While short-term profitability is largely determined by supply and demand, long-term profitability is determined by industry structure.

Industry structure is determined by the competitive forces that characterize the industry. These five forces determine the level of industry profitability over the long term through their collective effect on the distribution of value-added among industry participants, suppliers, and buyers. The key issues and factors that affect each of the five forces are discu ssed below.

Force One: The Threat of New Entrants into the Industry

Key Issue: What is the likelihood of new entrants emerging to alter the competitive landscape in a way that reduces the share of the value-added realized by our firm and other existing competitors?
Discussion: The strength of this force, meaning the likelihood of new entrants emerging, depends upon a variety of factors, most or all of which relate to the size of the barriers to entry present. All else being equal, the higher the barriers, the weaker the threat, and, the greater the pricing power of existing participants. Factors affecting this force include: Economies of scale that will make it difficult for new entrants to achieve critical mass. Product differences and brand identity that will deter customers from switching to new brands without costly inducements. Switching costs that the product user will incur if they decide to use the new entrant. Capital requirements to construct the facilities and other infrastructure required to enter the industry. Access to distribution channels, meaning that existing distributors may be at or near capacity and/or may not be willing to take on the new entrants products. Government policy may require licensing or other approvals to enter the industry, and these could be time-consuming or difficult to secure. Cost and/or quality advantages may be enjoyed by incumbent firms, and it may take time for the new entrant to reach the point where these advantages are realized.

Force Two: The Threat of Substitute Products

Key Issue: Do currently-available (or prospective) alternative products put a ceiling on the price buyers are willing to pay for the industrys current products? Discussion: Note that this force concerns not only existing potential substitutes, but also those that could become available in the future. This subtle distinction is an important onenot all substitutes must exist to have a pricing impact. Factors that affect the strength of this factor include:

The relative price performance of substitutes. Can the purported substitute products really do the job that the current products fulfill? If not, this force becomes much weaker. Buyer propensity to substitute, or how likely are the current buyers to switch, given a viable alternative. Rupturing a 20-year relationship when the marginal benefits of switching are small is unlikely. However, when the potential benefit to the product buyer is large, the propensity increases.
Switching costs, meaning what is the cost incurred by the buyer. If production processes need minor retrofitting and the costs are low, the switch is more likely to be made.

Force Three: The Bargaining Power of Buyers

Key Issue: How strong is the negotiating power of the buyers of the firms or industrys output, and what is the impact on the distribution of the value-added by the industry?
Discussion: The bargaining power of the buyers of the industry s product can be viewed as coming from two main sources bargaining leverage and price sensitivity.Bargaining leverage relates closely to factors affecting the other forces. Low switching costs and readily available substitutes give the buyers leverage and help to strengthen this force for buyers.
The buyers price sensitivity depends upon qualitative factors such as brand identity, product , differences, quality, and performance, as well as quantitative measures such as price relative to total purchases and profitability.

Force Four: The Bargaining Power of Suppliers

Key Issue: How strong is the negotiating position of the suppliers of production inputs to the industry, and what is the impact on the distribution of the value-added?

Discussion: The stronger the bargaining position of the suppliers, the greater their ability to increase their share of the value-added in the form of higher prices for the inputs they sell to the industry. Some key factors that help to determine the power of the suppliers are:
Differentiation of inputs that are acceptable to the industry. The greater the potential options, the lower the power of the suppliers. Presence of substitute inputs is closely related to the differentiation of inputs. The more actual or prospective substitutes that exist, the lower the supplier power. Supplier concentration implies that there are relatively few of them. A small number of suppliers increases their relative power, all else being equal. Importance of volume to the supplier. The more the seller seeks high volume, the harder they will work to maintain this volume and the lower their bargaining power. The threat of forward integration means that the supplier may be interested in entering the industry. This threat implies that the supplier will share in the value-added directly as an industry participant if they cant get the pricing power they want for their inputs. Switching costs. The greater the switching costs, the greater the supplier power.

Force Five: The Degree of Rivalry Among Existing Competitors

Key Issue: Will existing firms compete away the value-added component through lower prices and higher costs to compete?

Discussion: The main points are two-fold. Do the firms follow sensible pricing policies or engage in price competition that cannot be won? Do the firms engage in non-price competition that increases costs but fails to increase profits? The factors that help to determine the likelihood of excess rivalry among existing competitors include:
mber of competitors. The more there are, the greater the potential for rivalry. Industry growth implies demand for the product is strong, and the need to engage in competition, both price and non-price, is reduced. A high degree of operating or financial leverage makes it more likely participants will engage in price competition (or respond to such competition) to defend their market share and to cover fixed costs. The greater the participants commitment to business, the greater the likelihood of competitive behavior, particularly if their existing position is challenged.

Product differences make it more difficult to compete directly on price and reduce the strength of this force. Product shelf life. The shorter the shelf life, the greater the potential for price competition if the end of the shelf life is approaching. The existence of exit barriers, meaning that it is costly to leave the industry, will increase the potential for competition. The amount of informational complexity can make it difficult for competitors to communicate discretely in ways that can reduce the likelihood of damaging competition.

Various factors may affect an industry on a temporary basis but do not determine industry profitability and structure in the long term. For example:

Industry growth rate . A high growth diminishes rivalry but does not assure profitability if other forces are detrimental to profits. Innovation and technology . Improved technology does not improve profits if it attracts competitors. Low tech industries can be very profitable if the overall effect of the five forces is positive. Government policies . These can be good or bad and are prone to change through time. Examples include patent protection, licensing requirements, labor policies, bankruptcy code, etc. Complementary products . These are products that are used in conjunction with the firms products (like hot dogs and buns), and these can have a positive or negative effect. Some complements can create or increase barriers to entry and reduce the threat of substitutes, while others can increase industry rivalry to serve the demand generated by purchase of the complement.

Altering the Firms Existing Position

A firm can improve its attractiveness through its choice of competitive strategy. Managers should attempt to intentionally create changes in Porters Five Forces by reducing:

Customer power . For example, increasing service or bypassing the middleman and selling directly to end users (as pharmaceutical companies reduced physician power by direct advertising to consumers). Supplier power . For example, using standardized parts that can be sourced from many vendors or outsourcing labor to more favorable markets (as some health care providers have outsourced reading x-rays to overseas radiologists). Substitutes . For instance, making the product more widely available or enhancing product features. Cellular telephone makers compete against land lines by adding text messaging, music, photography, and various other features not feasible in wired telephones. entry . Raise the barriers to entry, for instance by raising fixed costs (through increased R&D or mechanization) or lobbying regulators (for more restrictive licensing or better patent protection). Certain banks have raised entry barriers by investing in large branch networks that make it difficult for smaller banks to compete. Rivalry . Rivalry tends to increase over time as industry growth slows and products converge to new industry standards. Companies should avoid price wars and focus on differentiating products and finding or creating new market niches and geographic segments. Capitalizing on Changes in the Industry

Industry structure and profitability tend to be very stable. However, change does occur over time, either because of decisions made by firms in the industry or because of changes in external factors. Examples include:
Forward or backward integration, such as clothing retailers development of their own designer labels. External forces such as improvements in a substitute, like cellular and Internet telephones as alternatives to land lines. Sudden and dramatic change like the impact e-mail had on document delivery services. These types of change offer opportunities to firms that are positioned to capitalize on them. Whether these opportunities are seized by industry leaders, smaller competitors, or new entrants depends upon the nature of the opportunity and the industry structure.

Creating Changes in the Industry Structure

A firm can move the entire industry in directions that improve industry attractiveness, either by enhancing industry value-added overall (e.g., eliminating inefficiencies in the supply chain or distribution network) or by redistributing the value-added in favor of industry participants (e.g., improving pricing by reducing customer power). Industry leaders are best positioned to reshape the industry because of their ability to absorb the related costs and the fact that they generally benefit most from improved industry conditions.

A firm should try to move the industry in directions that play to its strengths and enhance its competitive advantage (e.g., creating barriers to entry by raising fixed costs and increasing economies of scale if it is the largest competitor). Managers should be careful not to engage in practices that improve their competitive position in the short run but that undermine industry attractiveness in the long run (e.g., price discounting by the low-cost competitor).

Competitive Forces and Wal-Mart

Threat of new entrants. Wal-Marts cost advantage arises from a famously efficient distribution system, which requires enormous scale and massive capital investment. The barriers to entry for a broad-based discounter are very high. However, Wal-Mart competes with a large variety of specialized retailers in specific types of products, where barriers to entry may be quite low. Threat of substitutes. The threat of substitutes in the retailing industry arises largely from the potential elimination of brick-and-mortar retailers by Internet-based retailing. To mitigate this threat, Wal-Mart has launched its own Internet-based sales effort. Bargaining power of buyers. The bargaining power of buyers is virtually non-existent. Individual consumers have essentially no bargaining leverage against global corporate retailers, and Wal Mart does not target corporate customers. Wal-Mart is sufficiently large enough that even its biggest customers account for an infinitesimal proportion of its sales. Bargaining power of suppliers. The bargaining power of suppliers has historically been very low. Wal-Mart is well known for vigorous bargaining with its suppliers of both labor and products. Its enormous presence in the retail sales industry makes it the largest purchaser for many of its suppliers, giving them virtually no bargaining leverage against Wal-Mart. Wal-Mart has also vigorously resisted efforts to unionize its workers, who have historically had very little bargaining power. That is changing somewhat as accusations of unfair labor practices have cost Wal-Mart market prestige and position, giving labor more leverage with the firm. Even so, the bargaining power of suppliers of labor remains quite low.

Rivalry among existing competitors. Competition among existing competitors in the retail sales industry is very high. An indication of the competitiveness is in Wal-Mart s global market share, which is approximately 3%. The vast majority of other firms have market share too small to be significant on a global basis. Competition in retailing is focused on geographic region, and Wal Mart s market position varies widely. In the United States, Wal-Mart is the largest retailer of many items it sells and commands 20% of the grocery market. It has a much smaller presence in markets such as Germany, which it eventually abandoned after achieving only 2% share in foods against Aldi s 19%.