Process Innovation, Cost Leadership and Market Power --Analysis based on Electronic Information Industry 1

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1 Process Innovation, Cost Leadership and Market Power --Analysis based on Electronic Information Industry ZHU in Zhejiang Gongshang University, P.R.China, Abstract Selecting the electronic information industry as the objective of empirical study, this paper disclosed developed countries' MNCs usually establish and promote their market power through cost leadership in the global price competition. The paper analyzes the mechanism of how cost leadership makes for the firm s market power forming. Then, it holds that relying on the process innovation and effecting scale economy and speed economy is the key to achieving cost leadership. In the current situation, Chinese companies faced the problem of absence of market power in global competition seriously and they almost can not survive in the seriously price competition, the paper put forward the enlightenment to Chinese electronic information industry. Key words Market power, Cost leadership, Process innovation, Electronic Information Industry uestion Proposed In recent years, there is phenomena that the relations between "price competition - market power" are completely opposite in dynamic competition in global electronic information industry. On one hand, some superior MNCs who hold huge competitive advantage continuously expand their market power by price competition. On the other hand, developing countries' manufacturers continuously cut down price, but they still lose market power and even find difficult to survive. The former includes American Dell, which always adopts efficient sale and low cost as its competitive strategy to make product price be lowest in its industry. Dell's key to maintain price competitiveness is its strong and efficient ability to integrate global resources. Efficient logistics system ensures Dell's supply of low cost fittings. Depending on individuation sale mold, Dell can respond customers' demand quickly and reduce stock. Kumar (006) pointed out that since the 990s, there appear some MNCs, who become industry leaders depending on their low cost operating and low price competitive strategy in global consumer markets. MNCs in Electronic Information industry are similar to Dell. Although their income of per unit product is less than traditional rivals, their wealth growth rate is not lower than those competitors' who put high price strategy into practice. The latter includes flat-panel TV manufacturers in China. Although the flat-panel TV industry is in a continuous growth period and will enter into the era of universal consumption, the price competition among manufacturers is becoming more and more furious in the growing market. Taking 3-inch LCD TVs as example, their average price was 300 Yuan in 005, but the price had had dropped to less than 6,000 Yuan in 007. At the same time, the cost of panel products that come from Japan, Korea, Taiwan, etc, is 70% of whole cost of LCD TVs, moreover the price maintains on the high side. Domestic manufacturers face furious price competition at home, meanwhile they have to pay high cost of imported intermediate products. So it is difficult for them to develop. Above two different phenomenons seems to reflect complete reverse economic fact. The former shows that products or services can also occupy indusial leadship and access to huge profits depending on their low prices in recent global competition. Accordingly, the traditional thought, namely "market power associate with high monopoly price" is broken. The latter reveals that the furious price competition make many local Chinese enterprises be pushed into serious situation, which is lack of market forces. They are at the edge of deficit in the long term. How does price competition effect market power? Does it help enterprises to achieve market power just as Dell and ViewSonic or make enterprise lose earning ability This research has been supported by 007 Research Project of Zhejiang Philosophy and Social Science under Grant 07CGYJ00Z, and supported by Zhejiang Science and Technology Bureau. 358

2 absolutely? After analyzing the relation between price competition and market power, we point out how our Electronic Information enterprises can gain their own market power though process innovation in the case that price competition is inevitable. The Inevitability of Price Competition in Electronic Information Industry Electronic and information products especially consumer electronics products, widespread have feature such as economies of scale being obvious, product updating rapidly, and price elasticity of demand being great. According to the product life cycle theory, the electronic and information products' price competition process is as follows: at the beginning of new products who gains unique performance, functionality or style coming into the market, a few innovators can maintain the ability to control price for a while and can access to excess profits. As the technology being widespread and imitated, the product is entering into mature stage. As soon as manufacturer found competitors, he will lower price to expand his market and achieve economies of scale quickly. As the old products entering into the universal stage, the competition becomes more and more furious. The original product differentiation advantages gradually disappeared, price become the key factor for consumers to decide which product to select. At that time, price competition becomes inevitable. MR&MC MC E F MC MR Figure : Cost advantage and price competition Y So it is true that price competition is the main competitive way in electronic and information industry is decided by industry character. The leading companies can dominate price competition by cutting marginal cost. According to Figure, leading companies' original marginal revenue curve and marginal cost curve are MR and MC respectively. When product entering into maturing stage, leading companies has achieve scale economy, their marginal cost curve downward move to MC. And equilibrium point moves E to F. Because the slope of marginal revenue curve is negative, leading companies obtain the capacity to maintain the clearing price at a low level. Leading company's activity that they cut the price is an active choice. This activity does not make leading company lose market advantage, but guarantees their dynamic market power to achieve and maintain. 3 Cost Leadership and the Forming of Leading Firm s Market Power Applying Bori's inverse linear demand function, and hypothesizing there is no difference among Stephen, Martin. Advanced Industrial Economics. Shanghai University of Finance and Economics Press, 006:54 359

3 products, it is seen that manufactures' cost advantage is the key to maintaining mighty in price competition. Assume that there are N manufactures in the market and manufacture I produce product i. So, there are n products in the market. Using φ ( 0 φ ) to measure the level of difference between the products, ( φ ) means the level of substitution. At the extreme, whenφ = means substitutability among the products is zero. Whenφ = 0, there is no difference among the products. Manufacturei 's output and price of product are i and P i respectively. T j is total output of all products except i, namely n T j = j j i ( i j ). We can get manufacture I's Bori's inverse linear demand function: Pi = α β i + ( φ) T j, i, j =,..., n, i j () Assuming there is no difference among products, namely φ = 0 in Equation. For the sake of argument, we simplify the problem. Discussing the situation when N=, inverse demand function of the manufacture and are as follows respectively: P = α β + ( ) ( ) P = α β + () Assuming the average cost of manufacturers and as C and C, then as Equation shows, C < α C and < α,so we get the profit functions of both manufacturers.: W = ( P C ) = α β ( + ) C W = ( P C ) = α β ( + ) C (3) Then we can get the best production point as: α C = + β α C = + β (4) Then examine the market price competition. If the competition between manufacturers is completely "homogeneity" - there is no difference among products ( φ = 0 ) and no difference among cost (C = C = C). α C = = After price competing, P = P = C, β, W = W = 0. It reflects the homogenous price competition erodes market power completely. However, as long as one manufacture's cost lower than its competitors', this manufacture still can achieve market power even though there is no difference among products ( φ = 0 ) in price competition. Assuming C < C, manufacture who gain cost advantage will win initiative in price competition the price is P = P = C - η, and η can be slight. In the price competition, manufacture has no choice but to withdrawal from market because of deficit. Manufacture achieve complete market power depending on cost leadership. α + η C α + η C = W = ( C C η ) Its output and profit are β and β respectively. The cost advantage is more obvious, namely the difference between C and C is bigger, manufacture will obtain more profit. When the leading firm cut the price, being lack of understanding of market growth, concentration, excessive competition or in order to retrieve previous input, other manufactures are forced to engage into furious price competition. This furious competition force many late comers to withdraw from market. Market concentration is intensified. Meanwhile, leading manufactures strengthen their market power. 4 Process Innovation to Achieve Cost Leadership 360

4 Just as above analyzed, price competition weakens the late comers' ability to control price. The forming of their market power is inhibitory effected. The reason is as follow: when he products entering into the maturing stage, in the market where the product is absence of discrepancy, as soon as manufactures who have cost advantage cut the price, many companies who rely on technology-imitation to enter into market are in "Prisoner's Dilemma". They have no choice but to cut down their price. This makes "repeat game of cock" in-fighting competition become increasingly intense. Facing international buyers, domestic companies are hard to achieve their own market power in the perfect competition. This paper points out the key to break the "homogeneity" of price competition and form own market power is to achieve cost advantage though global resource integration and process innovation in this case that it is hard to gain more advanced technology. In a certain sense, the cost leadership is a kind of "difference". This difference is reflected by management efficiency, namely whether companies can form highly efficient management through innovation to achieve dynamic scale economy and expand market share and whether company can achieve speed economy in the efficient process to reduce cost and risk. Process Innovation Speed economy Cost leadership MC decreasing Cost barriers Scale barriers Market expansion Scale economy Market Power Figure: The linkage among process innovation, cost leadership and market power Market power was enterprises' dominative ability to price make-up. It could drive enterprises to innovate, avoiding the innovation being simulated soon and ensuring the profit of innovation being realized. In the terms of price make-up, market power is the ability to maintain the price beyond marginal cost (Utton, 995). In dynamic price competition, if manufacturers can reduce the marginal cost more than the price-lowing range, they still gain power and access to considerable profits in price competition. As we know, the innovation was indispensable for acquiring the market power. It was undoubted that the innovation based on integrating the global economic factors was the main instrument to acquire and maintain market power for enterprises. So those successful enterprises' trick was achieving the favorable interaction between market power and innovation. Figure describes the mechanism how companies obtain and maintain market power by process innovation. If one firm can form cost leadership in dynamic competition by process innovation, then the firm can take it easy in the price competition, which means it will acquire larger market share and scale by cutting down the price. Relatively, its future competitors will face cost barriers and scale barriers to get in the market unfortunately. The key to cost leadership is achieved scale economy and speed economy through process innovation. Process innovation includes innovation of process flow, logistics, management, etc. Its main function is reducing manufacturing cost and improving product quality (Baumol,004). Process innovation is the key factor for companies to make cost curve downward move (Figure) come true. When process innovation become mainstream in the competition, those companies who can substantially reduce the cost relying on process innovation will wash competitors out and strengthen their own market power in the market where concentration continuously increasing. Klepper (996) presented the model of evolution of industry and innovation (Figure 3). As 36

5 technology becoming mature and industry entering into growing stage, product is consumed cosmically. Price competition becomes inevitable. Those companies who can stand price competition and are efficient will remain in market. Those who can not stand price competition and are inefficient will be washed out. It should be emphasized that process innovation taking place of product innovation becomes the mainstream as market concentration ever-increasing. Enterprises number Path Product innovation Process innovation Market concentration increasing Total enterprises number in the market Path Time Figure3: Concentration and innovation Sourcing:Steven Klepper. Entry, Exit, Growth, and Innovation over the Product Life Cycle. The American Economic Review, 996, 86(3): At the background of price competition, manufacturers must maintain cost leadership and market power by process innovation. During the early stages of evolution of industry, few companies who gain product innovation capability achieve their own market power and access to excess profits. As time going on, more and more companies hold manufacturing ability. Product becoming mature, the realization of product innovation is less. Process innovation turns into mainstream. 5 Enlightenment to Chinese Electronic Information Industry In the current situation, Chinese companies faced the problem of absence of market power in global competition seriously and they almost can not survive in the seriously price competition, which directly leaded to the domestic enterprises being locked in the bottom of the smile curve of global value chain. It can be founded that the reason that Dell and other MNCs achieve scale economy and speed economy is process innovation. They maintain cost leadership in global industry by process innovation. Then they take the lead in implementing proactive pricing strategies and form strong market power. However, Chinese color flat panel TV manufacturers are locked into core technology being manipulated by others. They are lack of technology innovation ability. Meanwhile, they can not achieve effective process innovation. So Chinese companies are in "Prisoner's Dilemma" to face fierce price competition and lose market power absolutely at last. At the background of global competition, MNCs mainly improve their ability to integrate the elements to achieve process innovation. Such as look for the most efficient supply of intermediate product all over the world; Reconstruct operating activities to save unnecessary process and time; Apply flexible production system which is based on lean manufacture and agile manufacture, etc; ally and assort with upstream suppliers and downstream channel partners to strengthen efficiency of specialization and improve turnover rate of capital and reduce operational cost. Relying on the process innovation and effecting scale economy and speed economy is the key to achieving cost leadership. According to different causes, scale economy can be divided into technical scale economy and management scale economy. The current study always emphasis on technical scale 36

6 economy unilaterally but does not pay attention to management scale economy. The importance of enhancing management to reducing operating cost and achieving scale economy is neglected. In fact, when the capital accumulation is not sufficient but scale of production has progressed ahead of schedule, the border of management scale will restrict the border of the organization. At this time, process innovation appears to be particularly important. On the other hand, manufactures will lose transient market opportunities since uncertain factors in market competition grow daily. Just relying on scale economy, companies have been far from standing fierce competition. Companies must self-adapt and self-renew. Meanwhile, they should respond to new demands and new opportunities in order to survive and develop. "Speed economy" means time is a kind of valuable resource just as capital, technology and human capital. Time can help companies to access to excess profits and achieve market superiority. George & Thomas (990) put forward a concept of competition on time basis. In this competition, enterprises can reduce cost and increase revenue only if they continuously speed up to responding to market environment and demand of customers. Speed economy has become increasingly important in dynamic competition. The stress of enterprises' innovation turn into process innovation, namely reconstruct operating activities. Through process innovation, speed economy is reflected in operating activities of R&D, design, sale and service. On the basis of above-mentioned theoretical and empirical study, it can be concluded the general idea about how can domestic enterprises turn over the disadvantageous situation in price competition and improve the benefits in global competition, which is: Integrating the global economic factors to realize interaction between innovation and market power; forming cost leadership through process innovation. References [] Baumol. Miracle of Growth of Capitalism Free Market's Innovative Machine. China CITI Press, 004 [] Stephen, Martin. Advanced Industrial Economics. Shanghai University of Finance and Economics Press, 006 [3] Griffith, David E. & R. T. Rust. The Price of Competitiveness in Competitive Pricing. Journal of the Academy of Marketing Science, 997, 5 (): 09~6. [4] Michael Fradette & Steve Michaud. The Power of Corporate Kinetics. Simon & Schuster, 998. [5] Steven Klepper. Entry, Exit, Growth, and Innovation over the Product Life Cycle. The American Economic Review, 996, 86(3): 56~583. [6]Kumar,Nirmalya. Strategies to Fight Low-cost Rivals. Harvard Business Review, 006,84():04- [7] Utton, M. Market Dominance and Antitrust Policy. Aldershot: Edward Elgar,