Five Competitive Forces

The five competitive forces determine industry profitability and attractiveness. These forces are important in shaping the prices that firms can charge, the costs they have to bear, and the required investments to compete in the industry.

Value Chain Analysis

Competitive advantage grows out of the way as firms organize and perform discrete activities. The activities performed when competing in a particular industry can be grouped into categories, as these activities can be divided broadly into primary activities and support activities. Primary activities are those involved in the ongoing production, marketing, delivery, and servicing of the product. Whereas support activities are those that provide purchased inputs, technology, human resources or the overall infrastructure functions supporting the other activities. Every activity employs purchased inputs, human resources, some combination of technologies, and draws on firm infrastructure such as general management and finance. Activities vary in their importance vis-ŕ-vis competitive advantages from industry to industry.

All activities contribute to buyer value. Hence, firms create value for their buyers through such activities. The ultimate value a firm creates is measured by the amount buyers are willing to pay for the product or service offered. A firm is profitable if this value exceeds the collective cost of performing the required activities. To gain competitive advantage over its rivals, a firm must either provide comparable buyer value, but perform activities more efficiently than its competitors (lower cost), or perform activities in a unique way that creates greater buyer value and commands a premium price (differentiation).

Firms gain competitive advantage by conceiving of new ways to conduct activities, employing new procedures, new technologies, or different inputs. A firm is more than the sum of its activities. The value chain of a firm is an interdependent system or network of activities, connected by linkages. Linkages occur when the way in which one activity is performed affects the cost or effectiveness of other activities. Linkages often create trade-offs in performing different activities that must be optimized. For example, a more costly product design, more expensive components, and more thorough inspection can reduce after-sale service costs. A firm must resolve such trade-offs, in accordance with its strategy, to achieve competitive advantage. Thus, strategy guides the way a firm performs individual activities and organizes its entire value chain.

Linkages also require that activities are coordinated. The coordination of linked activities reduces transaction costs, allows better information for control purposes, and substitutes costly operations in one action with less costly ones elsewhere. Coordinating linked activities is also an important way to reduce the time required to perform them, which is increasingly important to ensuring competitive advantage. Careful management of linkages can be a decisive source of competitive advantage.

However, it is noteworthy that creating competitive advantage requires the management of the value chain as a system rather than a collection of separate parts. Reconfiguring the value chain by relocating, reordering, regrouping, or even eliminating activities is often at the root of a major improvement in competitive position.

In brief, the value chain provides a tool for understanding the sources of cost advantage. A firm’s cost position represents the sum of all costs incurred for performing all the required activities relative to competitors. Cost advantage can occur in any activity. Nevertheless, many managers reveal shortsightedness in viewing costs, and concentrate mostly on manufacturing. Successful cost leaders, however, are often low-cost product developers, low-cost marketers, and low-cost service providers. They draw cost advantage from the entire value chain. Gaining cost advantage usually requires optimizing the linkages among activities, as well as close coordination with suppliers and distribution channels. The value chain also exposes sources of differentiation.

Cluster Map

Clusters are geographic concentrations of interconnected firms and institutions in a particular field. Clusters encompass an array of linked industries and other entities that are important to competition. They include, for example, suppliers of specialized inputs such as components, machinery, services, and providers of specialized infrastructure. Quite often, clusters also extend downstream to channels and customers and laterally to manufacturers of complementary products and to firms in industries related by skills, technologies, or common inputs. Finally, many clusters include governmental and other institutions such as; universities, standards-setting agencies, think tanks, vocational training providers, and trades associations, which provide specialized training, education, information, research, and technical support.

The cluster map specifies all related and supporting elements of major industries. In addition, it illustrates the linkages between such elements, whether strong or weak, and indicates absent industries. The cluster analysis provides a pattern for understanding how major industries conduct their business and the way they compete, whilst simultaneously complementing and supporting one another.

Clusters encompass one facet of the diamond, but are best seen as a manifestation of the interactions between all four facets. Clusters affect competition in three broad ways: (1) by increasing the productivity of constituent firms or industries; (2) by increasing their capacity for innovation and thus the growth of productivity; and (3) by stimulating new business formation that supports innovation and expands the cluster. Many cluster advantages rest on external economies or spillovers across firms and industries of various sorts. A cluster is thus a system of interconnected firms and institutions whose entirety is more than the sum of its parts.

Normally clustering is revealed in the depth and breadth of clusters, most prominent in advanced economies. In developing economies, greater proportions of industries are locally based or consist largely of foreign subsidiaries serving the local market. Exporting industries tend to be resource-intensive, or those that produce labor–intensive products. Clusters in developing economies tend to be shallow and rely primarily on foreign components, services, and technology. Often firms are forced to integrate vertically. Not only may firms have to produce their own components but they may also have to generate back-up electricity, start their own schools, and build and operate infrastructure.

The development of well-functioning clusters is one of the essential steps in moving towards an advanced economy. Cluster formation in developing economies is impeded by local education and skill levels, weaknesses in technology, lack of access to capital, and poorly developed institutions. In addition, government policy usually works against cluster formation. Industrial location restrictions and subsidies spread firms out artificially. Universities and technical schools' curricula are centralized, and fail to meet cluster needs. Finally, the monopolistic behavior of firms protected from competition retards the cluster development.