WCM Educational Recap #4: Intro to Business Strategy

Recapped by Ariana Ghavami

Business Strategy, Competitive Advantage and Game Theory

This week we took a closer look at the qualities that give businesses a significant edge in the market, including supply advantage, demand advantage, and economies of scale. In addition to competitive advantage, we also introduced game theory.

Competitive Advantage

A competitive advantage is a characteristic unique to a certain business that allows it to operate in a superior position compared to its competitors. Businesses benefit from their competitive advantages because it can act as a barrier to entry, making it difficult for competitors to compete at the same tier or enter the industry altogether. That being said, a competitive advantage is not guaranteed to a firm, nor should it be taken for granted. External factors in the market change, and competitors will try to emulate a business’ competitive advantage. Therefore, a company with a robust competitive advantage needs to make strategic decisions to protect and maintain it in the long-run.

It is important to identify if a business has a competitive advantage because it can be used in internal decision making, or it can impact the strategic decisions of other businesses in the market. Two common attributes associated with competitive advantage are a stable market share that has fluctuated less than 2% in the last 5 to 8 years and a high return on capital (15%-25% after-tax).

A business’ characteristics that contribute to a competitive advantage generally fall into two categories: strong, genuine competitive advantage and weak or unstable competitive advantage. The strongest competitive advantage comes from either a supply advantage, demand advantage, economies of scale, or any combination of the three. On the other hand, branding/product differentiation, the “first-mover” advantage and regulatory barriers to entry are business advantages that have weak competitive advantages. Product differentiation can be emulated and lost as an advantage if competitors adopt similar marketing strategies, the “first-mover” advantage is not sustainable unless it is accompanied by cost advantages, customer captivity, or rapid scaling, and regulatory barriers to entry are not sustainable because it relies on government regulations that are outside business’s control.

• Supply Advantage: Supply advantage is essentially a cost advantage. A company that has spent many years in an industry has the opportunity to gain knowledge and experience that will enable it to reduce costs over time. In addition to the benefits of time and expertise in an industry, supply advantage references a businesses’ ability to protect intellectual property through patents. Supply advantage also includes proprietary access to inputs; For example, a restaurant may have an exclusive deal with one of its suppliers that grants them fresher produce.
• Demand Advantage: Demand advantage boils down to three types of customer captivity: habit, searching costs, and switching costs. Customers become captive due to habit when their purchases are made with little thought and are virtually automatic. A great example of the power of habitual customer captivity is in coffee drinkers; their habit of drinking morning coffee on the way to work makes them a consistent, repeat customer because the choice to get a coffee is virtually automatic. Additionally, searching costs create customer captivity because it can be very costly to locate a suitable alternative to the services a customer is already receiving. Similar to searching costs, the final type of customer captivity is switching costs. Customers are held captive and discouraged from taking their business elsewhere because switching costs may be strategically created. For example, switching costs may be incorporated into engagement contracts to penalize those who may want to leave earlier than originally agreed.
• Economies of scale: In essence, economies of scale is the idea that cost per unit declines as the volume produced increases. This happens because a business’s fixed costs (costs that are constant regardless of output levels) are spread across a larger amount of goods, lowering the cost per good. It is important to note that a business’s competitive advantage in the context of economics of scale is not a product of the absolute size of the company, rather the company’s size relative to its competitors.

Key Takeaways:

1. Competitive advantages based on economies of scale must be defended
2. Pure size is not the same as economies of scale
3. Growth of the market is generally the enemy of competitive advantage

Business Strategy

Business strategy can be divided into two types of decisions: strategic decisions and tactical decisions.

• Strategic Decisions: Strategic decisions look to answer big questions that impact the entire business like “What business do we want to be in?” or “How will we deal with competitors?”. Typically, these decisions are made by top management or the board of directors and focus on the allocation of corporate resources. Strategic decisions also focus on the long-term as they impact the business’s success and survival and are made in response to the actions and reactions of other entities.
• Tactical Decisions: Tactical decisions have a significantly smaller scope and are limited to divisional or departmental resource allocation. These decisions look to answer questions like “How do we improve delivery times?” or “How big a promotional discount do we offer?”. Typically tactical decisions carry limited risk and are made in yearly, monthly, or daily time frames.

What is Game Theory?

Game theory is the study of mathematical models of strategic interactions between rational decision-makers. To evaluate these interactions, game theory sets up several “games” with multiple “players.” The three that we will discuss further are the Prisoners’ Dilemma, Entry/Pre-Emption, and Co-operation. The Nash Equilibrium is a key concept to game theory that describes a situation where no player can gain an advantage by unilaterally changing their strategy.

The Prisoner’s Dilemma

The Prisoner’s Dilemma describes a situation where two bank robbers (A & B) are arrested and charged, but they can only be prosecuted if one testifies against the other. Subsequently, each robber is given a choice: remain silent, or testify. If both remain silent, they will only receive 1 year in jail each for petty crimes. If one testifies while the other remains silent, the prisoner testifying will receive 0 years while the other will receive 3 years. If both testify, each will get 2 years in jail for sharing responsibility for the crime.

The Prisoner’s Dilemma creates a paradox where both individuals acting in self-interest cannot produce the optimal outcome. The paradox arises because both prisoners are incentivized to cheat, and is often applied to business’ strategic actions.

Applying the Prisoner’s Dilemma to business, it is important for businesses to maintain a cooperative equilibrium (the prisoners’ cooperative equilibrium is for both to confess and both to serve 2 years). Two key factors that help maintain a competitive equilibrium are stable expectations between players and stable behaviour between players. Stability of expectations and behaviour contribute to a stable cooperative equilibrium, because they ensure all players adhere to the present choices and that no player can further improve their outcome.

Entry/Pre-Emption

Aside from price competition outlined in the Prisoner’s Dilemma, the other commonly occurring competitive situation is entry/pre-emption that involves deciding to enter a market or expand in an existing market. The main players are the entrant who attempts to enter the market and the incumbent who aims to preserve their market share. The general strategy for the entrant is to avoid head-to-head competition, limit their capacity, spread out their impact of entry, and move slow and steady. Conversely, the incumbent’s strategy is to maintain a large excess of capacity for confrontation, a war chest for financing and focus on a given product.

Cooperation

Rather than maximizing rewards through competitive strategy, the cooperation model determines collective reward sharing, rendering strategic and tactical decisions and secondary decisions. However, cooperation is difficult to implement due to antitrust concerns and accusations of collusion between firms.

Steps in Cooperation:

1. Parties determine attainable joint rewards
2. Determine an optimal choice framework
3. Maximize joining rewards within the framework
4. Agree on how to divide gains

Key Takeaways

1. Good Business vs. Good Investment: Overlapping, but not necessarily the same
2. Identifying Competitive Advantages: What keeps their market captive or position stable?
3. Game Theory: A firm’s actions are made relative to their environment