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Author: Cogitarius Big gold star, 5000 posts Old School Fool Home Fool Global Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 46821  
Subject: 101: Industry dynamics : Pricing power Date: 5/7/2005 2:29 AM
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One of Buffett's recent comments got me thinking : "It's not a great business when you have to have prayer sessions before raising prices a penny... The long-term strength of a business is closely related to its ability to raise prices without much agony... You can learn a lot about the durability of the economics of a business by observing pricing habits."
I have to agree with Morningstar's Pat Dorsey, a longtime WEB fan : 'One of Buffett's biggest strengths as a communicator, in my opinion, is his ability to boil a complex issue down into a single pithy insight.'
http://news.morningstar.com/doc/article/0,,133760,00.html

Here's why.

Professor Michael Porter's seminal Harvard Business Review article 'How competitive forces shape strategy' showed how the ultimate profit potential of an industry (long term R.O.I.C.) is the collective result of 5 key forces :
1. Threat of new entrants
2. Bargaining power of customers
3. Bargaining power of suppliers
4. Rivalry among existing firms
5. Threat of substitute products or services
http://boards.fool.com/Message.asp?mid=21493041

Extending Buffett's 'Pricing power' insight beyond its purely literal meaning provides a neat way to capture some of the essence of Porter's model in one power-packed phrase. However, this is not to say that competitive advantage is merely about pricing power. In some cases, other aspects of competitive advantage (e.g. patent protection, exclusive access, economies of scale) can actually be drivers of pricing power.

1. Threat of new entrants:
Predatory pricing power is a double-edged sword that can either cut out new entrants or cut down incumbents. Netscape learned this bitter lesson when it started giving away its browser free to kill Mosaic, which it did, to become the first browser monopoly. Though Netscape charged ISPs for offering their browser to clients, they assumed they could keep Microsoft at bay with their 'free-for-consumers' offer. Unfortunately Microsoft woke up to re-define 'free' by bundling a much improved Internet Explorer into Windows to squish Netscape!

Predatory pricing also helped Toyota dismantle US automakers' dominance by offering cheaper – and eventually better – Japanese models.

2. Bargaining power of customers:
Coke's been able to raise prices with impunity because it has captive bottlers - an example of weak customer bargaining power leading to high supplier profitability. The immensely profitable US pharma industry is an example of pricing power where the patient has little or no say in how much he pays for a drug. Buffett's comment also applies to power brands like Marlboro or Budweiser which have confidently taken price increases exploiting consumers' addiction or brand loyalty.

Conversely, extensive choice of retailers and retailing formats makes it very difficult for most of them to exercise significant pricing power - very often all the shopper has to do is walk out one store and walk into an adjacent store to buy what she wants at her chosen price.

3. Bargaining power of suppliers:
Wal Mart and Dell are probably the two best known 'category killers' who squeeze suppliers' profitability through relentless price bargaining. OTOH, OPEC is an example of cartel pricing power resulting in the entire oil industry being awash in money extracted from consumers' wallets.

4. Rivalry among existing firms:
Airlines are notorious for having cumulatively lost bucketloads of cash since inception due to constant fare wars well before budget carriers came in and made matters worse. Telecom overcapacity since the great buildout has similarly damaged the industry's ability to even hold prices.
Financial services, meanwhile continue to be immensely profitable because the non-standardization of their service offerings allows them to charge as much as they can get away with.

5. Threat of substitute products or services:
Cheap generics are the single biggest threat to pure pharms' pricing power because they give customers (patients and pharmacists) the power to choose to pay less. Store brands do the same to Consumer product companies selling branded toiletries. Conversely, until mobile phones came along, fixed line phone companies could price to the hilt because they had very little fear of substitution.

Buffett gave a newspaper substitution threat example quoted by Dardashti : “In the 1970s and 1980s, newspaper publishers raised rates on an annual basis, and didn't worry that people would drop their subscriptions or that advertisers would stop advertising. Now, publishers agonize about losing advertising and if a 20 cent increase will cause readers to just drop their subscriptions. [Shai Dardashti comment: The single change in newspaper business economics is clearly the widespread availability of free news coverage over the Internet.]”
http://boards.fool.com/Message.asp?mid=22431748

Hopefully the above examples will help you apply Buffett's neat 'pricing power' concept to analyze the competitive advantage – or 'moat' – of a firm. Once again, do keep in mind that there are many other aspects to building a deep, wide moat full of hungry reptiles to discourage potential threats.

Perhaps you'd like to share some examples of your from Porter's categories for discussion?
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