ANALYSING VALUE-ADDING STRATEGIES FOR GAINING AND SUSTAINING COMPETITIVE ADVANTAGE IN ELECTRONIC COMMERCE.

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1 ANALYSING VALUE-ADDING STRATEGIES FOR GAINING AND SUSTAINING COMPETITIVE Colin Combe Caledonian Business School Glasgow Caledonian University, Cowcaddens Road, Glasgow, Scotland G4 OBA ABSTRACT The emergence of electronic commerce as a means of transacting business has led many firms to develop business models to take advantage of the opportunities that Internet technology presents. However, few firms have been able to achieve profitability let alone sustain a competitive advantage. The e-commerce business environment is subject to rapid change and is governed by principles very different from traditional markets. Firms need to better understand the e- commerce competitive environment and develop strategies that create value and provide a means to profitability. This article critically assesses the value adding strategies available to firms and offers an assessment for gaining and sustaining competitive advantage through electronic commerce. KEYWORDS Strategies, value-adding, Internet, competitive, business, e-commerce. 1. INTRODUCTION Since the mid 1990 s there has been a huge increase in the amount of business transacted over the Internet. Although the USA leads the way in this area the use of the Internet in business has become a global phenomenon. E-commerce has the potential for creating wealth and changing the business landscape. To exploit the opportunities presented by the application of technology it is necessary to create business models suited to gaining and sustaining competitive advantage in the new business environment. However, to date, no dominant business model has emerged in this new fast-paced, knowledge-intensive and technology-based competitive environment. Electronic commerce refers to trading electronically. Transactions involve buying and selling products, services and information over a network (Turban et.al., 2000). E- commerce is changing the way businesses operate and is creating opportunities for developing new markets and products. One of the most important characteristics of the Internet is the ubiquity of information and the ease of access to that information. It is, therefore, little surprise that information driven industries have been at the forefront of developing and exploiting the advantages of e-commerce. E-commerce provides a mechanism for creating new wealth through entrepreneurship and innovative business ventures. In many industries this new method of transacting business has altered the competitive environment. This phenomenon has attracted the attention of scholars in economics and strategic management. Indeed, there is a strong link between the two streams of academic research in analysing e- commerce. However, the available literature on the theme of evaluating online business models using economic and strategic management theory remains relatively sparse. Despite receiving significant attention from both the academic and non-academic press, the literature to date has failed to fully articulate the key issues relating to this phenomenon. This paper attempts to fill the gap by using theory to link the unique features of virtual markets with an analytical framework for evaluating 30

2 ANALYSING VALUE-ADDING STRATEGIES FOR GAINING AND SUSTAINING COMPETITIVE business models designed for creating and sustaining competitive advantage. In particular the five forces model of Porter (1980) is used to link value adding e-commerce strategies for gaining competitive advantage with the competitive environment The discipline of economics (Rumelt, 1984) is called on to assess the potential for sustaining competitive advantage in the e-commerce arena. Of particular interest to this article is how the Internet alters the way firms seek to create value and effect a competitive advantage. Porter (1985) emphasised the concept of the physical value chain of the firm. That is, the value chain is where the most strategically important activities are to be found. In developing his value chain framework Porter (1985) focuses the analysis on manufacturing firms where there is a physical flow of material. However, in the digital age, more and more firms are conducting business electronically. This alters the way in which the value chain framework operates. Whereas, in a physical value chain, information acts as a support mechanism, in the virtual value chain information takes on a strategic function. For example, book publishing and bookselling are information intensive activities, both in terms of content and logistics. Though the physical value chain remains, added value is derived from the virtual value chain activities. Online booksellers such as Amazon.com seek to gain competitive advantage by combining both physical and virtual value chain activities. Amazon.com built warehouses in order to increase the speed and reliability of the delivery of products ordered online. This physical value adding activity is combined with the virtual value chain where gathering, organising, selecting, synthesizing and distributing information are the key activities (Rayport and Sviokla, 1995). Porter defines value as the amount buyers are willing to pay for what a firm provides them. Value is measured by total revenue. A firm is profitable if the value it commands exceeds the costs involved in creating the product (Porter, 1985). A generic strategy of differentiation can add value and create competitive advantage. Alternatively, a firm may focus on cost leadership as a means of creating competitive advantage. According to Porter (1980 and 1985) and Porter and Millar (1985), firms seek competitive advantage by responding to five key forces. These forces include the threat of entry; the extent of rivalry among incumbent firms in the industry; the threat of substitute products or services; the bargaining power of suppliers and the bargaining power of buyers. Effective analysis of these forces can help firms pinpoint where weaknesses exist in the five forces and inform strategists where market opportunities exist for creating competitive advantage. Thus, a cost leadership strategy may involve a low cost producing firm selling products or services not vulnerable to the threat of substitutes to powerful buyers. The firm exploits its low cost position and protects against competitive forces. 2. THE EFFECT OF THE INTERNET ON THE COMPETITIVE ENVIRONMENT One of the key characteristics of e-commerce is the ease of entry for firms. The cost of entry and exit is low relative to traditional industries, as firms do not require large sales teams, costly investment in infrastructure or high sunk costs in order to compete effectively. Increasing connectivity among potential customers ensures increasing competition among e-commerce firms as more are attracted to the source of potential revenue. Importantly, the Internet does away with geographical boundaries thereby increasing yet further the extent of comp etitive rivalry. The nature of competition is altered by the use of the Internet. Both cost structures and the types of products and services offered to customers differ from traditional industries. Reductions in cost can be achieved through smoothing the transactions between customers and suppliers, there are opportunities for customizing products to specific needs and building communities of buyers. The communications between interested parties is ratcheted up and may bring network externalities where the benefits accrued by increasing information on the Website are not reflected in the cost of usage or the price of products. The relationship between buyers and suppliers changes because of the Internet where switching costs play a crucial role in determining the balance of power. Also, the reduction in transaction costs of searching for products or services makes comparisons of prices easier for customers and intensifies price competition among firms (Bakos, 1998). The bargaining power lies with the customer. However, firms may offset this by using reductions in the administration of multiple prices for a range of products and services by engaging in price discrimination. Porter (2001) recognised that the Internet creates new substitution threats by enabling 31

3 International Conference WWW/Internet 2003 new approaches to meeting customer needs and performing business functions. These include facilities for promotion, integration of supply chain activities, distribution and delivery systems. 3. E-COMMERCE STRATEGIES FOR GAINING COMPETITIVE ADVANTAGE As noted earlier the Internet is characterized by the ubiquity of information available. This abundance poses theoretical challenges for traditional economic theory where scarcity forms the critical underpinnings. Easy access to the huge array of information facilitates consumers comparisons of prices and availability of products and services. This contrasts with traditional markets where consumers are reliant on firms to provide them with such information. This service is added to the price charged. In e-commerce firms need to compete effectively by offering lower prices because of the absence of significant search costs. This affects industry profitability and the level of competition. Firms need to adopt a range of strategies to counteract the shift in power to consumers. Differentiation, expanding the product range and price discrimination are some options that firms may pursue to create competitive advantage. 3.1 Differentiation Value can be created by differentiation across each stage of the value chain. This is achieved by undertaking activities that lower buyers costs or raise buyers performance. Firms have to make policy choices regarding what activities to perform and how they are to perform them in order to implement a differentiation strategy. The must also effect linkages within the value chain or with suppliers and distribution channels. Other factors may also drive product differentiation such as timing, location, the sharing of activities among business units, learning, integration, scale and institutional factors (Porter, 1985). Firms can also differentiate through mass customisation strategies. Existing products can be customised in innovative ways such as providing CD s with a compilation of selected music or providing a service related to customers specific interests. For example, Amazon.com allow readers to read short extracts from books before they make a purchasing decision. Customer relationship management provides information about customers that forms the basis of differentiating the service according to each of their customers tastes. The innovation associated with developing small niche markets according to specific customer needs means firms can charge higher prices (Sinha, 2000) and create a competitive advantage. The threat of substitute products is diminished, as is the level of competition among incumbent firms in the industry. Also, established firms can develop customer relationship management to differentiate the service or product and create brand loyalty or lock-in of customers. This reduces the threat of entry. 3.2 Expanding Product Lines Porter (1987) notes that firms can achieve competitive advantage by expanding into related product lines and exploiting the transfer of skills or the benefits of sharing of activities such as promotion or distribution. Sharing can lead to economies of scale, cost reduction and the maximum utilisation of the firm s resources. Crucially, the ability to achieve competitive advantage is determined by how well firms combine activities as a basis for increasing differentiation. Porter (1996) argues that the fit among activities reduces costs and increases differentiation. Amazon.com have actively pursued a strategy of extending their service provision beyond online bookselling to offer information on healthcare products, gardening tools, toys and a host of other products. This expansion has been possible because of the integration of activities within the firm such as information management, customer relationship management and development and utilization of superior technical knowledge. 32

4 ANALYSING VALUE-ADDING STRATEGIES FOR GAINING AND SUSTAINING COMPETITIVE 3.3 Price Discrimination There are many Websites that allow customers to compare prices, products and services. This can lower prices, increase competition and erode profits. Firms can counteract the shift in power to the customer by introducing price discrimination that makes comparisons more difficult (Bakos, 1998). There are numerous forms of price discrimination that firms can employ. In some instances firms only allow access to pricing information on receipt of specified information from customers such as zip codes or personal profile information. Others include charging different prices according to subscriber usage rates (price lining) or smart pricing where the charge relates to market conditions or diffe rences in how customers value the product. Some firms, such as AOL/Time Warner, bundle products to promote the benefits of a whole package (Shin, 2001). This prevents customers comparing prices of individual products. AOL/Time Warner use the convergence of technology to strengthen their bundling strategy by offering interactive services on television, music on computer and on mobile phones alongside their existing services. The rationale behind the strategy is that it is less expensive to sell an additional service to an existing customer than it is to attract a new customer (Schiesel, 2001). Product bundling is a form of price discrimination because it disallows the choice of buying single items. Customers are faced with the choice of buying a group of products to access the one they really want or not buy at all. There are some markets where price discrimination is not viable. Products in commodity markets are largely identical and customers can easily compare prices of competitors. Where price discrimination is not feasible firms will have to reduce cost to remain competitive. Where the marginal cost of production determines the lowest price, firms need to reduce production costs to remain competitive. In such markets cost leadership may determine competitive advantage. 4. SUSTAINING COMPETITIVE ADVANTAGE IN E-COMMERCE The frictionless world of e-commerce is designed to edge competitive environments closer to that of perfect competition. However, it can be seen that this presents as much of a threat to sustaining competitive advantage as it does opportunities for entry and cost reduction (Besanko, Dranove and Shanley, 2000). Indeed, opportunities for achieving profitability in such an environment quickly disappear as new entrants are attracted and upward pressure is asserted on supply and prices fall. One industry that comes remarkably close to this model is that of online bookselling where Amazon.com are the industry standard-bearers. Amazon.com had first mover advantages in terms of building market share and brand image. Although firms in the industry supply information on many genres of books the service provided is largely homogeneous based around product characteristics, price and delivery information. The firms face similar technologies and input costs. Eventually, as more and more firms enter the market each becomes a price taker. Competitive advantage built around differentiating brand and design is dissipated by the ease of entry and imitation by rivals. Thus, as Amazon.com have discovered, a hybrid strategy of cost leadership and differentiation to achieve competitive advantage is unsustainable. The above scenario can be illustrated using economic theory enunciated by Rumelt (1974). Figure 1 illustrates efficiency frontiers in a perfectly competitive market. The diagram represents a market in which consumers benefits are based on a single attribute of quality (Q). The model assumes consumers have identical price/quality preferences. These are shown by the upward sloping indifference curves. The efficiency frontier represents the most efficient cost/quality positions that are possible for firms in the market. That is, no firm can extend efficiency beyond the frontier. In a market, such as online bookselling, entry is free and imitation incurs negligible costs. This allows any firm (incumbents or potential entrants) to attain any position along the efficiency frontier. Higher quality at lower cost becomes unattainable for individual firms in the market due to the ease of imitation of the business model that brought it about. In Figure 1 price/quality preferences P1Q1 would not be sustainable because ease of entry would allow a new firm to offer higher quality (Q2) and lower price P2 and gain market share from incumbents. Opportunities for creating competitive advantage through price, cost or quality combinations end at point PX=CX/QX where the market is in equilibrium. By implication this models adds emphasis to the importance of lock-in for customers whereby the switching costs are significant enough to maintain brand loyalty. 33

5 International Conference WWW/Internet 2003 Unit cost, price P1 P2 EfficiencyFrontier I1 PX =CX I2 I3 Q1 Q2 QX Quality(Q) Figure 1. Efficiency Frontiers in a Perfectly Competitive Market 5. FIRST MOVER ADVANTAGES First mover advantages are significant in creating competitive advantage as they enable firms to amass a huge market value. A crucial first mover advantage is the development of network externalities. Timmers (1999) describes these as external benefits or costs of the presence of products in the market that are not reflected in the market price (as opposed to network effects which are reflected in price). There is no compensation through price and must, therefore, be viewed as market inefficiencies (Choi, Stahl and Whinston, 1997). The Internet is an ideal medium for creating increasing benefits for increasing numbers of customers joining the network. As customers are not charged for these benefits so they are termed network externalities. Many e-commerce firms have developed business models around the concept of creating virtual communities, Internet auctions, value chain integrators and a host of other applications. The more the community grows the greater the attraction of joining because information service continues to rise but the cost to users is static. First mover advantages help to develop a large customer base that later entrants have to overcome in order to compete effectively. Branding and building customer loyalty are other important first mover related advantages. Building a reputation based on service is vital for effecting customer loyalty. This is especially cogent to information driven e-commerce firms since their product is essentially an experience good that is, the quality is unknown until used. Key to competitive advantage is building a strategy around brand recognition and superior service such that customers are reluctant to switch to rivals even if the cost of doing so is zero. Indeed, the issue of switching costs are themselves a source of first mover advantage. New entrants have to contend with the knowledge that customers are already familiar with the modus operandi of the first mover s website. However, in many cases, including online book buying, there are many more potential customers than actual ones and, therefore, the competitive advantage is likely to be diluted as new entrants vigorously pursue old and new customers alike. Again, this makes competitive advantage unsustainable by first mover advantages 34

6 ANALYSING VALUE-ADDING STRATEGIES FOR GAINING AND SUSTAINING COMPETITIVE alone. Sustained competitive advantage must combine attributes such as first mover advantages, differentiation, value adding criteria and a robust business model. 6. THE EFFECT OF IMITATION ON PERFORMANCE High profile e-commerce firms such as e-bay and Amazon experienced exponential growth in sales and stock value through exploiting first mover advantages and monopoly status between 1995 and However, their business models attracted imitators. Even though most goods continue to be sold through traditional retail methods the potential of the online market is sufficient to attract traditional bricks and mortar firms. Many of the business models and website designs of new entrants closely resemble those developed by established incumbents. In response incumbent firms can vertically differentiate to create competitive advantage. Amazon created a differentiated product based on service, design and brand image. However, as new entrants arrive price competition ensues. The market illustrated in Figure1 has it that all consumers have the same preferences. A firm offering a price/quality trade-off inferior to competitors would be unable to compete. Nevertheless, as the market heads towards one of monopolistic competition sellers differentiate horizontally in distinct market segments. This allows prices to be raised without a fatal fall in demand. For a firm facing a downward sloping demand curve the optimal price is above marginal cost. This though does not guarantee profitability as total costs may not be covered. The industry structure will be determined by how long incumbent firms make profits that attract new entrants. Each successive new entrant chips away at industry profitability until it is no longer attractive. 7. CONCLUSIONS E-commerce has radically altered the way many firms conduct business. It has presented a number of opportunities for developing business models and strategies to achieve competitive advantage in a wide range of business sectors. However, few firms have attained profitability let alone sustained competitive advantage. This paper has identified some reasons behind the disappointments associated with e-commerce and includes high price competition, low transaction and switching costs that increase the power of customers, low entry barriers and the high investment of expanding the range of products and services. However, one fundamental aspect of analysing e-commerce has emerged to account for the lack of success among firms engaged in e- commerce. There is a distinct lack of a dominant business model around which firms can identify strategies most likely to achieve competitive advantage. The pace of change in the competitive environment requires firms to operate under very different principles and rules. Many firms have been unable to transform their businesses to the demands of online markets where traditional methods no longer apply. It has become necessary for strategists to redefine their competitive advantage across a host of criteria including differentiation, costs and products. To gain and sustain competitive advantage into the future traditional firms engaged in e-commerce need to develop unique strategies to integrate their traditional and online business (Gulati and Garino, 2000). Allied to this is a need to understand the impact of e-commerce on the competitive forces affecting their industry. REFERENCES Bakos, Y. August The Emerging Role of Electronic Marketplaces on the Internet, Communications of the ACM, 41 (8), pp Besanko, D, Dranove, D and Shanley, M.., 2000,. Economics of Strategy (Second edition), Wiley, Chichester. Choi, S.Y., Stahl, D.O. and Whinston, A.B., The Economics of Electronic Commerce, Macmillan Technical Publishing, Indianapolis. Gulati, R and Garino, J. May -June, Get the Right Mix of Bricks and Clicks, Harvard Business Review. Porter, M.E., 1980,.Competitive Strategy, Free Press, New York. 35

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