COMPETITIVE SOLUTIONS Competitive Solutions The Strategist’s Toolkit R. Preston McAfee PRINCETON UNIVERSITY PRESS Princeton and Oxford Copyright © 2002 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 3 Market Place, Woodstock, Oxfordshire OX20 1SY All Rights Reserved LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA McAfee, R. Preston. Competitive solutions : the strategist’s toolkit / R. Preston McAfee. p. cm. Includes bibliographical references and index. ISBN 0-691-09646-5 (alk. paper) 1. Strategic planning. 2. Business planning. 3. Decision making. 4. Game theory. 5. Pricing. 6. Antitrust law. 7. Industrial management. 8. Competition. 9. Strategic planning—Case studies. I. Title. HD30.28 .M3815 2002 658.4′012—dc21 2002020102 British Library Cataloging-in-Publication Data is available This book has been composed in Adobe Garamond Printed on acid-free paper. ∞ www.pup.princeton.edu Printed in the United States of America 1 3 5 7 9 10 8 6 4 2 FOR ELLIE AND KRISTIN Contents xiii Preface Preamble xiii Contents xvi What Is Strategy? xviii Acknowledgments xix 1. Introduction 1 Executive Summary—Introduction 7 2. Industry Analysis 9 The Five Six Forces 9 Entry 11 Buyer Bargaining Power 16 Supplier Bargaining Power 18 Substitute Products 18 Rivalry 19 Complements—The Sixth Force 23 Strategies for Complements 26 Industry Structures 27 Fragmented Industry 28 Dominant Firm 30 Tight Oligopoly 33 Loose Oligopoly 34 Executive Summary—Industry Analysis 34 3. Firm Strategies 36 Value/Cost Strategies 36 Quality Choice without Competition 37 Games and Best Responses 38 The Effects of Competition on Quality Choice 42 Accommodation and Dissuasion 44 Low-Cost Strategy 45 Cream-Skimming 47 Coherent Strategies 48 The Three-Layer Model 50 Stuck in the Middle 56 Dealing with Competitors 57 Executive Summary—Firm Strategies 58 4. Differentiation 61 Competition in Differentiated Products 63 Creating Synergies 70 Quality Complementarities 74 Networks 75 Technological Races 78 Patent Strategy 80 Hedonic Prices 85 Executive Summary—Differentiation 89 5. Product Life Cycle 91 Introduction 95 Growth 97 Maturity 98 Decline and Replacement 101 Summary of the Product Life Cycle 105 The Life Cycle for Durable Goods 108 Executive Summary—Product Life Cycle 112 6. Cooperation 113 Cooperation on a Variety of Issues 113 Tacit Collusion 116 Shared Interest 116 Punishment 119 Recovery 124 Problems of Tacit Cooperation in Price 127 Confessions 128 Many Producers 129 Differentiated Products 129 Reaction Time 130 Environmental Randomness 132 Motivating Managers 132 Efficient Allocation within a Cartel 133 Unenforceable Contracts 135 Risky Communication 135 Small or Failing Firms 135 Entry and Substitutes 136 Competition in Other Dimensions 137 Solutions to Tacit Cooperation Problems 138 Industry Association 138 Published Price Lists 139 Exclusive Territories 139 Preannouncing Future Price Increases 140 The Capture Theory 140 Incrementalism 141 Multimarket Contact 142 Multilevel Contact 144 Unused Capacity 144 Grow or Crush Small or Bankrupt Firms 145 Executive Summary—Cooperation 146 7. Organizational Scope 148 Make or Buy Decisions 151 Tapered Integration 158 The Multidivisional Firm 160 Transaction Costs 163 Prices or Quantities 170 Net Present Value 172 Project Selection and Risk Assessment 179 Executive Summary—Organizational Scope 184 8. Incentives 187 Agency 188 Efficiency Wages 191 Making Firms More Aggressive 192 Agent Selection 193 Managing Creative Talent 194 Multitasking 195 Common Agency 199 Tournaments and Yardstick Competition 201 Ratchet Effect 202 Executive Summary—Incentives 203 9. Antitrust 204 Major Laws 204 Sherman Act (1890) 205 Clayton Act (1914) 206 FTC Act (1914) 209 Exemptions and Special Treatment 210 Predation, Foreclosure, and Tying 211 Mergers 214 DOJ Guidelines for Horizontal Mergers 216 Vertical Mergers and Antitrust Enforcement 221 Executive Summary—Antitrust 224 225 10. Elementary Statistics Opinion Polls 226 The Precision of Statistics 234 The Normal Distribution or Bell Curve 236 Conditional Probabilities and Correlation 239 The Predator Theory of Tornadoes 244 Sample Selection Bias 246 The Hot Hand 247 Option Values 251 Scenario Analysis 255 Executive Summary—Elementary Statistics 258 260 11. Pricing Illustrative Examples 262 International Pricing by the Pharmaceutical Companies 262 Methyl Methacrylate 262 Hand-Me-Down by Armani 264 IBM LaserPrinter E 264 Sony MiniDisc 265 An Electric Utility’s Individualized Pricing 265 IBM’s Punchcard Metering 266 Buying Paint from an Airline 266 Direct Price Discrimination 268 Indirect Price Discrimination 273 Coupons 273 Quantity Discounts 274 Product Branding 276 Product Bundling 277 Peak-Load Pricing 278 Yield Management 281 Theatrical Yield Management 284 Robert Crandall on Airline Pricing 285 Competition and Price Discrimination 288 How to Soften Price Competition 289 Opportunism and Exclusive Dealing 289 Create Competition by Licensing 292 Vertically Integrate with the Buyers 292 Long-Term Contracts 292 Exclusive Contracts 293 Most-Favored-Customer Clauses 293 Uniform, Simple Contracts 294 Pricing of Complements 295 Price Dispersion and the Theory of Sales 297 Executive Summary—Pricing 300 303 12. Auctions Bidding 303 The English Auction 304 The Sealed-Bid Auction 305 The Winner’s Curve 307 Updating 311 Selling Strategy and Auction Design 312 When to Auction? 320 Executive Summary—Auctions 322 324 13. Signaling Signaling in Action 324 Law Firms’ Marbled Buildings 324 Service Plans and Warranties 325 The $25,000 Rolex Watch 327 Body Language 327 Education 328 Full Product Line 331 Appearing Informed in an Auction 333 Tylenol Recall 333 Lemons 337 Introductory Offers and Advertising 340 Entry Deterrence 342 Leadership 344 Acting Tough 345 Vaporware 348 Product Failures 349 Signaling Psychosis 350
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