Strategy Dynamics Briefing 50: Type-1 rivalry – developing potential customers

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The three types of rivalry from Briefing 49 can best be explained with a simplified example…Two new coffee-shops open up and operate in the same town.

The town has 5 000 customers, equally accessible to the two stores; i.e. the stores’ locations are of identical quality. Each customer normally uses a coffee store twice per week, unless value for money raises or lowers their usage. Each customer normally spends an average of $5.00 per visit, including both the coffee and snack foods, unless value for money raises or lowers their spending. The quality of products, service and environment are all good, both in our store and in our rival’s. Customers are won at the highest possible rate and do not leave, provided that value for money is “OK,” i.e. the price matches what they expect. At any lower level of perceived value — i.e. higher price — customers are won more slowly. Customers are lost back to the potential pool increasingly quickly as the price escalates.The price for a typical coffee is $2.95, the corresponding cost of raw materials is $0.90, and an equivalent gross profit margin is made on all products. Any change in the typical price of a coffee applies proportionately to all products. Since the cost of raw materials is fixed, any increase (decrease) in price raises (lowers) the gross profit by the same cash amount. The store’s staff and overheads cost $9000 per week.

Figure 1 shows the first year of each store’s growth, when potential customers are being captured either by our store, or by the competitor. Both stores start by charging the expected price of $2.95 for their typical coffee and capture about 2000 customers after six months. At that point, our competitor raises their typical price to $3.15, and we cut ours to $2.80. From that point in time:

  • We start to win customers more quickly, while the competitor’s win rate drops. They also start to lose customers more quickly than they win them, so their customer base starts to fall.
  • Our customers visit more often (2.2 times per week), and spend more per visit ($5.56), whereas their customers visit less frequently (1.8 times per week), and spend less on each occasion ($4.50).
  • Our sales jump somewhat, with the higher number of customer visits and spend, and then continue to rise. Their sales drop slightly, and start to decline, pushing their profits back down towards zero. Our profits would be still higher, except that we need to take on more staff to handle the greater number of customer visits.

Note: this is not a general rule that raising price loses customers so much as to reduce profits, either in this industry or others! The consequences of such an action depend on the specific responses of customers on each of the issues involved; that is, becoming and remaining customers, purchase frequency, spend per occasion, and so on.

Competing coffee stores capture potential customers in a previously unserved town. Click image to view larger.

Figure 1: Competing coffee stores capture potential customers in a previously unserved town. (click to enlarge)

This illustration raises the rather simple observation that our successful capture of a new customer does not just come at the expense of our rival’s win rate in the same week—it also denies them the possibility of winning that same new customer at any future time. This is a simple illustration of a “first-mover advantage” because our store has preempted strategically valuable resources — in this case customers. This is unlikely to be a sustained advantage, though, due to the ease with which customers may subsequently switch.

Until next time…

 
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Beware elasticity of demandStrategic Management Dynamics book cover

Some businesses try to work out pricing decisions by estimating the “price elasticity of demand” in their market; that is, the fraction by which demand changes for any fractional change in price. In practice, this relationship is complicated by dynamic effects. In figure 1, demand more or less stabilizes after 52 weeks for any given level of price charged by the two stores. If both stores charge higher prices, fewer customers are captured in total, more slowly; they visit less often and spend less on each occasion, resulting in lower overall sales volume.
Price changes, then, do not usually just shift demand to a new rate, they also initiate a movement in demand over future periods. These periods can be quite long. A shock-rise in gasoline prices, for example, immediately makes people drive less, and more carefully, but also changes their choice when they next change their vehicle – which may be some years after the price increased. Demand for gasoline therefore continues to decrease, long after the event.
This briefing summarises material from chapter 7 of Strategic Management Dynamics, pages 430-433.Read more about the book on the strategy Dynamics website
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