Writing Assignment
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Editor’s Note: In 1979, Harvard Business Review published “How Competitive Forces Shape Strat-
egy” by a young economist and associate professor,
Michael E. Porter. It was his fi rst HBR article, and it
started a revolution in the strategy fi eld. In subsequent
decades, Porter has brought his signature economic
rigor to the study of competitive strategy for corpora-
tions, regions, nations, and, more recently, health care
and philanthropy. “Porter’s fi ve 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 reaffi rms, 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.
THE FIVE COMPETITIVE FORCES THAT
by Michael E. Porter
hbr.org | January 2008 | Harvard Business Review 79
SHAPE
IN ESSENCE, the job of the strategist is to under-
STRATEGYSTRATEGY stand and cope with competition. Often, however, managers defi ne competition too narrowly, as if it occurred only among today’s direct competi- tors. Yet competition for profi ts goes beyond es- tablished industry rivals to include four other competitive forces as well: customers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all fi ve forces defi nes 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 driv- ers of profi tability 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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80 Harvard Business Review | January 2008 | hbr.org
delivery industry in Europe. But to under- stand industry competition and profi tabil- ity in each of those three cases, one must analyze the industry’s underlying struc- ture in terms of the fi ve forces. (See the ex- hibit “The Five Forces That Shape Industry Competition.”)
If the forces are intense, as they are in such industries as airlines, textiles, and ho- tels, almost no company earns attractive re- turns on investment. If the forces are benign, as they are in industries such as software, soft drinks, and toiletries, many companies are profi table. Industry structure drives competition and profi tability, 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 profi tability in the short run – including the weather and the business cycle – industry structure, manifested in the competitive forces, sets industry profi tability in the medium and long run. (See the exhibit “Differences in Industry Profi tability.”)
Understanding the competitive forces, and their under- lying causes, reveals the roots of an industry’s current profi t- ability while providing a framework for anticipating and infl uencing competition (and profi tability) over time. A healthy industry structure should be as much a competitive concern to strategists as their company’s own position. Un- derstanding industry structure is also essential to effective strategic positioning. As we will see, defending against the competitive forces and shaping them in a company’s favor are crucial to strategy.
Forces That Shape Competition The confi guration of the fi ve forces differs by industry. In the market for commercial aircraft, fi erce rivalry between dominant producers Airbus and Boeing and the bargain- ing power of the airlines that place huge orders for aircraft are strong, while the threat of entry, the threat of substi- tutes, and the power of suppliers are more benign. In the movie theater industry, the proliferation of substitute forms of entertainment and the power of the movie producers and distributors who supply movies, the critical input, are important.
The strongest competitive force or forces determine the profi tability of an industry and become the most important to strategy formulation. The most salient force, however, is not always obvious.
For example, even though rivalry is often fi erce in com- modity industries, it may not be the factor limiting profi t- ability. Low returns in the photographic fi lm industry, for instance, are the result of a superior substitute product – as Kodak and Fuji, the world’s leading producers of photo- graphic fi lm, learned with the advent of digital photography. In such a situation, coping with the substitute product be- comes the number one strategic priority.
Industry structure grows out of a set of economic and technical characteristics that determine the strength of each competitive force. We will examine these drivers in the pages that follow, taking the perspective of an incumbent, or a company already present in the industry. The analysis can be readily extended to understand the challenges facing a potential entrant.
THREAT OF ENTRY. New entrants to an industry bring new capacity and a desire to gain market share that puts pressure on prices, costs, and the rate of investment nec- essary to compete. Particularly when new entrants are diversifying from other markets, they can leverage exist- ing capabilities and cash fl ows to shake up competition, as Pepsi did when it entered the bottled water industry, Micro- soft did when it began to offer internet browsers, and Apple did when it entered the music distribution business.
Michael E. Porter is the Bishop William Lawrence University Pro-
fessor at Harvard University, based at Harvard Business School in
Boston. He is a six-time McKinsey Award winner, including for his
most recent HBR article, “Strategy and Society,” coauthored with
Mark R. Kramer (December 2006).
The Five Forces That Shape Industry Competition
Bargaining Power of Suppliers
Threat of New
Entrants
Bargaining Power of Buyers
Threat of Substitute Products or
Services
Rivalry Among Existing
Competitors
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The threat of entry, therefore, puts a cap on the profi t po- tential 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 in- vest 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 en- trants 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 profi t- ability is moderated. It is the threat of entry, not whether entry actually occurs, that holds down profi tability.
Barriers to entry. Entry barriers are advantages that incum- bents have relative to new entrants. There are seven major sources:
1. Supply-side economies of scale. These economies arise when fi rms that produce at larger volumes enjoy lower costs per unit because they can spread fi xed costs over more units, employ more effi cient 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 com- petitors, 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 fabrica- tion, 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 small- package delivery, economies of scale arise in national logisti- cal systems and information technology.
2. Demand-side benefi ts of scale. These benefi ts, also known as network effects, arise in industries where a buyer’s willing- ness to pay for a company’s product increases with the num- ber of other buyers who also patronize the company. Buyers may trust larger companies more for a crucial product: Re- call the old adage that no one ever got fi red 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 benefi ts of scale discourage
entry by limiting the willingness of customers to buy from a newcomer and by reducing the price the newcomer can com- mand until it builds up a large base of customers.
3. Customer switching costs. Switching costs are fi xed costs that buyers face when they change suppliers. Such costs may arise because a buyer who switches vendors must, for ex- ample, alter product specifi cations, 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 en- trant 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 ex- ample, the costs of moving to a new vendor are astronomical
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 fi nan- cial resources in order to compete can deter new entrants. Capital may be necessary not only for fi xed facilities but also to extend customer credit, build inventories, and fund start- up losses. The barrier is particularly great if the capital is required for unrecoverable and therefore harder-to-fi nance expenditures, such as up-front advertising or research and development. While major corporations have the fi nancial resources to invade almost any industry, the huge capital requirements in certain fi elds limit the pool of likely en- trants. Conversely, in such fi elds 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 at- tractive and are expected to remain so, and if capital markets are effi cient, investors will provide entrants with the funds they need. For aspiring air carriers, for instance, fi nancing is available to purchase expensive aircraft because of their high resale value, one reason why there have been numer- ous new airlines in almost every region.
5. Incumbency advantages independent of size. No matter what their size, incumbents may have cost or quality advan- tages not available to potential rivals. These advantages can stem from such sources as proprietary technology, preferen- tial access to the best raw material sources, preemption of the most favorable geographic locations, established brand identities, or cumulative experience that has allowed incum-
Industry structure drives competition and profi tability, not whether an industry is emerging or mature, high tech or low tech, regulated or unregulated.
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bents to learn how to produce more effi ciently. Entrants try to bypass such advantages. Upstart discounters such as Tar- get and Wal-Mart, for example, have located stores in free- standing sites rather than regional shopping centers where established department stores were well entrenched.
6. Unequal access to distribution channels. The new en- trant 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 lim- ited 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 distribu- tion 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 fl ights on the internet.
7. Restrictive government policy. Government policy can hinder or aid new entry directly, as well as amplify (or nul- lify) the other entry barriers. Government directly limits or even forecloses entry into industries through, for instance, licensing requirements and restrictions on foreign invest- ment. Regulated industries like liquor retailing, taxi services, and airlines are visible examples. Government policy can heighten other entry barriers through such means as ex- pansive patenting rules that protect proprietary technol- ogy 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 ba- sic research and making it available to all fi rms, new and old, reducing scale economies.
Entry barriers should be assessed relative to the capa- bilities of potential entrants, which may be start-ups, foreign fi rms, or companies in related industries. And, as some of our examples illustrate, the strategist must be mindful of the creative ways newcomers might fi nd to circumvent appar- ent barriers.
Expected retaliation. How potential entrants believe in- cumbents may react will also infl uence their decision to enter or stay out of an industry. If reaction is vigorous and protracted enough, the profi t 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 fi ght back,
including excess cash and unused borrowing power, avail-
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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 fi xed costs, which create a strong mo- tivation to drop prices to fi ll 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 fi nd ways to surmount the entry barriers without nullifying, through heavy invest- ment, the profi tability 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 par- ticipants. Powerful suppliers, including suppliers of labor, can squeeze profi tability out of an industry that is unable to pass on cost increases in its own prices. Microsoft, for in- stance, has contributed to the erosion of profi tability among personal computer makers by raising prices on operating systems. PC makers, competing fi ercely 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, exemplifi es this situation.
The supplier group does not depend heavily on the in- dustry for its revenues. Suppliers serving many industries will not hesitate to extract maximum profi ts from each one. If a particular industry accounts for a large portion of a sup- plier group’s volume or profi t, however, suppliers will want to protect the industry through reasonable pricing and as- sist in activities such as R&D and lobbying.
Industry participants face switching costs in changing suppliers. For example, shifting suppliers is diffi cult if com- panies have invested heavily in specialized ancillary equip-
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