External analysis: industry structure and the five forces

Why do some industries earn high returns year after year while others struggle to cover their cost of capital? Average returns on invested capital differ widely across industries: software, branded consumer goods and some medical products have historically earned well above the cost of capital, while airlines, many commodity producers and restaurants have often earned below it. Differences in management matter, but so does the structure of the industry itself. This lesson builds the main tool for analysing industry structure, Porter's five forces, and connects it to the economics of market structure from ECON-101 lessons 9 to 11. BUS-220 lesson 2 covered the broader marketing environment and PESTEL; here we narrow the focus to the forces that set how much value an industry's firms can capture.

Defining the industry

Before analysing an industry you must define it, and the definition changes the answer. Is a ride-hailing service in the taxi industry, the urban transportation industry or the mobile platform industry? The useful test is substitution from the customer's point of view and from the producer's: which products do customers treat as close alternatives, and which firms could easily switch their capacity to serve the same customers? Define the industry too broadly and the analysis becomes vague; define it too narrowly and you miss the substitutes and entrants that will discipline prices. A practical approach is to start with the product and geographic scope where firms compete directly, and then treat neighbouring products as substitutes and neighbouring firms as potential entrants.

Geography matters as much as product. Cement and ready-mix concrete are local industries because transport costs limit how far a plant can ship; a cement plant's rivals are those within a few hundred kilometres. Software and financial information compete globally. Grocery retail is regional: a chain's competitors are the stores its customers can reach. Getting the geographic scope right is also central to competition law, which lesson 8 discusses for mergers.

The five forces

Porter's framework, first published in 1979 and refined in 2008, holds that the profitability of an industry depends on five forces: rivalry among existing competitors, the threat of new entrants, the threat of substitutes, the bargaining power of buyers and the bargaining power of suppliers. The stronger the forces, the more of the value created in the industry is competed away to customers or captured by suppliers, and the lower the average return. The framework is a structured way to ask where the profits in an industry go.

Rivalry among existing competitors

Rivalry is intense when competitors are numerous or roughly equal in size, when industry growth is slow so firms can grow only by taking share, when products are undifferentiated and switching costs are low, when fixed costs are high relative to variable costs so firms cut prices to fill capacity, when capacity must be added in large lumps, and when exit barriers such as specialized assets, labour agreements or government pressure keep losing firms in the market. Rivalry on price is the most damaging, because it transfers value directly to customers. Rivalry on product features, service or innovation can expand the market and may raise everyone's returns.

Concentration is one indicator. The concentration ratio CR4 is the combined market share of the four largest firms. The Herfindahl–Hirschman index (HHI) is the sum of the squared market shares of all firms, measured in percentage points, so it ranges from near zero for a fragmented industry to 10,000 for a monopoly. ECON-101 lesson 11 introduced the HHI for competition policy. A higher HHI suggests less intense rivalry, but concentration is not the whole story: a concentrated industry with high fixed costs and perishable capacity, such as airlines, can still have fierce price wars.

# Concentration of two invented industries (market shares, %)
industries = {
    "Industry A": [34, 28, 21, 9, 5, 3],
    "Industry B": [12, 10, 9, 8, 8, 7, 7, 6, 6, 5, 5, 5, 4, 4, 4],
}
for name, shares in industries.items():
    shares = sorted(shares, reverse=True)
    cr4 = sum(shares[:4])
    hhi = sum(s * s for s in shares)
    level = "highly concentrated" if hhi > 2500 else "moderately concentrated" if hhi > 1500 else "unconcentrated"
    print(f"{name}: firms={len(shares)} CR4={cr4}% HHI={hhi} ({level})")

Industry A: firms=6 CR4=92% HHI=2496 (moderately concentrated)
Industry B: firms=15 CR4=39% HHI=746 (unconcentrated)

The thresholds in the code follow the conventional US agency bands of the 2010 guidelines (below 1,500 unconcentrated, 1,500 to 2,500 moderately concentrated, above 2,500 highly concentrated); the 2023 US merger guidelines and the 2024 Canadian amendments use 1,800 as a key threshold for presuming harm from a merger, as lesson 8 explains. For industry analysis the precise cut-off matters less than the comparison and the trend.

The threat of new entrants

Profitable industries attract entry, and the threat of entry caps prices even if no entrant appears. Barriers to entry include economies of scale on the supply side (a new entrant must either come in large and risk a price war or come in small at a cost disadvantage), demand-side economies of scale or network effects (lesson 6), customer switching costs, capital requirements, access to distribution channels and shelf space, incumbency advantages unrelated to size such as patents, proprietary technology, favourable locations and brand reputation, government policy such as licensing, spectrum allocation or foreign ownership limits, and expected retaliation from incumbents. Lesson 3 examines how incumbents use pricing and capacity to deter entry.

Barriers are not permanent. Cloud computing lowered the capital needed to start a software company; online channels lowered the cost of reaching customers for consumer brands; reusable rockets changed the economics of launching satellites. When analysing entry, ask not only how high the barriers are today but which technologies or policy changes could lower them.

The threat of substitutes

A substitute performs the same or a similar function by a different means: video calls for business travel, plant-based drinks for dairy milk, streaming for cable television, home fitness apps for gyms. Substitutes place a ceiling on prices, because if the industry's price rises too far customers switch. The threat is high when the substitute offers an attractive price-performance trade-off and switching costs are low. Substitutes are easy to overlook because they come from outside the industry as normally defined, which is why careful industry definition matters.

The bargaining power of buyers

Powerful buyers force prices down, demand higher quality or more service, and play suppliers against each other. Buyers are powerful when they are few or buy in large volumes relative to a seller's sales, when the product is standardized, when switching costs are low, when buyers could credibly integrate backward and make the product themselves, when the product is a large share of the buyer's costs (so the buyer shops hard), and when the buyer's own profits are thin. Large retailers have strong power over many consumer-goods makers; automakers over parts suppliers; governments over defence contractors. Consumers individually have little bargaining power, but price sensitivity and easy comparison shopping online can have similar effects.

The bargaining power of suppliers

Powerful suppliers capture value by charging more, limiting quality or shifting costs onto the industry. Suppliers are powerful when they are more concentrated than the industry they sell to, when they do not depend heavily on the industry for revenue, when switching suppliers is costly, when they offer differentiated or unique inputs, when there are no substitutes for what they supply, and when they could integrate forward into the industry. Labour can be a powerful supplier: skilled workers in short supply, or unions in industries with high fixed costs, capture a share of value. The power of a few chip designers over device makers, of pilots' unions over airlines, and of a single specialized software vendor over hospitals are examples.

Complements and the role of government

Two refinements are widely used. First, complements, products that are more valuable together, affect industry profitability: smartphones and apps, electric vehicles and charging networks, printers and ink. Complements are not a sixth force in Porter's view, because their effect works through the other forces, but they deserve explicit analysis because firms can shape them. Second, government is not a force in itself but affects every force: licensing changes entry barriers, competition law limits rivalry-reducing agreements, procurement makes government a powerful buyer, and regulation can create or remove substitutes.

Applying the forces: Canadian wireless

Canadian wireless is a frequently discussed example. Three national carriers have historically held most subscribers, with a fourth national competitor strengthened after Quebecor acquired Freedom Mobile in 2023 as a condition of the Rogers–Shaw merger approval. Entry barriers are high: spectrum must be bought at auction, networks cost billions to build across a large territory, and customers are reluctant to switch. Substitutes such as Wi-Fi calling limit some uses but not mobility. Buyers are individually weak, though price comparison and regulatory pressure have grown. Suppliers of handsets and network equipment are concentrated globally. The result has been an industry with historically strong margins and frequent political debate about prices, with regulators using spectrum set-asides and mandated wholesale access to encourage competition. Shares and margins change, so treat any figures as a snapshot.

# A simple five-forces scoring sheet (1 = weak force, 5 = strong force)
# Weights reflect how important the analyst considers each force.
forces = {
    "Rivalry":            (4, 0.30),
    "Threat of entry":    (2, 0.20),
    "Substitutes":        (3, 0.15),
    "Buyer power":        (3, 0.20),
    "Supplier power":     (4, 0.15),
}
total_weight = sum(w for _, w in forces.values())
score = sum(s * w for s, w in forces.values()) / total_weight
for name, (s, w) in forces.items():
    print(f"{name:<18} score {s}  weight {w:.2f}  " + "#" * s)
print(f"Weighted force intensity: {score:.2f} out of 5")
print("Attractiveness:", "low" if score >= 3.5 else "moderate" if score >= 2.5 else "high")

Rivalry            score 4  weight 0.30  ####
Threat of entry    score 2  weight 0.20  ##
Substitutes        score 3  weight 0.15  ###
Buyer power        score 3  weight 0.20  ###
Supplier power     score 4  weight 0.15  ####
Weighted force intensity: 3.25 out of 5
Attractiveness: moderate

Scoring sheets like this are useful for organizing a discussion and comparing industries, but the numbers are judgements. The analytical value lies in the reasoning behind each score and in identifying which force is changing.

Using the analysis

Five-forces analysis is a starting point, not an answer. Use it to explain current profitability, to anticipate changes (for example, a new technology that lowers entry barriers or a merger among suppliers), to find positions where the forces are weakest, and to identify actions that could reshape the structure in your favour, such as building switching costs, standardizing complements or consolidating a fragmented industry. Common errors include treating the framework as a checklist that ends with a list of 'high' and 'medium' labels, ignoring the industry definition, analysing a whole economy rather than an industry, and forgetting that the forces change over time. Lesson 3 adds the dynamics: how rivals interact and how industries evolve.