How do the Five Forces of Competition in an industry affect its profit potential?

Answer 1

The five forces of competition (the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitute products, and the rivalry among competing firms) jointly determine the profitability of an industry due to the way they shape the prices which can be charged, the costs which can be borne, and the investment require to compete within the industry. Leadership will use the five forces framework to determine the competitive structure of an industry.

The risk of entry by competitors increases the industry's capacity, starts a greater competition for market share, and generally lowers current pricing. Extreme rivalry among competing firms poses a strong threat to profitability to all firms within the industry. The bargaining power of buyers can reduce the profits within an industry by lower the prices and increasing the costs due to purchasing power (large quantity purchasers can drive down prices at a firm -- or the firm risks losing these large quantity sales to a competitor). On the other side of buyers, the bargaining power of suppliers can reduce a firm's profitability by increasing costs to the firm (or firms if the supplier provides multiple firms within an industry). Lastly, the threat of substitute products is a real threat to profits in that a large number of close substitutes for any product greatly increases competition in pricing and in turn drives profits down.

Cheers! Mike H.