1. STR 421 Economics of Competitive Strategy Michael Raith Spring 2007

2. Today’s class 2. Value creation and competitive advantage 2.1 Value creation and positioning 2.2 Sustainability of a competitive advantage

3. Sustainability of competitive advantage Efficient markets principle: if you have a competitive advantage, others will try to imitate what you’re doing Efficient markets principle: if you have a competitive advantage, others will try to imitate what you’re doing What will prevent them? What will prevent them?

4. Sources of sustainability a.k.a. “Isolating mechanisms”, “Sources of market power” a.k.a. “Isolating mechanisms”, “Sources of market power” All of these are also barriers to entry All of these are also barriers to entry 1.Impediments to imitation = Reasons why others cannot imitate you = Loosely speaking, returns from unique resources and skills 2.First (or early)-mover advantages = Reasons why it would be uneconomical for others to imitate you = Loosely speaking, returns from market power Distinction not clear-cut: how much does it cost to replicate an incumbent’s advantage? Distinction not clear-cut: how much does it cost to replicate an incumbent’s advantage?

5. 1. Impediments to imitation: (a)-(f) (a)Regulatory restrictions –Broadcasting rights, taxis, import tariffs and quotas –Not just given situation: companies spend $$$ to influence regulation (b)Patents = legally protected monopoly rights, exist to encourage innovation –Example: Patent protection important in pharmaceuticals, weaker in medical devices. Depends on Ability to innovate around existing patents Ability to innovate around existing patents Speed of innovation: new devices quickly become obsolete Speed of innovation: new devices quickly become obsolete (c)Secrecy about production process –Often chosen when obtaining patent protection is difficult and product is difficult to reverse-engineer

6. (d) Superior access to inputs or customers Inputs: Inputs: –De Beers until 1990 –Alcoa’s backward integration into bauxite in early 20 th century Customers: e.g. through exclusive-dealing contracts Customers: e.g. through exclusive-dealing contracts What about talented employees (=inputs)? What about talented employees (=inputs)? –Can be hired away if worth as much or more elsewhere –Cannot if they stand to lose human capital specific to the firm (or to a set of other employees, “cospecialized assets”)  “Unique resources” must be scarce and immobile

7. (e) Unique capabilities Examples: Examples: –Honda in engines –3M in adhesives and thin-film coating –Bombardier in trains –Canon: integration of microelectronics, fine optics and precision engineering = Capabilities that –are result of organizational learning over time, corporate culture, organizational structure –do not depend on individuals

8. (f) Strategic fit Examples: Southwest Airlines, Ikea, Dell; we’ll see others Examples: Southwest Airlines, Ikea, Dell; we’ll see others Good internal fit can be Good internal fit can be 1.Source of competitive advantage 2.Reason for its sustainability Hard for others to get all components of the system right at the same time. Hard for others to get all components of the system right at the same time. But successful imitation may only be question of time But successful imitation may only be question of time –E.g. pressure on airlines like Southwest, JetBlue

9. 2. First-mover advantages: basic logic Suppose A has discovered a market opportunity and is making a profit Suppose A has discovered a market opportunity and is making a profit B considers imitating A. Assume B can do so without any technological disadvantage (no impediments to imitation) B considers imitating A. Assume B can do so without any technological disadvantage (no impediments to imitation) What would happen? Upon entry, B might find itself What would happen? Upon entry, B might find itself –Sharing a limited market with A –Engaged in a price war with A –Without customers because for some reason customers stick with A As long as A is committed to staying, A can make profit if alone, but B as second mover cannot, and hence should stay out As long as A is committed to staying, A can make profit if alone, but B as second mover cannot, and hence should stay out A then has a first-mover advantage A then has a first-mover advantage

10. (a) Scale economies relative to size of market (segment) Basic logic: Basic logic: –A and B can share market if market > 2 MES –But if market smaller, competition will lead to losses –If A is more likely to stay because of sunk costs, B should not enter in the first place Examples: Examples: –Wal-Mart in small towns –Coors in West in 70s, A/B & Miller in East in 80s Closely related: Geographic or positional preemption in markets with differentiated goods Closely related: Geographic or positional preemption in markets with differentiated goods –CC&S in its niche of the market

11. (b) Reputation Established reputation for quality raises buyers’ WTP Established reputation for quality raises buyers’ WTP –What matters is perceived quality Competitors w/o reputation can only sell at lower price Competitors w/o reputation can only sell at lower price Reputation must often be maintained through advertising or R&D Reputation must often be maintained through advertising or R&D  Endogenous sunk-cost markets –E.g. Coke, Intel, Apple

12. Special case: brand image Perceived quality often more matter of brand image than based on tangible things Perceived quality often more matter of brand image than based on tangible things Companies spend $$$ to advertise brands Companies spend $$$ to advertise brands Importance of advertising depends on who makes/influences purchase decision Importance of advertising depends on who makes/influences purchase decision –Beer: consumers –Cans: companies –PCs: resellers, Consumer Reports, corporate/educational etc.

13. (c) Network effects Direct network effects: value to buyers increases with # of users Direct network effects: value to buyers increases with # of users –Fax machines, Word, eBay Indirect network effects: link through a complementary product Indirect network effects: link through a complementary product –The more people use PCs & Windows,  the more software for PCs is developed  the greater the value of PCs to buyers –Another example: DVDs/players and Blockbuster If a firm owns technology that customers are locked into, it has market power because rivals’ products will be less valuable to customers. If a firm owns technology that customers are locked into, it has market power because rivals’ products will be less valuable to customers. –PC industry is competitive, but Microsoft is monopolist Ask: how strong are network effects? Ask: how strong are network effects?

14. (d) Switching costs A firm has market power if its customers incur some cost if they switch to a different product A firm has market power if its customers incur some cost if they switch to a different product –Synergies with other products in same family, e.g. Microsoft Office –Familiarity with existing product, e.g. WordPerfect –eBay, NetFlix –Yahoo vs. Google: lock in users through personalized searches? Creating switching costs is powerful way to build customer loyalty and market power Creating switching costs is powerful way to build customer loyalty and market power –But rational customers must be willing to be locked in! Ask: How difficult is it really for customers to switch? Ask: How difficult is it really for customers to switch? –E.g. cell phones: regulation that allows customers to transfer home phone number to cell phone

15. (e) Learning effects (“experience curve”) lower AC as a result of higher cumulative output lower AC as a result of higher cumulative output  First-mover advantage through experience –E.g. aircraft Strategic consequences Strategic consequences –Being first important if you know there will be learning effects –BCG in 70s: invest in early stages of product life cycle to secure learning economies. Problems: 1.Existence of learning effects often known only afterwards 2.You may be investing in losing products Internal fit matters: union contracts at Lockheed diminished learning effects in producing the L-1011 TriStar (BDSS Ch. 2) Internal fit matters: union contracts at Lockheed diminished learning effects in producing the L-1011 TriStar (BDSS Ch. 2)

16. Sustaining a competitive advantage is hard Don’t assume any of these barriers exist for a particular firm; ask to what extent they may exist: Don’t assume any of these barriers exist for a particular firm; ask to what extent they may exist: 1.Having certain resources and capabilities does not mean they’re unique Imputed “unique capabilities” often used as shortcut to explain a firm’s success without careful analysis Imputed “unique capabilities” often used as shortcut to explain a firm’s success without careful analysis Firms often fool themselves by claiming to have certain unique capabilities Firms often fool themselves by claiming to have certain unique capabilities 2.Moving first does not by itself confer a first-mover advantage “Sustainability” is not yes-no matter, often only matter of time “Sustainability” is not yes-no matter, often only matter of time