Porter's Five Forces and PESTLE analysis

What decides how profitable an industry is?

Porter’s Five Forces is a framework for the structure of an industry, and structure determines its long-run returns on invested capital. If some or all of the forces are intense, almost no company earns an attractive return. If they are benign, the industry is highly profitable.

The survey in the previous lesson measured profitability. The forces explain why it is what it is, point to what to monitor, and give a first estimate of likely profitability for a new industry that has no history. The assessment is qualitative and there is no threshold that says a force is strong. Analysts decide which one or two matter most, often by testing scenarios on people who know the industry well: if the market leader put its prices up sharply, would its customers stay? If many would leave, look hard at customer power and substitutes.

Industry structureintense forces mean low returns on capital; benign forces mean high returns

• Threat of new entrants Memorize weak when entry is hard
  • Few recent entrants history of entry is a clue
  • Network effects, economies of scale and scope a newcomer starts small and costly
  • Brand loyalty and switching costs customers stay put
  • Control of inputs or customer access distribution, shelf space
  • Government policy licenses, patents, heavy regulation
• Threat of substitutes Memorize different product, same job
  • Cheaper alternative for the same need raises the threat
  • Customers can go without deferrable purchases raise the threat
  • Substitute improving fast raises the threat
  • Hard to switch lowers the threat
• Bargaining power of customers Memorize strong customers push prices down
  • Few, concentrated buyers raises their power
  • Standardized product raises their power
  • Large share of the customer budget raises their power
  • Product critical to the customer lowers their power
  • Can backward-integrate build instead of buy
• Bargaining power of suppliers Memorize strong suppliers push input costs up
  • Few, concentrated suppliers raises their power
  • Costly to switch supplier raises their power
  • Specialized or scarce inputs such as skilled, licensed labor
  • Substitutes for the supplier’s product lower their power
• Rivalry among existing competitors Memorize the intensity of competition, shaped by the other four
  • History of price competition raises rivalry
  • Many roughly equal-sized rivals raises rivalry
  • Undifferentiated products raise rivalry
  • High exit barriers weak firms stay and keep competing
  • Slow industry growth firms fight for share

How strong is the threat of new entrants?

The threat of new entrants is weak when it is hard for a newcomer to get started and win customers. Look for these barriers:

• Few recent entrants. Dozens of new coffee roasters opening each year says something very different from almost no new oil refineries being built.
• Network effects : the product is worth more to each user as the number of users grows, so a newcomer starts with a low-value product. A payment network that connects millions of shoppers and merchants is a typical case.
• Economies of scale : large fixed costs spread over high volume, so a newcomer needs time and losses to reach competitive costs. A cement plant, with its kilns and quarry permits, needs hundreds of millions in capital.
• Economies of scope : sharing costs or attracting customers across several business lines, such as a telecom company selling broadband, mobile and TV over one network to the same households.
• Brand loyalty, backed by laws that protect trademarks and other intangibles.
• Switching costs : the time, training or replacement cost to a customer of changing provider. Payroll software wired into a firm’s accounting and HR systems is hard to leave; a ride-hailing app is not.
• Control of inputs or of the customer interface, such as shelf-space agreements and owned distribution.
• Government policy: licenses, patents, subsidies for domestic firms, and regulation that only large companies can afford.

Experience and expertise are not lasting barriers: entrants can hire staff, copy methods, buy from the same suppliers and hire consultants.

How strong is the threat of substitutes?

The threat of substitutes comes from a different product that does the same job, which is what separates it from a rival. The threat is higher when a cheaper alternative meets the same need, when customers can simply go without (an elective purchase can be postponed), when the substitute is improving, and when switching is easy. Timber and steel frames can replace some concrete in buildings, e-books replace some printed books, and an electric scooter can replace a short taxi ride.

How strong are customers and suppliers?

Bargaining power of customers is higher when buyers are few and concentrated, the product is standardized, the product is a large part of their budget (they shop around), and they can integrate backward (backward integration means making for themselves what they buy). It is lower when the product is critical and cheap relative to the cost of failure. A few large construction groups buying most of a region’s cement are strong customers.

Bargaining power of suppliers is higher when suppliers are few and concentrated, switching supplier is costly, suppliers are differentiated or specialized (for example credentialed labor), and there are no substitutes for what they sell. Energy is a large, volatile input for cement, so energy suppliers matter.

Strong customers push selling prices down. Strong suppliers push input costs up. Either one reduces the industry’s profit.

How intense is the rivalry among competitors?

Rivalry among existing competitors is the visible result of the other forces plus its own drivers. It is higher with a history of price competition, with many roughly equal-sized firms, with undifferentiated products, with high exit barriers (weak firms stay and keep competing) and with slow industry growth. Airlines on a busy route often match each other’s fare cuts within hours, because an empty seat earns nothing. When a third fiber network reaches a town, broadband prices usually fall for every provider, since the service is much the same.

What are the outside influences on growth?

PESTLE analysis looks outside the industry at six types of influence. It identifies themes that investors may want exposure to or avoidance of, such as an aging population or a carbon tax.

PESTLE analysislooks outside the industry; identifies themes to monitor

• Political Memorize fiscal and monetary policy, government buying, regulation, geopolitics
• Economic Memorize GDP, income, inflation, interest rates, exchange rates
• Social Memorize demographics, culture, lifestyle, consumer trends
• Technological Memorize sustaining and disruptive innovation
• Legal Memorize the rules of the road: courts, laws, regulation of practices
• Environmental Memorize low-carbon transition, waste and land rules, protections

Influence	Examples	Matters most for
Political	fiscal and monetary policy, government buying, regulation, geopolitics	energy, healthcare, defense
Economic	gross domestic product (GDP), income, inflation, interest rates, exchange rates	cyclical sectors, multinationals
Social	demographics, health trends, tastes, lifestyle	consumer products
Technological	new products and processes, substitutes	almost every industry
Legal	competition law, product liability, protection of intellectual property	tobacco, cannabis, pharmaceuticals, technology
Environmental	climate rules, carbon prices, waste and land-use rules	energy, airlines, utilities, autos

Economic influences may follow the business cycle or be structural, such as differences in population and productivity growth across countries. Social influences matter more for consumer-facing industries, and companies can shape them through advertising. Legal influences are the often subtle rules of the road, and they overlap with political and environmental ones.

Technology has a distinction that matters. Sustaining and disruptive innovation are two different things. A sustaining innovation improves performance or adds features without changing the basic function, and incumbents usually lead it. A disruptive innovation brings a very different value proposition, often at first for customers the incumbents ignore, and most often comes from newcomers with no profitable business to protect. Incumbents then face the innovator’s dilemma: invest in the disruption and speed the decline of their own business, or ignore it and lose share while profits are still good.

Five Forces versus PESTLE. Five Forces look inside the industry and explain profitability. PESTLE looks outside and explains growth and shifts in market share. A shift toward plant-based diets is invisible in the five forces yet crucial for the growth of meat-substitute makers. External influences change slowly, so the analysis is not redone every quarter, and a handful of influences usually dominate for any one industry.

Exam tip A competitor’s new product, a customer buying a supplier, a rival’s price promotion: those are competitive moves inside the industry (Five Forces). A new tax, a demographic shift, a regulation under discussion: those are outside influences (PESTLE).

Go deeper Network effects as an entry barrier

Take a card payment network. A shop accepts a card only if many shoppers carry it, and shoppers carry the card that many shops accept. A new network must solve both sides at once, so even a better or cheaper product struggles to reach the scale at which it becomes useful. The barrier is not capital alone but the value that arrives only with users.

Go deeper Why fixed costs and perishable capacity intensify rivalry

When most costs are fixed and capacity cannot be stored (an empty airline seat or an idle cement kiln earns nothing), any sale at a price above the variable cost adds to profit. Every producer is tempted to cut price to fill capacity, and rivals have to follow. If products are also identical, price is the only lever left, and the whole industry’s margin drops.

Go deeper A rule can move two forces at once

Suppose a new rule requires every gym to install costly air-filtration systems but does not cover home-fitness apps. It raises the cost of opening a gym, which lowers the threat of new gym entrants, and it makes the apps relatively cheaper, which raises the threat of substitutes. Effects on rivalry can therefore go both ways. Ask which force each part of a change touches, one by one.