SOLUTION: The Five Competitive Forces the Threat of Substitute Products & Services Discussion

Awareness of the five forces can help a company understand the structure of its
industry and stake out a position that is more profitable and less vulnerable to attack.
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THE FIVE
COMPETITIVE
FORCES THAT
SHAPE
STRATEGY
STRATEGY
Peter Crowther
by Michael E. Porter
Editor’s Note: In 1979, Harvard Business Review
published “How Competitive Forces Shape Strategy” by a young economist and associate professor,
Michael E. Porter. It was his first HBR article, and it
started a revolution in the strategy field. In subsequent
decades, Porter has brought his signature economic
rigor to the study of competitive strategy for corporations, regions, nations, and, more recently, health care
and philanthropy. “Porter’s five forces” have shaped a
generation of academic research and business practice.
With prodding and assistance from Harvard Business
School Professor Jan Rivkin and longtime colleague
Joan Magretta, Porter here reaffirms, updates, and
extends the classic work. He also addresses common
misunderstandings, provides practical guidance for
users of the framework, and offers a deeper view of
its implications for strategy today.
IN ESSENCE, the job of the strategist is to understand and cope with competition. Often, however,
managers define competition too narrowly, as if
it occurred only among today’s direct competitors. Yet competition for profits goes beyond established industry rivals to include four other
competitive forces as well: customers, suppliers,
potential entrants, and substitute products. The
extended rivalry that results from all five forces
defines an industry’s structure and shapes the
nature of competitive interaction within an
industry.
As different from one another as industries
might appear on the surface, the underlying drivers of profitability are the same. The global auto
industry, for instance, appears to have nothing
in common with the worldwide market for art
masterpieces or the heavily regulated health-care
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LEADERSHIP AND STRATEGY
|
The Five Competitive Forces That Shape Strategy
delivery industry in Europe. But to understand industry competition and profitabilThe Five Forces That Shape Industry Competition
ity in each of those three cases, one must
analyze the industry’s underlying structure in terms of the five forces. (See the exThreat
hibit “The Five Forces That Shape Industry
of New
Competition.”)
Entrants
If the forces are intense, as they are in
such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment. If the forces are benign,
Rivalry
as they are in industries such as software,
Among
Bargaining
Bargaining
soft drinks, and toiletries, many companies
Power of
Power of
Existing
Suppliers
are profitable. Industry structure drives
Buyers
Competitors
competition and profitability, not whether
an industry produces a product or service, is
emerging or mature, high tech or low tech,
regulated or unregulated. While a myriad
of factors can affect industry profitability
Threat of
in the short run – including the weather
Substitute
Products or
and the business cycle – industry structure,
Services
manifested in the competitive forces, sets
industry profitability in the medium and
long run. (See the exhibit “Differences in
Industry Profitability.”)
Understanding the competitive forces, and their underThe strongest competitive force or forces determine the
lying causes, reveals the roots of an industry’s current profitprofitability of an industry and become the most important
ability while providing a framework for anticipating and
to strategy formulation. The most salient force, however, is
influencing competition (and profitability) over time. A
not always obvious.
healthy industry structure should be as much a competitive
For example, even though rivalry is often fierce in comconcern to strategists as their company’s own position. Unmodity industries, it may not be the factor limiting profitderstanding industry structure is also essential to effective
ability. Low returns in the photographic film industry, for
strategic positioning. As we will see, defending against the
instance, are the result of a superior substitute product – as
competitive forces and shaping them in a company’s favor
Kodak and Fuji, the world’s leading producers of photoare crucial to strategy.
graphic film, learned with the advent of digital photography.
In such a situation, coping with the substitute product becomes the number one strategic priority.
Forces That Shape Competition
Industry structure grows out of a set of economic and
The configuration of the five forces differs by industry. In
technical characteristics that determine the strength of
the market for commercial aircraft, fierce rivalry between
each competitive force. We will examine these drivers in the
dominant producers Airbus and Boeing and the bargainpages that follow, taking the perspective of an incumbent,
ing power of the airlines that place huge orders for aircraft
or a company already present in the industry. The analysis
are strong, while the threat of entry, the threat of substican be readily extended to understand the challenges facing
tutes, and the power of suppliers are more benign. In the
a potential entrant.
movie theater industry, the proliferation of substitute forms
of entertainment and the power of the movie producers
THREAT OF ENTRY. New entrants to an industry bring
and distributors who supply movies, the critical input, are
new capacity and a desire to gain market share that puts
important.
pressure on prices, costs, and the rate of investment necessary to compete. Particularly when new entrants are
diversifying from other markets, they can leverage existMichael E. Porter is the Bishop William Lawrence University Proing
capabilities and cash flows to shake up competition, as
fessor at Harvard University, based at Harvard Business School in
Pepsi
did when it entered the bottled water industry, MicroBoston. He is a six-time McKinsey Award winner, including for his
soft
did
when it began to offer internet browsers, and Apple
most recent HBR article, “Strategy and Society,” coauthored with
did
when
it entered the music distribution business.
Mark R. Kramer (December 2006).
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The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents
must hold down their prices or boost investment to deter
new competitors. In specialty coffee retailing, for example,
relatively low entry barriers mean that Starbucks must invest aggressively in modernizing stores and menus.
The threat of entry in an industry depends on the height
of entry barriers that are present and on the reaction entrants can expect from incumbents. If entry barriers are low
and newcomers expect little retaliation from the entrenched
competitors, the threat of entry is high and industry profitability is moderated. It is the threat of entry, not whether
entry actually occurs, that holds down profitability.
entry by limiting the willingness of customers to buy from a
newcomer and by reducing the price the newcomer can command until it builds up a large base of customers.
3. Customer switching costs. Switching costs are fixed costs
that buyers face when they change suppliers. Such costs may
arise because a buyer who switches vendors must, for example, alter product specifications, retrain employees to use
a new product, or modify processes or information systems.
The larger the switching costs, the harder it will be for an entrant to gain customers. Enterprise resource planning (ERP)
software is an example of a product with very high switching
costs. Once a company has installed SAP’s ERP system, for example, the costs of moving to a new vendor are astronomical
Industry structure drives competition and profitability,
not whether an industry is emerging or mature, high tech or
low tech, regulated or unregulated.
Barriers to entry. Entry barriers are advantages that incumbents have relative to new entrants. There are seven major
sources:
1. Supply-side economies of scale. These economies arise
when firms that produce at larger volumes enjoy lower costs
per unit because they can spread fixed costs over more units,
employ more efficient technology, or command better terms
from suppliers. Supply-side scale economies deter entry by
forcing the aspiring entrant either to come into the industry
on a large scale, which requires dislodging entrenched competitors, or to accept a cost disadvantage.
Scale economies can be found in virtually every activity
in the value chain; which ones are most important varies
by industry.1 In microprocessors, incumbents such as Intel
are protected by scale economies in research, chip fabrication, and consumer marketing. For lawn care companies like
Scotts Miracle-Gro, the most important scale economies are
found in the supply chain and media advertising. In smallpackage delivery, economies of scale arise in national logistical systems and information technology.
2. Demand-side benefits of scale. These benefits, also known
as network effects, arise in industries where a buyer’s willingness to pay for a company’s product increases with the number of other buyers who also patronize the company. Buyers
may trust larger companies more for a crucial product: Recall the old adage that no one ever got fired for buying from
IBM (when it was the dominant computer maker). Buyers
may also value being in a “network” with a larger number of
fellow customers. For instance, online auction participants
are attracted to eBay because it offers the most potential
trading partners. Demand-side benefits of scale discourage
because of embedded data, the fact that internal processes
have been adapted to SAP, major retraining needs, and the
mission-critical nature of the applications.
4. Capital requirements. The need to invest large financial resources in order to compete can deter new entrants.
Capital may be necessary not only for fixed facilities but also
to extend customer credit, build inventories, and fund startup losses. The barrier is particularly great if the capital is
required for unrecoverable and therefore harder-to-finance
expenditures, such as up-front advertising or research and
development. While major corporations have the financial
resources to invade almost any industry, the huge capital
requirements in certain fields limit the pool of likely entrants. Conversely, in such fields as tax preparation services
or short-haul trucking, capital requirements are minimal
and potential entrants plentiful.
It is important not to overstate the degree to which capital
requirements alone deter entry. If industry returns are attractive and are expected to remain so, and if capital markets
are efficient, investors will provide entrants with the funds
they need. For aspiring air carriers, for instance, financing
is available to purchase expensive aircraft because of their
high resale value, one reason why there have been numerous new airlines in almost every region.
5. Incumbency advantages independent of size. No matter
what their size, incumbents may have cost or quality advantages not available to potential rivals. These advantages can
stem from such sources as proprietary technology, preferential access to the best raw material sources, preemption of
the most favorable geographic locations, established brand
identities, or cumulative experience that has allowed incum-
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LEADERSHIP AND STRATEGY
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The Five Competitive Forces That Shape Strategy
bents to learn how to produce more efficiently. Entrants try
to bypass such advantages. Upstart discounters such as Target and Wal-Mart, for example, have located stores in freestanding sites rather than regional shopping centers where
established department stores were well entrenched.
6. Unequal access to distribution channels. The new entrant must, of course, secure distribution of its product or
service. A new food item, for example, must displace others
from the supermarket shelf via price breaks, promotions,
intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that
existing competitors have tied them up, the tougher entry
into an industry will be. Sometimes access to distribution
is so high a barrier that new entrants must bypass distribution channels altogether or create their own. Thus, upstart
low-cost airlines have avoided distribution through travel
agents (who tend to favor established higher-fare carriers)
and have encouraged passengers to book their own flights
on the internet.
7. Restrictive government policy. Government policy can
hinder or aid new entry directly, as well as amplify (or nullify) the other entry barriers. Government directly limits or
even forecloses entry into industries through, for instance,
licensing requirements and restrictions on foreign investment. Regulated industries like liquor retailing, taxi services,
and airlines are visible examples. Government policy can
heighten other entry barriers through such means as expansive patenting rules that protect proprietary technology from imitation or environmental or safety regulations
that raise scale economies facing newcomers. Of course,
government policies may also make entry easier – directly
through subsidies, for instance, or indirectly by funding basic research and making it available to all firms, new and old,
reducing scale economies.
Entry barriers should be assessed relative to the capabilities of potential entrants, which may be start-ups, foreign
firms, or companies in related industries. And, as some of
our examples illustrate, the strategist must be mindful of the
creative ways newcomers might find to circumvent apparent barriers.
Expected retaliation. How potential entrants believe incumbents may react will also influence their decision to
enter or stay out of an industry. If reaction is vigorous and
protracted enough, the profit potential of participating in
the industry can fall below the cost of capital. Incumbents
often use public statements and responses to one entrant
to send a message to other prospective entrants about their
commitment to defending market share.
Newcomers are likely to fear expected retaliation if:
• Incumbents have previously responded vigorously to
new entrants.
• Incumbents possess substantial resources to fight back,
including excess cash and unused borrowing power, avail-
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Differences in Industry Profitability
The average return on invested capital varies markedly from
industry to industry. Between 1992 and 2006, for example,
average return on invested capital in U.S. industries ranged as
low as zero or even negative to more than 50%. At the high
end are industries like soft drinks and prepackaged software,
which have been almost six times more profitable than the
airline industry over the period.
able productive capacity, or clout with distribution channels
and customers.
• Incumbents seem likely to cut prices because they are
committed to retaining market share at all costs or because
the industry has high fixed costs, which create a strong motivation to drop prices to fill excess capacity.
• Industry growth is slow so newcomers can gain volume
only by taking it from incumbents.
An analysis of barriers to entry and expected retaliation is
obviously crucial for any company contemplating entry into
a new industry. The challenge is to find ways to surmount
the entry barriers without nullifying, through heavy investment, the profitability of participating in the industry.
THE POWER OF SUPPLIERS. Powerful suppliers capture
more of the value for themselves by charging higher prices,
limiting quality or services, or shifting costs to industry participants. Powerful suppliers, including suppliers of labor,
can squeeze profitability out of an industry that is unable
to pass on cost increases in its own prices. Microsoft, for instance, has contributed to the erosion of profitability among
personal computer makers by raising prices on operating
systems. PC makers, competing fiercely for customers who
can easily switch among them, have limited freedom to raise
their prices accordingly.
Companies depend on a wide range of different supplier
groups for inputs. A supplier group is powerful if:
• It is more concentrated than the industry it sells to.
Microsoft’s near monopoly in operating systems, coupled
with the fragmentation of PC assemblers, exemplifies this
situation.
• The supplier group does not depend heavily on the industry for its revenues. Suppliers serving many industries
will not hesitate to extract maximum profits from each one.
If a particular industry accounts for a large portion of a supplier group’s volume or profit, however, suppliers will want
to protect the industry through reasonable pricing and assist in activities such as R&D and lobbying.
• Industry participants face switching costs in changing
suppliers. For example, shifting suppliers is difficult if companies have invested heavily in specialized ancillary equip-
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Profitability of Selected U.S. Industries
Average Return on Invested Capital
in U.S. Industries, 1992–2006
50
10th percentile
7.0%
25th
percentile
10.9%
Median:
14.3%
75th percentile
18.6%
Average ROIC, 1992–2006
90th percentile
25.3%
Number of Industries
40
30
20
10
0
0%
or lower
5%
10%
15%
20%
25%
30%
ROIC
35%
or higher
Return on invested capital (ROIC) is the appropriate measure
of profitability for strategy formulation, not to mention for equity
investors. Return on sales or the growth rate of profits fail to
account for the capital required to compete in the industry. Here,
we utilize earnings before interest and taxes divided by average
invested capital less excess cash as the measure of ROIC. This
measure controls for idiosyncratic differences in capital structure
and tax rates across companies and industries.
Source: Standard & Poor’s, Compustat, and author’s calculations
ment or in learning how to operate a supplier’s equipment
(as with Bloomberg terminals used by financial professionals). Or firms may have located their production lines adjacent to a supplier’s manufacturing facilities (as in the case
of some beverage companies and container manufacturers).
When switching costs are high, industry participants find it
hard to play suppliers off against one another. (Note that
suppliers may have switching costs as well. This limits their
power.)
• Suppliers offer products that are differentiated. Pharmaceutical companies that offer patented drugs with distinctive medical benefits have more power over hospitals,
health maintenance organizations, and other drug buyers,
for example, than drug companies offering me-too or generic products.
• There is no substitute for what the supplier group provides. Pilots’ unions, for example, exercise considerable supplier power over airlines partly because there is no good
alternative to a well-trained pilot in the cockpit.
• The supplier group can credibly threaten to integrate forward into the industry. In that case, if industry participants
make too much money relative to suppliers, they will induce
suppliers to enter the market.
THE POWER OF BUYERS. Powerful customers – the flip
side of powerful suppliers – can capture more value by forcing down prices, demanding better quality or more service …
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