Article Summary

Strategy refers to the set of activities that a company does for gaining long term sustainable
competitive advantage. If the company wants to have a competitive advantage in the
market, It is not only important to know about the company’s competitors, but also about
the other competitive forces which may affect the future profits of the company. This article
explains about the five competitive forces formulated by Michael E Porter. It is necessary to
know about the five forces which will help to position the company in a way which makes it
profitable and as well as less vulnerable to the threats.
The five Competitive forces are-
 Threat of new entry
 The power of suppliers
 The power of buyers
 Direct competition
 Threat of substitutes
These forces may vary from industry to industry and the profitability of any of these
industries totally depends on these competitive forces.

1) Threat of new entry – New entrants in any industry will bring new capacity and will be
wanting to gain market share that puts pressure on prices, cost and the rate of investment
to compete. When new entrants come into the market they will be diversifying from other
markets that will leverage existing capabilities and cash flows to shake up the competition.
The seven major factors that affect the entry barriers are-
a) Supply side economies of scale- These economies arise when firms that produce at larger
volumes enjoy lower costs per unit as they can spread fixed cost over more units, employ
better technology or direct better terms from suppliers.
b) Demand side benefits of scale- These benefits are also known as network effects.
Industries where a buyers willingness to pay for company product increases with the
number of other buyers who also patronize the company.
c) Customer switching cost- Switching cost is fixed cost that buyer face when they change
suppliers. The larger the switching cost, the harder it will be for the entrant to gain more
customers.
d) Capital Requirements- Capital may be necessary not only for the fixed facilities but also to
extend customer credit, built inventories and the funds that the start up losses. If the
industry returns are attractive and are expected to remain so, and if capital markets are
efficient investors will provide the funds they need.
e) Incumbency Advantages Independent of size- Incumbents may have cost or quality
advantages not available to potential rivals. These advantages can stem from sources such
as proprietary technology, preferential access to the best raw materials, establish brand
identity or cumulative experience that has allowed incumbents to learn how to produce
more efficiently.
f) Unequal access to distribution channels- The new entrants must secure distribution of its
product and services. The more limited the wholesale or retail channels are and the existing
competitors have tied them up, the tougher the entry in the industry will be.
g) Restrictive Government Policy- Government policy can hinder or aid new entry directly as
well as amplify or nullify the other entry barriers.
2) The power of suppliers – Powerful suppliers capture more of the value for themselves by
charging higher prices, limiting quality or services, or shifting cost to industry participants.
Powerful suppliers can squeeze profitability out of an industry that is unable to pass on cost
increases in its own prices.
3) The power of buyers – When the buyers are price sensitive they demand for lower prices.
The buyer may want to bring down the prices and also demand for better quality of service.
All this may affect the profitability of the industry.

4) Threat of Substitutes- Substitute products perform the same or similar functions that
your product does. It's very easy to overlook and neglect threat from substitutes because
they may appear very different from your product, but it's always there. The profitability of
the company is compromised when there is high threat of Substitutes. Therefore a company
through their product, marketing, performance etc should differentiate itself from its
substitutes to avoid suffering from profitability issues.
The threat of a substitute is high if:
1) The substitute product offers a better price performance trade off when compared to the
industry's product
2) The buyer's cost of switching to the substitute product is low.

5) Direct Competition- Direct competition takes many familiar forms such as price
discounting, service improvements, advertising campaigns, new introductions etc. Intense
rivalry among firms can cause a decline in the profitability. The degree of the decline
depends on what is the intensity of the rivalry and on what basis the companies are
competing. When all the competitors are fighting to cater to the same needs it results in
zero sum competition. By analyzing and understanding the underlying structure of rivalry,
strategists can steer the competition to a positive direction.

Conclusion

Most people think of business competition as a tug of war between rivals, with each
competing for more sales or market share. According to HBS professor Michael Porter,
competition is more complex than that. It is not about who is the biggest. It's about who is
the most profitable. Profitability is defined by 5 competitive forces. We have the buyers who
would always be happier to pay less and get more. In the airline industry price competition
is fierce because so many travellers want the cheapest price.

Then we have the suppliers who would ideally like to get paid more and deliver less.
Powerful suppliers will use their clout to raise prices or insist on other more favorable
terms.
A third source of competition comes from substitute products or services that meet the
same basic need your product does. These aren't always obvious rivals. The toughest
competitors may come from different industries.
New entrants can also create tension. For example, southwest airlines challenged the
industry by just flying one kind of airplane which reduces cost and allowed it to offer better
ticket deals. This pushes other carriers to spend more to retain their competitors.
Finally you still have to fight your existing rivals. Intense competition reduces everyone's
profitability. The major airlines have been in this position for years, forcing them to defend
increasingly narrow profit margins with fees for exit row upgrades, checked bags and even
snacks.
These 5 forces define every industry structure and shape your company's future. Once you
understand them you can make better predictions, create more competitive strategies and
increase your profits.