Sleeping with the enemy

Target used to outsource its e-commerce service provision to Amazon. Recently they decided to bring these operations in-house and have had some teething problems. After two embarrassing crashes, they’ve patched the site up for the holiday season and the former head of the operation has abruptly left the company. (One problem Target faced in quickly trying to build their site is a scarcity of programming talent–even hot Silicon Valley companies are having trouble recruiting skilled Web architects and coders.)

A simple question: Why is Target doing this? The question is not simply a classic make-or-buy decision but a decision about whether to “sleep with the enemy” by purchasing essential upstream inputs or services from a downstream rival. This issue comes up quite frequently in company scope discussions. One Harvard Business School case where it explicitly arises is PepsiCo’s Restaurants. Burger King, which had long poured Pepsi from its fountains (in contrast to the “all-American” combination of McDonalds and Coke), switched to Coke when Pepsi bought Taco Bell and KFC. The case claims that Coke salesfolk successfully argued that BK shouldn’t buy soda from its competitor in fast food.

There’s an instinctive tribal emotion that might motivate such behavior, but is there any rational reason to avoid “sleeping with the enemy” in this fashion? An oligopoly analysis actually favors such promiscuity, since being an upstream customer of one’s downstream rival actually reduces the rival’s incentive to steal customers from you (since they now have to net out the lost upstream sales). This effect reduces the rival’s willingness to make sunk promotional expenditures, for example, to capture market share from you–a point of market share grabbed from you now makes a smaller impact on the rival’s bottom line.

The obvious fear is of sabotage by one’s “enemy supplier.” (The rival would be raising your cost or reducing your value to gain a stronger competitive position.) This is the most common response given by outside analysts of Target: As e-commerce becomes more important, a company cannot allow its destiny to be controlled by a rival like Amazon. Given some past problems between Amazon and Toys R Us, this isn’t completely crazy, but as one analyst pointed out, Amazon has every incentive now to maintain a reputation as a reliable provider of cloud services given its giant investment in this fast-growing area.

 Here you have to look at the reputational impact on your rival’s upstream business if it’s caught doing this, as well as potential legal remedies you might have available (and might be able to negotiate contractually). Unless the supplier has subtle ways of screwing you that wouldn’t be easy for you to detect or to prove to others, this risk seems reasonably easy to control. (If the rival supplier is not a profit maximizer, e.g. a state-owned enterprise, the risks go up.)

Most of the other fears that firms could rationally entertain are the traditional ones for outsourcing, even from suppliers who are not also downstream rivals. For example, maybe Target anticipates the need for asset-specific investments between its e-commerce activities and its brick-and-mortar businesses and believes it faces either ex ante investment incentive problems a la Grossman and Hart or ex post haggling problems a la Williamson. I’m not sure just what these would entail that couldn’t be handled effectively with long-term relational contracts, but in any case Amazon’s status as a downstream rival has no bearing on them.

So it’s hard to come up with a plausible argument against sleeping with the enemy. But managers and analysts frequently express discomfort with it. Am I missing something?


7 Comments on “Sleeping with the enemy”

  1. I’ve had several experiences with this conundrum. Sometimes the decision is culturally-based. When you are at “war” with a competitor and you view their success as your failure, ‘sleeping-with-the-enemy is incomprehensible. I’ve been there. I’ve also been in situations where it made strategic sense to sleep with the enemy. When you do that, you get to know them better and there is opportunity for dialogue. The less “war-type” emotion in a competitive relationship, the better the profitability. But if one is not careful, that can lead to an unethical practice that is still pervasive in many markets – price fixing – even amongst the most respected companies on the globe. http://ceoafterlife.com/marketing/insider-insight-on-price-fixing-you-may-2/

  2. Steve,

    Thanks for a very useful post.

    I am not sure you can find a good rational for what could very well be an inherently irrational decision. One the decision is framed: “Sleeping with the enemy,” the framing effect could overpower any other more logical considerations.

    Thanks,

    Arie Goldshlager
    @ariegoldshlager

  3. This is a very common question in the technology industry overall (my view of Amazon is from that perspective, though I work for an enterprise software company). We work to make our database the absolute best database you could use with our competitor’s applications, which makes those applications more effective/valuable/competitive against our own applications, but it also makes our database much more valuable. Our competitors might also try to push alternative database technologies, but they can only go so far without hurting the value of their own core applications (which works best on our database, but even if it was a closer contest their customers all already have a lot of licenses for our technology). In the hardware space, we were actually sued by a competitor when we indicated we might stop releasing new versions of some of our software engineered to work with their proprietary systems.

    • srp says:

      Great anecdote about the hardware firm trying to place you in upgrade serfdom. You’d have to be classed as a dominant monopoly for that ploy to fly as an antitrust claim, I think.

      I won’t try to pierce your corporate veil (cough, Oracle?) but there are clearly some industries where these relationships are accepted and others where they make managers uncomfortable. Computing systems is definitely rife with them. Hollywood also has all sorts of distribution and financing deals between firms whose movies go head-to-head in the marketplace. In fact, they will work together even while locked in litigation with one another.

      It might be interesting to isolate the factors that make some industries more prone to sleeping with the enemy than others. I would have guessed that it has something to do with customer pressure to work together, but the Hollywood example doesn’t fit, since moviegoers and theater owners don’t care that much about who distributes a film.


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