The aggregate strength of these five competitive forces determines a firm's ability to achieve an average rate of return on investment in an industry that exceeds the cost of capital. The strength of these five competitive forces varies from industry to industry and can change as the industry evolves, with the result that industries are not uniform from the standpoint of their intrinsic profitability. In industries where all five forces are favorable, such as pharmaceuticals, soft drinks, and database publishing, many competing firms earn attractive returns, while in industries where pressure from one or more of these forces is concentrated, such as rubber, steel, and so on, few firms earn attractive returns despite the best efforts of managers. Industry profitability is not determined by the appearance of the product or the technology it contains, but by the structure of the industry.
The reason these five forces determine the profitability of an industry is that they affect prices, costs, and the investment required by firms in the industry, i.e., they affect the elements of the rate of return on investment. For example, buyer power affects the price that firms can command, as does the threat of substitutes; buyer power may also affect costs and investment because powerful buyers require costly services; the bargaining power of the supply side determines the cost of raw materials and other inputs; the intensity of competition affects the price of the product and the cost of competing in areas such as plant facilities, product development, advertising and sales forces. The cost of competing in areas such as plant facilities, product development, advertising, and sales force; the threat of entry by new competitors limits prices and creates the investment required to defend against entry.
The strengths of each of the five forces are a function of the structure of the industry or the economic and technological characteristics that underlie it. The structure of the industry is relatively stable, but changes over the course of the industry's development. Structural changes alter the overall and relative strengths of competitive forces, which can affect the profitability of the industry in positive or negative ways. The industry trends that are most important to strategy are those that affect the structure of the industry. If the determinants of the five competitive forces and their structure depended only on the intrinsic characteristics of the industry, then competitive strategy would depend to a large extent on picking the right industry and being slightly better than competing vendors at recognizing the five forces. However, when these are undoubtedly important tasks for any firm and in some industries are the essence of competitive strategy, the firm is usually not a slave to the structure of its industry. There are five forces that a firm can influence through its strategy, and if a firm can transform the structure of its industry, it can radically improve or destroy its attractiveness. Many successful strategies have changed the laws of competition in this way. Industry structure may drive all factors of competition within an industry. Not all five forces are equally important in any given industry, and the factors important to the particular structure will vary. Each industry is unique and has its own unique structure. The Five Forces framework enables companies to cut through the confusion, reveal exactly what is critical to competition in their industry, and identify the strategic innovations that will most improve the profitability of the industry and the company itself. The Five Forces framework does not preclude the need for creativity in exploring new ways of competing in an industry; rather, it directs managers' creativity toward those aspects of industry structure that are most important to long-term profitability. In doing so, the framework aims to enhance the likelihood of discovering satisfying strategic innovations.
The strategy of changing industry structure can be both a favorable and unfavorable thing. Because a firm can improve industry structure and profitability, it can just as easily destroy them. For example, a new product design that cuts down on barriers to entry or adds to the volatility of the competitive landscape may undermine the industry's long-term profitability, even if the company that introduces the new design is able to reap high profits for a while. In addition, protracted price-cutting may undermine the effect of distinctiveness, and unregistered goods may increase customer price sensitivity, trigger price competition, and weaken the high barrier effect of advertising that keeps newcomers out. Joint ventures established by major aluminum manufacturers to diversify risk and reduce the cost of capital may likewise have a subtle destructive effect on the structure of their industry. Major manufacturers invite a potentially dangerous group of new competitors into the industry and help remove barriers to entry. Joint ventures can also reinforce barriers to exit by requiring the consent of all parties to the joint venture before a plant can close.
Firms often make strategic choices without regard for the long-term consequences of industry structure. They see only that a successful move will strengthen their competitive position, but fail to anticipate that the reaction of their competitors will be disastrous. If the major competitors follow suit and end up destroying the structure of the industry, it will be a bad day for everyone. The "disruptors" in such industries are usually the secondary players who are trying to overcome their primary competitive disadvantage, the problematic players who are desperate to get out of their predicament, or the "schmucks" who don't care what it takes or who have unrealistic illusions about the future. " vendors.
The ability of firms to transform the structure of an industry places a special burden on the industry's leading players. Because of their size and influence on buyers, suppliers, and other competitors, the actions of leading firms may have varying degrees of impact on the structure of the industry. At the same time, the high market share of the leading firms ensures that any change in the overall industry structure will affect them as well. As a result, leading firms must continually adjust their competitive position to balance it with the health of the industry as a whole; they tend to improve their competitive position by taking steps to improve or protect the structure of the industry rather than by seeking larger competitive markets for themselves. Leading companies such as Coca-Cola and Campbell's Soup appear to be firms that follow this principle.
II. Determinants of the Intensity of Competition in an Industry
The five competitive forces - new entrants to the competition, the threat of substitutes, the bargaining power of buyers, the bargaining power of the supply side, and the counterbalance between existing competitors in the industry - reflect the fact that the industry's existing competitors are not in a position to compete with each other. -reflect the fact that competition in an industry extends well beyond the competitors already established in the industry. Customers, suppliers, substitute products and potential competitors are all the "competitors" of a manufacturer in a given industry, and their importance may vary to a greater or lesser extent, depending on the circumstances. In this broader sense, competition might be called "extended rivalry".
All five competitive forces ****identically determine the intensity and profitability of competition in an industry, and from a strategy formulation point of view, the strongest force or forces are dominant and decisive. For example, even if a firm has a very strong market position in an industry where potential new entrants pose little threat, it will be less profitable if it is faced with a dominant, lower-cost substitute. Even if substitutes do not exist and the entry of new competitors can be prevented, intense rivalry among existing competitors can limit potential gains. The extremes of competitive intensity occur in what economists call perfectly competitive industries, where participation in competition is free, where the existing players in the industry have no bargaining power over suppliers and customers, and where the rivalry is intense because the bulk of the players and products are roughly the same.
There are many economically and technologically important characteristics of a given industry which are essential to the strength of each competitive force. These characteristics will be discussed in turn.
(i) Threat of Entry
New competitors entering an industry bring new production capacity, promote the desire to gain market share, and often bring sizable financial resources. This situation may cause prices to plummet or costs to skyrocket for firms within the industry, thereby reducing profitability.
Firms that have diversified into the industry from other markets often use their financial power to cause some sort of drastic change, as Philip Morris did with Miller Brewing Company. Thus, entry into an industry in an attempt to consolidate its market position may be viewed as an attempt to compete, even if no new entity is formed. The threat of entry into an industry by a new player depends on the current barriers to entry and on the reaction that the entrant can expect from existing competitors in the industry. If the barriers are high, or if the new entrant can anticipate harsh retaliation from well-established competitors, then the threat posed by the new entrant entering an industry is low.
1. Barriers to Entry
There are seven major sources of barriers to entry:
(1) Economies of scale. Economies of scale mean that the unit cost of a product (or the cost of the operational or functional aspects of producing a product) declines as absolute output increases in each period. Economies of scale discourage entry by forcing an entrant to enter on a large scale and willingly risk a strong reaction from the industry's incumbents, or to enter on a small scale and face a cost disadvantage, both of which are unpleasant ways of doing business. Economies of scale may exist in virtually every function of a given firm, including manufacturing, purchasing, research and development, marketing, service outlets, sales capacity utilization and distribution. For example, Xerox and General Electric regrettably found that economies of scale in the manufacturing, research, marketing, and service sectors of the mainframe computer industry could be a major obstacle to the entry of new manufacturers into the industry.
Operations of scale may be associated with a complete functional area, as is the case in sales capacity, or they may arise from specific operations or activities that are integral to a functional area. For example, in television manufacturing, economies of scale are large in the production of color picture tubes and less significant in case joinery and complete assembly work. Therefore, in view of its special relationship between unit cost and scale of production, it is important to examine the components of cost separately.
(2) Product differences. Product differentiation refers to the fact that established manufacturers have a recognized brand name and customer loyalty, which arise from past advertising, customer service, product diversification, or simply as a result of the activities of the first to enter the industry. Product differentiation forces the entrant to spend a great deal of money to conquer existing customer loyalty, thus creating some kind of barrier to entry. This effort usually involves a loss of production and is experienced over a longer period of time. The investment in breaking out a certain brand is particularly risky because it has little residual value once entry fails.
Product differentiation is perhaps the most important barrier to entry in children's health care products, door-to-door retailing of pharmaceuticals, cosmetics, bank investments, and public accounting. In the brewing industry, product differentiation is often combined with economies of scale in production, marketing and distribution to produce high barriers.
(3) Capital requirements. The large investments required to be consumed by competition can create some barriers to entry, especially where that capital is required for risky or uncompensated, up-front advertising campaigns or research and development. Capital is required not only for production facilities, but also for things like customer credit, inventory, or to cover start-up losses. In the copier industry, for example, when Xerox chose to lease copiers rather than sell them quickly, this practice greatly increased the amount of working capital required, thus creating somewhat of a greater capital barrier to entry into the copier industry. While some of today's large corporations are financially strong enough to enter almost any industry, the large capital requirements of fields such as computers and mining limit the potential for partnerships among entrants. Even when capital is available in the capital markets, the use of funds for entry remains risky because the prospective entrant must assume the risk of paying interest. These circumstances are favorable to existing manufacturers.
(4) Pass-through costs. The presence of pass-through costs creates some sort of barrier to entry, which is a one-time cost that a given buyer faces when transferring a product from one supplying vendor to another. Pass-through costs may include the cost of retraining employees, the cost of new auxiliary equipment, the cost of testing a new source or verifying its conformity and the time it takes to do so, the cost of technical assistance due to reliance on the seller's engineering assistance, the cost of redesigning the product, or even the psychological cost of severing the relationship. If these types of pass-through costs are high, then the new entrant must make large improvements in cost or product performance in order for the buyer to move away from the vendors within an industry. For example, in the case of intravenous fluids and their sets of appliances used in hospitals, the way in which patients are injected differs between competing fluids, and the appliances used to suspend injection bottles are not interchangeable. In such cases, product switching can be met with strenuous resistance from nurses responsible for care, and new investments in hanging apparatus are required.
(5) Access to distribution channels. The need for new entrants to obtain distribution channels for their products creates some sort of barrier to entry. When the situation is such that the supply of the established manufacturer's product has been extended to those logical distribution channels, the new manufacturer must persuade those distribution channels to accept its product through price breaks, allowances for joint advertising, etc., which reduces profits. For example, the manufacturer of a new food product must persuade retailers to give it a place on the shelves of a highly competitive supermarket through a marketing pact, an aggressive sales effort by the retailer, or some other means.
The more restricted the wholesale or retail channels for a product are, and the more existing competitors block those channels, the more difficult it will obviously be to enter the industry. The existing competitor's connection to these channels may be based on a long-term relationship, high quality service, or even a specialized relationship with a particular manufacturer's channel. Sometimes this barrier to entry is so high that a new manufacturer would have to create an entirely new distribution channel to get past it, a maneuver used by Timix in the watch industry.
(6) Cost disadvantages not governed by size. Regardless of the size of the potential entrants and whether or not they achieve economies of scale, they will not be able to arrive at a cost advantage similar to that which an established player might have. The critical advantages are factors such as:
-- Proprietary product processes: The production skills or design features of a product that are kept proprietary through patents or secrecy.
--Favorable access to raw materials: perhaps as early as when demand for raw materials was lower than current demand, established manufacturers blocked the most favorable sources of raw materials at prevailing prices and froze foreseeable demand as well. For example, years ago, the mining technology of the Frasch Company enabled its sulfur vendors to take control of certain large and very favorable salt-slope sulfur deposits, as the Texas Gulf Sulfur Company did, before the owners of the deposits even realized the value of their deposits. However, oil companies engaged in petroleum exploration have often disappointed the discoverers of sulfur deposits, who do not take their high opinion of them lightly.
--Vantage points: Before market forces can inflate prices to capture their full value, established vendors may have monopolized those vantage points.
--Government Subsidies: Preferential government subsidies may enable established players to maintain their permanent advantage in certain businesses.
--Knowledge or Experience Curve: In some businesses, a tendency for unit costs to fall can be observed as manufacturers gain more and more experience in the production of their products. Costs fall because workers improve their methods and become more efficient (i.e., the typical knowledge curve), layouts are improved, specialized equipment and processes are developed, operations are progressively made more perfect through equipment, product design changes make manufacturing easier, measurement techniques and job control are improved, and so on.
Experience is nothing more than a conceptual name for certain technological changes that may apply not only to production but also to distribution, logistics, and other functions. As in the case of economies of scale, the decline in costs with experience is not related to the manufacturer as a whole, but arises from individual operations or the individual functions that make up the manufacturer. Experience can reduce costs in marketing, distribution, and other areas, as well as reducing production costs or the cost of operations in the production process. Each component of cost must be examined in order for experience to be effective.
(7) Government policy. The last major source of barriers to entry is government policy. By controlling applications for licenses and restricting access to raw materials (e.g., ski resorts to be built on coal fields or mountains), governments are able to limit or even prevent entry into an industry or industries. More obvious examples are the control of trucking, railroads, liquor retailing, air, land, and water freight forwarding, and the like. More subtly, governments can also limit entry through controls such as air and water pollution standards and product safety and efficacy regulations. Pollution control requirements, for example, can increase the capital required for entry and technical difficulty, and even the size of the most desirable facilities. Product testing standards prevalent in industries such as the food industry and other health-related products can impose much longer lead times, which not only raises the basic investment for entry, but also allows established players to be fully aware of impending entry, and thus sometimes to develop retaliatory strategies based on a comprehensive understanding of the new competitor's products. Government policies in these areas are bound to have immediate social benefits, but they can also have some side effects on entry with insufficient prior knowledge.
2. Anticipated retaliation
The expectations that potential entrants have about the reaction of existing competitors can also affect the threatening effect of entry. If the existing competitors are expected to react so strongly that the entrant's stay in the industry becomes an unpleasant event, there is every likelihood that entry will be prevented. The conditions which mark a high probability of retaliation against entry and consequently deter it are as follows:
- some history of strong retaliation against the entrant;
- retaliation by established players with substantial financial resources which includes excess cash and unused borrowing capacity, sufficiently excess production capacity to meet all possible future demand, or significant influence over distribution channels and customers;
- a number of established vendors who have taken on a large number of assignments to the industry as well as being able to use most of the industry's illiquid assets;
--Slow industry growth that would limit the industry's ability to absorb a particular new vendor without crippling the sales power and financial activities of established vendors.
(ii) Intensity of rivalry between incumbent competitors
Countervailing rivalry between incumbent competitors takes the familiar form of guerilla warfare and profit-seeking - the use of such tactics as price competition, advertising campaigns, product introductions, and the addition of customer-service programs or warranty offerings. Antagonism occurs because one or more competitors feel pressure or see an opportunity to improve their position. In most industries, a competitive action taken by one firm has a dramatic effect on its competitors, triggering efforts to retaliate or resist the action; that is, the firms are interdependent. Acting and reacting in this way may make things better for the initiating firm and for the industry as a whole. If the action and resistance escalate, then all the vendors in the industry will suffer to the point where they are worse off than they were in the past.
From the point of view of profitability, some forms of competition, such as aggressive price competition, are highly destabilizing and have a high probability of degrading the industry. Price cuts are quickly and easily copied by rivals, and once copied, they reduce the revenues of all manufacturers, unless the industry has a fairly high price-demand elasticity. On the other hand, an advertising war will sufficiently expand demand or raise the level of product differentiation within that industry to the benefit of all manufacturers. In some industries, rivalry can be characterized by phrases such as "belligerent," "bitter," or "brutal," while in others it is said to be It is "courteous"
or "gentlemanly". The dramatic struggle is the result of a large number of interacting structural factors.
A. Large number of competitors or evenly matched competitors. When there are a large number of players, the likelihood of each player acting on its own is high, and some players take it for granted that they can act at will without being noticed. Even where there are relatively few vendors, if they are relatively balanced in terms of size and sizable financial resources, instability arises because they can easily take on each other and have sufficient financial resources to retaliate consistently and aggressively. On the other hand, when the industry is highly concentrated or controlled by one or a few manufacturers, then there is no misleading relative strength, and the industry leader imposes discipline and a coordinating role within the industry by means of something like a pricing leadership system.
In many industries, foreign competitors, either foreign exporters to the industry or direct participants through foreign investment, play an important role in industry competition. Although there are some differences between foreign and domestic competitors, which will be pointed out later, foreign competitors should be treated in exactly the same way as domestic competitors for the purposes of structural analysis.
B. High fixed or storage costs. High fixed costs exert strong pressure on all firms to fill their production capacity, and often lead to a rapid escalation of price cuts when there is excess capacity. For example, many basic materials such as paper and aluminum suffer from this problem. The important characteristic of costs is that they are fixed costs related to value added, rather than fixed costs as a proportional relationship to total costs. Despite the fact that the absolute proportion of fixed costs is low, manufacturers who have a high proportion of incoming costs in external inputs (low value-added)
will feel enormous pressure to fill their production capacity in order to break even.
Somewhat related to high fixed costs is the situation where, once a product has been produced, it is very difficult or expensive to store it. In such cases, manufacturers will also be vulnerable to the temptation to cut prices in order to secure sales. In some industries, such as shrimping, hazardous chemicals manufacturing and some service industries, such pressures can keep profits low.
C. Lack of product differentiation or pass-through costs. In situations where products or services are understood to be some kind of commodity or quasi-commodity, the buyer's choice is based primarily on price and service, resulting in pressures for intense price and service competition. As already discussed, such forms of competition are particularly volatile. On the other hand, product differentiation creates some layers of isolation from conflict, as buyers have preferences and loyalties to particular sellers. Resale costs, described earlier, play the same role.
D. Massively expanded production capacity. Where economies of scale dictate a large increase in production capacity, the increase in production capacity often upsets the industry's supply and demand equilibrium, especially at the risk of stringing together additional production capacity. Industries can face periods of renewed overcapacity and price reductions, as those manufacturing chlorine, ethyl chloride and ammonia fertilizers have suffered.
E. Competitors of all shapes and sizes. Competitors who differ in strategy, origin, personality and relationship with their parent companies will have a variety of goals, different strategies for how to compete and will likely continue to kill each other as they interact. It may be a difficult time for them to understand each other's intentions accurately and to agree on a set of "rules of the game" for the industry. Strategic choices that are right for one competitor may be wrong for another.
Foreign competitors often add a great deal of diversity to the industry because of their different environments and often changing goals. The same can be said of small, independently owned manufacturers or service companies who are content to maintain their independence of private ownership by generally earning less than the normal rate of return on investment, yet such low returns are unacceptable and clearly unreasonable to a recognized large competitor. Within such an industry, the posture of such small players might limit the profitability of large firms. Similarly, those firms that view the market as some outlet for surplus production capacity (in the case of dumping) will adopt policies that are diametrically opposed to those firms that view the market as a primary outlet. Finally, differences in the relationship between competing business units and their parent firms are an important source of diversity in an industry. For example, if a business unit is part of a vertically organized chain of firms, it is quite possible for it to adopt different or even conflicting objectives than a small, autonomous manufacturer competing in the same industry. Or, if a business unit is a "golden calf" in its parent company's line of business, it will act differently than the kind of unit in that parent company that is being developed for long-term growth in the absence of other opportunities.
F. Highly strategic bets. If a large number of manufacturers place high stakes in an industry in order to succeed, the trade-offs within that industry can become more erratic. For example, a manufacturer engaged in a variety of businesses will place great emphasis on its success in a particular industry in order to facilitate the formation of a comprehensive strategy for its company. Or, a foreign manufacturer, such as Bosch, Sony, or Phillips, may feel a strong need to establish a strong position in the U.S. market in order to build global prestige or technical credibility. In this case, the goals of such manufacturers may not only take a different form, but are more volatile, since they are expansive and contain an underlying desire to sacrifice profitability.
G. Higher exit barriers. Barriers to exit are the economic, strategic and emotional factors that keep a company competitive among firms, even if the return on investment they receive is low or even negative. The main sources of exit barriers are as follows:
- Specialized assets: assets that are highly specialized to a particular business or location, have a low liquidation value or high transfer or exchange costs.
--Fixed Costs of Exit: Included in this category are labor agreements, relocation costs, the ability to repair parts, and so on.
--Strategic interrelationships: interrelationships between the business unit and other units within the firm in terms of goodwill, marketing capabilities, access to financial markets, shared facilities, and so on. This interrelationship allows the vendor to place a highly strategic focus on the business in which it is engaged.
--Emotional barriers: the role of self-importance to a particular business, loyalty to employees, fear for one's own personal career, pride, and other reasons make management reluctant to make an exit decision that is economically sound.
--Government and societal constraints: this type of constraint consists of the government's refusal to accept an exit or discouragement of an exit because of fears of unemployment problems and localized economic impacts; this type of constraint is especially prevalent outside the United States.
When barriers to exit are high, excess capacity has not been removed from the industry, and companies that have lost the competitive battle have not conceded defeat. Instead, they will remain resilient and, because of their weaknesses, have to resort to extreme tactics. As a result, the profitability of the industry as a whole will only continue to remain low.
While conceptually barriers to exit are distinct from barriers to entry, their ****same level is an important aspect of industry analysis. Barriers to exit and barriers to entry are often related to each other. For example, considerable economies of scale in production are usually associated with specialized assets, as is the case with the existence of proprietary technology.
Take the simplified case where barriers to exit and entry can be both high and low.
From the point of view of industry profitability, the best case scenario is one in which the barriers to entry are high and the barriers to exit are low. In this case, entry will be blocked and failed competitors will exit the industry. When both barriers to entry and barriers to exit are at high levels, potential profits are high, but are usually accompanied by greater risk. Although entry is blocked, the failed vendor will remain in the industry and continue to struggle.
It is not exciting enough to have both barriers to entry and barriers to exit low, but the worst case scenario is when the barriers to entry are low and the barriers to exit are high. In this case, entry will be lured by improved economic conditions or other temporary windfalls and will be easy to accomplish. However, it is not unlikely that production capacity will exit the industry when outcomes worsen, resulting in a backlog of production capacity in the industry and a prolonged loss of profitability. For example, an industry may be in the unlucky situation where a supplier or lender will happily agree to finance entry, but once entry is successful, the manufacturer will face large fixed financing costs.