Microsoft in 2004

1. Microsoft in 2004 Take Aways

2. 40 30 ROI% 20 10 0 1 2 3 4 5 6 7 8 9 10 Year A common finding in empirical analyses is that consistent out-performance is the exception rather than the rule ROI in Year 0 39% 3% Bottom Half Top Half Source: Pankaj Ghemawat, Commitment (New York: The Free Press, 1991)

3. Willingness to Pay Price Opportunity Cost Division of value between buyers and sellers Value Capturedby Buyer Added Value Value Capturedby Seller

4. Competitive advantage is achieved through increasing overall value added (and capturing more value than competitors) Willingness to Pay Value Capturedby Buyer Price Added Value Value Capturedby Seller* Opportunity Cost *Also known as value appropriated

5. Customers Competitors Company Complementors Suppliers Link between the Value Net and Added Value Players that increasecustomers’ WTP or reducesuppliers opportunity costs Players that reduce customers’ WTP or increasesuppliers opportunity costs Source: Brandenburger and Nalebuff, Co-opetition (New York: Doubleday, 1985), p.17.

6. Link between the Value Net and Added Value Customer’s Willingness to Pay Price to customer Company’s WTP for Supply Added Value Appropriated Value Price to supplier Company’s Opportunity Costfor Production Supplier’s Opportunity Cost

7. Added Value Appropriated Value Four types of threats to the sustainability of competitive advantage Substitution Imitation • Barnes & Noble v Amazon • Netscape vs. Microsoft (The Browser) • Sun vs. Microsoft(Platform-independent SW) • Linux vs. Microsoft(Open source SW) • Wal-Mart, K-mart & Target • Nutrasweet vs HSC • BSB vs. Sky • Oakland A’s • Unions at Wal-Mart • Players in MLB • Gov’t, competitors in Microsoft (may depend onyour view on the legalityof MS’s competitive tactics) • Talent at Microsoft Hold-up Slack Source: Ghemawat, 1999

8. Imitation • Imitation increases the “supply” of what a firm uniquely provides • Profits draw a crowd • Imitation is pervasive and can be deadly • Intel in DRAMs • Apple in user-friendly PCs • Netscape in browsers • Ben & Jerry’s in super-premium ice cream • Bridal registries on the Internet • But imitation can be deterred • Continental Lite vs. Southwest Airlines • Progressive’s high service offering Source: Ghemawat, 1999

9. Barriers to imitation • Scale or Scope Economies • Experience/Learning (Tacit Knowledge) • Relationships • Reputation • Retaliation • Response Lags • Upgrading/Investments • Fit Source: Ghemawat, 1999

10. Substitution • Substitution reduces the “demand” for what a firm uniquely provides by shifting the demand elsewhere • The better mousetrap • Due to changes in technology, customer needs, input prices, etc. • Substitution threats can be subtle and unexpected • Videoconferencing vs. air travel • Conventional contact lenses vs. disposables • For this reason, substitution is an especially effective way to attack dominant players Source: Ghemawat, 1999

11. Before: Scan the landscape broadly for threats Understand underlying customer needs But be prepared to ignore the needs of current customers After: Your Options Fight the threat Incorporate their benefits (e.g., orange juice supplemented with calcium) Incorporate their cost reductions ( Face up to your loss of added value, and reduce price before the substitute gets a foothold If you can’t beat them, join them Take the money and run Responses to substitution threats Source: Ghemawat, 1999

12. Hold-up • Hold-up diverts value to customers, suppliers, or complementors who have some bargaining leverage • They have bargaining leverage because they have something you need and can’t get elsewhere (added value) • Ex: Who makes all the profits from PCs? • Hold-up is especially threatening when parties in a relationship have invested in assets that are specific to that relationship (so it’s hard to walk away) • An electric plant built at the mouth of a coal mine • A railroad spur laid to a particular factory • Skills that are tailored to a particular employer Source: Ghemawat, 1999

13. 40% 30% Operating Margin 20% 10% software other components personal computers peripherals services microprocessors Share of Industry Revenue Hold-up in the PC industry Source: Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh Look at Strategy,” Harvard Business Review, May-June 1998, p.145

14. Responses to hold-up • Multiple sourcing • But investments in relationship-specific assets are important • Tough negotiation • Contractual arrangements • But contractual incompleteness limits this option • Vertical integration • Don’t base your competitive advantage on specific assets you can’t own (like a particular individual) Source: Ghemawat, 1999

15. Slack • Slack, or waste within the firm, dissipates value • Slack is hard to identify... • Plush carpets for their own sake are slack • But plush carpets to win customers and recruit talent might be wise investments • …but slack is thought to be large • 10-40% of revenues, typically!?! • Slack tends to be worst under certain conditions • Forgiving competitive environments • Settings in which managers must have wide discretion over productive processes Source: Ghemawat, 1999

16. Slack: the theory of free cash flow • Principal-agent problems between managers and stakeholders • Managers have incentives to grow the resources under their control • Free cash flow enhances managers’ ability to • Invest resources in negative-return activities • Waste resources Source: Ghemawat, 1999

17. Responses to slack • Monitoring of performance • Benchmarking • Time-motion studies • Outsiders on Boards • Managerial incentives • On average, top executives get roughly $3.25 for each $1,000 of shareholder value created (Jensen and Murphy) • Commitments to return cash to shareholders • e.g., dividends • Appeals to a higher calling, a sense of mission Source: Ghemawat, 1999

18. Responses to slack • Gathering information • Monitoring behavior • Offering performance incentives • Shaping norms • Bonding resources • Changing governance • Mobilizing for change Source: Ghemawat, 1999

19. Building sustainable advantages • Understand your own uniqueness • Scan the environment for • Technological changes • Variations in input supply • Demand shifts • Invest in opportunities that fit Source: Ghemawat, 1999

20. Conclusions • The best defense is a good offense, i.e., defend your advantage by continually upgrading it • Seek out ways to increase willingness to pay without incurring commensurate supplier opportunity costs • Seek out ways to reduce supplier opportunity costs without sacrificing commensurate willingness to pay • Make yourself a moving target • Remember that the landscape can shift under your feet Source: Ghemawat, 1999