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Five Forces that Shape Industry Competition

Future of Business (University of Sydney)

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Five Forces that Shape Industry Competition

Threat of Entry
- New Entrants to an industry bring new capacity and a desire to gain market share
- Pressure on prices, costs and rate of investment to compete
- It is the threat of entry, not whether entry actually occurs, that holds down
profitability.
- Threat of entry depends on:
o Entry barriers
 Supply-side economies of scale
 Firms produce that at larger volumes enjoy lower costs
 New entrants must either enter at a large scale or accept cost
disadvantage
 Demand-side benefits of scale (network effects)
 Buyer’s willing- ness to pay for a company’s product increases
with the number of other buyers who also patronize the
company
o Trust from number of other buyers
o Enjoyment of being in a “network” of other buyers
 Limiting the willingness of customers to buy from a newcomer
and reducing the selling price of newcomer until it builds up a
large base of customers.
 Customer switching costs
 Fixed costs that buyer faces when changing suppliers
 E.g. training costs for new system
 Capital requirements
 Need to invest large financial resources in order to compete
 Capital needed for e.g. facilities, extending customer credit,
inventory, start-up losses
 Barrier is great if capital is unrecoverable: e.g. advertising or
R&D
 However, capital can be provided by investors
 Incumbency advantages independent of size
 E.g. proprietary technology, preferential access to raw
material, favourable geographic locations, established brand
identities, or cumulative experience
 Unequal access to distribution channels
 Newcomer must secure distribution channel (tied up by their
competitors)
 May need to create own distribution channel
 Restrictive government policy
 Can aid or kinder new entries directly
o E.g. Licencing requirements, restrictions on foreign
investment
o E.g. Direct subsidies
 Can indirectly influence entry-barriers
o E.g. patenting rules that protect proprietary
technology, environmental and safety regulations

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o E.g. Funding research and making it available to all

firms (reducing scale economies)

o Expected retaliation from incumbents

 Newcomers are likely to fear retaliation if:
 Incumbents have previously responded vigorously to new
entrants.
 Incumbents possess substantial resources to fight back
o E.g. excess cash, unused borrowing power
 Incumbents seem likely to cut prices to retain market share at
all cost or to fill excess capacity in an industry with high fixed
costs
 Industry growth is slow so newcomers can gain volume only by
taking it from incumbents
Power of Suppliers
- Suppliers limit profitability of industry participants by charging higher prices, limiting
quality or services, shifting costs to industry participants
- A supplier group is powerful if
o It is more concentrated than the industry it sells to
 E.g. Microsoft’s near monopoly  fragmented PC industry
o Supply group does not depend heavily on the industry for revenue
 If an industry is vitally important to the supplier, it would try to
protect that industry
o Industry participants face switching costs in changing suppliers
 However, suppliers may have switching costs which limit their power
o Suppliers offer products that are differentiated
o No substitutes for what the supplier group provides
o Supplier group can threaten to integrate forward into the industry
 If industry participants make too much money relative to suppliers,
they will induce suppliers to enter the market.
Power of Buyers
- Buyers force down prices, demand better quality or more service, play industry
participants against one another, driving up costs
- A customer group has negotiating leverage if
o There are few buyers, or large volume buyers
 High fixed costs pressures suppliers to keep capacity filled
o The industry’s products are standardized or undifferentiated
 Buyer play one vendor against another
o Buyer face few switching costs in changing vendors
o Buyer can threaten to integrate backward and produce the product
themselves if the vendors are too profitable
 E.g. soft drink industry producing packaging
- A buyer group is price sensitive if:
o Product purchased represents a significant fraction of its cost structure
o Buyer group earns low profits, or is under pressure to cut costs
o Quality of the buyer’s output is little affected by industry’s product
o Industry’s product has little effect on buyer’s other costs

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 Some products improve productivity and reduces costs (e.g. machines

reduce labour costs)
- Intermediate customers (not end user) – such as assemblers or distribution channels,
gain significant bargaining power when they can influence the purchasing decisions
of customers downstream
- To diminish channel clout,
o Producers make exclusive arrangements with particular distributors or
retailers
o Market directly to end users
Threat of Substitutes
- Substitutes place a ceiling on prices for an industry, limiting profits
- The threat of a substitute is high if:
o It offers an attractive price-performance trade-off to the product
o Buyer’s cost of switching to the substitute is low
- Changes in other industries can create substitutes
Rivalry Among Existing competitors
- The degree to which rivalry drives down profitability depends on the intensity and
basis of competition
- The intensity of rivalry is greatest if:
o Competitors are numerous or are equal in size and power
 Without industry leader, desirable practises go unenforced
o Slow growth in industry
 Fights for market share
o Exit barriers are high
 Unprofitable firms refuse to exit due to exit barriers, damaging
profitability of healthy competitors
o Highly committed rivals who have goals beyond economic performance
o Firms lacking communication with each other, competing with different goals
- The dimensions on which competition takes place (whether businesses converge to
compete on the same dimension) affects profitability
o Destructive rivalry if focused on price competition
- Price competition is most liable to occur if:
o Products or services are nearly identical, low switching costs for buyers
o Fixed costs are high, marginal costs are low.
 Pressure for competitors to cut price below average cost to steal
incremental customers
o Capacity must be expanded in large increments to be efficient
o Product is perishable
 E.g. food, technologies, hotel accommodation (unused capacity not
recoverable)
- Competition on other dimensions is less likely to reduce profitability
o E.g. on product features, support services, delivery time, or brand image
o Improves customer value, supports higher prices, improve value relative to
substitutes, raise barrier to entry
- When all or many firms compete on the same dimensions, result is zero-sum
competition

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- When firms aim to serve the need of different customer segments (i.e. different
dimensions), result is higher profitability and industry growth

Factors affecting forces

Industry growth rate
- Fast growth tends to mute rivalry
- However,
o more power for suppliers
o High growth with low entry barriers attract entrants
o No guarantees of profitability if customers are powerful or substitutes are
attractive
 E.g. PC industry
Technology and innovation
- Advanced technology or innovations are not by themselves enough to make an
industry structurally attractive
Government
- Not inherently good or bad for industry profitability
o Depends on specific policies
Complementary products and services
- Affects overall demand for product
- However, effect on profitability depends on the influence on the 5 forces

Changes in Industry Structure

- May increase or reduce profitability
- May be caused by changes in technology, changes in customer needs, or other
events

Shifting threat of a new entry

- Changes to any of the seven barriers can raise or lower threat of new entry
o E.g. expiration of a patent  new entrants
- Strategic decisions of leading competitors have a major impact on threat of entry
o E.g. Wal-Mart, Kmart and Toys “R” Us heavily invested to increase economies
of scale, increasing entry barrier
Changing supplier or buyer power
- Influence of suppliers and buyers change over time
o E.g. travel agents losing clout due to airlines selling on internet
Shifting threat of substitution
- Advances in technology create new substitutes or shift price-performance
comparisons

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New bases of rivalry

- Rivalry intensifies over time as industry matures and growth slows
- Industry conventions emerge, technology diffuses, and consumer tastes converge
- However, does not have to be zero-sum competition (e.g. casino industry)
- Altered by mergers and acquisitions, technological innovations
- profit windfall from removing today’s competitors attracts new competitors and
backlash from customers and suppliers

Implications for Strategy

- Understanding of industry structure allows managers to
o Better cope with existing competitive forces
o Anticipate and exploit shifts in the forces
o Shape the balance of forces to create a more favourable industry structure
Positioning the Company
- Finding a position in the industry where forces are weakest
- Analyse entry and exit:
o Exit is indicated when industry structure is poor or declining and the
company has no prospect of a superior positioning
o Entry: Use framework to spot an industry with a good future before this good
future is reflected in the prices of acquisition candidates
Exploiting industry change
- When industry structure is in flux, new and promising competitive positions may
appear
- Structural changes open up new needs and new ways to serve existing needs
- Small industries can capitalise on change, or void may be filled by new entrants
Shaping industry Structure
- Innovator benefits most if it shifts competition in the directions where it excels
- Can be reshaped in 2 ways:
o Redividing profitability
 Reduce share of profits that leak to suppliers, buyers and substitutes,
or used to deter entrants
 Supplier: standardise parts (lower switching costs), cultivate
additional vendors, alter technology to avoid a supply group
 Customer: Expand services that raise switching costs, invest in unique
products to temper price-rivalry, neutralise powerful channels
o Expanding the profit pool
 When overall demand grows, the industry’s quality level rises,
intrinsic costs are reduced, or waste is eliminated, the pie expands
 E.g. firms working collaboratively with suppliers to improve
coordination and reduce cost in supply chain
 E.g. Quality standards for industry improves quality and prices,
benefiting rivals, suppliers and customers
- Industry leaders have a responsibility for improving industry structure
o They possess required resources
o They benefit the most

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o Their attempt to gain further market share can trigger strong reactions from
rivals, customers and suppliers
Defining the industry
- Five forces also define the relevant industry (or industries) in which a firm competes
- Industry boundaries clarifies causes of profitability and appropriate strategies

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