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 a Porter’s Five Forces example of the Coca-Cola company.
2. Threat of Substitute Products or Services: A substitute is a product that performs the same or similar function as another product. Microeconomics teaches that the more substitutes a product has, the demand for the product becomes more elastic. Elastic demand means increased consumer price sensitivity which equates to less certainty of profits. For example, public-transportation is a substitute for driving a car, and e-mail is a substitute for writing letters. Conditions that increase the threat of substitutes are:
- An attractive price of substitutes: The price of substitutes acts as a ceiling to the price of the subject product. An attractive price of a substitute acts inhibits an industry from reaching its profit potential.
- Increased quality of substitutes: If the quality of a substitute is high, there is increased pressure to increase the quality of the subject product. For example, products such as Netflix and Hulu have introduced video on demand services offered through the internet. Cable and internet companies have answered back by introducing fiber optic networks to not only compete in the video on demand space, but offer incredible picture quality not yet available to the new technologies.
- Low switching costs to consumers: Switching costs to consumers can come in the form of monetary costs (transferring cell phone service: termination and initiation fees) or lifestyle switching costs (switching from driving a car to public transportation). Monetary costs effectively increase the price of the substitute products whereas lifestyle costs are more subjective and difficult to identify. In either case, the easier and less costly it is to switch to a substitute, the higher threat of that substitute.