Summary: Economics of Strategy

Deze samenvatting is gebaseerd op collegejaar 2012-2013.

Chapter A: Economies of scale and scope

Horizontal boundaries: the varieties and quantities of products and services that a firm offers. The optimal horizontal boundaries of a firm depend on economies of scale and scope.

Economies of scale: due to an increase in the production of a given good or service, a firm can decrease its unit-cost.

Average costs curves are U-shaped: costs of small and large firms > costs of medium-size firms. (Graph: figure 2.1 p.75)

Average costs curves are L-shaped: average costs decrease up to the minimum efficient scale (MES) of production and it results that every firms have the same average costs if they produce beyond or at MES (Graph: figure 2.2 p.76).

Economies of scope: due to an increase of variety of goods and services produced, the firm can achieve saving. It is often defined as the fact that producing two or more different products together is cheaper that producing them separately.

Where do scale economies come from?

4 sources related with production:

  • Indivisibilities and the spreading of fixed costs: spreading of product-specific fixed costs, tradeoffs among alternative technologies.

Indivisibility: an input cannot be scaled down below a certain minimum size, even when the level of output is very small. Indivisibilities are often expected when production is capital intensive.

Economies of scale can be the result of an increase in capacity utilization (short-run economies of scale) with a given product technology and the result of the decision of a firm between different production technologies (e.g., adaptation of a technology with high fixed costs and low variable costs are long-run economies of scale).

  • Increased productivity of variable inputs

  • Inventories: inventories costs are proportional to the ratio of inventory holdings to sales. Therefore, inventories can generate economies of scales as a high volume of business allows to sustain a lower ratio of inventory to sales while achieving a similar level of stock-outs and thus, it decreases the average costs of goods sold.

  • Engineering principles associated with the “cube-square rule”: economies of scale increase due to the physical properties of units.

Special sources of economies of scale and scope:

3 Sources not related with production:

  • Purchasing

  • Advertising

  • Research and Development

  1. Purchasing: buying in bulk allows buying at a better price (eg. 6 packs of milk is cheaper than buying 6 packs separately, discounts for big businesses).

A supplier will care if sales of X units come from one or many different buyers for 3 reasons:

  • Less costly to sell in bulk if additional fixed costs are involved as writing a contract, delivery the product, etc.

  • Small price difference is bigger when buying in bulk

  • If the supplier is unsuccessful making business with a large purchaser, he may face costly disruption to operations or in bankruptcy. The supplier may offer a discount to the larger purchaser to assure a steady flow of business.

Those 3 conditions above need to be hold to allow purchasing economies.

  1. Advertising: the following formula shows the advertising cost per consumer of a product:

Cost of sending a message

Number of actual consumers as a result of a message

In general, larger firms often have lower advertising costs per potential consumer. Even if associated costs are high, they are spread over a lot of potential consumers.

Umbrella branding: a firm offers a broad product line under a single brand name. This strategy is profitable when the advertisement of one product is used in the mind of the consumers to make inference about other products with the same brand name and therefore, decreasing the costs in advertisement.

Umbrella branding can also reduce the risk of launching new products because consumers can refer to the reputation of the brand name.

  1. Research and development: Economies of scope arise when research and development generates positive spillovers to another project.

Sources of diseconomies of scale:

  • Labor costs and firm size: bigger firms offer better wages and benefits than small firms.

  • Spreading specialized resources too thin: duplication is not easy and problems to transmit success from one situation to another arise.

  • Conflicting out”: a potential client going to a professional services firm would like maybe to know if the firm is also doing business with some of its competitors. This can affect the decision of doing business or not.

  • Incentive and bureaucracy effects: difficulties in promoting effective worker performance because of communication problems for example.

The learning curve effect:

The learning curve or experience curve: advantages coming from accumulating experiences and know-how. This leads to lower costs, higher quality and more effective pricing and marketing.

Marginal cost of increasing production = expected marginal cost of the last unit of production that the firm expects to sell.

Therefore, even if short-run prices are lower than short-run costs, the learning firm should accept them. This can lead in negative accounting profits in the short-run but will prosper even more in the long run.

Learning and organization: managers should promote firm-specific learning rather than task-specific learning because if the learning is task-specific, employees getting skills while learning may be able to sell their knowledge in the form of higher salaries. When learning is firm-specific, worker knowledge is tied to their current employment, and the firm does not need to increase salaries as the worker become more productive.

The learning curve versus economies of scale: economies of scale can be important even when learning economies are minimal (capital-intensive activities) and learning economies can also be important even when economies of scale are minimal (labor-intensive activities) (see figure 2.10 page 99).

Managers who cannot exactly discern between economies of scale and learning can have incorrect conclusions about the benefits of size in a market. For instance, if a firm has lower unit costs, does it come from economies of scale or from learning? If it comes from economies of scale and the firm cut the current volume of production, unit costs will automatically increase. However, if it comes from learning, unit costs will not increase.

Chapter B: Diversification

Diversification could be done in many ways: by enlarging the product line, by enlarging markets, etc. and the goal is to reduce costs and improve market effectiveness by exploiting economies of scale and scope.

Why do firm diversify?

There are 2 reasons for this:

  • Diversification can be a benefit for the owners by increasing the efficiency of the firm.

  • Diversification could reflect the firm’s manager’s preferences if the owners do not take directly decisions.

Economies of scale and scope: if firms diversify with the aim of pursue economies of scope, usually, large firms would offer a related set of productions to a narrow group of consumers. Evidences have shown that observes patterns of diversification cannot be explicated by economies of scope from shared technologies or shared consumer groups.

Scope economies can be achieved by spreading a firm’s underused organizational resources to new area because a firm can have some particular resources that cannot be used in its current product market. So, instead of doing nothing with those resources, they can be better used in other product markets and will therefore allow economies of scope.

Economizing on transaction costs: important if diversification comes from mergers and acquisitions. Teece says that a firm should be diversified when coordination among independent firms is difficult to achieve due to transaction costs.

Internal capital market: how firms allocate financial and human resources to internal divisions and departments. A problem with internal market is that it is possible to have profitable projects that cannot be financed by external resources because external finance is expensive. If the project is the creation of a business by cash-rich firm and a cash-constrained firm, the cash-rich firm can be used to finance effective investments in the cash-constrained firm. Therefore, both firms do not need to share anything. However, the only condition to be successful is that one firm has cash in excess of its investment opportunities while the other has investment opportunities in excess of its available cash.

Diversifying shareholder’s portfolios:


  • Decrease risk

  • Smaller loss if a single firm fails.

Disadvantage: mergers and acquisitions as a tool for diversification can make shareholders worse off because a shareholder can diversify its portfolio himself by buying some shares of another company and does not need the company to acquire the other firms. Moreover, shareholders would maybe like to diversify their portfolios by having shares of another firm that the one acquired. Therefore, managers do not always act in the interest of shareholders.

Conclusion: diversification is better if shareholders cannot diversify their portfolios by themselves.

Identifying undervalued firms: if managers can recognize firms that are undervalued by the stock market, shareholders can be better off from diversification but this is very difficult to achieve for two reasons:

  • Market value of the target firm is not correct

  • No other investors have noticed it.

Therefore, the probability to find an undervalued firm on the stock market is very small.

Potential costs of diversification:

  • Important influence costs (combining two businesses in a single firm)

  • Expensive control system (some managers are rewarded on the basis of division profit or by business unit objectives).

  • Internal capital market may not work very well in practice

Benefits to managers from acquisitions: 3 potential reasons:

  • Managers can prefer larger firms (social prominence, public prestige, political power).

  • Unrelated acquisitions can be achieved because managers want to increase their compensations.

  • Unrelated acquisitions can be achieved because managers want to protect themselves against risk.

Problems of corporate governance: if shareholders would be able to say which acquisitions are profitable and which one are not, and if management would be able to act only on the behalf of shareholders, few or no problems of corporate governance will arise. However, this is difficult to achieve because:

  • Shareholders do not have the information and the knowledge to determine which acquisitions are profitable and which one are not.

  • Difficulties to change the choices of managers

  • A lot of shareholders in large businesses have only a very small part of the shares of the firm.

Performance of diversified firm: many studies find that the sources of performance gains from diversified firms are unclear. However, they show that efficiencies can be difficult to realize through diversification and poor performance is often linked with extensive diversification into unrelated areas. Moreover, diverse studies conclude that:

  • Moderately diversified firms had higher capital productivity. Firms with moderate to high levels of unrelated diversification had moderate or poor productivity (R. Rumelt, C. Montgomery).

  • Firms with restricted diversification to narrow markets performed better than broader firms, because of their learning particular market demand (N. Capon, L. Palich, L. Cardinal, C. Miller).

  • Firms pursuing related diversification outperformed those choosing either narrower or broader strategies (L. Palich, L. Cardinal, C. Miller).

  • Diversification led to a destructive “new toy” effect. After an acquisition, newly acquired plants saw an average productivity increase of 3%.

  • This improvement, however, occurred at the expense of the firm’s other plants. Incumbent plants’ productivity fell by 2% on average, and since there are typically far more incumbent plants than new ones, this decline implies an overall reduction in efficiency (A. Schoar).

Chapter C: Vertical boundaries

Vertical chain: the act of starting with the acquisition of raw material and finishing with the distribution and sale of finished goods and services.

Market firms: specialists in the market that sell input to other firms and allow a manufacturer to have for example superior marketing program, rapid low-cost distribution, higher sales without performing any of these activities by himself.

However, it is not always an advantage to use market firms. The central question that a manufacturer should ask is “are the costs of making cheaper that the cost of buying”? and therefore, he should compare the costs and benefits from making versus from buying. Those costs and benefits can be fund in table 3.1 page 109.

Some make-or-buy common mistakes:

  • It is better to make an asset if the asset represents a source of competitive advantage for the firm: if the asset is a source of competitive advantage, the firm can get it easily on the market.

  • It is better to buy to avoid the costs of making: all associated expenses activities are in charge of the manufacturer and total expenses may be more than the costs of making the input.

  • It is better to make otherwise the firm will have to pay a profit margin to the market firm: economic profit versus accounting profit, expertise needed can be difficult to obtain, the market firm is the only one to have economies of scale.

  • It is better to make as a vertically integrated firm to avoid paying high market prices for the input during periods of peak demand or scarce supply: hedge for example.

  • Firms should tie up a distribution channel to gain market share at the expense of rivals: antitrust laws, can pay too much for the acquisition, how is it difficult for competitors to open new channels of distribution?

Reasons to buy:

  • Market firms are usually more efficient (economies of scale and learning curve): Firms should make what they do better than competitors and leave other things to market firms.

The advantages of market firms are the following:

  • Proprietary information / patents that enable them to produce at low costs

  • Can aggregate the needs of many firms (economies of scale)

  • Use their experience in producing for diverse firms



  • Less bureaucracy:

    • Agency costs: costs that come from decisions or behaviors that are unprofitable for the firms (e.g. behavior: playing cards or sleeping instead of working / decision: overstaffing, using express mail instead of regular). Due to common overhead or joint costs with specific allocations, agency costs are difficult to observe and measure.

    • Influence costs: direct costs of influences activities and costs of bad decisions that increase from influence activities (e.g. resources that are misallocated because an inefficient division is skillful at lobbying for scarce resources).

Reasons to make:

Contracts are valuable because:

  • List what each party has to do and what each party supposes the other to perform.

  • Specify remedies if one party does not perform its obligations completely. (This implies that firms do not totally trust their trading partners.)

  • Protect parties to a transaction from opportunistic behavior.

Complete contracts: allow the elimination of opportunistic behavior but for this, specific requirements are necessary:

  1. Parties to the contract must be able to contemplate all relevant contingencies and they agree on a “mapping” that specifies for each contingency, a set of actions that each party must take.

  2. The parties can specify what represents satisfactory performance and must be able to measure performance.

  3. The contract must be enforceable.

Nevertheless, every contract is incomplete as they do not entirely indicate the “mapping” from every possible contingency to enforceable rights, responsibilities, and actions.

Therefore, they are 3 factors to prevent complete contracting:

  1. Bounded rationality: analysis of information, deal with complexity, and pursuit of rational goals have some capability limits that an individual can face. Bounded rational parties cannot contemplate or enumerate every contingency that might increase during a transaction.

  2. Difficulties specifying or measuring performance: it is impossible to describe rights and responsibilities of each party when performance under a contract is complex or subtle. Language in contracts is thus often vague and open-ended. Therefore, it can be unclear what represent fulfillment of the contract. A related problem is that performance may be ambiguous or hard to measure.

  3. Asymmetric information: a contract may still be incomplete because the parties do not have the same relevant information. If one party knows something more than the other party, information is said to be asymmetric, and the knowledgeable party may distort or misrepresent that information.

Coordination of production flows through the vertical chain: for a good coordination, firms need to make choices that also depend on the choices of others. Good coordination leads to a good fit along all dimensions of production. Examples consist of:

  • Timing Fit

  • Size Fit

  • Color Fit

  • Sequence Fit

Problems with bad coordination:

  • Shut down a factory

  • Undermine a brand’s image

  • Lead to a significant lost in of their economic value

And therefore, due to those problems, contracts are important in coordination as it specify delivery dates, design tolerances as well as other performances.

Furthermore, coordination is especially important in process with design attributes which are usually not outsourced. Failing coordination in process with design attributes can ruin a production. Moreover, the cost of a small error along the critical design attribute can be disastrous.

Leakage of private information: information that no one else knows (know-how, product design, or consumer information). However, there is a risk to share this information if the firm decides to use market firms. Therefore, patents can be useful to keep competitive advantage protected. Moreover, there is another risk with private information because usually, it needs to be shared with employees. However one solution is to have noncompete clauses for new employees that say that when an employee leaves the firm, he cannot directly compete with it for several years.

Transaction costs: costs that can be avoided when a firm’s decision is making instead of buying (e.g., time, expenses of negotiating, writing and enforcing contracts). Incomplete contracts involve transactions costs.

Relationship-Specific Assets: investments made to support a given transaction. Relationship-specific assets are difficult to use in another transaction because it is not costless and therefore, it implies diverse costs as adaptation costs of the asset to the new transaction or less bargaining situations. Therefore, switching trading partner requires a decrease in the value of those assets.

Assets specificity can take at least 4 forms:

  • Site specificity: assets that are located next to each other to minimize costs of transportation or inventory or to take advantage of processing efficiencies.

  • Physical asset specificity: physical or engineering properties are specifically tailored to a particular transaction.

  • Dedicated assets: investment in plant and equipment made to satisfy a particular buyer. Without the promise of that particular buyer’s business, the investment would not be profitable.

  • Human asset specificity: a worker or a group of workers has acquired skills, know-how, and information that are more valuable inside a particular relationship than outside it (firm specific or not).

Rent, quasi-rent and relationship-specific investment:

X = quantity produced

C = variable costs

I = cost of investment

P* = price per unit when selling to its best alternative

Pm = price per unit when selling to its second best alternative

Relationship-specific investment (RSI): amount of the investment that cannot be covered if a firm does not do business with its first-best alternative firm as it was planned. It requires that the investment is larger than the profit from selling to the next best alternative.

RSI = I - X(Pm - C)

Rent: the profit a firm expects to obtain from the investment with its first best alternative. The rent is X(P* - C) - I

Quasi-rent: the difference between the profit that a firm can have from selling as planned to its first alternative (rent) and the profit that it can have from selling to its second-best alternative. As the investment is a sunk cost, if X(Pm - C) > 0, the firm should sell to it next-best alternative so that variable costs are covered by the sales to distributors. The quasi-rent is [X(P* - C) - I] - [X(Pm - C) - I] = X(P* - Pm).

Holdup Problem: the profit that a firm can have from selling as planned to its first alternative and the profit that it can have from selling to its second-best alternative is the same. This implies that the asset is not relationship-specific and that the quasi-rent is equal to zero. If the quasi-rent is large, this requires that selling to its second-best alternative can be costly and it allows the first-best alterative firm to use this large quasi-rent by holdup, especially when contracts are incomplete. For example, the first-best alternative firm can react as the following: because the firm has already made the investment, this investment is sunk cost. So, if they know that the second-best alternative is willing to pay Pm per unit (Pm < P*), they can break up the contract and offer a price between Pm and P* and therefore, transferred some of the quasi-rent to itself.

The holdup problem can lead to important consequences if the rent is small and the quasi-rent is large because this implies that the first-best alternative firm is willing to pay a high price and the second-best alternative firm is willing to pay a low price, so that the difference between prices is big.

The holdup problem raises the cost of transacting arm’s length market exchanges in 4 different approaches:

  • Contracts’ negotiations and frequent negotiations are more difficult

  • Investments to improve ex-post bargaining positions

  • Distrust: increase of direct costs of contract negotiation and problems with sharing information or ideas to achieve production efficiencies or quality improvement

  • Reduced investment in relationship-specific investments: reduction of the scale of investments in relationship-specific assets (e.g., build a small factory instead of a large one).

Double marginalization: benefit that two firms with market power can have if they consider vertical integration together. However, this leads to higher price than the price that would maximize the joint profits of the supplier and buyer.

Chapter D: Vertical integration

Vertical integration is usually better for a firm with larger share of the product market, for a firm with multiple product lines or when the production of inputs needs investment in relationship-specific assets while forward integration is better when products required specialized investment in human capital or in equipment and facilities.

Technical efficiency: says if a firm is using the least-cost production process. For instance, if a firm did not provide special skills that are needed to produce a good, we can say that this firm has not realized full technical efficiency. It is then possible to attain this amount by purchasing the good or by investing to provide those skills.

Agency efficiency: says how is the organization of the exchange of goods and services in the vertical chain in order to minimize the coordination, agency, and transactions costs. To achieve full agency efficiency, the firm needs to minimize those costs

Economizing: when better technical efficiency decreases agency efficiency.

Technical efficiency and agency efficiency are represented in figure 4.1 page 138.

Residual rights of control: the owner of an asset can allow someone else to use the asset although he still has all rights of control that are not explicitly stipulated in the contract. Residual rights of control are only transferred when ownership is transferred. If contracts were complete, it would not matter who owned the assets. The contract would always say which actions should be taken at all times and how all parties were to be compensated (see in the book the example between PepsiCo and its bottlers).

The GHM (Grossman/Hart/Moore) theory: how ownership can influence the decision of parties to invest in relationship-specific assets.

Situation: transaction between 2 units (unit 1 being upstream from unit 2 in the vertical chain). Operating decisions are necessary. The GHM theory stipulates that unit 1 and 2 need to negotiate because it is not possible to write a contract with those operating decisions in advance.

Therefore, three options of how to manage the transaction is possible:

  1. Nonintegration: both units are independent firms

  2. Forward integration: unit 1 owns the assets of unit 2

  3. Backward integration: unit 2 owns the assets of unit 1

The GHM theory says that investments in relationship-specific assets are influenced by the form of integration.

With forward and backward integration, a unit can better negotiate and therefore, it allows it to have a biggest part of the economic value created by the transaction and it will increase its decision to invest in relationship-specific assets.

When one of the unit’s relationship-specific investment has a better impact than the other on the value created in the vertical chain, vertical integration is preferred.

Finally, nonintegration is preferred when investments have the same importance.

If the net balance of technical and agency efficiency is better in case of merger, firms should take this decision but remember that it is possible to have full governance rights over physical assets but never completely over human capital (how hard to work depends on each employee and not on the firm). Therefore, an acquiring firm needs to consider workers specialized human capital otherwise, the merged firm will be less profitable.

Alternatives to vertical integration

  • Tapered integration: mix between market exchange and vertical integration. For example, GM purchases market research from independent firms although it has it own market research division.


  • The firm’s input and/or output channels can be expanded without requiring important capital outlays.

  • Information about the costs and profitability of internal channels can be used to help to negotiate contracts with independent channels.

  • Internal input supply capabilities can be developed to protect the firm against holdup by independent input suppliers.

Disadvantages: the internal and external channel may not realize enough scale to attain efficient production because production needs to be shared.

As a result, coordination problems may arise if product specification and delivery time have not been agreed yet.

  • Strategic alliances and joint venture:

Strategic alliance: an agreement of minimum two firms for the collaboration on a project or an agreement on sharing productive resources or information. Alliances can be horizontal, vertical or in different industries or not related through the vertical chain. Usually, trust is very important in alliances and disputes are resolved through negotiation.

A joint venture: specific type of strategic alliances that involves the creation of a new independent organization owned by the parent firms.

Most of alliances’ transactions involve:

  • Complexity

  • Impediments to comprehensive contracting

  • Creation of relationship-specific assets by both parties in the relationship, and each party to the transaction could hold up the other

  • Expensive for one party to develop all of the essential know-how to carry out all of the activities itself.

  • The market opportunity that creates the need for the transaction is either transitory, or it is uncertain that it will continue on an ongoing basis.

  • The transaction or market opportunity occurs in a contracting or regulatory environment with unique characteristics that necessitate a local partner who has access to relationships in that environment.

Advantages of alliances:

  • Acquire political know-how

  • Site selection expertise

  • Business connections

  • Lower costs


  • Possibility to lose control over private information

  • Risk of delay and lack of focus due to coordination compromised between firms

  • Possibility of agency and influence costs that can lead to the free-rider problem. Agency costs can arise because alliance’s efforts are divided between many firms. Influence costs can increase because if there are no formal hierarchy and administrative structure in an alliance, employees will try to increase their resources and have a better status by participating in influence activities (lobbying, etc.)


  • Collaborative relationships:

Subcontractor networks: especially in Japan, where producers have close long-term relationship with independent subcontractors. Those relations imply larger cooperation between the producer and the subcontractor and more responsibilities for the subcontractor.

Keiretsu: close to subcontractor networks. However, they imply more formal relations. For instance, keiretsus have generally core banks and members in important industries. Usually, each members of a keiretsu is the first choice of another keiretsu member in future business dealings.

Some of the characteristics are that management teams from businesses of a keiretsu go to the same lunch club and business events, members have important loan from their central bank and as much from other banks, etc.

  • Implicit contracts and long-term relationship: an implicit contract is an unstated understanding among parties in a business relationship that is usually not enforceable in court. Therefore, to make it viable, firms need to focus on different options. One option is the risk of losing future profit if one party breaks the implicit contract for its own advantage. For example, if firm 1 learned that firm 2 increased its profit at the expense of the other, both firm will have to do business with an alternative trading partner and would have lower profit than if firm 2 did not break the contract.

The net present value of not breaking the implicit contract is:

[(Profit per year when firm 2 does business with firm 1) – (Profit per year when firm 2 does business with its alternative partner)] / Firm’s discount rate

Chapter E: Competitors

Direct competitors: if firm 1 decreases the price of a good, firm 2 will need to react with a pricing response.

Indirect competitors: when the strategic decision of a firm affects the performance of the other, but only through the strategic decision of a third firm.

To identify competitors, it is necessary to start with market identification. In the case that a business compete in both input and output market, each market needs to be considered separately because competition can be different.

SSNIP Criterion: small (< 5%) but significant nontransitory (at least one year) increase in price. Antitrust agencies argue that all rivals in a market can be known if a merger among them would lead to SSNIP. The SSNIP criterion is usually unrealistic but it says that two firms directly compete if customers of firm 1 decide to make their purchases at firm 2 because of an increase in the price of firm 1. This leads to the notion of substitutes.

Substitutes: 2 products are substitutes if due to the increase of the price of good X (price of good Y do not change), purchases of X decrease and purchases of X increase. 3 conditions are needed for products to be close substitutes:

  • Same or similar product performance characteristics (what it does for consumers).

  • Same or similar occasions for use (when, where and how it is used).

  • Sold in the same geographic market (sold in same locations, it is not costly to transport the goods and it is not costly for consumers to travel to buy the goods).

Cross-price elasticity of demand: measure the percentage change in demand for good Y that results from a 1 percent change in the price of good X:

ηyx = (ΔQy / Qy) / (ΔPx / Px)


ηyx is positive: purchases of good Y go up because the price of good X increases. Here, X and Y are substitutes.

Geographic competitor identification:

First step: countries, city. However, we cannot say for example, that all supermarkets in a city/country compete with each other. Therefore, it is better to identify rivals by directly examining the flow of goods and services across geographic regions. For this, a firm can ask its customers where else they shop but to identify each competitor, the firm should find out where its customers live. If a lot of its customers live in the city where the firm is located, then the firm should list among its competitors selling the same good. But if some local residents buy the same good outside the city, the firm should ask the residents of the city and not just its own customers where they buy the same good than it offers. This is an example of “flow analysis”.

Here, problems with flow analysis are the following:

  • Few customers currently leave the city, but this does not imply that they would not leave if stores in the city were to raise their prices.

  • It is possible that many customers currently shop outside the city because the product line is not large or specialized enough.

Measuring market structure

Market structure: the number and distribution of firms in a market.

The N-firm concentration ratio is usually a common measure to determine the market structure by calculating the combined market share of the N largest firms in the market. However, a disadvantage is that the ratio does not change if the sizes of the largest firms in the market differ.

Another frequent measure of market structure that avoids this problem is the Herfindahl index. If Si represents the market share of firm i:

Herfindahl index = Σi(Si)²

The Herfindahl index in a market with N equal-size firms: 1/N.

Market structure and competition

Perfect competition:

  • Many sellers of a homogeneous good

  • Many well-informed consumers who costlessly shop around for the best price

Therefore, there is a single market price. This price is found at the interaction between all sellers and buyers.

However, no one can control this price and it involves that a firm will have no revenue if it sells at a higher price than the market price. In the opposite case, it will sacrifice revenue. Therefore, the firm has an infinitely elastic demand and its only decision to take is how much output should the firm produce and sell.

When marginal revenue equal marginal costs, the quantity of output maximizes the profit.

The percentage contribution margin (PCM) = (P-MC)/P

P = price and MC = marginal cost.

The condition for non-profit maximization: PCM = 1/η

In perfect competition, η = ∞ and the optimal PCM is 0.

When minimum two of the following conditions are obtained, market conditions will try to decrease prices (could be to marginal costs):

  • Many sellers

  • The product is seen as homogeneous by consumers

  • Excess capacity

Each of these 3 conditions is going to be examined more in details:

  1. Many sellers: it is not usual for more than a handful of sellers to increase prices much above costs for a long period. This is correct for the following reasons:

  • Preferences for different prices. If a producer has low costs, he could choose to have a low price even if PCM is high.

  • Consumers will buy less if prices raise and therefore, sellers need to decrease their quantity to support higher price.

  • Even with a cut in production, some producers will try to raise their quantity by decreasing their price (especially small firms because they see this as a chance to gain market shares). As a result, a small firm can have learning benefits and economies of scale that enable it to have a better competitive position in the long-run. Moreover, a small firm can also believe that a bigger competitor will not be able to see its price decrease because there a many sellers in the market.

  1. Homogeneous products: characteristics of the products are (almost) the same across firms and therefore, customers can easily switch to get a lower price.

A raise in sales due to a decrease in price can come from 3 sources:

  • Current customers buy more of the good because of the lower price.

  • Customers buy the good because of the lower price but would not buy it at its original price.

  • Customers who wanted to buy the good from a rival but purchase at that firm because of the lower price. This is the largest source of sales gain.

As a result, due to firms with lower prices, price competition increases and those firms can expect larger sales.

Examples of homogeneous goods: gold, graded wheat, DVD
Examples of non-homogeneous good: medical services

  1. Excess capacity: if a firm is producing at total capacity but expects to sell less, it can still steal business from its competitors by offering its products at a lower price. However, if the price is below average costs, should the firm still sell it? The answer is yes because the increase in revenue can be higher than the increase in total cost. (See example in the book). In the long run, due to competition, price could be below average cost and firms may decide to leave the industry rather than maintain long-run economic losses. However, if a firm capacity is industry specific (the capacity can only be utilized for a particular industry), then the firm will have no other option than staying in the industry until the firm cannot produce anymore (end of useful life) or until demand increases. If demand does not increase, the firm can meet excess capacity with prices below average costs.


Monopoly power: as Fischer explains: “the ability to act in an unconstrained way” (e.g., raise in price, decrease in quality)

Monopolist: firm that faces little or no competition in one of its output market. The analysis is based on the capacity to increase output prices.

Monopsonist: the same than monopolist but in its input markets instead than output market and the analysis is based on the decrease in input prices.

For a monopolist, if it increases its price, quantity decreases. However, it can put a price without regard to how competitors will react (≠ oligopolists).

A monopolist chooses a price for which the marginal revenue from the last unit sold equals the marginal cost of producing it and therefore, price in a competitive market would equal marginal cost.

Antitrust enforces say that high monopolist profits are a disadvantage for the consumers because there are only expensive limited outputs. However, Demsetz disagree with this. He affirms that monopoly profits do not always mean that consumers are worse off. Monopoly exists because a firm finds a better approach to produce something that serves consumers’ needs in a better way. Therefore, consumers who take advantage of such innovations, have usually a higher benefit than monopoly profits. As a result, firms will continue to innovate only if they can expect high profit, so controlling monopoly profit can finally make consumers worse off in the long run by reducing innovation.

Monopolistic competition distinguishes markets according to two characteristics:

  • Many sellers that believe that what they do will not materially affect others.

  • Differentiated products for which an increase in price does not mean a lost in all customers.

Vertical differentiation: when it is unambiguously better or worse than competing products.

Horizontally differentiation: when only some consumers prefer a product to competing product (holding price equal).

The main source is “idiosyncratic preferences”, which means that tastes differ from one person to another. Geography is also very significant here because consumers want to make their purchases in locations near their house. To choose its shop, a consumer takes into account prices and the costs of travelling to each store (gasoline, time, etc.). Therefore, an increase in price does not mean a lost in all customers as some people are unwilling to travel. Furthermore, the degree of horizontal differentiation depends on search costs (is it easy or not to get information about alternative). Lower price and less profit following a decrease in horizontal differentiation are the results of low search costs because consumers have low “idiosyncratic preferences”.

Example of highly idiosyncratic preferences, resulting as high search costs: Physician’s services. Usually, because of insurance, patients are not really concerned about the price, but they believe that experience and access to specific specialists and hospitals are important. Looking for information can be difficult. Therefore, patients can ask their friends and family about their own experience with a particular physician. As a consequence, loyalty depends on the experience and even if a physician increases its price, he will not loose patients and can continue to have a higher price only if patients have idiosyncratic preferences.

Oligopoly: a market that is materially affected by the acts of individual firms. Usually, when there are only few sellers in the market, price and production strategies of any firm in the market will affect the decision of price and quantity of competitors.

Cournot quantity of competition: market with only two firms producing the same good with an identical price. First, firms choose the quantity. However, the market price (depending on total quantity) is important when choosing quantity and represents the price at which consumers want to buy the total production Q1 + Q2 and allows both firms to sell all their output. Therefore, the quantity that firm 1 produces depends on the expected production level of firm 2. As a result, each firm tries to guess the quantity that the other firm will produce when setting its own production level. Furthermore, because both firms are committed to production, their incremental costs are zero.

Firm 1’s best response to firm 2: profit-maximizing value of Q1.

Only one pair of output is simultaneously the best response to each other. These outputs are the intersection of both firms’ reaction functions.

Important consequence of the Cournot model: industrial profit is not maximized with the output found under Cournot. By independently maximizing their own profits, firm will produce more and have a higher profit but maximizing its own profit does not maximize the industry profits as a whole.

Bertrand price competition: a market in which each firm selects a price and meets all the demand for its product at that price. Each firm selects a price to maximize its own profits, given the price that it believes the other firm will select. Each firm also believes that its pricing practices will not affect the pricing of its rival; each firm views its rival’s price as fixed.

The Bertrand price is the best price that firms could set (lower price induces decrease of profit and higher price induces nothing sold)

Why are Cournot and Bertrand different?

  1. Different time frames.

  2. Different assumptions about expected reactions of their rivals on their own competitive moves.



Market in which firms must make production decisions in advance, are committed to selling all of their output

Market in which capacity is sufficient flexible that firms can meet all the demand that arises at the price they announce

Believe that competitors will keep their sales equal to their planned production volumes

All increase in sales will come through business stealing

Cannot expect to steal customers from its rivals if a firm lowers its price

If products are perfect substitutes, then competitors expect to steal customers from its rival through a small cut price

Competitors must suffer a substantial revenue destruction effect if they are to expend output

No revenue destruction effect that makes growth through price reductions a very attractive option

Price are charged less aggressively

Price are charged more aggressively

Example of a Bertrand model:

Situation: business downturns, excess capacity for airlines (undifferentiated products), search costs are low.

Conclusion: each airline can lower its price and steal business to its competitors to empty seats. As this is a price competition, the industry makes important losses.

Example of Cournot model:

Situation: boom time, airlines operate near capacity, little incentive to lower price.

Conclusion: airlines cannot steal business to competitor because they already have few empty seats. As this competition is based on capacity, it enables the airlines to reap considerable profits.

Bertrand price competition when products are horizontally differentiated:

Most of the customers are still loyal if another firm decreases its price or if the current firm increases its prices, and therefore, it is difficult to steal business.

Chapter F: Strategic commitment

Strategic commitment: decisions that have long-term impacts and are difficult to reverse (investing in new capacity, introducing new products). Strategic commitments can considerably influence competition in an industry.

It is important to make a difference between strategic commitments and tactical decisions. Tactical decisions are more or less the opposite of strategic commitments (impact in the short-run and easy to reverse) and can be adapted to each circumstance a business currently faces. Tactical decisions are the following: setting a price, quantity to produce in a given quarter.

Why commitment is important?

3 characteristics for a commitment to have the desired response from its rivals:

  • It must be visible

  • It must be understandable

  • It must be credible

Credibility is very important because large investments to create relationship-specific assets have high commitment value that makes them difficult to use for something else once the assets have been created. However, publicly announcements in the press for instance is to easy and not really credible because a firm does not need to invest something but it can be credible only if it is obvious that the reputation of the firm or its corporate management will be worse off if the firm does not do what it has said it will do.

Example of credibility: start to build a new plant if the firm announces to expand its capacity.

Contract with specific clause (MFCC = most favored customer clause) can simplify commitment. If a buyer has such a clause, he has the right to have the same price than other customers. That means that if a seller lowers its price for some customers (e.g., to steal a customer from a rival), the buyer with a MFCC has the right to ask the same discount. Therefore, MFCC can be seen as a credible commitment as it makes discounting expensive.

Strategic complement: Firm 1 and 2 are strategic complements if firm 2 decreases its price because firm 1 announces a massive cut in its price (reaction functions are upward sloping). For example: price in the Bertrand model

Strategic substitutes: Firm 1 and 2’ production volumes are strategic substitutes if firm 2 decreases its production because firm 1 increases its production, driving down prices to a percentage below current level (reaction functions are downward sloping). For example: quantities in the Cournot model.

Direct effect of a commitment: impact on the present value of the firm’s profit, assuming that the behavior of the rivals stays the same and that the firm adjusts its own tactical choices.

Strategic effect of the commitment: can be positive or negative and takes into account the competitive side effects of the commitment.

Though commitment: bad for competitors

Soft commitment: good for competitors.

Though commitment in Cournot: the firm making a though commitment will always produce more than without the commitment. The quantity that the other firm produces is not important.

  • Example of though commitment in Cournot: adoption of a process innovation that reduced the marginal cost of production of a firm (rightward shift in firm 1’s reaction curve).

Soft commitment in Cournot: the firm will produce less than without the commitment.

  • Example of a soft commitment in Cournot: firm 1, in addition of its current production under the Cournot market, has the opportunity to sell the same good as a monopolist in a second, geographically distinct, market. Suppose that the marginal cost of production increases as the firm produces more output overall (diseconomies of scale). The decision to enter the monopoly market would be a soft commitment. By making that decision, firm 1 would cause its marginal cost in the Cournot market to increase, and as a result, it would reduce its profit-maximizing output level for any given output expected from firm 2 (leftward shift in firm 1’s reaction curve).

Though commitment in Bertrand: the firm that makes the commitment will have a lower price than without the commitment. The price that the other firm sets has no importance

Soft commitment in Bertrand: the firm will have a higher price than without the commitment

  • Example of a soft commitment in Bertrand: direct and strategic effects of repositioning firm 1’s product to appeal to a narrower segment of the market in which consumers have more specialized tastes (rightward shift in firm 1’s reaction curve). Negative direct effect and positive strategic effect.

We can therefore see that the effects between Cournot and Bertrand are opposite.

Beneficial strategic effect on the firm making the commitment: when entrants and competitors act less aggressively

Harmful strategic effect: when entrants or competitors act more aggressively.

In conclusion, the strategic effect depends on the model (Cournot or Bertrand), how aggressively does competitor and entrant respond; but it can also depend on capacity utilization rates in the industry, and on the degree of horizontal differentiation among the firm making the commitment and its competitors (effect is larger with less differentiated products – see figure 7.6).

Flexibility and real options:

There are always uncertainty conditions (market conditions, costs, etc.) when strategic commitments are made. To be protected against flexibility, it exist several possibilities:

  • Modifications of the commitment when future conditions change (e.g., instead of building a large plant, build a smaller plant or even abandon the capacity expansion).

  • Wait for a better idea of profitability before making the commitment (e.g., waiting for the results of test marketing studies before launching a new product).

  • Decide to undertake an unprofitable commitment today in order to preserve the option of making a follow-on commitment in the future (e.g., a software firm may begin selling a new applications software today, even though it is likely to be unprofitable, because by selling the software today, it preserves the option to sell an improved version of the software several years from now).


Flexibility gives rise to real options. A real option exists when a decision maker has the opportunity to wait because some information will be received in the future. Example of real option: Airbus and Boeing offer airlines customers, the option of cancelling or downsizing orders. Airlines exercise these options when the demand for airlines’ service falls.

Advantage of waiting: allows the firm to take the right decision and avoid an investment mistake (e.g., investing in a new plant when demand is low).

Disadvantage of waiting: risk that a competitor takes the market opportunity and that the firm that wanted to enter would not be able to enter anymore in the market.

Chapter G: Pricing rivalry

Dynamic pricing rivalry: Bertrand and Cournot models are static rather than dynamic because all firms in each model simultaneously make once-and-for-all quantity or price selections. Production levels are based on the quantity that rivals chose in the previous move. Furthermore, a firm will choose quantity that maximizes the present value of its own profit over the entire time horizon and will need for this to predict what its competitors will do in the future and not based its decision only on the past. Therefore, Bertrand and Cournot models are not dynamic.

Colluding: firms that agree together to set a price above the Bertrand/competitive level. In most developed countries, colluding is illegal.

Cooperative pricing: situations in which firms can maintain prices in excess of those that would arise in situations such as Cournot or Bertrand.

Tit-for-tat strategy: in a tit-for-tat strategy, prices can often be different. For example, if firm 2 raises its price, firm 1 will try to let its original price, so that it can have 100% of the market but when firm 2 will learn that firm 1 did not follow its price strategy, it will put its price back to the original level and both firm will have 50% of the market as before. The conclusion is that if firm 1 had increased its price, both firms would have been better off in the future and have higher profit, even if firm 1 captured 100% of the market for one period.

Tit-for-tat pricing with many firms:

Π0 = per-period industry profit at a prevailing price P0

ΠM = the industry’s profit when all firms charge the monopoly price PM

The industry as all whole would be better off at the monopoly price than at the prevailing price P0, so, Π0 < ΠM.


  • N firms in the industry that face a prisoner’s dilemma

  • (N-1) Firms raise their price from P0 to PM

  • One individual firm decides to keep its price to P0


The individual firm will have a higher profit. Its gains for one period is Π0 – (1/N) * ΠM.

If now, firms are competitors and they discount future profits with a discount rate of i per period and if each firm supposes that its rivals will increase the price from P0 to PM in the current period and after that they will follow a tit-for-tat strategy, then each firm will have the incentive to increase it price to the monopoly price as long as:

Benefit-cost ratio = [(1/N) * (ΠM – Π0)] / [Π0 – (1/N) * ΠM] ≥ i

The folk theorem: if discount rates are low, any price between the marginal cost and the monopoly price can be sustained as an equilibrium in the infinitely repeated prisoners’ dilemma game.

Grim trigger strategy: firms will set the monopoly price and in each future period, if a firm changes its price, other firms will decrease their price to marginal cost in the next period and keep it there forever. This strategy suggests an infinite price war to avoid firms lowing their prices.


  • A firm believes a competitor is setting one price when it is actually setting another.

  • A firm misunderstands the reasons of a competitor’s pricing decision.

How market structure affects the sustainability of cooperative pricing:

Which market structure conditions can make cooperative pricing and competitive stability easier or more difficult?

  • Market concentration

  • Structural conditions that affect reaction speeds and detection lags

  • Asymmetries among firms

  • Price sensitivity of buyers

Market concentration and the sustainability of cooperative pricing: the benefit-cost ratio increases when the number of firm decreases.

As a result, cooperative pricing is more likely to be reached in a concentrated market (few firms) than in a fragmented market (many firms).

Relation between concentration, sustainability and destruction effect: When a firm wants to increase its market shares by stealing customers, it has to decrease its price for all customers and therefore, will certainly loose revenue in order to gain new customers. When there are few sellers, a firm’s market share and revenue destruction effect is bigger than when there are many sellers. Simultaneously, there are less prospective new customers leading to a decrease in the potential gains from price cutting (when they are few sellers).

Reaction speed, detection lags, and sustainability of cooperative pricing: a firm may not be able to respond rapidly to its competitors’ pricing moves because of 4 reasons:

  • Lags in detecting competitors’ prices

  • Infrequent interactions with competitors

  • Ambiguities in identifying which firms among a group of firms in a market is cutting price

  • Difficulties distinguishing drops in volume due to price cutting by rivals from drops in volume due to unanticipated decreases in market demand

Those factors are influenced by many structural conditions:

  • Lumpiness of orders: decrease the frequency of competitive interactions among firms and imply that price becomes more attractive for individual firms and intensify price competition.

  • Information about sales transactions: retaliation can occur faster when prices are public than when they are secret, leading to less attractiveness to steal market share by lowering price.

Secrecy becomes a very important problem when transactions imply other dimensions besides a list or an invoice price.

Deviations from cooperative pricing are also hard to determine because sometimes, product characteristics are tailor-made to individual buyers and therefore, the seller is able to raise its market share by changing the design of the product or by throwing in “extras” as a service agreement.

  • The number of buyers: it is easier to detect deviations from cooperative pricing when each firm sells to many small buyers rather than few large buyers because a potential consumer that obtains a lower price from one seller will usually inform other sellers, expecting to obtain even a better price. Therefore, the number of buyers can severely influence the detection of secret price cuts.

Probability that competitors will learn about at least one of these price cut: 1 – (X) A

X = probability that rivals do not learn of any price cut

A = number of customers who get a “secret” discount

  • Volatility of demand and cost conditions: price cutting is more difficult to be detected when market demand conditions are volatile. Demand volatility is an important issue when a firm knows only about its own price and volume because if the sales of a firm decrease, it would not be able to say if it is because of a decrease in market demand or if it is because a competitor has decreased its price.

Asymmetries among firms and the sustainability of cooperative prices:

It is more difficult to achieve cooperative pricing when firms are not the same.

Distinctions in capacity, quality or costs generate asymmetric incentives for firms to consent on cooperative pricing. For instance, small firms in an industry have more incentives to differ from cooperative pricing than large firms. The 2 reasons are the following:

  • Larger firms gain more from the move toward the cooperating price

  • Small firms expect not to be punished by larger firms.

When should a firm let a rival to sell a good at a lower price than it sets and when should it match a price cut by a rival or a newcomer? By allowing firm 2 to sell at a lower price that it charges, firm 1 would be extending a price umbrella to firm 2 and the price umbrella is optimal when:

α < β / PCM

In other words, “not matching” is optimal when firm 1 expects to lose less than β / PCM (in percent) of it business to firm 2.

β = the percentage of price cut

PCM = (P – C) / P = the percentage contribution margin of the large firm

α = the lost of business to competitor

Smaller firm have one more incentive to decrease price on products for which buyers make repeat purchases (usually most consumer goods).

As most consumers are loyal to those products, a small firm can lower its price to attract new consumers and believing that if it put its price at the original level, consumers who tried its products will become permanent consumers. Only if there is a lag between the small firm’s price decrease and any response by its larger rivals, this strategy will be successful.

Price sensibility of buyers and the sustainability of cooperative pricing:

When buyers are price sensitive, even a small decrease in price can significantly increase the quantity and the market share, and lead to a small revenue destruction effect relative to the additional revenue generated from new sales.

Facilitating practices:

Firms can also make cooperative pricing easier by themselves:

  • Price leadership: an approach to overcome the problem of coordinating on a focal equilibrium. In price leadership, each firm gives up its pricing autonomy and gives control over industry pricing to a single firm. Firms, thus, do not need to worry that competitor will steal market share.

  • Advance announcement of price changes: sometimes, firms announce the price they are going to set in the future. This seems to be an advantage for consumers; however, it can also lead to price increases at the disadvantage of consumers because this kind of announcements decreases the uncertainty that competitors will decrease their price.

  • Most favored customers clauses (MFCC): provision in a sales contract that assures a buyer that it will pay the lowest price the seller sets. Usually, most of the MFCC benefit buyers. There are 2 basic types:

Contemporaneous MFCC: the seller agrees that if it decreases the price of the product for other buyers, it will also decrease the price by the same amount for this particular buyer. This is only valid when the contract is not expired.

Retroactive MFCC: the contract involves a period (e.g., 2 years) after expiration for which the seller cannot “really” decreases the price (paid by the buyer) of the product stipulated in the contract. However, if the seller still decreases the price of the specific product, he will have to pay back the difference in price to the buyer.

  • Uniform delivered prices:

FOB pricing: the buyer absorbs delivering price. Therefore, when prices are reduced to attract consumers, there are reduced for all consumers, even current customers.

Uniform delivered pricing: single delivered price absorbed by the firm. Therefore, when prices are reduced, it is possible to reduce prices only for consumers the firm wants to attract, by reducing delivery price only.

Quality competition: Consumer decisions and firms strategies are not only based on price but also on product attributes such as durability and performance. However, to attain a better quality, costs increase. One way to cover those costs are by increasing price but this is restricted by the willingness of consumers to abandon the product category altogether. A good measure is the industry price elasticity of demand: if the elasticity is low, the firm can increase prices to cover the costs without driving away customers.

Quality choice of competitive market: When products are vertically differentiated, it is easier to say which products we prefer even with different quality and different prices. However, the market will oblige firms to charge identical price per unit of quality in a way that every consumer will be able to evaluate quality of every producer. If this is not possible, producers who have a higher price for a given quantity can take advantage because he still will have consumers.

To be able to evaluate quality correctly, a buyer needs information. However, information can be expensive but an uninformed buyer can judge the quality by observing informed buyers. For instance, an uninformed buyer can evaluate the quality of a car by observing the number of people driving this specific car.

Lemon market: low-quality products with high price

  • Uninformed buyers

  • Low-quality products are cheaper to make than high-quality products

Sometimes, only quality of some attributes of a product can be observed and evaluate (diplomas of lawyers and doctors, external appearance of shops, etc.).

If consumers are not able to evaluate quality, producers can set a high price for poor quality products.

As consumers know that sellers understand that they are uninformed, they may anticipate the low quality and ask to pay less and this is a problem for “real” high-quality products. Therefore, sellers of high-quality products should demonstrate their quality. The different ways to demonstrate quality are the following: money-back guarantees, review in independent consumer magazines, reputation, advertisement.

Moreover, another problem is underinvestment in information gathering. Consumers who invest in information searches can finally spend a lot without extra benefits compared to uninformed consumers. This occurs because uninformed consumers can determined information they need by observing informed consumers behavior.

Quality choices of sellers with market power: quality is an important tool that influences the demand of products coming from sellers with market power. As a result, higher quality means higher demand.

The marginal cost of increasing quality: the idea that it is costly to improve quality contrasts with the literature on continuous quality improvement. Consistent with the principles of continuous quality improvement, improvements in the production process can at the same time decrease costs and enhance quality.

The marginal benefit of improving quality: more consumers want to buy a product when its quality is improved, but the increase of revenue depends on 2 factors:

  • The increase in demand caused by the increase in quality

  • The incremental profit earned on each additional unit sold

On which kind of consumers should the firm focus to take it decision:

  • Inframaginal customers (loyal customers): the firm should not pay attention to them because they will still buy the product.

  • Marginal customers (indifferent to buy from that firm or another): the firm needs to pay attention to those customers because they would not be indifferent anymore if the firm offers a better quality.

However, an increase in quality does not necessarily mean more new customers. Increasing the number of new customers involves 2 more conditions:

  • There are more marginal customers

  • Marginal customers are able to determine that quality has, in fact, increase

Chapter H: Entries and exits

Early adopter: buyer willing to pay a high price for new technology

Threats from entrants:

  • Decrease in market share of incumbents firms

  • Competition increases and price decreases


  • A new firm

  • A firm that is already active in other market but wants to diversify

This difference is significant because being a new firm or being already active means different costs and different strategic responses.

Exit: removing a product from a market. The firm that removes its product has then 2 possibilities: operate in other markets or shut down completely.

Entry and exit have 4 significant implications for strategy:

  • When planning for the future, the manager must predict unknown competitors (the entrant).

  • Not many diversifying competitors will build new plants but the size of their plants can make them a serious threat.

  • Managers should expect most new ventures to fail quickly.

  • Managers should know the entry and exit conditions of their industry.

Entry and exit decisions: Basic concepts:

Barriers to entry:

Structural entry barriers: when the incumbent has a natural cost, marketing advantages, or benefits from favorable regulations.

Strategic entry barriers: when the incumbent deters entry aggressively

3 entry conditions:

  • Blockaded entry: the incumbent does not need to do something to deter entry because structural barriers are already so high (e.g. production may require large fixed investments).

  • Accommodated entry: the incumbent should do nothing because the costs of trying to deter entry are superior to the benefits it could gain from keeping the entrant out (e.g., market with growing demand or rapid technological improvements).

  • Deterred entry: use of an entry-deterring strategy that will let the entrant out and increase the profits of the incumbents. Also called predatory acts.

Analyzing entry conditions: the asymmetry requirement:

What distinguishes incumbents from entrants?

The asymmetry between incumbent firms and entrants arises with:

  • Sunk costs (entrants have not incurred their sunk costs).

  • Relationships with customers and suppliers (take years).

  • Moves of the incumbents on the learning curve

  • Higher costs for consumers to switch from one producer to another.

Structural entry barriers:

There are 3 main types of structural entry barriers:

  • Control of essential resources

  • Economies of scale and scope

  • Marketing advantage of incumbency

  1. Control of essential resources: when a useful resource for production is used in a better way by an incumbent than by an entrant and if the incumbent control this resource, an incumbent is protected by entry. Moreover, asymmetries increase because of accumulated knowledge, investments in technology, trade relationships, and brand identities. Therefore, firms should obtain the most important input to gain monopoly status. Nevertheless, this approach suggests some problems:

  2. Just when a firm thinks that it has tied up existing supplies, new input sources can emerge.

  3. Owners of scarce resources may hold out for high prices before selling to the would-be monopolist.

Patents: firms who want to use the process or make the products must ask the permission to the patent holder. However, patents face many problems: vary by country, could be very weak in some countries, can often be “invented around” (patent offices cannot always make a difference between new product and imitation)

However, some firms do no need to secure specialized know-how. Coca-Cola has guarded its cola syrup formula for a long time. But finally, firms may turn to the legally and ethically questionable practice of industrial espionage to steal such information.

  1. Economies of scale and scope: with important economies of scale, incumbent firms that operate at or beyond the minimum efficient scale (MES) will have a significant cost advantage over small newcomers (See figure 9.1 page 294).

The entrant can try to have a cost advantage over the incumbent by increasing its market share (e.g., investing in heavy advertisement). However, this supposes 2 costs:

  • Direct cost of advertisement and creating the sales force

  • If the entrant increases its shares, the incumbent will not leave the market easily and quickly because most of its costs are sunk. With an increase in industry output, price will fall and the entrant faces an impasse: to overcome its cost disadvantage, it will have to raise its market share, but with an increase in share, price competition may intensify.

Incumbents can also have a cost advantage from economies of scope (e.g., in the cereal industry). Important amounts spend in advertising, that the new entrant needs to establish an acceptable level of brand awareness, also allow economies of scope. In conclusion, entrants need an important amount of capital in a risky environment.

  1. Marketing advantages of incumbency: umbrella branding: a firm sells different products under the same brand name (economies of scope). When an incumbent want to introduce a new product, it can use the same brand than its other products.

Advantages of umbrella branding: offset uncertainty about the quality, less sunk costs, better negotiation position in the vertical chain and raise expected profits of new product launch.

Disadvantage: increase in risk (failure of the new product will result in brand reputation problems)

Barriers to exit: the production is stopped and assets are sold or redeployed.

However, before deciding to stop production, a firm should compare the value of its assets if deployed in their best alternative use against the present value from remaining in the market. (see figure 9.2 page 295).

If Pexit < Pentry , the firm stays in the market but price are below long run average costs. Therefore, exit barriers are often seen has high and negative:

  • Sunk costs: obligations of a firm when it stops production (labor agreements, commitment to purchase raw materials) make the marginal cost of staying in the market low and exit becomes less attractive.

  • Relationship-specific productive assets: low resale value

  • Government restrictions

Entry-deterring strategies:

Entry-deterring strategies are worthwhile only if 2 conditions are met:

  • The incumbent earns higher profits as a monopolist than it does as a duopolist.

  • The strategy changes entrant’s expectations about the nature of post-entry competition.

Apparently, a firm is always better of as a monopolist as it can charge prices higher than average cost. If a monopolist cannot increase its above long-run average cost, the market is perfectly contestable. The key requirement for contestability is hit-and-run entry.

Hit-and-run: enter the market with low price to have short-term profit and then exit the market. In a hit-and-run strategy, price should be high enough and time long enough to recover entry sunk costs.

If the market of the incumbent monopolist is not perfectly contestable, the incumbent by maintaining entrants outside its market can expect to have extra profits by 3 different approaches:

  • Limit pricing

  • Predatory pricing

  • Capacity expansion

Limit pricing: the incumbent firm sets a low price before entry trying to discourage entrants.

2 kinds of limit pricing:

  • Contestable limit pricing: the incumbent has excess capacity and a marginal cost advantage over entrants. The price is charged just below the marginal costs of entrants.

  • Strategic limit pricing: the incumbent has limited capacity or increasing marginal costs and the price is charged just below the marginal costs of entrants. Here, the incumbent cannot meet all demand or it will have to sacrifice profits to do so but the incumbent can still set a low price to deter entry.

Is strategic limit pricing rational?

Problems with strategic limit pricing:

  • The incumbent will have maybe to put its limit price indefinitely because there are still potential entrants. Therefore, a Cournot duopolist depending on costs and demands can be a better situation for the incumbent.

  • The incumbent can influence the expectations of the newcomer about the nature of post-entry competition. 2 situations that the entrant should predict in case of lower price from the incumbent :

    • Entrant does not enter the market: incumbent increases its price to the monopoly price

    • Entrant enters the market: incumbent increases its price to the Cournot price.

As a result limit pricing strategy fails because even if the incumbent decreases its price to discourage entry, price cannot be low forever and the entrant should know that.

Predatory pricing: a large incumbent charges a low price to put competitors out of the market and deter future competition. However, in a predatory pricing strategy, the incumbent makes losses but expects that those losses can be made up later through future monopoly profits.

The chain-store paradox: many firms are seen as firms that decrease their price to deter entry even if predator pricing strategy seems to be irrational.

Rescuing limit pricing and predation: the importance of uncertainty and reputation: despite that limit pricing and predatory pricing are irrational strategies, firms continue to pursue them. An explanation is that firms set prices irrationally. A most probable other explanation is that firms are rational but analysis does not have the essential elements of their strategies.

Games theorists have demonstrated that predatory actions can actually be profitable if incumbents know about their own costs or market demand that entrants lack. Thus, uncertainty and asymmetry make predation rational. The theory says that the incumbent should do in sort that it makes the entrant believe that post-entry prices low. Then, it follows 2 situations:

  • The entrant knows about how to determine post-entry price: analyze all scenarios and forecast the post-entry price correctly.

  • The entrant does not know how to determine post-entry price: the incumbent can affect the expectations of the entrants. Usually, limit price indicates that incumbent’s costs and/or market demand are low.

Though firms: firms that have low costs or do not like competition. They can sacrifice profit as they absolutely want to stay a monopolist. Fershtman and Judd propose that a firm can reward managers based on market share rather than profits. As a result, it could motivate managers to price aggressively in a way that increase profit and the reputation of the firm for toughness.

Capacity expansion: several firms carry excess capacity for many reasons:

  • Economical to add capacity only in large increments.

  • Decrease in demand for a single firm

  • Results from market forces

  • Strategic purposes: can influence the decision to enter or not because excess capacity of the incumbent represents sunk costs and the incumbent can expand its outputs at a lower cost. If the incumbent expands its outputs at a lower price, this will reduce the post-entry profit of the newcomer. If post-entry profit of the newcomer is less than its sunk costs of entry, it should not enter the market.

How can a firm deter entry by holding excess capacity? (Lieberman)

  • The incumbents should have a sustainable cost advantage (advantage in the event of entry and a subsequent price war).

  • Market demand growth is slow.

  • The investment in excess capacity must be sunk before entry.

  • The potential newcomer should not itself be attempting to establish a reputation for toughness.

Judo Economics”: Sometimes, the size of the incumbent can be used by smaller firms and potential entrants to their own advantage.

Puppy-Dog Ploy”: to deter entry, an incumbent can decrease its price that affects its own profit. When the incumbent has high volume, it may loose more than the entrant and should think before reducing its price, especially if the entrant is not a big long-term threat. Reducing price for such threat can lead to consequent losses for the incumbent; even more than if it allows the entry.

Exit-promoting strategies: it happens that sometimes, firms protest against predatory pricing by larger rivals by suggesting that consumers are going to be worse off if the incumbent sets low prices as it will lead in the future to domination of the market by the incumbent who will raise its prices to monopoly prices.

Wars of attrition: two or more parties expend resources battling with each other. For example, price wars. A price war hurts every firm in the market (especially large firms). In war of attrition, the loser even regrets participating as he got nothing anymore. For the winner, if the war was long (that no firms exit in the early stages), it is possible that the benefit of the winner is smaller than the war costs. However, the winner can then raise prices above the prewar level. Therefore, firms may ask themselves if they can survive. If no, it should directly exit. The conclusion is that even if there is a winner, all firms would have been better off without war of attrition, even the survivor.

Evidence of entry-deterring behavior: the major source on entry deterrence is antitrust cases. The main reasons are:

  • Firms are unwilling to say that they deter entry as this can be sensitive, competitive information and might also violate antitrust statutes.

  • Many entry-deterring strategies involve pricing below the short-term monopoly price. To know if a firm applies such strategy, it is necessarily to know the following: marginal cost and demand curve of the firm, the degree of industry competition, and the availability of substitutes.

  • The rate of entry without the predatory act needs to be known to allow the measure of the success of an entry-deterring strategy.

Chapter I: Industry analysis

Five-forces framework (Porter): analyze the economic factors that affect the profit of an industry. The five forces are the following:

  • Internal rivalry

  • Entry

  • Substitutes and complement products

  • Supplier power

  • Buyer power

Brandenberger and Nalebuff make an important extra contribution to this framework by describing the firm’s “Value Net” (suppliers, distributors, and competitors). However, the difference is that Brandenberger and Nalebuff see suppliers, distributors, and competitors as a source of profit increase and Porter as a firm’s profit destruction. Therefore, strategic analysis should take into account both cooperation and competition.

Limitation of the five-forces framework:

  • It pays little attention to factors that can affect demand (e.g., consumers’ income and tastes).

  • It focuses on a whole industry rather than on industry’s individual firms.

  • The role of the government is explicitly taken into account only when the government plays a major role (buyer or supplier).

  • The analysis is qualitative.

Internal rivalry: competition for share by firms within a market.

The first step of internal rivalry analysis is defining the market.

The incentives that a firm wants to decreases its price depend on its expectation to increase its market share. Therefore, here are the conditions that tend to heat up price competition:

  • Many sellers in the market (prices are lower)

  • The industry is stagnant or declining (cannot easily expand their outputs without stealing from competitors)

  • Different costs

  • Excess capacity (can rapidly expand output to steal business from rival)

  • Products are undifferentiated/buyers have low switching costs (undercut rivals’ price because this can generate a substantial increase in market share)

  • Prices and terms of sales are unobservable/prices cannot be adjusted quickly

  • Large/infrequent sales orders (undercut to secure a particularly large order)

  • Industry does not use “facilitating practice” or have a history of cooperative pricing

  • Strong exit barriers (can prolong price wars as firms struggle to survive instead of existing)

  • High industry price elasticity demand

Entry: entry affects incumbents’ profits by dividing market demand between sellers and by reducing market concentration and heating up internal rivalry.

The following conditions tend to influence the threat of entry:

  • Production entails significant economies of scale – minimum efficient scale is large relative to the size of the market (entrant must reach a substantial market share to achieve a minimum efficient scale, otherwise, cost disadvantage)

  • Government protection of incumbents

  • Consumers highly value reputation / consumers are brand loyal (entrants must invest heavily for strong reputation and brand awareness. Diversifying entrants using a brand umbrella can be more successful)

  • Access of entrants to essential inputs, including raw materials, technological know-how, distribution, and locations (patents or unique locations can be barriers to entry; it may be more profitable for an incumbent to sell its patent, location, etc.)

  • Experience curve

  • Network externalities

  • Expectations about post-entry competition

Substitute and complementary products: substitutes threaten profit in the same way as entrants. Complements increase the demand for the product and therefore increase profit opportunities for the industry. Factors to take into account when analyzing substitutes and complements are:

  • Availability of close substitutes and/or complements (product performance characteristics)

  • Price-value characteristics of substitutes/complements (if the price is too high, complement may fail to boost demand and close substitutes may pose little threat)

  • Price elasticity of industry demand (when industry-level price elasticity is large, rising the industry prices tend to drive consumers to purchase substitutes’ products.)

Supplier power: downstream industry and analyze the aptitudes of that industry’s upstream input suppliers to negotiate prices that profit to the industry.

Indirect power”: in a competitive market, when suppliers can sell their services to the highest bidder. The price they set depends on the supply and demand in the upstream market.

Direct power”: when a supplier can increase prices when its target market is faring well, and thus extracting a share of its customers’ profit.

Buying power: capacity of individual customers to negotiate purchase prices, taking some profits from sellers.

Indirect power”: competitive market, price depends on the force of the demand and supply.

Direct power”: when concentration of buyers or relationship-specific investment from sellers.

When analyzing supplier and buyer power, the following features need to be taken into account: (here, in terms of supplier power relative to the downstream industry that it sells to, an analogous factor must be assessed when considering buyer power):

  • Competitiveness of the input market

  • The relative concentration of the industry in question, its upstream, and its downstream industries

  • Purchase volume of downstream firms (larger purchases with better service and lower price)

  • Availability of substitute inputs (limits the price that suppliers charge)

  • Relationship-specific investments by the industry and its suppliers

  • Threat of forward integration by suppliers

  • Suppliers can discriminate prices

Coopetition and the value net:

Brandenberger and Nalebuff suggest that all others firms are not always competitors but their positive interactions can sometimes increase profits (those interactions are ignored by Porter).

Example of positive interactions:

  • Efforts by competitors to set technology standards that facilitate industry growth

  • Efforts by competitors to promote favorable regulations or legislations

  • Cooperation among firms and their suppliers to improve product quality to boost demand

  • Cooperation among firms and their suppliers to improve productive efficiency

Difference between the Value Net and the five-forces framework:

Five-forces analysis: assesses threats to profits

Value Net: assesses opportunities

Conclusion: a five-forces analysis should consider both threats and opportunities for each force.

Chapter J: Strategic positioning for competitive advantage

Competitive advantage: when a firm earns a higher rate of economic profit than the average rate of economic profit of other firms competing in the same market. A firm will have a competitive advantage if it creates and offers more economic value than its competitors.

Consumer surplus: the extent by which a consumer is better off. For instance, a consumer wants to buy a specific product that is worth $150 for him. If its market price is $80, he would buy it, so the consumer surplus is 150 – 80 = $70.

Which products will a consumer buy?

  • Products for which the consumers surplus is positive

  • The product with the largest consumer surplus

Therefore, it is important for sellers to deliver consumer surplus successfully. See figure 11.6 page 353 (the products below the indifference curve give higher value and above the indifference curve lower value).

Maximum willingness-to-pay: when the situation after purchase (purchase but less wealth) equals the situation before purchase (no purchase but wealth intact). The amount paid for the good represents the consumer’s maximum willingness-to-pay for the good: it represents the amount that a consumer wants to pay that will let the initial situation equal to the situation after purchase. In the previous example, the maximum willingness-to-pay is $150.

For an intermediate good that is used as an input in the production of a finished product, the maximum willingness-to-pay depends on the cost economics of the intermediate good and the cost economics of the alternative. If the price of the intermediate good is higher than the price of the alternative, the firm would save money by switching to the alternative. However, a change in the price of the alternative (for example, increase in price) will change the maximum willingness-to-pay for the firm.

Consumer surplus parity: when firms are offering to a consumer the same amount of consumer surplus (products are on the same indifference curve).

Same preferences: market share will be stable because consumers will not switch from one seller to another.

Same quality: each firm sets the same price

Value-created (economic value created): inputs and purchases components are mixed in order to introduce a product whose the perceived benefit B is greater that the cost C.

Value created = Consumer surplus + Producer surplus

= (B – P) + (P – C)

= B – C

Value creation and “win-win” business opportunities:

B – C < 0: consumers do not want to pay the minimum price that would able the firm to cover its costs of resources needed to make the product and therefore, it will be impossible for the firm to make a profit.

Some products used to have a B – C > 0 but because of changes in tastes and technology, the value created becomes negative and therefore, those products do not justify production anymore.

When B > C, it is always possible for an entrepreneur to strike a win-win deals with input suppliers and consumers that allow both parties to be better off than without the deal. Those win-win trade opportunities are called “gains from trade”.

Value creation and competitive advantage:

B – C > 0 is a necessary condition but it does not guarantee positive profits (e.g., easy market entry). The firm should also generate a higher B – C than its rival.

What’s happening if firms offer almost the same economic value in a market with low barriers? Competition will increase and price will fall to the point at which sellers will have a zero profit (P = C) and consumers will have the entire economic value created. However, in such competitive market, a firm can still earn positive profit but for this, the firm needs to provide a higher economic value than its rivals. So, one firm will capture all the business in the market and other firms will have a profit of zero.

Value creation and the value chain: Value is created as goods move along the vertical chain (value chain). Each activity in the value chain can add benefits B or costs C to the product.

Value creation, resources, and capabilities: 2 different ways for a firm to create more economic value than competitors:

  • Different value chain than competitors

  • Same value chain than competitors, but performing activities within that value chain better than competitors (e.g. acquire resources and capabilities than its competitors lack).

Resources: firm-specific assets (expertise, patent, know-how, bran-name reputation)

Capabilities: activities that a firm performs better than other firms.

Characteristics of capabilities:

  • They are typically valuable across multiple products or markets.

  • They are embedded in organizational routines (well-honed patterns of performing activities inside an organization). This involves that capabilities can persist even if individuals leave the organization.

  • They are tacit (difficult to reduce to simple algorithms or procedure guides).

Strategic positioning: cost advantage and benefit advantage

Generic strategies: benefit leadership, cost leadership, focus

Generic strategies explain how a firm positions itself to compete in the market it serves.

The strategic logic of cost leadership: more value created than rivals because the firm can offer products with lower costs that rivals. How can a firm do that?:

  • Benefit parity: product with the same B but at a lower C than its rival.

  • Benefit proximity: product with B that is not much less than competitors.

  • Qualitatively different products from those of its rivals: by building a competitive advantage (important differences that result in benefits or costs).

For the graph, see figure 11.13 page 366 (the cost leader has a higher profit margin than its higher-cost competitors, even with less quality)

The strategic logic of benefit leadership: more value created than rivals due to higher B. 3 ways to do this:

  • Cost parity: products with the same C but at a higher B than its rival.

  • Cost proximity: product with a C that is not too much higher than competitors

  • A firm can offer products with higher B and C when the product costs much more to produce than available substitutes, but had fewer side effects.

For the graph, see figure 11.14 page 368 (the benefit leader has a higher profit margin than its lower-benefit competitor, even with a cost disadvantage).

Extracting profits from cost and benefit advantage: the importance of the price elasticity of demand

Winner-take-all” auction: a firm will capture the entire market if it increases it consumer surplus and that no other competitors can offer a higher consumer surplus. This leads to two important situations for retaining profits for a firm that creates more value than its competitors:

  • A cost leader that has benefit parity with its competitors can decrease its price just below the unit cost of the firm with the next lowest unit cost. The cost leader will capture the entire market because the high-cost rival will not be able to decrease its own price.

  • A benefit leader that has cost parity with its competitors can increase its price just below its unit cost plus the additional benefit ΔB it creates relative to the competitor with the next highest B. Therefore, the benefit leader will capture the entire market because the rival will not be able to decrease its price below its unit cost.

Contrary to identical preferences, horizontal differentiations do not allow a large shift in market share when price decreases a little or quality increases. Of course, some consumers would like to switch from one seller to another but not all of them but for this to happen, the difference in price decrease or quality increase should be significant.

Strong horizontal differentiation: products have many attributes whose consumers evaluate the benefits and disagree about the desirability of those characteristics. Low price elasticity of demand

Weak horizontal differentiation: products with few attributes. Business buyers rather than households. High price elasticity of demand

Table 11.3 page 371 shows a good summary about “exploiting a competitive advantage through pricing”

Margin strategy: occurs in strong horizontal differentiation. The firm maintains price parity with its competitors and profits from its benefit or cost advantage through high price-cost margins rather than through higher market shares.

Share strategy: occurs in weak horizontal differentiation. A firm exploits its benefit or cost advantage through a higher market share rather than through a high price-cost margin.

Comparing cost and benefit advantages:

It is usually better to have a cost advantage than a benefit advantage if:

  • Chances to increase B is limited

  • Price-sensitive consumers

  • Search goods rather than experience goods

Search good: a consumer can evaluate the quality before the purchase (e.g., apparel, office furniture).

Experience good: a consumer cannot evaluate the product before the purchase. He evaluates the quality of a product only after the purchase and after using it for a while (e.g., automobile, appliance and consumer packages).

It is usually better to have a benefit advantage than a cost advantage if:

  • Possible to set high price if product attributes increase B

  • Economies of scale or learning are important (firms already exploited them)

  • Experience goods rather than search goods

Stuck in the Middle”: Porter suggests that a firm that wants to follow at the same time a cost and a differentiation advantage will be ineffective, resulting in a lower perceived benefit to consumers (than firms following only a differentiation advantage) and higher costs (than firms following only a cost advantage).

Strategic positioning: broad coverage versus focus strategies

Segmenting an industry:

2 characteristics of an industry:

  • Products’ varieties

  • Different types of customers (e.g., demographic factors, geography, use frequency, knowledge about the product, etc.)

Segmentation variables:

  • The buyer’s industry

  • The size of the purchasing firm

  • The consumer segments the buyer serves

  • The size of a buyer’s order

  • The buyer’s willingness to trade off price for performance

  • Speed of delivery

  • Other dimensions of quality

Nevertheless, buyers should be grouped according to their tastes, product needs, etc.

Broad coverage strategies: full line or related products to all customer groups (e.g., Gillette with shaving products – razors, shaving cream and after-shave lotions (complementary products) for both men and women). This strategy allows economies of scope (from production, distribution or marketing) and wants to create a benefit advantage in each segment the firm is active by offering many attributes to fit the needs of those consumers.

Focus strategies: narrow line of product varieties or/and narrow set of customers. This strategy can be based on customer specialization, product specialization or geographic specialization. An important advantage is that the focusing firm can be protected from competition (customer demand can be just enough for one or two firms to be profitable). Therefore, it could be better to follow a focus strategy in a low-demand segment than a broad coverage strategy in a higher-demand segment with much more competitors.

Customer specialization: variety of related products to a particular class of customers. Economic value created by customer specialization depends on how customers perceive product attributes offered by broad-coverage competitors.

Product specialization: concentration on producing a single type of product for a variety of market segments. The aim of this strategy is to satisfy the needs of the customers. Again, it is possible to have economies of scale and learning economies.

Geographic specialization: variety of related products within a narrowly defined geographic market. Advantages are economies of scale and the firm can take advantage of over-serving or under-serving by broad-based competitors.

Under-serving: firms do not offer enough product attributes that customers value.

Over-serving: firms offer expensive product attributes that customers do not value.

Chapter K: Competitive advantage

Competitive advantages can be suddenly imitated or neutralized by innovators through new technology for example. With a mix of bad luck, this can destroy small and large firms.

How hard is it to sustain profits?

Threats to sustainability under all market: a firm can sometimes not be successful anymore even if entry is blockaded or deterred because some factors (e.g., weather) cannot be controlled.

Regression to the mean: does a firm benefit from good luck if it performs well and does a firm have bad luck if it performs badly? So, if there is good or bad luck, it can be expected that the successful firm cannot perform well forever and the underperforming firm will start to improve. Therefore, the possibility of regression to the mean says that firms should not expect to repeat extreme good or bad performances for long.

Of course, extreme good or bad performances are not always the result of luck. Good performance can come from high barriers to deter entry or decrease competition by making advantage inimitable. However, this also does not always guarantee a good profit because the firm may not be protected from suppliers and buyers.

Evidence: the persistence of profitability: if obstacles exist to the competitive dynamic (e.g., barriers to imitation), the profit should be high and persist in the future. In the opposite case, economic profit should converge to zero. Evidence says that firms with above-average profits today will do so in the future while firms with low profits today will remain in the future.

Sustainable competitive advantage:

The resource-based theory of the firm: to attain competitive advantage, a firm should create more value. This extra value depends on resources and capabilities. However, this is not sufficient to ensure that a firm can sustain its advantage because the competitive advantage should be protected from imitation. Therefore, firms need different resources and capabilities.

The resource-based theory of the firm says that all firms in a market possess the same amount and identical resources and capabilities, so if a firm can use a strategy to create value and competitive advantage, other firms can do exactly the same and duplicate the strategy. For competitive advantage to be sustainable, a firm should have exceptional/rare resources and capabilities, but again that does not assure sustainability because firms will bid against to acquire those exceptional resources. Those resources can only be sustainable if there are imperfectly mobile – they cannot “sell itself” to the highest bidder.

Example of mobile resources: talented employees (can work for the company who offers the highest wages), patents and copyrights (as it can be sold), etc.

How to limit mobility: contracts or “noncompete clauses”.

Non-tradable resources: know-how acquired from cumulative experience, reputation of the firm for toughness in competition.

Co-specialized resources: resources that created more value when used together than separately (e.g., employees in a productive work team)

Isolating mechanisms: prevent competition and allow protection of the competitive advantage by limiting the extent to which a competitive advantage can be imitated or neutralized through the resource-creation activities of other firms.

2 kinds of isolating mechanisms:

  • Impediment to imitation: prevent existing firms and prospective newcomers from imitating the resources and capabilities of a firm.

  • Early mover advantages: once a firm acquires a competitive advantage, these isolating mechanisms increase the economic power of that advantage over time.

Impediments to imitation:

  • Legal restrictions: (e.g., patents, copyrights, etc) can prevent imitation. A firm that purchases a patent to protect its competitive advantage can pay a competitive price to have it but can also be better off by selling it to other firms.

  • Superior access to inputs or customers: high-quality or high-productivity inputs allow a firm to have a cost and quality advantages that it is not easy to duplicate. A way to have a better access to inputs is by controlling the sources of supply through ownership or long-term exclusive contracts and then, it will also get a better access to customers. When the best distribution channels or the most productive retail locations are protected, a firm outcompetes its rivals for customers. However, locations or contracts that provide the firm the control of limited inputs or distribution channels can also be sold. So, better access to inputs or customers can lead to competitive advantage only if the firm can protect access at prices below the market price.

  • Market size and economies of scale: a firm that has protected a large share of the market when there is a large minimum efficient scale relative to market demand can avoid imitation and entry. This is especially important in the case of specialized products or services for which the demand is just large enough to support one large firm. However, demand should not grow too large, otherwise newcomers will try to enter the market and smaller rivals will increase its production, trying to benefit from economies of scale.

  • Intangible barriers to imitating a firm’s distinctive capabilities:

Causal ambiguity: situations in which the causes of a firm’s ability to generate more value than its rivals are not perfectly understood. Usually, a firm’s distinctive capabilities imply tacit knowledge and therefore, causal ambiguity arises. Tacit capabilities are almost never written. As a consequence, managers can sometimes not really say what is performed better than competitors, and can therefore, be an important obstacle to duplication but also a cause of diseconomies of scale.

Dependence on historical circumstances: sometimes, rivals cannot imitate a firm’s capabilities leading to competitive advantages due to the fact that the characteristics of those capabilities are linked to the history of the firm (unique experiences in adapting to the business environment). However, historical dependence implies that the strategy of a firm may be viable for only a limited time.

Social complexity: interpersonal relations of managers in a firm and the relationship between the firm’s managers and those of its suppliers and customers (e.g., trust).

Due to the dependence of the factors mentioned above, most of the organizational changes may ignore them and therefore, hurt the firm’s position.

Early-Mover advantages:

  • Learning curve: a firm moves down the learning curve if it has sold more than rivals in earlier periods. As a result, the firm will have lower unit costs than competitors.

  • Reputation and buyer uncertainty: the reputation of the firm for the quality of an experience good can provide an important advantage to the early mover because consumers do not really want to switch for another brand if they got a positive experience and if there is a risk that the products from the competing brand will not work.

Reputation gives then also an advantage to attract new customers and increase the number of customers who had positive experiences. Thus, a later mover will face a disadvantage because he can enter the market only if its price is below other firms. Due to the fact that it just enters the market, its reputation is not created yet, and therefore, even if the price and products are identical, consumers will be unwilling to switch. The later-mover can also advertise a lot to persuade consumers to try its products and that the benefits offered are larger than those of the early mover. However, this is expensive and easier said than done. If the later mover fails on its strategy, the reputation of the early mover will become even stronger as more consumers will buy the product.

  • Buyer switching costs: sometimes, a buyer faces important costs when switching to another seller because:

    • Brand specific know-how is only specific to some products.

    • Specific know-how about the buyer is difficult to replicate.

Switching costs could be an important benefit to an early mover because it prevents newcomers to steal business.

Sellers have different approaches to increase switching costs:

  • Coupons or “frequent-customer” points

  • Warranties

  • Complementary products that fit together in a product line

But those 3 approaches got some limits: frequent-customer points are expensive, customers can expect expensive service costs in the case of warranties and for the last approach, the seller may find himself into a specific niche.

Disadvantage of switching costs: an incumbent firm does not really want to attract new customers by competing on price because if it reduces its price, it will decrease its profit margin on sales to its existing customers. The newcomer does not make such sacrifices because it has no loyal customers yet. Therefore, the incumbent firm will act as a “soft commitment” and newcomers will have a disproportionate share of the market demand growth over time, while the incumbent firm’s share will erode.

  • Network effects/externalities: consumers usually give a higher value to a product that is frequently used by other consumers.

Actual network: consumers can communicate with other consumers in the network. Therefore, an increase of the network (more consumers) leads to better chances to communicate and to a better value of the network.

Virtual network: consumers are not linked physically. The increase of the network effect is due to the use of complementary goods for which the demand increases simultaneously with the number of new customers, making the network stronger. An important feature of the network is that consumers do not need to communicate with each other to benefit from the network.

Competing “for the market” versus “in the market”: many factors to consider:

With identical factors, a firm will have higher expected profits by trying to reach the monopoly status for its own standard (competing for the market) than by settling for a share of the market with a common standard (competing in the market).

  • When two or more firms compete for the market, the winner is most of the time the firm with the largest installed base of customers, allowing to increase the value of the network and attracting even more customers. Moreover, developing the installed base can be very expensive (e.g., advertising) and firms could be better off if they agree on a common standard.

  • To win a standards war, it is important to focus on early adopters.

  • When complementary products are extremely important, a standards war can deter manufacturers of the complements from entering the market until a standard has emerged.

  • Complementary good’s manufacturers will prefer the standard that gives them the largest share of the value added. Therefore, a firm needs to pay attention to other firms in its value net if it wants to win a standards war.

Early-mover disadvantages:

  • Do not have the necessary complementary assets to commercialize the product

  • Bet on the wrong technologies or products

Imperfect imitation and industry equilibrium: imperfect imitation leads in a perfectly competitive market to firms that can maintain positive economic profits for a long time while other firms will have profits below average that could even be negative.

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