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Jorge Luis Ramírez García GCAB-02

THE FIVE COMPETITIVE FORCES THAT


SHAPE STRATEGY
by Michael E. Porter

In order to survive, companies have to understand and respond to competition. So


it is natural to look at immediate competitors and established rivals to develop a strategy. However,
this can restrict thinking, define competition too superficially, and ignore other strategic forces.

In 1979, economist and strategist Michael Porter changed people’s thinking on strategy.
Porter’s 1979 article “How Competitive Forces Shape Strategy” show that awareness of wider
competitive forces beyond the obvious competing companies can help an organization understand
the structure of its industry and develop a position that is more profitable and less vulnerable to
attack. According to Porter, there are five competitive forces that collectively define an industry’s
structure, shape the nature of competitive interaction within an industry, and ultimately determine
profitability. This model places existing competitors at the center, surrounded by four other forces:
customers, suppliers, potential entrants, and substitute products.

New entrants
If an industry is profitable and there are few barriers to entry, Porter says that competition will
increase, and profits will fall. Typically, existing organizations try to create ways to stop new
entrants. The threat of new entrants is high when the cost of entering the market is low, there is
little government regulation, customer loyalty is low, existing businesses can do little to retaliate
and economies of scale can be easily achieved. Risk is increased if existing companies have not
established brand reputation and do not possess patents, and when products are nearly identical.

Supplier power
When the bargaining power of suppliers is strong, it allows them to sell higher priced or lower quality
raw materials. This directly affects the profits of the company that is buying, because it has to pay
more for its raw materials. Suppliers have strong bargaining power when there are few of them but
many buyers, they hold scarce resources, the cost of switching raw materials is high, and when there
are few substitute raw materials or suppliers. Their power is increased if they are large and can
threaten to step in and produce themselves.

Buyer power
Buyers can demand lower prices or higher product quality from producers when their bargaining
power is strong. Both scenarios result in lower profits for producers, because lower prices mean
lower revenues, and higher-quality products usually incur higher production costs. Buyers exert
strong bargaining power when there are few of them, they buy in large quantities, they are price
sensitive, they control distribution to the final customer, there are many substitutes and switching
to another supplier can be done at low cost. Buyers may also be able to produce the product
themselves and so may use this as a threat.

Substitutes
The “threat of substitutes” force is very important because buyers in these markets can easily find
substitute raw materials or products that have attractive prices or are higher quality. What’s more,
buyers can switch from one product or service to another with little cost. For example, it costs
relatively little for a consumer to switch from tea to coffee, unlike switching from traveling by bicycle
to car. In some industries, companies try to limit the threat of potential substitutes by ensuring
wider product accessibility.

The force of “rivalry”


Rivalry among existing competitors is the major determinant of competitiveness and profitability
within an industry. In a very competitive industry, market share is tough to win and so profits are
harder to make. Intense competitor rivalry occurs when there are many competitors, growth in the
industry is slow, products are not differentiated and can be easily substituted, competitors are of
equal size, customer loyalty is low, and it is difficult and costly to exit the industry.

No matter how different industries appear on the surface, Porter’s model offers any company a way
of assessing profitability through analyzing five easily calculated, competitive forces. In revealing an
industry’s underlying structure, Porter’s model simplifies a mass of information, providing managers
with a clear process for making sense of industry data and using it to form effective strategy.