Porter’s Five Forces
Porter developed the Five Forces model as a framework for industry analysis. This model can be used to help understand the degree of competition in an industry and analyze its strengths and weaknesses. The model consists of five elements, each of which plays a role in determining the average profitability of an industry. In 2001 Porter wrote an article entitled ”Strategy and the Internet,” in which he takes this model and looks at how the Internet impacts the profitability of an industry. Below is a quick summary of each of the Five Forces and the impact of the Internet.
- Threat of substitute products or services. The first force challenges the user to consider the likelihood of another produce or service replacing the product or service you offer. The more types of products or services there are that can meet a particular need, the less profitability there will be in an industry. In the communications industry, the smartphone has largely replaced the pager. In some construction projects, metal studs have replaced wooden studs for framing. The Internet has made people more aware of substitute products, driving down industry profits in those industries in which substitution occurs. Please notice that substitution refers to a product being replaced by a similar product for the purpose of accomplishing the same task. It does not mean dissimilar products or services such as flying to a destination rather than traveling by rail.
- Bargaining power of suppliers. A supplier’s bargaining power is strong when there are few suppliers from which your company can obtain a needed product or service. Conversely, when they are many suppliers their bargaining power is lower since your company would have many sources from which to source a product. When your company has several suppliers to choose from, you can negotiate a lower price. When a sole supplier exists, then your company is at the mercy of the supplier. For example, if only one company makes the controller chip for a car engine, that company can control the price, at least to some extent. The Internet has given companies access to more suppliers, driving down prices.
- Bargaining power of customers. A customer’s bargaining power is strong when your company along with your competitors is attempting to provide the same product to this customer. In this instance the customer has many sources from which to source a product so they can approach your company and seek a price reduction. If there are few suppliers in your industry, then the customer’s bargaining power is considered low.
- Barriers to entry. The easier it is to enter an industry, the more challenging it will be to make a profit in that industry. Imagine you are considering starting a lawn mowing business. The entry barrier is very low since all you need is a law mower. No special skills or licenses are required. However, this means your neighbor next door may decide to start mowing lawns also, resulting in increased competition. In contrast a highly technical industry such as manufacturing of medical devices has numerous barriers to entry. You would need to find numerous suppliers for various components, hire a variety of highly skilled engineers, and work closely with the Food and Drug Administration to secure approval for the sale of your products. In this example the barriers to entry are very high so you should expect few competitors.
- Rivalry among existing competitors: Rivalry among existing competitors helps you evaluate your entry into the market. When rivalry is fierce, each competitor is attempting to gain additional market share from the others. This can result in aggressive pricing, increasing customer support, or other factors which might lure a customer away from a competitor. Markets in which rivalry is low may be easier to enter and become profitable sooner because all of the competitors are accepting of each other’s presence.
Porter’s five forces are used to analyze an industry to determine the average profitability of a company within that industry. Adding in Porter’s analysis of the Internet to his Five Forces results in the realization that technology has lowered overall profitability.