The competitive forces model, developed by Michael Porter and first printed in the Harvard Business Review in 1979, attempts to understand what makes businesses profitable. The model is often referred to as Porter's Five Forces as it states that there are five competitive forces being assessed. Porter contends that the major determinant of profitability for any firm is the type of industry the firm operates in. This dependence on the market has been discussed for years in economics from early theories of perfect competition to the other extreme of monopoly. The competitive forces model provides a useful and powerful tool for discovering where the profitability comes from. Perhaps more importantly for the businesses using it, it also provides strategies for continuing or even improving profitability.
The model is mainly used by firms analysing whether they should enter a market or assessing whether they should be in the market at all. However, as firms operate in a dynamic environment, it can also be used to try and figure out what areas of the industry can be improved to make it more profitable. It is also used by government departments when analysing whether firms in an industry are exploiting the public, for example by the Monopolies and Mergers commission in the UK or the Anti-Trust division of the Department of Justice in the USA.
The Five Forces
According to Porter there are five areas of the external environment that affect the profitability of the firm.
This force describes the ability of the firm's suppliers to dictate the terms under which they operate. Weak suppliers may have to accept the terms that the firm offers, which allows the firm to appropriate some of the value of the product for itself, effectively taking some of the profit from a firm higher up the production chain. However, strong suppliers can push prices of their goods higher than the firm wants to pay and reduce the profit margins.
There are several things that determine how much power a particular supplier has. The first is concentration of suppliers. If a firm's supplier has to compete with lots of other companies for business they are likely to accept more strict terms, after all the firm may decide to switch suppliers at short notice and any business is usually considered better than none. Another factor could be the importance of the component being supplied. A car manufacturer is more likely to cede power to its tyre suppliers than the company providing the rubber matting for the footwells.
Buyers can have a similar effect on profitability as suppliers, just in the other direction. A strong buyer can force prices down, reducing those profit margins, while weak buyers can be exploited for all they're worth. Again concentration is an issue. If the firm has only a very limited number of customers they are likely to wield more power than the customers in, say, a retail environment.
Similarly, if buyers are buying a large proportion of the firm's output they will have more say than a group that only wants to purchase a couple of units. Repeated interactions also favour buyers who then have the chance to go elsewhere if they feel unfairly exploited on a transaction.
Threat of New Entrants
Obviously, the last thing established firms want is someone else taking their profits, but this is always a possibility if other people can enter the industry easily. High profits in incumbent firms always attract attention, so profitable firms in easily accessible industries are constantly under pressure from new competitors. The most profitable industries are those that are very difficult to enter. They have barriers preventing entry by other companies. These barriers may take the form of exclusive access to raw materials, or the requirement of massive investment in technology, or patent protection; anything that gives the incumbent an unfair advantage.
Threat of Substitutes
Again, this is very similar to the threat of new entrants. If customers can get another product that does a similar job, they will not accept excessive profits in an industry. For example, if oil producers started charging too much for petrol, there would be swathes of people moving to riding bicycles instead of driving their cars. For the firm, the most desirable position is where there are no substitute products.
This is the force that can really swing things in favour of, or against, a profitable industry. An industry where all the incumbent firms hotly contest every little piece of custom is not going to be as attractive as an industry where the firms are just happy with the customers they've got. It is certainly far easier to carve out a consistent niche in the latter which allows profits to continue more certainly into the long term.
The Generic Strategies
So the analysis is finished but the industry isn't all that profitable. So how come there are still some firms making profits? Surely they should all be struggling together getting similar returns? Porter suggests that any firm can be profitable in any industry (even those unprofitable ones), it all depends on the strategy that the firm adopts. There are two significant strategies that any firm can follow to improve their profitability. The firms that fail are those that do not follow any strategy, or try to follow both. These firms get 'stuck in the middle'.
The firm adopts a position trying to minimise all its expenses. It should set prices below other firms in the market. Ordinarily this would seriously constrain profit margins, but the second aspect of this is that the costs of providing the product are pushed down even further so even though the firm sells at a lower price it still makes more profit than other firms in the industry.
If the firm's competitors are trying to undercut the prices of its products, there are two choices. Fight them in a price war to keep matching or undercutting their prices, or make the products different so that it doesn't matter how low their prices go, there will still be some customers that prefer the goods that the firm produces. The price war has a tendency to reduce profits almost completely, so obviously a different product is the slightly more desirable method. This is why there are so many subtly different products on the supermarket shelves.