The Competitive Environment Model: A Primer

By Dr. Kim A. Stewart

Jones International University
Michael Porters model (1) is one of the most important management models developed in the
last century. Porter presents us with a new way of looking at the competitive environment (an
industry) that focuses on how particular factors or forces in the environment affect the
profitability of the firms that compete in the industry. In doing so, Porters model gives us a very
useful tool for determining just how profitable and attractive an industry is. Thats important for
businesses thinking about moving into a new industry, entrepreneurs considering entering a
particular industry with a new product or service idea, and for businesses wanting to evaluate
their own industry and find ways to increase their profits.
The model identifies five forces in a business competitive environment (its industry) that directly
affect profits---customers, suppliers, potential new entrants (threat of entry), substitutes, and
competitor intensity or rivalry, all shown in Graphic 1-6. The model predicts that the more
powerful the force, the more able the force is to reduce the profits of competitors in the industry.
The model also shows how we can determine the strength of each force, and thus the strength of
its impact on a business profits.
The model presents some specific ways for a business to influence those forces, weaken their
strength, and preserve, and perhaps even increase its profitability. We will return to this issue in
Module 3. Note: Be sure you have a good understanding of the five forces as explained in
reading #3 (pp. 52-57) before proceeding.

The Five Forces and Profitability

Two factors are essential to a business profitability---the number of units of product (or service)
sold and profit margin. Lets define margin as the difference between the price the firm charges
for its product and the total cost the firm incurs in producing and selling the product on a per-unit
basis. For example, lets assume that we make and sell a particular type of running shoe. Our
shoe sells for $65 a pair. The amount it costs us to make, market and sell the shoes is $45 a pair.
Thus, our profit margin is $20. For every pair of shoes we sell, we make $20 profit pretax. To
increase our profits, we must increase the number of shoes we sell each year. And we must
protect our profit margin. If we lose our margin, we will not make a cent of profit no matter how
many pairs of shoes we sell.
Each of the five forces in the competitive environment can threaten our profitability by shrinking
our margin and in some cases, reducing the number of shoes we sell, as shown in the graphic,
The Five Forces and Profitability. Powerful customers can shrink our margin by pressuring us
to lower the sales price for our shoes or to increase the quality of our shoes before they will buy
them at a given price. Increasing our quality raises our costs and boosts the total cost of
providing the shoes, thus shrinking our profit margin. Powerful suppliers can cut our margin by
increasing the cost of supplies they sell us---all those materials we need to make our shoes, which
raises our total costs. A powerful substitute can shrink our margin because people are willing to
buy the substitute. Typically, we must improve our quality, engage in expensive marketing
tactics, and/or cut our price to compete and preserve our sales. Doing any of these
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(1) Porter, Michael E. (1980). Competitive strategy: Techniques for analyzing industries and
competitors. NY: The Free Press.

things reduces our profit margin. A strong threat of entry cuts our margin because if new
competitors are entering our industry, typically we will have to boost quality, cut our price or
increase marketing costs to protect our sales. Greater competitive rivalry cuts our margin because
intensified competition often means we must respond with lower prices, more marketing and/or
better and more costly quality, all of which reduces our margin.
Given the importance of the five forces, it is especially important for businesses to determine the
strength of each of the five forces in their competitive environment, and thus identify each forces
ability to threaten margin, sales, and profitability.

Determining the Strength of the Five Forces

Here is a checklist to help you determine the strength of each force (2):
Customers
Customers are buyers of the industrys product. They can be end consumers such of the buyers of
shoes, CDs, or cars, or they can be intermediate customers. For our purposes, lets assume that
the customers are people, the end users of the product. These consumers are more powerful if:
Product differentiation is low---the competitors offer very similar products.
Switching costs are low---the cost of changing from one competitors product to
another is low.
Customer loyalty is low---customers have little loyalty to a particular brand.
Suppliers
Suppliers are typically businesses that supply the materials (resources) that competitors need to
produce their product. Suppliers are more powerful when:
What they sell greatly affects the competitors product quality.
A large percentage of a competitors purchases come from one supplier.
Switching costs for the competitor are high---it is costly to switch suppliers.
There are few suppliers in the industry.
Threat of entry
Threat of entry is the likelihood that new businesses will enter the industry and make and sell
products that direct compete with the industrys current competitors. If the threat is great, current
competitors have a serious problem because new competitors need sales to survive and unless the
industry is growing like gangbusters (very unlikely in todays industries), they must take sales
away from the current firms to survive. If barriers to entry are strong, threat of entry is low.
These barriers include:
Capital requirements are high---it costs a great deal of money to get established
in the industry. Examples: the pharmaceutical industry, the auto
industry.
Product differentiation is high---products or services have unique features that
have created high brand loyalty among customers. Getting customers
to switch to a new competitors product is difficult and costly.
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(2) Ibid., chapter 1, pp. 3-33.

Economies of scale---the more product a firm makes and sells, the cheaper it is
to make and sell each one on a per unit basis. This advantage applies
more to the making of products than services.
Access to distribution channels is lowit is very difficult for a new competitor to
get its products on the shelves. Another type of limited distribution
access concerns location when current competitors enjoy close-to-customer
locations that are scarce and costly for a new competitor to obtain.
Cost disadvantages are high---current competitors have major cost advantages
such as access to limited raw materials.
Potential for retaliation is high---current competitors are known to react viciously
to eliminate new competitors (such as cut-throat price wars).
Government regulations are restrictive---regulations can keep new competitors
out of the industry.
When barriers are low (reasonable capital requirements, low product differentiation, low
switching costs and little consumer loyalty, low economies of scale, easy distribution access,
minimal cost disadvantages, low retaliation, and few governmental barriers), threat of entry is
high.
Threat of substitutes
Substitutes are products that have different characteristics but satisfy the same customer needs.
Examples: DVD movie rentals substitute for movie theatre viewing, lasik surgery substitutes for
eyeglasses, bottles substitute for aluminum cans. A substitute is powerful if, compared to the
industrys product:
Its quality is the same or better.
Its cost is the same or lower.
Customers switching costs are low.
Competitive rivalry
Competitive rivalry is the degree to which industry competitors aggressively fight each other for
sales and profits. Competition is intense when:
Industry growth rate is low. With a low growth rate, the only way a competitor
can grow is to take sales away from other competitors.
Product differentiation is low.
Consumer switching costs and brand loyalty are low.
Several competitors have great financial resources---these types of
companies can withstand costly price wars and are thus more likely to
wage them.
Exit barriers are highit is financially and/or psychologically difficult for a
competitor to leave the industry.

A Firms Response
Once a business analyzes its competitive environment and determines the power of each of the
five forces, management then considers how to reduce the power of the most troubling forces and
boost its own competitive position and profitability. Well address this issue in Module 3.
A final note. Often the strength of a force is moderate rather than high or low. Thats because
some of the factors affecting a forces strength boost the strength while other factors lower it.
Keep this in mind when you analyze the fast food industry.