Strategic Advantage

Strategic advantage consists of having supply advantages, demand advantages, and/or economies of scale acting as actual barriers to entry in a bounded market. Innovators create value by developing new customers to purchase new products. Innovators capture value by establishing a business model that can rapidly scale with strategic advantage.

Strategic advantage is described in Competition Demystified by Greenwald and Kahn [1]. Supply advantages include access to low cost resources and legal protection for proprietary products. Demand advantages include captive customers who buy out of habit and/or face high switching costs. Economies of scale spread fixed costs over a larger customer base in a bounded market space. Competitive advantages increase the valuation of dominant firms.

Two tests confirm barriers to entry in a profitable industry. First, either one, two, or several large firms hold stable market share. Second, these stable firms earn high return on capital.

The playing field is level when no firms in the industry demonstrate stable market share over significant periods of time. Firms in these competitive industries tend to have low return on capital because there are no barriers to entry. Firms on the level playing field must be efficient to survive.

The playing field is dominated by rivals when two or more firms have large stable market share and high return on capital. These rivals effectively send strategic messages to each other by independently running promotions and adjusting prices. If one firm acts as price leader, and the others as price followers, the profit margins of the whole group tend to be higher than if the rivals engage in price competition. Market share tends to remain stable either way in such industries.

The playing field is dominated when one firm has significantly more market share and high return on capital. The strategy of the dominant firm, called preemption, is to use pricing power to prevent new firms or rivals from capturing any new market share. The strategy of new entrants or expanding rivals, called market penetration, is costly and likely to fail. Market penetration efforts may succeed due to a combination of strategy, social change, and technological innovation.

References

[1] Competition Demystified, Bruce Greenwald and Judd Kahn, Portfolio (Penguin Group), 2005.