Porter’s Five Forces Model of Competition

Michael Porter (Harvard Business School Management Researcher) designed various vitalframeworks for developing an organization’sstrategy. One of the most renowned amongmanagers making strategic decisions is the fivecompetitive forces model that determines industrystructure. According to Porter, the nature of competition in any industry is personified in the following five forces:

i. Threat of new potential entrants

ii. Threat of substitute product/services

iii. Bargaining power of suppliers

iiii. Bargaining power of buyers

v. Rivalry among current competitors

FIGURE: Porter’s Five Forces model

The five forces mentioned above are verysignificant from point of view of strategyformulation. The potential of these forces differsfrom industry to industry. These forces jointlydetermine the profitability of industry because theyshape the prices which can be charged, the costswhich can be borne, and the investment requiredto compete in the industry. Before making strategicdecisions, the managers should use the five forcesframework to determine the competitive structureof industry.

Let’s discuss the five factors of Porter’s model in detail:

1. Risk of entry by potentialcompetitors:Potential competitors refer to the firms which are not currently competing in the industry but have the potential to do so if givena choice. Entry of new players increases the industry capacity, begins a competition for market share and lowers the current costs. The threat of entry by potential competitors is partially a function of extent of barriers to entry. The various barriers to entry are-

• Economies of scale

• Brand loyalty

• Government Regulation

• Customer Switching Costs

• Absolute Cost Advantage

• Ease in distribution

• Strong Capital base

2. Rivalry among current competitors: Rivalryrefers to the competitive struggle for market share between firms in an industry. Extreme rivalry among established firms poses a strongthreat to profitability. The strength of rivalryamong established firms within an industry is a function of following factors:

• Extent of exit barriers

• Amount of fixed cost

• Competitive structure of industry

• Presence of global customers

• Absence of switching costs

• Growth Rate of industry

• Demand conditions

3. Bargaining Power of Buyers: Buyers refer to the customers who finally consume the product or the firms who distribute the industry’sproduct to the final consumers. Bargainingpower of buyers refer to the potential of buyersto bargain down the prices charged by the firms in the industry or to increase the firmscost in the industry by demanding betterquality and service of product. Strong buyerscan extract profits out of an industry by lowering the prices and increasing the costs. They purchase in large quantities. They have full information about the product and the market. They emphasize upon qualityproducts. They pose credible threat of backward integration. In this way, they are regarded as a threat.

4. Bargaining Power of Suppliers: Suppliersrefer to the firms that provide inputs to the industry. Bargaining power of the suppliersrefer to the potential of the suppliers to increase the prices of inputs( labour, raw materials, services, etc) or the costs of industryin other ways. Strong suppliers can extractprofits out of an industry by increasing costs of firms in the industry. Suppliers products have a few substitutes. Strong suppliers’ products are unique. They have high switching cost. Theirproduct is an important input to buyer’sproduct. They pose credible threat of forward integration. Buyers are not significant to strongsuppliers. In this way, they are regarded as a threat.

5. Threat of Substitute products: Substituteproducts refer to the products having ability of satisfying customers needs effectively. Substitutes pose a ceiling (upper limit) on the potential returns of an industry by putting a setting a limit on the price that firms can charge for their product in an industry. Lesserthe number of close substitutes a product has, greater is the opportunity for the firms in industry to raise their product prices and earngreater profits (other things being equal).

The power of Porter’s five forces varies from industry to industry. Whatever be the industry, these five forces influence the profitability as theyaffect the prices, the costs, and the capitalinvestment essential for survival and competition in industry. This five forces model also help in making strategic decisions as it is used by the managers to determine industry’s competitive structure.

Porter ignored, however, a sixth significant factor- complementaries. This term refers to the reliancethat develops between the companies whose products work is in combination with each other. Strong complementors might have a strongpositive effect on the industry. Also, the five forcesmodel overlooks the role of innovation as well as the significance of individual firm differences. It presents a stagnant view of competition.