Porter’s Five Force Model

• An industry is defined as a group of companies

offering products or services that are close
substitutes of each other. Close substitutes are
those products or services that satisfy the same
basic customer needs. For example, tea is a close
substitute of coffee as it is considered a healthier
alternative with a lower caffeine content and
antioxidant properties that help develop body
resistance to cancer and heart disease. Any analysis
of the tea or coffee industry would have to consider
the other stimulant as a close substitute.
• Michael E. Porter has made immense contribution in the
development of the ideas of industry and competitive
analysis and their relevance to the formulation of
competitive strategies.
• He advocates that a structural analysis of industries be
made so that a firm is in a better position to identify its
strengths and weaknesses.
• A model has been proposed consisting of five
competitive forces - threat of new entrants, rivalry
among competitors, bargaining power of suppliers,
bargaining power of buyers and threat of substitute
products—that determine the intensity of industry
competition and profitability.
Threat of New Entrants.

• Any industry that is perceived as being profitable tends to

attract new entrants. These new entrants are firms that are
interested in investing in the industry to share the growth
prospects. Such new entrants augment the existing
production capacity and often possess a desire to make
large investment and secure substantial market share. The
existing firms have either to share a growing market pie
with a larger number of competitors or part with some of
their own market share to the new entrants. Either way,
new entrants may cause comparatively lesser sales volume
and revenue and lower the returns for all the firms in the
industry.
• The chance that new entrants will enter into an industry
depends on two factors: the entry barriers to an industry
and the expected retaliation from existing firms. Of these,
entry barriers are significant demotivators for new entrants.
The concept of entry barriers implies that there are
substantial cost involved in entering into a new industry. The
higher the entry barriers in an industry, the less likely are
the new entrants to enter that industry. So, higher entry
barriers serve to keep out potential entrants into an
industry.
• The entry barriers may arise as a consequence of several
factors such as those given below:

 Economies of scale in production and sale of products

leading to lower costs for existing firms
 Capital requirements being very high may prevent new
entrants from making investments
 Switching costs from the existing products or services to a
new one may discourage customers from making new
commitments owing to the costs incurred in buying new
ancillary equipment, retraining employees or establishing a
new network of relationship.
 Product differentiation by existing firms based on perceived
distinctiveness by the customers based effective
advertising, reputation as a service provider, brand loyalty
of customers towards existing firms or some such other
factor
 Access to distribution channel can be monopolised by the
existing firms on the basis of their long-term relationship
with the distributors.
 Cost disadvantages independent of scale may arise from
proprietary products technology, exclusive access to raw
materials, favourable location and benefit of governmental
subsidies
 Government policies through licensing and other means
can prevent the entry of new firms to an industry
• Besides the entry barriers, the expected retaliation to the
new entrants from the existing firms may be a potential
threat to entry. Any potential entrant to an industry would
have to predict the likely moves that the existing firms could
make. For instance, an existing firm with a large stake in the
industry may lower its price to create a difficult situation for
the new entrant. Or an existing firm with substantial
resources may attempt to alter the basis of competition so
that the new entrant is discouraged from making a foray.
• Despite the formidable hurdles posed by existing firms, new
firms do enter industries if they find them to be promising.
The popular strategy for doing so is finding market niches
not served by existing firms and to gradually build up a
presence in the industry.
Rivalry among Competitors
• Competition is a game in which normally, one player loses at
the expense of the other. A move on the part of a player
may cause other players to make countermoves or initiate
efforts to protect themselves from the danger posed by the
initial move. In this manner, firms within an industry are
mutually dependent. The situation in an industry keeps
changing with the actions and reactions of the constituent
firms. The desire to be the market leader or to corner a
larger market share leads to rivalry among competitors. The
extent of the rivalry among competitors in an industry
affects the competition within that industry. When the
rivalry is weak, there is likely to be lesser competition; when
such rivalry is high, the level of competition is higher. This
has implications for existing firms as well as those firms
contemplating entry into the industry.
• The dimensions of rivalry among competitors are several.
Some of the major ones are described below:
• • Competitive structure refers to the number of
competitors, their size and their diversity. Different types of
competitive structures have different implications for the
existing firms and for the new entrants Structures could
either be fragmented or consolidated. A fragmented
structure means that there are a large number of small or
medium-sized companies, none of them in a position to
dominate the industry. This structure is characterised by low
entry barriers and less or no differentiation, leading to
products becoming commodities.
• Competition is intense and the industry faces booms and
busts, leading to frequent changing of the structure. A
consolidated structure consists of a few large companies (an
oligopolistic market) or of just one large firm (a monopoly).
Such a structure has a closely-knit group of companies
whose actions and reactions are matched: the actions of
one lead to reactions from others.
• Competitive actions of the competitors are under close
watch by the others as they affect the distribution of market
share. The intensity of competition may range from benign
tolerance to fierce rivalry.
• In some industries, the competitors may adopt a policy of
'live and let live', while in others, there might be cut" throat
competition leading to under-pricing or severely fought
competitive battles on the basis of other factors such as
delivery, advertising or after-sale service. Diversity among
competitors means that different firms in an industry have
different ideas on the basis of which to compete, different
set of goals to achieve, or different organisational cultures.
An industry with greater diversity poses a higher potential
challenge to existing firms or new entrants for devising
competitive strategies.
• • Demand conditions refer to the nature of the customer
demand existing in an industry, A high demand or a growing
demand tends to moderate competition as each firm has
enough for it and need not grab it from others. Stagnant
demand may lead to competitive strategies designed to
snatch market share from others. Declining demand may
cause companies to maintain their market shares. Existing
firms or new entrants need to take the demand conditions
in the industry into account for the purpose of formulating
business strategies.
• • Exit barriers restrict the firms in an industry and prevent
them from leaving, even though the returns might be low or
might even be sometimes negative. The exit barriers are
economic, strategic or emotional factors preventing
companies from moving out after divestment of their
businesses. Economic factors could be the high investments
committed to plant and equipment that have no alternative
usage and high fixed costs of exit, such as, high
retrenchment costs or high severance pay owing to labour
agreements. Strategic factors could be interlinkages
between the different businesses of a company such as a
firm being its own supplier or buyer or different businesses
sharing a common pool of resources.
• Emotional factors could be a sentimental attachment to a
business, it being an ancestral business, or one founded by
the entrepreneur on his own, or unwillingness to part with a
business owing to loyalty to employees or distributors.

• Collectively, the three factors of competitive structure,

demand conditions and exit barriers determine the business
strategies that a firm is likely to adopt.
• As we described these three factors constituting the force of
competitive rivalry within an industry, you must have
noticed that business strategies are critically dependent on
the industry environment. The nature of industry
environment varies across industries and also with time.
There might be embryonic or introductory industries,
growth or sunrise industries, mature or stable industries
and declining or sunset industries.
• Each of these industries would require a different approach
to the formulation of business strategies. It is also important
to note that industries respond to time and follow a life
cycle.
• An industry in the mature stage today might be a declining
industry tomorrow. Here again, it is important for firms to
align their business strategies to the changing conditions in
the industry environment. The competitive equations
change, so do the demand conditions. Entry barriers
erected today may fall by the wayside as soon as some new
development takes place. Such is the dynamic nature of
strategic management where anything that a firm might do
today does not guarantee success tomorrow, unless there is
a willingness to respond to environmental conditions as
they arise in between.
Bargaining Power of Buyers

• The bargaining power of buyers constitutes the ability of the

buyers, individually or collectively, to force a reduction in
prices of products or services, demand a higher quality or
better service or to seek more value for their purchases in
any way. A high buyer bargaining power constitutes a
negative feature for existing firms or new entrants of an
industry. A low buyer bargaining power enables a firm to
pass on the cost escalation to buyers or to make the buyers
accept a lower quality of product and service at a higher
price.
• The bargaining power of buyers is high under these
conditions:

• • When the buyers are few in number

• • When the few buyers place large orders individually

• •When alternative suppliers are present, willing to supply at

a lower price or on favourable selling conditions

• •When the switching costs of buyers from one supplier to

the other is low
• • When the buyer itself charges a low price for its products
and is sensitive to price increases

• • When the purchased product constitutes a high

percentage of a buyer's costs, making it look around for
lower-priced supplies

• •When the buyer itself has the ability to integrate

backwards and create its own captive supply source
Bargaining Power of Suppliers

• Like the bargaining power of buyers, suppliers too have a

level of bargaining power. The bargaining power of suppliers
constitutes their ability, individually or collectively, to force
an increase in the price of the products or services or make
the buyers accept a lower quality of product or level of
service. A high supplier bargaining power constitutes a
positive feature for the existing firms or new entrants of an
industry. A low supplier bargaining power prevents a firm
from passing on its cost increases to the buyers or to make
the buyers accept a lower quality of product and service at a
higher price.
• The bargaining power of suppliers is high under these
conditions:

• • When the suppliers are few and the buyers are many

• • When the products or services are unique and are not

commonly available

• • When the substitutes of the products or services supplied

are not freely available

• • When the switching costs of a supplier from one buyer to

the other is low
• • When the supplier is not critically dependent on the
products or services supplied

• • When the buyer buys in small quantities and, therefore, is

not important to the supplier

• • When the suppliers have the ability to integrate forward

and use their own supplies for production of the end
product or service
Threat of Substitute Products

• Substitute products or services are those that apparently

are different but satisfy the same set of customer needs. We
referred to the example of tea and coffee as substitutable
products in the beginning of this section. We could also
include aerated drinks as another form of substitute in the
category of products serving the customer needs for drinks.
Other examples of substitute products and services could be
alternative modes of transportation, postal, fax and courier
services and electrical gadgets like bulbs and tube lights.
The platform for substitutability in every case, is the serving
of the customer need.
• The availability of close substitutes constitutes a negative
competitive force in an industry. In other words, those
industries which have no close substitutes are more
attractive than those that have one or more of such
substitutes. Obviously, firms in an industry having no close
substitutes can charge a higher price and earn higher
returns. For industries where close substitutes are available,
the level of price of products chargeable is restricted by the
price of the substitute available. Thus, firms have to
formulate their business strategies keeping in view the
intensity of the competitive force arising out of the
presence or absence of the threat of substitutes.
• With this, we come to an end of the discussion of the five
forces of competition in an industry. The purpose of an
industry analysis, in the context of strategic choice, is to
determine the industry attractiveness and to understand
the structure and dynamics of the industry with a view to
finding out the Continued relevance to strategic alternatives
that arc there before a firm. It that, for instance, if the
industry is not, or is no longer sufficiently attractive (i.e., it
does not offer long-term growth opportunities) then the
strategic alternatives that lie within the industry should not
be considered. It also means that alternatives may have to
be sought outside the industry, calling for diversification
moves.
• Using the five forces model of industry competition, a firm
can analyse its critical strengths and Weaknesses, its
position within the industry, the areas where strategic
changes may yield the maximum profits and the significant
opportunities and threats.