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Porters Five Forces (1) Five Forces Analysis framework, designed by Michael Porter, is now being widely used, when it comes to defining commercial entities competitiveness rate. According to Michael Porter, the competitive rivalry within the industry corresponds to the dynamics between customers and suppliers bargaining power. It is also being affected by the threat of new entrants and by the threat of substitute products. The reason why Porters framework has been steadily gaining popularity as the tool of economic analysis is that it is comparatively easy to understand and that it exploits the qualitative principle, within a context of research. In his article The Five Competitive Forces That Shape Strategy, Porter suggests that it is crucial for managers to understand the strategic positioning of a particular industry, in order to be able to define the full scope of economic factors that will affect companys overall commercial efficiency: The job of the strategist is to understand and cope with competition. Often, however, managers define competition too narrowly, as if it occurred only among todays direct competitors.
Yet competition for profits goes beyond established industry rivals to include four other competitive forces as well: customers, suppliers, potential entrants, and substitute products (Porter, 2008). In other words, author implies that managers need to have a strategic vision of a market, where their company intends to operate. At the same time, Five Forces Analysis is being often criticized for being too general in its essence, which makes it rather a consultative then a practical tool of economic management. In this paper, we will analyze all five Porters forces in details and will point out at frameworks conceptual inconsistencies. (2) In his book Competitive Strategy, Michael Porter suggests that five forces, which define the intensity of competition in every particular industry, often derive out of each other; therefore, managers need to think of Five Forces Analysis in terms of an integral theory: Even a company with a very strong market position in an industry where potential entrants are no threat will earn low returns if it faces a superior, low-cost substitute. Even with no substitutes and blocked entry, intense rivalry among existing competitors will limit potential returns (Porter, p. 35, 2004). Thus, the application of Porters analysis cannot yield any practical results, without managers being able to adopt a complex approach to utilization of this analysis.
However, in order for them to apply Five Forces Analysis in most effective manner, they need to understand the conceptual essence of frameworks components. Supplier Power Porter refers to Supplier Power as potential capability of suppliers to increase prices. If prices for raw materials continue to rise, it will eventually undermine the rate of companys commercial profitability, as margin between initial investments and the received profit is going to be minimized or even eliminated altogether. Therefore, before entering the market, companys managers need to conduct an extensive research on various factors that affect supplier power. Stanley Slater and Eric Olson, in their article A Fresh Look at Industry and Market Analysis, provide us with the insight on what corresponds to suppliers ability to drive up prices: The forces that lead to more supplier power are the same as those that lead to more customer power.
Suppliers have the greatest bargaining power when they are large, few in number, and can sell easily to alternate customers. Traditionally, supplier power has been seen as greater when the product provided represents a low percentage of the buyer's total costs (Slater, Olson, 2002). The situation on todays market of oil illustrates suppliers power the best. There are only few countries in the world with substantial oil resources and, as practice shows, they are capable of manipulating oil prices in the way they see fit, without consumers being able to do anything about it. Therefore, entering the market, associated with suppliers high power, represent a great challenge for commercial operators. Buyer Power Buyer Power can be best described as the mechanism of customers influence on a producing industry.
When there are many suppliers in a particular market, it often leads to creation of so-called monopoly a condition when buyer sets the price. This means that company will have to be ready to adjust the line of its products and services on continuous basis, in order to meet customers expectations, because only this will guarantee that this particular company will remain competitive in the long run. The existence of monopoly can easily be confirmed with so-called secondary indications, which point out to strong buyer power. The system of discounts and bonuses that companies offer to loyal customers serves as one of such indications. For example, there is a fierce competition on Americas market of air transportation, with UPS, FedEx, DHL and USPS offering virtually the same line of services. The fact that that mentioned companies are actually a large transnational corporations does not eliminate the challenge of dealing with factor of strong buyer power, on their part.
This is the reason why prices for air transportation services in U. S. , stayed within the same range over the course of many years. In fact, strong buyer power in this market resulted in mentioned companies to continuously strive to offer customers competitive prices. We can also name factors that weaken buyer power: the process of manufacturers integration, buyers fragmentation that is, their inability to recognize common existential interests, customers dependency on standardized products, which makes it more difficult for them to choose in favor of buying similar products from competing manufacturer. Competitive Rivalry Competitive rivalry is probably the most important element of Five Forces Framework, because companys chances to succeed commercially directly correspond to the numbers of its rivals, in particular sector of the market. Economists operate with the concept of industry concentration, when it comes to utilization of this part of Porters method.
Concentration Ratio (CR) indicates the percentage of market share held by the four largest firms. If this ratio is high, it means that that the industry, in analyzed segment of the market, can be referred to as concentrated. In its turn, this implies that the analyzed segment of the market is a subject of low competition between manufactures and providers of services, simply because in this case, the economic dynamics on the market are being controlled by semi-monopolist companies. We can say that high CR usually corresponds to a few large companies holding at least 80 % of the market. The low CR usually indicates the fact that the analyzed segment of the market can be defined by many rivalries, which entitles the process of competition with objective properties. At the same time, the high CR does not necessarily imply the fact that potential competitors will have a hard time, while trying to establish themselves on the market.
Alternatively, low CR does not always mean that competitive chances in particular segment of the market, on the part of companies that have similar economic potential, would be equalized. As Chris Mallon in his article: Porter's Five Forces Analysis points out: Rivals are competitors within an industry. Rivalry in the industry can be weak, with few competitors that dont compete very aggressively. Or it can be intense, with many competitors fighting in a cut-throat environment (Mallon, 2007). A large number of competing companies increases the factor of rivalry and vice versa. At the same time, the rivalry itself cannot be simply defined by the sheer number of competitors, which strive to satisfy the demands of the same market.
There many other factors that need to be taken into consideration, within a context of analyzing Porters third force: the pace of market growth, high or low fixed costs, high or low switching costs, the measure of rivals diversity, and industry shakeout (the process of too many competitors entering the same market). Threat of Substitution The Threat of Substitution is also a very important element of Porters framework, as it defines the chances of specific lines of products or services being substituted with identical or similar ones, on the part of competing rivalry. It is needless to say that if that happens, the company that faces such threat, might become a bankrupt. The Threat of Substitution gains increasingly bigger significance in era of Globalization, with close to 70 % of all industrial products being made in China.
The abundance of cheep labor in South-East Asia prompts more and more Western companies to move their production lines to this area. In its turn, this gives a powerful boost to local industry, resulting in situation when American retail companies, such as Wal-Mart, export close to 90 % of all retailed goods directly from China. One of the shortcomings of Five Forces theory is that it does not view the Threat of Substitution from global perspective. Moreover, it considers such threat as being purely economic, in its essence, whereas in fact, the Threat of Substitution is now better discussed in terms of geopolitics. The Threat of Substitution usually affects market with the mean of price competition: price-sensitive buyers, low manufacturing specialization, and the wide range of the market these factors set preconditions for the Threat of Substitution to begin affecting an industry. We can say that such threat is now being felt by companies in the field of electronic manufacturing the most.
At the same time, markets where peoples willingness to pay for perceived value does not play an important role, remain largely unaffected by such threat. Threat of New Entry This threat is last on Porters list of forces that affect companys competitive edge. In theory, there should not be any barriers for the commercial entity to enter the market it chooses. For example, when the profits of companies that operate in particular market increase, it automatically results in more companies willing to enter such market.
By doing it, they restore market equilibrium. However, in reality, the situation appears to be slightly different. Firms that had established themselves on the market over the long period of time, create an artificial barriers, which meant to prevent new competitors from endangering their business interests. Entry-deterring pricing is the most common method of dealing with the threat of new entrants.
For example, the reason why FedEx can afford charging only $ 20 for sending a medium size parcel to another part of the country is that it possesses the fleet of close to 100 cargo jet planes, which cost from 40 to 100 million each. Thus, only a corporation with annual turnover of hundreds of millions of dollars might be eligible to enter the market of air cargo transportation in America. Government also strives to prevent new entrants into well-established markets by requiring new companies to comply with its rules and regulations. Nevertheless, as practice shows, many companies were still able to get through the cracks into new markets.
What made their task easier was the existence of common technology, the weak factor of franchising, within an industry, and the access to distribution channels, on their part. For example, it only took 17 years for Korean company Daewoo to fully integrate into worlds car manufacturing industry, despite the fact that it originally specialized in production of microwaves. Pitfalls of Five Forces Analysis Even for the individual not overburdened with intelligence, the conceptual fallacies of Five Forces Analysis appear as being self-evident: 1) Porters framework is static in its essence, which is why it does not recognize the possibility of newly emerged factors to begin affecting companies competitiveness. It views industry's dynamics as being externally determined, which is not always the case. 2) While often dealing with purely quantitative data, Five Forces Analysis utilizes a qualitative approach. The article Industry Analysis in Practice, which is available on the web site of Harvard Business Review, suggests: The point of industry analysis is not to declare the industry attractive or unattractive but to understand the underpinnings of competition and the root causes of profitability. As much as possible, analysts should look at industry structure quantitatively, rather than be satisfied with lists of qualitative factors (Harvard Business Review, 2008).
In other words, Porters framework lacks that empirical objectiveness, as scientific method, which is why it rarely provides managers with understanding of full spectrum of competitive factors that affect a particular industry. 3) Porter emphasizes that it is the competitive environment that defines the very essence of companies functioning. Thus, he came to conclusion that companys organizational strategy must reflect the demands of the market, as its foremost priority. However, there are many examples of companies being able to actually form such demands with the mean of application of innovative business approaches and with masterfully designed advertisement campaigns. This simply does not quite fit into Five Forces Analysis, as credible scientific method. 4) Porter failed to understand that the overall profitability, associated with a particular industry, does not necessarily correspond to the profitability of every individual organization, within industry.
For example, the steel industry in U. S. has been steadily declining since fifties. However, this did not prevent governments subsidized steel manufactures in America from coming up with steady profits, up until now. 5) Competition is not only the factor that defines the objective realities, within a mainframe of post-industrial economics.
For example, there are numerous examples of companies business strategy being affected by environmental considerations. Apparently, Porter does not understand that in post-industrial world, the utilization of economic terminology does not always come in handy, within a context of discussing the very nature of modern economics. 6) Porter does not operate with such category as quality of strategic thinking, as if managers foremost task was to simply observe markets dynamics, as something that would alone allow them to choose in favour of proper organizational strategy. He absolutely denies any validity so such important thing, within a context of decision making, as intuition. Thus, even though Five Forces Analysis operates with scientific terminology, it does it for the sake of increasing its academic appeal. For example, we can discuss the threat of substitution for eternity, without our discussion bringing any practical results, simply because Five Forces Analysis is based on the principle of inductive inquiry. This means that, even though the application of this method might be appropriate when global economic issues are concerned, we cannot seriously be expecting the application of Porters framework to bring any practical dividends, within a context of managers designing organizational strategy.
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Free Press, New York. Mallon, C. Porter's Five Forces Analysis. Street Directory.
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Milford, CT, USA: Kogan Page Limited. Abstract: This paper discusses how Porters Five Forces determine the attractiveness of an industry and points out at frameworks pitfalls. Outline: Introduction Five forces Criticism
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Research essay sample on Porters Five Forces Porter Five Forces
