Porter’s five forces classification framework, Tools for Studying Industry Economics
Porter’s Five Forces Classification Framework
Porter suggests that five forces influence the level of competition and the profitability of firms in an industry.1 Three of the forces—rivalry among existing firms, potential entry, and substitutes—represent horizontal competition among current or potential future firms in the industry and closely related products and services. The other two forces— buyer power and supplier power—depict vertical competition in the value chain, from the suppliers through the existing rivals to the buyers. next and illustrate them within the soft drink/beverage industry. Exhibit 1.7 depicts Porter’s five forces in the soft drink/beverage industry.
1. Rivalry among Existing Firms. Direct rivalry among existing firms is often the first order of competition in an industry. Some industries can be characterized by concentrated rivalry (such as a monopoly, a duopoly, or an oligopoly), whereas others have diffuse rivalry across many firms. Economists often assess the level of competition with industry concentration ratios, such as a four-firm concentration index that measures the proportion of industry sales controlled by the four largest competitors. Economics teaches that in general, the greater the industry concentration, the lower the competition between existing rivals and thus the more profitable the firms will be.
PepsiCo and Coca-Cola dominate the soft drink/beverage industry in the United States. Because some consumers view the two companies’ products as being similar, intense competition based on price could develop. Also, the soft drink market in the United States is mature (that is, not growing rapidly), so price cutting could become a strategy to gain market share. Although intense rivalries have a tendency to reduce profitability, in this case, PepsiCo and Coca-Cola appear to tacitly avoid competing based on price and compete instead on brand image, access to key distribution channels (for example, fast-food chains and grocery store shelf space), and other attributes. Growth opportunities do exist in other countries, which both companies pursue aggressively. Thus, we characterize industry rivalry as moderate.
2. Threat of New Entrants. How easily can new firms enter a market? Are there entry barriers such as large capital investment, technological expertise, patents, or regulations that inhibit new entrants? Do the existing rivals have distinct competitive advantages (such as brand names) that will make it difficult for other firms to enter and compete successfully? If so, firms in the industry will likely generate higher profits than if new entrants can enter the market easily and compete away any potential excess profits. The soft drink/beverage industry has no significant barriers to entry. This is evident by the numerous small juice, sports drink, water, and soft drink companies that exist; the frequency with which new firms enter the industry; and the availability of generic and no-name beverage products. However, the existing major players in the soft drink/beverage industry have competitive advantages that reduce the threat of new entrants. Brand recognition by PepsiCo and Coca-Cola serves as a very powerfu
Porter suggests that five forces influence the level of competition and the profitability of firms in an industry.1 Three of the forces—rivalry among existing firms, potential entry, and substitutes—represent horizontal competition among current or potential future firms in the industry and closely related products and services. The other two forces— buyer power and supplier power—depict vertical competition in the value chain, from the suppliers through the existing rivals to the buyers. next and illustrate them within the soft drink/beverage industry. Exhibit 1.7 depicts Porter’s five forces in the soft drink/beverage industry.
1. Rivalry among Existing Firms. Direct rivalry among existing firms is often the first order of competition in an industry. Some industries can be characterized by concentrated rivalry (such as a monopoly, a duopoly, or an oligopoly), whereas others have diffuse rivalry across many firms. Economists often assess the level of competition with industry concentration ratios, such as a four-firm concentration index that measures the proportion of industry sales controlled by the four largest competitors. Economics teaches that in general, the greater the industry concentration, the lower the competition between existing rivals and thus the more profitable the firms will be.
PepsiCo and Coca-Cola dominate the soft drink/beverage industry in the United States. Because some consumers view the two companies’ products as being similar, intense competition based on price could develop. Also, the soft drink market in the United States is mature (that is, not growing rapidly), so price cutting could become a strategy to gain market share. Although intense rivalries have a tendency to reduce profitability, in this case, PepsiCo and Coca-Cola appear to tacitly avoid competing based on price and compete instead on brand image, access to key distribution channels (for example, fast-food chains and grocery store shelf space), and other attributes. Growth opportunities do exist in other countries, which both companies pursue aggressively. Thus, we characterize industry rivalry as moderate.
2. Threat of New Entrants. How easily can new firms enter a market? Are there entry barriers such as large capital investment, technological expertise, patents, or regulations that inhibit new entrants? Do the existing rivals have distinct competitive advantages (such as brand names) that will make it difficult for other firms to enter and compete successfully? If so, firms in the industry will likely generate higher profits than if new entrants can enter the market easily and compete away any potential excess profits. The soft drink/beverage industry has no significant barriers to entry. This is evident by the numerous small juice, sports drink, water, and soft drink companies that exist; the frequency with which new firms enter the industry; and the availability of generic and no-name beverage products. However, the existing major players in the soft drink/beverage industry have competitive advantages that reduce the threat of new entrants. Brand recognition by PepsiCo and Coca-Cola serves as a very powerfu
deterrent to potential new competitors. Another deterrent is these two firms’ domination of distribution channels. Most restaurant chains sign exclusive contracts to serve the beverages of one or the other of these two firms. Also, PepsiCo and Coca-Cola often dominate shelf space in grocery stores.
3. Threat of Substitutes. How easily can customers switch to substitute products or services? How likely are they to switch? When there are close substitutes in a market, competition increases and profitability diminishes (for example, between restaurants and grocery stores for certain types of prepared foods). Unique products with few substitutes, such as certain prescription medications, enhance profitability.
The carbonated soft drink industry faces substitute competition from an array of other beverages that consumers can substitute to quench their thirst. Fruit juices, bottled water, sports drinks, teas, coffees, milk, beers, and wines serve a similar thirst-quenching function to that of soft drinks. Over the years, Coca-Cola and PepsiCo have expanded their beverage portfolios to encompass virtually all nonalcoholic beverages. For example, PepsiCo purchased Tropicana and Gatorade to enhance its product offerings in juices, sports drinks, and bottled water, and has joint ventures with Lipton and Starbucks to sell teas and coffees. Because of the wide range of beverage products offered by PepsiCo and Coca-Cola and because of consumer buying habits, brand loyalty, and channel availability, the threat of substitutes in the soft drink/beverage industry is low. The primary substitute competition comes from alcoholic beverages such as beer and wine and from coffee-based beverages.
4. Buyer Power. Buyer power relates to the relative number of buyers and sellers in a particular industry and the leverage buyers have with respect to price. Are the buyers price takers or price setters? If there are many sellers of a product and a small number of buyers making very large purchase decisions, such as military equipment bought by governments or automobile parts purchased by automobile manufacturers, the buyer can exert significant downward pressure on prices and therefore on the profitability of suppliers. If there are few sellers and many buyers, as with beverages, the sellers have more bargaining power
Buyer power also relates to buyers’ price sensitivity and the elasticity of demand. How sensitive are consumers to product prices? If products are similar to those offered by competitors, consumers may switch to the lowest-priced offering. If consumers view a particular firm’s products as unique, however, they will be less sensitive to price differences. Another dimension of price sensitivity is the relative cost of a product. Consumers are less sensitive to the prices of products that represent small expenditures, such as beverages, than they are to higherpriced products, such as automobiles. However, even though individual consumers may switch easily between brands or between higher- or lower-priced products, they make individual rather than large collective buying decisions; so they are likely to continue to be price takers (not price setters). The ease of switching does not make the buyer powerful; instead it increases the level of competition betwee the rivals.
The carbonated soft drink industry faces substitute competition from an array of other beverages that consumers can substitute to quench their thirst. Fruit juices, bottled water, sports drinks, teas, coffees, milk, beers, and wines serve a similar thirst-quenching function to that of soft drinks. Over the years, Coca-Cola and PepsiCo have expanded their beverage portfolios to encompass virtually all nonalcoholic beverages. For example, PepsiCo purchased Tropicana and Gatorade to enhance its product offerings in juices, sports drinks, and bottled water, and has joint ventures with Lipton and Starbucks to sell teas and coffees. Because of the wide range of beverage products offered by PepsiCo and Coca-Cola and because of consumer buying habits, brand loyalty, and channel availability, the threat of substitutes in the soft drink/beverage industry is low. The primary substitute competition comes from alcoholic beverages such as beer and wine and from coffee-based beverages.
4. Buyer Power. Buyer power relates to the relative number of buyers and sellers in a particular industry and the leverage buyers have with respect to price. Are the buyers price takers or price setters? If there are many sellers of a product and a small number of buyers making very large purchase decisions, such as military equipment bought by governments or automobile parts purchased by automobile manufacturers, the buyer can exert significant downward pressure on prices and therefore on the profitability of suppliers. If there are few sellers and many buyers, as with beverages, the sellers have more bargaining power
Buyer power also relates to buyers’ price sensitivity and the elasticity of demand. How sensitive are consumers to product prices? If products are similar to those offered by competitors, consumers may switch to the lowest-priced offering. If consumers view a particular firm’s products as unique, however, they will be less sensitive to price differences. Another dimension of price sensitivity is the relative cost of a product. Consumers are less sensitive to the prices of products that represent small expenditures, such as beverages, than they are to higherpriced products, such as automobiles. However, even though individual consumers may switch easily between brands or between higher- or lower-priced products, they make individual rather than large collective buying decisions; so they are likely to continue to be price takers (not price setters). The ease of switching does not make the buyer powerful; instead it increases the level of competition betwee the rivals.
In the beverage industry, buyer power is relatively low because there are very few suppliers and they have access to essential distribution channels. Individual consumers tend to exhibit relatively low price sensitivity because of brand loyalty, and beverages comprise relatively small dollar amount purchases. However, certain buyers (for example, large retail and grocery chains such as Walmart and large fast-food chains such as McDonald’s) make such large beverage purchases on a national level that they can exert significant buyer power.
5. Supplier Power. A similar set of factors with respect to leverage in negotiating prices applies on the input side as well. If an industry is comprised of a large number of potential buyers of inputs that are produced by relatively few suppliers, the suppliers will have greater power in setting prices and generating profits.For example, many firms assemble and sell personal computers and laptops, but these firms face significant supplier power because Microsoft is a dominant supplier of operating systems and application software and Intel is a dominant supplier of microprocessors.
Beverage companies produce their concentrates and syrups with raw materials that are commodities. Although PepsiCo does not disclose every ingredient, PepsiCo is not likely to be dependent on one supplier (or even a few suppliers) for its raw materials. It also is unlikely that any of these ingredients are sufficiently unique that the suppliers could exert much power over PepsiCo. Given PepsiCo’s size, the power more likely resides with PepsiCo than with its suppliers.
5. Supplier Power. A similar set of factors with respect to leverage in negotiating prices applies on the input side as well. If an industry is comprised of a large number of potential buyers of inputs that are produced by relatively few suppliers, the suppliers will have greater power in setting prices and generating profits.For example, many firms assemble and sell personal computers and laptops, but these firms face significant supplier power because Microsoft is a dominant supplier of operating systems and application software and Intel is a dominant supplier of microprocessors.
Beverage companies produce their concentrates and syrups with raw materials that are commodities. Although PepsiCo does not disclose every ingredient, PepsiCo is not likely to be dependent on one supplier (or even a few suppliers) for its raw materials. It also is unlikely that any of these ingredients are sufficiently unique that the suppliers could exert much power over PepsiCo. Given PepsiCo’s size, the power more likely resides with PepsiCo than with its suppliers.
In summary:
- Competition in the soft drink/beverage industry rates low on supplier power, threat of new entrants, and threat of substitutes.
- The industry rates low on buyer power of consumers but moderate on buyer power of fast-food chains and large retail and grocery chains.
- The industry rates moderate on rivalry within the industry. Unless PepsiCo or Coca-Cola decides to compete on the basis of low price, you might expect these firms to continue to generate relatively high profitability
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