INVESTING FUNDAMENTAL ANALYSIS
Porter's Five Forces Explained and How
to Use the Model
The fundamentals you need to analyze an industry's
weaknesses and strengths
By PETER GRATTON Updated June 18, 2024
Reviewed by GORDON SCOTT
Fact checked by PATRICE WILLIAMS
DEFINITION:
Introduced in a 1979 article, Porter's five forces shape a given industry:
internal competition, the potential for new entrants, the negotiating power
of suppliers, the negotiating power of customers, and the customers'
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ability to find substitutes.
What Are Porter's Five Forces?
Michael Porter's five-force strategic analysis model, introduced in a 1979 article
published in the Harvard Business Review, remains a fundamental tool for
strategic analysts plotting the competitive landscape of an industry. [1]
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In a bid to mirror the complexity real strategists would face while keeping their
strategic analysis manageable, Porter set out five forces at play in a given
industry: internal competition, the potential for new entrants, the negotiating
power of suppliers, the negotiating power of customers, and the ability of
customers to find substitutes. Below, we take you through each of Porter's five
forces, detail the significant critiques of his approach, and show how to apply
the model to specific markets.
KEY TAKEAWAYS
Porter's five forces are used to identify and analyze an industry's
competitive forces.
The five forces are competition, the threat of new entrants to the
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industry, supplier bargaining power, customer bargaining power, and
the ability of customers to find substitutes for the sector's products.
The model guides businesses in determining the intensity of
competition and potential profitability within their market, helping
them better understand where power lies in their sector.
Porter's model was meant to critique "perfectly competitive" business
models, unlike real-world markets where competitors aren't just rivals
and firms in specific industries tend to rise and fall together.
Criticisms mounted against the model include that it's too static,
doesn't speak to the advantages or problems of specific companies,
doesn't account enough for collaborative business models, and
doesn't apply as well to quick-changing markets.
Investopedia / Xiaojie Liu
Understanding Porter's Five Forces
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Strategic analysis at the time of Porter's article tended not only to love
acronyms (SWOT, PEST, PESTEL, BCG Matrix, ETPS, etc.) but also models
focused on the internal dynamics of individual companies. [2]
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While it would be unfair to suggest they ignored the competitive environment
companies face, they were typically vague while doing so; e.g., the
"opportunities" and "threats" of SWOT analysis were too "macro" for many
dealing with the challenges of specific industries.
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Porter's 1979 article was also a broadside against the theoretical models found
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in the curriculums of the major business schools, where future strategists dealt
with a "perfectly competitive" market characterized by equilibrium and no
specific firm influencing prices—a model they were unlikely to find in the real
world.
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The first sentence of Porter's 1979 article could hardly be less controversial:
"The essence of strategy formulation is coping with competition." [1]
It's the following sentence that, in its understated way, would prove far more
consequential: "Yet it is easy to view competition too narrowly and too
pessimistically." [1]
Rather than viewing competition narrowly as rivalry among existing
competitors, which is his first force, Porter expanded the concept to include
four others: the bargaining power of suppliers and buyers, the threat of new
entrants, and the threat of substitute products or services. Let's take these in
turn.
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now.
Porter's Five Forces
1. Competitive Rivals
Porter's first force is what we usually mean when discussing business
competition. We think of Pepsi and Coca-Cola for soft drinks, Apple and
Samsung for smartphones, Nike and Adidas for sneakers, and Ford and General
Motors for autos.
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Indeed, some of these rivalries are so influential that consumers split almost
culturally among those who have an iPhone, drive a Ford, or prefer Netflix to
Hulu. Thus, it's no accident that we also consider business competition chiefly a
war among rivals.
Such rivalries can lead to price wars, high-priced marketing battles, and races
for slight advances that could mean a competitive advantage. These tactics can
stimulate companies to make ever better products but also erode profits and
market stability. [3]
Several factors contribute to the intensity of competitive rivalry in an industry:
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The number of competitors: The more competitors in an industry, the more
fierce the rivalry, each fighting for scraps of market share.
Industry growth: In an expanding industry, competition is usually less
dramatic because the market is growing so fast that competitors have little
need to fight for customers—think of the automobile industry of the early
20th century and the dot-com boom of the late 1990s. However, in a
stagnant or declining industry, competition can be ferocious as firms fight
for a larger piece of a shrinking pie, such as in the global coal mining or print
media industries of today.
Similarities in what's offered: When the products or services in a market are
awfully similar (think of the lower page of results in any Amazon product
search), competition tends to be intense because customers can easily
switch. However, if a company offers a unique product or service or has
earned brand loyalty, this can reduce competitive rivalry. Apple, Inc. (AAPL)
comes to mind in tech goods, just as Rao's Italian sauces or King Arthur flour
do in your supermarket aisles, each charging a higher price given its style,
taste, or whatever makes it unique.
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Exit barriers: When it's difficult or costly for companies to leave the industry
due to specialized assets, contractual obligations, or emotional attachment,
they may choose to stay and compete, even if the market's prospects grow
dimmer by the day. The airline industry is a classic example. Airlines have
high costs for their assets, contractual obligations (leasing agreements and
labor contracts), and regulatory requirements, which means that when
airlines face a shrinking market—or even an unprofitable route—they can't
retreat from the market quickly.
Fixed costs: Porter notes that if an industry has high fixed costs, companies
have a "strong temptation" to cut prices rather than slow production when
demand slackens. Paper and aluminum manufacturing are two good
examples that Porter gives. [1]
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TABLE OF CONTENTS
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2. Potential for New Entrants in an Industry
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Industries where new firms can enter more easily almost always have lower
profit margins, and the firms involved each have less market share. [1]
The sector for local restaurants has relatively low entry requirements: there
aren't significant investments or regulatory hurdles to surmount before
opening to the public. Thus, it's also the case that your favorite restaurant may
not stay open for long, given the hypercompetitive environment and constant
entrance of new restaurants opening.
Here are factors in measuring how much new entrants threaten an industry:
Economies of scale: Industries where large-scale production leads to lower
costs face less of a threat from new entrants. New firms would need to
achieve a similar size to compete on price, which might be difficult or costly.
Product differentiation: When existing firms have strong brand identities or
customer loyalty, it's harder for new entrants to gain market share, reducing
the threat of entry.
Capital requirements: High startup costs for equipment, facilities, etc., can
deter new entrants. For example, starting a car manufacturing business
requires significant investment, so until Tesla Inc.'s (TSLA) growth in the
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early 2010s, Americans from the 1950s could have named the major U.S. car
brands of the early 2000s.
Access to distribution channels: If existing firms control the distribution
channels—retail stores, online platforms, cable infrastructure, etc.—then
new entrants would need to find a way to replicate that structure while
competing with the established firms on price, a tricky proposition.
Regulations: Licenses, safety standards, and other regulatory standards can
create barriers, making it too ungainly or costly for new firms to enter the
market. Examples would include those looking to build new hotels in
downtown areas or supply power to a region.
Switching costs: If it's costly or difficult for customers to switch from existing
firms to new entrants, the threat of entry is lower.
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3. Supplier Power
Suppliers are powerful when they are the only source of something important
that a firm needs, can differentiate their product, or have strong brands. [1]
When the power of suppliers in an industry is high, this raises costs or otherwise
limits the resources a firm needs. Here are some factors used to measure the
supplier power of an industry:
The number of suppliers: When few firms can give a company something it
needs to stay in business, each has greater negotiating power. They can raise
prices or reduce quality without fear of losing business.
Uniqueness: If a supplier provides a unique product or it's not easy to find a
substitute, it is more dominant. Businesses can't easily switch to another
supplier.
Switching costs: If it's costly or time-consuming to switch suppliers, then
they have more power. Businesses are less likely to switch, even if prices
increase.
Forward integration: If suppliers can move into the buyer's industry, they
have more power. They already have access to the necessary supplies,
making it difficult for their former buyers to compete once they decide to
enter the market themselves.
Industry importance: Some sectors are tightly intertwined, such as
automotive suppliers and the major auto companies or the semiconductor
and tech industries, which can balance the power between the suppliers and
those in the sector. This is because the supplier needs these buyers to do
well so that it can, too. When a supplier can just as easily sell its products
elsewhere, that gives it a great deal more power.
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4. Customer Power
When customers have more strength, they can exert pressure on businesses to
provide better products or services at lower prices. This force intensifies under
certain conditions:
The number of buyers: The fewer the buyers, the more they have power. In
sectors like aerospace manufacturing, each major airline, the industry's
customers, has significant leverage in negotiations and can demand
favorable terms because the sellers depend on their business.
Purchase size: Just like you head off to the big box stores to buy in bulk for a
cheaper per-unit cost on whatever now fills up your garage, major retail
chains like Walmart Inc. (WMT) buy in large volumes and can negotiate
better terms and discounts.
Switching costs: In industries like telecommunications, where it's easy for
consumers to switch providers, companies such as Verizon
Communications, Inc. (VZ) and AT&T Inc. (T) have to offer competitive terms.
Price sensitivity: In the fast-fashion industry, where customers are highly
price-sensitive, brands must keep their prices low to attract cost-conscious
consumers.
Informed buyers: In many sectors, the customers are savvy, know the
competitive terrain well, and thus can negotiate better prices.
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Important: Porter chose the metaphor of forces because they aren't
static, so business must constantly adjust their strategies as forces in
an industry change.
5. Threat of Substitutes
When customers can find substitutes for a sector's services, that's a major
threat to the companies in that industry. [2]
Here are some ways that this threat can be magnified:
Relative price performance: If the cost of a substitute is lower and its
performance is comparable or better, customers are likely to switch to the
substitute. For instance, streaming services like Netflix became a substitute
for traditional cable TV, providing a lower price that soon threatened the
cable industry.
Customer willingness to go elsewhere: The threat is high if buyers find it
easy to switch to a substitute. For example, in the early 2010s, customers
found switching from taxis to ride-sharing apps like Uber or Lyft cheaper and
easier.
The sense that products are similar: If buyers perceive that there are few
differences between your product and a substitute, even if there are, they
may be more likely to switch.
Availability of close substitutes: Though this sounds the same as the last
bullet point, you have to strategize differently around it. There are times
when potential substitutes are very different from a company's products but
consumers still treat them as the same. But in other cases, there are
genuinely similar products in the market and the threat of substitutes is
high, such as between brand-name and generic medications.
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Competitive Measures
When published, Michael Porter's framework marked a departure from the
then-dominant models of business strategy, steeped in classic competition
theory. [4]
Those models, still echoed in Economics 101 textbooks, rested on several key, if
questionable, assumptions: markets as arenas for many small firms with no
significant market power, homogeneous products, perfect information
symmetry, and no barriers to market entry or exit.
While helpful for learning basic principles, this idealized view could be taken to
an extreme when strategizing with neatly constructed supply and demand
curves, assuming, for instance, new market entrants would stabilize rising
prices by increasing supply.
Business strategists need to deal with sectors where information asymmetry,
product differentiation, and significant entry and exit barriers are common.
Firms do have some control over prices, contradicting classical assumptions.
In short, where economists assumed most markets acted like the model, for
Porter, most firms are in industries with entrenched interests and different
supplier and customer relations. They need strategies for dealing with anything
but perfect competition. [5]
Mild-to-Intense Competition
Porter's five forces come together in different ways for any given sector. He
labeled industry competition as ranging from "intense" to "mild," with profits
harder to achieve as the intensity in a sector rises. In intensely competitive
industries, all or most of the five forces have a strong influence. [1]
The fast food industry is Porter's own example, which still remains the case. [1]
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In this sector, there's a fierce rivalry among established players like McDonald's
and Burger King, high bargaining power for suppliers and customers, and a
relentless threat of new entrants and substitutes, all of which means profits are
constantly getting squeezed for anyone in the sector.
Meanwhile, in "mild" industries, such as commercial aircraft manufacturing,
there are weaker forces. Here, low supplier bargaining power, a minimal threat
of new entrants, and a lack of direct substitutes (like commercial aircraft for
long-distance travel) help form a sector more conducive to higher profits.
Applying the Model
Since his 1979 Harvard Business Review article, Porter has published many
books on strategic analysis, including works where he has expanded on his five-
force model. He's also become very concise in providing the specific steps in
performing an industry analysis: [3]
1. Define the industry: The process begins with a clear description of the
industry, helping you to focus your analysis.
2. Identify the key players: Specify and group the major actors in the sector
into strategic categories based on relevant criteria.
3. Assess the strategic strengths: This means evaluating the firm and its
industry to determine the better and worse strategies that can be applied.
4. Analyze the industry structure: This involves examining the overall
structure of the industry, particularly the factors that influence how
profitable it is.
5. Evaluating the competitive forces: Only once you've done the above does
Porter advise doing a detailed analysis of the five competitive forces,
assessing their positive and negative effects, and then looking forward to
any changes in these forces ahead.
6. Identify the factors you have some control over: Here, you want to
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pinpoint aspects of the industry structure that could be influenced by
competitors, new market entrants, or your firm. In sum, what can be
changed?
Critiques of the Five Forces
Porter’s model helped reframe the understanding of competition. It wasn’t
confined to direct rivals but extended to suppliers and customers—traditionally
viewed in a transactional light.
Suppliers, especially those with unique resources or enjoying a monopoly,
could dictate terms, lower profits, or, in extreme cases, forward-integrate into
the buyer’s industry. Customers, too, wield power, especially when buying in
bulk or when they can just go elsewhere quickly or choose to bypass companies
for in-house products. [2]
But the model has its pitfalls. For example, many have critiqued the model’s
emphasis on sector affiliation. Porter concentrates on industry-wide forces,
which can sideline an individual company’s unique strategies and advantages.
This industry-centric view may not fully capture how distinct company
characteristics can change the game, not just play within an industry’s preset
rules. [6]
The model assumes clear lines among sectors, which may not be tenable given
the increasingly blurred lines in today’s business world, where companies are
simultaneously in several sectors. Industries are no longer isolated silos;
instead, they often intersect and interact, leading to a far more complex
environment than the model suggests. [4]
Porter’s five-force model has also been critiqued for not adequately addressing
the role of partnerships and collaboration. [6]
While Porter certainly entertained a competitive model where rivalry wasn’t just
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a war to the death, the problem is that he didn’t go far enough. In an
interconnected global economy, alliances and cooperative strategies are often
as pivotal to success as having a competitive advantage, a factor that the model
doesn’t explicitly consider.
Another critique that can be filed under “going in the right direction but not far
enough” is that the model is too static and fails to account for industries with
rapid changes in technology and consumer preferences. While effective in
stable sectors, critics say it doesn’t apply well to industries marked by fast-
paced innovation and shifting demand. [2]
Most strikingly, Porter’s model generalizes competition, implying a seemingly
uniform industry structure for every market. [2]
This might overlook the unique competitive scenarios in different sectors and
the increasing importance of the nontraditional strategies involved in digital
transformation and platform-based competition.
How Does Porter's Five Forces Differ From SWOT Analysis?
Both are strategic planning tools, but they serve different purposes. The five-
force model analyzes the competitive environment of an industry, looking at its
intensity and the bargaining power of suppliers and customers. SWOT analysis,
meanwhile, is broader and assesses a company's internal strengths and
weaknesses as well as its external opportunities and threats.
It can assist in strategic planning by pinpointing areas where the company
excels and faces obstacles, helping to align the company's strategy with its
internal resources and prospects in the market while mitigating its
vulnerabilities and external challenges.
How Can Porter's Five Forces Address the Effects of
Globalization on an Industry?
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Porter's model has been used to analyze how globalization affects industry
competition. For instance, globalization lowers barriers to entry in specific
industries, intensifying the threat of new entrants from different regions. [2]
It can also expand the pool of potential substitutes and alter the power
dynamics with suppliers and customers worldwide. While Porter and others
were doing this analysis for industries facing global competition decades ago,
it's still applicable to sectors undergoing this process in the 2020s.
How Does Porter's Five-Forces Model Apply to the AI Sector?
Using the model, we would begin by looking at the competitive rivalry. The AI
sector is marked by high competition with key players ranging from tech giants
to small startups. Rapid advances mean companies have to move quickly
simply to maintain relevance. We would then need to gauge the power of
suppliers of data sets and specialized hardware, which have ample power since
AI firms rely heavily on these resources.
Moving to consumers, we would need to review the needs of individual
consumers and whether larger companies can force AI firms to negotiate better
services and prices for them. The field of AI has been attracting many new
entrants, but there are significant barriers to entry, including high initial
research and development costs. Lastly, the threat from the last force, the
possibility of substitutes, depends on what a firm wants to do with its AI-based
technology. The more complicated the tasks the AI is given, the more likely
other goods and services can't substitute for it.
The Bottom Line
Porter's five-forces model sets out essential criteria for considering a company's
competitive landscape: the power of suppliers and buyers, the threat of new
entrants and substitutes, and competitive rivalry.
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While the economic terrain has evolved significantly since the 1970s and Porter
has updated his work ever since, the principles underlying Porter's model
remain current. It's still the case that companies don't rise and fall on their
portfolio of products alone but are jockeying with others in industries that have
their own logic and structural forces at play.
Today, while the five-forces model may require adapting it to rapid
technological change and the importance of collaboration across many
industries, it's a reliable way to help guide companies needing to navigate
industry-specific challenges in their competitive strategy.
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