Analyse an industry through the five competitive forces
The idea
Industry profitability is shaped by the threat of new entrants, which depends on barriers such as scale, capital requirements and regulation; the bargaining power of suppliers and of buyers, each stronger when concentrated or when switching is easy for them and hard for the other side; the threat of substitutes performing the same function differently; and the intensity of rivalry among existing competitors, which rises with fixed costs, slow growth and undifferentiated products. The framework explains why some industries sustain high returns for decades while others compete their profits away.
A practice question
Which factor raises barriers to entry in an industry?
- Low capital requirementsWhy not: Cheap entry is what makes an industry easy to enter, which is the opposite of a barrier.
- Large economies of scale - correct
- Rapid industry growthWhy not: Growth attracts entrants by making room for them, so it tends to lower the practical obstacle to entering.
Barriers to entry are obstacles that keep new firms out. Economies of scale means cost per unit falls as output rises: Unit cost = Total cost / Units produced. A newcomer too small to reach efficient size faces a lasting cost disadvantage. For example, if an incumbent making 10 million units has a unit cost of $4 and a start-up making 1 million units has $7, the start-up cannot match the price and still profit. Low capital needs and rapid growth make entry easier, not harder.
A harder one
Arkwright Components, a listed supplier, sells standard brake parts that rivals also make. Three automakers account for 70% of its sales, and each can move orders to rival suppliers at little cost. An analyst, Beth Cole, uses Porter's five forces to assess the bargaining power of Arkwright's buyers. What should she conclude?
- Weak, because few buyers depend on a single supplierWhy not: Concentrated buyers each control large volume, and with standard parts and low switching costs they do not depend on one supplier. The dependence runs the other way.
- Strong, but only because the buyers are so fewWhy not: Concentration is only half the answer. Low switching costs are what make the threat to withdraw volume credible, so both conditions together produce the strength.
- Strong, because buyers are few and can switch easily - correct
Porter's five forces is a way to judge industry competition. Buyer power is the ability of customers to push down prices. It is strong when buyers are few and can switch supplier easily. Here three automakers take 70% of sales, so each controls a large volume. The parts are standard and rivals make them, and switching costs are low, so the threat to move orders is believable. Both conditions together hand margin to the customers. Beth should conclude buyer power is strong. The dependence runs from Arkwright to the buyers, not the other way.
The hardest tier
Why does an industry with high fixed costs and slow growth tend toward intense rivalry?
- Because price cutting is the way to fill capacity - correct
- Because high fixed costs attract new entrantsWhy not: High fixed costs deter entry: they are a barrier, which is why they reduce the number of competitors rather than adding to it.
- Because slow growth reduces the number of competitorsWhy not: Slow growth eventually forces exit, but that is the shakeout resolving the rivalry, not a reason there is none.
Fixed costs are costs that do not change with output, such as plant. When they are high, the cost of each extra unit (marginal cost) is far below the average cost. Rule: any price above marginal cost adds to profit by covering some fixed cost. With slow growth, extra volume can only be won from rivals, so every firm has a reason to cut prices to fill its capacity. As all firms do this at once, rivalry becomes intense. High fixed costs keep new entrants out, so they do not explain it.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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