Since its introduction in 1979, Porter’s Five Forces has become the de facto framework for industry analysis. The five forces measure the competitiveness of the market deriving its attractiveness. The analyst uses conclusions derived from the analysis to determine the company’s risk from in its industry (current or potential). The five forces are (1) Threat of New Entrants, (2) Threat of Substitute Products or Services, (3) Bargaining Power of Buyers, (4) Bargaining Power of Suppliers, (5) Competitive Rivalry Among Existing Firms. Don’t forget to check out an example of a Porter’s Five Forces analysis of the Coca-Cola company.
1. Threat of New Entrants: Microeconomics teaches that profitable industries attract new competition until the downward pressure on prices has squeezed all the economic profit from the firms. New firms in an industry put downward pressure on prices, upward pressure on costs and an increased necessity for capital expenditures in order to compete. The less threat there is from firms entering the industry, the more stable a firm’s profits are. An attractive, low-risk industry, is one in which there are significant barriers to entry such as:
- Economies of Scale: The theory behind supply side economies of scale state is that the most efficient level of production in an industry is at the point in which the average total costs are at a minimum. In some industries, this takes a significant market share to attain and if a firm cannot attain this level of efficiency, than the firm’s cost structure is too high and the firm will not be competitive. Demand side economies of scale, or “network effects,” is the theory that the value of a product is dependent on the others using the same product. For example, a competitor to Microsoft’s Excel is highly unlikely to emerge because of the huge network of business consumers that currently utilize the program. Any spreadsheet software that aspires to compete with Excel must be widely adopted by the business community in order to be effective.
- Consumer Switching Costs: Any additional cost the consumer bears to switch to a new product increases the effective price of the new product. This creates an additional barrier to entry for the entering firm. This effect may be two-fold for some products such as business enterprise software; the business may incur costs to implement and customize the software in addition to incurring costs through employee retraining and initial unproductivity.
- Product Differentiation: In industries in which there is high product differentiation, there is more consumer loyalty to the product. This creates difficulty for an entering firm; marketing expenses must be sufficient enough to lure customers away from the product of their choice.
- Government Barriers: In certain industries, the government will erect barriers to protect the industry from competition or to protect consumers from the industry. Certain industries are called “natural monopolies,” in that it is more efficient for a monopoly to exist than to allow competition. In this instance the government will protect the natural monopoly and ban competition (e.g. cable or electricity). In other industries, the government protects consumers from the negative industry effects by introducing barriers. For example, pharmaceutical companies must get product approval before it is available for sale.
- Capital Requirements: Some industries require a large financial outlay in order to enter the industry (before even reaching economies of scale). For example: A new pharmaceutical or biotech firm must spend millions in research and development costs to develop a product. On the other hand, a new accounting or investment banking firm has little capital requirement outlays to compete within their industry.
- Access to Distribution Channels: Competition for space on a grocery store shelf is a zero-sum game, if one product wins access to the shelf, another product lost. Large providers such as Nabisco and Keebler have strong relationships with the major grocery store chains and a new firm in the cookie market may have difficulty finding a place to sell the product.