Real Benefit Provision

To command a price premium, a firm must offer unique value that is sufficiently compelling to customers to warrant the additional price of acquisition. In economic terms, from the customer’s perspective, the value being offered must provide a higher utility than other sources of similar value.

Firms sometimes with benefit provision because they fail to design and offer unique value that compels customers to “trade up.” The following are some of the necessary conditions that real benefit offerings must posses:

1. There must be fundamentally distinct and unique differences in the design and technology of the offering. Under this thinking, quality is a given – a hygiene factor, if you will. The product or service simply must be free from defects and perform as intended, first time, every time.

2. The functional performance provided by the offering must be superior to that provided by rival offerings. Customers must realize tangibly superior results from using the offering. Making improvements to a product or service which makes the offering look different do not count.

3. To compel the customer to move up the price ladder, some form of emotional engagement must take place. This can be achieved through brand values and cache, or “pampering” where the customer receives exceptional support and service over the life cycle of the offering.

The degree to which firms can satisfy these requirements for benefit provision will determine the degree to which they can realize the price premium they charge.

An Entry Deterrence Checklist

Deterring competitive entry is a key element of strategic thinking. There are two reasons why firms should consider entry deterrence tactics in their overall strategy:

  1. The firm can earn higher profits as the single entrant (monopolist) in its marketplace, or as a member of a small group (oligopoly) which holds the bulk of the market share.
  2. The firm wishes to change an entrant’s expectations about the nature of competition within the industry, following entry.

The second point is the one which is more relevant and important for the majority of firms competing in imperfect markets. If a potential entrant’s perception of the nature of competition within the industry is not altered by the strategy, then the strategy is useless.

We can identify the following barriers to entry that firms can consider using in their competitive strategies:

  1. Sunk costs. Entry can be deterred if the costs of entry are high, or perceived as being high, by a potential entrant.
  2. Switching costs. Entry will be deterred when the imitation of products and services can be prevented.
  3. Limit pricing. Entrants are unsure about either the level of demand and the costs to service it.
  4. Predatory pricing. Entry is deterred when an incumbent has a history of disciplining the industry through tough pricing practices.
  5. Excess capacity. Entrants may fear excess capacity will be used by an incumbent to drive down prices and margins.
  6. Limited access. If access to distribution channels is limited, entry is more likely to be deterred.
  7. Reputation. Strong relationships and linkages with suppliers and customers can deter entry.
  8. Barriers to production. Exclusive supply arrangements and economies of scale and scope can inhibit entry..

On Pricing

Firms should develop a pricing strategy. Setting prices at the same level as rivals, or discounting to land business, is not a pricing strategy,

Price is the translation of a strategic position. A firm’s strategy will determine its pricing. If a firm is positioned to offer unique value, that value will command a price premium in the marketplace. Conversely, if a firm is positioned to serve its customers with equivalent value as rivals but at a lower total cost, its price will be discounted below that of the competition.

How a firm creates these relative price differentials (price premium or discount) is a key element of strategy. Raising prices without a value proposition that supports a price premium will fail, as will discounting prices without a lower total cost structure to support the lower prices.

Few firms know the price sensitivity of their customers. A question I always ask client firms is, what would happen if you raised all your prices by 1 percent? Few can answer this question. Not only must a firm know its demand curve, it must also know its price elasticity of demand and by able to predict how the quantity demanded will vary if the price is changed.

Another common mistake is underpricing – where a firm sets its price too low relative to the value being offered. Often this is done in the mistaken belief that a higher price will make the firm uncompetitive with rivals. Price always has to be related to value and how unique that value is relative to the competition.

Competing on price is a dangerous game. Undercutting rivals on price and hoping to pick up additional volume can provoke undesirable competitive responses which can depress everyone’s profitability. Similarly, firms that charge premium prices which are not supported with sufficiently differentiated value may create a price umbrella which allows lower-cost rivals to roll up market share. Price must always flow from strategy and not be determined arbitrarily or by imitating the pricing policies of rivals.

A Firm’s Demand Side Comes First

It strikes me that firms seem overly preoccupied with working the supply side of their businesses. Most operational improvement methods and programs are focused on making the supply side function more efficiently and at lower cost. For example, Lean manufacturing allows a firm to supply more output with the same resources, or the same output with fewer resources. What’s really important, though, is how a firm plays the demand side of its business – how it creates, and keeps, customers.

The problem with supply-side only thinking is that ultimately it becomes mainly about price. Improving efficiencies and reducing costs will certainly improve margins and will allow a firm the flexibility to pass some of the cost savings through to customers in the form of lower prices. The problem is that operational improvements can be imitated by rivals and that a firm that Leans its way to lower prices may find itself with lower profits when rivals follow the same path.

What I am really interested in is how operational improvements can be used to influence a firm’s demand curve – to help shift it rightwards, if possible. This can only be done with a strategic approach – where the firm identifies and selects its preferred target customers, identifies the needs they will serve with unique value, and then determines how it will tailor its value chain to create relative price differences from rivals.

Under such an approach, initiatives like Lean begin to take on a new life – they are being used to create and keep customers, rather than reducing costs.

By themselves, operational improvements are not likely to shift a firm’s demand curve. Unless the improvements result in unique value being offered, the firm can only move along its demand curve – by offering a lower price to secure more demand and increase output. Unique value by definition provides a barrier to imitation and entry, unlike operational improvements which are vulnerable to imitation by rivals.

 

Misguided Criticism

A recent blog in Harvard Business Review by Ron Ashkenas (http://blogs.hbr.org/ashkenas/2012/05/its-time-to-rethink-continuous.html) takes aim at Lean, Six Sigma, and other continuous improvement methods and suggests that these approaches may be harmful to firms. While much of Ashkenas criticism is valid he misses two key points:

  1. Lean and Six Sigma are methods for improving operational effectiveness. You cannot build a sustainable competitive advantage through operational effectiveness alone. Strategy is what builds a competitive advantage and it is strategy that determines operations and their configuration. Improving operations outside of a strategic context is not only harmful, it is a misallocation of resources.
  2. Blindly pursuing Lean or Six Sigma means you have entered a race to be the best. Competition is not about being the best, it is about being unique. Rivals in many industries have homogenized themselves to uniformity and lower profits by converging at the same place through Lean and Six Sigma. It is valuable differences between firms that drives superior profitability, not trying to do the same thing as rivals, only better.

Working Against Yourself

Proposed changes to the Employment Insurance (EI) scheme by the federal government go against sensible economic thinking. Reducing the unemployment rate by requiring people to take lower paying jobs, or work outside their chosen field, may actually decrease output and employment, rather than raising it, as the government hopes.

As Keynes argued in The General Theory, employment is determined by the aggregate demand for goods, which is in turn determined (in a closed economy) by consumption demand and investment demand. Consumption depends mainly on the level of real income while investment demand depends on the interest rate, which is determined by money supply and the demand for money, and by business expectations. Thus, it is demand which determines the level of employment, not wages.

The level of employment thus determined may be less than the full employment level at which the supply and demand for labor (which depend on the real wage) become equal. Keynes also examined the aggregate supply side of the economy with a given money wage, and a production function relating output to employment, which determined the average price level. He argued that the wages are likely to be rigid downward when unemployment exists because of workers’ concern with their wage relative to that of others. The key insight is that, even if wages (and hence the price level) fall, this is likely to decrease the level of aggregate demand due to lower incomes and the negative effect of falling prices on investment demand.

Putting downward pressure on wages, which seems to be the unspoken policy of the current government, is therefore likely to be counterproductive. If lower wages result in lower consumption, and hence demand, unemployment will rise, not fall.

Is Canada Poised for a Minsky Moment?

Paul Krugman, in his excellent new book, End This Depression Now, has an excellent analysis of the dangers of high private debt levels and overleveraging. Krugman makes the point that, when debt levels get too high, the economy is vulnerable when things go wrong. This is the so-called Minsky Moment, named after economist Hyman Minsky – an economic phenomenon where debtors are forced to rapidly try to liquidate assets as they attempt to deleverage in a downturn. Of course, collectively they cannot and Fisher’s debt deflation spiral sets in.

Before the 2008 recession, household debt levels in the USA were above 100 percent of GDP. Today, In Canada, household debt levels are running close to 95 percent of GDP (see graph below).

The fear of a Minsky Moment has prompted both finance minister Jim Flaherty and Bank of Canada (BoC) governor Mark Carney to issue warnings to Canadians over the last few months on the dangers of high debt levels.

There can be no doubt that private debt levels in Canada are too high. Many Canadian families would have difficulty managing their debt loads if a serious economic downturn occurred. The escalating problems in Europe, coupled with continued uncertainty in the USA and elsewhere, give good cause for concern. In addition, should the BoC need to raise interest rates, many debtors would find themselves in great difficulty.

Household debt runup in Canada has accelerated following the 2008 recession. Part of the problem is many Canadians have been forced to assume debt because real wages are either stagnating or falling. With nominal wages rising only 1.8 percent and inflation running at 1.9 percent, many householders must use debt financing to maintain their standard of living. In addition, structural employment changes, where labour has shifted from high-paying manufacturing jobs to lower-paying service jobs, has meant many workers have had to settle for lower nominal wages.

Wage readjustment and stagnation has implications for how quickly Canadians can deleverage their debt positions down to more manageable levels. It will be interesting to see if Canada can avoid the undesirable consequences of a Minsky Moment should the economy take a downturn.