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July 26, 2006

Competition Demystified

In an excerpt from their 2005 book, Bruce Greenwald and Judd Kahn present a radical improvement to Michael Porter's strategy framework.

Topics: Strategy

Anyone running a business knows that competition matters and that strategy is important. But although most experienced businesspeople recognize that these two critical elements of business are associated, few understand their essential natures or the direct relationship between them.

Executives often confuse strategy with planning. Essentially, any plan that answers the question “How can we make money?” is considered strategic. As a result, too many leaders end up fighting wars they cannot win while failing to protect and exploit the advantages that are the real bases for their success.

Strategies are indeed plans for achieving and sustaining success. But they are not just any ideas for how to make a product or service and sell it profitably to customers. Rather, strategies are those plans that specifically focus on the actions and responses of competitors.

At its core, strategic thinking is about creating, protecting and exploiting competitive advantages. In a market open to all competitors on equal terms, competition will erode the returns of all players to a uniform minimum. Therefore, to earn profits above this minimum, a company must be able to do something that its competitors cannot. It must, in other words, benefit from competitive advantages. The appropriate starting point of any strategic analysis is a careful assessment of those economically advantageous aspects of a firm’s market situation that cannot be replicated by its competitors or, at most, can be reproduced by only a handful of them.

The existence or absence of competitive advantages forms a kind of continental divide when it comes to strategy. On one side are the markets in which no firms benefit from significant competitive advantages. Anything that one firm does to improve its position can and will be immediately copied. In these markets, the sensible course is not to try to outmaneuver the competitors, but rather to simply outrun them by operating as efficiently as possible.

On the other side of the divide are the markets where strategy is critically important. In these markets, incumbents have competitive advantages, and the race for profitability is shaped by how well companies manage the competition among their peers and how effectively they are able to fend off potential entrants. A focus on outsiders lies at the heart of business strategy.

What is Strategy?

For at least the last half century, strategy has been a major focus of management concern. Over the decades, definitions of strategy have changed, and the processes for developing it have undergone endless modifications and revolutions. Yet within all of this flux, one feature of strategy has stood out to distinguish it from other management responsibilities.

Strategy is big. Unlike tactical choices, everyone knows strategic decisions mean long-term commitments for the organization. They require large allocations of resources.

But big, whether measured by financial commitments or hours spent in planning, or even outcomes, is not the same thing as strategic. In our view, strategic decisions are those whose results depend on the actions and reactions of other economic entities. Tactical decisions are ones that can be made in isolation and hinge largely on effective implementation. Understanding this distinction is key to developing effective strategy.

Strategic choices are outward looking. They involve two issues that every company must face. The first issue is selecting the arena of competition, the market in which to engage. The second strategic issue involves the management of those external agents. In order to devise and implement effective strategy, a firm has to anticipate and, if possible, control the responses of these external agents.

One Single Force

Thanks to Michael Porter’s groundbreaking work Competitive Strategy, published in 1980, strategic thinking increasingly has come to recognize the importance of interactions among economic actors. By concentrating on external agents and how they behave, Porter clearly moved strategic planning in the right direction. But, for may people, identifying the many factors in Porter’s complex model and figuring out how they will play off one another has proven to be frustratingly difficult.

We agree with Porter’s view that five forces — Substitutes, Suppliers, Potential Entrants, Buyers and Competitors within the Industry — can affect the competitive environment. But we do not think that those forces are of equal importance. One of them is clearly much more important than the others. It is so dominant that leaders seeking to develop and pursue winning strategies should begin by ignoring the others and focus only on it. That force is barriers to entry — the force that underlies Porter’s “Potential Entrants.”

If there are barriers, then it is difficult for new firms to enter the market or for existing companies to expand. Essentially there are only two possibilities. Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not. No other feature of the competitive landscape has as much influence on a company’s success as where it stands in regard to these barriers.

If there are no barriers to entry, then many strategic concerns can be ignored. The company does not have to worry about interacting with identifiable competitors or about anticipating and influencing their behavior. There are simply too many of them to deal with. Life in an unprotected market is a game played on a level playing field. In these markets, only the very best players will survive and prosper, and even they have to be continually on their toes.

The existence of barriers to entry means that incumbent firms are able to do what potential rivals cannot. Thus barriers to entry and incumbent competitive advantages are simply two ways of describing the same thing. Entrant competitive advantages, on the other hand, have no value. By definition, a successful entrant becomes the incumbent. It then is vulnerable to the next entrant. So it is only in the presence of incumbent competitive advantages that strategy, in our sense of the term, comes to the fore.

Like most other recent authors on strategy, we owe a debt to Michael Porter. We have simplified his approach by concentrating first on the one force that dominates all the others: barriers to entry. Our purpose is not to ignore Porter’s forces but to prioritize and clarify them. Simplicity and clarity are important virtues of strategic analysis, provided we keep in mind Einstein’s admonition that “everything should be made as simple as possible, but not simpler.”

Which Competitive Advantages?

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

The analysis is made easier because there are only three kinds of genuine competitive advantage:

Supply. These are strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors. Sometimes the lower costs stem from privileged access to crucial inputs. More frequently, cost advantages are due to proprietary technology that is protected by patents or experience — know-how — or some combination of both.

Demand. Some companies have access to market demand that their competitors cannot match. This access is not simply a matter of product differentiation or branding, since competitors may be equally able to differentiate or brand their products. These demand advantages arise because of customer captivity that is based on habit, on the costs of switching or on the difficulties and expenses of searching for a substitute provider.

Economies of scale. If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large scale will enjoy lower costs than its competitors.

Beyond these three basic sources of competitive advantage, government protection or, in financial markets, superior access to information may also be competitive advantages, but these tend to apply to relatively few and specific situations. The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space.

Local Champions

In an increasingly global environment, with lower trade barriers, cheaper transportation, faster flow of information and relentless competition from both established rivals and newly liberalized economies, it might appear that competitive advantages and barriers to entry will diminish. But this macro view misses one essential feature of competitive advantages — that competitive advantages are almost always grounded in what are essentially “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 — than when it is large and scattered. That is because the sources of competitive advantage tend to be local and specific, not general and diffuse.

Paradoxically, in an increasingly global world, the key strategic imperative in market selection is to think locally. If the global economy follows the path of the more developed national economies, service industries will become increasingly important and manufacturing less significant. The distinguishing feature of most services is that they are produced and consumed locally. As a consequence, opportunities for sustained competitive advantages, properly understood, are likely to increase, not diminish. The chances of becoming the next Wal-Mart or Microsoft are infinitesimal, but the focused company that understands its markets and its particular strengths can still flourish.

© Copyright Bruce Greenwald and Judd Kahn, 2005. All rights reserved.

 

Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management and director of the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School.

Read the Research

Bruce Greenwald, Judd Kahn

"Competition Demystified: A Radically Simplified Approach to Business Strategy"

View abstract/citation 

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