2 1Five Forces AnalysisWhat is it?F

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Five Forces Analysis
What is it?
Five Forces Analysis is a tool that enables managers to study the key factors in an industry environment
that shape that nature of competition: (1) rivalry among current competitors, (2) threat
of new entrants, (3) substitutes and complements, (4) power of suppliers, and (5) power of buyers.
When do we use it?
In a strategic analysis, Five Forces Analysis is an excellent method to help you analyze how competitive
forces shape an industry in order to adapt or influence the nature of competition. Collectively,
the Five Forces determine the attractiveness of an industry, its profit potential, and the ease and
attractiveness of mobility from one strategic position to another. Because of this, the analysis is
useful when firms are making decisions about entry or exit from an industry as well as to identify
major threats and opportunities in an industry.
Why do we use it?
This analysis was originally developed by Michael Porter, a Harvard professor and a noted authority
on strategy. While all firms operate in a broad socioeconomic environment that includes legal,
social, environmental, and economic factors, firms also operate in a more immediate competitive
environment. The structure of this competitive environment determines both the overall attractiveness
of an industry and helps identify opportunities to favorably position a firm within an industry.
Porter identified five primary forces that determine the competitive environment: (1) rivalry among
current competitors, (2) threat of new entrants, (3) substitutes and complements, (4) power of suppliers,
and (5) power of buyers.
1. Rivalry. Among the direct and obvious forces in the industry, existing competitors must
first deal with one another. When organizations compete for the same customers and try
to win market share at the others’ expense, all must react to and anticipate their competitors’
actions.
2. Treat of Entrants. New entrants into an industry compete with established companies
placing downward pressure on prices and ultimately profits. In the last century, Japanese
automobile manufacturers Toyota, Honda, and Nissan represented formidable new entrants
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to the U.S. market, threatening the market position of established U.S. players GM, Ford,
and Chrysler. The existence of substantial barriers to entry helps protect the profit potential
of existing firms and makes an industry more attractive.
3. Substitutes and Complements. Besides firms that directly compete, other firms can affect
industry dynamics by providing substitute products or services that are functionally similar
(i.e., accomplishing the same goal) but technically different. The existence of substitutes
threatens demand in the industry and puts downward pressure on prices and margins.
While substitutes are a potential threat, a complement is a potential opportunity because
customers buy more of a given product if they also demand more of the complementary
product. For example, iTunes was established as an important complement to Apple’s iPod,
and now the firm has leveraged connections among its suite of products including iPhone,
iPad, and the like.
4. Power of Suppliers. Suppliers provide resources in the form of people, raw materials, components,
information, and financing. Suppliers are important because they can dictate the
nature of exchange and the potential value created farther up the chain toward buyers.
Suppliers with greater power can negotiate better prices squeezing the margins of downstream
buyers.
5. Power of Buyers. Buyers in an industry may include end consumers, but frequently the term
refers to distributors, retailers, and other intermediaries. Like suppliers, buyers may have
important bargaining powers that dictate the means of exchange in a transaction.
POTENTIAL
ENTRANTS
SUPPLIERS BUYERS
SUBSTITUTES
INDUSTRY
COMPETITORS
Rivalry Among
Existing Firms
Threat of
New Entrants
Bargaining
Power of
Suppliers
Bargaining
Power of
Buyers
Threat of Substitute
Products or Services
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According to Porter, successful managers do more than simply react to this environment; they act
in ways that actually shape or “enact” the organization’s competitive environment. For example,
a firm’s introduction of substitute products or services can have a substantial influence over the
competitive environment, and in turn this may have a direct impact on the attractiveness of an
industry, its potential profitability, and competitive dynamics.
How do we use it?
Step 1. Analyze rivalry among existing competitors.
First identify the competitors within an industry. Competitors may include (1) small domestic
firms, especially their entry into tiny, premium markets; (2) strong regional competitors; (3) big
new domestic companies exploring new markets; (4) overseas firms, especially those that either
try to solidify their position in small niches (a traditional Japanese tactic) or are able to draw on
an inexpensive labor force on a large scale (as in China); and (5) newer entries, such as firms offering
their products online. The growth in competition from other countries has been especially
significant in recent years, with the worldwide reduction in international trade barriers.
Once competitors have been identified, the next step is to analyze the intensity of rivalry within
the industry. One of the big considerations is simply the number of firms within an industry. All
else being equal, the more firms in an industry, the higher the rivalry. It is tempting to look at duopolies—industries
with two dominant players (e.g., Coke and Pepsi)—and declare they have “high
rivalry.” But duopolies are far less competitive—and typically far more profitable—than the alternative
of many firms competing. Two additional considerations include whether (1) the incentives
to “fight” are low and (2) coordination between competitors is possible. We consider each in turn.
Rivalry will be less intense if existing players have few incentives to engage in aggressive pricing
behavior (i.e., slashing prices to gain market share). A number of things push back on this tendency.
For example, substantial market growth within an industry, especially if firms are capacity
constrained, lowers the incentive to fight. Similarly, if there are opportunities to differentiate offerings,
firms can avoid head-to-head competition. The cyclical nature of demand in an industry
can also be a big driver. Industries where demand ebbs and flows either with the business cycle
or seasonally tend to suffer from overcapacity in the down times. During these times, firms have
high incentives to cut prices in an attempt to use their excess capacity. Consider hotels in college
towns: They tend to have huge demand on a limited number of weekends throughout the year (e.g.,
football games and graduation). As a result, they usually have excess capacity the rest of the year.
Simply observe the prices at your average college town hotel on a random Tuesday in July. Prices
will likely be substantially lower than during peak demand times.
Coordination that helps reduce pressures to engage in aggressive price cutting may be possible
between competitors. In the extreme, firms may explicitly coordinate pricing and/or output. OPEC
is a moderately successful cartel of oil-producing nations that tries to control the price of oil. In
most mature economies, such explicit collusion is restricted as an antitrust violation. But there are
sometimes factors that facilitate tacit coordination. For example, few competitors raise the prospects
that firms will simply settle on a high price. This is more likely to occur in industries where there
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is a dominant player that others may follow. More homogeneity among competitors also raises the
prospects for this to occur. Best-price clauses—matching the best price of your competitor—can
also serve paradoxically as a way to keep prices higher by removing the benefits of slashing your
own prices.
Step 2. Analyze threat of new entrants.
There are three main categories of considerations when assessing whether new entrants are likely
to enter an industry. In particular, potential entrants are less likely to enter if:
1. Entrant faces high sunk costs. Sunk costs are investments that cannot be recovered once
invested. While it is true that one should not consider sunk costs once invested, ex ante (i.e.,
beforehand) the likelihood of investments being sunk increases the riskiness of an investment
and thus raises the threshold for entering an industry. High capital expenditures, in
and of themselves, do not pose a high barrier to entry. Arguably, if the future cash flows accruing
to entrants are attractive, a firm should be able to raise capital from financial institutions.
For example, R&D is a sunk cost that, if required to enter an industry, could raise risk
and deter entry. On the flip side, a large multipurpose facility, while expensive, is less risky
if it could be repurposed in the event of an exit from the industry (i.e., a large investment
but one that is not sunk). In this case, this capital cost would be less of a barrier to entry.
2. Incumbents have a competitive advantage. If potential entrants are at a competitive disadvantage
compared to existing players, it simply may not be profitable to enter. Examples of
potential barriers to entry of this type include legal barriers such as patents and licenses.
For example, the requirement that practicing lawyers must pass the bar exam creates a barrier
to entry to the legal profession. Pioneering and iconic brands can also be a significant
barrier to entry. In the soft drink industry, Coca-Cola and Pepsi have nearly unassailable
positions due largely to their brands. Another barrier can be precommitment contracts, for
example, that give access to distribution networks that lock in incumbent firms and lock out
potential entrants. For example,