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Transcript
Review for GB 780: Pricing Strategy The first issue to be considered and to be incorporated into a rational pricing strategy is consistency of incentives and actions to the goal of the firm. Profit is the goal, Not market share Not “winning” against the competition Not finding a successful response to competitive actions. All of these are factors to be considered, but they are often misused as goals. Incentives for all employees, from the CEO to the sales person or production person, should be oriented to the long term profitability of the firm. Effective pricing should be integrated with the product design decision along with cost, financing, and customer needs. Customers have an incentive to provide false signals to signal a smaller demand for the product/service to try to keep the price down. Proactive pricing is essential to stake out desirable niches/competitive advantages for the long term benefit for the firm. Major issues (or mistakes): Cost plus pricing – it is easy, it is sometimes right (just like a stopped watch is right twice a day). If differences in price sensitivity (elasticity) are incorporated in the margins taken on different goods. In addition, complementarity and substitutability of each product with other products the firm sells need to be incorporated in the “contribution margin” and hence mark up. In addition, the long run/present value issues of potential competitive entry or consumer adjustability to price need to be considered. This eliminates some of the ease of mark up, but it also increases the profitability of the firm. There is also a lot of momentum in the pricing in the firm. This can lead to major mistakes, while assuming that it will propogate the past successes. Correct cost evaluation is necessary for correct pricing. - Next In First Out is the best method of evaluating inventory for an ongoing firm. FIFO is probably a best representation of the desired actual inventory movement, selling the oldest unit first. LIFO is the closest book-keepingfeasible method to cost inventory turnover since it more correctly reflects the marginal cost of the use of the inventory. It has the problem of potentially misrepresenting the value of the inventory remaining over time. - The “How much?” question, which is associated with the pricing question, is inherently a marginal cost = marginal revenue decision. - Sunk costs must be ignored when making pricing decisions. Since sunk cost is unchanged by the decision of price and/or quantity, it is irrelevant. Variable/semi-variable/incremental/marginal costs (all these concepts are very close in meaning) will be affected by the pricing/quantity decision. - The key is “How is profit affected by the decision being considered?” Contribution Margin is a measure of the marginal profit of an additional unit. To the extent that average variable cost is constant, $CM = P – AVC. To the extent that AVC varies with quantity over the quantity range being considered in the decision, the formula needs to take into account this variation. The simplest form of variation is the semivariable costs such as additional machines for specific increments of quantity. Percentage CM = %CM / P Contribution Margin can be use to evaluate the feasibility of price changes by determining the break-even quantities with alternative price changes. BE ( generic ) P CM P The minus sign is because a price increase will allow a decrease in quantity without loss in profit; a price decrease necessitates a quantity increase. P is there in the numerator as a measure of the change in the price (and the change in the revenue) which can be lost (or must be replaced) in order to break even. CM is the rate of profit gain or loss as quantity changes before the price change. CM + P is the rate of profit gain or loss as quantity changes after the price change. The result is the change in quantity allowed (necessary) to not change profit from the current profit. Note that this break even analysis is not your typical break even analysis since it does not assure zero profit overall. It assures no change in profit. With changes in variable costs caused by the quantity change the formula must incorporate these items. P AVC CM P AVC Careful with this formula. To the extent that changes in the variable costs only affect additional revenue, the AVC in the numerator is zero and the AVC in the denominator is zero for price increases. Again, the logic is that the denominator is the change in revenue experienced on current quantity; the denominator is the rate at which profit falls (or rises) as quantity changes to pay for these changes in current-volume revenue. BE When there are changes in (semi-) fixed costs, they have to dealt with differently. This is because they are not per-unit charges or revenues. They are fixed dollar amounts associated with the change contemplated. Care must be taken to make sure that the appropriate charge is assessed for the quantity change that is actually necessary. BE P AVC TFC CM P AVC (CM P AVC )Q The first term is the more general of the formulas above to repay the price and variable cost changes. The second term is change in total fixed costs divided by the cost recovery rate times the current quantity. This last variable (the current quantity) is there to convert the units necessary to recover the fixed costs to a percentage change in quantity to add to the first term. Some price changes are reactions to changes by a competitor. The question is not how to regain the current profit, the question is, “Given the expected change due to quantity change precipitated by the competitor’s action, should the price change of the competitor be matched to maintain current volume. So, current volume at a changed price is the base against which maintenance of current price at a changed volume is evaluated. P CM The way this works is that P is the change in revenue if the price is matched and CM is the rate of loss (or recovery) that the quantity change will cause if the price is not changed. The way to use this is if the price change of the competitor is positive, there will be an increase in profit. If you expect the gain in quantity with the unchanged price to exceed the break even quantity, keep the price low. If not raise the price. If the price change is negative, there will be a decrease in profit. If you expect the loss in quantity to be less than the break even quantity change, maintain the higher price. If not, match the price decrease. BE One more formula needs to be included in the list. This is the formula incorporating complementary or substitute relationships between this product and other products sold by the company. BE P AVC CM P AVC CM where CM is the additional (or the lost) profit contribution from complements (or substitutes). Notice that complementary products add to the profit recovery rate, decreasing the number of units necessary to break even for either price increases or price decreases. Substitutes cause negative contribution margin additions, increasing the number of units necessary to break even. This formula is the basis for choice of loss leaders. Those products or services that have a large number of complements will likely have low break even quantity changes associated with given price changes. This increases the probability that using price to attract business will be profitable. The other criteria for selection of loss leaders is the price sensitivity (elasticity) of the demand for the good in question. Possible Causes of differing elasticities 1. Reference Price Effect If the customer considers the product comparable to an expensive product, they will consider the value high and the price can be set high without appreciable loss of quantity sold. For example, Nike shoes will not be found in Walmart because the customer assumes anything in Walmart is inexpensive and potentially low quality. Nor will Bic pens be found in a jewelry store. Ex 2: Presenting the highest priced model in a family of products first tends to increase the reference value for the less expensive models. 2. Difficult Comparison Effect Structuring products (or quantities of given products) such that customers have difficulty comparing across brand or size will decrease the price sensitivity—the customer will have fewer (perceived) close substitutes available. Example: BJ's and Sam's Club use large (and often non-standard) sizes to make comparison with prices in other types of stores more difficult. This allows Walmart to separate the Walmart customer from the Sam's Club Customer and allows different pricing in these two stores. Walmart prices Colgate by the pound and Crest by the ounce to make the per volume (required by law) prices to be difficult to compare. This makes pricing of these two direct substitutes to be somewhat independent. 3. Switching Cost Effect If the customer faces a larger expenditure to avoid a particular purchase (e.g., blades for a Gillette razor are cheaper, even with a fairly high margin than replacing both razor and blades), they will be less sensitive to the price of the good (blades). Car parts are expensive because it is cheaper to buy the part than to replace the car. Hence, you are willing to pay high prices for parts. 4. Price-Quality Effect The difference in the price of an economy car and a luxury car is more than the difference in their costs because (among other things) there is a perception that the higher price signals a higher quality. The more expensive product is seen as qualitatively different than the less expensive product. "Snob appeal," "image," "status," etc. 5. Expenditure Effect The larger the purchase price relative to my budget, the more price sensitive I am. Hence family discounts, children's discounts, senior discounts, etc. Luxury items are bought by high income individuals. To the extent that income rises more than the price, the customer is less sensitive to price. 6. End-Benefit Effect To the extent that the product is only a small part of the end-benefit, the customer will be less sensitive to the price. This is why Michelin advertises safety of babies in their ads. How much is the child's safety worth? Doesn't this make the price difference between a Michelin and another brand seem small? This is especially useful as a tool for segmentation since many products can be used in a variety of markets. Careful placement and advertising can take advantage of this variety to make the product look like multiple products rather than one. 7. Shared-Cost Effect Economists usually call this third-party-pay. The idea is that if I pay none or only part of the cost, I am less sensitive to the cost of a product. Business travel vs. vacation travel will be separable and have different price elasticities. The health industry and airline travel are rampant with these issues. 8. Fairness Effect Historical pricing sets what the customer thinks is reasonable or fair. The higher the past prices, the less sensitive the customer is to a high price. Segmentation using this would be possible by adding features that are desired by the rich, warranting a higher price (with the increment being greater than the additional cost). One could also segment between previous purchasers and new purchasers as they might feel different about the fairness of the price. 9. Framing Effect Customers view gains differently than losses. This allows some segmentation through how the price is stated. Does it include service and transportation? Is there a rebate (rather than a lower price)? Are the radio, the braking system, A/C, tinted windows, etc., options or included? "Cash back" etc. MARKET STRUCTURE Perfect Competition Many Small sellers Many small buyers Homogeneous Product Free Entry and Exit Perfect Information Monopolistic Competition Many Small sellers Many small buyers Differentiated Product Free Entry and Exit Perfect Information Oligopoly Few sellers Many small buyers Differentiated Prod Some Barriers Perfect Information Monopoly One seller Many small buyers “Unique” Product Strong Barriers Perfect Info Monopoly is one pole, Perfect competition is the other pole. Monopolistic competition is close to perfect competition, but with differentiated product. An example would be the pain reliever or aspirin markets. There are many alternative brands, with slight variations and known, easily replicated formulas. Entry is easy and exit is easy. The products are slightly differentiated and heavily advertised. Oligopoly is close to monopoly. Inter-firm rivalry is personal in nature. Policy is made taking the competitors’ strategy in mind. Game theory is one way of understanding the dynamics of this type of industry. “If I do this, he/she will do that…” An example of an oligopoly and a strategy based upon this, Home Depot and Lowes are close competitors. One of the pricing strategies used by both is “We will match and any competitor’s advertised price.” This is a strategy that sounds like it is intense price competition, but in reality is a means of decreasing the profit from competitors trying to compete on price. BEHAVIOR: PERFECT COMPETITION Firms enter and leave in response to profits. This means that in the long run economic profits are zero. That is, firms will make a “normal rate of return” on the assest used in the firm, with no firm making excessive profits. Firms price at the current market price because there is no incentive to deviate. Higher prices lead to no revenue since the product is a commodity and the customer can get it elsewhere with no loss in quality. Lower prices are not appropriate because the firm can sell as much volume as they wish at the current price. This is the idealized market of the capitalist system. It maximizes the net value of society be producing the goods demand by the customers at the minimum price. The value (as expressed by the demand curve) of the last unit is equalized to the marginal cost of producing the product. The firm equalizes the marginal cost with the marginal revenue (which is equal to price due to the commodity nature of the product in a competitive market). MONOPOLY The firm is the industry in this case. The firm will take into account the fact that selling one more unit will required decreasing price. To the extent that everyone gets the same price, Marginal Revenue will be less than Price. The firm equalizes Marginal Revenue with Marginal Cost and both of these are less than price. This is the problem with monopoly from society’s stand-point. The value of the last unit produced (as shown by price on the demand curve) is higher than the marginal cost (= marginal revenue<P). The value of the last good exceeds the cost, and therefore society would be better off if more resources were devoted to this market. Due to barriers to entry, profits can be maintained and additional competition is not available to drive down price and expand quantity produced. Non-homogeneous product reflects the difficulty the customer has in replacing this product if the price rises, leaving open the opportunity for the monopolist to raise price. MONOPOLISTIC COMPETITION: Firms are price makers in the sense that they know that they can raise and lower price and not have all-or-nothing quantity. The demand for the firm is very elastic because there are good, although not perfect, substitutes. Marginal revenue is not much below price because of the high price elasticity. This means that marginal cost equals marginal revenue will bring marginal cost close to price. This is close to the competitive situation. With free entry and exit, the firm will have zero profit in the long run (entry dissipating profits, exit eliminating losses). The main difference between monopolistic competition and perfect competition is in the long run ATC=P>MR=MC. Notice that with MC<ATC this means that ATC is still decreasing—we are not at the minimum of the ATC. In words, differentiation means that we are not as cost efficient. The fact that you have choices means that each firm cannot minimize their ATC. Henry Ford was so successful at driving down cost because he did not offer variety. With larger markets, efficient scale economies can be achieved while still offering variety, to the extent that there are no barriers to entry, profits are dissipated, equalizing P and ATC, leaving us below minimum ATC quantity. OLIGOPOLY In the case of oligopolies, the interpersonal dynamics of the individual managers comes into play. This means that we have difficulty predicting behavior. This is why we spend so much time on Monopoly and Perfect Competition. These polar cases show the transition that occurs and knowing where the industry is placed in the continuum helps us understand the behavior. But when the interaction becomes personal, it becomes less predictable. What we do in this situation is start making up models to describe various behavior patterns. These are pretty good at describing the behavior in the specific situation, but may not be generalizable to other situations. Just to give you one example: KINKED DEMAND CURVE MODEL: The general assumption is that the market (or industry) has a small number of competitors who know each other and watch each other’s responses. Specific behavioral assumptions: 1. If I raise price, the assumption is that the competitors will not follow suit and will gladly accept my customers. This makes the demand for my product very elastic. 2. If I drop price, the assumption is that the competitor will follow suit rather than accept the loss of customers to me. This makes the demand elasticity comparable to the industry elasticity, as I will not be able to attract customers from competitors, but only from outside the industry. 3. This causes a kink at the current price. This causes the marginal revenue to be fairly close to price for price increases, and marginal revenue to be significantly lower than price for price decreases. This combination leads to Marginal cost being likely to be below the MR for price increases, causing me not to raise price. Marginal cost will likely be above the MR for price decreases, causing me to not want to decrease price. This model gives a theoretical justification for the observation of quite stable pricing in many situations with a small number of competitors. For example, notice the stability of the gas prices at any given corner. They typically move only in response to increases or decreases in the overall gasoline prices. And they will establish a consistent relationship (Exxon higher than Crown by 1-2 cents per gallon…). PRICE DISCRIMINATION (or MARKET SEGMENTATION) The general issue here is to charge more to customers who are less price sensitive, and less to those who are more price sensitive. The difficulty is identifying the specific customers in each group and separating them so that they will not be able to transfer goods from the lower priced market to the higher one, circumventing your separation. Criterion needed to be successful: 1. differing elasticities. 2. separable markets. In the greater elasticity market, marginal revenue is higher than it is in the lower elasticity market. By expanding in this market and contracting in the less elastic market, these marginal revenues can be drawn together and equated to marginal cost. Where do you want to sell a specific unit? Where MR is the greatest – initial units will be allocated to the market with the higher reservation price (otent the inelastic market) subsequent units will go to the market with the highest marginal revenue. This will lead to allocating more units to the elastic market beyond a certain point. If MR1>MR2, you can increase total revenue without affecting cost by moving a unit from market 2 to market one. This movement will increase MR2 and decrease MR1. Keep doing this until you equalize the MR’s across the markets. To the extent that costs differ across market, this will affect the MC and will need to be accounted for. This basic logic describes how to price and allocate inventory to alternative markets (even for alternative goods). The production effort should be allocated where the profit contribution is the greatest. The units produced should be allocated (sold in) the market where the marginal revenue is greatest (MC for a given unit is fixed, so the allocation issue is getting the largest contribution to revenue by that unit). REALISTIC PRICING IN THE FACE OF COMPETITION 1. Know your market sitution 2. Realize the “negative-sum” nature of competitive pricing 3. Know your own strengths and weaknesses—capitalize on the strengths and adjust for the weaknesses 4. Know your competitors’ strengths and weaknesses—pick your battles to give you the advantage. 5. Raise the cost to competitors of competing on price—“match advertised price.” a. Manage information b. Know competitors and customers needs c. Control timing and presentation of price changes d. Exhibit willingness to compete in order to preempt competitor actions. 6. Consider niche strategies. 7. Develop competitive advantages. GENERIC PRICING STRATEGIES Skim Benefits Use when Higher price=> Higher profit per unit Can afford Ads Can afford Quality High variable cost Low CM suggests the need for higher price Niches are available Quality is hard to measure, needing information about the product quality Customer is price insensitive, and there are some barriers to entry When the firm has a differentiation competitive advantage Problems May attract Competition Sequential skimming may be a response to the potential for entry that is slow Penetration Benefits Use when Problems Attracts volume Quality easily measured (no need for information, ads) Customer is price sensitive Limited demand for product differentiation Incremental costs are low When the firm has a cost advantage Enhances customer price sensitivity No product loyalty Neutral pricing Benefits Takes price out of the decision Does not require competitive advantage Use When The firm has no cost advantage and differentiation is not called for When other issues than price serve to attract customers (packaging, placement,…) Problems Subject to price competition of competitors Not good niche strategy TIMING ISSUES Life cycle determines the context for the product pricing decision Revenue Product Life Cycle Time Intro Growth Maturity Decline Introduction stage EDUCATION is the key during this phase of the life cycle. What is the product? What value can it provide the customer? What is the appropriate price to capture this value? The key pricing issue here is to price such that the desired reference price is established. Use of price as an enticement for experiencing the product can be dangerous in that it might set too low a reference price for the product and you may not be able to increase the price subsequently. So what do you do? 1. Choose a basic product strategy (penetration/skim). 2. Identify the target market(s). 3. Choose a distribution channel. 4. Then target the innovators within this market. 5. Bundle products in successful bundles (combine related products to the extent that successful use of the product requires it). The innovators are likely to be ones who want to be trend setters. Given this, they will likely be relatively price insensitive. So price tends to be high in this stage. If price is use to entice sampling or initial use, it should be explicitly temporary price decrease “first time” “temporary price” “regular price is… 50% off” “new buyer discount,” etc. Growth Stage The growth stage is key to the future of the company as the flexibility available in the growth stage is missing in the later stages. Unsuccessful positioning of the company in the growth stage will preclude success in future stages. (Notice how I phrase this— successful positioning during this stage is necessary for, but does not assure success in future stages). “A rising tide lifts all boats.” Growth will not necessarily come at the expense of competitors. The firm needs to position the product the future with a skim, penetration or neutral strategy. The first is called for where differentiation is possible and appropriate; the second where the firm has a cost advantage and the customer is price sensitive; the third is the generic for when price is not the desired tool for successful competition. Developing some competitive advantage is essential—cost, product differentiating attributes (or perceptions), or some other feature. This uses the growth stage to prepare for maturity and decline. 1. Generally Price lower than introduction due to greater competition and more price sensitive customer base. 2. Price reductions often supportable by cost savings (economies of scale, economies of experience). 3. Generally, price competition not intense, unless a. There are large scale economies requiring large market share to achieve. b. Standardization is called for, but the largest firm gets to choose the standard. c. Capacity grows faster than demand (leading to excess capacity). 4. If price competition becomes fierce, look for a niche to escape into. 6. Keep successful bundles together as a deterrent to entry. Maturity Stage Maturity leads to 1. Reduced brand loyalty as firms all attempt to grow while the market does not leading to intensified price competition. 2. New entrants will typically imitate the most successful products in the industry, making the product more of a commodity (more homogeneous). 3. Consumers who are better informed. 4. The stability of the market will attract new entrants who are good at distribution, marketing, finance, etc., rather than being product specialists. They will enter with cost advantages as the product becomes more homogeneous, unless the current firms have already implemented these cost savings. Strategies for Maturity 1. Unbundle related products. This allows accommodation of new small entrants in niches, without giving away the whole market. 2. Spend resources on measuring and forecasting better to more carefully and responsively design strategy. 3. Control costs – this is truly the most sustainable competitive advantage. 4. Excise non-producing products that do not complement the successful ones. 5. Leverage successful products by product extensions 6. Reevaluate distribution and marketing (education is no longer the issue, competition is). Decline Declining sales are likely to cause a consolidation of the number of firms in the industry. Thus one strategy is to design a graceful exit, either by sale of the division or harvesting (using the cash flow to develop other products). If the decision is to stay, the firm can specialize in only one part of the market (retrenching), or carefully work on developing the firm’s competitive advantage (consolidation). The key here is to recognize decline and choose a strategy to deal with it. NEGOTIATION There are short run benefits, and long term costs of negotiation. In the short run, you may add to sales. In the long run, you train your customers to negotiate, increasing the transactions cost and decreasing the potential for skim pricing. BETTER: 1. Quid pro quo—if you offer price discounts, decrease the service/good received. 2. Educate premium customers about value. 3. Selectively walk away from business that will dilute other business value. 4. Phase in fixed price regime. 5. Change incentives for the sales force from “sales” commissions to “profit” commissions. 6. Use non-price closers. 7. Build in escalation to normal price if concessions have to be made. Buyer tactics to beware of: 1. Service and price separated eventually forcing you to provide more services than is cost effective. 2. Discounts for incremental volume--Make sure the discount is only on the additional volume. Otherwise, they have set a new base price. 3. One sided contracts – if you commit to a lower price, be sure there is a comparable commitment of purchases. 4. Price performance ratios – the value may not be proportional to performance (e.g., the performance of the Arizona Diamondback pitchers was better, but the value was significantly greater.). This is especially true in “winner-take-all” markets. In these markets, small advantages have large value. Types of Buyers Price buyers – ARE NOT LOYAL, so be selective about whether you negotiate. If the deal is in the company’s best long term interest, participate. If not, do not count on future business to pay for it—walk. Relationship buyers – often are more interested in service and stability. If you negotiate with them, you train them to be price sensitive. Look for win-win solutions such as service options or long term contracts. Value buyers – focus on cost/benefit. Sell value, and price accordingly. Convenience buyers – not likely to be particularly price sensitive. Timing (high opportunity cost of search relative to value of search—resort locations, convenience store venue) and small cost of the item can contribute to this. You can price high relative to value. In fact, customers have come to expect this and therefore see the higher price as fair. Pocket Price—In the context to multiple criteria for discounts, the measure of how much of the revenue actually turns into net revenue after all discounts are taken. Control of these various discounts (often under the control of different people in the value chain) will make sure that there is a return from each of these discounts, not just a cost. SEGMENTED PRICING The goal is to allow price to be adapted to the customer’s specific price sensitivity. Less elastic demanders will be given a higher price (differentiated product). More elastic demanders will be offered a discount price with fewer features or lower quality. Ways of segmenting: Buyer Identification – seniors, children, AAA, AARP, etc. Allows separation of price elastic segments from non-price elastic segments. Location – Gas stations, real estate (3 most important factors in real estate value are location, location, and location) Time – Peak load pricing (charge customers who cause costs to be incurred) Yield management (airlines, to maximize revenue when marginal cost is low) Bundling – makes marginal cost of least desired attribute low. Increases total purchases. Volume discounts – decrease marginal cost of additional volume to customer, allow taking advantage of economies of scale for the firm. Order discounts – pass on the cost savings of less overhead for multiple orders Product design – multiple versions can appeal to different markets allowing price discrimination. PRICING AS IT IS RELATED TO THE OTHER THREE OF THE FOUR P’S Product Price is related to Product through the product’s interrelationships with other goods. See the formula discussion related to complements and substitutes. Price is related to product in the sense that the customer’s willingness to pay for certain features and the cost of these features should determine whether these features are added to the product. Clearly, the cost and value of features of the product affect the necessary price to make a profit and our ability to achieve profit. Promotion Promotion that includes price can sensitize the customer to price, calling for penetration pricing. Promotion can enhance the value of price decreases. Skim pricing calls for care in where the product is advertised. Penetration pricing also defines the desired advertising venues. Price as a promotion tool should 1. benefit the customer 2. be perceived as a price decrease 3. primarily benefit first-time buyers to add to customer base with minimal loss of revenue from current customer base. Placement Choice of distribution channel will affect pricing possibilities, enhancing or lessening the perceived value. Use of a distribution channel. - adds to cost of product - may provide value added through product enhancement or - can provide access to customer base - may change the quantity desired decision by decreasing the CM at the retail end of the chain - can close out competition - can affect perceived value of the product - can facilitate segmentation Pull advertising – advertising directly to the customer Push advertising – using incentives within the distribution channel to create incentives for sales effort Internet has changed the distribution environment. It has forced the channels to make sure they offer value added. Those that do not are being shut down by Internet allowing the manufacturer to go directly to the consumer. COMPETITIVE ADVANTAGE Developing a Competitive Advantage is the key to long term profitability. Bases for competitive advantage Cost: 1. Economies of Scope – multiple products sharing costs across markets 2. Economies of Scale – efficient allocation of inputs 3. Economies of Experience – learning by doing (possibly use penetration pricing to foster this learning “paying” for the price cuts with decreased costs 4. Buyer focus – become a specialist 5. Contract efficiencies – set pricing to create efficient incentives for price/volume choices 6. Transfer pricing – integration of CM to increase incentive for penetration pricing 7. temporary cot advantages – utilize to gain longer term advantages Product differentiation advantages 1. Product superiority – if value rises more than cost, this can create advantage 2. Product Augmentation – serve niches, bundle for specific types of customers Sustaining advantages 1. Become known supplier (Dell, Compaq, IBM) 2. Pre-empt distribution channel (soda machines) 3. Set standard (Intel, Jello, Klenex) 4. Serve small niche (no room for others) 5. Capture image (Mercedes, BMW, Dewalt) 6. Technological advance (outrun the competition – Intel, Sony)