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

Here is a recapitulation on the five competitve forces driving industry competition to a perfectly competitive level based on my previous posts.

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 have provided a discussion on the first three forces based on my previous posts. I shall continue to provide a simple discussion on the last two forces namely, intense competition among existing companies in an industry and threat from substitutes of products or services.

Intense competition among existing companies in an industry

Existing companies in an industry are always in a state of competition for market share and profits. When competiton gets more intense, the rate of returns in an industry decreases. This is due to companies competing on the prices of their products or services, increased marketing efforts, increased costs of researching to come up constantly with innovative and better products one step ahead of their competition.

When an industry is not dominated by any leaders, competition may be more intense resulting in price wars. In an industry that has an established leader with dominant market share, the leader may have strong influence on product prices and is able to lead it's other smaller competiton to establish product prices in an industry. An industry that has less vigourous competition is considered a stable industry with relatively stable product prices.

There are some factors which promote intense competition in an industry as follows:

1. Many equal strength competitors: In an industry where there are many equal strength competitors, intense competition may take place as companies compete for market share and profits. Such intense competition is beneficial to customers in an industry, but not for the competitors as it drives down rate of return in the industry. On the other hand, an industry with a dominant player or some extent of coorperation among companies will result in less intense competition and help to increase profitability in the industry.

2. Slow growth industry: An industry where growth is slow will promote more intense competition among companies to compete for sales. On the other hand, in a fast growing industry, companies can increase their sales without necessarily taking away sales from their competition.

3. Capital intensive industry: In a capital intensive industry, companies need to have high turnover in sales to maintain profitability. As such, competition may intensify as companies reduce prices to achieve high turnover in sales. Examples of such industries include paper and steel manufacturers.

4. Commodity type products: If products or services in an industry is commodity-like (every company is selling similar undifferentiated products or services), companies will compete intensely based on prices and additional services provided to their buyers. This will drive down margins and rates of return in the industry. Examples include sellers of bricks, cement, food crops and fertilisers.

5. Companies can only increase their capacity in large steps: In industries whereby companies can only increase their capacity in large steps (e.g. by building large scale plants each time), this will result in tendency for more intense competition as rival companies reduce their prices to compete against a significant increased capacity (from periods of sudden significant increase in supply) in the industry each time.

6. When different companies in an industry have different strategies and objectives: When companies in an industry have very different strategies and objectives, there is less likelihood for coorperation and understanding between companies and thus more intense competition. In such environment, it is harder to establish a set of game rules whereby companies in an industry can play by to earn high returns since every company is doing their own things. For example, some companies may be willing to accept lower returns seeing the industry as only part of a wider strategy of their overall businesses while others try to gain maximum returns seeing the industry as a cash-cow.

7. High barriers to exiting an industry: In a low return industry, it make sense that companies should exit such an industry. This will reduce the supply in the industry and benefit remaining companies. However, there are many possible barriers to their exit and thus many companies stay on despite low returns in an industry. This continues to promote competition and depress returns in the industry of low profitability.

One possible barrier to exit is that companies in a particular industry may have invested in high cost and specialised assets (e.g. production plants specific to the industry and cannot be used in other businesses) and it will be uneconomic to stop the business running even if such existing business has low returns.

Another barrier may be a high cost in exiting an industry for certain companies. Some companies may need to pay some forms of compensation to their employees, customers and suppliers upon closing down the business. Some businesses may be bonded by contracts to service their employees by retraining and reassigning them new jobs, and also to continue providing after-sales service to customers even after closing down the business. Thus, the cost of exiting is high.

Another barrier to exiting is the incurring of strategic loss to the company. A business segment in a company may be underperforming, but the company may be reluctant to close down the business segment if the business helps to boost the overall image or quality of the company's relationships with it's customers, suppliers or government. Also, an underperforming business segment may share facilities with other business segments and it will be uneconomic to close down the underperforming segment. The underperforming business segment may be an important link in a vertically integrated chain. Example, oil companies have different business segments in a vertically integrated chain such as oil exploration, oil extraction, oil refinining, and oil retailing. Even if one segment for example, the oil retailing has low returns, the company may still keep it for wider strategic objective.

Another barrier to exit is because of emotional reasons. Some managers of businesses have spend much effort and time to build a business over years, and they have form an emotional attachment to or pride over their businesses and so find it difficult to close down the underperforming business. While other managers find it difficult to close down their underpeforming businesses so as not to affect families of employees who depend on the continuation of the business for their livelihood.

Another barrier to exit is due to government stepping in to prevent a low return business from closing in order to protect the welfare of the workers and community at large who depend heavily on the business for their survival or it's products and services.

Threat from substitutes of products or services

Companies in an industry may also face competition from threat of substitutes of their products or services. If another rival company can offer a different product that have similar functions to an existing product at a cheaper price, this will reduce returns for the company with the original product due to competition. The rival company may also offer a substitute product that is more expensive but has much better functions than the existing product in a bid to compete and replace the original product. E.g. the internet has now become a threat to certain retailers of goods as shoppers can buy their products over the internet instead of buying from retail shops. Thus, internet has become a threat of substitute of conventional retailing that reduces margin of some retailers.

In conclusion, an investor has to consider in his assessment of a company whether it is facing much intense competition with rival companies in an industry based on different possible factors promoting competition. Intense competition reduces returns in an industry. One also need to consider any potential threat from substitutes of products or services to an existing company to see whether the company has downside pressure to it's margins due to such threats.