1. 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.

2. 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

3. 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)

4. 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

5. The Perfectly Competitive Dynamic

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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)

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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)

32. 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

33. 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

34. 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

35. 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

36. 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)

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

38. 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?

39. “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

40. “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

41. 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

42. 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)

43. 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

44. 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