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  • Writer's pictureTikona Capital

The Five Competitive Forces: Shaping Strategy

Updated: Sep 25, 2023

The competitive landscape of any industry is shaped by five key forces that determine its profitability and potential for growth. These forces include the threat of entry, the power of suppliers, the power of buyers, the threat of substitutes, and the rivalry among existing competitors. Understanding these forces is crucial for developing effective strategies that can help businesses thrive in their respective markets.

1. Threat of Entry:

The threat of new entrants to an industry can disrupt the market by introducing new capacity, products, and ideas. Incumbent companies must be prepared to compete aggressively when the threat of entry is high. Factors that determine the threat of entry include the height of entry barriers, such as capital requirements and government regulations, as well as the reaction of incumbents to new entrants. Even the perception of a potential threat can force incumbent companies to compete more aggressively, leading to lower prices, higher-quality products, and increased innovation. Such a situation took place in telecom when new licenses were issued. Moreover, when faced with the risk of new competitors and their inability to increase prices, it becomes difficult to create value.

2.Power of Suppliers:

Suppliers hold significant power when they can impose higher prices, reduce quality or services, or transfer costs to industry participants. Concentration, revenue dependency, switching costs, differentiation, and the lack of substitutes determine the power of a supplier group within an industry. If suppliers can credibly threaten to enter the industry themselves, excessive profitability may prompt them to become direct competitors, further impacting the industry's dynamics. Aircraft manufacturers given their bargaining power are able to extract larger pool of profits in the industry, leaving airlines to earn average profits.

3. Power of Buyers:

Buyers exert power when they have negotiating leverage relative to industry participants, especially if they are price sensitive. Factors that influence buyer power include the number and volume of buyers, product standardization, switching costs, and the ability of buyers to integrate backwards and produce the industry's product themselves. Buyers with substantial purchasing volumes or the ability to switch vendors easily can put pressure on prices, impacting industry profitability. Most auto companies negotiate hard with their suppliers given their dominance and threat to change the vendors as switching costs are lower in many cases.

4. Threat of Substitutes:

Substitutes refer to products or services that perform a similar function as the industry's offerings through different means. Substitutes can directly replace the industry's product or indirectly replace the buyer industry's product. The presence of substitutes restricts industry profitability and growth potential by imposing limits on prices. The threat of a substitute is higher when it offers an attractive price-performance trade-off and when the cost of switching to the substitute is low for buyers. Technological advancements and disruptions in other industries can also introduce new substitutes, affecting industry profitability. With advent of Technology stack in India, UPI , income for Payment services have dramatically got impacted. Similarly digital commerce is substituting traditional ways of doing commerce.

5.Rivalry among Existing Competitors:

Rivalry among existing competitors takes various forms, such as price discounts, new product launches, advertising campaigns, and service enhancements. High rivalry negatively impacts profitability, and its intensity depends on factors such as the number and size of competitors, industry growth rate, exit barriers, and the commitment of firms to the business. Price competition, in particular, can transfer profits from the industry to customers and diminish customer attention to product features and services. However, competition can also be positive-sum when competitors focus on serving different customer segments or offer unique value propositions, leading to higher average profitability and industry expansion. Most commodity players compete on prices and thereby unable to create long term value.

By analyzing and understanding these five competitive forces, businesses can develop effective strategies to navigate the market and position themselves for success. It is crucial to continuously monitor changes in these forces, as they can evolve over time and significantly impact industry dynamics. Rapid technology advancement, large capital and supply chain disruptions are gradually changing the environment in which these industry-specific competitive factors operate. Business executives must adapt by allocating resources, capital, and relationships in order to jump ahead and change the dynamics in a way that benefits their interests and that of their stakeholders. An investor needs to keep an eye on companies like these that are changing the competitive landscape in their favour to stay ahead of the market.

Sumit Poddar

Chief Investment Officer & Smallcase Portfolio Manager

Tikona Capital

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