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The Surprising Truth About Competition

Some of the things you learn you you apply a little science to the general beliefs that we held as true are that sexy industries are not high profit industries. For instance airlines industry it’s a sure way to become a millionaire, if you start as a billionaire. So don’t go there is risky. Also you’ll learn that high growth does not mean necessarily high profit. Watch the personal computer industry.

Also you’ll be happy to hear that relatively low-growth industries can be very profitable, and I’ll explain soon why. But, before going back to the text books also let’s express another not so surprising truth: with appropriate competitive positioning firms can mitigate negative market forces and make healthy earnings. And, with this, let’s see wha theory says and why common sense fails us in this regard.

Michael Porter defined the Five Forces Theory that allows us to assess the complex market environment, understand why some industries are more profitable that other, help us with entry and exit decisions, shows how positioning a company to deal with threats is possible and shapes a more favorable industry structure.

But let’s see these forces first:

  1. barriers to entry – Is it easy to start a business in that particular industry? Do you need a huge capital to start? Are there patent rights to stop you?
  2. threat of substitutes (not a direct rival) – What else can buy a customer if you don’t sell? That is, if they don’t come to your Gym what other they can do? And there are a lot of options here: walk, swim, go for a beer, and so on.
  3. bargaining power of suppliers – Can your supplier afford losing you as a client because they wanted to raise price? That is, are they selling commodities or rare goods? Do they have a monopoly or you can find a lot of other sellers,
  4. bargaining power of customers – Can your customers drive your offer in terms of prince and quality? Is there a way to choose between many offers looking more or less the same and having the same value?
  5. rivalry among existing competitors – There is always a problem when competitors engage in price-wars. Yes there is a good rivalry in terms of creativity that drives growth for competitors, bit existing rivalry will be a problem.

But, how can we apply this? First of all if you use this method on evaluating two industries, say airline and pharmaceutical, you’ll immediately see some big differences, and understand why airline industry is so difficult and why pharmaceutical industry is such a great industry even the barriers to entry are so high.

And, all this, because – again this is counterintuitive – competition has to be imperfect for companies to win. That is the winners are those who understand the above mentioned forces and use them to improve business strategy and execution, reversing the assumptions of perfect competition that translate into maximum welfare and zero economical profit.

Perfect competition assumes that there is free entry and exit form the market,  there are many buyers and seller (of relatively small or equal size), there is complete information about goods and services, homogenous goods are sold and each firm maximizes profit. So, knowing how to make competition not perfect, will ensure you the so precious competitive advantage.