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STR 421

STR 421. Economics of Competitive Strategy Michael Raith Spring 2007. Today’s class. 2. Value creation and competitive advantage 2.1 Value creation and positioning 2.2 Friday: Sustainability of a competitive advantage. Value. Value Created = Buyer’s benefit - Cost of inputs

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STR 421

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  1. STR 421 Economics of Competitive Strategy Michael Raith Spring 2007

  2. Today’s class 2. Value creation and competitive advantage 2.1 Value creation and positioning 2.2 Friday: Sustainability of a competitive advantage

  3. Value • Value Created = Buyer’s benefit - Cost of inputs = B - C = (B - P) + (P - C) = Consumer Surplus + Profit • The price P determines how much of the value created is captured by the seller, and how much by the buyer.

  4. Value and competition • Example: pricing of Glaxo’s Paxil vs. generic • Suppose Glaxo’s MC=100, generic’s MC=90 • Two types of customers • Type 1: B for Paxil = 150, B for generic = 110 • Type 2: B for Paxil = 120, B for generic = 100 • Both prefer brand, but type 1 has stronger brand preference • What prices should we expect to see?

  5. Suppose only customers of type 1 • Before expiry of patent, Glaxo can charge up to P=150 • After expiry of patent, Glaxo and generic compete in making “consumer surplus bids” B-P • Prices fall until Pgen=90, where buyers get surplus of 20 • Glaxo can still charge 150 – 20 = 130 • Or slightly less and get all of the business

  6. Suppose only customers of type 2 • Before expiry of patent, Glaxo can charge up to P=120 • After expiry of patent, prices fall until Pgen=90, where buyers get surplus of 10 • Glaxo can charge up to 120 – 10 = 110 • Or slightly less and get all of the business

  7. Suppose both types present in market • After expiry of patent, Glaxo can still price generic out of market with price below 110 • Merck priced Zocor below generic after expiry in 2006 • More likely: equilibrium where • Generic charges 100 and sells only to type 2 • Glaxo charges 150-10=140 and sells only to type 1 • Less business but much higher margin

  8. Conclusions • A firm’s competitive position depends on B and C. Price is determined through competition • With identical buyers (1 or 2), what matters is added value • Paxil’s value B – C is 50 or 20; generic’s value is 20 or 10 • Generic has no added value, gets no business in equilibrium • “Vertical product differentiation”: customers with different WTP for quality sort themselves to high/low (perceived) quality products

  9. Customer heterogeneity and product differentiation • For most products, customers’ preferences and products offered differ along many dimensions • Products are horizontally differentiated if different customers rank products in different ways • Products are vertically differentiated if all customers rank products in the same way • Different firms offer differentiated products because customers have heterogeneous preferences for product attributes or quality

  10. Dimensions of a company’s market position • Horizontal: type(s) of products offered • Geographical location • Product attributes: e.g. beverage vs. food cans • Vertical: level of (perceived) quality • Scope: broad or narrow product range • Broad strategy advantageous if there are scale or scope economies to exploit • Often chosen by market leaders as they grow over time, often not an option for new companies

  11. (Horizontal) differentiation relaxes rivalry • Recall: “Bertrand trap” result assumes homogeneous products • With differentiated products: • a firm cannot steal all customers from rivals by undercutting their price only slightly • Price cutting stops where gain from increase in demand is outweighed by decrease in margin • In equilibrium, prices above MC and positive profits! • See differentiated Bertrand model, Linesville market in BDSS Ch. 6 (Hotelling model)

  12. The vertical dimension: The seller’s cost-quality tradeoff

  13. The buyer’s price-quality trade-off Price-quality indifference curves:

  14. Different buyers have different WTP for quality: High valuation of quality Low valuation of quality

  15. Vertically differentiated industry: firms offer different levels of quality, targeting groups of customers that differ in their WTP for quality:

  16. Two related goals in choosing the right position • Choose what you want to do • choose position on the frontier: cost or differentiation strategy? • choose “horizontal” position: which segment(s) of market? • Be different! Most important way to avoid Bertrand trap • Reach or push out the productivity frontier: do most efficiently whatever you do • Strategic fit: all activities tailored to strategy • Competitive Advantage = • ability of a firm to outperform its industry • …in its segment of the market

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