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Industrial organization is a field of study that examines the differences between the “perfect” competition among companies found in economics textbooks, and the “imperfect” competition found in the real world. One tool derived from the field is Michael Porter’s “five forces” analysis, from the very beginning of his seminal book, Competitive Strategy.

Porter developed the five forces analysis as a more rigorous variation of the widely used SWOT analysis. The framework focuses on the level of competition within an industry to evaluate a company’s strategic position. In contrast to the SWOT analysis, the five forces survey the business environment, rather than examining a particular firm itself. Along with the PEST analysis, it digs deeper into the Opportunities and Threats of the SWOT.

The Five Forces

The five forces Porter includes in his analysis comprise threats from new entrants to an industry, rivalry from existing firms in the industry, the threat of substitution from outside the industry, and the respective power of buyers and sellers. Let’s look at each in turn.

When a company has no competitors, they can charge almost any price for their product. As more and more competition enters the market, profits drop until joining the industry is not longer appealing to new ventures. Barriers to entry also deter this new competition and can result in monopolies if they become sufficiently high.

Some factors that increase barriers to entry:

• Required capital investments
• Key intellectual property
• Specialist knowledge or expertise
• Economies of scale
• Regulation, governmental or otherwise

Substitution products are not simply a different brand (Pepsi vs. Coke), but an alternative product or service altogether (cola vs. root beer vs. mineral water). These alternatives aren’t competitors, they are a different industry, but they do threaten to substitute and reduce demand. The demand elasticity of a product can be a good proxy for how vulnerable it is to substitution.

Some important factors to consider:

• Relative prices of potential substitutes
• Relative performance of potential substitutes
• Ease of switching
• Customer inertia
• Cost of switching

In an industry that has only one consumer or a handful of very powerful consumers, these buyers have a significant impact. When Walmart or McDonald’s changes its food safety standards, this can have a ripple effect through all of their suppliers. The greater the asymmetry between the buyer and the supplier (the closer the relationship is to a monopsony) the more buyers can push for lower prices.

More factors to consider:

• Cost of switching to a new supplier
• Information available to buyers
• Essentialness of product to the buyer(s)
• Price sensitivity of buyers
• Total size of the market

Suppliers is one market will be buyers in another, so the similar factors are at play (number of suppliers, cost of switching) but from a different angle. An additional factor to consider is the specialization of the supplier’s product, that is, whether they face threats of substitution.

Some other factors to consider:

• Employee solidarity
• Strength of distribution channels
• Existence of commodity products
• Ability of the buyer to move production in-house
• Influence of supplied item on cost

Where new entrants pose an external threat to companies, they also face competition from other established firms within their industry. Generally, the number and capability of competitors is the primary factor in determining the level of rivalry within a sector, but even excluding outright collusion, companies may adhere to informal codes of conduct that inhibit competition.

Specific factors that increase rivalry:

• Large number of firms
• Barriers to exit
• High fixed costs
• Low customer loyalty
• Slow market growth