This is the first of four chapters concerned with issues of competitive strategy--how successful firms manage their relationships with competitors, suppliers, and customers in their chosen markets. In this chapter, and the following one, I consider issues of market position and product price. Different types of competitive environment are found in different markets. Some are stable. In these there are implicit rules of the competitive game, understood by all parties. There is, in effect, a relational contract between competitors. In other markets firms have neither desire nor opportunity to establish long-term relationships with competitors and pursue price wars or establish aggressive market positions indifferent to the future effect of current behaviour. I describe these as unstable competitive environments.
The two key influences on market prices are the costs of firms and the value offered to consumers. The less stable the competitive environment, the greater is the degree to which prices will be determined by cost rather than value. In the worst case, prices can be driven down to marginal or incremental cost. Marginal and incremental costs are often thought to be very low, but I explain how this is often a mistaken view and describe how activity-based costing helps to bridge the gap between theoretical concepts of marginal cost and accounting systems of cost allocation.
In other market environments there is more opportunity for prices to reflect the value of products to customers. In these, market segmentation-- the identification of as many distinct product and geographical markets as possible--is a principal means of securing as high a proportion as possible of the value offered to consumers as added value for the firm. There are two necessary conditions for effective market segmentation. There must be economically relevant differences between the separated markets. These may arise from differences in the incomes of customers, or in the ways they use the product, or in competitive structure. And there must also be effective barriers to arbitrage at both wholesale and retail level.