Existence of Competitive Advantages
I. Stability of market shares/relative market positions among firms: each player in the market can defend its market share.
II.High return on capital/profitability of firms within the segment: 15-25% after-tax returns usually imply presence of competitive advantages whereas 6-8% after-tax returns typically imply absence of competitive advantages.
Assessing Competitive Advantages
Three step process: develop an industry map, test for existing competitive advantages and look for sources of competitive advantages
Sources of Competitive Advantages
Sources of competitive advantage tend to be local in both geographical locations and product space, not general or diffused. Skills and competencies of even the best-run companies are available to competitors (talent, systems, etc. can all be improved). Strategy is concerned with structural barriers to entry.
There are only 3 kinds of genuine competitive advantages. The strongest competitive advantages arise from the interaction of one or more of the competitive advantages listed below (in order of weakest to strongest).
Supply: strictly cost advantages
In industries with complicated processes, learning and experience are a major source of cost reduction (if a company is tinkering with a product years after first producing it, although it may look ungainly, it also signals how hard it is to conquer that market quickly). Cost advantages is correlated with pace of technological change and have a shorter life expectancies in rapidly changing areas.
Demand: not product differentiation/branding, but customer captivity due to habit/switching costs/difficulties and expenses of switching
Product differentiation is over-rated. Think of Mercedes/Cadillac–it’s widely coveted by heads of states and so on, but still has an average rate of return because there’s no barrier to entry
Brands are not by themselves a type of competitive advantage, although some aspects of brand-related consumer behavior may lead to competitive advantages.
Habit needs to be classified as a lifecycle. Some can be inter-generational (such as Heinz), some can last a good part of a life-time (Coca-Cola/Pepsi), and last while someone is of a certain age.
Switching costs can be increased by encouraging by making purchases more frequent, spreading payments over time, and/or extending and deepening the range of services offered to ensnare customers in an ongoing relationship.
Economies of scale
This depends not on the absolute size of the company, but the size difference between it and its rivals (on market share, or even on a factory level–really any area where fixed costs stay fixed). One thing to think about is that if the incumbent build large factories but the efficient size is smaller, it makes no difference (Coors building 13 mm barrels factory in ’85 when the efficient size is 5 mm).
Most competitive advantages based on economies of scale are found in local/niche markets. Best course is to establish dominance in a local market and expand outward on the edge(e.g. Walmart)
It cannot be just about lower production costs. If an entrant has equal access to customers as incumbents, it can reach incumbents’ scale. Thus, for economies of scale to serve as a competitive advantage, it needs to be coupled with some degree of customer captivity.
In order to persist, this advantage has to be defended continuously because any market share gain by a competitor narrows the incumbents’ edge; thus if the rival introduces an attractive new feature, it has to be adopted by the incumbent rapidly. Mistakes include when Pepsi targeted supermarkets in ’50s as a distribution channel, or when American motorcycle industry didn’t challenge Honda when it introduced inexpensive cycles in ’60s.
Growth of the market is generally not a good thing for competitive advantage based on economies of scale, because as markets grow, fixed costs stay fixed and variable costs increase as a percentage of total costs and this lowers the hurdle for an entrant, undercutting the advantage of the incumbent. Furthermore, growing markets imply new customers, who, by definition, are non-captive, offering base of viable scale for new entrants.
Incumbents should put in effort to change as many variable costs to fixed costs to cement their dominance (advertising heavily, adding features that require significant capex, accelerating product development cycles etc.)
If an industry has high rates of return and none of these competitive advantages exist, then look for things such as government intervention that favors incumbents (licenses, subsidies, regulation etc.). If even these are not present, then it is likely that (a) market share/rate of return are temporary, or (b) this is the consequence of good management and can be emulated by a very focused entrant.
Competitive advantages are invariably market-specific and do not travel well with growth-obsessed management. For example, when Cisco move to provide services to telecom providers (vs. corporations and universities) in the late ’90s, it faced off with entrenched competitors such as Lucent and new competitors, had no captive customers (no scale advantages), and its R&D ballooned. Cola drinkers are among the most loyal customers around the world. But this habitual consumption does not make them any more likely to buy a particular brand of life insurance or even to favor a particular brand of salty snack or eat in a certain fast-food outlet. Choice of markets is a strategic decision as it determines the set of external characters who will affect company’s economic future.
Attractive Niche Model = Customer captivity (pricing power) + Small size relative to fixed cost + No dominant competitor (market size) + Extendable at edge = Think Local
Strategies Companies Adopt
Strategies become complicated only when a small number of powerful firms enjoy competitive advantages in common.
I.If a company doesn’t have a competitive advantage, then it should focus on just one thing–operational effectiveness–efficiency, efficiency, efficiency. If the product is a commodity, operational effectiveness is about controlling costs; if not, it is about both controlling costs and marketing effectively (and financing appropriately). Operationally effective systems tend to focus on a single business and on their own internal performance.
II.If the company does have a genuine competitive advantage and is a large dominant firm, then it should focus on managing that competitive advantage.
III.If the company does have a genuine competitive advantage and is NOT a large dominant firm, that is when things get interesting. When companies interact, they have to think about the move of their competitors, which is dependent on the competitors’ interpretation of signals sent by the company based on its actions and statements. Analysis of these dynamics is difficult because of this complexity can quickly spiral and feel akin to tracking a bouncing ball into a room of mirrors.
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