A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter identifies five forces that dictate the rules of competition in each industry. These forces determine industry profitability because they influence the prices, costs, and required investment of firms in an industry.

• The threat of substitutes. Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times. The threat of a substitute is high if it offers an attractive price-performance trade-off to the industry's product and/or the buyer's cost of switching to the substitute is low.

• The bargaining power of customers. How strong is the position of buyers? Can they work together in ordering large volumes? This force influences the prices that firms can charge. It can also influence cost and investment as powerful buyers demand costly services.

• The bargaining power of suppliers. How strong is the position of sellers? Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry's profits. In some cases, a monopolist supplier can dictate its terms to entire industries. This force determines the cost of raw materials and other inputs.

• The threat of new entrants. How easy or difficult is it for new entrants to start competing? Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive advantage.

• The intensity of rivalry. Does strong competition between the existing players exist? Is one player very dominant or are all equal in strength and size?

The elements of a thorough industry analysis include the following:

Barriers to Entry

In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry. They are advantages that incumbents have relative to new entrants.

The threat of entry in an industry depends on the height of entry barriers that are present. If entry barriers are low, the threat of entry is high and industry profitability is moderated.

Generally, high barriers to entry can lead to better pricing and less competitive industry conditions. However, barriers to entry are not barriers to success, and high barriers to entry do not necessarily lead to good pricing power and attractive industry economics. Barriers to entry can also change over time.

Industry Concentration

Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited.

Certainly there are important exceptions. There are industries that are concentrated with weak pricing power and there are also industries that are fragmented with strong pricing power. The level of industry concentration is just a guideline.

Industry Capacity

Tight capacity -> more pricing power
Overcapacity -> price cutting

The analyst should think not only about current capacity conditions but also about future changes in capacity levels: how long does it take for supply and demand to reach equilibrium? Are the tight supply conditions sustainable?

In general it takes longer to shift physical capacity than to shift financial and human capital to new uses.

Market Share Stability

Stable market shares -> less competitive industries
Unstable market shares -> highly competitive industries and limited pricing power

Industry Life Cycle

The industry life cycle reflects the vitality of an industry over time. Each industry develops along a similar cyclical path that includes the following stages:

• Embryonic: new products, slow growth, high price, weak revenue, high-risk investments.
• Growth: growing sales, significant profitability, and lack of competition.
• Shakeout: slowing growth, intense competition, and declining profitability. Competitive strategy is very important at this stage, since above-average growth can be attained only by increasing the market share.
• Mature: little or no growth, industry consolidation, and relatively high barriers to entry.
• Decline: falling demand, sales, and negative growth. Some companies fail, others exit the industry to compete in other lines of business. Companies that have the strongest competitive advantages remain in the industry and fight for market share.

There are certainly limitations of industry life-cycle analysis. Demographics and changes in technology as well as political and regulatory environments all play a role in affecting the cash flow and risk prospects of different industries. Some stages may become longer or shorter than expected and some stages may even be skipped altogether. Another limitation is that not all companies in an industry have similar performances.

Price Competition

Price competition and thinking like a customer are important factors that are often overlooked when analyzing an industry. Whatever factors most influence customer purchasing decisions are also likely to be the focus of competitive rivalry in the industry. Broadly, industries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.