Chapter 3

Competitive Advantage

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The goal of strategic thinking The focus of entrepreneurial action The motivation for top management’s vision for the

firm’s future A focus on economic fundamentals and performance

What is Competitive Advantage?

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What Determines Sustained Competitive Advantage?

A strong offense to attain market superiority Create a higher economic contribution than competitors

Contribution = Value - Cost

A strong defense of the market position against rivals Customer retention Defending against imitation

Both are necessary and neither is sufficient

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Value-Cost Framework

Value Willingness to pay: The highest price a customer would be

willing to pay for a product in absence of a competing product and in context of other purchasing opportunities

Cost Marginal cost to produce a unit of the product at a given level

of value Effective competitive positioning

Offering more value per unit cost than competitors, consistently over time

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Economic Contribution Distributed between Buyer and

Supplier

Figure 2.1

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Differentiator Invests in higher value (raising costs)

Cost leader Invests in lower costs (reducing value)

Generic Strategies

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Value and Cost: Substitutes or Complements

Figure 2.2

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Firms in the Middle

Two assumptions behind the belief that SIM (Stuck in the Middle) firms perform poorly SIM firm cannot compete on value with the Differentiator or

on cost with the Cost Leader SIM firm’s customer base is too small to allow it to improve

its competitive position Counter example: Target Corporation

Gross margin over revenues is close to that of higher value firms - JCPenney

Operating costs per revenue dollar is closer to low cost firm – Wal-Mart

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Competitors’ Value-Cost Profile

Target: The More Profitable Firm in Middle

Target’s Added Productivity

CostCost

Cost

Value

Wal-Mart

Target

JC Penney

Value

Value

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Unprofitable Firms in Middle:US Domestic Airline Industry

Figure 2.3

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Value versus Cost Advantage

Pursue value investments when:

Marginal customers are value-sensitive

Returns to increasing value are higher than returns on reducing costs

Pursue cost reductions when:

Marginal customers are price-sensitive

Value improvements are costly, difficult, or easily duplicated by competitors

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Value and Cost Drivers

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Examples of Value Drivers

Technology Functionality, features

Quality Durability, reliability,

aesthetics Delivery

Just-in-time production systems

Breadth of line Potential benefits: one-

stop shopping, interchangeable parts, interface compatibility and cross-selling

Service Responsiveness,

problem solving

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Customization Customer-based

product design Geography

Location, scope Risk assumption

Warranties Brand/ Reputation

Signals of price or quality

Network externalities Increase in product

value with each new customer – e.g., communication standard

Environmental policies Sustainable practices

Complements DVD players and disks

Examples of Value Drivers (cont’d)

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Examples of Cost Drivers

Scale or volume economies Average cost declines as volume increases based on high

recurring fixed costs or sunk costs Scope economies

Cost of producing two products together is lower than the cost of producing them separately

Learning curve Cost declines with cumulative volume as learning takes place

and practices improve

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Examples of Cost Drivers (cont’d)

Low input costs Firms with lower cost inputs are better positioned to take

advantage of industry opportunities and absorb changes Vertical integration

For tasks that are specialized to the firm, coordination costs are lower within the firm than with a market supplier

Organizational practices Firms develop process innovations to lower costs or improve

value in specific activities

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Isolating mechanisms

Mechanisms that prevent industry forces from eating up the firm’s profits Increase customer retention Reduce imitation by competitors

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Increasing Customer Retention

Increase switching costs Search costs

High for products whose value is apparent only after experiencing the product – experience goods

Transition costsCosts associated with shifting from old equipment or practices to

new Learning costs

Costs incurred in learning a new process

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Barriers to Imitation

Property rights Patents, trademarks

Dedicated assets Exclusive distribution channels, suppliers or location

Sunk Costs One time, non-repeated investments in technology, brand,

network scope and other assets whose economic benefits are reaped continuously afterward

Casual ambiguity Difficulty in copying a capability because it cannot be

modeled effectively

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Building Competitive Advantage

Figure 2.7

Value Drivers

Cost Drivers

Resources

Capabilities

Retaining Customers

Preventing Imitation

Superior Market Position Defendable Market Position

Sustainable Competitive Advantage

Market Position Isolating Mechanisms

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Chapter 4

Industry Analysis

4-21

An industry is composed of: Firms whose products provide value in functionally equivalent

ways (e.g., air conditioners – but not fans) Firms that compete directly through changes in product value

and price Firms that face common economic (e.g., common suppliers

and buyers) Producers of substitutes (outside the industry) are:

Firms whose products are functionally different from the industry’s products but compete to provide value to the industry’s buyers (e.g., snowboards are substitutes for skis)

What is an Industry?

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Firms create industries, not the reverse Competing firms influence each other with shifts

in product value and price Increasing strategic interaction establishes mutual

dependence between firms Behavior and performance subject to emerging industry

forces

How Do Industries Emerge?

4-23

Market Segmentation

Many industries have more than one market segment Segments are defined by the distribution of customer

preferences Firms align their product lines with one or more

segments, which could overlap Specialist firms

Tailor their product to one segment Generalist firms

Design their product for many segments

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What Determines Firm Profitability?

Macroeconomic factors Forces in the overall economy: e.g., regulation, interest rates,

tax policy Industry factors

Conditions specific to an industry, e.g., the level of competition, the presence of powerful buyers

The firm’s market position as determined by its resources and capabilities The firm’s value and cost compared to competitors and its

ability to defend this position

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Manufacturing Sector Transportation Sector

Services Sector

Percentage Contribution of Business Segment, Industry and Other Factors to Business Return on Assets 1980–1994 (U.S. data).

Relative Contributions of Industry and Business Unit to Economic

Performance

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Industry Forces Influencing Firm Performance

Porter’s five industry forces: Strength of competition Potential for entry into the industry The power of buyers The power of suppliers The strength of substitutes for the industry’s products

When forces are strong, profitability is low and when forces are weak, profitability is high

Add complements – e.g., cars and gas stations Strong complements raise the product’s value

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Figure 3.1Source: Michael Porter, Competitive Strategy (New York: Free Press, 1980), p. 4.

Porter’s Five Forces Framework

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Competition

Competition May reduce prices, while holding value and cost constant,

resulting in customers receiving higher buyer surplus May increase value without increasing the price of the product May increase cost if higher value is required to compete

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Effect of Competition on Transaction with Customers

Value to the Customer

Price

Cost

Strong Competition

Can Increase the Value Required to Compete

Reduces Price

Can Increase the Cost Required to Compete as

Investment in Value Rises

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Types of Competition

Perfect competition Strong rivalry among many very similar firms No firm makes a profit above its cost of capital, since rivalry

has driven the market price down Monopoly

Absence of rivalry Monopolists produce less and charge more Not illegal, but illegal to exploit

Oligopolistic competition Competition occurs among a few similar firms

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Characteristics of Perfect Competition

Many competitors A common set of buyers for all firms The same value offered by all firms The same cost structure in all firms Relatively costless entry Relatively costless exit

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Oligopoly and Industry Concentration

Oligopolies are found in concentrated industries Concentration is determined by:

Low ratio of market size to the minimum setup costs necessary to compete

High level of sunk costs investment made by incumbent companies

Entrants are at a cost disadvantage to compete with the incumbents

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Concentration-Profitability Relationship

More concentrated industries tend to be a little more profitable

Causes of the concentration-profitability relationship: Higher efficiency of large firms Non-cooperative strategic interaction to increase profits Collusion to increase profits

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Efficiency Differences among Firms

Higher profits are achieved from investing in scale-based innovations that reduce costs

So interaction with competitors and knowledge of their practices is necessary for profitability

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Noncooperative Strategic Interaction

Firms act by observing and analyzing competitors’ moves – i.e. they play a game with each other

Profits are possible in a noncooperative game Focus on a duopoly (two firms competing against each other –

e.g., Coke and Pepsi)Price takers

Value and price are the same across firms (e.g., oil companies) So compete on volume (see the cattle ranches on the next slide)

Price makers Value, prices and costs differ across firms (e.g., GM, Ford, Toyota and

Honda) So compete on value and price

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Quantity Competition Between Two Cattle Ranches

(best response for each combination is shown in bold)

Number of Steers

Delivered by

Reata

Number of Steers Delivered by the Ponderosa

10 20 30 40 50 60 70 80 90 100

10 19,19 18,36 17,51 16,64 15,75 14,84 13,91 12,96 11,99 10,100

20 36,18 34,34 32,48 30,60 28,70 26,78 24,84 22,88 20,90 18,90

30 51,17 48,32 45,45 42,56 39,65 36,72 33,77 30,80 27,81 24,80

40 64,16 60,30 56,42 52,52 48,60 44,66 40,70 36,72 32,72 28,70

50 75,15 70,28 65,39 60,48 55,55 50,60 45,63 40,64 35,63 30,60

60 84,14 78,26 72,36 66,44 60,50 54,54 48,56 42,56 36,54 30,50

70 91,13 84,24 77,33 70,40 63,45 56,48 49,49 42,48 35,45 38,40

80 96,12 88,22 80,30 72,36 64,40 56,42 48,42 40,40 32,36 24,30

90 99,11 90,20 81,27 72,32 63,35 54,36 45,35 36,32 27,27 18,20

100 100,10 90,18 80,24 70,28 60,30 50,30 40,38 30,24 20,18 10,10Best Response for Both Ranches Jointly

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Tacit Collusion Tacit collusion may occur to make profits above the

competitive outcome Required conditions among firms

Mutual familiarity Repeated interaction Consistent roles Strategic complementarity

Information signaling A mechanism for coordinating decisions

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Explicit Collusion

Explicit collusion is the coordination of firms’ major decisions through direct communication Generally illegal Hard to integrate and sustain

Extreme case of collusion leads to cartels Cartels are illegal in most of the developed world Cartels are often found in commodity industries Firms decide on cartel administration and policies

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Forces Influencing Cartelization

Reasons for cartel establishment Homogenous market positions Mutual familiarity through long-standing competition High industry concentration Lack of viable substitutes for the industry’s product

Reasons for cartel failure Inability to prevent entry into the industry Uncontrolled cheating or defection Fluctuating demand Bargaining problems within the cartel

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What Factors Raise Entry Barriers?

Lower prices by firms in the industry Limit pricing

High barriers to imitation Property rights Dedicated assets Causal ambiguity Learning curve and development costs

High customer switching costs

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Entry Barriers Affecting Transaction with Customers

Figure 3.3

Value to the Customer

Price

Cost

Low Barriers to Entry

Force the Firm to Lower Price

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Buyer Power

Buyer power is increased by: Availability of competing products with the same value and

price Buyer concentration (few buyers) Low market growth Percentage of product sold to the buyer Low importance of the product to the buyer High importance of selling product to buyer The firm’s need to fill capacity by selling to buyer Buyer’s credible threat of vertical (backward) integration

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The Effect of Buyer Power

Figure 3.4

Value

Price

Cost

Strong Buyers

Force the Firm to Increase Value

Force the Firm to Lower Price

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Supplier Power

Supplier power is increased by:

Supplier concentration (few suppliers)

Growth in demand for the firm’s product

Low percentage of supplier volume bought by customer (size of buyer relative to supplier)

High strategic importance of supplier to buyer

Low strategic importance of buyer to supplier

4-45

The Effect of Supplier Power

Figure 3.5

Value to the Customer

Price

Cost

Strong Suppliers

Decrease the Value of Their Inputs

Increase the Firm’s Cost by Raising Their Prices

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Substitutes

The threat of substitutes increases when: A firm has a low buyer surplus (value minus price) relative to

the substitute A firm’s customers have low switching costs

Defenses against substitutes: Increase the buyer surplus Raise switching costs

4-47

The Effect of Substitutes on Transaction with Customers

Figure 3.6

Value to the Customer

Price

Cost

Strong Substitutes

Increase the Value Required to Compete

Force Lower Prices

4-48

Forces Increasing Firm Performance

The strength of complements of the industry’s products (Legal) cooperation between buyers and suppliers Coordination among competitors Strategic groups

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Figure 3.7

Industry Forces that Increase Profitability:

The Value Net

SuppliersSuppliersCustomersCustomers

ComplementorsComplementors

CompetitorsCompetitors

The FirmThe Firm

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Coordination Among Competitors

Cooperative pricing (not price-fixing) to avoid price competition Readily available pricing information Comparable value-cost profiles for competitors

Interfirm partnerships For example, R & D consortia

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Cooperative Pricing

Often depends on the presence of a price leader Price leadership requires:

Observable prices Common buyers Strategic discipline A small number of firms

Common history of competitionComparable market positions

Adherence to antitrust law Cooperative output levels

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Cooperation Between Buyers and Suppliers

Sharing information Operating decisions (e.g., logistics) Strategic decisions (e.g., technology development)

Sharing resources and capabilities Quality management techniques

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Complements

Products in different industries whose patterns of demand are systematically positively correlated Skis and ski boots Sails and sailboats Tires and automobiles

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Strategic Groups

Strategic groups are a level of analysis between the firm and the industry.

Characteristics of strategic groups:

Firms within an industry that have similar cost and value drivers compared to firms in other groups

Firms which compete in the same market segment

Firms that take a similar approach to competing in an industry

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Mobility Barriers

Similar to barriers to entry to the industry – but between strategic groups

Entry-deterring behavior of firms in a group Isolating mechanisms specific to the group

Group limit pricing

Actions taken by stronger and more profitable competitors to protect their groups from entry by rival firms in the industry

Prevent the movement of firms from one strategic group to another

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Figure 3.8

Strategic Groups in the U.S. Domestic Airline Industry

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The Effect of Industry Forces on Value, Cost and Price

Five Industry Forces Effect on Value Effect on Cost Effect onPrice

StrongerRivalry

May be based onhigher customer value

May increase cost associated with higher value

Lowers the pricerequired tocompete inindustry

StrongerBuyers

Raise the valuerequired to competein industry

Lower the pricerequired tocompete in industry

StrongerSuppliers

Lower the valueprovided to firms in the industry

Raise the costs offirms in industry

Lower EntryCosts

Lower the price tokeep entrants outof industry

More PowerfulSubstitutes

Raise the valuerequired to competein industry

Lower the pricerequired tocompete in industry

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The Effect of Industry Force on Value, Cost and Price (cont’d)

Value Net Effect on Value Effect on Cost Effect onPrice

Cooperation Between Firmand Buyers

Raises the value tobuyers withoutcomparable rise infirm costs

Lowers firm costswithoutcomparable dropin buyer value

Cooperation Between Firmand Suppliers

Raises the value tofirm without acomparable rise insupplier costs

Lowers suppliercosts withoutcomparable dropin firm value

Cooperation Between FirmAnd Competitors

Raises the value toindustry buyerswithout a comparablerise in industry costs(shared innovation)

Lowers the costs inindustry without acomparable dropin value to industrybuyers (sharedinnovation)

Raises thepotential pricenecessary tocompete(cooperativePricing)

EffectiveComplements

Raise the value toindustry buyerswithout a comparablerise in industry costs

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