Economics of Strategy Fifth Edition Slides by: Richard Ponarul, California State University, Chico Copyright  2010 John Wiley  Sons, Inc. Chapter 13 Strategic Positioning for Competitive Advantage Besanko, Dranove, Shanley, and Schaefer

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

Unit Costs, Yields, and Market Shares in the U.S. Airline Industry, 2008

Revenue & Profitability in the U.S. Airline Industry, 2007

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

Competitive Advantage & Value Creation A firm is said to have a competitive advantage only if it can create more economic value than its competitors. A firm’s ability to create value depends on its cost position as well as its benefit position relative to its competitors

Framework for Competitive Advantage

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

Industry and Business Unit Effects in Profitability

Competitive Advantage and Value Creation The purpose of business is to create customers (Drucker). Businesses which create and deliver value create customers. Businesses survive and prosper by capturing part of the value created as profits.

Maximum Willingness to Pay and Consumer Surplus Maximum willingness to pay - Price at which the consumer is indifferent between buying the product and not buying Consumer surplus is the difference between the maximum the consumer is willing to pay (monetary value of the perceived benefit) and the prevailing market price

A Soft Drink Producer’s Maximum Willingness-to-Pay for Corn Syrup

Consumer Surplus and Competition Consumer surplus needs to be positive for the purchase to occur. If there is a choice between two or more products consumer will choose the one with the largest consumer surplus. To compete successfully firms need to deliver consumer surplus.

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

Value Map Points on the indifference curve represent price- quality with the same consumer surplus The steepness of the indifference curve reflects the tradeoff between price and quality that the consumers are willing to make

The Value Map

Value Map Products A and B exhibit consumer surplus parity Product C has a higher consumer surplus than A and B Product D has a lower consumer surplus

Indifference Curves & the Tradeoff between Price & Quality

Value Creation B = Maximum willingness to pay P = Price of the product C = Cost of making the product Value created = B – C = (B - P) + (P - C) Value created = Consumer surplus + Producer surplus If B - C (the value created) is not positive the product will not be viable. If B - C is positive, all parties are better off because the product was made and sold

Components of Value-Created in the Market for Aluminum Cans

Value Creation and Market Segments Value creation occurs with respect to particular customers. A firm may be successful in creating positive B – C in one segment while it takes another firm to do the same in another segment.

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

Economic Profitability of Personal Computer Makers

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

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

Value Chain

Each activity in the value chain can potentially add to perceived benefits. Each activity also adds to costs. In practice it is difficult to isolate the incremental perceived benefit and the incremental cost of each activity.

Value Added Analysis Value added analysis is a tool to identify where the value creation occurs along the value chain. To estimate the incremental value for the parts of the value chain we need market prices of semi finished and finished goods.

Value Creation Firms can create more economic value than its competitors by  either configuring its value chain differently from competitors or  performing the activities more effectively than the rivals

Value Creation, Resources, and Capabilities To perform activities more effectively than the rivals firms need resources and capabilities that the rivals do not have. Resources are specialized assets (patents, established brand name etc.) Capabilities are activities a firm can perform better than its rivals do.

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

Strategic Positioning A firm’s generic strategy describes how it positions itself (Porter). Two broad approaches to strategic positioning are  cost leadership and  benefit leadership Alternatively a firm can use a narrow focus strategy.

Porter’s Generic Strategies

Generic Strategies in the U.S. Personal Computer Industry

The Strategic Logic of Cost Leadership A cost leader can create more value than its competitors by  offering the same benefits as the competitors do (benefit parity)  offering a slightly lower benefit (benefit proximity) or  offering a qualitatively different product.

The Strategic Logic of Cost Leadership Firm F offers lower quality than the rest of the industry (E) and has much lower costs than the rest of the industry If the cost leader attains consumer surplus parity with the rest of the firms in the industry it earns a higher profit margin C E – C F > P E – P F P F – C F > P E – C E

The Strategic Logic of Benefit Leadership A benefit leader creates a larger B – C than its rivals by achieving a higher B than its rivals A benefit leader firm can create superior values by offering  cost parity  cost proximity  substantially higher benefit and higher cost

The Strategic Logic of Benefit Leadership Firm F offers higher benefit than the rest of the industry (E) at a slightly higher cost If the benefit leader attains consumer surplus parity with the rest of the firms in the industry it earns a higher profit margin P F – P E > C F – C E P F – C F > P E – C E

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

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

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

Stuck in the Middle? In reality, however, successful firms appear to have both types of advantages.  Firms that offer high quality products expand market share and enjoy cost advantages due to economies of scale and learning  Learning economies may be more important for high quality production than for low quality production  High quality producers may also be more efficient producers

“Stuck in the Middle” Trying to attain excellence in all dimensions often leads to unfocussed decision making. Trying to achieve cost advantage and benefit advantage may lead to uninspired imitation of “best practices.”

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