Competition and Strategy Chapter 8 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be...

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1

Competition and StrategyChapter 8


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Introduction


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The Supermarket

Supermarkets that dominated grocery retailing in the twentieth century are losing

their customers in the twenty-first. Managements of chains large and small are searching for strategies to restore their former dominance.

Individual stores and brands have some market power, but competition rules at all levels of the industry.


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What’s Next?

This chapter builds on earlier models to redirect our thinking about competition and

business decisions. Rivalry among the grocers is nearly the polar opposite of the passive

price-taking we saw in perfect competition. Each supplier is actively strategizing to earn and protect profits above opportunity cost, and each is subject to constant threats from

innovators and imitators.

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COMPETITIVE BEHAVIOR

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in

whole or in part.


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Competition: A Quest to Be Exceptional – Competitive Ideas

Competition starts with ideas. Asked how he had produced so many good ideas over his career, Nobel Prize–winning chemist Linus Pauling

responded that “the best way to have a good idea is to have lots of ideas.” Even the most original ideas

build on a foundation of other ideas.

A competitive idea is not necessarily a scientific one—it

may be as simple as opening a business in an underserved location, keeping it open all night, or outrightly imitating the success of a competitor.


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Competition: A Quest to Be Exceptional - The Paradox: Competing to Acquire Market Power

Businesses compete to distinguish themselves in the eyes of customers, and by becoming distinctive

they acquire some market power.

The competition that now interests us is quite unlike what we saw in the model of a perfectly competitive market. Inactual markets, businesses often compete by discounting prices rather than taking the equilibrium price as given and unalterable. Business try to bind customers to themselvesusing techniques like frequent-flier miles or other loyalty programs.


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Competition: A Quest to Be Exceptional - The Risks of Competition

Competition is risky, particularly for small startups. Only about 40 percent of startups show accounting

profits over their lifetimes, which may not cover their opportunity costs. Thirty percent break even and 30

percent are losers.


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Competition and Deception

Competitive conditions constrain the freedom of all producers, whether they face many competitors or

few. In this chapter we continue to assume that buyers and sellers act rationally on information that

is available to them. In particular we rule out strategies that only succeed if one

side can deceive the other.


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Pitfalls in Studying Competition - Selection Bias, Again

In studying competitive strategies we are often given the information that Company X used

Strategy A and prospered. Even if the author mentions several firms that succeeded with

Strategy A, the reader is likely to remain in the dark about (1) those that used Strategy A and

failed, and (2) those that rejected Strategy A and succeeded.


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Pitfalls in Studying Competition – What’s Wal-Mart’s Secret?

Here is a partial list of explanations that have been offered for Wal-Mart’s success: decentralized decision-making, centralized decision-making,

decision-making between the center and the stores, regional relationships, relationships with employees

and using economics to determine strategy.

Like it or not, no one really knows why Wal-Mart has attained its stardom.


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Pitfalls in Studying Competition – Self-Serving Recommendations

The structure of corporate business further complicates

the analysis of strategy. A corporation’s executives and board of directors might make

choices that are in their personal interests rather than those of their shareholders, who

would prefer decisions that maximize the values of their stock. As will be seen later, managers

whose firms produce substantial free cash flows may prefer to spend them on questionable

acquisitions that often fail to benefit shareholders.

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CREATING ECONOMIC VALUE


whole or in part.


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The Basics: One Seller and One Buyer

Buyer and seller both benefit from exchanging some good if the seller gets more than his

opportunity cost (i.e., the value of the best forgone alternative), and the buyer pays less than her valuation (maximum willingness to pay for it

before going elsewhere). Economic value is the difference between the cost and valuation that

they share.In this example there is $4 worth of value to be shared.


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The Basics: One Seller and One Buyer – Raising the Purchaser’s Valuation

Here, the seller chooses to incur a cost of $1 to alter his good’scharacteristics (possibly improving quality or making the good

available closer to the purchaser’s home). In so doing, heraises the purchaser’s valuation by $2 to $13, increasing the

economic value from $4 to $5.


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The Basics: One Seller and One Buyer – Lowering the Seller’s Costs

Here the seller devises a way to lower costs by $2, from $7 to $5.with the purchaser’s valuation constant at $11, this willincrease the economic value available from $4 to $6.


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The Basics: One Seller and One Buyer – Lowering Transaction Costs

Here is a situation that includes transaction costs. Seller’sopportunity cost is $5 plus $2 in transaction costs. Purchaser’s

valuation is $16 plus $3 in transaction costs. Even aftertransaction costs, there remains $6 in economic value available

to be shared.


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If the seller cuts his transaction costs by $1, the economic valueavailable to be shared rises to $7. Similarly, the purchaser

could reduce her transaction costs and increase the economicvalue available.


19


Here, the seller spends $1 in order to lower the purchaser’stransaction costs by $2. This will increase the economic value

available from $6 to $7.


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One Seller, Many Buyers - Raising Buyers’ Valuations

Here the seller increases variablecost to improve the product and

increase buyer valuation. Marginalcosts increases to MC’ and demand

shifts to D’. Price increases to $9.50and profit rises.


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One Seller, Many Buyers - Raising Buyers’ Valuations

Here the seller invests in fixed cost in order to

increase buyer valuation, perhaps building a new

plant that produces fewer defective units of output from the same variable

inputs as before. This will increase the

seller’s present and future profit but that increase in the profit stream must be

compared to the cost of the new plant to determine

whether to build.


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One Seller, Many Buyers – Lowering Production Costs

Here, lowering production costsfrom MC to MC’, increases annualprofit by $9 from $16 to $25. A

seller Be willing to invest up to $9per year to achieve such a

reduction in production costs.


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One Seller, Many Buyers – Lowering Transaction Costs

Here, buyers and sellers both facetransaction costs. Including

transaction costs, demand is D’(not D) and marginal cost is

MC’ (not MC). Incurring additionalcost (MC”), to reduce buyer

transaction costs shifts demandcurve to D pProfit.


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Many Buyers and Many Sellers

This shows what happens in a competitive market when a single firm initiallyadopts a cost-saving innovation. Other firms will follow and a new long-run

equilibrium will be restored where firms once again earn zeroeconomic profit.


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Many Buyers and Many Sellers

Four points emerge from this model:

1. as the innovation spreads among producers the earlier adopters will see longer-lived streams of profit before the market reaches its new long-run equilibrium.

2. the number of firms that survive after the innovation depends on the direction in which the innovation shifts the minimum point of average costs.

3. as the percentage of sellers that use the innovation increases, those who are slower to innovate will take losses if they cannot shut down temporarily or leave the market quickly.

4. any newcomer to the market will only survive if it uses the innovation.


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Many Buyers and Many Sellers – Upward Sloping Supply Curves

Supply curve S’ and demand curve D’ include a $3

transaction costfor sellers and a $2

transaction cost for buyers. The market equilibrium price is $10 with 75 units traded.

Suppose that all transaction costswere costlessly eliminated. Marketprice will fall to $9 with 110 units

traded.


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Many Buyers and Many Sellers – Outsider Reduces Transaction Costs

D1 would be the demand curve with

no transaction costs. With transportation costs of $18 to

buyers, the demand curve is D2. Market price will be $13 and 19

units will be traded.Imagine an intermediary reduces the

buyer transportation costs to $8,making the demand curve D3. Marketprice rises to $16.33 and the number

of units traded increases to 25.67.


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MERGERS AND AGREEMENTS


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Horizontal Mergers and Agreements - Mergers

Mergers and acquisitions can be important elements of strategy. A horizontal merger puts the assets of two firms that operate in the same

market under the sameownership. The consequences depend on market structure and on how the merger affects costs.


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Horizontal Mergers and Agreements - Mergers

Suppose the diagram to the rightdepicts a perfectly competitivemarket in equilibrium. If twoof the firms merge to reduce

costs, nothing happens. But, ifthis sets off a merger wave wemay end up with an oligopolywhose equilibrium looks like a

monopoly (12,000 units at $10).this would create a deadweight

loss equal to the small red triangle.


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Horizontal Mergers and Agreements - AgreementsU.S. antitrust law says that a “naked” agreement whose only

goal is to fix prices is per se illegal—its very existence is unlawful. Other agreements among competitors can be both

legal and economically desirable.

For example, members of the Recording Industry Association of America (RIAA) long ago agreed on common technical

specifications for music CDs. Such a standard allows CDs from any RIAA member (or nonmember who uses the format) to work

on many different players and computers.Antitrust law treats agreements like these under a rule

of reason standard that balances their favorable and unfavorable effects on competition.


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Vertical Mergers and Agreements

An industry’s output is often produced in stages. For example, oil is first extracted

from the ground, then refined, and finally the refined products are retailed.

A firm is vertically integrated if it subsumes multiple stages.


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Vertical Mergers and Agreements - Mergers

D is the market demand fordiamonds. A is DeBeers’ MC for

mining and B is the MC forindependent retailers. C would be

the sum of A & B which means 9diamond rings would be sold at

$15 each.

Should DeBeers extend into theRetail business?


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Vertical Mergers and Agreements - Agreements

Two firms in different stages of a vertical chain might reach an agreement that makes them a better

competitor when they act as a team. An agreement will be preferable to a merger if a single management

cannot monitor both stages as well as separate managements can.


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Vertical Mergers and Agreements – Restrictive Agreements

Many vertical agreements greatly restrict the future choices of both parties. A franchise contract between a carmaker and a dealer often prohibits

the manufacturer from opening another outlet close by, that is, it specifies an exclusive territory. Fast-food franchises often require the owner of an

outlet to buy all its food through the parent organization, and the parent organization promises to always have food on hand to fulfill its side of the

requirements contract.


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SUSTAINING AND EXTENDING COMPETITIVEADVANTAGE


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Barriers to Entry—Size and Commitment

Building barriers to entry that protect profits against existing and future competitors can be an

important element of strategy.

Size and specificity may serve as barriers to entry. A firmmay need to be sufficiently large to achieve available

economies of scale. Firms may also need to invest in specificassets that are not easily redeployed.


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Intangible Assets: Trademarks and Advertising

A seller wants to inform customers about more than price—consistent quality, for instance, may engender customer loyalty. A producer can use a brand name or trademark to assure buyers it will

produce the quality they expect.


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Influencing the Public and Government – Public Relations

Public recognition and approval of a firm’s practices can also be a competitive tool. In 2005, two hurricanes

destroyed much of the New Orleans and Beaumont–Port Arthur areas. While the relief efforts of local and national governments faltered, companies like Wal-Mart, Home Depot, and Lowe’s had stockpiled and

shipped necessities to the area before the storms hit, and the firms bypassed profits by keeping prices at pre-

disaster levels.Similarly, energy and auto producers advertise their environmental concerns. Campaigns for Toyota’s and

Honda’s hybrid cars stress their ecological impact rather than their performance.


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Influencing the Public and Government – Influencing Government

Government can also help a business to advantage itself or

disadvantage competitors. Among possible strategies, a

firm might seek legislation that makes competition illegal, as cable TV operators have done in many

cities. Cable, however, has failed to suppress satellite TV, which is beyond local control.Government can also make competition costly for

foreigners by imposing quotas or tariffs in return for support from the domestic industry.

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CHOOSING A COMPETITIVE STRATEGY


whole or in part.


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Resources and Strategies - What Are Resources?The originator of the resource-based model, Birger

Wernerfelt of MIT, writes:

By a resource is meant anything which could be thought of as a strength or weakness of a given

firm. More formally, a firm’s resources at a given time could be defined as those (tangible and

intangible) assets which are tied semipermanently to the firm. Examples of

resources are: brand names, in-house knowledge of technology, employment of skilled personnel, trade contacts, machinery, efficient

procedures, capital, etc.


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Resources and Strategies – Innovation Pro and Con

Strategy need not entail innovation or entry into new markets—some firms have

resources better suited to perfecting an established product. Properly carried out,

imitation can be as profitable as innovation and sometimes less risky. Ampex invented the VCR and Xerox invented the first office

computer, but neither firm found commercial success in those areas. Success is

surprisinglyshort-lived.


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Competence and Sustainability - Identification of Resources and Feasible Strategies

A firm’s strategy choice starts by identifying its resourcesand the resources of its competitors, paying attention to those

resources competitors have that it does not itself, and vice versa.

Discussions of strategy must go beyond simple modelsthat treat constraints as unalterable by the decision makers.

The best choice depends on our resources and those of our competitors.

We will often wish to use or acquire resources that make our strategy more resistant to their attacks.

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Competence and Sustainability - The Search for Strategies


The idea remains that no strategy that competitors can easily duplicate will produce long-term profit. The search for

strategy must be a continuing one.

Tactical moves are responses to idiosyncratic, short-lived developments. If your competitors are flexible and

unpredictable you might do better by deemphasizing global strategy and seeking to seize more immediate opportunities.

If competition is resource based, we will require a better understanding of the types, potential, and

limitations of these and other intangible resources. To do so, we must proceed beyond transactions in

markets.

Competition and Strategy Chapter 8 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be...

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