The Five Competitive Forces That Shape Strategy

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The Five Competitive Forces That Shape Strategy

Competition for industry profits goes beyond the direct competitors in the business. It included four other competitive forces as well:

Customers
Suppliers
Potential entrants
Substitute products

This extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within the industry. Industry structure drives profitability, not products or services, or mature or emerging etc. Understanding industry structure is essential to effective strategy.

The strongest competitive force (among the five) determines profitability within the industry, though it is not always obvious what that is. Industry structure grows out of a set of economic and technical characteristics that determine the strength of each force.

Aircraft Manufacturing – industry rivalry fierce; new entrants, substitute products, power of suppliers not so much •Movie theatres – production houses strong; substitute products abound;

Threat of Entry

The threat of entry puts pressure on prices, costs and the rate of investment necessary to compete. This puts pressure on profitability. Competitors must hold down prices or boost investment to deter new entrants.

Barriers to Entry

1.Supply-side economies of scale: Occurs when firms that produce larger volumes enjoy lower cost per unit, because they can spread high fixed costs over a large number of units, or have more efficient technology, or can command better terms from suppliers. 2.Demand – side economies of Scale: Network effects. The desire of a consumer to buy a product increases with the number of other buyers that buy the product. 3.Customer Switching Costs: There may be costs to switching suppliers, such as retooling costs, retraining costs. ERP software has high switching costs, as does autoparts industries. 4.Capital Requirements: Need to invest large financial resources can deter new entrants. (Fixed costs, working capital, initial losses). If industry is attractive and capital markets are efficient, then capital need not be a barrier. 5.Incumbency Advantages: Proprietary technology, preferential access to resources, locations, brand identity. 6.Unequal Access to Distribution Channels: A new food item must displace others from limited shelf space in grocery stores; requires price breaks, promotion, intense selling. 7.Restrictive Government Policy: Licensing requirements for foreign investment. Or liquor licensing, or taxi services, airlines. Patents. Incumbents must be aware of potential ways that new entrants might find to overcome barriers. New entrants must be aware of potential retaliation by incumbents; they may have a history of fighting back; or substantial resources and a willingness to use them; willingness to cut prices.

The Power of Suppliers

Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services, of shifting costs to industry participants. They can squeeze profitability out of an industry.

Microsoft squeezes profitability out of PC makers by raising the price of its operating software, which has to be included in each PC. Customers are very price sensitive, and there are not high switching costs.

A supplier group is powerful if:

It is more concentrated than the industry it sells to;
The supplier group does not depend heavily on the industry it sells to; •Industry participants face switching costs in changing suppliers; •Suppliers offer products that are differentiated (pharma companies with patented drugs have power over hospitals and HMOs); •There is no substitute for what the supplier provides;

The supplier group can credibly threaten to integrate forward into the industry. If industry players make too much money, the supplier will do just that. Instead, he charges dearly for the product he supplies....
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