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Porter’s Five Forces Model of Industry Competition

The “five forces” model developed by Michael E. Porter has been the most commonly used
analytical tool for examining the competitive environment. It describes the competitive environment in terms of five basic competitive forces:

  1. The threat of new entrants.
  2. The bargaining power of buyers.
  3. The bargaining power of suppliers.
  4. The threat of substitute products and services.
  5. The intensity of rivalry among competitors in an industry.

Each of these forces affects a firm’s ability to compete in a given market. Together, they
determine the profit potential for a particular industry. The model is shown in Exhibit 2.4.
A manager should be familiar with the five forces model for several reasons. It helps you
decide whether your firm should remain in or exit an industry. It provides the rationale for
increasing or decreasing resource commitments. The model helps you assess how to improve
your firm’s competitive position with regard to each of the five forces.56 For example, you
can use insights provided by the five forces model to understand how higher entry barriers
discourage new rivals from competing with you.57 Or you can see how to develop strong
relationships with your distribution channels. You may decide to find suppliers who satisfy
the price/performance criteria needed to make your product or service a top performer.
Consider, for example, some of the competitive forces affecting the hotel industry.58
Airbnb, a room-sharing site, offers more rooms than even Marriott. Online travel agencies
take a hefty cut of hotel bookings; and price-comparison sites make it difficult to raise room
rates. Growing supply may make it harder still. Steven Kent of Goldman Sachs expects that
the supply of new rooms in the next two years will outpace the previous five. Already, the
previous growth of American occupancy rates has begun to slow.

The Threat of New Entrants The threat of new entrants refers to the possibility that the
profits of established firms in the industry may be eroded by new competitors.59 The extent
of the threat depends on existing barriers to entry and the combined reactions from existing competitors. If entry barriers are high and/or the newcomer can anticipate a sharp retaliation from established competitors, the threat of entry is low. These circumstances discourage new competitors.

There are six major sources of entry barriers.
Economies of Scale Economies of scale refers to spreading the costs of production over the
number of units produced. The cost of a product per unit declines as the absolute volume
per period increases. This deters entry by forcing the entrant to come in at a large scale and
risk strong reaction from existing firms or come in at a small scale and accept a cost disadvantage. Both are undesirable options.
Product Differentiation When existing competitors have strong brand identification and
customer loyalty, product differentiation creates a barrier to entry by forcing entrants to
spend heavily to overcome existing customer loyalties.
Capital Requirements The need to invest large financial resources to compete creates a
barrier to entry, especially if the capital is required for risky or unrecoverable up-front advertising or research and development (R&D).
Switching Costs A barrier to entry is created by the existence of one-time costs that the
buyer faces when switching from one supplier’s product or service to another.
Access to Distribution Channels The new entrant’s need to secure distribution for its product can create a barrier to entry.

Cost Disadvantages Independent of Scale Some existing competitors may have advantages
that are independent of size or economies of scale. These derive from:
• Proprietary products
• Favorable access to raw materials
• Government subsidies
• Favorable government policies

The Bargaining Power of Buyers Buyers threaten an industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other.
These actions erode industry profitability.62 The power of each large buyer group depends
on attributes of the market situation and the importance of purchases from that group compared with the industry’s overall business. A buyer group is powerful when:
• It is concentrated or purchases large volumes relative to seller sales. If a large
percentage of a supplier’s sales are purchased by a single buyer, the importance of
the buyer’s business to the supplier increases. Large-volume buyers also are powerful
in industries with high fixed costs (e.g., steel manufacturing).
• The products it purchases from the industry are standard or undifferentiated.
Confident they can always find alternative suppliers, buyers play one company
against the other, as in commodity grain products.
• The buyer faces few switching costs. Switching costs lock the buyer to particular
sellers. Conversely, the buyer’s power is enhanced if the seller faces high switching
• It earns low profits. Low profits create incentives to lower purchasing costs. On the
other hand, highly profitable buyers are generally less price-sensitive.
• The buyers pose a credible threat of backward integration. If buyers either are partially
integrated or pose a credible threat of backward integration, they are typically able
to secure bargaining concessions.
• The industry’s product is unimportant to the quality of the buyer’s products or services.
When the quality of the buyer’s products is not affected by the industry’s product,
the buyer is more price-sensitive.

The Bargaining Power of Suppliers Suppliers can exert bargaining power by threatening
to raise prices or reduce the quality of purchased goods and services. Powerful suppliers
can squeeze the profitability of firms so far that they can’t recover the costs of raw material
inputs.64 The factors that make suppliers powerful tend to mirror those that make buyers
powerful. A supplier group will be powerful when:
• The supplier group is dominated by a few companies and is more concentrated
(few firms dominate the industry) than the industry it sells to. Suppliers selling to
fragmented industries influence prices, quality, and terms.
• The supplier group is not obliged to contend with substitute products for sale to the
industry. The power of even large, powerful suppliers can be checked if they compete
with substitutes.
• The industry is not an important customer of the supplier group. When suppliers
sell to several industries and a particular industry does not represent a significant
fraction of its sales, suppliers are more prone to exert power.
• The supplier’s product is an important input to the buyer’s business. When such inputs
are important to the success of the buyer’s manufacturing process or product quality,
the bargaining power of suppliers is high.
• The supplier group’s products are differentiated, or it has built up switching costs for
the buyer. Differentiation or switching costs facing the buyers cut off their options to
play one supplier against another.
• The supplier group poses a credible threat of forward integration. This provides a
check against the industry’s ability to improve the terms by which it purchases.

he Threat of Substitute Products and Services All firms within an industry compete
with industries producing substitute products and services.66 Substitutes limit the potential
returns of an industry by placing a ceiling on the prices that firms in that industry can profitably charge. The more attractive the price/performance ratio of substitute products, the
tighter the lid on an industry’s profits.
Identifying substitute products involves searching for other products or services that can
perform the same function as the industry’s offerings. This may lead a manager into businesses seemingly far removed from the industry. For example, the airline industry might not
consider video cameras much of a threat. But as digital technology has improved and wireless and other forms of telecommunication have become more efficient, teleconferencing
has become a viable substitute for business travel. That is, the rate of improvement in the
price–performance relationship of the substitute product (or service) is high.

The Intensity of Rivalry among Competitors in an Industry Firms use tactics like price
competition, advertising battles, product introductions, and increased customer service or
warranties. Rivalry occurs when competitors sense the pressure or act on an opportunity to
improve their position.68
Some forms of competition, such as price competition, are typically highly destabilizing
and are likely to erode the average level of profitability in an industry.69 Rivals easily match
price cuts, an action that lowers profits for all firms. On the other hand, advertising battles expand overall demand or enhance the level of product differentiation for the benefit of
all firms in the industry. Rivalry, of course, differs across industries. In some instances it is
characterized as warlike, bitter, or cutthroat, whereas in other industries it is referred to as
polite and gentlemanly. Intense rivalry is the result of several interacting factors, including
the following:
• Numerous or equally balanced competitors. When there are many firms in an
industry, the likelihood of mavericks is great. Some firms believe they can make
moves without being noticed. Even when there are relatively few firms, and they are
nearly equal in size and resources, instability results from fighting among companies
having the resources for sustained and vigorous retaliation.

• Slow industry growth. Slow industry growth turns competition into a fight for market
share, since firms seek to expand their sales.
• High fixed or storage costs. High fixed costs create strong pressures for all firms to
increase capacity. Excess capacity often leads to escalating price cutting.
• Lack of differentiation or switching costs. Where the product or service is perceived
as a commodity or near commodity, the buyer’s choice is typically based on price
and service, resulting in pressures for intense price and service competition. Lack of
switching costs, described earlier, has the same effect.
• Capacity augmented in large increments. Where economies of scale require that
capacity must be added in large increments, capacity additions can be very
disruptive to the industry supply/demand balance.
• High exit barriers. Exit barriers are economic, strategic, and emotional factors that
keep firms competing even though they may be earning low or negative returns
on their investments. Some exit barriers are specialized assets, fixed costs of exit,
strategic interrelationships (e.g., relationships between the business units and
others within a company in terms of image, marketing, shared facilities, and so
on), emotional barriers, and government and social pressures (e.g., governmental
discouragement of exit out of concern for job loss).

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