Porter’s five forces model is used to answer a few basic questions regarding strategic position analysis i.e.
What is the strength of competition in a market?
What is the nature of competition in a market or industry?
Why some industries are more profitable as compared to others?
Some markets are more competitive whilst other are comparatively less competitive. But how do we analyze a market? How do we say competition is strong or week?
This is all possible with the help of porter’s five force model. Porter Five forces model surrounds around;
- Threat from new entrants
- Threat from substitute products or services
- The Bargaining power of suppliers
- The Bargaining power of customers/buyer
- Competitive rivalry.
Competition in the market will be strong if any of the above five forces are strong. High competition will result in lower profitability. Similarly, competition will be relatively weaker, when the above five forces are weak. We will discuss each of them in detail with examples.
1. Threats from New Entrants
What attracts new entrants to a market or industry?
The answer is simple, they might be attracted by high profitability in the market.
If they are entering the market, they might be looking for a substantial share in the market. They will gain their desired market share by charging lower prices and offering better quality.
Is this threat significant for existing competitors?
According to porter’s 5 forces, it depends, if its easy for a newbie to enter the market and start selling, the threat from new entrants is quite significant. However, if a new entrant has to invest a lot in the course of entry to the market, the threat is not that significant. This is because, not everyone has the potential to invest a lot and enter the market.
The difficulties faced by a new entrant while entering a market are called ‘barriers to entry. If these barriers to entry are low, the profitability in the market will be low because competitors will charge low prices in order to gain higher market share. Similarly, under porters five forces, if these barriers are high, it will be difficult for a new entrant to enter, making the profitability higher for existing competitors.
What are the factors that create barriers to entry?
According to porter analysis, the following six forces might create barriers to entry:
- In a market, where new a new entrant has to invest a lot in assets, it might help creating high barriers to entry.
- In a market, where existing competitors reduce average costs by producing and selling goods in large quantities, it will be difficult for new comers to achieve such a production level. So, Economies of scale might help creating high barriers to entry.
- There are some industries where customers give priority to brands. In such a case, it might be difficult for a new entrant to establish itself and attract customer loyalty.
- Some markets are highly complex. They require a lot of time to understand them. It is also expensive to acquire know how of the market.
- Some markets have a very limited distribution channels or distribution outlets. As a new entrant, you might get find it difficult to access these distribution channels or distribution outlets.
- Part of the high barrier to entry is also credited to “costs that a buyer has to incur if he/she want to switch from current supplier to a new supplier”. These costs are called “Switching costs”. If such costs are high, new entrant will find it difficult to enter the market.
- Government regulations might act as a high barrier to entry. These regulations might be attached to obtaining a license to operate or getting registered in an industry.
2. Threat from Substitute Products or Services
Substitute products or services is the second name for alternative products or services. Some examples of substitute products are;
Tea and Coffee
Plastic containers and bottles are substitutes for glass containers and bottles.
Personal computers are substitute for typewriters.
Threat from Substitute product or service is significant when customers can easily switch from one substitute to another. For example, it’s easy for a customer to switch from coffee to tea.
Threat from substitute is different in different markets. For examples in transport services customers might switch from road to rail or air transport.
Current Day Example
You might have witnessed the growing trends in video streaming services like Netflix, Amazon prime. They are substitute to traditional cinemas and TV channels. According to analysts, they might kill cinema in the future.
Difference between a substitute and Competitor
It’s important to note here the difference between a substitute and a competitor.
Suppose A, B and C owns Tea Shops whilst C, D and E owns coffee shops. Now A, B, and C are competitors in their own service (Tea) whilst C, D and E are competitors for Coffee.
The substitutes here is the coffee for tea and tea for coffee. A, B and C have the threats from substitute i.e. Coffee whilst C, D and E are facing threat from tea.
3. Bargaining power of suppliers
In some industries, suppliers are very powerful. They use their power to demand higher prices from their buyers. Otherwise, they threaten to offer a lower quality product. In such a case, the buyer will have less profitability, as they are unable to pass on the high prices charged by suppliers to their customers.
According to porter analysis, bargaining power of suppliers might be strong in the following situations;
- A market having small number of suppliers
- A market offering a product or services to which no substitute exists.
- A market in which a supplier is offering better, distinct and more suitable product/service than any other supplier, such as Microsoft in the software industry.
- A market offering products or services which becomes an important component in the end-product or finished goods such as engine in a motor car.
- A market where a single buyer is not an important customer for the suppliers.
4. Bargaining power of Customers
In some industries, customers or buyer can also exert pressure on suppliers to reduce to reduce the prices or provide better quality products. A typical example is cab services in a locale, customers choose the one offering promotional codes, better services and cheap rides.
According to porter, buyers or customers are particularly more powerful in the following situations;
- When customer is buying in a large volume sufficiently enough compared to the size of the supplier.
- When their enough competitors offering the same goods/services, and costs of switching from one to another are low.
- When total costs of the buyer almost consist of the costs of the purchased item, that way the buyer will be more willing and motivated to find the lowest cost possible.
- When information about all the suppliers is readily available, such as prices, comparisons and reviews. A buyer will use this information to find the lowest cost.
5. Competitive rivalry
Another important factor out of five forces analysis is analyzing ‘competitive rivalry’. If competition is strong, all the competitors will charge low prices relative to the quality of the product. Consequently, profitability is low.
According to Porter, competitive rivalry might be prominent in the following situations;
- When competitors are of almost the same size and economic strength.
- When there are large number of competitors.
- When there is slow growth in the demand.
- When competitors are selling almost the same product i.e. undifferentiated product.
- When ease of leaving the market is very low or barriers to exit are high.
Conclusion of Porter’s Five Forces Model
According to Porter’s Five Forces Model, competition in a market is strong where:
- Barriers to entry are high,
- There is a high threat from substitute product,
- Market have powerful suppliers exercising bargaining power,
- Market have powerful customers are exercising bargaining power and
- There is high competition between rivals in the market.
Consequently, competition in a market is weak where;
- Barriers to entry are low,
- There is low or no threat from substitute product/products,
- The suppliers have low or no bargaining power,
- The buyers have low or no bargaining power and
- There is no or less competition between rivals.
Example of Porter’s Five Forces Model
Let’s analyze the market for ‘Assurance Services’ in a city with the help of porter’s five forces model.
Threat from new entrants are low in case of firms providing ‘Assurance services’, as the firms must be established by qualified chartered accountants or chartered public accountants. So, everyone cannot enter the market.
Threats from substitutes: There is no substitute to assurance services. All the companies falling in the criteria specified by the government must hire external auditors.
Suppliers’ Bargaining Power: Firms providing assurance services have no significant supplier. Therefor, the bargaining power of supplier does not exist at all.
Bargaining power of customers: Customers need assurance services more than assurance firms need customers. Therefore, bargaining power of customer is low.
Competitive rivalry: Assurance firms does not compete with other firms by offering lower fee. Therefore, competitive rivalry is low.
Using Michael Porter’s five forces model, Analyze the market for ‘Gym services’ in your city.
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