In 1969, Michael Porter graduated from Harvard Business School and then went on to get an Economics Ph.D. from Harvard University. In the economics department, he was taught that “excess profits were real and persistent” in some companies and industries, because of barriers to competition. For the economists, the existence of excess profits under the low-competition situation was a problem to be solved because they swore by perfectly competitive markets where there were no excess profits to be made and the consumer derived the full benefits. But Porter saw the situation differently.
Since Porter came to economics from a business background (Harvard MBA to boot) he saw that what was being viewed as a problem by economists, from a certain business perspective, was a solution to be enthusiastically pursued. It was the luring promise of above-average profits, which is what all business executives are laboring after in their jobs. The insight of Porter on this issue was that businesses could simply position themselves such that the existing and resulting structural barriers (which the economists so wanted to dismantle) would ensure endless above-average profits due to “sustained competitive advantage”. What those structural barriers were was the crux of the matter, to which Porter had an answer: they are the five basic forces of supplier power, buyer power, degree of competitive rivalry, threat of new entrants, and threat of substitutes.
Supplier Power: The power of suppliers is gauged by how easy it is for them to drive up prices. Factors that affect such power are (a) the number of suppliers of each key input, (b) the size of suppliers, (c) the uniqueness of their product or service, and (d) the cost of switching suppliers.
Buyer Power: Buyers have power to the extent they can drive the prices down. This power depends on (a) the number of buyers, (b) the importance of each individual buyer to your business, (c) the cost of switching to buying other products and services, (d) price sensitivity, and (e) differences between competitors.
Competitive Rivalry: The extent of rivalry is determined by the number and capability of one’s competitors. If there are many competitors offering equally good products or services, then you will have less power because suppliers and buyers will have the option of going elsewhere if your deal does not satisfy them. Other factors impacting this are slow market growth, switching costs, customer loyalty, costs of leaving the market, low levels of product differentiation, and the diversity of rivals.
Threat of Substitutes: If substituting what you offer is easy and viable, it weakens your market power. Typically, the substitutes are from other industries. There is a threat of substitutes if a product’s demand is affected by the change in the price of a substitute product. The price of aluminium beverage cans is affected by the price of plastic containers, glass bottles, and steel cans. These containers are substitutes. Except in remote areas, cable TV would find it difficult to compete with free TV from an aerial without its greater diversity of entertainment.
Threat of New Entrants: If competitors can quickly enter your market with less cost and time, your position is weakened. This is likely if (a) there are few economies of scale in place, (b) you have little protection for your key technologies through patents and proprietary knowledge, and (c) there is low asset specificity which allows assets to be used to produce a different product if necessary.
You should avoid using this model for an individual firm because it is designed for use on an industry basis. When using the model, make sure that you (a) Use this model where there are at least three competitors in the market, (b) Consider the impact of the government on the industry, (c) Consider the industry lifecycle stage, and (d) Consider the dynamic/changing characteristics of the industry.