The Five Competitive Forces Driving Industry Competition (Part 1 of 3)

Through my research, I came across a discussion on the five competitive forces driving industry competition (based on Michael Porter's work, Competitive Strategy (1980)). These forces drive returns in an industry to a perfectly competitive level, thus constraining any companies in an industry from achieving supernormal returns. As such, managers of companies have to constantly battle against these five forces to gain a competitive edge in an industry, thus steering their companies away from the perfectly competitive level.

These forces are:-
1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

I shall provide a simple discussion on two of these forces namely "Bargaining power of buyers (customers)" and "Bargaining power of suppliers" in this post.

Bargaining power of buyers (customers)

Buying power provides customers the chance to negotiate for cheaper prices, ask for better quality on the products they are buying or ask for better and more services they are receiving. All these will squeeze margins of companies in an industry.

There are different situations whereby buyers in an industry are in a strong bargaining position. This is disadvantageous to the company which is selling it's products or services in the particular industry. The different situations advantageous to buyers arise as follows when:-

1. There is concentration of buyers: It is disadvantegous to sellers of products if the number of buyers is lacking in the particular industry. The worst case is many sellers trying to sell their similar products to only one buyer (monopsony). In this case, the sole buyer has a strong bargaining power over the many sellers and the sellers in a bid not to lose businesses may coorperate with the requests of this buyer.

2. Product is undifferentiated: If many companies are selling similar undifferentiated products to their buyers, buyers of the products may take chance to negotiate for cheaper prices and better services. Buyers may also play one company against another to negotiate for better prices and services. Such cases are found in commodity types of products, e.g. raw materials, food crops whereby buyers are in strong bargaining position over the many sellers of commodity products which are undifferentiated.

3. Product takes up a large cost for the buyer: A buyer is more aggressive at negotiating for cheaper prices on products that are costly to them. This is disadvantageous to the sellers. On the other hand, a buyer of small cost or one-off purchase products may not be as price-sensitive.

4. Buyer has low switching cost: A buyer that can easily switch suppliers with minimal costs of switching may be inclined to do so if another supplier offers better prices for similar products and services. Of course, switching suppliers also involves breaking a long-standing relationship with an existing supplier which is a consideration the buyer has to think over carefully.

5. Buyer is concerned with cost-cutting: A buyer that belongs to a company or industry that has high cost of doing business is sensitive to cost-cutting. As such, the buyer will be inclined to negotiate for cheaper prices on products and services from it's suppliers. The buyer may even at extreme case threaten to close down their business due to reason of high cost, thus in turn threatening the supplier with a discontinuation of their business with the buyer. This is especially significant when the supplier depends heavily on the sale of their products to the particular buyer who is threatening them.

6. Buyer can make the products themselves: Sometimes, a buyer may have the expertise to make the product they are buying from a supplier. As such, the buyer may threaten the supplier asking for better prices on the product they are buying, failing which they will not buy from the supplier but instead make the product themselves.

7. Quality of product buyer is buying is of low importance: A buyer that is not particular about the quality of a product may choose to shop around different suppliers for better prices. This gives bargaining power to the buyer over the suppliers. On the other hand, a buyer that is sensitive to the quality of a product may be less price-sensitive and willing to even pay a price premium for quality products. For example, a hospital will be more focused on quality of medical equipment purchased over prices.

8. Buyer has information on their suppliers: A buyer that knows about their suppliers' margins, costs and order books will be more prepared when negotiating for purchasing prices on products. Such informed buyer will be less likely to be taken advantage by overpaying for products sold by their suppliers.

Bargaining power of suppliers

Even as buyers have strong bargaining position based on the above discussed situations, suppliers can also tip the scale in their favour when the following situations arise. Thus, suppliers of goods/ services facing the following situations can command better prices for their goods/ services and thus better margins.

1. There is concentration of sellers: When there are not many sellers around with many buyers, the sellers have a significant advantage over their buyers. An example is Coca Cola company whereby they have the most significant market share for their products. There are many eager buyers (retailers of Coca Cola products) including fast food chains, restaurant chains, supermarket chains and other local franchises. Thus, the seller (Coca Cola) can negotiate for better prices and terms from it's many buyers (retailers) to carry it's products since there is only one seller (Coca Cola) selling their famous branded carbonated beverage (the coke) to many buyers competing to carry the product.

2. The product is unique and has strong branding: A seller selling a unique product (that has no substitute) has bargaining power over it's buyers since the buyers can only buy from one seller. For example in the local context, we have the unique local newspapers produced from SPH. Of course, there are also other considerations such as regulations from governments and authorities that may prevent a particular company in a particular industry from exerting it's dominance over prices of it's unique products especially if the product is widely used.

3. The supplier can supply it's products over many different industries: The supplier that can supply it's products/ services which are used over many different industries can have a strong bargaining power for the price of it's products/ services. In such case, the supplier can choose between many buyers from different industries that use it's products and so being able to bargain for good prices over it's products/ services.

4. The product supplied by the supplier is very important to buyer: A product/ service provided by a supplier that has great importance and is critically essential to the survival of the businesses of it's buyers will allow the supplier bargaining power over it's buyers on the price of it's products/ services.

5. The supplier can take over the operations and tasks of it's buyers: If a supplier can threaten to easily take over the operations and tasks of it's buyers in their industry (forward integrate into the buyers' industry) and enter as a potential competitor to it's buyer should the buyer not coorperate with the requests of the supplier, the supplier may have a strong bargaining power for the price of it's products/ services over it's buyers.

6. There is high switching cost for the buyers: When there is high switching cost for buyers of a product supplied by a particular supplier, the supplier will have strong bargaining position for the price of it's products/ services. For example, a hospital that buys medical equipments from a particular supplier may not easily change it's supplier since it may involve high cost of switching in time and expenses on retraining it's medical staffs to use new different medical equipment from another different supplier.

As one can see, the situations for strong bargaining power of suppliers is a direct contrast to the situations for strong bargaining power of buyers. It is important to know the relative bargaining powers of a company as both a supplier of it's own goods/ services and buyers of goods/ services. For an investor of a company, one can look out for his invested company to have strong bargaining powers both as a supplier and buyer. This may help to provide a better competitive position and margins for the company.