Competitive Strategy

The Five Competitive Forces That Shape Strategy

Michael E. Porter How competitive forces shape

strategy. The job of the strategist is to understand and
cope with competition. Managers often define competition
too narrowly.
Strong forces No attractive returns
Weak forces Attractive returns
A healthy industry structure should be as much a
competitive concern to strategists as their companys own
position.

(1) Threat of New Entrants

Threat of entry puts a cap on the profit potential of an industry. When the threat is high, incumbents must hold
down their prices or boost investment to deter new competitors. The threat of entry in an industry depends on the
height of entry barriers.
Barriers to Entry
Supply-side economies of scale
o Can be found in virtually every activity in the value chain
Demand-side benefits of scale
o Network effects. Arise in industries when a buyers willingness to pay increases with the number
of buyers patronizing the company.
o Buyers may trust larger companies for a crucial product. Demand side benefits of scale discourage
entry by limiting the willingness of customers to buy from a newcomer.
Customer switching costs
o Switching costs are fixed costs that buyers face when they change suppliers.
Capital Requirements
o The need to invest large financial resources in order to compete can deter new entrants.
o The barrier is particularly great if the capital is required for unrecoverable and therefore harder-to-
finance expenditures such as up-front advertising or R&D.
Incumbency Advantages
o Cost or quality advantages not available to potential rivals. These advantages could stem from
sources such as proprietary technology, preferential access to the best raw material sources,
preemption, cumulative experience.
Unequal access to distribution channels
o Sometimes access to distribution is so high a barrier that new entrants must bypass distribution
channels altogether or create their own.
Restrictive government policy
o Government policy can hinder or aid new-entry directly, as well as amplify the other entry barriers.
Strategists must be mindful of the creative ways newcomers might find to circumvent apparent barriers, expected
retaliation. Newcomers are likely to fear expected retaliation if incumbents have previously responded vigorously
to new entrants.
(2) The Power of Suppliers
Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services
or shifting costs to industry participants. Powerful suppliers can squeeze profitability out of an industry that is
unable to pass on cost increases in its own prices. A supplier group is powerful if:
It is more concentrated than the industry it sells to.
The supplier group does not depend heavily on the industry for its revenues.
Industry participants face switching costs in changing suppliers
Suppliers offer products that are differentiated
The supplier group can credibly threaten to integrate forward into the industry
(3) The Power of Buyers
Powerful customers can capture more value by forcing down prices, demanding better quality or more service
and generally playing industry participants off against one another, all at the expense of industry profitability. A
customer group has negotiating leverage if:
Few buyers/buyer buying in large volumes
The industrys products are standardized or undifferentiated
Buyers face few switching costs in changing vendors
Buyers can credibly threaten to integrate backward
Intermediate customers gain significant bargaining power when they can influence the purchasing decisions of
customers downstream.
(4) The Threat of Substitutes
A substitute performs the same or a similar function as an industrys product by a different means. Substitutes
are easy to overlook because they may appear to be very different from the industrys product. The threat of
substitutes is high if:
It offers an attractive price-performance trade-off to the industrys product
The buyers cost of switching to the substitute is low
Strategists should be particularly alert to changes in other industries that may make them attractive
substitutes when they were not before.
(5) Rivalry Among Existing Competitors
The intensity of rivalry is greatest if:
Competitors are numerous or are roughly equal in size and power. Industry growth is slow. Slow growth
precipitates fight for market share
Exit barriers are high. Keeps companies in the market even though they may be earning low or negative
returns.
Clashes of personality and ego have sometimes exaggerated rivalry to the detriment of profitability
Price competition is likely to occur when the products are similar and there are few switching costs for
buyers. Fixed costs are high and marginal costs are low.
Capacity must be expanded in large increments to be efficient. The product is perishable.
Rivalry can be positive sum when each competitor aims to serve the needs of different customer segments. The
opportunity for positive-sum competition will be greater in industries serving diverse customer groups.
Factors, not Forces
A common mistake is to assume that fast-growing industries are always attractive. If the buyers and
suppliers power increases, even a fast-growing industry may not be profitable.
Same goes with technology and innovation. Mundane low-tech industries with price insensitive buyers
and other aided forces are often far more profitable than sexy industries.
Complements affect profitability through the way they influence the five forces.
Industry Analysis
Define the relevant industry, products & geographic scope
Identify participants and segments of the group (buyers, suppliers, competitors, substitutes)
Assess the underlying drivers of each competitive forces
Determine overall industry structure and test the analysis for consistency
Analyze recent and likely future changes in each force, both positive and negative
Identify aspects of industry structure that might be influenced by competitors/new entrants
Changes in Industry Structure
Competitive forces can be evaluated at a single point of time and across times as well. Shifts in Industry
structure may emanate from outside an industry or from within.
Shifting threat of new entry
Changing supplier or buyer power
Shifting threat of substitution
New bases of rivalry
Common Pitfalls
Defining the industry too broadly or too narrowly
Making lists instead of engaging in rigorous analysis
Paying equal attention to all the forces rather than digging into the most important one
Confusing effect (price sensitivity) with cause (buyer economics)
Using static analysis that ignores industry trends
Confusing cyclical or transient changes with true structural changes
Using the framework to declare an industry attractive or unattractive rather than using it to guide
strategic choices
The five forces reveal why industry profitability is what it is. Strategy can be viewed as building defenses
against the competitive forces or finding a position in the industry where the forces are weakest.
Exploiting/shaping industry structure is key.
A firm can lead its industry toward new ways of competing that alter the five forces for the better.
The innovator can benefit most if it can shift competition in directions where it can excel.
Industry leaders have a special responsibility for improving industry structure
Ill-advised changes in competitive positioning and operating practices can undermine industry structure.
Profit pool expands if channels become more competitive or when industry discovers latent buyers
A company needs a separate strategy for each distinct industry. Mistakes in industry definition made by
competitors present opportunities for staking out superior strategic positions.
New Game Strategies
Companies can soar dramatically into prominence in the face of giant competitors who seem to have all corners
of the marked covered by adopting innovative approach to doing business and rewriting the rules of the game to
suit their own strengths and upset the competitive balance in the industry.
Texas Instruments triumphed by using its new technology, different design and distribution policy.
Savin defied the accepted rules of the game by combining a different technology with different
manufacturing, distribution and service approach.
Rewriting the rules is not often consciously and purposefully pursued in business because of its inherent
risks
The Strategic Game Board
The successful new game strategist measures every strategic move
by its impact on his relative competitive position. Deployment of
forces is often more decisive than their strength and so aim to
choose the field and determine the manner and timing of the
conflict.
o Where to compete: entire market or few segments
o How to compete: Follow rules or rewrite
o When to compete: Timing of the action/phases
(1) Same Game, Across the Board
Company accepts the leaders market definition, copies their functional approaches and does its best to emulate
the key success factors in which the leaders excel. The follower will seldom succeed in displacing them if the
leaders are established. Yet many companies persist in a follower strategy.
(2) Same Game, Selective Approach
Companies seek to gain a competitive advantage selectively by trimming their ambitions to match their
resources, and concentrating on market niches in which they can bring particular strengths to bear
Avoids head-on competition, no basic changes in technology and erects no barriers to competitor response
and hence it is easily copied
A smaller company that relies on a giants forbearance is skating on thin ice (occupying niche segments)
New Game Strategies
Competitor-focused rather than market-focused. Offerings that block or limit competitors entry to that
market
Innovation rather than adaption is the objective
Exploit factors that have never been regarded as competitively important, defy conventional wisdom
(3) New Game, Selective Approach
Redefines some portion of the market, changing the way some groups of customers purchase, configure,
or use the product or services.
Carves out and appropriates a slice of the market by conditioning it to the companys unique way of doing
things
(4) New Game, Across-the-board
Greatest risks are taken and the greatest prizes are won through this strategy
 Rewrites the rules for entire market or industry and leaves the competitors high and dry
Circumvent barriers to entry and create new ones in their place
Establish new set of key success factors in the market
Competitive advantage secured by a new-game strategy is likely to prove more durable
Redefining the market
Same-game strategies Deductive & analytical
New-game strategies Intuitive & opportunistic
Clues to opportunities
o Emergence of new manufacturing process technology
o A head-on battle between major competitors
o Shifts in the economic, social or regulatory environment
o Emergence of substitute products or technologies
Requires studying customers, competitors, business system and the business environment
The business system framework (E.g.: technology product design manufacturing marketing
service distribution) can be used to discover the sources of greatest economic leverage in a business
A thorough diagnostic of ones own business can often uncover inconsistencies or inefficiencies
Tunnel vision is unavoidable. Strategic thinking can only flourish in organizations where successful risk-takers
and innovators are seen to reap the kudos and financial rewards. Although durable, the competitive advantage
resulting from new-game strategies will eventually be eroded by competitive forces.
Nature & Sources of Competitive Advantage
The primary goal of a strategy is to establish a position of competitive advantage. Competitive advantage may
not be revealed in higher profitability a firm may forego current profit in favor of investment in market share,
technology, customer loyalty or executive perks. For competitive advantage to exist, there must be some
imperfection of competition (perfect competition: financial and commodity markets)

Responsiveness to Change depends on ability to anticipate changes, speed/short cycle/reaction times

BCG: Notion of speed as a source of competitive advantage, time-based competition
Strategic innovations tend to involve pioneering along one or more dimensions of strategy
o New Industries
o New customer segments
 o New sources of competitive advantage, involves reconfiguring the industry value chain in order
to change the rules of the game within a market.
o Even innovative strategies are subject to imitation. The most durable forms of competitive
advantage are those that derive from management innovation. E.g. TPS
Sustaining Competitive Advantage
Sources of Isolating mechanisms to detract competitive imitation
Identification Obscure superior performance (e.g. theory of limit pricing)
Imitation Incentives Deterrence, signal aggressive intentions. Preemption: exploit all opportunities
o Preemption: Proliferation of product varieties, large capacity investments, patent proliferation
Diagnosis Rely on multiple sources of competitive advantage to create Causal ambiguity
o The difficult task is to identify which differences are critical determinants of advantage
o The outcome of causal ambiguity is uncertain imitability
Resource acquisition Base competitive advantage on immobile and difficult to replicate resources
If a companies success is the outcome of a complex configuration of strategy, structure, management systems,
personal leadership, and host of business processes, the implication is that imitation may well be impossible.
Types of Competitive Advantage
A firm can achieve a higher rate of profit over a rival in one of two ways
Supply an identical product or service at a lower cost
Supply a differentiated product/service in such a way that the customer is willing to pay a premium
Strategy elements and the resources required to achieve them
Cost Leadership
Scale-efficient plants Access to capital
Design for manufacture Process engineering skills
Control of overheads and R&D Frequent reports
Process innovation Tight cost control
Outsourcing Specialization of jobs and functions
Avoidance of marginal customer accounts Incentives linked to quantitative targets
Differentiation
Emphasis on branding, advertising, design, service, quality and NPD
o Marketing abilities
o Product engineering skills
o Cross-functional coordination
o Creativity
o Research capability
o Incentives linked to qualitative performance targets
In most industries, market leadership is held by a firm that maximizes customer appeal by reconciling effective
differentiation with low cost.
VRIO
The question of Value
o Do a firms resources and capabilities add value by enabling it to exploit opportunities and/or
neutralize threats?
o Firms resources may have added value in the past, changes in customer tastes, industry
structure, or technology can render them less valuable in the future, constantly evaluate.
o Firms have weathered environmental shifts by finding new ways to apply their traditional
strengths
The question of Rareness
o If a particular resource and capability is controlled by numerous competing firms, then that
resource is unlikely to be a source of competitive advantage for any one of them.
o Valuable but common resources and capabilities are sources of competitive parity
The question of Imitability
o A firm that possesses valuable and rare resources and capabilities can gain, at least, a temporary
competitive advantage.
o The importance of history (Caterpillar)
o The importance of numerous small decisions. Small decisions are essentially invisible to firms
seeking to imitate a successful firms resources and capabilities.
o The importance of socially complex resources. Reputation, trust, friendship, teamwork, culture
The question of Organization
o Formal reporting structure, management control systems, compensation policies commonly
referred to as complementary resources
Global Strategies and the Multinational Corporation
Internationalization is the most important pervasive force reshaping the competitive environment of
business. It has occurred through two mechanisms, trade and direct investment
The ability to take advantage of international opportunities has been a key determinant of overall
corporate success
Overambitious internationalization marked the beginning of corporate decline
Patterns of Internationalization
Sheltered Industries
o National/local market scope. After internationalization the industries left in this category are
fragmented service industries, small-scale manufacturing and industries producing perishable
products
Trading Industries
o Internationalization occurs primarily through imports and exports. Applies to products which are
transportable, not nationally differentiated and subject to substantial scale economies. E.g.
commercial aircraft, shipbuilding, and defense equipment.
Multidomestic Industries
o Internationalization occurs through direct investment, either because trade is not feasible or
because products are nationally differentiated
Global Industries
o Industries both into trade and direct investment. Most large-scale manufacturing industries tend to
evolve towards global structures in automobiles, consumer electronics, semiconductors etc.
In the case of services and other non-tradable products, Starbucks, can serve overseas markets only by creating
subsidiaries within these markets.
Implications for Competition
The entry barriers that were effective against potential domestic entrants may be ineffective against potential
entrants that are established producers in overseas countries.
Rivalry among existing firms
o Lowering seller concentration
o Increasing diversity of competitors Making tacit collusion less likely
o Increasing excess capacity
o Increasing the bargaining power of buyers
Porters National Diamond Framework
Factor conditions Resource constraints may encourage the
development of substitute capabilities
Related & Supporting Industries
Demand Conditions
Strategy, Structure & Rivalry The maintenance of strong
competition within domestic markets is likely to provide a powerful
stimulus to innovation and efficiency

Determinants of Geographical Location

National resource availability, Firm-specific competitive advantages, tradability
Different countries are likely to offer differential advantage at each stage of the value chain.
In principle, a firm can identify the resources required by each stage of the value chain, then determine
which country offers these resources at the lowest cost.
Companies that compete on speed and reliability of delivery typically forsake the cost advantages of a
globally dispersed value chain
Foreign Entry Strategies
If the firms competitive advantage is country based, the firm must exploit an overseas market by
exporting
Is the product tradable and what are barriers to trade?
Does the firm possess the full range of resources and capabilities for establishing a competitive
advantage in the overseas market?
Can the firm directly appropriate the returns to its resources?
What transaction costs are involved?
Joint ventures that share management responsibility are far more likely to fail than those with a dominant parent
or with independent management. The effective management of international alliances depends on a clear
recognition that collaboration is competition in a different form. Sharing benefits depends on three factors
The strategic intent of the partners
Appropriateness of the contribution
Receptivity of the company
Benefits of a Global Strategy
 Globalization of customer preferences
Economies of scale and economies of replication
Economies from International production
Economies of learning
Competing strategically
Need for National Differentiation
Laws and government regulations
Distribution channels
Presence of lead countries
Competitor Analysis

Game Theory
Ultimate goal of competitor analysis is favorable competitive outcome.
A valuable framework for modeling competitive decision-making is the method of game theory
An action which is always optimal regardless of the choice of the other player is known as dominant
strategy
Game theory predicts outcomes are in equilibrium, neither player has any incentive to unilaterally deviate
from his or her chosen action
Game Tree Look forward and reason backward
Game matrices/trees treat the games as static whereas in fact they are dynamic
Behavioral Theory
Behavioral theory in strategy research recognizes that firms like individuals often have non-financial
motives and deviate from profit maximizing behavior.
Underlying many behavioral biases is the general notion of bounded rationality or information processing
limitations.
Decision makers might end up exercising certain heuristics or rules of thumb to simplify the decisions
problem they are facing
Common behavioral limitation resulting from application of decision making heuristics is
o Representativeness bias - Tendency to underestimate error & reliability
o Overconfidence bias Overestimation of a firms capabilities & likelihood of success
o Confirmation bias Firms seek out information that confirms what they already believe
o Endowment effect Irrationally aggressive in defending its territory. They value goods more when
they own them than when they do not
o Status Quo effect Prefer the status quo they are in at all times, irrespective of the situation
The Components of Porters Analysis Framework
 What drives the competitor
o Future Goals At all levels of management and in multiple dimensions
o Assumptions Held about itself and the industry
What the competitor is doing and can do
o Current Strategy How the business is currently competing
o Capabilities Both strengths and weaknesses
Diversification Strategy
Deciding What business are we in? is the starting point of strategy. The business scope of firms changes over
time. The dominant trend of the past two decades has been refocusing on core businesses. Diversification is a
conundrum, chances of causing more destruction at the same time potential for a firm to free itself of the
restrictions of a single industry. Diversification decisions by firms involve the same two issues:
How attractive is the industry to be entered?
Can the firm establish a competitive advantage within the new industry?
Trends in Diversification Over Time

Motives for Diversification

Growth In the absence of diversification firms are prisoners of their industry
Risk Reduction Appeals more to managers than to owners/shareholders. As shareholders can diversify
risk by holding diversified portfolios at a much lower cost.
o Systematic risk Part of the variance of return that is correlated with overall market returns
o Corporate diversification does not reduce systematic risk. The simple act of bringing different
businesses under common ownership does not create shareholder value through risk reduction
o Unrelated diversification may even fail to lower unsystematic risk
o Diversification that reduces the risk of bankruptcy is beneficial to bondholders rather than
shareholders
The stability in the firms cash flow that results from diversification may reinforce independence from
external capital markets, reason why firms pursue hedging activities that only reduce unsystematic risk.
Value Creation Porters Essential Test
The attractiveness test The industries chosen must be structurally attractive or capable of being one
The cost-of-entry test Cost of entry must not capitalize all the future profits
 The better-off test Combining different, but related, businesses can enhance the competitive
advantages of the original business, the new business or both
Competitive Advantage from Diversification
The critical linkages arise through the sharing of resources and capabilities across different businesses
Economies of scope Using a resource across multiple activities uses less of that resource
Tangible/Intangible resources Shared resources, shared service organizations
Organizational capabilities
Economies from Internalizing transactions If the resource can be traded or licensed out for anything
close to its real value then it is not necessary to enter another business in order to capture the extra
profitability. If the resource cannot be traded, then it will be necessary to enter the new business
Parenting Advantage Parenting value that comes from the resources and general management skills
possessed by the parent company
Internal Capital Markets Balanced portfolio (Cash), diversified firms can avoid the costs including the
margin between borrowing and lending rates and the heavy costs of issuing new debt and equity. Strict
financial discipline, rigorous analysis and valuation necessary to keep politics out of allocation.
Internal Labor Markets Transfer employees, rely less on hiring and firing. Richer career development,
may also result in attracting a higher caliber of employees.
Diversification and Performance
Diversification that seeks only growth or risk reduction is likely to destroy value. A key problem is
distinguishing association from causation.
If moderately diversified firms are generally more profitable than specialized firms, it could mean
diversification increases profitability or because profitable firms channel their cash flows into diversifying
investments.
Related diversification Businesses closely related to the firms core activities are significantly more
profitable than unrelated diversification. The distinction between related and unrelated diversification
is not always clear.
Diversifications attractions are obvious and often irresistible. Yet, the experience is often disappointing
Turning Great Strategy into Great Performance
Strategy-Performance Gap
Most companies strategies deliver only 63% of their
promised financial value.
o Leaders press for better execution when they really
need a sounder strategy
o Leaders craft a new strategy when execution is the
true weak spot
o Leaders pull the wrong levers resulting in wasted
energy, lost time and continued underperformance
Disciplined planning & execution is required to close this
strategy-performance gap. If there is a shortfall, strong processes enable to discern the cause and take
corrective action.
 Companies rarely track performance against long-term plans.
Multiyear results rarely meet projections. Diagonal Venetian blinds.
Plans financial forecasts become unreliable, portfolio management
gets derailed and poor financial forecasts complicate communications
with the investment community.
Performance bottlenecks are frequently invisible to top
management. Performance shortfalls are often written off as just
another hockey-stick forecast
Fosters a culture of underperformance. Organizations culture
changes from meeting the goals at any cost to expecting the unrealistic
goals to fail all the time and spend time covering up tracks for failure
rather than identifying actions to enhance performance.
Seven Rules for Successful Strategy Execution
Rule 1: Keep it simple, make it concrete
Avoid drawn-out description of lofty goals, clearly describe dos & donts
Be clear about what the strategy is and isnt (boundaries well defined)
Rule 2: Debate/Challenge assumptions, not forecasts
Ensure that the underlying assumptions of the long-term strategic plans reflect real market economics and
your organizations actual performance relative to rivals.
More often than not the approach used to generate financial projection has built-in biases.
Rule 3: Use a rigorous framework, speak a common language
All teams must agree on a common framework for assessing performance
Rule 4: Discuss resource deployments early
Challenge business units about when theyll need new resources to execute their strategy. How fast can
you deploy the new sales force?, How quickly will competitors respond?, leads to more feasible
forecasts and plans
Rule 5: Clearly Identify priorities
Make strategic priorities explicit, so everyone knows what to focus on.
Rule 6: Continuously monitor performance
Track real-time results against your plan, resetting planning assumptions and reallocating resources as
needed. Youll remedy flaws in your plan and its execution and avoid confusing the two.
Rule 7: Reward and develop execution ability
No strategy can be better than the people who must implement it. Make selection and development of
managers a priority.
Companies that create tight links between their strategies, their plans, and ultimately, their performance often
experience a cultural multiplier effect. Eventually a culture of over performance emerges. Talent begets
performance, performance begets rewards, and rewards beget even more talent.
How Industries Change
Industries evolve along four distinct trajectories radical, progressive, creative, and intermediating. The
four trajectories set boundaries on what will generate profits in a business
Radical Change Relatively unusual. Industries that are on a radical change trajectory often remain profitable
for a long time.
Intermediating Change Business activities for dealing in both downstream and upstream markets are
simultaneously threatened. Toughest because firms have to simultaneously preserve their valuable assets and
restructure their key relationships. The value of core assets often escalates which compounds managers
confusion.
Creative Change This combination of unstable assets and stable relationships makes it possible to deliver
superior performance over the long term. It is easy to mistake it for radical change, despite the stability of
relationships within the network.
Progressive Change Buyers, suppliers, incumbents have incentives to preserve the status quo. Incremental
changes can lead to major improvements and major changes. Existing relationships can be deepened.
Identifying Trajectory
Define industry, 5% rule. IF a 5% price fluctuation by one
company causes customers or suppliers to switch to another
company, the businesses qualify as direct competitors.
Define the industrys core assets and activities. If it were
eradicated today, would profits be lower a year from now?
Determine whether the firms core assets and activities are
threatened with obsolescence.
Evaluate the phase of the evolutionary trajectory.
An industry generally evolves along just one trajectory at a
time. Almost always starts out on either a progressive or
creative trajectory. The threat of obsolescence can catapult the
industry on to either a radical or an intermediating trajectory.

Analyzing Radical & Intermediating Change Aggressively pursuing profits in the near term while avoiding
investments that could later prevent them from ramping down their commitments. Instead of viewing rivals in
conventional terms, consider whether you can use alliances to protect common interests and defend against new
completion from outsiders.
Surviving Radical & Creative Change The easiest way to do this is to identify how much you are spending
to renew them. Companies must have the mettle to disappoint some buyers and suppliers, regardless of their track
records, if the risks are too high. Ultimately one of the most successful strategies for companies in industries on
a progressive change trajectory is to develop a system of interrelated activities that are defensible because of their
compounding effects on profits, not because they are hard to understand or replicate.