Economics of Strategy Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc. Chapter 11 Strategic Positioning for Competitive Advantage Besanko, Dranove, Shanley and Schaefer, 3 rd Edition

Strategic Positioning Firms within the same industry can position themselves in different ways Not all positions will be equally profitable or lead to the same odds of survival A firm’s ability to create value and enjoy a competitive advantage over other firms depends on how it positions itself within its industry

Competitive Advantage and Value Creation A firms is said to have a competitive advantage in a market if it earns a higher rate of economic profit compared to the average economic profit in the industry Economic profit earned by a firm depends on the market conditions as well as the economic value created by the firm

Competitive Advantage and Value Creation A firm can achieve competitive advantage only if it can create more economic value than its competitors A firm’s ability to create value depends on its cost position as well as its benefit position relative to its competitors

Framework for Competitive Advantage

Competitive Advantage and Profitability: Evidence Research on the variation in profitability across firms by Anita McGahan and Michael Porter shows that – 19% of the variation is due to industry effects – 32% is due to competitive advantage of firms – 43% of the variation is random – 4% of the variation is attributable to the corporate parent and about 2% is the year effect

Competitive Advantage and Profitability: Evidence

Value Creation and Profitability Value created = consumer surplus + producer’s profit Consumer surplus is the difference between the maximum the consumer is willing to pay (monetary value of the perceived benefit) and the price Consumer surplus is analogous to a firm’s profit

Components of Consumer Surplus

A firm can increase consumer surplus by increasing the perceived benefit or by selling at a lower price The firm can also increase consumer surplus by reducing the cost of using the product and the transactions costs that the consumer incurs

Competition in Price-Quality Continuum When products differ in quality, competing firms can be viewed as submitting consumer surplus bids with their quality-price combinations When a firm fails to offer as much consumer surplus as its rivals, its sales will decline

Price-Quality Tradeoff

The steepness of the indifference curve reflects the tradeoff between price and quality that the consumers are willing to make Consumers are willing to pay  B more to obtain the incremental quality  q Firms try to offer their products at the lowest feasible indifference curve

Value Map: An Illustration

Mercedes slipped in sales when Japanese manufacturers started selling luxury cars of comparable quality at a lower price Over time, Mercedes lowered prices and the Japanese luxury cars become more pricey and the consumer surplus parity was restored

Value Created and Economic Profits Value created = Consumer surplus + Producer surplus = (B - P) + (P - C) = B - C A positive (B - C) does not guarantee economic profit. Competition among producers can allow consumers to capture all of the value created.

Value Created and Competitive Advantage To achieve competitive advantage, a firm must produce more value than its rivals Consumers will demand the same consumer surplus from the firm as from its rivals With superior value creation, the firm can offer as much consumer surplus as the rivals and still make an economic profit

Consonance Analysis of Value Creation Consonance analysis looks at a firm’s prospects for continuing to create value Ability to create value will be affected by – changes in market demand – changes in technology and – threats from other firms in the industry and from other industries

The Value Chain The value chain or the vertical chain is the representation of the firm as a set of value creating activities Activities in the value chain include primary activities like production and marketing as well as support activities such as human resource management and finance

Michael Porter’s Value Chain

Value Chain and Competitive Advantage Analysis of competitive advantage should not be limited to the firm’s value chain The entire vertical chain of production (including activities that are performed outside the firm) should be looked at Search for competitive advantage involves a reevaluation of the organization of the vertical chain

Evaluating the Organization of the Vertical Chain Make or buy decisions made in the past may have to be revisited because market conditions and technology may have changed Vertical integration that once made sense may be inefficient today because transactions costs have been declining

Value Creation and Resources and Capabilities If a firm does not possess resources and capabilities that the rivals lack, rivals can create its strategies for value creation Resources are firm specific assets like patents and trademarks Capabilities are things that the firm does better than its rivals

Value Creation and Resources and Capabilities Capabilities have some of the following characteristics – They are typically valuable across multiple markets and products – They are embedded in organizational routines that survive when individuals are replaced – They represent tacit knowledge in the organization

Value Creation and Value Redistribution A firm can increase economic profits either through value creation or value redistribution Value redistribution can be accomplished through harsh bargaining with buyers and suppliers and by identifying and acquiring undervalued businesses

Value Creation and Value Redistribution Firms rarely outperform their rivals solely through value redistribution With market competition, contest to acquire businesses quickly turn into an auction and all the surplus value gets competed away Competition to redistribute is fiercer than competition to create value

The Role of Industry Structure in Value Creation Value created = Value created by the average firm in the industry + differential value created by the firm over the industry average Due to variation in industry structure, opportunities to capture value created varies through the vertical chain

Division of Value Created in Production of Steel

Strategic Positioning There are two broad approaches to strategic positioning in order to achieve competitive advantage – Attain a lower cost while matching the benefit provided by the competitor (cost advantage) – Offer a higher benefit while keeping the cost the same the competitors’ (benefit advantage)

The Economic Logic of Cost Advantage A firm with a cost advantage can choose to offer the same benefit as the competitors do Alternately, the firm can offer a slightly lower benefit as long as the cost advantage overrides the benefit disadvantage The firm may also offer a qualitatively different product from its rivals

The Economic Logic of Cost Advantage

Firm F offers a larger consumer surplus (lower B, yet a larger B - P) than the competitors due to its cost advantage Competitors can lower the price to achieve consumer surplus parity Firm F will earn higher economic profit than the rivals even with consumer surplus parity is reached

The Economic Logic of Benefit Advantage A firm with a benefit advantage can offer higher consumer surplus than the rivals and earn higher profits than the rivals Successful benefit leaders go for cost proximity and offer significantly larger benefits

The Economic Logic of Benefit Advantage

Firm F produces a significantly higher quality (  B) at a slightly higher cost (  C) Firm F offers a higher consumer surplus than other producers and has room to make higher profits If the other firms match the consumer surplus offered by F, the economic profits of F will still be the highest

Extracting Profits From Cost and Benefit Advantage When the products are not differentiated, the firm that has a cost (or benefit) advantage over others can capture the entire market With product differentiation, this extreme result does not hold since firms face downward sloping demand curves With differentiated products, customers do not switch easily

Exploiting a Competitive Advantage Through Pricing When the product differentiation is weak the firm should follow a market share strategy With a cost advantage, the firm should underprice its rivals and build share With a benefit advantage, the firm should maintain price parity and let the benefit build the share

Exploiting a Competitive Advantage Through Pricing When the product differentiation is strong the firm should follow a profit margin strategy With a cost advantage, the firm should maintain price parity with its rivals With a benefit advantage, the firm should charge a price premium over the competitors

Conditions Suitable for Seeking a Cost Advantage Cost advantage should be sought – when the nature of the product does not allow benefit enhancement – when consumers relatively price sensitive and – when the product is a search good rather than an experience good

Conditions Suitable for Seeking a Benefit Advantage Benefit advantage should be sought – when consumers are willing to pay a premium for benefit enhancements – when economies of scale and learning have been already exploited and differentiation is the best route to value creation and – when the product is an experience good

Diversity of Strategies Firms need to deliver a distinct bundle of economic value through their strategy choices When consumers differ in their willingness to pay for product attributes, different strategies can coexist (Example: Walmart and Target)

“Stuck in the Middle” It can be argued that firms should either pursue a cost advantage or a benefit advantage but not both Firms that pursue both could, according to this argument, get stuck in the middle and have neither advantage In reality, successful firms appear to have both types of advantages simultaneously

“Stuck in the Middle?” There could be other explanations why cost advantage and benefit advantage appear together Firms that offer high quality products may expand market share and enjoy cost advantages due to economies of scale and learning

“Stuck in the Middle?” Learning economies may be more important for high quality production than for low quality production The high quality producers may also be more efficient producers than low quality producers

Strategic Positioning Two questions are important – How will the firm create value? [Benefit, cost] – Where will the firm do it? [Broad or narrow segments]

Segmenting an Industry An industry can be represented in two dimensions – Product varieties – Customer groups A potential segment is the intersection of a particular product group with a particular customer group

Segmenting an Industry Differences in segments arise due to – Customer preferences – Supply conditions – Segment size Customers within a group should have common features

Broad Coverage Strategies Offer a full line of products to serve a range of customer groups Economies of scope can arise from – Production – Distribution – Marketing

Focus Strategies Customer specialization: A wide range of products to a narrow customer group Product specialization: Limited product variety for a wide range of customers Geographic specialization: Exploit the unique conditions of the region