Chapter 13 The Origins of Competitive Advantage: Innovation, Evolution, and Environment Prepared by Charles Crompton Sam Etchegaray Gino Fumia AGB 450: Agribusiness Strategy Formulation Dr. Sean Hurley Cal Poly College of Agriculture December 5, 2003

Developing a Competitive Advantage Looking deep into the future to anticipate unmet or even unarticulated consumer needs. Betting on alternative technologies. Investing in the development of new products and new capabilities to produce and deliver those products to market. Being the first to introduce those products to the marketplace to benefit from early-mover advantages.

Origins of Competitive Advantage Part 1- Role of innovation and entrepreneurship in a market economy. Part 2- Firms’ incentives to innovate. Part 3- Competition among innovators. Part 4- Innovation from the perspective of evolutionary economics. Part 5- Relationship between the firm’s local environment and its ability to gain competitive advantage. Part 6- The process of managing innovation inside the firm.

Creative Destruction Creative Destruction, evolutionary process described by economist Joseph Schumpeter. Def- When quiet periods in markets are punctuated by fundamental “shocks” or “discontinuities” that destroy old sources of advantage and replace them with new ones. The entrepreneurs who exploit the opportunities these shocks create will achieve positive profits in the next period of comparative quiet. Comparative Quiet- Time in market where firms that have developed superior products, technologies, or organizational capabilities earn positive economic profits.

Creative Destruction Cont… Shumpeter says that Static Efficiency is less important than Dynamic Efficiency. Static Efficiency- The optimal allocation of society’s resources at a given point in time. Dynamic efficiency- The achievement of long-term growth and technological improvement. Competition between new products, new technologies, and new sources of organization are more important than price competition. Defends monopoly, concentration of wealth and power leads to greater investments in innovation and higher-rates of long term growth.

Dynamic of Competitive Advantage Economic Profitability Sustenance of Advantage Time Development of Advantage Erosion of Advantage

Disruptive Technologies Def- Class of technologies that has higher B-C than their predecessors, but does so through a combination of lower B and much lower C. Examples- Personal Computers (replacing more powerful mainframes) Ink Jet Printers (replacing higher resolution laser printers) E-Mail (replacing “snail mail” and telephones) MP3’s (replacing higher audio resolution compact disks) These products are inferior to the ones that they replaced, but the consumers did not put a high value on the extra features and quality of the older technology. Established firms forestall success of disruptive technologies by doing a better job of marketing their benefits.

Sustainability and Creative Destruction Prahalad and Hamel’s Ideas Strategic Intent- Idea that the fundamental focus of a firm’s strategy that commits it well beyond its current resource profile. Strategic Stretch- Idea which combines commitment to the firm’s ambitions with the flexibility to change with circumstances. Sony succeeded by sustaining their obsession with global dominance in their industry. Sony had to expand and adapt their current stock of resources and create new ones.

D’Aveni’s View Argues that the sources of competitive advantage are being created and and eroded at an increasingly rapid rate. Hypercompetition- Phenomenon that the length of sustainable advantage is decreasing. A firm can sustain positive economic profits only by continually developing new sources of advantage. Firms goal should be to disrupt existing sources of advantage in its industry (including its own) and create new ones.

D’Aveni, Prahalad, & Hamel A firm that does not create new sources of advantage will be displaced by more innovative rivals. Common in environments of rapid technological development and fickle tastes. Firms may be able to create their own shocks, rather than waiting for the environment to change or for other firms to disrupt existing sources of advantage in the industry.

The Incentive to Innovate Larger, more powerful companies can be overtaken by companies with a much smaller resource base Small firms are more nimble and less bureaucratic More willing to innovate and break with established practices Why don’t larger firms innovate in order to maintain market share? The sunk cost effect The replacement effect

The Sunk Cost Effect Occurs when a firm has already made a commitment to a particular technology or product concept Has invested resources in this idea and that are likely very specific Less valuable if the firm switches to a different technology A firm that has not yet committed to a technology can compare costs of all options and choose the best one More freedom

The Replacement Effect Do monopolies have a stronger or weaker incentive to innovate than a new entrant? Kenneth Arrow (Nobel Prize in economics) Considered the incentive to adopt a process which would lower the variable cost of production Whoever adopted the new technology would have monopoly power over the industry Who would innovate first? A firm who already had Monopoly power? New entrant in the market?

The Replacement Effect (cont) Concluded that an entrant would be willing to spend more than the monopolist to develop the innovation Why? Successful innovation by either firm results in a monopoly But since the established firm already had a monopoly its gain from innovation is less than the potential entrant “Through innovation an entrant can replace the monopolist, but the monopolist can only replace itself”

The Efficiency Effect Helps negate sunk cost and replacement effects (stops innovation) Strengthens an established firm’s incentive to innovate Efficiency effect occurs if the firm can anticipate innovation by new entrants A monopolist usually has more to lose from a new firm’s entry than the new firm has from entering Takes business away and drives prices down This makes a firm which already has a monopoly more likely to innovate since they would lose more than the potential entrant due to the increased competition. Which effect dominates a given situation depends on certain conditions. If the risk of smaller competitors or new entrants developing a new innovation is low than the sunk cost and replacement effects will most likely take place. However, if the monopoly predicts future innovation by competitors than the efficiency effect will dominate, since the firm does not want to lose a good portion of profits (innovate to keep competition out). Ex. Microsoft, etc.

Innovation Competition Response to the level of investment in R&D made by one firm Several firms competing, the one to innovate first gains a big advantage Patents First-mover advantage Consumer perception Patent- Pharmaceutical Companies First Mover- Consumer Perception –consumers view the attributes of the first brand as a benchmark against which all others are measured Palm Pilot

Patent Races The race between firms to innovate first Firms in a patent race must anticipate the R&D investments of competitors When a firm is deciding to increase its R&D spending it must answer: Does the increase in R&D increase its chances of winning the patent race? Will other firms increase R&D in response? How many competitors are there? Diminishing returns to productivity-increasing R&D outlays does not improve the chance of winning the race Increasing returns to productivity- increased spending is good unless competitors also increase R&D Decreases chances of winning the patent race If there are diminishing returns then several small firms may be a bigger threat If there are increasing returns then one large firm is dangerous since they can increase R&D at a greater rate

Choosing the Technology Firms may choose from a variety of methods when spending on R&D When choosing a research method, firms must consider what the competition is doing 2 dimensions when choosing the method: Riskiness of research method Degree to which success of one method is correlated to success of another

Riskiness of R & D Research methods often have completely different completion dates One method might be safe and be successful in 2-3 years Another method could be riskier and take anywhere from 1-4 years Monopoly would be indifferent between the two because both have identical expected times to development

Correlated Research Strategies Research methods may be correlated so that if one is successful, the other is more likely to be successful More beneficial to pursue uncorrelated strategies They increase the probability that at least one approach will be successful Will a firm use a research strategy that has a low probability of success? If many firms are competing then, YES If all firms use same strategy then all have the same probability of success The firm that uses the uncorrelated strategy stands to win the race if the popular approach fails (less competition)

Evolutionary Economics A firms decisions determined by routines: well practiced patterns of activity inside the firm Include methods of production, hiring procedures, and policies for determining advertising expenditure

Routines Routines determine its distinctive capabilities, or what they do better than competing firms Will firms frequently change their routine? Firms will seldom change there routine because getting their staff to change what has worked well in the past is an “unnatural act” However, Firms must find ways to continually change their act in order to survive, I.e. McDonald’s

Dynamic Capabilities A Firm’s ability to maintain the bases of it’s competitive advantage Firms with strong dynamic capabilities adapt their resources and capabilities over time and take advantage of new market opportunities to create new sources of competitive advantage I.e Costco,

Limitations to Dynamic Capabilities Path Dependency It is typically very hard for a company to ignore what has been done in the past and conceptualize a new idea Complementary Assets Assets that are valuable only in connection with a particular product, technology, or way of doing business, I.e. “Old school” Farmers Uncertain “Windows of Opportunity” When Firms get “locked out” by committing themselves to new markets. This is when being a first mover is a disadvantage. I.e a winery decides to make exclusively red wines and all the sudden white wines become popular

The Local Environment- It’s role in sustaining competitive advantage The argument that competitive advantage originates in the local environment in which the firm is based The four attributes in a firm’s home market that promote or impede its ability to achieve competitive advantage in global markets Factor conditions Demand Conditions Related supplier or support industries Strategy, structure, and rivalry

Factor Conditions Describe a nation’s position with regard to factors of production (human resources, infrastructure) that are necessary to compete in a particular industry In the 1950’s Japan had one of the highest numbers of engineering graduates per capita. This lead to success in industries such as automobiles and electronics I.E. USA has wide range of natural resources that help them compete in many industries

Demand Conditions Include size, growth, and character of home demand for the firm’s product. Sophisticated Customers or unique local conditions stimulate firms to enhance the quality of their products and to innovate. In Japan, summers are hot and humid and the houses are small and densely populated. Therefore, companies like Panasonic (Japanese Firm) developed small, quiet, energy efficient AC units rather than large and noisy AC units. Family Vans became more popular in the USA as families started evolving from the Baby Boom era

Related and Supporting Industries These firms usually have a strong base of internationally competitive supplier or support industries and will be positioned favorably to achieve competitive advantage in global markets Italian shoemakers have close relationships with leather producers this allows the shoemakers to learn textures and colors while the leather producers learn emerging trends. This will help shape innovation

Strategy, Structure, and Rivalry Includes local management practices, organizational structure, corporate governance, and the nature of local capital markets Germany and Switzerland=publicly traded firms owned by institutional investors who do not trade very often. They may spend more money on R&D than US and British firms. Local rivalry will affects the rate of innovation in markets Coke and Pepsi with new styles of cola Foreign Rivalries do not affect markets US airline industry is competitive while International industries are restricted by government, therefore an international flight on United would be different than a flight on an international airline

Managing Innovation Managing Innovation creates a dilemma Formal structure and controls are needed to coordinate innovation But looseness and flexibility can foster innovation, creativity, and adaptiveness to changing circumstances

Firms attempts to manage innovation Creation or corporate venture departments Larger corporations recognize the need to exploit opportunities for innovation beyond current products, processes, and services Spinoffs, joint ventures, and strategic alliance sometimes with educational institutions (Stanford and the Silicon Valley) Will help facilitate entry into new business areas or the development of new capabilities