STRATEGIC ANALYSIS FOR DUMMIES

THE SOURCES OF COMPETITIVE ADVANTAGE

I. PRODUCER (LOWER COST)

General indicators:

- Product is complex

- Technology is changing rapidly

- Protected by patents

- Makes use of special / rare resources (inputs)

(1) Technology

- Is it proprietary?

- Is it very difficult to copy?

(2) Learning Curve

- If you need Step #1 to get to Step #2

- If competitors can’t leapfrog over you

(3) Economies of Scale / Scope

General indicators:

- Costs decline with size (scale)

- Costs decline with variety (scope)

Ratios to use:

- COGS / units sold (better), or COGS v. Sales (doesn’t account for price variety)

- Productivity data (R&D, Inventory ratios) [elaborate here]

- Firm is large relative to the market

(a) Can be present in:

- Purchasing

- Advertising / marketing (local v. national)

- R&D

(b) DISECONOMIES of scale:

- Labor costs

- Cannibalization

- Rare inputs (rise in cost)

LOW-COST STRATEGIES CAN WORK IF:

(1) EOS are large and not yet exhausted

(2) Consumers are price sensitive

(3) Consumers don’t care much about performance / image

(4) It’s a “search good” -- buyer can assess quality at the time of purchase

II. CONSUMER (HIGHER PRICE)

General indicators:

- Price differences across industry

- Quantify the price premium

- High SG&A (e.g., high marketing costs) can indicate “market management” (creating demand)

(1) Habit

- Is it a high-frequency purchase?

- Is it uniform / not customized?

(2) Searching Costs

- Is Quality very important to buyer?

- Is it a complex product?

- these are all abt overcoming the risk aversion of the consumer

- e.g., can invest in a warranty program (signal of quality)

(3) Switching Costs

- Is it a complex product?

- Does it do more than one thing (multiple functions)?

- Are there direct switching costs?

- These can be real or psychological

HIGH-PRICE STRATEGIES CAN WORK IF:

(1) EOS are exhausted by most competitors

(2) Many people will pay a premium for the product

(3) It’s an “experience good” -- buyer can only assess quality through use

III. GOVERNMENT

- Can be either producer or consumer advantage

(1) Taxes / tariffs

(2) Subsidies

(3) Regulations

(4) Contracts

ANALYZING AN INDUSTRY

I. DEFINE THE MARKET

“Bottom up”:

(1) “Market” includes all SUBSTITUTES

- Same performance characteristics

- Occasions for use

- Geographic distribution

(a) Look at price elasticity (% change Q / % change P)

- If our demand is elastic, substitutes probably exist

- Inelastic demand indicates lack of subs

(b) Even substitutes don’t compete if:

- Geographic separation

- High transportation costs

- Tariffs

(2) Think: What separates customer groups? How secure is the separation?

“Top down”:

(2) Sketch the “Value Chain”

Common steps include:

- R&D

- raw materials (COGS)

- packaging

- processing

- distribution / transportation

- storage

- advertising

- shelf space costs (retail)

- apportioned overhead

- warranty / service costs

- margin

(3) Map the “Profit Pool”

- X-axis is % of total industry profits residing in each value chain step (adds to 100%)

- Y-axis is typical operating margin of each value chain step

II. MARKET STRUCTURE

- Continuum from perfect competition to monopoly

(1) What is the industry’s “concentration”?

- CR4 or CR8 Ratios (market share of top 4 or 8 companies)

- HHI (Herfindahl Index):

- (Share of #1 firm)^2 + (Share of #2 firm)^2 ....

- Monopoly: HHI > 0.6

- Oligopoly: HHI > 0.2

- In practice shares < 5% are not relevant

(2) Historical analysis:

- Continuous entry indicates low barriers

- Profitability (high ROE, ROA over 10 yrs) indicates high barriers

- Shifting market shares indicate low barriers

III. ENVIRONMENTAL ANALYSIS

(1) Demand

- What influences demand -- age? income? leisure time?

- Demographic changes

- Technological / distribution innovations on horizon?

GAMES

- “Games” are used to prevent / influence entry & profitability.

- There can be no “games” if there are no barriers to entry (see above).

I. Prisoners Dilemma

- Equilibrium is non-cooperation

- Cooperation would be better for both of you

- Ways to resolve - use strategic commitment (LT, difficult to reverse):

(a) Reduce incentive to deviate

(i) Limit your ability to respond [signals are costly]

- Differentiate your product - reduce substitutability

- Limit your capacity - reduce ability take market share

- Limit your flexibility - increase debt

- Tie compensation to profit - not market share

(ii) Broaden scope - more markets, more likely to cooperate

(b) Punish deviation

(i) Make your response clear (e.g., tit-for-tat)

(ii) Create sacrificial hostage (e.g., breakup fee, engagement ring)

(iii) “Meat or beat” clauses, MFN

- increase ability to detect deviation

- discourage price war

- Cooperation is harmed by:

- Misunderstandings during tit-for-tat

- Lack of market concentration

- Lack of detection ability

- Concentration of buyers - reduces detection ability

- Lumpy orders - raises payoff of cheating

- Volatile demand - leaves firms w/ extra capacity sometimes (temptation to cheat)

II. Substitutes and Complements - Static Rivalry

(1) Strategic Substitutes [usu. Q and Capacity]

- Reaction functions are downward sloping (Cournot quantity functions)

- More of an action one firm chooses (e.g. raise Q), more rival choose opposite

- Aggressive moves are met by aggressive moves

- Similar products

- Price depends on Q of both firms

- If you raise Q, rival’s profit-max action is to lower Q (e.g., semiconductors)

- [e.g. Nucor, USX, semiconductors]

Ways to compete w/ substitutes:

- Tough: [commit to high Q] [“Top Dog”]

- exploit economies of scale (lower costs, higher profits)

- move in close, seem willing to battle (e.g. Burger King)

- accumulate debt - increases incentives to cut costs

- overinvest in “experience” - lowers costs in future

- result: rivals will reduce production

- commitment causes rival to behave less aggressively

- Soft: [commit to low Q] [“Lean & Hungry”]

- commit to raising MC at higher Q (e.g. enter diff. mkt using same factory)

- profit-max Q will then be lower

- enter market with diseconomies of scale (higher costs)

- underinvest in expansion / learning - raises costs in future

- result: raises costs in market; rival raises Q

- commitment causes rival to behave more aggressively

(2) Strategic Complements [usu. Price]

- Upward-sloping reaction function (Bertrand price functions)

- Aggressive moves are met by accomodative moves

- More of an action one firm chooses (e.g. raise price), more rival will choose

- If you raise price, rival’s profit-max move is to raise price -- and vice versa

- Differentiated products

Ways to compete w/ complements:

- Tough: [commit to lower price] [“Puppy Dog”]

- makes investments to lower MC and AC

- just-in-time manufacturing

- lowers costs, implies lower price

- result: rival also lowers price

- commitment causes rival to behave more aggressively

- Soft [ commit to higher price] [“Fat Cat”]

- overinvest, build brand loyalty - discourage future price wars

- higher costs, implies higher price

- change product so it’s aimed at a niche market

- result: rival also raises price

- commitment causes rival to behave less aggressively

- [e.g., RTE cereals, Fox TV]

III. Dynamic Rivalry

(1) Strategies to deter Entry & Exit

- usu. simpler than management of rivalry

(a) Structural barriers to entry

- Control of essential inputs

- Economies of scale / scope

- Consumer advantages (can be “invented around”)

(b) Deterrence

- Incumbent takes actions to increase credibility / cost of war

- Overinvest if hurts rival (e.g. technology scale)

- Underinvest if investment helps rival (e.g. learning curve)

- Limit pricing (low now, high later)

- Predatory pricing - other non-profit max behavior

- Creation of dominant, proprietary standard

- Compatible standards can be win-win (consumers mix & match)

(2) Stragies of Entrant

(a) Judo economics - take small market, use incumbent’s size against it

(b) Commit to being small (“puppy dog ploy”)

- Install limited capacity

- Focus on smaller market (e.g. Southwest Airlines)

(3) Bargaining

- Mutually satisfactory

- Focus on outcomes, not strategies

(a) Figure out the costs / profits if a single firm controlled entire industry

(b) Each firm defines its “Threat Point”

- its profits in the event of no negotiated agreement

- can come from non-cooperative, Nash equilibrium

- high profits at Threat Point = high profits in cooperation

(4) Threats to Profitability

- these can cause some redistribution of economic profits

(a) Substitution

- see “bottom up” above

- this threatens obsolescence for our product (profits = 0)

(b) Imitation

- threatens uniqueness of our product

- econ profit should fall to normal rate of return for industry (no excess return)

(i) Happens when firm has specialized asset

- durable

- costly

- non-transferable to other markets

(ii) Solutions to this problem

- make assets less specialized

- all parties make specialized investments (including investments in each other)

- negotiate before you invest

- timing important: can’t write contracts to ensure effort (monitoring problem)

- vertically integrate

(iii) Examples:

- fountains can hold up Coke (easily switch to Pepsi)

- PBM’s can hold up pharma co’s (have asset of patient group)

UNCERTAINTY

(1) Categories of Risk

(a) Financing / liquidity - raising money, depends on market cycles (?)

(b) R&D

- what is the payoff?

- are we relying upon a home run (big drug, e.g.), or marginal improvement?

- approvals / changes in laws

- what are costs, timing of the process?

(d) Manufacturing

- how long will it take to est a working plant?

- how much will it cost?

- availability / specialization of labor?

(e) Market Acceptance / selling

- do we know the market?

- do they know us?

- how can we reach them?

(f) Price

- can we charge enough?

- for drugs, e.g., can open books to reveal high costs / help patients manage reimbursement

(g) Usual risks of rivalry (see above)

- Imitation, substitution & holdup

(2) Responses to Risk

(a) Responses that DO NOT see risk as an opportunity:

(i) Ignore it

(ii) Use current trends

-i.e., assume risk is already in your r*

(iii) Raise hurdle rates

- i.e., raise your discount rate (required return on new investments)

(b) Responses that DO see risk as an opportunity [these are usu. better]:

(i) Choose a posture

(1) Leader

(2) Follower

- can reap advantage by letting someone else take the big risks first

- only if you can copy / follow them

(3) Agnostic

(ii) Evaluate your bets

- what are the causes of the uncertainty?

- will the bet create competitive advantage? could it?

- what would happen if we win? lose?

(iii) Choose to hedge / spread the risk -- or NOT to hedge/ spread the risk

- do pilot programs, tests

- are you making a real commitment?

- are you creating a real option in the future?

- what does this cost?

(iv) Choose timing

- are we just waiting for the sake of waiting?

- what are the costs / advantages of speeding the process up?

(v) Choose to change uncertainty itself

- challenge “common wisdom” at every level of the industry

- are there opportunities in “necessary evils” accepted by everyone?

- you can change rules of the game

STRATEGIC ANALYSIS FOR DUMMIES - Chart

	SUBSTITUTES	COMPLEMENTS
French Patron Saint	Cournot	Bertrand
Competition is usually on ...	Q, Capacity	Price
Products are often ...	Similar	Differentiated
Reaction functions ...	Slope down	Slope up
If you move one way, your rival moves ...	The opposite way	The same way
For example, if you raise your ...