How can cost leadership and differentiation be used to position a firm in the context of the five forces of competition in a way that helps it earn above-average returns?

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justaguide | College Teacher | (Level 2) Distinguished Educator

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Michael E. Porter's 5-force model is a framework that can be used by a firm to maximize profits. The factors that prevent a firm from earning above average returns can be classified into:

  • Threat of new competition
  • Threat of substitute products or services
  • Bargaining power of customers (buyers)
  • Bargaining power of suppliers
  • Intensity of competitive rivalry

Cost leadership and differentiation are two ways in which a firm can tackle the threat from new competition. Cost leadership refers to the advantage a firm has if it can reduce the cost of production. This allows higher profits even if the product is sold at the price prevailing in the market for similar products. By doing so, the firm can deal with new competitors producing the same product but which have a higher cost of production. Cost leadership is achieved by finding ways to reduce operational cost and making the most effective use of available resources.

Product differentiation refers to adding features to the product that make it different from similar products produced by competitors. The differences could be small improvements to user experience, enhancing the look of the product, etc. If implemented properly, product differentiation allows a firm to price its products higher than similar products in the same class produced by its competitors; and this increases the profits made. A classic example of a firm that has benefited by using product differentiation is Apple.

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