Any business school graduate has probably had a healthy dose of Michael Porter’s Five Forces, and for good reason. The framework is a great way to look at the competitive landscape. Porter’s framework is designed to look at the competitiveness of a particular industry, as opposed to companies within that industry. For example, you might use the framework to determine the attractiveness of starting a soft drink company, as opposed to investing in PepsiCo versus The Coca-Cola Company. We’ve provided a broad overview of the tool in the past, but we’ve recently been taking time to look at each individual force in greater detail. Today, we’re diving deeper in the threat of new entrants.
Who’s Poised to Enter Your Market?
We previously looked at competitive rivalry, and we noted that the threat of new entrants is easier to understand once you grasp competitive rivalry. Competitive rivalry is the level of competition among your existing competitors. But be careful. You might feel safe and comfortable with your market share relative to your existing competitors, but there is always the chance that new competitors could enter the fray.
These days technology drives must of that competition. Just think of the massive disruption currently taking place in the healthcare, education and financial services arenas as technology changes the service area for these industries from local to international.
Why Would New Entrants Want to Challenge You?
We’ll get to how easy or difficult it is for new competitors to enter your industry in a minute. But first, let’s think about why potential competitors might be tempted to enter your market. Obviously, businesses are primarily driven by their bottom line. So the biggest temptation for new entrants is when they see how profitable the existing players are. In a world where the largest businesses are typically publicly held corporations, it’s easy to find out what the profit margin and ROI are for most of the key players.
Profits are typically highest where competition is low and there is room for growth in market share. Think of the dot-com bubble of the 1990s. Companies were making huge profits, and with more and more people joining the Internet Age every year, it seemed like everyone with a computer and some programming knowledge was starting a tech company.
Barriers to Entry
Just because a company wants to enter your industry doesn’t mean it’ll be easy. There are a number of factors that can make an industry more or less vulnerable to new entrants. The most important of these can be lumped together as barriers to entry: factors that prevent or inhibit the ability of potential new entrants.
Some important barriers to entry include the following:
Government Regulation
Some industries, such as utilities, are effectively government-sanctioned monopolies. Because of large economies of scale, it doesn’t really make sense for there to be ten utilities operating in the same market, so the government may limit the number of entrants.
Similarly, patents are another form of government-sanctioned monopoly. When a pharmaceutical company develops a new drug, it has an exclusive right to that formula for years, effectively granting it a monopoly for that drug.
Capital Requirements
Sticking with the utility example for a minute, the large capital requirements to enter an industry will deter many potential competitors regardless of government protection. Just because you see a large utility making great returns year after year doesn’t mean it’s a worthwhile investment to put millions of dollars into building or buying a fleet of power plants with a huge upfront cost.
Switching Costs
Switching costs refer to the burden — financial or otherwise — a consumer faces when switching from one provider to another. The higher the switching costs, the less likely consumers will be willing to try a new provider and the higher the barriers to entry. Think of a multi-year service contract with a penalty for early cancellation. Sure, that new company might be offering a cheaper monthly rate and better quality service, but the penalty I have to pay for leaving my existing provider is too great to make it worth it. Similarly, for some services, it’s simply too time consuming and annoying to jump through all the hoops required to cancel your contract, even if there is no penalty. If the difference in cost or service is marginal, most consumers simply don’t think it’s worth it.
An industry with high barriers to entry — and therefore low threat of new entrants — and high profits is always going to be an attractive one. Companies that find themselves in these industries can enjoy reaping the benefits of their good business sense (or good fortune) while potential competitors look on enviously from the sidelines.
How are you positioned within your industry? What current, and potential, threats do you face from new entrants to your market?
Recommended Reading:
Best Practices in Influencer Marketing
Tags: competition, disruptive innovation, Porter's Five Forces, Strategy, threat of new entrants