Compete or retreat

We live in an age of massive disruption in many industries. Technology is creating new opportunities for growth in financial services, media, retail, and increasingly in medicine, hospitality, and even agriculture. Established firms sometimes feel the pinch of disruptors and try to react to increasing competition. But maybe there is another way to limit the impact disruptors have on established industry leaders.

In a new paper, Orie Schelef and his colleagues looked at the payoffs of different reactions to disruptive entrants. The classic answer to deal with these new entrants is to compete with them or kill them by buying them. I have discussed this kill zone approach in a previous post and it is well known that companies like Facebook and Alphabet successfully used this tactic to reduce competitive pressures on their business. But if an incumbent isn’t willing (or able) to outright buy the competition, the usual approach is to compete using the larger resources the incumbent has to undercut the new entrant.

For example, if a company is operating in the service industry where person-to-person interaction is an important part of the business proposition, a new entrant may be able to capture market share due to its better knowledge of the local market where it is competing or by having better technology in place that enables it to deliver a better service. One possible reaction by incumbents is to move to the same area as the new entrant, thus increasing the local knowledge of the incumbent or more aggressively competing with the new entrant for market share by undercutting its prices and gaining market share despite the new entrant’s better service quality.  

Another common response by incumbents is to invest in R&D, marketing, or sales to “out-invest” the new entrant and grow market share so fast that it becomes difficult for the smaller competitor to grow or survive. That is for example what most banks did in response to the challenge from robo-advisers and other fintech disruptors.

But does it work? Not necessarily as the many failed attempts by banks to compete with disruptors in the fintech space testify.

This is where the paper by Shelef and his colleagues suggests an alternative way to react to disruptive competitors: retreat and adopt a live-and-let-live strategy.

Think of it this way. The more intense competition gets, the lower profit margins become. If an incumbent commits to aggressively compete with a disruptive entrant, it also commits to invest heavily and lower its profit margins due to lower prices for customers for at least some time. If all goes well, the incumbent will survive and be able to increase its profit margin later. But what if things don’t go well? What if it becomes a war of attrition and the increased competition just sucks up tons of money that could be more profitably invested in growth in other areas? If the technological advantage of the new entrant is too large, the most likely outcome is that the incumbent will be able to survive despite having smaller resources. Also, if the disruptive new entrant already has achieved a minimum level of profitability (so-called Ramen profitability) it might be able to survive and grow organically even if an incumbent chooses to compete aggressively.

In these cases, the better strategy for the incumbent would be to retreat, geographically or monetarily. For example, an incumbent may want to exit the home market of a disruptive new entrant and focus its resources on growing its business in neighbouring countries of the incumbent. It’s like retreating from the battlefield to fortify the defensive position nearby. This has two effects. First, the disruptive new entrant will see its growth opportunities increase in its home market, creating higher margins there. But at the same time, it will become more costly for the new entrant to expand internationally because the incumbent (forewarned about the strengths of the new entrant) will be able to make it harder for the new entrant to enter these markets. This simultaneous increase in growth opportunities in the domestic market while reducing opportunities in foreign markets disincentivises the new entrant from growing too much and reduces competitive forces to the benefit of the incumbent and the new entrant. In essence, the new entrant will be allowed to exist as a profitable niche player or regional player while the incumbent captures most of the market with higher profit margins than by trying to capture the whole market at low profit margins.

In the investment arena, the same thing is possible. Instead of investing aggressively in the disruptive new technology and becoming a late adopter, it may be better for the incumbent to reduce costs by exiting the areas where the disruptive technology cannot be replicated in time. The saved costs can then be used for investments in other areas where the incumbent can grow, or it can be used as a financial reserve to focus on the next wave of disruptive technology. It is the leapfrog approach where an incumbent ignores disruptive but transitory technological innovations like hybrid electric cars or mobile phones to invest in the development of fully electric cars or smartphones. Again, both the incumbent and the new entrant are better off by reducing competitive forces, reducing the need for investments with a potentially low rate of return and specialising in their own areas of strength and competitive advantage.