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The significance of Porter’s five forces model

A comprehensive framework to gauge the competition faced by businesses around the world.

porter's five forces

Whether it’s a family-owned start-up or a Fortune 500 company, everyone’s selling something. This could be any number or variety of goods and services. These could range anywhere from consultancies and shampoo companies to food-delivery services and bookstores. 

In a free market, however, there will always exist some sort of competition to every business. The topic of this article, Porter’s Five Forces, lays out a comprehensive framework to unveil the dynamics of a company’s competition. From rivalry among players to the power of suppliers and buyers, and the looming threat of new entrants or substitutes, it’s all here.

In this article, we’re going to explore what the Five Forces are, what they mean, and how they allow you to assess how competitive a business is – not only for your stock market investments, but for your personal ventures too.

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Porter’s Five Forces

Porter’s framework offers a unique lens through which you can understand the competitive dynamics of any industry. It was developed by Harvard Business School professor Michael E. Porter in 1979 and it has since been extensively used to evaluate how various forces in an industry play along with each other. The framework also helps analysts understand the metrics that shape an industry’s attractiveness and profitability. 

In Porter’s model, there are five forces that help shape industry competition. These are:

  • Competitive rivalry
  • The bargaining power of suppliers
  • The bargaining power of customers
  • The threat of new entrants
  • The threat of substitute products or services

Let’s explore these individually:

Competitive rivalry

Rivalry among competitors refers to the intensity of competition within an industry amongst various existing players. High rivalry often leads to price wars, which subsequently leads to reduced profitability for everyone. The ability of a company to undercut another company with the same quality of products is an ever-present risk in this category.

When competition is high, suppliers and buyers seek out better deals with other companies that could offer better deals or lower prices. On the other hand, when competition in a market is low, companies tend to monopolise and charge higher prices from consumers without losing business.

For instance, the smartphone industry showcases fierce competition among companies like Samsung, Apple, and Google, leading to constant innovation, aggressive marketing, and price fluctuations as they fight for market share and customer loyalty.

The bargaining power of suppliers

This refers to the power of suppliers to influence the terms and prices of goods that they supply as input to companies. When other entities have power over the input materials of a company, this poses a risk to their profitability and bottom-line – sometimes even their existence.

For instance, a computer manufacturing company must have strong supplier relationships with manufacturers for components like screens and processors. Without these, computers cannot be made. If suppliers start to leverage prices and quantity during peak manufacturing cycles, every process could start to spiral and the company could find themselves in a lot of trouble.

How much power suppliers have also depends on what the inputs are, how unique these inputs are, and what it would cost the company to switch suppliers. Naturally, the less the number of available suppliers, the more valuable every available supplier is.

The bargaining power of customers

Just like the input, the output or the market of the company is just as important. If customers of a company find suitable alternatives that offer them more competitive prices, companies could lose out on a lot of business and endanger their bottom line. Again, a buyer’s level of power depends on how big the customer market is, how significant each customer is to the company’s overall revenue stream, and what the customer acquisition cost is.

The threat of new entrants

This refers to the potential for newer companies to enter the space in which said company is already operational. New entrants disrupt the existing competitive balance and fight to obtain a piece of the market share either by offering more value, better prices, or better service.

Substitute forces are influenced by barriers to entry, such as high initial investment, economies of scale, and regulatory hurdles. For instance, the airline industry is a very difficult space for new companies to break into since it demands substantial capital for aircraft and infrastructure. However, disruptive technologies can lower these barriers; the rise of ride-sharing services like Uber posed a threat to the traditional taxi industry due to their innovative business models and low entry barriers.

The threat of substitute products or services

Companies also face threats from other entities that could satisfy customer demands in a similar way but with other products and services. This is best explained by the rapid shift from regular television coverage provided by cable TV services to OTT platforms and on-demand content consumption today.

The higher the threat, the more likely customers are to shift from one product to another, causing significant imbalances in market share.

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How are the forces used in strategic management?

Let’s understand this with an example. Let’s say you were to enter the electric vehicle (EV) market with a new company. Here’s how the different forces would guide you towards a business plan:

  • Competitive rivalry – Necessitate a robust marketing plan, tech innovation, and perhaps even collaboration with top competitors.
  • The bargaining power of suppliers – Drive negotiations for the setting up of a reliable supply chain mechanism.
  • The bargaining power of customers – Would drive investment into customer preference research and price sensitivities.
  • The threat of new entrants – Identifying barriers to entry, including extensive R&D, battery tech expertise, and establishment of chagrin infrastructure. This would also facilitate efficient allocation of funds.
  • The threat of substitute products or services – Sustainable differentiation and brand value become important under this category.

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Conclusion

By delving into the interconnectedness between the bargaining power of suppliers and buyers, the threat of new entrants and substitute products, and the intensity of rivalry among existing competitors, Porter’s Five Forces unveils several important insights for both businesses and investors. 

This framework not only assists in uncovering an industry’s current competitive landscape but also aids in formulating strategic decisions to navigate its challenges.

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Devansh Sinhal

I am passionate about stock investing and have a knack for simplifying complex market concepts. Providing readers with valuable insights and empowering them to make informed investment decisions is my jam.

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