STR 421

1. STR 421 Economics of Competitive Strategy: Course Wrap-up Michael Raith Spring 2007

2. 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?

3. 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

4. The Bertrand trap • A game you don’t 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

5. 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

6. 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

7. 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

8. 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

9. 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)

10. Part I: Obtaining and sustaining a competitive advantage • Industry analysis • Value creation and competitive advantage • Horizontal and vertical scope of the firm

11. 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

12. 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?

13. 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

14. 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

15. Sources of a sustainable advantage:1. Impediments to imitation • Regulatory restrictions • Patents: EMI? • Superior access to inputs or customers or complementors: Enterprise, Dupont • Strategic fit: CCS, Dell, Enterprise, ValuJet • Experience/organizational learning: Dupont

16. 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 => Sunk costs important • Entry unprofitable for second mover. Depends on • Market size => not too large! • Intensity of competition

17. 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

18. Types of first-mover advantages (cont’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 • 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

19. 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

20. 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?

21. 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?

22. 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

23. 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

24. 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?

25. 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

26. 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.

27. 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

28. 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

29. 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

30. 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 don’t invest: EMI) • 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.

31. 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

32. 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 it’s 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

33. 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?

34. 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?

35. 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