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Competition and Strategy
Chapter 8




            (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
                duplicated, or posted to a publicly accessible website, in whole or in part.
2




• How competition is rivalry to obtain a distinct advantage
• Categorizing and analyzing competitive strategies
• How mergers and lawful agreements among competitors can sometimes
increase economic value created in a market
• How restrictive vertical agreements between manufacturers and dealers
or parent companies and franchisees can increase competition and benefit
consumers
• Strategies for protecting profits
• costs and benefits of attempting to compete by influencing public
opinion or government policy
• How a business can identify tangible and intangible competitive
resources and formulate strategies that make the best use of them.




                   (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
                          duplicated, or posted to a publicly accessible website, in whole or in part.
3



 The Supermarket




Supermarkets that dominated grocery retailing in the twentieth century are losing
  their customers in the twenty-first. Managements of chains large and small are
 searching for strategies to restore their former dominance. Individual stores and
brands have some market power, but competition rules at all levels of the industry.

                    (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                     posted to a publicly accessible website, in whole or in part.
4



What’s Next?
  This chapter builds on earlier models to redirect our
  thinking about competition and business decisions.
 Rivalry among the grocers is nearly the polar opposite
      of the passive price-taking we saw in perfect
 competition. Each supplier is actively strategizing to
  earn and protect profits above opportunity cost, and
   each is subject to constant threats from innovators
                       and imitators.




            (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                             posted to a publicly accessible website, in whole or in part.
5




(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
    duplicated, or posted to a publicly accessible website, in whole or in part.
6


Competition: A Quest to Be
Exceptional – Competitive Ideas
Competition starts with ideas. Asked how he had produced
  so many good ideas over his career, Nobel Prize–winning
chemist Linus Pauling responded that “the best way to have
 a good idea is to have lots of ideas.” Even the most original
         ideas build on a foundation of other ideas.


  A competitive idea is not necessarily a scientific one—it
 may be as simple as opening a business in an underserved
 location, keeping it open all night, or outrightly imitating
                the success of a competitor.
              (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                               posted to a publicly accessible website, in whole or in part.
7


Competition: A Quest to Be
Exceptional - The Paradox: Competing
to Acquire Market Power
• Businesses compete to distinguish themselves in the eyes of
customers, and by becoming distinctive they acquire some market
power.
• A business implements a risky competitive idea in order to reap high
returns.
• The possibility of high returns induces risk-taking.
• But entry will erode profits




                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
8

                                          (c) 2010 Cengage
                                       Learning. All Rights
                                     Reserved. May not be
                                        scanned, copied or
                                  duplicated, or posted to a
                                         publicly accessible
                                    website, in whole or in


Competing to Acquire Market Power
                                                       part.




• The competition that now interests us is quite unlike
  what we saw in the model of a perfectly competitive
  market.
• In actual markets, businesses often compete by
  discounting prices rather than taking the equilibrium
  price as given and unalterable.
• Business try to bind customers to themselves using
  techniques like frequent-flier miles or other loyalty
  programs.
• In real markets advertising is valuable to offer
  information
9


  Competition: A Quest to Be
  Exceptional - The Risks of Competition

• Competition is risky, particularly for small startups.
• Only about 40 percent of startups show accounting profits over their
lifetimes, which may not cover their opportunity costs.
• Thirty percent break even and 30 percent are losers.




                   (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                    posted to a publicly accessible website, in whole or in part.
10



Competition and Deception
• Competitive conditions constrain the freedom of all producers, whether
they face many competitors or few.
• In this chapter we continue to assume that buyers and sellers act
rationally on information that is available to them.
• In particular we rule out strategies that only succeed if one side can
deceive the other (the sale of loss-leaders e.g).
•




                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
11


Pitfalls in Studying Competition -
Selection Bias, Again
 In studying competitive strategies we are often given the
     information that Company X used Strategy A and
 prospered. Even if the author mentions several firms that
succeeded with Strategy A, the reader is likely to remain in
  the dark about (1) those that used Strategy A and failed,
   and (2) those that rejected Strategy A and succeeded.




              (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                               posted to a publicly accessible website, in whole or in part.
12

                                       (c) 2010 Cengage
                                    Learning. All Rights
                                  Reserved. May not be
                                     scanned, copied or
                               duplicated, or posted to a
                                      publicly accessible



Selection Bias, Again
                                 website, in whole or in
                                                    part.




• People recall successes more easily than failures.
• They give more weight to more recent events.
• Our recall is biased and we often must use data
  that are not random samples of an underlying
  population.
• Now to the success of Wal-Mart
13


Pitfalls in Studying Competition –
What’s Wal-Mart’s Secret?
• Here is a partial list of explanations that have been offered for Wal-
Mart’s success:
• decentralized decision-making,
• centralized decision-making,
• decision-making between the center and the stores,
• regional relationships,
• relationships with employees
• using economics to determine strategy.

• Like it or not, no one really knows why Wal-Mart has attained its
stardom.
• Why have Sears and K-Mart been underperformers?


                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                   posted to a publicly accessible website, in whole or in part.
14


Pitfalls in Studying Competition – Self-
Serving Recommendations
• The structure of corporate business further complicates
the analysis of strategy.
• A corporation’s executives and board of directors might make
choices that are in their personal interests rather than those of their
shareholders, who would prefer decisions that maximize the values
of their stock.
• As will be seen later, managers whose firms produce substantial
free cash flows may prefer to spend them on questionable
acquisitions that often fail to benefit shareholders.
• This tactic increases the size of the firm which usually means
higher pay and prestige.


                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
15




• Both seller and buyer benefit from a transaction if the seller earns
more than his opportunity cost and the buyer pays a price below
maximum willingness to pay.
• Economic value is the difference between cost and valuation.




                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
                      duplicated, or posted to a publicly accessible website, in whole or in part.
16



The Basics: One Seller and One Buyer




Buyer and seller both benefit from exchanging some good
  if the seller gets more than his opportunity cost (i.e., the
 value of the best forgone alternative), and the buyer pays
less than her valuation (maximum willingness to pay for it
 before going elsewhere). Economic value is the difference
       between the cost and valuation that they share.
 In this example there is $4 worth of value to be shared.
              (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                               posted to a publicly accessible website, in whole or in part.
17


  The Basics: One Seller and One Buyer –
  Raising the Purchaser’s Valuation




 Here, the seller chooses to incur a cost of $1 to alter his good’s
characteristics (possibly improving quality or making the good
   available closer to the purchaser’s home). In so doing, he
  raises the purchaser’s valuation by $2 to $13, increasing the
                  economic value from $4 to $5.


                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
18


  The Basics: One Seller and One Buyer –
  Lowering the Seller’s Costs




Here the seller devises a way to lower costs by $2, from $7 to $5.
    with the purchaser’s valuation constant at $11, this will
     increase the economic value available from $4 to $6.




                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
19


 The Basics: One Seller and One Buyer –
 Lowering Transaction Costs




   Here is a situation that includes transaction costs. Seller’s
opportunity cost is $5 plus $2 in transaction costs. Purchaser’s
    valuation is $16 plus $3 in transaction costs. Even after
transaction costs, there remains $6 in economic value available
                           to be shared.
                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
20


 The Basics: One Seller and One Buyer –
 Lowering Transaction Costs




If the seller cuts his transaction costs by $1, the economic value
   available to be shared rises to $7. Similarly, the purchaser
 could reduce her transaction costs and increase the economic
                           value available.
                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
21


The Basics: One Seller and One Buyer –
Lowering Transaction Costs




  Here, the seller spends $1 in order to lower the purchaser’s
transaction costs by $2. This will increase the economic value
                     available from $6 to $7.


               (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                posted to a publicly accessible website, in whole or in part.
22

                                            (c) 2010 Cengage
                                         Learning. All Rights
                                       Reserved. May not be
                                          scanned, copied or
                                    duplicated, or posted to a
                                           publicly accessible



One Seller, Many Buyers
                                      website, in whole or in
                                                         part.




• Sellers can distinguish themselves in hopes that buyers
  will pay a premium for their product.
• Distinguishing implies establishing market power and a
  greater slope to the demand curve for their product.
• Depending on the substitutes available a seller may be
  able to charge a higher price for his differentiated good.
23


 One Seller, Many Buyers - Raising Buyers’
 Valuations – Altering Variable costs

  Here the seller increases variable
   cost to improve the product and
 increase buyer valuation. Marginal
 costs increases to MC’ and demand
shifts to D’. Price increases to $9.50
            and profit rises.




                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
24


One Seller, Many Buyers - Raising Buyers’
Valuations – Altering Fixed Costs
• Here the seller invests in fixed cost in
order to increase buyer valuation,
perhaps building a new plant that
produces fewer defective units of
output from the same variable inputs
as before.
• This will increase the seller’s present
and future profit but that increase in
the profit stream must be compared to
the cost of the new plant to determine
whether to build.




                   (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                    posted to a publicly accessible website, in whole or in part.
25


 One Seller, Many Buyers – Lowering
 Production Costs

 Here, lowering production costs
from MC to MC’, increases annual
 profit by $9 from $16 to $25. A
seller Be willing to invest up to $9
     per year to achieve such a
  reduction in production costs.




                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
26


  One Seller, Many Buyers – Lowering
  Transaction Costs
• Here, buyers and sellers both face
transaction costs.
• Including transaction costs, demand is D’
(not D) and marginal cost is MC’ (not MC).
• Incurring additional cost (MC”), to reduce
buyer transaction costs shifts demand
curve to D and increases profit.
• If the seller can cheaply reduce buyers
transactions costs output and profit
increase as do benefits to buyers.




                    (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                     posted to a publicly accessible website, in whole or in part.
27



  Many Buyers and Many Sellers




This shows what happens in a competitive market when a single firm initially
adopts a cost-saving innovation. Other firms will follow and a new long-run
       equilibrium will be restored where firms once again earn zero
                              economic profit.
                   (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                    posted to a publicly accessible website, in whole or in part.
28



Many Buyers and Many Sellers
            Four points emerge from this model:

1. as the innovation spreads among producers the earlier
   adopters will see longer-lived streams of profit before the
   market reaches its new long-run equilibrium.
2. the number of firms that survive after the innovation
   depends on the direction in which the innovation shifts the
   minimum point of average costs.
3. as the percentage of sellers that use the innovation increases,
   those who are slower to innovate will take losses if they
   cannot shut down temporarily or leave the market quickly.
4. any newcomer to the market will only survive if it uses the
   innovation.
               (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                posted to a publicly accessible website, in whole or in part.
29


 Many Buyers and Many Sellers –
 Upward Sloping Supply Curves
Supply curve S’ and demand curve
 D’ include a $3 transaction cost
 for sellers and a $2 transaction
   cost for buyers. The market
 equilibrium price is $10 with 75
           units traded.

Suppose that all transaction costs
were costlessly eliminated. Market
price will fall to $9 with 110 units
               traded.

                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
30


  Many Buyers and Many Sellers –
  Outsider Reduces Transaction Costs
 D1 would be the demand curve with
      no transaction costs. With
transportation costs of $18 to buyers,
   the demand curve is D2. Market
 price will be $13 and 19 units will be
                traded.

Imagine an intermediary reduces the
  buyer transportation costs to $8,
making the demand curve D3. Market
price rises to $16.33 and the number
 of units traded increases to 25.67.
                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
31




(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
       duplicated, or posted to a publicly accessible website, in whole or in part.
32


Horizontal Mergers and Agreements -
Mergers
 Mergers and acquisitions can be important elements of
   strategy. A horizontal merger puts the assets of two
 firms that operate in the same market under the same
    ownership. The consequences depend on market
      structure and on how the merger affects costs.




            (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                             posted to a publicly accessible website, in whole or in part.
33



 Horizontal Mergers and Agreements - Mergers
• Suppose the diagram to the right
depicts a perfectly competitive market in
equilibrium.
• If two of the firms merge to reduce
costs, nothing happens.
• But, if this sets off a merger wave we
may end up with an oligopoly whose
equilibrium looks like a monopoly (12,000
units at $10).
• This would create a deadweight
loss equal to the small red triangle.
• The net benefit of mergers is the algebraic
sum of cost savings and deadweight loss.
• Here it is positive but it could be negative.
• This is what anti-trust regulators assess.


                     (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                      posted to a publicly accessible website, in whole or in part.
34



 Horizontal Mergers and Agreements - Agreements

  U.S. antitrust law says that a “naked” agreement whose only goal is to
     fix prices is per se illegal—its very existence is unlawful. Other
   agreements among competitors can be both legal and economically
                                  desirable.

 For example, members of the Recording Industry Association of America
(RIAA) long ago agreed on common technical specifications for music CDs.
 Such a standard allows CDs from any RIAA member (or nonmember who
    uses the format) to work on many different players and computers.

          Antitrust law treats agreements like these under a rule
of reason standard that balances their favorable and unfavorable effects on
                                competition.

                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                   posted to a publicly accessible website, in whole or in part.
35



Vertical Mergers and Agreements
• An industry’s output is often produced in stages.
• For example, oil is first extracted from the ground, then
refined, and finally the refined products are retailed.
• A firm is vertically integrated if it subsumes multiple
stages.
• Integration can produce savings if it improves
coordination among the stages.
• But it also might raise costs if there are difficulties in
managing dissimilar activities.




               (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                posted to a publicly accessible website, in whole or in part.
36

                                           (c) 2010 Cengage
                                        Learning. All Rights
                                      Reserved. May not be
                                         scanned, copied or
                                   duplicated, or posted to a
                                          publicly accessible



Vertical Mergers and Agreements
                                     website, in whole or in
                                                        part.




• The degree of integration matters because costs and
  revenues can vary with the number of stages in which a
  firm operates.
• Costs may increase if there are problems managing
  dissimilar operations.
• Vertical mergers are hardly ever strongly scrutinized by
  anti-trust regulators.
• A firm will merge vertically to improve its
  competitiveness.
37


   Vertical Mergers and Agreements -
   Mergers
• D is the market demand for
diamonds.
• A is DeBeers’ MC for mining and B is
the MC for independent retailers.
• C would be the sum of A & B which
means 9 diamond rings would be sold at
$15 each.

Should DeBeers extend into the Retail
business?
Only if it can retail rings at lower cost
than jewelry stores.

                      (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                       posted to a publicly accessible website, in whole or in part.
38


 Vertical Mergers and Agreements -
 Agreements
• Two firms in different stages of a vertical chain might reach an agreement
that makes them a better competitor when they act as a team.
• An agreement will be preferable to a merger if a single management
cannot monitor both stages as well as separate managements can.
• Independent retail store managers searching for profit might have better
incentives than salaried employees of an integrated firm.
• Vertical agreements in apparel and textiles – integrated firms in this
industry are rare.




                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                   posted to a publicly accessible website, in whole or in part.
39


Vertical Mergers and Agreements –
Restrictive Agreements
• Many vertical agreements greatly restrict the future
choices of both parties.
• A franchise contract between a carmaker and a dealer
often prohibits the manufacturer from opening another
outlet close by, that is, it specifies an exclusive territory.
• Fast-food franchises often require the owner of an outlet
to buy all its food through the parent organization, and the
parent organization promises to always have food on hand
to fulfill its side of the requirements contract.



               (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                posted to a publicly accessible website, in whole or in part.
40

                                          (c) 2010 Cengage
                                       Learning. All Rights
                                     Reserved. May not be
                                        scanned, copied or



Vertical Mergers and Agreements –
                                  duplicated, or posted to a
                                         publicly accessible
                                    website, in whole or in
                                                       part.




Restrictive Agreements
• Manufacturers and retailers may have exclusive
  dealing contracts.
• All these contracts contain vertical restrictions that
  limit the parties choices.
• Often a parent will franchise outlets and hire employees
  to run others.
• McDonald’s only owns 15% of its stores.
• Starbucks Coffee has no individual franchises.
41




(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
       duplicated, or posted to a publicly accessible website, in whole or in part.
42


 Barriers to Entry—Size and
 Commitment
 • Building barriers to entry that protect profits against
 existing and future competitors can be an important
 element of strategy.
• Size and specificity may serve as barriers to entry.
• A firm may need to be sufficiently large to achieve available
economies of scale.
 Firms may also need to invest in specific assets that are not easily
 redeployed to other uses and locations. A power plant for instance.
• New competitors do not miraculously appear especially where
 economies of scale are important.
• Inexperienced competitors rarely appear except in new markets.
• The automobile market – incumbent disadvantages

                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                   posted to a publicly accessible website, in whole or in part.
43


Intangible Assets: Trademarks and
Advertising
• A seller wants to inform customers about more than
price—consistent quality, for instance, may engender
customer loyalty.
• A producer can use a brand name or trademark to assure
buyers it will produce the quality they expect.
• Signalling




            (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                             posted to a publicly accessible website, in whole or in part.
44


Influencing the Public and Government
– Public Relations
• Public recognition and approval of a firm’s practices can also be a
competitive tool.
• In 2005, two hurricanes destroyed much of the New Orleans and
Beaumont–Port Arthur areas.
• While the relief efforts of local and national governments faltered,
companies like Wal-Mart, Home Depot, and Lowe’s had stockpiled and
shipped necessities to the area before the storms hit, and the firms
bypassed profits by keeping prices at pre-disaster levels.
• Actions can be both charitable and competitive.

• Similarly, energy and auto producers advertise their environmental
concerns.
• Campaigns for Toyota’s and Honda’s hybrid cars stress their ecological
impact rather than their performance.
                 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                  posted to a publicly accessible website, in whole or in part.
45


Influencing the Public and Government
– Influencing Government
• Government can also help a business to advantage itself or
disadvantage competitors.
• Among possible strategies, a firm might seek legislation that makes
competition illegal, as cable TV operators have done in many cities.
Cable, however, has failed to suppress satellite TV, which is beyond
local control.



• Government can also make competition costly for foreigners by
imposing quotas or tariffs in return for support from the domestic
industry.


                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                 posted to a publicly accessible website, in whole or in part.
46




• How do businesses choose a competitive strategy?
• Strategy is resource-based and market-based.
• Firms in the same market will have different resources leading
to different choices.
• Strategy is about more than price.
• It can range from product design, to mergers, to political
activity.


                (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
                    duplicated, or posted to a publicly accessible website, in whole or in part.
47


Resources and Strategies - What Are
Resources?
  The originator of the resource-based model, Birger
              Wernerfelt of MIT, writes:

       By a resource is meant anything which could be
    thought of as a strength or weakness of a given
  firm. More formally, a firm’s resources at a given time
     could be defined as those (tangible and intangible)
     assets which are tied semi-permanently to the firm.
     Examples of resources are: brand names, in-house
       knowledge of technology, employment of skilled
        personnel, trade contacts, machinery, efficient
                   procedures, capital, etc.
            (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                             posted to a publicly accessible website, in whole or in part.
48


Resources and Strategies – Innovation
Pro and Con
  • Strategy need not entail innovation or entry into new
  markets—some firms have resources better suited to
  perfecting an established product.
  • Properly carried out, imitation can be as profitable as
  innovation and sometimes less risky.
  • Ampex invented the VCR and Xerox invented the first office
  computer, but neither firm found commercial success in those
  areas.
  • Success is surprisingly short-lived.




              (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                               posted to a publicly accessible website, in whole or in part.
49


 Competence and Sustainability -
 Identification of Resources and
 Feasible Strategies
         A firm’s strategy choice starts by identifying its resources
  and the resources of its competitors, paying attention to those resources
           competitors have that it does not itself, and vice versa.

           Discussions of strategy must go beyond simple models
        that treat constraints as unalterable by the decision makers.

• The best choice depends on our resources and those of our competitors.
• We will often wish to use or acquire resources that make our strategy
more resistant to their attacks.


                   (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                    posted to a publicly accessible website, in whole or in part.
50


Competence and Sustainability - The
Search for Strategies
• The idea remains that no strategy that competitors can easily duplicate
will produce long-term profit.
• The search for strategy must be a continuing one.
• Having a grand strategy may not be the road to success.


• Tactical moves are responses to idiosyncratic, short-lived developments.
• If your competitors are flexible and unpredictable you might do better
by deemphasizing global strategy and seeking to seize more immediate
opportunities.
• Emphasize tactics rather than a strategic mission.




                  (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
                                   posted to a publicly accessible website, in whole or in part.
51

                                      (c) 2010 Cengage
                                   Learning. All Rights
                                 Reserved. May not be
                                    scanned, copied or



Competence and Sustainability - The
                              duplicated, or posted to a
                                     publicly accessible
                                website, in whole or in
                                                   part.




Search for Strategies
• If competition is resource based, we will require
  a better understanding of the types, potential,
  and limitations of these and other intangible
  resources.
• To do so, we must proceed beyond transactions
  in markets.
• Contracts with enforceable commitments.

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Eco chapter 8

  • 1. 1 Competition and Strategy Chapter 8 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 2. 2 • How competition is rivalry to obtain a distinct advantage • Categorizing and analyzing competitive strategies • How mergers and lawful agreements among competitors can sometimes increase economic value created in a market • How restrictive vertical agreements between manufacturers and dealers or parent companies and franchisees can increase competition and benefit consumers • Strategies for protecting profits • costs and benefits of attempting to compete by influencing public opinion or government policy • How a business can identify tangible and intangible competitive resources and formulate strategies that make the best use of them. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 3. 3 The Supermarket Supermarkets that dominated grocery retailing in the twentieth century are losing their customers in the twenty-first. Managements of chains large and small are searching for strategies to restore their former dominance. Individual stores and brands have some market power, but competition rules at all levels of the industry. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 4. 4 What’s Next? This chapter builds on earlier models to redirect our thinking about competition and business decisions. Rivalry among the grocers is nearly the polar opposite of the passive price-taking we saw in perfect competition. Each supplier is actively strategizing to earn and protect profits above opportunity cost, and each is subject to constant threats from innovators and imitators. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 5. 5 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 6. 6 Competition: A Quest to Be Exceptional – Competitive Ideas Competition starts with ideas. Asked how he had produced so many good ideas over his career, Nobel Prize–winning chemist Linus Pauling responded that “the best way to have a good idea is to have lots of ideas.” Even the most original ideas build on a foundation of other ideas. A competitive idea is not necessarily a scientific one—it may be as simple as opening a business in an underserved location, keeping it open all night, or outrightly imitating the success of a competitor. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 7. 7 Competition: A Quest to Be Exceptional - The Paradox: Competing to Acquire Market Power • Businesses compete to distinguish themselves in the eyes of customers, and by becoming distinctive they acquire some market power. • A business implements a risky competitive idea in order to reap high returns. • The possibility of high returns induces risk-taking. • But entry will erode profits (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 8. 8 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in Competing to Acquire Market Power part. • The competition that now interests us is quite unlike what we saw in the model of a perfectly competitive market. • In actual markets, businesses often compete by discounting prices rather than taking the equilibrium price as given and unalterable. • Business try to bind customers to themselves using techniques like frequent-flier miles or other loyalty programs. • In real markets advertising is valuable to offer information
  • 9. 9 Competition: A Quest to Be Exceptional - The Risks of Competition • Competition is risky, particularly for small startups. • Only about 40 percent of startups show accounting profits over their lifetimes, which may not cover their opportunity costs. • Thirty percent break even and 30 percent are losers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 10. 10 Competition and Deception • Competitive conditions constrain the freedom of all producers, whether they face many competitors or few. • In this chapter we continue to assume that buyers and sellers act rationally on information that is available to them. • In particular we rule out strategies that only succeed if one side can deceive the other (the sale of loss-leaders e.g). • (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 11. 11 Pitfalls in Studying Competition - Selection Bias, Again In studying competitive strategies we are often given the information that Company X used Strategy A and prospered. Even if the author mentions several firms that succeeded with Strategy A, the reader is likely to remain in the dark about (1) those that used Strategy A and failed, and (2) those that rejected Strategy A and succeeded. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 12. 12 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Selection Bias, Again website, in whole or in part. • People recall successes more easily than failures. • They give more weight to more recent events. • Our recall is biased and we often must use data that are not random samples of an underlying population. • Now to the success of Wal-Mart
  • 13. 13 Pitfalls in Studying Competition – What’s Wal-Mart’s Secret? • Here is a partial list of explanations that have been offered for Wal- Mart’s success: • decentralized decision-making, • centralized decision-making, • decision-making between the center and the stores, • regional relationships, • relationships with employees • using economics to determine strategy. • Like it or not, no one really knows why Wal-Mart has attained its stardom. • Why have Sears and K-Mart been underperformers? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 14. 14 Pitfalls in Studying Competition – Self- Serving Recommendations • The structure of corporate business further complicates the analysis of strategy. • A corporation’s executives and board of directors might make choices that are in their personal interests rather than those of their shareholders, who would prefer decisions that maximize the values of their stock. • As will be seen later, managers whose firms produce substantial free cash flows may prefer to spend them on questionable acquisitions that often fail to benefit shareholders. • This tactic increases the size of the firm which usually means higher pay and prestige. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 15. 15 • Both seller and buyer benefit from a transaction if the seller earns more than his opportunity cost and the buyer pays a price below maximum willingness to pay. • Economic value is the difference between cost and valuation. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 16. 16 The Basics: One Seller and One Buyer Buyer and seller both benefit from exchanging some good if the seller gets more than his opportunity cost (i.e., the value of the best forgone alternative), and the buyer pays less than her valuation (maximum willingness to pay for it before going elsewhere). Economic value is the difference between the cost and valuation that they share. In this example there is $4 worth of value to be shared. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 17. 17 The Basics: One Seller and One Buyer – Raising the Purchaser’s Valuation Here, the seller chooses to incur a cost of $1 to alter his good’s characteristics (possibly improving quality or making the good available closer to the purchaser’s home). In so doing, he raises the purchaser’s valuation by $2 to $13, increasing the economic value from $4 to $5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 18. 18 The Basics: One Seller and One Buyer – Lowering the Seller’s Costs Here the seller devises a way to lower costs by $2, from $7 to $5. with the purchaser’s valuation constant at $11, this will increase the economic value available from $4 to $6. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 19. 19 The Basics: One Seller and One Buyer – Lowering Transaction Costs Here is a situation that includes transaction costs. Seller’s opportunity cost is $5 plus $2 in transaction costs. Purchaser’s valuation is $16 plus $3 in transaction costs. Even after transaction costs, there remains $6 in economic value available to be shared. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 20. 20 The Basics: One Seller and One Buyer – Lowering Transaction Costs If the seller cuts his transaction costs by $1, the economic value available to be shared rises to $7. Similarly, the purchaser could reduce her transaction costs and increase the economic value available. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 21. 21 The Basics: One Seller and One Buyer – Lowering Transaction Costs Here, the seller spends $1 in order to lower the purchaser’s transaction costs by $2. This will increase the economic value available from $6 to $7. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 22. 22 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible One Seller, Many Buyers website, in whole or in part. • Sellers can distinguish themselves in hopes that buyers will pay a premium for their product. • Distinguishing implies establishing market power and a greater slope to the demand curve for their product. • Depending on the substitutes available a seller may be able to charge a higher price for his differentiated good.
  • 23. 23 One Seller, Many Buyers - Raising Buyers’ Valuations – Altering Variable costs Here the seller increases variable cost to improve the product and increase buyer valuation. Marginal costs increases to MC’ and demand shifts to D’. Price increases to $9.50 and profit rises. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 24. 24 One Seller, Many Buyers - Raising Buyers’ Valuations – Altering Fixed Costs • Here the seller invests in fixed cost in order to increase buyer valuation, perhaps building a new plant that produces fewer defective units of output from the same variable inputs as before. • This will increase the seller’s present and future profit but that increase in the profit stream must be compared to the cost of the new plant to determine whether to build. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 25. 25 One Seller, Many Buyers – Lowering Production Costs Here, lowering production costs from MC to MC’, increases annual profit by $9 from $16 to $25. A seller Be willing to invest up to $9 per year to achieve such a reduction in production costs. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 26. 26 One Seller, Many Buyers – Lowering Transaction Costs • Here, buyers and sellers both face transaction costs. • Including transaction costs, demand is D’ (not D) and marginal cost is MC’ (not MC). • Incurring additional cost (MC”), to reduce buyer transaction costs shifts demand curve to D and increases profit. • If the seller can cheaply reduce buyers transactions costs output and profit increase as do benefits to buyers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 27. 27 Many Buyers and Many Sellers This shows what happens in a competitive market when a single firm initially adopts a cost-saving innovation. Other firms will follow and a new long-run equilibrium will be restored where firms once again earn zero economic profit. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 28. 28 Many Buyers and Many Sellers Four points emerge from this model: 1. as the innovation spreads among producers the earlier adopters will see longer-lived streams of profit before the market reaches its new long-run equilibrium. 2. the number of firms that survive after the innovation depends on the direction in which the innovation shifts the minimum point of average costs. 3. as the percentage of sellers that use the innovation increases, those who are slower to innovate will take losses if they cannot shut down temporarily or leave the market quickly. 4. any newcomer to the market will only survive if it uses the innovation. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 29. 29 Many Buyers and Many Sellers – Upward Sloping Supply Curves Supply curve S’ and demand curve D’ include a $3 transaction cost for sellers and a $2 transaction cost for buyers. The market equilibrium price is $10 with 75 units traded. Suppose that all transaction costs were costlessly eliminated. Market price will fall to $9 with 110 units traded. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 30. 30 Many Buyers and Many Sellers – Outsider Reduces Transaction Costs D1 would be the demand curve with no transaction costs. With transportation costs of $18 to buyers, the demand curve is D2. Market price will be $13 and 19 units will be traded. Imagine an intermediary reduces the buyer transportation costs to $8, making the demand curve D3. Market price rises to $16.33 and the number of units traded increases to 25.67. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 31. 31 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 32. 32 Horizontal Mergers and Agreements - Mergers Mergers and acquisitions can be important elements of strategy. A horizontal merger puts the assets of two firms that operate in the same market under the same ownership. The consequences depend on market structure and on how the merger affects costs. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 33. 33 Horizontal Mergers and Agreements - Mergers • Suppose the diagram to the right depicts a perfectly competitive market in equilibrium. • If two of the firms merge to reduce costs, nothing happens. • But, if this sets off a merger wave we may end up with an oligopoly whose equilibrium looks like a monopoly (12,000 units at $10). • This would create a deadweight loss equal to the small red triangle. • The net benefit of mergers is the algebraic sum of cost savings and deadweight loss. • Here it is positive but it could be negative. • This is what anti-trust regulators assess. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 34. 34 Horizontal Mergers and Agreements - Agreements U.S. antitrust law says that a “naked” agreement whose only goal is to fix prices is per se illegal—its very existence is unlawful. Other agreements among competitors can be both legal and economically desirable. For example, members of the Recording Industry Association of America (RIAA) long ago agreed on common technical specifications for music CDs. Such a standard allows CDs from any RIAA member (or nonmember who uses the format) to work on many different players and computers. Antitrust law treats agreements like these under a rule of reason standard that balances their favorable and unfavorable effects on competition. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 35. 35 Vertical Mergers and Agreements • An industry’s output is often produced in stages. • For example, oil is first extracted from the ground, then refined, and finally the refined products are retailed. • A firm is vertically integrated if it subsumes multiple stages. • Integration can produce savings if it improves coordination among the stages. • But it also might raise costs if there are difficulties in managing dissimilar activities. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 36. 36 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Vertical Mergers and Agreements website, in whole or in part. • The degree of integration matters because costs and revenues can vary with the number of stages in which a firm operates. • Costs may increase if there are problems managing dissimilar operations. • Vertical mergers are hardly ever strongly scrutinized by anti-trust regulators. • A firm will merge vertically to improve its competitiveness.
  • 37. 37 Vertical Mergers and Agreements - Mergers • D is the market demand for diamonds. • A is DeBeers’ MC for mining and B is the MC for independent retailers. • C would be the sum of A & B which means 9 diamond rings would be sold at $15 each. Should DeBeers extend into the Retail business? Only if it can retail rings at lower cost than jewelry stores. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 38. 38 Vertical Mergers and Agreements - Agreements • Two firms in different stages of a vertical chain might reach an agreement that makes them a better competitor when they act as a team. • An agreement will be preferable to a merger if a single management cannot monitor both stages as well as separate managements can. • Independent retail store managers searching for profit might have better incentives than salaried employees of an integrated firm. • Vertical agreements in apparel and textiles – integrated firms in this industry are rare. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 39. 39 Vertical Mergers and Agreements – Restrictive Agreements • Many vertical agreements greatly restrict the future choices of both parties. • A franchise contract between a carmaker and a dealer often prohibits the manufacturer from opening another outlet close by, that is, it specifies an exclusive territory. • Fast-food franchises often require the owner of an outlet to buy all its food through the parent organization, and the parent organization promises to always have food on hand to fulfill its side of the requirements contract. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 40. 40 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or Vertical Mergers and Agreements – duplicated, or posted to a publicly accessible website, in whole or in part. Restrictive Agreements • Manufacturers and retailers may have exclusive dealing contracts. • All these contracts contain vertical restrictions that limit the parties choices. • Often a parent will franchise outlets and hire employees to run others. • McDonald’s only owns 15% of its stores. • Starbucks Coffee has no individual franchises.
  • 41. 41 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 42. 42 Barriers to Entry—Size and Commitment • Building barriers to entry that protect profits against existing and future competitors can be an important element of strategy. • Size and specificity may serve as barriers to entry. • A firm may need to be sufficiently large to achieve available economies of scale. Firms may also need to invest in specific assets that are not easily redeployed to other uses and locations. A power plant for instance. • New competitors do not miraculously appear especially where economies of scale are important. • Inexperienced competitors rarely appear except in new markets. • The automobile market – incumbent disadvantages (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 43. 43 Intangible Assets: Trademarks and Advertising • A seller wants to inform customers about more than price—consistent quality, for instance, may engender customer loyalty. • A producer can use a brand name or trademark to assure buyers it will produce the quality they expect. • Signalling (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 44. 44 Influencing the Public and Government – Public Relations • Public recognition and approval of a firm’s practices can also be a competitive tool. • In 2005, two hurricanes destroyed much of the New Orleans and Beaumont–Port Arthur areas. • While the relief efforts of local and national governments faltered, companies like Wal-Mart, Home Depot, and Lowe’s had stockpiled and shipped necessities to the area before the storms hit, and the firms bypassed profits by keeping prices at pre-disaster levels. • Actions can be both charitable and competitive. • Similarly, energy and auto producers advertise their environmental concerns. • Campaigns for Toyota’s and Honda’s hybrid cars stress their ecological impact rather than their performance. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 45. 45 Influencing the Public and Government – Influencing Government • Government can also help a business to advantage itself or disadvantage competitors. • Among possible strategies, a firm might seek legislation that makes competition illegal, as cable TV operators have done in many cities. Cable, however, has failed to suppress satellite TV, which is beyond local control. • Government can also make competition costly for foreigners by imposing quotas or tariffs in return for support from the domestic industry. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 46. 46 • How do businesses choose a competitive strategy? • Strategy is resource-based and market-based. • Firms in the same market will have different resources leading to different choices. • Strategy is about more than price. • It can range from product design, to mergers, to political activity. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 47. 47 Resources and Strategies - What Are Resources? The originator of the resource-based model, Birger Wernerfelt of MIT, writes: By a resource is meant anything which could be thought of as a strength or weakness of a given firm. More formally, a firm’s resources at a given time could be defined as those (tangible and intangible) assets which are tied semi-permanently to the firm. Examples of resources are: brand names, in-house knowledge of technology, employment of skilled personnel, trade contacts, machinery, efficient procedures, capital, etc. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 48. 48 Resources and Strategies – Innovation Pro and Con • Strategy need not entail innovation or entry into new markets—some firms have resources better suited to perfecting an established product. • Properly carried out, imitation can be as profitable as innovation and sometimes less risky. • Ampex invented the VCR and Xerox invented the first office computer, but neither firm found commercial success in those areas. • Success is surprisingly short-lived. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 49. 49 Competence and Sustainability - Identification of Resources and Feasible Strategies A firm’s strategy choice starts by identifying its resources and the resources of its competitors, paying attention to those resources competitors have that it does not itself, and vice versa. Discussions of strategy must go beyond simple models that treat constraints as unalterable by the decision makers. • The best choice depends on our resources and those of our competitors. • We will often wish to use or acquire resources that make our strategy more resistant to their attacks. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 50. 50 Competence and Sustainability - The Search for Strategies • The idea remains that no strategy that competitors can easily duplicate will produce long-term profit. • The search for strategy must be a continuing one. • Having a grand strategy may not be the road to success. • Tactical moves are responses to idiosyncratic, short-lived developments. • If your competitors are flexible and unpredictable you might do better by deemphasizing global strategy and seeking to seize more immediate opportunities. • Emphasize tactics rather than a strategic mission. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  • 51. 51 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or Competence and Sustainability - The duplicated, or posted to a publicly accessible website, in whole or in part. Search for Strategies • If competition is resource based, we will require a better understanding of the types, potential, and limitations of these and other intangible resources. • To do so, we must proceed beyond transactions in markets. • Contracts with enforceable commitments.