Porter's Five Forces Model

Porter's Five Forces Model helps managers to understand the underlying industry structure, and thus aids in identifying threats and opportunities.

This model is depicted in Fig. 7, and highlights five forces that shape competition within an industry, and thus determine the overall industry profitability and its attractiveness. The viewpoint is that of an incumbent firm already active in an industry. These forces are: (1) the risk of entry by potential competitors; (2) the bargaining power of buyers; (3) the bargaining power of suppliers; (4) the threat of substitutes; and (5) the resulting intensity of rivalry among existing competitors (Porter, 1980).

The risk of entry concerns potential competitors that are not yet competing in your industry, but have the capability to do so if they choose. For example, in the Southeastern U.S. the TV cable company, Comcast, has entered the business for residential and commercial telephone services and Internet connectivity (as Internet Service Provider), thus emerging as a competitor for AT&T and Bell South, who recently merged. The risk of entry by potential competitors is determined by the barriers to entry, i.e., how costly an investment is it to enter the industry? Indeed, the height of barriers to entry has been found consistently to be the most significant predictor of industry profitability. For example, the pharmaceutical industry in the U.S. experienced between the end of World War II and 1975 only one entry, which was Syntex, based on the breakthrough innovation of the contraceptive pill. Thus, the industry was characterized by extremely high barriers to entry, which in turn was reflected by fairly average industry profitability (over 20% return on invested capital year after year). With the emergence of biotechnology, which represents a radical process innovation through which new drugs are discovered and commercialized, new entrants in the form of biotechnology start-ups were able to circumvent the entry barriers. As a consequence, over 2,000 new biotechnology firms entered the industry and clearly changed the underlying industry structure (Rothaermel, 2000, 2001a; Rothaermel & Hill, 2005). In general, the heights of entry barriers are determined by factors like government regulation, economies of scale, product differentiation, and customer switching costs.

The bargaining power of buyers concerns the pressure buyers can put on the seller's company's margin through demanding a lower price and higher product quality. Strong buyers can act to reduce the company's revenues.

Buyers have strong bargaining power when they purchase in large quantities and control many access points to the final customer. For example, Wal-Mart and Home Depot can exert tremendous pressure on their suppliers to lower prices and to increase quality, because these two companies will choose not to place the suppliers' products on their shelves. Buyers also are extremely