Michael Porter’s Strategy
Critical Thinking May Be Overdone
• “Meat, you’ve got to play this game with fear
and arrogance.”
• Reading with humility, reading with arrogance
• Fear and ignorance
Reading Porter
Reading Porter for what there is to be learned,
noting limitations along the way.
There is much in Porter that is fundamental.
We will read with humility and arrogance.
“Competition is war and war is hell”
This is Arthur Jerome Eddy, who published The
New Competition in 1912. The book
advocated avoidance of competition. He was a
leader in the trade association movement.
He was also one of the architects of the
Federal Trade Commission.
Like Porter, he didn’t much like
competition
Trade associations pursued “ethical behavior”
among firms. Ethical behavior could include
quality standards, fair business practices, and
occupational licensing.
Among other things, the movement
advocated “ethical pricing.”
Also known as price fixing.
But I digress…
An unfair slur on Michael Porter?
Well, probably, yes.
Porter’s economic policy v. Porters strategy
Law and Social Welfare
• Price fixing per se is illegal because in almost
all instances it will be harmful.
• Porter would not defend price fixing
• Product variety, however, it perfectly legal
and, in most instances, though not necessarily
all, socially beneficial.
Porter’s strategy does urge firms to
avoid direct competition
• The social consequences of product variety
• Chamberlin, Robinson emphasized the social cost
of variety.
• Modern economics acknowledges benefits of
variety, along with costs; a tradeoff.
A brief non-technical introduction to
oligopoly theory (again?)
• Cournot (a peace treaty)
• Bertrand (price war)
• Stackleberg Leader Follower
• Shared Monopoly
Direct Competition
• Cournot
– Helped by product differentiation
• Bertrand (price war)
– Profits forced out
• Stackleberg
– Credible commitment to a market position
• Shared Monopoly
– A better peace treaty (also facilitated by product
differentiation. )
“One-Upmanship is not a Strategy”
• The bed wars
• Free meals on flights (or bags, for that matter)
• “Competing to be the best leads inevitably to
a destructive game that no one can win.”
• “The very essence of zero sum.
• He is likening this to Bertrand price
competition.
And yet….
• New products and new features do arise
• Automobiles came to include self starters,
heaters, radios, air conditioners, etc,
eventually as standard equipment
• These can yield temporary competitive
advantages
• And then antilock brakes, traction control,
stability control, lane departure warning, side
monitoring, self parking….
We see this with
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Restaurants
Insurance
Cameras
Phones
Mortgages
Banking
Pharmaceuticals
An almost-general principle
If a product improvement costs less to produce
than the value that consumers place on the
good, then introducing the improvement adds
value.
The first firm to implement a particular
improvement will earn profits.
Basic ideas in Porter that may seem
obvious but are sometimes obscured
p. 40
The fundamental equation: Profit = Price – Cost
Or more correctly
Unit Profit Margin = Price – Cost (in Magretta)
And correctly:
Profit = Total Revenue – Total Cost
Avoiding what error in practice?
• Market share (Why?)
• Revenue (Why?)
• And even unit margin (Why?)
And yet these have their place.
• Market share (Why?)
• Revenue (Why?)
• And even unit margin (Why?)
And still, a simple useful message
• Profit is the difference between
• REVENUE
• COST
Structure determines profitability
• That’s the core claim of Porter’s approach to
strategy.
“[I]ndustry structure determines profitability—
not, as many people think, whether the
industry is high growth or low, high tech or
low, regulated or not, manufacturing or
service. Structure trumps these other, more
intuitive categories.” (p. 37)
Those five forces…
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Thinking critically
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Thinking critically
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Thinking critically
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Thinking critically
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Thinking critically
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Rivalry within the industry
Threat of entry
Threat of competition from substitutes
Market power of suppliers
Market power of customers
Competing for profits
Selectively from Magretta; sidebar p. 61
“The real point of competition is earning profits,
not taking business away from rivals.
[but it is] …the tug of war over who gets to
capture the value that an industry creates.”
Competing for profits
“Companies compete with their direct rivals, but
also with their customers, their suppliers,
potential new entrants and substitutes.”
(Repeating the five forces)
Competing for profits
“The collective strength of the five forces
determines the average profitability of the
industry… . A good strategy produces a P&L
better than this industry average baseline.”
Competing for profits
“Because industry structure can explain the income
statements and balance sheets of every company
in an industry, insights gained from it should lead
directly to decisions about where and how to
compete.”
OK, maybe some critical thinking would be a good
idea. Distinguishing between after the fact
“explaining” versus predicting.
Chapter 3: Competitive Advantage
• The value chain:
• The objective is to create value
• Through lower cost, premium price, or both
• As these occur in every aspect of the business
Economic Fundamentals
• ROIC (Return on invested capital) (in Porter)
• Competitive advantage v. Comparative
Advantage (not in Porter)
Why return on invested capital?
• Measures the efficiency of the use of resources.
(Porter)
• Ignoring capital investment distorts incentives,
ignoring the capital investment of the firm
• But the real reason is what investors seek, and
this is how the firm must compete in the capital
market.
Porter says, compare within the
industry. Why?
But first, why not? Why shouldn’t se compare
across industries?
If industry A consistently earns lower returns on
invested capital than industry B does, shouldn’t
investors move capital out of industry A in favor
or industry B?
Answer: Yes, if true. But…
It isn’t true.
(not in Magretta)
• Profits over book equity (invested capital)
gives a distorted picture. Because…
• Accounting depreciation rates do not reflect
true economic depreciation rages.
• Franklin Fisher, John McGowan, American
Econ Review, 1983.
A perpetuity
• Pays $80 per year on a $1,000 investment.
(no depreciation) Yields an 8% return.
A one year project
On a $1,000 investment, returns $ 1000,
and another $80. (All depreciation accounted
for in the year.)
This too yields an 8% return.
Now consider a thirty year project that
yields a constant annual flow for thirty
years, then yields nothing after that.
Which is kind of like a mortgage.
Principal
(level payments, 30 years)
30
Years
But now, look at accounting
depreciation
Principal
Early, depreciation overstated,
implied return understated
Late, depreciation
understated, profits
overstated
profit/asset
severely overstated.
30
Years
And the effects do not average out due to non linearity.
Getting back to Porter
• Firms in the same industry tend to have
similar project duration structures.
• So, Porter is right, it does make sense to
compare within industries.
• Though immature firms will face a different
bias structure.
The Value Chain: Premium Prices
• “A company can sustain a premium price only if it
offers something that is both unique and valuable
to its customers.”
• Product differentiation is anything that permits a
higher price.
• Moving away from perfect substitutes—creating
a degree of market power
More on Higher Prices
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Greater value to customer
Desirable features not found elsewhere
Image
Reliability or durability
Convenience
Style
Affiliation
Still More on Higher Prices
• Deskilling home production
– Meal in a box
– Prefinished craft materials—e.g. wood flooring
– Special tools for the semiskilled
• Satisfying personal values
– Environmental
– Natural
– Novel
– Authentic
The Value Chain: Lower costs
• Internal process of the firm
• Product efficiencies
• Supply chain advantages
• Location efficiencies
Lower costs
• Different product concept:
– Take and Bake Pizza
– Self serve anything
– Salad Bar
– Bring your own grocery bag
– Reduced content—less powerful, fewer features
(Just price discrimination?)
– Generally, do it yourself (Or, its opposite, we do it
for you, for a higher price)
Lower Costs
• Pack your own groceries (Aldi)
• Select your own airplane seats (Southwest)
• Make your own reservation: (Open table,
Hotels.com)
• Specify your own automobile (Several
Manufacturers
• Receive your bank or brokerage information
online
• Do your own investment research
No Exhaustive List of Value Increasing
Actions
• Or, if we can list it, it doesn’t belong on the list
• “The mind cannot foresee its own advance”
(Hayek)
And note the general problem,
Any of these things that are readily observed by
outsiders are readily imitated.
Unless protected by patent or copyright, or
possibly an important trademark, they may
not provide a sustainable competitive
advantage.