Prof. Amitai Aviram University of Illinois College of Law

Business strategy for lawyers Chapter 3: The individual firm (strategic actions)
Prof. Amitai Aviram University of Illinois College of Law Copyright © Amitai Aviram. All Rights Reserved S14D

The individual firm (strategic actions) Overview of Chapter 3
Strategic traits Strategic competences Strategic rigidities Reform (modifying strategic traits) From strategic traits to strategic actions Differentiation Coordination Confrontation Review (integrating the course’s components) © Amitai Aviram. All rights reserved.

Strategic traits Moving beyond environment…
Fighting over a slice of the Value Pool pie Environment determines the portion of the VP that is allocated to market participants (firm + rivals) Strategic actions increase firm’s portion of VP by improving the environment for the firm If rivals could employ the same strategic actions, firms would offset each other Therefore, strategic actions rely on firm’s strategic traits, which rivals don’t have © Amitai Aviram. All rights reserved.

Strategic traits What are strategic traits?
A strategic trait has two aspects: Positive aspect: strategic competence Often called “core competence” or “firm-specific resource” This is the “strengths” part of the SWOT analysis Negative aspect: strategic rigidity Possessing a strategic competence is always a trade-off: limits firm’s ability or incentive to take certain strategic actions or to develop certain new strategic competences This is the “weaknesses” part of the SWOT analysis © Amitai Aviram. All rights reserved.

Strategic competences Elements of a strategic competence (VRIO)
Value [facilitates a strategic act that exploits an opportunity/neutralizes a threat] A benefit that facilitates a strategic act For differentiation: value to customers (one of the bases of competition) For confrontation: ability to impose costs on rivals For coordination: low coordination costs Value through benefitting others Competence that benefits another firm can facilitate coordination w/that firm Competence that benefits politicians or their constituents can facilitate regulation (for the purposes of confrontation, coordination or differentiation) Benefit must be competitively superior (difficult for rivals to substitute) Rarity [unavailable to rivals] Competence is scarce (currently available only to one/few competing firms) Competence is difficult to imitate (rivals face cost/disadvantage to acquire/develop it) Organization [firm is able to capture the value of the competence] Value must be appropriable (i.e., firm can capture the value) Firm’s policies & procedures must support exploitation of the competence © Amitai Aviram. All rights reserved.

Strategic competences Strategic competence: organization
Organization element involves support on the following dimensions Skills/knowledge of individual employees Technical systems (proprietary processes & information) Managerial systems (firm policies on employee incentives) Values/norms Example: supporting a competence in handling US-China M&A Skills/knowledge: e.g., attorneys who can speak both English & Chinese and who know both US & Chinese corporate law Technical systems: e.g., timetables, procedures and templates for antitrust review in both US & China Managerial systems: policies that encourage temporary assignments in China; policies that facilitate hiring foreign-trained lawyers Values: e.g., foreign attorneys not disadvantaged in making partner © Amitai Aviram. All rights reserved.

Strategic competences Example: Elite M&A law firms
Competence: lawyers w/exceptional M&A skills/expertise Value: high Benefit: clients believe lawyer credentials indicate value of lawyer’s work (useful for differentiation, aiming at “bet the company” work) Competitively superior (difficult to substitute): somewhat Other client benchmarks also indicate work quality (e.g., media visibility) Rarity: somewhat Scarce: yes (in most markets, few rivals have highly-credentialed lawyers) Difficult to imitate: yes Limited talent, limited capacity of credential-creating institutions such as law schools, big cases Elite firms provide their lawyers more opportunities to credential themselves Organization: poor - lawyer can quit at any time, taking value with her This is a major weakness. What can firms do to mitigate it? © Amitai Aviram. All rights reserved.

Strategic competences Example: Best Buy goes green
Competence: combining Best Buy’s existing business activities with selling “green” vehicles (electric bikes/scooters) Value: high Benefit: economies of scope in demand (for differentiation); economies of scope in supply (for confrontation: isolation) In demand: if Best Buy’s customers are also interested in green vehicles, offering them leverages Best Buy’s reputation & accessibility In supply: this is a response to an increase in spare space in stores (flat screen TVs replace bulkier TVs; CD & DVD sales declining) Space is fixed cost, so more sales lower ATC, allowing lower prices Also utilizes Best Buy’s existing logistics capacity Rarity: somewhat Scarce: yes, at that point few mainstream stores offered green vehicles Difficult to imitate: this is Best Buy’s weakness; other firms can imitate. But green vehicles are bulky, so rivals will little available space can’t imitate. Organization: good (assuming appropriate procedures are in place) Lower ATC is captured by Best Buy (higher profit margins); higher value to customers captured via higher prices © Amitai Aviram. All rights reserved.

Strategic competences Example: Gyms with childcare
Competence: bundling gym membership with childcare Value: high benefit Benefit: economies of scope (differentiation), switching costs (confrontation: isolation). High cost for parents ascertaining that particular caregiver is “good” for child, and children get used to a particular caregiver Rarity: somewhat Scarce: so-so (multiple gyms have childcare, but perhaps direct rivals don’t) Difficult to imitate: somewhat Because trust takes time to build & is specific to the caregivers & gym, switching costs will remain even if other gyms also bundle childcare However, imitation by rivals can undo differentiation (copying popular toys & activities) Organization: moderate appropriability If parents & kids choose gym based on specific caregivers (as opposed to gym’s caregiver selection & supervision process), caregivers should capture some of the value (through higher salaries). But caregiver skill set is very common & proving trustworthiness is a gym-specific investment. © Amitai Aviram. All rights reserved.

Strategic competences Example: Landline & mobile service
Competence: operating in both landline phone service & wireless phone service Value: sometimes Benefit: efficient cashflow management; land line phones produces a lot of cash but market is dying; advanced wireless network demands high investment, but is growing So operating both land lines & wireless balances cashflow; increases VP by reducing financing costs Provides value only when capital markets overvalue capital (i.e., when it’s difficult to borrow) Rarity: perhaps Scarce: originally, yes (few firms operated both land & wireless) Once most rivals already operate in both markets, benefit is no longer scarce Difficult to imitate: only a few firms operate in each market; high barriers to entry into each market Organization: good appropriability © Amitai Aviram. All rights reserved.

Strategic competences Identifying strategic competences
Step 1: brainstorming Write in unstructured form all strengths & weaknesses that come to mind Check if each item you identified satisfied the three elements of strategic competences (value, rarity & organization) Step 2: examining each business activity Explained in the next slide Step 3: inversion Look at the competences you identified to see what rigidities they create Look at the rigidities you identified to see what competences they enable Rigidities often make value that’s otherwise easy to imitate inimitable E.g., many elite lawyers could counsel corporate raiders on hostile takeovers, but only those with the weakest reputation & fewest high-end clients (rigidity) would risk their reputation & existing relationships by representing raiders © Amitai Aviram. All rights reserved.

Strategic competences Identifying strategic competences
Examining each business activity Apply Porter’s value chain to the firm you are examining Translate each segment of the value chain into specific business activities that involve your firm Does your firm engage in these activities or outsource them? For each activity the firm engages in (rather than outsources) Is the firm better than, as good as, or worse than rivals? If better, define what makes firm better in strategic competence terms (value, rarity, organization) If worse, define what makes firm worse in strategic rigidity terms: why doesn’t firm change & what strategic acts does the rigidity preclude (or which strategic actions of rivals does the rigidity make the firm vulnerable to?) © Amitai Aviram. All rights reserved.

Strategic rigidities The dark side of strategic traits
No “end of history” for corporate strategy Strategic competences provide competitive advantages So why hasn’t one firm acquired all relevant competences & then held a permanent advantage over rivals? Reason: strategic competences create strategic rigidities (limits on firm’s ability or incentive to take certain strategic actions or to develop certain new strategic traits). © Amitai Aviram. All rights reserved.

Strategic rigidities The dark side of strategic traits
Examples of competences creating rigidities Kodak’s strength in film cameras limited incentive to develop digital cameras Exceptional engineering-focused firm culture limits ability to attract marketing/design talent, and limits ability of marketing/design executives to prioritize these aspects of the product’s value Gas refiner’s strong retail (gas station) brand reduces ability to coordinate with competing gas stations (e.g., sell them surplus gasoline) Giving local managers more discretion (less bureaucracy) means decisions are taken by less experienced managers, and there is less managerial slack (more harm from one bad or incapacitated manager) A firm that rents (rather than owns) its stores/factories has lower fixed costs (no need to buy real-estate), but higher variable costs (paying rent) © Amitai Aviram. All rights reserved.

Strategic rigidities Rigidities in a market analysis
Strategic rigidities affect a market analysis in 2 ways: Prevents firm from exploiting a strategic action This is an issue when a strategic action is desirable for the firm & would be feasible but for the existence of the rigidity E.g., firm’s luxury image makes it unable to lower prices (i.e., engage in differentiation through cost leadership) Allows rivals to exploit a strategic action This is an issue when a strategic action is desirable for a rival & is made feasible for the rival because firm’s rigidity prevents firm from copying the action E.g., Kodak’s rivals differentiate by introducing digital cameras; Kodak can’t reciprocate So, in some cases it may be desirable to replace the strategic competence that is creating the strategic rigidity © Amitai Aviram. All rights reserved.

Reform (modifying strategic traits) How are strategic traits created?
Traits are usually created/modified by Combining business activities; or Using different inputs (e.g., a different technology) Not every new input or new combination of business activities creates a strategic trait To be a strategic competence, need value, rarity & organization Rarity can be a result of Limitations on access to an input or activity (e.g., patented technology, high BTE into an activity, etc.) Rivals’ strategic rigidities preventing them from mimicking your firm © Amitai Aviram. All rights reserved.

Reform (modifying strategic traits) Using different inputs
The Pereira-Zimmerman article provides an example of modifying strategic traits through use of different technology (temporary stores) Replacing permanent stores with temporary stores replaces fixed costs (ownership of real-estate or termination costs of long-term lease) with variable costs (short-term rent, daily wages rather than annual contracts for employees) Reducing FC lowers the MES, making it profitable to operate even if sales are smaller But increasing VC raises the MC, which is the lowest price the firm can profitably sell the product (making it harder to compete on prices) © Amitai Aviram. All rights reserved.

Understanding toy sellers’ options The strategic environment Threat (VP): toys are not to be recession-proof: sales decline by 5% Opportunity (rivalry): weaker rivals have gone bankrupt (demand up for grabs) How can firms respond? Go all out after the demand: open new stores where old ones closed. Problems with this approach? Avoid risks, minimize damage: reduce prices to increase sales, reduce inventories to adjust to lower demand. Problems with this approach? Increase underutilized capacity to capture sales from bankrupt rivals. Why is Sears better equipped to do this than TRU? Use temporary stores to soak up sales from bankrupt rivals (or from seasonal increase) while maintaining ability to cut back when demand declines. What’s the trade-off of this response? © Amitai Aviram. All rights reserved.

Another example: technology often allows the opposite strategic trait modification: increasing FC to lower VC For example, a steam powered weaving machine may do the work of a dozen human weavers, with fuel and maintenance costing less than the weavers’ wages (lower VC, lowering the MC and therefore making it viable to lower prices), but the cost of the machine (higher FC) raises MES (see Section 1b4) © Amitai Aviram. All rights reserved.

Reform (modifying strategic traits) Constraints on trait modification
New trait must have value, rarity & organization (like all competences) E.g., an attempt to acquire a strategic competence by changing one aspect of supporting organization (e.g., excellence in design by hiring top designers) can fail if other aspects are unsupported. For example, if product development process doesn’t leave room for design input; if firm HR policies are unattractive for creative people; or if firm’s norms don’t value design Existing strategic rigidities may limit ability to acquire new strategic competences E.g., firm known for engineering excellence may find it difficult to build marketing excellence, because top marketing talent would prefer to be “top dog” in a marketing-focused firm New strategic competences come with new strategic rigidities that may clash with existing & future competences/strategic actions E.g., Google’s acquisition of a handset manufacturer (Motorola) threatens the attractiveness of its open source operating system (Android) to rival handset manufacturers © Amitai Aviram. All rights reserved.

From traits to actions Where do they fit in?
Strategy: creating a fit between the strategic environment and the firm’s strategic traits Environment determines how much value is captured by market participants (firm & rivals), at expense of customers & suppliers Strategic actions apply a firm’s strategic competences to capture a larger part of the market’s portion of VP, at expense of rivals Value pool The strategic environment (competition) Substitution Entry Rivalry Supply chain Total value created by biz activity Allocates the value pool between markets Strategic traits Strategic actions Strategic competences (VRIO) Differentiation Coordination Confrontation Strategic rigidities Does rigidity: (1) prevent firm from exploiting a strategy? (2) allow rivals to exploit a strategy? Reform (modifying strategic traits) © Amitai Aviram. All rights reserved.

From traits to actions Means of acting strategically
Unilateral actions: actions conducted within the firm (not with rivals or government) E.g. (1): firm creates BTE by increasing it’s capacity & reaching MES E.g. (2): firm reduces costs/increases value through proprietary R&D Coordinated actions: actions that synchronize between the firm & other players (rivals, suppliers, customers) E.g. (1): firm agrees with rivals not to enter each other’s market segments E.g. (2): firm agrees with rivals to have a joint venture for R&D Regulatory actions: actions that involve the government in the competitive environment E.g., firm gets a patent or lobbies for regulation that creates BTE for rivals E.g. (2): firm gets a grant for research (or has a government entity conduct and share research) that increases firm’s VP © Amitai Aviram. All rights reserved.

Differentiation What is it?
Differentiation is a process that reduces substitution between your product and rivals’ products Differentiation matches a market’s basis of competition with a firm’s strategic competences Sometimes differentiation is called “positioning” I don’t use this name because it may create confusion with Porter’s concept of “position”, which is a focus of a firm’s business activities – the result of a strategic analysis (which is then implemented by creating a fit) Differentiation is an important part of creating a position, but other things may dictate a position (e.g., market’s expected sales growth or margins, high BTE) Porter calls this “generic strategies” For Porter, “differentiation” is one of three generic strategies (cost leadership & focus are the other two). But all generic strategies differentiate on some basis of competition (price is one of them) – so why distinguish? © Amitai Aviram. All rights reserved.

Differentiation How to differentiate?
Firm differentiates by using strategic competences to offer a better response than rivals to a basis of competition in a market Identify bases of competition; your & rivals’ strategic traits Market-wide scope Do your strategic competences (vs. rivals’ strategic rigidities) allow you to provide a better response to an important basis of competition? E.g., lowest price; valued feature; best service; highest reliability Focused scope Do market-wide leaders over-serve / under-serve particular segments? Do your strategic competences (vs. rivals’ strategic rigidities) allow you to better serve a particular segment? Compare options by expected success & market attractiveness Align activities with the chosen differentiation plan © Amitai Aviram. All rights reserved.

Differentiation Viability
Differentiation makes sense if It gives significant advantage E.g., significant economies of scale, steep learning curve, market niche with promising VP (high margins, high growth) It is sustainable Significant barriers to imitation (e.g., patents) Trade-offs help sustainability by making it less attractive for firms to trade-off existing advantages to imitate your firm Market has a high propensity for coordination, and it is feasible & legal to coordinate with rivals so that they don’t imitate your differentiation © Amitai Aviram. All rights reserved.

Differentiation Cost leadership
Murray: viability of cost leadership is driven by the supply-side (low cost production), not by the demand-side (price sensitivity) Economies of scale Preferential access to complements Preferential access to raw materials (high BTE & concentration in the upstream market) Example 1: Control of oil reserves that are cheaper to extract Example 2: Producing aluminum requires bauxite (low BTE, relatively cheap to extract), and uses a lot of energy. Therefore, low-cost producers are those located next to cheap energy sources (Iceland: geothermal energy; Siberia: hydroelectric energy). Access to superior product or process technology Access to superior distribution channels © Amitai Aviram. All rights reserved.

Differentiation Cost leadership – Example (Uniqlo)
Uniqlo is a cost leader is the Japanese “basic clothing” (T-shirts, socks & jeans) market Difficult market for cost leadership Low BTE to raw materials markets (e.g., cotton, wool, labor) Ubiquitous product technology Low BTE to distribution channels How does Uniqlo achieve cost leadership? Relatively small (1K) number of items (production economies of scale, lower design costs, lower inventory management costs) Longer shelf life for each item (tradeoff: doesn’t attempt to chase fashion) Many colors (increases variety with minimal increase in costs) What are likely threats to Uniqlo’s strategic action? I.e., what changes to the environment would cause Uniqlo’s differentiation to be less profitable? © Amitai Aviram. All rights reserved.

Differentiation Product differentiation
Similar to cost leadership, except strategic competences support another basis of competition (rather than cost) Differentiation of easily ascertainable features (e.g., screen size) tends to be unsustainable because it is easily copied (unless something prevents copying; e.g., patents) Such differentiation is more viable early in a product life cycle (when customers don’t have info on any products & products vary widely) Differentiation of difficult to ascertain features (e.g., quality, reliability, service) is more sustainable because of customers’ learning costs Takes time to convince a customer that a new product is reliable Such differentiation is more viable later in a product life cycle © Amitai Aviram. All rights reserved.

Differentiation Focus
Identify over-served / under-served segments Overserved – cost focus; Underserved – differentiation focus Do your strategic competences (vs. rivals’ strategic rigidities) allow you to best serve segment? No sense in focusing if, once market sees you found a profitable segment, other firms can focus on it & outcompete you Murray: consider positive/negative synergies between segments Negative synergies between segments (e.g., tarnishing premium brand by also having a value brand) increase odds that segments are over- or under-served Positive synergies (e.g., advantage of offering entire line of products) undercut odds of success despite identifying over-/under-service Sometimes, synergies may be positive among a group of segments but negative among others – then, focus on multiple segments E.g., full-line of premium products, but not value products © Amitai Aviram. All rights reserved.

Differentiation Focus – Example (Independent films)
Independent film makers squeezed from high & low end of market High-end: blockbuster films become increasingly expensive E.g., advertising, special effects Low end: cheap digital videocams, editing software & online distribution 5,500 films in Cannes festival; only about 600 shown in cinemas Video on demand (VOD) to the rescue Distribution system more suited for niche movie preferences “Not everybody lives near an art-house cinema, but almost everybody has a remote control.” Much larger movie capacity than cinemas Cable companies help with advertising Trade-off: much less likely to have a blockbuster “Famous actors and directors distrust a platform that carries only slightly less stigma than a straight-to-video release. Cinemas do not want to touch any film that has appeared on television.” © Amitai Aviram. All rights reserved.

Differentiation Focus – Example (Independent films)
Using our analysis: VOD segment overserved by blockbuster movies – cost focus Customers often don’t plan ahead of time So, money spent on advertising (& resulting higher ticket price) is unneeded TV provides less auditory & visual experience than cinema So, special effects are wasted on VOD audience But this is diminishing as more people have large-screen, HD TVs VOD underserved by blockbuster movies – differentiation focus Customers experiment more when watching movies at home Physical presence in cinemas mean in less densely-populated places only very popular movies play in cinema Differentiation: movies that have large but dispersed audience Assess the threat from lower end content (e.g., YouTube) © Amitai Aviram. All rights reserved.

Coordination What is it?
Coordination is a strategic act that reduces (or eliminates) buyer/supplier power by directly involving the firm in the threatening upstream/downstream market Example: a power plant relies on a supply of coal from a monopolist coal miner. To reduce supplier power, the power plant can either: Start its own coal mining company (integration via organic growth) Buy the coal miner (integration via acquisition) Sign a long-term contract to buy the coal it needs for 30 years Have an informal agreement that the miner would sell coal to the power plant There’s a spectrum from complete integration to agreement At one extreme, complete integration means the firm fully owns & controls the coal miner (i.e., it has the right to control the coal mining activity) At the other extreme, agreement means that the firm has an understanding that it has rights to the coal It creates incentives, such as the threat of a breach of contract lawsuit, for the coal miner to comply with the power plant’s wishes © Amitai Aviram. All rights reserved.

Vertical coordination Make or buy?
Which is better: integration or agreement? This is sometimes called the “make or buy” decision Example: Firm A is active in a single market Refines oil into gasoline For every complement (upstream or downstream link in the supply chain), the firm can choose between: Make (integration): do this business activity yourself E.g., develop an operation that finds oil & extracts it, or develop a chain of gas stations Buy (agreement): let others handle this operation (outsource) Firm A buys oil from firm B, and sells refined gasoline to firm C © Amitai Aviram. All rights reserved.

Vertical coordination Specialization & outsourcing
Specialization generally reduces costs/increases value Economies of scale Accumulated experience Full managerial attention Decisions requiring trade-offs favor specialized product The value of specialization suggests that “buy” (outsource all activities except those in which you specialize) is a better option than “make” (do it all inside the firm) So why don’t we always outsource? Buyer/supplier power If we outsource to a firm that has buyer/supplier power over us, they will be able to extract most of the value pool © Amitai Aviram. All rights reserved.

Vertical coordination A response to buyer/supplier power
Recall the newspaper hypo in section 1b2: a newspaper can be exploited because of a $10M transaction-specific investment connecting its editorial computers to the printing press. To prevent exploitation, it hires Jane (an experienced printer) as an employee. Jane receives a fixed salary. At the extremes: Jane can work diligently, saving the newspaper expenses and producing a better product Jane can shirk, resulting in a more expensive, lower quality product What is Jane likely to do? © Amitai Aviram. All rights reserved.

Vertical coordination Reducing shirking
This is bad for the newspaper. Is it bad for Jane? How can the newspaper ensure Jane works hard? © Amitai Aviram. All rights reserved.

Vertical coordination Monitoring
Monitor Jane’s inputs Problems with this? Why aren’t punch clocks used to monitor professors? Monitor Jane’s outputs Problems? Benchmark Proportionality to efforts © Amitai Aviram. All rights reserved.

Vertical coordination Bonding
Bonding – actions that align Jane’s incentives with those of the newspaper. Successful bonding will result in Jane being worse off if she doesn’t do what she promised (e.g., work hard). E.g.: Bonus (carrots) Threat of getting fired (sticks) © Amitai Aviram. All rights reserved.

Vertical coordination Agency costs
Agency costs are the sum of: Monitoring costs Measuring the agent’s inputs/outputs Identifying/calculating the benchmark Risk allocation re effort-outcome relationship Inputs: Risk allocated to principal (proportionality to results) Outputs: Risk allocated to agent (proportionality to efforts) Bonding costs Cost of creating/maintaining the bonding mechanism Cost of greater risk (e.g., income volatility) to agent Residual loss - the cost to the principal from the degree to which the agent shirks despite monitoring & bonding © Amitai Aviram. All rights reserved.

Vertical coordination The transaction cost trade-off
Risk of opportunism more significant with agreements This risk tied to buyer/supplier power Buyer/supplier market power Asset specificity (transaction-specific investment) Agency costs more significant with integration Monitoring costs & bonding costs “Make vs. buy” depends on which cost is greater © Amitai Aviram. All rights reserved.

Vertical coordination Optimal form of combining activities
High Buyer/Supplier Power Leans toward integration (“make”) Low Agency Costs High Agency Costs Leans toward agreement (“buy”) Low Buyer/Supplier Power © Amitai Aviram. All rights reserved.

Vertical coordination Optimal form of combining activities
Leans toward integration High B/SP Family (Relational Firm) Firm (Difficult to dissolve) Relational Contract Low AC High AC Long-term Contract Firm (Easy to dissolve) Spot Contract Leans toward agreement Low B/SP © Amitai Aviram. All rights reserved.

Coordination Deterrence
Deterrence is a hostile form of coordination, in which a firm (F) sends a credible signal that a rival’s (R) unacceptable behavior (“trigger”) will bring a response from F that will cost R more than the benefit from the triggering event Element 1: credibility – F must persuade R that F will respond even if the response would be costly to it (e.g., losing money in a price war) To maintain credibility, either the response must not be costly to F (rare), or F must have “strategic inflexibility” (unable to avoid responding even if the response is costly) E.g., throwing steering wheel out of the window in a game of “chicken” Element 2: force – response must cost R more than benefit from trigger Tension with credibility (higher cost to R related to high cost to F) Response may be any action that imposes a cost on R (foreclosure or attrition, but likely attrition because F has to signal response, allowing R to better defend the target) Element 3: signal – trigger & response must be clearly communicated to R Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb (1964) ( – US president discusses with Soviet ambassador the Doomsday machine © Amitai Aviram. All rights reserved.

Deterrence in business is often created by investing in production assets with high fixed costs & low variable costs Element 1 – credibility: Once the asset (e.g., new production plant) is purchased, firm has an incentive to operate it to full capacity, even if this lowers price below ATC, as long as it price is above VC Credibility is improved if the asset has no use in other lines of production & can’t be sold to others, so it can’t be sold or diverted to another market Element 2 – force: if F operates the productive asset in full capacity & lowers prices below ATC, firms operating in the market will lose money May not deter incumbent rivals (since exiting will cost them their investment in the market), but likely to deter potential rivals, since they lose nothing from not entering Element 3 – signal: F publicizes acquisition of new capacity © Amitai Aviram. All rights reserved.

R’s possible responses Challenge credibility by Making small incremental provocations that just barely cross the trigger (each of which seems minor compared to cost of F’s action); or Counter-threatening (which increases the cost to F from confrontation) Challenge force by reducing the harm from F’s response (e.g., reducing costs so that R can profit even if F employs additional capacity) Failed deterrence results in costly confrontation; the commitment required for credible deterrence reduces F’s flexibility in such confrontations © Amitai Aviram. All rights reserved.

Confrontation Definitions
Players Confronting firm (F) Rival targeted for confrontation (R) Another rival of F (R2) Terms Actions: F’s actions or omissions that use F’s resources to impose costs on R (e.g., cutting prices, “stealing” R’s customers, blocking R’s access to complements) Resources: money and other assets that F’s actions require Capitulation: R’s acceptance of F’s goals in return for stopping the confrontation Variables Cost of confrontation to F (CF): this includes cost of resources plus harm to F’s business activities as a result of the confrontation Cost that F imposes on R if confrontation is successful (CR) Benefit that F perceives it will receive from its goal (GF) Cost that R perceives it will suffer if it capitulates to F’s goal (GR) Probability that F’s confrontation is successful (GP) © Amitai Aviram. All rights reserved.

Confrontation Key elements of confrontation plans
Goal: purpose of the confrontation Competitive advantage: F’s strategic competences exploited to impose CR Usually same as BTEs: restricting access to complements or to economies of scale/scope, or otherwise imposing disproportional costs Scope: extent of R’s activities that are targeted by F & extent of F’s resources devoted to confrontation 3-way tradeoff between CR, GP & flexibility Example F’s goal is to get R to raise its prices of widgets by 20% F has competitive advantage of lower production costs F decides to target only value (low-price) widgets (scope) F cuts the prices of its value widgets (action), taking away sales from R and reducing R’s economies of scale (market for premium widgets unaffected) Due to F’s cost advantage, R does not expect to win a price war against F, so R raises its prices by 20% and F ends the confrontation © Amitai Aviram. All rights reserved.

Confrontation Goal: general purpose
Usually: compel R to coordinate with F, on terms desirable to F The conflict signals to R and/or other rivals F’s ability to retaliate for undesirable behavior, which makes rivals conform to F’s wishes This is usually the most sensible goal: renegotiating the balance of power between F & R, or denying R’s attempt to renegotiate the balance of power In rare circumstances, confrontation has other goals: Eliminate R F causes R to exit the market Risky & often wrong goal: extremely costly & eliminating R often strengthens other rivals or opens way for new entrant Reduce R’s ability to compete F denies R strategic competences (e.g., sufficient scale of operations) Also risky goal: effect is often temporary (R finds ways to recover) & weakening R often strengthens other rivals or opens way for new entrant © Amitai Aviram. All rights reserved.

Confrontation Goal: requirements for the specific goal
Valuable: only if F can recoup CF after goal was achieved Recoupment (GF) depends on market structure after confrontation ends E.g., low BTEs prevent recoupment because once F tries to raise prices to recoup confrontation costs, new entrants capture sales & lower prices E.g., other rivals’ relative position – if R was a threat to R2, then R2 may become a bigger threat to F after R is eliminated Achievable: only if F is successful Ability to inflict CR > GR Tolerance for attrition (ability to sustain confrontation long enough to win) Better access to capital Management is able to ignore SHs’ desires (corporate governance) SHs have goals other than profits (or have longer-term horizons for achieving profitability) If CR is insufficient to make the goal achievable, need to: Define a more modest goal (reduces GR, but also reduces GF) Increase confrontation scope (increases CR, but also increases CF and/or reduces GP) Develop greater competitive advantage (increases CR, but hard to do & temporary) © Amitai Aviram. All rights reserved.

Confrontation Goal: common misperception
Knee-jerk confrontation plans (in business & war) Trigger for confrontation: R intentionally acts unfairly/immorally Goal of confrontation: destruction of R’s fighting capability (unconditional surrender) This makes no strategic sense Utility of confrontation not limited to addressing intentional or immoral acts No connection to ability to win the confrontation Destroying R may hurt you (e.g., strengthen R2) So why is this approach so common? Confrontation requires sacrifices; easier to justify sacrifices for a total war Day-to-day interactions require normative constraints on confrontation; need justification to shake off constraints; justifications become the triggers of confrontation Facilitating deterrence: deterrence is made credible by a social norm that mandates confrontation in response to a norm violation, regardless of the expected outcome But this can also backfire (e.g., confrontation with R reduces resources available to deter R2) Also limits F’s freedom to pick the best action when circumstances change © Amitai Aviram. All rights reserved.

Confrontation Competitive advantage
A competitive advantage is a strategic competence used by F’s actions to impose CR Impose CR > CF (either directly or by allowing F to “steal” R’s customers) Increase F’s (or reduce R’s) tolerance for attrition Typically, competitive advantages raise BTEs for R but not for F (in antitrust terminology, this action is called foreclosure) Limit R’s access to complements Limit R’s ability to exploit economies of scale/scope Otherwise impose disproportional costs on R E.g., capturing the only, the main, or the early customers of a products (e.g., lobbying the government to be their supplier of fighter jets) One way that competitive advantage negatively affects R but not F is for F to use a different business model than R (so that it’s profitable for F to compete in a way that clashes with R’s business model) E.g., Amazon enters the tablet market with business models that expects to profit from a complement (online purchases), so tablets can be sold at cost. This clashes with Apple’s business model, which relies on profits from the tablets. © Amitai Aviram. All rights reserved.

Example 1 (bottleneck): F controls a unique & necessary complement to the product F & R compete over Without the complement, R can’t compete Modified example 1 (“real foreclosure” – restriction but not elimination of access to complement): F has exclusive access to the lowest cost/highest quality complements Example 2 (cartel ringmaster): F arranges a quid pro quo with the complement producers F orchestrates a cartel between the complement producers, allowing them to charge higher prices/avoid price cutting In return, cartel members charge R higher prices than they charge F F is in good position to monitor cartel & punish deviation if it has a large market share, so cartel has interest in supporting F against R Modified example 2 (Frankenstein monster): instead of an inferior complement R faces an inferior market for complement Example: Firm A & B manufacture widgets. There are only 3 retailers through which they can sell the widgets. If Firm A signs an exclusivity agreement with two of them, Firm B can only work with one retailer, who will charge B as a monopolist (more than A has to pay) © Amitai Aviram. All rights reserved.

Sometimes foreclosure can be exercised through F’s “negative control” (e.g., blocking R from accessing the complement) Example: First railroad bridge over Mississippi River Government Bridge: Rock Island, IL to Davenport, IA (1856) Connected the Chicago & Rock Island Railroad (1854) with the Mississippi and Missouri Railroad (1855) © Amitai Aviram. All rights reserved.

Who is attempting to foreclose whom? (a bit of trivia) Fort Armstrong was built on Rock Island in 1816 as a frontier defense; closed in 1836 Nonetheless, U.S. Secretaries of War claimed jurisdiction over Rock Island Jefferson Davis (Secretary of War under Franklin Pierce) tried to use his jurisdiction to stop construction of the bridge He sued for an injunction, but lost Why would Davis oppose the bridge? (Consider where commerce could go if there’s no bridge at Rock Island, IL) © Amitai Aviram. All rights reserved.

Who is attempting to foreclose whom? (a bit of trivia) Two weeks after the bridge opens, a steamboat collides with the bridge Steamboat companies sue to have the bridge dismantled Railroads hire lawyer Abraham Lincoln to defend them In 1862, S.Ct. rules for the railroads What is plaintiff’s motivation in litigating this? © Amitai Aviram. All rights reserved.

Confrontation Competitive advantage: foreclosure & attrition
When F does not have the ability to foreclose R (make R’s business model unsustainable), F might still hope to win through attrition: actions that impose on R unacceptable losses (compared to GR) One common situation involves F entering R’s most profitable market in order to deflate R’s profits, so R is unable to threaten F’s key markets E.g., Microsoft, threatened by Netscape’s potential to undermine Windows, creates Explorer Common attrition actions: price competition, litigation Attrition is usually used when either: F has greater tolerance for attrition (F is able to sustain losses better than R) F has a favorable rate of attrition (inflicts greater loss on R than it costs F) CR > CF (e.g., price war when F has lower costs than R) F has lower sales than R, yet can drive down the price R receives R may respond by reducing confrontation to reduce attrition (e.g., reduce market share), increasing R’s tolerance for attrition or reducing F’s tolerance for attrition (e.g., get F SHs to rebel); counter-attacking where F is vulnerable Attrition is a risky plan (because it imposes high CF and strengthens R2), and is often the unintended result of a failed foreclosure plan © Amitai Aviram. All rights reserved.

© Amitai Aviram. All rights reserved.
Confrontation Scope Scope is the extent of R’s activities that are targeted by F & extent of F’s resources devoted to confrontation Total war: why not 100% of resources against all of R’s activities? Uncertainty: F can’t be sure about CR, GP & GR (affecting success) or about CF , GF (affecting the value to F from success) Escalation: R could respond with a counter-attack on F, or R2 could attack F (to exploit F’s commitment or to contain F) Optimal scope (economy of effort) involves a 3-way tradeoff between CR, GP & flexibility To maximize CR target more of R’s activities To maximize GP concentrate more resources on fewer targets (concentration of force) To maximize flexibility maintain a reserve of resources that aren’t committed to confrontation. Flexibility allows F to: adjust plans that fail or become too costly deter R/other rivals from escalating (since F can retaliate) protect F’s activities from R/R2 (security) © Amitai Aviram. All rights reserved.

Integrating course components The analytical framework
Strategy: creating a fit between the strategic environment and the firm’s strategic traits Environment determines how much value is captured by market participants (firm & rivals), at expense of customers & suppliers Strategic actions apply a firm’s strategic competences to capture a larger part of the market’s portion of VP, at expense of rivals Value pool The strategic environment (competition) Substitution Entry Rivalry Supply chain Total value created by biz activity Allocates the value pool between markets Strategic traits Strategic actions Strategic competences Differentiation Coordination Confrontation Strategic rigidities Does rigidity: (1) prevent firm from exploiting a strategy? (2) allow rivals to exploit a strategy? Reform (modifying strategic traits) © Amitai Aviram. All rights reserved.

Integrating course components The analytical framework
The market analysis evaluates: The strategic environment Strategic traits (of either the “starting point” firm or all major players) Strategic actions that exploit the traits to improve the environment Strategic actions (except modifying strategic traits) must rely on existing strategic competences Strategic actions cannot conflict with existing strategic rigidities Value pool [1d] The strategic environment (competition) Substitution [2c] Entry [2d] Rivalry [2e] Supply chain [2b] Margin Volume Market definition Economies of scale/scope Access to complements Imposing disproportional costs Propensity for coordination Propensity for differentiation Propensity for confrontation Buyer/supplier MP Asset specificity Price discrimination Competences [3a] Differentiation [3b] Coordination [3c]/Confrontation [3d] Rigidities [3a] Does rigidity: (1) prevent firm from exploiting a strategy? (2) allow rivals to exploit a strategy? Reform [3a] © Amitai Aviram. All rights reserved.

Integrating course components Generic structure of the report
Part 1: Environment Substitution Starting point product (SPP) [very specific] Customer needs: why would a customer want the SPP? [very specific] Customer benchmarks: how would customer tell if SPP adequately addresses needs? Market definition (what products rate similar to SPP on customer benchmarks?) Substitution directness: identify main rival products (closest substitutes within defined market) Entry Identify BTEs in your market (what prevents new firms from entering?) Rivalry Propensity for coordination (how likely is coordination within your market?) One of the factors is concentration (market share/concentration calculations) Propensity for differentiation Bases of competition other than price? Propensity for confrontation (examine firm-by-firm, discuss only if relevant) Barriers to expansion, ability to impose BTEs on rivals, lower cost structure, near MES Look for mavericks: firms that have an interest in confrontation Consider potential competition: firms outside the market that can quickly & at low cost produce a product in your market © Amitai Aviram. All rights reserved.

Part 1: Environment Supply chain What is the supply chain in which your market is a segment? Supplier/buyer power Market power: substitution, entry & rivalry in upstream/downstream markets Customer price sensitivity (if relevant) Asset specificity (relationship-specific assets vulnerable to suppliers/buyers; if relevant) Ability to price discriminate (if relevant) Value pool (discuss only if relevant) Do any segments of the market have significantly different (higher/lower) margins or volume growth? Summary Current constraints on profitability Threats/opportunities (elements of the environment that are likely to change or can be changed by the firm or its rivals) (if relevant & backed with evidence) © Amitai Aviram. All rights reserved.

Part 2: Competitive dynamics (individual firms) Strategic traits: for the firm producing the SPP & each of the firms producing the main rival products, identify - Strategic competences (show they satisfy VRIO: value, rarity & organization) Strategic rigidities Strategic actions Looking at the behavior of the firm & rivals in the recent past, identify events that demonstrate strategic actions by them I.e., how does firm/rival use its strategic traits to modify the business environment in its favor (examples of differentiation, coordination or confrontation) Discuss actions that actually occurred, not hypothetical actions This section should take, in terms of space, more than each of the other sections © Amitai Aviram. All rights reserved.

Integrating course components Writing a market analysis
The business intelligence component (acquiring information) is integrated into each part of the report Support all elements of your analysis with evidence Reference all evidence in footnotes Where direct evidence is not available, use proxies & explain: Why it is a good proxy When is the proxy biased & in which direction If the way you collected the data is not obvious from the reference, describe it in detail Method is obvious from reference: book, article, webpage Method is not obvious: survey (attach copy of survey, provide data on who answered it); interview (attach notes, questions asked, etc.); self-examination (attach notes) © Amitai Aviram. All rights reserved.

Integrating course components Writing a market analysis
The big biz strategy questions rely on common sense What makes this product good? (bases of competition; substitution) If Acme’s product is profitable, why aren’t others copying Acme? (entry) Will firms find it profitable to “play nice”? (rivalry) Balance of power between firm, suppliers & customers? (supply chain) How to exploit a firm’s strengths & weaknesses? (strategic actions) How do we add value, cut costs, increase sales? (value pool) Implications Detailed framework in this course helps you recognize common patterns, but shouldn’t be a straightjacket You can do a good job without a business background Qualitative data can be just as good as quantitative data Figure out what factors are most important in your industry and focus on them (e.g., Standard Oil case: BTE for refiners & FC/VC for railroads) © Amitai Aviram. All rights reserved.

Case study: Standard Oil Market definition
Starting point: Standard Oil’s kerosene Kerosene is a high-quality illuminating product, mostly exported to Europe via U.S. East Coast Bases of competition: price only Customer needs: lighting fuel, price as low as possible Customer benchmarks Lighting fuel: kerosene is a commodity; no quality variations Price: location of rival products doesn’t affect their pricing by much Oil produced mostly near Pennsylvania/Ohio border; refiners mostly in Cleveland & Pittsburgh; major port cities are New York & Philadelphia Refinery are close to oil wells & competition among railroads keeps transportation cheap Market definition: refining of crude oil into kerosene © Amitai Aviram. All rights reserved.

Case study: Standard Oil Environment
Substitution: somewhat benign Kerosene can be substituted with other illuminators, but has quality advantages Entry: threat Known & unpatented technology Relatively low economies of scale & low capital requirements Supply chain opportunities benefit entrants as well as incumbents Rivalry: threat Participating firms: numerous Low propensity to coordinate (fragmented industry & low BTE) Lack of differentiation between products makes price competition fierce © Amitai Aviram. All rights reserved.

Case study: Standard Oil Environment
Supply chain: benign Crude production Competition: high Substitution: low Entry – low BTE Rivalry – low concentration Asset specificity: not much (pipelines to oil fields) Crude/kerosene transportation Substitution: low until pipelines (transportation by horse impractical, by ship long & requires land transport to Miss. River or Lake Erie) Entry: high BTE (acquiring right of way & laying tracks is expensive) Rivalry: high (high ratio FC/VC; very little differentiation – price almost only factor, distance/time differences bw/railroads not significant for freight) Asset specificity: not much (only when destination doesn’t have a union station) Crude oil production Crude transport Kerosene transport Kerosene retail Kerosene export/wholesale Refining © Amitai Aviram. All rights reserved.

Case study: Standard Oil Firm’s traits
Strategic competence: Standard Oil is larger than rival refiners Value Benefit: normally size matters in exploiting economies of scale, but here it also places Standard in superior position to police a railroad cartel Detection: since it buys much of the oil & ships much of the kerosene, it can track each railroad’s market share & prices to ensure compliance w/cartel Punishment: if one of the railroads cheats, Standard Oil can punish by stopping to ship its oil & kerosene via that railroad Competitive superiority: rivals don’t have alternative trait making them superior in policing cartels Rarity Imitability: right now no refiner is big enough to rival Standard Oil. Normally, when BTE is low, rivals can quickly expand and become equally large, but here Standard Oil, as first mover, can get railroads to hinder rivals from expanding Organization: all value is captured by railroads, not by Standard Oil, so competence can only be used as part of quid pro quo with railroads © Amitai Aviram. All rights reserved.

Case study: Standard Oil Strategic actions
Differentiation: not feasible (price is only basis of competition) Strategic competences don’t provide Standard Oil much advantage on price Branding the kerosene to make quality a basis of competition? (3rd best option) [compare to GoDaddy.com] Coordination: not desirable Upstream/downstream markets not a threat Confrontation: cartel ringmaster is feasible Foreclosure (cartel ringmaster) – this is what Standard Oil did (1st best option) Reform: bring in & capture government regulation of oil refining & transportation (2nd best option) © Amitai Aviram. All rights reserved.

Case study: Standard Oil Strategic action: cartel ringmaster
Environment threats: low BTE; high rivalry (price competition) Strategic action: confrontation (foreclosure via cartel ringmaster plan) Railroads Environment threats: high rivalry (price competition), otherwise benign conditions (high BTE, low substitution) Bring in an outside firm (Standard Oil) as cartel policeman to overcome high rivalry The deal Standard Oil uses its competence (advantage in coordinating a railroad cartel) In return, railroads charge Standard Oil’s rivals higher rates (allowing Standard Oil to win the price competition & making entry unattractive) Railroads have incentive to allow Standard Oil a large market share, because it enhances its detection & punishment capabilities © Amitai Aviram. All rights reserved.

Prof. Amitai Aviram University of Illinois College of Law

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Prof. Amitai Aviram University of Illinois College of Law

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