A management assignment

137

How competitive forces shape strategy

Awareness of these forees can help a company stake out a position in its industry that is less vulnerable to attack

Michael E. Porter

The nature and degree of competition in an in- dustry hinge on five forces: the threat of new entrants, the bargaining power of customers, the bargaining power of sup- pliers, the threat of sub- stitute products or services (where applicahle), and the jockeying among current contestants. To estahlish a strategic agenda for dealing with these contending currents and to grow despite them, a company must under- stand how they work in its industry and how they affect the company in its particular situation. The author details how these forces operate and sug- gests ways of adjusting to them, and, where possihle, of taking advantage of them.

Mr. Porter is a specialist in industrial economics and business strategy. An associate professor of husi- ness administration at the Harvard Business School, he has created a course there entitled "Industry and Competitive Analy- sis." He sits on the hoards of three companies and

consults on strategy mat- ters, and he has written many articles for econom- ics journals and published two books. One of them, Interbrand Choice, Strat- egy and Bilateral Market Power (Harvard Univer- sity Press, 1976) is an out- growth of his doctoral thesis, for which he won the coveted Wells prize awarded by the Harvard economics department. He has recently completed two book manuscripts, one on competitive analysis in industry and the other (written with Michael Spence and Richard Caves) on compe- tition in the open economy.

The essenee of strategy formulation is coping with competition. Yet it is easy to view competition too narrowly and too pessimistically. While one some- times hears executives eomplaining to the eontrary, intense eompetition in an industry is neither coin- eidence nor bad luck.

Moreover, in the fight for market share, compe- tition is not manifested only in the other players. Rather, competition in an industry is rooted in its underlying economics, and competitive forces exist that go well beyond the established combatants in a particular industry. Customers, suppliers, poten- tial entrants, and substitute products are all com- petitors that may be more or less prominent or ac- tive depending on the industry.

The state of competition in an industry depends on five basic forces, which are diagrammed in the Exhibit on page 141. The collective strength of these forces determines the ultimate profit potential of an industry. It ranges from intense in industries like tires, metal eans, and steel, where no company earns spectacular returns on investment, to mild in industries like oil field services and equipment, soft drinks, and toiletries, where there is room for quite high returns.

In the economists' "perfeetly competitive" indus- try, jockeying for position is unbridled and entry to the industry very easy. This kind of industry struc- ture, of course, offers the worst prospect for long- run profitability. The weaker the forces collectively, however, the greater the opportunity for superior performance.

Whatever their eoUeetive strength, the eorporate strategist's goal is to find a position in the industry where his or her company can best defend itself against these forees or ean influence them in its favor. The collective strength of the forces may be

138 Harvard Business Review March-April 1979

painfully apparent to all the antagonists; hut to cope with them, the strategist must delve below the sur- face and analyze the sources of each. For example, what makes the industry vulnerable to entry? What determines the bargaining power of suppliers?

Knowledge of these underlying sources of eom- petitive pressure provides the groundwork for a strategic agenda of action. They highlight the criti- eal strengths and weaknesses of the company, ani- mate the positioning of the company in its industry, clarify the areas where strategic ehanges may yield the greatest payoff, and highlight the places where industry trends promise to hold the greatest signif- icance as either opportunities or threats. Under- standing these sources also proves to be of help in considering areas for diversification.

Contending forces

The strongest eompetitive foree or forces determine the profitability of an industry and so are of greatest importance in strategy formulation. For example, even a company with a strong position in an indus- try unthreatened by potential entrants will earn low returns if it faces a superior or a lower-eost sub- stitute product—as the leading manufaeturers of vacuum tubes and coffee percolators have learned to their sorrow. In such a situation, coping with the substitute product becomes the number one strate- gie priority.

Different forees take on prominenee, of eourse, in shaping eompetition in each industry. In the oeean-going tanker industry the key foree is prob- ably the buyers (the major oil companies), while in tires it is powerful OEM buyers coupled with tough competitors. In the steel industry the key forces are foreign competitors and substitute materials.

Every industry has an underlying strueture, or a set of fundamental economic and technical char- acteristics, that gives rise to these competitive forces. The strategist, wanting to position his company to cope best with its industry environment or to in- fiuenee that environment in the company's favor, must leam what makes the environment tiek.

This view of eompetition pertains equally to in- dustries dealing in services and to those selling products. To avoid monotony in this artiele, I re- fer to both products and services as "produets." The same general prineiples apply to all types of business.

A few eharacteristics are critical to the strength of eaeh competitive force. I shall diseuss them in this section.

Threat of entry

New entrants to an industry bring new eapaeity, the desire to gain market share, and often substan- tial resources. Companies diversifying through ac- quisition into the industry from other markets often leverage their resources to cause a shake-up, as Philip Morris did with Miller beer.

The seriousness of the threat of entry depends on the harriers present and on the reaction from exist- ing competitors that the entrant can expect. If barri- ers to entry are high and a newcomer can expect sharp retaliation from the entrenched eompeti- tors, obviously he will not pose a serious threat of entering.

There are six major sources of barriers to entry: 1. Economies of scale—These economies deter en-

try by foreing the aspirant either to come in on a large seale or to accept a eost disadvantage. Seale eeonomies in produetion, researeh, marketing, and serviee are prohably the key barriers to entry in the mainframe computer industry, as Xerox and GE sadly discovered. Eeonomies of seale ean also act as hurdles in distribution, utilization of the sales foree, finaneing, and nearly any other part of a business.

2. Product differentiation—Brand identification ereates a barrier by forcing entrants to spend heavily to overcome customer loyalty. Advertising, eustom- er service, being first in the industry, and product differenees are among the faetors fostering hrand identification. It is perhaps the most important entry barrier in soft drinks, over-the-counter drugs, cos- meties, investment banking, and public aeeounting. To create high fences around their businesses, brew- ers eouple brand identifieation with eeonomies of seale in production, distribution, and marketing.

3. Capital requirements—The need to invest large finaneial resourees in order to compete ereates a barrier to entry, particularly if the eapital is required for unreeoverable expenditures in up-front advertis- ing or R&D. Capital is necessary not only for fixed facilities but also for customer credit, inventories, and absorbing start-up losses. While major corpora- tions have the financial resources to invade almost any industry, the huge capital requirements in eer- tain fields, such as eomputer manufacturing and mineral extraction, limit the pool of likely entrants.

4. Cost disadvantages independent of size—En- trenched companies may have eost advantages not available to potential rivals, no matter what their

Cotnpetition shapes strategy 139

The experience curve as an entry barrier In recent years, the experience curve has become widely dis- cussed as a key element of industry structure. According to this concept, unit costs in many manufacturing industries (some dogmatic adherents say in all manufacturing industries) as well as in some service indus- tries decline with "experience," or a particular company's cumu- lative volume of production. (The experience curve, which encompasses many factors, is a broader concept than the better- known learning curve, which refers to the efficiency achieved over a period of time by workers through much repetition.)

The causes of the decline in unit costs are a combination of elements, including economies of scale, the learning curve for labor, and capital-labor substitu- tion. The cost decline creates a barrier to entry because new competitors with no "experi- ence" face higher costs than established ones, particularly the producer with the largest market share, and have difficulty catching up with the entrenched competitors.

Adherents of the expenence curve concept stress the impor- tance of achieving market lead-

ership to maximize this barrier to entry, and they recommend aggressive action to achieve it, such as price cutting in anticipa- tion of falling costs in order to build volume. For the combatant that cannot achieve a healthy market share, the prescription is usually, "Get out."

Is the experience curve an entry barrier on which strategies should be built? The answer is: not in every industry. In fact, in some industries, building a strat- egy on the experience curve can be potentially disastrous. That costs decline with experience in some industries is not news to corporate executives. The sig- nificance of the experience curve for strategy depends on what factors are causing the decline.

If costs are falling because a growing company can reap economies of scale through more efficient, automated facili- ties and vertical integration, then the cumulative volume of pro- duction is unimportant to its rela- tive cost position. Here the lowest-cost producer is the one with the largest, most efficient facilities.

A new entrant may well be more efficient than the more experienced competitors; if it has built the newest plant, it will face no disadvantage in having to catch up. The strategic pre- scription, "You must have the largest, most efficient plant," is a

lot different from, "You must produce the greatest cumulative output of the item to get your costs down."

Whether a drop in costs with cumulative (not absolute) vol- ume erects an entry barrier also depends on the sources of the decline. If costs go down because of technical advances known generally In the industry or because of the development of improved equipment that can be copied or purchased from equipment suppliers, the experi- ence curve is no entry barrier at all-infacf, new or less experi- enced competitors may actually enjoy a cost advantage over the leaders. Free of the legacy of heavy past investments, the newcomer or less experienced competitor can purchase or copy the newest and lowest-cost equipment and technology.

If, however, experience can be kept proprietary, the leaders will maintain a cost advantage. But new entrants may require

less experience to reduce their costs than the leaders needed. All this suggests that the experi- ence curve can be a shaky entry barrier on which to build a strategy.

While space does not permit a complete treatment here, I want to mention a few other crucial elements in determining the appropriateness of a strategy built on the entry barrier pro- vided by the experience curve;

D The height of the barrier depends on how important costs are to competition compared with other areas like marketing, selling, and innovation.

D The barrier can be nullified by product or process innova- tions leading to a substantially new technology and thereby creating an entirely new experi- ence curve.' New entrants can leapfrog the industry leaders and alight on the new experi- ence curve, to which those leaders may be poorly posi- tioned to jump.

D If more than one strong company is building its strategy on the experience curve, the consequences can be nearly fatal. By the time only one rival is left pursuing such a strategy, industry growth may have stopped and the prospects of reaping the spoils of victory long since evaporated.

"For an example drawn Irom Ihehisiory of the automobile induslry, see William J. Abemathy and Kenneth Wayne. "The Limits of the Learning Curve," HBR September- October 1974, p.109.

size and attainable economics of scale. These ad- vantages ean stem from the effeets of the learning eurve (and of its first eousin^ the experienee eurve), proprietary teehnology, aceess to the best raw ma- terials sources, assets purchased at preinflation prices, government subsidies, or favorable loeations. Sometimes eost advantages are legally enforceable, as they are through patents. (For an analysis of the much-diseussed experience eurve as a barrier to entry, see the ruled insert ahove.)

5. Access to distribution channels—The new boy on the block must, of course, secure distribution of his product or service. A new food product, for ex-

ample, must displace others from the supermarket shelf via price breaks, promotions, intense selling efforts, or some other means. The more limited the wholesale or retail channels are and the more that existing competitors have these tied up, obviously the tougher that entry into the industry will be. Sometimes this barrier is so high that, to surmount it, a new contestant must create its own distribution channels, as Timex did in the watch industry in t h e 19SOS.

6. Government policy—The government can limit or even foreclose entry to industries with such con- trols as license requirements and limits on access to

140 Harvard Business Review March-April 1979

raw materials. Regulated industries like trucking, liquor retailing, and freight forwarding are notice- able examples; more subtle government restrietions operate in fields like ski-area development and coal mining. The government also can play a major in- direct role by affecting entry barriers through con- trols such as air and water pollution standards and safety regulations.

The potential rival's expectations about the reaction of existing competitors also will influence its deci- sion on whether to enter. The company is likely to have second thoughts if incumbents have previ- ously lashed out at new entrants or if:

• The incumbents possess substantial resources to fight baek, including excess cash and unused bor- rowing power, productive capacity, or clout with dis- tribution channels and customers.

• The incumbents seem likely to cut prices be- cause of a desire to keep market shares or because of industrywide excess capacity.

n Industry growth is slow, affecting its ability to absorb the new arrival and probably causing the financial performance of all the parties involved to decline.

Changing conditions From a strategic standpoint there are two important additional points to note about the threat of entry.

First, it changes, of course, as these conditions change. The expiration of Polaroid's basic patents on instant photography, for instance, greatly re- duced its absolute cost entry barrier built by pro- prietary teehnology. It is not surprising that Kodak plunged into the market. Product differentiation in printing has all hut disappeared. Conversely, in the auto industry economies of scale increased enor- mously with post-World War II automation and ver- tical integration—virtually stopping successful new entry.

Second, strategic deeisions involving a large seg- ment of an industry can have a major impact on the conditions determining the threat of entry. For ex- ample, the actions of many U.S. wine producers in the r96os to step up product introductions, raise ad- vertising levels, and expand distribution nationally surely strengthened the entry roadblocks by raising economies of scale and making access to distribution channels more difficult. Similarly, decisions by members of the recreational vehicle industry to vertically integrate in order to lower costs have greatly increased the economies of scale and raised the capital cost barriers.

Powerful suppliers &l buyers

Suppliers can exert bargaining power on participants in an industry by raising prices or reducing the quality of purchased goods and services. Powerful suppliers can thereby squeeze profitability out of an industry unable to recover cost increases in its own prices. By raising their prices, soft drink concentrate producers have contributed to the erosion of profit- ability of bottling companies because the bottlers, facing intense competition from powdered mixes, fruit drinks, and other beverages, have limited free- dom to raise their prices accordingly. Customers likewise ean foree down prices, demand higher quality or more service, and play competitors off against each other—all at the expense of industry profits.

The power of each important supplier or buyer group depends on a numher of characteristics of its market situation and on the relative importance of its sales or purchases to the industry compared with its overall business.

A suppher group is powerful if: D It is dominated by a few companies and is more

concentrated than the industry it sells to. D Its product is unique or at least differentiated,

or if it has built up switching costs. Switching costs are fixed costs buyers face in changing suppliers. These arise beeause, among other things, a buyer's product speeifications tie it to particular suppliers, it has invested heavily in specialized ancillary equip- ment or in learning how to operate a supplier's equipment [as in computer software), or its produc- tion lines are connected to the supplier's manufac- turing facilities (as in some manufacture of beverage containers).

D It is not obliged to contend with other products for sale to the industry. For instance, the competi- tion between the steel companies and the alum- inum companies to sell to the can industry checks the power of each supplier.

n It poses a credible threat of integrating forward into the industry's business. This provides a check against the industry's ability to improve the terms on which it purchases.

D The industry is not an important customer of the supplier group. If the industry is an important customer, suppliers' fortunes will be closely tied to the industry, and they will want to protect the in- dustry through reasonable pricing and assistance in activities like R&D and lobbying.

A buyer group is powerful if: • It is concentrated or purchases in large vol-

umes. Large-volume buyers are particularly potent

Competition shapes strategy 141

forces if heavy fixed costs characterize the industry —as they do in metal containers, eorn refining, and bulk chemicals, for example—which raise the stakes to keep capacity filled.

D The products it purchases from the industry are standard or undifferentiated. The buyers, sure that they can always find alternative suppliers, may play one company against another, as they do in aluminum extrusion.

D The products it purchases from the industry form a component of its product and represent a significant fraction of its cost. The buyers are likely to shop for a favorable priee and purehase selec- tively. Where the product sold by the industry in question is a small fraction of buyers' costs, buyers are usually much less price sensitive.

• It earns low profits, which create great incen- tive to lower its purehasing costs. Highly profitable buyers, however, are generally less price sensitive (that is, of course, if the item does not represent a large fraction of their costs).

D The industry's product is unimportant to the quality of the buyers' products or services. Where the quality of the buyers' products is very much affected by the industry's product, buyers are gen- erally less price sensitive. Industries in which this situation obtains include oil field equipment, where a malfunction can lead to large losses, and en- closures for electronic medical and test instruments, where the quality of the enclosure can influence the user's impression about the quality of the equip- ment inside.

n The industry's product does not save the buyer money. Where the industry's product or service can pay for itself many times over, the buyer is rarely price sensitive; rather, he is interested in quality. This is true in services like investment banking and public accounting, where errors in judgment can be costly and embarrassing, and in businesses like the logging of oil wells, where an accurate survey can save thousands of dollars in drilling costs.

• The buyers pose a credible threat of integrat- ing backward to make the industry's product. The Big Three auto producers and major buyers of cars have often used the threat of self-manufacture as a bargaining lever. But sometimes an industry en- genders a threat to huyers that its members may in- tegrate forward.

Most of these sources of buyer power can be at- tributed to consumers as a group as well as to in- dustrial and commercial buyers; only a modifica- tion of the frame of reference is necessary. Consum- ers tend to be more price sensitive if they are pur- chasing products that are undifferentiated, expen-

Exhibit Forces governing competition in an industry

sive relative to their incomes, and of a sort where quality is not particularly important.

The buying power of retailers is determined by the same rules, with one important addition. Re- tailers can gain significant bargaining power over manufacturers when they can influence consumers' purchasing decisions, as they do in audio compo- nents, jewelry, appliances, sporting goods, and other goods.

Strategic action A company's choice of suppliers to buy from or buyer groups to sell to should be viewed as a crucial strategic decision. A company can improve its stra- tegie posture by finding suppliers or buyers who possess the least power to inffuence it adversely.

Most common is the situation of a company being able to choose whom it will sell to—in other words, buyer selection. Rarely do all the buyer groups a company sells to enjoy equal power. Even if a com- pany sells to a single industry, segments usually exist within that industry that exercise less power [and that are therefore less price sensitive) than others. For example, the replacement market for most pro- ducts is less price sensitive than the overall market.

142 Harvard Business Review Miirch-April 1979

As a rule, a company can sell to powerful buyers and still come away with above-average profitabil- ity only if it is a low-cost producer in its industry or if its product enjoys some unusual, if not unique, features. In supplying large customers with electric motors, Emerson Electric eams high returns because its low cost position permits the company to meet or undercut competitors' prices.

If the company lacks a low cost position or a unique product, selling to everyone is self-defeating because the more sales it achieves, the more vul- nerable it becomes. The eompany may have to mus- ter the courage to turn away business and sell only to less potent customers.

Buyer selection has been a key to the success of National Can and Crown Cork & Seal. They focus on the segments of the can industry where they can create product differentiation, minimize the threat of backward integration, and otherwise mitigate the awesome power of their customers. Of course, some industries do not enjoy the luxury of selecting "good" buyers.

As the factors creating supplier and buyer power change with time or as a result of a company's strategic decisions, naturally the power of these groups rises or deelines. In the ready-to-wear cloth- ing industry, as the huyers (department stores and clothing stores) have become more concentrated and control has passed to large chains, the industry has come under increasing pressure and suffered falling margins. The industry has heen unable to differen- tiate its product or engender switching costs that lock in its buyers enough to neutralize these trends.

Substitute products

By placing a ceiling on priecs it can charge, substi- tute products or services limit the potential of an industry. Unless it can upgrade the quality of the product or differentiate it somehow (as via market- ing), the industry will sufTcr in earnings and pos- sibly in growth.

Manifestly, the more attractive the price perform- anee trade-off offered by substitute products, the firmer the lid placed on the industry's profit poten- tial. Sugar producers confronted with the large scale commercialization of high-fructose corn syrup, a sugar substitute, are learning this lesson today.

Substitutes not only limit profits in normal times; they also reduce the bonanza an industry can reap in boom times. In r978 the producers of fiberglass insulation enjoyed unprecedented demand as a re- sult of high energy costs and severe winter weather. But the industry's ability to raise prices was tem-

pered by the plethora of insulation substitutes, in- cluding cellulose, rock wool, and styrofoam. These substitutes arc bound to become an even stronger force once the current round of plant additions by fiberglass insulation producers has boosted capacity enough to meet demand (and then some).

Substitute products that deserve the most atten- tion strategically are those that (a) are subject to trends improving their price-performance trade-ofT with the industry's produet, or (b) are produced by industries earning high profits. Substitutes often eome rapidly into play if some development in- creases competition in their industries and causes priee reduction or performance improvement.

Jockeying for position

Rivalry among existing competitors takes the famil- iar form of jockeying for position—using tactics like price competition, product introduction, and adver- tising slugfests. Intense rivalry is related to the pres- ence of a number of factors:

n Competitors are numerous or are roughly equal in size and power. In many U.S. industries in recent years foreign contenders, of course, have hecome part of the competitive picture.

• Industry growth is slow, precipitating fights for market share that involve expansion-minded members.

D The product or service lacks differentiation or switching costs, which lock in buyers and protect one combatant from raids on its customers by an- other.

D Fixed costs are high or the product is per- ishable, creating strong temptation to cut prices. Many basic materials businesses, like paper and aluminum, suffer from this problem when demand slackens.

n Capacity is normally augmented in large incrc- ments. Such additions, as in the chlorine and vinyl chloride husinesses, disrupt the industry's supply- demand balance and often lead to periods of over- capacity and price cutting.

D Exit barriers are high. Exit barriers, like very specialized assets or management's loyalty to a par- ticular business, keep companies competing even though they may be earning low or even negative returns on investment. Excess capacity remains functioning, and the profitability of the healthy competitors suffers as the sick ones hang on.^ If the entire industry suffers from overcapacity, it may

i. Fur a mure complttL- dis;:ussian of exit barriers anJ ihcit implitatinns fin strategy, sec my article, "Please Note Lniiation of Nearest Exit," CohjoTula Mani!f!,cmi!nt Review, W i m t r 1 9 7 6 , p - ^ ' -

Competition shapes strategy 143

seek government help—particularly if foreign com- petition is present.

• The rivals are diverse in strategies, origins, and "personalities." They have different ideas about hovk' to compete and continually run head-on into each other in the process.

As an industry matures, its growth rate changes, re- sulting in declining profits and (often) a shakeout. In the hooming recreational vehicle industry of the early 1970s, nearly every producer did well; but slow growth since then has eliminated the high returns, except for the strongest members, not to mention many of the weaker companies. The same profit story has been played out in industry after industry —snowmobiles, aerosol packaging, and sports equip- ment are just a few examples.

An acquisition can introduce a very different per- sonality to an industry, as has been the case with Black fit Decker's takeover of McCuUough, the producer of chain saws. Teehnological innovation can boost the level of fixed costs in the production process, as it did in the shift from batch to continu- ous-line photo finishing in the 1960s.

While a company must live with many of these factors—because they are built into industry eco- nomics—it may have some latitude for improving matters through strategic shifts. For example, it may try to raise buyers' switching costs or increase prod- uet differentiation. A focus on selling efforts in the fastest-growing segments of the industry or on market areas with the lowest fixed costs can reduce the impact of industry rivalry. If it is feasible, a eompany can try to avoid confrontation with com- petitors having high exit barriers and can thus side- step involvement in bitter price cutting.

Formulation of strategy

Once the corporate strategist has assessed the forces affecting competition in his industry and their un- derlying causes, he can identify his company's strengths and weaknesses. The crucial strengths and weaknesses from a strategic standpoint are the com- pany's posture vis-a-vis the underlying causes of each force. Where does it stand against substitutes? Against the sources of entry barriers?

Then the strategist can devise a plan of action that may include (1) positioning the company so that its capabilities provide the best defense against the

competitive force; and/or (2) influencing the bal- ance of the forces through strategic moves, thereby improving the company's position; and/or (3) an- ticipating shifts in the factors underlying the forces and responding to them, with the hope of exploit- ing change by choosing a strategy appropriate for the new competitive balance before opponents recognize it. I shall consider each strategic approach in turn.

Positioning the company

The first approach takes the structure of the indus- try as given and matches the company's strengths and weaknesses to it. Strategy can he viewed as building defenses against the competitive forces or as finding positions in the industry where the forces are weakest.

Knowledge of the company's capabilities and of the causes of the competitive forces will highlight the areas where the company should confront com- petition and where avoid it. If the company is a low- cost producer, it may choose to confront powerful buyers while it takes care to sell them only products not vulnerable to competition from substitutes.

The success of Dr Pepper in the soft drink in- dustry illustrates the coupling of realivStic knowledge of corporate strengths with sound industry analysis to yield a superior strategy. Coca-Cola and Pepsi- Cola dominate Dr Pepper's industry, where many small concentrate produeers compete for a piece of the action. Dr Pepper chose a strategy of avoiding the largest-selling drink segment, maintaining a nar- row flavor line, forgoing the development of a cap- tive bottler network, and marketing heavily. The company positioned itself so as to be least vulner- able to its competitive forces while it exploited its small size.

In the $11.s billion soft drink industry, barriers to entry in the form of hrand identification, large- scale marketing, and aceess to a bottler network are enormous. Rather than accept the formidable costs and scale economies in having its own bottler net- work—that is, following the lead of the Big Two and of Seven-Up—Dr Pepper took advantage of the different fiavor of its drink to "piggyback" on Coke and Pepsi bottlers who wanted a full line to sell to customers. Dr Pepper coped with the power of these buyers through extraordinary service and other efforts to distinguish its treatment of them from that of Coke and Pepsi.

Many small companies in the soft drink business offer cola drinks that thrust them into head-to-head competition against the majors. Dr Pepper, however.

144 Harvard Business Review March-April 1979

maximized product differentiation by maintaining a narrow line of beverages built around an unusual flavor.

Finally, Dr Pepper met Coke and Pepsi with an ad- vertising onslaught emphasizing the alleged unique- ness of its single flavor. This campaign built strong brand identifieation and great customer loyalty. Helping its efforts was the fact that Dr Pepper's formula involved lower raw materials cost, which gave the company an absolute cost advantage over its major competitors.

There are no economies of scale in soft drink concentrate production, so Dr Pepper could prosper despite its small share of the business (6%). Thus Dr Pepper confronted competition in marketing but avoided it in product line and in distribution. This artful positioning combined with good imple- mentation has led to an enviable record in earnings and in the stock market.

Influencing the balance

w h e n dealing with the forces that drive industry competition, a company can devise a strategy that takes the offensive. This posture is designed to do more than merely cope with the forces themselves; it is meant to alter their causes.

Innovations in marketing can raise brand identifi- cation or otherwise differentiate the product. Capi- tal investments in large-scale facilities or vertical in- tegration affect entry barriers. The balance of forces is partly a result of external factors and partly in the company's control.

Exploiting industry change

Industry evolution is important strategically because evolution, of course, brings with it changes in the sources of competition I have identified. In the familiar product life-cycle pattern, for example, growth rates change, product differentiation is said to decline as the business becomes more mature, and the companies tend to integrate vertically.

These trends are not so important in themselves; what is critical is whether they affect the sources of competition. Consider vertical integration. In the maturing minicomputer industry, extensive verti- cal integration, both in manufaeturing and in soft- ware development, is taking place. This very signif-

icant trend is greatly raising economies of scale as well as the amount of capital necessary to compete in the industry. This in t u m is raising barriers to entry and may drive some smaller competitors out of the industry once growth levels off.

Obviously, the trends carrying the highest prior- ity from a strategic standpoint are those that affect the most important sources of competition in the industry and those that elevate new causes to the forefront. In contract aerosol packaging, for exam- ple, the trend toward less product differentiation is now dominant. It has increased buyers' power, low- ered the barriers to entry, and intensified compe- tition.

The framework for analyzing competition that I have described can also be used to predict the even- tual profitability of an industry. In long-range plan- ning the task is to examine each competitive force, forecast the magnitude of each underlying cause, and then construct a composite picture of the likely profit potential of the industry.

The outcome of such an exercise may differ a great deal from the existing industry structure. To- day, for example, the solar heating business is pop- ulated by dozens and perhaps hundreds of com- panies, none with a major market position. Entry is easy, and competitors are battling to establish solar heating as a superior substitute for conven- tional methods.

The potential of this industry will depend largely on the shape of future barriers to entry, the im- provement of the industry's position relative to sub- stitutes, the ultimate intensity of competition, and the power captured by buyers and suppliers. These eharaeteristics will in turn he influenced by such factors as the establishment of brand identities, sig- nificant economies of scale or experience curves in equipment manufacture wrought by teehnological ehange, the ultimate capital costs to compete, and the extent of overhead in production facilities.

The framework for analyzing industry competi- tion has direct benefits in setting diversification strategy. It provides a road map for answering the extremely difficult question inherent in diversifica- tion decisions: "What is the potential of this busi- ness?" Combining the framework with judgment in its application, a company may be able to spot an industry with a good future before this good future is refiected in the prices of acquisition candidates.

2. Theodore Levitt, "Marketing Myopia," reprinted as an HBR Classic, Sepicmber-Ociiibci iy7s, p. 16.

Competition shapes strategy 145

Multifaceted rivalry

Corporate managers have directed a great deal of attention to defining their businesses as a crucial step in strategy formulation. Theodore Levitt, in his classic i960 article in HBR, argued strongly for avoiding the myopia of narrow, product-oriented in- dustry definition.- Numerous other authorities have also stressed the need to look beyond product to function in defining a business, beyond national boundaries to potential international competition, and beyond the ranks of one's competitors today to those that may become competitors tomorrow. As a result of these urgings, the proper definition of a eompany's industry or industries has become an endlessly debated subject.

One motive behind this debate is the desire to ex- ploit new markets. Another, perhaps more impor- tant motive is the fear of overlooking latent sources of competition that someday may threaten the in- dustry. Many managers concentrate so single-mind- edly on their direet antagonists in the fight for mar- ket share that they fail to realize that they are also competing with their customers and their suppliers for bargaining power. Meanwhile, they also neglect to keep a wary eye out for new entrants to the eon- test or fail to recognize the subtle threat of sub- stitute produets.

The key to growth—even survival—is to stake out a position that is less vulnerable to attack from head- to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buy- ers, suppliers, and substitute goods. Establishing such a position can take many forms—solidifying relationships with favorable customers, differentiat- ing the product either substantively or psychologi- cally through marketing, integrating forward or backward, establishing technological leadership.^