A Model for Maturing Markets
You are the CEO of a fast-rising technology-based company. You’ve carved out a niche in your industry with an innovative product that generates a tidy profit. Suddenly new entrants are elbowing their way into your market, threatening to set off a storm of competition and drive prices-and profits-down. What do you do?
Ask Henry Birdseye Weil.
Weil, a senior lecturer in the Strategic and International Management Group of MIT’s Sloan School of Management, says the process of “commoditization”-the descent into entrenched price warfare that erodes profit margins and chokes off funding for innovation-is inevitable in any industry. However, he maintains that top managers often fail to perceive options for slowing the spiral. He has created a computer simulation of the commoditization process that can be adapted to any industry.
“My goal,” says Weil, “is to understand the forces that drive the life cycle of companies and industries, and to work with individual companies to help them anticipate or contend with these forces.”
Commoditization is an “understudied” area, notes William Lukas, executive director of MIT’s International Center for Research on the Management of Technology (ICRMOT), which funds Weil’s research. So far, Weil has adapted the simulation to model the airline, telecommunications, and oil and chemical industries; he hopes next to turn his attention to mobile telecommunications service providers in Hong Kong, an “adolescent” industry just beginning to grapple with the dynamics of a maturing market.
Weil’s project began in 1994 when a group of telecommunications companies affiliated with ICRMOT approved his proposal to create a model of the U.S. airline industry to examine the impact of deregulation. “I felt that there would be strong parallels between what happened in the airline industry and what is happening in the telecommunications industry,” Weil explains. “Remember, in the early years of deregulation, airlines were viewed as an exciting growth industry with lots of capital and lots of startups. Fifteen years later, it is widely viewed as a sick industry. We wanted to understand what happened-and to what extent these dynamics might be universal across industries.”
The simulation he developed is based on systems dynamics, a computer-modeling method pioneered at MIT in the 1960s by Jay Forrester. The simulation explores feedback relationships among economic and industry variables such as the rate of overall economic expansion, growth in demand, intensity of competition, production capacity, and the pace of technological change.
Weil then used the simulation to test alternative business strategies that the airlines might have pursued. “The airlines could have behaved in a much more intelligent way,” he says. The established airlines failed to predict that the new carriers entering the deregulated market would devastate the existing fare structure. By anticipating those price changes and cutting costs sooner, he argues, airlines might have avoided colossal losses.
The airlines also misread the effects of deregulation on market growth. Although slashing fares released a certain amount of pent-up demand, the spurt in market growth wasn’t sustainable. As a result of their mistaken reading of the market, the airlines bought more planes than they needed-and then had to cut prices again to fill them.
The airline simulation “helped us see how telecommunications companies in other parts of the world-France, Germany, Latin America, and parts of Asia-could contend with similar dilemmas as they follow the United States into deregulation,” Weil says. With the cooperation of ICRMOT member companies France Tlcom, Electricit de France, the British Cable and Wireless Group, and its affiliate Hong Kong Telecom, he adapted the simulation to create a model of that industry. His research attracted the interest of two other ICRMOT sponsors, British Petroleum and the chemical firm ICI, which asked Weil to create a model of the petroleum industry last year.
Since then, Weil has used his simulation to identify strategy options for companies facing maturing markets-and his models have generated some counterintuitive solutions. Traditionally, for example, established companies have tried to limit total capacity in an industry by forcing new entrants to duplicate established companies’ investments. This strategy is based partly on the belief that, once competitors have entered the field, the need to earn a return on their investment will force them to keep prices high.
“History has shown that that’s absolutely incorrect logic,” Weil asserts. “Once the capacity is in place, it’s a sunk cost and people will compete very aggressively to fill it up.” According to his models, established companies may even find it to their advantage to offer capacity to new entrants. For instance, one British telecommunications company recently decided to lease excess network capacity to newcomers to the market rather than force them to build their own networks; the leases have become a substantial new revenue source.
Weil is quick to rattle off other ways companies can maintain their positions in maturing markets, such as outsourcing key components of their work and packaging their products with new services to retain customer loyalty. Eventually, he notes, they may simply have to develop new products or niches and move on.
Weil stresses that computer simulation can serve as a teaching tool by allowing companies to test out ideas and strategies in advance. Simulations can also help overcome organizational inertia: experimenting with different options can help managers generate evidence to persuade senior executives of the need for change.
Graham Hillier, planning and quality manager of ICI’s petrochemicals and fertilizers division, says using Weil’s model has helped managers stop basing decisions “on gut feelings.” In particular, he hopes it will improve the company’s forecasting, which has tended to be overly cautious: “The model has shown us that we tend to underforecast peaks and overforecast troughs. We get the pattern right, but the change is much bigger than we expect.” By playing it too safe, the company may not have taken full advantage of opportunities presented in the market.
Both organizational and technological innovation, Weil says, can play a crucial role in helping a company break out of the commodity cycle. For companies that desperately need to innovate, he adds, his simulation provides “a tool for reducing the risk of failure.”