What are Porter's Five Forces and how are they used?

Michael Porter devised a framework called 'The Five Forces of competition' to classify and analyse the factors that determine the intensity and levels of competition in different industries.

The five forces include three sources of horizontal competition: competition from rivals already established in the industry, competition from substitute products and competition from potential new entrants in the industry; and two sources of vertical competition: the power of suppliers who provide the raw materials used by companies to produce their products and services and the power of buyers who decide to buy (or not) the companies' products.

Let's take the example of the chocolate industry and see how we can apply the Five Forces:

- rivalry among existing firms is High - there are many players in different segments of the industry, such as Mars, Mondelez International, Kraft, Ferrero, etc, so there is high competition.

- threat of new entrants is Low - there are already too many players in the industry and the capital requirements to enter would be high to acquire the necessary machinery and marketing power, this would mean low profit margins for new entrants, which would deter them from entering this industry.

- threat of substitutes is Medium - this threat depends on the importance consumers give to certain products and their ability/will of consumer to switch products. Even though I couldn't possibly substitute chocolate for anything else I know friends of mine could easily buy fruit or candy instead. This means this treat is only Medium for companies in the industry.

- the power of suppliers is High - the production of chocolate depends on one key ingredient (cocoa beans) that can't be found everywhere in the world, chocolate producers therefore depend on cocoa beans suppliers for their products, and should they go on strike, raise their prices or have a bad harvest season, the companies will suffer.

- the power of buyers is High - since the industry is so big and competitive and there are many buyers for chocolate products, most of whom are price sensitive and will switch from one brand to another if prices changes. Additionally, the more buyers there are the more bargaining power they have over the companies in the industry, forcing them to lower their prices or offer new products.

In conclusion, the five forces are 3 High, 1 Medium and 1 Low, so the chocolate industry can be considered to be Highly competitive.

See how easy this was? You have just used the Five Forces!

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