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Why is the middle a tough place to operate?

January 20, 2014

For any given product, one can usually find businesses that succeed on either end of the quality spectrum. On the lower end of the quality spectrum, successful firms use scale in order to produce the simplest, cheapest version of a product. On the other end of the spectrum, success depends on producing the best possible product while charging a price that more than offsets a lack of scale. Businesses that attempt to sell a product in the middle of the quality spectrum tend to struggle because it is not possible to offset the advantages of scale without charging a disproportionately higher price. All of this begs the question: could a company successfully produce a mid-tier product simply by applying the advantages of scale to additional features? The answer is no, for two reasons that are related. First, it is difficult to offer new features while taking advantage of scale because scale requires simplicity. Second, the moment a firm successfully incorporates a new feature into their production process without adding significant marginal cost, competitors will simply incorporate that same feature into their own production process and offer the same product at a lower price again. In essence, every time a firm successfully accomplishes this goal, the low end of the quality spectrum shifts up. As a consumer, I must have witnessed this process play itself out with DVD players. At one point, the differentiating feature between the cheapest and most expensive DVD players on the shelf at Target was something called “progressive scan”, which increased the resolution of the image. Eventually, the cheap DVD players all offered progressive scan without charging a higher price. Someone must have figured how to incorporate the progressive scan technology into their manufacturing process without adding much to the marginal cost of each DVD players. The cheap DVD players on Target’s website today list progressive scan among their features while upscale production has shifted to Blu-ray technology and other new-fangled gadgets.

Framed this way, I believe it is relatively clear why it can be hard to produce mid-tier products at a profit. A consumer-based view, on the other hand, can distort the picture and that is why I thought this was worth pointing out. A hypothetical example this time: an entrepreneur notices that 90% headphones sold today are inexpensive and of low quality while 10% are extremely expensive headphones with features such as noise cancelling technology. Within the 90% of consumers purchasing cheap headphones there is actually a wide range in income from people making close to nothing to people earning $100,000 per year. Because both individuals earning $100,000 and those earning very little income are purchasing the same headphones, the entrepreneur concludes that there is demand for a middle quality product. Unfortunately, what the entrepreneur eventually discovers is that while the demand is in fact there, the sale price of the headphones is not high-enough to offset his loss of scale.

I was thinking about all of this today because I have started to notice a pattern in business and economic news where firms in the middle are unable to compete. In one example from last week’s edition of The Economist, both General Motors and Land Rover are performing well at the moment, but mid-size firms such as Peugeot-Citroen are not. In another example, Capitol Grille and Chipotle are succeeding at the same time that casual dining chains such as Red Lobster are floundering. The labor market is not immune to these forces either: how many headlines have there been reaffirming the “hollowing out” of the job market? Talented executives are earning higher pay while jobs are always open for those willing to accept low pay, but there seems to be little in between. The fact is, the middle is not a safe place to operate because profits are built on scale or price and there is no happy medium between the two.

-TVB

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