Notes – Competition Demystified: Chapter 3

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Economies of scale depend on market share

Economies of scale are a competitive advantage that work most effectively in combination with another advantage such as customer captivity.

With some degree of customer captivity, the entrants never catch up and stay permanently on the wrong side of the economies of scale differential.

In general, smaller markets (in terms of geography or product space) present easier realms to obtain a competitive advantage, even with regards to economies of scale. As a market grows in absolute size, it becomes easier and easier for competitors to obtain their own economies of scale and erode the incumbent firms advantages in terms of fixed costs.

By keeping a competitive market small, the incumbent firm can outspend entrants in absolute dollars even if each firm spends the same proportion of revenues on things like R&D, advertising, marketing, distribution, etc.

Erosion in market share are the greatest threat to a firm with competitive advantages derived from economies of scale because as market share falls, the proportion of total costs which are fixed rises and thereby defeats the cost advantage of economies of scale.

Maintaining market share through customer captivity is critical

Customer captivity can be enhanced a number of ways:

• habit – make purchases more frequent and spread their cost out over time to create a relationship that is easier to continue than replace; encourage repeated, nearly automatic purchases that don’t allow time for critical consideration of alternatives
• switching costs – extend and deepen the range of services offered, thereby increasing the opportunity cost of switching to a competitor
• search costs – integration of multiple features into one pricing plan complicates comparison shopping and increases risk of picking a half-effective service or product

The strategy of economies of scale

Economies of scale…

1. tend to be the longest lived of the three major types of competitive advantage
2. are vulnerable to gradual erosion and therefore must be defended vigorously

Establishing dominance in a local market and then expanding outward gradually from that hub is the best strategy for firms relying on EoS. Small, local markets only have room for a few competitors, at most, meaning the firm that gains dominance will also gain EoS (if possible) while preventing the competitor from obtaining that same advantage.

Markets grow rapidly because they attract many new customers, who are by definition non-captive. They may provide a base of viable scale for new entrants.

Both incumbents and entrants should focus on niche markets, characterized by:

• customer captivity
• small size relative to the level of fixed costs
• absence of vigilant, dominant competitors
• readily extendable at the edges

Ultimately, the more variable costs can be shifted to fixed costs, the stronger will be the competitive advantage from EoS.

Remember:

Competitive advantages are invariably market-specific. They do not travel to meet the aspirations of growth-obsessed CEOs.

Questions from the reading

1. The authors mention an example of Aetna vs. Oxford in the metropolitan insurance market. They argue that because medical service is a local market, Aetna’s national network confers no economies of scale advantage because Oxford has a larger market share of in-network medical providers in specific local markets, such as NYC (60% of market vs. 20%). But part of Aetna’s cost advantages come from general administrative overhead, where EoS at the national level become important. How do you weigh the value of EoS in adminstrative/overhead costs at the corporate level against specific EoS in supply/inventory costs at the local level?
2. Suggested case study– In 2006, Nintendo (NTDOY) introduced their  Wii home video game console as a part of their effort to achieve the corporate goal of “Gaming Population Expansion“. However, this is a goal with strategic implications as well as tactical ones because it serves to broaden the total market for NTDOY as well as competitors’ (MSFT, SNE) products and thereby changes the way NTDOY competes in that market. Considering the lessons of Chapter 3, how would you judge NTDOY’s strategy? Is this a brilliant way to create a new market niche (casual gamers) that have traditionally been ignored and underserved by the market that NTDOY can profitably keep to itself? Or will this decision result in a growing market that invites new entrants while eroding any advantages NTDOY may have had as a result of EoS? Additionally, NTDOY has been criticized for ignoring the massive, wildly profitable “hardcore gamer” market. Would you criticize NTDOY for this decision? Would you recommend they attempt to make inroads? What broad strategic recommendations might you make to NTDOY with regards to maximizing competitive advantages related to EoS and customer captivity?