Value Gaps and Profitability

Abstract

In the value-based approach to business strategy, a firm’s value creation with a buyer—i.e., its value gap—is an important measure. In many formal and informal results, firm profitability depends on whether the firm can identify buyer segments in which it has the largest value gap—namely, a value-gap advantage. These results typically assume, either explicitly or implicitly, that firms have constant marginal costs. In this paper, we show that if a firm’s value gap is defined as its marginal value creation with a buyer, value gaps provide a foundation for a firm’s profitability more generally. By allowing for nonconstant marginal costs, two important factors emerge. First, a firm’s value-gap advantage with respect to a buyer should be based on comparing the firm’s marginal value creation with the buyer’s best alternative for value capture, not value creation. Second, a firm’s guaranteed profitability depends critically on buyer competition. We show that in addition to excluded buyers, there are two other sources of buyer competition. A competitor’s buyer acts like an excluded buyer of a given firm if it can create more value with the given firm. We call such buyers envious buyers. Additionally, because of linkages in buyer preferences—which we call market-price effects—a firm may benefit from a competitor’s excluded or envious buyer. Consequently, a firm can benefit from demand for seemingly unrelated products, even when that demand includes buyers who have zero willingness-to-pay for the firm’s product. These additional sources of buyer competition explain how, in environments of excess supply, a firm can still be guaranteed profits due to competition.