1. Planning does not equate to business strategy. Executives 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 entities. Strategic thinking is about creating, protecting and exploiting competitive advantages. Tactical 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 determines the cast of external external characters 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 returns of all players players to a uniform minimum, minimum, where there is no “economic profit” i.e. no returns above the cost of invested capital. 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:
Management level
Strategic
Tactical/Operational/Functional
Top management, Board of
Mid-level, functional, local
directors 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?
How do we improve delivery time?
What critical competencies must
How big a promotional discount do
we develop?
we offer?
How are we going to deal with
What is the best career path for our
competitors?
salespeople?
6. Porter’s Five Forces (Substitutes, Suppliers, Potential Entrants, Buyers, and Competitors) can affect the competitive environment. environment. But one of them is clearly much more important than others and leaders should begin by ignoring the others and only o nly 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) co mpared 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 3 rd 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 a bout 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 cu stomers 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 mark et 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 2 nd 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 nextgeneration 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 p articular 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 t o 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 co mpany 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 p lay 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 sp end 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.
