The twelve year return-on-equity data for the Tobacco Industry of 27.9% is substantially above the all-industry average of 14.1% given in the Business Week data. Examining Porters five forces reveals the keys to the Tobacco industries superior profit performance.
The price customers are willing to pay for a product depends, in part, on the availability of substitutes. The absence of close substitutes in the case of cigarettes means that consumers are comparatively insensitive to price increases. This makes price demand for tobacco inelastic with respect to price. The buyer's propensity to substitute cigarettes for another product is largely dependent on their price-performance characteristics. The needs being filled by cigarettes are very complex and the performance differences are very difficult to discern, leading to a low substitution propensity on the basis of price differences.
If an industry is profitable, other firms will inevitably attempt to enter the market. However, if the capital costs of getting established in an industry is large, many would be competitors will be discouraged.
The tobacco industry enjoys high capital requirements in land, equipment, and manufacturing that make it difficult for small competitors to enter. Additionally, tobacco firms are large companies capable of larger-scale operations which enable them to benefit from economies of scale. If competitors are to enter, they either enter on a small scale and accept high unit costs or enter on a large scale and risk the underutilization that would result while sales volume is built up. Tobacco firms have high product differentiation that is established through advertising and demonstrated by high brand loyalty. Additionally, new firms are not likely to enter this industry because of the government and legal pressures that the industry as a whole is facing concerning serious health issues caused by smoking. Lastly, the established players in the tobacco industry...