1. Competitive Advantage
Chapter 3
Competitive Advantage
3-1

2. What is Competitive Advantage?
The goal of strategic thinking
The focus of entrepreneurial action
The motivation for top management’s vision for the firm’s future
A focus on economic fundamentals and performance
3-2

3. What Determines Sustained Competitive Advantage?
A strong offense to attain market superiority
Create a higher economic contribution than competitors
Contribution = Value - Cost
A strong defense of the market position against rivals
Customer retention
Defending against imitation
Both are necessary and neither is sufficient
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4. Value-Cost Framework Value Cost Effective competitive positioning
Willingness to pay: The highest price a customer would be willing to pay for a product in absence of a competing product and in context of other purchasing opportunities
Cost
Marginal cost to produce a unit of the product at a given level of value
Effective competitive positioning
Offering more value per unit cost than competitors, consistently over time
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5. Economic Contribution Distributed between Buyer and Supplier
Figure 2.1
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6. Generic Strategies Differentiator Cost leader
Invests in higher value (raising costs)
Cost leader
Invests in lower costs (reducing value)
3-6

7. Value and Cost: Substitutes or Complements
Figure 2.2
3-7

8. Firms in the Middle
Two assumptions behind the belief that SIM (Stuck in the Middle) firms perform poorly
SIM firm cannot compete on value with the Differentiator or on cost with the Cost Leader
SIM firm’s customer base is too small to allow it to improve its competitive position
Counter example: Target Corporation
Gross margin over revenues is close to that of higher value firms - JCPenney
Operating costs per revenue dollar is closer to low cost firm – Wal-Mart
3-8

9. Target: The More Profitable Firm in Middle
JC Penney
Target
Value
Value
Competitors’ Value-Cost Profile
Wal-Mart
Value
Cost
Target’s Added Productivity
Cost
Cost
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10. Unprofitable Firms in Middle: US Domestic Airline Industry
Figure 2.3
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11. Value versus Cost Advantage
Pursue value investments when:
Marginal customers are value-sensitive
Returns to increasing value are higher than returns on reducing costs
Pursue cost reductions when:
Marginal customers are price-sensitive
Value improvements are costly, difficult, or easily duplicated by competitors
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12. Value and Cost Drivers
3-12

13. Examples of Value Drivers
Technology
Functionality, features
Quality
Durability, reliability, aesthetics
Delivery
Just-in-time production systems
Breadth of line
Potential benefits: one-stop shopping, interchangeable parts, interface compatibility and cross-selling
Service
Responsiveness, problem solving
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14. Examples of Value Drivers (cont’d)
Customization
Customer-based product design
Geography
Location, scope
Risk assumption
Warranties
Brand/ Reputation
Signals of price or quality
Network externalities
Increase in product value with each new customer – e.g., communication standard
Environmental policies
Sustainable practices
Complements
DVD players and disks
3-14

15. Examples of Cost Drivers
Scale or volume economies
Average cost declines as volume increases based on high recurring fixed costs or sunk costs
Scope economies
Cost of producing two products together is lower than the cost of producing them separately
Learning curve
Cost declines with cumulative volume as learning takes place and practices improve
3-15

16. Examples of Cost Drivers (cont’d)
Low input costs
Firms with lower cost inputs are better positioned to take advantage of industry opportunities and absorb changes
Vertical integration
For tasks that are specialized to the firm, coordination costs are lower within the firm than with a market supplier
Organizational practices
Firms develop process innovations to lower costs or improve value in specific activities
3-16

17. Isolating mechanisms
Mechanisms that prevent industry forces from eating up the firm’s profits
Increase customer retention
Reduce imitation by competitors
3-17

18. Increasing Customer Retention
Increase switching costs
Search costs
High for products whose value is apparent only after experiencing the product – experience goods
Transition costs
Costs associated with shifting from old equipment or practices to new
Learning costs
Costs incurred in learning a new process
3-18

19. Barriers to Imitation Property rights Dedicated assets Sunk Costs
Patents, trademarks
Dedicated assets
Exclusive distribution channels, suppliers or location
Sunk Costs
One time, non-repeated investments in technology, brand, network scope and other assets whose economic benefits are reaped continuously afterward
Casual ambiguity
Difficulty in copying a capability because it cannot be modeled effectively
3-19

20. Building Competitive Advantage
Market Position
Isolating Mechanisms
Resources
Capabilities
Value Drivers
Cost Drivers
Retaining Customers
Preventing Imitation
Superior Market Position
Defendable Market Position
Sustainable Competitive Advantage
Figure 2.7
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21. Chapter 4
Industry Analysis
4-21

22. What is an Industry? An industry is composed of:
Firms whose products provide value in functionally equivalent ways (e.g., air conditioners – but not fans)
Firms that compete directly through changes in product value and price
Firms that face common economic (e.g., common suppliers and buyers)
Producers of substitutes (outside the industry) are:
Firms whose products are functionally different from the industry’s products but compete to provide value to the industry’s buyers (e.g., snowboards are substitutes for skis)
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23. How Do Industries Emerge?
Firms create industries, not the reverse
Competing firms influence each other with shifts in product value and price
Increasing strategic interaction establishes mutual dependence between firms
Behavior and performance subject to emerging industry forces
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24. Market Segmentation Many industries have more than one market segment
Segments are defined by the distribution of customer preferences
Firms align their product lines with one or more segments, which could overlap
Specialist firms
Tailor their product to one segment
Generalist firms
Design their product for many segments
4-24

25. What Determines Firm Profitability?
Macroeconomic factors
Forces in the overall economy: e.g., regulation, interest rates, tax policy
Industry factors
Conditions specific to an industry, e.g., the level of competition, the presence of powerful buyers
The firm’s market position as determined by its resources and capabilities
The firm’s value and cost compared to competitors and its ability to defend this position
4-25

26. Transportation Sector
Relative Contributions of Industry and Business Unit to Economic Performance
Manufacturing Sector
Transportation Sector
Services Sector
Percentage Contribution of Business Segment, Industry and Other Factors to Business Return on Assets 1980–1994 (U.S. data).
4-26

27. Industry Forces Influencing Firm Performance
Porter’s five industry forces:
Strength of competition
Potential for entry into the industry
The power of buyers
The power of suppliers
The strength of substitutes for the industry’s products
When forces are strong, profitability is low and when forces are weak, profitability is high
Add complements – e.g., cars and gas stations
Strong complements raise the product’s value
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28. Porter’s Five Forces Framework
Source: Michael Porter, Competitive Strategy (New York: Free Press, 1980), p. 4.
Figure 3.1
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29. Competition Competition
May reduce prices, while holding value and cost constant, resulting in customers receiving higher buyer surplus
May increase value without increasing the price of the product
May increase cost if higher value is required to compete
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30. Effect of Competition on Transaction with Customers
Can Increase the Value Required to Compete
Value to the Customer
Reduces Price
Strong Competition
Price
Cost
Can Increase the Cost Required to Compete as Investment in Value Rises
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31. Types of Competition Perfect competition Monopoly
Strong rivalry among many very similar firms
No firm makes a profit above its cost of capital, since rivalry has driven the market price down
Monopoly
Absence of rivalry
Monopolists produce less and charge more
Not illegal, but illegal to exploit
Oligopolistic competition
Competition occurs among a few similar firms
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32. Characteristics of Perfect Competition
Many competitors
A common set of buyers for all firms
The same value offered by all firms
The same cost structure in all firms
Relatively costless entry
Relatively costless exit
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33. Oligopoly and Industry Concentration
Oligopolies are found in concentrated industries
Concentration is determined by:
Low ratio of market size to the minimum setup costs necessary to compete
High level of sunk costs investment made by incumbent companies
Entrants are at a cost disadvantage to compete with the incumbents
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34. Concentration-Profitability Relationship
More concentrated industries tend to be a little more profitable
Causes of the concentration-profitability relationship:
Higher efficiency of large firms
Non-cooperative strategic interaction to increase profits
Collusion to increase profits
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35. Efficiency Differences among Firms
Higher profits are achieved from investing in scale-based innovations that reduce costs
So interaction with competitors and knowledge of their practices is necessary for profitability
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36. Noncooperative Strategic Interaction
Firms act by observing and analyzing competitors’ moves – i.e. they play a game with each other
Profits are possible in a noncooperative game
Focus on a duopoly (two firms competing against each other – e.g., Coke and Pepsi)
Price takers
Value and price are the same across firms (e.g., oil companies)
So compete on volume (see the cattle ranches on the next slide)
Price makers
Value, prices and costs differ across firms (e.g., GM, Ford, Toyota and Honda)
So compete on value and price
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37. Best Response for Both Ranches Jointly
Quantity Competition Between Two Cattle Ranches (best response for each combination is shown in bold)
Number of Steers Delivered by
Reata
Number of Steers Delivered by the Ponderosa 10 20 30 40 50 60 70 80 90
100
19,19
18,36
17,51
16,64
15,75
14,84
13,91
12,96
11,99
10,100
36,18
34,34
32,48
30,60
28,70
26,78
24,84
22,88
20,90
18,90
51,17
48,32
45,45
42,56
39,65
36,72
33,77
30,80
27,81
24,80
64,16
60,30
56,42
52,52
48,60
44,66
40,70
32,72
75,15
70,28
65,39
60,48
55,55
50,60
45,63
40,64
35,63
84,14
78,26
72,36
66,44
60,50
54,54
48,56
36,54
30,50
91,13
84,24
77,33
70,40
63,45
56,48
49,49
42,48
35,45
38,40
96,12
88,22
80,30
64,40
48,42
40,40
32,36
24,30
99,11
90,20
81,27
72,32
63,35
54,36
45,35
36,32
27,27
18,20
100,10
90,18
80,24
50,30
40,38
30,24
20,18
10,10
Best Response for Both Ranches Jointly
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38. Tacit Collusion
Tacit collusion may occur to make profits above the competitive outcome
Required conditions among firms
Mutual familiarity
Repeated interaction
Consistent roles
Strategic complementarity
Information signaling
A mechanism for coordinating decisions
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39. Explicit Collusion
Explicit collusion is the coordination of firms’ major decisions through direct communication
Generally illegal
Hard to integrate and sustain
Extreme case of collusion leads to cartels
Cartels are illegal in most of the developed world
Cartels are often found in commodity industries
Firms decide on cartel administration and policies
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40. Forces Influencing Cartelization
Reasons for cartel establishment
Homogenous market positions
Mutual familiarity through long-standing competition
High industry concentration
Lack of viable substitutes for the industry’s product
Reasons for cartel failure
Inability to prevent entry into the industry
Uncontrolled cheating or defection
Fluctuating demand
Bargaining problems within the cartel
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41. What Factors Raise Entry Barriers?
Lower prices by firms in the industry
Limit pricing
High barriers to imitation
Property rights
Dedicated assets
Causal ambiguity
Learning curve and development costs
High customer switching costs
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42. Entry Barriers Affecting Transaction with Customers
Value to the Customer
Force the Firm to Lower Price
Low Barriers to Entry
Price
Cost
Figure 3.3
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43. Buyer Power Buyer power is increased by:
Availability of competing products with the same value and price
Buyer concentration (few buyers)
Low market growth
Percentage of product sold to the buyer
Low importance of the product to the buyer
High importance of selling product to buyer
The firm’s need to fill capacity by selling to buyer
Buyer’s credible threat of vertical (backward) integration
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44. The Effect of Buyer Power
Force the Firm to Increase Value
Value
Strong Buyers
Price
Force the Firm to Lower Price
Cost
Figure 3.4
4-44

45. Supplier Power Supplier power is increased by:
Supplier concentration (few suppliers)
Growth in demand for the firm’s product
Low percentage of supplier volume bought by customer (size of buyer relative to supplier)
High strategic importance of supplier to buyer
Low strategic importance of buyer to supplier
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46. The Effect of Supplier Power
Decrease the Value of Their Inputs
Value to the Customer
Strong Suppliers
Price
Cost
Increase the Firm’s Cost by Raising Their Prices
Figure 3.5
4-46

47. Substitutes The threat of substitutes increases when:
A firm has a low buyer surplus (value minus price) relative to the substitute
A firm’s customers have low switching costs
Defenses against substitutes:
Increase the buyer surplus
Raise switching costs
4-47

48. The Effect of Substitutes on Transaction with Customers
Increase the Value Required to Compete
Value to the Customer
Strong Substitutes
Price
Force Lower Prices
Cost
Figure 3.6
4-48

49. Forces Increasing Firm Performance
The strength of complements of the industry’s products
(Legal) cooperation between buyers and suppliers
Coordination among competitors
Strategic groups
4-49

50. Industry Forces that Increase Profitability: The Value Net
Suppliers
Customers
Complementors
Competitors
The Firm
Figure 3.7
4-50

51. Coordination Among Competitors
Cooperative pricing (not price-fixing) to avoid price competition
Readily available pricing information
Comparable value-cost profiles for competitors
Interfirm partnerships
For example, R & D consortia
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52. Cooperative Pricing Often depends on the presence of a price leader
Price leadership requires:
Observable prices
Common buyers
Strategic discipline
A small number of firms
Common history of competition
Comparable market positions
Adherence to antitrust law
Cooperative output levels
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53. Cooperation Between Buyers and Suppliers
Sharing information
Operating decisions (e.g., logistics)
Strategic decisions (e.g., technology development)
Sharing resources and capabilities
Quality management techniques
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54. Complements
Products in different industries whose patterns of demand are systematically positively correlated
Skis and ski boots
Sails and sailboats
Tires and automobiles
4-54

55. Strategic Groups
Strategic groups are a level of analysis between the firm and the industry.
Characteristics of strategic groups:
Firms within an industry that have similar cost and value drivers compared to firms in other groups
Firms which compete in the same market segment
Firms that take a similar approach to competing in an industry
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56. Mobility Barriers
Similar to barriers to entry to the industry – but between strategic groups
Entry-deterring behavior of firms in a group
Isolating mechanisms specific to the group
Group limit pricing
Actions taken by stronger and more profitable competitors to protect their groups from entry by rival firms in the industry
Prevent the movement of firms from one strategic group to another
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57. Strategic Groups in the U.S. Domestic Airline Industry
Figure 3.8
4-57

58. The Effect of Industry Forces on Value, Cost and Price
Five Industry Forces
Effect on Value
Effect on Cost
Effect onPrice
Stronger
Rivalry
May be based on
higher customer
value
May increase cost
associated with
higher value
Lowers the price
required to
compete in
industry
Buyers
Raise the value
required to compete
in industry
Lower the price
compete in industry
Suppliers
Lower the value
provided to firms
in the industry
Raise the costs of
firms in industry
Lower Entry
Costs
Lower the price to
keep entrants out
of industry
More Powerful
Substitutes
4-58

59. The Effect of Industry Force on Value, Cost and Price (cont’d)
Value Net
Effect on Value
Effect on Cost
Effect onPrice
Cooperation Between Firm
and Buyers
Raises the value to
buyers without
comparable rise in
firm costs
Lowers firm costs
without
comparable drop
in buyer value
and Suppliers
firm without a
supplier costs
Lowers supplier
costs without
in firm value
And Competitors
industry buyers
without a comparable
rise in industry costs
(shared innovation)
Lowers the costs in
industry without a
in value to industry
buyers (shared
innovation)
Raises the
potential price
necessary to
compete
(cooperative
Pricing)
Effective
Complements
Raise the value to
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