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Chapter 9 How to Keep Profit from Eroding COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 9 – Take Aways A competitive firm can earn positive or negative profit in the short run until entry or exit occurs. In the long run, competitive firms are condemned to earn only an average rate of return. Profit exhibits what is called mean reversion, or ‘‘regression toward the mean.’’ If an asset is mobile, then in equilibrium, the asset will be indifferent about where it is used (i.e., it will make the same profit no matter where it goes). This implies that unattractive jobs will pay compensating wage differentials, and risky investments will pay compensating risk differentials (or a risk premium). The difference between stock and bond yields exhibits mean reversion; this difference is a useful indicator of whether the market is overvalued.

Chapter 9 – Take Aways Monopoly firms can earn positive profit for a longer period of time, but entry and imitation eventually erode their profit as well. The industrial organization economics (IO) perspective assumes that the industry structure is the most important determinant of long-run profitability. According to the resource-based view (RBV), individual firms may exhibit sustained performance advantages owing to their superior resources. To be the source of sustainable competitive advantage, those resources should be valuable, rare, and difficult to imitate/substitute. Strategy is the art of matching the resources and capabilities of a firm to the opportunities and risks in its external environment for the purpose of developing a sustainable competitive advantage. To stay one step ahead of the forces of competition, a firm can adopt one of three strategies: cost reduction, product differentiation, or reduction in the intensity of competition.

Review of Chapter 8 Demand describes buyer behavior Supply describes seller behavior in a competitive market Increase in “quantity demanded” vs. “increase in demand”  “Movement along” vs. “shift of” Equilibrium price: Q s =Q d Market making is costly Effects of devaluations Explaining changes with shifts in supply and demand curves

Introductory Anecdote: Oakland A’s Oakland A’s won the American League West in 2002, 2003, and 2004 with one of the lowest payrolls in baseball The team relied on statistical analysis to analyze performance  Found that on-base percentage and slugging percentage were best performance predictors  But, other teams did not seem to recognize value of on- base percentage They created an advantage by buying players with higher on-base percentages at prices lower than “true” value to team Unfortunately, the advantage did not last long

Sustainable Competitive Advantage Warren Buffett’s most important investment criterion: “sustainable competitive advantage" SCA creates a “moat” around the company helping protect its profits from the forces of competition A company's prosperity is driven by how powerful and enduring its competitive advantages are Stock price = discounted flow of future profits  Challenge: keep profits from eroding

Competitive Forces Erode Profits Definition: A competitive firm is one that cannot affect price.  close substitutes  elastic demand  many rivals and no cost advantage  no barriers to entry Proposition: In equilibrium, capital is indifferent between entering this industry or any other, and P=AC.

Competitive Firms Cannot affect price; chooses how much to produce Can sell all it wants at the competitive price, so the marginal revenue of another unit is equal to the price. Price equals marginal revenue, so if MC P, produce less Perfect competition is a theoretical benchmark  But, many industries come close  And, the benchmark is valuable to expose the forces that move prices and firm profit in the long run

Competitive Firms (cont.) A competitive firm can earn positive or negative profit in the short-run only Positive profit leads to industry entry driving profit back down Negative profit leads to industry exit allowing profits to rise In the long-run, competitive firms are condemned to earn only an average rate of return

“Mean Reversion” of Profits Asset flows force price to average cost, e.g. economic profits will always revert back to zero. Silver lining to dark cloud  Discussion: If profits recover, what does this say about EVA ® adoption? Reversion speed is 38% per year.  if profits are 20% above the mean one year, in the next year they will be only 12.4% above the mean, on average.

Mean Reversion of Profits

Indifference Principle Proposition: In equilibrium, a mobile asset will be indifferent about where it is used. Discussion: Suppose that San Diego is a lot more attractive than Nashville. Discussion: Michael Porter has tried to convince businesses to re-locate in the inner city.

Compensating Wage Differentials Discussion: Why do embalmers make more than rehabilitation counselors? Discussion: Give example of a compensating wage differential.  Is there a compensating marriage differential?

Finance: Risk vs. Return Proposition: In equilibrium, differences in the rate of return reflect differences in the riskiness of the investment, e.g. risk premium return = (P t+1 -P t )/P t Risk premium on stocks analogous to compensating wage differential

Earnings “Yields” Must Compete with Bond Rates The yield on stocks (i.e. the E-P ratio) must compete with the bond yield.  “mean reversion” of difference

Can you Use This to Predict Stock Prices? Would have missed big structural change in 1980 Discussion: Why did risk premium on stocks fall?

Monopoly (Different Story, Same Ending) Definition: A monopoly firm is one that faces a downward sloping demand curve.  They produce a product or service with no close substitutes;  They have no rivals; and  There are barriers to entry, so no other firms can enter the industry. Proposition: In the very long run, monopoly profits are driven to zero by the same competitive forces.  Example: 1983 Macintosh

Strategy – Trying to Slow Erosion What is the key to competitive advantage and positive economic profit? Two schools of thought  Industrial organization economics – industry is the key!  Resource-based view – firm resources are the key!

IO View of Strategy Industry is the key issue – focus on the external environment Industry structure determines the conduct of firms, which in turn determines their performance. Typical structural characteristics that are of interest to IO researchers include barriers to entry, product differentiation among firms, and the number and size distribution of firms.

IO View of Strategy (cont.) The key to generating economic profit for a business is its selection of industry. According to the Five Forces model of Michael Porter, the best industries are characterized by:  High barriers to entry  Low buyer power  Low supplier power  Low threat from substitutes  Low levels of rivalry between existing firms So, the advice is to pick a good industry and work to make it even more attractive

Support for the IO View Profitability differences do exist across industries

The Resource-Based View According to the resource-based view, individual firms may exhibit sustained performance advantages due to the superiority of their resources (internal focus) Resources are defined as “the tangible and intangible assets firms use to conceive of and implement their strategies” If a resource is both valuable and rare, it can lead to at least a temporary competitive advantage over rivals.

The Resource-Based View (cont.) Resources that may generate temporary competitive advantage do not necessarily lead to a sustainable competitive advantage.  SCA requires that resources must be difficult to imitate or substitute for So from the resource based view perspective, resources and capabilities that are valuable, relatively rare, and difficult to successfully imitate/substitute are at the core of sustained, excellent firm performance.

Generic Strategies Reduce costs Reduce intensity of competition Differentiate product  Example: Frank Purdue  Example: Prelude Lobster

Alternate Intro Anecdote In 1924, Kleenex tissue was invented as a means to remove cold cream. After studying customer usage habits, however, the manufacturer (Kimberly-Clark) realized that many customers were using the product as a disposable handkerchief. The company switched its advertising focus, and sales more than doubled. Kimberly-Clark built a leadership position by creating an innovative use for a relatively common product.

Alternate Intro Anecdote (cont.) As others saw the profits, however, they moved into the market. The managers of the company maintained profitability through a continuing stream of innovations and investment in advertising/promotion  Printed tissue in the 1930’s  Eyeglass tissue in the 1940’s  Space-saving packaging in the 1960’s  Lotion-filled tissue in the 1980’s. Without this continuing stream of innovations and brand support, the product’s profits would have been slowly eroded away by the forces of competition.