See assignment 4 for instructions.Awareness of the five forces can help a company understand the structure of its
industry and stake out a position that is more profitable and less vulnerable to attack.
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THE FIVE
COMPETITIVE
FORCES THAT
SHAPE
STRATEGY
STRATEGY
Peter Crowther
by Michael E. Porter
Editor’s Note: In 1979, Harvard Business Review
published “How Competitive Forces Shape Strategy” by a young economist and associate professor,
Michael E. Porter. It was his first HBR article, and it
started a revolution in the strategy field. In subsequent
decades, Porter has brought his signature economic
rigor to the study of competitive strategy for corporations, regions, nations, and, more recently, health care
and philanthropy. “Porter’s five forces” have shaped a
generation of academic research and business practice.
With prodding and assistance from Harvard Business
School Professor Jan Rivkin and longtime colleague
Joan Magretta, Porter here reaffirms, updates, and
extends the classic work. He also addresses common
misunderstandings, provides practical guidance for
users of the framework, and offers a deeper view of
its implications for strategy today.
IN ESSENCE, 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 today’s 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. The
extended rivalry that results from all five forces
defines an industry’s structure and shapes the
nature of competitive interaction within an
industry.
As different from one another as industries
might appear on the surface, the underlying drivers of profitability are the same. The global auto
industry, for instance, appears to have nothing
in common with the worldwide market for art
masterpieces or the heavily regulated health-care
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LEADERSHIP AND STRATEGY
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The Five Competitive Forces That Shape Strategy
delivery industry in Europe. But to understand industry competition and profitabilThe Five Forces That Shape Industry Competition
ity in each of those three cases, one must
analyze the industry’s underlying structure in terms of the five forces. (See the exThreat
hibit “The Five Forces That Shape Industry
of New
Competition.”)
Entrants
If the forces are intense, as they are in
such industries as airlines, textiles, and hotels, almost no company earns attractive returns on investment. If the forces are benign,
Rivalry
as they are in industries such as software,
Among
Bargaining
Bargaining
soft drinks, and toiletries, many companies
Power of
Power of
Existing
Suppliers
are profitable. Industry structure drives
Buyers
Competitors
competition and profitability, not whether
an industry produces a product or service, is
emerging or mature, high tech or low tech,
regulated or unregulated. While a myriad
of factors can affect industry profitability
Threat of
in the short run – including the weather
Substitute
Products or
and the business cycle – industry structure,
Services
manifested in the competitive forces, sets
industry profitability in the medium and
long run. (See the exhibit “Differences in
Industry Profitability.”)
Understanding the competitive forces, and their underThe strongest competitive force or forces determine the
lying causes, reveals the roots of an industry’s current profitprofitability of an industry and become the most important
ability while providing a framework for anticipating and
to strategy formulation. The most salient force, however, is
influencing competition (and profitability) over time. A
not always obvious.
healthy industry structure should be as much a competitive
For example, even though rivalry is often fierce in comconcern to strategists as their company’s own position. Unmodity industries, it may not be the factor limiting profitderstanding industry structure is also essential to effective
ability. Low returns in the photographic film industry, for
strategic positioning. As we will see, defending against the
instance, are the result of a superior substitute product – as
competitive forces and shaping them in a company’s favor
Kodak and Fuji, the world’s leading producers of photoare crucial to strategy.
graphic film, learned with the advent of digital photography.
In such a situation, coping with the substitute product becomes the number one strategic priority.
Forces That Shape Competition
Industry structure grows out of a set of economic and
The configuration of the five forces differs by industry. In
technical characteristics that determine the strength of
the market for commercial aircraft, fierce rivalry between
each competitive force. We will examine these drivers in the
dominant producers Airbus and Boeing and the bargainpages that follow, taking the perspective of an incumbent,
ing power of the airlines that place huge orders for aircraft
or a company already present in the industry. The analysis
are strong, while the threat of entry, the threat of substican be readily extended to understand the challenges facing
tutes, and the power of suppliers are more benign. In the
a potential entrant.
movie theater industry, the proliferation of substitute forms
of entertainment and the power of the movie producers
THREAT OF ENTRY. New entrants to an industry bring
and distributors who supply movies, the critical input, are
new capacity and a desire to gain market share that puts
important.
pressure on prices, costs, and the rate of investment necessary to compete. Particularly when new entrants are
diversifying from other markets, they can leverage existMichael E. Porter is the Bishop William Lawrence University Proing
capabilities and cash flows to shake up competition, as
fessor at Harvard University, based at Harvard Business School in
Pepsi
did when it entered the bottled water industry, MicroBoston. He is a six-time McKinsey Award winner, including for his
soft
did
when it began to offer internet browsers, and Apple
most recent HBR article, “Strategy and Society,” coauthored with
did
when
it entered the music distribution business.
Mark R. Kramer (December 2006).
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The threat of entry, therefore, puts a cap on the profit potential of an industry. When the threat is high, incumbents
must hold down their prices or boost investment to deter
new competitors. In specialty coffee retailing, for example,
relatively low entry barriers mean that Starbucks must invest aggressively in modernizing stores and menus.
The threat of entry in an industry depends on the height
of entry barriers that are present and on the reaction entrants can expect from incumbents. If entry barriers are low
and newcomers expect little retaliation from the entrenched
competitors, the threat of entry is high and industry profitability is moderated. It is the threat of entry, not whether
entry actually occurs, that holds down profitability.
entry by limiting the willingness of customers to buy from a
newcomer and by reducing the price the newcomer can command until it builds up a large base of customers.
3. Customer switching costs. Switching costs are fixed costs
that buyers face when they change suppliers. Such costs may
arise because a buyer who switches vendors must, for example, alter product specifications, retrain employees to use
a new product, or modify processes or information systems.
The larger the switching costs, the harder it will be for an entrant to gain customers. Enterprise resource planning (ERP)
software is an example of a product with very high switching
costs. Once a company has installed SAP’s ERP system, for example, the costs of moving to a new vendor are astronomical
Industry structure drives competition and profitability,
not whether an industry is emerging or mature, high tech or
low tech, regulated or unregulated.
Barriers to entry. Entry barriers are advantages that incumbents have relative to new entrants. There are seven major
sources:
1. Supply-side economies of scale. These economies arise
when firms that produce at larger volumes enjoy lower costs
per unit because they can spread fixed costs over more units,
employ more efficient technology, or command better terms
from suppliers. Supply-side scale economies deter entry by
forcing the aspiring entrant either to come into the industry
on a large scale, which requires dislodging entrenched competitors, or to accept a cost disadvantage.
Scale economies can be found in virtually every activity
in the value chain; which ones are most important varies
by industry.1 In microprocessors, incumbents such as Intel
are protected by scale economies in research, chip fabrication, and consumer marketing. For lawn care companies like
Scotts Miracle-Gro, the most important scale economies are
found in the supply chain and media advertising. In smallpackage delivery, economies of scale arise in national logistical systems and information technology.
2. Demand-side benefits of scale. These benefits, also known
as network effects, arise in industries where a buyer’s willingness to pay for a company’s product increases with the number of other buyers who also patronize the company. Buyers
may trust larger companies more for a crucial product: Recall the old adage that no one ever got fired for buying from
IBM (when it was the dominant computer maker). Buyers
may also value being in a “network” with a larger number of
fellow customers. For instance, online auction participants
are attracted to eBay because it offers the most potential
trading partners. Demand-side benefits of scale discourage
because of embedded data, the fact that internal processes
have been adapted to SAP, major retraining needs, and the
mission-critical nature of the applications.
4. Capital requirements. The need to invest large financial resources in order to compete can deter new entrants.
Capital may be necessary not only for fixed facilities but also
to extend customer credit, build inventories, and fund startup losses. The barrier is particularly great if the capital is
required for unrecoverable and therefore harder-to-finance
expenditures, such as up-front advertising or research and
development. While major corporations have the financial
resources to invade almost any industry, the huge capital
requirements in certain fields limit the pool of likely entrants. Conversely, in such fields as tax preparation services
or short-haul trucking, capital requirements are minimal
and potential entrants plentiful.
It is important not to overstate the degree to which capital
requirements alone deter entry. If industry returns are attractive and are expected to remain so, and if capital markets
are efficient, investors will provide entrants with the funds
they need. For aspiring air carriers, for instance, financing
is available to purchase expensive aircraft because of their
high resale value, one reason why there have been numerous new airlines in almost every region.
5. Incumbency advantages independent of size. No matter
what their size, incumbents may have cost or quality advantages not available to potential rivals. These advantages can
stem from such sources as proprietary technology, preferential access to the best raw material sources, preemption of
the most favorable geographic locations, established brand
identities, or cumulative experience that has allowed incum-
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The Five Competitive Forces That Shape Strategy
bents to learn how to produce more efficiently. Entrants try
to bypass such advantages. Upstart discounters such as Target and Wal-Mart, for example, have located stores in freestanding sites rather than regional shopping centers where
established department stores were well entrenched.
6. Unequal access to distribution channels. The new entrant must, of course, secure distribution of its product or
service. A new food item, for example, must displace others
from the supermarket shelf via price breaks, promotions,
intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that
existing competitors have tied them up, the tougher entry
into an industry will be. Sometimes access to distribution
is so high a barrier that new entrants must bypass distribution channels altogether or create their own. Thus, upstart
low-cost airlines have avoided distribution through travel
agents (who tend to favor established higher-fare carriers)
and have encouraged passengers to book their own flights
on the internet.
7. Restrictive government policy. Government policy can
hinder or aid new entry directly, as well as amplify (or nullify) the other entry barriers. Government directly limits or
even forecloses entry into industries through, for instance,
licensing requirements and restrictions on foreign investment. Regulated industries like liquor retailing, taxi services,
and airlines are visible examples. Government policy can
heighten other entry barriers through such means as expansive patenting rules that protect proprietary technology from imitation or environmental or safety regulations
that raise scale economies facing newcomers. Of course,
government policies may also make entry easier – directly
through subsidies, for instance, or indirectly by funding basic research and making it available to all firms, new and old,
reducing scale economies.
Entry barriers should be assessed relative to the capabilities of potential entrants, which may be start-ups, foreign
firms, or companies in related industries. And, as some of
our examples illustrate, the strategist must be mindful of the
creative ways newcomers might find to circumvent apparent barriers.
Expected retaliation. How potential entrants believe incumbents may react will also influence their decision to
enter or stay out of an industry. If reaction is vigorous and
protracted enough, the profit potential of participating in
the industry can fall below the cost of capital. Incumbents
often use public statements and responses to one entrant
to send a message to other prospective entrants about their
commitment to defending market share.
Newcomers are likely to fear expected retaliation if:
• Incumbents have previously responded vigorously to
new entrants.
• Incumbents possess substantial resources to fight back,
including excess cash and unused borrowing power, avail-
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Differences in Industry Profitability
The average return on invested capital varies markedly from
industry to industry. Between 1992 and 2006, for example,
average return on invested capital in U.S. industries ranged as
low as zero or even negative to more than 50%. At the high
end are industries like soft drinks and prepackaged software,
which have been almost six times more profitable than the
airline industry over the period.
able productive capacity, or clout with distribution channels
and customers.
• Incumbents seem likely to cut prices because they are
committed to retaining market share at all costs or because
the industry has high fixed costs, which create a strong motivation to drop prices to fill excess capacity.
• Industry growth is slow so newcomers can gain volume
only by taking it from incumbents.
An analysis of barriers to entry and expected retaliation is
obviously crucial for any company contemplating entry into
a new industry. The challenge is to find ways to surmount
the entry barriers without nullifying, through heavy investment, the profitability of participating in the industry.
THE POWER OF SUPPLIERS. Powerful suppliers capture
more of the value for themselves by charging higher prices,
limiting quality or services, or shifting costs to industry participants. Powerful suppliers, including suppliers of labor,
can squeeze profitability out of an industry that is unable
to pass on cost increases in its own prices. Microsoft, for instance, has contributed to the erosion of profitability among
personal computer makers by raising prices on operating
systems. PC makers, competing fiercely for customers who
can easily switch among them, have limited freedom to raise
their prices accordingly.
Companies depend on a wide range of different supplier
groups for inputs. A supplier group is powerful if:
• It is more concentrated than the industry it sells to.
Microsoft’s near monopoly in operating systems, coupled
with the fragmentation of PC assemblers, exemplifies this
situation.
• The supplier group does not depend heavily on the industry for its revenues. Suppliers serving many industries
will not hesitate to extract maximum profits from each one.
If a particular industry accounts for a large portion of a supplier group’s volume or profit, however, suppliers will want
to protect the industry through reasonable pricing and assist in activities such as R&D and lobbying.
• Industry participants face switching costs in changing
suppliers. For example, shifting suppliers is difficult if companies have invested heavily in specialized ancillary equip-
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Profitability of Selected U.S. Industries
Average Return on Invested Capital
in U.S. Industries, 1992–2006
50
10th percentile
7.0%
25th
percentile
10.9%
Median:
14.3%
75th percentile
18.6%
Average ROIC, 1992–2006
90th percentile
25.3%
Number of Industries
40
30
20
10
0
0%
or lower
5%
10%
15%
20%
25%
30%
ROIC
35%
or higher
Return on invested capital (ROIC) is the appropriate measure
of profitability for strategy formulation, not to mention for equity
investors. Return on sales or the growth rate of profits fail to
account for the capital required to compete in the industry. Here,
we utilize earnings before interest and taxes divided by average
invested capital less excess cash as the measure of ROIC. This
measure controls for idiosyncratic differences in capital structure
and tax rates across companies and industries.
Source: Standard & Poor’s, Compustat, and author’s calculations
ment or in learning how to operate a supplier’s equipment
(as with Bloomberg terminals used by financial professionals). Or firms may have located their production lines adjacent to a supplier’s manufacturing facilities (as in the case
of some beverage companies and container manufacturers).
When switching costs are high, industry participants find it
hard to play suppliers off against one another. (Note that
suppliers may have switching costs as well. This limits their
power.)
• Suppliers offer products that are differentiated. Pharmaceutical companies that offer patented drugs with distinctive medical benefits have more power over hospitals,
health maintenance organizations, and other drug buyers,
for example, than drug companies offering me-too or generic products.
• There is no substitute for what the supplier group provides. Pilots’ unions, for example, exercise considerable supplier power over airlines partly because there is no good
alternative to a well-trained pilot in the cockpit.
• The supplier group can credibly threaten to integrate forward into the industry. In that case, if industry participants
make too much money relative to suppliers, they will induce
suppliers to enter the market.
THE POWER OF BUYERS. Powerful customers – the flip
side of powerful suppliers – can capture more value by forcing down prices, demanding better quality or more service
(thereby driving up costs), and generally playing industry
participants off against one another, all at the expense of
industry profitability. Buyers are powerful if they have negotiating leverage relative to industry participants, especially
if they are price sensitive, using their clout primarily to pressure price reductions.
As with suppliers, there may be distinct groups of customers who differ in bargaining power. A customer group has
negotiating leverage if:
• There are few buyers, or each one purchases in volumes
that are large relative to the size of a single vendor. Largevolume buyers are particularly powerful in industries with
high fixed costs, such as telecommunications equipment, offshore drilling, and bulk chemicals. High fixed costs and low
marginal costs amplify the pressure on rivals to keep capacity filled through discounting.
• The industry’s products are standardized or undifferentiated. If buyers believe they can always find an equivalent
product, they tend to play one vendor against another.
• Buyers face few switching costs in changing vendors.
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40.9%
37.6%
37.6%
31.7%
28.6%
27.3%
26.4%
21.3%
21.0%
19.5%
19.5%
19.2%
19.0%
17.6%
17.0%
16.5%
16.0%
15.6%
15.4%
Average industry
15.0%
ROIC in the U.S.
13.9%
14.9%
13.8%
13.7%
13.4%
13.4%
12.6%
11.7%
10.5%
10.4%
5.9%
5.9%
Security Brokers and Dealers
Soft Drinks
Prepackaged Software
Pharmaceuticals
Perfume, Cosmetics, Toiletries
Advertising Agencies
Distilled Spirits
Semiconductors
Medical Instruments
Men’s and Boys’ Clothing
Tires
Household Appliances
Malt Beverages
Child Day Care Services
Household Furniture
Drug Stores
Grocery Stores
Iron and Steel Foundries
Cookies and Crackers
Mobile Homes
Wine and Brandy
Bakery Products
Engines and Turbines
Book Publishing
Laboratory Equipment
Oil and Gas Machinery
Soft Drink Bottling
Knitting Mills
Hotels
Catalog, Mail-Order Houses
Airlines
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• Buyers can credibly threaten to integrate backward and
produce the industry’s product themselves if vendors are
too profitable. Producers of soft drinks and beer have long
controlled the power of packaging manufacturers by threatening to make, and at times actually making, packaging materials themselves.
A buyer group is price sensitive if:
• The product it purchases from the industry represents
a significant fraction of its cost structure or procurement
budget. Here buyers are likely to shop around and bargain
hard, as consumers do for home mortgages. Where the product sold by an industry is a small fraction of buyers’ costs or
expenditures, buyers are usually less price sensitive.
• The buyer group earns low profits, is strapped for cash,
or is otherwise under pressure to trim its purchasing costs.
Highly profitable or cash-rich customers, in contrast, are generally less price sensitive (that is, of course, if the item does
not represent a large fraction of their costs).
• The quality of buyers’ products or services is little affected by the industry’s product. Where quality is very much
affected by the industry’s product, buyers are generally less
price sensitive. When purchasing or renting production quality cameras, for instance, makers of major motion pictures
opt for highly reliable equipment with the latest features.
They pay limited attention to price.
• The industry’s product has little effect on the buyer’s
other costs. Here, buyers focus on price. Conversely, where
an industry’s product or service can pay for itself many times
over by improving performance or reducing labor, material,
or other costs, buyers are usually more interested in quality
than in price. Examples include products and services like tax
accounting or well logging (which measures below-ground
conditions of oil wells) that can save or even make the buyer
money. Similarly, buyers tend not to be price sensitive in services such as investment banking, where poor performance
can be costly and embarrassing.
Most sources of buyer power apply equally to consumers and to business-to-business customers. Like industrial
customers, consumers tend to be more price sensitive if they
are purchasing products that are undifferentiated, expensive
relative to their incomes, and of a sort where product performance has limited consequences. The major difference with
consumers is that their needs can be more intangible and
harder to quantify.
Intermediate customers, or customers who purchase the
product but are not the end user (such as assemblers or distribution channels), can be analyzed the same way as other buyers, with one important addition. Intermediate customers
gain significant bargaining power when they can influence
the purchasing decisions of customers downstream. Consumer electronics retailers, jewelry retailers, and agriculturalequipment distributors are examples of distribution channels that exert a strong influence on end customers.
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Producers often attempt to diminish channel clout
through exclusive arrangements with particular distributors
or retailers or by marketing directly to end users. Component manufacturers seek to develop power over assemblers
by creating preferences for their components with downstream customers. Such is the case with bicycle parts and
with sweeteners. DuPont has created enormous clout by
advertising its Stainmaster brand of carpet fibers not only
to the carpet manufacturers that actually buy them but
also to downstream consumers. Many consumers request
Stainmaster carpet even though DuPont is not a carpet
manufacturer.
THE THREAT OF SUBSTITUTES. A substitute performs
the same or a similar function as an industry’s product by a
different means. Videoconferencing is a substitute for travel.
Plastic is a substitute for aluminum. E-mail is a substitute
for express mail. Sometimes, the threat of substitution is
downstream or indirect, when a substitute replaces a buyer
industry’s product. For example, lawn-care products and services are threatened when multifamily homes in urban areas
substitute for single-family homes in the suburbs. Software
sold to agents is threatened when airline and travel websites
substitute for travel agents.
Substitutes are always present, but they are easy to overlook because they may appear to be very different from the
industry’s product: To someone searching for a Father’s Day
gift, neckties and power tools may be substitutes. It is a substitute to do without, to purchase a used product rather than
a new one, or to do it yourself (bring the service or product
in-house).
When the threat of substitutes is high, industry profitability suffers. Substitute products or services limit an industry’s
profit potential by placing a ceiling on prices. If an industry
does not distance itself from substitutes through product
performance, marketing, or other means, it will suffer in
terms of profitability – and often growth potential.
Substitutes not only limit profits in normal times, they
also reduce the bonanza an industry can reap in good times.
In emerging economies, for example, the surge in demand
for wired telephone lines has been capped as many consumers opt to make a mobile telephone their first and only
phone line.
The threat of a substitute is high if:
• It offers an attractive price-performance trade-off to the
industry’s product. The better the relative value of the substitute, the tighter is the lid on an industry’s profit potential. For example, conventional providers of long-distance
telephone service have suffered from the advent of inexpensive internet-based phone services such as Vonage and
Skype. Similarly, video rental outlets are struggling with the
emergence of cable and satellite video-on-demand services,
online video rental services such as Netflix, and the rise of
internet video sites like Google’s YouTube.
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• The buyer’s cost of switching to the substitute is low.
Switching from a proprietary, branded drug to a generic
drug usually involves minimal costs, for example, which is
why the shift to generics (and the fall in prices) is so substantial and rapid.
Strategists should be particularly alert to changes in other
industries that may make them attractive substitutes when
they were not before. Improvements in plastic materials, for
example, allowed them to substitute for steel in many automobile components. In this way, technological changes
may participate in an industry for image reasons or to offer
a full line. Clashes of personality and ego have sometimes
exaggerated rivalry to the detriment of profitability in fields
such as the media and high technology.
• Firms cannot read each other’s signals well because of
lack of familiarity with one another, diverse approaches to
competing, or differing goals.
The strength of rivalry reflects not just the intensity of
competition but also the basis of competition. The dimensions on which competition takes place, and whether rivals
Rivalry is especially destructive to profitability if it gravitates
solely to price because price competition transfers profits directly
from an industry to its customers.
or competitive discontinuities in seemingly unrelated businesses can have major impacts on industry profitability. Of
course the substitution threat can also shift in favor of an
industry, which bodes well for its future profitability and
growth potential.
RIVALRY AMONG EXISTING COMPETITORS. Rivalry
among existing competitors takes many familiar forms, including price discounting, new product introductions, advertising campaigns, and service improvements. High rivalry
limits the profitability of an industry. The degree to which rivalry drives down an industry’s profit potential depends, first,
on the intensity with which companies compete and, second,
on the basis on which they compete.
The intensity of rivalry is greatest if:
• Competitors are numerous or are roughly equal in size
and power. In such situations, rivals find it hard to avoid
poaching business. Without an industry leader, practices desirable for the industry as a whole go unenforced.
• Industry growth is slow. Slow growth precipitates fights
for market share.
• Exit barriers are high. Exit barriers, the flip side of entry
barriers, arise because of such things as highly specialized
assets or management’s devotion to a particular business.
These barriers keep companies in the market even though
they may be earning low or negative returns. Excess capacity
remains in use, and the profitability of healthy competitors
suffers as the sick ones hang on.
• Rivals are highly committed to the business and have
aspirations for leadership, especially if they have goals that
go beyond economic performance in the particular industry.
High commitment to a business arises for a variety of reasons.
For example, state-owned competitors may have goals that
include employment or prestige. Units of larger companies
converge to compete on the same dimensions, have a major
influence on profitability.
Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers. Price cuts are
usually easy for competitors to see and match, making successive rounds of retaliation likely. Sustained price competition also trains customers to pay less attention to product
features and service.
Price competition is most liable to occur if:
• Products or services of rivals are nearly identical and
there are few switching costs for buyers. This encourages
competitors to cut prices to win new customers. Years of airline price wars reflect these circumstances in that industry.
• Fixed costs are high and marginal costs are low. This
creates intense pressure for competitors to cut prices below
their average costs, even close to their marginal costs, to steal
incremental customers while still making some contribution
to covering fixed costs. Many basic-materials businesses, such
as paper and aluminum, suffer from this problem, especially
if demand is not growing. So do delivery companies with
fixed networks of routes that must be served regardless of
volume.
• Capacity must be expanded in large increments to be
efficient. The need for large capacity expansions, as in the
polyvinyl chloride business, disrupts the industry’s supplydemand balance and often leads to long and recurring periods of overcapacity and price cutting.
• The product is perishable. Perishability creates a strong
temptation to cut prices and sell a product while it still has
value. More products and services are perishable than is
commonly thought. Just as tomatoes are perishable because
they rot, models of computers are perishable because they
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soon become obsolete, and information may be perishable
if it diffuses rapidly or becomes outdated, thereby losing its
value. Services such as hotel accommodations are perishable
in the sense that unused capacity can never be recovered.
Competition on dimensions other than price – on product
features, support services, delivery time, or brand image, for
instance – is less likely to erode profitability because it improves customer value and can support higher prices. Also,
rivalry focused on such dimensions can improve value relative to substitutes or raise the barriers facing new entrants.
While nonprice rivalry sometimes escalates to levels that
undermine industry profitability, this is less likely to occur
than it is with price rivalry.
As important as the dimensions of rivalry is whether rivals compete on the same dimensions. When all or many
competitors aim to meet the same needs or compete on the
same attributes, the result is zero-sum competition. Here,
one firm’s gain is often another’s loss, driving down profitability. While price competition runs a stronger risk than
nonprice competition of becoming zero sum, this may not
happen if companies take care to segment their markets,
targeting their low-price offerings to different customers.
Rivalry can be positive sum, or actually increase the average profitability of an industry, when each competitor aims
to serve the needs of different customer segments, with different mixes of price, products, services, features, or brand
identities. Such competition can not only support higher average profitability but also expand the industry, as the needs
of more customer groups are better met. The opportunity
for positive-sum competition will be greater in industries
serving diverse customer groups. With a clear understanding of the structural underpinnings of rivalry, strategists can
sometimes take steps to shift the nature of competition in
a more positive direction.
Factors, Not Forces
Industry structure, as manifested in the strength of the five
competitive forces, determines the industry’s long-run profit
potential because it determines how the economic value
created by the industry is divided – how much is retained
by companies in the industry versus bargained away by customers and suppliers, limited by substitutes, or constrained
by potential new entrants. By considering all five forces, a
strategist keeps overall structure in mind instead of gravitating to any one element. In addition, the strategist’s attention remains focused on structural conditions rather than
on fleeting factors.
It is especially important to avoid the common pitfall of
mistaking certain visible attributes of an industry for its underlying structure. Consider the following:
Industry growth rate. A common mistake is to assume
that fast-growing industries are always attractive. Growth
does tend to mute rivalry, because an expanding pie offers
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opportunities for all competitors. But fast growth can put
suppliers in a powerful position, and high growth with low
entry barriers will draw in entrants. Even without new entrants, a high growth rate will not guarantee profitability if
customers are powerful or substitutes are attractive. Indeed,
some fast-growth businesses, such as personal computers,
have been among the least profitable industries in recent
years. A narrow focus on growth is one of the major causes
of bad strategy decisions.
Technology and innovation. Advanced technology or innovations are not by themselves enough to make an industry structurally attractive (or unattractive). Mundane, lowtechnology industries with price-insensitive buyers, high
switching costs, or high entry barriers arising from scale
economies are often far more profitable than sexy industries, such as software and internet technologies, that attract
competitors.2
Government. Government is not best understood as a
sixth force because government involvement is neither inherently good nor bad for industry profitability. The best
way to understand the influence of government on competition is to analyze how specific government policies affect the
five competitive forces. For instance, patents raise barriers
to entry, boosting industry profit potential. Conversely, government policies favoring unions may raise supplier power
and diminish profit potential. Bankruptcy rules that allow
failing companies to reorganize rather than exit can lead to
excess capacity and intense rivalry. Government operates at
multiple levels and through many different policies, each of
which will affect structure in different ways.
Complementary products and services. Complements
are products or services used together with an industry’s
product. Complements arise when the customer benefit
of two products combined is greater than the sum of each
product’s value in isolation. Computer hardware and software, for instance, are valuable together and worthless when
separated.
In recent years, strategy researchers have highlighted the
role of complements, especially in high-technology industries where they are most obvious.3 By no means, however,
do complements appear only there. The value of a car, for example, is greater when the driver also has access to gasoline
stations, roadside assistance, and auto insurance.
Complements can be important when they affect the
overall demand for an industry’s product. However, like
government policy, complements are not a sixth force determining industry profitability since the presence of strong
complements is not necessarily bad (or good) for industry
profitability. Complements affect profitability through the
way they influence the five forces.
The strategist must trace the positive or negative influence
of complements on all five forces to ascertain their impact on
profitability. The presence of complements can raise or lower
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Industry Analysis in Practice
Good industry analysis looks rigorously at the
structural underpinnings of profitability. A first
step is to understand the appropriate time
horizon. One of the essential tasks in industry
analysis is to distinguish temporary or cyclical changes
from structural changes. A good guideline for the
appropriate time horizon is the full business cycle for
the particular industry. For most industries, a threeto-five-year horizon is appropriate, although in some
industries with long lead times, such as mining, the
appropriate horizon might be a decade or more. It is
average profitability over this period, not profitability in
any particular year, that should be the focus of analysis.
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. Many elements of the five forces
can be quantified: the percentage of the buyer’s
total cost accounted for by the industry’s product (to
understand buyer price sensitivity); the percentage of
industry sales required to fill a plant or operate a logistical network of efficient scale (to help assess barriers
to entry); the buyer’s switching cost (determining the
inducement an entrant or rival must offer customers).
The strength of the competitive forces affects
prices, costs, and the investment required to
compete; thus the forces are directly tied to
the income statements and balance sheets of
industry participants. Industry structure defines
the gap between revenues and costs. For example,
intense rivalry drives down prices or elevates the costs
of marketing, R&D, or customer service, reducing
margins. How much? Strong suppliers drive up input
costs. How much? Buyer power lowers prices or
elevates the costs of meeting buyers’ demands, such
as the requirement to hold more inventory or provide
financing. How much? Low barriers to entry or close
substitutes limit the level of sustainable prices. How
much? It is these economic relationships that sharpen
the strategist’s understanding of industry competition.
Finally, good industry analysis does not just list
pluses and minuses but sees an industry in overall, systemic terms. Which forces are underpinning
(or constraining) today’s profitability? How might shifts
in one competitive force trigger reactions in others?
Answering such questions is often the source of true
strategic insights.
barriers to entry. In application software, for example, barriers to entry were lowered when producers of complementary operating system software, notably Microsoft, provided
tool sets making it easier to write applications. Conversely,
the need to attract producers of complements can raise barriers to entry, as it does in video game hardware.
The presence of complements can also affect the threat
of substitutes. For instance, the need for appropriate fueling
stations makes it difficult for cars using alternative fuels to
substitute for conventional vehicles. But complements can
also make substitution easier. For example, Apple’s iTunes
hastened the substitution from CDs to digital music.
Complements can factor into industry rivalry either positively (as when they raise switching costs) or negatively (as
when they neutralize product differentiation). Similar analyses can be done for buyer and supplier power. Sometimes
companies compete by altering conditions in complementary industries in their favor, such as when videocassetterecorder producer JVC persuaded movie studios to favor
its standard in issuing prerecorded tapes even though rival Sony’s standard was probably superior from a technical
standpoint.
Identifying complements is part of the analyst’s work. As
with government policies or important technologies, the
strategic significance of complements will be best understood through the lens of the five forces.
Changes in Industry Structure
So far, we have discussed the competitive forces at a single
point in time. Industry structure proves to be relatively stable, and industry profitability differences are remarkably
persistent over time in practice. However, industry structure
is constantly undergoing modest adjustment – and occasionally it can change abruptly.
Shifts in structure may emanate from outside an industry
or from within. They can boost the industry’s profit potential
or reduce it. They may be caused by changes in technology,
changes in customer needs, or other events. The five competitive forces provide a framework for identifying the most
important industry developments and for anticipating their
impact on industry attractiveness.
Shifting threat of new entry. Changes to any of the seven
barriers described above can raise or lower the threat of new
entry. The expiration of a patent, for instance, may unleash
new entrants. On the day that Merck’s patents for the cholesterol reducer Zocor expired, three pharmaceutical makers entered the market for the drug. Conversely, the proliferation of products in the ice cream industry has gradually
filled up the limited freezer space in grocery stores, making
it harder for new ice cream makers to gain access to distribution in North America and Europe.
Strategic decisions of leading competitors often have a
major impact on the threat of entry. Starting in the 1970s, for
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example, retailers such as Wal-Mart, Kmart, and Toys “R” Us
began to adopt new procurement, distribution, and inventory control technologies with large fixed costs, including
automated distribution centers, bar coding, and point-of-sale
terminals. These investments increased the economies of
scale and made it more difficult for small retailers to enter
the business (and for existing small players to survive).
Changing supplier or buyer power. As the factors underlying the power of suppliers and buyers change with time,
their clout rises or declines. In the global appliance industry,
for instance, competitors including Electrolux, General Electric, and Whirlpool have been squeezed by the consolidation
of retail channels (the decline of appliance specialty stores,
for instance, and the rise of big-box retailers like Best Buy
and Home Depot in the United States). Another example is
travel agents, who depend on airlines as a key supplier. When
the internet allowed airlines to sell tickets directly to customers, this significantly increased their power to bargain
down agents’ commissions.
Shifting threat of substitution. The most common reason
substitutes become more or less threatening over time is
that advances in technology create new substitutes or shift
price-performance comparisons in one direction or the other.
The earliest microwave ovens, for example, were large and
priced above $2,000, making them poor substitutes for conventional ovens. With technological advances, they became
serious substitutes. Flash computer memory has improved
enough recently to become a meaningful substitute for lowcapacity hard-disk drives. Trends in the availability or performance of complementary producers also shift the threat
of substitutes.
New bases of rivalry. Rivalry often intensifies naturally
over time. As an industry matures, growth slows. Competitors become more alike as industry conventions emerge,
technology diffuses, and consumer tastes converge. Industry
profitability falls, and weaker competitors are driven from
and geographic segments (such as riverboats, trophy properties, Native American reservations, international expansion,
and novel customer groups like families). Head-to-head rivalry that lowers prices or boosts the payouts to winners has
been limited.
The nature of rivalry in an industry is altered by mergers
and acquisitions that introduce new capabilities and ways of
competing. Or, technological innovation can reshape rivalry.
In the retail brokerage industry, the advent of the internet
lowered marginal costs and reduced differentiation, triggering far more intense competition on commissions and fees
than in the past.
In some industries, companies turn to mergers and consolidation not to improve cost and quality but to attempt to
stop intense competition. Eliminating rivals is a risky strategy, however. The five competitive forces tell us that a profit
windfall from removing today’s competitors often attracts
new competitors and backlash from customers and suppliers. In New York banking, for example, the 1980s and 1990s
saw escalating consolidations of commercial and savings
banks, including Manufacturers Hanover, Chemical, Chase,
and Dime Savings. But today the retail-banking landscape
of Manhattan is as diverse as ever, as new entrants such as
Wachovia, Bank of America, and Washington Mutual have
entered the market.
Implications for Strategy
Understanding the forces that shape industry competition
is the starting point for developing strategy. Every company
should already know what the average profitability of its
industry is and how that has been changing over time. The
five forces reveal why industry profitability is what it is. Only
then can a company incorporate industry conditions into
strategy.
The forces reveal the most significant aspects of the competitive environment. They also provide a baseline for sizing
Eliminating rivals is a risky strategy. A profit windfall from
removing today’s competitors often attracts new competitors and
backlash from customers and suppliers.
the business. This story has played out in industry after industry; televisions, snowmobiles, and telecommunications
equipment are just a few examples.
A trend toward intensifying price competition and other
forms of rivalry, however, is by no means inevitable. For example, there has been enormous competitive activity in the
U.S. casino industry in recent decades, but most of it has
been positive-sum competition directed toward new niches
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up a company’s strengths and weaknesses: Where does the
company stand versus buyers, suppliers, entrants, rivals, and
substitutes? Most importantly, an understanding of industry
structure guides managers toward fruitful possibilities for
strategic action, which may include any or all of the following: positioning the company to better cope with the current
competitive forces; anticipating and exploiting shifts in the
forces; and shaping the balance of forces to create a new in-
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Using the five forces framework, creative strategists may be
able to spot an industry with a good future before this good future
is reflected in the prices of acquisition candidates.
dustry structure that is more favorable to the company. The
best strategies exploit more than one of these possibilities.
Positioning the company. Strategy can be viewed as building defenses against the competitive forces or finding a position in the industry where the forces are weakest. Consider,
for instance, the position of Paccar in the market for heavy
trucks. The heavy-truck industry is structurally challenging.
Many buyers operate large fleets or are large leasing companies, with both the leverage and the motivation to drive
down the price of one of their largest purchases. Most trucks
are built to regulated standards and offer similar features, so
price competition is rampant. Capital intensity causes rivalry
to be fierce, especially during the recurring cyclical downturns. Unions exercise considerable supplier power. Though
there are few direct substitutes for an 18-wheeler, truck buyers face important substitutes for their services, such as cargo
delivery by rail.
In this setting, Paccar, a Bellevue, Washington–based company with about 20% of the North American heavy-truck
market, has chosen to focus on one group of customers:
owner-operators – drivers who own their trucks and contract
directly with shippers or serve as subcontractors to larger
trucking companies. Such small operators have limited clout
as truck buyers. They are also less price sensitive because of
their strong emotional ties to and economic dependence on
the product. They take great pride in their trucks, in which
they spend most of their time.
Paccar has invested heavily to develop an array of features with owner-operators in mind: luxurious sleeper cabins,
plush leather seats, noise-insulated cabins, sleek exterior styling, and so on. At the company’s extensive network of dealers,
prospective buyers use software to select among thousands
of options to put their personal signature on their trucks.
These customized trucks are built to order, not to stock, and
delivered in six to eight weeks. Paccar’s trucks also have aerodynamic designs that reduce fuel consumption, and they
maintain their resale value better than other trucks. Paccar’s
roadside assistance program and IT-supported system for distributing spare parts reduce the time a truck is out of service.
All these are crucial considerations for an owner-operator.
Customers pay Paccar a 10% premium, and its Kenworth and
Peterbilt brands are considered status symbols at truck stops.
Paccar illustrates the principles of positioning a company
within a given industry structure. The firm has found a portion of its industry where the competitive forces are weaker –
where it can avoid buyer power and price-based rivalry. And it
has tailored every single part of the value chain to cope well
with the forces in its segment. As a result, Paccar has been
profitable for 68 years straight and has earned a long-run
return on equity above 20%.
In addition to revealing positioning opportunities within
an existing industry, the five forces framework allows companies to rigorously analyze entry and exit. Both depend on
answering the difficult question: “What is the potential of
this business?” Exit is indicated when industry structure is
poor or declining and the company has no prospect of a superior positioning. In considering entry into a new industry,
creative strategists can use the framework to spot an industry with a good future before this good future is reflected in
the prices of acquisition candidates. Five forces analysis may
also reveal industries that are not necessarily attractive for
the average entrant but in which a company has good reason
to believe it can surmount entry barriers at lower cost than
most firms or has a unique ability to cope with the industry’s
competitive forces.
Exploiting industry change. Industry changes bring the
opportunity to spot and claim promising new strategic positions if the strategist has a sophisticated understanding of
the competitive forces and their underpinnings. Consider,
for instance, the evolution of the music industry during the
past decade. With the advent of the internet and the digital
distribution of music, some analysts predicted the birth of
thousands of music labels (that is, record companies that
develop artists and bring their music to market). This, the
analysts argued, would break a pattern that had held since
Edison invented the phonograph: Between three and six
major record companies had always dominated the industry.
The internet would, they predicted, remove distribution as
a barrier to entry, unleashing a flood of new players into the
music industry.
A careful analysis, however, would have revealed that
physical distribution was not the crucial barrier to entry.
Rather, entry was barred by other benefits that large music
labels enjoyed. Large labels could pool the risks of developing new artists over many bets, cushioning the impact of
inevitable failures. Even more important, they had advantages in breaking through the clutter and getting their new
artists heard. To do so, they could promise radio stations and
record stores access to well-known artists in exchange for
promotion of new artists. New labels would find this nearly
impossible to match. The major labels stayed the course, and
new music labels have been rare.
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This is not to say that the music industry is structurally
unchanged by digital distribution. Unauthorized downloading created an illegal but potent substitute. The labels tried
for years to develop technical platforms for digital distribution themselves, but major companies hesitated to sell their
music through a platform owned by a rival. Into this vacuum
share of profits that leak to suppliers, buyers, and substitutes
or are sacrificed to deter entrants.
To neutralize supplier power, for example, a firm can standardize specifications for parts to make it easier to switch
among suppliers. It can cultivate additional vendors, or alter
technology to avoid a powerful supplier group altogether.
Faced with pressures to gain market share or enamored with
innovation for its own sake, managers can spark new kinds of
competition that no incumbent can win.
stepped Apple with its iTunes music store, launched in 2003
to support its iPod music player. By permitting the creation
of a powerful new gatekeeper, the major labels allowed industry structure to shift against them. The number of major
record companies has actually declined – from six in 1997 to
four today – as companies struggled to cope with the digital
phenomenon.
When industry structure is in flux, new and promising
competitive positions may appear. Structural changes open
up new needs and new ways to serve existing needs. Established leaders may overlook these or be constrained by past
strategies from pursuing them. Smaller competitors in the
industry can capitalize on such changes, or the void may well
be filled by new entrants.
Shaping industry structure. When a company exploits
structural change, it is recognizing, and reacting to, the inevitable. However, companies also have the ability to shape
industry structure. A firm can lead its industry toward new
ways of competing that alter the five forces for the better.
In reshaping structure, a company wants its competitors
to follow so that the entire industry will be transformed.
While many industry participants may benefit in the process,
the innovator can benefit most if it can shift competition in
directions where it can excel.
An industry’s structure can be reshaped in two ways: by redividing profitability in favor of incumbents or by expanding
the overall profit pool. Redividing the industry pie aims to
increase the share of profits to industry competitors instead
of to suppliers, buyers, substitutes, and keeping out potential
entrants. Expanding the profit pool involves increasing the
overall pool of economic value generated by the industry in
which rivals, buyers, and suppliers can all share.
Redividing profitability. To capture more profits for industry rivals, the starting point is to determine which force or
forces are currently constraining industry profitability and
address them. A company can potentially influence all of the
competitive forces. The strategist’s goal here is to reduce the
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To counter customer power, companies may expand services
that raise buyers’ switching costs or find alternative means
of reaching customers to neutralize powerful channels. To
temper profit-eroding price rivalry, companies can invest
more heavily in unique products, as pharmaceutical firms
have done, or expand support services to customers. To scare
off entrants, incumbents can elevate the fixed cost of competing – for instance, by escalating their R&D or marketing
expenditures. To limit the threat of substitutes, companies
can offer better value through new features or wider product
accessibility. When soft-drink producers introduced vending
machines and convenience store channels, for example, they
dramatically improved the availability of soft drinks relative
to other beverages.
Sysco, the largest food-service distributor in North America, offers a revealing example of how an industry leader
can change the structure of an industry for the better. Foodservice distributors purchase food and related items from
farmers and food processors. They then warehouse and deliver these items to restaurants, hospitals, employer cafeterias, schools, and other food-service institutions. Given low
barriers to entry, the food-service distribution industry has
historically been highly fragmented, with numerous local
competitors. While rivals try to cultivate customer relationships, buyers are price sensitive because food represents a
large share of their costs. Buyers can also choose the substitute approaches of purchasing directly from manufacturers
or using retail sources, avoiding distributors altogether. Suppliers wield bargaining power: They are often large companies with strong brand names that food preparers and
consumers recognize. Average profitability in the industry
has been modest.
Sysco recognized that, given its size and national reach, it
might change this state of affairs. It led the move to introduce private-label distributor brands with specifications tailored to the food-service market, moderating supplier power.
Sysco emphasized value-added services to buyers such as
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credit, menu planning, and inventory management to shift
the basis of competition away from just price. These moves,
together with stepped-up investments in information technology and regional distribution centers, substantially raised
the bar for new entrants while making the substitutes less
attractive. Not surprisingly, the industry has been consolidating, and industry profitability appears to be rising.
Industry leaders have a special responsibility for improving industry structure. Doing so often requires resources that
only large players possess. Moreover, an improved industry
structure is a public good because it benefits every firm in
the industry, not just the company that initiated the im-
Defining the
Relevant Industry
Defining the industry in which competition actually takes place is important
for good industry analysis, not to
mention for developing strategy and
setting business unit boundaries. Many
strategy errors emanate from mistaking the relevant industry, defining it too
broadly or too narrowly. Defining the
industry too broadly obscures differences among products, customers, or
geographic regions that are important
to competition, strategic positioning,
and profitability. Defining the industry
too narrowly overlooks commonalities
and linkages across related products or
geographic markets that are crucial to
competitive advantage. Also, strategists must be sensitive to the possibility that industry boundaries can shift.
The boundaries of an industry consist of two primary dimensions. First is
the scope of products or services. For
example, is motor oil used in cars part
of the same industry as motor oil used
in heavy trucks and stationary engines,
or are these different industries? The
second dimension is geographic scope.
Most industries are present in many
parts of the world. However, is competition contained within each state,
or is it national? Does competition take
place within regions such as Europe
or North America, or is there a single
global industry?
provement. Often, it is more in the interests of an industry
leader than any other participant to invest for the common
good because leaders will usually benefit the most. Indeed,
improving the industry may be a leader’s most profitable
strategic opportunity, in part because attempts to gain further market share can trigger strong reactions from rivals,
customers, and even suppliers.
There is a dark side to shaping industry structure that is
equally important to understand. Ill-advised changes in competitive positioning and operating practices can undermine
industry structure. Faced with pressures to gain market share
or enamored with innovation for its own sake, managers may
The five forces are the basic tool to
resolve these questions. If industry
structure for two products is the same
or very similar (that is, if they have the
same buyers, suppliers, barriers to entry, and so forth), then the products are
best treated as being part of the same
industry. If industry structure differs
markedly, however, the two products
may be best understood as separate
industries.
In lubricants, the oil used in cars is
similar or even identical to the oil used
in trucks, but the similarity largely ends
there. Automotive motor oil is sold to
fragmented, generally unsophisticated
customers through numerous and often powerful channels, using extensive
advertising. Products are packaged in
small containers and logistical costs are
high, necessitating local production.
Truck and power generation lubricants
are sold to entirely different buyers in
entirely different ways using a separate
supply chain. Industry structure (buyer
power, barriers to entry, and so forth)
is substantially different. Automotive
oil is thus a distinct industry from oil
for truck and stationary engine uses.
Industry profitability will differ in these
two cases, and a lubricant company
will need a separate strategy for competing in each area.
Differences in the five competitive forces also reveal the geographic
scope of competition. If an industry
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has a similar structure in every country
(rivals, buyers, and so on), the presumption is that competition is global,
and the five forces analyzed from a
global perspective will set average
profitability. A single global strategy is
needed. If an industry has quite different structures in different geographic
regions, however, each region may
well be a distinct industry. Otherwise,
competition would have leveled the differences. The five forces analyzed for
each region will set profitability there.
The extent of differences in the five
forces for related products or across
geographic areas is a matter of degree,
making industry definition often a matter of judgment. A rule of thumb is that
where the differences in any one force
are large, and where the differences
involve more than one force, distinct
industries may well be present.
Fortunately, however, even if industry boundaries are drawn incorrectly,
careful five forces analysis should
reveal important competitive threats.
A closely related product omitted from
the industry definition will show up as a
substitute, for example, or competitors
overlooked as rivals will be recognized
as potential entrants. At the same
time, the five forces analysis should
reveal major differences within overly
broad industries that will indicate the
need to adjust industry boundaries or
strategies.
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trigger new kinds of competition that no incumbent can win.
When taking actions to improve their own company’s competitive advantage, then, strategists should ask whether they
are setting in motion dynamics that will undermine industry
structure in the long run. In the early days of the personal
computer industry, for instance, IBM tried to make up for
its late entry by offering an open architecture that would
set industry standards and attract complementary makers
of application software and peripherals. In the process, it
ceded ownership of the critical components of the PC – the
operating system and the microprocessor – to Microsoft and
Intel. By standardizing PCs, it encouraged price-based rivalry
and shifted power to suppliers. Consequently, IBM became
the temporarily dominant firm in an industry with an enduringly unattractive structure.
Expanding the profit pool. When overall demand grows,
the industry’s quality level rises, intrinsic costs are reduced,
or waste is eliminated, the pie expands. The total pool of
value available to competitors, suppliers, and buyers grows.
The total profit pool expands, for example, when channels
become more competitive or when an industry discovers
latent buyers for its product that are not currently being
served. When soft-drink producers rationalized their independent bottler networks to make them more efficient and
effective, both the soft-drink companies and the bottlers
benefited. Overall value can also expand when firms work
collaboratively with suppliers to improve coordination and
limit unnecessary costs incurred in the supply chain. This
lowers the inherent cost structure of the industry, allowing
higher profit, greater demand through lower prices, or both.
Or, agreeing on quality standards can bring up industrywide
quality and service levels, and hence prices, benefiting rivals,
suppliers, and customers.
Expanding the overall profit pool creates win-win opportunities for multiple industry participants. It can also reduce
the risk of destructive rivalry that arises when incumbents
attempt to shift bargaining power or capture more market share. However, expanding the pie does not reduce the
importance of industry structure. How the expanded pie
is divided will ultimately be determined by the five forces.
The most successful companies are those that expand the
industry profit pool in ways that allow them to share disproportionately in the benefits.
Defining the industry. The five competitive forces also
hold the key to defining the relevant industry (or industries)
in which a company competes. Drawing industry boundaries
correctly, around the arena in which competition actually
takes place, will clarify the causes of profitability and the appropriate unit for setting strategy. A company needs a separate strategy for each distinct industry. Mistakes in industry
definition made by competitors present opportunities for
staking out superior strategic positions. (See the sidebar
“Defining the Relevant Industry.”)
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Typical Steps in Industry Analysis
Define the relevant industry:
■ What products are in it? Which ones are part of
another distinct industry?
■ What is the geographic scope of competition?
Identify the participants and segment them into
groups, if appropriate:
Who are
■ the buyers and buyer groups?
■ the suppliers and supplier groups?
■ the competitors?
■ the substitutes?
■ the potential entrants?
Assess the underlying drivers of each competitive
force to determine which forces are strong and which
are weak and why.
Determine overall industry structure, and test the
analysis for consistency:
■ Why is the level of profi tability what it is?
■ Which are the controlling forces for profi tability?
■ Is the industry analysis consistent with actual
long-run profitability?
■ Are more-profi table players better positioned in
relation to the five forces?
Analyze recent and likely future changes in each
force, both positive and negative.
Identify aspects of industry structure that might be
influenced by competitors, by new entrants, or by
your company.
Common Pitfalls
In conducting the analysis avoid the following common mistakes:
■ Defining the industry too broadly or too narrowly.
■ Making lists instead of engaging in rigorous
analysis.
■ Paying equal attention to all of the forces rather than
digging deeply into the most important ones.
■ Confusing effect (price sensitivity) with cause
(buyer economics).
■ Using static analysis that ignores industry trends.
■ Confusing cyclical or transient changes with true
structural changes.
■ Using the framework to declare an industry attractive
or unattractive rather than using it to guide strategic
choices.
hbr.org
12/5/07 5:35:20 PM
Competition and Value
P.C. Vey
The competitive forces reveal the drivers of industry competition. A company strategist who understands that competition extends well beyond existing rivals will detect wider
competitive threats and be better equipped to address them.
At the same time, thinking comprehensively about an industry’s structure can uncover opportunities: differences in
customers, suppliers, substitutes, potential entrants, and rivals that can become the basis for distinct strategies yielding
superior performance. In a world of more open competition
and relentless change, it is more important than ever to
think structurally about competition.
Understanding industry structure is equally important
for investors as for managers. The five competitive forces
reveal whether an industry is truly attractive, and they help
investors anticipate positive or negative shifts in industry
structure before they are obvious. The five forces distinguish
short-term blips from structural changes and allow investors
to take advantage of undue pessimism or optimism. Those
companies whose strategies have industry-transforming
potential become far clearer. This deeper thinking about
competition is a more powerful way to achieve genuine
investment success than the financial projections and trend
extrapolation that dominate today’s investment analysis.
If both executives and investors looked at competition
this way, capital markets would be a far more effective force
for company success and economic prosperity. Executives
and investors would both be focused on the same fundamentals that drive sustained profitability. The conversation
between investors and executives would focus on the structural, not the transient. Imagine the improvement in company performance – and in the economy as a whole – if all
the energy expended in “pleasing the Street” were redirected
toward the factors that create true economic value.
1. For a discussion of the value chain framework, see Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (The Free
Press, 1998).
2. For a discussion of how internet technology improves the attractiveness of
some industries while eroding the profitability of others, see Michael E. Porter,
“Strategy and the Internet” (HBR, March 2001).
3. See, for instance, Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition
(Currency Doubleday, 1996).
Reprint R0801E
To order, see page 139.
“Do you have to barge into my office every day and talk about work?”
hbr.org
1808 Porter.indd 93
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January 2008
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Harvard Business Review 93
12/5/07 5:35:27 PM
THE EXTERNAL ENVIRONMENT
1
FIRMS CONSTANTLY NEED TO RESPOND
TO THE EXTERNAL ENVIRONMENT
• Soft drinks companies and restaurant chains:
Public health concerns re: obesity and diabetes
• Pharmaceutical companies: Demographic
trends (need more research on geriatric
diseases now that people tend to live longer)
• Real estate firms: Geographic trends within and
across states
• MNCs: Tax differences between countries
2
The External
Environment
3
THREE LEVELS OF ANALYSIS
• General environment
– We will analyze using six segments
• Industry environment
– We will analyze using Porter’s five forces model
• Competitor environment
– We will analyze through competitive dynamics, in
a separate presentation
4
EXTERNAL ENVIRONMENTAL ANALYSIS
• A continuous process which includes
– Scanning for early signals of potential
changes and trends in the general environment
– Monitoring changes to see if a trend emerges from among
those spotted by scanning
– Forecasting projections of outcomes based on monitored
changes and trends
– Assessing the timing and significance of changes and trends
on the strategic management of the firm
5
THE ECONOMIC SEGMENT
– Inflation rates
– Interest rates
– Trade deficits or surpluses
– Budget deficits or
surpluses
– Personal savings rate
– Business savings rates
– Gross domestic product
6
THE SOCIOCULTURAL SEGMENT
– Women in the workplace
– Workforce diversity
– Attitudes about quality of
work-life
– Concerns about environment
– Shifts in work and career
preferences
– Shifts in product and service
preferences
7
THE GLOBAL SEGMENT
– Product innovations
– Applications of knowledge
– Focus of private and
government-supported R&D
expenditures
– New communication
technologies
– Challenges for a firm to
remain just when there are
few institutional constraints
8
THE TECHNOLOGICAL SEGMENT
– Product innovations
– Applications of knowledge
– Focus of private and
government-supported
R&D expenditures
– New communication
technologies
9
THE POLITICAL/LEGAL SEGMENT
– Antitrust laws
– Taxation laws
– Deregulation philosophies
– Labor training laws
– Educational philosophies
and policies
10
THE DEMOGRAPHIC SEGMENT
– Population size
– Age structure
– Geographic distribution
– Ethnic mix
– Income distribution
11
THE INDUSTRY ENVIRONMENT
• What is an industry?
– A group of firms producing products that are close
substitutes
• Firms that influence one another
• Includes a rich mix of competitive strategies that
companies use in pursuing strategic competitiveness
and above-average returns
• The product offerings exhibit cross-elasticity of demand
12
PORTER’S FIVE FORCES MODEL
13
THREAT OF NEW ENTRANTS
• Mitigated by Barriers to Entry








Economies of scale
Product differentiation
Capital requirements
Switching costs
Access to distribution channels
Cost disadvantages independent of scale
Government policy
Expected retaliation
14
BARGAINING POWER OF SUPPLIERS
• Supplier power increases when:
– Suppliers are large and few in number
– Suitable substitute products are not available
– Individual buyers are not large customers of suppliers
and there are many of them
– Suppliers’ goods are critical to buyers’ marketplace
success
– Suppliers’ products create high switching costs.
– Suppliers pose a threat to integrate forward into buyers’
industry
15
THREAT OF SUBSTITUTE PRODUCTS
• Example: Video Conferencing is a substitute for air
travel
• The threat of substitute products increases when:
– Buyers face few switching costs
– The substitute product’s price is lower
– Substitute product’s quality and performance are equal
to or greater than the existing product
• Differentiated industry products that are valued by
customers reduce this threat
16
COMPETITIVE RIVALRY
• Industry rivalry increases when:




There are numerous or equally balanced competitors
Industry growth slows or declines
There are high fixed costs or high storage costs
There is a lack of differentiation opportunities or low
switching costs
– When the strategic stakes are high
– When high exit barriers prevent competitors from leaving the
industry
17
INTERPRETING INDUSTRY ANALYSES
Low entry barriers
Suppliers and buyers
have strong positions
Strong threats from
substitute products
Intense rivalry
among competitors
All suggest an
unattractive
industry
Low profit potential
18
INTERPRETING INDUSTRY ANALYSES
High entry barriers
Suppliers and buyers
have weak positions
Few threats from
substitute products
Moderate rivalry
among competitors
All suggest an
attractive
industry
High profit potential
19
[In order to understand this assignment, you will have to read the PPT on “External
Environment” that is uploaded under “Course Documents”. It contains information
about the five forces.]
In defending his famous 5-Forces model, Michael Porter had suggested that the
airline industry was an example of a “bad” industry, where the five forces were
against incumbents. http://www.youtube.com/watch?v=mYF2_FBCvXw. Also, in his 2008
HBR article (attached), he has a chart on page 83 where airlines are at the bottom of
the list (average ROIC 1992-2006 was 5.9%, the lowest, compared to >40% for
security brokers, and >37% for soft drinks and packaged software).
However, in 2012, we heard a different story, as we can see in this NYT report

Now the incumbents are sitting pretty.
Please write a 500-word essay with an original title where I would like you to comment on two
things:
1. Did circumstances change since 2008, or is Porter’s argument flawed?
2. Are there any technology issues that need to be addressed? (Remember, the internet was especially
unkind to the airlines, when passengers used their enhanced access to information to bargain down
prices. How did the airlines solve this problem? You can argue that technology is incidental here
(regulation, fuel prices and other issues might be more explanatory), but do offer an assessment on
the role of technology in this industry.

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