Sun Tzu reminded us of the importance of analyzing your enemy, understanding your competitor. This is crucial in business strategy, as well as in the military. Strong businesses put themselves in the shoes of their rivals, and they try to anticipate how those competitors will react. And they use that information to help them plot a more effective strategy.
Failed Business Strategy — Netflix vs. Blockbuster
Let’s think about this in the context of Netflix and Blockbuster. Netflix entered the market 1999, confronting the incumbent, Blockbuster. Now, Blockbuster had a choice. How hard do we fight this new player, or do we accommodate? How did that play out in the movie-rental business? Well one important factor, one important decision, that the incumbent, Blockbuster, confronted early on was, do we cut our late fees?
Recall that Netflix came in the market with a different pricing model. They weren’t charging per movie; they were charging a monthly subscription. You paid a certain fixed amount per month and rented as many movies as you wanted. Within that, you didn’t have to return each movie in a prescribed period of time. You could keep the movie for more days than Blockbuster typically allowed their customer to keep the movie. But of course, you couldn’t rent new movies unless you eventually returned the movies you had. So there’s some limit there, that Netflix imposed. But there were not traditional late fees.
Now, Blockbuster had to decide. Do we cut late fees, which we know some customers really dislike, to compete with this upstart Netflix. And Netflix is thinking, what do we anticipate about what Blockbuster will do? Will they come after us hard?
It’s interesting to look at the economic motives of Blockbuster, and I’m sure Netflix did, based on my conversations with people in the industry. Blockbuster was generating at least $300 million per year in late fees in the early 2000s. In some years, that was more than the total operating profit of the entire company. They were dependent on late-fee revenue for their profitability.
What about Netflix? Who were they in the beginning? Well, in those first few years, they only had a few hundred thousand subscribers. Blockbuster had millions of customers. So do the math. If you’re Blockbuster, and you cut late fees, you destroy the entire profitability of the firm. But what do you gain? You save a tiny slice of market share. So what do you do? Blockbuster chose to accommodate. They said, we’ll keep late fees in place. We’ll cede a few 100,000 customers to Netflix. But in our interest, we’re looking and saying, preserve our profitability today, rather than try to save a bit of market share and sacrifice so much of our profitability.
Blockbuster’s estimation, their projection, was that Netflix would not grow that rapidly, that it was a niche player, catering to a certain subset of customers, but it would never go mainstream.
Of course, you might say that was very shortsighted. What about the long run? What, if Netflix starts to grow and grow rapidly? Blockbuster’s estimation, their projection, was that Netflix would not grow that rapidly, that it was a niche player, catering to a certain subset of customers, but it would never go mainstream. So with that expectation, they weren’t willing to eliminate late fees to save this tiny slice of the market.
This is a transcript from the video series Critical Business Skills for Success. It’s available for audio and video download here.
Avoid a Failing Strategy with Competition — Clorox vs. Procter & Gamble
But there’s a few other principles here that we can learn about competitors and how they respond to one another. For the incumbent, one key is, what signal am I sending to other potential entrants by my behavior today? So, not, what is the short-term impact on my profit, but what is the long-term impact on the competitive dynamic? If I play nice, or if I fight? Perhaps if I fight aggressively, I will deter other entrepreneurs from coming into my segment.
If you think about what you’re trying to do as an incumbent player in these markets, what you’d love to do is be able to take action up front to deter entry before the player even comes in. Could you fight a little preemptively, and therefore, avoid the situation of having to take a huge hit to profits later on to fight them in reality? Could you engage in preemptive action?
Several years ago, Clorox and Procter & Gamble were in an interesting competitive situation. Procter & Gamble, maker of laundry detergents, like Tide, was thinking about entering the bleach category. This was one area in the laundry detergent aisle that they did not compete in. Clorox was the dominant player. Most Americans use the word Clorox and bleach interchangeably; the brand was the product.
Now, Procter & Gamble was planning on test marketing this product in Portland, Maine, their new bleach. Why Portland Maine? It was far from Clorox’s headquarters in California. It was a small market, and they were all set with a couponing and sampling strategy for introducing their product and testing it out.
Clorox caught wind of this, and they said to themselves, how might we deter entry by P&G? They launched a preemptive attack. They delivered a gallon of bleach to every household in Portland, Maine.
What did Procter & Gamble do? They said to themselves, well, our whole sampling and couponing strategy won’t do much good now that everyone has an extra bottle of bleach already on hand. Moreover, we just learned that Clorox is going to fight to the death in this market. This won’t be an easy battle.
What did Procter & Gamble do? They said to themselves, well, our whole sampling and couponing strategy won’t do much good now that everyone has an extra bottle of bleach already on hand. Moreover, we just learned that Clorox is going to fight to the death in this market. This won’t be an easy battle. They never entered the market; they decided to forsake the bleach category. A preemptive strike that deterred entry, a very effective business strategy.
Assessing the competitors’ response, as a potential entrant, you’re thinking about a range of factors that might suggest aggressive moves coming from the incumbent that could be harmful to you as an entrepreneur. Is this a slow-growth market? Is this a situation where the incumbent is starving for new customers, where there is no growth, and therefore, they might fight to preserve the customers they already have.
Economy of Scale and Failing Business Strategy
In the 1980s, NutraSweet was the dominant player in the aspartame, or artificial sweetener, market. And their biggest customers were Coke and Pepsi. In fact, Coke and Pepsi accounted for almost half of their sales worldwide. Their patents were about to expire, and new businesses were looking at entering the market. Holland Sweetener was one of those firms thinking about coming in to compete with NutraSweet.
Would NutraSweet retaliate aggressively? How might they respond? Well, Holland Sweetener made a single, big mistake in their efforts to enter this market, and that was, they didn’t fully understand how powerful the cost advantage that the incumbent player had on them.
It turns out, in the aspartame market, there were huge economies of scale and a substantial learning curve. NutraSweet had a huge cost advantage over this new player, Holland Sweetener. The learning curve was so powerful that the cost of producing aspartame had been falling significantly for years, as NutraSweet gained more and more experience producing this good.
It was the same, basic product. With no cost advantage and no differentiation, they were toast.
And as for huge economies of scale — you only needed a few factories to produce enough aspartame to serve the entire worldwide market. What dis this mean for Holland Sweetener? It meant the incumbent could fight, and fight aggressively, because they could bring price way down and still make money due to their cost advantage. Plus, Holland Sweetener had no other way of differentiating their product. It was the same, basic product. With no cost advantage and no differentiation, they were toast.
Moreover, they made one other mistake. They didn’t apply a little game theory to understand NutraSweet’s behavior with respect to Coke and Pepsi. Holland Sweetener was counting on Coke and Pepsi to shift some of their volume over. They figured Coke and Pepsi don’t want to be so dependent on NutraSweet. They’ll want to shift some of their volume, especially if we offer them an attractive price.
But Coke and Pepsi were caught in a prisoner’s dilemma, explained by NYU Professor Adam Brandenburger. He said Coke and Pepsi were caught in a situation, where, it would have been in their interest to switch some volume and get a better price from Holland Sweetener, but neither wanted to move first. Each looked and said, if we move, will our opponent attack us? Will Pepsi say to Coke, you’re changing an ingredient, and it’s changing the taste of your soda. Maybe that’s not true, but would they try to argue that to the customer. And so, NutraSweet was able to retain those customers. Neither wanted to switch, and Holland Sweetener never made money in the artificial sweetener market.