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Five Forces Model
In any industry, the rules of competitive are embodied in the five competitive forces:
(i) The threat of new entrants
(ii) The threat of substitutes
(iii) The bargaining power of buyers
(iv) The bargaining power of sellers
(v) Internal rivalry between firms in the industry.
The collective strength of these factors determines the ability of firms in an industry to earn, on an average, rates of return on investment in excess of cost of capital. The strength of the five forces varies from industry to industry, and can change as an industry evolves. The result is that all industries are not alike in terms of inherent profitability. In industries where the five forces are favorable, many competitors earn attractive returns. But industries where pressure from one or more of the forces is intense, few firms are able to command attractive returns. The five forces determine industry profitably because they influence the prices, costs, and required investment of firms in an industry, the elements of ROI.
This seems to be contradictory to what we have been learning as it seems to suggest that no matter what efforts the management puts in, the ROI will depend on the strength of eh five competitive forces. Not true, because the real utility of Porters model is the learning that a firm is not a prisoner of the industry structure or the five forces. Companies can and should shape the structure and can fundamentally change an industry’s attractiveness for better or for worse. Only those firms that understand the competitive structure of their industries intuitively can shape their future through appropriate business strategies.
Each of the five forces and their impact on industry is explained hereunder.
Intensity of rivalry between firms
Intensity of rivalry between firms can be characterized as cutthroat, intense, moderate, weak or stable. The intensity of rivalry depends on several factors:
1. Concentration ratio or % of market share hold
In oligopolistic industries, the concentration ratio is high, because of the presence of a few firms, each holding a sizeable market share.
Competition is such industry is more stable, hence intensity of rivalry is less. Can you state why rivalry would be more stable?
In industries where there are a large number of competitors, none with significant market share (also known as fragmented markets) competition is more intense or even cutthroat as each firm tries to improve its market share.
2. Market growth rates
When market growth rates are high, all firms in the industry can grow without having to fight for market share. The rate of growth for each firm will of course necessarily depend on their respective business strategies.
When market growth rates slow down, a large part of the firm’s growth now comes from taking market share away from the rivals. Hence slow market growth rates increases intensity of rivalry.
3. Overcapacity
When industry is experiencing growth, most firms are adding production capacity to meet the increased demand expectations. When demand weakens, firms struggle with excess capacity, puts greater pressure on margins, which in turn leads to a greater fight for market share consequently increases intensity of rivalry.
4. Higher fixed costs
Industries that have a high fixed cost structure which puts a pressure on the firms to pursue a sales volumes strategy. With all firms pursuing volume, rivalry is likely to be more intense. Also industries which have experienced a slowdown and consequent overcapacity, feel the burden of higher fixed costs, which in turn increases rivalry.
5. Perishable products
Product perishability is also seen to increase rivalry between firms. A seat on an particular route or to sell room nights is very intense.
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(i) The threat of new entrants
(ii) The threat of substitutes
(iii) The bargaining power of buyers
(iv) The bargaining power of sellers
(v) Internal rivalry between firms in the industry.
The collective strength of these factors determines the ability of firms in an industry to earn, on an average, rates of return on investment in excess of cost of capital. The strength of the five forces varies from industry to industry, and can change as an industry evolves. The result is that all industries are not alike in terms of inherent profitability. In industries where the five forces are favorable, many competitors earn attractive returns. But industries where pressure from one or more of the forces is intense, few firms are able to command attractive returns. The five forces determine industry profitably because they influence the prices, costs, and required investment of firms in an industry, the elements of ROI.
This seems to be contradictory to what we have been learning as it seems to suggest that no matter what efforts the management puts in, the ROI will depend on the strength of eh five competitive forces. Not true, because the real utility of Porters model is the learning that a firm is not a prisoner of the industry structure or the five forces. Companies can and should shape the structure and can fundamentally change an industry’s attractiveness for better or for worse. Only those firms that understand the competitive structure of their industries intuitively can shape their future through appropriate business strategies.
Each of the five forces and their impact on industry is explained hereunder.
Intensity of rivalry between firms
Intensity of rivalry between firms can be characterized as cutthroat, intense, moderate, weak or stable. The intensity of rivalry depends on several factors:
1. Concentration ratio or % of market share hold
In oligopolistic industries, the concentration ratio is high, because of the presence of a few firms, each holding a sizeable market share.
Competition is such industry is more stable, hence intensity of rivalry is less. Can you state why rivalry would be more stable?
In industries where there are a large number of competitors, none with significant market share (also known as fragmented markets) competition is more intense or even cutthroat as each firm tries to improve its market share.
2. Market growth rates
When market growth rates are high, all firms in the industry can grow without having to fight for market share. The rate of growth for each firm will of course necessarily depend on their respective business strategies.
When market growth rates slow down, a large part of the firm’s growth now comes from taking market share away from the rivals. Hence slow market growth rates increases intensity of rivalry.
3. Overcapacity
When industry is experiencing growth, most firms are adding production capacity to meet the increased demand expectations. When demand weakens, firms struggle with excess capacity, puts greater pressure on margins, which in turn leads to a greater fight for market share consequently increases intensity of rivalry.
4. Higher fixed costs
Industries that have a high fixed cost structure which puts a pressure on the firms to pursue a sales volumes strategy. With all firms pursuing volume, rivalry is likely to be more intense. Also industries which have experienced a slowdown and consequent overcapacity, feel the burden of higher fixed costs, which in turn increases rivalry.
5. Perishable products
Product perishability is also seen to increase rivalry between firms. A seat on an particular route or to sell room nights is very intense.
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