Sustaining Competitive Advantage Economics of Strategy Besanko, Dranove, Shanley and Schaefer, 3rd Edition Chapter 12 Sustaining Competitive Advantage Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc.

Sustaining Competitive Advantage In a perfectly competitive market, price competition will ensure that competitive advantage will not be sustained Even without perfect competition, sustaining competitive advantage is not easy Rivals can imitate a successful firm’s products or neutralize the firm’s advantage through new technologies, products and business practices

Sustaining Competitive Advantage Some firms have been successful in sustaining their competitive advantage (Coca-Cola, Dell Computers) Others have allowed their competitive edge to erode under pressure from their competitors (Dominick’s Pizza, Silicon Graphics)

Perfect Competition and Competitive Advantage In a perfectly competitive industry where firms are price takers, competitive advantage does not exist Even when the product is not homogenous (and varies on a cost-quality continuum), dynamics of perfect competition can work

The Perfectly Competitive Dynamic

The Perfectly Competitive Dynamic The efficient frontier is the theoretical boundary that no firm can cross Free entry and costless imitation will force all the firms to move to the tangency point and the economic profit will be zero

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 and sets the price above marginal cost

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 (while price > marginal cost) Profitability cannot be sustained unless entry is deterred

Threats to Sustainability Regardless of Market Structure Even when incumbents can deter entry, powerful suppliers/buyers can threaten profitability regardless of market structure Sometimes good performance may be simply due to luck and over time profits regress to the mean

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 profit persistence reports the following Firms with abnormally high ROA will experience a decline over time Firms with abnormally low ROA will experience an improvement over time 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 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

Competitive Advantage of Firms and Industry Profitability Industry conditions that determine industry-wide profitability are distinct from forces that sustain a firm’s competitive advantage A firm in a fiercely competitive industry may continue to have an edge over its rivals Firms within an industry with high entry barriers and higher than competitive profits 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 Scarce resources and capabilities that are critical for value creation can be imperfectly mobile and cannot be acquired in the open market

Resource Based Theory of the Firm Resources may be non-tradable (Example: Customer loyalty built through a frequent flyer program) Resources may be relationship specific (Example: Landing slots in an airline’s hub)

Isolating Mechanisms Isolating mechanisms are to firms what entry barriers are to industries Two distinct types of isolating mechanisms can be observed 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 exist 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 in the open market will not lead to economic profits unless the firm can deploy this asset in superior ways

Superior Access to Inputs/Customers Firms often achieve exclusive access to key resources either through vertical integration or long term contracts Firms can deny rivals access to distribution channels through the use of exclusive dealing clauses

Superior Access to Inputs/Customers Competitive advantage may not exist if access to channels was acquired at “below-market” prices Bidding for access in the open market brings in the “winner’s curse” problem

Market Size and Scale Economies Scale based barriers are likely to be effective in markets for specialized products where the demand is large enough for only one producer Scale based barriers may come down if the market experiences growth

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, both within the firm and of the suppliers and customers Even if the rivals understand the source of competitive advantage, they cannot replicate the complex social interactions

Intangible Barriers and Organizational Change When major organizational changes are undertaken, it is easy to overlook intangible sources of competitive advantage (such as casual ambiguity, historical circumstances and social complexity) 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

Limitations of the Reputation Effects Firms may overly rely on a brand and overexploit its reputation Reputation benefits may be appropriated by powerful downstream players in the vertical chain (Example: Mass merchandisers exercising buyer power)

Limitations of the Reputation Effects Demographic changes and changes in tastes may undermine the value of an established brand Technology may narrow the quality gap between the top brands and the lower brands

Switching Costs Consumers who make brand specific investments (for example, learning to use a software program) can end up with large switching costs Frequent buyer points in grocery stores and frequent flyer miles from airlines are means of increasing switching costs

The Downside of Switching Costs For established firms, a large installed base could serve as a soft commitment When a firm has a large installed base, it is costly to compete on price for new customers

Network Effects Product shows network effects if customer values the product depending on how many others are using the product The usefulness of joining a telephone network depends on the number of customers already on it (actual networks) Use of complementary goods may create virtual networks

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 (Example: computer operating system and application software)

First Mover Advantage Network effects offer opportunities to the first mover Size of the network will attract new customers

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?” Is it possible 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 It is critical to attract early adopters Without a common standard, complementary products may not be forthcoming

“For the Market” or “In the Market?” To enlist manufacturers of complementary products, share value added with them If the standards war gets too costly, agree on a common standard

Fighting a Dominant Standard Successfully Installed base gives the incumbent the edge The challenger should offer superior quality (Sony vs. Nintendo) Should be able to tap into the complementary goods market

Early Mover Disadvantages Early movers may lack the complementary assets to make their products succeed Early movers can make mistakes that lock them into inferior technologies and others can learn from these mistakes (Example: Wang Laboratories)

Imperfect Imitability and Industry Equilibrium With imperfect imitability and otherwise competitive conditions, average firms will make below average profits and some firms consistently earn economic profits If the firms are uncertain about their post-entry position, pre-entry (ex-ante) expected economic profit will be zero

Imperfect Imitability and Industry Equilibrium Average firms earn below average profits since below average firms may exit Observed average profits for the industry will be overstated due to survivorship bias