A recent research paper by Wharton management professor Olivier Chatain and INSEAD strategy professor Peter Zemsky offers some perspective on this topic by combining two types of business strategy analysis. Their advice: When developing business strategies, consider not just what your company does, but how it fits into its industry. Looking at both, you might find ways to improve and woo more customers. You might realize an opportunity to leapfrog over a bigger competitor. Or you might discover that your approach to the market is fine the way it is.
To be sure, Chatain and Zemsky's paper, "Value Creation and Value Capture with Frictions, " is pure academic theory, not a business how-to. Funded as a joint project by the Wharton-INSEAD alliance, the paper introduces a mathematical framework that links together two well-known theories of business strategy.
One theory focuses exclusively on industry forces, looking at a firm's surrounding environment to determine how well a business can compete. Known as "industry analysis," the framework's "five forces" of the market -- rivalry, barriers to entry, the existence of substitute products, buyer power and supplier power -- have formed the hub of classic business strategy research since Michael E. Porter of Harvard Business School introduced them in 1979.
The other theory concentrates on the company itself, making the assumption that markets work efficiently, and that stronger firms are simply better in some way than others. Known as "firm-level analysis" or the "resource-based view," this analytical framework assumes that a business is successful because it possesses some type of competitive advantage -- a patent, a unique way of doing business, a rare knowledge or talent, a special product -- that other companies in the industry lack.
Up to now, most business strategists have used these models in isolation, against a backdrop of perfect competition. By combining the two theories, the researchers hoped to better understand how the two levels work together. Ultimately, their goal was to paint a more accurate picture of what makes an industry or a company profitable.
"What we do in this paper is use mathematics and game theory to explore the links between these concepts," says Chatain. "All these concepts have been developed in the last  years, but we know very little about how they interact with each other."
To mathematically link the two levels of analysis, Chatain and Zemsky set a value for what they call "frictions." The word describes any forces that make it difficult for buyers and sellers to connect. For example, a poor location could be a source of friction for a retailer, because customers will have to go out of their way to visit the store. A poorly designed web site could create friction for an online business if potential customers are unable to find what they are looking for easily. Even a flu outbreak in a company's sales force or a management shakeup that throws a company into disarray could be a temporary source of friction if it suddenly reduces the number of sales calls the company makes to potential clients.
Some industries naturally have higher frictions than others. The consumer market for gasoline, for example, has very little friction: The price and type of gasoline is clearly posted, and gas stations are located at nearly every major intersection, so customers don't have to research locations of gas stations ahead of time to figure out where to go. The market for a good plumber, on the other hand, has a very high level of friction. The service is highly personal, it's difficult to compare prices because the cost of each service varies from job to job, and there isn't a single marketplace where plumbers and customers can meet. "A market with a lot of frictions is a market where it is hard to shop around," Chatain says. That means buyers and sellers in some markets may never match up.
By adding frictions to their model, Chatain and Zemsky account for the fact that real-world competition is not perfect. There may be an equal number of buyers and sellers in the marketplace, but they don't always connect. And while one company may offer a better product than another, if customers don't know about both companies, they will never switch to the better product.
Plugging numbers into the new model yielded some surprising results. First, Chatain and Zemsky discovered that the five forces of industry-level analysis interact with each other in highly complex ways. "When we teach strategy to our students, we teach the five forces, but we can't really say when one is more important than the other. In this paper, one of the things we discovered is that it's more complex than we thought." Chatain notes. "You have to think carefully about how they interact."
Second, in regard to frictions, the researchers discovered an inverted U-shaped curve: A company's profits would suffer whenever frictions in the market were extremely high or low, but at moderate levels, a company's profits could increase. So there is an optimal level of friction in the marketplace, the researchers concluded. "Even if you're the best firm around, you still want some friction, and this is somewhat counterintuitive," Chatain says. "When you reduce friction, one would usually think it must be good for the strong firm. But it's not always the case. We found that stronger firms want to have less friction than weaker firms, but they don't want to [entirely] eliminate frictions."
That's because the less friction there is, the more firms have to compete directly with each other -- in industry-level parlance, rivalry increases. To win customers, the strong firm will have to cut prices. Eventually price-cutting shaves profit margins to the point that winning over new customers isn't worth it. Having a small amount of friction in the industry allows a company to keep prices at an optimal level.
Third, on the firm level, researchers gained insight into why some firms innovate while others don't. Traditionally, firm-level analysis assumed that if a company did not innovate to become more like its rival, it was because the firm was weak in some way -- slow to adapt a new technology, unable to duplicate a competitor's way of doing business, or simply less efficient -- or because there were barriers to imitation. "The thinking up to now was mostly that they did not [innovate] because it was hard to imitate," Chatain states. "Our conclusion is that, to some extent, one additional possible reason why firms stay different... is that because of the level of frictions, they don't have the incentive to invest to become better."
Chatain and Zemsky showed that when frictions increase, rivalry decreases, and firms compete head-to-head with each other less. So, weaker firms benefit from high levels of friction because it allows them to capture customers in small niche markets. A firm that is considerably weaker than a competitor might be able to survive because of friction, but would have little incentive to improve, because improvement would not earn it significant market share.
Again, Chatain points out, the level of friction is important. In the case where two rivals are competing relatively closely, and there is a low level of friction in the market, the weaker rival might be able to use a new innovation or technology to leapfrog over its competition.
"The more friction there is, the harder it is to leapfrog," Chatain says. "If you're much less efficient than your competitor, it's going to be very hard to leapfrog. However, if you're not too far [behind], and if a new technology comes up, you... might be able to leapfrog over your competitor. But you will have to carefully manage competitors' and customers' expectations to pull that off."
From a strategic point of view, accounting for frictions is important. Developing a business strategy based solely on an industry-level analysis or on a firm-level analysis would not be complete, because the strategy would fail to consider how these two levels interact and affect each other. Considering the whole picture allows a firm to make better choices about where it wants to invest its resources to increase profit. "As a producer, what this paper suggests is that it's a good idea to understand against whom you are competing," according to Chatain. "You have to understand what share of your customer base is really making you compete against the other suppliers, and who the suppliers are."
The Little Guy's Advantage
Take an example of an old neighborhood hardware store competing with a newer chain store a few miles away. A firm-level analysis might conclude that the chain store will always win customers over the local hardware store, because it has efficiencies that give it a competitive edge -- its ordering system might be computerized, for example, so every item is always in stock. An industry-level analysis may remark that this market is highly competitive and that the chain store will be the most likely to survive thanks to its ability to offer the lowest price. Both analyses might conclude that the local hardware store will die unless it changes to become more like the new chain store.
Add frictions to the model, and the story becomes more complex. Some of the local hardware store's customers, for example, may go there because they don't have a car to drive to the chain store. Other customers may occasionally go to the chain store, but they live so close to the local hardware store that they will often make small purchases there for the sake of convenience. Some customers might dislike national chains, and will make an extra effort to support the local hardware owner, even though it is inconvenient. Other customers won't even bother going to the local hardware store because aspects of the new, modern store appeal to them more.
In other words, frictions split the hardware stores' customers into different segments. Some customers will always go to the chain store, others will always go to the local hardware store, and a portion will go to both. This is much more complicated than the theoretical world of perfect competition, where every customer has equal access to every supplier. "In the perfect competition model, you never think of the cost of finding alternatives," says Chatain. At the chain store "you might find a cheaper hammer, but it's going to be a very small savings."
From a strategic standpoint, this means the two hardware stores are only competing head-to-head for a portion of their customers. If the local hardware store wants to increase its business, it should focus on the portion of its customers who are actually putting it in competition with the chain store, not the die-hard chain store devotees that it will never win. It may never be able to modernize enough to win over the customers who like the chain store better. But if it invests in the right way, it might be able to capture more business from customers it already has. And, depending on the local hardware store's market share, the best change could be no change at all.
"It makes sense for them not to try to be like the other one," Chatain notes. "They are better off concentrating on the small customer segment that doesn't bring them into competition with the other firm... If you realize that some of your potential customers are not really in play, you can focus on them to be more loyal."
This article is reprinted with permission from Knowledge@Wharton.
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