Business Journal 4

Spring 2018

Lecture 7

ECO 526: Business Strategy

Plan

• De Beers Case Discussion

• Differentiation and Strategic Positioning: Conceptual issues

Differentiation and Strategic Positioning

 Differentiation allows firms to maintain prices above marginal costs, even with high/intense competition

• Differentiation and positioning keys

• Exploit opportunities (find “gaps”)

• Identify meaningful segments

• Mitigate strength of industry forces

• Consider costs (entrenchment, commitments, complexity, cannibalization)

• Establish a defensible/durable position

• Differentiation mechanisms

• Horizontal (variety)

• Vertical (quality)

V = v - |xB – xA| * t

V: Willingness to pay for the actual product offering

v: Willingness to pay for the product with ideal characteristics |xB – xA|: Difference between ideal and actual product characteristics

t: Marginal disutility from consuming a non-ideal product (“transp. cost”)

Horizontal Differentiation

• Products differ by their location in the Product Space

• Preferences are represented by consumer’s location

• Consumer Heterogeneity: Different consumers have different

locations and ‘costs’ for consuming a remote product

v : Willingness to pay for ideal cup of coffee

xB & xA : Ideal and actual locations of the coffee shop

t : Transportation cost / loss from having to travel for coffee

Ex: Geographic Differentiation; Coffee Shops

Suppose that the city is laid out on a single, mile long street

• 100 consumers live in the town and their homes

are uniformly distributed along this street

• Each consumer has v = $5 and t = $1/mile

Also assume that all coffee shops are identical, except for

where they locate in the city, and that the marginal cost of

producing a cup of coffee (c) is $1

Given these conditions, where should the shops locate?

Recall: Consumers will select the product with a higher (V - P)

Coffee Shops…

Equilibrium 1 – “Go where the demand is”

v - |xB – xA|*t for each product…

→ P =

- Hotelling’s Principle

- Profits?

Hotelling Example: Gas Stations in Bay Area

Coffee Shops…

Equilibrium 2 – Strategic Positioning / Differentiation

• Optimal (Monopolistic) Location

• Given location, what prices maximize profits?

• The usual economics tradeoff

• Price

• Quantity demanded

Coffee Shops – Differentiated Equilibrium

• Solving for optimal price yields (see posted Appendix)

P* = t + c =

• Profits?

• Lowering price just below your competitor’s price no longer captures the whole market

• Drawback: Earn less revenue from ‘loyal’ customers

• Benefit: Capture some customers from competitor

• Contrary to non-differentiation, the benefit of cutting prices is lower because of the proximity (loyalty) of some customers to the other product  Softer price competition

• Max differentiation is desirable, but there may be constraints to differentiation (or an allure of going where the demand is)

Coffee Shops: Conclusion

• Spatial model applies to any horizontal-type differentiation

• Distance and location are metaphors for consumers’ preferences and product attributes

• Extensions

• Many firms

• Cost (product and transportation) heterogeneity

• Asymmetric consumer distributions

Basic Model: V = θ*s θ = “Units of quality” in the product s = $/unit consumer is willing to pay for quality

Vertical Differentiation

• Vertical Differentiation — Products differ in actual quality

• Assume consumers have identical preference orderings

• Consumer Heterogeneity — Different individuals have

varying amounts that they are willing to pay for quality

θ = # of stars that the motel receives

s = $ that consumer is willing to pay for each ⋆ worth of quality

Example: Motels (Mazzeo, 2002)

• Possible values for V:

Suppose: Two consumers — Sal has s = 16, Bob has s = 20

Motels’ costs increase in the number of stars —

For simplicity assume C = $10 per ⋆

Stars (θ) Sal (s=16) Bob (s=20)

1 V = 16 V = 20

2 V = 32 V = 40

3 V = 48 V = 60

Motels…

• Given these preferences, how should two competing motels position their products?

• Key: Consumers choose product with higher (V-P)

• Nash Equilibrium 1: No quality differentiation

• E.g., both motels offer ⋆⋆ (V-P) is identical for the two products P = Profit =

Motels…

• Nash Equilibrium 2: Quality differentiation

• E.g., Motel X Offers ⋆⋆⋆, Motel Y Offers ⋆

• Equilibrium prices and profits?

• Motel X Charges P = → Bob stays at Motel X

→ (P-C) =

• Motel Y Charges P = → Sal stays at Motel Y

→ (P-C) =

Motels – Evidence

• Price and Quality (# of stars) data collected for 1,800+ motels located nearby 492 separate rural interstate highway exits

• Motels classified into two categories (low and high) based on the number of stars assigned by AAA

• Econometric model related a motel’s price to (a) number of competitors at the exit, (b) whether the competitors were same quality or different quality than the motel in question, and other control variables

• Main Finding: The presence of a same-quality competitor lowered the observed motel price, but the presence of a different-quality competitor did not

Differentiation and Positioning: Implications

Higher prices can be maintained when

– Identify segments that exploit what is good and avoid what

is bad about the industry (understand industry forces)

– Bring right capabilities to this segment and invest to defend

your position and preempt competition (“consonance”)

– Optimal positioning allows you to earn a price premium

– Transportation costs/consumer preferences are stronger

– Product is closer to the ideal of many consumers

– Differentiation between competing products is greater

Differentiation and Positioning: Segmentation

Examples :

Segments of an industry are groups of buyers with a

strong and specific set of preferences

– Buyer segments: Consider subsets of consumers with

alternative/underserved preferences

– Channel segments: Distribution to distinct customers

– Product segments: Focus on actual differences in attributes

– Geographic segments: Based on physical location

Golden Rule of Differentiation: Segments with more consumers and fewer firms will be the most profitable

Differentiation and Positioning - Examples

– Product segments: Actual differences in attributes

Whole Foods

Retail supermarket that focuses on high quality, natural, and

organic foods and products. Prices are correspondingly higher,

but customers interested in these offerings are willing to pay…

Differentiation and Positioning - Examples…

The New York Mets

Targeting the Hispanic market for baseball fans in

New York City by emphasizing the signing of prominent

Latino players – particularly important, given….

– Buyer segments: Consider subsets of consumers

Differentiation and Positioning – Examples…

Kmart’s retail stores in Bridgehampton, NY, and

Exmore, VA

None or little direct competition in the area –

Despite Kmart’s hard times, these particular stores

continued to perform well…

– Geographic segments:

Differentiation and Positioning – Examples…

– Channel segments: Distribution to distinct customers

Mail distribution channel softened direct

competition, and attracted a higher

income, growing customer base; but…

as technology changed…

Next Session

 Enterprise-Rent-A-Car discussion

 Dynamics, Growth, and Sustainability – Conceptual issues

 Check D2L/syllabus for readings