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Textbook excert: explanation of cannibalization.

Negative Within-Firm Externalities

If a retailer like Gap opens a new store that is close to its existing stores, then the new store might attract customers who would otherwise buy from the existing stores, reducing the old stores’ cash flows. Therefore, the new store’s incremental cash flow must be reduced by the amount of the cash flow lost by its other units. This type of externality is called cannibalization, because the new business eats into the company’s existing business. Many businesses are subject to cannibalization. For example, each new iPad model cannibalizes sales from MacBook Air laptops. Those lost cash flows should be considered, and that means charging them as a cost when analyzing new products.

Dealing properly with negative externalities requires careful thinking. If Apple decided not to come out with a new model of iPad because of cannibalization, another company might come out with a similar new model, causing Apple to lose sales on existing models. Apple must examine the total situation, and this is definitely more than a simple, mechanical analysis. Experience and knowledge of the industry are required to make good decisions in most cases.

One of the best examples of a company getting into trouble as a result of not dealing correctly with cannibalization was IBM’s response to the development of the first personal computers in the 1970s. IBM’s mainframes dominated the computer industry, and they generated huge profits. IBM used its technology to enter the PC market, and initially it was the leading PC company. However, its top managers decided to deemphasize the PC458 division because they were afraid it would hurt the more profitable mainframe business. That decision opened the door for Apple, Dell, Hewlett-Packard, Sony, and Chinese competitors to take PC business away from IBM. As a result, IBM went from being the most profitable firm in the world to one whose very survival was threatened. IBM’s experience highlights that it is just as important to understand the industry and the long-run consequences of a given decision as it is to understand the theory of finance. Good judgment is an essential element for good financial decisions.