Lecture: Course Wrap-up
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Transcript Lecture: Course Wrap-up
STR 421
Economics of
Competitive Strategy:
Course Wrap-up
Michael Raith
Spring 2007
1
The key question
Efficient markets: successful strategies quickly attract
imitators
How, then, can companies achieve and maintain
above-normal returns?
– Why do some companies consistently make more profits than
others?
2
Part I: Obtaining and sustaining a
competitive advantage
1. Competition and markets
2. Value creation and competitive advantage
3. Horizontal and vertical scope of the firm
3
The Bertrand trap
A game you don’t want to be in
Assumptions:
1. Homogeneous goods
2. No capacity constraints
3. One-shot game
Prediction: competition drives prices toward MC
With fixed costs, firms make losses
4
Sellers offering goods
of different quality
Sellers compete by offering consumer surplus bids B-P.
– PS #2, FMA and network effects
What matters for winning is not benefit or cost but the
difference: Dell, RTE cereal: brands vs. private labels
Prices reflect costs, benefits, and competitive bidding
Firms with a competitive advantage often have some
freedom in choosing prices: Dell, Dupont
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Three ways out of
the Bertrand trap
1. Limit industry capacity: Dupont
2. Cooperate on prices: American Airlines, RTE cereal,
Infant formula
3. Differentiate = be different
– Differentiation relaxes price competition
– CCS, Dell, Enterprise, ValuJet
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Five forces analysis –
Taking a snapshot of an industry
What’s going on in the industry in general?
Who appropriates value created? Firms in industry or others?
– Extreme cases: Metal cans vs. RTE cereal
Don’t forget about complementors = 6th force; e.g. Enterprise: dealers
Dig deep: Why does the industry look the way it does?
– Product differentiation, role of advertising/R&D, first-mover
advantages, ability to collude, etc.
– A useful analysis already requires considerable knowledge of how
markets work
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Limitations of Five Forces
1. No conclusive answer to question “Should we enter this
industry?”
entry decision must focus on competitive advantage
2. Only snapshot; industry may look different in a few
years
8
Industry dynamics – What determines
market structure in the long run?
Good strategic decisions must anticipate likely changes in the
market, and market structure, in the future
– Coors, Birds Eye, Dupont, RTE cereal, EMI
Predictions about market growth and entry are related: Dupont
Forces towards a more concentrated market:
1. Economies of scale (look at MES/market size): Dupont
2. Intense price competition: Metal cans, PCs, opposite: PS #1,
“Restaurants”
3. Escalation of spending on endogenous fixed or sunk costs:
Beer, RTE cereal, CT scanners (as market matures)
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Part I: Obtaining and sustaining a
competitive advantage
1. Industry analysis
2. Value creation and competitive advantage
3. Horizontal and vertical scope of the firm
10
Positioning: horizontal and vertical
product differentiation
Firms are vertically differentiated when they offer
different quality/cost combinations.
– Brands vs. private labels in frozen food and cereal, Delta vs.
ValuJet
– “Cost” vs. “benefit/differentiation” strategy
Firms are horizontally differentiated when they
– target particular groups of customers: Dell, Enterprise
– offer products with attributes that appeal to some customers but
not others: (light-bodied) Coors, Honey Nut Cheerios
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Activities and strategic fit
Check how a firm’s activities fit with the market environment
(“external fit”) and one another (“internal/strategic fit”)
Same market can support different strategies and sets of
activities: Dell vs. Compaq
A successful strategy is supported by all activities of the firm
– CCS: e.g. one-month inventory
– Dell: all activities tailored to particular subset of business
customers
– Enterprise: HR policies
Most choices involve some tradeoff.
– Why aren’t other firms doing the same?
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The “productivity frontier” in practice:
assessing competitive advantage
To assess your or rival’s competitive position, look at
– Cost drivers: what factors determine costs?
Beer: transport costs
Dupont: scale and experience
RTE cereal: ingredients, packaging
– Benefit drivers: what factors contribute to buyer’s valuation?
Coors: mystique, freshness
CCS: quick response
EMI: technology, service
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Quantitative cost/quality
comparison
Simple: compare $/unit, not % of sales or costs
– Coors
– PS #3, ValuJet vs. Delta
Fancier: use own cost/quality position, and cost and
benefit drivers, to estimate rivals’ cost/quality positions.
– Dell
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Sources of a sustainable advantage:
1. Impediments to imitation
a) Regulatory restrictions
b) Patents: EMI?
c) Superior access to inputs or customers or
complementors: Enterprise, Dupont
d) Strategic fit: CCS, Dell, Enterprise, ValuJet
e) Experience/organizational learning: Dupont
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Sources of a sustainable advantage:
2. First/early-mover advantages
PS #2, “First-mover advantage?”;
PS #3, Capacity choice game
Three conditions:
1. Being first/early mover
2. First move (e.g. entry) is a credible commitment
Second movers not deterred if first mover might exit/ back
down => Sunk costs important
3. Entry unprofitable for second mover. Depends on
Market size => not too large!
Intensity of competition
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Types of first-mover advantages
a) Scale economies: Look at MES/ size of relevant market
– Dupont
b) Geographic or positional preemption:
– CCS as last-resort canner, Coors in 70s (location),
Enterprise, RTE cereal
c) Reputation for quality:
– CCS, Infant formula
– Building reputation/brand image through advertising: Are
buyers responsive? Beer, RTE cereal: yes; PCs: not much,
Frozen food: initially yes, later less so
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Types of first-mover advantages
(cont’d)
d) Switching costs: how difficult is it for buyers to switch?
– Metal cans: no; Instant messaging: yes
– What exactly is the nature of switching costs? CT scanners
e) Network effects: where do they come from? How
strong?
– Direct: Instant messaging
– Indirect: Choice Hotels (guests and affiliated hotels)
– With new products, network effects often difficult to predict
f) Learning effects: are there any? How big?
– Dupont yes, Metal cans no
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Strategies are
commitment-intensive
Strategic decisions are often hard to reverse, due to sunk costs,
inertia etc.
– Coors’ regional vs. national strategy
Even firms with well-designed strategies can be adversely affected
by changes in market : Compaq, Birds Eye
Anticipate, don’t react
– Monitor/anticipate developments in the market:
Dell, Enterprise: luck or foresight?
– Try to anticipate others’ moves
– Extreme examples: Coors vs. Dupont
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Part I: Obtaining and sustaining a
competitive advantage
1. Industry analysis
2. Competitive positioning and competitive advantage
3. Horizontal and vertical scope of the firm
– How broadly should a firm choose its activities beyond its core
business?
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Good and bad reasons
to expand scope
Most expansion efforts fail! Two main reasons:
1. Agency problems: growth objective
2. Firms overestimate generality of their capabilities
Think of narrow focus/ outsourcing as default
– Independent partners/suppliers have better incentives, are
– …better able to realize economies of scale: Birds Eye
Two key questions:
1. What are the synergies/economies of scope?
2. Can they be realized by contract, or is integration only
solution?
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Look for economies of scope
Efficient use of resources:
–
–
–
Choice Hotels’ reservation system and umbrella branding;
GE in sales and service for CT scanners and other products
Wal-Mart: products with different seasonal structures
Benefits of co-location: soft-drink bottlers and metal cans
Coordination/quality control: Coors into everything (!?), Birds Eye
Pricing of complementary products/double marginalization: Coors
into cans in 1970s?
Benefits of bundling for buyers: cross-selling at Choice Hotels,
Wal-Mart: toys and clothes
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What about contractual solutions?
No need for integration if contracting is easy
– Reservation systems in car rental, airlines
– Output-based contracts for pea farmers etc.
Maybe integrate if contracting seems too difficult
– Holdup problems: Soft drink bottlers and can-making facilities;
Birds Eye and cold stores
How big are relationship-specific investments?
How much uncertainty about future?
– Problems with performance measurement: cross-selling efforts
at Choice Hotels
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Part II: Strategic interaction
Any major strategic decision you make will likely
provoke some kind of response from competitors
Use insights from game-theoretic models to anticipate
your competitors’ capabilities and moves
–
–
–
–
American Airlines: will competitors go along?
Dupont: how will others respond to expansion plans?
Instant messaging: what is logic of the game being played?
ValuJet: how will/should Delta respond to entry?
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Price dynamics:
Logic of cooperative pricing
Oligopoly pricing is a Prisoners’ Dilemma situation
Cooperative pricing requires long enough time horizon
Key questions
– How easy is it for firms to tacitly agree on prices?
– How tempting is it for a firm to cut price?
– How effectively can deviations be detected and punished?
Industry’s ability to cooperate on prices often matters
more than a firm’s relative performance in industry
– Shrimp game, airline vs. cereal industry
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Price dynamics: industry factors
and facilitating practices
Ability to cooperate depends on industry factors.
– Airlines: transparency vs. asymmetries and excess capacity
– Infant formula, RTE cereal: several conducive factors
Firms can also facilitate cooperative pricing in a variety
of ways.
– American Airlines: establish price leadership, increase
transparency, standardize products, spatial pricing rules
– PS #3, HMOs
Keep antitrust restrictions in mind! Price-fixing
agreements prohibited for good reasons.
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Strategic commitments
Key idea: limit your own options in the future to
influence your rival’s behavior to your advantage
Basic ingredient of any first-mover advantage
Commitment is simple in theory, but hard in practice
– Moving first is not a commitment
– How costly is it to change your mind later? If not much, you’re
not committed
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Commitment tactics
Sunk costs: sinking costs in a useful way credibly
increases incentives to stay in the game
– Dupont: actual construction of a new plant
– PS #3, Capacity choice game
Short of true commitment, rely on reputation, or engage
in tactics to influence rivals’ and buyers’ perceptions
– Crandall’s claims about commitment to Value pricing
– Dupont’s announcements of expansion plans
– MSN’s claims about bug in AIM
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Strategic effects: anticipate competitors’
responses to strategic commitments
E.g. if I invest in lowering costs and want to lower my price, how
will you respond, and how will that affect my price & profit?
With strategic complements (e.g. prices),
– tough commitments have a negative strategic effect: PS #3, export
subsidy for railroad engines
– soft commitments have a positive strategic effect: ValuJet
With strategic substitutes (e.g. capacity), tough commitments have
a positive strategic effect: Dupont
Short-run competition is normally in price, long-run competition
may be about capacities: apply Cournot model
29
Entry deterrence
Ways to deter entry:
1. Preemption: Incumbent has incentive to preempt entry if
otherwise entry is certain (efficiency effect)
CCS in plastics, Dupont, PS #3: capacity choice game
Preemption strategies are investments in a first-mover
advantage (or don’t invest: EMI)
2. Any other investments that reduce entrant’s potential profits:
Pricing strategies to deter/fight entrants: limit pricing, predatory
pricing: Delta vs. ValuJet
Antitrust law prohibits attempts to monopolize.
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Entry games
For small entrants: reduce incumbents’ incentive to
respond aggressively
– “Judo economics”: stay small, differentiate
– ValuJet
(Groups of) Firms may get caught up in a “war of
attrition” if they fight for market in which only one fits
– Another game you don’t want to be in
– Like $20 auction
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Innovation management
Company that makes innovation is not necessarily best positioned
to produce/market final product: EMI
–
Options: go alone, JV, license, sell
Normally: sell innovation if it’s worth more to others than to you
–
Need capabilities in production, marketing etc. as well
Value of innovation is irrelevant!
Basic problem: if I want to sell you my idea, I have to tell you first
what it is, but then you already have the idea…
Contracting may be difficult if intellectual property protection is
weak
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Standards
How strong are forces towards standardization?
– Can competing technologies exist? Instant messaging: yes
Go alone or alliance/licensing/open standard?
– Go alone: good if you (1) have a great product, (2) are the first
mover, (3) can produce complementary product (if relevant)
AOL
– Alliance etc: good to increase chance of establishing own
technology as standard: JVC in VCRs, supporters of open
standard in instant messaging
But how will you make money?
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Fact-based strategy: Use/collect
data to inform strategic decisions
Quick & dirty investment analysis: Coors
Cost & benefit comparisons:
–
–
–
–
(Simple) How is Coors positioned?
(Better) How large is Dell’s cost advantage?
Can Big 3 in cereal squeeze private labels by cutting price?
(Fancy) Is Dupont’s cost advantage big enough to pull off “growth”
strategy?
Entry decisions:
– Is Delta pricing like a monopolist?
– What does it take to enter the cereal industry as a small player?
Market forecasts: When will CT scanner market be saturated, and
how does that affect EMI’s options?
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Concluding remarks
Principles of good strategy are enduring and do not
change with management fashions.
But companies are unique and must apply those
principles to discover the optimal strategy for them.
– Cookie-cutter recommendations rarely helpful
Economics is useful for strategy.
– How can companies make profits in the long run?
– Unique resources and capabilities don’t come out of the blue
– Ultimately, understanding how firms interact in markets is
essential for answering the question
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