In piece Porter’s Five Forces – Four Forces Too Many?, we covered the conditions that exist when no company exhibits competitive advantages.
“If no forces interfere with the process of entry by competitors, profitability will be driven to levels at which efficient firms earn no more than a ‘normal’ return on their invested capital. It is barriers to entry, not differentiation by itself, that creates strategic opportunities.” Greenwald & Kahn
The process of strategic analysis begins with a market by market assessment of the existence and sources of competitive advantages.
“Barriers to entry lie at the heart of strategy. The first task in our simplified approach to strategic thinking is to understand what barriers are and how they arise. Skills and competencies that a firm may possess and genuine barriers to entry, which are the characteristics of the structure economics of a particular market.”
The authors explain that skills and competencies of the market leaders are available to competitors, at least in theory. Systems can be replicated, talented employees poached by a competitor and the latest technology purchased by a competitor. These are related to operational efficiency.
Whereas strategy is concerned with the structural barriers to entry. “Identifying those barriers and understanding how they operate, how they can be created, and how they must be defended is at the core of strategic formulation.”
A firm within the barriers must be doing something that potential entrants cannot, no matter how deep their pockets or how effectively they copy their best practices, systems and talent of the most successful companies.
In Australia recently, Woolworths (a supermarket chain) in partnership with Lowes, destroyed billions of shareholder dollars, in their failed attempt to enter the hardware market in Australia. They failed to strategically analyse the barriers to entry that Bunnings (owned by Wesfarmers) enjoys within the industry.
The authors propose that there are only three genuine types of competitive advantages – demand advantages, supply advantages and economies of scale – and two straightforward tests to confirm their existence – high return on capital and market-share. Become a member for an in-depth explanation for each.
The authors also mention that Government regulation is another advantage, including licences, tariffs and quotas, authorised monopolies, patents, direct subsidies, and various kinds of regulation.
“Government favour aside, the other sources of competitive advantages are rooted in basic economic conditions.” Greenwald and Kahn
A business enjoying high returns on invested capital due to competitive advantages, considered an elephant, will find itself in two situations.
The first situation will consist of a single firm dominating the market, like an elephant surrounded by ants. Management of competitive advantages becomes their sole focus.
The second situation occurs when a few firms dominate a single market (two to three elephants) and it’s the most common situation.
In both situations the elephants that dominate their markets dominate local markets. Be it geographically or their geographic product space.
Watch Bruce Greenwald explain why firms need to dominate local not global markets.
We’ll focus on the situation where more than one firm dominates a single market, and if you want to know how both situations play out in today’s World you will need to become a premium lifetime member. The authors provide the example of the soft drink industry in the United States, Coke Cola and Pepsi, as an example. Coke and Pepsi are two elephants, with the other competitors noticeably smaller, although as the authors point out that in particular geographical markets, regional favourites like Dr Pepper are legitimate competitors. Commercial aircraft manufacturing in particular large jets is another market dominated by Boeing and Airbus.
When a company is in this situation enjoying competitive advantages with other elephants (potent competitors), it requires the company to figure out how to manage their main competitors by developing an effective strategic plan.
The authors explain that there are three distant approaches valuable in developing competitive strategies: game theory, simulation and cooperative analysis.
“Classical game theory is particularly useful because it imposes a systematic approach to collecting and organising the mass of information about how competitors may behave. Game theory, as the Stanford Encyclopaedia of Philosophy describes it, is ‘the study of ways in which strategic interactions among rational players produce outcomes with respect to the preferences (or utilities) of those players, none of which might have been intended by any of them.” Greenwald and Kahn
And there are two particular game theory games that capture the fundamental dynamics of the great majority of competitive situations.
Prisoner’s dilemma (PD), a game describing the interactions between two firms concerning price and quality.
The authors describe the other game as focusing on entry/pre-emption behaviour, by capturing the dynamics of quality and capacity competition. Whenever a company decides to build a new plant or open a new store in a market served by a competitor, entry/pre-emption is the game being played.
The authors propose a valuable approach to analysis starts first by identifying the competitive situations to which these two games can be applied. PD is normally found in the trenches of a long-lived and debilitating price war within an industry. Entry/pre-emption is found when a firm expands and the other firms are induced to expand to counter and entry/pre-emption provides the template for strategic analysis.
Simulation is simply assigning individuals or teams to represent each competitor, supplying them with the appropriate choices for actions and the motives and having them pay out different scenarios.
The last strategic approach is cooperation among the elephants. Which assumes that the elephants focus on how they can cooperate for mutual gains instead of battling each other.
This three-part series is a general introduction to understanding, identifying and analysing competitive advantages held by firms.