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The Escalation Trap

The author defines escalation as a form of competition that consists of constant one-upmanship, as each firm attempts to capture customers by offering more benefits at the same or lower price than its rivals.

Danger signs of escalation are listed:

Escalation is a winning game for the customers, who get more and more for their money, but an unsustainable race for firms that have to take on the expense of providing more (and greater cost) for the same price.

Case Study: Artificial Sweeteners

The author looks to the market for artificial sweeteners as an escalation race. Initially, it was a simple product regarded as a sugar substitute, both in manufactured goods and consumer use.

In addition to making the core product better (sweeter and with less aftertaste), manufacturers began adding secondary benefits such as nutrition and flexibility of use, different heat stabilities, longer shelf lives, and the like.

Saccharin dominated the market until 1981, when it was pulled for safety reasons (that were later discovered to be false), then came aspartame, then sucralose, and a host of others.

The problem for manufacturers is that newer forms of artificial sweetener are more expensive to manufacture, but were priced in the same range as older forms to be competitive - which resulted in customer expectation that they would remain the same price.

(EN: This is where the notion of escalation becomes a bit hazy, though I suppose it sill applies. While it's difficult to conceive of a product quality such as "tastes sweeter" as an added feature, the nature of competition is the same: to make a better product at the same price.)

Case Study: Primo

The author discusses the work of Primo, a company that provides "high-tech material used in components" (EN: I did a search to gather more information, and came up empty - I think that this is the "Puerto Rico Industrial Manufacturing Operations Corporation", but couldn't find details to augment the author's vague description.)

As a manufacturing supplier, Primo served cost-conscious customers: a factory that is attempting to contain its own costs and will seek out the lowest-cost supplier of materials, and as such considered price to sensitive, but were still conscious of quality - as the consequences of buying cheap equipment is a perennial topic of importance in every manufacturing management textbook.

The firm offered a differentiated product like that included premium-priced products compared to its major rivals. Competition on quality involved things such as fewer defects, materials of multiple sizes, durability, and the like. And because manufacturers of a given good had similar operations, the products and features became standardized and the competition was on making the materials more suitable for specific uses.

The combination of the two resulted in escalation: customers expected to pay a standard price for materials that were tailored to their idiosyncratic needs.

For a time, Primo assumed it occupied the lead - it dominated the high end of the product lines, which was the most profitable segment, and its competitors were struggling to match its quality at the same price. What it didn't seem to realize was how quickly the customers might catch up and over take them.

Per the author's analysis, it would be about two years, which spun up the company's management. It was not sufficient merely to raise quality across the board, because customers were varied and fickle - the qualities that they valued differed from one firm to the next, and even from one day to the next.

The author speaks to two factors:

  1. The inertia of sufficient value - Especially when a firm leads an industry, in presumes that whatever it chooses to do is "good enough" because there's no higher standard.
  2. The allure of more value - In a market where prices are fixed by competitive offers, the one that provides more value for the same price quickly attracts customers away from existing providers.

The constant threat of competition becomes a dilemma for firms who seek to retain market share in this situation. To deliver more value at the same price destroys their margin, and to discount products undermines the esteem of their brand. But if no action is taken in either direction, competitors will lure away its market.

The company's reaction began with aggressive investment in R&D to increase the margin by which the quality of its high-end products exceeded the offerings of the competition, and an operational analysis that could eliminate or mitigate the costs of doing so, such that it would not be required to raise prices significantly. It also split its products into three lines, one that focused on low cost, a second that focused on high quality, and a "standard" line that balanced the two. It's reported that their profits didn't erode very much because the actions counterbalanced one another.

Because it already had market dominance, Primo was able to influence the expectations of the market: to modify expectations about the price a customer should expect to pay and the level of quality he should expect at a given price-point. Primo's mid-level offering offered the same balance of price and performance as the high-level offerings of other suppliers. This took rivals by surprise - for example, Neutryno (a domestic rival) found demand for its mid-level product was wiped out.

A precipitating benefit was an increase in demand in general, giving Primno the financial resources to increase the distance between itself and its rivals. Research that was financed by sales of its high-end products could be applied to its mid-range and low-end products without additional expense. Doing so effectively stopped a few Japanese rivals from undercutting its prices, because they could not do so without undertaking the expenses to improve their own quality.

The next move was to increase the value of its high-end offerings by providing cutting-edge features that, again because of its dominance, became expectations of the consumer that competitors could not match.

Within a few years, Primo had not only escaped the escalation trap, but had turned the trap on its rivals. While this was good and well fro Primo, its competitors found itself unable to compete: they did not have deep enough pockets to raise quality on their own, and decreasing price would mean substantial losses. Such are the benefits of having market dominance, and the importance of working to maintain a lead.

Case Study: Dell Computers

The computer industry in the 1990s is one of the best examples of a market trapped in an escalation war: customers had a set price they felt was reasonable for a personal computer, and firms sought to lure them to their offering by offering a faster processor, bigger hard drive, more numerous and advanced connection ports, and other features , all without increasing the price out of the customer's range.

Michael Dell entered the industry as a small operator (one young man working in his college apartment) at a time where products were priced such that it was cheaper to buy and assemble components than purchase a factory-assembled computer, and grew this business into a Fortune 500 company.

Dell continued on the model of custom computers assembled from parts based on customer orders, which gave it the advantage of responsiveness: when a newer motherboard came out, Dell could begin installing it immediately whereas competitors had to retool assembly lines. It wasn't long before it drove rivals out of the residential market, and encroached on the small office market.

Both HP and IBM exited the home computer market but found other niches: HP flocked to the corporate market, where buyers ordered standardized products in bulk, and focused largely on printers for the residential market, whereas IBM concentrated on its server solutions and sold off its PC operations to Chinese manufacturer Lenovo.

The latter posed a problem for Dell, because Lenovo minimized assembly costs by offshoring its operations to underprice Dell - which attacked the firm on what was its strongest competitive advantage. This threatened to place Dell in a commodity trap, where it would have to reduce price to compete for the lowest end of the market.

As a result, Dell switched from developing completely customized workstations to offering a small line of standard offerings. Following Apple's practices, Dell enabled the customer to begin wit ha standardized machine and then customize it in limited ways (more memory, different operating system, bundled accessories, and software options).

In effect, Dell has become the embodiment of the competitors it was able to defeat in a time when technology was more aggressively advancing. And while it has established a strong position as an industry leader, it has taken on the same vulnerabilities: when the timing is right, Dell will likely find itself beset by aggressive competitors in the same way it once attacked the establishment.

Strategies for Responding to Escalation

The author discusses strategies to adopt in a market that is commoditized by escalation, following his typical escape/destroy/exploit categorization scheme.

Escape the Trap: Re-seize the Momentum

One method of escaping the trap is to undertake a more radical transformation, leveraging the firm's competencies to enter an entirely different market. One example is the "smart phone," which began as a cell phone, but additional capabilities were added to the point where it became and entirely different device, a portable computer terminal for which voice communications are a feature that is often forgotten. The drawback is that competitors will often follow you into a new field, so the escape is often temporary for the first firm to discover and make the transition.

The author considers the automotive industry: he sets 1993 as the year in which firms stopped focusing on the features of a vehicle (size, number of passengers, trunk space, etc.) and started focusing on external factors, such as longevity and reliability as reported by Consumer Reports and other sources. Then in 1999, the emphasis switched to safety; and a few years later, to fuel efficiency. In the automotive industry, it seems that the primary focus of the market shifts every three or four years, and it's likely there is a similar cycle for any consumer product.

This is also true, and perhaps especially true, in retailing. The author considers the decades of change that gas stations had faced:

The author emphasizes that these changes were not initiated by the industry, but were a reaction to consumer demand as a result of changes in environmental factors (automotive technology, lifestyle patterns, and the like), which should be a clear enough indication of where a firm should be looking to predict the competitive landscape of the future.

Changes also occur to the competitive landscape where the primary product remains the same. Consider the insurance industry: the fundamental nature of a property insurance policy has remained the same for centuries, but the elements that customers value have changed: they once considered only the financial strength of the firm; later came to value diversity of products (one policy covers multiple perils, and the same firm will insure your home, car, and boat); then sought discount pricing; then looked for specialty insurance for specific niches; and presently (as evidenced by the success of Geico on the "so easy a caveman could do it" campaign) focused on the ease of application and servicing.

(EN: The author seems to regard change as being a result of external influences, but my sense is that it is often the result of escalation itself. For example, the first gas station to provide a car wash had a unique advantage; when its competitors imitated them, customers took for granted that they could get a car wash at any service station; so firms then had to compete on something else, such that having a car was not considered important; so many firms dropped their car wash facilities; and eventually it will become an unusual feature again. Point is, once a need is widely satisfied, buyers and sellers turn their attention to something else - it's not so much a random switch as market saturation and commoditization.)

The firm that struggles the least in a battle of escalation is the one is setting the pace rather than following its competitors: it is operating normally, planning according to its capabilities and moving at a comfortable stride rather than having to change its capabilities and hurrying to catch up with others. This requires a firm to:

  1. Doing the routine tasks of manufacturing and selling current projects
  2. Setting up the organization, particularly plant and distribution, for the next generation of products
  3. Planning the generation of products after the next generation
  4. Envisioning the third, fourth, and following generations of products

In order to be effective at pacing the market, firms must be doing all four of these tasks, which usually means each of the tasks has specific people, budget, and facilities assigned exclusively to doing it. Granted, these assets often move with their products through planning, setup, and execution: once a product is planned, the executive in charge of planning then takes charge of execution.

There are firms that operate in a "relay race" fashion: one group of people is responsible for developing goals, a separate group for planning the execution of those goals, a separate group for actually implementing the resulting program, and a fourth group who will maintain the operation going forward. The main problem with this approach is managing the hand-off between these groups of people, and the baton is often fumbled.

A second problem is cultural: in a relay-race situation, the separate teams are at conflict with one another and change management becomes a constant problem of change-management as each set of employees is compelled to accept direction from the previous one, which is a hindrace to their current operations.

A third problem is a matter of expertise: those employees who are in charge of developing plans never have to execute upon them. The ideas they come up with are increasingly divorced from the limitations of reality, such that they are never held responsible for the results (the implementation group takes the blame for an idea that was flawed) nor do they have the opportunity to learn from their mistakes.

Another bad tactic that firms use to proactively set the pas is to be strict about timetables and budgets, setting project milestones that require that an idea will be discovered and fully developed within a set amount of time. This results in reckless behavior poor planning done in haste. While the intention is to drive the firm ahead of its rivals, it often results in serious and sometimes catastrophic mistakes. It is a challenge to develop ideas quickly, but using a stopwatch is not an effective solution and creates an even bigger problem for the firm.

A last bit is in choosing the right cues: what tells a firm when it is time to make a change? Firms that do not change until the market has already shifted will be perpetually behind the rivals who are driving those market changes. First that are constantly changing face the problem of introducing new products constantly, and are throwing away the margins they would have earned by selling a product to a mature market.

Destroy the Trap: Reverse the Momentum

A second approach to responding to escalation is to slow or reverse the momentum in the marketplace to restore a sense of balance to the industry and prevent further escalation - to maintain prices and product features at a level the market desires and simply refuse to compete based on the assumptions that the features are valued. This seems like a retreat, but it is more of a return to common sense.

For any product, there is a theoretical limit. Consider the war of the late 1990s regarding the processor speed of computers, when industry advertising was driven by each firm bragging that its latest processor was a few megahertz faster than their competitors. Once processor speed became fast enough to suffice for customers needs (mainly, playing video games and movies), further competition was unnecessary. Advertising switched from having a faster processor to other qualities the customer valued: such as being affordable, easy to use, designed for a specific need, etc. and firms that continued to push processor speed found themselves wasting a great deal of R&D expense for marginal improvements that the customer did not value.

The author also comments on the industrial competition between General Electric and Westinghouse over turbine power generators in the 1960s. In this instance, an innovative solution to the battle was that GE became a supplier to Westinghouse - it purchased some of he firms that were suppliers to both, and even licensed some of its technology to Westinghouse related to the small-turbine market. This made Westinghouse dependent on GE, and had to follow its leadership in the market because the components drive pricing. This was fouled by government scrutiny, which felt that the relationship between the two largest suppliers was incestuous and collusive, and by the later purchase of Westinghouse by Siemens, who had deep enough pockets to vertically integrate its operations and abandon GE as a supplier.

Another tactic is to seek to lock customers into term contracts that prevent them from switching, or impose high switching costs to impose brand loyalty. Sometimes customers see this as being to their advantage, particularly for industrial supplies such as gasoline or carbon black, the customer feels a sense of security in getting a guaranteed quantity and price of a needed good for a given term. In the consumer sector, customers resent being "locked in" to term contracts from cell phone providers and fitness clubs. (EN: and back to the other extreme, a lease on a rental house provides a renter with certainty the will not be evicted on short notice.) For the supplier, a term contract provides a certainty of income, better operations planning, and the ability to react more gradually to market changes.

The same benefit naturally accrues to any product that is used over a longer duration. Customers purchase large appliances (stoves and refrigerators) very infrequently, so there is little pressure for rapid innovation. A firm can seek to gain this advantage by increasing the durability of its product, and selling them on the notion that it will serve them for a longer period of time.

Turn the Trap to Your Advantage: Harness the Momentum

A firm that has, or has taken, a long lead in an escalation battle is often well served by turning the trap to its advantage. The author gave the example of a manufacturer of nigh-vision goggles, which offered "a thousand times the power ... for half of the price," which gave it a long lead over competitors.

To be successful at this strategy, the market leader must be able to profit throughout the escalation process. That is, it must seek operational efficiencies to control the costs while maintaining a competitive price. A firm that has a considerable lead may be able to slow the pace of its own innovation: rather than constantly widening the gulf, conserve financial strength by pacing itself to remain slightly ahead of competitors and speed up only when the competition appears to be gaining ground.

Apple is mentioned as a firm that does this: it seems to constantly be releasing new versions of its iPhone, and each model provides more capabilities at the same price (or a lower one) than the previous version. However, it is not releasing the new capabilities all at once, but on a fairly regular schedule (about every six months, a new model comes along) and it is not making sudden or radical changes to leap further forward: it releases new features and increased capabilities only as necessary to remain just ahead.

Choosing A Momentum Strategy

The author repeats that the escalation process in an industry causes all firms to offer more value without raising prices, which is highly advantageous to the customer, but very difficult for the suppliers. The choice of how to respond (escape, destroy, or exploit) requires a firm to consider its capabilities, particularly in three areas:

  1. Innovation - Some companies are good at operations, performing the same tasks repeatedly, and change is disruptive. Others are better at coming up with new ideas, but not very good at executing on them. Firm wish to be good at both, but tend to be stronger in one area. And innovation itself may be a means to escape escalation rather than win at escalating when the innovation is so radical that the market sees the improved product as a new product instead (which can be beneficial or disastrous).
  2. Market Power - In order to drive change, a firm must have power not only with customers, but also with other firms in the value chain. Without this power, a firm cannot be effective in promoting or mitigating demand, but is relegated to following the pace set by others.
  3. Market Knowledge - A new product or feature is not automatically embraced by consumers, so the firm must know what is valued by them to determine whether a new feature has appeal. Apple's attempt to offer mobile computing (the Newton) and AT&T's attempt to market video phones both failed miserably a few decades ago, but are highly popular products today.

The author also mentions external conditions: in a market in which there are relatively few competitors that are equally matched and there are high barriers to entry, escalation is easier to mitigate because the customer lacks power to choose among many suppliers, and no firm has sufficient power to sway the market. Market conditions can change - but until they do, a firm in such a market has little interest or need to escalate.

Improving a product without reducing price is so difficult a task many firms simply prefer not to take it on: they continue producing a product with which they are familiar and already have the requisite resources and competence, so long as it remains profitable to do so, and remain laggards in the marketplace.

This is a valid and profitable choice: it is the strategy that Microsoft has followed. While there are some products (Web browsers) for which Microsoft was compelled to provide new capabilities in advance of its competition, its typical approach has been to watch what innovative companies offer the market and imitate them only when the features and capabilities seem to be in demand. By doing so, it has avoided the expense and risk of being innovative and supplied the market segment (business) that is happy to buy a standardized product at a lower price, even if it is a step behind what innovative firms are offering.

Manage Perpetual Motion

Momentum is more critical in markets where there is aggressive competition and rapid technological change. In recent decades, these conditions have risen in markets that had been stagnant for long periods of time in the past, in which a few competitors happily provided a standard product to a specific segment and left other segments to its competitors to serve.

It is also a competition that is based on the benefit to the customer: the product that wins may not be intrinsically better, but it is (or is perceived to be) better at serving a specific need. A firm outpaces the competition by successfully serving the needs of its customers.

A firm can also outpace the competition by redefining the customer's assessment of their needs: it is quite common for the market to value one benefit as primary and see other benefits as secondary, such as in the automotive market (once, fuel efficiency was the primary need, then it changed to safety, then to affordability, then to something else). This cycle seems endless.

A firm can escape the cycle entirely by changing its product in a way that serves a completely different market segment or a different set of needs: consider the way in which baking soda is no longer sold as a product for baking, but for household cleaning, dental care, and a myriad of other uses.

And a firm can slow the cycle itself in certain circumstances by maintaining the value of its product, resisting (and getting the buyers in the market to resist) the notion that new products are valuable at all.

As a last note, it's mentioned that escalation is an ongoing battle - you don't escape it once and forever. When technology offers new capabilities, consumer tastes change, and new competitors enter the arena, the battle of escalation can be restarted.

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