Michael Porters Five Forces of Industry Model - Essay Example

I. Introduction Michael Porter’s Five Forces of Industry model has long been used as an environmental assessment tool for companies. The model helps firms in determining the current state of the industry and its potential as regards economic profits for the firm. This analysis also allows firms to craft competitive strategies depending on the forces apparent in the industry where it is currently a player, or is planning to enter. Being an environmental assessment tool used by businesses, globalization or the emergence of global companies and companies with international operations incorporates additional factors that may affect the industry factors within the firm. Factors such as culture and history are not included in the Porter’s five forces industry analysis. Because of this, the model is seen as inadequate as an environmental assessment tool. Moreover, the forces behind the model are grounded on the premise of constant returns to scale by Alfred Marshall in his ‘theory of production.’ This paper aims to discuss the changes, such as increasing returns to scale and their effect on the intensity of the forces. Factors such as culture and history and their effect on the forces are also explored. II. Body A. The constant returns to scale versus the increasing returns to scale When constant returns to scale is a vital premise where Michael Porter has derived his Five Forces of the industry model, it mainly based on Alfred Marshall’s theory of production. According to Marshall’s theory of production, for a certain increase in the level of all inputs, the output will increase by the same proportion (ILSTU.edu 2009). This has been identified as the constant returns to scale. The concept of constant returns to scale has been the traditional assumption as regards the theory of production. However, changes in our times state that the concept of constant returns to scale is not always the case for production. As firms strive to build production competitive advantage in order to lead the competition, they strive to produce more outputs for a given increase in the level of the inputs, hence increasing returns to scale. As stated in Porter’s five forces: “In the traditional economic model, competition among rival firms drives profits to zero. But competition is not perfect and firms are not unsophisticated passive price takers. Rather, firms strive for a competitive advantage over their rivals. The intensity of rivalry among firms varies across industries, and strategic analysts are interested in these differences (AUEB.gr).” This has significant implications on the Five Forces model’s primary assumption. B. The increasing returns to scale and Porter’s five forces 1. Threat of new entrant Under the constant returns to scale assumption, one of the factors that will determine the threat of a new entrant is the barriers to entry. Barriers to entry are defined as: “[…] unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firms competitive advantage (AUEB.gr).” If the barriers to entry are high, new entrants will be less compelled to enter the industry under the constant returns to scale assumption: even if these new entrants increase all their inputs and expand, they will be able to increase their output only equal to the increase in the level of inputs, and their average cost will remain the same. Hence, they will not be able to gain higher yields and get better economic incentives in terms of capital recovery. However, the idea of constant returns to scale is not always the case. Because of work specialization and evolution of concepts such as synergy, increasing returns to scale have entered the industry picture. Firms strive to gain competitive advantage through production by crafting a cost structure that will enable them to get increasing returns to their incremental investments. As the constant returns to scale assumption is substituted by the increasing returns to scale assumption, we can see that new entrants will then still be motivated to enter the firm as they can get economic incentives only if they will adopt a cost structure as competitive, or even better than those of the current players. The threat of a new entrant is then drastically increased in this new assumption. 2. Threat of substitute The constant returns to scale assumption affects the threat of a substitute product in that, under such assumption a firm that offers a substitute product cannot entirely compete against the product directly and enter the same market unless the firm that manufactures the substitute product invests a substantial amount in order to increase its level of output. According to Porter, the threat of a substitute product is defined as: “[…] products refer to products in other industries. To the economist, a threat of substitutes exists when a products demand is affected by the price change of a substitute product. A products price elasticity is affected by substitute products - as more substitutes become available, the demand becomes more elastic since customers have more alternatives. A close substitute product constrains the ability of firms in an industry to raise prices (AUEB.gr).” Under this assumption, as the average cost will remain the same because the increase in inputs will only offer the same level of increase in output, this firm that manufactures the substitute product will not find it attractive to enter the new market as it will have a hard time recovering its investment. When the increasing returns to scale assumption comes into picture, we see that for a given level of investment, a firm that manufactures a substitute product will have more incentive of entering new markets. It will further reduce its average costs, and as it sells more, the returns get higher. This change in assumption increases the threat of substitute; suddenly, the threat is not as low as it is perceived to be if the constant returns to scale assumption is used. The firm that manufactures a substitute product can easily become a major competitor to a firm in a different industry if it enters the same market. The degree of consumer nudging suddenly increases in this assumption, making the threat of substitute significantly higher. 3. Bargaining power of suppliers When there are a few suppliers in the market and the success of a firm is dependent on the relationship it has with its suppliers, it is said that the suppliers have higher bargaining power under the constant returns to scale assumption. If there are more suppliers, as the competitive rules suggest, power will be more dispersed and companies as customers will have more options, thus the ability of suppliers to absorb the profits from these companies as customers is reduced. This is because, under such assumption suppliers only have as much output to produce given a certain increase in inputs; hence its sales given the number of outputs which will enable it to recoup its investment will be determined by its relationship with the customers and their bargaining power is reduced. Also, significant cost to switch suppliers and credible forward integration threat by suppliers are some of the factors that determine if suppliers are powerful (AUEB.gr). Under the increasing returns to scale assumption, when suppliers can increase all their inputs for a given level, the outputs are increased more than the proportion. This can give more choices for suppliers; they can enter more markets. This can neutralize the bargaining power of customers, and can increase their bargaining powers. The suppliers can then have an increased degree of freedom in influencing the price over a certain set of customers. Thus, under this assumption, the bargaining power of suppliers is increased. According to an article by the Australian Business School in University of New South Wales: “EOS [economies of scale] affect the number of competitors that can compete successfully in any market. If EOS are high, then there are likely to be fewer players, increasing the power of the supplying industry over buyers. As EOS decline in importance, the supplying industry will have more competitors, increasing the supplier power in downstream industries, which will have more choices and be less threatened by hold-up (AGSM.edu.au 1997).” 4. Bargaining power of buyers The bargaining power of buyers is defined as the ability of buyers to influence the price in the market. When there is small number of big buyers in the market, their power to bargain is higher. The bargaining power of buyers is defined as follows: “[…] when buyer power is strong, the relationship to the producing industry is near to what an economist terms a monopsony – a market in which there are many suppliers and one buyer. Under such market conditions, the buyer sets the price. In reality few pure monopsonies exist, but frequently there is some asymmetry between a producing industry and buyers (AUEB.gr).” As they constitute most of the market share, firms will struggle to get these customers up to the extent of giving some of the industry profits to them as firms cut down prices and engage in price wars. According to Ruffle, in instances where there is increasing returns to scale, large customers can threaten industry players with their self-sufficient ability to venture into vertical integration (2005). Because of increasing returns, there will be more incentive to buyers to vertically integrate, thus eliminating the role of its supplier in the supply chain. This forces industry players to concede in terms of price and give some of the industry profits to the customers (2005). Thus, under the increasing returns to scale assumption, the bargaining power of large customers is greatly increased. 5. Degree of rivalry The degree of rivalry under the constant returns to scale assumption is a factor of the interaction of the four other forces. However, these forces change under the increasing returns to scale assumption. And as the degree of rivalry is determined by the interaction of these four forces, this last force is significantly affected. When the constant returns to scale assumption is substituted by the increasing returns to scale concept, the threat of new entrant is increased as well as the threat of substitute product. Because of the increasing returns to scale, more choices will be available to suppliers and this gives them a certain leeway to influence the price, hence their bargaining power can slightly increase. Threats of vertical integration through self-sufficiency of large customers make firms concede and lower the prices to entice customers to maintain them in the customers’ supply chain. Hence, under the increasing returns to scale assumption, large customers tend to have higher bargaining powers. Overall, as outputs increase more than proportionately the increase in all of a firm’s inputs under the increasing returns to scale assumption, firms gain advantage as their production increases and average cost decreases. Depending on a firm’s cost structure, it can grow as much which intensifies the degree of rivalry in the industry. According to an article by the Australian Business School in University of New South Wales: “EOS affect market size and concentrations, which in turn affect the nature of rivalry in the industry. With EOS, only one or very few large firms will be able to produce at or above MES. Smaller firms will be at a cost disadvantage. Competition tends to be fiercer when there are only a few firms in the industry. With this market structure, there can be little mistake concerning the relative power of individual firms, as well as who the industry leaders are (AGSM.edu.au 1997).” Therefore, the degree of rivalry is influenced by the factors that make the industry more crowded, or with less space for all the stakeholders to act. As the forces grow stronger which push the firms with fewer choices, the remaining space in the market leads to an increase in rivalry. The distinction between this ‘crowding of spaces’ defines the difference between the industry forces under the constant returns to scale assumption, and the increasing returns to scale assumption. C. Influence of culture and history on the intensity of the forces Culture and history are important factors in determining the intensity of these forces in the given industry. Traits which are inherent in a certain culture such as aversion to risk and emphasis on doing business on the grounds of not only profitable, but good human relationships among the stakeholders such as suppliers and customers play a huge role in the intensity of these forces. Hofstede has identified four cultural dimensions as basis for classifying countries (Johansson 2000, 63). According to him, these four dimensions include the following: individualism versus collectivism; power distance; masculine versus feminine; and uncertainty avoidance (which is partly related to aversion to risk as previously discussed). These dimensions have implications on the industry forces where a firm chooses to operate in. Hofstede has defined power distance as “the extent to which the less powerful members of organizations and institutions (like the family) accept and expect that power is distributed unequally (Bentley.edu).” This power distance, even between a firm and its stakeholders such as its customers and suppliers has an impact on the intensity of the industry forces. When a firm holds some degree of bargaining power over its suppliers and customers, the extent of which it exploits its power may pose relevant issues as some cultures may criticize these practices, thus giving a company some negative reputation. If the power distance is high, this behavior can be much tolerated, if not endorsed as unequal distribution of power in the society is the norm, and currently accepted. On the contrary, if the society has low power distance, the culture may criticize such action, and the degree of exploitation of such power can be neutralized as other stakeholders will rise to their feet to defend their position. The second dimension, individualism, is described as follows: “Individualism on the one side versus its opposite, collectivism, that is the degree to which individuals are integrated into groups. On the individualist side we find societies in which the ties between individuals are loose: everyone is expected to look after him/herself and his/her immediate family. On the collectivist side, we find societies in which people from birth onwards are integrated into strong, cohesive in-groups, often extended families (with uncles, aunts and grandparents) which continue protecting them in exchange for unquestioning loyalty (Bentley.edu).” This second dimension affects the intensity of the industry forces whether the stakeholders identify themselves as individual entities versus groups. The more individualist cultures pose relatively little impact as they tend to influence the industry in a non-collusive manner. In collectivist societies where entities are integrated into a larger group, they have greater tendencies to join their forces in order to increase their powers in the industry. Masculinity is determined as “versus its opposite, femininity, refers to the distribution of roles between the genders which is another fundamental issue for any society to which a range of solutions are found. […] The assertive pole has been called masculine and the modest, caring pole feminine (Bentley.edu).” Impersonality and aggressiveness can be classified as masculine traits; on the other side is relationship-orientation and caring as feminine traits. Different cultures emphasize the impersonality of dealing with stakeholders, as long as they are profitable and healthy to the firm’s finances. On the other hand, there are cultures that emphasize the long-term, more personal relationships between firms—relationships to stakeholders such as key suppliers and customers. Therefore, the forces will intensify depending on the degree of masculinity and femininity in the society of the industry. If the society leans toward the more masculine side, aggressiveness of firms will be increased, and can result in increased rivalry. On the contrary, if the society favors more a relationship-oriented, caring and modesty as major traits, such aggressive behaviors will be criticized and looked upon as negative. For example, even when new entrants perceive entry in an industry a good choice despite the barriers to entry, their decision to get in the industry will be determined by the culture’s aversion to risk. If the culture rewards taking risks, the threat of new entrant may still be high despite the high barriers to entry. If the culture rewards otherwise, no matter how relatively low the barriers to entry are, the threats of new entrant can be just moderate. According to Hofsted, this is the fourth dimension which is uncertainty avoidance. Uncertainty avoidance is defined as follows: “Uncertainty Avoidance Index (UAI) deals with a societys tolerance for uncertainty and ambiguity; it ultimately refers to mans search for Truth. It indicates to what extent a culture programs its members to feel either uncomfortable or comfortable in unstructured situations. Unstructured situations are novel, unknown, surprising, different from usual (Bentley.edu).” These four dimensions determine the relative intensity of the forces in the industry. As these four dimensions have continuums, a lean toward one end rather than the other end could pose significant implications on the intensity of the force. III. Conclusion All in all, Porter’s Five Forces model is inadequate in assessing the industry. By comparing the intensity of the forces under the constant returns to scale assumption with that under the increasing returns to scale assumption, the difference is significance. The forces under the increasing returns to scale assumption are more intense than under the constant returns to scale idea. This underrepresented picture of the industry competition is very significant as apparent in the difference, to just not consider it. This inadequacy limits the analysis of Porter’s five forces model. Apart from the differences under the two sets of assumptions, important factors which determine the level of the competition as well as the intensity of the forces are not included in the model. These include the history and the culture of the country where the firm wishes to enter. These four cultural dimensions presented by Geert Hostede are helpful in determining the relative intensity of the forces in the industry. According to him, these four dimensions include the following: individualism versus collectivism; power distance; masculine versus feminine; and uncertainty avoidance (which is partly related to aversion to risk as previously discussed). These dimensions have implications on the industry forces where a firm chooses to operate in. As these four dimensions have continuums, a lean toward one end rather than the other end could pose significant implications on the intensity of the force. In assessing the environmental factors in a market where a firm wishes to enter, culture is a set of norm that determines the acceptable behavior in the market which could also influence the market players, in the process. Bibliography Arthur, W. B. (1994) Increasing returns and path dependence in the economy. Michigan: University of Michigan Press. Athens University of Economics and Business Department of Management Science and Technology (2009). “Porter’s five forces: a model for industry analysis.” AUEB.gr. Date accessed: February 15, 2009 from http://e-learning.dmst.aueb.gr/mis/Cases/7-Eleven/Case/Porter_Five_Forces.pdf Bentley University (2009). “Hofstede’s cultural attitudes research—cultural dimensions.” Bentley.edu. Date accessed: February 15, 2009 from http://web.bentley.edu/empl/b/hboyd/readings_files/Global/hofstede-plus.pdf Chen, Zhiqi (2008 January 10). “Defining buyer power.” Carleton University.ca. Date accessed: February 15, 2009 from http://http-server.carleton.ca/~zchen/Defining%20Buyer%20Power%20Revised.pdf Johansson, Johny K. (2000). Global Marketing Management. 5th ed. United Kingdom: McGraw Hill Intl, Ltd. Illinois State University Department of Economics (2009). “Alfred Marshall and Neoclassical Economics.” ILSTU.edu. Date accessed: February 15, 2009 from http://www.econ.ilstu.edu/ntskaggs/ECO372/readings/alfred_marshall.htm Ruffle, Bradley J. (2005 December). “Buyer countervailing power: a survey of theory and experimental experience.” Ben-Gurion University of the Negev Department of Economics. 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