This is “Firm Strategies in Highly Competitive Markets”, section 6.10 from the book Managerial Economics Principles (v. 1.0).
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Markets that closely resemble the perfect competition model or its variants might be ideal from the standpoint of market customers and as a means of increasing social surplus. From the perspective of individual selling firms, highly competitive markets require that sellers carefully attend to cost and market conditions, while promising only modest returns on assets and invested capital for those firms that manage to survive. Despite the limited opportunity for profit in these markets over the long run, good and well-executed strategies can help firms in these markets be among the survivors and perhaps extend the period in which they can do better than sell products at average cost.
Michael Porter of Harvard University prepared a guidebook for firms to prevail in these competitive markets in his text Competitive Strategy.See Porter (1980). Basically, he advises that firms adopt an aggressive program to either keep their costs below the costs of other sellers (called a cost leadership strategyA response to a highly competitive market in which a firm adopts an aggressive program to keep its costs below the costs of other sellers.) or keep their products distinguishable from the competition (called a product differentiation strategyA response to a highly competitive market in which a firm adopts an aggressive program to keep its products distinguishable from the products of other firms.). The logic of either of these strategies can be viewed as trying to delay the development of the assumed conditions of perfect competition, so as to delay its long-run conclusions of zero economic profit.
The perfect competition model allows that some firms will do better than others in the short run by being able to produce a good or service at lower cost, due to having better cost management, production technologies, or economies of scale or scope. However, the model assumption of perfect information means that any firms with cost advantages will soon be discovered and mimicked. The cost leadership strategy prescribes that firms need to continually look for ways to continue to drive costs down, so that by the time the competition copies their technology and practices, they have already progressed to an even lower average cost. To succeed, these programs need to be ongoing, not just done once.
The monopolistic competition model allows for some differentiation in a product and the opportunity to charge a higher price because buyers are willing to pay a premium for this. However, any short-run opportunity for increased economic profit from selling a unique version of the product will dissipate as the competition takes notice and copies the successful variant. Porter’s product differentiation strategy is basically a steady pursuit of new product variants that will be prized by the consumer, with the intent of extending the opportunity for above-normal profits. However, as with the cost leadership strategy, to be successful, a firm must commit itself to continued product differentiation with up-front investment in development and market research.
Porter suggests that each of his two strategies may be geared toward participation in a broader market or limited to a particular segment of the market, which he calls a focus strategy. A focus strategy endeavors to take advantage of market segmentation. As we discussed in Chapter 3 "Demand and Pricing", the population of buyers is not usually homogeneous; some are willing to pay a higher price (less price elastic) and some are willing to purchase in greater volume. By focusing on a particular segment, a firm may be able to maintain an advantage over other sellers and again forestall the onset of the long-run limitations on seller profits. The goal of the focus strategy is to be able to serve this segment either at lower cost or with product variations that are valued by the customer segment. Of course, by focusing on just one or a subset of buyer segments, a firm loses the opportunity for profits in other segments, so depending on the product, the circumstances of the market, and the assets of the firm, a broader application of cost leadership or product differentiation may be better.
The potential for success using a cost leadership strategy or a product differentiation strategy might suggest that a firm can do even better by practicing both cost leadership and product differentiation. Porter advises against this, saying that firms that try to use both strategies risk being “stuck in the middle.” A firm that tries to be a cost leader will typically try to take advantage of scale economies that favor volume over product features and attract customers who are sensitive to price. Product differentiation seeks to attract the less price sensitive customer who is willing to pay more, but the firm may need to spend more to create a product that does this. Firms that try to provide a good or service that costs less than the competition and yet is seen as better than the competition are endeavoring to achieve two somewhat opposing objectives at the same time.