Michael Porter's five-forces model

Date: 2015-10-07; view: 712.

Michael Porter devised a model to explain the forces that determine the competitive intensity of an industry and thereby the profit potential for companies within the industry. He defines the industry as ‘the group of firms producing products that are close substitutes for each other'. The five competitive forces are depicted in the figure below.

· Potential entrants or the strength of barriers to entry - how easy is it for new rivals to enter the industry? New entrants offer an industry greater capacity and greater competition for market share, thus posing a threat to existing competitors. The extent of this threat depends on barriers to entry. If barriers are high, then the threat of new entrants is low. Sources of barriers to entry include:

o Economies of scale, whereby unit costs decline as the volume produced increases. New entrants may thus enter on a large scale or not at all. If they enter on a small scale, they face cost advantages.

o Product differentiation, which may be based on building brand identification over time, entailing substantial expenditure on advertising. New entrants, for example, in the soap powder market, which is dominated by a few strong brands such as Ariel and Persil are faced by the huge potential costs of advertising and promotions to gain market share.

o Capital requirements, whereby the necessity to make a huge capital investment deters new entrants. A new entrant in an industry which relies on high levels of expenditure on research and development (R&D), such as the pharmaceutical industry, will need a huge amount of capital to compete with the large companies.

o Access to distribution channels, whereby the new entrant may have difficulty finding willing distributors. For example, the maker of a new food product may struggle to persuade supermarkets to stock it.

· Industry competitors or the extent of rivalry among existing competitors – how competitive is the existing market? The intensity of rivalry may depend on several factors:

o Numerous or equally balanced competitors – where firms are numerous, companies tend not to keep a close eye on competitors' moves, but where they are more equally balanced, each tracks others' moves with a view to countering competitors' strategies.

o Rate of industry growth – where an industry is growing rapidly, there is plenty of opportunity for firms to expand. Where an industry is growing slowly, on the other hand, competition centres on gaining market share.

o Product or service characteristics – if a product is so basic as to be essentially the same, regardless of supplier, then it resembles a commodity, and the buyer's choice depends on price and services, there intense competition results.

o Level of fixed costs (fixed costs are those that are not related to the actual production and thus do not vary with the level of production) – where there are high fixed costs, there is pressure for companies to fill capacity, cutting prices in order at least to cover fixed costs. An example is the airline industry. Scheduled flights may fly at less than their capacity of passengers and airline companies may offer discounted fares through various outlets.

o High exit barriers – these are the ‘economic, strategic, and emotional factors' that keep a company in an industry. It may have invested in particular assets, for example, which would be difficult to sell or convert to other users. Managers are inclined to carry on business so long as they are not making huge losses.

· Supplier power – the greater the power, the less control the organisation has on the supply of its inputs. A supplier is in a powerful position if (1) the supply industry is dominated by a few powerful companies such as the petrol industry; (2) there are few available substitutes for its product such as petrol.

· Buyer power – how much power do customers in the industry have to force down prices or bargain for higher quality? The buyers who are in the strongest position are those who (1) purchase a large proportion of the seller's output; or (2) can change to alternative suppliers with ease, as the product is a standard one.

· Threat from substitutes – what alternative products and services are there and what is the extent of the threat they pose? Substitute products may appear to be different, but serve the same function. Substitutes in effect place a ceiling on the prices that companies in the industry can charge.

The stronger these forces, the greater threat they pose, and the more constrained a company is in its ability to raise prices and increase profits in the short term. However, in the long term, a company may respond to strong competitive forces with strategies designed to alter the strength of particular forces to its advantage.

►Question/Answer session:

1. Describe in short each of the five competitive forces by Michael Porter.

2. What sources of barriers to entry could you refer to?

3. What factors can influence the intensity of rivalry?

4. What buyers can be thought of as having a bargaining power?

5. What suppliers are considered to have a bargaining power?

6. How could a competitive force called ‘threat from substitutes' work in case of such quite different substitutes as tea and coffee?

►Place the following points onto the five forces model (the first is done for you):

1. High rate of industry growth (industry competitors → plenty of opportunity for firms to expand)

2. Huge potential costs of advertising and promotions

3. Well-developed infrastructure

4. The supply industry is dominated by a few powerful companies such as the oil industry

5. High level of expenditure on R&D

6. Consumers in the area easily switch from one product to another

7. The necessity to make a huge capital investment

8. Wide range of related products on the market.

‘PUZZLE-1' POINT