The Five Competitive Forces Driving Industry Competition (Part 2 of 3)

I have mentioned in my previous post about five competitive forces (based on Michael Porter's work, Competitive Strategy, 1980) that drive industry competition to a perfectly competitive level. The five forces are as follows:-

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

In my previous post, I have provided a simple presentation on his work on two of these forces namely bargaining power of buyers (customers) and bargaining power of suppliers. In this post, I shall present another competitive force, threat from potential entrants that also drive industry competition to a perfectly competitive level, restraining any company in an industry from achieving supernormal returns.

Threat from potential entrants

Any industry that shows better rate of returns than other industries (of similar amount of risks) will attract potential entrants into that industry. The potential entrants also want a portion of the pie in the lucrative industry. By having new entrants into the industry, the existing companies in that industry will meet with falling prices and rising costs of doing businesses when they spend more on marketing and extending favourable credit terms for customers, etc. to fight off increased competition and protect their market share.  
 
To slow down or put in check the advancement of new entrants, existing companies engage in two general strategies, putting barriers in the path of new entrants, and sending clear message to the new entrants that if they cross over a certain tolerance line they will be subjected to strong retaliatory attack until they are driven out of the industry.
 
Sending clear message of strong retaliation by existing companies should new entrants cross their lines 
 
The message of the threat of strong retaliatory attack by existing companies should new entrants cross their lines must be based on strong grounds to keep these new entrants at bay. To gain strong grounds on the message of retaliation, existing companies must show that they have defended agressively against past entrants into the industry. Also, existing companies must show they have a large amount of resources to fight off the new entrants (e.g. large cash reserves, strong borrowing capacity, strong working relationships with their suppliers and customers). Existing companies must also show they are strongly commited to the industry by having their assets mainly deployed within the industry.
 
Putting barriers in the path of new entrants
 
Existing companies in an industry can put barriers in the path of new entrants in the following ways:-
1. Having large economies of scale and scope: Existing companies that are operating at a large scale have the advantage of lower product costs since they are producing their products on an efficient scale. Smaller entrants are disadvantaged by incurring relatively higher product costs since their production is not yet on an efficient scale. Some existing companies may have economies of scope by being able to share their costs between different product lines (e.g. food manufacturers can add increased product lines making use of same distribution network and retailers). In order to compete against smaller entrants, sometimes larger existing companies may take advantage of their large economies of scale and scope to engage in price wars that will drain out the available financial resources of the smaller entrants when they try to keep up to the competition with the larger existing companies. 
 
2. Difficulty in imitation: It is not always easy for new entrants to imitate how existing successful companies are being run. For example, existing successful companies may already learn a great deal about their industry, their suppliers' and buyers' industries. They may also know how to reduce their cost of doing business by experience. All these technical experience and knowledge is a barrier to entry into the industry for potential entrants. 
 
3. Difficulty in accessing distribution channels: New entrants often find it difficult to break into existing distribution channels for their products. The existing companies in the industry would have established strong relationship with their retailers or buyers of products. New entrants may have to reduce the prices of their products in order to compete for retailers to carry their products or buyers to buy their products which is costly to the new entrants.
 
4. High switching costs for buyers: Buyers of certain products of existing companies may have high switching costs should they change companies to buy their products from. If the switching costs is high involving time and expenses in retraining their employees to use the new products offered by new entrants, buyers may not want to do a switch (e.g. hospital involving costs and time in retraining it's staffs to use medical equipment from a new entrant supplier). This puts the new entrants at disadvantage as they have to reduce their product price and introduce other significant attractive offers to convince buyers to do a switch which may not be easy.
 
5. Product differentiation and branding: Existing companies may have established differentiated product of strong branding offering high value for their buyers. It is not always easy for new entrants to compete against such strong brands and differentiated products. E.g. A new entrant carbonated beverage company will find it almost impossible to compete against established companies like Coca-Cola or Pepsi-Cola to gain market share even after draining large financial resources in research, marketing and distributing their products.
 
6. Government legislation and patents: Government legislation may prevent entry into an industry. This may protect the existing company/ies from new entrants. For example, limited number of transport or private healthcare companies in a country. Patents can also protect existing companies (e.g. pharmaceutical companies having patents over their products have exclusive rights on the making, distribution and sale of their products).
 
7. Control over suppliers and customers: Some existing companies may have control over their suppliers to sell to them and customers to buy from them (e.g. certain retailers may have strong power over their suppliers to sell through them). This makes it difficult for new entrants to compete against existing companies to persuade suppliers to supply to them or buyers to buy from them.
 
For an investor, he may check whether his invested company has a strong competitive position and economic moat by the ability to send clear credible message of retaliation to potential new entrants into it's industry or put barriers to stop or slow down the advancement of new entrants.