Notes – Competition Demystified: Chapter 2

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

Differentiation is not a competitive advantage

The tired old story that many companies tell their investors (and many managers tell themselves) is that they can avoid the commoditization of their product through “differentiation”. Convince your customers that your limestone is not generic limestone but “Jeff’s Best limestone”, for instance, and they’re sure to pay a premium price!

The trouble with this strategy is not the gullibility of the consumer, but the mutual ability of the competitor to adopt it for himself.

The reality of the competitive market is that high profits attract competition and without real, sustainable barriers to entry, high profits will be eroded by market fragmentation and declining margins. Product differentiation may allow a firm to charge a “premium” for their product, but it will not protect their market share and as market share falls, the effects of fixed-costs on margins will rise.

Firms producing differentiated goods and services will still face the economics of commodity markets, namely, if they can not produce at a cost at or below the price established in the market, they will fail. This is because differentiated products require additional investments in advertising, marketing, sales and service, product distribution, etc., to make the differentiated claims credible, and these higher costs ultimately lower returns.

Barriers to entry = competitive advantages

As the authors note,

Systems can be replicated, talent hired away, managerial quality upgraded

The only way to obtain real, sustainable competitive advantages is through barriers to entry: obstacles and costs that competitors can not overcome or do not have the resources to cover. These barriers to entry apply only to incumbents, as entrant competitive advantages are essentially available to everyone and therefore are available to no one in the long run, being of limited and transitory value (once you establish yourself in a market, you’re now and incumbent and have lost your competitive advantage).

There are three basic, authentic types of competitive advantage:

  1. supply advantages
  2. demand advantages
  3. a combination of the two

The authors specifically note that,

Measured by potency and durability, production advantages are the weakest barrier to entry; economies of scale, when combined with some customer captivity, are the strongest.

Supply advantages

Supply advantages essentially translate to lower cost structures, which provides the firm with two benefits:

  1. higher profitability through wider margins
  2. ability to strategically lower prices to resist potential entrants or other competitors while maintaining profitability

These lower cost structures normally come from:

  1. lower input costs (special access to a supply that can’t be replicated by the competition at the same cost)
  2. economies of scale
  3. proprietary technology, normally protected by patents/intellectual property laws (any government grant of monopoly would similarly apply as it has the same effect)

Rapid technological change in supply methods can create entrant advantages as pre-existing incumbents find their out-dated technology confers a cost dis-advantage. Conversely, as the pace of technological change in an industry slows, any incumbent advantage due to technological advances can be eroded as rival firms acquire learned efficiencies of their own.

Many strategic analysts cite the role of “innovation” in imbuing certain firms with competitive advantages but these advantages are only sustainable if these innovations can’t be learned, “stolen” or otherwise acquired by competitors over time. In other words,

Innovations that are common to all confer competitive advantages on none.

Meanwhile, privileged access to raw materials is normally only useful in markets which are local in terms of geography or product space.

Demand advantages

Access to customers that rivals can not match translate to demand advantages. Customer captivity is a result of one of three dynamics:

  1. habit – typically applies to one product, not a firm’s portfolio of products, and is a result of frequent and automatic purchases
  2. switching costs – reinforced by network effects, ie, selecting a technology system that becomes common and popular economy-wide
  3. search costs – common when products or services are complex, customized and crucial
Demand side advantages are typically more durable. However, because they rely on the customer for their power they’re susceptible to customers moving, growing old (developing new preferences and needs) and dying. New customers entering the market are uncommitted and can potentially be captured by anyone.

The strongest possible demand advantage, then, would be one which generates an intergenerational transfer of habit.

Questions from the reading

  1. The authors state on pg. 31 that United’s advantageous geographical position at Chicago O’Hare can not be extended to other airports; is this true? Why or why not? Ultimately, what is the source for United’s supply advantage at Chicago O’Hare?
  2. Many of the supply advantages stem from government interference in the market through patent, copyright and other “intellectual property” laws. How might the strategic/competitive landscape change in a “free intellectual market”?
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Notes – Competition Demystified: Preface, Chapter 1

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

What is strategy?

Strategy is the art of making business decisions with respect to the actions and responses of competitors. Strategy revolves around creating, protecting and exploiting competitive advantages.

Strategy and competitive advantage go hand in hand; where there is no possibility to develop a competitive advantage, there can be no strategic decisions. Markets where competitors have similar access to customers, technology and other cost advantages are not strategic but tactical markets where the only strategy possible is to outrun the competition through operational efficiency– most competitors will be about the same size and none will manage to make or maintain an outsize profit margin as the lack of competitive advantages will drive economic profits toward average cost.

What are the differences between strategy and tactics?

The easiest way to think about the difference between strategy and tactics is to understand that strategic decisions are focused on competitors, while tactical decisions are focused on operations. In other words, strategy is external, tactics are internal in nature.

This helpful table from Competition Demystified may also convey the differences:

  • Strategic Decisions
    • Management level –> top management, board of directors
    • Resources –> corporate
    • Time frame –> long-term
    • Risk –> success or survival
    • Questions: “What business do we want to be in?”, “What critical competencies must we develop?”, “How are we going to deal with competitors?”
  • Tactical Decisions
    • Management level –> midlevel, functional, local
    • Resources –> divisional, departmental
    • Time frame –> yearly, quarterly, monthly
    • Risk –> limited
    • Questions: “How do we improve delivery times?”, “How big a promotional discount do we offer?”, “What is the best career path for our sales representatives?”

Additionally, there are two major strategic issues every business faces:

  1. the arena of competition – which external characters will affect the firm’s economic future?
  2. the management of competition – how do you anticipate and, if possible, control, the actions of these external agents?

Porter’s “Five Forces” and the Greenwald/Kahn “One Ring” that binds them

Michael Porter, author of [amazon text=Competitive Strategy&asin=0684841487] (1980), identified “Five Forces” critical to the competitive environment:

  • Substitutes
  • Suppliers
  • Potential Entrants
  • Buyers
  • Competitors Within the Industry

Greenwald and Kahn focus on one as being the dominant force, potential entrants, specifically from the viewpoint of barriers to entry.

Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not.

Barriers to entry are critical for maintaining stable businesses and above average profit margins as without them the market will be flooded with competitors whose existence serves to drive down average industry profitability.

As more firms enter, demand is fragmented among them. Costs per unit rise as fixed costs are spread over fewer units sold, prices fall, and the high profits that attracted the new entrants disappear.

The end result is all firms are placed on the operational efficiency treadmill where no firm ever reaches the goal of above average profitability and everyone must run as fast as they can simply to stay in place.

Operational effectiveness might be thought of as a strategy, indeed, as the only strategy appropriate in markets without barriers to entry.

How to conduct a strategic analysis

Ask yourself, in the market in which the firm currently competes or is considering an entrance:

  1. do any competitive advantages exist? And, if so,
  2. what kind of advantages are they?

Exploring competitive advantage

There are only three types of genuine competitive advantage:

  1. supply – a company can produce or deliver its products or services more cheaply than competitors
  2. demand – a company has access to market demand that competitors can not match, usually based upon…
    1. habit
    2. switching costs
    3. search costs
  3. economies of scale – an incumbent firm operating at large scale will enjoy lower costs than its competitors

Companies which manage to grow yet maintain profitability usually achieve this one of three ways:

  • replicate their local advantage in multiple markets
  • continue to focus on their product space as that space becomes larger
  • gradually expand their activities outward from the edges of their dominant market position

Elephants versus ants

Markets which offer competitive advantages are typically characterized by one or two large firms which possess the competitive advantage, elephants, and several smaller, less profitable “competitors”, the ants.

A firm which finds itself in a market where it is the ant should consider getting out of the market as painlessly as possible. A firm which is considering entering a market where an elephant already resides should reconsider the decision as the only real hope for competing in that market is if the elephant creates an opportunity by making a mistake.

With a competitive advantage in place, an elephant can enjoy the outsized profits of his competitive position. Still, developing strategic awareness about its competitive advantages will allow it to:

  • reinforce and protect existing advantages
  • identify areas of growth (geographic and product line-related) that are likely to yield high returns
  • develop policies that extract maximum profitability from the firm’s competitive circumstances
  • identify threats that are likely to develop
Strategic planning

In other words, strategic planning concerns itself with the different areas of business decision-making that competitors can respond to, such as:

  • pricing policies
  • new product lines
  • geographic expansions
  • capacity additions

Questions from the reading

  1. With regards to the elephant vs. ant paradigm, why do ants exist at all, that is, why don’t more firms exit markets where they are ants?
  2. What are common ways in which elephants misstep and allow competition from the ants?