BurnYourBoat_chevalier and scott morton.pdf

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Unformatted text preview: :.'_rr - we: age: :fu‘bgu-y mum - . 1“?" When it can be good to burn your boats by Judith A. Chevalier requirement for a business at all times. But there are situations in which making irreversible commitments can have important strategic value. In this article I consider two types of commitments: commitments to being a “tough” competitor and commitments to being a "soft” competitor. Maintaining the flexibility to change its course of action might seem a valuable Commitments to be tough The classic example of the strategic value of commitment comes not from business. but from war. In 400150 Sun-tzu in The Art of War wrote: “At the critical moment, the leader of an army acts like one who has climbed up a height, and then kicks away the ladder behind him." The Spanish conquistador Hernan Cortes took this advice to heart in 1519. On landing in Mexico, in preparation for his invasion of the Aztec city of Tenochtitlan, Cortes sunk most of his ships. As Cortés’s companion Bernal Diaz de Castillo wrote: “We could look for no help or assistance except from God for we now had no ships in which to return.” Clearly, the sinking of the ships would have provided extra motivation for the army. However, it also sent a powerful signal to the opponent. It was clear to the Aztec king Moctezuma that resistance to Cortés’s invasion would lead to a bloody fight to the death, not to the retreat of Cortés’s men. The Aztecs clause not to resist Cortés’s invasion of Tenochtitlan, Thus the commitment to act aggressively engendered the desired passive response from the opponent. Quoting Sun-tzu again: “The skillful leader subdues the enemy’s troops without any lighting.” Reversibility A strategic commitment, like the sinking of a ship, is a decision that is difficult to reverse. When companies build factories, sign contracts, and launch advertising mimpaigns, they are making decisions that might be difficult to go back on. This irreversibility can have both benefits and costs. The main benefit of an irreversible mmmitment is the effect it has on competitors. Consider this example. A new trucking company is contemplating entering two _ lm'al markets to haul agricultural products. Suppose the two local markets are _ identical in every respect, except for the identity of the incumbent company ‘ i (Iiiwrating in the market. In the first market, the incumbent company is a railroad. - The incumbent spent $20m to construct the railroad and the operating cost of hauling grain for the railroad is $0.20 per ton-mile. In the second market, the incumbent is another trucking company. The trucking company has $20111 worth of firm-ks operating on the route. The operating cost of hauling grain for the incumbent trucking company is $0.20 per ton-mile. Which market is the new trucking company there likely to enter? At first, the conditions in the two markets seem identical. However, there is an 47 2 - Strategy and micro-economics 48 important difference. Most of the costs in constructing the railroad relate to clearing the land and laying the track; these are irrecoverable should the railroad decide to shut down. In contrast, if the incumbent trucking company decides to close, it could almost fully recover its $20m investment. Trucks obviously are easy to move from place to place, and there is a fairly liquid market for them. Thus, for the incumbent trucking company to want to remain in the market, it needs to cover its operating cost. and earn a return on its investment in the trucks. If it is not earning an adequate return on its trucks, it will sell them or take them elsewhere. For the incumbent railroad company to choose to stay in the market, it needs to cover its operating cost and earn a return only on the (relatively small) scrap value of the railroad: The track investments are totally irrecoverable, or “sunk,” and thus the railroad does not consider their value when deciding whether or not to stay in business. Should prices and quantities fall in the market, it is quite likely the railroad will wish that it had never made the investments in laying track. However, as the track is there, unless market conditions are extremely poor, it makes sense to continue operating the railroad. Thus, the entrant will have a much easier time inducing the trucking company to exit than it will have inducing the railroad company to exit. Entering the market currently occupied by the trucking company is, therefore, more attractive. The irreversibility of the railroad’s investments acts as a commitment by the railroad to stay in the market, and may deter the entrant from entering the market. Thus, the commitment allows the railroad company to “subdue the enemy’s troops without any fighting.” Commitments to be soft When thinking about commitments in the context of strategic management, a manager has first to determine what kind of commitments might be valuable and then determine whether the strategic advantages of commitment outweigh the benefits of retaining flexibility. The types of commitments that managers might want to make fall into two broad categories: commitments to be “tough” and commitments to be “soft.” A company might benefit from a commitment to be tough when it wants to deter entry into its markets, encourage a rival to build only small capacity, or even induce exit. The Cortés and railroad examples above are instances of commitments to be tough. Alternatively, a company might benefit from a commitment to be “soft.” If two competitors are competing by setting prices in a market in which exit is unlikely, commitments to be “soft” might be valuable. Consider, for example, the fierce competition between mass—market discount department stores. A number of these are now adopting “frequent customer cards” and other loyalty programs. In order to encourage the customer not to shop around, these programs give rewards to those who accumulate a large number of purchases with the retailer. However, introduction of such programs raises a question to outside observers: wouldn’t the cost of the awards and the infrastructure for the program be better spent simply lowering prices? Wouldn’t customers appreciate this just as much or more than prizes? Club 2 Customers might appreciate lower prices just as much as “loyalty rewards,” but the effect on competition would be very different. Consider the largest, and perhaps E.- “.0, ”-04.5: When it can be good to burn your boats most successful, retail loyalty program in North America. Approximately one-third of all Canadian residents belong to Club Z, the loyalty program for the Canadian mass merchandiser Zeller Stores. Eight out of ten of Zeller’s shoppers are estimated to be members. What signal does the adoption and maintenance of this loyalty program send to Zeller's competitors? At first one might guess that the fact that Zeller has customers who don’t like to shop around is unambiguously bad news for its competitors, such as the US retailers Wal-Mart and Sears Roebuck. However, Zeller’s customer loyalty also has a positive side for its competitors. As Zellers president Thomas Haig noted in an issue of Discount Store News: “We can position ourselves a bit above Wal-Mart in price.” If Zeller’s customers are loyal and unwilling to shop around, this would tend to make Zeller reluctant to compete fiercely by cutting prices, After all, cutting prices might help Zeller to pick up a few new customers, but it would be giving up margins on all of the customers who were willing to pay a bit more. Thus, its strong customer loyalty program serves as a commitment on Zeller’s part not to cut prices too fiercely. How should Wal-Mart respond to this? Wal-Mart will surely choose prices that are lower than Zeller’s prices, but it will not compete as fiercely on price as it might otherwise. After all, it will be very costly to dislodge those customers from Zeller who don’t shop around much. And, if Zeller isn’t competing too hard to attract those “non-loyal” customers, Wal-Mart doesn’t have to charge extremely low prices to capture them. Wal-Mart competes less aggressively due to Zeller’s loyalty program, and this less aggressive competition benefits Zeller. In considering what kinds of commitments to make, it is important to figure out what one’s objectives are and how competition is taking place in the market. For example, Zeller’s loyalty program is a good strategy because the company is engaged m price competition with a competitor that it cannot hope to try to induce to exit. Maintaining “soft” price competition is probably the most profitable tactic for Zeller. However, if it were trying to induce Wal-Mart’s exit, the loyalty program might prove a hindrance. Suppose Zeller cut its prices to try to persuade Wal-Mart to exit. Wal—Mart would probably stand firm, knowing that the existence of loyal customers who are willing to pay higher prices makes price cutting a very expensive strategy for Zeller. Wal-Mart knows that Zeller won’t want to keep up a price war for too long. Foreseeing that Wal-Mart can see through its motivations. Zeller would probably never attempt to cut prices to induce Wal-Mart to exit. it is important to stress that an easily reversible decision does not function as a rredible commitment that will alter a competitor’s behavior. Moctezuma might not . - have been impressed had Cortés merely announced, “We will not return to Cuba.” - _ ‘_ The scuttling of the ships convinced Moctezuma that even if the invasion turned out wry poorly, making Cortés want to retreat to Cuba, he could not do so. Moctezuma _ Would not have considered an announcement by Cortés to be credible. In June 1999, - for example, online bookseller Amazoncom announced that it was building a new ‘ A 800.000 sq. ft distribution facility in the state of Georgia that would employ 1,000 e ‘ pimple. While this represents a measurable capacity expansion for Amazon, it does flu! represent a commitment to expand. A distribution facility’s infrastructure does not tend to be specialized, and the site could easily be sold as a i. '=" _ distribution/warehouse facility for some other type of business. Thus, when mmwetitors consider whether to expand into Amazon’s markets, they would not rnnsider the distribution facility as a commitment on Amazon’s part not to reduce mpmtity in the future. 49 2 ~ Strategy and micro-economics 50 One might argue that Zeller could easily discontinue its loyalty program. However, it has made considerable investments in setting up infrastructure for this program. These investments are unrecoverable. The loyalty program functions as a commitment because it affects Zeller’s incentives in the future. Zeller understands, and its competitors understand, that having created loyal customers through this program. maintaining this loyalty by continuing the program is relatively cheap. The loyal customer base that Zeller has created functions like an asset that it has purchased and that has very little scrap value. The fact that the major investments in creating a loyalty program have already been made means that the company is likely to remain on the path of promoting customer loyalty rather than switch to that of‘fierce price competition. CD technology Commitments, then, can often be valuable in altering a competitor’s responses. However, when considering a commitment, it is crucially important to consider the value of the flexibility forgone by undertaking the commitment. Harvard Business School professor Anita McGahan considers an example of a company facing the decision of whether to build a large factory ahead of demand, in an article entitled “The incentive not to invest: capacity commitments in the compact disc introduction.” In 1982, on the eve of the launch of its compact disc in the US market, the Dutch electronics group Philips NV had to decide whether to build a large local facility immediately to press discs. As the innovator of the CD, Philips could bring a facility into production in 1983, much faster than any rival presser could enter the market. If the compact disc achieved US acceptance, Philips’s lead in moving down the learning curve and its large installed capacity might deter others from building their own pressing facilities. By moving early, Philips might be able to deter others from entry and protect itself from destructive price competition in the future. However, there was an important downside to this option. In 1982, it was not at all clear that CDs would achieve popular acceptance. After all, consumers already had record players and libraries of LPs. The next innovation, digital audio tape, was only a few years down the line. Should the CD not catch on, Philips would be saddled with a $25m facility with almost no alternative uses. Excluding the possibility of competition, it seemed to make sense for Philips to import CDs from existing facilities in Europe and not to invest in US capacity until it became clear that CD3 would be accepted in that market. By waiting to see whether US consumers would be attracted to the CD, Philips could preserve the valuable option not to invest if acceptance were too low. Philips, fearing that popular acceptance of the CD might be low, chose to wait and see how the US CD market evolved. Unfortunately for the company, however, Sony built a CD facility in the US in 1984. CDs were, of course, a great commercial success, and Philips and others entered with rival plants soon after. While CD prices themselves have held fairly steady over the years, the prices charged to the record labels by the pressing facilities have declined precipitously, due to overcapacity and fierce price competition in the pressing market. An earlier move by Philips might well have resulted in a different market outcome. However, opting for flexibility may have been the right decision given the information available at the time. This example illustrates the difficult trade-off between undertaking a commitment strategy and maintaining flexibility. While The pros and cons of entering a market both strategies can be valuable, neither strategy provides insurance against later regret. Summary irreversible commitments can have an important strategic value, explains Judith A. Chevalier, in this article she describes two broad categories of commitment — the “tough” and the “soft." The tough approach can be used to deter a competitor from entering a market or to force it out. The soft approach may be more appropriate where exiting the market is not an option for a competitor and no players would benefit from heavy competition on price. The benefits of making a strategic commitment — never more dramatically illustrated than by the Spanish conquistador Hernan Cortes’s decision to scuttle his __ ships — need to be weighed carefully against the advantages of maintaining flexibility. Neither strategy 1': provides insurance against later regret. A. I The pros and cons of entering a market sili'mluctory economics textbooks generally tell us to expect new entrants into an Iriirtnstry whenever the incumbent companies are earning profits greater than llmi cost of capital. Furthermore, we are told that entry will occur until profits net {If the rust, of capital are driven to zero. Obviously, this View of the world is too 'mpiist it. We can think of many examples of markets with no regulatory barriers to m in which incumbent companies are making high profits, yet little or no entry '- dura- For example, in a 1999 working paper, Boston University economist Marc Rysman - "Iiitlt‘h‘ that the profits of US Yellow Pages directory publishers average 85 to 40 _ writ of revenue. Despite this, relatively few independent publishers have entered ' ' - ‘z‘tzzirket to compete with local telephone companies in providing Yellow Pages _ than, in contrast, we can think of several examples of markets like online " - milling: where. despite the virtual absence of profitability, many new companies ' m be starting up. In this article, I will explore some of the factors a company " . hi consider when deciding whether or not to enter a new market. In doing so, I _. _ ._ , tr to reconcile the entry patterns we observe in real business with the basic -. plea of economics. ii - Iconomics of entry : or the textbook case of entry dynamics. A company enters a new market and '_ ll profitable. Typically, that market will then attract further entry, eroding the ." r'rz profitability. Profits are eroded for two reasons. First. the pioneer loses 51 2 - Strategy and micro-economies 52 market share to new entrants. Second, the presence of the entrants often brings vigorous price competition, eroding margins on each unit sold. The case of Rollerblade skates. .now owned by Italy’s Benetton Sportsystem, conforms fairly well to the textbook example. Rollerblade introduced inline skates in the US market in 1980. At the same time, the company invested considerable resources in popularizing the sport. It was successful; the market for inline skates exploded in the late 1980s and early 19903. Participation in the sport in the US rose from 3.1m in 1989 to more than 20m in 1995. However, the explosion of the market for inline skating did not escape the notice of others. While Rollerblade did have patents for features of its skate boot, it did not have a patent for the basic idea of lining up skate Wheels. This idea had been around for a long time. Indeed, inline skates had been a fad in the 1860s. Thus, Rollerblade could not prevent entry into the market. In the late 1980s, Rollerblade had Virtually all of the market and its cheapest model sold for $90. The company’s only competitor at that time, First Team Sports, sold its skates for about 15 percent less than the comparable Rollerblade models. By 1994, approximately 30 companies had entered the inline skates market. Rollerblade’s market share had dropped to about 40 percent. The cheapest skates on the market sold for $29.99; Rollerblade’s cheapest skates sold for $69.99. As mentioned before, the erosion of profits through entry occurs at differing speeds in different markets. Economists use the term “barriers to entry” to describe situations in which incumbent companies are earning profits in a market and yet entrants do not find it worthwhile to enter that market. Barriers to entry Legal barriers to entry Some markets have legal barriers to entry. For example, entry into a market can be blocked by government regulation and by patent protection. However, even when patents exist, they might not stop competition, depending on the breadth of the patent protection. ' A 1987 survey by Richard Levin and others in the Brookings Papers on Economic Activity asked R&D executives to rank the effectiveness of patents at preventing duplication of their innovations. Using a seven-point scale in which one represented “not at all effective” and seven represented “very effective,” mean responses were 3.52 for process patents and 4.33 for product patents. The highest ranking for product patents, 6.5, was given by executives in the pharmaceutical industry. While product patents are sometimes effective at preventing duplication, they don’t prevent all forms of imitation, even in the pharmaceutical industry. For example, in the late 1960s and early 1970s, US pharmaceuticals company Eli Lilly owned the US market for cephalosporins, a type of powerful antibiotic. Its patented products, Keflin and Keflex, were both among the top-selling drugs in the US. While rivals could not produce the same chemical compounds as Keflin and Keflex until those patents expired, they could not be stopped from innovating powerful antibiotics using similar inputs that worked the same way in the body. By early 1982, the year in which the first of the two cephalosporin patents was to expire, Lilly’s share of the cephalosporin market had dropped to 75 percent. High minimum efficient scale relative to market size Even in the absence of legal bar...
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