Economics of Strategy

Fifth Edition
Besanko, Dranove, Shanley, and Schaefer

Chapter 14

Sustaining Competitive
Advantage
Slides by: Richard Ponarul, California State University, Chico
Copyright

2010 John Wiley Sons, Inc.

Sustaining Competitive Advantage

Sustaining competitive advantage over time is not

easy.
Rivals can imitate the formula for success.
Rivals can use new technologies, products and
business practices to erode the competitive
advantage of industry leaders.
Yet Some firms have been successful in sustaining
their competitive advantage (Coca-Cola, Dell
Computers) for long periods of time.

Perfect Competition & Competitive Advantage

In a perfectly competitive industry where

firms are price takers, competitive

advantage does not exist.
Even when the product varies on a cost-

quality continuum dynamics of perfect

competition can work.

The Perfectly Competitive Dynamic

The efficient frontier is the boundary with the best

feasible price-quality combinations.

A price-quality point such as (PA, qA) is not

sustainable if there is free entry since a rival can

enter at (PB, qB).

Free entry and costless imitation will force all the

firms to move to the tangency point and the

economic profit will be zero.

The Perfectly Competitive Dynamic

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

Sellers get to set the price above marginal cost but

there is no guarantee of economic profits.

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.
Profitability cannot be sustained unless entry is

deterred

Threats to Sustainability
Even when incumbents can deter entry economic

profits may not be sustainable.

Sometimes good performance may be simply due

to luck.
Over time profits regress to the mean.

Threats to Sustainability
Good performance is not always attributable to

luck.
A firm might develop advantages that are hard to

imitate.
Yet if the suppliers/buyers are powerful they can

extract the profits.

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.

Evidence on the Persistence of Profitability

Dennis Muellers study of U. S. manufacturing firms
finds that:

Firms with abnormally high ROA will experience a

decline over time

Firms with abnormally low ROA will experience an

improvement over time and

high ROA firms and low ROA firms do not converge to a

common mean

Evidence on the Persistence of Profitability

Muellers results indicate that there are some

forces that push markets towards the competitive

rate of return 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 .

The Persistence of Profitability in Muellers Sample

Competitive Advantage of Firms

and Industry Profitability
A firm in a fiercely competitive industry may

continue to have an edge over its rivals if its

competitive advantage is difficult to imitate.
Firms within an industry with high entry barriers

may earn economic profits but may all be equally

profitable.

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.

Resource Based Theory of the Firm

Resource based theory of the firm explains

sustained competitive advantage in terms of

heterogeneity in resources and capabilities.

To support competitive advantage resources and

capabilities have to be

scarce

imperfectly mobile and

unavailable in the open market.

Resource Based Theory of the Firm

Immobile resources may be inherently non-

tradable (Example: Reputation for toughness)

Immobile resources may be relationship specific

(Example: Landing slots in an airlines hub)

Isolating Mechanisms
Isolating mechanisms limit the rivals from eroding

a firms competitive advantage.

Isolating mechanisms are to firms what entry

barriers are to industries.

Two distinct types of isolating mechanisms are

Impediments to imitation
Early mover advantage

Impediments to Imitation
These mechanisms impede the potential entrants

from duplicating the resources and capabilities of

the incumbent firm
Five important types of impediments are

legal restrictions
Superior access to inputs/customers
Market size and scale economies
Intangible barriers

Intangible Barriers to Imitation

Barriers to imitation will be intangible if the firms

advantage lies in distinctive organizational

capabilities.
Three such barriers to imitation can be identified.

Casual ambiguity
Historical circumstances
Social complexity

Casual Ambiguity
A firms 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.

Historical Circumstances
Distinctive capabilities may be bound up with the

history of the firm

Dependence of the capabilities on historical

circumstances may limit the firms growth

potential
Historical dependence may also mean that the

strategies may be viable for only a limited time

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, suppliers and customers.

Complex social interactions are not easily imitated

even when understood.

Intangible Barriers & Organizational Change

When major organizational changes are

undertaken, it is easy to overlook intangible

sources of competitive advantage.
Major organizational changes are more likely to

achieve the desired results in greenfield plants

than in established ones.

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

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?
What does it take to topple the existing standard?

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.
If the standards war is going to be too costly, it

may be better to accept a common standard.

It is critical to attract early adopters to build the

installed base of customers.

For the Market or In the Market?

Standards war may discourage the production of

complementary products, hurting the entire

industry.
To win the standards battle manufacturers of

complementary products may have to be offered a

greater share value added.

Fighting a Dominant Standard Successfully

Installed base gives the incumbent the edge.
To challenge the dominant standard the rival

should offer superior quality or new options.

The rival should also tap into the complementary

goods market.

Early Mover Disadvantages

Early movers may lack the complementary assets

to make their products succeed

Early movers can lock themselves into inferior

technologies and rivals can learn from these

mistakes (Example: Wang Laboratories)

Imperfect Imitability & Industry Equilibrium

With imperfect imitability, but otherwise

competitive conditions, some firms consistently

earn economic profits.
Yet to potential entrants the industry appears to

offer zero expected profits

Lippman and Rumelt explain this outcome using

entrants uncertainty regarding their costs.

Imperfect Imitability & Industry Equilibrium

Competition makes entrants pre-entry (ex-ante)

expected economic profit zero

Entrants are uncertain about their post-entry cost

structure.
Ex-post if an entrant turns out to be a high cost

producer it quits.
Observed average profits for the industry will be

positive due to survivorship bias.