Porter's Five Forces

A MODEL FOR INDUSTRY ANALYSIS

The model of pure competition implies that risk-adjusted rates of return should be
constant across firms and industries. However, numerous economic studies have
affirmed that different industries can sustain different levels of profitability part of this
difference is e!plained by industry structure.
"ichael Porter provided a framework that models an industry as bein# influenced by
five forces. The strate#ic business mana#er seekin# to develop an ed#e over rival firms
can use this model to better understand the industry conte!t in which the firm operates.
Diagram of Porter's 5 Forces

SUPPLIER POWER
$upplier concentration
%mportance of volume to supplier
&ifferentiation of inputs
%mpact of inputs on cost or differentiation
$witchin# costs of firms in the industry
Presence of substitute inputs
Threat of forward inte#ration
'ost relative to total purchases in industry

BARRIERS
TO ENTRY
(bsolute cost advanta#es
Proprietary learnin# curve
(ccess to inputs
)overnment policy
*conomies of scale
'apital re+uirements
,rand identity
$witchin# costs
(ccess to distribution
*!pected retaliation
Proprietary products
TREAT OF
SUBSTITUTES
-$witchin# costs
-,uyer inclination to
substitute
-Price-performance
trade-off of substitutes
BUYER POWER
,ar#ainin# levera#e
,uyer volume
,uyer information
,rand identity
Price sensitivity
Threat of backward inte#ration
Product differentiation
,uyer concentration vs. industry
$ubstitutes available
DE!REE OF RI"ALRY
-*!it barriers
-%ndustry concentration
-Fi!ed costs-.alue added
-%ndustry #rowth
-%ntermittent overcapacity
-Product differences
-$witchin# costs
-,rand identity
-&iversity of rivals
,uyers' incentives -'orporate stakes
I# Ri$a%r&
%n the traditional economic model, competition amon# rival firms drives profits to /ero.
,ut competition is not perfect and firms are not unsophisticated passive price takers.
0ather, firms strive for a competitive advanta#e over their rivals. The intensity of rivalry
amon# firms varies across industries, and strate#ic analysts are interested in these
differences.
*conomists measure rivalry by indicators of industry concentration. The 'oncentration
0atio 1'02 is one such measure. The ,ureau of 'ensus periodically reports the '0 for
major $tandard %ndustrial 'lassifications 1$%''s2. The '0 indicates the percent of
market share held by the four lar#est firms 1'0's for the lar#est 3, 45, and 56 firms in an
industry also are available2. ( hi#h concentration ratio indicates that a hi#h
concentration of market share is held by the lar#est firms - the industry is concentrated.
7ith only a few firms holdin# a lar#e market share, the competitive landscape is less
competitive 1closer to a monopoly2. ( low concentration ratio indicates that the industry
is characteri/ed by many rivals, none of which has a si#nificant market share. These
fragmented markets are said to be competitive. The concentration ratio is not the only
available measure the trend is to define industries in terms that convey more
information than distribution of market share.
%f rivalry amon# firms in an industry is low, the industry is considered to be disciplined.
This discipline may result from the industry's history of competition, the role of a leadin#
firm, or informal compliance with a #enerally understood code of conduct. *!plicit
collusion #enerally is ille#al and not an option in low-rivalry industries competitive
moves must be constrained informally. However, a maverick firm seekin# a competitive
advanta#e can displace the otherwise disciplined market.
7hen a rival acts in a way that elicits a counter-response by other firms, rivalry
intensifies. The intensity of rivalry commonly is referred to as bein# cutthroat, intense,
moderate, or weak, based on the firms' a##ressiveness in attemptin# to #ain an
advanta#e.
%n pursuin# an advanta#e over its rivals, a firm can choose from several competitive
moves8
'han#in# prices - raisin# or lowerin# prices to #ain a temporary advanta#e.
%mprovin# product differentiation - improvin# features, implementin# innovations
in the manufacturin# process and in the product itself.
'reatively usin# channels of distribution - usin# vertical inte#ration or usin# a
distribution channel that is novel to the industry. For e!ample, with hi#h-end
jewelry stores reluctant to carry its watches, Time! moved into dru#stores and
other non-traditional outlets and cornered the low to mid-price watch market.
*!ploitin# relationships with suppliers - for e!ample, from the 9:56's to the
9:;6's $ears, 0oebuck and 'o. dominated the retail household appliance
market. $ears set hi#h +uality standards and re+uired suppliers to meet its
demands for product specifications and price.
The intensity of rivalry is influenced by the followin# industry characteristics8
9. A %arger '(m)er of firms increases rivalry because more firms must compete
for the same customers and resources. The rivalry intensifies if the firms have
similar market share, leadin# to a stru##le for market leadership.
4. S%o* mar+et gro*t, causes firms to fi#ht for market share. %n a #rowin# market,
firms are able to improve revenues simply because of the e!pandin# market.
<. ig, fi-e. costs result in an economy of scale effect that increases rivalry.
7hen total costs are mostly fi!ed costs, the firm must produce near capacity to
attain the lowest unit costs. $ince the firm must sell this lar#e +uantity of product,
hi#h levels of production lead to a fi#ht for market share and results in increased
rivalry.
=. ig, storage costs or ,ig,%& /eris,a)%e /ro.(cts cause a producer to sell
#oods as soon as possible. %f other producers are attemptin# to unload at the
same time, competition for customers intensifies.
5. Lo* s*itc,i'g costs increases rivalry. 7hen a customer can freely switch from
one product to another there is a #reater stru##le to capture customers.
>. Lo* %e$e%s of /ro.(ct .iffere'tiatio' is associated with hi#her levels of rivalry.
,rand identification, on the other hand, tends to constrain rivalry.
;. Strategic sta+es are ,ig, when a firm is losin# market position or has potential
for #reat #ains. This intensifies rivalry.
3. ig, e-it )arriers place a hi#h cost on abandonin# the product. The firm must
compete. Hi#h e!it barriers cause a firm to remain in an industry, even when the
venture is not profitable. ( common e!it barrier is asset specificity. 7hen the
plant and e+uipment re+uired for manufacturin# a product is hi#hly speciali/ed,
these assets cannot easily be sold to other buyers in another industry. ?itton
%ndustries' ac+uisition of %n#alls $hipbuildin# facilities illustrates this concept.
?itton was successful in the 9:>6's with its contracts to build @avy ships. ,ut
when the .ietnam war ended, defense spendin# declined and ?itton saw a
sudden decline in its earnin#s. (s the firm restructured, divestin# from the
shipbuildin# plant was not feasible since such a lar#e and hi#hly speciali/ed
investment could not be sold easily, and ?itton was forced to stay in a declinin#
shipbuildin# market.
:. A .i$ersit& of ri$a%s with different cultures, histories, and philosophies make an
industry unstable. There is #reater possibility for mavericks and for misjud#in#
rival's moves. 0ivalry is volatile and can be intense. The hospital industry, for
e!ample, is populated by hospitals that historically are community or charitable
institutions, by hospitals that are associated with reli#ious or#ani/ations or
universities, and by hospitals that are for-profit enterprises. This mi! of
philosophies about mission has lead occasionally to fierce local stru##les by
hospitals over who will #et e!pensive dia#nostic and therapeutic services. (t
other times, local hospitals are hi#hly cooperative with one another on issues
such as community disaster plannin#.
96. I'.(str& S,a+eo(t# ( #rowin# market and the potential for hi#h profits induces
new firms to enter a market and incumbent firms to increase production. ( point
is reached where the industry becomes crowded with competitors, and demand
cannot support the new entrants and the resultin# increased supply. The industry
may become crowded if its #rowth rate slows and the market becomes saturated,
creatin# a situation of e!cess capacity with too many #oods chasin# too few
buyers. ( shakeout ensues, with intense competition, price wars, and company
failures.
,') founder ,ruce Henderson #enerali/ed this observation as the 0ule of Three
and Four8 a stable market will not have more than three si#nificant competitors,
and the lar#est competitor will have no more than four times the market share of
the smallest. %f this rule is true, it implies that8
o %f there is a lar#er number of competitors, a shakeout is inevitable
o $urvivin# rivals will have to #row faster than the market
o *ventual losers will have a ne#ative cash flow if they attempt to #row
o (ll e!cept the two lar#est rivals will be losers
o The definition of what constitutes the AmarketA is strate#ically important.
7hatever the merits of this rule for stable markets, it is clear that market stability
and chan#es in supply and demand affect rivalry. 'yclical demand tends to
create cutthroat competition. This is true in the disposable diaper industry in
which demand fluctuates with birth rates, and in the #reetin# card industry in
which there are more predictable business cycles.
II# T,reat Of S()stit(tes
%n Porter's model, substitute products refer to products in other industries. To the
economist, a threat of substitutes e!ists when a product's demand is affected by the
price chan#e of a substitute product. ( product's price elasticity is affected by substitute
products - as more substitutes become available, the demand becomes more elastic
since customers have more alternatives. ( close substitute product constrains the ability
of firms in an industry to raise prices.
The competition en#endered by a Threat of $ubstitute comes from products outside the
industry. The price of aluminum bevera#e cans is constrained by the price of #lass
bottles, steel cans, and plastic containers. These containers are substitutes, yet they
are not rivals in the aluminum can industry. To the manufacturer of automobile tires, tire
retreads are a substitute. Today, new tires are not so e!pensive that car owners #ive
much consideration to retreadin# old tires. ,ut in the truckin# industry new tires are
e!pensive and tires must be replaced often. %n the truck tire market, retreadin# remains
a viable substitute industry. %n the disposable diaper industry, cloth diapers are a
substitute and their prices constrain the price of disposables.
7hile the threat of substitutes typically impacts an industry throu#h price competition,
there can be other concerns in assessin# the threat of substitutes. 'onsider the
substitutability of different types of T. transmission8 local station transmission to home
T. antennas via the airways versus transmission via cable, satellite, and telephone
lines. The new technolo#ies available and the chan#in# structure of the entertainment
media are contributin# to competition amon# these substitute means of connectin# the
home to entertainment. *!cept in remote areas it is unlikely that cable T. could
compete with free T. from an aerial without the #reater diversity of entertainment that it
affords the customer.
III# B(&er Po*er
The power of buyers is the impact that customers have on a producin# industry. %n
#eneral, when buyer power is stron#, the relationship to the producin# industry is near
to what an economist terms a mo'o/so'& - a market in which there are many suppliers
and one buyer. Bnder such market conditions, the buyer sets the price. %n reality few
pure monopsonies e!ist, but fre+uently there is some asymmetry between a producin#
industry and buyers. The followin# tables outline some factors that determine buyer
power.
Buyers are Powerful if: Example
Buyers are concentrated - there are a few buyers with
significant market share
DOD purchases from defense contractors
Buyers purchase a significant proportion of output -
distribution of purchases or if the product is standardized
Circuit City and Sears' large retail market provides power
over appliance manufacturers
Buyers possess a credible backward integration threat -
can threaten to buy producing firm or rival
arge auto manufacturers' purchases of tires

Buyers are Weak if: Example
!roducers threaten forward integration - producer can take
over own distribution"retailing
#ovie-producing companies have integrated forward to
ac$uire theaters
Significant buyer switching costs - products not
standardized and buyer cannot easily switch to another
product
%B#'s &'( system strategy in the )*'('s
Buyers are fragmented +many, different- - no buyer has
any particular influence on product or price
#ost consumer products
!roducers supply critical portions of buyers' input -
distribution of purchases
%ntel's relationship with !C manufacturers
I"# S(//%ier Po*er
( producin# industry re+uires raw materials - labor, components, and other supplies.
This re+uirement leads to buyer-supplier relationships between the industry and the
firms that provide it the raw materials used to create products. $uppliers, if powerful,
can e!ert an influence on the producin# industry, such as sellin# raw materials at a hi#h
price to capture some of the industry's profits. The followin# tables outline some factors
that determine supplier power.
Suppliers are Powerful if: Example
Credible forward integration threat by suppliers
Ba.ter %nternational, manufacturer of hospital supplies,
ac$uired /merican 0ospital Supply, a distributor
Suppliers concentrated Drug industry's relationship to hospitals
Significant cost to switch suppliers #icrosoft's relationship with !C manufacturers
Customers !owerful Boycott of grocery stores selling non-union picked grapes

Suppliers are Weak if: Example
#any competitive suppliers - product is standardized 1ire industry relationship to automobile manufacturers
!urchase commodity products 2rocery store brand label products
Credible backward integration threat by purchasers 1imber producers relationship to paper companies
Concentrated purchasers 2arment industry relationship to ma3or department stores
Customers 4eak 1ravel agents' relationship to airlines
"# Barriers to E'tr& 0 T,reat of E'tr&
%t is not only incumbent rivals that pose a threat to firms in an industry the possibility
that new firms may enter the industry also affects competition. %n theory, any firm should
be able to enter and e!it a market, and if free entry and e!it e!ists, then profits always
should be nominal. %n reality, however, industries possess characteristics that protect
the hi#h profit levels of firms in the market and inhibit additional rivals from enterin# the
market. These are barriers to entry.
,arriers to entry are more than the normal e+uilibrium adjustments that markets
typically make. For e!ample, when industry profits increase, we would e!pect additional
firms to enter the market to take advanta#e of the hi#h profit levels, over time drivin#
down profits for all firms in the industry. 7hen profits decrease, we would e!pect some
firms to e!it the market thus restorin# a market e+uilibrium. Fallin# prices, or the
e!pectation that future prices will fall, deters rivals from enterin# a market. Firms also
may be reluctant to enter markets that are e!tremely uncertain, especially if enterin#
involves e!pensive start-up costs. These are normal accommodations to market
conditions. ,ut if firms individually 1collective action would be ille#al collusion2 keep
prices artificially low as a strate#y to prevent potential entrants from enterin# the market,
such e'tr&1.eterri'g /rici'g establishes a barrier.
,arriers to entry are uni+ue industry characteristics that define the industry. ,arriers
reduce the rate of entry of new firms, thus maintainin# a level of profits for those already
in the industry. From a strate#ic perspective, barriers can be created or e!ploited to
enhance a firm's competitive advanta#e. ,arriers to entry arise from several sources8
9. !o$er'me't creates )arriers# (lthou#h the principal role of the #overnment in
a market is to preserve competition throu#h anti-trust actions, #overnment also
restricts competition throu#h the #rantin# of monopolies and throu#h re#ulation.
%ndustries such as utilities are considered natural monopolies because it has
been more efficient to have one electric company provide power to a locality than
to permit many electric companies to compete in a local market. To restrain
utilities from e!ploitin# this advanta#e, #overnment permits a monopoly, but
re#ulates the industry. %llustrative of this kind of barrier to entry is the local cable
company. The franchise to a cable provider may be #ranted by competitive
biddin#, but once the franchise is awarded by a community a monopoly is
created. ?ocal #overnments were not effective in monitorin# price #ou#in# by
cable operators, so the federal #overnment has enacted le#islation to review and
restrict prices.
The re#ulatory authority of the #overnment in restrictin# competition is historically
evident in the bankin# industry. Bntil the 9:;6's, the markets that banks could
enter were limited by state #overnments. (s a result, most banks were local
commercial and retail bankin# facilities. ,anks competed throu#h strate#ies that
emphasi/ed simple marketin# devices such as awardin# toasters to new
customers for openin# a checkin# account. 7hen banks were dere#ulated,
banks were permitted to cross state boundaries and e!pand their markets.
&ere#ulation of banks intensified rivalry and created uncertainty for banks as
they attempted to maintain market share. %n the late 9:;6's, the strate#y of banks
shifted from simple marketin# tactics to mer#ers and #eo#raphic e!pansion as
rivals attempted to e!pand markets.
4. Pate'ts a'. /ro/rietar& +'o*%e.ge ser$e to restrict e'tr& i'to a' i'.(str&#
%deas and knowled#e that provide competitive advanta#es are treated as private
property when patented, preventin# others from usin# the knowled#e and thus
creatin# a barrier to entry. *dwin ?and introduced the Polaroid camera in 9:=;
and held a monopoly in the instant photo#raphy industry. %n 9:;5, Codak
attempted to enter the instant camera market and sold a comparable camera.
Polaroid sued for patent infrin#ement and won, keepin# Codak out of the instant
camera industry.
<. Asset s/ecificit& i',i)its e'tr& i'to a' i'.(str&# (sset specificity is the e!tent
to which the firm's assets can be utili/ed to produce a different product. 7hen an
industry re+uires hi#hly speciali/ed technolo#y or plants and e+uipment, potential
entrants are reluctant to commit to ac+uirin# speciali/ed assets that cannot be
sold or converted into other uses if the venture fails. (sset specificity provides a
barrier to entry for two reasons8 First, when firms already hold speciali/ed assets
they fiercely resist efforts by others from takin# their market share. @ew entrants
can anticipate a##ressive rivalry. For e!ample, Codak had much capital invested
in its photo#raphic e+uipment business and a##ressively resisted efforts by Fuji
to intrude in its market. These assets are both lar#e and industry specific. The
second reason is that potential entrants are reluctant to make investments in
hi#hly speciali/ed assets.
=. Orga'i2atio'a% 3I'ter'a%4 Eco'omies of Sca%e# The most cost efficient level of
production is termed Mi'im(m Efficie't Sca%e 1"*$2. This is the point at which
unit costs for production are at minimum - i.e., the most cost efficient level of
production. %f "*$ for firms in an industry is known, then we can determine the
amount of market share necessary for low cost entry or cost parity with rivals. For
e!ample, in lon# distance communications rou#hly 96D of the market is
necessary for "*$. %f sales for a lon# distance operator fail to reach 96D of the
market, the firm is not competitive.
The e!istence of such an economy of scale creates a barrier to entry. The
#reater the difference between industry "*$ and entry unit costs, the #reater the
barrier to entry. $o industries with hi#h "*$ deter entry of small, start-up
businesses. To operate at less than "*$ there must be a consideration that
permits the firm to sell at a premium price - such as product differentiation or
local monopoly.
,arriers to e!it work similarly to barriers to entry. *!it barriers limit the ability of a firm to
leave the market and can e!acerbate rivalry - unable to leave the industry, a firm must
compete. $ome of an industry's entry and e!it barriers can be summari/ed as follows8
Easy to Enter if there is:
Common technology
ittle brand franchise
/ccess to distribution channels
ow scale threshold
Difficult to Enter if there is:
!atented or proprietary know-how
Difficulty in brand switching
5estricted distribution channels
0igh scale threshold
Easy to Exit if there are:
Salable assets
ow e.it costs
%ndependent businesses
Difficult to Exit if there are:
Specialized assets
0igh e.it costs
%nterrelated businesses
DYNAMI5 NATURE OF INDUSTRY RI"ALRY
Eur descriptive and analytic models of industry tend to e!amine the industry at a #iven
state. The nature and fascination of business is that it is not static. 7hile we are prone
to #enerali/e, for e!ample, list )", Ford, and 'hrysler as the A,i# <A and assume their
dominance, we also have seen the automobile industry chan#e. 'urrently, the
entertainment and communications industries are in flu!. Phone companies, computer
firms, and entertainment are mer#in# and formin# strate#ic alliances that re-map the
information terrain. $chumpeter and, more recently, Porter have attempted to move the
understandin# of industry competition from a static economic or industry or#ani/ation
model to an emphasis on the interdependence of forces as dynamic, or punctuated
equilibrium, as Porter terms it.
%n $chumpeter's and Porter's view the dynamism of markets is driven by innovation. 7e
can envision these forces at work as we e!amine the followin# chan#es8
To/ 67 US I'.(stria% Firms )& Sa%es 6869 1 68::
1917 194 19!! 19"# 19""
) 6S Steel 2eneral #otors 2eneral #otors 7..on 2eneral #otors
8 Swift 6S Steel 9ord 2eneral #otors 9ord
& /rmour Standard Oil -:; Standard Oil -:; +7..on- #obil 7..on
< /merican Smelting 6S Steel 2eneral 7lectric 1e.aco %B#
= Standard Oil -:; Bethlehem Steel Chrysler 9ord 2eneral 7lectric
' Bethlehem Steel Swift #obil %B# #obil
> 9ord /rmour 1e.aco Socal +Oil- Chrysler
? Du!ont Curtiss-4right 6S Steel Du!ont 1e.aco
* /merican Sugar Chrysler %B# 2ulf Oil Du!ont
)( 2eneral 7lectric 9ord 2ulf Oil Standard Oil of %ndiana !hilip #orris
67 Largest US Firms )& Assets; 6878 a'. 68:9
19$9 19"7
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7@@O: +Standard Oil trust
broken up in )*))-
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Didde, %ncE, )*'*C sold to #cean %ndustries, )*>?C bankruptcy, )*?'
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sold to Con/gra-
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!ENERI5 STRATE!IES TO 5OUNTER TE FI"E FOR5ES
$trate#y can be formulated on three levels8
corporate level
business unit level
functional or departmental level.
The business unit level is the primary conte!t of industry rivalry. "ichael Porter
identified three #eneric strate#ies 1cost leadership, differentiation, and focus2 that can
be implemented at the business unit level to create a competitive advanta#e. The
proper #eneric strate#y will position the firm to levera#e its stren#ths and defend a#ainst
the adverse effects of the five forces.
Recomme'.e. Rea.i'g
Porter, "ichael *., Competitive Strategy: Techniques for Analyzing Industries and Competitors
Competitive Strategy is the basis for much of modern business strate#y. %n this classic work, "ichael
Porter presents his five forces and #eneric strate#ies, then discusses how to reco#ni/e and act on market
si#nals and how to forecast the evolution of industry structure. He then discusses competitive strate#y for
emer#in#, mature, declinin#, and fra#mented industries. The last part of the book covers strate#ic
decisions related to vertical inte#ration, capacity e!pansion, and entry into an industry. The book
concludes with an appendi! on how to conduct an industry analysis.