,afirmmustcompete.Someofanindustry'sentryandexitbarrierscanbesummarizedasfollows:EasytoEnterifthereis:CommontechnologyLittlebrandfranchiseAccesstodistributionchannelsLowscalethresholdDifficulttoEnterifthereis:Patentedorproprietaryknow-howDifficultyinbrandswitchingRestricteddistributionchannelsHighscalethresholdEasytoExitifthereare:SalableassetsLowexitcostsIndependentbusinessesDifficulttoExitifthereare:SpecializedassetsHighexitcostsInterrelatedbusinesses

DYNAMICNATUREOFINDUSTRYRIVALRYOurdescriptiveandanalyticmodelsofindustrytendtoexaminetheindustryatagivenstate.Thenatureandfascinationofbusinessisthatitisnotstatic.Whilewearepronetogeneralize,forexample,listGM,Ford,andChryslerasthe"Big3"andassumetheirdominance,wealsohaveseentheautomobileindustrychange.Currently,theentertainmentandcommunicationsindustriesareinflux.Phonecompanies,computerfirms,andentertainmentaremergingandformingstrategicalliancesthatre-maptheinformationterrain.Schumpeterand,morerecently,Porterhaveattemptedtomovetheunderstandingofindustrycompetitionfromastaticeconomicorindustryorganizationmodeltoanemphasisontheinterdependenceofforcesasdynamic,orpunctuatedequilibrium,asPortertermsit.InSchumpeter'sandPorter'sviewthedynamismofmarketsisdrivenbyinnovation.Wecanenvisiontheseforcesatworkasweexaminethefollowingchanges:Top10USIndustrialFirmsbySales1917-1988

191719451966198319881USSteelGeneralMotorsGeneralMotorsExxonGeneralMotors2SwiftUSSteelFord

GeneralMotorsFord3ArmourStandardOil-NJStandardOil-NJ(Exxon)MobilExxon4AmericanSmeltingUSSteelGeneralElectricTexacoIBM5StandardOil-NJBethlehemSteelChryslerFord

GeneralElectric6BethlehemSteelSwift

Mobil

IBMMobil7Ford

ArmourTexacoSocal(Oil)Chrysler8DuPont

Curtiss-WrightUSSteelDuPontTexaco9AmericanSugarChryslerIBM

GulfOilDuPont10GeneralElectricFord

GulfOilStandardOilofIndianaPhilipMorris10LargestUSFirmsbyAssets,1909and1987

190919871USSTEELGM(Notlistedin1909)2STANDARDOIL,NJ(Now,EXXON#3)SEARS(1909=45)3AMERICANTOBACCO(Now,AmericanBrands#52)EXXON(StandardOiltrustbrokenupin1911)4AMERICANMERCANTILEMARINE(RenamedUSLines;acquiredbyKidde,Inc.,1969;soldtoMcLeanIndustries,1978;bankruptcy,1986IBM(Ranked68,1948)5INTERNATIONALHARVESTER(RenamedNavistar#182);divestedfarmequipmentFORD(Listedin1919)6ANACONDACOPPER(acquiredbyARCOin1977)MOBILOIL7U