Porter’s Five Forces is a business analysis model that helps to explain why different industries are able to sustain different levels of profitability. The model was originally published in Michael Porter’s book, “Competitive Strategy: Techniques for Analyzing Industries and Competitors” in 1980.
The model is widely used to analyze the industry structure of a company as well as its corporate strategy. Porter identified five undeniable forces that play a part in shaping every market and industry in the world. The forces are frequently used to measure competition intensity, attractiveness and profitability of an industry or market.
These forces are:
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Competition in the industry;
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Potential of new entrants into the industry;
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Power of suppliers;
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Power of customers;
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Threat of substitute products.
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Threat of new entrants.
This force determines how easy (or not) it is to enter a particular industry. If an industry is profitable and there are few barriers to enter, rivalry soon intensifies. When more organizations compete for the same market share, profits start to fall. It is essential for existing organizations to create high barriers to enter to deter new entrants. Threat of new entrants is high when:
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Low amount of capital is required to enter a market;
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Existing companies can do little to retaliate;
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Existing firms do not possess patents, trademarks or do not have established brand reputation;
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There is no government regulation;
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Customer switching costs are low (it doesn’t cost a lot of money for a firm to switch to other industries);
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There is low customer loyalty;
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Products are nearly identical;
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Economies of scale can be easily achieved.
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Bargaining power of suppliers.
Strong bargaining power allows suppliers to sell higher priced or low quality raw materials to their buyers. This directly affects the buying firms’ profits because it has to pay more for materials. Suppliers have strong bargaining power when:
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There are few suppliers but many buyers;
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Suppliers are large and threaten to forward integrate;
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Few substitute raw materials exist;
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Suppliers hold scarce resources;
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Cost of switching raw materials is especially high.
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Bargaining power of buyers.
Buyers have the power to demand lower price or higher product quality from industry producers when their bargaining power is strong. Lower price means lower revenues for the producer, while higher quality products usually raise production costs. Both scenarios result in lower profits for producers. Buyers exert strong bargaining power when:
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Buying in large quantities or control many access points to the final customer;
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Only few buyers exist;
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Switching costs to other supplier are low;
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They threaten to backward integrate;
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There are many substitutes;
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Buyers are price sensitive.
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Threat of Substitutes.
This force is especially threatening when buyers can easily find substitute products with attractive prices or better quality and when buyers can switch from one product or service to another with little cost. For example, to switch from coffee to tea doesn’t cost anything, unlike switching from car to bicycle.
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Rivalry among existing competitors.
This force is the major determinant on how competitive and profitable an industry is. In competitive industry, firms have to compete aggressively for a market share, which results in low profits. Rivalry among competitors is intense when:
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There are many competitors;
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Exit barriers are high;
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Industry of growth is slow or negative;
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Products are not differentiated and can be easily substituted;
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Competitors are of equal size;
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Low customer loyalty.
Although, Porter originally introduced five forces affecting an industry, scholars have suggested including the sixth force: complements. Complements increase the demand of the primary product with which they are used, thus, increasing firm’s and industry’s profit potential. For example, iTunes was created to complement iPod and added value for both products. As a result, both iTunes and iPod sales increased, increasing Apple’s profits.
Application of Porter’s Five Forces Model
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Competitive Analysis:
Companies use the model to assess the competitive dynamics within their industry. By evaluating the intensity of each force, businesses can gain insights into the level of rivalry, bargaining power of suppliers and buyers, threat of substitutes, and barriers to entry.
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Market Entry Strategy:
Before entering a new market, businesses can apply the Five Forces Model to assess the potential risks and opportunities. This analysis helps in making informed decisions about the feasibility and attractiveness of entering a specific market.
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Strategic Planning:
Companies use Porter’s model as a strategic planning tool. It helps in formulating business strategies that capitalize on industry strengths and mitigate weaknesses. For example, a company might focus on differentiation strategies if there is high rivalry, or explore cost leadership if there is significant supplier power.
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Mergers and Acquisitions (M&A):
When considering M&A activities, firms evaluate the industry’s competitive forces to understand how the acquisition target fits into the broader competitive landscape. This analysis informs decisions about potential synergies and risks associated with the acquisition.
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Supplier and Buyer Negotiations:
Understanding the bargaining power of suppliers and buyers allows companies to negotiate more effectively. If suppliers have high power, companies might seek alternative sources or negotiate for better terms. Similarly, if buyers have high power, companies might focus on adding value to their products or services.
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Product Development and Innovation:
Companies use the model to identify opportunities for innovation and new product development. By assessing the threat of substitutes and understanding customer preferences, businesses can create products that meet specific market demands.
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Risk Assessment and Management:
The Five Forces Model helps companies identify potential risks and vulnerabilities within their industry. This includes risks associated with intense competition, supplier disruptions, changes in customer preferences, and the emergence of new substitutes.
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Market Positioning and Differentiation:
The analysis of competitive forces informs decisions about how a company positions itself in the market. It helps in identifying areas where differentiation can provide a competitive advantage. For example, a company facing high rivalry might focus on unique value propositions to stand out.
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Regulatory and Policy Impact Assessment:
Changes in regulations and government policies can have a significant impact on industry dynamics. Companies use the model to assess how regulatory changes might influence the competitive forces in their industry and adjust their strategies accordingly.
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Investment Decisions:
Investors utilize Porter’s Five Forces Model to assess the attractiveness of an industry before making investment decisions. By evaluating the competitive forces, investors can gauge the potential returns and risks associated with investing in a particular sector.
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Scenario Planning:
Companies use the model for scenario planning, evaluating how changes in competitive forces might impact their business in different future scenarios. This helps in preparing for potential shifts in industry dynamics.
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