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www.downloadslide.com PART 4 PRICING AND OUTPUT DECISIONS: STRATEGY AND TACTICS I n the previous chapters, we developed the theories and modeling techniques useful in analyzing demand, production, and cost relationships in a firm. In this part of the book, we consider the profit-maximizing price-output decisions, especially as they relate to the firm’s strategic choices in competitive markets (Chapter 10). Asymmetric information conditions in a so-called lemons market as well as ideal full information exchanges are discussed. Chapters 11 and 12 consider price and output determination in dominant-firm monopoly and oligopoly markets. Chapter 13 presents a game-theory framework for analyzing rival response tactics. The final chapter in Part 4, Chapter 14, examines value-based (not cost-based) differential pricing in theory and practice, and Appendix 14A presents the concept of revenue management. Web Appendix E addresses specialized pricing problems including pricing for the multiproduct firm, pricing of joint products, and transfer pricing. ECONOMIC ANALYSIS AND DECISIONS ECONOMIC, POLITICAL, AND SOCIAL ENVIRONMENT 1. Demand Analysis and Forecasting 2. Production and Cost Analysis 3. Pricing Analysis 4. Capital Expenditure Analysis 1. Business Conditions (Trends, Cycles, and Seasonal Effects) 2. Factor Market Conditions (Capital, Labor, Land, and Raw Materials) 3. Competitors’ Responses 4. External, Legal, and Regulatory Constraints 5. Organizational (Internal) Constraints Cash Flows Risk Firm Value (Shareholders’ Wealth) 333 Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com 10 CHAPTER Prices,Output,andStrategy:Pure and Monopolistic Competition CHAPTER PREVIEW Stockholder wealth-maximizing managers seek a pricing and output strategy that will maximize the present value of the future profit stream to the firm. The determination of the wealth-maximizing strategy depends on the production capacity, cost levels, demand characteristics, and the potential for immediate and longer-term competition. In this chapter, we provide an introduction to competitive strategic analysis and discuss Michael Porter’s Five Forces strategic framework. Thereafter, we distinguish pure competition with detailed analyses of the home contractor industry and monopolistic competition with detailed analyses of advertising expenditures in ready-to-eat cereals. In a “lemons market,” the implications of asymmetrically informed sellers, the rational hesitation of buyers to pay full price, and the resulting problem of adverse selection are also discussed. MANAGERIAL CHALLENGE Resurrecting Apple1 Apple Computer revolutionized personal computing operating systems by introducing a graphical user interface (GUI) with their Macintosh in 1983. The GUI was reverse engineered and quickly imitated by Microsoft whose PC (personal computer) operating system Windows captured a 92 percent market share by 1997. Windows-equipped IBM and then Compaq, Dell, and Hewlett-Packard (HP) came to dominate the PC business. Apple retained PC market leadership only in the education, graphics design, and publishing sectors. Because 55 percent of all PC and operating systems sales are in corporations, 33 percent are in the home, 7 percent in government, and only 5 percent are in education, Apple’s market share of U.S. PC sales slipped from 9.4 percent in 1993 to 2.6 percent in 1997. Today, the assembly of personal computers is outsourced to a wide variety of Chinese and Taiwan supply chain partners operating at massive scale. Dell Computers and HP, for example, assemble overseas whatever components the buyer wants, and they then deliver “direct to the customer” through FedEx hubs the next day. With few outsourced components, high overhead, and extensive R&D costs, Apple’s least expensive product offering is $1,700, whereas “comparable” HP machines sell at $1,100, and Dell’s PCs are as low as $600. Apple initially sold primarily through retail outlets like Computertree, but to target the consumer sector, Apple has recently launched dozens of companyowned Apple stores. In addition, Apple adopted a closed (proprietary, unlicensable) operating system architecture. This approach sacrifices the huge installed base of Microsoft customers who attract independent software vendors to write Windows applications programs. Without compatibility to this Wintel-installed base, Apple’s offering stagnated. Cont. 334 Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com Chapter 10: Prices, Output, and Strategy: Pure and Monopolistic Competition 335 MANAGERIAL CHALLENGE Continued Apple’s share of PC shipments 10% © Junophoto/fStop/Getty Images 8 6 4 2 0 1993 ⬘95 2000 2005 Discussion Questions 2010 I In 1999, Steve Jobs regained the leadership of Apple, intent on restoring the brand image of the once highly innovative company. The introduction of the spiffy iMac PC made a good start, allowing Apple’s market share in the U.S. personal computer market to climb back to 9.6 percent in 2010. Jobs also oversaw Apple’s effort to reinvent itself by introducing the iPod digital music player. This time, Apple was ready with layer upon layer of enhanced capabilities for each new generation of its resurgent products. The competitive advantages of the iPod are process-based, rather than product-based, and rely upon cumulative capabilities with its iTunes Music Store and in partnerships with Disney Inc. and record labels. Apple maintains a 73 percent share of the $9 billion digital music industry. I I What prices to charge for iMacs and iPods remains a central issue for Apple management. Have you visited an Apple Store? Did the instore experience enhance your perceived value for an Apple product? On what basis would you justify paying a price premium for an Apple laptop? What about an Apple iPod? 1 Based on Apple Computer 1992, 1995 (A), 1996, and 1997, Harvard Business School Publishing; “The Road Ahead,” Wall Street Journal (June 28, 2000), p. A3; “Is Apple Losing Its Sheen?” Wall Street Journal, (June 28, 2004), p. B1; “Just What Apple Needs: Intel,” BusinessWeek (January 9, 2006), p. 1; “The Best Performers, BusinessWeek (March 23, 2006), p. 1; and Apple Inc., 2008, Harvard Business School Case Publishing. INTRODUCTION core competencies Technology-based expertise or knowledge on which a company can focus its strategy. To remain competitive, many companies today commit themselves to continuous improvement processes and episodes of strategic planning. Competitive strategic analysis provides a framework for thinking proactively about threats to a firm’s business model, about new business opportunities, and about the future reconfigurations of the firm’s resources, capabilities, and core competencies. Figure 10.1 displays the components of a business model in the context of a firm’s prerequisite knowledge and strategic decisions. All successful business models begin by identifying target markets—that is, what businesses one wants to enter and stay in. Physical assets, human resources, and intellectual property (like patents and licenses) sometimes limit the firm’s capabilities, but business models are as unbounded as the ingenuity of entrepreneurial managers in finding ways to identify new opportunities. Next, all successful business models lay out a value proposition grounded in customer expectations of perceived value and then identify what part of the value chain leading to end products the firm plans to create. Business models always must clarify how and when revenue will be Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com 336 Part 4: Pricing and Output Decisions: Strategy and Tactics FIGURE 10.1 The Strategy Process Components of a Business Model 1. Target market Prerequisite Knowledge 2. Value proposition Decisions 1. Customers 3. Role in value chain 1. Products 2. Competitors 4. Revenue sources 2. Prices 3. Market conditions 5. Margins defined 3. Marketing plans 4. Capital raising 6. Network value 4. Supply chains 5. Resource availability 7. Investment required 5. Distribution channels 6. Socio-political constraints 8. Competitive strategy 6. Projected cash flows to lenders and equity owners Source: Adapted from H. Chesbrough, Open Innovation (Cambridge, MA: Harvard University Press, 2003). realized and analyze the sensitivity of gross and net margins to various possible changes in the firm’s cost structure. In specifying the required investments, business models also assess the potential for creating value in network relationships with complementary businesses and in joint ventures and alliances. Finally, all successful business models develop a competitive strategy. COMPETITIVE STRATEGY The essence of competitive strategy is threefold: resource-based capabilities, business processes, and adaptive innovation.2 First, competitive strategy analyzes how the firm can secure differential access to key resources like patents or distribution channels. From humble beginnings as an Internet bookseller that contracted out its warehousing and book delivery service, Amazon managed to become the preferred fulfillment agent for Internet sales in general. That is, the book seller Amazon acquired enough regular customers searching for CDs, office products, tools, and toys that companies like Toys “R”Us adopted Amazon as their Internet sales channel. Second, competitive strategy designs business processes that are difficult to imitate and capable of creating unique value for the target customers. For example, the high-frequency point-to-point streamlined operations processes of Southwest Airlines prove very difficult for hub-and-spoke airlines to imitate, and, as a result, in 2005 Southwest had a market capitalization equal to that of all the major U.S. carriers combined. Similarly, at one point in their respective corporate histories, both Dell and Compaq had $12 billion in net sales and approximately $1 billion in net income in 1998. But Compaq’s business model required $6 billion in net operating assets (i.e., inventories plus net plant and equipment plus working capital) to earn $1 billion, while Dell’s required only $2 billion. How could Dell produce the same net income with one-third as much plant and equipment, inventories, and working capital as Compaq? The answer is that Dell created a direct-to-the-customer sales process; Dell builds to order with 2 This section is based on H. Chesbrough, Open Innovation (Boston: Harvard Business School Press, 2003), pp. 73–83. Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com Chapter 10: Prices, Output, and Strategy: Pure and Monopolistic Competition 337 WHAT WENT RIGHT • WHAT WENT WRONG Xerox3 Xerox invented the chemical paper copier and thereafter realized phenomenal 15 percent compound growth rates throughout the 1960s and early 1970s. When their initial patents expired, Xerox was ready with a plain paper copier (PPC) that established a first-mover technology advantage, but ultimately the company failed to receive any broad patent extension.4 Xerox’s target market was large corporations and government installations who valued high-quality, high-volume leased machines with an enormous variety of capabilities and full-service maintenance contracts, even though supplies and usage fees were expensive. Unable to compete on product capabilities, Japanese competitors Canon and Ricoh realized that tremendous market potential lay in smaller businesses where affordability per copy was a major value proposition issue. Installation and service were outsourced to highly competitive independent dealer networks, and the smaller-volume copy machine itself was sold at very low initial cost with self-service replacement cartridges being the principal source of profitability. As with later events at Apple, Xerox insisted on closed architecture software and built all of its copier components in-house rather than pursuing partnerships that could reduce cost and trigger a larger installed base of machines. Competitors pursued just the opposite open architecture and partnership strategy to achieve network effects and drive down costs. Between 1975 and 1985, Xerox copier sales doubled from $4 billion to $8.4 billion while those of Canon grew 25-fold from $87 million to $2.2 billion. During this “lost decade,” Xerox’s market share fell to 40 percent worldwide, and Canon and Ricoh both became $2 billion firms in a copier business that Xerox had totally dominated only 15 years earlier. Failure to adapt its once-dominant business model had doomed Xerox to nearly second-rank status. 3 Based on Chesbrough, op. cit.; and on C. Bartlett and S. Ghoshal, Transnational Management (Boston: Irwin-McGraw-Hill, 1995), Case 4–1. 4 In fact, because of Xerox’s 93 percent monopoly of the copier industry in 1971, the U.S. Federal Trade Commission forced Xerox in 1975 to license its PPC technology at low royalty rates. subassembly components bought just in time from outside contractors, and it realizes cash from a sale within 48 hours. These value-creating business processes generated 50 percent ($1B/$2B) return on investment at Dell, whereas the comparable ROI at Compaq was just 16 percent ($1B/$6B).5 Finally, competitive strategy provides a road map for sustaining a firm’s profitability, principally through innovation. As industries emerge, evolve, and morph into other product spaces (e.g., think of Polaroid to digital cameras, calculators to spreadsheets, and mobile phones to smart phones), firms must anticipate these changes and plan how they will sustain their positioning in the industry, and ultimately migrate their business to new industries. IBM, the dominant mainframe leasing company in the 1970s, has reinvented itself twice—first in the 1980s as a PC manufacturer, and a second time in the 1990s and 2000s as a systems solution provider for a “smarter planet.” In contrast, some firms like Xerox or Kodak become entrenched in outdated competitive strategic positions. industry analysis Assessment of the strengths and weaknesses of a set of competitors or line of business. Generic Types of Strategies6 Strategic thinking initially focuses on industry analysis—that is, identifying industries in which it would be attractive to do business. Michael Porter’s Five Forces model (discussed later) illustrates this approach. Soon thereafter, however, business strategists want to conduct competitor analysis to learn more about how firms can sustain their relative profitability in a group of related firms. Efforts to answer these questions are often 5 Return on invested capital is defined as net income divided by net operating assets (i.e., net plant and equipment plus inventories plus net accounts receivable). 6 This section is based in part on C. De Kluyver and J. Pearce, Strategy: A View from the Top (Upper Saddle River, NJ: Prentice-Hall, 2003). Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com 338 Part 4: Pricing and Output Decisions: Strategy and Tactics sustainable competitive advantages Difficult to imitate features of a company’s processes or products. product differentiation strategy A businesslevel strategy that relies upon differences in products or processes affecting perceived customer value. Example described as strategic positioning. Finally, strategists try to isolate what core competencies any particular firm possesses as a result of its resource-based capabilities in order to identify sustainable competitive advantages vis-à-vis their competitors in a relevant market. Product Differentiation Strategy Profitability clearly depends on the ability to create sustainable competitive advantages. Any one of three generic types of strategies may suffice. A firm may establish a product differentiation strategy, a lowest-delivered-cost strategy, or an information technology (IT) strategy. Product differentiation strategy usually involves competing on capabilities, brand naming, or product endorsements. Xerox in copiers and Kodak in photo paper and chemicals for film development compete on product capabilities. Coca-Cola is by far the world’s most widely recognized brand. Marlboro, Gillette, P&G’s Pampers, Nestlé, Nescafe, and Kellogg’s each has nearly 50 percent shares. All of these branded products command a price premium worldwide simply because of the product image and lifestyle associated with their successful branding. Other differentiated products like Air Jordan compete on the basis of celebrity endorsements. Rawlings Sporting Goods Waves Off the Swoosh Sign7 Even though $200 million Rawlings competes against heavily branded Nike with annual sales of $14 billion, Rawlings baseball gloves are extremely profitable. The key is that they are used by more than 50 percent of major leaguers, such as St. Louis Cardinal Albert Pujol and Yankees shortstop Derek Jeeter. These superstars receive $20,000 for licensing their autographs to Rawlings for engraving on Little League gloves. But player after player can talk about a feature of Rawlings’ equipment that keeps them coming back year after year. Rawlings is very attentive to this feedback and will lengthen the webbing or stiffen the fingers on a new model in just a few weeks to please their celebrity endorsers. Quick adaptation to the vagaries of the consumer marketplace is a requisite part of any product differentiation strategy. Based on “I’ve Got It,” Wall Street Journal (April 1, 2002), p. A1. 7 Which of the three generic types of strategies (differentiation, cost savings, or IT) will be most effective for a particular company depends in part on a firm’s choice of competitive scope—that is, on the number and type of product lines and market segments, the number of geographic locations, and the network of horizontally and vertically integrated businesses in which the company decides to invest. For example, the most profitable clothing retailer in the United States, Gap, once undertook to expand its competitive scope by opening a new chain of retail clothing stores. Old Navy’s bargain-priced khakis, jeans, and sweaters immediately began cannibalizing sales at its mid-priced parent. Even fashion-conscious teens could see little reason to pay $16.50 for a Gap-emblazoned T-shirt when Old Navy’s branding offered style and a nearly identical product for $12.50. The configuration of a firm’s resource capabilities, its business opportunities relative to its rivals, and a detailed knowledge of its customers intertwine to determine the preferred competitive scope. Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com Chapter 10: Prices, Output, and Strategy: Pure and Monopolistic Competition cost-based strategy A business-level strategy that relies upon low-cost operations, marketing, or distribution. Example 339 Cost-Based Strategy Competitive scope decisions are especially pivotal for cost-based strategy. A firm like Southwest Airlines with a focused cost strategy must limit its business plan to focus narrowly on point-to-point, medium-distance, nonstop routes. Think Small to Grow Big: Southwest Airlines Southwest adopted operations processes for ticket sales, boarding, plane turnaround, crew scheduling, flight frequency, maintenance, and jet fuel hedging that deliver exceptionally reduced operating costs to target customers in their price-sensitive market niche. Anything that works against this cost-based strategy must be jettisoned from the business plan. Southwest has clearly accomplished its goal. As air travel plummeted in the months following the September 11, 2001, attacks on the World Trade Center, only Southwest had a break-even that was low enough to continue to make money. Southwest can cover all of its costs at 64 percent load factors (unit sales/seat capacity). American Airlines, United, Delta, and US Airways often operate well below their break-even points of 75 to 84 percent. Much has been made of the difference in labor cost—that is, that Southwest has labor costs covered by 36 percent of sales dollars while United, American, and US Airways have labor costs covered by 48 percent of sales dollars, but the $0.07 gap between United’s $0.12 cost per revenue passenger mile (rpm) and Jet Blue’s $0.05 and Southwest’s $0.06 cost per rpm reflects process differences. Booz, Allen, Hamilton found that only 15 percent of the operating cost difference between fullservice and low-cost carriers was labor cost. Rather, the largest source of cost difference was process differences in check-in, boarding, reservations, crew scheduling, and maintenance, These processes make possible the famed 15-minute turnaround time at Southwest. In contrast, Dell Computers’ cost leadership strategy allows it to address a wide scope of PC product lines at prices that make its competitors wish to exit the market, as IBM did in 1999. Gateway was also unable to keep pace with Dell’s cost-cutting and by 2006 found itself at 5.3 percent market share versus a 10.6 percent peak in 1999. Information Technology Strategy information technology strategy A businesslevel strategy that relies on IT capabilities. Finally, firms can seek their sustainable competitive advantage among relevant market rivals by pursuing an information technology strategy. In addition to assisting in the recovery of stolen vehicles, satellite-based GPS has allowed Allstate Insurance to confirm that certain cars on a family policy are not being driven to work, while other less expensive cars are being exposed to the driving hazards of commuting. This allows Allstate to cut some insurance rates and win more business from their competitors. The e-commerce strategy of Southland Corporation’s 7-Eleven convenience stores in 6,000 locations across Japan (see the Example on the next page) provide another good example. In conclusion, a company’s strategy can result in higher profits if the company configures its resource-based capabilities, business processes, and adaptive innovations in such as way as to obtain a sustainable competitive advantage. Whether cost-based Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com 340 Part 4: Pricing and Output Decisions: Strategy and Tactics Example Dell’s Cost Leadership in PC Assembly8 Dell sells over the phone and over the Internet direct to the consumer and then assembles and delivers mass-customized PCs usually within 48 hours. In contrast, Compaq’s large dealer network requires 35 days to convert a sale into realized cash. Even rival mail-order company Gateway takes 16 days. Having no dealer network and realizing cash quickly might be processes to imitate, but Michael Dell pushed the just-in-time approach down his supply chain. Every company that builds critical components for Dell must warehouse within 15 minutes’ travel time of a Dell factory. Consequently, Dell does not even order components until the customer commits to a purchase. Even after developing Internet distribution channels, Compaq’s slower production process requires that subassembly components sit on the shelves for months. Less inventory at Dell means tying up less working capital, and less working capital means lower cost. Between 1990 and 1998, Dell drove PC prices down, and as a result even Dell’s gross margin (the difference between net sales revenue and the direct costs of goods sold as a percentage of net sales revenue) also fell, from 33 percent to 23 percent. However, Dell’s net profit margin actually increased from 8 to 11 percent over this period. How could this happen? Dell’s selling, general, and administrative expense (SG&A) declined from 21 percent of sales to 9 percent. Again, less overhead means lower cost, and lower cost can mean higher profitability, even in an era of steeply falling prices. The overall effect of this cost leadership strategy on market share, profits, and capitalized value has been stunning. Between 1996 and 2001, Dell’s market share in PC shipments grew from 7 percent to 24 percent. Dell’s net income increased tenfold from $260 million in 1996 to $2.3 billion in 2001. And Dell’s market capitalization grew from $6 billion to $70 billion, which was the fastest growing valuation among NYSE-listed companies in several of those years. Based on “The New Economy Is Stronger Than You Think,” Harvard Business Review (November/December 1999), pp. 104–105; Chesbrough, op. cit., p. 55; and “How Dell Fine Tunes Its Pricing,” Wall Street Journal (June 8, 2001), p. A1. 8 Example The E-Commerce of Lunch at 7-Elevens in Japan9 Japanese office workers put in very long hours, often arriving at 8:00 A.M. and staying well into the evening. In the midst of this long day, most take a break to go out on the street and pick up lunch. Boxed lunches, rice balls, and sandwiches are the routine offerings, but the fashion-conscious Japanese want to be seen eating what’s “in.” This situation makes an excellent opportunity for Southland Corporation’s 7-Eleven stores, which is the biggest retailer in Japan and twice as profitable as the country’s second-largest retailer, the clothing outlet Fast Retailing. Half of 7-Eleven’s sales revenue comes from these lunch items. The key to 7-Eleven Japan’s success has been electronic commerce and its information technology strategy. 7-Eleven Japan collects sales information by proprietary satellite communication networks from 8,500 locations three times a day. Like other retailers, 7-Eleven Japan uses the data for merchandising studies to improve its product packaging and (Continued) Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com Chapter 10: Prices, Output, and Strategy: Pure and Monopolistic Competition 341 shelf placements with laboratory-like experiments in matched-pair stores throughout the country. But there is more, much more. 7-Eleven Japan has built systems to analyze the entire data inflow in just 20 minutes. Specifically, 7-Eleven forecasts what to prepare for the lunch crowd downtown today based on what sells this morning and what sold yesterday evening in suburban locations. As customers become more fickle, product fashion cycles in sandwiches are shortening from seven weeks to, in some cases, as little time as 10 days. 7-Eleven Japan forecasts the demand daily on an item-by-item, store-by-store basis. Of course, such short-term demand forecasting would be useless if food preparation were a production-to-stock process with many weeks of lead time required. Instead, supply chain management practices are closely monitored and adapted continuously with electronic commerce tools. Delivery trucks carry bar code readers that upload instantaneously to headquarters databases. Orders for a particular sandwich at a particular store are placed before 10:00 A.M., processed through the supply chain to all component input companies in less than seven minutes, and delivered by 4:00 P.M. for the next day’s sales. Most customers praise the extraordinary freshness, quality ingredients, and minimal incidence of out-of-stock items. All this competitive advantage over rival grocers and noodle shops has led to consistent price premiums for 7-Eleven’s in-house brand. Based on “Over the Counter Commerce,” The Economist, (May 26, 2001), pp. 77–78. 9 relevant market A group of firms belonging to the same strategic group of competitors. concentrated market A relevant market with a majority of total sales occurring in the largest four firms. fragmented A relevant market whose market shares are uniformly small. consolidated A relevant market whose number of firms has declined through acquisition, merger, and buyouts. strategy, product differentiation strategy, or information technology strategy provides the most effective route to competitive advantage depends in large part on the firm’s strategic focus. IT-based strategy is especially conducive to broad target market initiatives. In addition to using IT for merchandizing lunch items, 7-Eleven Japan “drives” customer traffic to its convenience stores by allowing Internet buyers to pick up their Web purchases and pay at the 7-Eleven counter. Is 7-Eleven Japan a convenience store, an Internet fulfillment agent like Amazon, or a warehouse and distribution company? In some sense, 7-Eleven Japan is all of these. Unlike Southwest Airlines’ cost-focused strategy, 7-Eleven Japan has a much broader IT-based strategy that conveys a competitive advantage across several relevant markets. The Relevant Market Concept A relevant market is a group of firms that interact with each other in a buyer-seller relationship. Relevant markets often have both spatial and product characteristics. For example, the market for Microsoft’s Windows operating system is worldwide, whereas the market for Minneapolis-origin air travel is confined to suppliers in the upper Midwest. Similarly, the market for large, prime-rate commercial loans includes large banks and corporations from all areas of the United States, whereas the market for bagged cement is confined to a 250-mile radius around the plant. The market structure within these relevant markets varies tremendously. The four largest producers of breakfast cereals control 86 percent of the total U.S. output—a concentrated market. In contrast, the market for brick and concrete block is fragmented—with the largest four firms accounting for only 8 percent of the total U.S. output. Recently, the share of the total U.S. output produced by the largest four firms in the women’s hosiery industry has consolidated, growing from 32 percent to 58 percent. These differences in market Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part. www.downloadslide.com 342 Part 4: Pricing and Output Decisions: Strategy and Tactics structures and changes in market structure over time have important implications for the determination of price levels, price stability, and the likelihood of sustained profitability in these relevant markets. PORTER’S FIVE FORCES STRATEGIC FRAMEWORK Michael Porter10 developed a conceptual framework for identifying the threats to profitability from five forces of competition in a relevant market. Figure 10.2 displays Porter’s Five Forces: the threat of substitutes, the threat of entry, the power of buyers, the power of suppliers, and the intensity of rivalry. Today, a sixth force is often added—the threat of a disruptive technology—such as digital file sharing for the recorded music industry or video on-demand over Web-enabled TVs for the video rental industry. The Threat of Substitutes First, an incumbent’s profitability is determined by the threat of substitutes. Is the product generic, like AAA-grade January wheat, two-bedroom apartments, and office FIGURE 10.2 Porter’s Five Forces Strategic Model Substitutes and complements Threat of substitute products and services • Value-price gap for functionally related products • Branded vs. generic • Network effects Level of competition in industry Sustainable industry profitability Intensity of rivalry • • • • • • • Industry concentration Tactical focus Switching costs Exit barriers Cost fixity or perishability Industry growth rate Speed of adjustment Threat of new entrants High capital requirements Economies of scale Absolute cost advantages High switching costs Lack of access to distribution channels Bargaining • Objective product power of differentiation buyers • Public policy constraints Bargaining power of suppliers Supplier power • • • • • Potential entrants Unique suppliers Number of potential suppliers Supply shortage/surplus Vertical requirements contracting Potential for forward integration • • • • • Buyer power • Buyer concentration or volume purchase • Industry overcapacity • Homogeneity of buyers • Potential for backward integration • Outside alternatives • Network effects • Industry standards Source: Adapted from M. Porter, Competitive Strategy (Cambridge, MA: The Free Press, 1998). 10 Michael Porter, Competitive Strategy (Cambridge, MA: The Free Press, 1998). See also Cynthia Porter and Michael Porter, eds., Strategy: Seeking and Securing Competitive Advantage (Cambridge, MA: Harvard Business School Publishing, 1992). Copyright 2011 Copyright 2011 Cengage Cengage Learning. Learning. All All Rights Rights Reserved. Reserved. May May not not be be copied, copied, scanned, scanned, or or duplicated, duplicated, in in whole whole or or in in part. part.