competition demystified
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1. Planning does not equate to business strategy. Executives often
mistaken any plan that helps the company make more money qualifies as a
business strategy, e.g. increasing customers or margins. This mistaken
notion causes executives to fight wars they cannot win and fail to protect
and exploit the advantages that will lead them to success.
2. Strategic decisions are outward looking and are those whose results
depend on the actions and reactions of other economic entities.
Strategic thinking is about creating, protecting and exploiting competitive
advantages. Tactical decisions can be made in isolation and hinge
largely on effective implementation.
3. There are 2 main strategic choices a company must face are: 1. Selecting
the arena of competition, i.e. the market in which to engage. The choice of
markets is strategic because it determines the cast of external characters
who will affect a company’s economic future. 2. Managing external agents.
In order to devise and implement effective strategy, a firm has to anticipate
and, if possible, control the responses of those external agents. Although
this isn’t easy as these interactions are complicated and uncertain, devising
strategy without taking into account that response can be a glaring mistake.
4. On a level playing field, in a market open to all competitors on equal terms,
competition will erode the returns of all players to a uniform minimum,
where there is no “economic profit” i.e. no returns above the cost of
invested capital. If demand conditions allow any single firm to earn
unusually high returns, other companies will notice the same opportunity
and flood in. Demand will be fragmented among the greater number of
firms, and cost per unit rise as fixed costs are spread over fewer units sold,
prices fall, and the high profits that attracted the new entrants disappear.
To earn profits above this minimum, a company must be able to benefit from
competitive advantage.
5. Strategy is big and means long-term commitment for the organization. They
require large allocations of resources and is made by management, and
changing strategies doesn’t happen quickly. The distinction between
strategic and tactical decisions are:
Strategic Tactical/Operational/
Functional
Management
level
Top management, Board of
directors
Mid-level, functional, local
Resources Corporate Divisional, departmental
Time frame Long-term Yearly, Monthly, Daily
Risk Determines success/survival Limited
Questions What business do we want to
be in?
What critical competencies
must we develop?
How are we going to deal with
competitors?
How do we improve delivery
time?
How big a promotional
discount do we offer?
What is the best career path
for our salespeople?
6. Porter’s Five Forces (Substitutes, Suppliers, Potential Entrants, Buyers, and
Competitors) can affect the competitive environment. But one of them is
clearly much more important than others and leaders should begin by
ignoring the others and only focusing on barriers to entry (Potential
Entrants). If there are barriers, then it is difficult for new firms to enter the
market or for existing companies to expand.
7. Barriers to entry and incumbent competitive advantage means the same
thing, as the existence of barriers to entry means that incumbent firms are
able to do what potential rivals cannot. Entrant competitive advantage have
no value as a successful entrant becomes the incumbent, and is then
vulnerable to the next entrant who benefits from new technology, less
expense labour, or some other temporary competitive edge. The lack of
barriers to entry means the cycle doesn’t stop.
8. In an increasingly global environment with lower trade barriers, cheaper
transportation, faster flow of information, and relentless competition from
establish rivals and newly liberalized economies, it might appear that
competitive advantages and barriers to entry will diminish, e.g. profits
disappearing due to imports. But competitive advantages are almost always
grounded in “local” circumstances. Competitive advantages that lead to
market dominance, either by a single company or by a small number of
essentially equivalent firms are much more likely to be found when the
arena is local, bounded either geographically or in product space, rather
than when it is large and scattered. The process is where a company
establishes local dominance, and expand into related territories, both in
terms of physical territory and product market space. E.g. Walmart began as
a small regionally focused discount store where it had little competition, and
it expanded incrementally outward from this geographic base at the
periphery of its existing territory. As it pushed the boundaries of this region
outward, it consolidated its position in the newly entered territory before
continuing its expansion. Microsoft also started by dominating the segment
for operating systems, before expanding at the edge of this business, adding
adjacent software products like the Office Suite.
9. The key strategic imperative in market selection is to think locally and
achieve dominance at the local level. Service industries will become
increasingly important and manufacturing less so, and the distinguishing
feature of most services is that they are produced and consumed locally.
Opportunities for sustained competitive advantages are likely to increase as
services becomes a bigger part of our economies.
10.There are 3 kinds of genuine competitive advantage: Supply, Demand and
Economies of Scale. Measured by potency and durability, production
advantages (i.e. Supply) are the weakest barrier to entry, economies of scale
when combined with some customer captivity, are the strongest. Demand
side barriers to entry are more common and generally more robust than
advantages stemming from the supply or cost side. These 3 competitive
advantages are most likely present in markets that are either local
geographically or in product space. Other rarer specific situations form of
competitive advantages including government intervention e.g. license,
tariffs and quotas, authorized monopolies, patents, direct subsidies, and
various kinds of regulations, and in financial markets having superior access
to information.
11.Supply competitive advantages are strictly cost advantages that allow a
company to produce and deliver its products or services more cheaply than
its competitors. The incumbent can earn attractive returns under prevailing
market conditions (prices and sales levels) but potential entrants, thanks to
their high cost structures, cannot. Such an advantage deters must sensible
firms from entering the incumbent’s market, but if some optimistic firms try
anyway, the incumbent, taking advantage of its lower cost structure, can
under price, out advertise, out service, or out market the entrant and they
will eventually exit the market. The lowest costs can stem from 1. Privileged
access to crucial inputs e.g. easily extracted commodities, or 2. Proprietary
technology that is protected by patents or by experience or a combination of
both.
12.Cost advantages due to lower input costs are very rare. Labour, capital in all
forms, raw materials, and intermediate inputs are all sold in markets that
are generally competitive. Some companies have to deal with powerful
unions that are able to raise labour cost, and they may also face an
overhang of underfunded pension and retiree health-care liabilities. But if
one company can enter the market with non-union, low-benefit labour,
others can follow, and the process of entry will eliminate any excess returns
from lower labour costs. The first company to outsource labour to countries
like China may gain a temporary advantage over rivals who are slower to
move, but the benefit soon disappears as others follow suit. Access to cheap
funding or deep funding is also an illusionary advantage. Easy funding
doesn’t ensure success and only a small number of companies have been
forced to the wall by competitors whose sole advantage was their deep
pockets. In fact, companies with deep pockets have hurt themselves by
spending lavishly on mistaken venture partly simply because they have
money. “Cheap” capital due to government support is best thought of as a
competitive advantage based on government subsidy. In the absence of
government support, the notion of “cheap” capital is an economic fallacy.
Sometimes “cheap” capital is based on access to funds that were raised in
the past at unusually low costs, but the real cost of funds is not “cheap”. If
the funds cost 2% to raise, and the capital market at large offer a 10%
return on investments, investing capital in projects that return 2% is a 8%
money loser even if it doesn’t actually lead to losses. Taking advantage of
“cheap” capital like this is stupidity, not a competitive advantage and are
unlikely to be sustainable for long. Some companies do have privileged
access to raw materials or to advantageous geographical locations, but
these advantages tend to be limited in the markets in which they apply, and
the extent to which they can prevent competitive entry. The same is true for
exceptional talent as they can switch companies. With few exceptions,
access to low-cost inputs is only a source of significant competitive
advantage when the market is local, either geographically or in product
space, otherwise it is not much help as a barrier to entry.
13.Proprietary technology protected by patents is a product line or process.
During the term of the patent, protection is nearly absolute. Patent
infringement penalties and legal fees make the potential costs to a would-be
entrant impractically high. However, the cost advantages from patents are
only sustainable for limited periods till they expire. Patent protection is
relatively brief (on average 17 years) compared to long-term dominance of
markets by Microsoft and Coca Cola.
14.Proprietary technology protected by experience can be found in industries
with complicated processes, where learning and experience are a major
source of cost reduction, e.g. the % of good yields in chemical and
semiconductor processes often increase dramatically over time, due to
numerous small adjustments in procedures and inputs. Higher yields mean
lower costs, both directly and indirectly by reducing the need for expensive
interventions to maintain quality and reduce the amount of labour and other
inputs required. Companies that are continually diligent can move down
these learning curves ahead of their rivals and maintain a cost advantage for
periods longer than most patents can afford. But there are limits to the
sustainability of these learning-based proprietary cost advantages. Much
depends on the pace of technological change. In industries where
technological change is swift, it can undermine advantages that are specific
to processes that quickly become outdated and cost advantages have shorter
life expectancies in rapidly changing areas like semiconductor and
biotechnology. But if the pace of technological change slows down as an
industry matures, rivals will eventually acquire the learned efficiencies of
the leading incumbents. Simple products and processes are not fertile
ground for proprietary technology advantages as they are hard to patent
and easy to duplicate and transfer to other firms. If a particular approach to
production/service can be fully understood by a few employees, competitors
can hire them away and learn the essentials of the processes involved. If the
technologies are simply, it is difficult for the developer to make the case for
intellectual theft of proprietary property since much of that technology will
look like “common sense”. This limitation is particularly important in
services e.g. medical care, transaction processing, financial services,
education, retailing, as the technology in these fields tend to be either
rudimentary or developed by specialist 3rd parties. For technology to be truly
proprietary they must be produced within the firm. Markets in which
consultants or suppliers are responsible for most product or process
innovations cannot be markets with substantial cost advantages based on
technology because the advantages are available to anyone willing to pay for
them. The idea that information technologies will be the source of
competitive advantage is misguided as most of the innovations in I.T. are
created by companies like SAP, Microsoft, Oracle, who make their living by
disseminating innovations as widely as they can. Innovations that are
common to all confer competitive advantages on none. Companies making
better use of those innovation is a matter of organizational effectiveness and
not competitive advantage.
15.When a company enjoys competitive advantages related to proprietary
technologies, its strategy should be to exploit and reinforce it where they
can. To exploit its competitive advantages, with lower costs, it can strike a
balance between under-pricing competitors to improve sales and charging
the same to keep the full benefit of the cost advantage. So long as the firm is
alone in the market or surrounded by a myriad of smaller and weaker
competitors (i.e. not a few large dominant firms) it can determine the
appropriate price level by trial and error. It needs to monitor its steps to see
which price levels and marketing choices provide the best return, but it
doesn’t have to worry explicitly about the reactions of particular
competitors. The process of exploitation is largely a matter of operational
effectiveness and strategies only become complicated when a small number
of powerful firms enjoy competitive advantages in common. To reinforce
cost advantages from proprietary technologies, the company wants to
improve them continuously and to produce a successive wave of patentable
innovations to preserve and extend existing advantages. This is again a
matter of organizational effectiveness, making sure investments in R&D are
productive.
16.Demand competitive advantages are when companies have access to market
demand and customers that their competitors cannot match. Branding in the
sense of quality image and reputation by itself is not sufficient to establish
superior access to demand. Competitive demand advantages arise because
of customer captivity based on habit, costs of switching, or the difficulties
and expenses of searching for a substitute provider. It may not be
impossible for entrants to lure loyal customers away from an incumbent, by
cutting prices, giving away products for people to try etc. But customer
captivity still entails competitive advantage as entrants cannot attract
customers anywhere near the same terms as the established firm. Unless
entrants have found a way to produce the item or deliver the service at a
cost substantially below that of the incumbent (which is unlikely), either the
price at which they sell their offerings or the volume of sales they achieve
will not be profitable for them and thus unsustainable. The incumbent can
do what the challenger cannot, selling its product at a profit to captive
customers. However, these advantages fade over time as new customers are
unattached and available to anyone. Existing captive customers ultimately
leave the scene; they move, mature or die, putting a natural limit on the
duration of customer captivity. Even Coca Cola was vulnerable to Pepsi, and
only very few venerable products seem to derive any long-term benefits
from intergenerational transfer of habit.
17.Customer captivity based on habit is when frequent purchases of the same
brand establish an allegiance that is difficult to understand and undermine,
e.g. cigarette brands, Coca Cola. For reasons that are not entirely known,
the same kind of attachment doesn’t extend to beer drinkers. Habit
succeeds in holding customers captive when purchases are frequent and
virtually automatic. We find this behavior in supermarkets, not car dealers
or computer suppliers. For computer buyers, buyers shop for replacement
hardware on the basis of price, features and dependability, regardless of
existing brand. They do think about compatibility with existing software, but
that is a legacy issue and a switching cost issue, and not that they are
creatures of habit. Habit is also usually local in the sense that it relates to a
single product, not to a company’s portfolio of offerings.
18.Customer captivity based on switching costs are when it takes substantial
time, money and effort to replace one supplier with a new one. Software is
the product most easily associated with high switching costs. The costs can
be prohibitive as it includes more than the substitution of the software itself,
but also retraining of people in the firm who are the application users, and
the fact that new systems are likely to bump up the error rate. Especially
when the applications involved are critical to the company’s operations
(order entry, inventory, invoicing and shipping, patient records, bank
transactions), companies are unlikely to abandon a functioning system even
for one that promises vast increases in productivity, if it holds the threat of
terminating the business through system failure. There costs are reinforced
by network effects, e.g. the computer system must work compatibly with
others, and it is difficult to change to an alternatives when others aren’t
compatible, even if the alternative is in some ways superior. The move will
be costly, to ensure continued compatibility, and even disastrous if the new
system cannot be integrated with the existing one. Besides software, other
products or services that require a supplier to learn a great deal about the
lives, needs, preferences, and other details of a new customer, there is a
switching cost involved for the customer who has to provide all this
information, as well as a burden on the supplier to master it, e.g. lawyers,
doctors who are comfortable prescribing a particular medicine may be
reluctant to substitute with a new drug with which they are less familiar.
Low switching costs exist in standardized products, especially if the
standards are not proprietary.
19.Customer captivity due to search costs exists when it is costly to locate an
acceptable replacement. Minimal search costs exists when information and
ratings on competitive products are easily available e.g. consumer goods.
But for goods and services where there is no ready source of the kind of
information a prospective buyer wants, and where there is a personal nature
of the relationship between buyer and supplier where there may be an
intense level of personal contact, there is no alternative to direct
experience, e.g. finding a new doctor or professional services. High search
costs are an issue when products or services are complicated, customized,
and crucial. Standardized products have low search costs. For businesses,
the more specialized and customized the product or service, the higher the
search cost for a replacement and the easier it is to upgrade or continue
with the current provider, even if not totally satisfied since finding a new
one is costly and risky. To avoid the danger of being locked into a single
source, many firms develop relationships with multiple suppliers, including
professional service providers.
20.To formulate strategies to exploit and reinforce demand side competitive
advantages, a company with captive customers can charge more than the
competition does. So long as the firm is alone in the market or surrounded
by a myriad of smaller and weaker competitors, it can determine the
appropriate price level by trial and error. It needs to monitor its steps to see
which price levels and marketing choices provide the best return and
doesn’t have to worry explicitly about the reactions of particular
competitors. The process of exploitation is a matter of operational
effectiveness. To reinforce its competitive advantage from customer
captivity, the company wants to encourage habit formation in new
customers, increase switching costs, and make the search for alternatives
more complicated and difficult. For expensive items, it wants to make
purchases more frequent and to spread payments out over time, to ensnare
the customer in an ongoing relationship that is easier to continue than to
replace, e.g. car companies using highly visible annual style changes to
encourage frequent purchases, accepting trade-ins and monthly payments to
ease financial burden. To reinforce habit-based customer captivity,
companies have customer loyalty programs and the Gillette strategy of
selling razor cheaply and making money from regular purchase of blades.
These approaches encourage repeated, virtually automatic and non-
reflective purchases that discourage the customer from a careful
consideration of alternatives. To reinforce switching costs-based customer
captivity, it is a matter of extending and deepening the range of services
offered. E.g. Microsoft adding features to basic operating system, making
the task of switching to other systems and mastering their intricacies more
onerous, or banks adding in automated bill payments, pre-established lines
of credit, direct salary deposit and other routine functions, and customers
are more reluctant to leave for another bank even if they offer superior
terms on some products. To reinforce search costs-based customer captivity,
the same tactic of providing more integration of multiple features apply.
Comparison shopping is more difficult if the alternatives are equally
complicated but not exactly comparable. Also as the importance and added
value of products and services increases, so does the risk of getting a poor
outcome from an alternative provider. Potentially poor results also raise the
cost of sampling as something might go very wrong during the trial period
e.g. of a cardiologist or residence insurer. Complexity, high added value and
significance all add to high search costs.
21.The most durable competitive advantages comes from economies of scale
with customer captivity. Understanding how they operate together, e.g. that
a growing market is not a good thing, can help design effective strategies to
reinforce them. Economies of scale competitive advantages are when costs
per unit decline as volume increases, because fixed costs make up a larger
share of total costs, and even with the same technology, an incumbent firm
operating at a large scale will enjoy lower costs than its competitors. The
larger firms can be highly profitable at a price level that leaves its smaller
competitors, with their higher average costs, losing money. The competitive
advantage of economies of scale depends not on the absolute size of the
dominant firm but on the size difference between it and its rivals, i.e. on
market share. The cost structure that underlies these economies of scale
usually combines a significant level of fixed cost and a constant level of
incremental variable costs. However, in addition to this cost structure, for
economies of scale to serve as a competitive advantage, incumbents need to
have a degree of customer captivity. If an entrant has equal access to
customers as the incumbents, it will be able to reach the incumbents’ scale.
A market in which all firms have equal access to customers and common
cost structures, in which the entrants and incumbents offer similar products
on similar terms, should divide more or less evenly among competitors, and
this holds true for commodity or differentiated markets. All competitors who
operate efficiently should achieve comparable scale and thus comparable
average cost. However with incumbent customer captivity, if an efficient
incumbent matches his competitors on price and other marketing features,
then thanks to customer captivity, it will retain its dominant share of the
market. Though entrants may be efficient, they will not match the
incumbent’s scale of operations, and their average costs will be permanently
higher. The incumbent can thus lower prices to a level where it alone is
profitable and increase its share of the market, or eliminate all profit from
competitors who matches its prices. With some degree of customer
captivity, the entrants never catch up and stay permanently on the wrong
side of the economies of scale differential. It seems reasonable to think that
a persistent entrant will sooner or later reach an incumbent’s scale of
operations if it has access to the same basic technologies and resources. If
the incumbent is not vigilant in defending its market position, the entrant
may catch up, but if an incumbent diligently defends its market share, the
odds are in its favour.
22.There are benefits in operating in markets with limited boundaries. It is
difficult to establish or sustain dominance when the boundaries are vast.
Most companies that manage to grow and still achieve a high level of
profitability do it in 1 of 3 ways. They replicate their local advantages in
multiple markets e.g. Coca Cola, they continue to focus within their product
space as that space itself becomes larger e.g. Intel, or they gradually expand
their activities outward from the edges of their dominant market positions
e.g. Walmart and Microsoft. Most markets in which companies can establish
competitive advantages by achieving defensible economies of scale will be
local, either geographically or in product space. If companies look carefully,
they will find possibilities for dominance in some of their markets, where
they can earn above normal returns on investments, but unfortunately, local
opportunities are often disregarded in pursuit of ill-advised growth
associated with global strategic approaches.
23.Small markets are more hospitable than large ones for attaining competitive
advantages. For example, a small town can only support one discount store,
and a determined retailer who develops such a store should expect to enjoy
an unchallenged monopoly as if a 2nd store were to enter the town, neither
would have enough customer traffic to be profitable. Other things being
equal, the 2nd entrant could not expect to drive out the 1st, so the best choice
would be to stay away, leaving the monopoly intact. A large city can support
many essentially same stores and the ability of a powerful, well-financed
incumbent to prevent entry by a newcomer will be limited and thus unable
to establish effective barriers to entry via economies of scale relative to its
competitors. This principle applies to product as well as geographic space.
E.g. Walmart first had high levels of profit and dominant market share in
regional areas due to regional economies of scale in distribution,
advertising, and store supervision.
24.The best strategy for an incumbent with economies of scale is to match the
moves of an aggressive competitor, price cut for price cut, new product for
new product, niche by niche. Then, customer captivity or just customer
inertia will secure the incumbent’s greater market share and the entrant’s
average costs will be uniformly higher than the incumbent’s at every stage
of the fight. While the incumbent’s profits will be impaired, the entrant’s will
be even lower, often so low that it disappears.
25.Economies of scale coupled with better access in the future to existing
customers also produces an advantage in the contest for new customers and
for new technologies. Customers may be accustomed to dealing with their
incumbent supplier and are comfortable with the level of quality, supply
stability, and service support received from it. Even if other smaller
incumbents or potential entrants perform as well in these areas, but with a
much smaller market share and less interactive, these competitors does not
have the same intimate association customers. If both the dominant
incumbent and its competitors both produced similarly advanced new
technologies, at equal prices, at roughly the same time, the dominant firm
will inevitably capture a dominant market share as all the dominant firm has
to do is to match its smaller competitors’ offerings to retain its dominant
market share via customer captivity. Thus, in planning for its next-
generation technology, the dominant firm can afford to invest a lot more
than its competitors, knowing that its profits will be much greater, even if
the technology ends up being no better than competitors’. A rough rule of
thumb should lead both the dominant firm and its smaller competitors to
invest in proportion to their current market share, causing the dominant
firm to invest an absolute large sum, giving it an enormous advantage in the
race for developing the next generation technology. Even if smaller
competitors can produce a better new product, customers would almost
certainly allow the dominant firm a grace period to catch up rather than
switch supplier immediately. Thus the dominant firm’s larger investments
usually pay off in superior technology, and its customer captivity allows it
time to catch up when its smaller competitors have taken the lead.
Economies of scale with customer captivity enables the dominant firm to
sustain its technological edge over many generations of technology.
26.Economies of scale in distribution and advertising also helps perpetuate and
amplify customer captivity across generations of consumers, giving giants
an edge in winning new generations of customers. Even if smaller rivals can
spend the same proportion of revenue on product development, sales force,
and advertising, they cannot come close to matching the giants on actual
dollars deployed to attract new customers. E.g. Coca Cola has local
economies of scale in advertising and distribution and thus have an edge in
acquiring new customers as it can appeal to them (advertise) and serve
them (distribute) at a much lower cost per unit than can its smaller
competitors. However, these advantages are particular to specific
geographic regions and despite worldwide recognition, it isn’t the dominant
soft drink everywhere.
27.In order to persist, competitive advantages based on economies of scale
must be vigorously defended as they are vulnerable to gradual corrosion.
Any market share lost to rivals narrows the leader’s edge in average cost.
Each step a competitor takes towards increasing the size of its operations
and closing the gap makes the next step easier, because its margins and
thus its resources are improving as its cost declines. In contrast, competitive
advantages based on customer captivity or cost advantages are not affected
by market share losses. When economies of scale are important, the leader
must be always on guard. If a rival introduces attractive new product
features, the leader must adopt them quickly. If a rival initiates a major
advertising campaign or new distribution systems, the leader has to
neutralize them. The incumbent also cannot concede unexploited niche
markets, which are an open invitation to entrants looking to reach a
minimally viable scale of operations, e.g. new distribution channel, new
products. The incumbent can also take the first step and increase fixed
costs, e.g. advertising heavily, and it will present smaller competitors with
the nasty alternative of matching the expenses and hurting their margins or
not matching and losing the competition for new customers. Production and
product features that require capital expenditures, like building centralized
facilities to provide automated processing, will also make life more difficult
for smaller competitors. Accelerating product development cycles, and thus
upping the cost of R&D is another possibility. Anything that efficiently shifts
costs from variable to fixed will reinforce advantages from economies of
scale. Ill-conceived growth plans will do the opposite and companies should
not spend copiously in markets where they are newcomers battling powerful
incumbents, but instead defend the markets in which they are dominant and
profitable. Competitive advantage are market-specific and companies should
stay within their areas of fundamental competitive advantage.
28.Pure size is not the same as economies of scale, which depends on the share
of the relevant market. Economies of scale arise when the dominant firm in
a market can spread the fixed costs of being in that market across a greater
number of units than its rivals. The relevant market is the area, geographic
or product space, in which the fixed costs stay fixed. E.g. for a retail
company, the relevant market is each metropolitan area or regional cluster,
where distribution infrastructure, advertising expenditures, and store
supervision expenses are largely fixed in an area. If sales are added outside
that territory, fixed costs rise and economies of scale diminish. Thus, a
company that is larger nationally can have a higher fixed cost per dollar of
revenue in a particular region than its competitor, who controls a far great
market share of the relevant territory. For product lines, R&D costs, start-
up costs of new production lines and product management overhead are
fixed costs associated with specific product lines. Network economies of
scale are when customers gain by being part of densely populated networks,
but the benefits and economies of scale extend only as far as the reach of
the network. E.g. insurance coverage of doctors for a firm might be larger
nationally, but what matters in a region is insurance coverage of doctors in
the region, so a firm with 60% share of doctors is more appealing than a
large national firm with only 20% share of doctors in the relevant local
region. There are only a few industries in which economies of scale coincide
with global size, e.g. the globally connected markets for operating systems
and CPUs, where Microsoft and Intel are the beneficiaries of global
geographic economies of scale. However, they concentrate on a single
product line and hence on local product space economies of scale.
29.The big size and rapid growth of a market is generally the enemy of
competitive advantage based on economies of scale, not the friend. The
strength of this advantage is directly related to the importance of fixed costs
and as a market grows, fixed costs remains constant, and variable costs
increase at least as fast as the market itself. Thus fixed costs declines as a
proportion of total cost. Markets growing rapidly are attracting new
customers, who are by definition non-captive and may provide a base of
viable scale for new entrants. This reduces the advantages provided by
greater incumbent scale. Growth in the market lowers the hurdle an entrant
must clear in order to become viably competitive as the incumbent need a
smaller market share given a bigger market in order to have fixed costs as a
particular percentage of total costs. As markets become international and
massive, e.g. the global market for automobiles is so large that many
competitors have reached a size, even with a small market share, at which
they are no longer burdened by an economies of scale disadvantage. For
very large potential markets, the relative importance of fixed costs are
unlikely to be significant. If new entrants can capture a market share
sufficient to support the required infrastructure, established online sales
companies like Amazon will find it difficult to keep them out. Although
counterintuitive, most competitive advantages based on economies of scale
are found in local and niche markets, where either geographical or product
spaces are limited and fixed costs remain proportionately substantial.
Markets that are not large enough for a 2nd or 3rd company to reach viable
scale will fare better in terms of profitability. Big markets will support many
competitors even when there are substantial fixed costs.
30.The appropriate strategy for both incumbents and entrants is to identify
niche markets, understanding that not all niches are equally attractive. An
attractive niche must be characterized by customer captivity, small size
relative to fixed costs, and the absence of vigilant, dominant competitors.
Ideally it will also be readily extendable at the edges. Economies of scale
advantages with customer captivity can also be created in markets with
significant fixed costs, currently serviced by many small competitors, with a
degree of customer captivity. A firm will have the opportunity to capture a
dominant market share that will be defensible. The best course is to
establish dominance in a local market and expand outwards from it, either
geographically or in product space. Even where incumbent competitors have
dominant positions, lack of vigilance on their part may present openings for
successful encroachment. Economies of scale in local markets are thus the
key to sustainable competitive advantages.
31.Strategic analysis should begin with 2 key questions: 1. In the market in
which the firm currently competes or plans to enter, do any competitive
advantages actually exist? 2. If they do, what kind of advantages are they?
32.Markets in which no firms benefit from significant competitive
advantages doesn't need to concern itself with strategy (which looks
outward to the marketplace and the actions of competitors). If there
are no barriers to entry, then the company doesn’t have to worry about
interacting with identifiable competitors or about anticipating and
influencing their behavior as there are too many of them to deal with. Lots
of competitors have equal access to customers, technologies, and cost
advantages. Each firm is more or less in the same competitive position
and there is a level playing field, and anything that one does to
improve its position can and will be immediately copied. The process
of innovation and imitation repeats continually. It is difficult for a single firm
to shift the basic economic structure of such a market significantly for its
benefit. The sensible course in such markets is not to try to outmaneuver
competitors and forget visionary strategic dreams, but rather to simply
outrun them by operating as efficiently as possible. What matters is
efficiency in managing costs, in product development, in marketing, in
pricing to specific customer segments, in financing, etc. Constant pursuit
of operational efficiency is essential in markets without competitive
advantages. It is a tactical matter, not a strategic one, and focuses
internally on a company's systems, structures, people, and
practices. Although it is not strategic, it is very important, but it does not
require consideration of all the external interactions that are the essence of
real strategy. Operational effectiveness can make one company much more
profitable than its rivals even in an industry with no competitive advantages,
where everyone has basically equal access to customers, resources,
technology, and scale of production. Firms that are operationally effective
tend to focus on a single business and their own internal performance.
33.In markets where incumbents have competitive advantage, companies need
to identify the nature of the competitive advantages, and manage the
competition among their peers and how effectively they are able to fend off
potential entrants. If the advantages dissipate, whether because of poor
strategy or bad execution, these companies will be on a level economic
playing field under the no competitive advantage branch, where profits are
average at best, except for the exceptionally managed companies.
34.In the situation where there is 1 large dominant firm with competitive
advantage and many smaller ones, a company in this market is either an
elephant, or an ant. The ants operate with a competitive disadvantage and if
it already in the industry, it should get out as painlessly as possible and
return the economic resources of whatever is salvageable to its owners. If a
firm is considering entering a market with an elephant as an ant, the
company should stop and look elsewhere because its slim chance for success
depends on the elephant competitor messing up. Even if the incumbent
elephant’s advantage shrinks and the barriers to entry disappear, the new
firm will be just one of many entrant pursuing profit on an essentially level
playing field.
35.The elephant in the situation where there is 1 large dominant firm with
competitive advantage and many smaller ones still have to manage its
competitive advantages. Complacency can be fatal, as can ignoring or
misunderstanding the sources of one’s strength. The company should
recognize its sources of competitive advantage, along with its limitations,
and seek to sustain it (it doesn’t have to confront the complexities of explicit
mutual interactions among competitors). This will allow it to reinforce and
protect existing advantages and make those incremental investments that
will extend them. It also allows management to distinguish potential areas of
growth, both geographically and in product lines, that are likely to yield
high returns from tempting areas that might undermine the advantages. It
highlights policies that extract maximum profitability from the firm’s
situation, and spots threats that are likely to develop and identifies those
competitive inroads that require strong countermeasures. It also allows
functional departments to properly carry out capital budgeting, evaluating
M&A, and for new ventures.
36.If a market has competitive advantage that are shared by several companies
who enjoy roughly equivalent competitive advantages with similar
capabilities, strategy formulation is most intense and demanding as
companies need to manage their competitors. To develop an effective
strategy, a company needs to know what its competitors are doing and
anticipate these competitors’ reaction to any move the company makes as
their reactions are critical to a company’s own performance, e.g. pricing
policies, new product lines, geographical expansions and capacity addition.
There are 3 approaches that can help companies develop competitive
strategies: game theory, simulation and cooperative analysis. Taken
together, they will produce a balanced and comprehensive treatment to the
problem of formulating strategy in markets with a few genuine competitors,
all mutually capable and conscious of each other.
37.Classical game theory is useful because it imposes a systematic approach to
collecting and organizing the mass of information about how competitors
may behave. Game theory is the study of the ways in which strategic
interactions among rational players produce outcomes with respect to the
utilities/preferences of those players, none of which might have been
intended by any of them. A competitive situation consists of the players (a
restricted number of identifiable competitors; if the list is not short and
manageable, there are probably no genuine barriers to entry), the choices
available to each player, the motives that drives each player (most
commonly profitability, or other goals like winning against competitors
regardless of costs) and the rules that govern the game (who goes when,
who knows what and when, and what penalties there are for breaking the
rules). The fundamental dynamics of majority of competitive situations can
be captured by 2 relatively simple games. The Prisoner’s Dilemma game
describes competition that concerns price and quality. A lot is known about
how a PD game is likely to play out, and this knowledge can be brought to
bear on any situation in which price/quality competition is key to
competitive interactions. The other game focuses on entry/pre-emption
behavior by capturing the dynamics of quantity and capacity competition.
Whenever a company decides to build a new plant or open a new store in a
market already served by a competitor, entry/pre-emption is the game bring
play, and like PD we can use the wealth of established knowledge on how a
situation will work out.
38.Given that a company is in a situation where competitive advantages are
shared by multiple competitors, an approach to strategic analysis would be
to start by identifying the competitive situations to which one or another of
these 2 games can be appropriately applied. If an industry’s history has
been dominated by a long-lived and debilitating price war, then the place to
look for a solution is the accumulated knowledge of how to play the PD
game. If the industry is one in which any expansion by 1 firm has habitually
induced its rival to counter with their own expansions, then the entry/pre-
emption game provides the template for strategic analysis. In simple
straightforward interactions, it may be possible to anticipate how the game
will evolve merely by listing the various courses of action and comparing the
results. In practice alternative possibilities multiply rapidly and the analysis
becomes intractable, and a better way is to proceed with simulation. One
can assign individuals or teams to represent each competitor, provide them
with appropriate choices for actions with motives, and then play the game
several times. The simulation should provide a rough sense of the dynamics
of the situation, even the outcomes are only rarely definitive.
39.Cooperative analysis is analysing competition among the elephants by
assuming that instead of battling, companies can learn how to cooperate for
mutual gains and to fairly share the benefits of their jointly held competitive
advantage. This type of “bargaining” interaction makes all the players better
off than fighting each other, but requires an outlook and a disposition rarely
found in a competitive environment. Even if it isn’t immediately practical
and are rare, players need to think about what this ideal state of affairs
would look like, as it reveal aspects of the strategic situation that can guide
company decision making even in the absence of full-fledge cooperation. It
also adds a bargaining perspective as a complement to the more traditional
non-cooperative treatment of the problems of formulating strategy in
markets with a few genuine competitors, all mutually capable and conscious
of each other. Companies need to identify joint gains and envision the best
configuration of market activity, where costs are minimized, products and
services most efficiently produced and delivered, and prices set to maximize
income. In the ideal configuration, everyone in the market including
competitors must benefit, i.e. how would the market look like if it were
organized as a cartel or monopoly? The players also have to decide upon a
fair division of the spoils because cooperative arrangements don’t last if any
participants believes it is being unfairly treated. Analysing the theoretical
ideal configuration helps identifies the possibilities a cooperative posture
might produce, and helps a firm on the margin of a protected market or a
potential entrant to set reasonable strategic goals. E.g. for a relatively high
cost supplier with no captive customers, it should see that it cannot expect
to gain any advantage through strategic alliances, competitive threats or
other means as if the market is configured efficiently, such a supplier has no
role to play as other competitors won’t support it at the price of a reduction
in overall industry performance, especially when the others have to pay the
costs. The high cost firm’s continued existence will hinge on irrational and
non-cooperative behavior from other companies. Identifying and exploiting
that behavior and making sure they don’t get together becomes the core of
its strategy.
40.Commodity businesses should be avoided as any operation in which sellers
offer essentially identical products to price-sensitive customers faces an
intense struggle for economic survival and must accept a lower than
average level of profitability. A flawed wisdom in business is that
management shouldn’t allow themselves to be trapped in a commodity
business and to differentiate its products from that of the competition.
However, differentiation as a strategy to escape the woes of a commodity
business doesn’t work. Differentiation may keep one’s product from being a
generic commodity item, but it doesn’t eliminate the intense competition
and low profitability that characterizes a commodity business. Although the
nature of the competition may change (from pure price competition to
minimal price competition but lower volumes due to fragmentation of
market across the variety of substitute differentiated products, causing
higher fixed costs per unit), the damage to profit persists because the
problem is not a lack of differentiation but the absence of barriers to
entry. By itself, product differentiation doesn’t eliminate the
corrosive impact of competition and well-regarded brands are no
better protected than commodities. High returns attract new entrants or
expansion by existing competitors or both. If no forces interfere with the
process of entry by competitors, profitability will be driven to levels at which
efficient firms earn no more than a “normal” return on their invested capital.
It is barriers to entry, not differentiation by itself, that creates strategic
opportunities.
41.An example of high differentiation but low commodity-type profits can be
found in automobiles. Despite the recognition and associations with quality,
Mercedes-Benz have not been able to translate the power of its brand into
an exceptionally profitable business. MB first dominated its local market and
made exceptional profits, attracting other companies to enter its market,
seeking a share of high returns. If luxury cars were a pure commodity
business, the entry of new competitors would have undermined prices.
However, MB continued to sell for premium prices even with the entry of
imports because the imports did not, as a rule, undercut them on price. But
with a wider variety of luxury cars available, the sales and market share of
MB began to decline. Meanwhile, the fixed costs of its differentiation
strategy – product development, advertising, maintaining dealer and service
networks – did not contract. Thus the fixed cost of each car went up, and
price remained constant, so profit margin per car dropped. MB found itself
selling fewer cars with lower profit margins and profitability shrank even
though products were thoroughly differentiated. The flood of entrants would
only case when lucrative profit opportunities in the luxury car market
vanishes after entrants have fragmented the market to such an extent that
high fixed costs per unit eliminated any extraordinary profits.
42.In markets with no barriers to entry, efficiency is vitally linked in survival. In
a pure commodity market, if a company cannot produce at a cost at or below
the price established in the market, it will fail and ultimately disappear.
Since the market price of a commodity is determined in the long run by the
cost levels of the most efficient producers, competitors who cannot match
this level of efficiency cannot survive. The same conditions apply to markets
with differentiated products. Companies must invest in advertising, product
development, sales and service departments, product specialists,
distribution channels, and a host of other functions to distinguish their
offerings from those of their competitors. If they cannot operate all these
functions efficiently, then they will lose out to better-run rivals. The prices
their products command and/or their market share will trail those of their
competitors and thus the return they earn on the investments made to
differentiate their products will fall below that of their more efficient
competitors. When the successful companies expand, market shares of less
efficient firms decline further and even if they can still continue to charge
premium prices, the returns they earn on their investments in differentiation
will fail. When the returns no longer justify the investment, the less efficient
companies will struggle to stay afloat.
43.The need for efficiency is vital in both commodities and differentiated
products, but in differentiated products, efficiency is more difficult to
achieve. In commodities, efficient operations are largely a matter of
controlling production costs and marketing requirements are usually
minimal. With differentiated products, efficiency is a matter of both
production cost control and the effectiveness in all the functions that
underlie successful marketing. Competition extends to dimensions beyond
simple cost controls such as managing product and packaging
developments, market research, product portfolio, advertising and
promotion, distribution channels, a skill sales force, and doing them all
without wasting money. Unless something interferes with the processes of
competitive entry and expansion, efficient operations in all aspects of the
business are key to successful performance.
44.Meaning of a “normal” return – implies average return over a period of
years. Investors in a business needs to be compensated for the use of their
capital. To be “normal”, the return to capital should be equivalent to what
the investor can earn elsewhere, suitably adjusted for risk. If investors can
earn a 12% return by buying stocks in companies with average risk, then the
companies have to earn 12% on their own average risk investments.
Otherwise, investors will ultimately withdraw their capital. In practice, a
management that produces a lower rate of return can hang on for many
years before the process runs its course, but in the long run, the company
will succumb.
45.It is essential to distinguish between skills and competencies a firm may
possess, and genuine barriers to entry. Skills and competencies of the best-
run companies are available to competitors, at least in theory. Systems can
be replicated, talent hired away, managerial quality upgraded, and all these
are ultimately parts of the operational effectiveness of the company.
Barriers to entry are characteristics of the structural economics of a
particular market. Identifying those barriers and understanding how they
operate, how they can be created, and how they must be defended, is at the
core of strategic formulation. If barriers to entry exists, then firms within
the barriers must be able to do things that potential entrants cannot, no
matter how much money they spend and how effectively they emulate the
practices of the most successful companies.
46.Just as extraordinary profits attract new competitors or motivate existing
ones to expand, below-average profitability will keep them away. If the
process is sustained long enough, the less efficient firms within the industry
will wither and disappear. However, it takes longer for an industry with
excess capacity and below-average returns to eliminate unnecessary assets
than it does for an industry with above average returns to add new capacity.
Periods of oversupply last longer than periods in which demand exceeds
capacity. The problem is compounded by the longevity of new plants and
products. For mature, capital-intensive businesses, these time spans are apt
to be longer than for younger industries that require less in the way of plant
and equipment. Commodity businesses are generally in the mature camp,
and part of their poor performance stems from their durability, even after
they are no longer earning their keep. Competitors with patient capital and
an emotional commitment to the business can impair the profitability of
efficient competitors for many years.
47.Barriers to entry and competitive advantages are the same thing. Barriers to
entry are identical to incumbent competitive advantages, whereas entrant
competitive advantages (situations in which the latest firm to arrive in the
market enjoys an edge due to the benefit of the latest technology, hottest
product design, no costs for maintaining legacy products or retired workers)
are of limited and transitory value. Once an entrant enters a market, it
becomes an incumbent. The same type of advantages it employed to gain
entry and win business from existing firms now benefit the next new
company. If the last firm always has the advantage, there are no barriers to
entry and no sustainable excess returns. Since competitive advantages
belong only to the incumbents, their strategic planning must focus on
maintaining and exploiting those advantages. For firms bold enough to enter
markets protected by barriers to entry, they should devise plans to make it
less painful for incumbents to tolerate them than to eliminate them.