COURSE NOTES FOR SPRING
Competitive Forces and Strategy - Feb. 16, 2000

Porter poses four contending forces that affect the competitive situation. These are:

• Threat of New Entrants
• Bargaining Power of Suppliers
• Bargaining Power of Buyers
• Threat of Substitutes

New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. The seriousness of the threat of entry depends on the barriers present and on the reaction from existing competitors that the entrant can expect. The six major entry barriers are:

1. Economies of scale. This may force an aspirant either to come in on a large scale or to accept a cost disadvantage.

2. Product differentiation. Brand identification creates a barrier by forcing entrants to spend heavily to overcome customer loyalty.

3. Capital requirements. The need to invest large financial resources in order to compete creates a barrier to entry, especially if the capital is required for unrecoverable expenditures in up-front advertising or R&D.

4. Cost disadvantages independent of size. Entrenched companies may have cost advantages not available to potential rivals, such as effects of the learning curve (and the experience curve), proprietary technology, access to the best raw materials sources, assets purchased at preinflation prices, government subsidies, or favorable locations.

5. Access to distribution channels. The more limited the wholesale or retail channels are and the more that existing competitors have those tied up, the tougher that entry into the industry will be.

6. Government policy. The government can limit or even foreclose entry to industries with such controls as license requirements and limits on access to raw materials.

The power of each important supplier or buyer group depends on a number of characteristics of its market situation and on the relative importance of its sales or purchases to the industry when compared with its overall business.

A supplier group is powerful if:

• It is dominated by a few companies and is more concentrated than the industry it sells to.

• Its product is unique or at least differentiated, or if it has built up switching costs (fixed costs buyers face in changing suppliers).

• It is not obliged to contend with other products for sale to the industry. The example Porter uses is the competition between the steel companies and the aluminum companies to sell to the can industry; each checks the power of the other.

• It poses a credible threat of integrating forward into the industry's business.

• The industry is not an important customer of the supplier group.

A buyer group is powerful if:

• It is concentrated or purchases in large volumes.

• The products it purchases from the industry are standard or undifferentiated.

• The products it purchases from the industry form a component of its product and represent a significant fraction of its cost. The buyers are likely to shop for a favorable price and purchase selectively.

• It earns low profits, which create great incentive to lower its purchasing costs.

• The industry's product is unimportant to the quality of the buyers' products or services. If the quality of the buyers' products is very much affected, buyers are generally less price sensitive.

• The industry's product does not save the buyer money. Where the industry's product or service can pay for itself many times over, the buyer is rarely price sensitive; rather, he is interested in quality.

• The buyers pose a credible threat of integrating backward to make the industry's product.

Many of these attributes are attributable to consumers as well. 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 quality is not particularly important.

By placing a ceiling on prices it can charge, substitute products or services limit the potential of an industry. Substitute products that deserve the most attention strategically are those that are (1) subject to trends improving their price-performance trade-off with the industry's product, or (2) produced by industries earning high profits. Substitutes often come rapidly into play if some development increases competition in the industries and causes price reduction or performance improvement.

Determinants of substitute threat include:

• Relative price performance of substitutes
• Switching costs
• Buyer propensity to substitute

Rivalry among existing competitors takes the form of jockeying for position - using tactics like price competition, product introduction, and advertising. Intense rivalry is related to the presence of a number of factors:

• Competitors are numerous or are roughly equal in size and power.

• Industry growth is slow, precipitating fights for market share.

• The product or service lacks differentiation or switching costs.

• Fixed costs are high or the product is perishable, creating strong temptations to cut prices.

• Capacity is normally augmented in large increments. This can lead to periods of overcapacity and price cutting.

• Exit barriers are high. Exit barriers, like very specialized assets or management's loyalty to a particular business, keep companies competing even though they may be earning low or even negative returns on investment.

• The rivals are diverse in strategies, origins, and "personalities." They have different ideas about how to compete and continually run head on into each other in the process.

We will discuss in class some of the generic strategies companies can take when re-positioning and re-thinking strategy.

Page revised Feb. 15, 2000.