Timing-based strategies and dynamic strategic interaction

The timing of a firm’s rents and cash outflows depends upon the timing of its competitors’ movements into new markets and the timing of the firm’s own development of new technology and other know-how. This often de­pends upon whether firms choose to make revolutionary or evolutionary product changes. Moreover, the timing of the rents and cash outflows de­pends upon which of these two strategies is chosen.

While the traditional models reviewed above (like Fruhan’s) recognize that rents on intangible resources will decline as the uniqueness of the asset erodes due to imitation, they do not provide an understanding of how and when competitors neutralize the uniqueness of an opponent’s re­sources. They do not provide guidance on how to preserve the uniqueness of the first mover’s assets. They also do not distinguish between creating value by a single high-profit, one-shot effort versus a series of actions that aren’t sustainable but that also produce the same cumulative value for shareholders. Moreover, while recognizing the importance of timing and know-how, they do not offer any prediction about the type of competitive countermoves that will be used. And they do not show how imitation oc­curs or when it can be impeded. Models based on the net present value of an innovation seem to focus on a “single-wave” picture of a one-shot know-how leap that generates cash for many years rather than on a suc­cessful strategy of several waves occurring sequentially or simultaneously, each lasting only temporarily. These models say only that, given the pat­tern of cash flows generated by a unique resource, its value to shareholders can be calculated.

A more dynamic view of strategy looks at the way competitors interact to build their own advantage through entry timing, the creation of know­how, and the methods used to erode the uniqueness of their competitors’ resources. Ultimately this dynamic plays a greater role in shaping the firm’s future rents than does the value of the expected cash flows from an investment viewed in isolation of the countermoves that might occur. While traditional financial models provide the ability to incorporate an estimate of the impact of countermoves, they provide no guidance about what these countermoves will be or why they will occur.

Thus, competition develops among firms with respect to ( 1) building their resource base (especially know-how) and destroying the uniqueness of the opponent’s resource bases and (2) the timing of moves that emanate from use of that resource base—first mover versus follower. These moves
and countermoves create an escalation ladder of dynamic strategic inter­actions in which firms enter markets, innovate, and imitate each other until they compete away all the unique advantage provided by know-how and other intangible assets.

1. The First Dynamic Strategic Interaction: Capturing First Mover Advantages

For every strategic move, the firm has a choice: to act first or to wait. Turning back to our struggle to escape the cycles of quality and price com­petition, a company may eventually find that the only way to move up is to move out. Entering a mature market puts the company right back in the press of intense competition. The only markets that offer relief from this competition are those that either don’t exist yet or are virtually untapped.

Arriving first at the market, as we saw in the examples of Hoffmann- LaRoche and Wang, can offer a tremendous advantage. It also creates sig­nificant risks. If Hoffmann-LaRoche had been wrong about vitamins and later studies disproved their usefulness, its strategy could have cost it the firm. If the market did not adopt vitamins, Hoffmann-LaRoche could have been left with a very costly but useless product line. Wang suffered an even bigger risk commonly associated with being a first mover. It put all its eggs in one basket and failed to adapt to the subsequent moves of entrants in that market.

The advantages of being a first mover include the following:⁶

• Response lags In the time it takes for second movers to reach the market, the first mover can earn substantial rents as a temporary monopolist.
• Economies of scale The first mover has time to achieve economies of scale before later entrants arrive. First movers tend to have significantly broader served markets.
• Reputation and switching costs Establishing brand loyalty first, so followers must convince customers to bear the costs and risks of switching to an untried, unknown late entrant’s brand. The first mover is also helped by the cost of evaluating switching to a new product, which often leads to customers buying from the market leader.
• Advertising and channel crowding By the time later entrants arrive, it may be harder for them to find uncluttered advertising space and distribution networks.
• User-base effects Some products such as telephones increase in value as the number of users increases. By arriving first, the innovator can set the standard and build a stable, large user base that provides funds for the next leap in products.
• Producer learning Moving down the production and technology experience curve faster than competitors.
• Preemption of scarce assets First movers have their choice of unique natural resources (e.g., Nickel Mines with the lowest extraction costs), valuable land (e.g., McDonald’s restaurant locations), or shelf space (e.g., P&G’s control of supermarket displays and shelving).

Empirical evidence from the PIMS database ( containing almost six hundred consumer goods firms and thirteen hundred industrial goods firms) shows evidence that first movers earn the biggest profits for long periods of time when they move into industries with significant switching costs.8 The advantage is strongest in industries with high product-purchase prices and low new-product sales and in high-value-added product markets. The first mover advantages are weakest in markets with high price competition, in which direct-sales-force expenditures are high and products are highly customized or service is important.9 First movers in consumer goods industries, because of the generally low costs of purchases, appear to benefit most when there is consumer uncertainty regarding product quality and not much to be gained by a long and time-consuming search for information from sources like Consumer Reports. These are situations in which brand loyalty will be important. Because of the high purchase amount, first movers in industrial goods industries appear to benefit most when there are severe buyer-switching costs and unique patents that hold up over time and when they form strategic alliances with customers. Followers do better when there is a high retail purchase price for consumer goods and a low retail purchase price for industrial goods. Thus, where consumers find it easy to switch, followers benefit most.

First movers also benefit from ambiguity that makes it harder for competitors to unravel the source of advantage of the innovating firm. This makes it hard for competitors to determine which actions to imitate. In particular, process R&D (the results of which are usually much less visible than product R&D) can provide longer-lasting advantages.10

To be effective, first movers must develop some special know-how, including the following:

• Innovation skills Their R&D must be fast, innovative, risk-taking. Pilkington spent more than seven years and twenty-one million dollars to perfect its new float plate glass process. The results trans formed the industry and assured Pilkington’s dominance in it, but a failure would have been a major loss. Sony, from its start, bet the company on breakthroughs in technology, beginning with the de­velopment of a tape recorder after the war and gambling on creating the first pocket transistor radio. Sometimes the risks didn’t pay off as well, as in the case of Beta video machines.
• Customer knowledge They must be intuitively in touch with the marketplace because market research usually doesn’t work with completely new products. Customers cannot articulate a desire for products they have never seen.
• Market penetration skills Their marketing skills must be fast and good enough to gain quick market share after early product introduc­tion, and they must have a brand name that is capable of sustaining a premium price large enough to recapture R&D investments before competitors move into the market.
• Flexible manufacturing skills Their manufacturing skills must be flex­ible enough so that new products can be introduced quickly and so that components can be created that are not available on the open market, increasing the element of surprise. First movers are often not: organized to do routine mass production because their systems are designed to be flexible enough to switch from one new product to another.

Because these skills and knowledge are not easy to create, many firms choose to stand and wait rather than make the first move into the market. After observing what the first mover has done, other players countermove, as illustrated in the next dynamic strategic interaction, imitation.

2. The Second Dynamic Strategic Interaction: Imitation and Improvement by Followers

Being a first mover can be very risky. As we have examined above, the first mover faces substantial challenges. Customers do switch products. Brand loyalty can be overcome in consumer products industries, and switching costs can be circumvented in industrial products industries. Innovations diffuse among competitors. Diffusion is especially rapid when

• reverse engineering is easy
• equipment suppliers help transfer key technologies or other business know-how
• industry observers, trade associations, or collegial professional socie­ties help transfer technologies and other business know-how
• buyers encourage other manufacturers to become qualified second or third sources

• personnel move to rival firms frequently
• leaks of secret information are commonplace and not punishable le-gally;

Thus, first mover advantages are often very tenuous in nature, and they may not create the barriers to imitation that people commonly assume.

The risks of being a first mover can be minimized by being a close fol-lower. Quite often imitators profit more from an innovation than the in-novating firm. The product succeeds fabulously, but the company that first brings it to market is not the one to profit from it. Imitators do follow. One study found that 60 percent of patented successful innovations were imi-tated within four years, and the imitator’s development costs were 35 per-cent less than the innovator’s.¹¹ Another study found that major patented innovations could be imitated within three years in half of the 129 lines of business studied. For unpatented inventions the statistics were worse, with about 65 percent copied in a year or less.¹² Imitation barriers appear to be low.

Historically, Japanese firms have gained time and cost advantages in mitation due to acquisition of the know-how of competitors. Most advan-tage comes not from internal technology, but from external technology bought or copied from competitors.⁰ In nearly three-hundred cases of links between U.S. and Japanese companies, more than 90 percent in-volved a transfer to Japan, according to a report by the National Academy of Sciences.¹⁴ In Japan firms take about 25 percent less time and spend about 50 percent less money to carry out an innovation because of their use of external technology rather than inventing in-house. Moreover, this is true in all industries.¹⁵

Peter Drucker observed several advantages to following.¹⁶ The follower allows the first mover to test the waters. It learns from the innovator’s mistakes and can move in with a product better suited to the actual needs of the market. The imitator can avoid the tremendous expenses of devel-opment through reverse engineering and other methods. The imitator canfocus its attention and resources on process technology rather than prod-uct technology, allowing it to produce a higher-quality product and/or to make the product more efficiently.

The follower also can take advantage of subsequent product or process innovations such as more powerful computers or chips, while the first mover may be locked into the technology at the time of the product’s de­velopment because of sunk costs in research, manufacturing, distribution, and other areas. Thus, the close follower can arrive with a better product at a lower price.

A fast second mover or even a slow third mover can sometimes outper­form the innovator. In some cases, such as Matsushita’s VHS recorders, the follower wins. But in other cases, such as DuPont’s Teflon, the inno­vator wins. See Figure 2-6 for other examples.

There are three things needed for the imitator to win: regimes of appropriability, dominant design paradigm, and complementary assets.¹⁷ Appropriability is related to the strength of patents and other legal protec­tion, as well as the difficulty for followers in using technology to invent around patents. If followers can enter before the emergence of a dominant design, they have a shot at offering their own design against that of the original innovator. The follower needs complementary assets such as mar­keting, manufacturing, and other capabilities that allow it to produce the new product.

FIGURE2-6

TAXONOMY OF OUTCOMES FROM THE INNOVATION PROCESS

Source: David J. Teece, “Profiting from Technological Innovation: Implications for Integration, Collaboration, Licensing and Public Policy,” p. 187 in Chapter 9 (pp. 185-219) of The Competitive Chal klenge: Snakes far Industrial Innovation and Renewal, edited by David J. Teece (Cambridge, MA: Ballinger Publishing, 1987).

This strategy of imitation is not without its risks and challenges. Fol, lowing can splinter the company’s efforts by offering too many variants and improvements without a clear focus. Piecemeal following may result in a set of products that cannot be integrated into one unified system. An, other risk is that the follower, who is looking at the competitor, may mis, read customer needs and trends. This may make the follower unable to follow or improve when customers needs change again. For the follower strategy to work, the follower has to gain market share before the first mover has taken over the market. The success of this strategy also depends on the ease of imitation of the product. Complex products, for example, are harder to reverse,engineer and imitate.

With longer development times and higher technology costs, it can take a long time for second movers to crank up to speed to enter a promis, ing market. On the other hand, a follower who moves too quickly can incur many of the same costs and risks as the first mover without gaining the advantage of arriving in the market first.

Follower strategies work best when the first mover is unable to keep up with demand, is not satisfying all segments of customers or all varieties of customer needs, or has a product with a design flaw that can be corrected. For example, aspirin was hard on the stomach, so buffered aspirin could move in to take over the market for pain relievers. This “design flaw” also left the door open for more revolutionary innovations such as acetamino, phen and ibuprofen.

It is not just technology that can be imitated but also services. For ex, ample, even as Dell Computer was cloning the technology of the IBM personal computer and offering it at a lower price with higher service, other competitors were imitating Dell’s approach to direct marketing. Smaller companies entered the market with direct,mail operations, offer, ing a little less service for substantially lower prices. Even large competi, tors such as Digital are entering the mailorder business or increasing their telephone support and service to users.¹⁸

Direct imitation of the first mover, however, sometimes produces a less than appealing product. Why should happy customers switch to a new product when they are satisfied with the product of the first mover? This creates a need for more elaborate forms of imitation to differentiate the imitator from the first mover. Several methods are used, including pure imitation, adding bells and whistles, stripping down, creating flanking products, and reconceptualizing the product, all of which are summarized in the next section.

ALTERNATIVE STRATEGIES FOR FOLLOWING

There are several strategies the imitator can use to overcome switching costs and brand loyalty and to make up for his late arrival and lack of nov­elty.¹⁹ In some ways these strategies are similar to those discussed in cost- quality competition in the first arena, but they are different in their de­gree. An automaker might move in the first arena by producing different cars with gasoline engines, but a car company might move in the second arena by introducing electric or solar cars or minivans. Of course, the two arenas, as we noted in the introduction, are separated here only to clarify the interactions. Actions in one arena affect competition in the others; a strategy to differentiate the imitator obviously has an impact on quality and cost.

Among the strategies used to differentiate the second mover are

• Pure imitation Here the second mover uses superior know-how to make the same product at a lower price. This is, in one sense, price competition, as noted in the first arena. But to offer a lower price, particularly when the first mover already has a head start on the ex­perience curve, the follower has to be able to cut its costs of develop­ment and production. This can be done through better manufactur­ing processes and technology, reduced R&D costs, and reduced marketing outlays.
• Adding bells and whistles A lower price is not the only way a follower can steal customers. Adding features to the product or service allows followers to gain ground in the existing market. For example, when Procter & Gamble introduced Crest, it was a basic no-nonsense, cavity-fighting toothpaste. But some followers realized that it is not how customers feel but how they look that is important. So Lever Brothers came out with Close-Up, adding new ingredients to freshen breath and whiten teeth. Lever then followed with Aim, combining both a gel and fluoride protection. Beecham then came out with Aqua-Fresh, a swirl of paste and gel to fight cavities and improve the user’s social life at the same time. In Chapter 1, we saw a similar type of escalation in product features in the disposable dia­per market, where basic diapers became better-quality diapers and then gender-specific diapers and finally age- and gender-specific dia­pers.
• Stripping-down The reverse strategy is to take away options, creating a less-expensive model for a more focused market segment. Rather than imitate the service and fare schedules of existing airlines, Peo­ple Express stripped down air travel to its no-frills minimum—get­ting from point A to point B. It eliminated flight attendants, meals, and reservations to offer lower-priced flights to nonbusiness travel­ers. To take an example of a product that has been stripped down, consider the massive copier-printing machines, designed to print truckloads of documents, that were scaled down to create machines for a single office or a single person. This is the difference between the approach of Xerox and Savin.

• Flanking products Another strategy is to create products that serve the same purpose for the same or similar customers but in a slightly different way. This is a variation on the bells-and-whistles approach that can be used to outflank a competitor by creating products that are smaller, larger, contain fewer calories, are in smaller packages, or are more convenient. Sony, for example, used miniaturization to enter the low end of the electronics market, and it used larger sizes, such as its thirty-two-inch television, to take the high end. Head Ski’s oversized tennis racket is another example of the use of a larger size to distinguish an imitative product. Other features that are fre­quently used to ■ distinguish a product include reduced calories, as in Miller Lite or Stouffer’s Lean Cuisine; convenience of purchase, such as Avon’s door-to-door marketing of products to women; and repackaging, such as milk in small aseptic cartons or orange juice cartons with screw-on lids. These flanking strategies have become increasingly important in competitive strategy. They can help the company shift the rules of competition, one of the New 7-S’s that we will explore in Part III.
• Reconcep lized products Instead of changing the product, the imi­tating firms sometimes change the uses of the product. For example, baking soda was once used primarily in cooking, but is now offered as laundry detergent, toothpaste, and refrigerator deodorant. Motorcy­cles are variously seen as inexpensive transportation, a vehicle for fun or recreation, or a status symbol of macho power and prestige. This reconceptualization strategy is also becoming increasingly im­portant, as we will examine in our discussion of searching for new opportunities in Part III.
• Branded products When customers are not likely to search out new products because it is too time-consuming and they are unwilling to test new products because they fear they may be low quality, the fol­lower can advertise, provide warranties, or give free samples or free demonstrations of the product to overcome consumer unwillingness to switch.

• Compatible products When the customer must incur a cost to switch to a new product, followers often make compatible products. Per­sonal computers and peripheral devices are frequently IBM-compat­ible to encourage IBM users to switch. Even software products are now compatible. If all of a firm’s word processing was done in Word Star, it can be converted to WordPerfect relatively easily with soft­ware provided by WordPerfect.

The wide range of options for imitators indicates the fertile field that second movers enjoy. But innovators, facing this threat, do not sit idly and watch their market share erode. They are forced to make countermoves, illustrated in the next dynamic strategic interaction.

3. The Third Dynamic Strategic Interaction: Creating Impediments to Imitation

First movers can anticipate imitators by using the above strategies before the followers do so. However, this is often not done. First movers are not set up to imitate themselves. Their R&D labs often are looking for new technologies, and their scientists are often insulted if asked to modify ex­isting products instead of inventing new, exciting ones. Moreover, this an­ticipation strategy only engages the first mover in an activity it sought to avoid by being a first mover. That is, it wants to be involved in untapped markets so it can act as a monopolist with a novel product. It does not want to compete by covering all the niches and becoming a full-line pro­ducer. This only drains resources away from its core mission: innovation and invention. Thus, first movers often tum to other strategies to prevent or delay imitation.

In developing and marketing their products or services, first movers often create obstacles for imitators. There are several major impediments to imitation. ²⁰ These are the smoke screens and roadblocks that pioneers use to delay the entrance of followers. The nine impediments are deterent pricing, secret information or know-how, size economies, contractual rela­tionships with suppliers, threats of retaliation, patents, bundled products, switching costs, and restrictive licensing. We will examine each of these in turn.

• Deterrent pricing By anticipating the follower in its pricing, the first mover can discourage entry. If the first mover sets its prices as shown in Figure 2-7, placing its price slightly above its costs, the competi­tor has an easier time matching the first mover’s price than if the first mover had taken an initial loss, as shown in Figure 2-8. The intro­ductory price in Figure 2-8 is below the actual costs of producing the product and is meant to deter entrants by forcing them to enter at such a low price that their introductory losses might be prohibitive. Later, the first mover can establish a “price umbrella” to recapture its investments in R&D and its losses due to product introduction. This umbrella, drawn from its monopoly power, allows the company to price far above its cost. As soon as followers enter, after overcoming the delay of the first mover’s initial low price, the first mover begins dropping its price to slow their entry. Eventually the market reaches a point of price competition. Once the first mover develops a repu­tation for pricing in this manner (i.e., per Figure 2-8), imitators may learn that following will not be very lucrative.

• Secret infoamtion By keeping information or know-how secret, first movers can prevent imitators from snatching their ideas. Know-how (technical information that is based on specialized experience and not divulged in patents) makes it much harder for competitors to imitate.²¹ Whether it is the “special sauce” on a McDonald’s Big Mac, the formula for Coca-Cola, or the huge investment in software for American Airlines’ SABRE reservations system, the know-how that the first mover has accumulated is kept from competitors for as long as possible. Ironically, firms often avoid patenting or copyright­ing their secrets to keep them out of the public domain.

FIGURE 2-7

SIMPLISTIC PRICING BASED ON COST ASSUMING A LEARNING CURVE

FIGURE2-8

ENTRY DETERRING AND UMBRELLA PRICING

• Size economies If the first mover has gained economies of scale, then the later entrant must join the market at least at that scale if he wants to capture equivalent costs per unit. The cost of entering at that level may be too great for later entrants. This is a particularly effective deterrent if the remaining market for the product is too small to support another producer at the scale of the first mover. This means the first mover’s large scale not only ups the ante for entering the market but also leaves little room for competitors to gain enough market share to be competitive.
• Contractual relationships The first mover’s contractual relationships with suppliers or distributors may help lock out the follower from the market. If the follower cannot obtain necessary components or can­not bring his product to market, it is difficult for him to enter.
• Threats of retaliation: If the first mover threatens the entrant with retaliation, the follower may be more reluctant to enter the first mover’s turf. We will examine various forms of retaliation to this type of turf invasion in more detail in the next chapter.
• Patents Patents provide an obvious defense against unwanted late entry by competitors. First movers often control the patents to a new product or process, making it more difficult (or sometimes even im­possible) for competitors to imitate without infringing on the first mover’s patent rights.
• Bundled products Bundled products are component systems that use a full line of pieces not made by the follower. If the follower cannot gain access to the components, then it cannot imitate the first mover.
• Switching costs Brand equity, customer loyalty, and other switching costs can make it hard for imitators to break into the market. Car companies such as GM and computer makers such as IBM have ben- efited from switching costs in the past. Brand loyalty and familiarity tended to keep buyers wedded to the first mover’s products.
• Restrictive licensing First movers can use licensing to slow or restrict (but not eliminate) imitation in some locations by licensing their products to competitors but restricting them to specific geographic areas or regulating the timing of the followers’ entry. But the draw- back is that in each case the technology is transferred to the compet­itor. The resulting learning in the competitor’s organization makes it easier for it to replicate the first mover’s technological know-how.

The entrance of followers also may be delayed by response lags such as delays in retooling or gaining FDA approval for drugs. These lags can be anticipated by the first mover. Moreover, delays can be enhanced by keep­ing plans secret or guarding technological know-how, thereby delaying the competitor’s awareness of the innovation and its understanding of the know-how needed to produce it. If the delay allows the first mover to es­tablish itself firmly in the market, the second mover may have a dimin­ished chance of entering.

But resourceful imitators do not sit idly by and accept these obstacles. Imitators have several incentives to enter the market as quickly as possi­ble. First, it is easier to attract new customers than to woo customers away from the first mover. Second, by limiting the first mover’s share of the market, the imitator can decrease the first mover’s economies of scale and its experience curve effects and thereby decrease the resources the first mover can put into its next innovation. If the potential market is desirable enough, imitators will find a way to overcome these obstacles, as we can see in the next countermove, the fourth dynamic strategic interaction.

3. The Fourth Dynamic Strategic Interaction: Overcoming the Impediments

Even when the first mover has scattered the path with obstacles, imitators can find ways to make countermoves in the market. Barriers to imitation tend to decay over time. This decay can be hastened by a technological breakthrough or through aggressive competition. This erosion can be slowed or reversed by continual reinvestment in know-how to increase the difficulty of imitation.²²

In response to the nine impediments to imitation outlined above, here follows some actions that imitators take to overcome these barriers:

• Deterrent pricing If followers have sufficient resources, they may be able to match the first mover’s prices, even during the period of its low introductory price. Particularly if the follower can develop pro­cess technology that reduces the cost of production, it may be able to match the first mover’s prices at a much lower volume. This will force the first mover to drop its prices more quickly, reducing the profits earned by eliminating its price umbrella.
• Secret information By careful investigation, private information is often legally discovered, either by hiring away personnel from the first mover or by taking apart his products. Depending on the type of information, this may be more or less of a baưier. If a new fast-food chain wants to get a good idea of what’s in the “special sauce” at McDonald’s, it just buys a few Big Macs for chemical analysis or ex­periments to find an equivalent recipe. Even the Coca-Cola formula, which has never been replicated, has been hurt by the Pepsi Cola formula, developed by experimenting and adding more sweetness to a cola-based formula. On the other hand, a biotechnology company may have a stronger hold on secret information because of the com­plexity of the underlying technology, processes, and products (but such a hold is no longer as strong as companies think, as we will discuss in more detail when we examine entry barriers in Chapter 3).
• Size economies Some followers improve the product so they can enter at a higher price without the need for the lowest costs. Others improve the manufacturing process technology so they enter the market with a competitive price, even without economies of scale. By making the process more efficient, followers often quickly in­crease their scale and eventually overtake the first mover. Size econ­omies also provide little protection if the market is growing faster than the capacity of the first mover to meet it. In this case, the first mover will not be able to fulfill the needs of the market, providing a ready entry point for an imitator. Other followers build up their scale in a protected geographic market and then enter another market with sufficient economies of scale to win. The entry of Japanese firms into the United States provides a good example of this process.
• Contractual relationships Contractual relationships with suppliers and distributors are overcome by finding or developing new suppliers or outlets for the product. If there is a demand, there will probably be suppliers and distributors to meet it. Also, upstream or downstream vertical integration by the imitator often eliminate the need for these contractual relationships.
• Threats of retaliation Frequently threats are not perceived as credible when push comes to shove. Some types of retaliation, such as price wars, can hurt the first mover as much as the follower by taking away funds that could be used for future innovation. In our discussion of signals in Part III, we will provide more detail about how companies make these threats credible.
• Patents A study of forty-eight innovations found that patents tend to increase imitation costs only by 11 percent (although they are more effective in some industries than others). Within four years 60 percent of the patented successful innovations had been copied. “Contrary to popular opinion,” the study’s authors concluded, “pa­tent protection does not make entry impossible, or even unlikely.”⁷³ Slight variations in the product are often not covered by patents. For example, adding an atom to a drug molecule can result in a “differ­ent” product with all the same pharmaceutical properties as the orig­inal. Close substitutes can also be developed, as when animal insulin was replaced by biogenetically produced human insulin for sale in the diabetic market. Patents also expire. In 1992, for example, pa­tents were expiring on drugs that accounted for half of Upjohn’s 1991 profits. Patents also don’t provide protection in all parts of the world. Microsoft Corporation loses hundreds of millions of dollars each year to pirated software in other countries, with more than 75 percent of all software sales in many European and Asian nations coming from illegal copies.²⁴
• Bundled products As in the case of contractual relationships, imita­tors sometimes overcome bundled products by vertical integration or through joint ventures. By gaining or obtaining the capacity to cre­ate or buy the components of the product, imitators can do the same kind of bundling. This gives the imitators the same access to compo­nents as the first mover, overcoming the obstacle of bundled prod­ucts.
• Switching costs Not only can switching costs be overcome—through advertising, discounting, and direct comparisons that show the follower’s product is better—high switching costs may actually be an attraction to new entrants. A recent study argued that markets with high switching costs were more attractive to entrants because, once they gained a foothold in the market, they benefited from the same switching costs.²⁵ Thus, it was worth the effort to break through these barriers.

• Restrictive licensing As mentioned above, restrictive licensing doesn’t stop the imitator and may actually give the following firm access to vital technology. The trick for the follower is to overcome the restrictions on the licensing. This can be done by developing its own international technology base to replicate the first mover’s product or introduce the next generation of products, thereby elimi­nating the need for licensing.
• Response lags By improving internal processes and consistently ad­vancing its technology, followers reduce the response lags due to in­ternal constraints. External lags can also be mitigated. For example, the FDA clearance process can be accelerated for products that are “substantially equivalent” to existing drugs or for life-saving pharma­ceuticals such as AZT. In this way the standard response lags are shortened considerably.

Thus, we see it is nearly impossible for the first mover to shut the door completely on imitators, a fact to which the personal computer market provides ample witness. So there is no safe haven where the first mover can rest on its laurels. The followers keep getting better at following, shortening the product life cycle and giving the first mover less time to recapture R&D investments through premium pricing within a price um­brella. The first mover is thus forced to sell at a higher and higher price if it is to recapture its R&D in less time. This makes financing a first-mover strategy more difficult and slows the rate at which it will preempt market share, a key goal of the first-mover strategy.

The eventual entrance of followers forces the first mover to react. For a while the first mover may try to make incremental improvements in its products to meet the imitator’s challenge. But the imitator’s resources are focused on incremental improvements, while the first mover is often more adept at more dramatic innovations. This leads to the next dynamic stra­tegic interaction, wherein the first mover is forced to respond to the en­trant after it successfully follows into the market. The first mover may try to fight new entrants on their own terms—becoming a low-cost producer and abandoning its innovative efforts by redirecting resources away from R&D to focus on lowering manufacturing costs. In such a case the first mover advantage is abandoned. But some first movers continue to push forward with the next generation of innovations to create a new advan-tage. To do this, they need to move to the next dynamic strategic interac­tion.

4. The Fifth Dynamic Strategic Interaction: Transformation or Leapfrogging

Eventually imitators become very good at imitating and overcoming the impediments thrown up by the first mover and achieve technical parity with the first mover, much as the Japanese consumer electronics giants, such as Matsushita, have moved from mere copying to mastering the tech­nology for leadership in such new consumer electronics advances as HDTV and DAT. Over time, by learning to imitate the products, Matsushita has also imitated the intangible resource base (i.e., the know­how) of its competitors. At this point the first mover has lost any advan­tage it once had from its know-how, and the follower has the chance to take the leadership role. The first mover must then create a new set of intangible resources to win. This leads to either a leapfrog strategy or a transformation strategy.

Up to this point we have assumed that the first mover will continue to move ahead of the second mover. In fact, true competition is more com­plex. The second mover, as we noted, can move ahead of the first, forcing the first mover to catch up. This means, in effect, that the first mover becomes a follower. With roles reversed, hypercompetition still follows the pattern of moves and countermoves with each player trying to over­take the other. The interactions can thus become quite complex, as shown by Figure 2-9, which illustrates a series of three successive interactions between two competitors.

In the first interaction, the follower surpasses the first mover. Then (in interaction 2) the first mover catches up without surpassing the follower, allowing the follower the opportunity to jump ahead once again. Finally (in interaction 3), the first mover responds by overtaking the first mover, only to lose its lead once again. The first mover could retain the initiative throughout each interaction, the follower could seize the initiative and retain it, or it could move back and forth as in the above example. Even­tually, after a series of such interactions, the players reach the fifth dy­namic strategic interaction, where one or both players seek to put an end to this endless jockeying for position by leapfrogging the other player or transforming itself.

In the leapfrog strategy the company develops the resources to serve a new customer or create an entirely new product. In the transformation strategy the company develops new resources that allow it to execute the strategy of its opponent and directly compete with the opponent on its own terms.

FIGURE 2-9

ILLUSTRATION OF A SITUATION WHERE A FIRST MOVER AND FOLLOWER
JOCKEY FOR LEADERSHIP

TRANSFORMATION OF THE RESOURCE BASE

For the first mover the transformation strategy strikes at the follower while it is still on the beach or beats it back into the ocean if it already has a substantial beachhead. This strategy requires a transformation on the part of the first mover. The first mover must shift from competing on technol- ogy or product know-how to competing on price and manufacturing know-how. The first mover also must match any incremental product im­provements made by the follower. The primary questions at this point are how much it will cost to become a low-cost producer and whether there will be enough cash to fund future product R&D efforts.

This means the first mover has to find ways to become better at mass production and incremental product improvements. This requires a funda­mental transformation of the first mover’s culture and skills base, certainly no small undertaking.

Even if successful, the transformation strategy places the first mover in a war of attrition, a perfectly competitive environment. At the same time that it is improving its product and processes, the imitator is doing the same thing and is probably better at it. The follower is experienced at price competition and the incremental development of product improvements. With many similar products the market becomes increasingly price com­petitive. Competition focuses more on the price-quality arena and often evolves into a price war. The first mover is virtually indistinguishable from the followers (and vice versa), and price becomes the primary interest of consumers.

Compaq, fighting for its survival, transformed itself from a premium-priced innovator to a low-cost manufacturer. Compaq had built its reputation and market share by rolling out an IBM-compatible portable computer before IBM in 1982.²⁶ Compaq’s engineering focus allowed it to create innovative products offering “better than IBM” PCs at premium prices. But the entry of low-cost, mail-order companies such as Dell and AST drove prices down at the same time that customers were becoming increasingly sophisticated in their computer purchases. Facing intense price competition, Compaq posted its first quarterly loss in the fall of 1991.²⁷ According to Business Week, Compaq’s board ousted cofounder and CEO Rod Canion in 1991, and newly appointed CEO Eckhard Pfeiffer set about transforming the com­pany to a low-cost clone maker.²⁸ He cut costs and slashed prices, making Compaq competitive with Dell and others, moved into new retail distribution channels, and drastically reduced cycle times for rolling out new products. In 1992 Compaq rolled out forty-five new models. Business Week reported that Compaq’s ProLinea 386SX computer, for example, was less than half the price of a comparable DeskPro, its old model.²⁹ From 1991 to 1992, Compaq’s share of the U.S. PC market shot up from 3.5 percent to 5.1 per­cent, according to Fortune³⁰

There are many risks to this strategy. Even though Compaq’s sales in third-quarter 1992 increased by 50 percent, lower prices cut into its mar­gins, according to Fortune ³¹ Meanwhile, Fortune reported that Dell and AST cut their prices in response to Compaq’s move, and even large competitors, including IBM, eyeing Compaq’s success, are moving aggressively into the low end of the market, further heating up price wars. Although Compaq con­tinues to differentiate itself on innovation, its transformation cuts into its re­sources and reputation for creating technological innovations. As Forbes asked in May 1992, “What is Compaq Computer Corp.? A clonemaker that sells on price or a market leader that sells on technological prowess? It’s somewhere in between, and that’s a dangerous place to be right now.”³²

Because of the competitive risks and organizational challenges posed by the transformation strategy, many first movers opt instead for leapfrogging strategies, choosing to switch rather than fight. Transformation is a retreat to fighting in the price-quality arena and may require deep pockets of the kind discussed in Chapter 4 on the deep-pockets arena.

LEAPFROGGING STRATEGIES: THE CREATION OF A NEW RESOURCE BASE

When markets become too crowded, the innovator often heads on to the next untapped frontier. But this strategy, as we will see, has its own danger:

Each leap is longer and requires greater expenditures to build new re­sources appropriate to the new market. Observation of leapfroggers indi­cates that each leap becomes more costly and more risky than the one before, until finally one giant mistake puts an end to the firm or the cost becomes too great and the firm runs out of cash.

Sony is a leapfrogger. Early on, it built tape recorders and used the know­how and resources from that project to fuel its development and production of transistor radios. It brought out a pocket-sized transistor radio at a time when most radios were the size of a briefcase. Then Sony built on that suc­cess with the development of the Trinitron television in the late 1960s, and the superiority of the product made it a leader in that market. But many new entrants in the television market tended to force Sony into the very large and very small ends of the market. Sony then moved on to a new technology, creating the first consumer videocassette recorder in the world. Although Sony scientists believed their Beta system was technologically superior to the VHS format, Sony lost out in the marketing war to establish the standard for the industry. As the market was flooded with recorders and videotapes, Sony moved on to a new market—small, portable, personal listening de­vices, the first of which was the Walkman. Again, Sony used and extended its skills in miniaturization and audio technology to develop this next innova­tion.

As illustrated in Figure 2-10, with each innovation the company gained profits quickly while it controlled the market. When the profits from one product declined because of followers, Sony moved on to a new product, generating a new upward curve in profits. For each product Sony battles the problem of Matsushita and others entering as fast followers. Then, typically, later followers such as the Korean manufacturers enter with even lower costs.

The problem with a leapfrogging strategy is that each leap often takes more resources than the one before. First movers often pick the easy tar­gets first. Thus, each subsequent jump is often steeper in its costs. Follow­ers move in more quickly because they have gained skill at following and competing from previous attempts at imitating the first mover’s product, contracting the cycle times from trough to trough more and more (as shown in Figure 2-10).³³ This limits the amount of time that the first mover has to recoup its R&D investment. As shown in Figure 2-10, the complexity of each successive innovation makes pushing the envelope more risky. In Sony’s case, profits fluctuated to higher peaks and lower valleys with each new product, and the time from valley to valley got shorter. As more competitors entered the market, the fierceness of price competition intensified, further eroding profits. Thus, the risks to the company escalate with each new product. Eventually the leapfrog re-sponse becomes unsustainable when new projects consume more funds than the company can raise, especially if profits can’t be made due to fast imitation. Eventually the first mover is forced to “bet the company” on its latest project, or its leapfrogging hits a brick wall.

FIGURE 2-10

SHORTER CYCLES AND HIGHER AMPLITUDES ASSOCIATED
WITH INNOVATIONS AT SONY CORPORATION

The risks of such a strategy at this point are staggering. Gordon Moore, cofounder of Intel, says his business “lived on the brink of disaster” as it moved from innovation to innovation in microchip technology, one step ahead of the competition. Moore said, “As soon as you could make a de­vice with high yield, you calculated that you could decrease costs by trying to make something four times as complex, which brought your yield down again.”³⁴ As each new microchip was developed, Intel had to take it quickly into production, forcing it to build both strong R&D and strong flexible production skills.

These risks increase as competitors have become more aggressive and faster. Intel’s highly successful innovations in chip design have been in­creasingly pressured by fast and innovative followers such as Cyrix and by aggressive attempts by rivals making RISC-based chips to unseat Intel as the PC industry standard. At first, Cyrix introduced a clone of Intel’s 486
chip in eighteen months, compared to a standard three- or four-year de­sign cycle in the industry. The “workalike” chip is based on a different design but made to offer the same results. Cyrix was also able to produce its 486 for only 4 percent of Intel’s initial investment After the success of the 486 and the accumulation of knowledge from that effort, the company announced plans to leverage its fast-follower skills and know-how to be­come a first mover. It announced plans to beat Intel to market for the next generation chip, the Pentium.³⁵ The key questions are, Will Cyrix catch up to or pass Intel? and Will Intel’s success lead it to be just complacent enough to underestimate Cyrix’s aggressiveness? The dynamics of the stra­tegic interaction between first movers and followers often reverse them­selves when one player becomes complacent and the other is hungry for a win.

At the same time that Intel is under attack by rivals such as Cyrix on innovation in its existing family of chips, it also faces increasing pressure from competitors who threaten to leapfrog past it by establishing a new standard for microprocessors. Several companies that have developed fast RISC (reduced instruction set computing) chips are fighting to depose Intel’s CISC (complex instruction set computing), which has been the standard since the advent of personal computers. Makers of RISC-based chips face significant obstacles in their battle with dominant Intel, includ­ing the reluctance of software writers to support the technology and the challenge of convincing PC makers and users to adopt a different technol­ogy.³⁶ But many powerful industry players have joined the RISC fight, and other less radical technological assaults on Intel have become increasingly aggressive in 1993. For example, an alliance among Apple, IBM, and Motorola introduced the PowerPC chip in 1993 with a direct attack on Intel’s new Pentium chip before the Pentium was even available. An ad announcing the PowerPC chips in the Wall Street Journal crows, “It has the power to blow away Pentium.”³⁷ The key questions are, Can Intel continue to move fast enough in developing new technology to match or exceed the performance of competing technologies? Can it maintain the X86 family as the industry standard? Should it be moving into RISC chips on its own, even at the sacrifice of its existing position in the market? Former follow­ers are now trying to seize the initiative and the market innovator could just lose the gains it has made as the first mover and standard setter of the industry.

Transformation and leapfrogging strategies are not mutually exclusive, but the managerial energy put into one detracts from what a company can put into the other. For example, if the first mover chooses the transforma­tion strategy, it will have to divert resources from product R&D into im­proving production and distribution systems. But at the same time, the product R&D costs are amplifying tremendously if the first mover wants to pursue future leapfrog efforts.

This pattern is most pronounced in high-tech markets such as semicon­ductors and audio-video equipment, but similar patterns of resource and know-how escalation are seen in other markets. Even a decidedly low-tech industry such as fast food can ^uhit the wall” with some new innovations. As McDonald’s leapfrogged its competitors by reconceptualizing itself as not just a burger restaurant, it considered selling shrimp but realized that its demand would outstrip the entire world’s shrimp catch. Moreover, at some point McDonald’s will be considering new menu items that have only limited consumer demand. So even if funds are not the constraining resource, other constraints may interfere with significant leapfrog activi­ties.

In sum, the leapfrog strategy can’t be used forever, and the transforma­tion strategy leads to more price competitive markets. Leapfrogging forces the imitator to replicate the first mover’s new resource base, and transfor­mation requires the first mover to replicate the follower’s manufacturing resource base. Thus, once each resource base is replicated, neither player has an advantage in the long run. Both of these strategies, as we have seen, push the limits of the firm’s resources and know-how, leaving the firm fighting a bloody price war on a crowded field akin to perfect competition. One escape from this endless cycle of price wars without competitive ad­vantage is to expand downstream, leading US to the next countermove.

5. The Sixth Dynamic Strategic Interaction: Downstream Vertical Integration

If leapfrogs and transformation become too expensive or difficult for the first mover to implement, the first mover sometimes moves downstream to offer higher value to the customer and more product variety. An alumi­num company, for example, might offer sheet metal and ducts, fabricated parts for equipment, and aluminum construction materials to the same customers. This gives it an advantage over companies that offer only alu­minum. It might also offer aluminum pots and foil to a completely differ­ent market, consumers. Faced with strong price competition and increas­ingly skilled followers, such as Matsushita, in the consumer electronics market, Sony entered the software side of the entertainment business with the purchase of a motion picture giant, Columbia Pictures. We also see this vertical integration with IBM’s move from being a hardware company to being a company where software is as important as hardware. And we see this move in Intel’s transition from being a semiconductor maker to entering downstream markets with chips that are essentially a full com­puter market (combining processing and storage capabilities on one chip) to escape the chip imitators. All of these moves help the first mover to differentiate its now undifferentiated product and to expand its resource base into arenas where its imitators are not present.

Thus, forward vertical integration is similar to the strategy of leapfrog­ging on technology in that it develops new resources and know-how to offer new products or services. And like the leapfrogging strategy, it leads to a new cycle of competition as imitators duplicate these new resources. The typical counterresponse to this move is for the competitor to acquire or build similar downstream operations. We can see this one-upmanship with Matsushita’s purchase of MCA in response to Sony’s earlier acquisi­tion of an entertainment firm. It is not clear whether either of these firms can manage such a subsidiary, given their unique cultures and competen­cies. But, as we can see from this example, even downstream services may be imitable by acquisition. If the acquisitions are managed well, relatively undifferentiated products result, and the firms offer a similar variety of products, making price the only means of competition again.

One problem with both the transformation and downstream vertical integration strategies is that they tie up resources that could be fruitfully committed to building the company’s core business. For example, the move by Sony and Matsushita moves them away from their electronics competencies (movies are not required to build VCRs). These strategies should be used only if there are resources left after doing what is needed in the core business. Sometimes opportunities in the core business are so nar­row because of competition that the company has no choice but to look elsewhere for profits. But it is a common error of many vertical integration moves to divert funds that could be productively invested in building the core business.

Source: D’aveni Richard A. (1994), Hypercompetition, Free Press.