Saturday, September 09, 2006

Competitive Strategy: The Five Forces (Part 1)

When pursuing a qualitative analysis of a business, one of the key components of an analysis is the competitive dynamics of the industry the business is in. Michael Porter, in his book, competitive strategy, outlined the five key forces that determine the profitability of an industry. And while these five forces are not exhaustive, they form a useful guide to analysing a firm's competitive environment.

Force 1: Internal Rivalry Within the Industry

Internal rivalry refers to the state of competition between companies in the industry itself. A company in an industry characterised by low competition is likely to exhibit high amounts of abnormal profits. For example, Microsoft competes in the operating system industry, and has very little competition in this area. For all practical purposes, the company has a monopoly in the desktop operating system market, and faces very little competition. This enables it to raise prices and maximise profit, without having to worry about competitors undercutting its prices to compete away market share. A company such as Microsoft is said to be a price maker, since it has much power to set the prices of its Windows products.

Conversely, a business that is in an industry with a highly competitive market structure is likely to be a price taker. This means that it is forced to take the price that is set by the market. For example, the average soybean farmer's produce, with his few acres of farmland, only constitutes a drop in the ocean amongst the global soybean market. As an individual producer, the farmer has no say on the price of soybeans, since any attempt to sell his produce above the market rate will fail (nobody will buy his soybeans since they can get the same product at a cheaper price), and besides, he has no incentive to sell below the market rate when he can clear his barns at the going rate.

It therefore follows that companies that are within a competitive industry should seek to shape the competitive landscape so as to minimise competition, and derive competitive advantage. This, however, is the subject of another essay.

Force 2: Potential Entrants/Barriers to Entry

Even though a company might be in an industry with little competition, the competitive landscape of the industry can change rapidly once new competitors enter the industry. Thus, industries are attractive to the extent that there exist barriers to entry into the industry. For instance regional newspapers often operate with high barriers to entry. The large amount of fixed costs involved with purchasing and setting up printing equipment, coupled with the high editorial and administrative costs that are necessary to maintain a newspaper, prevent competitors from entering small regional markets. Customer brand loyalty can also create large barriers to entry, since there is little incentive for a reader to switch newspapers when he or she has been reading it for the last 20 years. High barriers to entry deter competition, and in turn help to maintain abnormal profits associated with lesser amounts of competition.

Conversely, an industry with low barriers to entry will invite competition, and companies in the industry will see any abnormal profits competed away rather quickly. For example, it is easy to set up a lemonade stall along the beach to sell drinks to passers by. Any abnormal profits, however, will quickly attract competitors who will rapidly compete away these profits. The lack of barriers to entry allows other enterprising individuals to quickly enter the lemonade market, and the lemonade stall owner can do little to keep them out.

No comments: