RECOMMENDED READING

1. Michael E Porter, Competitive Strategy: Techniques For Analyzing

Industries and Competitors.
2. Michael E Porter, Michael E Porter on Competition.

Porter’s five competitive forces

Michael Porter has identified the five competitive forces that determine
profitability in an industry:
• Entry of new competitors into the arena
• Threat from substitutes based on other technology
• Bargaining power of buyers
• Bargaining power of supplier’s
• Competition between companies already established on the market

Potential
entrants

Threat of
new entrants

Competitors
in the industry
Bargaining power Bargaining power
Suppliers Buyers

Rivalry among
existing firms

Threat of
substitutes

Substitutes

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Competitive strategies (business strategies) are derived from an understand-
ing of the rules of competition that govern an industry and determine its
attractiveness. The ultimate goal of competitive strategy is to influence those
rules in our own company’s favour. The rules of competition can be
described by the five competitive forces shown in the figure.

Potential entrants
The establishment of a new company in an industry implies an increment
of capacity. This can result in price-cutting, or inflate the cost structures
of companies in the industry and reduce their profitability. According to
Porter there are six major obstacles to would-be entrants:
1. Economies of scale, which mean that the unit cost of a product
or service falls with rising volume per unit of time. The economies
of scale deter new entrants by forcing them either to start out on
a massive scale, which calls for heavy investment, or to risk
crushing retaliation from established companies in the industry.
2. Differentiation of production, which means that established
companies hold recognized trade marks and enjoy brand loyalty
as a result of marketing efforts or tradition. The new entrant must
spend a lot of money to break down existing loyalties.
3. Need for capital, which makes it difficult to get started in cases
where it takes a large capital stake to be able to compete. This
hurdle naturally grows higher with the uncertainty factor. Capital
may be needed not only for production but also to extend credit
to customers, build up stocks and cover initial losses. Rank Xerox
set up an effective barrier to new entrants in the office copier
business by renting machines instead of selling them, thereby
upping the capital ante for potential competition.
4. Conversion costs, a one-off expense for buyers who switch
suppliers. These costs may include retraining of personnel, new
production equipment, need for technical service, new production
design and risk of production stoppages.
5. Lack of distribution channels, which may make it impossible for
new entrants to establish a foothold in the trade. New players
must resort to cut-price offers, subsidizing advertising and other
inducements to persuade established distributors and outlets to
accept their products, thereby cutting into their profit margins.

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 6. Other cost obstacles unrelated to the economies of scale may,
according to Porter, arise from advantages enjoyed by established
companies in the industry. These include:
• Patented product technology
• Access to raw materials on favourable terms
• Advantageous location
• Priority claim on government subsidies
• Lead in know-how or experience

Competition among existing companies

Competition among existing companies follows well-known procedures
for gaining a more advantageous position. These include tactical exercises
like price offers, advertising campaigns, product launches, customer service
and warranties.

Rivalry arises, according to Porter, when one or more competitors are in

a squeeze or see an opportunity to improve their position. The intensity
of competition in an industry can range from the polite or gentlemanly
to fierce or cutthroat. Porter points to a number of factors that determine
the intensity of competition:
• many competitors or competitors of compatible strength.
• slow growth rate in the industry.
• high fixed manufacturing or inventory costs.
• no differentiation (no conversion costs).
• quantum leaps in capacity.
• competitors of different kinds.
• high strategic value.
• high exit barriers

Substitutes
All the companies in a given industry compete, in a broad sense, with other
industries that deliver substitute products. Substitutes limit the profit poten-
tial of an industry by putting a ceiling on the prices that companies in the

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industry can ask without losing profitability. To identify substitutes, we
must look around for other products that can perform the same function
as our own. This can sometimes be difficult, leading the analyst into areas
that are apparently far removed from the industry concerned.

Bargaining power of buyers

Buyers compete with an industry by exerting a downward pressure on its
prices, negotiating for higher quality or better service, and playing off one
competitor against another, all at the expense of an industry’s profitabil-
ity. The strength of each of the industry’s most important groups or buyers
depends on a number of factors that characterize the market situation.

A group of buyers is powerful if it meets the following criteria:

• It is concentrated, or buys large volumes in relation to the volume
of suppliers’ sales.
• The products it buys from the industry represent an important
proportion of its own costs or volume of purchases.
• The products it buys from the industry are standardized or
undifferentiated.
• It is not sensitive to conversion costs.
• Its profit margins are small.
• The industry’s product is not crucial to the quality of the buyers’
own products or services.
• It is well informed.

Bargaining power of suppliers

Suppliers can put pressure on the players in an industry by threatening
to raise the price or cut the quality of the goods and services they deliver.
Suppliers in a position of strength can thus reduce the profitability of an
industry that is not in a position to cover cost increases by raising its own
prices. The factors that make suppliers powerful tend to reflect those that
make groups of buyers powerful.

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 A group of suppliers is powerful if it meets the following criteria:
1. It is dominated by a few companies and is more concentrated
than the industry it sells to.
2. It is not forced to compete with substitutes for the products it
sells to the industry.
3. The industry concerned is not one of its most important customers.
4. Its products are crucial to the industry’s business.
5. Its products are differentiated.
6. It poses a credible threat of forward integration, that is, of
establishing itself in the industry.

According to Porter, a company can identify its own strengths and weak-
nesses in relation to its industry by analyzing the forces that affect
competition in the industry and their underlying causes.

RECOMMENDED READING

1. Michael E Porter, Competitive Strategy: Techniques for Analyzing

Industries and Competitors.
2. Michael E Porter, Michael E Porter on Competition.

Porter’s generic strategies

In Competitive Strategy (1980), Michael Porter presents three basic
generic strategies for improving competitive power. A company that wants
to achieve a competitive edge must make a strategic choice to avoid becom-
ing ’all things to all men’.

The three basic strategies are:

• Cost leadership
• Differentiation
• Focusing

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