The Resource Based View of the Firm B189 Simon Rodan, PhD

Recap Three ‘levers’ involved in generating economic profit: –Creating value –Appropriating value (raising prices) –Managing (reducing) costs Profit (producer surplus) = (price – cost)*quantity

The RBV RBV helps us answer the question: “What kind of resources does a firm need to create and appropriate value over time?” It is a theory of sustainable competitive advantage

The Object of Strategic Analysis Explain why a firm or a group of firms is making above normal returns –i.e. More than their long run average costs

Normal returns Revenue = long run average costs Assumes resources are optimally deployed (no opportunity costs) Normal returns =>economic profit is zero Above normal returns = economic profit Accounting profit may be larger than economic profit since it ignores opportunity cost of misused resources

Why are firms making profits? Two possible explanations –It’s something to do with the industry in which they operate External analysis – Porter’s 5 Forces –It’s something the firm has Internal analysis, the RBV

The Resource Based View Empirical observation: some firms in ‘competitive industries’ make above normal returns –First explanation proposed - uncertain imitability (Lipmann & Rumelt, 1982) Empirical study: what accounts for variation in performance, firms or industries? (Rumelt, 1992) ‘Market’ for strategic factors: –Efficient Market Hypothesis (Barney, 1986) –Implications for inimitable resources (Dierickx & Cool, 1989) What gives a firm a sustainable competitive advantage? –Properties of resources that support profitable value creating activity

Classic microeconomic assumptions Firms in competitive markets are identical –Either at inception –Or adopt and acquire identical production technologies All firms sell the same number of units, at the same price and make the same profit

A Puzzle… In some highly competitive industries some firms are making above normal returns Some industries are concentrated despite having no obvious barriers to entry

Uncertain imitability Two assumptions –Firms are all different in some way –Firms cannot figure out exactly what other firms do and why they are ‘better’ (uncertain imitability) Theses two assumptions are all that are needed to explain: –Concentrated industries with no obvious entry barriers –Many (if not all) of those firms make above normal returns.

Lippmann and Rumelt’s Model Each period firms consider entering the industry Based on their expected costs, the entering firm calculates its expected profit If current industry prices are above its estimated costs it enters. If it enters it finds out what its costs really are All firms (new entrant and incumbents) recalculate their optimal quantity - a new industry price emerges Firms whose costs exceed this new price leave

Hypothetical example: mobile phones E[cost] = ? Frequency band B (4c / min) Frequency band A (5c / min) Frequency band C (3c / min) Three different frequency bands, A, B and C Allocated by the FCC through a lottery… p=1/3

Hypothetical example: mobile phones E[cost] = 4c / min Frequency band B (4c / min) Frequency band A (5c / min) Frequency band C (3c / min) Best estimate of likely cost is… p=1/3

Hypothetical example: mobile phones E[cost] = 4c / cal Imitation allows all firm to achieve 3c / call costs If firms can imitate their more efficient competitors…

Hypothetical example: mobile phones E[cost] = 4c / call Any 5c firms are forced out when price falls below 5c Without imitation, firms retain their initial costs, good or bad… 4c firms are forced out and entry ceases

Profitability (ROS): Rumelt v.s. Cournot 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% RumeltCournot Time

Implications of the model Barriers to entry are not needed to explain industry concentration Above normal returns can come from both firm heterogeneity and industry concentration The focus is on firms and the factors that lead to uncertain imitability

Rumelt’s 1992 study Firm Profit

Rumelt’s 1992 study Firm Profit If industry was all that mattered… Indy AIndy BIndy C

Rumelt’s 1992 study Firm Profit Rumelt found that within industry variance about twice that found between industries… Indy AIndy BIndy C

Conclusion Most (~60%) of the variation in firm performance is a function of the firm rather the industry in which the firm operates Implications –Internal resource focus –Horizontal integration and market power

So, what resources do firms need? If higher than normal profits are possible in industries without barriers to entry, what should firms in competitive industries look for? Something that make them distinctive, different, unique Distinctiveness that stems from resources… –That help create something of value to customers –Not available off the shelf (no market for strategic factors) –That are hard to imitate E.g. based on tacit knowledge, hard to transfer skills Time compression diseconomies a complex (social) system

Resource “properties” Resources that deliver competitive advantage must be: –Valuable –Rare and non-substitutable –Inimitable

Barriers to imitation Property rights –Patents, copyrights Tacit knowledge –Riding a bicycle Dispersed knowledge –Formula for Coke Time Complex social system (culture) Complex “activity systems”

Three questions Do we create value? –for our customers –for ourselves Is it rare –We can only appropriate if we have a distinctive advantage Is our advantage inimitable –Is is sustainable »V.R.I.

Resources and economic transformation TANGIBLE RESOURCES Physical assets Finished product or service INPUT RESOURCES Raw materials Energy, Parts INTANGIBLE KNOWLEDGE-BASED ‘TRANSFORMING’ RESOURCES (CAPABILITIES) Knowledge, SOPs and routines, skills

Resources and economic transformation INTANGIBLE KNOWLEDGE-BASED ‘TRANSFORMING’ RESOURCES (CAPABILITIES) Knowledge, SOPs and routines, skills TANGIBLE RESOURCES Physical assets Finished product or service INPUT RESOURCES Raw materials Energy, Parts COMPETENCE

Terminology Capabilities (knowledge resources) –know-how, skills, routines, SOP’s Competencies –particular configuration of capabilities and input resources that successfully transform the inputs into more valuable outputs. Distinctive competencies –a unique competence, i.e one other firms don’t have Core competencies –a distinctive competence that has multiple applications Competence Distinctive competence Core Competence Knowledge Resources or Capabilities Tangible Resources

Fruin’s ‘bow tie’ model of core competency Capabilities and resources e.g. Honda Small internal combustion engine Products Motorcycles Cars Lawn mowers Outboard motors ATVs Generators Core (distinctive) competency

“V.R.I.” Valuable –To customers Which means we may be able to raise prices above those of our less valued competitors. –To us Which means we may be able to maintain lower costs than our competitors Their costs are a floor below which prices will not fall, leaving us with a profit even when they have none. Rare –If customers have no alternative they will have to pay more than it costs us to make the product or deliver the service –We can appropriate some of the value we create Inimitable –ensures rarity into the future

Resource “properties” Valuable –a competence –May not be distinctive –May be temporary Rare (and non-substitutable) –A distinctive competence –May be temporary Inimitable –Sustainable competitive advantage

“V.R.I.N.” – raising prices Valuable Rare Inimitable Value Price P C Competitors … to customers

“V.R.I.N.” - reducing costs Valuable Rare Inimitable Cost … to you P C Competitors

Complex activity systems Some firms are made up of complicated interlocking systems Complicated systems are hard to copy One missing piece and the entire system will not work

Summary If there is no structural advantage in our industry, we must look for sources of competitive advantage inside our firm Firm levels factors that deliver competitive advantage must be –Valuable (i.e. a competence) –Rare and non-substitutable (i.e. distinctive) –Inimitable (and thus persist over time) Distinctive competences with multiple uses are termed ‘core’ competences