Economics of Strategy Sixth Edition

Copyright 2013 John Wiley Sons, Inc.

Chapter 11

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.

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.

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.

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

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

Legal Restrictions

Legal restrictions such as patents and copyrights as well as government regulation through licensing and certification can impede imitation.

Acquiring a patent or a copyright at open market prices will not yield economic profits unless the firm can deploy this asset in superior ways

Market Size and Scale Economies

Scale based barriers are likely to be effective when the market demand can be met by one producer (Markets for specialized products).

Scale based barriers may come down if the market experiences growth and entry becomes profitable.

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

Learning Curve

A firm that sells more than its competitors in the early periods moves farther down the learning curve and achieves lower unit costs than its rivals.

The lower unit cost allows the firm to undercut its rivals, increase volume and further move down the learning curve.

Reputation and Buyer Uncertainty

For experience goods, a firm’s reputation for quality provide a significant early mover advantage.

Pioneering brands can influence the formation of consumer preferences and present the attributes of the brand as the ideal for the product category

Switching Costs

In some situations buyers end up incurring significant switching costs if they change to another supplier. Consumers who make brand specific investments (for

example, learning to use a software program)

When sellers develop buyer specific knowledge (for example in banking)

Customers who belong to loyalty programs in grocery stores or frequent flyer programs of airlines

Network Effects

Product shows network effects if customer values the product depending on how many others are using the product

There are actual networks whose usefulness depends on the number of customers already on it (telephone networks, social networks)

Virtual networks arise from the use of complementary goods (software and PCs)

Virtual Network

In virtual networks, consumers are not physically linked.

Increase in the number of the consumers increases the demand for complementary goods.

Supply of complementary goods enhances the value of the network.

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”?

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.

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.

Creative Destruction

Markets have periods of comparative quiet punctuated by shocks and discontinuities

During the period of quiet firms that posses superior products and technology earn economic profits

Entrepreneurs who exploit the opportunities created by the shocks enjoy economic profits during the next period of quiet

Creative Destruction and Growth

Schumpeter considered static efficiency - allocative efficiency at a point in time - to be less important than dynamic efficiency

Society benefits much more from competition between new products, new technologies and new forms of organization than from price competition

Creative Destruction & Competitive Advantage

Creative destruction implies that the isolating mechanisms that protect a firm’s competitive advantage will not be permanent

The life expectancy of a competitive advantage shrinks as technology and tastes change rapidly

Disruptive Technologies

Many of the disruptive technologies have higher perceived benefits and lower costs

Some times disruptive technologies can have lower benefits and much lower costs (example: Downloadable MP3 recordings versus higher resolution in CDs)

Innovation and the Market for Ideas

If there is a market place for ideas, the incumbent can acquire the technology of the entrant.

The entrant can sell its ideas for full value.

Incumbent has incentive to invest in R & D to improve its bargaining position.

Incumbent may also skip R & D investment to avoid duplication.

Market for Ideas

For the innovator to realize the full value of the innovation technology should be protected by patents and

the required expertise in production and marketing of the innovative products is not scarce

The balance of power shifts away from the innovator to the established firms if such expertise is scarce.

Market for Ideas

Incentives in allocating capital to innovation differ between small and large firms.

Small firms face the external capital market with uninformed investors.

Large firms use internal capital markets where allocation can shift away from faltering projects quickly.

Innovation Competition

Staying even slightly ahead of the rivals will produce disproportionate benefits

First innovator will benefit from

patent protection

network externalities (even when there is no patent protection) and

consumer perceptions.

Patent Race

In a “winner take all” race to obtain a patent, a firm should look at the following factors before deciding whether or not to increase its R & D investment

Effect of additional investment in R & D productivity

Response by the rivals to increased investment by the firm

The number of competitors in the field

Evolutionary Economics and Dynamic Capabilities

In traditional economics, a firm is assumed to make decisions to maximize economic profit.

Evolutionary economics views decisions made by a firm as determined by established routines.

Routines include methods of production, hiring policies, etc.

Evolutionary Economics and Dynamic Capabilities

Usually a firm’s routines change slowly over time (if they do change).

To ensure survival, firms need to continuously improve their routines.

Firms with dynamic capabilities can adapt their resources and capabilities and exploit opportunities created by market shocks and discontinuities.

Factors that Limit Dynamic Capabilities

A firm’s dynamic capabilities are inherently limited because of

the path dependence of sources of competitive advantage

limited availability of complementary assets

“windows of opportunity” that do not stay open for long

Path Dependence

Firm’s routines can only change incrementally and cannot have a clean break from the past

The new source of advantage will be path dependent

With threats from new entrants, even small path dependencies can have major implications for the firm’s competitiveness

Complementary Assets

Complementary assets are assets that are valuable only with a product or technology.

If changes in a routine lowers the value of complementary assets, the firm will be reluctant to adopt the changes.

Windows of Opportunity

Early in a product’s life, its design and specifications will be fluid and firms will have room for experimentation.

Over time a narrow set of design and specifications emerge as dominant and it is hard for new firms to challenge market leaders.

Those who do not exploit the window of opportunity get shut out.

The Environment

Michael Porter suggests that the firm’s local environment is a major influence on its competitive environment.

Even as a modern firm transcends local markets, the source of its competitive advantage remains localized.

The Environment

A firm’s home nation and home markets play an important role in its ability to sustain its competitive advantage

by supporting the accumulation of valuable resources and capabilities and

by exerting pressure on the firm to innovate, invest and improve

The Environment and the Origins of Competitive Advantage

Factor Conditions

A firm’s competitive advantage in the global markets is enhanced by the availability of specialized factors of production in the home market.

To be globally competitive, availability of highly skilled workers in the home nation may be more important than availability of low wage workers.

Demand Conditions

A firm’s competitive advantage is enhanced by the size, growth and nature of demand in the home market.

When home market places a high value on quality, the firm is stimulated to make improvements in the quality dimension.

Unique local conditions can also be a source of innovations.

Related and Supporting Industries

A strong base of competent suppliers and support industries at home will help a firm achieve competitive advantage globally.

Sharing scarce production know-how is easier with geographical proximity.

Strategy, Structure, and Rivalry

Local management practices, corporate governance norms and nature of the local capital markets can influence the competitive advantage of global firms.

Local rivalry may hold down local profits but make the firms well positioned in the global arena.

Firms that enjoy local protection often fail to make a mark outside the home nations.

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