No more oxygen left in the room

Sometimes the truth is so obvious and has been repeated so many times it becomes difficult to keep in focus. Business school frameworks are often derided for overcomplicating and obfuscating otherwise perfectly simple ideas and processes. The quintessential simple business school framework is from Michael’s Porter’s Competitive Strategies. Although many people are taken in with new ways of looking at the world and the endless possibilities of digital business models, ultimately they, too, reduce to Porter’s two degrees of freedom.
Is the business a cost-leader and therefore able to keep lower prices longer than its competitors? Is the business offering a differentiated product, a new category of one, and therefore able to keep generating above-average economic profits while it kicks into scale? If neither of these, it is relegated to an endlessly bloody battle for 4th place on the podium. You can worry about focus or customer segments as needed but it essentially revolves around the same binary positioning.

These two sources of competitive advantage aren’t static in time. They are dynamic laws of business that respond to the time dimension. Companies with higher relative market share tend to accumulate more experience, faster. Higher accumulated experience tends to offer opportunities for economies of learning and reductions in unit costs. This can either lead to higher sustained profits if the incumbent keeps market prices stable, or to higher sustained profits if the incumbent drives down prices in tandem with costs and forces the exit of most of its competitors. Higher relative market share therefore tends to lead to higher profitability over time.

This is an example of the Power Law in action. The Power Law is a relationship between two quantities where a relative change in one produces a proportional change in another. Most of the best selling books are written by few authors. Most of the highest-grossing music albums are published by a few artists. Most of the returns of an investment fund are delivered by a few companies. This stark pattern, in which a small few radically outstrip all rivals, surrounds us everywhere in the natural and social world. The market power of an incumbent tends towards accumulation, slowly sucking all the oxygen out of the room and consuming every last corner of producer surplus.

There are precious few ways to break out of this dynamic for a small underdog player trying to keep pace with the market, but without enough accumulated experience to keep up with lowering costs.

One way is to find a sufficiently small niche market that is too unattractive for large incumbent players to dominate effectively, and then become the incumbent in that space. This can work for quite a long time, provided the underdog is comfortable with few growth prospects. Another way is for the market to turn and decide it no longer wants a given product or service. This can come from endogenous changes in consumer preference. It can also come from exogenous shocks such as technological improvements. Underdogs don’t tend to have much of an influence on either source of change in demand.

The other alternatives for bit players to thrive rely on being able to either outspend the incumbent for long enough to replace it or to create a sufficiently differentiated product that it can hardly be said to be in the same market at all. Both of these require a substantial amount of capital to execute properly and still require good helpings of luck to carry the story along. A player could always 'correct' its path on the ROA/RMS chart but will only ever run further and further behind larger competitors.

Technological change carries with it the promise of upheaval and renewal. The turbulence that accompanies rapid growth is easy to get carried away in as endlessly optimistic for everyone. It may feel like the future is inevitable and that the old can go out in favor of the new only in one direction. But what is truly the source of competitive advantage? Is it about delivering a differentiated product, responding to a new well of consumer demand? Or is it about offering the most competitive prices behind an ability to serve at much lower prices? Regardless of the industry there are after all only two real sources of competitive advantage.

When sectors are growing at triple digit rates it may seem like there is enough air for everyone. But eventually things stabilize and the jostling for relative market share that took place during the rise will dictate the law. Before this happens, even change agents in the full effervescence of growth should stop to check. Who is breathing slightly deeper than everyone else? Who will suck all the oxygen out of the room?