Business Policy 1

The Five Forces Framework

Background

Writers such as Michael Porter believe that strategic analysis and the achievement of a
position of sustainable competitive advantage begin with a consideration of the
competitive environment of the individual firm or strategic business unit. This is then
followed by an appraisal of the resources of the organization relative to the chosen
environment

The competitive environment of any organization may be broken down into the ‘general’
environment and the ‘task’ or ‘transactional’ environment. The former comprises wider
variables such as the economic, social, political and technological features that are largely
beyond the reach of individual businesses to change, yet which govern their
competitiveness and strategy. Analysis of this component of the competitive
environment is couched in terms of the ‘PESTEL’ framework [see Exploring Corporate
Strategy, 7th ed., pp. 64-71]. This environment is often seen as comprising
macroeconomic, technological etc variables that are common to a whole industry and
with which the individual firm simply has to live, and to which it is only to a limited
extent able to respond actively. By contrast, the task or transactional environment is
unique to each individual firm in a market, and is generally regarded as a set of
circumstances to which the firm can positively adjust its strategy or which the firm itself
can influence – as in the case of market mergers and acquisitions or barriers to new
competition. Porter himself instances the pharmaceuticals or medicines market as one
that offers a ‘naturally’ benign competitive environment to existing competitors, in terms
of both general and task environment features such as the impact of economic growth,
technology, legislation and ‘consumer’ behaviour. This may be contrasted with the
evolution of certain traditional textile markets or possibly the airline industry.

The Five Forces Framework

The task or transactional environment has been summarized by Porter in the five forces
framework. Each competitor in the market has a unique task or transactional
environment, and Porter argues that five key forces in this environment both determine
the degree of competitiveness of a market and should guide the firm in its strategy.
These five forces are discussed below.

Competitive Rivalry

This is the hub of competition in any market, and comprises the broad market conditions
such as the size and growth of the market itself, the resources and behaviour of other
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members of the present ‘strategic group’ of which the firm is a member together with the
general nature of competition or ‘conduct’ in the market. It should also embrace such
resource issues as the level or capital investment required to participate in the market and
the rate of technological change.

Thus the extent or force of competitive rivalry will depend, for example, upon the rate of
growth of the market, the respective size, market share and relative resource competence
of market competitors, and the way in which firms in the strategic group compete in the
market. On the basis of such market structure and conduct or behaviour variables some
markets will be inherently more competitive and less profitable than others, and this is
the area of competitive analysis on which traditional economics focuses. These
circumstances, as emphasized above, will also guide the firm in the adoption of particular
strategies.

The Threat of Potential Entry

In addition to facing competition from current members of the strategic group, a firm
may face the threat of potential entry by firms that are capable of joining this group: that
is, firms that are capable of pursuing similar strategies but which are not currently in the
group. The most obvious source of this potential additional competition is entry into a
regional market across a geographical boundary by a competitor organization, or import
competition. Examples of this would be the earlier entry into Scottish regional retail
banking by the National Westminster Bank (prior to its acquisition by RBS) or Japanese
import competition in the UK motor car market.

Such potential entrants face a number of barriers to entry: including economies of scale,
absolute cost disadvantages, the patronage entry barrier or large initial capital
requirements. Depending upon the height of such entry barriers – which may be ‘natural’
or ‘strategic’ – existing members of the strategic group may enjoy some protection from
such competition. It is, of course, possible for existing member of the strategic group to
raise the patronage entry barrier - for example, through increased expenditure on
branding or product development – or to engage in specific entry-forestalling pricing.

Threat of Substitute Products

This relates to changes in the type of membership or the nature of the strategic group. It
occurred as firms in the traditional UK retail banking strategic group experienced
competition from former building societies and now even from grocery supermarket
chains, as ‘discount’ grocery supermarket groups such as Lidl, Aldi or Netto came to
compete against established UK supermarkets, or as e-mail has taken the place of
traditional postal communication. In the first of these cases a new, enlarged strategic
group has emerged within which it may now be difficult to distinguish former banks and
building societies. In the second case, the discount supermarkets have found it difficult
to dislodge the established grocery supermarkets partly because UK consumers want
more than the discount offer and partly as a result of the established national grocery
supermarket chains offering both a much wider merchandise range and a range of
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discount own-label products. In the last example, Royal Mail in the UK has seen a
considerable reduction in its traditional market because of e-mail.

Bargaining Power of Suppliers

Firms at any stage of a market chain may experience the adverse bargaining power of
their suppliers if these are larger organizations than their customers, if there are relatively
few suppliers and thus limited opportunities for customers to ‘shop around’, if buyers
face significant ‘switching costs’ from existing suppliers, if there is generally excess
demand for such supplies, or if suppliers have specialist knowledge not available to
buyers. In these circumstances customers will have to pay enhanced prices and suppliers
will enjoy high profit margins associated with these. Suppliers may, of course, adopt a
number of strategies designed to increase their bargaining power, such as customizing
their products for individual buyers or appealing over the heads of their customers to final
consumers – as in the case of certain national brand grocery products or PC processors.

One obvious response on the part of customers is to engage in backward vertical

integration: ‘making what was previously bought’. However, there may be a number of
barriers to entry to such a strategy, and the backward integrating firm has to consider
what its own cost conditions etc would be at the previous stage of production.

Bargaining Power of Customers

Correspondingly, some firms may be faced by considerable buying power on the part of
their customers – referred to in industrial economics as oligopsony. This is likely to be
the case if such customers are large in size and few in number, if there is generally an
excess supply in the market in terms of either the level of supply or the number of
suppliers, if customer switching costs are low such that it is easy for customers to move
from one supplier to another, if competitive selling arrangements such as sealed bids
apply and thus deny competitor suppliers knowledge of others’ prices, if demand is
‘lumpy’ and competitors are thus particularly anxious to obtain some of a limited number
of individual units of demand, if supplier price comparisons are technologically or
administratively easy for customers to make (as is increasingly the case for final
consumers now in respect of a wide range of products), or if customers possess specialist
knowledge of the market not available to their suppliers.

One of the most widely discussed examples of this phenomenon is the relative weakness
of food suppliers – both farmers and even large international food processors such as
Heinz or Kellogg – relative to the very large grocery supermarket firms. Tesco, for
example, is a very large organization with a very significant UK market share, it is often
responsible for a large proportion of the output of its individual suppliers, and it
possesses considerable knowledge both of food production and distribution technology
and consumer buying patterns. These circumstances, it is argued, form the basis of the
much higher levels of profitability on the part of Tesco compared with even the largest
among the food manufacturers.