• Porter’s Five Forces Model

    Posted on March 27, 2012 by admin in Strategy.

    Porter’s five forces model is used for assessing the nature of competition and attractiveness in an industry. The basic porter’s five forces model is demonstrated in the below diagram.

    Porter explains that there are five forces that determine industry attractiveness and long-run industry profitability. These five “competitive forces” are

    1. Threat of new entrants
    2. Threat of substitutes
    3. Bargaining power of buyers
    4. Bargaining power of suppliers
    5. Degree of rivalry between existing competitors

    The below diagram shows Porter’s 5 forces model to judge the competitiveness and attractiveness of a particular sector or industry.

    Porters 5 forces Model

    Threat of New Entrants

    Threat of new entrants increases competition in a particular sector or industry. It depends on the barriers to new entry, initial investments and government policies. Threat of new entrants is low in some sectors like Telecom and high in some sectors like Real Estate.

    The Threat of new entrants depends on the following parameters.

    • Economies of scale
    • Initial investment required
    • Licensing/Patent cost
    • Government Policy
    • Brand Identify
    • Customer switching costs
    • Distribution channels and proper access to the same
    • Exit cost and total assets

    Threat of new entrants will be high if entry is difficult for the new companies which depends on restricted distribution channel, high investment, patents/licensing costs etc. At the same time, it is easier for new companies to enter into a sector if the initial investment is low and the distribution network is easily accessible by all the companies.

    Threat of Substitutes

    Threat of substitutes affects the price elasticity of a product and makes the demand curve more elastic as the customers have more options available in the market for a particular type of product. Also due to more alternative options and higher price elasticity, the industry becomes highly competitive and lowers the profitability of the companies. The threat of substitute depends on the following parameters.

    • Customer willingness to substitute
    • Relative price and comparison of the substitute products
    • Switching cost to substitute products

    High threat of substitutes is good from customers’ point of view while low threat of substitutes is good for the companies or the services providers’ point of view in a particular industry.

    Bargaining Power of Suppliers

    Bargaining power of suppliers affects the Price elasticity of the products in one particular industry. Higher bargaining power of the suppliers leads to higher price of one product and make the demand curve less elastic.

    Bargaining power of Suppliers becomes very high when there is very less number of substitutes or alternative options available in the market or switching cost is very high. Higher price of the raw materials due to high bargain power of the suppliers can have significant impact on the profitability of the companies operating in a particular industry and affects their business in the long run. As a result, the industry loses its attractiveness.

    The bargaining power of suppliers is high for the following scenarios

    • When there are many buyers but only a few dominant suppliers in the market
    • Negligible number of substitutes available in the market.
    • Less bargain power of the buyers due to high number of buyers
    • Importance of volume to supplier
    • High Switching costs to other available raw materials
    • Threat of forward integration by the suppliers

    High bargain power of suppliers exists for high quality products which are achieved through innovations and R&Ds. The price is decided by the manufacturing company and buyers don’t have any other options available rather than buying the same product at the high price. Also it exists for drug industry where a particular patent is available only to a specific number of drug companies and they decide about the end price.

    Bargaining Power of Buyers

    Bargaining power of buyers affects the Price elasticity of the products in one particular industry. Higher bargaining power of the buyers leads to lower price of one product.

    Bargaining power of buyers becomes very high when there is very high number of substitutes or alternative options available in the market or switching cost is very low. High bargain power of the buyers leads to high competition in the market and lower price. As a result, it affects the profitability of the companies operating in a particular industry and the industry also loses its attractiveness

    The bargaining power of buyers is high for the following scenarios

    • High number of suppliers or players in the market
    • Demand is driven by the consumers and high buyer volume
    • Low Brand identity and switching cost very low
    • Products are standardized so high number of available substitute products
    • Buyers threaten to integrate backward into the industry

    An example where bargain power of buyers is high can be defense purchase by big countries. Lots of defense weapon suppliers bid for the same and the bargain power stays with the buyers. At the same time, in telecom industry with many telecom operators, the subscribers or users have the bur gaining power.

    Intensity of Rivalry

    The intensity of rivalry among the competitors decreases attractiveness of the industry. Here the companies fight for survival and always take strategic decisions to showcase the rivalry. The Intensity of rivalry depends on the following conditions

    • Intensity of rivalry is high when there are many small or equally sized competitors in the market place and intensity of rivalry is less there are some market leaders who control the overall market
    • High fixed cost increases rivalry as companies try to utilize unused capacity by producing more products
    • Intensity of rivalry increases for low differentiation among the products like Steel, Electricity, and Oil etc.
    • Intensity of rivalry increases with high switching cost
    • High exit cost increases rivalry as companies can not exit a particular market or industry easily.
    • Lower Industry growth or saturated industry exhibits more rivalry among the players

    An the industry is considered to be disciplined if rivalry among the companies is low while high rivalry often leads to legal and business issues among the companies. High rivalry between Apple and Samsung in the smart phone market leads to multiple court cases for patent violations.

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