1. Planning does not equate to business 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 thinking is about creating, protecting and exploiting competitive

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 the cast of external 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 of all players to a uniform minimum,

where there is no “economic profit” i.e. no returns above the cost of

invested 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:

Strategic Tactical/Operational/

Functional

Management

level

Top management, Board of

directors

Mid-level, functional, local

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?

What critical competencies

must we develop?

How are we going to deal with

competitors?

How do we improve delivery

time?

How big a promotional

discount do we offer?

What is the best career path

for our salespeople?

6. Porter’s Five Forces (Substitutes, Suppliers, Potential Entrants, Buyers, and

Competitors) can affect the competitive environment. But one of them is

clearly much more important than others and leaders should begin by

ignoring the others and only 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) compared 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 3rd 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 about 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 customers 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 market 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 2nd 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 next-

generation 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 particular 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 to

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 company 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 play 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 spend 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.