Porter's Five Forces Model: analysing industry structure
Author: Jim Riley Last updated: Sunday 23 September, 2012
Overview of the Five Forces Model Porter identified five factors that act together to determine the nature of competition within an industry. These are the: Threat of new entrants to a market Bargaining power of suppliers Bargaining power of customers (“buyers”) Threat of substitute products Degree of competitive rivalry
He identified that high or low industry profits (e.g. soft drinks v airlines) are associated with the following characteristics:
Let’s look at each one of the five forces in a little more detail to explain how they work. Threat of new entrants to an ...view middle of the document...
g. the threat of price war will act to discourage new entrants But note that competition law outlaws actions like predatory pricing
What makes an industry easy or difficult to enter? The following table helps summarise the issues you should consider:
Easy to Enter Common technology Access to distribution channels Low capital requirements No need to have high capacity and output Absence of strong brands and customer loyalty Difficult to Enter Patented or proprietary know-how Well-established brands Restricted distribution channels High capital requirements Need to achieve economies of scale for acceptable unit costs
Bargaining power of suppliers If a firm’s suppliers have bargaining power they will: Exercise that power Sell their products at a higher price Squeeze industry profits If the supplier forces up the price paid for inputs, profits will be reduced. It follows that the more powerful the customer (buyer), the lower the price that can be achieved by buying from them. Suppliers find themselves in a powerful position when: There are only a few large suppliers The resource they supply is scarce The cost of switching to an alternative supplier is high The product is easy to distinguish and loyal customers are reluctant to switch The supplier can threaten to integrate vertically The customer is small and unimportant There are no or few substitute resources available Just how much power the supplier has is determined by factors such as:
Factor Uniqueness of the input supplied Number and size of firms Note If the resource is essential to the buying firm and no close substitutes are available, suppliers are in a powerful position A few large suppliers can exert more power over market prices
supplying the resources Competition for the input from other industries Cost of switching to alternative sources
that many smaller suppliers each with a small market share If there is great competition, the supplier will be in a stronger position A business may be “locked in” to using inputs from particular suppliers – e.g. if certain components or raw materials are designed into their production processes. To change the supplier may mean changing a significant part of production
Bargaining power of customers Powerful customers are able to exert pressure to drive down prices, or increase the required quality for the same price, and therefore reduce profits in an industry. A great example in the UK currently is the dominant grocery supermarkets which are able exert great power over supply firms. You can see a great video about this issue here. Several factors determine the bargaining power of customers, including:
Factor Number of customers Their size of their orders Number of firms supplying the product The threat of integrating backwards The cost of switching Note The smaller the number of customers, the greater their power The larger the volume, the greater the bargaining power of customers The smaller the number of alternative...