Porter's Five Force Theory

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Business rivalry is a good thing for consumers. It forces businesses to provide superlative service and quality or face financial ruin. Few deny this. Michael Porter's Theory of Five Forces is a model for business management and managerial economics relative to rivalry among firms in a specific field.

Considerations

  • Porter's approach is a complex model of business competition. The dependent variable, that which is to be explained, is the intensity of rivalry among businesses. The independent variables, those forces which do the explaining, are reduced to four: substitutes, buyer power, supplier power and barriers to entry. All of these variables work together to explain and understand the intensity (or lack thereof) of competition and business rivalry.

Features

  • If consumers can easily substitute one type of product for another (alcohol instead of anti-depressants, for example), businesses will compete more intensely to keep customers. If buyers have a lot of power (if there are few of them, or they are well organized), then they can set the terms of the transactions. For example, WalMart gets to set the terms for commodity production because they buy so much and guarantee a large market for all suppliers who play by their rules. Rivalry for the WalMart market becomes intense. If the producers have power, they can increase prices to tap into seller's markets. For example, if raw materials are in the hands of few suppliers (say, oil), then the supplier then forces those who need the product into intense rivalry for a good deal. Lastly, if there are high barriers to entry into a specific market, then rivalry is lessened. When profits go up, more competitors enter the arena. When profits go down, the opposite occurs. This is the basic dynamic in that all these forces work together to determine the nature of competition.

Function

  • This approach lays out the main variables that dictate levels of competition among firms. A manager can then schematically lay these variables out in order to come to a rational decision about cutting costs or marketing new products. It is a highly rational way for managers to make decisions, and different sorts of firms will then have different approaches to marketing or pay scales.

Significance

  • The real concept here is that firms are not the same. Abstract economic forces are inappropriate variables for managers. If an industry is protected by a patent, for example, then rivalry is reduced and profits (and market control) go up. If a drug company patents a new treatment for depression, then managers move quickly move to take as much of the market as possible as aggressively as possible. Once the patent expires, the strategy becomes very different.

Benefits

  • Ultimately, this is about understanding the market as a complex mix of real, tangible factors, not as a group of mathematical forces so dear to professional economists. Porter's approach to competition and rivalry deals with qualitative data, the actual description of a flesh and blood economic world.

References

  • Photo Credit chess image by Victor M. from Fotolia.com
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