The five-forces model:
Rivalry among existing competitors
Threat of new entrants
Threat of substitute products and services
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
Rivalry among industry players can affect industry profits through (a) downward pressure on prices, (b) increased innovation, (c) increased advertising, (d) increased service/product improvements, among others. In economics, a monopoly industry structure earns the most profit while the “perfect competition” industry structure earns the least. An increase in competitive rivalry among existing firms brings an industry closer to the theoretical “perfect competition” state. Factors that increase competitive rivalry among existing firms include:
- Large Number of Firms: If there are more firms within an industry, there is an increased competition for the same customers and product resources. There is even greater competition if industry players are equal in size and power, as rivals compete for market dominance.
- Slowed Industry Growth: When an industry is growing rapidly, firms are able to increase profits because of the expanding industry. When growth slows and industries reach the maturity stage of the industry lifecycle, competition increases to gain market share (and continue the profit growth that investors require).
- High Fixed Costs or High Storage Costs: In industries where the fixed costs are high, firms will compete to gain the largest amount of market share possible to cover the fixed costs.
- High Exit Barriers: When high exit barriers exist, firms will stay and compete in an industry longer than they would if no exit barriers existed
In addition, price competition is more likely to exist when:- Products or services are identical and/or low switching costs: This encourages price competition to gain market share.
- Fixed costs high and/or marginal costs low: This encourages competitors to cut prices below their average costs (but not below marginal costs) to recoup some of their fixed costs.
- Capacity must be expanded in large increments to be efficient:
- The products are perishable: When a product is perishable, at a certain time it loses its value completely. This creates pressure on a competing firm to sell its product at a price while it still has value. This is true not only for food but for many industries where technology is consistently being improved (e.g. cars, computers, etc).
Threat of new entrants
Power is also affected by the ability of people to enter your market. If it costs little in time or money to enter your market and compete effectively, if there are few economies of scale in place, or if you have little protection for your key technologies, then new competitors can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.
Threat of substitute products and services
The existence of products outside of the realm of the common product boundaries increases the propensity of customers to switch to alternatives. For example, tap water might be considered a substitute for Coke, whereas Pepsi is a competitor's similar product. Increased marketing for drinking tap water might "shrink the pie" for both Coke and Pepsi, whereas increased Pepsi advertising would likely "grow the pie" (increase consumption of all soft drinks), albeit while giving Pepsi a larger slice at Coke's expense. Another example is the substitute of traditional phone with VoIP phone.
Potential factors:
- Buyer propensity to substitute
- Relative price performance of substitute
- Buyer switching costs
- Perceived level of product differentiation
- Number of substitute products available in the market
- Ease of substitution
- Substandard product
- Quality depreciation
Bargaining power of customers (buyers)
The bargaining power of customers is also described as the market of outputs: the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. Firms can take measures to reduce buyer power, such as implementing a loyalty program. The buyer power is high if the buyer has many alternatives.
Potential factors:
- Buyer concentration to firm concentration ratio
- Degree of dependency upon existing channels of distribution
- Bargaining leverage, particularly in industries with high fixed costs
- Buyer switching costs relative to firm switching costs
- Buyer information availability
- Force down prices
- Availability of existing substitute products
- Buyer price sensitivity
- Differential advantage (uniqueness) of industry products
- RFM (customer value) Analysis
- The total amount of trading
Bargaining power of suppliers
The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm when there are few substitutes. If you are making biscuits and there is only one person who sells flour, you have no alternative but to buy it from them. Suppliers may refuse to work with the firm or charge excessively high prices for unique resources.
Potential factors:- Supplier switching costs relative to firm switching costs
- Degree of differentiation of inputs
- Impact of inputs on cost or differentiation
- Presence of substitute inputs
- Strength of distribution channel
- Supplier concentration to firm concentration ratio
- Employee solidarity (e.g. labor unions)
- Supplier competition: the ability to forward vertically integrate and cut out the buyer.
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