Economics of Strategy Fifth Edition Slides by: Richard Ponarul, California State University, Chico Copyright  2010 John Wiley  Sons, Inc. Chapter 15 The Origins of Competitive Advantage: Innovation, Evolution and the Environment Besanko, Dranove, Shanley, and Schaefer

Competitive Advantage Acquiring a competitive advantage involves  anticipating unmet and unarticulated consumer needs deep into the future  investing development of new products  investing in capabilities to produce and distribute these products and  be the first to do so

Entrepreneurship and Competitive Advantage Competitive advantage arises from a firm’s entrepreneurial ability to exploit market shocks and discontinuities New sources of competitive advantages displace established ones (Schumpeter’s creative destruction)

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 and Monopoly Schumpeter’s ideas have been used to defend monopoly. Presumably monopoly leads to greater investment in innovation and higher long term growth.

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)

Sustainability and Creative Destruction Access to ongoing scientific expertise is essential for riding the wave of creative destruction. Biotech and pharmaceutical firms stay in close touch with the scientific and academic community. They reward scientists for generating general scientific knowledge.

Strategic Intent and Strategic Stretch According to Hamel and Prahalad, successful firms like CNN, SONY and Honda tend to have strategic intent - an obsession with global dominance in their industries For these firms, there is a gap - strategic stretch - between their strategic intent and their current resources and capabilities

Hypercompetition Firms are said to enter a state of hypercompetition state when competitive advantages can only be sustained for very short periods. According to Richard D’Aveni, several industries are in this state. Firms in these industries continually seek new sources of competitive advantage.

Hypercompetition Strategies A firm’s chief strategic goal should be to disrupt the existing sources of advantages including its own. A firm that relies solely on its existing source of advantages will be displaced by more innovative rivals. Firms may be able to create shocks on their own rather than waiting for them to occur.

Incentives to Innovate Established firms face certain incentives to refrain from innovation.  Sunk cost effect  Replacement effect They also face certain incentives to become innovators.  Efficiency effect

The Sunk Cost Effect For established firms, costs incurred to commit to a particular technology are sunk costs. Investment in resources and capabilities specific to the technology will be less valuable with another technology. Established firms tend to favor the current technology.

Replacement Effect The opportunity to innovate is assumed to be available to either an incumbent monopolist or a potential entrant. The innovation will lower the average variable cost. If the entrant gets to innovate it can displace the monopolist and its incentive to do so depends on the value of becoming the monopolist.

Replacement Effect Monopolist’s incentive to innovate will be less since it will be replacing itself. Established firms will be less willing to innovate that potential entrants.

Efficiency Effect If the monopolist anticipates that the entrant may get an opportunity to innovate, its incentives to innovate will be stronger. If the monopolist can continue to be monopolist by innovating, its incentives will greater than the potential entrants.

The Incentive to Innovate All three effects (sunk cost, replacement and efficiency) will work simultaneously to determine if the incumbent will innovate or not. Replacement and sunk cost effects may dominate if the probability of innovation by entrants is low. Efficiency effect will dominate if the potential entrants are likely to capitalize on the incumbents failure to innovate.

Innovation Competition Competition to innovate can be like a “winner take all” contest When firms compete to develop the same product, the firm that does it first will enjoy a significant advantage The winner may be able to get a patent and/or the advantages of a first mover

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

Choosing the Technology When multiple R & D methodologies are available, a firm should consider the following characteristics  Riskiness of each methodology (uncertainty about the anticipated completion date)  Correlation between methodologies (when the uncertainties are resolved, how often are the outcomes similar?)

Riskiness of R&D A monopolist will be indifferent about risk as long as the expected completion date is the same for all methodologies When firms compete, each firm will end up choosing a high variance strategy over a low variance strategy, if the expected completion date is the same

Riskiness of R&D If all the other firms follow a low variance methodology, a firm that follows a high variance methodology improves its odds of being the first to reach the desired outcome Every firm faces the same incentive to switch to a high variance methodology and no firm will choose a low variance methodology

Correlated Research Strategies Society benefits more if firms pursue uncorrelated methodologies (compared with correlated ones) since the probability of any one firm reaching the goal is higher with uncorrelated methodologies It turns out that firms left to decide on their own will choose uncorrelated strategies

Correlated Research Strategies If many firms pursue the same methodology, each firm will have a small probability of success. Any one firm will benefit by pursuing an uncorrelated methodology and increase its chance of winning. A niche R & D strategy (uncorrelated) can be valuable even when the probability of success is small.

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

Managing Innovation A firm has to contend with two opposing forces in trying to manage innovation. To foster innovation, creativity and entrepreneurship, the organization should be sufficiently flexible. However, coordination of innovative activities will require formal structure and controls.