Strategic Balance

A recent brand positioning facilitation at a client by ALCG colleague Angelo Lyall on points of parity and differentiation reminded me of a key strategy concept: strategic balance (Deephouse, 1999).  This concept is particularly important for firms wishing to pursue a differentiation, or value (benefit) advantage, strategy.

 In his facilitation, Angelo pointed out that while differentiation in positioning a brand is good and usually beneficial, it is also important not to overlook points of parity where you can least match competitive offerings. This is important because failure to identify and communicate points of parity can lead consumers to prefer or choose a rival brand over yours.

 This thinking can be extended from brand positioning to the more general arena of competitive strategy, particularly where a differentiation strategy is being pursued. Firms pursuing a differentiation strategy are staking out a high-quality position in the value/cost space. Doing this successfully requires balancing two opposing forces.

 The first force arises out of the need for a firm to be different from rivals. This, after all, is the essence of differentiation. Firms which successfully differentiate themselves from rivals enjoy reduced rivalry, softer price competition, reduced threat from competitive entry, and increased performance.

 Opposing this first force is the need for a firm to retain some similarity to rivals. If a firm creates extreme differentiation, with little or no similarity to rivals, there is the risk that it can be perceived as a misfit firm within its industry. This perception can erode consumer confidence in the firm’s offerings, causing consumers to prefer rival brands. It may also cause the firm to experience difficulty in acquiring needed resources such as labour and capital, as well as hindering the formation of strategic alliances and partnerships. In short, extreme differentiation in which there are few points of parity with rivals may create the perception of an illegitimate market player.

 In addition, similarities (or points of parity) between rivals provide the context where valuable differences become apparent. Put another way, if nothing is the same, it’s hard for consumers to tell what is really distinctive and different about a firm’s product and service offerings.

 The lesson: avoid extreme differentiation where all points of parity with competitors are sacrificed. Points of parity highlight where a firm at least matches the competition and they accentuate differentiation all the more as distinct differences are highlighted.

 Recommended actions:

  • If your firm is pursuing a differentiation strategy, assess the degree to which parity with rivals is preserved. If your differentiation is extreme, with little or no parity with rivals, you incur the risk of being perceived as a misfit firm.
  • The trick when differentiating is to not merely be different; it is to create meaningful differences that are valuable for customers. Review the degree to which your differentiation is creating more benefit for customers. If you are not creating more benefit for customers than rivals, you need to adjust your differentiation to avoid price competition.

 
Author:
Stewart Anderson
Partner at ALCG
stewart@andersonlyall.com
www.andersonlyall.com

Marketing with Limited Resources and Information

It’s important for companies that are beginning or expanding their marketing efforts, not to wait until they’ve amassed a holistic, all encompassing group of research data and information, before they begin.  This approach is all too tempting, and all too paralyzing for small and medium-sized organizations that may not have sophisticated software and systems to capture customer and market data. 

Certainly, more information availability is better, but usually it isn’t all needed at once.  To get your marketing campaigns up and running faster, identify the steps that need to be taken, and the market or customer information essential to achieving each of those specific steps.  Then, isolate the information needed for just the first step.  By using this approach, your company can begin to move forward and save a lot of time that it might have spent stalled, trying to amass a huge inventory of upfront information. 

Recommended Actions
With your team, perform the activity discussed in this short article.
1. List the steps that need to be taken in order to launch your marketing campaign.

2. Attribute essential information that must be gathered for each step, to the step that requires it.

3. Assign resources to gather the information needed for the first step (keep a macro-view, in case later steps require time-based trend information to be gathered).

For information about effective methods for gaining market intelligence with limited resources and time, contact Anderson Lyall Consulting Group (information below). 

Author:

Angelo Lyall
Partner at ALCG

angelo@andersonlyall.com
www.andersonlyall.com

Network Goods and Network Effects

Consumers often place a higher value on a product or service if other consumers use it. When this occurs, the product/service exhibits network effects or network externalities. A network good is a good (product or service) that has a higher value the more customers that use it. One person with a cell phone has limited value; however, if thousands have people have cell phones the more valuable the cell phone network is to each user because more people can be reached. When a network effect is present, the value of a product or service increases as more people use it.

In some networks, consumers are physically linked; examples are cell phone and email networks. In these cases, the network effect arises because consumers can readily communicate with other users in the network. These networks are called actual networks. The more users in an actual network, the greater the opportunities for communication, and the more valuable the network becomes.

Virtual networks, in contrast, are those where consumers are not physically linked. In a virtual network, the network effect arises from the use of complementary goods or services. A computer operating system, such as Microsoft Windows, is an example of a virtual network. As the number of users of Microsoft’s Windows operating system increases, the demand for complementary goods, such as Windows-compatible software, increases. The increased supply and availability of Windows-compatible software, in turn, increases the value of the network. In a virtual network, users need never communicate with each other; as long as the collective buying power of the network encourages the supply of complementary products, each individual consumer benefits from being part of the network.

First movers benefit greatly from network effects. The firm that first establishes a large installed base of customers has a decided advantage in the market. Marginal customers, those consumers not already on the network, will observe the size of the network and tend to gravitate towards it. Thus, strategically, exploiting network effects offers a prime opportunity for first movers to develop a relative advantage in the marketplace, provided the first mover can develop a large installed base.

The converse of this is also true: that network effects can be a powerful barrier to entry for rival firms wishing to challenge the network incumbent. Ownership of a network good can be incredibly valuable because entry against an established incumbent is difficult. When a network effect is present, a large market share creates an advantage much like an economy of scale – entrants have a difficult time overcoming the value created by the large number of users in the network.

Networks, by their very nature, tend to create switching costs which serve to lock-in customers. Switching costs are the costs consumers experience by changing brands. If, for example, consumers have opted to run Microsoft Windows and use Windows-compatible software, there will be significant costs, in terms of time and money, to switch to a competitive operating system and compatible software.

Firms can intensify customer lock-in by basing a network good on proprietary formats or standards which are incompatible with rival products and services, thereby increasing switching costs. Customer lock-in can also be increased by upgrading, at relatively modest cost, inframarginal customers (those customers already on the network) to enhanced capabilities or features offered in the network good.

An important strategic question for providers of network goods is the extent to which complementarities can be exploited. Complementarities, or synergies, can be exploited in several ways.

The first is to ensure that the elements of value which make up the network good in question are coherent – that each of the value elements fits with the others and thus reinforces and multiplies the total effect. Thus, the value elements making up a network good must be wisely chosen and designed so that the level of coherence is high.

The second way to exploit complementarities is through the provision of complementary third-party goods and services. Integrating complementary third-party goods and services into a network good can significantly increase the total value being offered. At the same time, if the supply of these third-party goods and services are secured under and exclusive agreement, a significant barrier to imitation and entry can be erected.

The promise of profits from network goods often leads to intense competitive rivalry which can become a war of attrition. Where competing network goods are vying for customers, such as happened in the VHS versus Beta video wars, potential customers often look to market share as the key indicator of who is likely to win. Because the firm with the larger market share is perceived as the one more likely to win the competitive battle, the firm with the larger share possesses a relative advantage in the marketplace. In this case, a large market share may be a self-fulfilling prophecy of success.

Recommendations for Action
Does your firm produce and supply a network good? If so, assess the degree to which your firm is fully aware of, and exploiting, the network effects associated with your product. In particular, review the following:

• The growth rate of your network. Is your network growing in size due to new customer acquisition, or is it shrinking due to customer attrition? Networks that scale up too slowly can fail to achieve the critical mass necessary to exploit network effects. Remember that, over time, positive network effects can create a bandwagon effect (positive feedback loop) as the network becomes more valuable and more people join.

• Customer lock-in. Is there opportunity to intensify customer lock-in, perhaps through bundling of products and services or offering product/service upgrades?

• Complementarities. Are you fully exploiting synergies that can multiply the network effect? Complementarities can be exploited through value coherence and integration with third-party products and services.

• Beware of negative network effects. If too many people use a good or service, negative network effects, such as congestion, can occur. Negative network effects lower the efficiency of the network and are a turn-off for customers.

Author:
Stewart Anderson
Partner at ALCG
stewart@andersonlyall.com
http://www.andersonlyall.com

Using Social Media and Websites to Communicate your Brand – Tough Mudder LLC Case Study

When it comes to marketing your brand, social media and other interactive media can represent an effective means of reaching and engaging with target consumers.  On the internet, brand is not only communicated in content that flows form firms to consumers, but also from consumers to one another.  Since this conversation is much less linear, and less controlled by the firm, the objective is to manage digital conversations.  The goals of interactive media content management are to guide conversations towards topics that will offer your firm valuable feedback, and to create engagement with consumers.  Visit the links provided in this case study, as you read each paragraph.

Tough Mudder LLC is a good example of an interactive approach to marketing a brand.  If you don’t already know about them, Tough Mudder  offers obstacle courses for adults, that test their mental and physical toughness.  

Tough Mudder uses positive imagery and content in a variety of interactive platforms, to build awareness, and promote their events as being positive growth experiences for individuals and groups (both personal and business).

YouTube – Geographically-Segmented Awareness
https://www.youtube.com/channel/UCg79vIcf0XmsoFm2IJz6aMg

Tough Mudder is targeted primarily to active, young and middle-aged adults.  Acknowledging this, and that their events are geographically constrained, Tough Mudder displays promotional videos for major locations where their events are held.  By showing participants going through the viewers’  local course, and by branding the content as empowering, Tough Mudder appeals to target segments clearly and directly.  Additionally, participants can add upload their own experiences to youtube via their own accounts.  This has spawned a movement of training and tips videos, to help future participants prepare for the course.  The flooding of videos form both Tough Mudder directly, and via participants and active people, has created a massive volume of video and text content.


Twitter – Association, Retention & Consistency
https://twitter.com/ToughMudder
Tough Mudder posts motivational content, and photos of people wearing merchandise or being active.  The strategy is to communicate with people who are already aware of the brand, and to support those people in their active lifestyles.  This can lead to long-term benefits of customer loyalty, including repeat business and referral.

Facebook:

Mixing the Strategies of Youtube and Twitter
https://www.facebook.com/toughmudder
Tough Mudder’s Facebook accounts allow people to become aware of the brand as a whole by joining the corporate page, or joining pages that pertain to specific geographies.  On these pages, viewers can find photos, links to videos, and an interactive atmosphere where experiences and ideas are shared.  This helps to promote the community, and the idea that participation is not just about going to an event, but that participating in Tough Mudder events symbolizes a lifestyle choice, and a personal affiliation with fitness as well as the brand.

Website – Building “Mudder Nation” through Awareness and Interest allowing Evaluation, and Encouraging Adoption
https://toughmudder.com/?gclid=CI7bxMDr274CFaNhMgodbHAAUA
Tough Mudder’s website serves many functions (as most websites do).  One place that’s worth noting is the page titled “Mudder Nation”.  By navigating to this part of the website, the user accesses information about overcoming obstacles and views stories and questions from past participants.  This offers a glimpse of the community that participation grants them access to, and serves to address concerns and alleviate any fears or perceptions of risk or insecurity, helping the user feel more inclined to participate.  The sign up option is available and prevalent on this page.

Third Party Content
http://www.reformer.com/sports/ci_25879369/another-year-another-tough-mudder

The idea of “Mudder Nation” has inspired strong beliefs in the events and the positive growth associated with them.  As a consequence, many third party articles have popped up form various sources, such as the one linked above.  

All of this activity surrounding this brand, creates a very strong, meaningful and unique message, that reaches, attracts, and keeps customers involved well past the conclusion of their first events.  In the absence of this approach, Tough Mudder would be events that some people participated in and quickly forgot about.  But since Tough Mudder has used interactive new media to create a more strong and meaningful message, they have succeeded in “keeping the conversation going” between events, and into the futures of their participants, giving them a sense of achievement and purpose that they will come back for again and again.  Not to mention, this firm’s brand communication is almost exclusively done vie new media, with no tv commercial placements.


Recommended Actions:
1. Select a large firm with which you are familiar (e.g. Nike, Adidas, Starbucks).  Visit their corporate and social media websites.
- What brand image and associations do they create?
- What objectives are they accomplishing with each of these sites?
- How do the sites work together to move the audience through the phases of awareness, interest, evaluation,
preference, and adoption?
- How do they support their existing customer base with their online presence?

2. Visit your own website and social media sites.
- What is your firm doing right in its interactive media communications?
- What could it improve?


Author:
Angelo Lyall
Partner at ALCG
angelo@andersonlyall.com
www.andersonlyall.com

Coherent Strategies

Coherent Strategies Anderson Lyall Consulting Group

Effective business strategies are coherent strategies. A coherent strategy is one where the elements of the strategy fit together and reinforce each other. A coherent strategy produces more value, with each element of the strategy producing more because of the presence of the other elements.

Incoherent strategies, on the other hand, produce less value and are less effective. Strategic incoherence results when a firm brings together disparate elements that contradict each other and which fail to reinforce each other as a result. For example, a firm that chooses a strategy which offers an upmarket high quality product at down-market lower prices will generally fail: higher quality usually entails higher expenditures, which in turn requires higher prices. Such a strategy is a recipe for poor performance.

Research in Motion (RIM), the makers of the Blackberry digital communication devices, is an example of a firm that suffered from an incoherent strategy. RIM’s strength was the security and reliability of its operating network for business users. RIM’s foray into developing products that directly competed with mass-market offerings from Apple and Microsoft did not fit well with its core strength and created strategic incoherence.  Only recently has the company managed to reinvent itself by redefining its business and creating a more coherent business strategy.

Reinforcement in a strategy often comes about when complementarities are identified and exploited. For example, Toyota’s manufacturing strategy (the Toyota Production System) exploits complementarities that exist between smaller batch sizes, lower inventories, lower setup times, worker training, etc. These complementarities reinforce each other and work together as a system to create greater value, superior productivity, and lower costs.

Toyota is an example of a firm that has created a relative advantage over rivals by exploiting complementarities. Because this relative advantage derives its power from multiple sources which fit together as a coherent system, it is very hard for rivals to imitate Toyota’s relative advantage in the marketplace.

Good strategic coherence begins with product definition. By defining its offering precisely, a firm can identify synergies and complementarities that exist between products and services, and these can be exploited through a coherent strategy. Such an approach also allows a firm to identify how best to structure its organization, which areas of the business will generate the highest returns, and which areas should be de-emphasized, sold off, or closed down.

Recommended Actions

  • Evaluate the coherence and fit of the elements making up your firm’s business strategy. Do the elements of the strategy fit and reinforce each other, or are they disparate with little fit and reinforcement? If the latter, consider revising or updating the strategy to obtain better fit and coherence among the elements which make it up.
  • Are there opportunities for your firm to exploit complementarities which can create a relative advantage over rivals? Consider where the sources of your relative advantage might lie and whether these can be extended and deepened. Instead of trying to be the absolute best in your industry, consider how your firm might be able to create a relative advantage that is valuable to customers because it addresses a particular problem customer need or challenge that is either unmet or underserved

Author:
Stewart Anderson
Partner at ALCG
stewart@andersonlyall.com
www.andersonlyall.com

Revenue-Generating Communication

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In order for your firm’s communication tools to be effective in generating revenue, they must be intentionally designed around objectives that align with the stages of buyer readiness.  Here is a guide to help you make strategic decisions about your firm’s communication efforts.

Stage 1:  Awareness
Awareness must be generated about the brand and products before we can expect consumers to consider us as a buying option.  To succeed in the objective of creating awareness, we should communicate an effective snapshot of the product and its benefits, rather than introduce large volumes of heavy, comparative or statistical content.

Lesson: Focus on generating basic awareness about your offering and its benefits.  From there, you will be able to guide your audience to more in-depth forms of communication. 

Stages 2 and 3: Understanding & Favourable Judgment
This is achieved by using promotions whose objectives are to generate interest and evaluation.  These can be gained by introducing more rich and informative content than the previous stage, and by making intelligent use of frames of reference.  This can be done through website, collateral materials, and a variety of other ways.  In these stages, we also influence the associations that we want our audience to make with our brand. For example, Nike uses prominent athletes to communicate their brand and create an association with those figures and their performance. Another example is Tough Mudder LLC., who generates an association between the completion of their events and a commitment to ongoing active, healthy lifestyle, which they support with their “Mudder Nation” community of past event participants, to encourage them in their active lives moving forward.

Lesson: After your audience has become aware of your basic offering and benefits, your promotions should focus on guiding the consumer to learn more, view favourable comparative information, and make positive associations that resonate with their own beliefs, lifestyles, etc.

Stage 4: Procurement
To encourage the adoption of products, communication tools include personal selling, and sales promotions.  These efforts represent significant costs, due to their personalized nature.  The key is to engage with consumers who are already aware of your brand and products or services, and have some understanding and favourable opinions about your offering.  By doing this, we can target these high-cost communication activities at individuals with the highest probability of buying and thus generating a return on our investment.  Without having first successfully generated awareness, understanding and favourable judgment of your offering, sales activities have limited effectiveness and run higher costs.

Lesson: After the objectives of awareness, understanding, and favourable judgment have been accomplished, sales-based communications that represent higher cost to your firm can now be utilized in a targeted and qualified manner.  This gives us the highest change of generataing a positive return on investment for our higher-cost communication activities.

Stage 5: Loyalty/Ongoing Procurement
Communications that encourage brand loyalty are important because loyal customers can represent a very high return on investment over their lifetime.  To communicate with existing customers, interactive media and internal policies can offer effective solutions.  Interactive media, such as facebook, twitter, newsletters, blogs, etc. are an effective way of continuing the conversation with consumers after they’ve purchased form your business.  In addition, policies that govern when and how your firm contacts customers, can have a positive impact on encouraging repeat purchases.

Lesson:  Using interactive media as well as sound internal policies for communicating with existing customers will help turn buyers into loyal, repeat buyers.  Loyal customers can represent a very high return on investment over the long term, and add to the sustainability of a business.

 

Internet-based media (new media), is an effective way for businesses to achieve the objectives of each stage at a relatively low cost.  New Media has initial creation and setup fees, but is relatively inexpensive after that.  It is important not to discount new media as applying only to Stage 5 of buyer readiness.

Recommended Actions:
1) List your current communication tools.  Evaluate each of their objectives and how they align with the stages of buyer readiness.
2) How well are your current communications balanced among the stages?  What could be done to improve this?
3) How do your current communications work together, to move potential buyers through the stages from awareness through to procurement and loyalty?  What could be done to improve this?


Author:
Angelo Lyall
Partner at ALCG
angelo@andersonlyall.com
www.andersonlyall.com

Lessons From the Mop Wars

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After 5 years of faithful service, the Swiffer® WetJet® mop I had been using finally gave out recently and had to be replaced! Shopping for a replacement mop was revealing and served to illustrate how a differentiation advantage can be eroded or modified.

When Proctor and Gamble introduced their Swiffer WetJet mop in 2001, they created an alternative to the traditional floor mop. They also locked users by creating a switching cost by requiring users to employ the WetJet brand of cleaning fluids and replacement pads with the mop. Backed up by the marketing might of Proctor and Gamble, an aggressive marketing campaign around the WetJet was mounted and the product gained market share rapidly.

Then the inevitable happened – the Swiffer WetJet success spawned imitators. The imitators undercut the WetJet in price and managed to erode its share. The main threat to the Swiffer WetJet came, however, not from imitators, but from new product substitutes which severely undercut the WetJet’s differentiated value proposition and switching costs.

Enter alternatives to the Swiffer WetJet, such as the Vileda, which lowered users’ costs by allowing them to use cleaning solutions of their own choice with their mop, together with washable pads. This innovation effectively eliminated the switching costs for the WetJet erected by Proctor & Gamble. Needless to say, my Swiffer WetJet has now been replaced by a Vileda mop on which we can use any cleaning solution and avoid the cost of having to buy replacement pads.

Vileda (and similar offerings) have eroded the market position of the Swiffer WetJet by lowering consumers’ costs. For many consumers, these competitive offerings present a new and more powerful value proposition than that offered by the Swiffer WetJet.

The lesson:  through the Swiffer WetJet, Proctor & Gamble created a differentiated offering with a unique value proposition. However, that value proposition was eventually undercut and eroded by an even more powerful expression of value. No differentiated value last forever, especially when success and higher profitability attracts new entrants and imitators. For most firms, deterring imitation and entry can only go so far. The trick is not just to differentiate, but to keep on differentiating. Happy cleaning!

Recommended Actions

  • Creating differentiation is not a “Me too” strategy. Real differentiation consists of differences that are valuable to customers. If the customer is not willing to pay extra for the difference you are offering, then you haven’t created real differentiation.
  • All differentiation can be eroded to some extent. When creating differentiated products and services, consider how your firm will protect its differentiated position from erosion by new market entrants or imitation by rivals. Patents and trademarks, moving down the learning curve rapidly, and using other entry-deterring techniques such as limit pricing or capacity expansion can all help to maintain a differentiated position once created. However, because no differentiated position lasts forever, you will need to think about how you continuously innovate and improve your product and service offerings to stay ahead of the competition and maintain your position in the marketplace.


Author:

Stewart Anderson
Partner at ALCG
stewart@andersonlyall.com
www.andersonlyall.com

Customers Only buy what they Understand

All businesses must offer some form of relative advantage, compared to competitive products and services in their marketplace.  Often, businesses with impressive advantages can still find themselves struggling with sales.  This article will take a brief look at how perceived complexity can prevent good innovations from selling.  People don’t buy what they don’t understand.

Have you ever thought, or heard somebody say, that their product or service offering is their industry’s “best kept secret”?  Obviously, this statement comes from a belief that the offering contains a strong relative advantage, but that a significant portion of the marketplace does not understand the offering’s value.

The key idea is that we, as marketers of our own offerings, understand our value proposition intuitively.  Sometimes we must take a step back and remember that consumers usually don’t share the same intimate experience with your products and services, and therefore may not share the confidence that you feel about your value proposition.

For this reason, when marketing products that consumers don’t easily understand, we need to focus on promotions that educate.  For products that are perceived as complex, it isn’t enough for consumers to understand that your offering is superior to competitors, they must also understand how it works.

Let me restate; to ensure that the marketplace understands how your product or service works, promotions should focus on educating.  It isn’t enough to list features or offer case studies.  Create simple, yet descriptive content, which clarifies the way your product works, and then connect that to how that uniqueness benefits the customer.  Diagrams, simple statistics, and non-technical descriptive content will help clear the haze that consumers feel about your product, which may be preventing them from buying.

Recommended Actions
1. Assess your current web and collateral content.
2. Evaluate whether your current promotional content leaves readers who are inexperienced with your products, with enough understanding and confidence about the product, how it works, and how it will benefit them.
3. Brainstorm ideas about what types of visuals, content, and statistics, would help give your target audience clarity and confidence in your offering, and how it offers superior benefits to them compared to your competitors.

Author:
Angelo Lyall
Partner at ALCG
angelo@andersonlyall.com
www.andersonlyall.com

PRODUCTIVITY AND FIRM PERFORMANCE IN INTEGRATED MARKETS

Globalization is synonymous with market integration. As trade barriers come down, the geographic boundaries between markets are removed, allowing firms to compete against foreign rivals in a larger market. How well firms can compete in that enlarged competitive space is inextricably linked to how well they perform.

Market integration leads to an increase in competition between firms. The effects of increased competition means some firms will gain from trade while others will lose. What separates the winners from the losers is firm performance: the best performing firms will stand to gain from expanded markets and international trade, while weaker, poorer performing firms will lose and may even be forced to exit their industry.

There are two dimensions across which firms may achieve performance differences from rivals. Firms may achieve superior performance through strongly differentiated product and service offerings, allowing them to extract a price premium for their distinctive offerings. This price premium translates into higher revenues which more than offsets the higher costs associated with differentiation. Or, firms may achieve a cost advantage over rivals, where lower production costs facilitate price leadership in the marketplace.

For either approach to be successful and sustainable, the sources of the differentiation or cost advantage must be distinct and difficult for rivals to replicate. With market integration and the resulting increase in the number of competitive firms within an industry, differences between producers become less pronounced.

Product or service differentiation between firms may be eroded or watered down, while cost advantaged domestic producers may find themselves competing with foreign entities that enjoy even lower costs of production due to lower labour rates. The market structure may begin to approximate monopolistic competition, with a large number of firms offering minimally differentiated products and services, and with no single firm able to exercise significant market power as a result. In such a market structure, productivity and firm cost structure are necessary, but not sufficient, factors in shaping a firm’s competitiveness.

The diagram below shows the effects of differing cost structures on the performance of two firms. As the panel on the left shows, Firm 1 has higher productivity, and therefore lower marginal cost, than Firm 2 (C1 < C2). Both firms face the same demand curve and marginal revenue curve. They choose the output quantities (Q1 for Firm 1, Q2 for Firm 2) where marginal revenue equals marginal cost in order to maximize their profits.

Integration 1

Both firms set prices (P1 for Firm 1, P2 for Firm 2) that correspond to their respective output levels on the demand curve. Firm 1 sets a lower price than Firm 2 and produces a higher output. Firm 1 also makes a higher markup over marginal cost than Firm 2, translating into a higher profit. Marginal cost differences between firms represent a performance difference. Marginal cost differences can be a function of differences in productivity. Compared to a firm with lower productivity and therefore a higher marginal cost, a firm with a lower marginal cost will:

  1. Set a lower price, but at a higher markup over marginal cost;
  2. Produce more output;
  3. Earn higher profits.

Firms with lower productivity and higher marginal costs are likely to have trouble competing in integrated markets. These firms will tend to set higher prices, produce less output, and generally be less competitive. Improving productivity becomes a necessity for these firms if they are to remain competitive in international markets.  

The Effects of Increased Market Size Larger markets can support an increased number of firms. However, larger markets also mean increased competition and greater choices for consumers.

Integration 2

As the number of competitors in a market increases, the market demand curve shifts (see diagram above). Specifically, the demand curve (D1) becomes flatter and more elastic (D2). This flatter demand curve is more advantageous to those firms that have lower cost levels – these firms can accommodate to the increased competition by lowering their price (and hence their markup) to gain additional market share. For the better performing firms with lower marginal costs, this translates into greater share and increased profits.

While free trade and market integration is generally beneficial, increased market size generates winners and losers among firms in an industry. Firms that have higher productivity and are therefore able to compete on lower costs will generally thrive and increase their profits. Higher-cost firms will be less competitive and may be forced to exit the industry.

Integration 3

This is shown in the diagram above: as the demand curve flattens from economic integration, firms with marginal costs between the old threshold level or cutoff (c1) and the new one (c2) are forced to exit the industry. Some firms with the lowest marginal cost levels will gain from integration and their profits will increase. Thus, the lower-cost firms will tend to thrive and increase their profits, while the higher-cost firms may struggle and eventually exit the industry.

These effects have been noted in Canada since the advent of the North American Free Trade Agreement (NAFTA) where, following market integration with U.S. manufacturers, some Canadian manufacturers have been forced to exit their industries.  

Recommended Actions
Since economic integration and globalization is the new reality, the following should be noted by firms and policy makers alike:

  • Firm performance is a key marker of whether an organization is likely to gain or lose from competing in an integrated market. Because firm performance is strongly correlated to cost performance, the increased competition in integrated markets tends to hit the poorest performing firms hardest.
  • Every integrated market has a marginal cost threshold level beyond which a firm cannot expect to operate profitably in that market. This marginal cost threshold level is likely to be different, and usually lower, than that for the domestic market.
  • Firms with higher production costs may have difficulty competing in global markets due to their marginal cost being above the threshold level. The exception is where the firm is offering a differentiated product or service that commands a price premium high enough to offset the higher costs of production. In the absence of a differentiated competitive strategy, firms should strive to lower their costs of production before entering global markets.
  • Firm productivity is a key driver of costs. Improving productivity means making interventions at both the firm level and the policy level. Individual firms must improve their use of physical and human capital, particularly in the areas of innovation and firm technology. At the policy level, governments must create and implement policies that stimulate and influence productivity through their effects on firm and industry-specific variables.
  • Productivity should not be confused with work intensity. Improving productivity means finding more efficient and effective ways to produce goods and services so that more can be produced with the same amount of effort. It is also about producing higher-value-added products and services that are worth more in the marketplace. The onus for improving productivity lies not just with governments, but with individual firms.
  • Low cost production, by itself, will not be sufficient to ensure sustainable competitiveness in global markets. Since integrated markets are likely to be monopolistically competitive, firms must consider how they will innovate differentiated value that will avoid their being locked into price-cost competition with rivals. Doing what rivals do, only cheaper, will only lead to convergence around low costs and prices.
  • Firms should consider the impact of trade costs when deciding to engage in export trade. Trade costs are those costs associated with products and services crossing borders. While some trade costs have been reduced through free trade agreements, they have not been eliminated. Trade costs reduce the profitability of all firms that export. For some firms, these costs of trade may make exporting unprofitable.

Author:
Stewart Anderson
Partner at ALCG
stewart@andersonlyall.com
www.andersonlyall.com