Five Forces Analysis (Also include game theory, complements, comparative advantage (from Science of Success), and government (Fed, State, and Local)) Jonathon Barnett
Summary
The Five Forces model is a strategic management model conceived by Dr. Michael Porter of Harvard Business School. He developed it as a tool for analyzing competitive advantage within industries, which can be utilized in a number of different ways (Barney, Jay; Gaining and sustaining competitive advantage, New York: Addison-Wesley; 1996; p.6). Primarily, the Five Forces model is used to analyze an industry by a potential entrant into that industry. It can also be used in evaluating cases where competitive advantage is being manipulated, such as in antitrust cases. It has also been adapted for use in risk management by the Defense Department (Rice, John; Adaptation of Porter’s Five Forces Model to Risk Management; 2010, p.378). For this wiki, I have used it to analyze different antitrust cases, which has been very intriguing.
The first of the Five Forces is intensity of competitive rivalry. We have covered this topic fairly extensively in class. Intensity of competitive rivalry simply refers to how many firms compete in an industry, and how strongly they compete. In a market that exhibits near-perfect competition, a firm has absolutely no market power- their individual demand curve is horizontal, emanating from the prevailing market price. They are price takers, and in the long run earn zero economic profit (Behe, p266). In a couple of the antitrust cases I analyzed, the defendant firm was trying to move the market as far away from the direction of perfect competition as possible. Specifically, Bayer Corp and several coconspirators colluded in the late 90’s to keep the price of certain chemicals artificially high, and to keep any possible entrants from deciding to enter (DOJ, http://www.justice.gov/atr/cases/bayer3.htm). Another interesting case is US V. Andrew Bodnar. Bodnar was a senior VP at Bristol-Myers-Squibb, one of the major pharmaceutical firms in the US. When one of his company’s products, Plavix, was losing its patent exclusivity and entering generic production, Bodnar intentionally deceived the FTC into believing that BMS was planning on launching its own generic. This would have prevented another company, Apotex, from producing the generic form of Plavix for an additional 180 days. Bodnar’s action was solely to prevent another company from competing with BMS (DOJ, http://www.justice.gov/atr/cases/f244500/244551.htm). In sum, intensity of competitive rivalry is a very important factor to consider when entering a market, or analyzing competition within a market.
The second of the five forces is threat from new entrants. This can be affected by a number of factors, including necessary economies of scale, start-up requirements, and other barriers to entry. To use an example that has been cited in class, Budweiser, Miller, and Coors face little threat from new entrants in their domination of the domestic, generic beer market. An entrant wanting to chip into their market share would have to create a manufacturing process that mimics their economies of scale, would have to set up a nationwide distribution network, and would in general have phenomenally high start-up costs. On the opposite end of the spectrum, I posted a link to a Five Forces analysis of the smartphone gaming industry (http://sgentrepreneurs.com/commentary/2011/11/24/starting-a-new-company-do-industry-analysis-part-one/). The threat from new entrants in that industry is incredibly high, because there are few barriers to entry, and the costs to start up are miniscule (they can really only be measured in the value of the programmer’s labor).
The third of the Five Forces is the threat from substitutes. From a new entrant’s perspective, this force applies to them insofar as how is their product differentiated within the industry? Are they creating a novel and innovative product within their industry that will have no immediate substitutes? Or are there already firms out there that produce your product or something close to it? From a big, established firm’s perspective, the fear of the threat from substitutes is the reason behind a majority of antitrust filings by the DOJ. In these situations, a large firm is afraid that a new entrant will be able to provide the same good or service they do, either more quickly, more effectively, or more cheaply than they can. Thus, they act in a sometimes-unlawful manner to try and prevent substitutes from entering their market. This was the case in US v. GE, where GE attempted to block substitutes for its high-cost maintenance labor on some of its advanced medical machines. Hospitals who buy and use these machines were attempting to train their staff on their maintenance, and then market these services to other hospitals who couldn’t afford to maintain a full-time staff. GE saw that this would be a perfect substitute for its own maintenance services, and they attempted to block it (http://www.justice.gov/atr/cases/f1000/1047.htm).
The fourth Force is the bargaining power over buyers. In many cases, the bargaining power of buyers over a firm’s product will be limited to their choice whether or not to buy your product. In a limited number of cases, however, buyers can act in collusion to drive down retail prices. For example, Groupon.com utilizes the bargaining power of buyers in negotiating reduced prices for goods and services for its members. One notable case where the bargaining power of buyers is extremely high would be in the health care products market in countries with single-payer health care. In the UK, for example, the NHS (National Health Service) administrates all hospitals and doctors offices in the country. There are a few private, for-profit hospitals, but for the most part there, the NHS has control over all of them. In such a situation, the makers of health care products such as prescription drugs, prosthetics, MRI machines, etc., have only one buyer- the NHS. As such, they must tailor their products and prices to meet that one buyer’s needs.
The fifth Force is the bargaining power over suppliers. This refers to the strength of the firms that provide the goods a firm uses to produce its products. For example, a possible entrant into the gas station market would have to take into account that their power over the price of the main product they sell, gasoline, is dictated by their suppliers. They cannot demand a lower price or even attempt to negotiate a lower price for their supplies with the oil companies because those companies own the means of production for gasoline. Thus, it has essentially no bargaining power over its suppliers. Conversely, the suppliers of gasoline can dictate at will the price of the good that gas stations charge, and there is nothing that the gas station can do about it, unless it decides that it wants to sell below market cost and lose money. An inverse of this situation would be where a firm has tremendous power over its suppliers. A case in point would be Walmart. Because of the sheer size of Walmart, it can dictate to its suppliers how much and what they should be supplying, and what price they need to sell at. Thus, large, dominant firms in some industries have tremendous bargaining power over their suppliers.
Quiz questions
1) If you were assessing a market, and wanted to know how many rivals you would have if you decided to enter, which of the Five Forces would be most useful in your analysis?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
f. A & B g. A, B, C
h. All of the above
2) In which of the following markets would the bargaining power of buyers be strongest?
a. Fast food industry
b. Ebay
c. Used car market
d. Single-payer health care country e. B & D
f. All of the above
3) You are a prospective entrepreneur in an industry that has extremely high start-up costs. Which of the Five Forces best applies to your situation?
a. 1) Intensity of competitive rivalry b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
4) You are a nationwide company that owns and operates movie theaters. You are seeking to merge with one of your competitors. The resulting merged company will, in some markets, be the sole purveyor of first-run, commercial movies. The Department of Justice has decided to file suit seeking to block this merger. Which of the Five Forces best explains the DOJ’s action? a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
5) You are the CFO of Meijer. You have just concluded contract negotiations which resulted in your company becoming the sole big-box retailer selling Masterlock combo locks, at a price that is lower than what your smaller competitors charge. The DOJ has just filed an injunction to block the implementation of this contract. Which of the Five Forces would best be used by you to describe the rationale behind the DOJ’s action?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers e. 5) Bargaining power over suppliers
Summaries -Oligopoly An oligopoly is a market structure in which there are a few large sellers. Examples of such a market include Satellite TV providers, OPEC, and cell phone companies. The types of oligopolies within this discussion are Cournot, Stackelberg, and Bertrand. The other oligopolistic situation discussed is collusion, in which there are many firms in an industry, but they coordinate their actions to prevent entry by new firms, keep prices high, or keep profits high
-Monopoly
A monopoly is a market structure in which one single firm serves the entire market, where there are no close substitutes. In the real world, there are few examples of pure monopolies in industries, as most products have close substitutes that prevent monopolies from emerging. However, even with antitrust laws in most developed nations, monopolies can still exist. One example is local utility companies. In most markets across the country, a household buys its electricity from only one company (exceptions might be if that household invests in clean sources such as wind or solar). Another example in the private sector would be the DeBeers diamond company. That company at one point owned over 90% of every level of production in the diamond industry.
-Market Failures
Market failure is used to describe the situation when a given market does not provide the socially efficient level of output. This situation can arise from a number of factors, such as externalities, public goods, monopolies, and rent-seeking. An externality refers to a cost bourne by parties not directly involved in the production of a good, the most classic example being pollution. Public goods can suffer market failure if they are non-rival and non-exclusionary. A good example would be the air- another person's use of it doesn't affect my use of it, and there is no way to prevent me from using it. Monopolistic markets suffer market failure conditions because of the deadweight loss they create in the market. Rent-seeking causes market failures because it is a malevolent effort to affect another party's marketplace decision, which can cause the market to not produce the socially efficient level of output.
-Concentration indices
These indices are used to quantitatively measure the power of firms in a given market. The most commonly used indices are the Four-Firm Concentration ratio (measures the market share of the 4 largest firms), the Herfindal-Hirschman Index (used to evaluate individual firms, scaled from 0-10,000, with 10,000 being a pure monopoly), and the Lerner Index (similar to HHI in that it measures an individual firm's power in the marketplace, but the scale is 0-1, with 1 being monopolistic).
-Government policies (price ceilings, price floors, excise taxes, prohibition)
A price ceiling is a an upper limit on what producers can charge for their product. Perhaps the most famous recent example of a nationwide price ceiling was in the late-70's, when in response to oil shortages the government set a maximum on what firms could charge for gasoline. A price floor is a government-imposed minimum price in a market. A current example would be farm subsidies, in which the federal government essentially creates a price floor by buying up excess agricultural products to artificially inflate the market price. Excise taxes are taxes levied against a specific class of consumption items. Examples include liquor, cigarettes, and fast food.
Summary
The Five Forces model is a strategic management model conceived by Dr. Michael Porter of Harvard Business School. He developed it as a tool for analyzing competitive advantage within industries, which can be utilized in a number of different ways (Barney, Jay; Gaining and sustaining competitive advantage, New York: Addison-Wesley; 1996; p.6). Primarily, the Five Forces model is used to analyze an industry by a potential entrant into that industry. It can also be used in evaluating cases where competitive advantage is being manipulated, such as in antitrust cases. It has also been adapted for use in risk management by the Defense Department (Rice, John; Adaptation of Porter’s Five Forces Model to Risk Management; 2010, p.378). For this wiki, I have used it to analyze different antitrust cases, which has been very intriguing.
The first of the Five Forces is intensity of competitive rivalry. We have covered this topic fairly extensively in class. Intensity of competitive rivalry simply refers to how many firms compete in an industry, and how strongly they compete. In a market that exhibits near-perfect competition, a firm has absolutely no market power- their individual demand curve is horizontal, emanating from the prevailing market price. They are price takers, and in the long run earn zero economic profit (Behe, p266). In a couple of the antitrust cases I analyzed, the defendant firm was trying to move the market as far away from the direction of perfect competition as possible. Specifically, Bayer Corp and several coconspirators colluded in the late 90’s to keep the price of certain chemicals artificially high, and to keep any possible entrants from deciding to enter (DOJ, http://www.justice.gov/atr/cases/bayer3.htm). Another interesting case is US V. Andrew Bodnar. Bodnar was a senior VP at Bristol-Myers-Squibb, one of the major pharmaceutical firms in the US. When one of his company’s products, Plavix, was losing its patent exclusivity and entering generic production, Bodnar intentionally deceived the FTC into believing that BMS was planning on launching its own generic. This would have prevented another company, Apotex, from producing the generic form of Plavix for an additional 180 days. Bodnar’s action was solely to prevent another company from competing with BMS (DOJ, http://www.justice.gov/atr/cases/f244500/244551.htm). In sum, intensity of competitive rivalry is a very important factor to consider when entering a market, or analyzing competition within a market.
The second of the five forces is threat from new entrants. This can be affected by a number of factors, including necessary economies of scale, start-up requirements, and other barriers to entry. To use an example that has been cited in class, Budweiser, Miller, and Coors face little threat from new entrants in their domination of the domestic, generic beer market. An entrant wanting to chip into their market share would have to create a manufacturing process that mimics their economies of scale, would have to set up a nationwide distribution network, and would in general have phenomenally high start-up costs. On the opposite end of the spectrum, I posted a link to a Five Forces analysis of the smartphone gaming industry (http://sgentrepreneurs.com/commentary/2011/11/24/starting-a-new-company-do-industry-analysis-part-one/). The threat from new entrants in that industry is incredibly high, because there are few barriers to entry, and the costs to start up are miniscule (they can really only be measured in the value of the programmer’s labor).
The third of the Five Forces is the threat from substitutes. From a new entrant’s perspective, this force applies to them insofar as how is their product differentiated within the industry? Are they creating a novel and innovative product within their industry that will have no immediate substitutes? Or are there already firms out there that produce your product or something close to it? From a big, established firm’s perspective, the fear of the threat from substitutes is the reason behind a majority of antitrust filings by the DOJ. In these situations, a large firm is afraid that a new entrant will be able to provide the same good or service they do, either more quickly, more effectively, or more cheaply than they can. Thus, they act in a sometimes-unlawful manner to try and prevent substitutes from entering their market. This was the case in US v. GE, where GE attempted to block substitutes for its high-cost maintenance labor on some of its advanced medical machines. Hospitals who buy and use these machines were attempting to train their staff on their maintenance, and then market these services to other hospitals who couldn’t afford to maintain a full-time staff. GE saw that this would be a perfect substitute for its own maintenance services, and they attempted to block it (http://www.justice.gov/atr/cases/f1000/1047.htm).
The fourth Force is the bargaining power over buyers. In many cases, the bargaining power of buyers over a firm’s product will be limited to their choice whether or not to buy your product. In a limited number of cases, however, buyers can act in collusion to drive down retail prices. For example, Groupon.com utilizes the bargaining power of buyers in negotiating reduced prices for goods and services for its members. One notable case where the bargaining power of buyers is extremely high would be in the health care products market in countries with single-payer health care. In the UK, for example, the NHS (National Health Service) administrates all hospitals and doctors offices in the country. There are a few private, for-profit hospitals, but for the most part there, the NHS has control over all of them. In such a situation, the makers of health care products such as prescription drugs, prosthetics, MRI machines, etc., have only one buyer- the NHS. As such, they must tailor their products and prices to meet that one buyer’s needs.
The fifth Force is the bargaining power over suppliers. This refers to the strength of the firms that provide the goods a firm uses to produce its products. For example, a possible entrant into the gas station market would have to take into account that their power over the price of the main product they sell, gasoline, is dictated by their suppliers. They cannot demand a lower price or even attempt to negotiate a lower price for their supplies with the oil companies because those companies own the means of production for gasoline. Thus, it has essentially no bargaining power over its suppliers. Conversely, the suppliers of gasoline can dictate at will the price of the good that gas stations charge, and there is nothing that the gas station can do about it, unless it decides that it wants to sell below market cost and lose money. An inverse of this situation would be where a firm has tremendous power over its suppliers. A case in point would be Walmart. Because of the sheer size of Walmart, it can dictate to its suppliers how much and what they should be supplying, and what price they need to sell at. Thus, large, dominant firms in some industries have tremendous bargaining power over their suppliers.
Quiz questions
1) If you were assessing a market, and wanted to know how many rivals you would have if you decided to enter, which of the Five Forces would be most useful in your analysis?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
f. A & B
g. A, B, C
h. All of the above
2) In which of the following markets would the bargaining power of buyers be strongest?
a. Fast food industry
b. Ebay
c. Used car market
d. Single-payer health care country
e. B & D
f. All of the above
3) You are a prospective entrepreneur in an industry that has extremely high start-up costs. Which of the Five Forces best applies to your situation?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
4) You are a nationwide company that owns and operates movie theaters. You are seeking to merge with one of your competitors. The resulting merged company will, in some markets, be the sole purveyor of first-run, commercial movies. The Department of Justice has decided to file suit seeking to block this merger. Which of the Five Forces best explains the DOJ’s action?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power of suppliers
5) You are the CFO of Meijer. You have just concluded contract negotiations which resulted in your company becoming the sole big-box retailer selling Masterlock combo locks, at a price that is lower than what your smaller competitors charge. The DOJ has just filed an injunction to block the implementation of this contract. Which of the Five Forces would best be used by you to describe the rationale behind the DOJ’s action?
a. 1) Intensity of competitive rivalry
b. 2) Threat from new entrants
c. 3) Threat from substitutes
d. 4) Bargaining power of buyers
e. 5) Bargaining power over suppliers
Summaries
-Oligopoly
An oligopoly is a market structure in which there are a few large sellers. Examples of such a market include Satellite TV providers, OPEC, and cell phone companies. The types of oligopolies within this discussion are Cournot, Stackelberg, and Bertrand. The other oligopolistic situation discussed is collusion, in which there are many firms in an industry, but they coordinate their actions to prevent entry by new firms, keep prices high, or keep profits high
-Monopoly
A monopoly is a market structure in which one single firm serves the entire market, where there are no close substitutes. In the real world, there are few examples of pure monopolies in industries, as most products have close substitutes that prevent monopolies from emerging. However, even with antitrust laws in most developed nations, monopolies can still exist. One example is local utility companies. In most markets across the country, a household buys its electricity from only one company (exceptions might be if that household invests in clean sources such as wind or solar). Another example in the private sector would be the DeBeers diamond company. That company at one point owned over 90% of every level of production in the diamond industry.
-Market Failures
Market failure is used to describe the situation when a given market does not provide the socially efficient level of output. This situation can arise from a number of factors, such as externalities, public goods, monopolies, and rent-seeking. An externality refers to a cost bourne by parties not directly involved in the production of a good, the most classic example being pollution. Public goods can suffer market failure if they are non-rival and non-exclusionary. A good example would be the air- another person's use of it doesn't affect my use of it, and there is no way to prevent me from using it. Monopolistic markets suffer market failure conditions because of the deadweight loss they create in the market. Rent-seeking causes market failures because it is a malevolent effort to affect another party's marketplace decision, which can cause the market to not produce the socially efficient level of output.
-Concentration indices
These indices are used to quantitatively measure the power of firms in a given market. The most commonly used indices are the Four-Firm Concentration ratio (measures the market share of the 4 largest firms), the Herfindal-Hirschman Index (used to evaluate individual firms, scaled from 0-10,000, with 10,000 being a pure monopoly), and the Lerner Index (similar to HHI in that it measures an individual firm's power in the marketplace, but the scale is 0-1, with 1 being monopolistic).
-Government policies (price ceilings, price floors, excise taxes, prohibition)
A price ceiling is a an upper limit on what producers can charge for their product. Perhaps the most famous recent example of a nationwide price ceiling was in the late-70's, when in response to oil shortages the government set a maximum on what firms could charge for gasoline. A price floor is a government-imposed minimum price in a market. A current example would be farm subsidies, in which the federal government essentially creates a price floor by buying up excess agricultural products to artificially inflate the market price. Excise taxes are taxes levied against a specific class of consumption items. Examples include liquor, cigarettes, and fast food.