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How Competitive Forces Shape Business: Examples and Importance
Business Essentials · Chapter 1: The Business Environment and Ethical FoundationsSection 1.3 · lesson 3 of 10513 min · free with a free account
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In this lesson
Who a business really competes with, and what sets an industry's profits.
- Distinguish direct, indirect and potential competition
- Apply the five competitive forces to an industry
- Explain six barriers to entry and how they vary
- Locate the line in gathering competitive intelligence
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The Business Environment and Ethical Foundations
How Competitive Forces Shape Business: Examples and Importance
Ask a business owner who the competition is, and you usually get a short list of lookalikes. This section argues that the list is too short, and shows how to build a better one. First, we separate direct competitors, indirect competitors, and potential entrants. Then we work through five competitive forces, which together shape how profitable an industry is. We apply them to a fictional group of coffee roasters, and look closely at barriers to entry. We see why the environment keeps shifting, and where gathering intelligence on rivals crosses a line. And we finish with a print shop that defined its competition far too narrowly.
Who Is The Competition?
Three Kinds of Competitor
Competition is the rivalry among businesses for the same customers, resources, or revenue. It sounds simple. It is often hard to apply, because real competitors do not always resemble you. Three kinds are worth separating. Direct competitors offer essentially the same thing to the same customers. Think of two pizzerias in one neighborhood. Indirect competitors meet the same underlying need in a different way. A supermarket's prepared-meal counter meets the need for a quick dinner, just as the pizzeria does. Potential entrants do not compete yet, but could begin to. They may work in an adjacent market, or a barrier that once kept them out may have fallen. Here is the counter-intuitive part. Direct rivals are the least dangerous group. They are visible, and their behavior is familiar. The other two can change the terms without warning. So the practical test is to define the customer's need, not the business's product. Someone buying coffee at a cafe is buying a hot drink, and a place to sit for ten minutes. Anything supplying either one competes.
Force 1
Rivalry Among Existing Competitors
A widely used method for analyzing competition examines five forces. Treat it as a framework for asking questions about an industry. It is not a formula that produces a number. The first force is rivalry among existing competitors, the intensity of the contest among firms already in the industry. Rivalry rises when competitors are numerous, and similar in size. It rises when the industry grows slowly, so one firm's gain is another's loss. It rises when products are hard to tell apart. It rises when fixed costs are high, because firms then have to fill their capacity. And it rises when leaving is costly. Rivalry falls in the opposite conditions. When firms differ from one another, when demand is growing, and when customers value more than price. Notice that most of these are features of the industry, not choices made by any one firm.
Forces 2 And 3
Entry and Substitutes
The second force is the threat of new entrants. That is how easily new firms can begin competing. It depends on barriers to entry, which we come to shortly. Entrants bring new capacity, and often a willingness to cut prices to win customers. So a credible threat of entry holds prices down, even when no entrant has arrived yet. The third force is the threat of substitutes. These are products from outside the industry that meet the same need. Substitutes set a ceiling on price. Raise it far enough, and customers switch. This force is easily missed, because a substitute sits outside the industry as the business defines it. A stationery maker that thinks its industry is stationery will not see the note-taking app as a rival. A bus company that thinks its industry is bus travel will overlook the car-sharing service. The remedy is the same test as before. Define the industry by the need it serves.
Forces 4 And 5
Buyer and Supplier Power
The fourth force is the bargaining power of buyers. Buyers with power can force prices down, demand better quality or service, or play competitors against one another. Buyer power rises when buyers are few and large, and when they buy in volume. It rises when the product is standard, so switching is easy, and when buyers could make the product themselves. The fifth force, supplier power, is the mirror image. It is the ability of input sellers to raise prices, or restrict terms. It rises when suppliers are few, when the input is specialized or has no substitute, and when the supplier could enter the buyer's business. Two situations show how this bites. Selling to a few large customers brings volume and predictability. But it costs bargaining position. Losing one customer may mean losing a large share of revenue. So that customer can demand price cuts, longer payment terms, or special specifications. And the business cannot refuse. The second is single-source dependence, relying on one supplier for a critical input. The supplier sets the terms, and any disruption at the supplier becomes a disruption at the business. Both are managed the same way. Broaden the customer or supplier base where possible, and build the capability to change.
Figure 1.3.1
Five Forces on Coffee Roasters
Here are the five forces applied to one industry. It is a fictional composite. Independent coffee roasters, supplying local cafes. Rivalry sits at the center, with the other four forces pressing in on it. Each force was given an illustrative rating, and four of them come out moderate or lower. One stands out. Buyer power. Two large cafe groups buy most of the roasters' output, and they can change roasters cheaply. That makes buyer power the force that most constrains profitability here. This is the usual pattern. The squeeze on profit tends to come mainly from one or two forces. Find which ones, and you know where the margin is being lost.
Barriers To Entry
Six Costs an Entrant Must Bear
A barrier to entry is anything that makes it costly, or difficult, for a new firm to start competing. Six are commonly described. Capital requirements are the money needed to begin, in plant, equipment, and working funds. Scale economies are cost advantages that come with large volume. They force an entrant either to start large, or to accept higher unit costs. Regulation and licensing are legal permissions to operate. They cost time and money, and may limit the number of firms. Established brands and customer relationships give current firms trust. An entrant must spend heavily, or wait long, to build it. Access to distribution is the ability to reach customers through the channels they use. Others may control those channels. Switching costs are the expense, effort, and risk a customer bears when changing suppliers. They lock customers to the firms they already use. Every one of these is a cost the entrant bears before earning anything.
Table 1.3.1
High in One Industry, Low in Another
Each barrier can be high in one industry, and low in another. Capital is high for building commercial aircraft, which needs vast plant and long development. A freelance copy editor needs a computer. Scale economies are high in cement, where cost per ton falls sharply with plant size. In hand-made ceramics, each piece costs about the same at any volume. Regulation is high in retail banking. Banks need charters, and must meet prudential rules. A freelance graphic designer typically needs no license at all. Brand and relationships matter enormously for funeral services in a small town. Families choose a provider they already trust. A street-food customer, by contrast, chooses on the day. Distribution is a high barrier for packaged groceries, because retailers control scarce shelf space. A download can be sold directly. Switching costs are high for enterprise accounting systems. Changing means retraining, migrating data, and risking errors. Changing your bottled water costs nothing. So barriers are a matter of degree. The same business idea can be easy to start in one field, and nearly impossible in another.
The Central Claim
Structure Sets Profitability
Now the framework's central claim. An industry's structure, meaning the strength of its five forces, determines how profitable it is for its typical member. Picture an industry with intense rivalry, easy entry, and close substitutes. Add buyers who dictate terms, and suppliers who dictate prices. Almost every firm in it will earn poor returns, however capable its managers. Where the forces are weak, even average managers tend to earn good returns. That is a strong claim, and it deserves some caution. Firms within one industry vary considerably. The framework describes the average tendency, not the outcome for any given firm. Its real value is a shift of attention. It moves the question from how well the business performs, to the conditions it faces.
A Moving Target
An Environment That Changes
The competitive environment is not fixed. Three things commonly shift it. Deregulation is the removal or loosening of rules that limited entry or competition. It can open an industry to newcomers. Firms from adjacent industries can enter, applying capabilities they developed elsewhere. And technological change can lower a barrier, by making a capability available cheaply. For example, a business may now reach customers without a physical distribution network. Each of these changes the strength of one or more forces. So an industry analysis has to be repeated, not done once. And the analysis is not an end in itself. Its purpose is to reveal where profit is being competed away, and where a business might position itself. It might move toward customers with less power, or raise the barrier that protects it. Or it might lower its dependence on a powerful supplier. Choosing a target market and building an advantage is strategy, and that belongs to chapter twelve.
Competitive Intelligence
Where the Line Falls
Competitive intelligence is the systematic collection and analysis of information about competitors and the wider environment. A great deal can be learned legitimately, from public sources. Competitors' published prices and websites. Their advertising, and their public filings, if they are publicly traded. Trade publications. And what customers and suppliers say freely. Job advertisements are especially revealing. They show what capabilities a competitor is building. The boundary is crossed when information is obtained by deception or theft. That means misrepresenting your identity, taking confidential documents, or inducing an employee to breach confidentiality. These are ethically wrong. They may also be illegal under federal and state trade-secret law. That law protects information a business takes reasonable steps to keep secret. There is a separate legal danger when competitors exchange information about prices or intentions. Agreements that suppress rivalry are the concern of the competition statutes named in subchapter one point one. The ethical reasoning for doubtful cases is developed in subchapter one point six.
Case Vignette
Brightwater Print and Copy
To close, a composite case. Dorian manages Brightwater Print and Copy, a fictional shop in a mid-sized town. It prints documents, flyers, and bound reports. Dorian's list of competitors holds the two other print shops in town. Their prices are known, and their owners are familiar. Dorian answers their offers with occasional discounts. Over several years, volume falls. Yet neither rival has gained. Customers have started sharing documents on screen, and signing agreements electronically. They print short items on inexpensive machines, at home or at the office. None of these is a print shop, and none appears on Dorian's list. Matching the rivals' prices answered a threat that was not the real one. The error was describing the business by its product, printing. The customer's need was to put information in front of another person. Define it that way, and the substitutes are plain.
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