The five forces framework

The most known framework in strategic management is the five forces framework. The five forces are: bargaining power of suppliers, bargaining power of buyers, industry rivalry, threat of entry, and threat of substitutes. I will discuss these forces in more detail in later postings. In the current posting I will provide a broader perspective. It is useful to consider the five forces as five evil forces that are after the profit generated in the industry. If all the five evil forces are strong then most of the profit generated in the industry will be taken away by these evil forces.

This is post four in a series on industry analysis.



Structural model. The five forces are foremost about structural factors that influence industry profitability. The model was introduced by Porter (1980, Competitive Strategy), but he built on decades of research in industrial organisation, a field of applied microeconomics. Bain (1959) formulated the structure-conduct-performance framework. (No relationship to the consulting company Bain.) The underlying notion is that there are strong structural forces leading to certain behaviour (conduct), which in turn leads to a certain performance level. The industrial organisation research had a public policy perspective and tried to identify structural factors that made industries more competitive, and hence transferred more of the surplus to the end-consumers. A lot of empirical research in industrial organisation was conducted in the 1960s, 1970s, and 1980s. Porter (1980) turned the framework around and focused on an opposite question; what kind of industry structures leads to more profit for the companies in the industry.

In its extreme form, the structure-conduct-performance framework assumes that behavior (conduct) does not matter, because it is predetermined by the structural factors. In other words, we can treat performance as predetermined by a number of structural factors. If the analyst can identify the structural factors, he can forecast the industry's performance without paying any attention to firms' conduct. Such a structural perspective is quite common in sociology, which often considers individuals as slaves under some (hidden) structural dimensions that really determine their behaviour. Sociologists have speculated about many such structural factors. A few examples will suffice: Marx considered class structure as the overarching driving force explaining behaviour. Adler considered the birth-order structure as one important driving force of individual behaviour. Merton described how our behaviour is driven by reference groups (based on gender, age, race). Sometimes these models take such strong hold on our minds, that we become dogmatic; that is in itself another structural factor. In its original form, the structure-conduct-performance model considers companies to be the slaves under the structural factors. Many academics and consultants actually believed something to this effect up until the 1970s; businesspersons have of course always known better.

Relative importance of structure and conduct. While it should be acknowledged that industry analysis gets it power from a structural perspective, there is no need to assume that 100% of performance is predetermined by structural factors. In the 1990s academics tried to understand the relative importance of structure vs conduct (e,g. Rumelt, 1991;  McGahan & Porter, 1997). They found that the company's conduct was more important in explaining company performance than industry structure. This might not sound surprising, but it was a surprising finding to many academics at the time. Stable industry effect explained 19% of the variance of performance, but stable company effects explained 36% of the variance. Most of the remaining variance was explained by more temporary factors, like a company doing really well over a few years and then being replaced by a competitor. When we conduct an industry analysis, we should be aware that it is not the most important determinant of performance.

Why just five forces? The five forces is a framework that organises a lot of the research that has been done in industrial organisation and management on industry profitability. Some scholars have tried to improve on the framework by including additional forces. However, I believe for good reasons, non of these additional forces have been generally accepted. The following suggestions have been made:

• Government as a sixth force. It is correct to note that the government can influence an industry's attractiveness. However, Porter has pointed out that the influence occurs through one or more of the individual forces. Just to mention a few examples: The government can deregulate an industry and thereby increasing the power of new entrants. The government can establish price controls and thereby increasing the power of buyers. The government can enforce antitrust regulation more aggressively and thereby increasing the rivalry in the industry.
• Complementors as a sixth force. A complement is the opposite of a substitute. Sale of substitutes takes demand away from the focal industry. Sale of complements increases demand in the focal industry. A complement to a DVD player is DVD disks. If there are more titles of DVDs available or more DVDs sold, the demand for DVD players will increase, and vice verso. This force has not received much general support, but there is some value in the perspective.It is probably best seen as a factor influencing industry rivalry rather than a separate force.
• Technology as a sixth force. Technological innovation is very important, but technology does not directly to influence the performance. Technology makes it influence primarily on the structural factors. Here are a few examples: A technological innovation can make it easier for new entrants to establish themselves in the market. Or it might make economies of scale more important for the industry. Economies of scale will lead to a higher concentration ratios when companies merge to be able to afford the required investments. Multipurpose technologies like the internet (or more recently the mobile internet) will influence many of the five forces in many industries. The result could be that some industries end up as more attractive and some less attractive.

Other criticism of the five forces model will be discussed in another posting.

Applying the framework. In my experience, students generally have problems applying the framework. The framework is a collection of a large number of structural relationships. It is impossible to master the framework by just applying it a handful times. A lot of judgment-calls are needed. Having a frame of reference gained by having performed several analyses across industries over time will improve the judgments. In the beginning of an undergraduate or an MBA class, it is quite common to observe an almost random opinion on the power of a particular force; i.e. a uniform distribution from weak to strong. During a semester, more and more students learn to apply the framework correctly. A remaining problem is when some students get so engrossed by the individual structural relationships so that they forget to step back and make an overall assessment of the five forces and the industry.

It is necessary to focus on the structural factors, but to the extent possible triangulate by also studying  conduct. It is generally very difficult to measure conduct quantitatively so qualitative evidence should be gathered. If the industry is highly concentrated and there is a clear market-share leader, the we would expect little price competition and deference to the market leader. If we observe this kind of conduct (e.g. similar price level, market leader takes initiative to all price changes), we can be more certain about the structural factor playing an important role.