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CHAPTER 5
Building Competitive Advantage Through
Business-Level Strategy
SYNOPSIS OF CHAPTER
The purpose of the chapter is to discuss the various business-level strategies that a company can use to compete
effectively in a business and in industry. The chapter argues that the basis of all business-level strategy choice is a
process of deciding what products to offer, what market segments to serve, and what distinctive competencies to
pursue.
Next, the generic competitive strategies of cost leadership, differentiation, and focus are discussed; and it is
argued that each represents a different set of choices concerning products, markets, and distinctive competencies.
Pursuing a particular business-level strategy involves combining these choices successfully. These sections are
very detailed and complete. There are also discussions of pursuing a simultaneous low-cost and differentiation
strategy and to being “stuck in the middle.”
This chapter then discusses three tools that managers use to decide on competitive positioning of their firm.
Strategic groups analysis helps managers understand the behavior of their closest competitors. In addition,
companies can alter the competitive dynamics of their industry by raising mobility barriers to movement across
strategic groups. Investment strategies at the business level aid managers in comparing the returns the competitive
strategy is expected to generate with the costs of developing it. Two factors influence this decision: the relative
strength of the company’s competitive position and the industry life cycle. Finally, the contribution of game
theory to understanding competitive positioning is discussed.
TEACHING OBJECTIVES
1.
Familiarize students with the main ways to compete in a business or industry.
2.
Discuss Porter’s generic strategies of cost leadership, differentiation, and focus; and the opposite, being
stuck in the middle, as well as the combined cost leadership/differentiation strategy.
3.
Familiarize students with the advantages and disadvantages of these strategies, and discuss the ways in
which the company can achieve these strategies.
4.
Discuss three tools of competitive positioning: strategic groups analysis, investment analysis, and game
theory.
OPENING CASE: TOYOTA’S GOAL? A HIGH-VALUE VEHICLE TO
MATCH EVERY CUSTOMER NEED
The global auto industry is huge, with high sales and high competitive intensity. Increasingly, automakers are
working to develop a wide range of vehicles to appeal to every customer. Toyota’s lean production methods and
fast time to market have aided the firm in quickly developing car models focused on different market segments.
Toyota’s first effort to win the important market segment of buyers in their twenties was unsuccessful; their fuelefficient Echo subcompact was marred by unattractive styling. The firm quickly changed its approach, introducing
Matrix, with sporty hatchback styling and electronic music capability, in 2002. Toyota is also known for its ability
to segment markets, such as offering six different SUV models in varying price ranges. The Japanese automaker
balances the number of products against cost constraints, and it also closely monitors the actions of its
competitors, especially in emerging market segments.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
57
Teaching Note: This case demonstrates how Toyota pursued both a low cost and a differentiation strategy, leading
to an enduring competitive advantage. The case also demonstrates competitive dynamics, as Toyota was forced to
adapt to changes in consumer tastes as well as the actions of competitors. In this case, students should recognize
the way that firms must attempt to balance several factors, each of which may be pulling the firm in different
directions—in this case, Toyota was pressured to keep costs low, create unique products that competitors did not
yet have, and appeal to many customer segments with diverse needs.
LECTURE OUTLINE
I.
II.
Introduction
A. This chapter examines the issue of how a company can use business-level strategy to compete
effectively in an industry, maximizing its competitive advantage and profitability.
B.
Business-level strategy refers to the plan of action that strategic managers adopt for using a
company’s resources and distinctive competencies to gain a competitive advantage over its rivals in a
market or industry.
What Is Business-Level Strategy?
A. To choose an appropriate business-level strategy, a firm must first describe its business model. One
critical component of a business model is the company’s definition of customer needs, which
describes “what” is being satisfied. Customer needs are desires that can be satisfied by attributes of a
product.
1.
Customer needs can be satisfied by the product’s price or by its differentiation from other,
similar products.
2.
All companies must differentiate their products to satisfy some customer needs, but some
companies do this to a much greater degree than others.
3.
Companies that use differentiation are seeking to create something unique about their products
to satisfy needs in ways in which other companies cannot. Even within relatively narrow market
segments, customer needs differ widely.
4.
Companies must balance their desire to differentiate their product against the accompanying
increase in price. However, customers are often willing to pay a premium price for a product
that closely meets their specific needs.
5.
Uniqueness springs from product attributes.
a.
Uniqueness may spring from physical characteristics of the product, such as quality or
reliability.
b.
Uniqueness may be based on an appeal to a psychological need of customers, such as
status or prestige.
B.
A second component of a business model is the definition of customer groups and market
segmentation, or “who” is to be satisfied. Market segmentation depends on the way the company
groups its customers according to important differences in needs or preferences.
1.
Market segmentation may be based upon the price the customer is willing to pay, or it may be
based on the particular need being satisfied by a product.
2.
Companies must develop a strategy for differentiating products for each market segment.
a.
One strategy is to serve the average customer, ignoring market segmentation.
b.
Another strategy consists of segmenting the market into different groups and developing
a product to suit each group. As compared to the “average customer” strategy, this
strategy allows the firm to better serve more customers’ needs, generating more revenue.
c.
A third strategy has companies concentrating their efforts on serving only one or a few
market segments.
3.
Some products do not allow very much differentiation, such as cement. In this industry, price
becomes the most important consideration.
C.
The third component of a business model is the decision about what type of distinctive competency to
pursue, or “how” a customer’s needs are to be satisfied. The four major types of distinctive
competencies are superiority in efficiency, quality, innovation, and responsiveness to customers. (See
Chapter 4 for a thorough discussion of these concepts.)
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
Show Transparency 30
Figure 5.1: The Dynamics of Business-Level Strategy
D.
Differentiation and costs affect each other in a dynamic process.
1.
The decision to differentiate increases value for the customer, which increases demand, leading
to economies of scale and lower unit costs.
2.
Differentiation also requires higher costs, to provide the attributes that contribute to the
product’s uniqueness, and that contributes to higher unit costs.
3.
Pricing then must be carefully set, to compensate for the cost of differentiation, but not so high
as to stifle demand.
4.
Companies must seek to drive down costs, while maintaining the source of differentiation.
5.
In addition, each of these above decisions is made in a competitive environment, so companies
must carefully consider the actions of their competitors as they choose their level of
differentiation, cost structure, pricing, and so on.
Show Transparency 31
Table 5.1: Product/Market/Distinctive-Competency Choices and Generic Competitive Strategies
III.
Choosing a Generic Business-Level Strategy
A. There are several generic business-level strategies. “Generic” refers to the fact that these strategies
could be pursued by any company, operating in any industry.
B.
A company’s goal in pursuing a cost leadership strategy is to outperform competitors by producing
goods and services at a lower cost.
1.
This strategy can lead to above-average profits.
a.
First, when all companies charge the same price, the cost leader makes higher profits
because its costs are lower.
b.
Second, if price wars develop and competition increases, then high-cost companies will
be driven out of the industry before the cost leader.
2.
To become the cost leader a company must make choices about its product, market, and
distinctive competencies.
a.
The cost leader chooses low product differentiation, aiming for a level of product
differentiation obtainable at low cost.
b.
The cost leader chooses to serve the needs of the average customer to avoid the high costs
of serving different market segments. Perhaps no one is wholly satisfied with the product,
but because its price is lower, some customers choose it.
c.
The cost leader chooses to develop competencies in manufacturing, because it must ride
down the experience curve to lower costs. Materials management and information
technology are other important sources of cost savings. Other functions tailor their
distinctive competencies to meet the needs of these three areas.
3.
The cost leadership strategy provides businesses with some advantages, as discussed in terms of
Porter’s five forces model.
a.
In the area of competitors, the cost leader is protected by its cost advantage.
b.
Lower costs mean that the cost leader will be less affected by powerful suppliers than
competitors. Also, the cost leader’s large volume purchases give the firm an advantage
over suppliers.
c.
The cost leader is less affected by buyers’ power to set prices, because its prices are
already low.
d.
The cost leader is better able than its competitors to reduce its price in order to compete
against potential substitutes.
e.
Potential entrants face high barriers to entry because of the cost leader’s low-price
advantage.
4.
A cost leader faces some dangers.
a.
Competitors may find ways of lowering their costs, perhaps because of technological
developments or because of cost savings, such as those foreign competitors can
sometimes achieve.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
59
STRATEGY IN ACTION 5.1: LEVI STRAUSS’S BIG CHALLENGE
Levi’s dominated the jeans market for decades, but in the early 1990s, competitors moved their production
function offshore, dramatically reducing their expenses. Levi’s prices remained higher than its rivals, causing big
retailers to focus selling efforts on lower-priced store brands. As competitors and buyers are now following a lowcost strategy, Levi’s has been forced to follow suit; it has closed almost all of its U.S. factories. The cost
leadership strategy is necessary just to survive in the industry, but the firm is still struggling to catch up with its
rivals in cost reduction.
Teaching Note: This case provides an excellent example of a firm that was risking getting stuck in the middle,
when its traditional advantages were overcome by rival’s new business models. This case demonstrates how tough
it is for a firm to change its strategy—in spite of the company’s continued long-term efforts, competitors still have
a cost advantage. This case could be used as the basis for class discussion, by asking students to describe some of
the actions in each functional area that Levi’s would have to undertake in order to change from a differentiation to
a low-cost strategy. You can also ask students to consider other companies pursuing a cost leader or differentiator
strategy, and then ask them to describe the changes required to switch strategies. This discussion would give
students some idea of the magnitude of the decision to change a business-level strategy.
Competitors may imitate the cost leader’s methods, reducing their own costs.
In a single-minded effort to reduce costs, the cost leader may lose sight of changes in
consumer tastes.
5.
The choice of a cost leadership strategy has some implications for managers.
a.
Managers must diligently pursue cost advantages in every function, especially the key
cost drivers of manufacturing, materials management, and information technology.
b.
Managers must constantly monitor changing industry conditions, and be alert to the
possibility of competitors mimicking their firm’s low-cost methods.
c.
Managers must monitor the industry’s differentiators to ensure that their firm doesn’t fall
too far behind in offering attributes that customer desire.
The objective of differentiation is to achieve a competitive advantage by creating a product or service
that is perceived to be unique in some way.
1.
This strategy can lead to above-average profits.
a.
A differentiator can charge a premium price for its products—that is, a price higher than
its competitors’ prices—because customers perceive the product’s differentiated qualities
to be worth it.
b.
For a differentiator, product pricing is done on the basis of what the market will bear.
2.
To become a differentiator a company must make choices about its product, market, and
distinctive competencies.
a.
The differentiator aims for a very high level of differentiation and frequently produces a
wide range of products. Differentiation can be achieved through quality, innovation, and
responsiveness to customers.
b.
A differentiator segments its market into many niches, offering products for many market
niches.
c.
For a differentiator, the importance of each function depends on the source of the
differentiation. For example, if it seeks a competitive advantage based on innovation, the
key function is R&D. This does not imply that manufacturing is unimportant. Instead, the
differentiator wants to control costs enough so that the price charged is not higher than
what customers are willing to pay.
3.
The differentiation strategy provides businesses with some advantages, as discussed in terms of
Porter’s Five Forces Model.
a.
Competitors are less of a threat for differentiators, due to the company’s brand loyalty.
b.
Powerful suppliers are rarely a problem because the differentiator’s strategy is not as
focused on driving down costs as is a cost leader’s strategy. Increased costs can often be
passed on to customers.
c.
Powerful buyers are rarely a problem because only the company can supply the
differentiated product.
d.
The threat of substitute products is low, due to the low probability of finding another
product that can meet the same customer needs and break brand loyalty.
b.
c.
C.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
e.
4.
Potential entrants are discouraged by the high cost of developing a unique product to
compete against the differentiator, who enjoys strong brand loyalty.
A differentiator faces some risks.
a.
The differentiator must maintain its perceived uniqueness in customers’ eyes and defend
itself against agile imitators. This is especially critical when the source of the
differentiation is a physical feature of the product, which is often relatively easy to
imitate.
STRATEGY IN ACTION 5.2: WHY SO MANY AMERICAN EXPRESS CARDS?
American Express dominated high-end credit cards, with high annual fees, no-balance charging, and celebrity
endorsements. But in the 1990s AmEx’s traditional differentiation strategy came under increasing attack from
other credit cards, which offered monthly balances, no or low fees, and wider acceptance than the more expensive
AmEx cards. Other cards also developed affiliation programs with companies like GM, GE, AT&T, and airlines
to offer benefits to customers that used the branded cards. Managers at AmEx did not see the new cards as threats,
and continued with their old business model. The result is that the American Express card has lost its
differentiated appeal. To regain it differentiation status, the firm has begun to offer increased value to customers,
including smart cards, rebates, and affiliated cards of its own.
Teaching Note: Unfortunately for AmEx, the firm’s earlier myopia, as they ignored changes in consumer
preferences for credit cards, has created a significant disadvantage for the firm, and it now must play “catch up”
with its rivals. The firm’s efforts now may be an example of too little, too late. You can spark a classroom
discussion by asking the students if they think that AmEx’s new strategy is likely to lead to a sustainable
competitive advantage. The students will quickly realize that the answer is “no,” and in fact, that AmEx may
never regain market leadership. This demonstrates very clearly for your class the disastrous impact that a serious
strategic misstep can have on a firm’s future performance, perhaps even threatening its continued survival.
b.
D.
E.
Another threat is that a source of uniqueness may be overridden by changes in consumer
tastes and demands. A company must constantly look for ways to match its unique
strengths to changing product/market opportunities.
c.
A differentiator must be cautious in setting prices. If prices are perceived as too high,
customers may switch in spite of the differentiated product’s uniqueness.
Due primarily to the impact of flexible manufacturing technologies, it is possible to follow both
generic strategies simultaneously.
1.
Flexible manufacturing systems enable companies to manufacture many different models of a
product at little extra cost than if they produced large batches of standardized products.
2.
Flexible manufacturing allows companies to build many different models of a product costeffectively, because of the use of standardized components.
3.
Some companies provide efficient customization by allowing customers to choose from a
limited number of options.
4.
Many firms are using the Internet to have customers perform some of their own service, paying
bills, gathering information, and so on. This reduces costs allowing the company to differentiate
itself through higher service.
5.
Direct sales businesses use the Internet for marketing and logistics, reducing costs and
increasing responsiveness to customers.
6.
Overseas manufacturing reduces labor expenses so much that companies are able to produce
differentiated products at very low cost.
7.
Firms that pursue both strategies have a competitive advantage compared with the differentiator
because they have lower production costs; they also have an advantage compared with the cost
leader because they can charge a premium price. Consequently, more and more firms are
pursuing both strategies simultaneously.
The focus strategy positions a company to compete for customers in particular market segment, based
on geography, customer type, or market segment.
Show Transparency 32
Figure 5.2: Why Focus Strategies Are Different
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
1.
61
A focus strategy can be pursued using either a differentiation or a low-cost approach.
a.
If a company adopts a focused low-cost strategy, it competes against the market cost
leader only in those segments where it has no cost disadvantage, such as small niches or
complex products that do not lend themselves to economies of scale.
b.
If a company adopts a focused differentiation strategy, it competes against the
differentiator by exploiting their knowledge of a small customer set or of a particular
specialization within the broader range of products.
c.
Focused differentiators may also be more innovative than larger firms, because the
focuser is concentrating on the needs of just one type of customer.
STRATEGY IN ACTION 5.3: FINDING A NICHE IN THE OUTSOURCING MARKET
Companies often turn to outsourcing to satisfy their needs for complex, specialized, and rapidly changing
technology. Large companies, such as EDS and IBM, are the leading companies in the outsourcing market for
data processing and systems management. Yet smaller, focused companies survive and prosper because they
concentrate on products for specific kinds of companies. These focused differentiators dominate in some market
segments because they are closer to their customers than the giant national firms.
Teaching Note: Students are often perplexed about the advantages of a focus strategy. They often may reason, “If
the firm is so good, why doesn’t it expand its product line further and become a differentiator?” This example
shows students how a focus strategy can bring a lasting advantage, through allowing a smaller firm to concentrate
on a niche that may be too small to appeal to large-scale differentiators. Classroom discussion of this case can
then lead into a more creative exercise, by asking students to consider the opportunities for a successful focus
strategy in industries dominated by a few large firms (for example, auto manufacturing, discount retailing, or
broadcasting).
2.
3.
4.
To become a focuser a company must make choices about its product, market, and distinctive
competencies.
a.
Product differentiation is low for a focused cost leader and high for a focused
differentiator.
b.
Market segmentation is low, with the focuser filling just one or a few niches.
c.
The choice of distinctive competency depends on the company’s source of competitive
advantage. If it is differentiation, the competency could be R&D or service; if it is low
cost, the competency could be local manufacturing.
The focused strategy provides businesses with some advantages. Focusers can find a niche that
is unfilled by the large firms, and then develop a specialized product to fill that need. Focused
companies can also grow by taking over other focusers. Other advantages exist, as discussed in
terms of Porter’s Five Forces Model.
a.
Focusers are protected against rivals because it can provide a product or service at a price
or quality others cannot offer.
b.
Powerful suppliers are a threat because the focuser buys in such small volumes that it has
less bargaining power. However, if the company is pursuing a focused differentiation
strategy and can pass on price increases, this is less of a problem.
c.
A focuser’s ability to satisfy unique customer needs gives the company power over its
buyers; they cannot get the same thing from other companies.
d.
Potential entrants have to overcome the hurdle of consumer loyalty, so the focuser is
somewhat protected.
e.
Substitute products must overcome consumer brand loyalty, so again, the focuser is
somewhat protected.
A focuser faces some risks.
a.
Because the focuser produces at smaller volumes, its costs will be higher than those of the
low-cost company.
b.
If the focuser’s niche suddenly disappears because of changes in technology or consumer
tastes, it is hard to switch to a new niche quickly.
c.
Large differentiators may compete for the focuser’s niche if it becomes very profitable, as
occurred in IBM’s fight with Apple.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
F.
When a company chooses a generic strategy that is inconsistent with its capabilities and resources, or
when a company simply fails to choose and implement a coherent strategy, that firm is said to be
stuck in the middle.
1.
Such firms are unable to obtain a competitive advantage, and they will earn below-average
profits.
STRATEGY IN ACTION 5.4: HOLIDAY INNS ON SIX CONTINENTS
Holiday Inns founded the market for average price, average quality motel rooms. But in the 1970s the chain ran
into trouble because it failed to see that the market was fragmenting, creating the need for different kinds of
products, ranging from luxurious resort features to basic, no-frills accommodation. Holiday Inns was left stuck in
the middle, with its undifferentiated product and average costs. In the 1980s the company fought back by
differentiating to offer a range of products, from the inexpensive Hampton Inns chain to the luxury Crowne
Plazas. These moves were successful, and led to a temporary advantage, but by the late 1990s, Holiday Inns was
again in decline. The firm needs to find a new strategy to ensure that it prospers in the highly competitive hotel
industry.
Teaching Note: The case of Holiday Inns shows how easily a market leader may become stuck in the middle
through strategic inattention. The firm’s reliance on their original business model made them great, yet it led them
into difficulty when it became over-reliance. The case also demonstrates the difficulties in trying to move from
being stuck in the middle to once again successfully pursuing a generic strategy. You can ask students to discuss
what it would take for Holiday Inns to regain market leadership in differentiation, and whether they think the
company will be able to implement that strategy successfully. You can then use that as a springboard for thinking
about the risk of becoming stuck in the middle for other leading companies (e.g., Dell, Exxon, Wal-Mart).
2.
IV.
There are many paths that lead to a company becoming stuck in the middle.
a.
A company may start out by pursuing a generic strategy but loses that strategy because it
makes the wrong choices or because the environment changes.
b.
A successful focuser may unsuccessfully try to become a broad differentiator.
c.
Differentiators may find competitors entering their market and chipping away at their
competitive advantage.
Competitive Positioning and Business-Level Strategy
A. One of the tools that managers can use to position themselves with regard to competitors is strategic
group analysis.
1.
Companies in an industry that are pursuing the same business-level strategy make up a strategic
group.
2.
A careful analysis of strategic groups can help managers understand the past actions and likely
future actions of competitors.
3.
A company is most threatened by members of its own strategic group, because those firms are
pursuing the same strategy, and consumers tend to view their products as being substitutes.
4.
Different strategic groups can have a different standing with respect to each of Porter’s five
forces because the five forces affect companies in different ways.
5.
Mobility barriers inhibit the movement of companies between strategic groups, and the height
of mobility barriers determines how successfully companies in one group can compete with
companies in another.
6.
If companies in one strategic group can either lower their costs or increase differentiation, they
can compete successfully with companies in another strategic group. In effect, they have
created yet another strategic group—a combined low-cost and differentiation strategic group,
which has the strongest competitive advantage and the greatest ability to earn above-average
profits.
B.
Another tool that managers can use to position themselves with regards to competitors is investment
analysis.
1.
An investment analysis refers to decisions about the amount and type of resources that must be
invested to gain a competitive advantage.
2.
Different strategies require different amounts and types of resources. Differentiation is the most
expensive strategy because of the need to provide uniqueness. Cost leadership is less expensive,
once the initial investment in plant and equipment has been made. Focus is the least expensive
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
3.
63
because fewer resources are needed to serve just one market segment rather than the whole
market.
In deciding on an investment strategy, the company must evaluate the returns from a strategy
against the cost of developing that strategy. Two factors are important in determining the
potential returns from an investment strategy: the strength of a company’s competitive position
and the stage of the industry life cycle.
a.
One required factor in choosing an investment strategy is knowledge about the strength of
a company’s competitive position.
(1) Competitive position is a function of a firm’s market share. Large market share
provides the company with experience-curve effects or suggests that the company
has brand loyalty. Also, a large market share creates a large cash flow, providing
resources for investment in developing competencies.
(2) Competitive position is also a function of a firm’s strength in its distinctive
competencies. For example, the more difficult its R&D or service expertise is to
imitate, the stronger is its position.
(3) These factors reinforce one another, so a company with both is in a very strong
position and is probably a good investment.
b.
The second factor influencing investment strategy is the stage of the industry life cycle.
(1) The nature of the opportunities and threats from the environment is different at
each stage, affecting the potential returns from a competitive strategy.
Show Transparency 33
Table 5.2: Choosing an Investment Strategy at the Business Level
(2)
C.
At the embryonic stage, companies are developing a distinctive competency, so
investment needs are very great, leading to a strategy for building market share.
Companies require large amounts of capital to develop a competitive advantage and
much of this must come from outside investors.
(3) At the growth stage, a company should try to grow in pace with the growth of the
market, in order to consolidate its position and survive the coming shakeout.
Growing requires large amounts of capital, as does the development of distinctive
competencies. Companies in strong positions segment their markets to increase
market share, whereas companies in a weak position become a focuser, to lower
expenses. Very weak companies exit the industry.
(4) By the shakeout stage, companies in strong competitive positions are increasing
their market share by attracting customers from exiting companies. Cost leaders
invest in cost control. Differentiators enter more market segments and offer more
products. Weak companies choose a focus strategy, or if very weak, a harvest or
liquidation strategy.
(5) By the maturity stage, companies want to reap profits from their past investment in
the business. All companies tend to pursue both cost leadership and differentiation.
Strong companies stop aggressively pursuing new customers and invest less. This
works well if the environment is constant and the number of competitors stable. All
too often, however, large companies rest on their laurels and allow competitors to
catch them unawares. Weak companies use the decline strategies (see below).
(6) The decline stage starts when demand for the industry’s products begins to fall.
Companies in strong positions that are cost leaders choose a market concentration
strategy, consolidating products and markets, or an asset-reduction (or harvest)
strategy, decreasing investment and milking profits. Strong companies that are
differentiators use a turnaround strategy. If these strategies are not possible, the
company may liquidate assets, or it may sell the entire business, called
“divestiture.”
Another tool that managers can use to position themselves with regards to competitors is game theory.
1.
Game theory is a branch of social sciences theory that describes the actions and reactions of
rivals in a competitive game.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
2.
3.
4.
Business competition can be modeled using game theory. In this game, companies make
decisions that can affect outcomes (profitability) without knowing each other’s moves.
a.
Games may be sequential, with moves following one after another, such as occurs in
chess.
b.
Games may also be simultaneous when players choose at the same time, as occurs in
rock-paper-scissors.
c.
Business competition entails use of both sequential and simultaneous games.
Game theory works well in describing situations where the number of rivals is stable and
limited, and the interdependence between the players is high. This situation occurs in mature,
competitive industries.
Game theory consists of a number of related principles.
a.
The principle of “look forward and reason back” says that managers should try to predict
and anticipate the future and then use that information to reason backward to determine
the strategic moves they need to make today.
(1) Strategies that appear at first glance to be effective may not be when the likely
reactions of competitors is included in the model.
(2) Decision trees are one tool that can be used to look forward and reason back.
Show Transparency 34
Figure 5.3: A Decision Tree for UPS’s Pricing Strategy
b.
c.
A second principle of game theory is “know thy rival,” because a company’s ability to
make accurate predictions about a competitor’s likely future actions is based upon
knowledge about the competitor’s cost structure, pricing, and so on.
A third principle is “find the most profitable dominant strategy.” This principle asks
managers to try to find a strategy that gives their company an advantage, no matter what
strategies competitors follow.
(1) A payoff matrix can be used to determine likely outcomes under different
combinations of strategies selected by a company and its competitors.
Show Transparency 35
Figure 5.4: A Payoff Matrix for GM and Ford
A common outcome is that, when each company picks its “best” strategy, the
resulting combination offers the lowest profits to the competitors. This sets up a
prisoner’s dilemma situation, in which competition leads to low outcomes while
cooperation results in higher outcomes.
A fourth principle is “strategy shapes the payoff structure of the game.”
(2)
d.
Show Transparency 36
Figure 5.5: Altered Payoff Matrix for GM and Ford
(1)
(2)
This principle, taken together with the first three principles, for example, says that
the way out of a destructive price war is for competitors to change their business
models and increase their product differentiation, reducing customers’ sensitivity to
price.
Another implication of this principle is that companies need to think about more
than just the effectiveness of a particular strategy, they also need to consider how
their strategic choices can affect the payoff structure of competition in their
industry.
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Chapter 5: Building Competitive Advantage Through Business-Level Strategy
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STRATEGY IN ACTION 5.5: COCA-COLA AND PEPSICO GO HEAD TO HEAD
From the 1940s to the 1970s, the cola industry was dominated by just two players, Coca-Cola and PepsiCo. These
giants competed on advertising, but never on price, leading to high industry profitability. In the 1970s, numbertwo ranked PepsiCo introduced the Pepsi challenge, a blind taste test, in which Pepsi was overwhelmingly
preferred by consumers. Pepsi thus was able to differentiate its product on a real attribute: taste. Coke could not
compete on taste, and so it responded with sharp price discounts, a strategy that was quickly matched by Pepsi.
Today, price discounting is expected by consumers, and the entire industry is less profitable.
Teaching Note: The decades-long competition between Coke and Pepsi provides a wonderful illustration of game
theory principles, and especially of the prisoner’s dilemma game. As long as the two competitors did not use price
competition, both firms could be highly profitable, although Coke took the lead position. When Pepsi tired of its
number-two status, it changed the nature of competition in ways that damaged both firms, although Pepsi gained
market share. A thought-provoking question for students is “Which is most important to corporate managers,
market share or profitability?” Another is “Which should be most important?” Examples of prisoner’s dilemma
abound in other industries, and you can ask students to identify some of them (for example, Nike versus Reebok;
the cereal price wars; the airline industry; the Big Eight, then Big Five; then Big Four in the audit and accounting
services industry).
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