1. Planning does not equate to business strategy.

Executives often mistaken any

plan that helps the company make more money qualifies as a business strategy, e.g.
increasing customers or margins. This mistaken notion causes executives to fight wars
they cannot win and fail to protect and exploit the advantages that will lead them to
success.

2. Strategic decisions are outward looking and are those whose results depend
on the actions and reactions of other economic entities. Strategic thinking is
about creating, protecting and exploiting competitive advantages. Tactical decisions
can be made in isolation and hinge largely on effective implementation.

3. There are 2 main strategic choices a company must face are: 1. Selecting the arena of
competition, i.e. the market in which to engage. The choice of markets is strategic
because it determines the cast of external characters who will affect a companys
economic future. 2. Managing external agents. In order to devise and implement
effective strategy, a firm has to anticipate and, if possible, control the responses of those
external agents. Although this isnt easy as these interactions are complicated and
uncertain, devising strategy without taking into account that response can be a glaring
mistake.

4. On a level playing field, in a market open to all competitors on equal terms, competition
will erode the returns of all players to a uniform minimum, where there is no economic
profit i.e. no returns above the cost of invested capital. If demand conditions allow any
single firm to earn unusually high returns, other companies will notice the same
opportunity and flood in. Demand will be fragmented among the greater number of
firms, and cost per unit rise as fixed costs are spread over fewer units sold, prices fall,

and the high profits that attracted the new entrants disappear. To earn profits above this
minimum, a company must be able to benefit from competitive advantage.

5. Strategy is big and means long-term commitment for the organization. They require
large allocations of resources and is made by management, and changing strategies
doesnt happen quickly. The distinction between strategic and tactical decisions are:

Management level

Strategic

Tactical/Operational/Functional

Top management, Board of

Mid-level, functional, local

directors
Resources

Corporate

Divisional, departmental

Time frame

Long-term

Yearly, Monthly, Daily

Risk

Determines success/survival

Limited

Questions

What business do we want to be in?

How do we improve delivery time?

What critical competencies must

How big a promotional discount do

we develop?

we offer?

How are we going to deal with

What is the best career path for our

competitors?

salespeople?

6. Porters Five Forces (Substitutes, Suppliers, Potential Entrants, Buyers, and

Competitors) can affect the competitive environment. But one of them is clearly much
more important than others and leaders should begin by ignoring the others and only
focusing on barriers to entry (Potential Entrants). If there are barriers, then it is difficult
for new firms to enter the market or for existing companies to expand.

7. Barriers to entry and incumbent competitive advantage means the same thing, as the
existence of barriers to entry means that incumbent firms are able to do what potential
rivals cannot. Entrant competitive advantage have no value as a successful entrant
becomes the incumbent, and is then vulnerable to the next entrant who benefits from
new technology, less expense labour, or some other temporary competitive edge. The
lack of barriers to entry means the cycle doesnt stop.

8. In an increasingly global environment with lower trade barriers, cheaper transportation,

faster flow of information, and relentless competition from establish rivals and newly
liberalized economies, it might appear that competitive advantages and barriers to entry
will diminish, e.g. profits disappearing due to imports. But competitive advantages are
almost always grounded in local circumstances. Competitive advantages that lead to
market dominance, either by a single company or by a small number of essentially
equivalent firms are much more likely to be found when the arena is local, bounded
either geographically or in product space, rather than when it is large and scattered. The
process is where a company establishes local dominance, and expand into related
territories, both in terms of physical territory and product market space. E.g. Walmart
began as a small regionally focused discount store where it had little competition, and it
expanded incrementally outward from this geographic base at the periphery of its
existing territory. As it pushed the boundaries of this region outward, it consolidated its
position in the newly entered territory before continuing its expansion. Microsoft also
started by dominating the segment for operating systems, before expanding at the edge
of this business, adding adjacent software products like the Office Suite.

9. The key strategic imperative in market selection is to think locally and achieve
dominance at the local level. Service industries will become increasingly important and
manufacturing less so, and the distinguishing feature of most services is that they are

produced and consumed locally. Opportunities for sustained competitive advantages are
likely to increase as services becomes a bigger part of our economies.

10. There are 3 kinds of genuine competitive advantage: Supply, Demand and Economies of
Scale. Measured by potency and durability, production advantages (i.e. Supply) are the
weakest barrier to entry, economies of scale when combined with some customer
captivity, are the strongest. Demand side barriers to entry are more common and
generally more robust than advantages stemming from the supply or cost side. These 3
competitive advantages are most likely present in markets that are either local
geographically or in product space. Other rarer specific situations form of competitive
advantages including government intervention e.g. license, tariffs and quotas, authorized
monopolies, patents, direct subsidies, and various kinds of regulations, and in financial
markets having superior access to information.

11. Supply competitive advantages are strictly cost advantages that allow a company to
produce and deliver its products or services more cheaply than its competitors. The
incumbent can earn attractive returns under prevailing market conditions (prices and
sales levels) but potential entrants, thanks to their high cost structures, cannot. Such an
advantage deters must sensible firms from entering the incumbents market, but if some
optimistic firms try anyway, the incumbent, taking advantage of its lower cost structure,
can under price, out advertise, out service, or out market the entrant and they will
eventually exit the market. The lowest costs can stem from 1. Privileged access to crucial
inputs e.g. easily extracted commodities, or 2. Proprietary technology that is protected
by patents or by experience or a combination of both.

12. Cost advantages due to lower input costs are very rare. Labour, capital in all forms, raw
materials, and intermediate inputs are all sold in markets that are generally competitive.
Some companies have to deal with powerful unions that are able to raise labour cost, and
they may also face an overhang of underfunded pension and retiree health-care
liabilities. But if one company can enter the market with non-union, low-benefit labour,
others can follow, and the process of entry will eliminate any excess returns from lower
labour costs. The first company to outsource labour to countries like China may gain a
temporary advantage over rivals who are slower to move, but the benefit soon disappears
as others follow suit. Access to cheap funding or deep funding is also an illusionary
advantage. Easy funding doesnt ensure success and only a small number of companies
have been forced to the wall by competitors whose sole advantage was their deep
pockets. In fact, companies with deep pockets have hurt themselves by spending lavishly
on mistaken venture partly simply because they have money. Cheap capital due to
government support is best thought of as a competitive advantage based on government
subsidy. In the absence of government support, the notion of cheap capital is an
economic fallacy. Sometimes cheap capital is based on access to funds that were raised
in the past at unusually low costs, but the real cost of funds is not cheap. If the funds
cost 2% to raise, and the capital market at large offer a 10% return on investments,
investing capital in projects that return 2% is a 8% money loser even if it doesnt actually
lead to losses. Taking advantage of cheap capital like this is stupidity, not a competitive
advantage and are unlikely to be sustainable for long. Some companies do have
privileged access to raw materials or to advantageous geographical locations, but these
advantages tend to be limited in the markets in which they apply, and the extent to
which they can prevent competitive entry. The same is true for exceptional talent as they
can switch companies. With few exceptions, access to low-cost inputs is only a source of
significant competitive advantage when the market is local, either geographically or in
product space, otherwise it is not much help as a barrier to entry.

13. Proprietary technology protected by patents is a product line or process. During the term
of the patent, protection is nearly absolute. Patent infringement penalties and legal fees
make the potential costs to a would-be entrant impractically high. However, the cost
advantages from patents are only sustainable for limited periods till they expire. Patent
protection is relatively brief (on average 17 years) compared to long-term dominance of
markets by Microsoft and Coca Cola.

14. Proprietary technology protected by experience can be found in industries with

complicated processes, where learning and experience are a major source of cost
reduction, e.g. the % of good yields in chemical and semiconductor processes often
increase dramatically over time, due to numerous small adjustments in procedures and
inputs. Higher yields mean lower costs, both directly and indirectly by reducing the need
for expensive interventions to maintain quality and reduce the amount of labour and
other inputs required. Companies that are continually diligent can move down these
learning curves ahead of their rivals and maintain a cost advantage for periods longer
than most patents can afford. But there are limits to the sustainability of these learningbased proprietary cost advantages. Much depends on the pace of technological change.
In industries where technological change is swift, it can undermine advantages that are
specific to processes that quickly become outdated and cost advantages have shorter life
expectancies in rapidly changing areas like semiconductor and biotechnology. But if the
pace of technological change slows down as an industry matures, rivals will eventually
acquire the learned efficiencies of the leading incumbents. Simple products and
processes are not fertile ground for proprietary technology advantages as they are hard
to patent and easy to duplicate and transfer to other firms. If a particular approach to
production/service can be fully understood by a few employees, competitors can hire
them away and learn the essentials of the processes involved. If the technologies are
simply, it is difficult for the developer to make the case for intellectual theft of
proprietary property since much of that technology will look like common sense. This
limitation is particularly important in services e.g. medical care, transaction processing,

financial services, education, retailing, as the technology in these fields tend to be either
rudimentary or developed by specialist 3rd parties. For technology to be truly proprietary
they must be produced within the firm. Markets in which consultants or suppliers are
responsible for most product or process innovations cannot be markets with substantial
cost advantages based on technology because the advantages are available to anyone
willing to pay for them. The idea that information technologies will be the source of
competitive advantage is misguided as most of the innovations in I.T. are created by
companies like SAP, Microsoft, Oracle, who make their living by disseminating
innovations as widely as they can. Innovations that are common to all confer competitive
advantages on none. Companies making better use of those innovation is a matter of
organizational effectiveness and not competitive advantage.

15. When a company enjoys competitive advantages related to proprietary technologies, its
strategy should be to exploit and reinforce it where they can. To exploit its competitive
advantages, with lower costs, it can strike a balance between under-pricing competitors
to improve sales and charging the same to keep the full benefit of the cost advantage. So
long as the firm is alone in the market or surrounded by a myriad of smaller and weaker
competitors (i.e. not a few large dominant firms) it can determine the appropriate price
level by trial and error. It needs to monitor its steps to see which price levels and
marketing choices provide the best return, but it doesnt have to worry explicitly about
the reactions of particular competitors. The process of exploitation is largely a matter of
operational effectiveness and strategies only become complicated when a small number
of powerful firms enjoy competitive advantages in common. To reinforce cost
advantages from proprietary technologies, the company wants to improve them
continuously and to produce a successive wave of patentable innovations to preserve and
extend existing advantages. This is again a matter of organizational effectiveness,
making sure investments in R&D are productive.

16. Demand competitive advantages are when companies have access to market demand
and customers that their competitors cannot match. Branding in the sense of quality
image and reputation by itself is not sufficient to establish superior access to demand.
Competitive demand advantages arise because of customer captivity based on habit,
costs of switching, or the difficulties and expenses of searching for a substitute provider.
It may not be impossible for entrants to lure loyal customers away from an incumbent,
by cutting prices, giving away products for people to try etc. But customer captivity still
entails competitive advantage as entrants cannot attract customers anywhere near the
same terms as the established firm. Unless entrants have found a way to produce the
item or deliver the service at a cost substantially below that of the incumbent (which is
unlikely), either the price at which they sell their offerings or the volume of sales they
achieve will not be profitable for them and thus unsustainable. The incumbent can do
what the challenger cannot, selling its product at a profit to captive customers. However,
these advantages fade over time as new customers are unattached and available to
anyone. Existing captive customers ultimately leave the scene; they move, mature or die,
putting a natural limit on the duration of customer captivity. Even Coca Cola was
vulnerable to Pepsi, and only very few venerable products seem to derive any long-term
benefits from intergenerational transfer of habit.

17. Customer captivity based on habit is when frequent purchases of the same brand
establish an allegiance that is difficult to understand and undermine, e.g. cigarette
brands, Coca Cola. For reasons that are not entirely known, the same kind of attachment
doesnt extend to beer drinkers. Habit succeeds in holding customers captive when
purchases are frequent and virtually automatic. We find this behavior in supermarkets,
not car dealers or computer suppliers. For computer buyers, buyers shop for
replacement hardware on the basis of price, features and dependability, regardless of
existing brand. They do think about compatibility with existing software, but that is a
legacy issue and a switching cost issue, and not that they are creatures of habit. Habit is

also usually local in the sense that it relates to a single product, not to a companys
portfolio of offerings.

18. Customer captivity based on switching costs are when it takes substantial time, money
and effort to replace one supplier with a new one. Software is the product most easily
associated with high switching costs. The costs can be prohibitive as it includes more
than the substitution of the software itself, but also retraining of people in the firm who
are the application users, and the fact that new systems are likely to bump up the error
rate. Especially when the applications involved are critical to the companys operations
(order entry, inventory, invoicing and shipping, patient records, bank transactions),
companies are unlikely to abandon a functioning system even for one that promises vast
increases in productivity, if it holds the threat of terminating the business through
system failure. There costs are reinforced by network effects, e.g. the computer system
must work compatibly with others, and it is difficult to change to an alternatives when
others arent compatible, even if the alternative is in some ways superior. The move will
be costly, to ensure continued compatibility, and even disastrous if the new system
cannot be integrated with the existing one. Besides software, other products or services
that require a supplier to learn a great deal about the lives, needs, preferences, and other
details of a new customer, there is a switching cost involved for the customer who has to
provide all this information, as well as a burden on the supplier to master it, e.g. lawyers,
doctors who are comfortable prescribing a particular medicine may be reluctant to
substitute with a new drug with which they are less familiar. Low switching costs exist in
standardized products, especially if the standards are not proprietary.

19. Customer captivity due to search costs exists when it is costly to locate an acceptable
replacement. Minimal search costs exists when information and ratings on competitive
products are easily available e.g. consumer goods. But for goods and services where
there is no ready source of the kind of information a prospective buyer wants, and where

there is a personal nature of the relationship between buyer and supplier where there
may be an intense level of personal contact, there is no alternative to direct experience,
e.g. finding a new doctor or professional services. High search costs are an issue when
products or services are complicated, customized, and crucial. Standardized products
have low search costs. For businesses, the more specialized and customized the product
or service, the higher the search cost for a replacement and the easier it is to upgrade or
continue with the current provider, even if not totally satisfied since finding a new one is
costly and risky. To avoid the danger of being locked into a single source, many firms
develop relationships with multiple suppliers, including professional service providers.

20. To formulate strategies to exploit and reinforce demand side competitive advantages, a
company with captive customers can charge more than the competition does. So long as
the firm is alone in the market or surrounded by a myriad of smaller and weaker
competitors, it can determine the appropriate price level by trial and error. It needs to
monitor its steps to see which price levels and marketing choices provide the best return
and doesnt have to worry explicitly about the reactions of particular competitors. The
process of exploitation is a matter of operational effectiveness. To reinforce its
competitive advantage from customer captivity, the company wants to encourage habit
formation in new customers, increase switching costs, and make the search for
alternatives more complicated and difficult. For expensive items, it wants to make
purchases more frequent and to spread payments out over time, to ensnare the customer
in an ongoing relationship that is easier to continue than to replace, e.g. car companies
using highly visible annual style changes to encourage frequent purchases, accepting
trade-ins and monthly payments to ease financial burden. To reinforce habit-based
customer captivity, companies have customer loyalty programs and the Gillette strategy
of selling razor cheaply and making money from regular purchase of blades. These
approaches encourage repeated, virtually automatic and non-reflective purchases that
discourage the customer from a careful consideration of alternatives. To reinforce
switching costs-based customer captivity, it is a matter of extending and deepening the

range of services offered. E.g. Microsoft adding features to basic operating system,
making the task of switching to other systems and mastering their intricacies more
onerous, or banks adding in automated bill payments, pre-established lines of credit,
direct salary deposit and other routine functions, and customers are more reluctant to
leave for another bank even if they offer superior terms on some products. To reinforce
search costs-based customer captivity, the same tactic of providing more integration of
multiple features apply. Comparison shopping is more difficult if the alternatives are
equally complicated but not exactly comparable. Also as the importance and added value
of products and services increases, so does the risk of getting a poor outcome from an
alternative provider. Potentially poor results also raise the cost of sampling as something
might go very wrong during the trial period e.g. of a cardiologist or residence insurer.
Complexity, high added value and significance all add to high search costs.

21. The most durable competitive advantages comes from economies of scale with customer
captivity. Understanding how they operate together, e.g. that a growing market is not a
good thing, can help design effective strategies to reinforce them. Economies of scale
competitive advantages are when costs per unit decline as volume increases, because
fixed costs make up a larger share of total costs, and even with the same technology, an
incumbent firm operating at a large scale will enjoy lower costs than its competitors. The
larger firms can be highly profitable at a price level that leaves its smaller competitors,
with their higher average costs, losing money. The competitive advantage of economies
of scale depends not on the absolute size of the dominant firm but on the size difference
between it and its rivals, i.e. on market share. The cost structure that underlies these
economies of scale usually combines a significant level of fixed cost and a constant level
of incremental variable costs. However, in addition to this cost structure, for economies
of scale to serve as a competitive advantage, incumbents need to have a degree of
customer captivity. If an entrant has equal access to customers as the incumbents, it will
be able to reach the incumbents scale. A market in which all firms have equal access to
customers and common cost structures, in which the entrants and incumbents offer

similar products on similar terms, should divide more or less evenly among competitors,
and this holds true for commodity or differentiated markets. All competitors who
operate efficiently should achieve comparable scale and thus comparable average cost.
However with incumbent customer captivity, if an efficient incumbent matches his
competitors on price and other marketing features, then thanks to customer captivity, it
will retain its dominant share of the market. Though entrants may be efficient, they will
not match the incumbents scale of operations, and their average costs will be
permanently higher. The incumbent can thus lower prices to a level where it alone is
profitable and increase its share of the market, or eliminate all profit from competitors
who matches its prices. With some degree of customer captivity, the entrants never catch
up and stay permanently on the wrong side of the economies of scale differential. It
seems reasonable to think that a persistent entrant will sooner or later reach an
incumbents scale of operations if it has access to the same basic technologies and
resources. If the incumbent is not vigilant in defending its market position, the entrant
may catch up, but if an incumbent diligently defends its market share, the odds are in its
favour.

22. There are benefits in operating in markets with limited boundaries. It is difficult to
establish or sustain dominance when the boundaries are vast. Most companies that
manage to grow and still achieve a high level of profitability do it in 1 of 3 ways. They
replicate their local advantages in multiple markets e.g. Coca Cola, they continue to focus
within their product space as that space itself becomes larger e.g. Intel, or they gradually
expand their activities outward from the edges of their dominant market positions e.g.
Walmart and Microsoft. Most markets in which companies can establish competitive
advantages by achieving defensible economies of scale will be local, either geographically
or in product space. If companies look carefully, they will find possibilities for
dominance in some of their markets, where they can earn above normal returns on
investments, but unfortunately, local opportunities are often disregarded in pursuit of
ill-advised growth associated with global strategic approaches.

23. Small markets are more hospitable than large ones for attaining competitive advantages.
For example, a small town can only support one discount store, and a determined
retailer who develops such a store should expect to enjoy an unchallenged monopoly as
if a 2nd store were to enter the town, neither would have enough customer traffic to be
profitable. Other things being equal, the 2nd entrant could not expect to drive out the 1st,
so the best choice would be to stay away, leaving the monopoly intact. A large city can
support many essentially same stores and the ability of a powerful, well-financed
incumbent to prevent entry by a newcomer will be limited and thus unable to establish
effective barriers to entry via economies of scale relative to its competitors. This
principle applies to product as well as geographic space. E.g. Walmart first had high
levels of profit and dominant market share in regional areas due to regional economies
of scale in distribution, advertising, and store supervision.

24. The best strategy for an incumbent with economies of scale is to match the moves of an
aggressive competitor, price cut for price cut, new product for new product, niche by
niche. Then, customer captivity or just customer inertia will secure the incumbents
greater market share and the entrants average costs will be uniformly higher than the
incumbents at every stage of the fight. While the incumbents profits will be impaired,
the entrants will be even lower, often so low that it disappears.

25. Economies of scale coupled with better access in the future to existing customers also
produces an advantage in the contest for new customers and for new technologies.
Customers may be accustomed to dealing with their incumbent supplier and are
comfortable with the level of quality, supply stability, and service support received from
it. Even if other smaller incumbents or potential entrants perform as well in these areas,
but with a much smaller market share and less interactive, these competitors does not
have the same intimate association customers. If both the dominant incumbent and its

competitors both produced similarly advanced new technologies, at equal prices, at

roughly the same time, the dominant firm will inevitably capture a dominant market
share as all the dominant firm has to do is to match its smaller competitors offerings to
retain its dominant market share via customer captivity. Thus, in planning for its nextgeneration technology, the dominant firm can afford to invest a lot more than its
competitors, knowing that its profits will be much greater, even if the technology ends up
being no better than competitors. A rough rule of thumb should lead both the dominant
firm and its smaller competitors to invest in proportion to their current market share,
causing the dominant firm to invest an absolute large sum, giving it an enormous
advantage in the race for developing the next generation technology. Even if smaller
competitors can produce a better new product, customers would almost certainly allow
the dominant firm a grace period to catch up rather than switch supplier immediately.
Thus the dominant firms larger investments usually pay off in superior technology, and
its customer captivity allows it time to catch up when its smaller competitors have taken
the lead. Economies of scale with customer captivity enables the dominant firm to
sustain its technological edge over many generations of technology.

26. Economies of scale in distribution and advertising also helps perpetuate and amplify
customer captivity across generations of consumers, giving giants an edge in winning
new generations of customers. Even if smaller rivals can spend the same proportion of
revenue on product development, sales force, and advertising, they cannot come close to
matching the giants on actual dollars deployed to attract new customers. E.g. Coca Cola
has local economies of scale in advertising and distribution and thus have an edge in
acquiring new customers as it can appeal to them (advertise) and serve them (distribute)
at a much lower cost per unit than can its smaller competitors. However, these
advantages are particular to specific geographic regions and despite worldwide
recognition, it isnt the dominant soft drink everywhere.

27. In order to persist, competitive advantages based on economies of scale must be

vigorously defended as they are vulnerable to gradual corrosion. Any market share lost
to rivals narrows the leaders edge in average cost. Each step a competitor takes towards
increasing the size of its operations and closing the gap makes the next step easier,
because its margins and thus its resources are improving as its cost declines. In contrast,
competitive advantages based on customer captivity or cost advantages are not affected
by market share losses. When economies of scale are important, the leader must be
always on guard. If a rival introduces attractive new product features, the leader must
adopt them quickly. If a rival initiates a major advertising campaign or new distribution
systems, the leader has to neutralize them. The incumbent also cannot concede
unexploited niche markets, which are an open invitation to entrants looking to reach a
minimally viable scale of operations, e.g. new distribution channel, new products. The
incumbent can also take the first step and increase fixed costs, e.g. advertising heavily,
and it will present smaller competitors with the nasty alternative of matching the
expenses and hurting their margins or not matching and losing the competition for new
customers. Production and product features that require capital expenditures, like
building centralized facilities to provide automated processing, will also make life more
difficult for smaller competitors. Accelerating product development cycles, and thus
upping the cost of R&D is another possibility. Anything that efficiently shifts costs from
variable to fixed will reinforce advantages from economies of scale. Ill-conceived growth
plans will do the opposite and companies should not spend copiously in markets where
they are newcomers battling powerful incumbents, but instead defend the markets in
which they are dominant and profitable. Competitive advantage are market-specific and
companies should stay within their areas of fundamental competitive advantage.

28. Pure size is not the same as economies of scale, which depends on the share of the
relevant market. Economies of scale arise when the dominant firm in a market can
spread the fixed costs of being in that market across a greater number of units than its
rivals. The relevant market is the area, geographic or product space, in which the fixed

costs stay fixed. E.g. for a retail company, the relevant market is each metropolitan area
or regional cluster, where distribution infrastructure, advertising expenditures, and store
supervision expenses are largely fixed in an area. If sales are added outside that territory,
fixed costs rise and economies of scale diminish. Thus, a company that is larger
nationally can have a higher fixed cost per dollar of revenue in a particular region than
its competitor, who controls a far great market share of the relevant territory. For
product lines, R&D costs, start-up costs of new production lines and product
management overhead are fixed costs associated with specific product lines. Network
economies of scale are when customers gain by being part of densely populated
networks, but the benefits and economies of scale extend only as far as the reach of the
network. E.g. insurance coverage of doctors for a firm might be larger nationally, but
what matters in a region is insurance coverage of doctors in the region, so a firm with
60% share of doctors is more appealing than a large national firm with only 20% share
of doctors in the relevant local region. There are only a few industries in which
economies of scale coincide with global size, e.g. the globally connected markets for
operating systems and CPUs, where Microsoft and Intel are the beneficiaries of global
geographic economies of scale. However, they concentrate on a single product line and
hence on local product space economies of scale.

29. The big size and rapid growth of a market is generally the enemy of competitive
advantage based on economies of scale, not the friend. The strength of this advantage is
directly related to the importance of fixed costs and as a market grows, fixed costs
remains constant, and variable costs increase at least as fast as the market itself. Thus
fixed costs declines as a proportion of total cost. Markets growing rapidly are attracting
new customers, who are by definition non-captive and may provide a base of viable scale
for new entrants. This reduces the advantages provided by greater incumbent scale.
Growth in the market lowers the hurdle an entrant must clear in order to become viably
competitive as the incumbent need a smaller market share given a bigger market in
order to have fixed costs as a particular percentage of total costs. As markets become

international and massive, e.g. the global market for automobiles is so large that many
competitors have reached a size, even with a small market share, at which they are no
longer burdened by an economies of scale disadvantage. For very large potential
markets, the relative importance of fixed costs are unlikely to be significant. If new
entrants can capture a market share sufficient to support the required infrastructure,
established online sales companies like Amazon will find it difficult to keep them out.
Although counterintuitive, most competitive advantages based on economies of scale are
found in local and niche markets, where either geographical or product spaces are
limited and fixed costs remain proportionately substantial. Markets that are not large
enough for a 2nd or 3rd company to reach viable scale will fare better in terms of
profitability. Big markets will support many competitors even when there are substantial
fixed costs.

30. The appropriate strategy for both incumbents and entrants is to identify niche markets,
understanding that not all niches are equally attractive. An attractive niche must be
characterized by customer captivity, small size relative to fixed costs, and the absence of
vigilant, dominant competitors. Ideally it will also be readily extendable at the edges.
Economies of scale advantages with customer captivity can also be created in markets
with significant fixed costs, currently serviced by many small competitors, with a degree
of customer captivity. A firm will have the opportunity to capture a dominant market
share that will be defensible. The best course is to establish dominance in a local market
and expand outwards from it, either geographically or in product space. Even where
incumbent competitors have dominant positions, lack of vigilance on their part may
present openings for successful encroachment. Economies of scale in local markets are
thus the key to sustainable competitive advantages.

31. Strategic analysis should begin with 2 key questions: 1. In the market in which the firm
currently competes or plans to enter, do any competitive advantages actually exist? 2. If
they do, what kind of advantages are they?

32. Markets in which no firms benefit from significant competitive advantages

doesn't need to concern itself with strategy (which looks outward to the
marketplace and the actions of competitors). If there are no barriers to entry,
then the company doesnt have to worry about interacting with identifiable competitors
or about anticipating and influencing their behavior as there are too many of them to
deal with. Lots of competitors have equal access to customers, technologies, and cost
advantages. Each firm is more or less in the same competitive position and
there is a level playing field, and anything that one does to improve its
position can and will be immediately copied. The process of innovation and
imitation repeats continually. It is difficult for a single firm to shift the basic economic
structure of such a market significantly for its benefit. The sensible course in such

markets is not to try to outmaneuver competitors and forget visionary strategic dreams,
but rather to simply outrun them by operating as efficiently as possible. What matters is
efficiency in managing costs, in product development, in marketing, in pricing to specific
customer segments, in financing, etc. Constant pursuit of operational efficiency is
essential in markets without competitive advantages. It is a tactical matter,
not a strategic one, and focuses internally on a company's systems,
structures, people, and practices. Although it is not strategic, it is very important,
but it does not require consideration of all the external interactions that are the essence
of real strategy. Operational effectiveness can make one company much more profitable
than its rivals even in an industry with no competitive advantages, where everyone has
basically equal access to customers, resources, technology, and scale of production.
Firms that are operationally effective tend to focus on a single business and their own
internal performance.

33. In markets where incumbents have competitive advantage, companies need to identify
the nature of the competitive advantages, and manage the competition among their
peers and how effectively they are able to fend off potential entrants. If the advantages
dissipate, whether because of poor strategy or bad execution, these companies will be on
a level economic playing field under the no competitive advantage branch, where profits
are average at best, except for the exceptionally managed companies.

34. In the situation where there is 1 large dominant firm with competitive advantage and
many smaller ones, a company in this market is either an elephant, or an ant. The ants
operate with a competitive disadvantage and if it already in the industry, it should get
out as painlessly as possible and return the economic resources of whatever is
salvageable to its owners. If a firm is considering entering a market with an elephant as
an ant, the company should stop and look elsewhere because its slim chance for success
depends on the elephant competitor messing up. Even if the incumbent elephants

advantage shrinks and the barriers to entry disappear, the new firm will be just one of
many entrant pursuing profit on an essentially level playing field.

35. The elephant in the situation where there is 1 large dominant firm with competitive
advantage and many smaller ones still have to manage its competitive advantages.
Complacency can be fatal, as can ignoring or misunderstanding the sources of ones
strength. The company should recognize its sources of competitive advantage, along with
its limitations, and seek to sustain it (it doesnt have to confront the complexities of
explicit mutual interactions among competitors). This will allow it to reinforce and
protect existing advantages and make those incremental investments that will extend
them. It also allows management to distinguish potential areas of growth, both
geographically and in product lines, that are likely to yield high returns from tempting
areas that might undermine the advantages. It highlights policies that extract maximum
profitability from the firms situation, and spots threats that are likely to develop and
identifies those competitive inroads that require strong countermeasures. It also allows
functional departments to properly carry out capital budgeting, evaluating M&A, and for
new ventures.

36. If a market has competitive advantage that are shared by several companies who enjoy
roughly equivalent competitive advantages with similar capabilities, strategy
formulation is most intense and demanding as companies need to manage their
competitors. To develop an effective strategy, a company needs to know what its
competitors are doing and anticipate these competitors reaction to any move the
company makes as their reactions are critical to a companys own performance, e.g.
pricing policies, new product lines, geographical expansions and capacity addition.
There are 3 approaches that can help companies develop competitive strategies: game
theory, simulation and cooperative analysis. Taken together, they will produce a
balanced and comprehensive treatment to the problem of formulating strategy in

markets with a few genuine competitors, all mutually capable and conscious of each
other.

37. Classical game theory is useful because it imposes a systematic approach to collecting
and organizing the mass of information about how competitors may behave. Game
theory is the study of the ways in which strategic interactions among rational players
produce outcomes with respect to the utilities/preferences of those players, none of
which might have been intended by any of them. A competitive situation consists of the
players (a restricted number of identifiable competitors; if the list is not short and
manageable, there are probably no genuine barriers to entry), the choices available to
each player, the motives that drives each player (most commonly profitability, or other
goals like winning against competitors regardless of costs) and the rules that govern the
game (who goes when, who knows what and when, and what penalties there are for
breaking the rules). The fundamental dynamics of majority of competitive situations can
be captured by 2 relatively simple games. The Prisoners Dilemma game describes
competition that concerns price and quality. A lot is known about how a PD game is
likely to play out, and this knowledge can be brought to bear on any situation in which
price/quality competition is key to competitive interactions. The other game focuses on
entry/pre-emption behavior by capturing the dynamics of quantity and capacity
competition. Whenever a company decides to build a new plant or open a new store in a
market already served by a competitor, entry/pre-emption is the game bring play, and
like PD we can use the wealth of established knowledge on how a situation will work out.

38. Given that a company is in a situation where competitive advantages are shared by
multiple competitors, an approach to strategic analysis would be to start by identifying
the competitive situations to which one or another of these 2 games can be appropriately
applied. If an industrys history has been dominated by a long-lived and debilitating
price war, then the place to look for a solution is the accumulated knowledge of how to

play the PD game. If the industry is one in which any expansion by 1 firm has habitually
induced its rival to counter with their own expansions, then the entry/pre-emption game
provides the template for strategic analysis. In simple straightforward interactions, it
may be possible to anticipate how the game will evolve merely by listing the various
courses of action and comparing the results. In practice alternative possibilities multiply
rapidly and the analysis becomes intractable, and a better way is to proceed with
simulation. One can assign individuals or teams to represent each competitor, provide
them with appropriate choices for actions with motives, and then play the game several
times. The simulation should provide a rough sense of the dynamics of the situation,
even the outcomes are only rarely definitive.

39. Cooperative analysis is analysing competition among the elephants by assuming that
instead of battling, companies can learn how to cooperate for mutual gains and to fairly
share the benefits of their jointly held competitive advantage. This type of bargaining
interaction makes all the players better off than fighting each other, but requires an
outlook and a disposition rarely found in a competitive environment. Even if it isnt
immediately practical and are rare, players need to think about what this ideal state of
affairs would look like, as it reveal aspects of the strategic situation that can guide
company decision making even in the absence of full-fledge cooperation. It also adds a
bargaining perspective as a complement to the more traditional non-cooperative
treatment of the problems of formulating strategy in markets with a few genuine
competitors, all mutually capable and conscious of each other. Companies need to
identify joint gains and envision the best configuration of market activity, where costs
are minimized, products and services most efficiently produced and delivered, and
prices set to maximize income. In the ideal configuration, everyone in the market
including competitors must benefit, i.e. how would the market look like if it were
organized as a cartel or monopoly? The players also have to decide upon a fair division of
the spoils because cooperative arrangements dont last if any participants believes it is
being unfairly treated. Analysing the theoretical ideal configuration helps identifies the

possibilities a cooperative posture might produce, and helps a firm on the margin of a
protected market or a potential entrant to set reasonable strategic goals. E.g. for a
relatively high cost supplier with no captive customers, it should see that it cannot expect
to gain any advantage through strategic alliances, competitive threats or other means as
if the market is configured efficiently, such a supplier has no role to play as other
competitors wont support it at the price of a reduction in overall industry performance,
especially when the others have to pay the costs. The high cost firms continued existence
will hinge on irrational and non-cooperative behavior from other companies. Identifying
and exploiting that behavior and making sure they dont get together becomes the core
of its strategy.

40. Commodity businesses should be avoided as any operation in which sellers offer
essentially identical products to price-sensitive customers faces an intense struggle for
economic survival and must accept a lower than average level of profitability. A flawed
wisdom in business is that management shouldnt allow themselves to be trapped in a
commodity business and to differentiate its products from that of the competition.
However, differentiation as a strategy to escape the woes of a commodity business
doesnt work. Differentiation may keep ones product from being a generic commodity
item, but it doesnt eliminate the intense competition and low profitability that
characterizes a commodity business. Although the nature of the competition may change
(from pure price competition to minimal price competition but lower volumes due to
fragmentation of market across the variety of substitute differentiated products, causing
higher fixed costs per unit), the damage to profit persists because the problem is not a
lack of differentiation but the absence of barriers to entry. By itself, product
differentiation doesnt eliminate the corrosive impact of competition and
well-regarded brands are no better protected than commodities. High returns
attract new entrants or expansion by existing competitors or both. 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.

41. An example of high differentiation but low commodity-type profits can be found in
automobiles. Despite the recognition and associations with quality, Mercedes-Benz have
not been able to translate the power of its brand into an exceptionally profitable
business. MB first dominated its local market and made exceptional profits, attracting
other companies to enter its market, seeking a share of high returns. If luxury cars were
a pure commodity business, the entry of new competitors would have undermined
prices. However, MB continued to sell for premium prices even with the entry of imports
because the imports did not, as a rule, undercut them on price. But with a wider variety
of luxury cars available, the sales and market share of MB began to decline. Meanwhile,
the fixed costs of its differentiation strategy product development, advertising,
maintaining dealer and service networks did not contract. Thus the fixed cost of each
car went up, and price remained constant, so profit margin per car dropped. MB found
itself selling fewer cars with lower profit margins and profitability shrank even though
products were thoroughly differentiated. The flood of entrants would only case when
lucrative profit opportunities in the luxury car market vanishes after entrants have
fragmented the market to such an extent that high fixed costs per unit eliminated any
extraordinary profits.

42. In markets with no barriers to entry, efficiency is vitally linked in survival. In a pure
commodity market, if a company cannot produce at a cost at or below the price
established in the market, it will fail and ultimately disappear. Since the market price of
a commodity is determined in the long run by the cost levels of the most efficient
producers, competitors who cannot match this level of efficiency cannot survive. The
same conditions apply to markets with differentiated products. Companies must invest
in advertising, product development, sales and service departments, product specialists,

distribution channels, and a host of other functions to distinguish their offerings from
those of their competitors. If they cannot operate all these functions efficiently, then they
will lose out to better-run rivals. The prices their products command and/or their
market share will trail those of their competitors and thus the return they earn on the
investments made to differentiate their products will fall below that of their more
efficient competitors. When the successful companies expand, market shares of less
efficient firms decline further and even if they can still continue to charge premium
prices, the returns they earn on their investments in differentiation will fail. When the
returns no longer justify the investment, the less efficient companies will struggle to stay
afloat.

43. The need for efficiency is vital in both commodities and differentiated products, but in
differentiated products, efficiency is more difficult to achieve. In commodities, efficient
operations are largely a matter of controlling production costs and marketing
requirements are usually minimal. With differentiated products, efficiency is a matter of
both production cost control and the effectiveness in all the functions that underlie
successful marketing. Competition extends to dimensions beyond simple cost controls
such as managing product and packaging developments, market research, product
portfolio, advertising and promotion, distribution channels, a skill sales force, and doing
them all without wasting money. Unless something interferes with the processes of
competitive entry and expansion, efficient operations in all aspects of the business are
key to successful performance.

44. Meaning of a normal return implies average return over a period of years. Investors
in a business needs to be compensated for the use of their capital. To be normal, the
return to capital should be equivalent to what the investor can earn elsewhere, suitably
adjusted for risk. If investors can earn a 12% return by buying stocks in companies with
average risk, then the companies have to earn 12% on their own average risk

investments. Otherwise, investors will ultimately withdraw their capital. In practice, a

management that produces a lower rate of return can hang on for many years before the
process runs its course, but in the long run, the company will succumb.

45. It is essential to distinguish between skills and competencies a firm may possess, and
genuine barriers to entry. Skills and competencies of the best-run companies are
available to competitors, at least in theory. Systems can be replicated, talent hired away,
managerial quality upgraded, and all these are ultimately parts of the operational
effectiveness of the company. Barriers to entry are characteristics of the structural
economics of a particular market. 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. If barriers to entry exists, then firms within the barriers must be
able to do things that potential entrants cannot, no matter how much money they spend
and how effectively they emulate the practices of the most successful companies.

46. Just as extraordinary profits attract new competitors or motivate existing ones to
expand, below-average profitability will keep them away. If the process is sustained long
enough, the less efficient firms within the industry will wither and disappear. However,
it takes longer for an industry with excess capacity and below-average returns to
eliminate unnecessary assets than it does for an industry with above average returns to
add new capacity. Periods of oversupply last longer than periods in which demand
exceeds capacity. The problem is compounded by the longevity of new plants and
products. For mature, capital-intensive businesses, these time spans are apt to be longer
than for younger industries that require less in the way of plant and equipment.
Commodity businesses are generally in the mature camp, and part of their poor
performance stems from their durability, even after they are no longer earning their
keep. Competitors with patient capital and an emotional commitment to the business
can impair the profitability of efficient competitors for many years.

47. Barriers to entry and competitive advantages are the same thing. Barriers to entry are
identical to incumbent competitive advantages, whereas entrant competitive advantages
(situations in which the latest firm to arrive in the market enjoys an edge due to the
benefit of the latest technology, hottest product design, no costs for maintaining legacy
products or retired workers) are of limited and transitory value. Once an entrant enters a
market, it becomes an incumbent. The same type of advantages it employed to gain entry
and win business from existing firms now benefit the next new company. If the last firm
always has the advantage, there are no barriers to entry and no sustainable excess
returns. Since competitive advantages belong only to the incumbents, their strategic
planning must focus on maintaining and exploiting those advantages. For firms bold
enough to enter markets protected by barriers to entry, they should devise plans to make
it less painful for incumbents to tolerate them than to eliminate them.