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    The Five Competitive Forces That Shape Strategy - En.es

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    Armando M. Tobon
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    2 OCU BU ee UC mun mel aR Cee ia Cie tated Pi CU cer em RUC aC ec eMC el eerie) i i THE FIVE COMPETITIVE FORCES THAT SHAPE STRATEGY by Michael E. Porter Editor's Note: In 1878, Harvard Business Review ublished "How Competitive Farses Shas Strat- say" by young economist and assuslete profess, icheot Pore. (twas his fret HBR amici, ang started 4 revolution ine stratagy iad. mn subsequent cacades, Port hue broughi his signature sesnome ger W the atusy af somaiive stiaaay for carporn: tions, regions. rations, and, mats recently, hesth eare and philsethropy. “Porter's five foroms" have ahead 3 -generatisn of euudumis research aod business practice. With predieing an assistance fram Harvie Business Schoo! Professor Jan Rivitn and inngtine ecvinsgue Jean Magram, Porter he fares, uredetes, ana ‘extends tha cizssle work. He also saareszen common ‘Misundersndings, provides procter! quisanes tee gam of tha framework, and offers. deeper view ot he lrptleadons fox suategy tony. IM ESSENCE, the job of the strategist isto under stand and cope with competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s direct competi- tors. Yet competition for profits goes beyond es tablished industry rivals to include four other compeittve forces as well: customers, suppers, Potential entrants, and substitute products. The extended rivalry that results from all ve forces defines an industry's structure and shapes the nature of competitive interaction within an industry. AAs different from one anether a5 industries might appear on the surface, the underlying driv. 13 of profitability are the same. The global auto Industry, for instance, appear: to have nothing in common with the worldwide market for art Masterpieces or the heavily regulated health-care | Harvard Busioass aviow 79 Hororg | Janvery 2 LEADERSHIPAND STRATEGY | Tho Five Gomperitive Forees That industry in Europe. But to under Scand industry competition and prostabil ity im each of those thee cases, one must analyze the industry's underlying struc ture in terms of the five forces. (See the ex- hibit “The Five Forces That Shape Industry Competition”) I the forees are Intense, as they are in ‘uch industries as alrines, textiles, and ho- {els alriost no company earns attractive re tumson investment Hthe forces are benign, as they are in Industries such as somtware, soft drinks, and toiletries, many companies are profitable, Industry structure drives competition and profteblty, noe wheter an industry produces a productor sevice,is emerging or mature, high tech or low tech, regulated or unregulated. While a myriad cf Facters Con affect industry profitability fn the short rin including the weather and the business cycle industry structare, ‘manifested in the competitive forces, sets industry profitability in the medium and Jong rus. (Seo the eshibie “Differences in Industry Profitability”) Understanding the competitive forces, and their under lying causes, reveal the roots ofan indusery'scurrene profit ability while providing a fremework for anticipating and Influencing competition (and profitability) over time. A healthy industry structure should be as mucha competitive concer to strategists as their company’s own postion. Un- derstanding industry structure isalso esential to effective strategic positioning. As we will se, defending against the competitive forces and shaping thom i 8 company’s favor are crucial to stracegy. Forces That Shape Competition “The configuration of the five forces ciffers by industry. in the market for commercial arcreft,flese rivalry between dominant producers Albus and Boeing and the bangsin- ing poser ofthe arlies that place huge orders for aitraft are strong, while the threat of entry, the threat of substi- tutes, and the power of suppliers are more benign. In the ‘movie theater industry, the proliferation of substitute forms of emercainment and tae powier of the movie producers and distributors who supply movies, the critical input, ace ‘important. Michael E. Porter © the Sisnop Win Lavance Universny Fro fessor 2 Hust Linvattiy, bates at Harvard Businens Scho! in Boston He i 2 ancime Mickiney Aorard winner, MCUCING TOF MS valegy ard Sosiety,” soeuthored with Mark A kcames (December 2006) mast recent HBR atic, 88 Harvtd Busiass Review | January 2008 | no. hepe Strategy The Five Forces That Shape Industry Competition ‘The strongest competitive force or forces determine the profitability oF an industry and become the most important to strategy formulation. The most salient force hhoweveris not alvays obvious. For example, even though rivalry is ofign ferse in som rmodity industries, it may not be the factor limiting profit- ability. Low setums in the photographic film industry, for instance, are the result of a superior substitute product —as Kodek and Fuji, the world’s leading producets of phoio- graphic fm, learned with theadvent of digital paotograpay. In such a situation, coping with the substitute product be ‘somes the number one strategie prioriy. Industry structure grows out of a set of economic and technical characteristics that determine the strength of each competitive force. We will examine these drivers inthe pages that follow, taking the perspective of an incumbent, ‘or company already present in the inlastry. The analysis ‘can be readily extended to understand the challenges facing A potential eatrant. THREAT OF ENTRY, New entrants 10 an inchastry bring new capacity and a desire to gain market share thet puts pressure on prices, costs, and the rate of investment nec- essary to compete. Particularly when new entrants are Giversifying from other markets, they can leverage exist ing capabilities. and cash flows to shake up competition, as Pepsi did when i entered the bottled water industry, Micro soft did when it began tooffer internet browsers and Apple dlid when it entered the music distribution business. ‘The threat of entry, therefore, pute a cap om the profit po- tential ofan industry. When the threat is high, incumbents must hold down their prices or boo:t investment to deter new cewipetitors. In specialty coffee retailing, for example, relatively low entry barriers mean that Starbucks must in- ‘est aggressively in modernizing stores and menus, ‘The threat of entry in an industry depends on the height cof entry barriers that are present and on the reaction ex twants can expect from incumbents. entry barriers are Low and newcomers expect litle retaliation from the entrenched compatitors, the threat of entry i high and industry profit ability is moderated. 1 i the threat of entay, not whether entry actually occurs,that holds down profitability, Industry structure drives compe «entry by limiting the willingness of customers to buy from a ‘newcomer and by reducing the price the newcomer can com- ‘mand until it builds up a large base of customers 3 Customer switching costs Switching costs are sed ests that buyers face when they change suppliers. Such casts may arise because a buyer who switches vendors must, for et- ample alter product specifications, retrain employees to use 4 new product, or medify processes or Informatfon systems. ‘The larger the switching cost, the harder it willbe for an en- trant to gain customers Enterprise resource planning (ERP) softwareisan example ofa product wth very high switching caxis.Oace acompany has installed SAPS ERP system, foret- ample, the costs of moving toa new vendorae astranomica ion and profitability, not whether an industry is emerging or mature, high tech or low tech, regulated or unregulated. Barriors to entry Entry barrfersare advantages that incum- bents have relative to new entrants. There sre seven major 1. Supplyside economies of scale. These economies arise when firms that produce at larger valumasenjay lover easts Per unit because they con spread fixed costs aver more units, employ more efficient technology, or command better terms from suppliers. Supp?side scale econemies deter entry by forcing the aspiring entrant eitherto come intothe industry. oma lagge scale, which requires dislodging entrenched som- patitors or to accept a cast disadvantage. ‘Scale economies can be found in virwally every activity in the value chain; which ones are most important Vartes by industry’ In microprocessors, incumbents such as Intel ate protected by scale economies in research, chip fabricae tion and consumer marketing, For lav care companieslike seotts Mitacle-Gro, the most important scale economiesare found in the supply chain and media advertising tn small package delivery; economies of scale arise in national logit ‘al systems and information technology. 2, Demmandside benefits of scale. These benefits, also known, as network effects, arive in industries where a buyer's willing iis to pay fora company’s product increases with the nam- ber of ether buyers wio also patronize the company: Buyers may trust larger companies more for a crucial product: Re- call the old adage that no on ever got fied forbuying fiom IBM (when it was the dominant computer meker). Buyers may also value being ina “network” with a larger number of fellow customers. For instance, online suction participants are attracted to eBay because It offers the most potential trading partners, Demandsside benefits of scale discourage because of embedded data, the fact that internal processes have been adapted to SAP, major retraining néeds, ard the inission-critical nature of the applications. 4: Capital reawirerments, Ths need to invest large finan’ cial resources in order to compete can deter new entrants. Capital may be necessary notonly for fixed facilites but also {extend customer credit, build inventories,and fund stare tup losses. The barrier is particularly great ifthe capital fx ‘equited for unrecoverable and therefore harcerto-finance ‘expenditures, such as uptront advertising or research and. evelopment. While major eorporations have the financial resources to invade almost any industry, the huge capital requirements in certain fields limit the pool af Itkely en- trants Conversely in such fields as tax preparation services for shorehaul trucking, capital requirements are minimal ‘and potcntial entrants plentiful. Ieisimportant not tvoversate the degree to which capital requirements alone deter entry. If industry returns see at tractiveand are expected to remain so,and ifeapital mackets are efficent, investors will proride entrants with the funds they need. For aspiring air earers, fae instance, financing i: available to purchase expensive aircraft because of their high resale valte, one reason why there have been numer cus new airlines in almost every region. 5. ncumbency advantages independent of size. No matter ‘what their siz, incumbents may have cost or quality advan- tages nt available to potential rivals. These advantages can stem from such sources as proprietary technology, preferen- tial access to the best rew material sources, preemption of the most favorable geographic locations established brand identities, orcumulative experience that hae ablowed ineum- hovorg | January 2008 | Hervera Business Review #1 LEADERSHIP AND STRATEGY | The Five Comnpatitive Forces That Shape Straiaay bents to earn how to produce more efficiently. Entrants try ‘to bypass such advantages. Upstart discounters such as Tar- get and Wal-Mart, for example, have located stores in free- standing sites rather than regional shopping centers where ‘established department stores were well entrenched. 6. Unequal access to distribution channols. The ne¥ en- ‘rant must, of course, secure distribution of its product or service. A new food item, for example, must displace athers from the supermarket shelf via price breaks, promotions, intense selling efforts, or some other means. The more lim ited the wholesale or retail channelsare and the moze that existing competitors have tled them up, the tougher entry into an induszry will be. Sometimes access to distribution isso high a barrier that new entrants must bypass distribu- tion channels altogether or create their own, Thus, upstart lovecost airlines have avoided distribution through travel agents (who tend t0 vor established higherfare carriers) and have encouraged passengers to book their own Mights onthe internet. 7. Restrictive government poticy. Government policy can hinder or aid new entry directly, as well as amplify (or nul lity)the other entry barriers, Government cirectly limits or ‘even forecloses entry into industries through, for instance, licensing requirements and restrictions on foreign invest ‘ment. Regulated Industries Uke liquor retall ing, taxi services, ‘and aifliaes are visible examples. Government policy can heighten other entry barriers through such means as ex- pansive patenting rules that protect proprietary technol ‘ogy from imitation of environmental or safety regulations {that mise scale economies facing newcomers. OF coarse, government policies may also make entry easier—directiy through subsidies, for instance, or indirectly by funding ba- sic research and making it available to all firms. new and old, reducing scale economies. Entry barriers should be assessed relative to the capa- bilitiesof potential entrants, which may be start ups, foreign firms, or companies in related industries. And, as some of ‘our cxamplesilhisitate,the strategists be mindfulof the creative ways newcomers might find to cltcurwent appar ent partis. Expected eataliation How potential entiants believe In- ‘cumbents may react will aso influence their decision to enter or stay auit of an industry. If reaction is vigorous and ‘Protracted enough, the profit potential of participating in ‘the industry can fall below the cost of capital. Incumbents ‘often use publi statements and responses to one entrant ‘to send a message to other prospective entrants about their commitment o defending market share. ‘Newcomers are likely to fear expected retaliation if incumbents have previously responded vigorously to incumbents possess substantial resources to fight back, incluting excess cash and unused borrowing power, avail- 182 Havverd Business Review | January 20 Differences in Industry Profitability ‘The average rots on imasted capital varies markedty from Industy 1 indusrry. Borween 1892 ana2008, for example, avetags fatuin on investedtcanital n US. industries ranged 1s oer 262900 oF aven negative to more than 50%. At the high cong are lnustiigs tng soft chinks and propackaged sofware, whieh have bean almost sir ines mata profitabla than the Airing ncusty over the period. able productive capacity or clout with distribution channels ad customers incumbents seem likely to cut prices because they are ‘committed to retaining market share at all costs or because {the industry has high fixed costs, which create a strong mo- tivation to drop prices to fillexcesscapacity. industry growth {5 slow so newcomers can gain volume ‘only by taking it from incumbents. An analysisof barriers to entry andexpected retaliation is ‘obviously crucial for any company contemplating entry into 4 nei industry. The challenge is to find ways to surmount ‘the entry burrlers without nullifying, through heasy lnvest- ‘ment, the profitability of participating in the industry ‘THE POUIER OF SUPPLIERS. Poxwerful suppliers capture ‘more ofthe value for themselves by charging higher prices, limiting quaticy or services, or shifting costs to industry par- ticipants. Powerful suppliaes, including suppliers af Isbor, ‘can squeeze profitabiligy out of an industry that is unable ‘toppass on sos increases in its own prices: Microsoft, for fn- stance, has contributed tothe erosion of profitability amon personal computer makers by raising prices on operating, systems, PG makers, competing flercely for customers who «an easly switch among them, have limited freedom to raise their pricesaccordingly. ‘Companies depend on a vie range of different supplier ‘groups for inputs. A supplier group is posserful if +t is more concentrated than the industry it sells to. Microsoft's near menopoly in operating systems, coupled ‘with the fragmentation of PC assemblers, exemplifies this: situation +The supplier sroap does not depend heavily on the in dustry for its revenues. Suppliers serving many industries ‘will not hesitate to extract maximum profits trom each one. Ifa particular industry accounts for @ large portion of a sup- pliet group's volume or profit, however, suppliers will want to protect the industry through reasonable pricing and 2s- sist in activities such as R&D and lobbying. Industry participants Face switching costs in changing supplies. For example, shifting suppliers is cificut if com- panies have invested heavily in specialized ancillary equip~ Average Return on Invested Cepital in US. Industries, 1992-2006 ‘ment orin lauming how ta operate a supplier's equipment (a3 with Bloomberg terminals used by financial profession: als).Or firms may have located their production lines adja- stitute, the tighter i the If on an industry’s profit poten: tial. For example, conventional providers of long-distance telephone service have suffered from the advent of inex: penbive intemet-based phone services such 3s Vonage and Skype: Similarly, video rental outletsare struggling with the emergence of cable and satellite video-on-demand services, online video rental services auch as Netix, and the rise of meet video stes like Google's YouTube, -he buyer’ eost of switching to the substitute is lor ‘Switching from a proprietary, branded drug to a generic drug usually involves minimal costs, for example, which is ‘shy the shift to generics and the fll in prices) ss substan- ‘Cal and rapid. Strategists should be particuarly alert o changes in ether Industries that may make then attractive substcutes when they were not before, Improvements in plastic materials, for example, allowed them to substitute for steel in many au- fomabile components. In this way, technological changes may participate in an industry for image reasons or to offer 8 full line, Clashes of personality and ego have sometimes exaggerated rivalry to the detriment of profitability in fields suchas the media and high technology, «Firms cannot read each other's signals well because of lack of familiarity with one another, diverse approaches to competing, or differing goals. ‘The strength of rivalry reflects not just the intensity of compatition hut alto the basis of competition. The dimen sions on which competition takes place, ancl whether rivals Rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers. or competitive discontinuities in seemingly unrelated usi- nesses cant have major impacts an industry profitability. OF course the substitution threat éan alo shift in favor of an industry, which bodes well for its future profitability and growth potential. RIVALRY AMONG EXISTING COMPETITORS. Rivalry among existing compeitiors takes many familiar forms, ine cluding price discounting, new product introductions, ad- vertising campaigns, and service improvements. igh rivalry limits the profitability of en industry. The degree to which ri valry drives down an industry’sprofit potential depends, ist, tn the intensity with which companies compete and, second, tn the basison which they compete. ‘The intensity af rivalry s greatest Competitors ate numerous or are roughly equal in size and power In such situations, rivals find it hard to avoid poaching business, Without an industry leader, practices de~ sirable forthe industry asa whole gounenforced. Industry growth is slow. Slow growth precipitates fights for market shar + Exit barriers are high. Exit barriens, the flipside of entry barriers, arise because af such things as highiy specialized assets or management's devotion to a particalar business. ‘These barriers Keep companies tn the market even though they maybe earning low or negative returns. Ercess capacity remains tn use, and the profitability of healthy competitors suffersasthe sick ones hang on. + Rivals are highly committed to the business and have aspirations for leadership, especially if they have goals that gobeyond econamic performance in the particular industry. High commitment toa business arisesfor a variety of reasons, For example, sare-owmed competitors may have goals that Include employment or prestige. Units of larger companies converge to:compete on the some dimteasions, have a major Influence on provitasity, Rivalry is especially destructive to profitability if it gravi- tates solely to price because price competition transfers prof its ditectly from an industry to its eusterners Price cuts are usually easy for competitors to see and match, making suc ‘cessive rounds oF retalistion likely. Sustained price compet tion ako trains customers to pay less attention to product features and service, Pricesompstition is most liable to occur i Products or services of rivals are nearly identical and there are feve switching costs for buyers. This encourages ‘sompetitors te ett prises to win new customers Yearsor al line price wars reflect these circumstances in that industry, +Fved costs are high and marginal costs are lov. This ‘creates intense pressure for competitors to cut prices below their average cosis,even close ro their marginal costs tosieal incremental customers while stillmaking sormeeontribution to covering fixed costs Manybasicmaicrials businesses such 2 paper and aluminum, suffer from this problem, especially if demand is not growing. So do delivery companies with fixed metworks of toutes that must be served regardless of volume, + Capacity must be expanded in large increments to be efficient. The need for large capacity expansions, asin the polyvinyl chlorige business disrupts the industry’s supply demand balance and often leads to long and recurring peri- ods of avercapncity and price cutting. ‘The product is perishable, Pecfshabilty creates a strong temptation fo cut prices and sella procct while it sil has Aalue, More products and services ere perishable than is ‘commonly thought. Just as tomatoes are perishable because they roi medsls ef computers are perishable because they hibeove | January 2008 | Harvard Susinate Review 96 LEADERSHIP AND STRATEGY | The Five Competitive Forces That Shave Strategy soon become obsolete, and informaiton may be perishable {fic autuses rapidly or becomes outdated, thereby losing its valu. Services saci as hote accommodations are perishable inthe conse that unused capacity can never be recovered, ‘Comipetition ondimenstons other than price = on product features, support services, delivery time, or brand image, for instance —i less likely to evade protabilty because iti proves customer value and car support higher prices, As, rivalry focused on such dimensions can improve value rela- tive tosubsitutes or rice the barriers facing new entrants. While nonprice rivalry sometimes escalates (0 levels that ‘undermine industry profitably, this i less likely to occur than itis with price rivalry. As Important as the dimensions of rivalry is whether #- vals compete on the same dimensions. When all or many compatitors aim to meet the same needs or compete on the Same attributes, the rosult ie zore sum competition. Here, one firm's gain is often another's loss, driving down pronte ablity, While price competitian runs & stronger sk than onprice competition of becoming zer9 sum, this may not happen i sompanies take care to segment their markets, Langeting their low price offering to different customers. Rivalry canbe positive cum, or actually increase Uhe aver age profitability of an industry, when cach competitor aims to serve the needs of different eustomer segments with dif ferent mixes of price, products, servites, features, or brand identities. Such competition can net only support higher av rege profitably but also expand the tndustry.as the needs of more customer groups ate better met. The opportunity for positivesum competition will be greater in industries serving diverse customer groups, Wilh a ¢lear understand ingorthe structural underpinnings of rivalry, strategis'scan sometimes take steps to shif the nature of competion in mare postive Factors, Not Forces Industry structure, as manifested in the strength of the five competitive forces, determines the industry's long-run profit Potential because it determines how the economic value created by the industry is divided —how much is retained by companies in the industry versus bargained away by cus- tomers and suppliers, limited by substitutes,or constrained ‘by potential new entrants. By considering all five forces, a strategist keeps overall seructure in mind instead of gravkat ing to any one element. in addition, the strategists atten- tion remains focused on structural conditions rather than ‘on fleeting factors. {is especially important 1 avoid the common pittall of mistaking certain visible attributes of an industry for its un- deriving striscture. Consier the followin Inclustry growth rete. A common mistake is to assume ‘that ‘stgrowing industries are always attractive. Growth dogs tend to: mute rivalry, because an expanding pie offers 20 Hteveru Business ie Sanwary 2008 | nts-org opportunities for all competitors. But fast growth can put suppliers in a powerful position, and high growth with low ‘entry barriers will draw in engran’s. Even without nev en ‘rants, a high growth rate vill not guarantee profitabi ‘customers are powerful or substitutes are attractive. Indeed, some fastgronth businesses, such as personal computers, Ihave been amoug the least profitable industies in recent years. A namo focus on growth is one of the major causes of bad strategy decisions. Techaology and Innovation. Advanced technology oF In ovations are not by themselves enough to make an indus- try structurally attractive (oF unattractive). Mundane, low technology industries with price-insensitive buyers, high switching costs, or high entry barriers arising from scale economies are often far more profitable than sexy indus- ‘ties,such assoftware and intemet technologies, that attract compettiors? Govemmant. Government is not best understood as a sixth force because government invelvement is neither in- horently good nor bad for industry profabiity. The best 'Way fo understand the influence of government on compet tion is toanalyre howspecific government policies affect the five competitive forces. For insane, pate false batters {0 entry, boosting industry profit potential. Conversely, gov- ermment policies favoring unions may raise supplier power and diminish profit potentil, Bankruptcy rales that allow failing companies to reorganize rather than exit can ead to ‘excess capacity and intense rivalry, Government operates at multiple levelsand through many different policies, cach of whic will affect structure in different ways, ‘Complementary products and servieas. Complements are products or services used together with an industry's product. Complements arise when the customer benef of wo products combined is greater than the sum of each product’ value in isolation. Camputer hareware and soft ‘ware, for instance, are valuable together and worthless when separated. In recent years, strategy researchers have highlighted the role oF complements, especially in high technology indus trics where they are most obvious.’ By nu means, however do complements appear only there, The value of a car, for ex: ample, is greatet when the driver also: has access to gasoline stations, roadside assistance, and auto insurance. ‘Complements can be important when they affect the overall demand for an industry’s product. However, like government policy, complements aie not a sith force de- {ermnining industry proftabitty since the presence of strong complements is not necessarily bad (or good) for industry Profitability. Complements afect profitability through the way they influence the five forces, ‘Thestrategist must trace the positiveor negative induence ‘ofcomplemants on all ve Forces to ascertain theiimpacton profitability The presence af complements can Fale cr lawer Industry Analysis in Practice vets look rigerously atthe innings of profkability. A fr Step isto understand the appropriate time otizan, Cre of the essential resin ingustry andiysis is todistinguish temporary a cyclicatchanges ftom structural changes. A gpod guideline for the _spproprate rene horzoa s the Tull ousness cycie fot ‘He particular industry For rrost indusiies, 8 tree: tosivesyear honzon is anpropriste, athaughin eoma Industries wan long lead times, such ws mining. the apprapiate Notion might bea decade mare. fs rofbliry over this pari, not profitably in veer, that shouldbe the focus of analsis. “The paint af industry ansiysie fe not ts declare ‘theindustry attractive er unattractive butte understand the underpinnings of competition ‘and the root causes of profitability. As uct ss possible, analysts should tne a industry struct ‘quanttavvoly,rathat than besotted with tats ot Quelteinvg factors. Many slemenis of vie fv canbe quant cost accounted or by tha industey’speocuet (to Understand buyor prise eansiy) ho porcomtage of Industry sas required to fila plant or operates loos oa networeot ef cient scale Ho help assess bares {0 Ent); the buyar's ewitchingeost (determining the Indicement an entrant or sval must offer customs) ‘The strength ol thecompetitivg forces alfevts prlees, costs, ane the nvestmentrequirsate ‘compete; thas the larces aredirectly tied to theineome statements and balance shosts of inclustry participants. industry structure defines ‘the gap between revenues andeosts For exampe, merge rvary dives down pricas oraluvatas he costs cf marketing, FAD, or customer service, reducing margins How much? Svangaupsiers deus up put ‘sesis, Hovirtuch? Buyer power lowers pricosor Glovates the costs of meeing tuyers’ demancs, such {3 the requrernent to hola mora inventory oF OME financing. How muck? Low aniars wo anttyarelose ‘subeteutuelim ths loval of eustuinable grits. How ‘much? Its inese eccriomsc relauonships tat sherpen the sustegists unsarstanaing ct mdusiry competion Finally, aood industey analysis dees not just let pluses and minuses but save an industry in ovar- all, systemietarms. Vihich ‘orcas are underainning any prottapiity? Haw might shtts in ove competitive force trggar reactions in others? ‘ansevering such questionsig often the coutea of uo barriers to entry. n application software, for example, barsi- crs to entry were lowered when producers of compiemen- Lary operating system software, notably Microsoft, provided tool sets making it easior to write applications. Conversely, the need to attrast produsers of somplements can rae bet= riers toentry, a8 it doesin video game hardware. ‘The presence of complerments can also affect the threat ‘of substitutes, For instance, the need forappropriate fueling Mations makes it difficult for cars using altemative fuels to substitute for conventional vehicles. But complements can also make substitution easier For example, Apple's iTunes, hhastemed the substitution from CDs to digital music Complements can factor into industry rivalry either posi- tively (as when they raise switching costs) or negatively (as ‘when they neutralize prosustdiffeeentiatlon), Simllaransaly- ses can be cane for buyer and supplier power. Sometimes companies compete by altering conditions in complemen fary industries in thelr faverysuch as when videocassette- recorder producer JVC persuaded movie studios to favor its standard in issuing prerecorded tapes even thaigh ti- ‘val Sony's standard was probably superior from a technical standpoint. dentitying complements is part ofthe analyst's work. As with government policies or important technologies, the strategic significance of complements will be best under stood through the lens af the five forces Changes in Industry Structure $0 far, we have discussed the competitive forces at a single point in time. Industry structure proves ta be relatively sta blo, and industry profitability differences are remaricably persistent onertime in practice, However Industry structure ‘constantly undergoing madest adlustment—and accasion- ally itcan change abruptly. Shifts In structure may emanate frem outside an industry or fremtwithin They can boost he inclustry’s profit potential or reduce it. They may he caused by changes in technology, changes in customer needs, or other events. The five som petitiverorees provide a frameworl fr identifying the most important industry developments and far anticipating theit impact on industry aractiveress. ‘Shifting threat of naw entry. Changes to any of the seven barriersdescribed above can raise or Lower the threat of nets entry The expiration of a patent, for instance, may unleash new entrants. On the day that Merck's patents for the cho lesterol reducer Zocer expired, three pharmacetitical male ersentered the market for the drug. Conversely, the prolif cration of products in the kee ercam incustry has gradually filled up the limited Freezer space in grocery storesymaking itharder for new ice cream makers ovgain access to divtribue tion in North America and Europs, strategic decisions of leading competitors often have a ‘major impact on the threat afentry.Starting in the 19706,f0r hobnaig | danuary 2008 | Harvard Business Review 97 LEADERSHIP AND STRATEGY | The Five Competitive Forees That Shape Stratogy example, retailers such as WalMart, Kmart, and Toys"R"Us ‘began vo adopt new procurement, distribution, and inven- tory control technologies with large fixed costs, including automated disribotion centers, barceding,and polnt-ofsale serminals. These investments increased the economies of scale and made it more difficult for small retailers to enter the business (and for existing small players to survive) Changing supplier o- buyer powar, As the factors under lying the powsr of suppliers anid buyers change with time, theirclout mses or declines. Inthe global appliance industry, for instance, competitors including Electrolux, General Elec: Aric,and Whiripool have been squeezed by the consolidation of retail channels (the decline of appliance specialty stores, for instance, and the rive of big-bax retailers like Best Buy and tome Depot in the United States). Another example Is travel agents, wiho depend on airlines asa keysupplier. When the intemet allowed airlines te sell tickets directly to cus tomers, this significantly increased their power to bargain down agents’ commissions, Shifting threat of substitution. The most common reason substitutes become more or less threatening over time is {hat advances in technology create new substitutes or shift price performance comparisons in ane direction or theather. ‘The earliest microwave ovens, for example, were large and prised above 52,000, mzking them poor substiutes tur cone \entional ovens. With technological advances, they became serious substitutes. Fash computer memory has improved snough resent (o become « meaningful substitute far bw capacity hard-disk drives. Trends in the availability er per formance of complementary producers aso shit the threat of substitutes. ow bases of rvairy, Rivalry often intensifies naturally over time, As an inkhustry matures, growth slows. Competi- tors become more alike as industry conventions emerge, technology sitfuses, andl consumer tastes converge. Industry profitability falls, and weaker competitors are driven from and geographic segments (such as riverboats trophy proper ties, Native American reservations, intemational expansion, and novel customer groups like families). Mezcto-head ri valry that lonsrs pres or boos the payoutstowvinners has been limited. “The natu of rivalryin an incustry is altered by mergsrs and acquisitions that introduce new capabilities and ways of competing. Or technological innovation can reshape rival In the retail brokerage industry, the advent ofthe intemat lowered marginal costs and reduced differentiation, trigger ing fer mote intense competition on commissions and fees ‘than in the past. 1m some industries, companies turn to mergers and com. solidation not to impiove cost and quality but to attempt to stop intense competition. Eliminating rials is a risky strat gy. however. The five competitive forces tell usthata profit vsindtall from removing today’s competitors often atiracts new rasolve tress questions. Ifindustiy structure fortwo productsis the same very srmias (mat is, ittney navethe same burers, suppliers, barriers t6 en uy. and 20 fonh), ten theproduess are best rieatea as teing pare ot ine same induswy. ineustry steusters difers markodly, however, the wo predcte ‘may be best uncersions #s seper Inlubricents. the al usedin ene ‘ammilat or even iertical othe el used in trucks, but the senilartylargely ands there. Automotive motor ol is fold 10 fagmenies, sorarally wnaophistioated ‘easiomers zhrough numerous and ten powerful ehanva's, using extensive advertsing. Products ate packaged in inal cortsinersand logistical cosss are igh, recossiztinglacal production, Truck and power generation luiviesnis bre zold io ensiely diferent buyers in eurely dttorent ways using a separate supply cain. industry structure bayer ‘Rowan buviare 19 entry. rel 20 forty ‘esubslanialy ferent, Astorotwve (os thus 2 stinctindusty from oll for tuck and stasonary engine se Incusty protnatiaty wit ‘iyo cases, and a lubricant company te statagy for coer petingin eacharea Ditterences inte five competi= tive forces alsa revel the gwogeaptic scope of compatiton. [Fan industry piotement Oficn, it is more in the interests of an industry leader than any other participant to invest for the common ‘good because leaders will usually benefit the most Indeed, improving the industry may be a leader's most profitable strategic opportunity in part because attempts to gain far- ther market share can tiezer stone ceactions from rivals, ccustomers,and even suppliers. ‘There is a dark side to shaping industry structure that is ‘equally important to uncerstand, lkadvised changes incom- petitive positioning and operating practises can snadermine industry stricture, Faced with pressureste gain market share orenamored with innovation or its own suke, managersmay ‘has similar sictwrein every county Uivale, buyers. and ro 9r, hor: surrotion isthat competition & gfobal and ihe five forces anelyied froma lobal perspective wiliset average profitability. single gicbal stategy it needed, ten indusiyhas quis difor tent structuresin differen paagrephic regions, howover, eh rapion may ‘wellbe 2 distrctindustry, Otherwise, ‘competition would have avaled the feronces. Tha va foreas analysed for ‘sect region wil sei profiabiliy there The extent of attarences int tue forces ior ranted praeiets or seeses \geogtophic areas isa meter cf degree, -maieng industry dessin often a raat Tero judameet. A rulge! thumbs tat ‘ynere the etferencesin ny ene force are large, and wnare tte attereaces involemare than onetores, cistnct ndustras may well be present, Fortunately, howsver, eveniF nous try Boundaries are crawn incoweetl, caretulfive tors anaiyss should reveal mponont compattive tests ‘A clesery rete praduet ont trom Ihe industry definition wal show up asa Substivie, for example, er compotitors ‘verooked 25 vale wil ba recognized ‘8s potential anirants. At the sama time, the five forees araleie ould rover major dilferances within very (broad industries that wilngicate the neodite adjust industry bovndariss or suatgies. in thes noroeg | January 2098 | Harvarc Businessfeview 91 LEADERSHIPAND STRATEGY | The Five Competitive Forees That Shaps Strategy trigger new hinds of competition thet noincumbent can win, ‘When taking actions to improve thetr own company’s come petitive advantage, then, strategists should ask whether they atesetting in motion dynamics that will undermine industey skruc wie In the long run. tn the early days oF the personal computer industry, fer instance, IBM tried to: make vp for fee late entry by offering an open architecture that would set industry standards and atiract complementary makers ‘of application software and peripherals, In the proces it ceded cvsmership ofthe critical components of the PC— the ‘operating system and the microprocessor ~to Microsoft and Intel By standardizing PCs itensouraged price-based nvalry and shifted power to suppliers. Consequently, IBM became the temporarily dominant frmin an industry with an endur ingly unattractive siructure, Expanding the profit bool, When overall demand grows, the industrys quality level rises, intrinsic costs are reduced, for waste ip eliminoted, the pis expands. The total poo! of valve available to competitors suppliers, and buyers grows. ‘The total proft pool expanck. for example, when channels become more competitive or when an industry discovers latent buyers for its product that are not curently being served. When softsfrink producers rationalized their inde- pendent botiler networks tomake them more efficient and cffective, both the softdrink companies and the bottlers benefited. Qverall value can ao expand when firms work collzbovatively with suppliers to improve coordination and limit unnecessary costs incurred in the supply chain This lowers the inherent cost structure ofthe industry, allowing higiter profit greater demand through lower prices, or bath. Or, agreeing on quality standards can bring up indstrywide ‘quality and service levels and hence prices, benefiting rival, suppliets, and customers. Expanding the overall profit poo! creates win win oppor tunities for multiple industry participants. I can also reduce the rik of destructive ralry that arises when incumbents attempt to shift bargaining power or capture more mar It share, However, expanding the pe does not reduce the importance of industry structure. How the expanded pie is divided will ulimatcly be determined by the five forces ‘The most successful companies are those that expand the indusity prose poo! in ways that allow them tashare elspra- Portionately in the benefits. Dolining the industry. The Five competitive farses also hold the key tercefining the refevant industry (or industries) invshich acompany competes. Drawving industry boundaries correctly, around the arena in which competition actually takes place, will clarify the causes of proftability and the ap- ‘propriate unit for setting strates. A company needs a sepa- Tate strategy for each distinct industry. Mistakes in industry

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