Business and the Competitive Environment (AQA A-Level Business): Revision Notes
Business and the Competitive Environment
Understanding Porter's Five Forces Model
The Five Forces Model, developed by Michael Porter, is a framework that helps businesses analyse the level of competition in their industry. Porter is widely regarded as a leading expert on competitiveness, making this model particularly valuable for strategic planning.
The model examines five competitive forces that shape every industry. Businesses can use this framework to:
- Assess market conditions and determine the best strategy to achieve a competitive advantage
- Understand how profitable a market is likely to be
- Identify where to position themselves in the market
- Decide whether entering a particular market is worthwhile
By understanding these forces, businesses can make more informed strategic decisions and identify opportunities to strengthen their market position. Each force can be influenced through deliberate business strategies.
The five competitive forces
1) Barriers to entry
This force examines how easy or difficult it is for new firms to enter a market. Existing businesses benefit when barriers are high, as this limits new competition.
When barriers to entry are high:
New companies face significant challenges entering the market because existing firms have made it deliberately difficult. This protects established businesses from increased competition.
Factors that create high barriers to entry:
- High start-up costs: Expensive equipment or technology requirements can discourage potential entrants. For example, setting up a car manufacturing plant requires massive capital investment
- Patents and trademarks: Legal protection prevents new firms from copying products or branding, making it harder to offer similar goods
- Control of distribution channels: When established firms control how products reach customers, new entrants struggle to access the market
Strategies businesses use to raise barriers to entry:
- Patents or trademarks: Legal protection makes it harder for newcomers to sell similar products
- Forward vertical integration: Taking control of distribution channels limits market access for competitors
Forward Vertical Integration Example:
An outdoor clothing manufacturer might buy out or merge with outdoor clothing retailers. By controlling the retail outlets, they make the market less attractive to new entrants who would struggle to find places to sell their products.
- Threatening price wars: Large established businesses with economies of scale can undercut prices (predatory pricing) to force competitors out
Legal Warning - Predatory Pricing:
While threatening price wars can be an effective strategy, businesses must comply with EU competition law, which prevents businesses from selling at a loss solely to eliminate competition. Violating these regulations can result in significant fines and legal consequences.
2) Buyer power
This force considers how much negotiating power buyers have. Buyers always want to pay as low a price as possible for products and services.
When buyer power is high:
Buyers have more leverage to negotiate lower prices and better terms when certain conditions exist:
- Few buyers with many sellers: When there are limited customers in the market, each buyer becomes more important to suppliers, giving them stronger bargaining positions
- Standardised products: When products aren't differentiated, buyers can easily switch between suppliers, forcing businesses to compete on price. It's much harder for firms to charge premium prices when goods or services are similar
- Main customer relationships: If a supplier relies heavily on one major customer, that buyer can negotiate special deals and demand lower prices
Who are "buyers"?
Buyers include business customers, wholesalers, retailers, and the general public—not just end consumers. When analysing buyer power, consider all types of customers in the supply chain.
Strategies to reduce buyer power:
- Backwards vertical integration: A company might buy out its supplier to gain more control
Backwards Vertical Integration Example:
A burger chain purchasing a beef farm gives them control over their supply chain. This strategy reduces their dependence on external suppliers and protects them from supplier price increases or buyer power issues.
- Form buying groups: Similar businesses can combine their purchasing power by creating a buying group. By ordering bigger volumes together, they secure a better deal and can compete more effectively with larger businesses
3) Supplier power
This force examines how much control suppliers have. Suppliers aim to charge as high a price as possible for their goods or services.
When supplier power is high:
Suppliers gain negotiating strength in certain market conditions:
- Few suppliers with many buyers: When there are limited suppliers but lots of firms wanting to buy from them, suppliers can demand higher prices
- High switching costs: If it's expensive or difficult for customers to switch suppliers, the existing supplier has more power to set prices
Strategies to reduce supplier power:
- Long-term contracts: Businesses can tie buyers into extended agreements to prevent them switching suppliers easily
Long-term Contract Example:
Mobile phone companies often use 2-year contracts that lock customers (handsets) to their network. This strategy reduces customer power to switch and ensures steady revenue over the contract period.
-
Forward integration: Suppliers can establish their own retail outlets or purchase the retailers they supply to, gaining direct access to customers and more control over pricing
-
Develop unique products with patent protection: Creating innovative products and protecting them with patents gives suppliers exclusive selling rights. Being the only ones selling a product means they can charge a premium price, knowing customers have no alternatives
4) Threat of substitutes
This force measures how likely consumers are to buy an alternative product that meets the same need.
When the threat of substitutes is high:
The willingness of customers to switch to substitute products depends on several factors:
- Relative price and quality: Buyers won't change to a substitute if it offers poor value. Both price competitiveness and product quality matter
- Product differentiation: For undifferentiated products (like washing powder), the threat from substitutes is higher than for unique products where alternatives don't match the original's specific features
Strategies to reduce the threat of substitutes:
- Make switching costly or difficult: Businesses can create barriers that discourage customers from trying substitutes, though they must be careful not to frustrate customers
Creating Switching Barriers - Amazon Kindle:
Amazon's Kindle ecosystem is an effective example of making switching difficult. When you buy books through Amazon, they're formatted specifically for Kindle devices and apps. This makes it inconvenient to switch to other e-readers or formats, as your entire library would need to be repurchased or converted.
-
Build brand loyalty: When customers are loyal to a brand and perceive it as superior, they're less likely to try substitutes. Companies achieve this through differentiation—making their product stand out from competitors. Strong brand loyalty significantly reduces the threat from substitute products
-
Identify unmet customer needs: Businesses can find groups of customers whose needs aren't being fully met and create products that satisfy those needs exactly
Identifying Unmet Needs:
Environmentally-conscious parents might buy eco-friendly disposable nappies if no suitable substitutes exist. This creates a market niche with reduced substitute threat until other businesses notice the opportunity and enter that market segment.
5) Rivalry within the industry
This force assesses how much competition exists between firms already operating in the market.
When rivalry is intense:
Competition becomes particularly fierce in certain industry conditions:
- Many equally-sized competitors: Markets with lots of similarly-sized firms experience intense rivalry as no single business dominates
- High fixed costs: Industries with very competitive conditions, such as parcel delivery companies with expensive vehicles, face intense rivalry. Firms must sell large volumes to cover their fixed costs, so they compete aggressively for customers. Even if they're not making a profit, it's often difficult to exit the market because their expensive equipment is hard to sell, which increases rivalry further
- Standardised goods: Industries producing standardised goods (like steel, milk, or flour) have intense rivalry because products are interchangeable
- Young, growth industries: Rivalry is also intense when competitors in developing markets are pursuing growth strategies, each trying to capture market share
Strategies to reduce the effects of rivalry:
- Make switching easy: Some businesses try to make it simple for customers to switch between standardised goods, often by offering incentives
Making Switching Easy - Banking Services:
Banks frequently provide a hassle-free switching service for customers changing bank accounts. They handle the process of transferring direct debits and updating details, removing barriers that might prevent customers from switching. This strategy helps them attract customers from competitors in a highly competitive market.
- Invest in promotional activities: Businesses with a bigger promotional budget tend to perform better in highly competitive markets. Effective marketing helps them stand out from rivals and attract customers despite intense competition
Key Points to Remember:
- Porter's Five Forces Model analyses five competitive pressures: barriers to entry, buyer power, supplier power, threat of substitutes, and rivalry within the industry
- Businesses can use strategic actions to improve their position regarding each force—such as vertical integration, creating barriers to entry, building brand loyalty, or differentiating products
- High barriers to entry and low rivalry generally make markets more profitable for existing businesses
- Buyer power increases when there are few buyers or standardised products; supplier power increases when there are few suppliers or high switching costs
- Understanding these forces helps businesses develop effective competitive strategies and make informed decisions about entering or competing in markets