STR 421

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STR 421

• Economics of
• Competitive Strategy
• Course Wrap-up
• Michael Raith
• Spring 2007

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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?

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Part I Obtaining and sustaining a competitive
advantage

• Competition and markets
• 2. Value creation and competitive advantage
• 3. Horizontal and vertical scope of the firm

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The Bertrand trap

• A game you dont want to be in
• Assumptions
• Homogeneous goods
• No capacity constraints
• One-shot game
• Prediction competition drives prices toward MC
• With fixed costs, firms make losses

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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

• Limit industry capacity Dupont
• Cooperate on prices American Airlines, RTE
  cereal, Infant formula
• Differentiate be different
• Differentiation relaxes price competition
• CCS, Dell, Enterprise, ValuJet

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Five forces analysis Taking a snapshot of an
industry

• Whats going on in the industry in general?
• Who appropriates value created? Firms in industry
  or others?
• Extreme cases Metal cans vs. RTE cereal
• Dont 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/RD,
  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

• No conclusive answer to question Should we enter
  this industry?
• entry decision must focus on competitive
  advantage
• Only snapshot industry may look different in a
  few years

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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
• Economies of scale (look at MES/market size)
  Dupont
• Intense price competition Metal cans, PCs,
  opposite PS 1, Restaurants
• 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

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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 firms 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 arent other firms doing the same?

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The productivity frontier in practice
assessing competitive advantage

• To assess your or rivals 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
  buyers 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 advantage1.
Impediments to imitation

1. Regulatory restrictions
2. Patents EMI?
3. Superior access to inputs or customers or
   complementors Enterprise, Dupont
4. Strategic fit CCS, Dell, Enterprise, ValuJet
5. 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
• Being first/early mover
• First move (e.g. entry) is a credible commitment
• Second movers not deterred if first mover might
  exit/ back down gt Sunk costs important
• Entry unprofitable for second mover. Depends on
• Market size gt not too large!
• Intensity of competition

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Types of first-mover advantages

• Scale economies Look at MES/ size of relevant
  market
• Dupont
• Geographic or positional preemption
• CCS as last-resort canner, Coors in 70s
  (location),
• Enterprise, RTE cereal
• 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 (contd)

• 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
• 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
• 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, dont 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
• Agency problems growth objective
• 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
• What are the synergies/economies of scope?
• 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 dynamicsLogic 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?
• Industrys ability to cooperate on prices often
  matters more than a firms 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 rivals 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, youre 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
• Crandalls claims about commitment to Value
  pricing
• Duponts announcements of expansion plans
• MSNs 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

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Entry deterrence

• Ways to deter entry
• 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 dont invest EMI)
• Any other investments that reduce entrants
  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 dont 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
• Need capabilities in production, marketing etc.
  as well
• Options go alone, JV, license, sell
• Normally sell innovation if its worth more to
  others than to you
• 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 Dells cost advantage?
• Can Big 3 in cereal squeeze private labels by
  cutting price?
• (Fancy) Is Duponts 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 EMIs 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 dont come out
  of the blue
• Ultimately, understanding how firms interact in
  markets is essential for answering the question