THE FIVE COMPETITIVE FORCES THAT SHAPE STRATEGY

While making strategy, an organization has to understand and cope with competition in the
market. Understanding such competition goes beyond existing rivalry and has to include four
other competitive forces: customers, suppliers, potential entrants, and substitute products. This
extended rivalry which result from all five forces shape an industry’s structure and its
competitiveness within the industry.

If the forces are intense, as they are in industries such as airlines, textiles, and hotels, almost no
company earns attractive returns on investment. If the forces are benign, as they are in industries
such as software, soft drinks, and toiletries, many companies are profitable. Other macro-
economic factors may affect industry’s profitability in short run but it is the interaction between
five forces which shape industry’s future in medium or long run. A healthy industry structure
should be as much as competitive as their company’s own position. Defending against the
competitive forces and shaping them in a company’s favor are crucial to strategy.

FORCES

1. Threat of Entry:

New entrants to a market bring new capacity and desire to gain market share which puts
pressure on the incumbents. Similarly when new entrants are diversifying form other markets,
they can make use of their existing capabilities to make competition. The incumbents have to
hold down their prices or invest more on production to deter new competitors.

The threat of new entry depends on the height of barriers to entry faced by new entrants. Entry
barriers are advantages to the incumbents relative to new entrants. Major sources of entry
barriers are:

i. Supply-side economies of scale: The firms that produce at larger volumes enjoy
lower cost per unit because they can spread fixed costs over more units. This scale
deters entry by forcing the new entrant either to come into the market on a large
scale or to accept the cost disadvantage.
ii. Demand-side benefits of scale: This arises in industries where a buyer’s
willingness to pay for a company’s product increases with the number of other
buyers who also patronize the company. This scale discourages entry by limiting
the willingness of customer to buy from newcomer.
iii. Consumer switching costs: Switching costs reflect how easy it is for buyers to
switch their suppliers. The larger the switching costs, the harder it will be for an
entrant to gain customers.
iv. Capital requirements: Need of large investment of financial resources in certain
industry may deter a possible entrant. Even more when investment is for
unrecoverable purpose such as up-front advertising or research and development
 that can deter entry. If industry returns are attractive and are expected to remain
so, and if capital markets are efficient, then investors will provide entrants with
the funds they need.
v. Incumbency advantages independent of size: Irrespective of their size incumbents
may enjoy certain advantages, owing to their years of experience, which are
generally not available to new entrants. These advantages include proprietary
technology, preferential access to the best raw material sources, preemption of the
most favorable geographic locations, or established brand identities.
vi. Unequal access to distribution channels: The more limited the wholesale or retail
channels are and the more that existing competitors have tied them up, the tougher
entry into an industry will be. Sometimes access to distribution is so high a barrier
that new entrants must bypass distribution channels altogether or create their own.
vii. Restrictive government policy: Government policy can hinder new entry through
licensing requirements or restrictions in foreign direct investment or
environmental and safety rules. Regulated industries like liquor retailing, taxi
services, and airlines are visible examples.

Expected retaliation: If reaction is vigorous and protracted enough, the profit potential of
participating in the industry can fall below the cost of capital then newcomers may fear
retaliation, if incumbents have shown such retaliation before and they have the resources
for it. Expected retaliation can also become barrier to new entrant.