Thursday 16 February 2023

5 Forces framework

Not all industries are equal, the dynamics and structure of an industry or market segment, can impact the future profit potential of firms who operate in a particular industry, or are looking to operate in a particular market or industry.  When we talk about an industry we are referring the "Industry Environment"

Broadly we can think of a three layer onion, with the organisation or business at the core, the 'Macro Environment' as the most outer layer and the 'Industry Environment' between the two. At the 'Industry Environment' layer we analyse the impact of competitors, suppliers, consumers, etc. To understand these market discrepancies we are going to focus our attention onto the 'industry Environment' layer and not focus on the individual organisations that make up an industry or market segment.

If we recall the fundamental principle of business strategy 

This means that in a perfectly level playing field competitors can only compete on price, and in theory consumers will take the best value, meaning all things equal, the competitive space turns into a race to the bottom. We know that in practice this does not generally hold true, in almost all but the simplest of industries their is generally one or a few firms that are the successful leaders, who turn greater profits than their competitors. 

There are two perspectives on profits:

  • Monopoly rents: that some barrier to entry exists, that prevents competition from entering the market to drive the price down, this could be number of things, however generally it is considered to be some sort of governing body. Monopoly rents focus on barriers to competition.
  • Ricardian rents: that inherently one or a few organisations will have some sort of competitive advantage, a trade secret, a patent . Ricardian rents  focuses on barriers to imitation.

From an industrial organisation perspective the 'Industry Environment' greatly influences how profitable an organisation or business can be, in essence firms that operate in highly profitable industries are generally more profitable than firms that operate in low. This can be considered obvious, however the questions we want to answer are: 

  • how can we identify whether an industry is highly profitable? 
  • how to identify if an industry will remain profitable or will turn into a race to the bottom?
  • how to best position oneself for profitability within an industry?

Historically the industries with the highest levels of profitability have the most barriers to entry, meaning the more difficult it is to enter an industry, the fewer competitors will be in that space, cannibalising each other's profits. Most often industries which are protected by patents and government regulation tend to be more profitable then those open to competition. These monopolistic barriers to competition are what often results in certain industries being far more profitable than others.

The Five forces analysis tool takes into account the five key competitive forces that minimize or dampen the prospects of profitability in a particular industry: The five competitive forces all work against or threaten the profitability potential of an industry or a market segment. 

  • will stiff price competition within the industry drive prices down?
  • will the bargaining power of suppliers force organisations to pay more for what they need to stay in business?
  • will the bargaining power of the buyers force prices down?
  • will new entrants into the industry pose a serious competitive risk, with new innovations or just saturating the market?
  • is there a threat of substitution, is there a similar enough product or service that customers could use as an alternative?

Threat of Entry

The threat of entry describes how difficult it is for competitors to enter an industry, the lower the threat level, the less likely a competitor will enter the market. Basically, A low threat of entry means that it is hard for new competitors to enter the industry. 

High sunk costs: It is far less likely for competitors to enter a given industry if they face high sunk costs. Sunk costs are not just regular costs. If the bar to entry is a lot of capital, then entering the industry is not nearly as dangerous as if the requirement is high sunk costs. High sunk costs could come in the form of very expensive assets or licences. Sunk costs discourage new entries into an industry because if things do not go well they will not be able to recoup as much if any of their investment capital.

Incumbents have a competitive advantage: Potential entrants are at a competitive disadvantage compared to existing players, simply not profitable to enter. If the established players within an industry or market have a patent or their brand, pre-commitment contracts, steep learning curves, large economies of scale.

Entrant faces Retaliation: Potential entrants are likely to be forced out of business by strategic pricing behavior of incumbents. an incumbent can operate at a break even point or even a loss to force competition out of an industry.

Scale economies: costs generally decline as an organisation produces more of their product, the more widgets you produce, the cheaper per unit production costs are, the higher profit potential exists per unit.

Scope economies: costs generally decline the higher breadth of related products a firm produces, leveraging lessons learned as well as cross design.

Learning curve Economies: costs decline as an organisation gains more experience and learns how to do things faster/cheaper.

Bargaining power of buyers

In economics there is a concept known as 'monopsony', which means that there are a few concentrated buyers for our good or service. Generally the fewer buyers exist, the more bargaining power they have. The concept is simple, if you are selling to hundreds of thousands of buyers, if one doesn't like your price, you can find a different one. If you are dealing with a 'monopsony', that is a small pool of buyers, and one doesn't like your price, you only have a handful of alternatives; even worse if the 'Monopsony' binds together they can force you to lower your price. A 'Monopsony' is the opposite of a 'monopoly', in  monopoly, there is one seller who any buys must deal with, where as in a 'Monopsony' there few buyers and many sellers.

Switching costs can also be a major factor when it comes to bargaining power of suppliers, if the capital outlay for changing product or service is high, then that will also impact the bargaining power of suppliers. For example if a delivery service has a fleet of trucks, switching to insurance on those trucks could prove to be expensive, if there is a cancelation fee.

Backward integration: one major threat of supplier bargaining power, is if the supplier can backward integrate into the product or service you are providing. For example if you are providing a particular component or service, one of your buyer may simply be able to replicate your product or service and backward integrate it into their own supply chain. Either cutting you out, or drastically increasing their own bargaining power.

Price discrimination: Companies, assuming that there is price opaqueness, can engage in price discrimination, that is some buyers are willing to pay more for the exact same product or service, for example the aviation industry greatly discriminates based on what kind of computer you are using all the way to the dates you are selecting. Price discrimination is the act of optimising the price directly to the consumer, charging individual prices based on what individuals are willing to pay.

Intensity of Rivalry

The intensity of rivalry is often what is thought of when we think of strategic competition. The fewer the number of competitors there are in a space, the less intense the rivalry is. It is visible in the case of Window vs Apple, the appearance is that the competition is fierce, however this is more of a marketing point of view, the reality is that with fewer rivals prices are generally higher, the more competitors in a space, the more competition for customers or consumers the higher the intensity of rivalry in an industry.

It boils down to supply and demand, if the market or industry is growing, there is more potential customers or consumers, then the intensity of rivalry will stagnate, when their is not enough room in the market for all of the existing players, then they will compete with one another for the available consumers of their product or service.

If exist costs are high, this will also increase the intensity of rivalry. In some industries as the Rivalry increases, an organisation can choose to simply leave that industry and redeploy or refocus their capital in a different one, for example apple in the early 2000s exited a number of high rivalry industries to refocus their energy on music players and eventually smartphones. However if the cost of exiting an industry is prohibiting an exit, then that organisation may have to stay and fight for lack of an alternative.

When we have high industry concentration, meaning that there are only a few firms that control the majority of the market share, then price rivalry tends to be low. Two ways of calculating industry concentration are:

  • 4-firm concentration ratio: Simply what is the combined percentage market share of the top four firms in an industry, if that share is high, say 40%+ then competition on price will be low.
  • Hirschman Herfindahl Index (HHI): sum of the squared percentage market shares of all firms in an industry, again the higher the HHI, the less likely price competition will be high. 

Bargaining power of suppliers

In many industries organisations must use suppliers, they need to purchase a good or service to provide their own good or service, the concept is, if you build wooden furniture, you need to buy wood from a supplier. Generally when you are in an industry, ideally you want the bargaining power of your supplier to be low. The lower the bargaining power of your supplier the safer you are from creeping costs. 

The more suppliers you can source material from, the lower their bargaining power is, the fewer you can source from the higher their bargaining power is. If you have a one to one relationship with a particular supplier who has a patent on some component that you need then you have symbiotic relationship, you need each other, however if you are in a position where there is only one supplier, but multiple buyers, then they have more power and can raise their prices, to maximise their profits. 

A mitigating factor can also be if their is a substitute product that your organisation could source to replace or offset the cost of a particular supplier.

Another key factor is the forward integration threat of your suppliers, for example, if our wood supplier suddenly decides that rather than selling their product to us, they simply start manufacturing furniture on their own and sell to our customers, then their bargaining power increases, if we try to drive their price too low, they can turn around and cut us out of the supply chain. 

Threat of substitutes

The threat of substitutes is not a direct apples to apples comparison, a substitute will generally not come from a direct competitor, but the product or service though not the same as the one offered by our organisation, can in the eyes of some consumers can be direct competition. For Example, butter vs margarin, not the same product, and consumers may have a distinct preference, however if the price of one increases significantly over the other a consumer may easily shift, to the more cost effective alternative.

To assess the severity of the threat of substitutes we can take a look at Cross-Price Elasticity.

There are three types of cross-price elasticity:

Perfectly Elastic Demand: Means that as the price of one product increases, the demand of the substitute product also increase, meaning that it is an excellent substitute.

Moderately Elastic demand: as the price increases, some consumers will switch to a substitute product or service.

Perfectly Inelastic demand: Means that as the price of the product increases, the demand of the substitute does not increase, meaning that it may not be a valid substitute, or it can only be a partial substitute and most consumers cannot make the switch.

One major disincentivizor would be a high switching cost, that means is there a hight cost to change products.

Pivotal force

When it comes to the five forces analysis, one must keep in mind that the weakest of the forces is far more dangerous to profits than the strongest; this means that an industry in which you have medium risk across the five forces, you'll generally be able to see more profits than in an industry in which you have four low risks and one high. This one high risk is the Pivotal force, the one that can negatively impact a firms ability to earn profit.