Lesson 2: Porter's five forces and why some industries pay better
Porter's five forces explain why some industries earn fat profits and others do not. Learn each force, score an industry, and see the margin arithmetic.
In Lesson 1 you learned that a competitive advantage is a reason customers choose you that rivals cannot easily copy. This lesson steps back from the single company and asks a different question: why do some whole industries make good money while others, full of smart and hardworking people, struggle to earn anything? By the end you will be able to name the five forces that shape an industry's profits, explain in plain words how each one squeezes or protects a business, score an industry on all five using a simple method, and use a margin calculation to see what a supplier price rise or a buyer's demand for a discount does to a firm. You need no business background, only the idea of competitive advantage from Lesson 1. All the industry scores and the rupee figures below are made-up examples chosen to teach the idea. They are not measurements of any real company or sector, and you should replace them with your own research when you analyse a real market.
The question behind the framework
Start with a puzzle. Two shopkeepers each work twelve hours a day. One sells mobile phone recharge vouchers in a lane with six identical shops. The other runs the only pharmacy open at night in a small town. Both are honest, both are careful with stock, yet the pharmacist keeps a much higher share of every rupee of sales. Skill and effort do not explain the gap. The structure of the market each one works in does.
That is the central idea of the five forces framework, popularised by the Harvard professor Michael Porter. His claim was that the average profit of an industry is not an accident or a matter of how clever its managers are. It is shaped by a small number of pressures, and once you can see those pressures you can predict whether an industry is a comfortable place to be or a punishing one.
This matters for three kinds of reader. If you are choosing where to start a business or which sector to join, the forces tell you what kind of fight you are walking into. If you already run a business, they show where your profit is leaking and which move would help most. If you are an investor, an analyst or a manager preparing a strategy paper, they give you a checklist so you do not forget a whole side of the picture, such as the power of suppliers, while you stare at the competitors you already know.
A word about what the framework is not. It does not tell you what to do. It describes the terrain. It also does not say that a hard industry is a bad choice, because a company with a strong advantage can do well even in a harsh sector, and a weak company can do badly even in a kind one. Think of it as a weather report for an industry: useful before you set out, not a substitute for knowing how to sail.
Profit is a pie that several parties want
The easiest way to hold the idea in your head is to picture an industry as a pie. The pie is the total profit that would be left in the industry if nobody took any more than they needed. Every customer pays a price. Part of that price goes to the suppliers who sell inputs, part goes to the workers and the firms in the industry, and what is left over is profit. Several parties are pulling at that leftover profit from different directions.
Rivals pull at it by cutting prices or spending more to win customers.
Customers pull at it by bargaining the price down or demanding more for the same money.
Suppliers pull at it by raising what they charge for the things you must buy.
New entrants pull at it by arriving, adding capacity and competing for the same customers.
Substitutes pull at it by offering a different product that does the same job, which limits how high any price can go.
Those five pulls are the five forces. The stronger each one is, the smaller the slice that stays with the firms in the industry. A weak force leaves more profit for the firms. An industry in which all five are weak is a gold mine. An industry in which all five are strong is a place where even the best-run firm earns only what it needs to stay alive.
Notice the link to Lesson 1. A competitive advantage is what lets one firm keep a bigger slice than its neighbours. The five forces describe how big the whole slice is that the industry gets to share in the first place. You need both views: the size of the pie, and your share of it.
Force one: rivalry among existing competitors
The first force is the one everybody sees: how hard the firms already in the market fight each other. Rivalry is intense when there are many firms of similar size, when the industry grows slowly so that one firm can only grow by taking customers from another, when the product looks the same from one firm to the next, and when it is costly to leave the industry, so that failing firms stay and keep cutting prices rather than closing.
Think of Indian domestic air travel as a standing illustration of the pattern. Seats on a given route are close substitutes in the buyer's eye, a plane that flies half empty still has to be paid for, and so airlines have a strong reason to fill seats by cutting fares. A flight that takes off with empty seats earns nothing from them, so selling at a low price feels better than not selling. When several airlines think this way at once, fares fall together. That pattern is typical of an industry where fixed costs are high and the product is hard to tell apart. We use this only as a way of seeing the logic, and the example is not a claim about any particular airline's accounts.
Compare that with a small-town pharmacy that has no nearby rival. There is no one to undercut, so the owner can hold the price. The difference in rivalry is the main reason the two shopkeepers at the start of this lesson earn so differently.
Here is a short list of signs that rivalry is high:
Many competitors with similar size and strength.
Slow industry growth, so gains come only from rivals' losses.
High fixed costs, which push firms to fill capacity at almost any price.
Products that customers see as the same, so the lowest price wins.
High exit barriers, such as specialised equipment that cannot be sold, which keep weak firms in the fight.
Signs that rivalry is low are the opposite: few firms, a growing market, products that customers can tell apart, and an easy way out for firms that want to leave.
Force two: the threat of new entrants
The second force asks how easy it is for a newcomer to walk in. If it is easy, then any time the existing firms earn high profits, new firms will arrive, add supply and bid the profits away, exactly as the chai stalls did in Lesson 1. If it is hard, existing firms can keep their profits for longer. What matters is therefore not who is in the market today but how hard it is to join them. Strategy writers call the obstacles barriers to entry, and the common ones are these:
Scale. If the cheapest way to produce is at a huge size, a small newcomer starts with higher costs than the giants and has to hope to grow into the same scale before it runs out of money.
Money needed. A cement plant, a steel mill or a telecom network costs a great deal before it earns a rupee. Not many people can fund that.
Brand and habit. If customers trust an existing name or are used to a product, a newcomer must spend heavily to win them over.
Access to distribution. A new snack brand needs shelf space in shops that are already full of established brands.
Network effects. A payment app is more useful when more people and shops accept it, so a newcomer starts with the disadvantage of having few users, and few users make it less useful, which makes it harder to gain more.
Rules and licences. Where a licence is needed to lend, to insure or to broadcast, the licence itself is a barrier. These barriers can be high and can also change when the rules change.
How the existing firms react. If incumbents are known to cut prices hard when someone arrives, would-be entrants may stay away.
Notice that the force is about threat, not about actual entry. An industry can be safe because the barrier is high even though nobody has tried to enter for years. And an industry can be pushed into lower prices by the mere possibility of entry, because the existing firms know that very high prices would invite someone in.
The next simulator turns the idea into arithmetic. Try it before reading on: move the cost to enter and the yearly profit an entrant could expect, and see how long the newcomer would take to earn back what it spent. When the payback is short, many people will want to try, and the barrier is weak. When it is very long, few will, and incumbents are safer.
Force three: the bargaining power of suppliers
Every business buys something: raw material, components, software, electricity, labour, money. The people and firms who sell those things have power over you when they can charge more without losing you. The power of suppliers is high when:
There are only a few suppliers and many buyers, so each supplier can pick.
There is no good alternative to what they sell.
Switching to another supplier is costly, for instance because your system is built around one supplier's product.
The supplier could, if it wished, start selling directly to your customers and become a competitor.
Your purchases are a small part of the supplier's business, so losing you costs them little.
Labour is a supplier too. In a field where skilled people are scarce, the workers have bargaining power, and wages absorb more of the revenue. Money is another: a lender that is the only source of funding for a young company can ask for tough terms.
Take an illustrative case. A small packaged-snacks maker depends on a single large oil refiner for its cooking oil, and oil is half the cost of each packet. If the refiner raises its price by ten per cent, the snacks maker's cost rises by five per cent of its total cost, and unless it can pass the rise on, that comes straight out of its profit. A maker with three interchangeable suppliers can get quotes from all three and negotiate. The first maker is exposed because the supplier holds the stronger hand.
The next idea is the one that most readers miss. Suppliers' power depends not only on how many there are, but on how important their input is to your product and how much of your cost it makes up. A cheap component that is critical, such as a certified safety part, can give its maker great power. An expensive component with easy substitutes gives its maker little.
Force four: the bargaining power of buyers
Buyers are the mirror image of suppliers. They have power when they can push your price down or ask for better quality or service for the same money. Buyers are powerful when:
A few buyers account for most of your sales, so losing one would hurt.
Your product is much the same as your rivals', so the buyer can switch freely.
The buyer's cost of switching is low.
The product is a large part of the buyer's own costs, so the buyer cares about every rupee.
The buyer could make the product itself.
The buyer is well informed about prices, which the internet has made easier in almost every field.
Picture a small manufacturer of auto parts whose biggest customer is one large car maker that takes two thirds of its output. The car maker can ask for a lower price each year, knowing the parts maker cannot easily find another buyer on the same scale. That is high buyer power. By contrast, a clinic with a long waiting list of patients holds the power, and the patients hold little.
Buyers and suppliers often pull at the same firm from both ends. A firm squeezed between a strong supplier and a strong buyer has its margin crushed from the two sides, like a lemon in a press.
The margin squeeze in numbers
Predict first: a firm earns ₹20 on each ₹100 unit. Its supplier raises its price by 10 per cent on ₹50 of inputs, and its buyer forces a 5 per cent discount. Does the profit fall by about 15 per cent, about 30 per cent or about 50 per cent? Decide, then read on. The answer is about 50 per cent: the price falls to ₹95, inputs rise to ₹55, and with ₹30 of other costs the profit is ₹10.
Use the simulator below to see exactly how the squeeze works. A firm sells a unit for ₹100. Its inputs cost ₹50, and its own costs for labour, rent and everything else come to ₹30, so it earns ₹20 on each unit, a margin of 20 per cent. Now let the supplier raise its price and let the buyer insist on a discount. Try a supplier rise of 10 per cent and a buyer discount of 5 per cent, then push both further and watch where the profit hits zero.
With the default numbers the profit per unit falls from ₹20 to ₹10, which is half of it gone, though the supplier raised its price by only ten per cent and the buyer asked for only five per cent. This is the lesson of operating leverage on a small margin: a small change in price or cost, on a thin base, is a large change in profit. A firm earning 20 per cent can lose half its profit to two modest squeezes. This is why strategists watch supplier and buyer power so closely.
Force five: the threat of substitutes
The fifth force is the easiest to overlook. A substitute is a different product that does the same job for the customer. It is not a rival who sells the same thing. A video call is a substitute for a business flight. A packaged-water bottle can substitute for a cup of tea on a hot day. A bank's fixed deposit competes, in a saver's mind, with a mutual fund, with gold and with a plot of land.
Substitutes set a ceiling on price. However strong your position in the industry, if your price rises far above what a substitute costs, customers will move. This is why even a monopoly seldom has full pricing freedom: the substitute is the monopolist's invisible competitor.
The threat of substitutes is higher when:
The substitute offers a better trade between price and performance.
The cost to the customer of switching is low.
The customer is already inclined to switch, because of dissatisfaction or fashion.
New technology keeps improving the substitute.
When you analyse substitutes, start from the job the customer is hiring the product to do, not from the product itself. Ask what else could do this job. A taxi company that thinks it sells "taxi rides" sees only other taxi firms. One that thinks it sells "getting across the city" also sees the metro, the bike and the car-pool app.
How to run an analysis: a step-by-step method
Knowing the forces is one thing and using them is another. The sequence below works for a team analysing a market in an afternoon.
1. Define the industry narrowly enough to mean something. "Food" is too broad. "Packaged snacks sold through small shops in one state" is a market whose five forces you can really judge. The same company can sit in several industries, and each one has its own forces.
2. List the players for each force. Name the actual rivals, the likely entrants, the major suppliers, the biggest buyers and the substitutes. A list of names stops you from reasoning in generalities.
3. Score each force from 1 (weak) to 5 (strong). Write one sentence of evidence for each score. If you cannot write the sentence, you do not yet know enough to score it.
4. Look for the dominant force. In most industries one or two forces matter more than the others. In a market with few buyers, buyer power usually dominates. In a technology market, substitutes and entrants often do.
5. Ask how each force is changing. A force that is weak today but strengthening is more important than one that is fixed. Regulation, technology and customer habits all move the forces over time.
6. Decide what you can do about it. You may choose a part of the industry where the forces are weaker, build a barrier, reduce your dependence on a strong supplier or buyer, or lock customers in with something that raises their cost of switching.
Step 3 is the one people hurry. The simulator below turns your scores into a single "pressure" reading. Each force is scored from 1 to 5, and a high score means a strong force, which is bad for profit. Try it first on an industry you know well, and then on your own.
Worked example one: a regional airline (illustrative)
Take a made-up regional airline flying between mid-sized cities in India. We score it as follows.
Rivalry: 5. Several carriers fly the same routes, seats are the same product, and the cost of an empty seat is high.
New entrants: 3. Starting an airline needs aircraft, licences and a safety record, which is a real barrier, but leasing planes and the arrival of new brands show that people do try.
Suppliers: 4. Aircraft come from a handful of makers, fuel is a large cost set by markets rather than by the airline, and airports charge fees. Workers such as pilots are scarce.
Buyers: 4. Travellers compare fares on a screen in seconds and have no loyalty to a seat.
Substitutes: 3. Trains are a substitute on shorter routes, and video calls reduce business travel.
The average is 3.8, close to harsh. Read the chart and you can see the story: nearly every force is strong, so an airline of this kind must work very hard on cost or on a niche, such as a route with no rival, to earn a decent profit. This is not a verdict on any real carrier. It is a worked example of how the scoring organises your thinking.
Worked example two: a payments app (illustrative)
Now consider a made-up app that lets people pay shops by scanning a code. Apply the same five steps.
Rivalry: 4. Several apps do the same thing, and customers can use more than one at the same time.
New entrants: 3. The shared payment rails make it easy for a new app to plug in, but a new app must win users, and users and shops both go where the others already are.
Suppliers: 3. The app depends on banks and on the shared payment rails. Their rules and fees can change what the app earns.
Buyers: 5. Customers pay nothing and can switch with a few taps, and shops can accept every app at once.
Substitutes: 3. Cash, cards and bank transfers all do the same job.
The notable thing is the force with the top score. When the buyer's switching cost is close to zero and the buyer pays nothing, the app cannot charge for the basic service, so any profit has to come from something else, such as loans, insurance or services for shops. That is exactly the kind of strategic conclusion the five forces are meant to bring out: not "this is a bad business" but "this force dominates, so the money must come from elsewhere".
Worked example three: a local cement maker (illustrative)
Cement is heavy and cheap for its weight, so moving it far costs a lot. That one fact changes several forces at once. In a given region, only the plants within a certain distance can compete, so the number of real rivals is smaller than the national count would suggest. A new plant costs a great deal and needs limestone deposits and approvals, which makes entry hard. Buyers are many and small, such as builders and households, so none of them has much power individually, though large contractors may. There are few real substitutes for cement in ordinary construction. The main pressure comes from suppliers of fuel and power, whose price swings land directly on costs.
If you scored this made-up regional cement market, you would likely give low marks for entrants, buyers and substitutes, and high marks for suppliers and, in a downturn, for rivalry, because plants with high fixed costs fight to keep running. The overall picture is a more comfortable industry than the airline's, but one where profits swing with fuel costs and demand. Notice again how a physical fact, the cost of moving the product, reshapes the framework. Always look for the fact about the product or the market that changes the forces.
Reading the forces over time
A single scorecard is a photograph. The real value comes from asking how it is changing. Four common movers are worth checking every year.
Technology. New technology can lower barriers (cloud services let a tiny software firm serve a country), create substitutes (streaming replaced rented videos) or hand buyers more information.
Regulation. A new licence rule can raise barriers and protect incumbents, and the removal of one can open the gates.
Customer behaviour. When customers get used to switching, buyer power rises. When they form habits, it falls.
Industry structure. A merger that leaves two large firms where there were five can reduce rivalry, and a supplier acquiring another can raise supplier power.
A good practice is to write the scorecard each year and keep the old ones. After three years you can see which force has been rising, and that is usually where strategy needs to change.
Common mistakes
Confusing a hot industry with a profitable one. A fast-growing industry can still have punishing forces. Growth attracts entrants, and a growing market with low barriers often ends in a price war. Judge the structure, not the headline growth.
Defining the industry too broadly or too narrowly. Too broad and the forces average out into mush. Too narrow and you miss the substitutes and entrants who sit just outside your definition.
Looking only at rivals. Most people can describe their competitors in detail and say almost nothing about suppliers or substitutes. The framework exists to correct this blind spot.
Treating the scores as exact. A score of 4 against 3 is a judgement. The point is the conversation and the evidence behind each score, not the decimal.
Stopping at the diagnosis. A scorecard that does not lead to a decision is only decoration. Finish by writing the one or two moves that would shift the strongest force in your favour.
Forgetting that forces differ by segment. A firm may face weak buyers in one customer segment and strong ones in another. Analyse the segment you actually serve.
Assuming a weak force is permanent. Barriers that look solid can disappear with a rule change or a new technology. Ask what would have to happen for the force to flip.
Key takeaways
- An industry's average profit is shaped by five forces: rivalry, new entrants, supplier power, buyer power and substitutes.
- The stronger the forces, the smaller the slice of profit that stays with the firms in the industry.
- Barriers to entry such as scale, capital needs, brand, network effects and licences protect incumbents, and the threat matters even when nobody enters.
- Suppliers and buyers can squeeze a firm from both sides, and on a thin margin a small price move becomes a large profit move.
- Substitutes set a ceiling on price, so analyse the job the customer is hiring the product to do, not just the product.
- Score each force with evidence, find the dominant one, track how it is changing and finish with a decision.
Check yourself
1. What are the five forces? Rivalry among existing competitors, the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers and the threat of substitutes.
2. Why can an industry be safe from entrants even if nobody has tried to enter for years? Because high barriers, such as scale, capital needs or licences, make entry unattractive, so the threat is low without anyone testing it.
3. A firm earns ₹20 on a ₹100 unit. Its supplier raises input costs of ₹50 by 10 per cent and the buyer forces a 5 per cent discount. What is the new profit per unit, with other costs unchanged? Price falls to ₹95, inputs rise to ₹55, own costs stay ₹30, so profit is 95 - 55 - 30 = ₹10, half the old profit.
4. What is a substitute, and how does it differ from a rival? A substitute is a different product that does the same job for the customer, while a rival sells the same kind of product.
5. Name two signs that buyer power is high. A few buyers account for most sales, and the buyer can switch to another seller at low cost (any two of the listed signs are fine).
6. Why must you define the industry carefully before scoring the forces? Because the forces differ by market, so a definition that is too broad or too narrow gives scores that mean little.
Try this
Set aside 40 minutes with a pen, a sheet of paper or a spreadsheet, and pick one industry you know from work or from daily life, such as your employer's market, a local business or an app you use.
1. Define the industry in one line (5 minutes). Write the product, the customer and the area, for example "home-delivered groceries in Pune".
2. List the names (10 minutes). For each force, write down the actual players: three or four rivals, any recent or likely entrants, the two or three most important suppliers, the biggest buyers or buyer groups, and two substitutes. If you do not know enough, search for news about the industry and note down what you find, and write down where you found each fact.
3. Score the forces (10 minutes). Score each force from 1 to 5 and write one sentence of evidence next to each score. Use the scoring simulator above to see the average and the strongest force.
4. Find the dominant force (5 minutes). Circle the one or two forces that matter most, and write why.
5. Write the trend (5 minutes). Next to each force, write an arrow up, down or flat for the next three years, with a few words on what would move it.
6. Write two moves (5 minutes). Write two things a firm in this industry could do to weaken the dominant force, for example find a segment with weaker buyers or reduce reliance on one supplier.
A good result is a single page that a colleague could read in two minutes and argue with. It names real players, gives evidence for every score, picks the dominant force and ends in two concrete moves. If every score is a 3 and none has evidence, go back to step 2: you have not yet found out enough about the industry.
Tags: Business Strategy Porter's five forces Industry analysis Competition Beginner