Michael E. Porter's Competitive Strategy, originally published in 1980, is a definitive work on industry competition. In the book, the Harvard professor provides a framework for understanding competitor behavior and a firm's strategic positioning in its industry. Much of Porter's framework should be familiar as it underpins our thinking about economic moats.
In essence, Porter provided a framework of five forces that can be used to understand an industry's structure. Since firms strive for competitive advantage, the first four forces at work help to assess the fifth, an industry's level of rivalry:
- Barriers to Entry. How easy is it for new firms to start competing in a market? Higher barriers are better.
- Buyer (Customer) Power. Similar to switching costs, what keeps customers locked in or causes them to jump ship if prices were to increase? Lower power is better.
- Supplier Power. How well can a company control the costs of its goods and services? Lower power is better.
- Threat of Substitutes. A company may be the best widget maker, but what if widgets will soon become obsolete? Also, are there cheaper or better alternatives?
- Degree of Rivalry. Including the four factors above, just how competitive is a company's industry? Are companies beating one another bloody over every last dollar? How often are moats trying to be breached and profits being stolen away?
Porter's five forces considered together can help you to determine whether a firm has an economic moat. The framework is particularly useful for examining a firm's external competitive environment. After all, if a company's competitors are weak, it may not take much of a moat to keep them at bay. Likewise, if a company is in a cutthroat industry, it may require a much wider moat to defend its profits.
A Five Forces Example: Consumer Products >>