Beyond the Reach of the Invisible Hand: Impediments to Economic Activity, Market Failures, and Profitability Dennis A. Yao Strategic Management Journal, Vol. 9, Special Issue: Strategy Content Research. (Summer, 1988), pg By Amit Jain

MARKETS ARE EFFICENT Product Differentiation Capital Barriers to Imitation Govt Policy Distribution Channels Switching Costs Scale Transaction Costs Production Economies and Sunk Costs Imperfect Information

Basic Relationships 1. Entry barriers as operational combinations of IEAs 2. IEAs cause market failure 3. Absent IEAs, entry barriers may not cause market failure

Shortcomings of Economic Theory The Efficient Market: ◦Consumers and producers act as price takers ◦Markets exist for all commodities ◦Buyers and sellers have complete information ◦Thus, all firms will make normal (average) profits  Perfectly competitive markets lead to long-run profits that are average  Good strategy leads to survival, not excess profits So why do we observe companies making excess profits? ◦Market failure has created ‘supra-normal’ profitability ◦Strategists are interested in identifying factors that create an imperfect market (i.e. imperfect competition)

Industrial Organization – Barriers to Entry: A source of market failure Industrial Organization (IO) Literature ◦Barriers to Entry (Bain 1956, Caves and Porter 1977), such as product differentiation or capital requirements Example of product differentiation ◦The perception of a product as being different works only if the buyer is uninformed about the products in the market  Absence of cost-effective credible information  Imperfect information Therefore, there is more to market failure (and more sources) than B2E

Impediments Theory – another source of market failure  Transaction Costs  Production Economies  Sunk Costs  Imperfect Information

Transaction Costs Two relevant types ◦Free-rider problem: Costs of excluding non-buyers from use of a product or service  Excluding non-subscribers from benefits of product review ◦Costs of communication and information  Writing long-term contracts when all future contingencies cannot be predicted Strategies for dealing with transaction costs ◦Vertical integration ◦Culture change: match employee’s goals with organization’s goals ◦Develop long-term relationships with outside organizations

Production Economies, Sunk Costs, Imperfect Information Production Economies ◦Economies of Scale, Learning Curve, Economies of Scope Sunk Costs ◦In absence of sunk costs, entry and exit become costless (‘contestible’ markets) Imperfect Information ◦Absence of perfect buyer information leads to above average price-cost margins ◦Ways to exploit: provide information oriented strategies  Reputations: brand loyalty.  Product differentiation through advertising  Signaling quality through warranties  “Price reflects Quality” – high price, high quality.

Concluding Thoughts and Comments The paper integrates B2E with IEA. However, the paper’s implications on transaction costs is limited. ◦Here’s an extended definition: The firm exists by minimizing transaction costs, which includes costs associated with opportunism, complexity, and uncertainty. Can transaction costs theory encompass impediments theory? ◦Since production economies (quasi-rents), sunk costs (sunk investments), and imperfect information (uncertainty) are handled within the boundaries of the firm, then transaction costs may be sufficient.