Economics of Strategy

Strategic Positioning for

Competitive Advantage
 Competitive Advantage

• Traditional Management Definition

– “the ability of the firm to favorably distinguish
itself from its competitors in the the eyes of
consumers”
 Competitive Advantage
• Economists Definition
– “a firm has a competitive advantage when it
outperforms competitors who sell in the same market
(i.e., earns higher rates of profitability than)”
• Traditional definition focused on sales (i.e.,
demand factors)
• This definition is much broader
– includes stake-holders beyond consumers
– explicitly addressed costs
 Competitive Advantage
• Depends upon two major factors
– creating firm value through the cost side
– creating firm value through the demand or product
differentiation side
• both are in relative terms compared to peer
competitors who sell in the same market
• Profitability depends upon both the industry you are
in and your relative performance within that industry
– see figure 12.1, p. 442
 Analysis of Competitive
Advantage
• Consumer Surplus
– the difference between what the consumer pays
for a product and the perceived benefits by the
consumer
– treat the demand curve as a marginal benefit
curve
• consumers buy products which maximize
their consumer surplus
 Perceived Gross Benefits
to the consumer
• Start with product attributes
• subtract out user costs
• subtract out the transactions costs
 Perceived Attributes

• performance
• reliability
• durability
• convenience
• aesthetics
• image
• resale value
 User Costs

• installation costs
• learning costs
• operations costs
• maintenance costs
• disposal costs
 Transactions Costs

• the costs of organizing and transacting an

exchange
Price The Value Map
Indifference Curve 1

Indifference Curve 2

Preference direction
“higher consumer surplus”

Quality
 Value Creation
• Value is created as the product moves through
the vertical chain from raw materials to
finished product
• B as the perceived benefit to the final consumer
• C as the costs of inputs
– all economic inputs including opportunity costs
• Value Created = B - C
• Value created is split into consumer surplus +
producer surplus
 Value-Creation and Competitive
Advantage
• To achieve competitive advantage the firm
– must create value AND
– it must create more value than its competitors
in the industry
• competition among firms is a process of
bidding for both the dollar votes of
consumers and the dollar votes of investors
 Value-Creation and Competitive
Advantage
• Why do customer’s choose your product over the
other choices they have?
• How do production, distribution, and sales
technology affect your firm?
• What is the underlying cost structure of your firm?
– Are there economies of scale or scope?
– How do non-production costs affect your overall cost
structure? (Production, distribution, sales?)
– How do costs change with experience?
 Value-Creation and the Value
Chain
• The value chain identifies processes within
the firm that create value
• Each stage can potentially add or reduce B
and/or C
• To have competitive advantage the firm
must create more value (the spread between
B and C) than its competitors
• This requires resources and capabilities
 Resources
• firm-specific assets that cannot be easily
duplicated or acquired by your competitors
– patents, copyrights, trademarks
– brand recognition
– organizational culture
– good relationships with work force
– protected access to channels of distribution
– monopoly power through legislation
 Capabilities

• clusters of activities that your firm performs well

relative to competitor firms
– developed expertise
• Disney in cartoons
• American Airlines in yield management
• Employee relationships at Saturn
• Honda and small internal combustion engines and power
trains
• Harley Davidson and The American Mystique
• Bausch and Lomb in optics
 Capabilities - Common
Characteristics
• They are typically valuable across multiple
markets or products
• They are typically embedded in
organizational routines
– well-honed patterns of performing activities
inside the organization
• They are difficult to quantify or reduce to
simple algorithms or procedure lists
 Key Success Factors
• Skills and assets a firm must possess to
achieve profitability in the industry
• these are necessary but not sufficient
– necessary - they are required to be in the game
(join the industry)
– sufficient - they are not what creates
competitive advantage (within the industry)
among your peer competitors
Creating Value vs. Redistributing
Value

• Competition for the former is fierce

– dependent upon bargaining skill
– usually one-time gain
• The former is less likely to be replicable
– usually ongoing gain
 Retained Value for the Firm
• The firm wants to be able retain the value-
created
• Industry structure affects their ability to do
so
• Position in the vertical chain affects their
ability to do so
– lower levels on the vertical chain are often more
commodity-like, hence more competitive
 Cost Advantage and
Differentiation Advantage

• Cost Advantage - creating value on the cost

side relative to peer competitors
• Differentiation Advantage - creating value
on the demand side relative to your
competitors
 Cost Advantage

• Create value by lowering your costs relative

to your peer competitors
 Benefit Parity
• You could offer the same benefits to
consumers as your peer firms but
– obtain competitive advantage by reducing your
cost structures
• e.g., Lexus, Accra, Infinity vs. Mercedes Benz
 Benefit Proximity
• You could offer slightly lower benefits than
your peer firms
– obtain your competitive advantage by reducing
cost structures
– cost structures themselves may be lower due to
reductions in quality which consumers value
• e.g., oil filters - Fram vs. MotorCraft
 Produce a qualitatively different
product

• Redefine the product in ways that allow for

substantial differences in benefits or costs
relative to traditional product definitions
– compete on much lower costs and quality
• McDonalds, Timex watches, Bic pens and lighters
– compete on much higher costs and quality
• Hatteras Yachts, Rolex, pork rinds ;-)
 Differentiation Advantage
• You can offer a higher perceived benefit to
consumers
– where the percentage increase in perceived
benefits exceed the percentage increase in costs
 Extracting Profits
• Vertical Differentiation
– sellers seek competitive advantage by providing
increased perceived benefits to all consumers
– more likely where the product is more
homogeneous
– more likely in competitive markets
 Extracting Profits
• Horizontal Differentiation
– sellers seek competitive advantage by providing
increased perceived benefits to some consumers but
decreased perceived benefits to other consumers
• carving up market niche based upon quality
• more likely with numerous product attributes
– e.g., automobiles, boats, breakfast cereals, cigars
– More likely outside of the pure competition model
(product differentiation)
 Extracting Profits - Horizontal
Differentiation

• Ed becomes very important

– The more elastic the demand, the more
important volume becomes
• consumers are very price-sensitive
– The more inelastic the demand, the more
important margins become
• consumers are not very price sensitive
 Pursue Cost Strategies
– when economies of scale and learning economies are
potentially significant but no firm in the market seems
to be exploiting them
– when opportunities for enhancing the product’s
perceived benefits are limited by the nature of the
product
– when customers are relatively price sensitive and
unwilling to pay for quality, performance, or image
– when the products attributes are easily observable at
the time of purchase (a search good)
Pursue Differentiation Strategies
– when consumers are willing to pay for
increased perceived benefits
– when economies of scale and learning
economies are significant and being fully
exploited
– when the products attributes supply increased
perceived value and are difficult to replicate (an
experience good)
Implications for Functional Areas

• See Table 12.2, p. 474

 “Stuck in the Middle”

• Michael Porter has argued that firms have

great difficulty pursuing both cost and
differentiation strategies simultaneously
because product differentiation costs
• Mixed empirical results on this thesis
Countering the “Stuck in the
Middle” Theory
– A firm that offers high-quality products
increases its market share, which may result in
economies of scale or learning curve effects
• figure 12.10, p.477
– The rate at which accumulated experience
reduces costs is greater for higher-quality
products than for lower-quality products
– Inefficiencies muddy the relationship between
cost position and differentiation position
 Segmenting the Market

• How can we segment out consumers into

relatively homogeneous groups so that we
can price to each group accordingly?
 Why Segment?

• To extract consumer surplus

• Airline example
 Targeting the Market

• Which segments do we go after?

– Focus strategies
– Broad-coverage strategies
 Broad Coverage Strategies

• offer a full line of related products

– economic logic can be found in economies of
scope across the related products
• Frito Lay (production and distribution facilities)
• Statistical Software - SPSS Modules
• Television Cable Services
• Victoria's Secret (women’s lingerie and clothing)
 Broad Coverage Strategies

• “one-size-fits-all” approach
• a common product line is marketed to a
variety of different market segments
• economic logic for a one-size fits all can be
found in economies of scale
• Software Office Suites
• Programming packages (C+)
• Toothbrushes
 Focus Strategies

• offer a single product or target a single

market
– product specialization
– geographic specialization
– customer specialization
– niche specialization
 Focus Strategies

• Economic logic
– deep economies of scale by focusing on one
product and/or one market
– learning effects come more quickly
– establish market power within the niche
– choose niches where customers are less price
sensitive
 Targeting a segment and pricing

• Targeting is connected to pricing

• see figure 12.12
 Segmentation and Competition

• Different segments of the market face

varying competitive environments
 Strategic Groups

• a collection of firms within an industry that

are similar to one another and sufficiently
different from other collections of firms
firms in the industry in one or more key
strategic dimensions
 Identification by Strategic
Dimension
• Organization Characteristics
– scale and scope, distribution channels, vertical
integration, diversification, relationship to
government
• Marketing and Product Characteristics
– price, quality, image, service, technology
• Financial Characteristics
– costs, debt position
 Strategic Maps

• Identify to critical strategic dimensions

• Classify firms according to these
dimensions
• Map onto a Cartesian plane
• Group the clusters to determine strategic
competitors
 Strategic Groups

• compete with one another

• competitive advantage cannot be
maintained without barriers to entry
– patent, trademark, copyright
– unique location
– scale or scope economies