A note on Porter’s Five Forces Model
A note on Porter’s Five Forces Model
a) Rivalry between established competitors
What are the major factors determining the nature and intensity of competition between established firms?
In general, the fewer the number of firms in an industry, the easier is coordination of pricing behaviour, and the smaller the chance that one firm will initiate aggressive price competition An industry dominated by a single firm displays little competition and the dominant firm can exercise considerable discretion over the prices it charges. Diversity of competitors
The ability of the firms in an industry to avoid competition depends not only upon the number of firms but also on their similarities in terms of objectives, costs, strategies. Example: Oil suppliers in OPEC: they were aligned in the 70’s and prices rose up. They were disaligned in the 80’s and prices decreased
The more similar the offerings of rival firms, the more willing are customers to move from one supplier to the other. Where products are indistinguishable, the product is a commodity and the sole basis for competition is price
Example of commodities:
Raw materials : crude oil, gold bullions;
Some finished products: DRAM chips, US Treasury bills
Excess capacity and exit barriers
The propensity of firms in an industry to resort to aggressive price competition depends upon the balance between capacity and output. The presence of unused capacity encourages firms to compete for additional business in order to spread fixed costs over a greater sales volume. Excess capacity may be the result of declining market demand or cyclical market demand or overinvestment.
The period during which excess capacity overhangs an industry depends on the ease with which firms and resources can leave the industry. Costs and other impediments to leaving an industry are “barriers to exit”. Barriers to exit may be substantial where resources are durable and specialized, or where employees are entitled to job protection Example: Closure of mines in the 80s in Western countries were difficult as miners were heavily unionized
Cost condition: economies of scale and the ratio of fixed to variable costs The more important the economies of scale are, the greater are the incentives for expanding sales at the expense of competitors.
The higher the ratio of fixed to variable costs, the greater the willingness of firms to reduce prices in order to utilize spare capacity
Example: This is typically the case in petrochemicals, tires, steel.
b) Threat of entry
If an industry is earning a return on invested capital in excess of the cost of capital, that industry will act as a magnet to firms outside the industry.
An industry where no barriers to entry or exit exist is contestable. However in most industries, new entrants cannot enter on equal terms to those of established firms. The size of the advantage of established over entrant firms measures the height of barriers to entry, which determines the extent to which an industry can in the long term enjoy profits
The principal barriers to entry are:
Example: Exxon in the 80s spent almost $1 Billion in a vain attempt to catch up with existing players and become a player in the office computer systems market Economies of scale
In some industries, particularly those which are capital intensive or research intensive, efficiency requires producing at a very large scale.
New entrants are faced with the choice of entering either on a small scale and accepting high unit costs, or a large scale and running the risk of drastic under utilization of capacity while they build up sales volume
Example: Commercial jet engines for commercial airliners: Big economies of scale, thus only 3 players [General Electric/Snecma; Pratt and Whitney; Rolls Royce] Absolute cost advantages
Such advantages are usually associated with “first mover advantages”: by being early into the industry the established firms may have been able to acquire low cost sources of raw materials and by being longer they benefit from economies of learning. Example: in petroleum: ownership of oil fields prevents any second mover Product differentiation
In an industry where products are differentiated, established firms possess an advantage over new entrants by virtue of brand recognition and customer loyalty. New entrants must spend heavily on advertising and promotion to gain similar levels of brand awareness, or accept a small market share which can be gradually expanded
Example: Auditing, advertising, investment banking: established reputations and relationships are entry barriers
Access to channels of distribution
This barrier to entry is due to the distributors’s preference for established firms’ products: Limited capacity within distribution(eg shelf space), risk aversion, and fixed costs associated with carrying an additional product result in distributors’ reluctance to carry a new manufacturer’ product
Exemple : Ice cream storage in small outlets
Governmental and legal barriers
Granting of a license by a public authority
Examples: Taxi-cab services, broadcasting
In knowledge intensive industries: patents, copyrights and trade secrets Procurement regulation: the costs of becoming listed as an “approved supplier” are a barrier
Environmental and safety standards: the costs of compliance weigh more heavily on newcomers
The effectiveness of all these barriers to entry in excluding potential entrants depends upon the entrants’ expectations as to possible retaliation by established firms. Example of retaliation: Aggressive price-cutting, increased advertising, or legal maneuvers
c) Competition from substitutes
When there are few substitutes for a product, customers willing to pay a potentially high price In micro economic terms, demand is inelastic to price
Examples: Gasoline; Cigarettes
If there are close substitutes for a product, then there is a limit to the price customers are willing to pay and any increase in price will cause some customers to switch towards substitutes In micro economic terms, demand is elastic with respect to price. Example: frozen foods versus canned food and fresh produce
The extent to which the threat of substitutes is high depends upon two factors:
The propensity/willingness of buyers to substitutes
Example: Efforts by city planners to relieve traffic congestion either by charging the motorist or by subsidizing public transport have been ineffective in the US in encouraging motorists to forsake their cars for buses
The price performance characteristics of substitutes (ie the relative performance of alternative products in relation to their price)
If two products meet the same customer needs and one performs better than the other across all criteria, the price of the superior products determines the maximum price for the inferior product – example: batteries of identical size and voltage: the one with the shorter life expectancy will only sell if it undercuts the price of the longer-life battery Where products are meeting more complex needs and no product dominates all performance dimensions, a niche position in the market may be sustainable despite premium pricing
Example: Harley Davidson : inferior speed, acceleration, technical sophistication than Japanese motorcycles, but priced higher
Difficulty in perceiving performance differences can also inhibit substitution on the basis of price
Example: The subjective nature of flagrance makes comparison difficult for
the consumer. Direct copies (same ingredients!) of popular perfumes at less than half the price have not gained substantial market share
d) Bargaining power of buyers
Firms operate in two markets: the market for inputs (raw materials, components, finance, labor services) and for outputs (products and services sold to customers – be distributors, consumers or other manufacturers).
In both markets the relative profitability of the two parties to a transaction depends upon relative economic power.
Two factors are important in determining the strength of buying power
Some key points on buyers’price sensitivity:
1) It depends on the importance of the item as a proportion of their total cost Example: For food processing companies, metal cans are one of the largest single items in their purchase of materials. These companies are highly sensitive to the prices of metal cans
2) The less differentiated are the products of the supplying industry, the more willing is the buyer to switch suppliers based on the basis of price
Example: Supermarket chains can switch suppliers of packaged white breads
3) The greater the competition between buyers, the lower their profit margins, the greater their eagerness to achieve price reductions from their sellers Example: Automobile manufacturers place high pressures on their component suppliers
4) The greater the importance of the sold product to the quality of the buyer’s product or service, the less sensitive are buyers to the prices they are charged Example: PC vendors had to accept Microsoft’s Software prices
Relative bargaining power
Bargaining power rests ultimately upon refusal to deal with the other party. The balance of power between the two parties to a transaction depends on the credibility and effectiveness with which each makes this threat.
Key determinants of the relative bargaining power:
– the relative costs which each party sustains as a result of the transaction not being consummated
– the expertise of each party in leveraging its position through gamesmanship 3 factors are likely to be important in determining the bargaining power of buyers relative to that of sellers:
1) Size and concentration of buyers relative to suppliers
The smaller the number of suppliers, the less easy is it for a supplier to find alternative customers if one is lost.
The bigger the purchases of the customer, the greater is the damage from losing the customer.
The larger the size of the buyer relative to the supplier, the better able is the buyer to withstand any financial losses arising from failure to reach agreement.
Example: Buying consortiums are created to pool orders
2) Buyer’s information
The first essential for the exercise of bargaining power by buyers is that they are able to compare the prices and qualities of different suppliers’ products or services.
Examples: Lawyers, doctors, traders in the bazaars of Istanbul do not display the prices they charge
Note that knowledge of price is of little value if the characteristics of a product or service are not easily ascertained before purchase Example: It is
difficult to assess beforehand the value of investment advices, management consulting (or baldness treatment!)