eco chapter 8

Competition and StrategyChapter 8

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(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.

• 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.


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The Supermarket


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Supermarkets that dominated grocery retailing in the twentieth century are losingtheir 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.

What’s Next?


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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.


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Competition: A Quest to Be Exceptional – Competitive Ideas


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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—itmay be as simple as opening a business in an underserved location, keeping it open all night, or outrightly imitating

the success of a competitor.

Competition: A Quest to Be Exceptional - The Paradox: Competing to Acquire Market Power


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• 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

Competing to Acquire Market Power

• 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

(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.

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


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• 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.

Competition and Deception


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• 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).•

Pitfalls in Studying Competition -Selection Bias, Again


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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.

Selection Bias, Again

• 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





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Pitfalls in Studying Competition –What’s Wal-Mart’s Secret?


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• 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?

Pitfalls in Studying Competition – Self-Serving Recommendations


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• The structure of corporate business further complicatesthe 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.

• 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.


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The Basics: One Seller and One Buyer


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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.

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


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Here, the seller chooses to incur a cost of $1 to alter his good’scharacteristics (possibly improving quality or making the good

available closer to the purchaser’s home). In so doing, heraises the purchaser’s valuation by $2 to $13, increasing the

economic value from $4 to $5.

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


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

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


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Here is a situation that includes transaction costs. Seller’sopportunity cost is $5 plus $2 in transaction costs. Purchaser’s

valuation is $16 plus $3 in transaction costs. Even aftertransaction costs, there remains $6 in economic value available

to be shared.



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If the seller cuts his transaction costs by $1, the economic valueavailable to be shared rises to $7. Similarly, the purchaser

could reduce her transaction costs and increase the economicvalue available.



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Here, the seller spends $1 in order to lower the purchaser’stransaction costs by $2. This will increase the economic value

available from $6 to $7.

One Seller, Many Buyers• 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.





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


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Here the seller increases variablecost to improve the product and

increase buyer valuation. Marginalcosts increases to MC’ and demand

shifts to D’. Price increases to $9.50and profit rises.

One Seller, Many Buyers - Raising Buyers’ Valuations – Altering Fixed Costs


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• 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.

One Seller, Many Buyers – Lowering Production Costs


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Here, lowering production costsfrom MC to MC’, increases annualprofit by $9 from $16 to $25. A

seller Be willing to invest up to $9per year to achieve such a

reduction in production costs.

One Seller, Many Buyers – Lowering Transaction Costs


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• Here, buyers and sellers both facetransaction 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 demandcurve to D and increases profit.• If the seller can cheaply reduce buyers transactions costs output and profit increase as do benefits to buyers.

Many Buyers and Many Sellers


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This shows what happens in a competitive market when a single firm initiallyadopts a cost-saving innovation. Other firms will follow and a new long-run

equilibrium will be restored where firms once again earn zeroeconomic profit.

Many Buyers and Many Sellers


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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.

Many Buyers and Many Sellers –Upward Sloping Supply Curves


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Supply curve S’ and demand curve D’ include a $3 transaction costfor sellers and a $2 transaction

cost for buyers. The market equilibrium price is $10 with 75

units traded.

Suppose that all transaction costswere costlessly eliminated. Marketprice will fall to $9 with 110 units

traded.

Many Buyers and Many Sellers –Outsider Reduces Transaction Costs


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D1 would be the demand curve withno 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 thebuyer transportation costs to $8,

making the demand curve D3. Marketprice rises to $16.33 and the number

of units traded increases to 25.67.


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Horizontal Mergers and Agreements -Mergers


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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 sameownership. The consequences depend on market

structure and on how the merger affects costs.

Horizontal Mergers and Agreements - Mergers


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• Suppose the diagram to the rightdepicts a perfectly competitive market in equilibrium. • If two of the firms merge to reducecosts, nothing happens. • But, if this sets off a merger wave wemay end up with an oligopoly whose equilibrium looks like a monopoly (12,000 units at $10).• This would create a deadweightloss 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.

Horizontal Mergers and Agreements - Agreements


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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 ruleof reason standard that balances their favorable and unfavorable effects on

competition.

Vertical Mergers and Agreements


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• 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.

Vertical Mergers and Agreements• 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.





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Vertical Mergers and Agreements -Mergers


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• D is the market demand fordiamonds. • 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.

Vertical Mergers and Agreements -Agreements


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• 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.

Vertical Mergers and Agreements –Restrictive Agreements


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• 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.

Vertical Mergers and Agreements –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.





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Barriers to Entry—Size and Commitment


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• 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 availableeconomies of scale. Firms may also need to invest in specific assets that are not easilyredeployed to other uses and locations. A power plant for instance.• New competitors do not miraculously appear especially whereeconomies of scale are important.• Inexperienced competitors rarely appear except in new markets. • The automobile market – incumbent disadvantages

Intangible Assets: Trademarks and Advertising


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• 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

Influencing the Public and Government – Public Relations


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• 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.

Influencing the Public and Government – Influencing Government


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• Government can also help a business to advantage itself ordisadvantage 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.

• 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.


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Resources and Strategies - What Are Resources?


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The originator of the resource-based model, BirgerWernerfelt 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.

Resources and Strategies – Innovation Pro and Con


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• 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.

Competence and Sustainability -Identification of Resources and Feasible Strategies


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A firm’s strategy choice starts by identifying its resourcesand 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 modelsthat 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.

Competence and Sustainability - The Search for Strategies


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• 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.

Competence and Sustainability - The 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

Education

cengage learning

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competition rules

perfect competition

competitive strategies

risky competitive idea

benefitconsumers strategies

good ideas