Porter's Five Forces: Business Study Notes

🎯 Porter's Five Forces Analysis

• What the framework is, who created it, and why it was developed
• Horizontal versus vertical competition
• The five forces: threat of new entrants, threat of substitutes, bargaining power of customers, bargaining power of suppliers, competitive rivalry
• Factors that are not forces: industry growth rate, technology and innovation, government, complementary products and services
• How the framework is used in practice
• Criticisms and extensions

📌 Overview

Porter's Five Forces Framework is a method of analysing the competitive environment of a business.

• It is rooted in industrial organization economics.
• It identifies five forces that determine the competitive intensity of an industry and, consequently, its attractiveness or unattractiveness with respect to profitability.
• An "unattractive" industry is one in which these forces collectively limit the potential for above-normal profits.
• The most unattractive industry structure would approach that of pure competition, in which available profits for all firms are reduced to normal profit levels.

Origin

• Originator: Michael E. Porter of Harvard Business School.
• First published in Harvard Business Review in 1979.
• Porter developed it in response to the then-prevalent SWOT analysis, which he criticized for its lack of analytical rigor and its ad hoc application.
• The model is grounded in the structure–conduct–performance paradigm of industrial organization economics.
• Other strategic tools developed by Porter: the value chain framework and the concept of generic competitive strategies.

Microenvironment

• Porter refers to these forces as the microenvironment, in contrast to the more general term macroenvironment.
• They are the forces close to a company that affect its ability to serve its customers and make a profit.
• A change in any of the forces normally requires a business unit to re-assess the marketplace given the overall change in industry information.
• Overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms can apply their core competencies, business model or network to achieve a profit above the industry average.

Example: the airline industry

• Industry profitability is low because of its underlying structure: high fixed costs and low variable costs, which give enormous latitude in the price of airline travel.
• Airlines tend to compete on cost, which drives down the profitability of individual carriers and of the industry itself, because it simplifies the customer's decision to buy or not buy a ticket.
• A few carriers, such as Richard Branson's Virgin Atlantic, have tried, with limited success, to use sources of differentiation to increase profitability.
• Lesson: businesses must continuously evaluate their competitive landscape and adapt strategies as industry dynamics change.

⚖️ Horizontal and Vertical Competition

Type	Forces
Horizontal competition (three sources)	Threat of substitute products or services; threat posed by established industry rivals; threat of new entrants
Vertical competition (two sources)	Bargaining power of suppliers; bargaining power of buyers

🚪 Force 1: Threat of New Entrants

• New entrants put pressure on current firms through their desire to gain market share.
• This in turn puts pressure on prices, costs, and the rate of investment needed to sustain a business in the industry.
• The threat is particularly intense if entrants are diversifying from another market, because they can leverage existing expertise, cash flow, and brand identity, straining existing companies' profitability.

Barriers to entry

• Barriers to entry are advantages that existing, established companies have over new entrants. They restrict the threat of new entrants.
  • High barriers: threat reduced.
  • Low barriers: risk of new companies entering is high.
• The most attractive segment is one in which entry barriers are high and exit barriers are low. However, high barriers to entry almost always make exit more difficult.
• Porter differentiates two factors affecting how much of a threat new entrants may pose: barriers to entry and expected retaliation.

Porter's seven major sources of entry barriers

#	Source	Explanation
1	Supply-side economies of scale	Spreading fixed costs over a larger volume of units reduces cost per unit. A new entrant must either start at a smaller volume and accept a price disadvantage, or risk entering at large scale to try to displace the market leader.
2	Demand-side benefits of scale	A buyer's willingness to purchase a product increases with other people's willingness to purchase it. Also known as the network effect: people value being in a "network" with a larger number of users of the same company.
3	Customer switching costs	Illustrated by structural market characteristics such as supply chain integration, but can also be created by firms. Example: airline frequent flyer programs.
4	Capital requirements	The Internet has influenced this dramatically: websites and apps can be launched cheaply and easily, unlike the brick-and-mortar industries of the past.
5	Incumbency advantages independent of size	For example, customer loyalty and brand equity.
6	Unequal access to distribution channels	If there are few distribution channels, new entrants may struggle to find a retail or wholesale channel because existing competitors have a claim on them.
7	Government policy	Sanctioned monopolies, legal franchise requirements, patents, and regulatory requirements.

Expected retaliation

• Example: in oligopoly markets, prices generally settle at an equilibrium because any price rise or cut is easily matched by the competition.

🔄 Force 2: Threat of Substitutes

• A substitute product uses a different technology to try to solve the same economic need.
• Examples of substitutes:
  • meat, poultry, and fish
  • landlines and cellular telephones
  • airlines, automobiles, trains, and ships
  • beer and wine

Coke, Pepsi and tap water

• Tap water is a substitute for Coke.
• Pepsi uses the same technology (albeit different ingredients) to compete head-to-head with Coke, so it is not a substitute.
• Increased marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi.
• Increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks), while giving Pepsi a larger market share at Coke's expense.

Potential factors

• Buyer propensity to substitute: includes tangible and intangible factors. Brand loyalty can be very important (as in Coke and Pepsi), and contractual and legal barriers are also effective.
• Relative price performance of the substitute.
• Buyer's switching costs: well illustrated by the mobility industry. Uber and its competitors took advantage of the incumbent taxi industry's dependence on legal barriers to entry; when those fell away, it was trivial for customers to switch. There were no costs, as every transaction was atomic, with no incentive for customers not to try another product.
• Perceived level of product differentiation: classic Porter, in that there are only two basic mechanisms for competition, lowest price or differentiation. Developing multiple products for niche markets is one way to mitigate this factor.
• Number of substitute products available in the market.
• Ease of substitution.
• Availability of close substitutes.

🛒 Force 3: Bargaining Power of Customers

• Also described as the market of outputs.
• It is the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes.
• Firms can take measures to reduce buyer power, such as implementing a loyalty program.
• Buyer power is higher if buyers have many alternatives, lower if they have few choices.

Potential factors

• Buyer concentration to firm concentration ratio
• Degree of dependency upon existing channels of distribution
• Bargaining leverage, particularly in industries with high fixed costs
• Buyer switching costs
• Buyer information availability
• Availability of existing substitute products
• Buyer price sensitivity
• Differential advantage (uniqueness) of industry products
• RFM (customer value) analysis

🏭 Force 4: Bargaining Power of Suppliers

• Also described as the market of inputs.
• Suppliers of raw materials, components, labour, and services (such as expertise) can be a source of power over the firm when there are few substitutes.
• Example: if you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it.
• Suppliers may refuse to work with the firm or charge excessively high prices for unique resources.

Potential factors

• Supplier switching costs relative to firm switching costs
• Degree of differentiation of inputs
• Impact of inputs on cost and differentiation
• Presence of substitute inputs
• Strength of the distribution channel
• Supplier concentration to the firm concentration ratio
• Employee solidarity (e.g. labor unions)
• Supplier competition: the ability to forward vertically integrate and cut out the buyer

⚔️ Force 5: Competitive Rivalry

• Competitive rivalry is a measure of the extent of competition among existing firms.
• Competitive moves that might limit profitability and lead to further competitive moves include:
  • price cuts
  • increased advertising expenditures
  • investing in service/product enhancements and innovation
• For most industries, the intensity of competitive rivalry is the biggest determinant of the competitiveness of the industry.
• Understanding industry rivals is vital to successfully marketing a product. Positioning depends on how the public perceives a product and distinguishes it from that of competitors.
• An organization must be aware of its competitors' marketing strategies and pricing, and be reactive to any changes made.
• Rivalry tends to be cutthroat and industry profitability low when the potential factors below are present.

Potential factors

• Competitive advantage through innovation
• Competition between online and offline organizations
• Level of advertising expense
• Powerful competitive strategy, potentially realized by adhering to Porter's work on low cost versus differentiation
• Firm concentration ratio

🧩 Factors, Not Forces

Other factors should also be considered when evaluating a firm's strategic position. They are commonly mistaken for the underlying structure of the firm, but the underlying structure consists of the five forces above.

Industry growth rate

• Bad strategy decisions can be made when there is a narrow focus on an industry's growth rate.
• Rapid growth can seem attractive, but it can also attract new entrants, especially if entry barriers are low and suppliers are powerful.
• Profitability is not guaranteed if powerful substitutes become available to customers.
• Example: Blockbuster dominated the rental market throughout the 1990s. In 1998, Reed Hastings founded Netflix and entered the market, and Netflix's CEO was famously laughed out of the room. Blockbuster's key pitfall was ignoring its competitors and focusing on its growth in the industry.

Technology and innovation

• The technology industry continues to expand rapidly, yet has inherent limitations, most notably that customers often cannot physically interact with or test products.
• Technology alone does not always deliver a compelling customer experience.
• In some cases, companies in traditional industries with high barriers to entry, high switching costs and price-sensitive buyers can achieve greater profitability than those positioned as "tech-savvy."
• Example: websites with menus and online booking attract customers to a restaurant, but the restaurant experience cannot be delivered online. Food delivery companies like Uber Eats can deliver food but cannot replace the restaurant's atmospheric experience.

Government

• Government cannot be a standalone force; it is a factor that can affect the structure of the five forces. It is neither good nor bad for an industry's profitability.
• Examples:
  • patents can raise barriers to entry
  • supplier power can be raised by union favoritism from government policies
  • failing companies reorganizing due to bankruptcy laws

Complementary products and services

• Like government, complements cannot be a standalone factor, because they are not necessarily bad or good for industry profitability.
• Complements occur when a customer benefits from multiple products combined. Individually, those standalone products can be redundant.
  • Example: a car would be unusable without petrol/gas and a driver.
  • Example: a computer is best used with computer software.
• This factor is controversial, as many believe it to be a 6th force. However, complements influence the forces more than they form the underlying structure of the market.
• Complements can:
  • influence barriers to entry by lowering or raising them (e.g. Apple providing a set of tools to develop apps lowers barriers to entry)
  • make substitution easier (e.g. Spotify replacing CDs)
• A strategy consultant's job is to identify complements and apply them to the forces above.

🧭 Usage

• Strategy consultants occasionally use the framework for a qualitative evaluation of a firm's strategic position.
• For most consultants it is only a starting point; value chain analysis or another type of analysis may be used in conjunction.
• Like all general frameworks, an analysis that uses it to the exclusion of specifics about a particular situation is considered naïve.
• According to Porter, it should be used at the line-of-business industry level, not at the industry group or industry sector level.
• An industry is defined at a lower, more basic level: a market in which similar or closely related products and/or services are sold to buyers.
• A firm that competes in a single industry should develop, at a minimum, one five forces analysis for its industry.
• For diversified companies, the primary issue in corporate strategy is the selection of industries (lines of business) in which to compete. The average Fortune Global 1,000 company competes in 52 industries.

🗣️ Criticisms and Extensions

Three dubious assumptions (Coyne and Subramaniam)

Kevin P. Coyne and Somu Subramaniam claim that three dubious assumptions underlie the five forces:

1. Buyers, competitors, and suppliers are unrelated and do not interact and collude.
2. The source of value is a structural advantage (creating barriers to entry).
3. Uncertainty is low, allowing participants in a market to plan for and respond to changes in competitive behavior.

Complementors: the "6th force"

• In the mid-1990s, Adam Brandenburger and Barry Nalebuff of Yale School of Management used game theory to add the concept of complementors (also called "the 6th force") to explain the reasoning behind strategic alliances.
• Complementors are known as the impact of related products and services already in the market.
• The idea of complementors as the sixth force has often been credited to Andrew Grove, former CEO of Intel Corporation.
• Porter indirectly rebutted this by referring to innovation, government, and complementary products and services as "factors" that affect the five forces.

Resource-based view

• It may not be feasible to evaluate the attractiveness of an industry independently of the resources a firm brings to it.
• It is argued (Wernerfelt 1984) that the theory should be combined with the resource-based view (RBV) to give the firm a sounder framework.

Other criticisms

• It places too much weight on the macro-environment and does not assess more specific areas of the business that also impact competitiveness and profitability.
• It does not provide any actions to help deal with high or low force threats (e.g., what should management do if there is a high threat of substitution?).