Week 5

Introduction
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Stages of R&D
 Stages of R&D (I/III)
Basic Applied Product
Research Research Development
 Stages of R&D (I/III)
Basic Applied Product
Research Research Development

Development of scientific knowledge that is applicable to wide range of

potential uses

Example:
Research on radio waves
 Stages of R&D (II/III)
Basic Applied Product
Research Research Development

 Application of scientific knowledge to the solution of a specific problem

 Development of a new product or process

Example:
Development of mobile phone prototype
 Stages of R&D (III/III)
Basic Applied Product
Research Research Development

 Identification of the relevant consumers

 Tailoring of the product / process to the
needs of these consumers

Example:
Adjusting size, shape, colour of mobile
phone to consumer taste
 Patents and Consequences (I/II)
Basic Applied Product
Research Research Development

 Outcomes difficult to protect

publications
 Subject to knowledge
spillovers between firms personnel contacts
 Prisoner‘s dilemma
 Mainly done by universities, public
laboratories or networks of firms
 Patents and Consequences (II/II)
Basic Applied Product
Research Research Development

Can often be protected by patents or copyright

 Possible to stop others from making use of it
 If two firms develop similar products,
whoever comes first wins
 Often leads to patent races
 Behaviour of competitors very important
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Types of Innovation
 Product vs. Process Innovation
Product Innovation Process Innovation
 Improvement of an existing  Novel way of producing an
product existing product
 Increase in willingness to pay  In most cases reduction of
of existing / potential buyers production costs
 Product vs. Process Innovation
Product Innovation Process Innovation

Example: Example:
New mixture of rubber New way of curing the tire which
that keeps the car stable decreases production costs by 25%
at high speeds
 Drastic vs. Incremental Innovation
Drastic Innovation Incremental Innovation
The innovator can behave as a The innovator can increase profits
monopolist in the market but its strategy is still restricted
(despite substitute products) by other non-innovating firms
 Drastic vs. Incremental Innovation
Drastic Innovation Incremental Innovation
Example: Example:
Development of electric car Improvement of battery unit that
increases range of electric car
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Incentives to Innovate I
Competitive Market
 Set-Up (I/II)
 100 consumers interested in motorbikes
• 60 consumers would pay maximum 500 Euros
• 40 consumers would pay maximum 400 Euros
 With current technology: total production costs of 300 Euros

 Now process innovation: total production costs of 200 Euros

 Whoever spends most on the innovation
gets the innovation
• By being granted a patent
• By being first on the market
 Set-Up (II/II)
 Competitive Market
 10 companies producing and selling motorbikes
 Prior to innovation, all have the same production technology
 Without Innovation
 Total production costs of 300 Euros
 Each company sets price equal to costs
 Each company makes profits of zero
 With Innovation
 Total production costs of
• 200 Euros for company that gets innovation
• 300 Euros for all others
 Company with innovation can set a price of 299 Euros
 All consumers buy from this company
 The overall profits of the company are

 All other companies do not sell

anything and make zero profits
 Value of Innovation
Value of innovation to the focal company
 Profits with innovation

 Profits without innovation

Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Incentives to Innovate II
Monopolist
 Set-Up (I/II)
 100 consumers interested in motorbikes
• 60 consumers would pay maximum 500 Euros
• 40 consumers would pay maximum 400 Euros
 With current technology: total production costs of 300 Euros

 Now process innovation: total production costs of 200 Euros

 Whoever spends most on the innovation
gets the innovation
• By being granted a patent
• By being first on the market
 Set-Up (II/II)
 Monopolist
 1 company producing and selling motorbikes
 No threat of entry by competitors
 Without Innovation
 Production costs of 300 Euros
 Monopolist sets price of 500 Euros
• 60 consumers buy motorbike
• Profits are

 Monopolist sets price of 400 Euros

• 100 consumers buy motorbike
• Profits are
 With Innovation
 Production costs of 200 Euros
 Monopolist sets price of 500 Euros
• 60 consumers buy motorbike
• Profits are

 Monopolist sets price of 400 Euros

• 100 consumers buy motorbike
• Profits are
 Value of Innovation
Value of innovation to the monopolist
 Profits with innovation

 Profits without innovation

 Comparison
Value of innovation
 Competitive market 9.900 Euros

 Monopolist 8.000 Euros

 Replacement Effect
Value of innovation
 Competitive market 9.900 Euros

 Monopolist 8.000 Euros

 For a given market structure, a monopolist

has less incentive to innovate because of
the higher level of pre-innovation profits.
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Incentives to Innovate III

Monopolist with Threat of Entry
 Set-Up (I/II)
 100 consumers interested in motorbikes
• 60 consumers would pay maximum 500 Euros
• 40 consumers would pay maximum 400 Euros
 With current technology: total production costs of 300 Euros

 Now process innovation: total production costs of 200 Euros

 Whoever spends most on the innovation
gets the innovation
• By being granted a patent
• By being first on the market
 Set-Up (II/II)
 Monopolist
 1 company producing and selling motorbikes

 Potential entrant
 Potential entrant interested in innovating
 With Innovation
 Entrant stays out of the market
 Production costs of 200 Euros for monopolist
 Monopolist sets price of 500 Euros
• 60 consumers buy motorbike
• Profits are
(500-200) Euros * 60 = 18.000 Euros
 Monopolist sets price of 400 Euros
• 100 consumers buy motorbike
• Profits are
(400-200) Euros * 100 = 20.000 Euros
 Without Innovation
 Entrant enters the market
 Monopolist and entrant agree on price of 400 Euros
 Market is shared equally (50 consumers each)
 Production costs of
• 300 Euros for monopolist
• 200 Euros for entrant
 Profits for monopolist are

 Profits for entrant are

 Value of Innovation (I/II)
Value of innovation to the monopolist
 Profits with innovation

 Profits without innovation

 Value of Innovation (I/II)
Value of innovation to the entrant
 Profits with innovation

 Profits without innovation

 Comparison
Value of Innovation
 Competitive market 9.900 Euros
 Monopolist 8.000 Euros
 Monopolist with 15.000 Euros
threat of entry
 Entrant 10.000 Euros
 Efficiency Effect
Value of innovation
 Competitive market 9.900 Euros
 Monopolist 8.000 Euros
 Monopolist with 15.000 Euros
threat of entry
 Entrant 10.000 Euros

 Under the threat of entry, a monopolist has

higher incentives to innovate than a potential
entrant into the market
 Trade-Off

Replacement Efficiency
Effect Effect
Probability
 Less innovation by of entry  More innovation by
monopolist monopolist
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Innovation under
Competition
 Trade-Off
R&D

Chance of innovation Risk of losing

with promising returns R&D investments
 If no success at all
 If other company is faster
 Set-Up
 Pharmaceutical companies (A and B)
 Have to decide whether to engage in R&D
for a new drug against asthma
 Fixed costs for R&D activity of £ 10mn
 With likelihood p they come up with a marketable innovation
 Profits from innovation

• £ 24mn if alone on the market

• £ 10mn if with a competitor on
the market
 Payoffs for Company A
 Company A engages in R&D, company B does not

 Both companies engage in R&D

 Company A does not engage in R&D

 Payoff Matrix

Firm B
No R&D R&D

No R&D 0/0 0 / 24p - 10

Firm A

24p (1-p) + 10p2 - 10 /

R&D 24p - 10 / 0
24p (1-p) + 10p2 - 10

in £ mn
 Low Success Rate
Likelihood p that R&D generates innovation = 0.25
Firm B
No R&D R&D

No R&D 0/0 0 / 24p - 10

Firm A

24p (1-p) + 10p2 - 10 /

R&D 24p - 10 / 0
24p (1-p) + 10p2 - 10

in £ mn
 Low Success Rate
Likelihood p that R&D generates innovation = 0.25
Firm B
No R&D R&D

No R&D 0/0 0 / -4
Firm A

R&D -4 / 0 -4.875 / -4.875

in £ mn
 Medium Success Rate
Likelihood p that R&D generates innovation = 0.5
Firm B
No R&D R&D

No R&D 0/0 0 / 24p - 10

Firm A

24p (1-p) + 10p2 - 10 /

R&D 24p - 10 / 0
24p (1-p) + 10p2 - 10

in £ mn
 Medium Success Rate
Likelihood p that R&D generates innovation = 0.5
Firm B
No R&D R&D

No R&D 0/0 0/2

Firm A

R&D 2/0 -1.5 / -1.5

in £ mn
 High Success Rate
Likelihood p that R&D generates innovation = 0.75
Firm B
No R&D R&D

No R&D 0/0 0 / 24p - 10

Firm A

24p (1-p) + 10p2 - 10 /

R&D 24p - 10 / 0
24p (1-p) + 10p2 - 10

in £ mn
 High Success Rate
Likelihood p that R&D generates innovation = 0.75
Firm B
No R&D R&D

No R&D 0/0 0/8

Firm A

R&D 8/0 0.125 / 0.125

in £ mn
 Comparison of Success Rates
 Low success rate  No R&D at all

 Medium success rate  R&D by one firm and pre-emption

 High success rate  R&D by both firms

Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

Sleeping Patents
 Phenomenon
 Companies often apply for relatively minor patents

 They have no intention of ever commercialising these

 Why?
 Idea
Patenting innovations that are close to own main product

 Preventing competitors from inventing a close rival to own product

 Maintaining monopoly position

 Example
 Xerox was using sleeping patents to secure
monopoly position in professional copier market

 Was asked by competition authorities to

license sleeping patents to competitors

 Reasoning: Practice was hindering

technological progress
Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich

© 2013 LMU Munich

Week 5

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

© 2013 LMU Munich