Porter’s five forces, founded in the 1980’s, is the classical framework used to understand and analyze competitive forces in an industry. In the 1990’s, a new framework was formed, the Value Capture Model. The Value Capture Model extends on previous frameworks in two ways. One, it formally describes competition as a positive and negative force, as competition for the firm and competition for the firm’s transaction partners. Two, it attempts to quantify the implications of competitive forces on the value capture ranges of each firm in a value network. It does this by connecting all transaction partners in a network, and analyzing all potential transactions.
The Market, its Value Networks and its Agents
The market is defined as a collection of agents that could potentially transact with each other. These agents may be suppliers, customers or competitors. In any given market, the value created by the market (v(M)) is the sum of the best transactions within the various value networks in the market, assuming that all the agents are acting rationally. The value networks are composed of the agents that do transact with each other, each with its own v(N).
For example, in a market of Person C selling a house, Person A who is willing to pay $1 million, and Person B who is willing to pay $1.5 million. Intuitively Person C will sell the house to the highest bidder, Person B. It may also be obvious that Person B does not have to pay how much he is willing to pay, he just needs to outbid Person A at slightly above $1 million. Person B will then be happy that he paid below $1.5 million, and Person C would be happy that he got more than $1 million. Value capture model formalizes the intuition by explicitly assigning numbers to value created. The v(M) is $1.5 million, with two value networks are formed: Person C with Person B, and Person A by himself.
So far, we only talked about value creation. After value is created by the networks that transact, the value must be split by the agents. The distribution of value to each agent is what we call value capture. Value capture is bounded by a few conditions, one of which we have alluded to already.
- Agents has to make more than its value to another network, otherwise they will transact with the other network
- Agents cannot make more than its value to the entire market, otherwise the other agents will transact without him
- These conditions form an agent’s first order minimum and maximum value capture, which can then be affected by the minimums and maximums of the other agents
After considering all agents in the market, we will arrive at a minimum and maximum for each agent in the market. This range fulfills the competitive consistency condition of the value capture model. What the firms capture within this range will be determined by its ability to negotiate, or alpha.
For example, we said Person B should not bid too high, as anything above $1 million is enough to win the bid. This is formalized by condition 1, where Person C’s value to the other network is $1 million, thus Person C must capture at least $1 million from Person B. Alternatively, Person C cannot capture more than $1.5, its added value to the market, as Person B would rather not transact with Person C than lose value. Anything between $1 million and $1.5 million is a plausible transaction price, and that will depend on how charming Person C is relative to Person B.
Now that we defined the conditions for value capture, it is theoretically possible to solve for all the value capture ranges through a system of equations. However, it can be difficult to estimate the required values, analyzing its implications qualitatively is often the best we can do.
Applying Value Capture Model for Strategy
To apply VCM qualitative, we start with an environmental analysis. The steps are as follows:
- Understand the current value networks
- Analyze the value creation
- Analyze the distribution of value
- Explain the distribution of value
If there is low value capture or high value capture, we want to understand why. For example, if an agent’s value capture is low, the agent could have a low min, a low max, or a low alpha. If the agent has a low min, it could be due to a low value added to the other network, or the other networking having significant added value to the market. If the agent has a low max, it could be due to a low value added to the market, or significant competition for its transaction partners. If neither are low, the agent may have poor persuasive abilities, and this could be due to a variety of factors:
- The agent deals with perishable goods
- The agent incurs significant costs during negotiations
- The agent is bounded by government rules and regulations
Once we understand the competitive environment, we can apply strategy to increase value capture. For example, if the agent has a low value added to the other network, the agent could create goods that are less specialized to its own network. A printer ink company could make ink cartridges that fit more than one type of printer. Alternatively, if the agent has significant competition for its transaction partners, it could use parts that are less demanded by outside parties. A game console company could use slightly older technology to reduce how much it has to pay for the technology.
Another way to think about an agent’s value added to the market and other network is its irreplaceability and scarcity, both a type of uniqueness. An irreplaceable agent has high value to the market, and cannot be replaced if it chooses to exit the market. A scarce agent has high value to the other network, and can switch to other networks in the market if it finds the current network undesirable. Your internal strategy would then be to increase your irreplaceability or scarcity, or your alpha. Your external strategy would be to make your partner more replaceable or less scarce, or decrease their alpha.