Economics of Strategy Fifth Edition Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc. Chapter 14.

Economics of StrategyFifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 14

Sustaining Competitive Advantage

Besanko, Dranove, Shanley, and Schaefer

Sustaining Competitive Advantage

Sustaining competitive advantage over time is not easy.

Rivals can imitate the formula for success.Rivals can use new technologies, products

and business practices to erode the competitive advantage of industry leaders.

Yet Some firms have been successful in sustaining their competitive advantage (Coca-Cola, Dell Computers) for long periods of time.

Perfect Competition & Competitive Advantage

In a perfectly competitive industry where firms are price takers, competitive advantage does not exist.

Even when the product varies on a cost-quality continuum dynamics of perfect competition can work.

The Perfectly Competitive Dynamic

The efficient frontier is the boundary with the best feasible price-quality combinations.

A price-quality point such as (PA, qA) is not sustainable if there is free entry since a rival can enter at (PB, qB).

Free entry and costless imitation will force all the firms to move to the tangency point and the economic profit will be zero.

The Perfectly Competitive Dynamic

Sustainability with Monopolistic Competition

In monopolistic competition, firms sell horizontally differentiated products to consumers who differ in their tastes.

Each seller faces a downward sloping demand curve due to product differentiation

Sellers get to set the price above marginal cost but there is no guarantee of economic profits.

Sustainability with Monopolistic Competition

Entrants can slightly differentiate their products from the incumbents’ and create their own niche.

Free entry will cut into the market share of the incumbents and make the economic profit become zero.

Profitability cannot be sustained unless entry is deterred

Threats to Sustainability

Even when incumbents can deter entry economic profits may not be sustainable.

Sometimes good performance may be simply due to luck.

Over time profits regress to the mean.

Threats to Sustainability

Good performance is not always attributable to luck.

A firm might develop advantages that are hard to imitate.

Yet if the suppliers/buyers are powerful they can extract the profits.

Effect of Competitive Forces on Profitability

Entry, imitation and price competition will force economic profits to eventually go to zero

Competitive forces will make return on assets (ROA) to equal the cost of capital

Regardless of where a given firm is today, with passage of time its profits will converge to competitive levels.

Evidence on the Persistence of Profitability

Dennis Mueller’s study of U. S. manufacturing firms finds that:

Firms with abnormally high ROA will experience a decline over time

Firms with abnormally low ROA will experience an improvement over time and

high ROA firms and low ROA firms do not converge to a common mean

Evidence on the Persistence of Profitability

Mueller’s results indicate that there are some forces that push markets towards the competitive rate of return and other forces that impede that dynamic.

The net result is a persistent ROA gap between firms that start out as high ROA firms and firms that start out as low ROA firms .

The Persistence of Profitability in Mueller’s Sample

Competitive Advantage of Firms and Industry Profitability

A firm in a fiercely competitive industry may continue to have an edge over its rivals if its competitive advantage is difficult to imitate.

Firms within an industry with high entry barriers may earn economic profits but may all be equally profitable.

Sustaining Competitive Advantage

Competitive advantage is sustainable if it persists despite competitors’ efforts to duplicate it or neutralize it.

Sustainability can occur in two ways. Firms may differ with respect to resources and

capabilities and the differences persist.

Isolating mechanisms (analogous to barriers to entry) may work to protect the competitive advantage of firms.

Resource Based Theory of the Firm

Resource based theory of the firm explains sustained competitive advantage in terms of heterogeneity in resources and capabilities.

To support competitive advantage resources and capabilities have to be scarce

imperfectly mobile and

unavailable in the open market.

Resource Based Theory of the Firm

Immobile resources may be inherently non-tradable (Example: Reputation for toughness)

Immobile resources may be relationship specific (Example: Landing slots in an airline’s hub)

Isolating Mechanisms

Isolating mechanisms limit the rivals from eroding a firm’s competitive advantage.

Isolating mechanisms are to firms what entry barriers are to industries.

Two distinct types of isolating mechanisms are Impediments to imitation Early mover advantage

Impediments to Imitation

These mechanisms impede the potential entrants from duplicating the resources and capabilities of the incumbent firm

Five important types of impediments are legal restrictions Superior access to inputs/customers Market size and scale economies Intangible barriers

Intangible Barriers to Imitation

Barriers to imitation will be intangible if the firm’s advantage lies in distinctive organizational capabilities.

Three such barriers to imitation can be identified. Casual ambiguity Historical circumstances Social complexity

Casual Ambiguity

A firm’s superior ability to create value may be obscure and imperfectly understood, even by those in the firm.

Casual ambiguity may become a source of diseconomies of scale because the firm may be unable to replicate its success from one plant to the next.

Historical Circumstances

Distinctive capabilities may be bound up with the history of the firm

Dependence of the capabilities on historical circumstances may limit the firm’s growth potential

Historical dependence may also mean that the strategies may be viable for only a limited time

Social Complexity

Competitive advantage may be hard to replicate if the advantage is rooted in socially complex processes

Such processes include interpersonal interactions among managers, suppliers and customers.

Complex social interactions are not easily imitated even when understood.

Intangible Barriers & Organizational Change

When major organizational changes are undertaken, it is easy to overlook intangible sources of competitive advantage.

Major organizational changes are more likely to achieve the desired results in “greenfield” plants than in established ones.

Early-Mover Advantage

Four different isolating mechanisms fall under the category of early mover advantage

Learning curve Reputation and buyer uncertainty Switching costs Network Effects

Networks and Standards

Many networks are based on standards (telephone, railroads)

Established standards are difficult to replace

Two key questions: Should a firm compete “for the market” or “in the

market?” What does it take to topple the existing standard?

“For the Market” or “In the Market”?

Monopoly in a smaller market may be more valuable than competing as a small player in a large market.

If the standards war is going to be too costly, it may be better to accept a common standard.

It is critical to attract early adopters to build the installed base of customers.

“For the Market” or “In the Market”?

Standards war may discourage the production of complementary products, hurting the entire industry.

To win the standards battle manufacturers of complementary products may have to be offered a greater share value added.

Fighting a Dominant Standard Successfully

Installed base gives the incumbent the edge.

To challenge the dominant standard the rival should offer superior quality or new options.

The rival should also tap into the complementary goods market.

Early Mover Disadvantages

Early movers may lack the complementary assets to make their products succeed

Early movers can lock themselves into inferior technologies and rivals can learn from these mistakes (Example: Wang Laboratories)

Imperfect Imitability & Industry Equilibrium

With imperfect imitability, but otherwise competitive conditions, some firms consistently earn economic profits.

Yet to potential entrants the industry appears to offer zero expected profits

Lippman and Rumelt explain this outcome using entrants’ uncertainty regarding their costs.

Imperfect Imitability & Industry Equilibrium

Competition makes entrants’ pre-entry (ex-ante) expected economic profit zero

Entrants are uncertain about their post-entry cost structure.

Ex-post if an entrant turns out to be a high cost producer it quits.

Observed average profits for the industry will be positive due to survivorship bias.