The Five Forces: Competing for Profits

Excerpt from Understanding Michael Porter by Joan Magretta

  • Most people think competition is a direct contest between rivals to win a sale. It’s not. At least not entirely. It’s more about earning (and competing for) profits, which is more complex.
  • Companies compete for profits against Five Forces:
    • direct competitors
    • customers, who would like to pay less
    • suppliers, who’d like to charge more
    • producers, who could make substitute products
    • potential competitions…threat of new entrants places limits on how much a company could charge
  • Most industries are more similar than they appear on the surface
  • Industry structure determines profitability
  • Industry structures are sticky; they are stable over time…structural change on the other hand takes a long time
  • Porter’s prevailing framework for sizing up an environment is called ‘SWOT’: strengths, weaknesses, opportunities, and threats
    • SWOT is a weak tool. No economic principles inform it….SWOT analysis can lead to arbitrary outputs
    • SWOT is biased toward confirming long-standing beliefs
  • The more powerful the force, the more pressure it will put on costs and prices or both
  • Assessing each Force and how it affects profit…
    • Buyers: powerful buyers push costs down to capture more value
    • Suppliers: powerful suppliers will use negotiating leverage to charge higher prices or get better terms
    • Substitutes: put a cap on industry profitability…erode incumbent sales. Switching costs play a big role in substitution
    • New entrants: incumbents erect barriers to deter newcomers
    • Rivalry: when rivalry is intense, profitability is lower (i.e. price cuts, more advertising, new product roll-outs, and increased customer service)
      • Price competition is the most damaging form of rivalry…erodes profits
  • Why Only Five forces?
    • encompasses all relationships relevant to commerce: buyer and seller, seller and supplier, between rival sellers, and between supply and demand
    • Memorizing the five forces won’t make you a better thinker. You have to get the deeper point. There are a limited number of structural forces at work in every industry that systemically impact profitability in a predictable direction
    • Other factors that are important but are not structural (i.e. a Force) include…
      • Gov’t regulation, technology, and and industry growth rates
  • Sixth Force?
    • ‘Complements’ are sometimes proposed as a sixth force. Complements can affect the demand for a product (i.e. software affects hardware)
      • But dismissed because their effects are not direct enough. They affect profitability in a round about way
  • Implications for strategy?
    • Steps in Industry Analysis
      • Define an industry (by both product and geography)
      • Identify players constituting each of Five Forces
      • Assess drivers of each Force
      • Assess overall industry structure
      • Analyze changes/trends in forces
      • Think about positioning
  • Industry structure is dynamic…changes all the time
    • the more you understand an industry using the five force framework the more you can exploit changes when they happen

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