How Competition Shapes the Creation and Distribution of Economic Value

Introduction to Business Strategy
Prof. Marvin Lieberman
UCLA Anderson School of Management
How Competition Shapes
the Creation and Distribution
of Economic Value
Lecture 3: Competitive Advantage
©2009 by Marvin Lieberman
Competitive Advantage
In the previous lecture, we considered how
Porter's “five forces” operate at the level of
an industry. In this lecture, we look within
an industry and consider how differences
among firms – and potentially among their
customers – give rise to “competitive
advantage.”
©2009 by Marvin Lieberman
Porter (1980) proposed that there are
two types of “competitive advantage”
• Cost Advantage
• Differentiation Advantage
Experts in business strategy hold differing views about the exact
nature and sources of competitive advantage. Most would agree,
however, that competitive advantage must be based on cost or
differentiation factors.
Let’s start by considering cost advantage.
*Michael E. Porter (1980). Competitive Strategy. Free Press, Boston.
Example 3.1
Assume that that F1 and F2 can produce an identical product at a cost of 50 cents per unit.
Neither firm has an output constraint, and there is no collusion.
F1
F2
c=.5
c=.5
B1
B2
wtp=1
wtp=1
In this case of identical costs,
neither firm has an advantage.
Each buyer can play off the two
sellers to bargain the price down
to cost, or just slightly above.
There are two potential buyers. Each buyer can consume one unit, and they are
willing to pay up to $1.
• What will be the price of the “product”?
P = 0.5 (“Bertrand” competition)
• How much economic value is created?
V = 1 ( = 0.5 x 2 )
• Who captures that value?
F1 and F2 get zero
B1 gets 0.5
B2 gets 0.5
Example 3.2
Now, assume that that F1 can produce at a cost of zero per unit. Neither firm has an
output constraint.
F1
F2
c= 0
c=.5
B1
B2
wtp=1
wtp=1
In this case, F1 has a cost advantage.
If F1 charges just below $.50, it can
drive F2 out of the market. Buyers
may try to get a lower price, but if F2
knows that they are willing to pay
$.50 or more, F2 can capture the full
value of its cost advantage over F1.
There are two potential buyers. Each buyer can consume one unit, and they are
willing to pay up to $1.
• What will be the price of the “product”?
P = 0.5 - ε (“Bertrand” competition)
• How much economic value is created?
V=2
• Who captures that value?
F1 gets 1
F2 gets zero
B1 gets 0.5
B2 gets 0.5
Limiting the industry to two firms and two customers may
seem restrictive, so let’s add greater realism by increasing
the number of buyers, and then the number of sellers.
We’ll start by considering the case of two firms with
identical costs, facing multiple potential buyers who differ
in their willingness to pay.
Example 3.3
Assume that that both F1 and F2 can produce at unit cost=0.8. Neither firm has an
output constraint. Each buyer can consume one unit.
F1
F2
c=.8
c=.8
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
• What will be the price of the “product”?
P = 0.8 (“Bertrand” competition)
• How much value is created?
V =.2
• Who captures that value?
F1 and F2 get zero
B1 gets 0.2
B2 gets 0
Example 3.4
Now assume that that F1 has a “cost advantage” and can produce at cost 0, but F2 has
unit cost=0.8. Neither firm has an output constraint.
F1
F2
c=0
c=.8
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
In this case F1 has a big cost advantage and can drive F2 out of the market. F1 maximizes
profit by charging a price of $.60, just like the monopolist in Example 1.5 from Lecture 1.
• What will be the price of the “product”?
P = 0.6
• How much value is created?
V = 2.4
• Who captures that value?
F1 gets 1.8; F2 gets zero
B1 gets 0.4
B2 gets 0.2
B3 gets 0
So, F1’s cost advantage creates additional
value of 2.2 (= 2.4 – 0.2), which is split
between F1 and its customers.
(= 1 + .8 + .6)
Now, let’s increase the number of firms and consider how
the heterogeneity of sellers and buyers leads to the
economic concept of supply and demand curves.
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
• What will be the price of the “product”?
P = 0.6
• How much value is created?
V = 1.2
• Who captures that value?
F1 gets 0.4; F2 gets 0.2; F3 gets 0
B1 gets 0.4; B2 gets 0.2; B3 gets 0
To see why this outcome arises, let’s draw supply and demand curves for this case.
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
We can plot the supply curve by
calculating the number of units
that firms are willing to produce
as price increases.
1.0 0.8 0.6 0.4 0.2 0
0
1
2
3
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
1.0 0.8 -
Similarly, the demand curve
shows the total number of units
that customers are willing to buy
at any given price.
0.6 0.4 -
Industry Demand Curve
0.2 0
0
1
2
3
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
This area corresponds to
industry profit, called “producer
surplus” in economics. It is the
economic value that is captured
by producers (F1 and F2 in this
example).
Price
1.0 -
Industry Supply Curve
0.8 0.6 0.4 Industry Demand Curve
0.2 0
0
1
2
3
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
1.0 0.8 0.6 0.4 Firm 1 has a cost advantage.
This rectangle represents its
profit.
0.2 0
0
1
2
3
Industry Demand Curve
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
1.0 0.8 0.6 0.4 Firm 2 also has a cost advantage,
albeit smaller than F1’s. This
rectangle represents F2’s profit.
0.2 0
0
1
2
3
Industry Demand Curve
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
F3 has no advantage and will produce only if its
costs are at least slightly below B3’s WTP of $.60.
1.0 0.8 0.6 0.4 Industry Demand Curve
0.2 0
0
1
2
3
4
5
Quantity
©2009 by
Marvin
Lieberman
Example 3.5
Each firm can produce one unit at the indicated unit cost,
and each buyer can consume one unit with the indicated WTP.
F1
F2
F3
F4
F5
c=0.2
c=0.4
c=0.6
c=0.8
c=1.0
B1
B2
B3
B4
B5
wtp=1.0
wtp=0.8
wtp=0.6
wtp=0.4
wtp=0.2
Price
Industry Supply Curve
The supply and demand curves have
a stair step shape in these examples,
given the small number of buyers
and sellers. The curves become
smoother when the number of firms
and customers increases .
1.0 0.8 0.6 0.4 -
Industry Demand Curve
0.2 0
0
1
2
3
4
5
Quantity
©2009 by
Marvin
Lieberman
Now, let’s consider some cases with “differentiation advantage.”
Differentiation advantage is a bit more complicated than cost
advantage, as it is necessary to introduce the notion of product
quality. Differentiation advantage can arise if the buyers’ WTP
differs among products offered by the competing firms.
We will consider examples with two firms facing two buyers. For
comparison purposes, let’s start with a base case where there is
no difference between the firms or their products.
©2009 by
Marvin
Lieberman
Example 3.6
Two firms, each able to produce “product” at cost=0 with no capacity constraints.
F1
F2
c=0
c=0
B1
B2
wtp=1
wtp=1
Two buyers, each able to consume one unit of the “product” and willing to pay at
most $1. (i.e., the value to each buyer of consuming the product is $1.)
In the absence of differentiation, price falls to zero (or just slightly above) and neither firm makes
any profit. It is hard to make money in a commodity product industry unless there are capacity
constraints or differential costs – or collusion among producers.
• What will be the price of the “product”?
P=0
• How much value is created?
V=2
• Who captures that value?
B1 and B2 each get $1.
F1 and F2 make no profit.
(“Bertrand competition”)
©2009 by
Marvin
Lieberman
Example 3.7
Now, assume that F2 improves its product to increase buyers’ wtp:
Two firms, each able to produce at cost=0 without capacity constraints.
F1
F2
c=0
c=0
Value of product to buyer:
B1
B2
Firm 1
Firm 2
Buyer 1
1.0
1.5
Buyer 2
1.0
1.5
Buyers are willing to pay at most $1 for the product made by F1, and at most $1.5 for
the product of F2. Each buyer can consume one unit.
F2 has what Porter calls a “broad scope differentiation advantage,” given that F2’s differentiation
appeals to a broad range of buyers (both of the two buyers in this limited case). As illustrated in
this example, F2‘s advantage is sufficient to drive F1 out of the market.)
• What will be the price of the “products”?
P1=0; P2 = 0.5 - ε;
• How much value is created?
V=3
• Who captures that value?
B1 and B2 each get $1.
F2 gets $1 (= $0.5 x 2)
©2009 by
Marvin
Lieberman
Example 3.7
Now, assume that F2 improves its product to increase buyers’ wtp:
Two firms, each able to produce at cost=0 without capacity constraints.
F1
F2
c=0
c=0
Value of product to buyer:
B1
B2
Firm 1
Firm 2
Buyer 1
1.0
1.5
Buyer 2
1.0
1.5
Buyers are willing to pay at most $1 for the product made by F1, and at most $1.5 for
the product of F2. Each buyer can consume one unit.
According to Porter, differentiation advantage arises when the firm can charge a price premium that
exceeds the cost of differentiating the product. In this case, F2 has obtained its differentiation without
any increase in cost. How large a unit cost penalty can F2 afford to pay and still maintain an advantage?
• What will be the price of the “products”?
P1=0; P2 = 0.5 - ε;
• How much value is created?
V=3
• Who captures that value?
B1 and B2 each get $1.
F2 gets $1 (= $0.5 x 2)
©2009 by
Marvin
Lieberman
Example 3.7
Now, assume that F2 improves its product to increase buyers’ wtp:
Two firms, each able to produce at cost=0 without capacity constraints.
F1
F2
c=0
c=0
Value of product to buyer:
B1
B2
Firm 1
Firm 2
Buyer 1
1.0
1.5
Buyer 2
1.0
1.5
Buyers are willing to pay at most $1 for the product made by F1, and at most $1.5 for
the product of F2. Each buyer can consume one unit.
Answer: F2 maintains an advantage as long as its cost remain below $.50. So, if F2 incurred
costs of $.40 per unit to achieve its differentiation, it would still have a competitive advantage.
• What will be the price of the “products”?
P1=0; P2 = 0.5 - ε;
• How much value is created?
V=3
• Who captures that value?
B1 and B2 each get $1.
F2 gets $1 (= $0.5 x 2)
©2009 by
Marvin
Lieberman
In the previous example, Firm 2’s advantage comes from
what economists call vertical product differentiation.
Differentiation of this type makes the firm’s product more
attractive to all potential customers. In the example, both
buyers consider the differentiated product to be of higher
quality and are willing to pay more for it. (The term
vertical comes from the fact that all customers have the
same ordering of product quality from high to low.)
Another type of differentiation is what economists call
horizontal product differentiation. With horizontal
differentiation, buyers differ in their tastes and
preferences. Let’s see what happens when the market
offers opportunities for horizontal product differentiation.
©2009 by
Marvin
Lieberman
Example 3.8
Now, let’s assume that each firm improves its product for specific buyers:
Two firms, each able to produce at cost=0 without capacity constraints.
F1
F2
c=0
c=0
Value of product to buyer:
B1
B2
Firm 1
Firm 2
Buyer 1
1.5
1.0
Buyer 2
1.0
1.5
B1 is willing to pay at most $1.5 for F1’s product, and at most $1.0 for F2’s product. B2 is
willing to pay at most $1.0 for F1’s product, and at most $1.5 for F2’s product.
Each buyer can consume one unit.
In this case both firms can charge $1.0 for their products without losing their buyer to
the other firm. (If they charge more than $1.0, the other firm will undercut.)
Thus, there is an unique equilibrium in this market at price $1.0 for each product.
• What will be the price of the “products”?
P1 = P2 = 1.0 (This is subtle.)
• How much value is created?
V=3
• Who captures that value?
F1 and F2 each get $1.0.
B1 and B2 each get $0.5.
©2009 by
Marvin
Lieberman
Example 3.8
Now, let’s assume that each firm improves its product for specific buyers:
Two firms, each able to produce at cost=0 without capacity constraints.
F1
F2
c=0
c=0
Value of product to buyer:
B1
B2
Firm 1
Firm 2
Buyer 1
1.5
1.0
Buyer 2
1.0
1.5
B1 is willing to pay at most $1.5 for F1’s product, and at most $1.0 for F2’s product. B2 is
willing to pay at most $1.0 for F1’s product, and at most $1.5 for F2’s product.
Each buyer can consume one unit.
Note that each firm captures a different buyer “segment.”
The firms enjoy an added benefit in that “rivalry” is diminished.
• What will be the price of the “products”?
P1 = P2 = 1.0 (This is subtle.)
• How much value is created?
V=3
• Who captures that value?
F1 and F2 each get $1.0.
B1 and B2 each get $0.5.
©2009 by
Marvin
Lieberman
This case illustrates a number of features about differentiation advantage:

By appealing to different market “segments,” many firms can enjoy
differentiation advantage within the same industry. Both firms in
Example 3.8 have a differentiation advantage, and they earn identical
profits.
Thus, differentiation advantage need not be earned by one firm at the
expense of another. This differs from cost advantage, where profits are
determined by a given firm’s cost position relative to other firms in the
market.

Although not addressed in the previous lecture on how Porter's Five
Forces influence the distribution of profits in an industry, product
differentiation tends to diminish the rivalry among firms. As a result,
industries with high product differentiation often have a relatively large
number of firms with high profitability. We see this in Example 3.8,
where the fact that the firms are pursuing different customers reduces
the intensity of price competition.
©2009 by
Marvin
Lieberman
A closing footnote on defining “competitive advantage”: As noted at the start of this lecture, there is
currently debate the field of business strategy about the appropriate definition of "competitive advantage".
In our last example, both firms earned attractive returns by differentiating their products. Their profits
were equal, and neither firm was superior to the other. We have described this as a case where both firms
have achieved competitive advantage. But those who define advantage as superiority over rivals within a
specific market would argue that neither firm has a competitive advantage in this case. (At issue is whether
the profits from differentiation should be attributed to the industry or to the firm.)
In our previous examples where one firm has lower cost than rivals, "competitive advantage" may depend
on how the value created by the firm is distributed among stakeholders. If this value flows to shareholders
in the form of profits, few would question that the firm has competitive advantage. However, if this value is
captured by the firm's management and employees, many would argue that the firm lacks competitive
advantage, even though the firm may be far more efficient than its rivals.
For instance, consider an industry where one firm, through the cooperation of management and labor, is
able to produce a given output with only half the number of employees as competitors. If the resulting
surplus is paid out to shareholders, there is little question that the firm enjoys a competitive advantage.
However, if the surplus is captured entirely by managers and workers in the form of higher salaries, wages
or bonuses, many would argue that the firm does not have competitive advantage. (The claim in this case
is that the firm has an advantage in "efficiency" but not in "cost".)
Thus, the existence and magnitude of "competitive advantage“ depends on how the concept is defined.
©2009 by
Marvin
Lieberman
This concludes our analysis of cost and differentiation advantage. The
most basic points to remember are the following:
 Cost advantage arises when firms are heterogeneous in their cost positions.
 Differentiation advantage arises when a firm is able to enhance the quality
of its product(s) in a way that raises buyer's WTP (and hence the price
charged by the firm) by more than the cost of achieving differentiation.
While we have established some conceptual foundations for understanding
these two forms of competitive advantage, we have said nothing about how
firms are able to achieve low cost or high quality positions in practice.
Those managerial challenges are fundamental, but they lie beyond the
scope of these brief lectures. Many of the tactics for gaining competitive
advantage are addressed in strategic management, marketing and
operations courses. Hopefully, these lectures have prepared you to think
about those courses, and about business in general, in terms of value
creation and capture.
©2009 by
Marvin
Lieberman