Extracting Profits from Cost and Benefit Advantage

Strategic Positioning: Cost Advantage and Benefit Advantage • 313

extraction takes an especially stark form. When a firm increases its consumer surplus “bid” slightly above competitors, it captures the entire market. This leads to two clear recipes for retaining profits for a firm that creates more value than its competitors. Both involve making consumer surplus bids that the firm’s rivals cannot match:

1.A cost leader that has benefit parity with its rivals can lower its price just below the unit cost of the firm with the next lowest unit cost. This makes it unprofitable for higher-cost competitors to respond with price cuts of their own and thus allows the firm to capture the entire market.

2.A benefit leader that has cost parity with its rivals can raise its price just below the sum of the following: (1) its unit cost, plus (2) the additional benefit DB creates relative to the competitor with the next highest B. To top this consumer surplus bid, a competitor would have to cut price below its unit cost, which would be unprofitable. At this price, then, the firm with the benefit advantage captures the entire market.

What happens if one firm is a cost leader and the other is a benefit leader? If consumers have identical preferences, then the firm that offers the higher B 2 C can capture the entire market, by setting price at the point where the other firm cannot make a better consumer surplus bid and still cover its costs.

These extreme scenarios, in which one firm captures the entire market, result because consumers are assumed to have identical preferences. This would not happen in a market characterized by horizontal differentiation. As we discuss in Chapters 5 and 10, horizontal differentiation is likely to be strong when there are many product attributes that consumers weigh in assessing overall benefit B, and consumers disagree about the desirability of those attributes. In markets where there is horizontal differentiation, lowering price or boosting quality will attract some consumers, but others will not switch unless the differential in price or quality is large enough. In these markets, the price elasticity of demand an individual firm faces becomes a key determinant of a seller’s ability to extract profits from its competitive advantage. Table 9.2 summarizes how the price elasticity of demand facing a firm influences the choice between two polar strategies for exploiting competitive advantage: a margin strategy and a share strategy.

Consider, first, a firm that has a cost advantage. When the firm’s product has a low price elasticity of demand (i.e., when consumers are not very price-sensitive because of strong horizontal differentiation among competitors’ products), even deep price cuts will not increase the firm’s market share much. In this case, the optimal way for a firm to exploit its cost advantage is through a margin strategy: the firm maintains price parity with its competitors and profits from its cost advantage primarily through high price–cost margins rather than through higher market shares. By contrast, when the firm’s product has a high price elasticity of demand (i.e., when consumers are price sensitive because horizontal differentiation is weak), modest price cuts can lead to significant increases in market share. In this case, the firm should exploit its cost advantage through a share strategy: the firm underprices its competitors to gain market share at their expense. In practice, the distinction between a margin strategy and a share strategy is one of degree and firms with cost advantages will often pursue mixed strategies: cutting price to gain share but also “banking” some of the cost advantage through higher margins.

Table 9.2 illustrates the notion that the logic governing the exploitation of a benefit advantage is analogous to that governing the exploitation of a cost advantage.

Strategic Positioning: Cost Advantage and Benefit Advantage • 315

can sometimes create conditions that are more hospitable to one kind of advantage versus another.

An advantage based on lower cost is likely to be more profitable than an advantage built on superior benefits when:

•The nature of the product limits opportunities for enhancing its perceived benefit B. This might be the case for commodity products, such as chemicals and paper. If so, then, more opportunities for creating additional value may come from lowering C rather than from increasing B. Still, we must bear in mind that the drivers of differentiation include far more than just the physical attributes of the product and that opportunities may exist for differentiation through better after-sale service, superior location, or more rapid delivery than competitors offer.

•Consumers are relatively price sensitive and will not pay much of a premium for enhanced product quality, performance, or image. This would occur when most consumers are much more price sensitive than quality sensitive. Graphically, this corresponds to the case in which consumer indifference curves are relatively flat, indicating that a consumer will not pay much more for enhanced quality. Opportunities for additional value creation are much more likely to arise through cost reductions than through benefit enhancements.

•The product is a search good. As detailed in Chapter 10, a search good is one whose objective quality attributes the typical buyer can assess prior to the point of purchase. Examples include commodity products as well as items such as stationery and office furniture. With search goods, the potential for differentiation lies largely in enhancing the product’s observable features. But if buyers can discern among different offerings, so can competitors, which raises the risk that the enhancements will be imitated.

An advantage based on superior benefits is likely to be relatively more profitable than an advantage based on cost efficiency when:

•The typical consumer will pay a significant price premium for attributes that enhance B. This corresponds to the case in which the typical consumer’s indifference curve is relatively steep. A firm that can differentiate its product by offering even a few additional features may command a significant price premium.

•Economies of scale or learning are significant, and firms are already exploiting them. In this case, opportunities for achieving a cost advantage over these larger firms are limited, and the best route toward value creation would be to offer a product that is especially well tailored to a particular niche of the market. Microbreweries, such as the Boston Beer Company, have attempted to build a competitive advantage in this way.

•The product is an experience good. An experience good is a product whose quality can be assessed only after the consumer has purchased it and used it for a while. Examples include automobiles, appliances, and consumer packaged goods. As we discuss in Chapter 10, consumers often judge experience goods on the basis of a firm’s image, reputation, or credibility, which can be difficult for rivals to imitate or neutralize. In the early 2000s, Sony’s strong reputation in consumer electronics helped it become a dominant player in the widescreen television market despite the fact that its LCD technology was inferior to the DLP technology offered by Samsung, a Korean firm with a weaker reputation at that time.