Thursday, August 2, 2012

Why Is Price the Ultimate Competitive Advantage? (Playing Games)

This is a shared post with (here). Forgive the self-plagiarism, but I think you'll see how the idea is tied tightly with many of the investment ideas (especially the string of what actually makes for a competitive business advantage) discussed on Adjacent Progression.

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. 

The ability to raise prices for your offerings - demanding a premium over competitors’ products based on something you do better than they do - is an excellent indication that your business offers some form of competitive advantage. Otherwise you probably couldn’t charge a higher price. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must satisfy some consumer desire for functionality, novelty, or style. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term, or whether it's fleeting and likely to dissipate with time. And, of course, most advantages do go away with time. New fashion designs get mimicked, and the public’s taste for a particular style is fickle. Innovation in technology may provide a lead over the peloton of competitors for a while, but it has a tendency to figure out your tricks, duplicate your product features, and draw you back into the pack over time. 

Most competitive advantages are decidedly NOT enduring. 

But when a company dedicates itself to offering the lowest prices (and maintaining a low cost structure to boot), it has a durable advantage that is very, very difficult to compete against. It is the ultimate competitive advantage, better than those that allow a business the ability to charge higher prices. 


Consider this statement attributed to David Glass, the former Walmart CEO: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. *

To understand Glass’s point, we have to dabble a bit here in a rough (very rough) game theory scenario. (My apologies in advance to actual game theorists.) Let’s reduce the totality of competitive capitalism - that unrelenting tug-o-war among firms to gain the slightest of edge over rivals - to the following matrix (the Price-Cost Matrix) and assume that a company must fit into one of the squares. We’ll further assume that no company possesses an insurmountable competitive advantage over another. Any one company might stumble upon a popular fad that drives sales, or its engineers might cobble together a product whose innovation wows customers. But competitors will eventually figure out the advantage and replicate it. Again, the peloton sucks everyone back in. 

So, in this game, the only true differentiation, over the long-term, is price. Who can offer the lowest price?

Price-Cost Matrix

Your prices can either be high relative to competitors, or low. Same with your costs. So we get four possible combinations to define the companies: High Price, High Cost; Low Price, High Cost; High Price, Low Cost; and Low Price, Low Cost. 

Conventional wisdom says you want to be in the top left hand quadrant (High Price, Low Cost) with the power to raise prices. That’s where the fat profit margins reside, that exalted place where you have low costs to acquire or produce your products yet can sell them with a big markup. Everyone loves profits. In fact I’d go so far as to say most people are blinded in their business decisions by an overwhelming profitability bias

The problem with profits is that competitors notice them. Nothing grabs more attention than high profits. And they’ll want a piece of the action. They’ll enter your market and go after your customers. And in this game scenario of ours, they’ll woo your customers with the offer of a better price. You get sucked into a price war. 

The game theory part of this exercise (and this is ultimately David Glass’ point) is this: you must extend any business competition to its furthest – and even most absurd – logical conclusion. If it’s a price war, you must imagine which player can engage in battle the longest and prevail. 

So let’s imagine it from the perspective of the game’s predator: Low Price, Low Cost. He will source his merchandise at the lowest possible cost, he will maintain the lowest possible overhead, and he will work with evangelical zeal to uncover inventive ways to make both even lower. Then, he will turn around and put a frighteningly slim markup on his items. He offers everything at the lowest price he can muster, and he keeps his costs below those of everyone else. 

He is a fanatic, and he has an insatiable appetite for growth. How do players in the other quadrants fare in a price war against Low Price, Low Cost?

Low Price, Low Cost Starts a Price War

In our game, Low Price, Low Cost goes on the offensive. First, he attacks Low Price, High Cost. This skirmish is easy. Low Price, High Cost is a terrible business that’s stuck, for some reason, in the unenviable position of having to sell its products at a low price yet incapable of revising its cost structure. It’s limping along on tiny margins. All the predator must do is make his prices just a bit lower (enough that a price match would get rid of any remaining profits from Low Price, High Cost), and then wait it out as the wounded competitor goes out of business. It cannot afford to lower prices enough to compete, and so Low Price, Low Cost wins these customers. 

Next is High Price, High Costs. This battle would be easier than the first, expect that High Price, High Costs has some cash on its balance sheet (from earning decent margins over the years) and is foolhardy enough to spend it on the fight. The predator makes his price dramatically lower, the prey tries to match, but in the end it must relent. Its high cost structure means it cannot afford to offer low prices for long. Low Price, Low Cost wins these customers. 

Finally we have High Price, Low Cost. This is a long, drawn-out battle. High Price, Low Cost has plenty of cash to fight, having built deep reserves over the years from its fat profit margins. It price matches the predator, even ups the ante by lowering its own prices further and challenging the predator to match. It can afford this because its costs are so low. But over time its resolve is tested. It had grown used to that big margin (more importantly, its investors had grown accustomed to the profit). It tries to reinvent its culture to dedicate itself to low prices, too. Alas, cultures are very hard things to change. 

The competitors go back and forth on price, creating a war of attrition with both sides taking deep losses. But in the end, the predator remains fanatical about his cost structure. He lowers it more and more, and High Price, Low Cost just can’t keep up. It goes broke, perhaps just five percent before the predator would have. But that doesn’t matter in the end. At the end of the game, Low Price, Low Cost is the only player still standing. 

You may argue that this game is unrealistic. And, of course, it is. The practice of competition is much more nuanced than a hypothetical game. But history shows that, over time, the competitive advantages that protect businesses and allow them to earn high margins…well, they grow weaker as competition learns the secrets. In the long run, everything is commoditized. 

And in the light of this extreme game – one taken to its absurd logical conclusion - we can reconsider David Glass’ words: 

We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. 

The companies that want the most enduring competitive advantage commit themselves to staying in the bottom left quadrant in the Price-Cost Matrix, as far below and to the left of the competition as they can. To do it, they muster a fanatical devotion to staying low price and low cost. More on that next…

This is the fifth post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous posts, The Growth Levers in Retail: Price, Selection, ConvenienceUnlocking the Broad Middle (Hint: Price Is the Key)Sam Walton, Panties and Power Laws; and The Productivity Loop (Walmart's Feedback Loop).

* Quote from Charles Fishman's excellent The Wal-mart Effect

No comments:

Post a Comment