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Subject 1. The five competitive forces

The article, The Five Competitive Forces That Shape Strategy, is written by renowned Harvard business expert, Professor Michael E. Porter. A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter identifies five forces that dictate the rules of competition in each industry. These forces determine industry profitability because they influence the prices, costs and required investment of firms in an industry.

Threat of Entry

How easy or difficult is it for new entrants to start competing?

It is not only incumbent rivals that pose a threat to firms in an industry; the possibility that new firms may enter the industry also affects competition. In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry.

Barriers to entry are more than the normal equilibrium adjustments that markets typically make. For example, when industry profits increase, we would expect additional firms to enter the market to take advantage of the high profit levels, over time driving down profits for all firms in the industry. When profits decrease, we would expect some firms to exit the market thus restoring a market equilibrium. Falling prices, or the expectation that future prices will fall, deters rivals from entering a market. Firms also may be reluctant to enter markets that are extremely uncertain, especially if entering involves expensive start-up costs. These are normal accommodations to market conditions. But if firms individually (collective action would be illegal collusion) keep prices artificially low as a strategy to prevent potential entrants from entering the market, such entry-deterring pricing establishes a barrier.

Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive advantage.

Threat of new entrants depends on:

  • Economies of scale (both supply-side and demand-side ones).
  • Customer switching costs.
  • Capital/investment requirements.
  • Incumbency advantages independent of size. These include access to technology and raw materials, favorable geographic locations, brand loyalty, etc.
  • Access to industry distribution channels.
  • Government regulations. Can new entrants get subsidies?
  • The likelihood of retaliation from existing industry players.

The Power of Suppliers

How strong is the position of sellers? Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry's profits. In some cases, monopolist supplier can dictate its terms to entire industries. This force determines the cost of raw materials and other inputs.

The bargaining power of suppliers depends on:

  • concentration of suppliers. Are there many buyers and few dominant suppliers?
  • Is the industry a key customer group to the suppliers?
  • Switching costs. Is it easy for suppliers to find new customers?
  • Branding. Is the brand of the supplier strong?
  • Suppliers threaten to integrate forward into the industry (e.g., brand manufacturers threatening to set up their own retail outlets).

The Power of Buyers

How strong is the position of buyers? Can they work together in ordering large volumes? This force influences the prices that firms can charge. It can also influence cost and investment as powerful buyers demand costly service.

This competitive force depends on many factors:

  • Concentration of buyers. Similarly, in the market where a number of companies are selling to a few customers (concentration of buyers), profits of suppliers will be quite low, holding all else constant.
  • Differentiation. Are products standardized?
  • Switching costs. Is it easy for buyers to switch their supplier?
  • Profitability of buyers. Are buyers forced to be tough?
  • Threat of backward and forward integration into the industry.

The Threat of Substitutes

This force also influences the prices that firms can charge. It depends on:

  • Quality. Is a substitute better?
  • The relative price and performance of substitutes
  • Switching costs: Is it easy to change to another product?
  • Buyers' willingness to substitute between the products that satisfy similar needs.

Rivalry among Existing Competitors

Does a strong competition between the existing players exist? Is one player very dominant or are all equal in strength and size? This force is located at the center of the diagram below. The intensity of rivalry depends on:

  • The structure of competition. Rivalry will be more intense if there are lots of small or equally sized competitors; rivalry will be less if an industry has a clear market leader.
  • The structure of industry costs. Industries with high fixed costs encourage competitors to manufacture at full capacity by cutting prices if needed.
  • Degree of product differentiation. Industries where products are commodities (e.g., steel, coal) typically have greater rivalry.
  • Switching costs. Rivalry is reduced when buyers have high switching costs.
  • Strategic objectives. If competitors pursue aggressive growth strategies, rivalry will be more intense. If competitors are merely "milking" profits in a mature industry, the degree of rivalry is typically low.
  • Exit barriers. When barriers to leaving an industry are high, competitors tend to exhibit greater rivalry.

The collective strength of these five forces determines the ability of firms in an industry to earn, on average, rates of return on investment in excess of the cost of capital. Note that:

  • Each industry is unique and has its own unique structure. In any particular industry, not all of the five forces will be equally important and the particular structural factors that are important will differ. A company manager must analyze industry structure, determine the most relevant forces that drive competition within the industry, and develop appropriate strategy that would result in stronger competitive advantage for the company.

  • Industry structure is relatively stable, but the strength of each force can change as industry structure changes over time. It can also be influenced by competitive strategies that firms choose to pursue. Consequently, firms should consider long-term results of their competitive strategies, including the potential retaliation response of their competitors.

Practice Question 1

Which of the following are competitive forces of an industry according to Porter?

I. Bargaining power of suppliers.
II. Bargaining power of buyers.
III. Bargaining power of management and employees such as unions.
IV. Bargaining power of competitors.

Correct Answer: I and II

Practice Question 2

Determinants of entry barriers include:

I. Economies of scale.
II. Switching costs.
III. Brand identity.
IV. Capital requirements.
V. Diversity of competitors.
VI. Buyer volume.

Correct Answer: I, II, III and IV

Proprietary product differences, access to distribution, absolute cost advantages, government policy and expected retaliation are also determinants of entry barriers.

Practice Question 3

Examples of powerful suppliers include:

I. Baxter International, manufacturer of hospital supplies, acquired American Hospital Supply, a distributor.
II. Microsoft's relationship with PC manufacturers.
III. Grocery store brand label products.
IV. Garment industry relationship to major department stores.

Correct Answer: I and II

I. Credible forward integration threat by suppliers.
II. Significant cost to switch suppliers.
III. Purchase commodity products (weak supplier).
IV. Concentrated purchasers (weak supplier).

Practice Question 4

Which of the following is not a determinant of rivalry within an industry?

I. Industry growth.
II. Concentration and balance.
III. Diversity of competitors.
IV. Ability to backward integrate.
V. Ability to forward integrate.

Correct Answer: IV and V

Determinants include Industry growth, concentration and balance, diversity of competitors, intermittent overcapacity, product differences, brand identity, switching costs, exit barriers, etc.

Practice Question 5

Which of the following is not a determinant of supplier power?

A. Presence of substitute inputs.
B. Supplier concentration.
C. Capital requirements.

Correct Answer: C

Determinants of supplier power include differentiation of inputs, switching costs of suppliers, presence of substitute inputs, supplier concentration, importance of volume to supplier, cost relative to total purchases in the industry, impact of inputs on cost or differentiation, and threat of forward integration relative to threat of backward integration by firms in the industry.

Practice Question 6

Examples of weak buyers include:

I. The U.S. Dept. of Defense (DOD) purchases from defense contractors.
II. Movie-producing companies have integrated forward to acquire theaters.
III. Large auto manufacturers' purchases of tires.
IV. Most consumer products.

Correct Answer: II and IV

I. Buyers are concentrated - there are a few buyers with significant market share.
II. Producers threaten forward integration - producer can take over own distribution/retailing.
III. Buyers possess a credible backward integration threat - can threaten to buy producing firm or rival.
IV. Buyers are fragmented (many, different) - no buyer has any particular influence on product or price.

Practice Question 7

Determinants of buyer power include:

I. buyer concentration vs. firm concentration.
II. buyer volume.
III. buyer switching costs relative to firm switching costs.
IV. Ability to backward integrate.
V. Product differences.
VI. Brand identity.

Correct Answer: All of them

Additional determinants include: price/total purchases, impact on quality/performance, buyer profits, decision maker's incentives, substitute products, etc.

Practice Question 8

Which of the following statements is (are) true with respect to how the bargaining power of buyers shape the competitiveness within an industry?

I. If the cost of the industry product to the buyer is relatively small compared to the buyer's total expenditures, then the buyer is deemed to have more bargaining power.
II. If switching among the various products proves to be costly for a buyer, than the industry would be more competitive.
III. Buyers that have the ability to integrate backwards, will have a greater degree of bargaining power.
IV. Competition within an industry becomes lower it the customer base is more profitable.

Correct Answer: I, III and IV

II is incorrect because if switching among the various products proves to be costly for a buyer, then the industry would be less competitive as most firms will realize that buyers will not easily be lured away from their current suppliers.

IV is true because if the customer base if profitable, they will be inclined to bargain, and hence competition among firms id less likely to escalate.

Practice Question 9

Which of the following is not a determinant of substitutes?

A. Relative price and performance of substitutes.
B. Switching costs.
C. Brand identity.
D. Buyer propensity to substitute.

Correct Answer: C

Practice Question 10

Which of the following characteristics increase rivalry among existing competitors?

I. A large number of firms.
II. Fast market growth.
III. Low levels of product differentiation.
IV. High exit barriers.

Correct Answer: I, III and IV

I. This is because more firms must compete for the same customers and resources.
II. Slow market growth causes firms to fight for market share. In a growing market, firms are able to improve revenues simply because of the expanding market.
III. Brand identification, on the other hand, tends to constrain rivalry.
IV. This places a high cost on abandoning the product. The firm must compete.

Practice Question 11

Brand identity can have an impact on the following competitive forces:

I. Buyer power.
II. New entrants.
III. Rivalry within the industry.
IV. Substitutes.

A. I, II and III
B. I, II, III and IV
C. II, III and IV

Correct Answer: A

According to Porter, brand identity is a determinant of buyer power, new entrants and rivalry within the industry.

Practice Question 12

Product differences can have an impact on the following competitive forces:

I. Buyer power.
II. New entrants.
III. Rivalry within the industry.
IV. Substitutes.

A. I, II and III
B. I, II, III and IV
C. I and III

Correct Answer: C

According to Porter, product differences is a determinant of buyer power and rivalry within the industry.

Practice Question 13

Which of the following statements is (are) true with respect to how barriers to entry shape the competitiveness within an industry?

I. Costly exit barriers have just as much impact on industry competitiveness as do costly entry barriers.
II. Economies of scale would only be regarded as an obstacle for manufacturing industries, not service industries.
III. The lower the switching costs among products, the easier it will be for new competitors to enter the industry.
IV. Since governments in general aim to promote competition, government policies may be viewed as lowering the barriers to entry into an industry.

A. I and III
B. III and IV
C. I and II

Correct Answer: A

II is incorrect because economies of scale would be regarded as an obstacle for entry in both manufacturing and service industries.

III While it is true that governments prefer to promote competition, their policies more often than not act to increase the barriers to entry into an industry. For instance, patent protections and license eligibility are just some of the ways that governments directly impose barrier to entry.

Practice Question 14

Which of the following statements is (are) true with respect to how rivalry between existing competitors shape the competitiveness within an industry?

I. Industries characterized with smaller firms but more of them, will be less competitive than industries whereby there are clear leaders.
II. Industries exhibiting a higher growth rate will involve more rivalry among its number firms than an industry with a slower growth rate.
III. Industries characterized with a heavier variable cost structure will see a greater degree of rivalry amongst its members.
IV. The more diverse the strategies employed by the various firms within the industry, the greater the potential will be for rivalry amongst them.

A. II and III
B. I, III and IV
C. IV only

Correct Answer: C

I is incorrect because industries characterized with smaller firms but more of them, will be far more competitive than industries whereby there are clear leaders. In the latter case, there would be more order among the fewer number of firms.

II is incorrect because industries exhibiting a higher growth rate will mean that there is more business to go around for its members; thus it will involve less rivalry. On the other hand, rivalry for any remaining business will increase if an industry is exhibiting a slower growth.

III is incorrect because its industries characterized with a heavier fixed cost structure that find themselves with higher break-even points, and thus, there will be a greater degree of rivalry amongst its members.

Practice Question 15

Which of the following statements is (are) true with respect to how the bargaining power of suppliers shape the competitiveness within an industry?

I. Supplier groups that are generally comprised of many firms, will impose a greater bargaining power.
II. If there are heavy costs involved in switching from one supplier to another, then the bargaining power of suppliers will be greater.
III. Frequent shortages of suppliers' product would imply that suppliers have a weaker bargaining position.
IV. The less importance that the suppliers place on the firms of a particular industry, the more bargaining power they will exercise.

A. I, II, and IV
B. II and IV
C. II and III

Correct Answer: B

I is incorrect because supplier groups that are generally comprised of many firms, will impose a weaker bargaining power.

III is incorrect because frequent shortages of suppliers' product would imply that demand for that product exceeds its supply, thus giving the suppliers a greater bargaining position.

Practice Question 16

Examples of weak suppliers include:

I. Drug industry's relationship to hospitals.
II. Boycott of grocery stores selling non-union picked grapes.
III. Tire industry relationship to automobile manufacturers.
IV. Travel agents' relationship to airlines.

A. I and II
B. III and IV
C. I, III and IV

Correct Answer: B

Both I and II are examples of powerful suppliers.

I. Suppliers concentrated.
II. Customers Powerful.
III. Many competitive suppliers - product is standardized.
IV. Customers Weak.

Practice Question 17

Examples of strong buyers include:

A. Walmart and Sears' large retail market provides power over appliance manufacturers.
B. IBM's 360 system strategy in the 1960's.
C. Intel's relationship with PC manufacturers.

Correct Answer: A

A. Buyers purchase a significant proportion of output - distribution of purchases or if the product is standardized.
B. Significant buyer switching costs - products not standardized and buyer cannot easily switch to another product.
C. Producers supply critical portions of buyers' input - distribution of purchases.

Practice Question 18

Low buyer switching costs:
I. increases rivalry among existing competitors.
II. is an indication that the buyers are powerful.
III. indicates that the suppliers are weak.

A. I, II and III
B. I and II
C. I only

Correct Answer: B

This has nothing to do with the power of suppliers.

Practice Question 19

Which one of the following is not one of Porter's three generic strategies for firms?

A. Cost leadership
B. Focus
C. Customer service

Correct Answer: C

The third generic strategy is Differentiation.

Study notes from a previous year's CFA exam:

a. distinguish among the five competitive forces and explain how they drive industry profitability in the medium and long run;