Porter’s Five Forces is a framework for industry analysis and business strategy that was formed by a Harvard Business School affiliate, Michael E. Porter in 1979. This framework is used for identifying the five structural determinants of intensity of competition and of profitability of firms in oligopolistic industries.
This paper will discuss these Five Forces in detail and apply all relevant microeconomic concepts to explore the relationship between Porter’s framework and the oligopolistic industries and its effects on today’s market.
Michael Porter’s Strategic Framework Michael Porter’s five forces that make up his proposed strategic framework include the threat from substitute products, the threat of entry, the bargaining power of buyers, the bargaining power of suppliers, and lastly, the intensity of rivalry among existing competitors. Because Porter’s references are in reference to oligopolistic industries, we must first start out by defining exactly what an oligopoly is. The definition given in the text Managerial Economics in a Global Economy by Dominick Salvatore states that Oligopoly as the form of market organization in which there are few sellers of a homogeneous or differentiated product. It further states that Oligopoly is the most prevalent form of market organization in the manufacturing sector of industrial nations, including the United States.
The five forces of Porter’s strategic framework represent strategic challenges facing firm managers as they seek to maximize profits in oligopolistic markets. The firm will earn higher than average industry profits if it does not face much of a threat from substitute products and from the entry of potential competitors, if buyers and suppliers do not exert much market power of the firm, and if there is low intensity of rivalry and competition among existing firms. Economics has showed us that if an organization raises its prices, the demand for substitute products will increase. In an oligopoly, if much of the market is owned by the oligopoly institutions, then there will not be much competition and therefore is not a concern in this area. Additionally, the greater the differentiation and uniqueness of a product the firm sells and the greater the brand loyalty of consumers for the firm’s product, the higher is the markup that the firm can apply and the greater the profits of a firm.
According to Porter, New entrants to an industry bring new capacity to desire to gain market share, and often substantial resources. To deter this, Porter states that there are six major sources of barriers to entry which are Economies of scale, Product differentiation, Capital requirements, Cost disadvantages independent of size, Access to distribution channels, and government policy. The potential rival’s expectation about the reaction of existing competitor also will influence its decision on whether or not to enter the market.
The Long-run Efficiency Implications of an Oligopoly Cost curves may differ under various forms of market organization. You can make a few generalizations to be interpreted cautiously. To begin, the perfectly competitive firm and the monopolistically competitive firm break even in long-run equilibriums. Therefore, consumers get the commodity at cost of production. However, the monopolist and the oligopolist can and usually do make profits in the long run. These profits may lead to more research and development and to faster technological progress and a rising standard of living in the long run.
A perfectly competitive firm in long-run equilibrium produces the output at which P=MC, the imperfectly competitive firm produces the output at which P exceeds MC. Therefore there is an under allocation of resources in these imperfectly competitive industries and a misallocation of resources in the economy. Meaning under any form of imperfect competition, the firm is likely to produce less and charge a higher price than in perfect competition. This difference is greater in pure monopoly and oligopoly than in monopolistic competition because of the greater elasticity of demand in monopolistic competition.
While the perfectly competitive firm produces at the lowest point on its LAC curve in long run equilibrium, the monopolistic and the oligopolistic are very unlikely to do so, and the monopolistic competitor never does. However, the size of the efficient operation is often so large in relation to the market that only a few firms are required in the industry. Perfect competition under such circumstances would either be impossible or lead to unaffordable high costs. Lastly, the waste resulting from excessive sales promotion is probably going to be zero in perfect competition, and larger in oligopoly competition.
Advantage and Disadvantage of the Oligopoly Market Structure
Some disadvantages of the Oligopoly market structure are as in monopoly, price usually exceeds LAC so that profits in oligopolistic markets can persist in the long run because of restricted entry, oligopolists usually do not produce at the lowest point on their LAC curve as perfectly competitive firms do, because the demand curves facing oligopolists are negatively sloped, P>LMC at the best level of output (except by the followers in a price leadership model by the dominant firm) and so there is an underallocation of the economy’s resource to the firms in an oligopolistic industry, and when oligopolists produce a differentiated product, too much may be spent on advertising and model changes. Some advantages of an oligopoly is that ologopolists spend a great deal of their profits on research and development, and many economists believe that this leads to much faster technological advance and higher standards of living than if the industry were organized along perfectly competitive lines. Also, advertising is useful because it informs consumers, and some product differentiation has economic value in satisfying different consumer’s tastes.
The Reason for the Rapid Spread of Global Oligopolists The formation of global oligopolies has accelerated as the world’s largest corporations have been getting bigger and bigger through internal growth and mergers according to Salvatore. Corporations are no longer satisfied with their status in the market place if they are not the leading organization in their industry or sector. The reason for the rapid spread of global oligopolists is simple, it’s because nobody wants to be left behind in a market that consistently evolving in areas of technology and globalization.
Summary In conclusion, this paper touched on several operating and marketing strategies of an oligopoly and Porter’s strategic framework. We’ve learned oligopolists generally spend too much on advertising and model changes. However, economies of scale make large-scale production and oligopoly inevitable in many industries and may even lead to more technological change than alternative forms of market organization. According to Salvatore, the sales maximization model postulates that oligopolistic firms seek to maximize sales after they have earned a satisfactory rate of profit to satisfy stockholders.