Saturday, March 24, 2012

Competition Demystified: Chapter 11

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

The strategic elements to consider in price competition were discussed two chapters ago. This chapter is about quantity or volume competition, which differs from price competition in meaningful ways. The first difference is one of timing, as expanding capacity requires long lead time. The second is that decisions cannot be reversed as easily, and therefore decisions (exiting a market) have enduring repercussions.

Instead of using a matrix to analyze outcomes, the authors recommend a decision tree. This is because the sequence of events is important; a firm's course of action is dependent on what capacity decisions have already been incurred. To illustrate via example, the authors discuss what a decision tree would like for Lowe's and Home Depot if one of them were to infringe in another's market. The response to the aggressor can send a message that aggressiveness will not be accepted, but this could come at the risk of lower profitability for all. At the same time, a lack of response could be seen as a sign of encouragement to continue being aggressive, but it could also result in higher profitability, as long as other entrants don't get the idea that entering the market is possible.

To determine the course of action to follow, the authors suggest executives run repeated simulations, each playing the part of the different agents. The authors then suggest some strategies for entrants to avoid retaliation by incumbents, and strategies for incumbents to avoid (or at least put off) having to face aggressors. The strategy employed by Rupert Murdoch that was discussed in the previous chapter is argued as a masterful "entrant" performance.

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