Porter’s five-forces model - Business Environment

Porter’s model5 says that the structure of an industry and the ability of firms in that industry to act strategically depend upon the relative strengths of five forces: current competition, potential competition, the threat of substitute products, the power of buyers and the power of suppliers. Each of these five forces will be examined in turn. The case study at the end of this chapter uses this model to analyse the market for mobile phones.

Current competition
Current competition has already been considered under the heading of market structure but the important point to remember is that by acting strategically firm scan change the structure of the industry. Firms in a highly competitive market might be unhappy with the lack of power they have over various factors like pricing and may through their strategic actions try to change the situation. If they are successful there will be a change in the level of current competition and therefore in market structure.

Potential competition (or threat of new entry)
It has been shown that market structure or current competition affects the behavior of firms in an industry. However, looking at the number of firms in an industry does not provide the whole picture. It is possible that firms in an oligopolistic market might act in a way consistent with perfect competition because of the threat of potential competition. This threat can affect the behaviour of firms even if it does not happen. The degree of potential competition depends upon the existence and height of barriers to entry and exit.
Barriers to entry
Barriers to entry are any barriers which prevent or inhibit the entry of firms into the industry. There are several sources of barriers to entry.
Some industries are what are called ‘natural monopolies’ in that the production process is such that competition would be wasteful. The old public utilities are good examples of these, as it would be very wasteful for there to be two national grid systems in the electricity industry.Some production processes are subject to economies of scale. As firms grow in size, or as the scale of production increases, certain economies occur which serve to reduce the average cost of production. The scale of production can be increased in many ways, for example by increasing the capacity of the existing plant, by increasing the number of plants or by increasing the product range. Figure show the average cost of production changes as the scale of production changes.The downward-sloping part of the curve shows falling average cost or economies of scale. The upward-sloping part shows rising average cost or dis economies of scale. Economies of scale reduce average cost and therefore benefit the producer and also the consumer if they are passed on in lower prices. The sources of economies of scale are usually classified under three headings:technical; marketing; and financial.Technical economies come from increased specialization and indivisibilities. The larger the scale of production the more the production process can be broken down into its component parts and the greater the gain from specialization. There are certain indivisibilities involved in production, which only large firms can benefit from. For example, a small firm cannot have half a production line as that is meaningless, but might not be big enough to use a whole production line. Another type of indivisibility is involved in the notion of fixed costs. Fixed costs like the cost of rates or the fees of an accountant, for example, remain the same irrespective of the level of production. Therefore the greater the level of production, the lower will be the average cost of items as it is being spread over a larger output.Marketing economies come from spreading marketing costs over a larger output, so that average costs will be lower. The company can also take advantage of bulk buying, and will probably have a specialized department devoted to marketing.Financial economies come from the fact that larger companies find it easier and often cheaper to borrow capital.Added to these is risk diversification which is possible with larger companies as they may well have interests in other industries. All of these economies of scale give rise to falling average cost and therefore explain the downward-sloping part of the cost curve in Figure. Economies of scale are a very effective barrier to entry.If the incumbent firm in an industry has lower average cost as a result of economies of scale, it will be hard for a newcomer to compete effectively at a smaller scale of production. Gas, electricity and water are examples of this. The production processes of these goods are subject to economies of scale and it is therefore difficult for others to come into the market in competition with established firms. This is why such industries are called ‘natural monopolies’.Barriers to entry can be legal ones, as in the case of patents and franchises which serve to restrict competition and prevent new firms from entering an industry. Advertising and branding can also be barriers, in that industries where brand names are well established are difficult to enter without massive expenditure on advertising.Some industries require a high initial capital investment to enter, for example, dry cleaning, where the machinery is very expensive. Switching costs can also be regarded as a barrier to entry. If the consumer has to bear a cost in switching from one good to another that might be enough to deter the consumer from doing so and therefore serve as a barrier to entry. The recent practice of the building societies and banks of offering low fixed-rate mortgages with penalties for early withdrawal can be seen as an example of the introduction of switching costs into the market.
A contestable market is one in which there are no barriers to entry or exit. This means that all firms (even potential entrants) have access to the same technology and there are therefore no cost barriers to entry. It also means that there are no sunk or unrecoverable costs which would prevent a firm leaving the industry. It follows that it is possible to ensure that firms behave in a competitive way, even if the market structure they operate in is imperfectly competitive, by ensuring that the market is contestable. What is regulating market behaviour then is not actual competition but potential competition.
Barriers to exit
Exit barriers are those which prevent or deter exit from an industry; they are mainly related to the cost of leaving the industry. The cost of exit depends upon how industry-specific the assets of the firm are. If we take physical assets as an example, a printing press is highly specific to the printing industry and could not be used for anything other than printing. There will be a secondhand market for printing presses but it would probably have to be sold at a loss, therefore incurring a high cost. A van, however, would be different, as it is still a physical asset but one that would not be specific to a particular industry, therefore the loss involved in selling would be less. Generally speaking, the more industry-specific an asset is the lower will be the second-hand value and the higher the cost of exit. An intangible asset like knowledge of the market or expenditure on research and development cannot be resold and must be left in the market, and therefore is a sunk cost a non-recoverable cost.Barriers to entry and exit can be ‘innocent’ or can be deliberately erected.Economies of scale can be regarded as innocent barriers to entry since they are inherent in the production process. Advertising and branding can be thought of as deliberately erected barriers to entry since they increase the expense of any firm entering the market. Similarly, the introduction of penalty clauses on mortgages is a deliberately erected barrier since it incurs switching costs for the consumer.

Where innocent barriers to entry or exit are low, potential competition will be high and firms within such a market are faced with the choice of accepting the situation or deliberately erecting some barriers. This is an example of strategic behaviour on the part of firms; whether it is attempted or not depends on the likelihood of success and the relative costs and benefits. It is another area where game theory is used to formulate strategic possibilities.

The threat of substitute products
The threat from substitute products largely depends upon the nature of the goodbeing traded in the market and the extent of product differentiation. It has a clearimpact upon market structure, because if there are no substitutes for a good theproducer of that good will face little competition and have a great deal of marketpower. However, as was seen earlier, even industries which appear to be puremonopolies like the former British Rail face competition from substitutes sincethere are other ways to travel. Much of the expenditure by firms to differentiate their products is designed to reduce the threat from substitute products. The power of buyersSo far this chapter has concentrated on the competition between producers in a market, but the amount of competition between buyers will also have an impact on an industry. Markets will range from those where there are many buyers, as in the case of retailing, through markets where there are a small number of buyers, as in the case of car and parts manufacturers, to markets where there is only one buyer.
This latter type of market is called a monopsony, and it is the buyer who has a great deal of market power rather than the seller. An example of this is the coal industry,where the majority of output goes to the electricity producers. Increasingly in retailing the giant retailers are exerting a great deal of power over the manufacturers.TOYS ‘R’ US, the world’s largest toy retailer, is involved very early on by manufacturers in the design process for new toys and as a result gets many exclusives that are not available in other toy shops.
The level of buyer power could be measured in the same way as seller power but no data are collected centrally on the level of buyer concentration.It is clear, however, that there are many markets in which powerful buyers can and do exert a great deal of control over suppliers, and this power is an important source of marketing economies of scale. It is possible to put together the level of competition between producers and consumers in order to predict behaviour.For example, a market which consists of a single buyer and a single seller will have quite different characteristics from a market which has many buyers and sellers.The existence of strong buyers might have beneficial effects on the market as they could offset the power of strong producers or it could lead to higher seller concentration as sellers come together to counteract the power of the buyer.In markets where there are strong sellers and weak buyers the producers’ power can be offset by, for example, consumer advice centers or watch-dog bodies, as in the case of the former public utilities.

A distinction can be made between existing and potential customers. Existing customers are particularly significant to firms in industries where repeat orders are important or where goods are supplied on a regular basis, as in grocery retailing. It is no surprise that the large grocery retailers are using loyalty cards to increase the loyalty of existing customers. The power of existing customers is much lower where the firm supplies goods on a one-off basis, although the firm cannot disregard existing customers as this will affect its reputation and the ability to attract potential customers. Potential customers might be new to the market or can be buying from an existing competitor at present.

Power of suppliers
The power of suppliers over the firm is likely to be extremely important in certain markets, depending upon the nature of the product being supplied. For example: Is the product highly specialized? Is the same or similar product available from elsewhere?
How important is the product in the production process? The importance of good and reliable supplies has assumed greater significance since firms have started to adopt just-in-time production methods. Reducing stock levels to reduce costs can only be effective if firms can depend upon their suppliers; hence there has been the development of partnership sourcing as firms develop long-term relationships with their suppliers.

Another important factor here is whether or not the firm itself can produce the components it needs in the production process. If it can the power of suppliers is greatly reduced. The decision as to whether to produce or to buy from a supplier is the subject of a relatively new area of economics called transaction cost economics.

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