Porter's Model of Industry Competition

Potential Entrants
Source: Michael E. Porter, "Industry Structure and Competitive Strategy: Keys to Profitablility," Financial Analysis Journal (July-August 1980): 33.

scale require potential entrants either to establish high levels of production or to accept a cost disadvantage. Absolute cost advantage is enjoyed by firms with proprietary technology or favorable access to raw materials and by firms with production experience. In addition, high capital requirements, high switching costs (i.e., the cost to a buyer of changing suppliers), product differentiation, limited access to distribution channels, and government policy can act as entry barriers.

A substitute product that serves essentially the same function as an industry product is another source of competition. Since a substitute places a ceiling on the price that firms can charge, it affects industry potential. The threat posed by a substitute also depends on its long-term price/performance trend relative to the industry's product.

Bargaining power of buyers refers to the ability of the industry's customers to force the industry to reduce prices or increase features, thus bidding away profits. Buyers gain power when they have choices—when their needs can be met by a substitute product or by the same product offered by another supplier. In addition, high buyer concentration, the threat of backward integration, and low switching costs add to buyer power.

Bargaining power of suppliers is the degree to which suppliers of the industry's raw materials have the ability to force the industry to accept higher prices or reduced service, thus affecting profits. The factors influencing supplier power are the same as those influencing buyer power. In this case, however, industry members act as buyers.

These five forces of competition interact to determine the attractiveness of an industry. The strongest forces become the dominant factors in determining industry profitability and the focal points of strategy formulation, as the following example of the network television industry illustrates. Government regulations, which limited the number of networks to three, have had a great influence on the profile of the industry. This impenetrable entry barrier created weak buyers (advertisers), weak suppliers (writers, actors, etc.), and a very profitable industry. However, several exogenous events are now influencing the power of buyers and suppliers. Suppliers have gained power with the advent of cable television because the number of customers to whom artists can offer their services has increased rapidly. In addition, as cable television firms reduce the size of the network market, advertisers may find substitute advertising media more cost-effective. In conclusion, while the industry is still very attractive and profitable, the changes in its structure imply that future profitability may be reduced.

A firm should first diagnose the forces affecting competition in its industry and their underlying causes and then identify its own strengths and weaknesses relative to the industry. Only then should a firm formulate its strategy, which amounts to taking offensive or defensive action in order to achieve a secure position against each of the five competitive forces.12 According to Porter, this involves

• Positioning the firm so that its capabilities provide the best defense against the existing array of competitive forces.

• Influencing the balance of forces through strategic moves, thereby improving the firm's relative position.

• Anticipating shifts in the factors underlying the forces and responding to them, hopefully exploiting change by choosing a strategy appropriate to the new competitive balance before rivals recognize it.13

Take, for example, the U.S. blue jeans industry. In the 1970s most firms except for Levi Strauss and Blue Bell, maker of Wrangler Jeans, took low profits. The situation can be explained with reference to industry structure (see Exhibit 4-7). The extremely low entry barriers allowed almost 100 small jeans manufacturers to join the competitive ranks; all that was needed to enter the industry was

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