1. David Bryce © 1996-2002 Adapted from Baye © 2002 Strategy & Economics: Introduction to Economic Rents and Competitive Advantage MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. David Bryce © 1996-2002 Adapted from Baye © 2002 What is Strategy? A planned sequence of actions to achieve a goal or resultA planned sequence of actions to achieve a goal or result Sequences of moves and countermoves among competitors where each is trying to achieve a more favorable position relative to othersSequences of moves and countermoves among competitors where each is trying to achieve a more favorable position relative to others A pattern in a stream of decisionsA pattern in a stream of decisions A planned sequence of actions to achieve a goal or resultA planned sequence of actions to achieve a goal or result Sequences of moves and countermoves among competitors where each is trying to achieve a more favorable position relative to othersSequences of moves and countermoves among competitors where each is trying to achieve a more favorable position relative to others A pattern in a stream of decisionsA pattern in a stream of decisions

3. David Bryce © 1996-2002 Adapted from Baye © 2002 What is the Goal of Strategy in Business? To secure sustained profit for the firmTo secure sustained profit for the firm In economics, profit is defined asIn economics, profit is defined as π = R – C – OC (Profit = Revenue – Costs – Opportunity Cost of assets) (Profit = Revenue – Costs – Opportunity Cost of assets) Contrast to Accounting Profit:Contrast to Accounting Profit: π acc = R – C To secure sustained profit for the firmTo secure sustained profit for the firm In economics, profit is defined asIn economics, profit is defined as π = R – C – OC (Profit = Revenue – Costs – Opportunity Cost of assets) (Profit = Revenue – Costs – Opportunity Cost of assets) Contrast to Accounting Profit:Contrast to Accounting Profit: π acc = R – C

4. David Bryce © 1996-2002 Adapted from Baye © 2002 How to Secure Profit? Exploit the Conditions of Imperfect Competition Numerous sellers and buyers unable to affect priceNumerous sellers and buyers unable to affect price Perfect InformationPerfect Information Homogenous productsHomogenous products No barriers to entry or exit; mobile resourcesNo barriers to entry or exit; mobile resources Zero Economic Profits Numerous sellers and buyers unable to affect priceNumerous sellers and buyers unable to affect price Perfect InformationPerfect Information Homogenous productsHomogenous products No barriers to entry or exit; mobile resourcesNo barriers to entry or exit; mobile resources Zero Economic Profits Few competitors, numerous suppliers and buyers Asymmetric Information Heterogeneous Products Barriers to entry Positive Economic Profits (also referred to as supernormal profit) Few competitors, numerous suppliers and buyers Asymmetric Information Heterogeneous Products Barriers to entry Positive Economic Profits (also referred to as supernormal profit) Perfect CompetitionImperfect Competition

5. David Bryce © 1996-2002 Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

6. David Bryce © 1996-2002 Adapted from Baye © 2002 How Industry Structure Influences Profitability Percent of Market Others (>10,000) ConAgra Stouffer Swanson Campbell Green Giant Others (>10) Safeway Kroger American Others (>1000) 34 25 17 4 20 90 2 3 4 1 99

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Economic Rents Strategists especially seek a kind of profit called economic rentStrategists especially seek a kind of profit called economic rent Economic rent is the excess received over the opportunity cost of an assetEconomic rent is the excess received over the opportunity cost of an asset A portion of accounting profit is usually economic rentA portion of accounting profit is usually economic rent Strategists especially seek a kind of profit called economic rentStrategists especially seek a kind of profit called economic rent Economic rent is the excess received over the opportunity cost of an assetEconomic rent is the excess received over the opportunity cost of an asset A portion of accounting profit is usually economic rentA portion of accounting profit is usually economic rent

8. David Bryce © 1996-2002 Adapted from Baye © 2002 Example Suppose two firms in an industry own their land outrightSuppose two firms in an industry own their land outright Firm A is located near a major railroad and can ship products for $10,000 a year less than Firm B, which is 100 miles distant.Firm A is located near a major railroad and can ship products for $10,000 a year less than Firm B, which is 100 miles distant. Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to Firm A in lower costs)Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to Firm A in lower costs) Thus, Firm A earns rent of $10,000 on its landThus, Firm A earns rent of $10,000 on its land Suppose two firms in an industry own their land outrightSuppose two firms in an industry own their land outright Firm A is located near a major railroad and can ship products for $10,000 a year less than Firm B, which is 100 miles distant.Firm A is located near a major railroad and can ship products for $10,000 a year less than Firm B, which is 100 miles distant. Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to Firm A in lower costs)Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to Firm A in lower costs) Thus, Firm A earns rent of $10,000 on its landThus, Firm A earns rent of $10,000 on its land

9. David Bryce © 1996-2002 Adapted from Baye © 2002 Economic Rent (continued) When opportunity costs are persistently lower than the rents earned on assets, positive economic profit can be sustainedWhen opportunity costs are persistently lower than the rents earned on assets, positive economic profit can be sustained But how can opportunity costs be lower than rents?But how can opportunity costs be lower than rents? Answer: When assets (or resources) cannot be soldAnswer: When assets (or resources) cannot be sold But when can resources not be sold?But when can resources not be sold? Answer: When markets for rent-earning assets are inefficient or failAnswer: When markets for rent-earning assets are inefficient or fail When opportunity costs are persistently lower than the rents earned on assets, positive economic profit can be sustainedWhen opportunity costs are persistently lower than the rents earned on assets, positive economic profit can be sustained But how can opportunity costs be lower than rents?But how can opportunity costs be lower than rents? Answer: When assets (or resources) cannot be soldAnswer: When assets (or resources) cannot be sold But when can resources not be sold?But when can resources not be sold? Answer: When markets for rent-earning assets are inefficient or failAnswer: When markets for rent-earning assets are inefficient or fail

10. David Bryce © 1996-2002 Adapted from Baye © 2002 Why Markets for Assets May Fail The source of the rent cannot be precisely identified by external or sometimes even internal observersThe source of the rent cannot be precisely identified by external or sometimes even internal observers Separating the assets from the context of the firm renders them useless or significantly impairs their usefulness or valueSeparating the assets from the context of the firm renders them useless or significantly impairs their usefulness or value The assets encounter Arrow’s Information (knowledge) Paradox:The assets encounter Arrow’s Information (knowledge) Paradox: –A potential buyer of information must know what the information is in order to assess its worth. But once the buyer knows enough to assess its worth, he is in possession of the essentials, which he has acquired without cost. Therefore, the “assets” never go up for sale (OC is near 0), but they earn positive rentsTherefore, the “assets” never go up for sale (OC is near 0), but they earn positive rents The source of the rent cannot be precisely identified by external or sometimes even internal observersThe source of the rent cannot be precisely identified by external or sometimes even internal observers Separating the assets from the context of the firm renders them useless or significantly impairs their usefulness or valueSeparating the assets from the context of the firm renders them useless or significantly impairs their usefulness or value The assets encounter Arrow’s Information (knowledge) Paradox:The assets encounter Arrow’s Information (knowledge) Paradox: –A potential buyer of information must know what the information is in order to assess its worth. But once the buyer knows enough to assess its worth, he is in possession of the essentials, which he has acquired without cost. Therefore, the “assets” never go up for sale (OC is near 0), but they earn positive rentsTherefore, the “assets” never go up for sale (OC is near 0), but they earn positive rents

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Examples of ‘Assets’ that May be Subject to Market Failure A complex social process among scientists at a pharmaceutical firm that, along with good science, leads to consistent innovation in new drug discoveryA complex social process among scientists at a pharmaceutical firm that, along with good science, leads to consistent innovation in new drug discovery The knowledge that Intel applies at its wafer fabrication facilities to keep defects lowThe knowledge that Intel applies at its wafer fabrication facilities to keep defects low The exclusive relationships that Coca-Cola Company has with its bottlers that keep others from utilizing the bottlers’ resourcesThe exclusive relationships that Coca-Cola Company has with its bottlers that keep others from utilizing the bottlers’ resources Wal-Mart’s location in small, rural communities in which no other entering competitors could attract a remaining market large enough to be profitableWal-Mart’s location in small, rural communities in which no other entering competitors could attract a remaining market large enough to be profitable A complex social process among scientists at a pharmaceutical firm that, along with good science, leads to consistent innovation in new drug discoveryA complex social process among scientists at a pharmaceutical firm that, along with good science, leads to consistent innovation in new drug discovery The knowledge that Intel applies at its wafer fabrication facilities to keep defects lowThe knowledge that Intel applies at its wafer fabrication facilities to keep defects low The exclusive relationships that Coca-Cola Company has with its bottlers that keep others from utilizing the bottlers’ resourcesThe exclusive relationships that Coca-Cola Company has with its bottlers that keep others from utilizing the bottlers’ resources Wal-Mart’s location in small, rural communities in which no other entering competitors could attract a remaining market large enough to be profitableWal-Mart’s location in small, rural communities in which no other entering competitors could attract a remaining market large enough to be profitable We refer to such “assets” as Strategic Assets

12. David Bryce © 1996-2002 Adapted from Baye © 2002 Definition: Sustainable Competitive Advantage (SCA) Earning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantageEarning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantage

13. David Bryce © 1996-2002 Adapted from Baye © 2002 Definition: Competitive Advantage When a firm earns positive economic profit, the firm possesses a competitive advantageWhen a firm earns positive economic profit, the firm possesses a competitive advantage Reminder: How is positive economic profit secured?Reminder: How is positive economic profit secured? Answer: By earning rents on assets that are subject to market failureAnswer: By earning rents on assets that are subject to market failure Thus, strategy is about creating assets that are subject to market failure or otherwise exploiting the conditions of failed (imperfect) marketsThus, strategy is about creating assets that are subject to market failure or otherwise exploiting the conditions of failed (imperfect) markets When a firm earns positive economic profit, the firm possesses a competitive advantageWhen a firm earns positive economic profit, the firm possesses a competitive advantage Reminder: How is positive economic profit secured?Reminder: How is positive economic profit secured? Answer: By earning rents on assets that are subject to market failureAnswer: By earning rents on assets that are subject to market failure Thus, strategy is about creating assets that are subject to market failure or otherwise exploiting the conditions of failed (imperfect) marketsThus, strategy is about creating assets that are subject to market failure or otherwise exploiting the conditions of failed (imperfect) markets

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Definition: Sustainable Competitive Advantage (SCA) Earning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantageEarning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantage