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