Porter's five forces analysis

Porter refers to these forces as the microenvironment, to contrast it with the more general term macroenvironment. They consist of those forces close to a company that affects its ability to serve its customers and make a profit. A change in any of the forces normally requires a business unit to re-assess the marketplace given the overall change in industry information. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability. Firms are able to apply their core competencies, business model or network to achieve a profit above the industry average. A clear example of this is the airline industry. As an industry, profitability is low because the industry's underlying structure of high fixed costs and low variable costs afford enormous latitude in the price of airline travel. Airlines tend to compete on cost, and that drives down the profitability of individual carriers as well as the industry itself because it simplifies the decision by a customer to buy or not buy a ticket. This underscores the need for businesses to continuously evaluate their competitive landscape and adapt strategies in response to changes in industry dynamics, exemplified by the airline industry's struggle with profitability despite varying approaches to differentiation. A few carriers – such as Richard Branson's Virgin Atlantic – have tried, with limited success, to use sources of differentiation in order to increase profitability.

Porter's Five Forces include three sources of "horizontal competition"—the threat of substitute products or services, the threat posed by established industry rivals, and the threat of new entrants—and two sources of "vertical competition"— the bargaining power of suppliers and the bargaining power of buyers.

Porter developed his Five Forces Framework in response to the then-prevalent SWOT analysis, which he criticized for its lack of analytical rigor and its ad hoc application. The Five Forces model is grounded in the structure–conduct–performance paradigm of industrial organization economics. Other strategic tools developed by Porter include the value chain framework and the concept of generic competitive strategies.

Five forces that shape competition

Threat of new entrants

New entrants put pressure on current within an industry through their desire to gain market share. This in turn puts pressure on prices, costs, and the rate of investment needed to sustain a business within the industry. The threat of new entrants is particularly intense if they are diversifying from another market as they can leverage existing expertise, cash flow, and brand identity which puts a strain on existing companies profitability.

Barriers to entry restrict the threat of new entrants. If the barriers are high, the threat of new entrants is reduced, and conversely, if the barriers are low, the risk of new companies venturing into a given market is high. Barriers to entry are advantages that existing, established companies have over new entrants.

Michael E. Porter differentiates two factors that can have an effect on how much of a threat new entrants may pose:

Barriers to entry

The most attractive segment is one in which entry barriers are high and exit barriers are low. It is worth noting, however, that high barriers to entry almost always make exit more difficult.

Michael E. Porter lists seven major sources of entry barriers:

• Supply-side economies of scale – spreading the fixed costs over a larger volume of units thus reducing the cost per unit. This can discourage a new entrant because they either have to start trading at a smaller volume of units and accept a price disadvantage over larger companies, or risk coming into the market on a large scale in an attempt to displace the existing market leader.
• Demand-side benefits of scale – this occurs when a buyer's willingness to purchase a particular product or service increases with other people's willingness to purchase it. Also known as the network effect, people tend to value being in a 'network' with a larger number of people who use the same company.
• Customer switching costs – These are well illustrated by structural market characteristics such as supply chain integration but also can be created by firms. Airline frequent flyer programs are an example.
• Capital requirements – clearly the Internet has influenced this factor dramatically. Websites and apps can be launched cheaply and easily as opposed to the brick-and-mortar industries of the past.
• Incumbency advantages independent of size (e.g., customer loyalty and brand equity).
• Unequal access to distribution channels – if there are a limited number of distribution channels for a certain product/service, new entrants may struggle to find a retail or wholesale channel to sell through as existing competitors will have a claim on them.
• Government policy such as sanctioned monopolies, legal franchise requirements, patents, and regulatory requirements.

Expected retaliation

For example, a specific characteristic of oligopoly markets is that prices generally settle at an equilibrium because any price rises or cuts are easily matched by the competition.

Threat of substitutes

A substitute product uses a different technology to try to solve the same economic need. Examples of substitutes are meat, poultry, and fish; landlines and cellular telephones; airlines, automobiles, trains, and ships; beer and wine; and so on. For example, tap water is a substitute for Coke, but Pepsi is a product that uses the same technology (albeit different ingredients) to compete head-to-head with Coke, so it is not a substitute. Increased marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi, whereas increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks), while giving Pepsi a larger market share at Coke's expense.

Potential factors:

• Buyer propensity to substitute. This aspect incorporated both tangible and intangible factors. Brand loyalty can be very important as in the Coke and Pepsi example above; however, contractual and legal barriers are also effective.
• Relative price performance of substitute
• Buyer's switching costs. This factor is well illustrated by the mobility industry. Uber and its many competitors took advantage of the incumbent taxi industry's dependence on legal barriers to entry and when those fell away, it was trivial for customers to switch. There were no costs as every transaction was atomic, with no incentive for customers not to try another product.
• Perceived level of product differentiation which is classic Michael Porter in the sense that there are only two basic mechanisms for competition – lowest price or differentiation. Developing multiple products for niche markets is one way to mitigate this factor.
• Number of substitute products available in the market
• Ease of substitution
• Availability of close substitutes

Bargaining power of customers

The bargaining power of customers is also described as the market of outputs: the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. Firms can take measures to reduce buyer power, such as implementing a loyalty program. Buyer power is higher if buyers have many alternatives, lower if they have few choices.

Potential factors:

• Buyer concentration to firm concentration ratio
• Degree of dependency upon existing channels of distribution
• Bargaining leverage, particularly in industries with high fixed costs
• Buyer switching costs
• Buyer information availability
• Availability of existing substitute products
• Buyer price sensitivity
• Differential advantage (uniqueness) of industry products
• RFM (customer value) analysis

Bargaining power of suppliers

The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labour, and services (such as expertise) to the firm can be a source of power over the firm when there are few substitutes. If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it. Suppliers may refuse to work with the firm or charge excessively high prices for unique resources.

Potential factors are:

• Supplier switching costs relative to firm switching costs
• Degree of differentiation of inputs
• Impact of inputs on cost and differentiation
• Presence of substitute inputs
• Strength of the distribution channel
• Supplier concentration to the firm concentration ratio
• Employee solidarity (e.g. labor unions)
• Supplier competition: the ability to forward vertically integrate and cut out the buyer.

Competitive rivalry

Competitive rivalry is a measure of the extent of competition among existing firms. Price cuts, increased advertising expenditures, or investing in service/product enhancements and innovation are all examples of competitive moves that might limit profitability and lead to competitive moves. For most industries, the intensity of competitive rivalry is the biggest determinant of the competitiveness of the industry. Understanding industry rivals is vital to successfully marketing a product. Positioning depends on how the public perceives a product and distinguishes it from that of competitors. An organization must be aware of its competitors' marketing strategies and pricing and also be reactive to any changes made. Rivalry among competitors tends to be cutthroat and industry profitability is low while having the potential factors below:

Potential factors:

• Competitive advantage through innovation
• Competition between online and offline organizations
• Level of advertising expense
• Powerful competitive strategy which could potentially be realized by adhering to Porter's work on low cost versus differentiation.
• Firm concentration ratio