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137 How competitive forces shape strategy Awareness of these forees can help a company stake out a position in its industry that is less vulnerable to attack Michael E. Porter The nature and degree of competition in an industry hinge on five forces: the threat of new entrants, the bargaining power of customers, the bargaining power of suppliers, the threat of substitute products or services [where applieahle), and the jockeying among current contestants. To estahlish a strategic agenda for dealing with these contending currents and to grow despite them, a company must understand how they work in its industry and how they affect the company in its particular situation. The author details how these forees operate and suggests ways of adjusting to them, and, where possible, of taking advantage of them. Mr. Porter is a spcciahst in industrial economics and business strategy. An associate professor of husiness administration at the Harvard Business School, he has created a course there entitled "Industry and Competitive Analysis." He sits on the hoards of three companies and consults on strategy matters, and he has written many articles for economics journals and published two books. One of them, Interbrand Choice, Strategy and Bilateral Market Power (Harvard University Press, 1976) is an outgrowth of his doctoral thesis, for which he won the coveted Wells prize awarded by the Harvard economics department. He has recently completed two book manuscripts, one on competitive analysis in industry and the other [written with Michael Spence and Richard Caves) on competition in the Dpen economy. The essence of strategy formulation is coping with competition. Yet it is easy to view competition too narrowly and too pessimistically. While one sometimes hears executives complaining to the contrary, intense eompetition in an industry is neither coincidence nor bad luck. Moreover, in the fight for market share, competition is not manifested only in the other players. Rather, competition in an industry is rooted in its underlying economics, and competitive forces exist that go well beyond the established combatants in a particular industry. Customers, suppliers, potential entrants, and substitute products are all competitors that may be more or less prominent or active depending on tbe industry. The state of competition in an industry depends on five basic forces, wbich are diagrammed in tbe Exhibit on page 141. The collective strength of these forces determines the ultimate profit potential of an industry. It ranges from intense in industries like tires, metal cans, and steel, where no company earns spectacular returns on investment, to mild in industries like oil field services and equipment, soft drinks, and toiletries, where there is room for quite high returns. In the economists' "perfectly competitive" industry, jockeying for position is unbridled and entry to the industry very easy. This kind of industry structure, of course, offers the worst prospect for longrun profitability. The weaker the forces collectively, however, the greater the opportunity for superior performance. Whatever their collective strength, the eorporate strategist's goal is to find a position in the industry where his or her company ean best defend itself against these forees or can influence them in its favor. The collective strength of the forces tnay be 138 Harvard Business Review painfully apparent to all the antagonists; but to cope with them, the strategist must delve helow the surface and analyze the sources of eaeh. For example, what makes the industry vulnerable to entry? What determines the bargaining power of suppliers? Knowledge of these underlying sourees of competitive pressure provides the groundwork for a strategic agenda of action. They highlight the critical strengths and weaknesses of the eompany, animate the positioning of the company in its industry, clarify the areas where strategic changes may yield the greatest payoff, and highlight the places where industry trends promise to hold the greatest significance as either opportunities or threats. Understanding these sourees also proves to he of help in considering areas for diversification. A few characteristics are critical to the strength of each competitive force. I shall discuss them in this section. Contending forces The strongest competitive force or forces determine the profitability of an industry and so are of greatest importance iti strategy formulation. For example, even a company with a strong position in an industry unthreatened by potential entrants will earn low returns if it faces a superior or a lower-cost substitute produet—as the leading manufaeturers of vacuum tubes and coffee percolators have learned to their sorrow, hi such a situation, coping with the substitute produet becomes the number one strategic priority. Different forces take on prominence, of course, in shaping competition in each industry. In the oeean-going tanker industry the key force is probably the buyers [the major oil companies), while in tires it is powerful OEM buyers coupled with tough competitors. In the steel industry the key forces are foreign competitors and substitute materials. Every industry has an underlying structure, or a set of fundamental eeonomic and technical characteristics, that gives rise to these competitive forces. The strategist, wanting to position his company to cope best with its industry environment or to influence that environment in the company's favor, must leam what makes the environment tick. This view of competition pertains equally to industries dealing in services and to those selling products. To avoid monotony in this article, I refer to both produets and services as "products." The same general principles apply to all types of business. March-April 1979 Threat of entry New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resourees. Companies diversifying through acquisition into the industry from other markets often leverage their resources to cause a shake-up, as Philip Morris did with Miller beer. The seriousness of the threat of entry depends on the harriers present and on the reaetion from existing eompetitors that the entrant ean expect. If barriers to entry are high and a newcomer can expect sharp retaliation from the entrenched competitors, obviously he will not pose a serious threat of entering. There are six major sources of barriers to entry: 1. Economies of scale—These economies deter entry hy foreing the aspirant either to come in on a large scale or to accept a cost disadvantage. Scale eeonomies in produetion, research, marketing, and service are prohably the key barriers to entry in the mainframe computer industry, as Xerox and GE sadly discovered. Economies of scale ean also act as hurdles in distribution, utilization of the sales force, financing, and nearly any other part of a business. 2. Product differentiation—Brand identification ereates a barrier by forcing entrants to spend heavily to overcome customer loyalty. Advertising, eustomer service, being first in the industry, and product differences are among the factors fostering brand identification. It is perhaps the most important entry barrier in soft drinks, over-the-counter drugs, cosmetics, investment banking, and public accounting. To create high fences around their businesses, brewers couple brand identification with economies of scale in production, distribution, and marketing. 3. Capital requirements—The need to invest large financial resources in order to compete creates a barrier to entry, particularly if the capital is required for unrecoverable expenditures in up-front advertising or R&D. Capital is necessary not only for fixed faeihties but also for customer credit, inventories, and absorbing start-up losses. While major corporations have the finaneial resources to invade almost any industry, the huge capital requirements in certain fields, such as computer manufacturing and mineral extraction, limit the pool of likely entrants. 4. Cost disadvantages independent of size—Entrenched companies may have cost advantages not available to potential rivals, no matter what their Competition shapes strategy 139 The experience curve as an entry barrier In recent years, the experience curve has become widely discussed as a key element of industry structure. According to this concept, unit costs in many manufacturing industries (some dogmatic adherents say in all manufacturing industries) as well as in some service industries decline with "experience," or a particular company's cumulative volume of production. (The experience curve, which encompasses many factors, is a broader concept than the betterknown learning curve, which refers to the efficiency achieved over a pencxj of time by workers through much repetition.) The causes of the decline in unit costs are a combination of elements, including economies of scale, the learning curve for labor, and capital-labor substitution. The cost decline creates a barrier to entry because new competitors with no "experience" face higher costs than established ones, particularly the producer with the largest market share, and have difficulty catching up with the entrenched competitors. Adherents of the experience curve concept stress the importance of achieving market lead- ership to maximize this barrier to entry, and they recommend aggressive action to achieve it, such as price cutting in anticipation of falling costs in order to build volume. For the combatant thai cannot achieve a healthy market share, the prescription is usually, "Get out," Is the experience curve an entry barrier on which strategies should be built? The answer is: not in every industry. In fact, in some industries, building a strategy on the experience curve can be potentially disastrous. That costs decline with experience in some industries is not news to corporate executives. The significance of the experience curve for strategy depends on what factors are causing the decline. If costs are falling because a growing company can reap economies of scale through more efficient, automated facilities and vertical integration, then the cumulative volume of production is unimportant to its relative cost position. Here the lowest-cost producer is the one with the largest, most efficient facilities, A new entrant may well be more efficient than the more experienced competitors; if it has built the newest plant, it will face no disadvantage in having to catch up. The strategic prescription, "You must have the largest, most efficient plant," is a lot different from, "You must produce the greatest cumulative output of the item to get your costs down," Whether a drop in costs with cumulative (not absolute) volume erects an entry barrier also depends on the sources of the decline. If costs go down because ot technical advances known generally In the industry or because of the development of improved equipment that can be copied or purchased from equipment suppliers, the experience curve is no entry barrier at all-infact, new or less experienced competitors may actually enjoy a cost advantage over the leaders. Free of the legacy of heavy past investments, the newcomer or less experienced competitor can purchase or copy the newest and lowest-cost equipment and technology. If, however, experience can be kept proprietary, the leaders will maintain a cost advantage. But new entrants may require less experience to reduce their costs than the leaders needed. All fhis suggests that the experience curve can be a shaky entry barrier on which to build a strategy. While space does not permit a complete treatment here, I want to mention a few other crucial elements in determining the appropriateness of a strategy built on the entry barrier provided by the experience curve; D The height of the barrier depends on how important costs are to competition compared with other areas like marketing, selling, and innovation, D The barrier can be nullified by product or process innovations leading to a substantially new technology and thereby creating an entirely new experience curve,' New entrants can leapfrog the industry leaders and alight on the new experience curve, to which those leaders may be poorly positioned to jump, D If more than one strong company is building its strategy on the experience curve, the consequences can be nearly fatal. By the time only one rival is left pursuing such a strategy, industry growth may have stopped and the prospects of reaping the spoils of victory long since evaporated. "For an example drawn Irom Ihehistoryol the automobile industry, see William J. Abematfiy and Kenneth Wayne, "The Limits of the Learning Curve," HBR SeptemberOctober 1974, p.109. size and attainable economics of scale. These advantages ean stem from the effeets of the learning eurve (and of its first eousin^ the experience curve), proprietary teehnology, access to the best raw materials sources, assets purchased at preinflation prices, government subsidies, or favorable locations. Sometimes cost advantages are legally enforceable, as they are through patents. (For an analysis of the tnuch-discussed experience curve as a barrier to entry, see the ruled insert above.) 5. Access to distribution channeh—Thc new boy on the block must, of course, secure distribution of his product or service. A new food product, for ex- ample, must displace others from the supermarket shelf via price breaks, promotions, intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that existing competitors have these tied up, obviously the tougher that entry into the industry will be. Sometimes this barrier is so high that, to surmount it, a new contestant must create its own distribution channels, as Timex did in the watch industry in t h e 19SOS. 6. Government policy—The government can limit or even foreclose entry to industries with such controls as license requirements and limits on access to 140 Harvard Business Review raw materials. Regulated industries like trucking, liquor retailing, and freight forwarding are noticeable examples; more subtle government restrictions operate in fields like ski-area development and eoal mining. The government also can play a major indirect role by affecting entry barriers through controls sueh as air and water pollution standards and safety regulations. Powerful suppliers &l buyers The potential rival's expectations about the reaction of existing competitors also will infiuence its decision on whether to enter. The company is likely to have second thoughts if incumbents have previously lashed out at new entrants or if: • The incumbents possess substantial resources to fight baek, including excess cash and unused borrowing power, productive capacity, or clout with distribution channels and customers. • The incumbents seem likely to cut prices because of a desire to keep market shares or because of industrywide excess capacity. n Industry growth is slow, affecting its ability to absorb the new arrival and probably causing the financial performance of all the parties involved to decline. Changing conditions From a strategic standpoint there are two important additional points to note about the threat of entry. First, it changes, of course, as these conditions change. The expiration of Polaroid's basic patents on instant photography, for instance, greatly reduced its absolute cost entry barrier built by proprietary technology. It is not surprising that Kodak plunged into the market. Product differentiation in printing has all but disappeared. Conversely, in the auto industry economies of scale increased enormously with post-World War II automation and vertical integration—virtually stopping successful new entry. Second, strategic deeisions involving a large segment of an industry can have a major impact on the conditions determining the threat of entry. For example, the actions of many U.S. wine producers in the 1960s to step up produet introductions, raise advertising levels, and expand distribution nationally surely strengthened the entry roadblocks by raising eeonomies of scale and making access to distribution channels more difficult. Similarly, decisions by members of the recreational vehicle industry to vertically integrate in order to lower costs have greatly increased the economies of scale and raised the capital cost barriers. March-April 1979 Suppliers can exert bargaining power on participants in an industry by raising prices or reducing the quality of purchased goods and services. Powerful suppliers can thereby squeeze profitability out of an industry unable to recover cost increases in its own prices. By raising their prices, soft drink coneentrate producers have contributed to the erosion of profitability of bottling companies because the bottlers, facing intense competition from powdered mixes, fruit drinks, and other beverages, have limited freedom to raise their prices accordingly. Customers likewise can force down prices, demand higher quality or more service, and play competitors off against each other—all at the expense of industry profits. The power of each important supplier or buyer group depends on a number of characteristics of its market situation and on the relative importance of its sales or purchases to the industry compared with its overall business. A supplier group is powerful if: D It is dominated by a few companies and is more concentrated than the industry it sells to. D Its product is unique or at least differentiated, or if it has built up switching costs. Switching costs are fixed costs buyers face in changing suppliers. These arise beeause, among other things, a buyer's produet specifications tie it to particular suppliers, it has invested heavily in specialized ancillary equipment or in learning how to operate a supplier's equipment [as in computer software), or its production lines are connected to the supplier's manufacturing facilities (as in some manufacture of beverage containers). D It is not obliged to contend with other produets for sale to the industry. For instance, the competition between the steel companies and the aluminum companies to sell to the can industry checks the power of eaeh supplier. n It poses a credihle threat of integrating forward into the industry's business. This provides a check against the industry's ability to improve the terms on which it purchases. D The industry is not an important customer of the supplier group. If the industry is an important customer, suppliers' fortunes will be closely tied to the industry, and they will want to protect the industry through reasonable pricing and assistance in activities like R&D and lobbying. A buyer group is powerful if: • It is concentrated or purchases in large volumes. Large-volume buyers are particularly potent Competition shapes strategy forces if heavy fixed costs characterize the industry —as they do in metal containers, corn refining, and bulk chemicals, for example—which raise the stakes to keep capacity filled. D The products it purchases from the industry are standard or undifferentiated. The huyers, sure that they can always find alternative suppliers, may play one company against another, as they do in aluminum extrusion. D The products it purehases from the industry form a component of its product and represent a significant fraction of its cost. The huyers are likely to shop for a favorable priee and purchase selectively. Where the product sold by the industry in question is a small fraction of buyers' costs, buyers are usually much less price sensitive. • It earns low profits, wbich create great incentive to lower its purchasing costs. Highly profitable buyers, however, are generally less price sensitive (that is, of course, if the item does not represent a large fraction of their costs). D The indus ...
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