Business Strategy - How to boost profitability

I'm Alaya or housed in an old Victorian building built
in eighteen sixty one, which is a really famous building
in the Sacramento area. People really want to get inside
and they want to take pictures in front of it.
It's just kind of an icon of Sacramento. So I
think that's kind of where we set ourselves apart.
In the last episode of Things Like an Economist, our
friend Samir of Milka Coffee Roasters told us about how
there's a lot of demand for coffee and Sacramento and
it can make it a really attractive market for new
coffee shops to open up.
Those new coffee shops might be great for consumers, but
for for me, there's a darker side. They're going to
reduce his profits. If everyone sells fairly similar products, that
extra competition is going to cut into his market share,
reduce his prices, and lower his profits. He might not
even be able to stay in business.
Businesses are always chasing extra profits sumber of ways they
do this. One way is to position their product as
unique in some way that makes customers prefer them to
their competitors.
Sama's best hope is to show that his coffee is
different than everyone else's.
We've positioned ourselves as the beautiful coffee shop, and that's
I think why we've done so well. It's a massive building,
you know, It's thirty five feet tall, has the Queen
Anne Bay windows right in front of you, has brick
steps going up to the front door. It's got a
curved shaped front door, makes you feel like you're going
back in time you open the door. We've got a
maple half round bar with like gorgeous emerald green tiles
with plants kind of cascading down everywhere, so you feel
like you're walking into like a Victorian atrium. People are
drawn to coming to Milka because it's a be all thing,
like if you want to have a nice chat with
a friend, or if you want to have a business meeting,
or if you just want to sit there and study,
throw your headphones on. And we have a whole patio
outside for people to kind of bring their dogs too,
so we kind of have a lot of different spaces
for people to do almost whatever they want.
In Milker sounds beautiful, and it's clear that Sami has
spent a lot of time thinking about what makes his
business unique. It's not just the drinks, and the snacks,
but he's ensuring that Milker is an experience good, a
really nice place to hang out.
That's a key part of his business strategy. And business
strategy is our topic for this week's episode of Think
Like an Economist with Me Betsy Stevenson and.
I'm Justin Wolfers. This is the podcast where we're teaching
you the tools from economics that can transform your life
and any business plans you have too. Nestre and Tebercoli fire.
Is with us.
Economists tend to talk a lot about perfectly competitive markets,
and we've learned some previous episodes how free entry and
exit play an important role in lowering profits and in
keeping the market competitive. Today, we're going to switch gears
and we're going to talk about how businesses try to
create excess profits and how they try to block the
forces of competition that keep prices and profits down right.
There are tricks that businesses can use to boost their profitability,
and what we're going to dig into today are the
fact is that determine your company's long run profitability.
One of them is figuring out what makes you unique,
because the more unique your products are, the more you
can act like a monopolist. After all, no one else
has the building Samir has, so he's a monopolist coffee
provider in that exact space.
Trying to offer a unique product isn't the only strategy
businesses us. We're going to go through the five Forces framework,
which will get you to focus on the five forces
that determine the structure of competition in your market and
hint your prospects for long run profitability. Managers use this
to help determine their long run strategy.
If you've been to business school, you may have heard
of the five forces framework because it's taught in most
business schools. If you haven't been, then we're letting you
in on something new. Usually have to pay a lot for.
Yeah, And what's nice about the five forces is that
it's like a checklist. We can go through each one
of them to see if it suggests our business will
be successful.
Right. This will make more sense as we go through it,
but let's start by naming the five The first is,
of course, competition from your existing rivals. The second is
the threat of new businesses entering your market. The third
is the threat of new substitutes emerging to your product.
The fourth is the bargaining pair of your supplies, and
the fifth is the bargaining pair of your customers.
So let's go through these to really understand them, and
we're also going to hear how these apply to the
decision samear megs over at milk a coffee.
Our first force is competition from existing competitors. This is
probably the one most of a start by thinking about.
And here we're talking about both the intensity of the
competition you face and the type of competition.
Generally, we say rivalry is more intense when you have
more rivals, and this is going to determine your market power.
You'll remember from our earlier episode on market power that
when you're I have no rivals, when you're a monopoly,
that means you have a lot of market power. And
at the other extreme, if there's perfect competition and you're
one of a gajillion business is selling identical cords, then
you'll have no market power.
In Between these two, maybe you have only a few competitors,
then you might have some market power either because you
have a small monopoly in your local area, Like if
you're the only coffee shop within five miles, people may
not want to travel to the other coffee shop, or
you can have market power because you and your competitors
coordinate with each other, either implicitly or explicitly.
That's the intensity of competition. But there's also the type
of competition.
Right, So one type of competition is price competition. That's
when businesses compete by offering lower prices. This can be
a bit of a downward spiral because if I slash
my prices, my competitor might then respond by slashing nails
and we'll both end up with lower profits.
Yeah, but that's exactly what price competition is meant to do.
It's why profits go to zero in perfect competition.
So customers like it, but if you own a business,
it may not be a preferred way to compet it.
It doesn't mean Samir wouldn't earn any money, just that
if his market is perfectly competitive, his profits get driven
down so that he's not making any more money running
his coffee shop than he'd make doing something else.
Price competitions most likely when you and your rivals sell
really similar products, when it's really easy to observe prices,
and when switching costs a low Because if all three
of these things happen, then reducing your price by just
a little bit will send a whole lot of customers
your way, and that becomes an irresistible temptation.
You know. It really comes down to this. If your
customers are pretty indifferent between what you are selling and
what your rivals are selling, then they're going to focus
on the price you're offering them.
Yeah, that's why companies try to build customer loyalty, which
really means a preference for that company even when they
have higher prices.
Yes, this is the non price competition, when businesses compete
for customers by making their products unique in some way,
which we call productif diferentiation.
Think effect us like drinking a cup of coffee in
a beautiful building, So like the case at Milka Coffee Roasters,
or all the other ways that businesses try to win
you over even if their prices are a little higher.
Earlier on, Samir told us that he's positioned Milka to
be the beautiful coffee shop. That's not the only way
he's made Milka Coffee Roasters stand out or differentiated their product.
The main way that we try to differentiate between us
and other specialty coffees is through our different flavors offering,
like all the crazy things we can come up with,
like the mit macha or the apple Hill latte, which
is kind of like a spiced apple syrup that goes
into our drink. So I think a lot of the
times we're looking at how can we find flavors that
no one else is doing that are going to make
people come to us because that flavor is something that
they're looking for.
The more you can stand out, the more market power
you have as a company. If I can only get
an Apple Hill lat in a beautiful space at Milka,
then Samirka avoid price competition because no one else has
that product. I have to go to him to get it.
When it comes to product positioning, there are two ideas
that are sort of intentional. You need to keep him balance.
The best way to make sure that you don't face
price competition is to position your product to be as
unique as possible. So that's why Betsy just said she
has to go to Milk in order to get an
apple Hill light in a beautiful space. That's the supply side,
but samir also has to think about the demand site.
After all, how many people want Apple Hill lattes. It's
kind of a specialty drink, and by offering products that
are so obscure, he's not going to be as attractive
to quite as many customers.
Right, So he wants to offer products that are similar
to his competitors so he can learn more of those
customers away as well as trying to be unique. That's
what he has to keep imbalance.
I always find it weird when I see two businesses
that essentially selve the exact same thing right next to
each other.
It does seem weird, but it turns out there's a
famous economic model that can help explain this. Each business
is trying to capture as many customers as possible, so
they all want to locate right in the middle, so
they're each as close to as many customers as possible,
and then ends up putting them right next to each other.
There's a metaphor that you used to teach this concept,
which is to think about a long beach with two
ice cream sellers. If they sell the same ice cream,
people just want to go to whicheveryone is closest to them,
so each seller moves down the beach until they're right
next to each other, smack in the middle of the beach.
So going back to Samir, he offers a lot of
really unique beverages, but at the same time he also
sells standard coffees that everyone has. I guess that's part
of the compromise between finding your unique position but also
making sure you're similar enough to your competitors to try
to seal their customers.
And keep in mind that it's hard to stay unique.
Even when you successfully differentiate like Samir has, you're gonna
have to watch out. After all, there are other beautiful
spaces and someone can probably figure out the recipe for
an apple hill late.
This brings us to our next force in the five
forces framework, which is potential competitors. For Samir is the
threat that some other coffee shop opens in a beautiful
space nearby and start selling apple hell lattes.
Right.
And here's the challenge. If you succeed in differentiating your product,
then you're going to really make a tidy profit. But
the fact that you're making these large profits is going
to attract imitators. As imitators enter the market offering a
similar product, that's going to push prices down, take some
of your market share, and reduce your profits.
This is why businesses try to erect barriers to entry
to discourage potential competitors from opening up. They seek patterns
to prevent imitators and other government regulations that might make
it hard for a new business to open and compete
with them.
Sometimes they charge really low prices, not to give their
customers a good deal, but to scare their competitors away,
and once the threat of that potential entrance go on,
they raise their prices again.
Amazon has been accused of doing this.
And it's not just about competitor in your exact market,
but competitors in other markets can also be rivals with
the potential to drive down your profits.
Competitors in other markets is the third of our five forces,
and this force is about the thread of potential substitutes.
For example, the post office has been hit pretty hard
by email. People don't send letters anymore. Instead they send
email or make a phone call. When was the last
time you wrote a friend or family member a letter?
You know, in the early nineteen nineties, I lived in
London for a while and I couldn't afford phone calls
and there was no email. I wrote a lot of
letters that I mailed through the post office.
But by the time I moved to the US in
the mid nineties. Email was widely available, and I wrote
my family emails. My mom printed them out like they
were letters back then, but the post office didn't see
a dime.
Email is a great example of a competitor in another market.
The Internet uphended a lot of businesses that might not
have seen it coming, Like encyclopedias.
I always wanted a complete encyclopedia set in my house
as a kid.
You were that kid, wonn't you busy?
I was definitely that kid. I spent a lot of
time in a library looking up random things in all
those books, and now I can do it on my
phone for free.
A more modern example is Zoom is going to play
an important role reducing business travel, and so it's going
to eat the airlines lunch, right.
So airlines might not have seen this potential substitute coming,
but that's going to be an important player for them.
You know, we've been talking a lot about technological change here,
but when we think about substitutes, it's not always just
about technology. I mean, for example, in Samir's business coffee,
he needs to think about the home coffee market as
well as the going into the shop coffee market. For
a lot of people like me to drink coffee every day.
We're sort of always on the fence between do I
make it at home or buy it to bring home,
or do I go and have it in a coffee shop.
Sami is pretty on the ball with all this. He's
already been thinking of potential substitutes to coming into Beautiful
Milka for a unique mint marcher or apple hill late.
One of the main substitutes for coming into the shop.
But I'm worried about currently is can drinks. It's a
little cheaper, it's quicker than coming into the shop, and
so here at Milka we're trying to figure out exactly
how we want to address that, and most likely we're
just going to get into making our own can drinks
and try to get him on the shelves of local
supermarkets and even on our own shops.
Samir has a great, if you can't beat him, join
him attitude.
He sees canned drinks coming for his business, and he's
decided that he should also start offering can drinks. Of course,
if you can buy some of his can drinks at
the supermarket, you'll be less likely to come to his shop.
But he's betting on the fact that he will gain
more customers in the supermarket then he'll lose in his
shop if he expands into this market.
He's probably also hoping that people who come into milk
Us will buy some cans to take home for later.
Sama seems like he's got a pretty good grasp not
just of his current competitors and potential new entrants, but
also possible substitutes for what he's selling.
There are two more forces for him to consider, the
bargaining power of his suppliers and the bargaining power of
his customers.
These are the fourth and fifth forces in the five
forces framework. Now say that quickly, Betsy, I.
Think I'm gonna skip that. Look. Before we dive into
each of them separately, we need to explain by what
we mean by bargaining power.
Your bargaining power is just your ability to negotiate a
good deal.
Right, That's right. We all want to negotiate a good deal,
but our ability to do so is constrained by something important.
Our next best alternative.
This is the opportunity cost principle at work. Remember that
you're always supposed to ask yourself or what this is
true when you're negotiating as a buyer, the answer to
the or work question is what you would do instead,
buy somewhere else, buy a slightly different product, or go without.
And for business, your next best alternative might be to
sell to someone else, or to make a different product,
or to cut back on production.
And it's your next best alternative that determines your bargaining power,
because if you don't get a good enough deal, that's
what you'll do.
That's right, And what it means is that people who
have a really good backup plan also have the most
bargaining power to get a good deal out of their
first plan.
So you should get a good backup plan. And this
applies which side of the bargaining table you're on.
As a business, your bargaining power is determined by your
next best alternative, and when you're negotiating with your suppliers,
their bargaining power is determined by their next best alternative.
So this takes us to the fourth force in the
five forces framework, which is the bargaining power of suppliers.
Now it seems surprising because your supplies are in the
same boat as you, so if you do well, you'll
probably want more of their supplies given they depend on
you buying their products.
But they could also threaten your success by charging you
higher prices, which would eat into your profits. Look, Samirs
counting on his physical space as part of what differentiates Milka.
So the bargaining power of his landlord, the supplier of
his physical presence, will help determine his rent which could
be a really big factor in his profitability.
Ah, but Samir is ahead of the game and that's
why he bought the building.
Luckily, we do own the building, so we've kind of
taken that out of the equation. That was really important
for me to only start businesses and buildings I own personally,
because landlords can come five years in and double the
price and then you've just lost all that work.
This is a great example. When Sami was starting his
business and searching for space, his next best alternative was
renting or buying another beautiful building. But once he's built
his successful business in that particular space, his nixt best
alternative is tearing it all down to relocate somewhere else.
Samir is pretty savvy. What Samir noticed was that the
landlord's bargaining power could grow with the success of Samir's
bi business, and that could lead his landlord to raise
his rent further down the line, taking a big share
of Samir's profits with it.
So Samia solved the problem with bogaining power by buying
a building he doesn't have a landlord. More generally, the
way to improve your bargaining power is to improve your
nick's best alternative.
Yeah, and Sami kind of hinted at this.
We're pretty heavily dependent on suppliers in a way. Coffee
is number one. If we start to have any sort
of like big increase in cost, a lot of people
drop out of the market. That could be a big issue,
which honestly we're looking at all the time. And then
milk is a huge one. Luckily we have a great
milk guy, he's the best, and our tea and pastries,
so we have a lot of things where depending on
a lot of people.
Notice that Samir says a big fear is that a
lot of suppliers drop out of the market. That's because
if he has a lot of suppliers, his next best
option is another supplier. Maybe the best milk guy isn't
a great but he still provides milk. That limits how
much his milk supplier can mark up the price of
the milk he sells him. Same thing's true for his
coffee suppliers.
You can use this insight in your own life. When
you're looking for a job, it can pay to seek
out a whole lot of jobs and job offers at
the same time. That way, you can make a big
salary request knowing that your next best option is a
pretty good job somewhere else.
Or if you're buying a house, don't get your heart
set on one specific house. Remember your bargaining power comes
from your next best option. Try to find two or
three that you'd be happy with and what you'd be
willing to pay for each. Then make an offer, knowing
that rather than pay more, you could take that other house.
This is a trick we've used in our own lives
every time we stay focused on the next best place
to live when we're negotiating to buy or rent a house.
So I can tell you it's a really handy trick
to both raise your bargaining power and keep your emotions
a little cooler.
Okay, so let's turn to the fire force in our
five forces framework, the bargaining power of buyers. If your
customers are indifferent between your coffee and coffee from somewhere else,
then the customers are going to have all the bargaining power.
Your customers will have less bargaining power the more they
love you, because their love for what you're selling is
what makes their next best alternative worse.
So if Sami wants more bargaining power, he needs his
customers to love his drinks.
But all businesses know you've got to work to earn
that love.
Our customers have quite a bit of bargaining power. They
definitely vote with their dollar. The people who are coming
in here spending their hard earned money, they have a
say too. So we want to make sure that we're
always doing things that they receive and they respect and
that they want, you know, so we're consistently asking them.
I mean that's the easiest thing you can do, is
just ask them on hey, is this something you like
or is this working for you? And so we kind
of are constantly doing that here and I think people
really respect that about us, that we're willing to listen
to them and make changes.
What's cool is that submit actually uses this feedback to
make their coffees even better and to really lock those
customers in and perhaps gain new ones too.
We had a friend of a friend come in and
was not particularly excited about the way our moga tasted,
which I took to heart, and so that moment I
was just like, all right, from now and we're only
doing good stuff. So we went out and luckily we
have one of the best chocolate tears in the world
in Sacramento Crew Chocolate and started using their chocolate. Everyone
loves the chocolate, and the person who had not enjoyed
their previous mocha experience at our shop, that person was
excited when he came back, and I think that made
him a customer for life.
So the customer really is king, yes, because if they
don't love you, they have all the bargaining power.
But in order to get them to love you, you're
gonna have to work really hard. And that's why even
in specialty coffee shops like Milker's, it's hard to make
big profits.
And this gets even more difficult if you've only got
one or two big customers. Think about a defense contractor
where they can either sell their arms to the US
government or their next best alternative is no customers and
go and bust.
Wow.
The five forces framework has a lot to take in,
but I'm going to keep thinking about all this because
i know it's the heart of a lot of what
people learn in business school.
Yeah, don't tell my business school friends. Is because you've
just gotten the heart of an NBA strategy class without
having to pay tens of thousands of dollars for it.
You know, this season we're really focusing on the types
of lessons that you learn in business school. But today
was really I think the heart of it. Those five
forces are what you want to think through if you
run a business.
Now we know more about the five forces, how can
we use this framework in our daily lives.
Remember, two of those forces are about bargaining power, and
the big idea there is that your bargaining power is
determined by your next best alternative. So having good alternatives
is key. That's always true in life, whether you're running
a business or just going about your every day.
That's why I kept dating other people for a while, Joz.
I had to know what my next best alternative was.
Let me just remind you where you landed. And so
Bitsy's point, of course, is that identifying an opportunity, whatever
that opportunity is, really requires thinking through the five forces framework.
Let me tell you it was a hell of a
first date.
Like economists often say, in a market economy, all you
need to be successful is to invent a better mousetrap. Well,
that metaphor is the idea that at the end of
the day, a quality new product will succeed. But it's
actually not quite that simple, because competitors could quickly come
in and copy your new quality price, or.
Your customers could demand a better deal, or your suppliers
could raise their cost to you, or that new entrants
might come into the market, or new substitutes might emerge.
That's the big idea of the five forces identifying those threats.
Yeah, so you know, the point is like Starbucks did
invent a better mousetrap, I mean coffee, but their success
is not purely a function of the deliciousness of their coffee.
I mean, honestly, pizza is better. So the advice is
take it, yes and approach. I mean, yes, I need
an awesome new idea and I need to do a
careful five forces analysis to make sure I succeed.
And that's the story of our relationship.
So nas, are you gonna think about your dating life differently, or.
Your business life.
Now, why are your.
Business life I'm gonna think of my bargaining pole for sure.
Yes,