Capturing these customers requires a careful pricing strategy. They don’t look just for a good price, but for the absolute best price, gravitating elsewhere if the price goes even modestly higher. A successful intruder exploits this pattern, translating its cost advantage into prices at the very bottom of the market. These prices attract customers in extraordinary volume that more than compensates for the margin lost in the discount. Thus, a relatively low price, near the market bottom, is not as profitable as the lowest price at the market bottom. In the early stages of invasion, this phenomenon works to the advantage of the lowest-cost intruders.
At the same time, even price-sensitive customers know the difference between “bare bones” and “shoddy.” They’re naturally suspicious that a below-market price reflects inferior product quality or poor service. So a typical successful intruder works hard to build and maintain a reputation for candor, no-frills quality, reliability, and excellent customer service. It secures its relationship with customers through the openness of its menu and the clarity of its choices. The tendency of a new format to improve its product’s quality and consistency helps establish that reputation.
Stage III — Expansion. The extraordinary profits that flow from the new format’s huge cost advantage nurture rapid expansion: double-digit growth at margins hitherto unheard of in the industry. Format innovations aren’t usually patentable technologies, so additional entrants soon emerge, imitating the new format. They would naturally prefer to compete against the old-format players than to compete against one another, so these imitators target market segments — customers, products, or geographies — into which the new format hasn’t yet penetrated. A free-for-all ensues, as the new-format intruders race to occupy as much market “space” as they can.
Old-format incumbents may try to meet the intruders’ low prices. But that seldom lasts long, since the incumbents labor under two disadvantages: the significantly higher costs inherent in the old format, and the broader amenity set they have customarily offered. So they typically redefine their target market upward, forsaking the price-driven customers now flocking to the intruders. There is a tempting but ultimately shortsighted rationale for abandoning these customers: Many of them are new to the category, “so we never actually lost them.”
Retreating up-market relieves the incumbents’ immediate pressures, but only postpones the problem. As the new format proliferates, it further erodes the old-format players’ business, draining away their volume and depressing their prices. Their financial returns deteriorate, and investment in the old format gradually ceases.
The recent flurry of activity among European airlines nicely illustrates this expansion phase. Ryanair, easyJet, and a plethora of other new-format competitors have piled into the European air-travel market. They expanded far more rapidly than their acknowledged model, Southwest, did in the U.S., precisely because the U.S. example demonstrated how much potential the new format has.
The intensifying financial pressures on old-format European carriers already have eliminated some (Swissair, Sabena) and encouraged others to merge (KLM with Air France). Yet some of these incumbents remain convinced that the new-format upstarts are “for backpackers, not for businesspeople” and “cannot extend into long-haul markets” — as one executive at a traditional European airline told us quite recently.
Stage IV — Consolidation. The new-format players continue to expand, broadening their target market beyond price-sensitive customers. Adding amenities without giving up the new format’s cost advantages becomes their next challenge; if they surmount it, they become very attractive to mainstream customers.
As the mainstream fills up with new-format players, competition among them pushes prices down toward the new format’s long-run level, reducing their margins to more “normal” levels. At that point, the remaining traditional-format players must crumble, or retreat into minor niches. Meanwhile, the toughening environment gradually forces the new-format players to switch their attention from expansion to grinding competition among themselves — through incremental efficiencies, differentiated amenities, or intensified sales campaigns — with better performers acquiring weaker ones. Eventually, equilibrium is reestablished and the new business format dominates the market.