Porter's Five Forces analysis of market structure

The competitive structure of an industry can be analysed using Porter's five forces.

This model attempts to analyse the attractiveness of an industry by considering five forces within a market.

According to Porter (1980) the likelihood of firms making profits in a given industry depends on five factors:

1. The likelihood of new entry i.e. the extent to which barriers to entry exist. The more difficult it is for other firms to enter a market the more likely it is that existing firms can make relatively high profits.

The likelihood of entering a market would be lower if:

• the entry costs are high e.g. if heavy investment is required in marketing or equipment
• there are major advantages to firms that have been operating in the industry already in terms of their experience and understanding of how the market works (this is known as the "learning effect")
• government policy prevents entry or makes it more difficult; for example, protectionist measures may mean a tax is placed on foreign products or there is a limit to the number of overseas goods that can be sold. This would make it difficult for a foreign firm to enter a market
• the existing brands have a high level of loyalty
• the existing firms may react aggressively to any new entrant e.g. with a price war
• the existing firms have control of the supplies .e.g. entering the diamond industry might be difficult because the majority of known sources of diamonds are controlled by companies such as De Beers.

2. The power of buyers.

The stronger the power of buyers in an industry the more likely it is that they will be able to force down prices and reduce the profits of firms that provide the product.

Buyer power will be higher if:

• there are a few, big buyers so each one is very important to the firm
• the buyers can easily switch to other providers so the provider needs to provide a high quality service at a good price
• the buyers are in position to take over the firm. If they have the resources to buy the provider this threat can lead to a better service because they have real negotiating power

3. The power of suppliers.

The stronger the power of suppliers in an industry the more difficult it is for firms within that sector to make a profit because suppliers can determine the terms and conditions on which business is conducted.

Suppliers will be more powerful if:

• there are relatively few of them (so the buyer has few alternatives)
• switching to another supplier is difficult and/or expensive
• the supplier can threaten to buy the existing firms so is in a strong negotiating position

4. The degree of rivalry

This measures the degree of competition between existing firms. The higher the degree of rivalry the more difficult it is for existing firms to generate high profits.

Rivalry will be higher if:

• there are a large number of similar sized firms (rather than a few dominant firms) all competing with each other for customers
• the costs of leaving the industry are high e.g. because of high levels of investment. This means that existing firms will fight hard to survive because they cannot easily transfer their resources elsewhere
• the level of capacity utilisation. If there are high levels of capacity being underutilised the existing firms will be very competitive to try and win sales to boost their own demand
• the market is shrinking so firms are fighting for their share of falling sales
• there is little brand loyalty so customer are likely to switch easily between products

5. The substitute threat.

This measures the ease with which buyers can switch to another product that does the same thing e.g. aluminium cans rather than glass or plastic bottles. The ease of switching depends on what costs would be involved (e.g. transferring all your data to a new database system and retraining staff could be expensive) and how similar customers perceive the alternatives to be.

Using Porter's analysis firms are likely to generate higher returns if the industry:

• Is difficult to enter
• There is limited rivalry
• Buyers are relatively weak
• Suppliers are relatively weak
• There are few substitutes.

On the other hands returns are likely to be low if:

• The industry is easy to enter
• There is a high degree of rivalry between firms within the industry
• Buyers are strong
• Suppliers are strong
• It is easy to switch to alternatives

The implication of Porter's analysis for managers is that they should examine these five factors before choosing an industry to move into. They should also consider ways of changing the five factors to make them more favourable.

For example:

• if firms merge together this can reduce the degree of rivalry . This has happened a great deal in industries such as automobiles, pharmaceuticals and banking where firms have joined together to remove competitors
• if firms buy up distributors (this is called forward vertical integration) they can gain more control over buyers
• if firms differentiate their product perhaps by trying to generate some form of Unique Selling Proposition (USP) that makes it stand out from the competition. This lies at the heart of many marketing and brand building activities. Coca Cola, for example, has fought hard to promote itself as "the real thing"; everything else is just imitation!
• if they react aggressively to a firm that enters its market this may deter potential entrants in the future

The five forces will change over time as market conditions alter. For example, more information is available nowadays to enable customers to compare offerings and prices; this gives buyers more power. The opening up of world markets (for example through the efforts of the World Trade Organisation to reduce protectionist measures that limit trade and the expansion of the European Union enabling free trade between more countries) has led to much more rivalry in markets in recent years. In North America, for example, the sales of Japanese firms such as Toyota have gradually been reducing the market share of American producers such as General Motors as consumers have more choice. Meanwhile, the success of the internet has made it easier for producers to enter many markets such as finance, book retailing and clothes retailing; the ability to start selling online has reduced a major barrier to entry which was the investment required to set up a network of shops. As ever the business world is not static and the conditions in any industry will always be changing. As this happens the various elements of the five forces are always shifting requiring established firms and potential entrants to review their strategies.

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