Industry Structure & Competitive Strategy: Keys to Profitability

Michael E. Porter The first step in structural analysis is an assessment of the competitive environment in which the company operatesthe basic competitive forces and the strength of each in shaping industry structure. The second is an assessment of the company's own strategyof how well it has positioned itself to prosper in this environment. Taken together, these steps are the key to forecasting a company's earning power. !E S"CCESS #$ % C#MP%&'(S competitive strategy depends on ho) it relates to its environment. %lthough the relevant environment is very broad* encompassing social as )ell as economic forces* the +ey aspect of the company,s environment is the industry or industries in )hich it operates. Industry structure has a strong influence in defining the rules of the competitive game as )ell as the strategies potentially available to the company. he intensity of competition in an industry is not a matter of luc+. -ather* competition is rooted in underlying industry economics and goes )ell beyond the established competitors. &ot all industries have e.ual potential. hey differ fundamentally in their ultimate profit potential as the collective strength of the forces of competition differs/ the forces range from intense in industries li+e tires* paper and steel* )here no firm earns spectacular returns* to relatively mild in industries such as oil field e.uipment and services* cosmetics and toiletries* )here high returns are common. he essence of competitive strategy for a company is to find a position in its industry )here it can best cope )ith these competitive forces or can influence them in its favor. Kno)ledge of the underlying sources of competitive pressure can reveal the basic attractiveness of an industry* highlight the critical strengths and )ea+nesses of a company* clarify the areas )here strategic changes may yield the greatest payoff and pinpoint the industry trends that promise the greatest significance as either opportunities or threats. Structural Determinants of Competition Competition in an industry continually )or+s to drive do)n the rate of return on invested capital to)ard the competitive floor rate of return* or the return that )ould be earned by the economist,s 0perfectly competitive0 industry. his competitive floor* or 0free mar+et*0 return is appro1imated by the yield on long2term government securities ad3usted up)ard by the ris+ of capital loss. Investors )ill not tolerate returns belo) this rate for very long before s)itching their investment to other vehicles* and firms habitually earning less than this return )ill eventually go out of business. he presence of rates of return higher than the ad3usted free mar+et return serves to stimulate the inflo) of capital into an industry either through ne) entry or through additional investment by e1isting competitors. he strength of the competitive forces in an industry determines the degree to )hich this inflo) of investment drives the return do)n to the free mar+et level* hence the ability of firms to sustain above2average returns. he state of competition in an industry depends on five basic competitive forces. he collective strength of these forces determines the ultimate profit potential in the industry* )here

profit potential is measured in terms of return on invested capital. Competition e1tends )ell beyond the established players. Customers* suppliers* substitutes and potential entrants are all competitors and may be more or less prominent depending on the particular circumstances. %ll five competitive forces 3ointly determine the intensity of industry competition and profitability* but the strongest force or forces become crucial from the point of vie) of strategy formulation. $or e1ample* even a company )ith a very strong mar+et position in an industry )here potential entrants are no threat )ill earn lo) returns if it faces a superior* lo)er cost substitute. Even )ith no substitutes and bloc+ed entry* intense rivalry bet)een e1isting competitors )ill limit potential returns. 4ifferent forces ta+e on prominence* of course* in shaping competition in each industry. In the ocean2going tan+er industry the +ey force is probably the buyers 5the ma3or oil companies6* )hile in tires it is po)erful original e.uipment mar+et buyers coupled )ith tough competitors. In the steel industry* the +ey forces are rivalry )ith foreign competitors and substitute materials. he underlying structure of an industry* reflected in the strength of its five competitive forces* should be distinguished from the many short2run factors that can affect competition and profitability in a transient )ay. $luctuations in economic conditions over the business cycle can influence the short2run profitability of nearly all firms in an industry* as can material shortages* stri+es* spurts in demand and the li+e. 7hile such factors have tactical significance* the focus of structural analysis is on identifying the stable* underlying characteristics of an industry8its economic and technological structure8that shape the arena in )hich competitive strategy must be set. Industry structure can shift gradually over time* and firms )ill have uni.ue strengths and )ea+nesses in dealing )ith structure. 'et understanding industry structure must be the starting point for strategy analysis. he +ey economic and technological characteristics critical to the strength of each competitive force are discussed belo). Threat of Entry &e) entrants to an industry bring ne) capacity* the desire to gain mar+et share and other substantial resources. hey can bid do)n prices or inflate costs* reducing profitability. Companies diversifying through ac.uisition into an industry from other mar+ets often apply their resources to cause a sha+e2up* as Philip Morris did )ith Miller beer. hus ac.uisition into an industry )ith intent to build position should probably be vie)ed as entry* even if it doesn,t add a competitor in the literal sense. he cost of entry into an industry )ill depend in part on the probable reaction from existing competitors. If a potential entrant e1pects the incumbents to respond forcefully to ma+e its stay in the industry a costly and unpleasant one* it may )ell decide not to enter. If the industry has a history of vigorous retaliation to entrants* if the incumbent firms have substantial resources to fight bac+ 5including e1cess cash and unused borro)ing capacity* e1cess productive capacity or great leverage )ith distribution channels or customers6* or if the industry,s gro)th is sufficiently slo) that entry of a ne) competitor )ould depress the sales and financial performance of established firms* then potential entrants are li+ely to meet strong retaliation from incumbents. he cost of entry )ill also depend importantly on barriers to entry into the industry. Entry barriers are features of an industry that give incumbents inherent advantages over potential entrants. % number of industry characteristics commonly lead to such barriers.

he need to invest large financial resources in order to compete creates a barrier to entry* )hether those resources must be raised in the capital mar+ets or not. 7hile today,s ma3or corporations have the financial resources to enter almost any industry* the huge capital re.uirements in fields li+e computers and mineral e1traction limit the pool of li+ely entrants. Capital may be re.uired not only for production facilities* but also for things li+e customer credit* inventories or covering start2up loses. 9ero1 created a ma3or barrier to entry in copiers* for e1ample* )hen it chose to rent copiers rather than sell them outright. Potential entrants )ill generally be at a disadvantage in the capital markets. "nless a company is entering an industry through diversification* the ne)comer is in an inherently ris+ier position than the established firms* and this )ill be reflected in the ris+ premiums it )ill have to pay to attract capital. % potential entrant )ill face barriers if the industry is characteri:ed by economies of scale declines in unit costs of a product 5or operation or function that goes into producing a product6 as the absolute volume produced per period increases. Scale economies deter entry by forcing the entrant either to come in at large scale and ris+ strong reaction from e1isting firms or to accept a cost disadvantage* both undesirable options. Scale economies can be present in nearly every function of a business8production* research and development* mar+eting* service net)or+* sales force utili:ation or distribution. $or e1ample* scale economies in production* research* mar+eting and service are probably the +ey barriers to entry in the mainframe computer industry* as 9ero1 and ;E sadly discovered. Scale economies may relate to an entire functional area* as in the case of a sales force* or they may stem from particular operations or activities. In television set manufacturing* economies of scale are large in color tube production but less significant in cabinetma+ing and set assembly. Each component of costs must be e1amined separately to determine the e1tent of economies of scale. Scale economies may form a particularly significant entry barrier if the companies in an industry are generally diversified or vertically integrated. % company that is part of a multibusiness firm may be able to achieve scale economies if it is able to share operations or functions sub3ect to economies of scale )ith other companies in the firm. Consider* for e1ample* a company that manufactures small electric motors that go into industrial fans* hairdryers and cooling systems for electronic e.uipment assembled by other divisions of the firm. If its economies of scale in motor manufacturing e1tend beyond the number of motors needed in any one mar+et* it )ill reap economies in motor manufacturing that e1ceed those available if it only manufactured motors for use in* say* hairdryers. hus related diversification around common operations or functions can remove restraints imposed by limited volume of a given mar+et. he prospective entrant must be appropriately diversified or face a cost disadvantage. he benefits of sharing are particularly potent )hen a company can incur joint costs. <oint costs occur )here a firm producing product % 5or an operation or function that is part of producing %6 must inherently produce product =. $or e1ample* technological constraints limit the amount of space airline passenger services can devote to passengers* but ma+e available cargo space and payload capacity. Since it can spread the cost of putting the plane into the air over both passengers and freight* the firm that competes in both passenger and freight may have a substantial advantage over the firm competing in only one mar+et. % similar advantage accrues to businesses )hose manufacturing processes result in byproducts. he entrant that cannot capture the highest incremental revenue from the by2products )ill face a disadvantage if incumbent firms can.

he potential entrant also faces the possibility of foreclosure of inputs or mar+ets for its product if most established competitors in the industry are vertically integrated 5operate in successive stages of production or distribution6. In such cases* incumbents purchase from in2house units or sell their inputs in2house. he unintegrated entrant )ill face a difficult time getting comparable prices and may get 0s.uee:ed0 if integrated competitors offer it different terms from those offered their captive units. Entry can be deterred by an entrant,s need to secure distribution channels for its products. E1isting competitors may have ties )ith channels based on long relations* high .uality service or even e1clusive contracts )hereby the channel is solely identified )ith a particular manufacturer. o the e1tent that logical distribution channels for the product are served by established firms* the ne)comer must persuade the channels to accept its product* using price brea+s* cooperative advertising allo)ances and other measures that generally cut into profits. % ne) food product* for e1ample* must displace others from the fiercely competitive supermar+et shelf via promotions* intense selling efforts or heavy advertising to create consumer pull. Sometimes this barrier to entry is so high that* to surmount it* a ne) firm must create an entirely ne) distribution channel in order to get into the industry. &e)comers )ill find it particularly difficult to compete )ith established firms for distribution channels and buyers if the industry is characteri:ed by product differentiation. Product differentiation means that established firms have brand identification and customer loyalties stemming from past advertising* customer service and product differences. &ot infre.uently* these firms can benefit from economies of scale as a result. he cost of creating a brand name* for instance* need only be borne once/ the name may then be freely applied to other products of the company* sub3ect only to any costs of modification. % ne)comer* on the other hand* must spend heavily to overcome e1isting distributor and customer loyalties. Investments in building a brand name are particularly ris+y* since they are unrecoverable. Product differentiation is perhaps the most important entry barrier in baby care products* over2the2counter drugs* cosmetics* investment ban+ing and public accounting. In the bre)ing industry* product differentiation is coupled )ith economies of scale in production* mar+eting* and distribution to create high barriers. Entry can also be deterred if switching costs are high. S)itching costs are one2time costs of s)itching brands or s)itching from one supplier,s product to another,s. S)itching costs may include such things as employee retraining costs* the cost of ne) ancillary e.uipment* the cost and time needed to test or .ualify a ne) source or to redesign a product or even the psychic costs of severing a relationship. If such costs are high* the entrant must offer a ma3or improvement in cost or performance to induce the buyer to s)itch. $or e1ample* suppliers of intravenous solutions and +its for use in hospitals have different procedures for attaching solutions to patients* and the hard)are for hanging the solution bottles are not compatible. his industry is characteri:ed by relatively high returns. Government policy may also represent a substantial entry barrier in some industries. ;overnment can consciously or unconsciously limit or even foreclose entry into industries* using such controls as licensing re.uirements or limits on access to ra) materials 5e.g.* coal lands or mountains suitable for s+i areas6. ;overnment regulation restricts entry to such industries as truc+ing* railroads* li.uor retailing* broadcasting and freight for)arding. More subtle restrictions on entry can stem from government subsidies to incumbents or from governmental controls such as air and )ater pollution standards or product safety and efficacy regulations. Pollution control re.uirements can raise capital needed for entry and can increase

re.uired technological sophistication and even optimal scale of facilities. Standards for product testing* common in industries li+e food and other health2related products* can impose substantial lead times on getting into an industry* not only raising the cost of entry but giving established firms ample notice of impending entry and* sometimes* full +no)ledge of competitor products. ;overnment policy in such areas certainly may have social benefits* but it often has second2order conse.uences for entry that go unrecogni:ed. 7hile the barriers mentioned so far can perhaps be surmounted by entrants )illing to invest the capital* established firms may have other cost advantages not replicable by potential entrants no matter )hat their si:e and attained economies of scale. $or instance* some industries are characteri:ed by proprietary product technology+no)2ho) or techni.ues that are +ept proprietary through patents or secrecy. In others* the established firms may have loc+ed up the most favorable raw material sources, or tied up foreseeable ra) material needs early at prices reflecting a lo)er demand for them than currently e1ists. $or e1ample* $rasch sulfur firms li+e e1as ;ulf Sulfur gained control of some very favorable salt dome sulfur deposits many years ago* before mineral right holders )ere a)are of their value as a result of the $rasch mining technology. 4iscoverers of sulfur deposits )ere often disappointed oil companies e1ploring for oil. Similarly* established firms in some industries may have cornered favorable locations before mar+et forces bid up prices to capture their full value. Potential ne)comers )ill enter at a permanent competitive disadvantage. %nother important factor that creates cost advantages is the experience curve. In some businesses* unit costs tend to decline as the firm gains more cumulative e1perience in production. E1perience is 3ust a name for certain +inds of technological change. 7or+ers become more efficient 5the classic learning curve6* layout improves* e.uipment and processes become speciali:ed. Changes in product design techni.ues and operations control ma+e manufacturing easier. Cost declines )ith e1perience seem to be most significant in businesses involving a high labor content and>or comple1 assembly operations 5aircraft* shipbuilding6. hey are nearly al)ays greatest in the early and gro)th phases of a product,s development* diminishing in later phases. In some )ays* cost declines )ith e1perience operate in the same manner as scale economies. E1perience can lo)er costs in mar+eting* distribution and other areas as )ell as production or operations )ithin production* and each component of costs must be e1amined for e1perience effects. 4iversification can enhance cost declines due to e1perience* since diversified firms can share operations or functions sub3ect to e1perience cost declines and units in diversified firms can benefit from the e1perience gained by other related units. In the case )here an activity li+e ra) material fabrication is shared by multiple business units* e1perience obviously accumulates faster than it )ould if the activity )ere used solely to meet the needs of one company. Economies of scale are often cited as one of the reasons costs decline )ith e1perience. =ut economies of scale are dependent on volume per period* not cumulative volume* and are very different analytically from cost declines )ith e1perience. Economies of scale and e1perience also have very different properties as entry barriers. he presence of economies of scale always leads to cost advantage for the large2scale or properly diversified firm* presupposing that the large firm has the most efficient facilities* distribution systems* service organi:ations and other functional units for its si:e. E1perience is a more ethereal entry barrier than scale. he mere presence of an e1perience curve does not ensure an entry barrier. he e1perience must be proprietary8i.e.* not available to

competitors and potential entrants through 5?6 copying* 5@6 hiring competitors, employees or 5A6 purchasing the latest machinery from e.uipment suppliers or the relevant +no)2ho) from consultants or others. If the e1perience curve can be +ept proprietary by established firms* then they can erect an entry barrier. &e)ly started firms* )ith no e1perience* )ill have inherently higher costs than established firms and )ill have to incur heavy start2up losses from belo) or near2cost pricing before they can gain the e1perience re.uisite to cost parity )ith established firms. =ecause of their lo)er costs* established firms 5particularly the mar+et share leader6 )ill have higher cash flo)s to invest in ne) e.uipment and techni.ue. &e) entrants )ill never catch up. % number of firms 5notably e1as Instruments* =lac+ and 4ec+er and Emerson Electric6 have built successful strategies based on the e1perience curve through aggressive investments to build cumulative volume early in the development of their industries* often by pricing in anticipation of future cost declines. Many times* ho)ever* e1perience cannot be +ept proprietary. Even )hen it can* it may accumulate more rapidly for the second and third firms in the mar+et than it did for the pioneer. he later firms can observe some aspects of the pioneers operations. In situations )here e1perience cannot be +ept proprietary* ne) entrants may actually have an advantage if they can buy the latest e.uipment or adapt to ne) methods unencumbered by having operated the old )ay in the past. %n e1perience barrier can be nullified by product or process innovations leading to a substantially ne) technology that creates an entirely ne) e1perience curve.A &e) entrants can leapfrog the industry leaders and alight on the ne) e1perience curve* to )hich the leaders may be poorly positioned to 3ump. Similarly* technological change may penali:e the large2scale firm if facilities designed to reap economies of scale are speciali:ed* hence less fle1ible in adapting to ne) technologies. Commitment either to achieving scale economies or to reducing costs through e1perience has some potential ris+s. It may cloud the perception of ne) technological possibilities* or of other )ays of competing less dependent on scale or e1perience. Emphasis on scale over other valuable entry barriers such as product differentiation may )or+ against image or responsive service. !e)lett2Pac+ard has erected substantial barriers based on technological progressiveness in industries li+e calculators and minicomputers* )here other firms are follo)ing strategies based on e1perience and scale. Properties of Entry Barriers %ll entry barriers can and do change as conditions in the industry change. he e1piration 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 Koda+ plunged into the mar+et. Product differentiation in the maga:ine printing industry has all but disappeared* reducing barriers. Conversely* in the auto industry economies of scale increased enormously )ith post)ar automation and vertical integration* virtually stopping successful ne) entry. 7hile entry barriers sometimes change for reasons largely outside a company,s control* company strategic decisions can have a ma3or impact on entry barriers. In the ?BCDs* many ".S. )ine producers stepped up product introductions* raised advertising levels and e1panded distribution nationally* increasing entry barriers by raising economies of scale and product differentiation and ma+ing access to distribution channels more difficult. Similarly* decisions by

members of the recreational vehicle industry to integrate vertically have greatly increased the economies of scale there. $inally* some firms may possess resources or s+ills that allo) them to overcome entry barriers into an industry more cheaply than most other firms. ;illette* )ith )ell developed distribution channels for ra:ors and blades* faced lo)er costs of entry into disposable lighters than many other potential entrants )ould have faced. Rivalry Between Existing Competitors -ivalry bet)een e1isting competitors ta+es the familiar form of 3oc+eying for position8using tactics li+e price competition* advertising battles* product introductions and increased customer service or )arranties. -ivalry occurs because one or more competitors either feel pressured or see the opportunity to improve position. In most industries* competitive moves by one firm have noticeable effects on its competitors and thus may incite retaliation. $irms are conse.uently mutually dependent. % se.uence of actions and reactions may or may not leave the initiating firm and the industry as a )hole better off. If moves and countermoves escalate* then all firms in the industry may suffer and be )orse off than before. Some forms of competition 5notably price competition6 are highly unstable and li+ely to leave the entire industry )orse off from a profitability standpoint. Price cuts are .uic+ly and easily matched by rivals and* once matched* lo)er revenues for all firms unless industry price elasticity of demand is very great. %dvertising battles* on the other hand* may )ell e1pand demand or raise the level of product differentiation in the industry* to the benefit of all firms. -ivalry in some industries is characteri:ed by such phrases as 0)arli+e*0 0bitter0 or 0cut2throat*0 )hile in other industries it is termed 0polite*0 or 0gentlemanly.0 he intensity of rivalry can be traced to the presence of a number of interacting structural factors. 7hen the competitors in an industry are numerous, the li+elihood of maveric+s that )ill touch off rivalry is great* since some firms may believe they can ma+e moves )ithout being noticed. Even if there are relatively fe) firms* if they are relatively balanced in terms of the resources for sustained and vigorous retaliation* they may be prone to ta+e each other on. #n the other hand* )hen an industry is highly concentrated or dominated by one or a fe) firms* relative po)er )ill be stable and apparent to everyone* and the leader or leaders )ill be able to impose discipline through devices li+e price leadership. low industry growth is generally a destabili:ing force for rivalry* since it can turn competition into a mar+et share game for firms see+ing e1pansion. 7hen industry gro)th is rapid* firms can improve results 3ust by +eeping up )ith the industry/ in fact* all their financial and managerial resources may be consumed by e1panding )ith the industry. !igh fixed costs create strong pressures for all firms to fill capacity* )hich often leads to rapidly escalating price cutting. Many basic materials li+e paper and aluminum suffer from this problem. he +ey is fi1ed costs relative to value added* rather than the absolute level of fi1ed costs. $irms purchasing a high proportion of costs in outside inputs 5lo) value added6 may feel enormous pressures to fill capacity to brea+ even* even if the absolute proportion of fi1ed costs is lo). % similar situation faces industries )hose products are very difficult or costly to store. !ere firms )ill be vulnerable to temptations to shade prices in order to ensure sales. his sort of pressure +eeps profits lo) in lobster fishing and in industries that manufacture certain ha:ardous chemicals.

7hen the industry product is perceived as a commodity or near" commodity, buyer choice )ill largely be dictated by price and service* creating strong pressures for price and service competition. 4ifferentiation* on the other hand* creates layers of insulation against competitive )arfare because buyers have preferences and loyalties to particular sellers. Similar insulation against rivalry is provided by switching costs 5defined earlier6. -ivalry is increased by pressures that lead to chronic overcapacity. $or e1ample* )here economics dictate that capacity can be augmented only in large increments* capacity additions can be chronically disruptive to the industry supply2demand balance* particularly )hen there is a ris+ of bunching of capacity additions. he industry may face chronic periods of the +ind of overcapacity and price cutting that afflict chlorine* vinyl chloride and ammonium fertili:er. #ompetitors that are diverse in strategies* origins* personalities and relationships to their parent companies create volatile rivalry because they have differing goals and differing ideas about ho) to compete and are continually colliding head2on in the process. hey have a hard time accurately reading each others, intentions and agreeing on the rules of the game for the industry. Strategic choices 0right0 for one competitor )ill be 0)rong0 for the others. $oreign competitors often add a great deal of diversity to industries because of their differing circumstances and often differing goals. #)ner2operators of small manufacturing or service firms may be )illing to accept subnormal rates of return on their investment capital in e1change for independence/ such lo) returns may appear unacceptable or irrational to a large publicly held competitor. In such an industry* the posture of the small firms may limit the profitability of the larger concern. Similarly* firms vie)ing a mar+et as a dumping outlet for e1cess capacity )ill adopt policies contrary to those of firms that vie) the mar+et as their main business. 4ifferences in the )ay companies competing in an industry relate to their corporate parents is another important source of diversity. % company that is one part of a vertical chain of businesses )ithin its corporate organi:ation may )ell adopt goals very different from those of a free2standing company competing in the same industry. % company that represents a 0cash co)0 in its parent company,s portfolio of businesses )ill behave differently from one being developed for long2run gro)th. Industry rivalry becomes even more volatile if a number of firms in the industry have high stakes in achieving success. $or e1ample* a diversified firm may place great importance on achieving success in a particular industry in order to further its overall corporate strategy. #r a foreign firm li+e =osch* Sony or Philips may perceive a strong need to establish a solid position in the ".S. mar+et in order to build global prestige or technological credibility. Such firms may be )illing to sacrifice profitability for the sa+e of e1pansion. $inally* industry riva?ry can be volatile )hen an industry faces high exit barriersfactors that +eep companies competing in businesses even though they may be earning lo) or even negative returns on investment. E1cess capacity does not leave the industry* and companies that lose the competitive battle do not give up. -ather* they hang on grimly and* because of their )ea+ness* sometimes resort to e1treme tactics that can destroy the profitability of the entire industry. E1it barriers may be high )hen assets are highly speciali:ed to a particular business or location* hence difficult to li.uidate/ )hen labor agreements* resettlement costs or spare parts maintenance create fi1ed costs of e1it/ )hen interrelationships bet)een one company and others in a multibusiness firm in terms of image* mar+eting ability* access to financial mar+ets* shared

facilities and so on lend the business broader strategic importance/ )hen government denies or discourages e1it because of 3ob loss and regional economic effects 5particularly common outside the ".S.6/ or )hen managements are un)illing to ma+e economically 3ustified e1it decisions because of loyalty to employees* fear of the conse.uences for their o)n careers* pride or other emotional reasons. 7hile e1it barriers and entry barriers are conceptually separate* their combination is an important aspect of the analysis of an industry. E1it and entry barriers often rise and fall together. he presence of substantial economies of scale in production* for e1ample* usually implies speciali:ed assets* as does the presence of proprietary technology. he best case from the vie)point of industry profits is )here entry barriers are high but e1it barriers are lo). !ere entry )ill be deterred and unsuccessful competitors )ill leave the industry. 7here both entry and e1it barriers are high* profit potential is high but is usually accompanied by more ris+. %lthough entry is deterred* unsuccessful firms )ill stay and fight in the industry. 7hile the case of lo) entry and e1it barriers is une1citing from a profitability standpoint* the )orst case is )here entry barriers are lo) and e1it barriers are high. !ere entrants )ill be attracted by upturns in economic conditions or other temporary )indfalls. hey )ill not leave the industry* ho)ever* )hen results deteriorate. %s a result* industry capacity )ill stac+ up and profitability )ill usually be chronically poor. Shifting Rivalry Industry features that determine the intensity of competitive rivalry can and do change. %s an industry matures* its gro)th rate declines* resulting in intensified rivalry* declining profits and 5often6 a sha+eout. In the booming recreational vehicle industry of the early ?BEDs* nearly every producer did )ell/ but slo) gro)th since then has eliminated the high returns to all e1cept the strongest members. he same story has been played out in industry after industry8 sno)mobiles* aerosol pac+aging and sports e.uipment* to name a fe). -ivalry can also shift )hen an ac.uisition introduces a very different personality into an industry. his has been the case )ith Philip Morris, ac.uisition of Miller =eer and Procter & ;amble,s ac.uisition of Charmin Paper Company. %lso* technological innovation can boost the level of fi1ed costs in the production process and raise the volatility of rivalry* as it did in the shift from batch to continuous2line photofinishing in the ?BCDs. 7hile a company must live )ith many of the factors determining the intensity of industry rivalry that are built into industry economics* it may have some latitude to influence rivalry through its choice of strategy. % company may try to raise buyers, s)itching costs by designing its product into its customers, operations or by ma+ing its customers dependent for technical advice. % company can attempt to raise product differentiation through ne) +inds of service* mar+eting innovations or product changes. $ocusing selling efforts on the fastest gro)ing segments of the industry or on mar+et areas )ith the lo)est fi1ed costs can reduce the impact of industry rivalry. If it is feasible* a company can try to avoid confrontation )ith competitors having high e1it barriers* thus sidestepping involvement in bitter pace cutting. Pressure from Substitute Products %ll firms in an industry are competing* in a broad sense* )ith industries producing substitute products. Substitutes limit the profit potential of an industry by placing a ceiling on the prices firms in the industry can charge. he more attractive the pace2performance tradeoff offered by substitutes* the tighter the lid on industry profits. Sugar producers confronted )ith the large2scale

commerciali:ation of high fructose corn syrup* a sugar substitute* are learning this lesson today* as are producers of acetylene and rayon* )ho face tough competition from lo)er cost alternatives. Substitutes not only limit profits in normal times* but also reduce the bonan:a an industry can reap in boom times. In ?BEF* the producers of fiberglass insulation en3oyed unprecedented demand as a result of high energy costs and severe )inter )eather. =ut the industry,s ability to raise paces )as tempered by the plethora of insulation substitutes* including cellulose* roc+ )ool and styrofoam. hese substitutes are bound to become an even stronger force once the current round of plant additions by fiberglass insulation producers has boosted capacity enough to meet demand 5and then some6. Identifying substitute products entails searching for other products that can perform the same function as the product of the industry. Sometimes this can be a subtle tas+* one that ta+es the analyst into businesses seemingly far removed from the industry in .uestion. Securities* for e1ample* face increasing competition from alternative investments such as real estate* insurance and money mar+et funds. ;overnment regulations* subsidies and ta1 policies should also be considered in the search for substitutes. he ".S. government is currently promoting solar heating* for e1ample* using ta1 incentives and research grants. ;overnment decontrol of natural gas is .uic+ly eliminating acetylene as a chemical feedstoc+. Safety and pollution standards also affect relative cost and .uality of substitutes. %ttention should focus on substitute products that 5a6 are en3oying steady improvement in price2performance tradeoff )ith the industry,s product* 5b6 )ould entail minimal s)itching costs for prospective buyers or 5c6 are produced by industries earning high profits. In the latter case* substitutes often come rapidly into play if some development increases competition in their industries and causes pace reduction or performance improvement. Effective defense against substitute products may re.uire collective industry action. 7hile advertising by one firm in an industry does little to bolster the industry,s position against a substitute* heavy and sustained advertising by all industry participants may )ell improve the industry,s collective position against the substitute. Similar arguments apply to collective industry response through industry groups and other means in areas such as product .uality improvement* mar+eting efforts and product distribution. rend analysis can be important in deciding )hether company strategy should be directed to)ard heading off a substitute strategically or accepting the substitute as a +ey competitive force. Electronic alarm systems* for e1ample* represent a potent substitute in the security guard industry. Electronic systems can only become more important as a substitute since labor2intensive guard services face inevitable cost escalation* )hile electronic systems are highly li+ely to improve in performance and decline in cost. !ere the appropriate response of security guard firms is probably to offer pac+ages of guards and electronic systems* )ith the security guard redefined as a s+illed operator* rather than attempt to compete against electronic systems )ith a traditional guard service. Bargaining Power of Buyers =uyers represent a competitive force because they can bid do)n prices* demand higher .uality or more services* and play competitors off against each other8all at the e1pense of industry profitability. he po)er of each important buyer group depends on a number of characteristics of

its mar+et situation and on the relative importance of its purchases from the industry compared )ith the industry,s overall business. % buyer group )ill be po)erful if it purchases large volumes relative to seller sales, so that retaining its business is financially important to the seller. Garge volume buyers are particularly potent forces if heavy fi1ed costs characteri:e the industry 5as in corn refining and bul+ chemicals6 and raise the sta+es to +eep capacity occupied. =uyer po)er is enhanced if the products purchased from the industry represent a significant fraction of total purchases. In this case* the buyer )ill be prone to e1pend the resources necessary to shop for a favorable pace and to purchase selectively. If the product sold by the industry is a small fraction of the buyers costs* the buyer )ill usually be much less pace sensitive. Similarly* a buyer suffering from low profits has great incentive to lo)er purchasing costs. Suppliers to Chrysler* for e1ample* are complaining that they are being pressed for superior terms. !ighly profitable buyers are generally less pace sensitive and more concerned about the long2run health of their suppliers 5that is* unless the purchase represents a large fraction of their costs6. =uyer po)er is also increased if buyers have a lot of information about mar+et conditions* supplier costs and offers to other buyers. If buyers are either already partially integrated or pose a strong threat of backward integration, they are in a position to demand bargaining concessions. Ma3or automobile producers li+e ;eneral Motors and $ord fre.uently use this bargaining lever. hey engage in the practice of tapered integration, or producing some of their needs for a given component in2house and purchasing the rest from outside suppliers. &ot only is their threat of further integration particularly credible* but partial manufacture in2house gives them detailed +no)ledge of costs* )hich is a great aid in negotiation. =uyer po)er can be partially neutrali:ed )hen firms in the industry offer a threat of for)ard integration into the buyer,s industry. $inally* the impact of the supplier's product on the buyer,s business )ill help determine the bargaining po)er of purchasers. If the .uality of the buyers product is very much affected by the .uality of the industry,s product* the buyer )ill generally be less price sensitive. In oil field e.uipment* for instance* a malfunction can lead to large losses 5as )itness the enormous cost of the recent failure of a blo)out preventer in a Me1ican offshore oil )ell6/ the .uality of enclosures for electronic medical and test instruments can greatly influence the user,s impression about the .uality of the e.uipment inside. $inally* switching costs 5defined earlier6 loc+ the buyer to particular sellers and mitigate buyer po)er. #n the other hand* if the industry,s products are standard or undifferentiated* buyers* sure that they can al)ays find alternative suppliers* may play one company against another* as they do in aluminum e1trusion. Most sources of buyer po)er apply to consumer as )ell as to industrial and commercial buyers. $or e1ample* consumers tend to be more price sensitive if they are purchasing products that are undifferentiated or e1pensive relative to their incomes. he po)er of )holesalers and retailers is determined by the same rules* )ith one important addition. -etailers can gain significant bargaining po)er over manufacturers if they can influence consumer's purchasing decisions, as they do in audio components* 3e)elry* appliances and sporting goods. Similarly* )holesalers can gain bargaining po)er if they can influence the decisions of the retailers or other firms to )hich they sell. ltering Buying Power

he po)er of buyers can rise or fall as the underlying factors creating buyer po)er change )ith time or as a result of a company,s strategic decisions. In the ready2to2)ear clothing industry* for e1ample* the buyers 5department stores and clothing stores6 have become more concentrated and control has passed to large chains/ as a result* the industry has come under increasing buyer pressure and suffered failing profit margins. So far the industry has been unable to differentiate its products or to engender s)itching costs that )ould loc+ its buyers in sufficiently to neutrali:e these trends. % company,s choice of the buyer group it sells to is a crucial strategic decision. % company can improve its strategic posture by finding buyers )ho possess the least po)er to influence it adversely8in other )ords by buyer selection. -arely do all the buyer groups a company sells to en3oy e.ual po)er. Even if a company sells to a single industry* there are usually segments )ithin that industry that e1ercise less po)er 5and that are less price sensitive6 than others. $or e1ample* the replacement mar+et for most products is less pace sensitive than the original e.uipment mar+et. Bargaining Power of Suppliers Suppliers can e1ert a competitive force in an industry by raising prices or reducing the .uality of the goods they sell. Such pace increases can s.uee:e profitability out of an industry unable to recover cost increases in its o)n paces. =y raising their prices* for e1ample* chemical companies have contributed to the erosion of profitability of contract aerosol pac+agers because the pac+agers* facing intense competition from self2manufacture by their customers* have limited freedom to raise their prices. he conditions ma+ing suppliers po)erful are largely the inverse of those ma+ing buyers po)erful. If a supplier group is dominated by a few companies and more concentrated than the industry it sells to, it )ill be able to e1ert considerable influence on prices* .uality and terms. #n the other hand* the po)er of even large po)erful suppliers can be chec+ed if they have to compete )ith substitutes. Industries producing alternative s)eeteners* for e1ample* compete sharply for many applications even though individual suppliers are large relative to individual customers. If suppliers sell to a number of industries* so that one particular industry does not represent a significant fraction of sales, they )ill be much more prone to e1ert pacing pressure. If the industry is an important customer* suppliers, fortunes )ill be closely tied to the industry* and suppliers )ill )ant to protect the industry through reasonable pricing and assistance in activities li+e research and development and lobbying. $ifferentiation and switching costs cut off buyers, options in playing one supplier off against another and raise supplier po)er. %nd a credible threat of forward integration provides a chec+ against an industry,s ability to improve the terms on )hich it purchases. It is important to recogni:e labor as a supplier* and one that e1erts great po)er in many industries. here is substantial empirical evidence that scarce* highly s+illed employees 5e.g.* engineers and scientists6 and>or tightly unioni:ed labor can bargain a)ay a significant fraction of potential profits in an industry. he features that determine the potential po)er of employees as a supplier include those outlined above plus labor,s degree of organi%ation and the ability of the supply of scarce varieties of employees to expand. 7here labor is strongly organi:ed and supply of scarce employees constrained from e1pansion then can be a factor in competition. 7here

labor is strongly organi:ed and supply of scarce employees constrained from e1pansion they can be a factor in competition. Government, )hich has been discussed primarily in terms of its possible impact on entry barriers* must also be recogni:ed as a potentially po)erful buyer and supplier. In these roles* government can often influence industry competition by the policies it adopts. ;overnment plays a crucial role as a buyer of defense2related products and as a supplier of timber through the $orest Service,s control of vast timber reserves in the )estern "nited States. Many times government,s role as a supplier or buyer is determined more by political factors than by economic circumstances* and this is probably a fact of life. he conditions determining supplier po)er are fre.uently beyond a company,s control. !o)ever* as )ith buyer po)er* the firm can sometimes improve its situation through strategy. It can promote a threat of bac+)ard integration* see+ to eliminate s)itching costs and the li+e. Structural nalysis and Competitive Strategy #nce the forces affecting competition in an industry and their underlying causes have been diagnosed* a company is in a position to identify its strengths and )ea+nesses relative to the industry. he crucial strengths and )ea+nesses from a strategic standpoint are the company,s posture vis2a2vis the underlying causes of each competitive force. 7here does it stand against substitutesH %gainst the sources of entry bartersH In coping )ith rivalry from established competitorsH Competitive strategy is ta+ing offensive or defensive action in order to strengthen a company,s position in relation to the five competitive forces8positioning the company so that its capabilities provide the best defense against the e1isting array of competitive forces* influencing the balance of forces through strategic moves that improve the company,s relative position or anticipating shifts in the factors underlying the forces and responding so as to e1ploit change by choosing a strategy appropriate to the ne) competitive balance before rivals recogni:e it. % positioning strategy ta+es the structure of the industry as given and matches the company,s strengths and )ea+nesses to it* building defenses against the competitive forces or finding positions in the industry )here the forces are )ea+est. Kno)ledge of the company,s capabilities and of the causes of the competitive forces )ill highlight the areas )here the company should confront competition and )here it should avoid competition. If the company is a lo)2cost producer* for e1ample* it may choose to confront po)erful buyers )hile it ta+es care to sell them only products not vulnerable to competition from substitutes. %lternatively* a company can ta+e an offensive approach by developing strategies designed to influence the balance of competitive forces. Innovations in mar+eting can raise brand identification or other)ise differentiate the company,s product. Capital investments in large2scale facilities or vertical integration can bolster entry barriers. Structural analysis can be used to identify the factors driving competition that )ill be most susceptible to strategic actions. Industry evolution is important strategically because evolution can present opportunities to exploit changes in the sources of competition. In the familiar product life cycle pattern of industry development* for e1ample* gro)th rates change as the business matures* advertising declines and companies tend to integrate vertically.

hese trends are not so important in themselves/ )hat is critical is )hether they affect the structural sources of competition. $or e1ample* e1tensive vertical integration* both in manufacturing and in soft)are development* is ta+ing place in the maturing minicomputer industry. his very significant trend has greatly increased economies of scale as )ell as the amount of capital necessary to compete in the industry. his in turn has raised entry barriers and threatens to drive some smaller competitors out of the industry. #bviously* the trends carrying the highest priority from a strategic standpoint are those that affect the most important sources of competition in the industry and those that elevate ne) structural factors to the forefront. In contract aerosol pac+aging* for instance* the dominant trend to)ard less product differentiation has increased the po)er of buyers* lo)ered the barriers to entry and intensified competition. The task of structural analysis in the long run is to examine each competitive force, forecast the magnitude of each underlying cause and construct a composite picture of the likely profit potential of the industry. #f course* this picture may differ considerably from present realities. oday* the solar heating business is populated by do:ens and perhaps hundreds of companies* none )ith a ma3or mar+et position. Entry is easy and competitors are battling to establish solar heating as a superior substitute for conventional heating methods. he potential of solar heating )ill depend largely on the shape of future barriers to entry* the improvement of the industry,s position relative to substitutes* the ultimate intensity of competition and the po)er that )ill be captured by buyers and suppliers. hese characteristics )ill* in turn* be influenced by such factors as the establishment of brand identities* the creation of significant economies of scale or e1pedience curves in e.uipment manufacture* the ultimate capital costs and the eventual importance of fi1ed costs in production. #f course* no structural analysis can be complete )ithout a diagnosis of ho) present and future government policy* at all levels* may affect competitive conditions. $or purposes of strategic analysis it is usually more illuminating to consider ho) government affects competition through the five competitive forces than to consider it as a force in and of itself. !o)ever* strategy may )ell involve treating government as a factor to be influenced. Structural nalysis and Diversification he frame)or+ for analy:ing industry competition is obviously useful in setting diversification strategy* since it provides a guide for ans)ering the e1tremely difficult .uestion inherent in diversification decisions. 7hat is the potential of this businessH he frame)or+ may allo) a company to spot an industry )ith a good future before this potential is reflected in the paces of ac.uisition candidates. It )ill also help a company identify industries )here its strengths )ill allo) it to overcome entry barriers more cheaply than other firms. %nd the frame)or+ can help in identifying ac.uisitions that can ta+e advantage of e1isting operations8for e1ample* ac.uisitions that )ould allo) a firm to overcome +ey entry barriers by providing shared functions or pre2e1isting relations )ith distribution channels.

References

?. o avoid needless repetition* the term 0product*0 rather than 0product or service*0 is used throughout to refer to the output of an industry. he principles of structural analysis )ill apply e.ually to product and service businesses. hey also apply to industry competition in any country or international mar+et* although some of the institutional circumstances may differ. @. $or this entry barrier to be significant* it is crucial that the shared operation or function be sub3ect to economies of scale that e1tend beyond the si:e of any one mar+et. If this is not the case* cost savings of sharing can be illusory. % company may see its costs decline after entering a related business as overhead is spread* but this depends solely on the presence of e1cess capacity in the operation or function in the base business. Such economies are short2run* and once capacity is fully utili:ed the true cost of the shared operation )ill become apparent. A. $or an e1ample of this dra)n from the history of the automobile industry* see 7illiam <. %bernathy and Kenneth 7ayne. 0 he Gimits of the Gearning Curve*0 !arvard &usiness 'eview, September2#ctober ?BEI* p. ?DB.