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 that a new entrant cannot match — correct
- Rapid industry growthWhy not: Growth attracts entrants by making room for them, so it tends to lower the practical obstacle to entering.
An entrant unable to reach efficient scale faces a permanent cost disadvantage, which deters entry even where returns look attractive.
A harder one
An industry sells to three large customers who can readily change supplier. What does that imply?
- High buyer power, because buyers are concentrated and switching is easy for them — correct
- Low buyer power, because there are few buyers to organiseWhy not: Few buyers is the source of their power, not a limit on it: each one's volume is large enough to matter.
- No effect on profitability, since the number of buyers is a demand matterWhy not: Buyer concentration is one of the five forces precisely because it determines where the margin ends up.
Power comes from concentration on one side and from easy alternatives for the party holding it.
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.
Each competitor has a strong incentive to cut, and volume can only be won from rivals. With marginal cost far below average cost, any price above marginal cost improves the position of the firm cutting it, and when the market is not growing that logic applies to every competitor at once.
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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