Five Forces

Porter's five forces analysis is a framework for industry analysis and business strategy development formed by Michael E. Porter of Harvard Business School in 1979. It draws upon industrial organization (IO) economics to derive five forces that determine the competitive intensity and therefore attractiveness of a market. Attractiveness in this context refers to the overall industry profitability.

Internal rivalry refers to the jockeying for share by firms within a market. Thus, an analysis of internal rivalry must begin by defining the market. All the firms that constrain each other's strategic decision making have to be included. It is necessary to pay atten tion to both the product market and the geographic market definitions. Firms may compete on a number of price and non-price dimensions. Price competitions erode profits by driving down price cost-margins. Non-price competitions erode profits by driving up fixed costs and marginal costs. Obviously, it is easier to pass cost increases along to the consumers if we are not competing on price.

A firm reduces prices if it believes it can gain market share by doing so. Hence, the incentives for a firm to reduce price are related to the degree to which it expects its market share to increase.

* There are many sellers in the market  prices are lower when there are many firms in the market.

* The industry is stagnant or declining  firms cannot expand without stealing from the competitors.

* Undifferentiated products with low switching costs  firms are tempted to undercut their rivals prices because this can generate a substantial increase in market share.

* Large sales orders  a firm may be tempted to undercut its rivals to secure a particularly large order.

* Strong exit barriers  prolong price wars

Entry divides up the market demand among more sellers and decrease market concentration, heating up internal rivalry and reducing price-cost margins. Although most entry barriers are structural, some are strategic. The following ones tend to affect the treat of entry:

* Production entails significant economies of scale  this increases the risk of entry.

* Consumers are brand loyal Entrants must invest heavily to establish a strong reputation.

* Access of entrants to key inputs  patents, unique locations, etc can all be natural barriers to entry. The new firm may overpay in order to tie up unique inputs.

* Start up investment  As big as it is, less likely new firms would like to compete.

Although the five-forces analysis does not directly consider demand, it does consider two important factors that influence demand - substitutes and complements. Substitutes