Lecture 8Industry Analysis: Porter’s

Five Forces Model

Overview

Performing a Five-Forces Analysis– Internal rivalry– Entry– Substitutes and complements– Supplier power – Buyer power

Applying the Five Forces– Wine industry– Airline manufacturing

2

Industry Analysis

Industry analysis facilitates– assessment of industry and firm performance– identification of factors that affect

performance– determination of the effect of changes in the

business environment on performance– identification of opportunities and threats –

SWOT Analysis

Porter’s Five-Forces Model

Michael Porter developed a model for industry analysis that incorporates many of the concepts we have studied so far. http://www.youtube.com/watch?v=mYF2_FBCvXw

If we want to understand the nature and intensity of competition among firms in a market, we must understand the outside forces acting on firms in that industry. These forces include supplier power, buyer power, the threat of substitutes, and the threat of entry. We must also understand the market structure of the industry that inherently affects internal rivalry.

When there are only a few firms in an industry, and those firms are somewhat insulated from the other four forces, then the internal rivalry aspect of a market gets interesting.

Internal Rivalry

Internal rivalry is the competition for market share among the firms in the industryCompetition could be on price or some

non-price dimensionPrice competition erodes the price cost

margin and profitability

Internal Rivalry

Competition on non-price dimension can drive up costsTo the extent customers are willing to pay

a higher price for improvements in the non-price dimensions, non-price competition does not erode profits as severely as price competition

Internal Rivalry: Conditions that Increase Price Competition

Presence of many sellers – prices are lower when there are many firms in the marketStagnant or declining industrySome firms’ cost advantage over othersExcess capacity Undifferentiated products/ low switching

costs

Internal Rivalry: Conditions that Increase Price Competition

Hard to observe prices and sale termsInability to adjust prices quicklyLarge and infrequent sales ordersAbsence of “facilitating practices” Absence of a history of cooperative pricingStrong exit barriers – firm would prefer to

operate at a loss than shut down in the short term

Internal Rivalry: Conditions that Increase Price Competition

Market demand for product is highly elastic

Entry

Entry hurts the incumbents in two different ways – Entry cuts into the incumbents’ market share– Entry intensifies internal rivalry and leads to a

decline in price cost margin

Factors that Affect the Threat of Entry

Minimum efficient scale is large relative to the size of the market—economies of scale or scopeBrand loyalty of consumers and value

placed by consumers on reputationEntrants’ access to critical resources such

as raw materials, technical know how, and distribution networkGovernment policies that favor the

incumbents

Factors that Affect the Threat of Entry

Steepness of the learning curveNetwork externalities that give the

incumbents the benefit of a large installed baseIncumbents’ reputation regarding post-

entry competitive behavior

Substitutes and Complements

Availability of substitutes erode the demand for the industry’s outputComplements boost industry demandWhen the price elasticity of demand is

large, pressure from substitutes will be significantChange in demand can in turn affect

internal rivalry and entry/exit

Supplier Power

Suppliers can erode the profitability of downstream firms – If the upstream industry is concentrated,

suppliers can increase prices, to extract profits from the downstream firm

– If the customers are locked into the relationship through relationship-specific assets, there are costs associated with switching suppliers. Supplier can raise prices without firm switching to a competing supplier.

Assessing Supplier Power

The factors that determine supplier power– Competitiveness of the input market– Relative concentration of upstream and

downstream firms– Purchase volume by downstream firms– Extent of relationship-specific investments—

threat of hold-up– Availability of substitute inputs– Threat of forward integration by suppliers– Suppliers’ ability to price discriminate

Assessing Buyer Power

Factors that determine buyer power are analogous to those that determine supplier powerEven when there is no buyer power,

willingness to shop for the best price can create internal rivalry among sellers and make the market price competitive

Some Strategies Regarding the Five Forces

Firms can position themselves to outperform their rivals by developing a cost advantage or a differentiation advantageFirms can seek an industry segment

where the five forces are less severe

Some Strategies Regarding the Five Forces

Firms can try to change the five forces– By reducing internal rivalry by increasing the

switching costs,– By adopting entry deterring strategies, or– By reducing supplier/buyer power through

vertical integration

“Five Forces” and “Value Net”

The five forces framework tends to view other firms – competitors, suppliers or buyers – as threats to profitabilityIn the Value Net model (Brandenberger

and Nalebuff) interactions between firms can be positive or negative

Examples of Cooperative Interactions Among Firms

Firms cooperate in setting industry standards that facilitate industry growth Firms cooperate in lobbying for favorable

regulation or legislationFirms cooperate with their suppliers to

improve product quality and thus boost demand

More Examples of Cooperative Interactions Among Firms

Firms cooperate with their suppliers to improve productive efficiencyFirms cooperate with buyers/suppliers to

improve inventory management

The Value Net Concept

The value net consists of – Suppliers– Customers– Competitors and– Complementors (producers of complementary goods

and services) Considers both threats and opportunities posed by the

five forces Complete five forces analysis should aslo consider

opportunities

Value Net Illustration: DVD

When DVD was introduced, sales were lack luster and DIVX was a major threatThen manufacturers cut prices on some

models and advertised heavilyOther members of the value net chipped in

– Movie studios released popular titles in DVD format and priced them moderately

– Retailers promoted the DVD hardware and software

Limitations to Five-Forces Analysis

Ignores other factors that can affect demand such as preferences and incomeDoes not consider advertisingIgnores the government

– Can be purchaser or supplier– Regulatory role

Purely qualitative

25

Five Forces Example for Wineries: Internal Rivalry

Rivalry = head-to-head competitionOften in each region, there are a small

number of large producers with the majority of market share, and a larger number of smaller producersGlobally, the wine industry is very

competitive– Wineries compete for shelf space

Five Forces Example for Wineries: Internal Rivalry

Within regions, competition at local levels is important to industry’s successWineries compete for customers through

tasting room as well as on retailer’s shelf– Wineries compete with other tourist

attractions

Five Forces Example for Wineries: Internal Rivalry

However, competitors can also be complementary for wineries:– When several wineries exist in close proximity

to each other, it is beneficial for all the wineries:

• They can establish the region as one known for quality wines

• Several wineries located in the same area create a greater tourist draw than a single winery

http://www.wavwines.com/

Five Forces Analysis of Wineries: Entry

Threat of new entrants is unique in the wine business– A winery is capital intensive. Market entry can

take multiple years due to initial production time to grow the vines and produce the wine.

• Buy juice initially

Five Forces Analysis of Wineries: Entry

May be a steep learning curveA strong knowledge of winemaking is

required to produce high-quality wines– Hire this labor?

Some barriers to entry

Five Forces / Wineries: Substitutes/Complements

Substitutes for wine include more than just beerWine is served with meals—complement

with fine foodA winery is also a holiday destination and

entertainment, and it competes against other holiday destinations

Five Forces / Wineries: Supplier Power

Several options for wineries: own vineyard (grow grapes), purchase grapes, purchase juiceRaw materials are commodity items and

vary cyclically in price– Over supply of grapes results in low price– Adverse growing conditions result in low yield

and high prices

Five Forces / Wineries: Supplier Power

Bargaining power of supplier may be increased if:– Winery needs specific type of grape– Small winery is not able to purchase large

quantities to receive volume discountSmall winery can offset second concern by

cooperating with other small wineries to purchase grapes/juice collectively

Five Forces / Wineries: Supplier Power

Labor is also an important componentQuality wine maker is important for

producing quality wines– Wine makers can work for multiple wineries– High quality wine maker commands a

premium price—more bargaining power

Five Forces Analysis of Wineries: Buyer Power

Wineries usually have three types of buyers:– Direct consumers– Wholesalers– Retailers

Wholesalers have a significant amount of bargaining power because they are few in number and have considerable influence over which wines are sold by retailers

Legislation in the U.S. restricts the ability of wineries to sell directly to retailers in some states

Five Forces Analysis of Wineries: Summary

Force Threat to ProfitsEntry Medium

Internal rivalry Medium to HighSupplier Power MediumBuyer Power MediumSubstitutes/

ComplementsMedium

Five Forces Analysis of Wineries: SummaryWine production appears to be a fairly

competitive industry with most wineries earning very little economic profit.

Commercial Airframe Manufacturing: Market Definition

Analysis limited to commercial aviationBoeing and Airbus compete globallyOther fringe players in aircraft with fewer

than 100 seats

Commercial Airframe Manufacturing: Internal RivalryAirbus is younger, established by an

European consortium (Great Britain, France, and Germany)Little product differentiationSome airlines have developed loyalties,

most have not– Some advantages to flying only planes from

one producer

Commercial Airframe Manufacturing: Internal RivalryStable market shares and reduced

incentive for price warsConditions in the industry make it difficult

to collude on priceCompete on both price and qulatiy

Commercial Airframe Manufacturing: Barriers to EntryHuge development costs

– Learning-by-doingBuyer reluctance to buy from startupsLeasing economiesCustomer loyalty to current suppliers

Commercial Airframe Manufacturing: Substitutes and ComplementsSmall plane manufacturers cut into demand for

Boeing and Airbus planes Increase in point to point flights As demand for air travel increases, airlines

switching back to larger planesOther forms of transportation could be

substitutes (High speed rail, driving your car)Fall in communication costs may reduce

business travel

Commercial Airframe Manufacturing: Supplier PowerBoeing and Airbus do not have the upper

hand in dealing with jet engine manufacturersOther part suppliers also deal directly with

airlinesUnionized labor has significant power

Commercial Airframe Manufacturing: Buyer PowerTwo kinds of buyers

– Airlines– Leasing companies

Each order could be of the order of 15% of annual sales revenueBuyers may cancel orders during

economic downturns

Commercial Airframe Manufacturing: Summary

Force Threat to ProfitsEntry Low

Internal rivalry Low to MediumSupplier Power MediumBuyer Power MediumSubstitutes/

ComplementsMedium