Economics of Strategy

Strategic Positioning for Competitive Advantage

Competitive Advantage

• Traditional Management Definition– “the ability of the firm to favorably distinguish

itself from its competitors in the the eyes of consumers”

Competitive Advantage

• Economists Definition– “a firm has a competitive advantage when it

outperforms competitors who sell in the same market (i.e., earns higher rates of profitability than)”

• Traditional definition focused on sales (i.e., demand factors)

• This definition is much broader– includes stake-holders beyond consumers– explicitly addressed costs

Competitive Advantage• Depends upon two major factors

– creating firm value through the cost side

– creating firm value through the demand or product differentiation side

• both are in relative terms compared to peer competitors who sell in the same market

• Profitability depends upon both the industry you are in and your relative performance within that industry– see figure 12.1, p. 442

Analysis of Competitive Advantage

• Consumer Surplus– the difference between what the consumer pays

for a product and the perceived benefits by the consumer

– treat the demand curve as a marginal benefit curve

• consumers buy products which maximize their consumer surplus

Perceived Gross Benefitsto the consumer

• Start with product attributes

• subtract out user costs

• subtract out the transactions costs

Perceived Attributes

• performance

• reliability

• durability

• convenience

• aesthetics

• image

• resale value

User Costs

• installation costs

• learning costs

• operations costs

• maintenance costs

• disposal costs

Transactions Costs

• the costs of organizing and transacting an exchange

The Value Map

Quality

PriceIndifference Curve 1

Indifference Curve 2

Preference direction“higher consumer surplus”

Value Creation• Value is created as the product moves through

the vertical chain from raw materials to finished product

• B as the perceived benefit to the final consumer

• C as the costs of inputs– all economic inputs including opportunity costs

• Value Created = B - C

• Value created is split into consumer surplus + producer surplus

Value-Creation and Competitive Advantage

• To achieve competitive advantage the firm – must create value AND– it must create more value than its competitors

in the industry

• competition among firms is a process of bidding for both the dollar votes of consumers and the dollar votes of investors

Value-Creation and Competitive Advantage

• Why do customer’s choose your product over the other choices they have?

• How do production, distribution, and sales technology affect your firm?

• What is the underlying cost structure of your firm?– Are there economies of scale or scope?

– How do non-production costs affect your overall cost structure? (Production, distribution, sales?)

– How do costs change with experience?

Value-Creation and the Value Chain

• The value chain identifies processes within the firm that create value

• Each stage can potentially add or reduce B and/or C

• To have competitive advantage the firm must create more value (the spread between B and C) than its competitors

• This requires resources and capabilities

Resources

• firm-specific assets that cannot be easily duplicated or acquired by your competitors– patents, copyrights, trademarks– brand recognition– organizational culture– good relationships with work force– protected access to channels of distribution– monopoly power through legislation

Capabilities

• clusters of activities that your firm performs well relative to competitor firms– developed expertise

• Disney in cartoons• American Airlines in yield management• Employee relationships at Saturn• Honda and small internal combustion engines and power

trains• Harley Davidson and The American Mystique• Bausch and Lomb in optics

Capabilities - Common Characteristics

• They are typically valuable across multiple markets or products

• They are typically embedded in organizational routines – well-honed patterns of performing activities

inside the organization

• They are difficult to quantify or reduce to simple algorithms or procedure lists

Key Success Factors• Skills and assets a firm must possess to

achieve profitability in the industry

• these are necessary but not sufficient – necessary - they are required to be in the game

(join the industry)– sufficient - they are not what creates

competitive advantage (within the industry) among your peer competitors

Creating Value vs. Redistributing Value

• Competition for the former is fierce– dependent upon bargaining skill– usually one-time gain

• The former is less likely to be replicable– usually ongoing gain

Retained Value for the Firm

• The firm wants to be able retain the value-created

• Industry structure affects their ability to do so

• Position in the vertical chain affects their ability to do so– lower levels on the vertical chain are often

more commodity-like, hence more competitive

Cost Advantage and Differentiation Advantage

• Cost Advantage - creating value on the cost side relative to peer competitors

• Differentiation Advantage - creating value on the demand side relative to your competitors

Cost Advantage

• Create value by lowering your costs relative to your peer competitors

Benefit Parity

• You could offer the same benefits to consumers as your peer firms but– obtain competitive advantage by reducing your

cost structures• e.g., Lexus, Accra, Infinity vs. Mercedes Benz

Benefit Proximity

• You could offer slightly lower benefits than your peer firms– obtain your competitive advantage by reducing

cost structures – cost structures themselves may be lower due to

reductions in quality which consumers value• e.g., oil filters - Fram vs. MotorCraft

Produce a qualitatively different product

• Redefine the product in ways that allow for substantial differences in benefits or costs relative to traditional product definitions– compete on much lower costs and quality

• McDonalds, Timex watches, Bic pens and lighters

– compete on much higher costs and quality• Hatteras Yachts, Rolex, pork rinds ;-)

Differentiation Advantage

• You can offer a higher perceived benefit to consumers – where the percentage increase in perceived

benefits exceed the percentage increase in costs

Extracting Profits

• Vertical Differentiation– sellers seek competitive advantage by providing

increased perceived benefits to all consumers – more likely where the product is more

homogeneous – more likely in competitive markets

Extracting Profits

• Horizontal Differentiation– sellers seek competitive advantage by providing

increased perceived benefits to some consumers but decreased perceived benefits to other consumers

• carving up market niche based upon quality• more likely with numerous product attributes

– e.g., automobiles, boats, breakfast cereals, cigars

– More likely outside of the pure competition model (product differentiation)

Extracting Profits - Horizontal Differentiation

• Ed becomes very important

– The more elastic the demand, the more important volume becomes

• consumers are very price-sensitive

– The more inelastic the demand, the more important margins become

• consumers are not very price sensitive

Pursue Cost Strategies– when economies of scale and learning economies are

potentially significant but no firm in the market seems to be exploiting them

– when opportunities for enhancing the product’s perceived benefits are limited by the nature of the product

– when customers are relatively price sensitive and unwilling to pay for quality, performance, or image

– when the products attributes are easily observable at the time of purchase (a search good)

Pursue Differentiation Strategies

– when consumers are willing to pay for increased perceived benefits

– when economies of scale and learning economies are significant and being fully exploited

– when the products attributes supply increased perceived value and are difficult to replicate (an experience good)

Implications for Functional Areas

• See Table 12.2, p. 474

“Stuck in the Middle”

• Michael Porter has argued that firms have great difficulty pursuing both cost and differentiation strategies simultaneously because product differentiation costs

• Mixed empirical results on this thesis

Countering the “Stuck in the Middle” Theory

– A firm that offers high-quality products increases its market share, which may result in economies of scale or learning curve effects

• figure 12.10, p.477

– The rate at which accumulated experience reduces costs is greater for higher-quality products than for lower-quality products

– Inefficiencies muddy the relationship between cost position and differentiation position

Segmenting the Market

• How can we segment out consumers into relatively homogeneous groups so that we can price to each group accordingly?

Why Segment?

• To extract consumer surplus

• Airline example

Targeting the Market

• Which segments do we go after?– Focus strategies– Broad-coverage strategies

Broad Coverage Strategies

• offer a full line of related products – economic logic can be found in economies of

scope across the related products• Frito Lay (production and distribution facilities)

• Statistical Software - SPSS Modules

• Television Cable Services

• Victoria's Secret (women’s lingerie and clothing)

Broad Coverage Strategies

• “one-size-fits-all” approach

• a common product line is marketed to a variety of different market segments

• economic logic for a one-size fits all can be found in economies of scale

• Software Office Suites

• Programming packages (C+)

• Toothbrushes

Focus Strategies

• offer a single product or target a single market– product specialization– geographic specialization– customer specialization– niche specialization

Focus Strategies

• Economic logic – deep economies of scale by focusing on one

product and/or one market– learning effects come more quickly– establish market power within the niche– choose niches where customers are less price

sensitive

Targeting a segment and pricing

• Targeting is connected to pricing

• see figure 12.12

Segmentation and Competition

• Different segments of the market face varying competitive environments

Strategic Groups

• a collection of firms within an industry that are similar to one another and sufficiently different from other collections of firms firms in the industry in one or more key strategic dimensions

Identification by Strategic Dimension

• Organization Characteristics– scale and scope, distribution channels, vertical

integration, diversification, relationship to government

• Marketing and Product Characteristics– price, quality, image, service, technology

• Financial Characteristics– costs, debt position

Strategic Maps

• Identify to critical strategic dimensions

• Classify firms according to these dimensions

• Map onto a Cartesian plane

• Group the clusters to determine strategic competitors

Strategic Groups

• compete with one another

• competitive advantage cannot be maintained without barriers to entry – patent, trademark, copyright– unique location– scale or scope economies