Why we do Economic Modeling

Economic models are simplified descriptions of reality. Models can be used to yield insights into economic behaviour. These insights, in turn, can be used to develop hypotheses about future behaviours that can be tested. So, the power of models lie in their ability to generate insights and develop predictions about what may happen in the future.

Simple models – toy models, as I call them – can yield surprisingly powerful insights about economic behaviour. For example, even the simple line model developed by Harold Hotelling can yield surprisingly useful insights about firm behaviour under product differentiation.

How do we build models? Hal Varian, Google’s chief economist has written extensively on this (Paul Krugman is another), and we tend to follow the principles espoused by those two eminent thinkers. As Varian says, the first step is to identify the various pieces of the model. For example, in most models there are economic agents who interact in some way. These economic agents could be firms, consumers, etc. These agents have to make choice decisions in order to achieve their desired objectives. The choices of the economic agents are usually bounded or constrained within the model – for example, buyers may face budget constraints, firms may face capacity constraints, etc. The presence of constraints suggests that there must be something in a model that adjusts to ensure that the choices made by economic agents are mutually consistent.

When modeling, we always strive for simplicity or, more properly, to simplify complexity. It is a complex world out there, and a model should always strive to reduce complexity to something that is tractable. For example, simple one or two-period models, with two agents, two goods, and linear utility can often yield surprisingly powerful insights into consumer behaviour. Relaxing the assumptions on which the model may be built – for example, homogenous goods, constant prices, etc. – allows the modeler to more closely approximate reality, yielding further insights.

Economic models are powerful tools with which to try and make sense of complex market interactions and behaviours. Besides yielding useful insights, they often yield results that can challenge well-held assumptions and beliefs. As such, economic models are an integral part of our strategy and marketing practice at ALCG.

Building a Market Strategy: Some Key Questions

In many markets, consumers rarely view competing products as identical. Even if the features, characteristics and attributes of competing products are the same, branding may create perceived differentiation in the consumer’s mind. These thoughts suggest some key questions that firms should consider when thinking about product differentiation.

First there is the question of how consumers perceive products and services. This is another way of saying that it is really consumer preferences that determine differentiation. Heterogeneity among consumers, in terms of preferences, gives rise to differentiation – firms may choose to design products and services which serve particular bundles of consumer preferences. This implies that, in order to achieve differentiation which is valuable to customers, firms must study and understand consumer preferences.

Secondly, it is important to know the extent to which different consumers share the same preferences. Choosing to serve consumer preferences which are not widely shared may lock a firm into serving a small and static market niche. Thus, firms need to also study and understand the distribution of consumer preferences over the population of consumers who may buy the product or service being offered.

Thirdly, firms should try to understand the demand curves of the various consumers who may buy a product or service. Here, the issues of discrete choice (brand preference) and unit demand need to be considered. For example, in the car market, it is a reasonable assumption that consumers will buy a single car, but this population of consumers will have heterogeneous tastes and preferences. In other markets, however, these assumptions may not hold. For example, with beer or carbonated drinks, discrete choice is often a reasonable assumption to make, but consumers will differ in their individual demand curves.

Finally, firms should consider the extent to which consumers care for product variety. In some markets, consumers enjoy and welcome variety. For example, in the wine market, a large number of consumers actually enjoy product variety and they will buy variable quantities of product. In these cases, neither discrete choice nor unit demand are good assumptions to make.

Why are these questions important? Simply that the answers to these questions drive the assumptions that an analyst might make when attempting to model consumer behaviour and product differentiation. Overlooking these questions, or failing to address them, can result in models that are not good representations of reality. This, in turn, can result in misguided market and product strategies.

Further Thoughts on Differentiation

The objective of differentiation is to create a position in the marketplace which is unique. Rather than engaging in price competition, a firm pursuing a differentiation strategy aims to create a defensible competitive position based on non-price factors. In industries where there are many sellers and relatively homogenous products, differentiation is critical to avoiding price competition.

Before talking about differentiation, it is, of course, possible to compete through a cost advantage strategy. Achieving the lowest cost structure in an industry allows a firm to extract a higher margin or price lower than rivals. However, it is not easy to achieve an industry-leading cost structure, and such competitive positions can rarely be maintained as the sources of lower costs can often be copied by rivals. Lower input costs (i.e., raw material costs) are always preferable but are rarely the source of an enduring cost advantage. Unless the supply of these inputs is protected under some sort of exclusive arrangement, these lower input costs may be replicated by rivals. In addition, cost advantages are rarely created by lower input costs alone; rather, they are often created by exploiting economies of scale, economies of learning, standardized product design, or the ability to rapidly flex capacity in response to changes in market demand.

Secondly, differentiation is about creating meaningful differences, not better sameness. The degree to which a firm can successfully differentiate itself allows that firm to gain some market power and achieve a markup over cost. Where differentiation is weak, price competition will prevail and markups over marginal cost will be small. Where differentiation is strong, price premiums can be charged and markups over marginal cost will be correspondingly larger. A key point to note is that successful differentiation allows an optimal pricing strategy, which is a proportional markup over marginal cost that is independent of other firms’ pricing strategies. Thus, with good differentiation, prices can be maintained no matter what pricing strategy rivals adopt.

However, differentiation doesn’t just allow a firm to charge a higher markup and achieve a higher margin. Equally important, differentiation desensitizes the customer to competitive offerings. When a customer perceives that the value being offered is in some way distinct and superior, that customer becomes less willing to substitute a competitive offering, even if that offering has a lower price. Thus, differentiation can make a firm’s demand curve less elastic.

A final point to make: differentiation can be achieved without altering the product itself. While making physical changes to a product can be a source of differentiation, the same effect can sometimes be achieved by creating, in the customer’s mind, a different perception of the value being offered. This is especially important for “commodity” type products where it may not be possible to make physical changes to the offering. Thus, how the product is described and marketed to the customer may, in itself, be a source of differentiation.

Other sources of differentiation beyond the physical product can be brand (or image), service (sometimes bundled with the product), and personnel. It is interesting to note that quality is often misused as a differentiating factor. For many customers, what is important is quality parity among suppliers, where a certain level of quality is expected. However, these same customers may not necessarily be willing to pay for additional levels of quality.

It may even be that, in some cases, differentiation doesn’t even have to meaningful to succeed.  For example, Alberto Culver makes a shampoo called Natural Silk to which it does add silk, despite admitting in an interview that silk does nothing for hair. But offering and promoting this product attribute attracts attention, creates a distinction, and implies a better working formula which, in turn, attracts customers.

Achieve a Strategic Balance When Differentiating

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 and also cause the firm to experience difficulty in acquiring needed resources such as labour and capital. 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.

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 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 value of a cell phone network increases significantly: the more people who are connected, the more valuable the cell phone because more people can be contacted.

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 a 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.

Coherent and Incoherent Strategies

Good 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.

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.

Performance Improvement Projects: Four Key Questions for Success

How well does your firm carry out its performance improvement projects and initiatives? Is success the exception rather than the rule? To avoid getting bogged down with your performance improvement projects,  here is a checklist of key questions to ask when selecting and executing projects.

Question #1: Are we doing the right things? All activities and projects aimed at improving a firm’s performance should be done within the context of the organization’s overall competitive strategy. There is no point in spending time, effort and expense to improve those things that should not be done. Similarly, not all improvement opportunities have the same priority: given a firm’s overall strategy, it is likely that some improvement opportunities should take precedence over some others. Strategy is what gives performance improvement direction and focus.

Question #2: Are we doing things the right way? This question is often misunderstood. It does not refer to how well a firm’s performance improvement projects are being executed. Rather, it refers to a firm’s design and structure – the architecture that allows improvements to succeed. It is a firm`s overall architecture that provides the fabric which allows it to integrate its business processes across functions. When an organization`s architecture is either lacking or not understood at the top leadership level, it is likely that performance improvement projects that cut across business functions will flounder and not succeed.

Question #3: Are we getting things done well? This is the execution question. However, it transcends execution to ask first if the commitment and discipline needed to ensure success has been assured from top leadership. Commitment and discipline from top leadership ensures that the necessary resources are in place, that deliverables and actions to be taken are clearly understood and communicated, and that the authorities and responsibilities needed to ensure productive working relationships from all affected personnel have been established and delegated.

Many performance improvement projects fail, not because they were poorly executed at the tactical level, but because the project became dysfunctional. Dysfunction usually arises when the working relationships between personnel involved in a project have become polluted. This can only be avoided by securing top-level commitment and the outset and ensuring that everyone involved is clear about the rationale for the project, the delegated responsibilities and authorities, the actions to be taken, the methodology to be followed, and the metrics and process for monitoring and review in place as the project unfolds.

Question #4: Are we getting the right results? At every stage of the project life cycle, a project team must review and evaluate if the desired results, outcomes and benefits are being achieved. a surprising number of performance improvement projects are undertaken where there is a lack of clarity about desired outcomes and results. Since virtually every performance improvement project contemplated or undertaken by a firm involves a commitment of resources and time, the outcomes and results achieved must be regularly monitored and reviewed by top management.

Many improvement projects flounder because outcomes, results and measurables have not been defined at the outset, and/or because the management review timeframe for the project is too long. In the first case, it will be impossible for management to review the progress of any improvement project if desired outcomes and their metrics have not been defined; in the second case, if progress reviews are held after too much time has elapsed, it will be too late to implement corrective actions designed to get the project back on track. Having outcomes and measurable defined alone is not enough – progress reviews must be frequent enough to ensure that corrective actions can be taken in a timely manner to prevent project failure.

Pathways to Efficiency

A firm may have lower average costs than rivals because it has been able to realize production process efficiencies that these rivals have not yet attained. Thus, a firm may use less inputs than its competitors to produce a given level of output, or a firm’s production technology may use lower-priced inputs than those used by its competitors.

Realizing production process efficiencies is often a product of learning – this type of change is epitomized by the so-called learning curve, where a firm’s efficiency is a function of cumulative output and learning. Improving production processes through learning by doing is a powerful pathway to greater efficiency and lower average costs.

However, moving down a learning curve through learning by doing is not the only pathway to greater efficiency and lower costs. Other pathways involve adjusting a firm’s market scope, discretionary cost control, and superior coordination and execution of customer transactions.

A firm may lower its average costs by scoping or focusing its activities on selected segments in the market. By targeting only one or a few market segments, a firm can achieve lower costs by purposefully choosing to eliminate certain activities which add little or no value to the targeted customers. Thus, the wisely scoped firm is able to configure its value chain in such a way that it operates at a lower cost than that of rivals who choose to serve the broader market.

Discretionary cost control is another way for a firm to lower its average costs. A firm may choose to avoid incurring some costs that rivals are bearing by avoiding the activities that result in these costs. Thus, a firm may incur lower marketing costs than rivals by emphasizing online marketing and social media strategy rather than national advertising in more expensive media such as print and TV.

Interactions and transactions with customers and suppliers also drive a firm’s costs by consuming resources unnecessarily. Information asymmetries are often at the root of high transaction costs in customer and supplier-facing processes. Addressing the root cause of these asymmetries can often reduce transaction costs considerably. A firm that conducts a supplier exchange via the market may also have higher transaction costs than a firm in which the same exchange is vertically integrated. In this case, vertically integrating the supply function within the firm’s boundaries will result in lower costs.

Job Creation Myths

Another provincial election underway here in Ontario now and the promises of jobs, jobs, and more jobs re already spilling out of the politician’s mouths. Provincial Conservative party leader Tim Hudak is promoting his “Million Jobs Plan”, Liberal party leader Kathleen Wynne is promising a continuation of subsidies and grants to specific industries and firms to create jobs, and NDP leader Andrea Horwath has still to formulate her policy.

While we can argue about the merits of each party’s program, one thing is clear: politicians clearly believe that anything that creates jobs is good, and each leader believes his or her program will create jobs while their opponent’s will cost jobs.

The idea that anything that creates jobs must be good is so ingrained in our consciousness that many people have ceased to think rationally about the subject. Enhancing labour demand by creating jobs doesn’t necessarily mean that either economic growth or welfare is enhanced. There are only so many workers to go around and when one sector or industry gains jobs, others may lose. There is an adding-up constraint for labour in the economy as a whole.

In an economy with a slack labour market, it makes sense for politicians to put forward job creation initiatives. When the economy is healthy, these policies may exacerbate labour shortages by encouraging workers to move from one sector to another – moves that take time and which can cause labour shortages in the sectors from which workers have moved. This means that, in the long run, all that may happen is that workers will move from one sector another, but that overall there will be no net gain in the total number of employed workers.

Jobs are a cost, not a benefit. The next time you hear a politician talk about job creation, think about what they have in mind. Will they be putting people to work doing things that are beneficial to society as a whole, or are they rationalizing job creation through inefficient and costly initiatives that will yield little net benefit to our welfare?

Unbundling

It will be interesting to see how successful the Conservative government’s planned strategy to allow consumers to pick-and-choose their channel packages from satellite and cable TV providers will be. I say this because bundling channel packages and other services together is a key element of the strategy and business models that the telecommunications firms use to capture more consumer surplus and maximize their profits. By allowing consumers to “unbundle”, these business models may be undone.

Bundling works best when the demands for different products are negatively correlated. When the demand for different goods is negatively correlated, bundling is more profitable as it reduces the spread in the valuations that different customers place on different goods. Telcos pursue strategies of both pure and mixed bundling in their TV channel packages. Pure bundling means that consumers cannot buy individual services (i.e., channels) separately, the very thing that the government is proposing to allow. Mixed bundling allows consumers to buy either a bundle or individual channels; for example, while I subscribe to a Rogers bundle, I am still able to purchase, on demand, certain channels that are omitted from my bundle. In both cases, the government’s proposed initiative may dilute or undermine these business models.

Bundling is a form of price discrimination that allows a firm to capture more consumer surplus than it would otherwise, thereby increasing revenues and profits. How the telcos will react to the government’s plans will be interesting, particularly given the contentiousness that erupted over Verizon’s aborted entry into the Canadian telecommunications market.