Market forces are a significant force in shaping strategies. Examples of market forces include:
- Existing competition
- The entry of new competitors
- Rivalry among competitors
- The threat of substitutes
- Bargaining power of buyers and suppliers
- Current economic conditions
- Global market changes
- How well the organization is positioned for growth and
- Changing customer expectations
Porter's Five Forces Model is a framework for understanding strategic business decisions by identifying external factors affecting competition within industries.
Michael E. Porter provided a framework to analyze the competition of a business. He proposed five forces that determine the competitive intensity and, therefore, the industry's attractiveness (or lack of it) in terms of its profitability. The Five Forces analysis can be used to guide business strategy.
The Five Competitive Forces:
1. Industry/Competitive Rivalry:
In general terms, the first force refers to the total number of companies competing for an industry's market share. With so many competitors out there offering similar products and services, companies often find themselves at a disadvantage compared to their competition. When competition for market share is high, companies must compete by offering lower prices and better service than their competitors.
Rivalry is intense when there are many strong competitors in the industry. This leads to price-cutting, high advertisement efforts.
Rivalry level may depend on: (some examples)
- High fixed and low variable cost leads to higher rivalry
- Low cost (or barrier) of switching leads to higher rivalry
- Less product differentiation leads to higher rivalry
- Low exit cost makes the industry more attractive
2. Threat (and barrier) of New Entrants:
Furthermore, companies' power is also affected by the forces exerted by new entrants into their marketplaces. If it takes less time and money for a new competitor than yours to become an effective competitor, then your competitors' positions may weaken. In an industry where there are no major competitors (or the entry barrier is very high), established companies can set high prices and get away with charging whatever they want because nobody else has enough power to compete against them.
The threat of new entrants increases: (some examples)
- Lower economies of scale and learning curve
- Existing products have a weak brand identity
- Low cost (or barrier) of switching
- Low entry and low exit barriers
3. Threat of substitutes
Substitutes are goods that have the same purpose. A change in the price of one item leads to a change in the demand of others.
Companies whose products or services cannot be easily replaced by others will have greater pricing power than their competitors. If close alternatives are available, customers may choose not to buy from you because they prefer an alternative instead.
The threat of substitutes increases: (some examples)
- Low cost (or barrier) of switching
- Relative prices of products
- Brand loyalty
4. Bargaining power of customers
A company's ability to charge a higher price largely depends on how many customers they have, how powerful these existing customers are, and the costs associated with finding new customers. A business with many small and independent clients will be able to charge higher prices for their products because they have less bargaining power. On the other hand, if the company has a few powerful clients, then the company might not be able to charge a higher price.
The threat of customers bargaining power varies with: (some examples)
- Concentrated purchasing power (a few buyers)
- It's low when the switching cost is high
- The possibility of backward integration increases the bargaining power of the buyer.
5. Bargaining power of suppliers
When firms lack alternatives for suppliers of raw materials, components parts, labor, and services, they may find themselves at an disadvantage. Because in this case they can not look for alternate suppliers, and the supplier can take an advantage of this situation.
Suppliers bargaining power varies with: (some examples)
- A few buyers reduces the bargaining power of suppliers
- It’s high when the switching cost is high
- If the price of substitute is high, the supplier will have more bargaining power
- If the industry is organized (e.g. OPEC)
The Effect of Five Competitive Forces:
1. Industry rivalry
- The larger the competition, the lesser will be the bargaining power of the company
- When rivalry is low, the company can achieve higher profits
2. The threat of new entrants
- The most favourable situation is when there is a high entry barrier and low exit barrier
3. Threat of substitutes
- Companies that produce goods or services with no close substitutes have more power to increase the price.
4. Bargaining power of customers
- A small and more powerful customer will have better negotiation power to get better terms from the company.
- A company with many smaller customers will be better positioned to charge a higher price.
5. Bargaining power of suppliers
- The fewer suppliers are in the industry; the more company depends on suppliers.
- If there are more suppliers and there are low switching costs, that help the company to reduce costs.
Conclusion
Understanding Porter’s five forces and how they apply to any particular market enables companies to understand their competitive environment and adapt accordingly.