Porter’s Five Forces: Analyzing Market Profitability
Porter’s Five Forces Model
Business Background
Objectives:
- Introduce a set of theoretical tools suited for analyzing and interpreting the drivers of the profitability of a specific market.
- Develop a conceptual framework to single out the potential sources of competitive advantage in a specific market.
- Compare different potential strategies for entering a market with respect to the competitive and environmental characteristics of the market.
- Identify the optimal short-run and long-run strategic positioning in the market after entry.
Factors Affecting Profitability
According to the model of Competitive Strategy, any market or industry context can be interpreted along five main dimensions or “forces”:
- It is a highly flexible model.
- Internal rivalry is affected by the other forces.
- Analysts should assess to what extent each force can erode profits.
Internal Rivalry
Within a specific market, rivalry among firms can take the form of:
- Price competition: profits are eroded by contraction in price-cost margins.
- The degree of price competition can be estimated by the firm-level price elasticity of demand.
- Non-price competition: profits are eroded by increases in fixed costs and marginal costs (R&D investments for vertical differentiation of products).
Determinants of Price Competition Strength
- Fixed costs/value added
- Products are considered homogeneous by consumers.
- Brand identity
- Infrequent sale orders.
Market Concentration
- The Herfindahl Index of market concentration.
- Evidence on market share structure and average profits.
- The notion of contestable markets and hit-and-run competition.
Over-Capacity
- Seasonal demand.
Switching Costs
- Technology-related cost (bundling of products)
- Costs related to companies’ practices (banking sector).
Informational Complexity
- Limited observability of prices
- Complex tariff systems.
Multi-Market Contact
- Capability to fix higher prices and avoid harsh price competition.
Exit Barriers
- Presence of non-redeployable assets.
- Long-term contractual relationships.
Entry Barriers
The profitability of a market is positively correlated to the presence and extent of barriers to potential entrants.
- Economies of scale and scope
- Minimum efficient scale
- Access to key production/distribution inputs: skills or technical infrastructure
- Proprietary learning curve: is it possible to close a knowledge gap?
- Network externalities: profits are conditional on reaching a minimum critical mass.
- Standard-setting processes
- Intellectual property rights
- Government policy
- Possibility of retaliations and entry deterrence strategies.
Substitute Products
In order to identify the profitability of a market, it is fundamental to consider the presence of actual and potential substitute products.
Substitute products can refer also to different, apparently unrelated, markets.
Substitute products can emerge as a consequence of technological development.
Examples:
- Telecommunications based on Internet infrastructure.
- Digital technologies replacing previous products.
- (3M Corp. and plastics for healthcare applications).
Buyer Power
The strength of the competitive force related to buyer power is linked to a number of factors:
- Buyer concentration
- Buyer volume
- Switching costs
- Buyer information
- Ability to backward integrate
- Presence of relationship-specific investment
- Supplier concentration
- Substitute suppliers
- Supplier volume
- Product differences
- Brand identity
- Switching costs
- Low buyer information
- Threat of forward integration.
What is relevant is the nature of the relationships with the supplier, not the “importance” of the input supplied (See the case of Jet fuel).