Michael Porter gave his famous five force model in an article in the Harvard Business Review, when he was a young associate professor. The five forces model is a very simple yet very influential tool to determine where the control lies within a business or an industry. This analytical tool can help firms evaluate industry attractiveness, how and which trends can impact the industry competition, which industries to compete in and where to position itself for success. Porter Five Forces model can be used by a company to formulate its corporate strategy i.e. decision to be a part of which industries, allocating available resources amongst them and its business strategy i.e. positioning the company in the industry for a competitive advantage.
The five forces of Porter are competition from substitutes, threat of new entrants, bargaining power of the buyers, bargaining power of the suppliers and the rivalry amongst established competitors. All of these five forces are detailed below:
Competition from the Substitutes
Price the customers are ready to pay for a particular service or product directly depends on the pricing and the availability of substitute products or services. If a new product in the market meets the same basic needs in a different way, the industry profitability declines. The absence of closely related substitutes indicates that the consumers are not sensitive to prices and an inelastic demand exists such as is in the case of gasoline. However, the existence of a substitute shows that the demand is elastic and consumers are sensitive to pricing. The consumers will immediately switch to substitute product or service in case if prices are increased. E.g. tea is a substitute for coffee, video conferencing is a substitute of travelling etc (Harvard Business School, n.d.).
Threat of New Entrants
A profitable industry always attracts new entrants into it. The addition of new players into the industry leads to a reduction of prices and profits. In every industry, there are a number of barriers called entry barriers that make it difficult to enter into the industry for new entrants. These are initial capital requirements of the business, economies of scale, differentiation of the product, access to different channels of distribution and legal & government barriers are the barriers to new entrants to various industries.
Bargaining Power of Buyers
Powerful buyers can cause the prices to drop or demand more services at the existing prices and in turn the profit in an industry to drop through a downward pressure. The size of the buyer, their relative quantity, their price sensitivity, undifferentiated products and low switching costs are the factors that can make a buyer powerful. E.g. large retail chains due to their bulk purchases force the supplier for large discounts allowing them to lower prices of their products (Grant, n.d.).
Bargaining Power of Suppliers
As described earlier for a buyer, same can be said for a supplier in terms of pricing and profits. If there is a large monopoly of a single supplier in the industry and the product supplied by that supplier is a critical part of the final product, the supplier can be a key decision maker of the industry’s success and profitability. When the product is highly differentiated, only one or two suppliers exist and switching suppliers is costly as well as consumes time, the bargaining power of the supplier will be very high.
Rivalry Amongst Established Competitors
Inside an industry, if the rivalry amongst the established competitors is intense, it can cause the prices to drop or decrease profits by increasing other costs such as innovation, advertising etc. The factors which influence this force are industry concentration, cost conditions, exit barriers, excess capacity, product differentiation and diversity of competitors (Porter, 2008).
Porters Five Force model has been applied to almost every industry to gain valuable insight into the factors that affect its structure and profit margins. It is a very effective analytical tool for an industry.
References
Grant, R.M., n.d. ORIGINS AND SIGNIFICANCE OF THE FIVE. [Online] Available at: http://onlinelibrary.wiley.com/store/10.1002/9781118785317/asset/homepages/weom120173.pdf;jsessionid=055D5EEAD5F78852FFC5CE06EED3D466.f01t01?v=1&s=f38efd0c2a9f3d5ab513e2b4cf59412e1f8a23d8 [Accessed 5 June 2017].
Harvard Business School, n.d. The Five Forces. [Online] Available at: http://www.isc.hbs.edu/strategy/business-strategy/pages/the-five-forces.aspx [Accessed 5 June 2017].
Porter, M.E., 2008. The Five competitive forces that shape strategy. Harvard Business Review, 57(1), pp.57-71.