Porters Five Forces Analysis - Threat of Substitutes © Jeff Miles Business Doctor Secrets

Today we will look at three of the forces in the Porters Five Forces Analysis.

1. Threat of Substitutes

Substitute products are products in other industries. 

From an economist's perspective, a threat of substitute is when demand for a product is affected by the price change of a substitute product.

A product's price is always affected by substitute products.

As more substitute products become available the demand becomes more unstable because customers have more options. If a substitute is very similar to the original this limit's the company's ability to raise prices.

The competition that comes from a Threat of Substitute comes from product outside the industry.

For example, the price of aluminum cans is affected by the price of glass bottles and plastic containers. These containers are substitute but not rivals in the aluminum can industry.

In the trucking industry, tires are expensive and have to be replaced often. Therefore, retreading old tires is a viable market and serves as a Threat of Substitute to new tire manufacturers.

In the cloth diaper industry, disposable diapers are a threat of substitute and keeps prices in check.

Price competition isn't the only way Threat of Substitutes impacts a business. In the entertainment industry new technology creates substitutes because there are now a variety of ways for consumers to access entertainment (cable, satellite, cell phone, and internet).

For example, to compete with free TV, cable TV has to offer a greater variety of stations and entertainment.

2. Buyer Power

Buyer power is the impact that customers have on an industry. When buyer power is strong, the situation is what an economist terms a monopsony.

This is a market in which there are many suppliers and one buyer. Under these market conditions, the price is set by the buyer. In reality there are only a few pure monopsonies, but there often is some imbalance between an industry and buyers.

Here are some factors that determine buyer power:

Buyers are Powerful When:

- - Buyers are concentrated, leaving only a few buyers with significant market share. For example,
    Department of Defense purchases from contractors
- - Buyers can threaten to buy the firm or a competitor's firm
- - Buyers purchase a significant proportion of output - Example: Circuit City and Sears' huge retail
     market gives them power over appliance manufacturers.

Buyers are Weak When:

- - Producers can provide their own retailing and distribution 
- - Large buyer switching costs - Buyers can't easily switch to a new product
- - Buyers are fragmented because there are so many of them and no buyer has any special influence
     on the price. This is the case with most consumer products.
- - The products supply a critical component to the buyer - Example: PC manufacturers' reliance on
     Intel.

3. Supplier Power

A business that manufactures products requires raw materials for those products as well as labor and other components. This creates relationships between buyers and suppliers.

Powerful suppliers can exert a large influence on the industry by selling raw materials at a high price and keep some of the industry's profits to themselves.

Here are some factors that determine supplier power:

Suppliers are concentrated. For example, the drug industry's relationship with hospitals
Cost of switching suppliers is too high - Such as Microsoft's relationship with PC manufacturers.
Customers are powerful

Suppliers are Weak If:

- - There are many competitive suppliers and the product is standardized- - There are generic brands
- - Customers are weak
- - Purchases are concentrated