Narrator: Listen to part of a lecture in a business management class.
Professor: OK, let’s begin—there’s a lot to cover today. Last week, we talked about different frameworks for strategic decision-making. We mentioned PESTEL, which is an acronym that stands for “political, economic, social, technological, environmental, and legal” factors. This is a kind of a laundry list of external factors, meaning factors that arise outside of a company, that shape business opportunities and therefore strategic decision-making. Next, we talked about SWOT analysis, which stands for “strengths, weaknesses, opportunities, and threats.” SWOT takes into account both internal factors—the strengths and weaknesses of a company—and external ones—the opportunities and threats.
What we did not get into last week is Michael Porter’s Five Forces. This is probably the most well-known strategic framework used in business today. It was published in 1979, in the Harvard Business Review, and has radically changed the way executives think about competitiveness in their industries. We are going to spend a while talking about this framework, because it is so commonly used.
The five forces: bargaining power of suppliers… bargaining power of customers… the threat of new entrants… the threat of substitute products or services… and competitive rivalry. Basically, what Porter said is that these five forces dictate the level of competitiveness in any industry. They are all essential components of an industry landscape for any business executive to understand, before making any strategic decisions. Stamp these forces into your memory! OK. Let’s start by talking about the two “bargaining” forces.
When either suppliers or buyers hold a powerful position, it leads to increased competitiveness. For example, think about Walmart. For most mainstream consumer goods companies, Walmart will be a buyer for your products. It is a massive company, will purchase your goods in very large quantities, and therefore will be able to dictate the terms of pricing and delivery much more than, say, a thousand mom-and-pop shops that all buy their product from you. Likewise, if a supplier produces a unique product that your company needs, or has a dominant market share, that supplier can exert a lot of pricing pressure on your company. Powerful suppliers or buyers increase competition in your industry, and this reduces your profitability.
Now, let’s look at the threats. The threat of new entrants. Let’s say, for example, that your company makes a product that has patent protection. This will create something known as a “barrier to entry” from competitors. In other words, it will be difficult for a competitor to enter the market and fill the demand that your product fulfills. Now, patents can be circumvented, but still, it provides something of a barrier—a, a form of protection—against aggressive competition. Other things can be barriers to entry, like government regulation or high fixed costs to begin operations. Or, what’s called “economies of scale,” which means that production costs decrease the bigger a company gets. Any of these barriers to entry tend to decrease competition and improve profits. A lack of barriers means that strong profits will not last very long, because new competition will quickly enter the market.
Next, the threat of substitutes. So, a simple example here. Let’s say you own a company that has a very profitable business producing extremely high-quality butter. Never mind other butter manufacturers—just assume for a moment that your company produces the world’s best butter, and also has an insurmountable barrier to entry. OK? This should be great for your company’s bottom line, right? Really strong profits? Well, maybe. But, consider this—people aren’t going to pay a ridiculous amount of money for your butter. Why? Because at some point, they will just switch to a different product instead. A substitute product. Maybe olive oil… maybe heavy cream… maybe even soy milk. It just depends on what the butter is used for. There is a reasonable substitute for practically every use of butter. So your ability to raise prices, and thereby generate large profits, is limited. Now, contrast this with, say, a company that has developed a life-saving drug. No other drug has the same effectiveness—in that case, there are no reasonable substitutes. So while the world’s best butter manufacturer will hit a limit, the drug manufacturer—assuming it has proper barriers to entry—will be able to charge just about anything for this drug. I mean, what people are going to skimp on paying for a drug that will save their own lives?
We’re almost out of time. So, next time we will discuss competitive rivalry—which is fine, because that topic is important enough to merit an entire lecture. Competitive rivalry simply refers to the degree to which existing companies in an industry compete with each other. So, for next time, think of an industry in which competitive rivalry is very high. And think of one in which competitive rivalry is relatively low. We will share these examples next week, and talk about factors that can cause an industry to have very high or very low competitive rivalry.
|
What is the main topic of this lecture? |
Gist-content. The lecture primarily focuses on Porter’s Five Forces, a framework for strategic analysis of an industry and competitive decision-making. |
|
| ✗ | A How to improve bargaining power with suppliers and buyers |
Bargaining power of suppliers and buyers are two of the five forces, but this is only a subset of what’s covered in the lecture. Also, Porter’s Five Forces is more focused on understanding bargaining power dynamics, rather than improving them. |
| ✗ | B How to create barriers to entry |
While barriers to entry can be very helpful for protecting a company’s profitability, this is not the main focus of the lecture. Also, Porter’s Five Forces is more focused on understanding barriers to entry, rather than creating them. |
| ✗ | C How to eliminate substitute products from the marketplace |
The threat of substitutes is one of the five forces, but this only a subset of what’s covered in the lecture. Also, Porter’s Five Forces is more focused on understanding substitutes, rather than eliminating them. |
| ✓ | D How to analyze industry dynamics for strategic decision-making |
Correct. This encompasses all of the topics discussed in the lecture. |
|
According to the professor, what might be two sources of barriers to entry? Choose 2 answers. |
Detail. In the middle of the lecture, the professor discusses a number of sources of barriers to entry, including government regulation, high fixed costs to begin operations, and patent protection. |
|
| ✗ | a A lack of pricing coordination among suppliers |
Suppliers are not mentioned in the lecture as having anything to do with barriers to entry. |
| ✓ | b Patent protection |
Correct. The professor mentions this as a possible barrier to entry. |
| ✗ | c A high degree of competitive rivalry |
Competitive rivalry is one of Porter’s Five Forces, but is not mentioned in the lecture as having anything to do with barriers to entry. |
| ✓ | d High fixed costs to begin operations |
Correct. The professor mentions this point in the lecture. |
|
Why does the professor talk about Walmart? |
Organization. The professor mentions Walmart as a very large retailer that will be a powerful buyer for many products that companies produce—particularly consumer products. This will enable Walmart to exert heavy influence on companies that it buys from. |
|
| ✗ | A To emphasize the importance of selling to large retailers |
This idea is not mentioned anywhere in the lecture. |
| ✓ | B To provide an example of a buyer with significant bargaining power |
Correct. Because Walmart will purchase such a large amount of any product it carries, it can exert significant pressure on manufacturers. |
| ✗ | C To illustrate the difference between a supplier and a buyer |
This is not the reason Walmart is mentioned in the lecture. |
| ✗ | D To give an example of a company with significant barriers to entry |
While barriers to entry are discussed in the lecture, this is not the reason Walmart is mentioned. |
|
In the discussion of barriers to entry, what does the professor imply about new competitors when barriers to entry are low? |
Inference. The professor states that “barriers to entry tend to decrease competition and improve profits. A lack of barriers means that strong profits will not last very long, because new competition will quickly enter the market.” The implication is that the new entrants reduce profitability in the market, presumably by reducing pricing. |
|
| ✗ | A They will tend to avoid entering a market that has low barriers to entry. |
The opposite is true. The professor states that new competition will enter a market when barriers to entry are low. |
| ✗ | B They will deliver a product that is superior to the original. |
This idea is not mentioned or implied in the lecture. |
| ✓ | C They will reduce the potential profitability for companies in the market they enter. |
Correct. This professor says that “strong profits will not last very long, because new competition will quickly enter the market.” This implies that the new competition will cause reduced profit potential for everyone in the market. |
| ✗ | D They will seek to develop new barriers to entry, often by seeking patent protection. |
This idea is not mentioned or implied in the lecture. |
|
What is the professor’s point when she discusses the example of the butter manufacturer? |
Organization. The professor grants this hypothetical butter manufacturer strong market position and barriers to entry, but notes that profit making potential will be limited because of the existence of substitute products. |
|
| ✗ | A Even the simplest products can sometimes produce strong profits. |
While this may be the case, this idea is not discussed in the lecture. |
| ✗ | B Threats from new entrants and substitute products are less important than the degree of competitive rivalry. |
The professor directly states that threats from new entrants and substitute products are important, and is using the butter manufacturer example to illustrate the threat of substitutes. |
| ✗ | C It is often difficult to make strong profits without patent protection. |
While patent protection often leads to barriers to entry, that is not the purpose of the discussion of the hypothetical butter manufacturer. |
| ✓ | D The threat of substitutes by itself can limit a business’s profit-making potential. |
Correct. The professor assumes very strong market position and barriers to entry for this butter manufacturer, but states: “There is a reasonable substitute for practically every use of butter. So your ability to raise prices, and thereby generate large profits, is limited.” |
Narrator: Listen again to part of the lecture. Then answer the question.
Professor: So while the world’s best butter manufacturer will hit a limit, the drug manufacturer—assuming it has proper barriers to entry—will be able to charge just about anything for this drug. I mean, what people are going to skimp on paying for a drug that will save their own lives?
Narrator: What does the professor mean when she says this:
Professor: I mean, what people are going to skimp on paying for a drug that will save their own lives?
|
What does the professor mean when she says this? |
Function of What Is Said. In this quote, the professor delivers the point about substitute products threatening profit potential. The highlighted quote reinforces the idea that pricing power is much stronger for a life-saving drug than for a product like butter that has substitutes. |
|
| ✓ | A The drug manufacturer has significant pricing power due to its lack of substitutes. |
Correct. Because the drug fills an important need and has no realistic substitutes, very high prices for the drug can be charged. |
| ✗ | B Some people may balk at paying high prices for a drug, even if it does help save lives. |
In this case, the professor is asserting the exact opposite. She is saying that people will pay very high prices for a life-saving drug. |
| ✗ | C Some people may be more interested in helping others than saving their own lives. |
This is not the professor’s intention from this statement. |
| ✗ | D The drug manufacturer’s ability to charge high prices will be limited by its ability to create barriers to entry. |
The professor does make this caveat—she states that she’s assuming the drug maker has proper barriers to entry. However, this is not the main point of her statement. |