BUS303: Strategic Information Technology

The analysis of competitive conditions within an industry has dominated efforts to understand and develop firm performance. In summary, this approach says the following:

• We try to make profits by offering products for which customers will pay us more than the products cost us to provide.
• The more powerful our customers are, the more they can force us to cut prices, reducing our profitability.
• The more powerful our suppliers are, the more they can charge us for the inputs we need, again reducing our profitability.
• If we do manage to make profits, our success will attract the efforts of competitors, new entrants, and providers of substitutes, who will all try to take business away from us, yet again depressing our profitability.

These five forces - buyers, suppliers, rivals, new entrants, and substitutes - thus explain something of industries' ability to sustain profitability through time.

The impact of Netflix on Blockbuster is a classic example of the five forces at work, made possible by the increasing availability and usage of the Internet. The arrival of Netflix allowed consumers to switch to its lower price service from Blockbuster.

In other markets too, e-businesses can offer valuable products at very low cost by eliminating substantial costs associated with conventional supply chains, resulting in attractive profit margins. Buyers face few switching costs in taking up these alternatives. By getting very big very fast, the new providers establish buying power over their own suppliers and erect barriers against would-be rivals. The established suppliers are the substitutes, whose brick-and-mortar assets weigh them down and prevent them from competing in the new business model.

Unfortunately, the five forces framework also describes quite neatly why most such initiatives are doomed. Buyers who are able to switch to the new offering face very low barriers to switching among the host of hopeful new providers, and do so for the slightest financial incentive. The new business model is often transparent, requiring little investment in assets, so rivals and new entrants can quickly copy the offering. Worst of all, many enterprises see the same opportunity for the same high returns from the same business models, so there is a rush of new entrants. Anticipating hefty future profits, many give away more than the margin they ever expected to make, in the hope that, as the last survivor, they will be able to recapture margin in later years.

We saw the five forces at work again in the fiasco of the subprime lending boom of 2003–2007 that brought the world's banking system to its knees. Someone spotted the opportunity to lend money for home purchases to people whose income levels or credit ratings were low. A fraction of these borrowers would likely default on these mortgages, but that was OK because the much higher interest that was charged to these borrowers would give sufficient income to cover those losses and more.

There was no way to keep this new business opportunity a secret, and nothing about it was hard for bank after bank to copy. New entrants to the market intensified competition, but in this case rivalry took the form not of lower prices but acceptance of increasingly risky customers. Ultimately, the total rate of defaults experienced by the subprime mortgage providers was not sufficiently covered by the high interest rates charged, and profitability collapsed. This whole sorry episode was made worse by banks' packaging up of these toxic debts and selling them on to other institutions that did not appreciate the true risk, but fundamentally the whole edifice was built on appallingly bad strategic management.