For analyzing an industry efficiently, it is essential to consider various competitive forces and how they interact with each other to create pressure on one another. These factors decide the nature of competition in the industry. Studying these competitive forces is necessary because industry can only be scrutinized thoroughly. Porter’s five forces is mandatory for its study.
Porter’s Five Forces of Industry Analysis
Michael Porter developed a model explaining that a firm’s industry is affected by five forces. The strategic business manager can use Porter’s model to analyze an industry on these five forces and then judge the strengths and weaknesses of his firm based on his industry analysis. It is known as Porter’s five forces of industry analysis.
The industry analysis will enable the manager to review each force’s strength in a particular industry. This model thus helps the firm to gain an edge over its rivals in the industry. An industry is loosely defined as a group of firms producing similar products and services so that the customer can substitute one for the other.
This five forces model is a widely used technique for analyzing the industry. It also illustrates the nature and level of competition in the industry, along with the forces shaping a business and its functions. An industry consists of several firms that produce and sell similar products or services to consumers.
Therefore the five-force model is quite significant in understanding the complex and diverse characteristics of the competition in different industry areas. The competition a firm faces is much broader as it includes current and potential competitors. A company can face negative consequences with the emergence of new technologies and new competitors as well as existing competitors.
Decision Regarding Boundaries of Industries
Before analyzing the nature and scope of competition in an industry, it makes sense to define its boundaries. This helps in the following ways:
1) Define Arena
It helps define the firm’s arena (or playing field).
2) Focus on the Competitors
Setting the industry boundaries helps the firm get an idea of its competitors and the firm manufacturing substitute products.
3) Identify Key Factors for Success
This helps allocate and deploy the key success factors in the industry.
Various Components of Porter’s Five Forces Model
1) Rivalry inside the Industry
According to the perfect competition model, no firm can enjoy super-normal profits, and in the long run, the competition drives the excess profits to zero. The competition could be better in the real market, and the firms are not just entities interested in charging money from consumers. They seek a competitive advantage over their rivals. The level of rivalry in an Industry is of great importance to economists and strategic analysts. One such ratio which gives an idea of the prevalent state of competition in an industry is the concentration ratio (CR).
A high industry concentration ratio means that only a few firms command a very high market share in that industry. For example, the petrochemical industry in India is dominated by Reliance Industries and has a very high concentration ratio. If the concentration ratio is low, then the industry is considered to be a disciplined one. It is one of the main component of Porter’s five forces model.
This discipline might result from a code of conduct or mutual amenability among the firms. This discipline results from the history of competition in the industry, the presence of a great leading firm, and an informal or tactical understanding between the players to not break the rules. However, a rebel firm can cause havoc with its business activities even in a disciplined industry.
2) Threat of Substitutes
Substitutes can be defined as the products of other industries that have the ability to satisfy similar needs. For example, coffee can be a substitute for tea, as it can also be a caffeine drink in the morning.
When the price of a substitute product changes, the demand for a related product also gets affected. When the number of substitute products increases, competition increases as the customers have more alternatives to select from. This forces the companies to raise or lower the prices. It is the component of Porter’s five forces model. Therefore, the competition created by the substitute firms is price competition. The presence of several substitutes impacts the ability of the company to increase the price of its products, as increasing the price will make the substitutes more attractive to the target market.
Since the substitute products serve the same or similar purposes. Therefore, a close substitute may act as a negative competitive force in the market. Hence, industries with no close substitutes are more attractive for various firms as they can charge higher prices when required. For example, when Coca-Cola came out with pricing of Rs5 for its 200ml bottles, it acquired customers from substitute products like – coconut water, mango, fresh juice, etc.
3) Buyer Power
The bargaining power of buyers also has a very important effect on the manufacturing industry. When there are many producers and a single customer in a market, that situation is termed a “monopsony”. In these markets, the position of the buyer is very strong, and he sets the price. In reality, only a few monopsony markets exist. Buyer power is the main component of Porter’s five forces model. The buyers’ power or bargaining power of buyers compels the firms to reduce the prices. They may also demand a product or service of higher quality at a low price or added value in exchange for their money.
The buyers have more power in the following conditions:
- When the number of buyers is relatively less.
- When buyers purchase in bulk.
- Availability of alternate suppliers who can provide the same product or service at a competitive price.
- When the cost of switching from one producer to the other is quite low.
- When the buyers, Le., wholesaler, retailer, etc., charge low prices from the consumers and are unlikely to pay high prices.
- When the buyers pay the maximum share of the total cost of the product. This may lead organizations to search for cheaper alternatives.
- If the buyer is capable of starting a new alliance by integrating backward with other firms, making itself a powerful supplier.
4) Supplier Power
Since the company needs raw materials for production, the producers must build relationships with suppliers. When suppliers have power, they can influence the producing firms by selling them raw materials at higher prices. For example, Walmart, as an organization, thrives based on its relationship with its suppliers.
The bargaining power of the suppliers is their ability to influence an industry through individual or group interaction with the company. The suppliers have the bargaining power to raise the prices of products or services or force customers to purchase low-quality products or services. This empowers the position of suppliers in the industry.
5) Threat of New Entrants
The market is full of competition. Not only do the existing firms threaten the business, but the arrival of new entrants is also a challenge. As per the ideal scenario, the market is always open for entry and exit, resulting in comparable profits for all the firms. But, this is not applicable in the real picture market. In reality, all industries have some traits that protect their high profits and help them ward off potential new entrants by erecting barriers.
Various factors that hinder the entry of new firms into the industry are called “barriers to entry”. These barriers prevent new firms from entering the industry. This helps in maintaining profit levels for the existing firms. These barriers can either be developed or fully utilized to improve the performance of an organization. These entry barriers can be a source of competitive advantage for the firms.