Industry Structure and Firm Strategy: The Five Forces Model

INDUSTRY VS. FIRM EFFECTS IN DETERMINING FIRM PERFORMANCE

Firm Performance = { Industry Effects, Firm Effects }

Industry Effects – Firm performance attributed to the structure of the industry in which the
firm competes.
- describe the underlying economic structure of the industry.
- The structure of an industry is determined by elements common to all industries.
Porter’s 5 Forces – Industry Level Framework

Firm effects - Firm performance attributed to the actions managers/strategic leaders take.
 Firms within the same industry can differ
 Differences among firms can lead to competitive advantage
RBV – Firm level Framework
A firm’s strategy -> Can reveal 55% of its performance!

Industry: An industry is a group of incumbent companies facing more or less the same set of
suppliers and buyers.
- Also, group of firms producing similar products and services.

Industry analysis : A method to (1) identify an industry’s profit potential [the level of
profitability that can be expected for the average firm]
and
(2) derive implications for a firm’s strategic position within an industry.

Strategic Position: A firm’s strategic profile based on the difference between value creation
and cost (V − C ).

Five forces model

A framework that identifies five forces that determine the profit potential of an industry and
shape a firm’s competitive strategy.
Not a tool for internal analysis.

Porter derived two key insights: 1. Competition to be considered broadly – not just
competitors, but other stakeholders too.
2. Profit potential is neither random nor entirely determined by industry specific factors. It is
a function of 5 forces.

Economic value a firm creates = V (Value the firm creates with its products and services) – C
(cost of producing V)

V-C should be as maximum as possible – capture as much economic value in the industry as
possible.

As a rule of thumb, the stronger the five forces, the lower the industry’s profit potential—
making the industry less attractive for competitors.
Conversely, the weaker the five forces, the greater the industry’s profit potential—making
the industry more attractive.

1. Threat of entry: The risk that potential competitors will enter an industry.
Entry Barriers: Obstacles that determine how easily a firm can enter an industry and often
significantly predict industry profit potential.

Incumbent firms can benefit from several important sources of entry barriers:
■ Economies of scale -> spread fixed costs over more units, employ technology more
efficiently, benefit from a more specialized division of labor, and demand better terms
from their suppliers.
■ Network effects -> The value of a product or service for an individual user increases with
the number of total users.
- This is an example of a positive externality.
■ Customer switching costs -> Switching costs are incurred by moving from one supplier to
another.
- One time sunk cost, and a great barrier.
■ Capital requirements -> The potential new entrant must carefully weigh the required
capital investments, the cost of capital, and the expected return.
Threat of entry is high when capital requirements are < the expected returns.
■ Advantages independent of size -> brand loyalty, proprietary technology, preferential
access to raw materials and distribution channels, favorable geographic locations, and
cumulative learning and experience effects.
■ Government policy -> threat of entry is high when restrictive government policies do not
exist or when industries become deregulated.
■ Credible threat of retaliation -> to protect their market share, often initiating a price war
with the goal of driving out these new entrants.
Threat of entry is high when new entrants expect that incumbents will not or cannot
retaliate.

If the barriers to entry for an industry are low, then the industry’s attractiveness (as per
Porter’s framework) is low.
The stronger competitive forces in the industry are the less profitable it is. An industry with
low barriers to enter, having few buyers and suppliers but many substitute products and
competitors will be seen as very competitive and thus, not so attractive due to its low
profitability.

2. THE POWER OF SUPPLIERS: This force reduces a firm’s ability to obtain superior
performance for two reasons:
1. Powerful suppliers can raise the cost of production by demanding higher prices for
their inputs or by reducing the quality of the input factor or service level delivered.
2. Powerful suppliers are a threat to firms because they reduce the industry’s profit
potential by capturing part of the economic value created.

The relative bargaining power of suppliers is high when:

■ The supplier’s industry is more concentrated than the industry it sells to.
■ Suppliers do not depend heavily on the industry for a large portion of their revenues.
■ Incumbent firms face significant switching costs when changing suppliers.
■ Suppliers offer products that are differentiated.
■ There are no readily available substitutes for the products or services that the suppliers
offer.
■ Suppliers can credibly threaten to forward-integrate into the industry.

3. THE POWER OF BUYERS: Powerful buyers are a threat to the producing firms because
they reduce the industry’s profit potential by capturing part of the economic value
created.

The power of buyers is high when:

■ There are a few buyers and each buyer purchases large quantities relative to the size of
a single seller.
■ The industry’s products are standardized or undifferentiated commodities.
■ Buyers face low or no switching costs.
■ Buyers can credibly threaten to backwardly integrate into the industry.

Companies need to be aware of situations when buyers are especially price sensitive. This is
the case when:
■ The buyer’s purchase represents a significant fraction of its cost structure or procurement
budget.
■ Buyers earn low profits or are strapped for cash.
■ The quality (cost) of the buyers’ products and services is not affected much by the quality
(cost) of their inputs.

The bargaining power of buyers also increases when their switching costs are low. This
threat is even more pronounced if the products are non-differentiated commodities from
the consumer’s perspective.
Buyers are also powerful when they can credibly threaten backward integration. Backward
integration occurs when a buyer moves upstream in the industry value chain, into the
seller’s business.

4. THE THREAT OF SUBSTITUTES

The threat of substitutes is the idea that products or services available from outside the
given industry will come close to meeting the needs of current customers.

A high threat of substitutes reduces industry profit potential by limiting the price the
industry’s competitors can charge for their products and services.
The threat of substitutes is high when:
■ The substitute offers an attractive price-performance trade-off.
■ The buyers cost of switching to the substitute is low.
In addition to a lower price, substitutes may also become more attractive by offering a
higher value proposition.

5. RIVALRY AMONG EXISTING COMPETITORS

Rivalry among existing competitors describes the intensity with which companies within
the same industry jockey for market share and profitability.
- The other four forces all exert pressure upon this rivalry.
- The stronger the forces, the stronger the expected competitive intensity, which in
turn limits the industry’s profit potential.

When intense rivalry among existing Alternatively, competitors can use non-
competitors brings about price price competition to create more value in
discounting, industry profitability erodes. terms of product features and design,
quality, promotional spending, and after-
sales service and support.

However, when these moves create unique products with features tailored closely to meet
customer needs and willingness to pay, then average industry profitability tends to increase
because producers are able to raise prices and thus increase revenues and profit margins.

The intensity of rivalry among existing competitors is determined largely by the following
factors:
■ Competitive industry structure -> The competitive industry structure refers to elements
and features common to all industries. The structure of an industry is largely captured by:
- The number and size of its competitors.
- The firm’s degree of pricing power.
- The type of product or service (commodity or differentiated product).
- The height of entry barriers.
 Fragmented Consolidated / Monopoly
Lower Profit Potential Highly Profitable

The four main competitive industry structures are:

1.Perfect competition: A perfectly competitive industry is fragmented and has many
small firms, a commodity product, ease of entry, and little or no ability for individual
firm to raise its prices.
- Firms are approxly similar in size and resources
- Consumers make purchasing decisions solely on price.
- Firms can only achieve competitive parity.

2.Monopolistic competition: A monopolistically competitive industry has many firms, a

differentiated product, some obstacles to entry, and the ability to raise prices for a
relatively unique product while retaining customers.
- Firms now offer products or services with unique features.
- While products between competitors tend to be similar, they are by no means
identical.
- Firms selling a product with unique features tend to have some degree of monopoly
power over pricing, thus the name “monopolistic competition.”
- Degree of product differentiation acheived through advertising.

3.Oligopoly: An oligopolistic industry is consolidated with a few large firms,

differentiated products, high barriers to entry, and some degree of pricing power.
- The degree of pricing power depends on the degree of product differentiation.
- Key feature of an oligopoly : competing firms are interdependent.
- The actions of one firm influence the behaviors of the others - often analyzed using
game theory, which attempts to predict strategic behaviors by assuming that the
moves and reactions of competitors can be anticipated.
- Firms have an incentive to coordinate their strategic actions to maximize joint
performance.
 - Preferred mode of competition: Non-price competition

4.Monopoly: An industry is a monopoly when there is only one, often large firm
supplying the market.
- The firm may offer a unique product, and the challenges to moving into the industry
tend to be high.
- Considerable pricing power - firm and thus industry profit tends to be high.
- “The one firm is the industry”
- Natural monopolies: Gas, Water, Power supply and such utilities.
- Near monopolies: These are firms that have accrued significant market power, for
example, by owning valuable patents or proprietary technology.
- These near monopolies are firms that have accomplished product differentiation to
such a degree that they are in a class by themselves, just like a monopolist.

■ Industry growth -> Industry growth directly affects the intensity of rivalry among
competitors. Because the pie is expanding, rivals are focused on capturing part of that larger
pie rather than taking market share and profitability away from one another.
Competitors are able to avoid price competition and, instead, focus on differentiation that
allows premium pricing.
In contrast, rivalry among competitors becomes fierce during slow or even negative industry
growth. Price discounts, frequent new product releases with minor modifications, intense
promotional campaigns, and fast retaliation by rivals are all tactics indicative of an industry
with slow or negative growth.

Competitive rivalry based solely on cutting prices is destructive to profitability as it transfers

most of the value created in the industry to the customer.

■ Strategic commitments -> Firm actions that are costly, long-term oriented, and difficult to
reverse.
- Can stem from large, fixed cost requirements, but also from noneconomic considerations.
- May also be the result of more political than economic considerations.

■ Exit barriers -> The rivalry among existing competitors is also a function of an industry’s
exit barriers, the obstacles that determine how easily a firm can leave that industry.
- Comprise both economic and social factors.
- Include fixed costs that must be paid regardless of whether the company is operating in
the industry or not.
- Contractual obligations to suppliers, etc & Social factors include elements such as
emotional attachments to certain geographic locations are the key determinants.
- Other social and economic factors include ripple effects through the supply chain. When
one major player in an industry shuts down, its suppliers are adversely impacted as well.
- An industry with low exit barriers is more attractive.

In a nutshell, leverages weak forces into opportunities and

mitigates strong forces because they are potential threats to
the firm’s ability to gain and sustain a competitive advantage.
A SIXTH FORCE: THE STRATEGIC ROLE OF COMPLEMENTS
Complement: A complement is a product, service, or competency that adds value to the
original product offering when the two are used in tandem. Complements increase demand
for the primary product, thereby enhancing the profit potential for the industry and the
firm.

Complementor: A company is a complementor to your company if customers value your

product or service offering more when they are able to combine it with the other company’s
product or service. Firms may choose to provide the complements themselves or work with
another company to accomplish this.

Co-opetition: Cooperation by competitors to achieve a strategic objective.

Five Forces Competitive Analysis Checklist