Week 6

Introduction
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Bertrand Paradox I
Theoretical Model
 Bertrand Model
 2 companies 2 ice cream sellers on a beach
 Price competition Sellers set prices
 Identical products Same ice cream
 Game played once Price setting once
 Market transparency All consumers know both prices
 Infinite price elasticity Seller with lower price gets all customers
 No capacity constraints Each seller can produce endless amounts
of ice cream
 Fixed Prices
Each seller can set
 Low price
 High price
Seller B
High Low
Seller A

High 50% / 50% 0% / 100%

Low 100% / 0% 50% / 50%

Share of consumers
 Continuous Prices
Each seller can set any price

Unique Nash Equilibrium

 Prices equal costs (no fixed costs)
 Profits equal zero

In reality firms do make profits.

Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Bertrand Paradox II
Adjusting Model Assumptions
 Bertrand Model
 2 companies
 Price competition
 Identical products
 Game played once
 Market transparency
 Infinite price elasticity
 No capacity constraints
 Model Assumptions (I/III)
 Identical products
In reality, consumers have different Each seller
taste and products are differentiated produces a different
Monopolization not possible flavour of ice cream

 Game played once

In reality, game has indefinite Every summer season,
repetitions sellers set their prices
Collusion possible through
threat of retaliation
 Model Assumptions (II/III)
 Market transparency
In reality, imperfect market Some consumers
transparency know price of
Undercutting prices has an effect one seller only
on some consumers only

 Infinite price elasticity

In reality, costs for consumers Sellers introduce
associated with switching seller loyalty programme
(e.g. 10th ice cream for free)
Undercutting prices has limited effect
 Model Assumptions (II/III)
 No capacity constraints
In reality, companies have Each seller can
limited capacity produce limited
amount of ice cream
No incentive to induce a price war
only
over the complete demand
 What Firms Can Do
Firms can actively influence these aspects to avoid the Bertrand trap
 Agree on prices, implicitly or explicitly
 Play the game repeatedly, make sure there is no endpoint
 Limit your capacity
 Increase switching costs
 Differentiate your product
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Product Differentiation I
Introduction
 Consumer Preferences
Differentiation is beneficial if consumer preferences are heterogeneous

 Technical features Cell phones

 Durability Shoes
 Resale value Real estate
 Taste / Image Cars
 Location Gasoline station
 Time Flights
 Horizontal vs. Vertical (I/II)
Products can be differentiated along two lines

Horizontal differentiation Vertical differentiation

Given equal prices, some Given equal prices, every
consumers would choose consumer would choose
product A whereas others product A over product B
would choose product B
 Horizontal vs. Vertical (II/II)
Products can be differentiated along two lines

Horizontal differentiation Vertical differentiation

Second hand car Second hand car

20.000 km 20.000 km

40.000 km 40.000 km

60.000 km 60.000 km

Red Silver Black Red Silver Black

 Horizontal and Vertical (I/II)
Often, products can be differentiated horizontally and vertically

First Class

Flights New York - Paris

Business

Economy
7.00h 12.30h 20.00h
 Horizontal and Vertical (II/II)
Often, products can be differentiated horizontally and vertically

Core i7 CPU

Laptops
Core i5 CPU

Core i3 CPU
Compaq Dell HP
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Product Differentiation II
Horizontal Differentiation
 Hotelling Bertrand Model
 Goes back to Harold Hotelling and Joseph Bertrand

 Highly relevant for analysing product differentiation

 Set Up
 Beach
 Consumers (C)
• Lying at the beach
• Feel discomfort from walking
 2 ice cream sellers
• Same ice cream
• Located in the middle

C C C C C C C C
 Outcome
Severe price competition

PriceA = costsA PriceB = costsB

ProfitA = zero ProfitB = zero

C C C C C C C C
 Moving Along the Beach (I/II)
Reduced price competition

PriceA > costsA PriceB > costsB

ProfitA > zero ProfitB > zero

C C C C C C C C
 Moving Along the Beach (II/II)
Further reduced price competition

PriceA >> costsA PriceB >> costsB

ProfitA >> zero ProfitB >> zero

C C C C C C C C
 Supporting Factors
Factors positively influencing prices and profits

 Distance of sellers from each other

 Magnitude of discomfort from walking

 Number of consumers along the beach

 Interpretation of Parameters
The parameters in the beach example can be interpreted in a broader sense

 Different locations of sellers Horizontal differentiation of products

along one product dimensions

 Distance of sellers Degree of differentiation of the products

 Position of a certain consumer Preference of this consumer regarding

along the beach the products

 Discomfort from walking Strength of preference, loss by

deviating from the ideal good
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Product Differentiation III

Vertical Differentiation
 Set Up
 London City Centre C
 Consumers (C)
• Some would pay a lot C High
for good ice cream quality
• Others have money constraints C
and prefer an average ice cream
at a reasonable price C
 2 ice cream sellers
C Low
• Same ice cream
quality
• Located next to each other C
 Outcome
C

C High
quality
PriceA = costsA C PriceB = costsB
ProfitA = zero ProfitB = zero
C

C Low
quality
C
 Changing Quality (I/II)
C

C PriceB > costsB High

quality
ProfitB > zero
C

C
PriceA > costsA
C Low
ProfitA > zero quality
C
 Changing Quality (ÎI/II)
C
PriceB >> costsB
C ProfitB >> zero High
quality
C

C Low
PriceA >> costsA quality
ProfitA >> zero C
 Supporting Factors
Factors positively influencing prices and profits
 Difference in quality of the products
 Degree of heterogeneity in terms of willingness to pay

Firms offering low quality products can realize

positive profits just as firms offering high quality.
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Pricing & Product

Decisions I
Generic Strategies
 Overview
 Three generic strategies for creating a defendable position and
outperforming competitors in an industry
 These require different organizational arrangements, control
procedures, incentive systems and resources
 Cost Leadership
 Low-cost relative to competitors as strategic main theme
 Central elements of the strategy
• Efficient-scale facilities
• Rigorous cost reductions from experience
• Avoidance of marginal customer accounts
• Cost minimization in areas like R&D,
service, sales force and advertising
 Aggressive pricing to achieve market share
 Differentiation
 Differentiating the product or service, offering something that is
perceived industry-wide as being unique
 Exemplary forms of differentiation
• Design or brand image
• Technology
• Customer service
• Dealer networks
 Differentiation along multiple dimensions
 Often incompatible with low prices and high
market shares (e.g. due to exclusivity)
 Focus
 Focus on particular buyer group, segment of the product line or
geographic market
 Central rationale: Serving narrow strategic target group more effectively
or efficiently than competitors
 Lower costs or more differentiation with regard to single niche
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Pricing & Product

Decisions II
Stuck in the Middle
 Stuck in the Middle (I/II)
Firms that fail to develop their strategy in at least one of the three
directions are in poor strategic position
 Firms lack the market share, capital investment, and resolve to “play the
low-cost game”
 Firms lack industry-wide differentiation to obviate the need for a low-cost
position
 Firms lack focus to create differentiation or
low-cost position
 Stuck in the Middle (II/II)
Profits

Differentiation/ Cost
Focus Leadership

Stuck in the
Middle
Market Share
 Ambidexterity
 Stuck in the middle does not mean that firms
cannot pursue multiple strategies simultaneously
 The pursuit of hybrid / ambidextrous strategies might
lead to even better results than following pure strategies
 But tensions within organizations need to be managed

Example: NikeID Shoes

 Mass customization through online stores
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 6

Wrap Up
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich