Let us adopt the working definition of an industry as the group of firms producing products that are close substitutes for each other. In practice there is often a great deal of controversy over the appro-priate definition, centering around how close substitutability needs to be in terms of product, process, or geographic market boundaries. Because we will be in a better position to treat these issues once the basic concept of structural analysis has been introduced, we will as-sume initially that industry boundaries have already been drawn.
Competition in an industry continually works to drive down the rate of return on invested capital toward the competitive floor rate of return, or the return that would be earned by the economist‘s “perfectly competitive” industry. This competitive floor, or “free market” return, is approximated by the yield on long-term govern-ment securities adjusted upward by the risk of capital loss. Investors will not tolerate returns below this rate in the long run because of their alternative of investing in other industries, and firms habitually earning less than this return will eventually go out of business. The presence of rates of return higher than the adjusted free market re-turn serves to stimulate the inflow of capital into an industry either through new entry or through additional investment by existing com-petitors. The strength of the competitive forces in an industry deter-mines the degree to which this inflow of investment occurs and drives the return to the free market level, and thus the ability of firms to sustain above-average returns.
The five competitive forces—entry, threat of substitution, bar-gaining power of buyers, bargaining power of suppliers, and rivalry among current competitors—reflect the fact that competition in an industry goes well beyond the established players. Customers, sup-pliers, substitutes, and potential entrants are all “competitors” to firms in the industry and may be more or less prominent depending on the particular circumstances. Competition in this broader sense might be termed extended rivalry.
All five competitive forces jointly determine the intensity of in-dustry competition and profitability, and the strongest force or forces are governing and become crucial from the point of view of strategy formulation. For example, even a company with a very strong market position in an industry where potential entrants are no threat will earn low returns if it faces a superior, lower-cost substi-tute. Even with no substitutes and blocked entry, intense rivalry among existing competitors will limit potential returns. The extreme case of competitive intensity is the economist‘s perfectly competitive industry, where entry is free, existing firms have no bargaining power against suppliers and customers, and rivalry is unbridled be-cause the numerous firms and products are all alike.
Different forces take on prominence, of course, in shaping com-petition in each industry. In the ocean-going tanker industry the key force is probably the buyers (the major oil companies), whereas in tires it is powerful original equipment (OEM) buyers coupled with tough competitors. In the steel industry the key forces are foreign competitors and substitute materials.
The underlying structure of an industry, reflected in the strength of the forces, should be distinguished from the many short– run factors that can affect competition and profitability in a tran-sient way. For example, fluctuations in economic conditions over the business cycle influence the short-run profitability of nearly all firms in many industries, as can material shortages, strikes, spurts in de-mand, and the like. Although such factors may have tactical signifi-cance, the focus of the analysis of industry structure, or “structural analysis,” is on identifying the basic, underlying characteristics of an industry rooted in its economics and technology that shape the arena in which competitive strategy must be set. Firms will each have unique strengths and weaknesses in dealing with industry structure, and industry structure can and does shift gradually over time. Yet understanding industry structure must be the starting point for strategic analysis.
A number of important economic and technical characteristics of an industry are critical to the strength of each competitive force. These will be discussed in turn.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.