Walk into any local coffee shop, and you might see people using Amazon Kindles—but you’re not likely to spot anyone with a Sony Librie, even though Sony was the first company to make an e-reader in 2004.
“It was probably a better product,” says Rebecca Karp, assistant professor in the Strategy Unit at Harvard Business School. “It was better designed and nicer to use.”
However, when Amazon released its Kindle e-reader three years later, it included an important feature: a connection to wifi that allowed readers to download books more easily onto the device. That feature proved to be the key perk that allowed Amazon to capture market share and eventually blow past Sony, which after years of struggling, closed its e-reader store in 2014.
Without creating a competitive advantage, it is difficult for companies to produce and maintain sufficient returns on invested capital.
“Amazon understood what people were really willing to pay for,” Karp says. “Having great features is different than having features that will incentivize people to use your product.”
As mixed economic signals and the rise of artificial intelligence threaten to upend markets, companies with a strong competitive advantage—one that captures more value than rivals’—will be positioned to prosper. In a new note, Karp breaks down three paths that companies use to gain an edge. “Without creating a competitive advantage,” Karp says, “it is difficult for companies to produce and maintain sufficient returns on invested capital.”
What is a competitive advantage?
Some industries, such as airlines, may have low profit margins, while others, such as pharmaceuticals, have higher ones—but within each of those industries, some firms are better at generating returns than others.
Broadly speaking, companies can create a competitive advantage and capture more value in two main ways—by increasing the customer’s willingness to pay or decreasing the minimum compensation paid to employees and suppliers.
If you can keep that gap wide enough, then you are creating value not just for the company, but for the customer, or for employees and suppliers as well.
“Competitive advantage,” Karp says, occurs “when you can create a wider wedge between a customer’s willingness to pay and the minimum compensation you must pay to employees and suppliers, compared to your rivals.”
A customer’s willingness to pay is different than the price, Karp notes. In some cases, a company might keep its prices lower than the amount customers might be willing to part with to earn brand loyalty or hedge against market fluctuations. Similarly, a company may pay employees or suppliers for added stability.
“If you can keep that gap wide enough, then you are creating value not just for the company, but for the customer, or for employees and suppliers as well,” Karp says.
Differentiation is key
Many companies achieve a competitive advantage by differentiating themselves from their rivals in the market. For example:
Chipotle uses ingredients to set itself apart from Taco Bell. Fast-food customers looking for healthy options are willing to pay more for what they consider a higher-quality product. At the same time, however, “you can imagine that the cost of sourcing this type of produce would be relatively more expensive,” says Karp, “so it would be hard at the same time to pursue a strategy where you are decreasing minimum compensation.” While Chipotle has increased its willingness to pay, that advantage is offset by needing to increase its minimum compensation, driving down the company’s overall competitive advantage.
Hermès makes Birkin bags hard to get. The ultra-lux handbag designer limits how many Birkin bags it sells, driving up customers’ willingness to pay. While that increases the company’s competitive advantage, says Karp, that doesn’t necessarily translate into a higher return on investment. “It also means you are going to limit how many people are going to be able to access your product, creating a natural barrier if you want to sustain your position.” In cases such as these, she says, it’s essential that companies seek out other markets or product extensions so they can continue to sell more products to the same customers.
The Ordinary reduces costs. The no-frills cosmetic brand eschews the kind of product customization and coveted celebrity endorsements often seen in the industry, cutting research and development and advertising costs. At the same time, its direct-to-consumer model also reduces fees that other brands pay department stores and other distributors. While it doesn’t charge the premium prices of competitors, its lower costs help it maintain an advantage. Perhaps recognizing that threat, Estee Lauder acquired The Ordinary’s parent company in 2021.
Innovation can be a successful strategy
As Facebook’s rivals have discovered, innovation isn’t a surefire way to create a competitive advantage—especially when you spend time and money creating a new product just to have a well-funded competitor copy it. Some companies, however, have turned innovation into a successful strategy.
Consider, Moderna. When the company created the COVID vaccine, it took market share from bigger companies like Pfizer. Companies that successfully pursue an innovation strategy, says Karp, focus beyond just one product. “They are very good at the process of developing innovation as a set of capabilities that they as a firm can hone, monitor, and manage,” she says. Those capabilities then allow the company to continuously produce innovative products at the same time they are creating more efficiency in manufacturing and attracting top talent, making innovation more sustainable in the long run.
Network effects can provide an advantage
Some products become more competitive the wider the network of customers. For instance, Facebook benefits from the wide user base that increases value for customers by allowing them to interact with more of their family and friends. In addition to increasing the customer’s willingness to use the platform, it could also increase the advertiser’s willingness to pay to reach that audience. So far, at least, the company has been able to take advantage of its network effects by copying the features of rivals—as it did with location check-in to compete with Foursquare and Facebook Stories to compete with Snapchat—or by outright acquiring competitors, as it did with Instagram.
Karp notes, however, that network effects can suffer from diminishing returns. If you have 1,000 Facebook friends, adding one more isn’t likely to entice you to use the product more often—and at some point, network effects could even turn into a negative. “Imagine you have a huge network on LinkedIn,” she says. “That could just lead to more people bothering you.”
As all of these examples show, there isn’t a single, sure-fire approach that works to create a competitive advantage, Karp says. The specific strategy a company pursues depends on its industry, its product, and its resources. Whichever strategy they pursue, however, companies must think through all of the potential pluses and minuses to maintain their advantage for the long haul.
“There is no one-size-fits-all approach,” says Karp. “Each approach presents tradeoffs. Understanding those tradeoffs is critical to creating a competitive advantage—and more importantly, to sustaining it.”
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Image: iStockphoto/kajakiki
