The Nature and Sources of Competitive Advantage Chapter 7

Introduction A firm can earn a rate of profit in excess of its cost of capital either by locating in an attractive industry or by establishing a competitive advantage over its rivals/Chapter 1/ Of these two sources of superior profitability, competitive advantage is the more important On this chapter we focus on the relationship between competitive advantage and the competitive process

Objectives Identify the circumstances in which a firm can create a competitive advantage over a rival Understand how responsiveness and innovation can create competitive advantage Predict the potential for competition to erode competitive advantage through imitation Recognize the role of resource conditions in creating imperfections in the competitive process and, therefore, opportunities for competitive advantage Distinguish the two primary types of competitive advantage

The Emergence of Competitive Advantage When two or more firms compete within the same market, one firm possesses a competitive advantage over its rivals when it earns/ or has the potential to earn/ a persistently higher rate of profits. Competitive advantage - the ability of the firm to outperform rivals on the primary performance goal-profitability.

The Emergence of Competitive Advantage Competitive advantage may not be revealed in higher profitability: a firm may trade current profit for investment in market share or technology, or a firm may forgo profits in the interests of customer satisfaction, philanthropy, employee benefits.

External Sources of Change Differences in profitability between competing firms are a disequilibrium phenomenon – the emergence of competitive advantage requires some form of change to occur. The source of change may be external or internal to the industry. Figure:The emergence of competitive advantage

External Sources of Change For an external change to create competitive advantage, the change must have differential effects on companies because of their different resources and capabilities or strategic positioning. For example, during , Chrysler was the most profitable of words major car companies.However, by the third quarter of year 2000,Chrysler reported a loss- a result,in part, of the rising value of the US dollar and the tripling of oil prices.Conversely,the competitive positions and profitability of Renault and Peugeot were greatly improved by these same factors.

External Sources of Change The extent to which external change creates competitive advantage and disadvantage depends on the magnitude of the change and the extent of firms strategic differences. The more turbulent the industrys environment, the greater the number of sources of change, and the greater the differences in firms resources and capabilities, the greater the dispersion of profitability within the industry

Competitive Advantage from Responsiveness to Change The competitive advantage that arises from external change also depends on a firms ability to respond to external change. Any external change creates opportunities for profit The ability to identify and respond to opportunity lies in the core management capability that we called entrepreneurship

Competitive Advantage from Responsiveness to Change To the extent that external opportunities are fleeting or subject to first-mover advantage, speed of response is critical to exploiting business opportunity. An unexpected rain shower creates an upsurge in the demand for umbrellas. Those street vendors who position themselves outside a busy railroad station at the onset of rain will benefit most from this business opportunity.

Competitive Advantage from Responsiveness to Change As markets become increasingly turbulent, so responsiveness to external change has become increasingly important as a source of competitive advantage. Wal-Marts ability consistently to outperform Kmart and other discount retailers is based on a business system that responds quickly and effectively to changes demand. Responsiveness to the opportunities provided by external change requires one key resource- information - and one key capability- flexibility of response

Information Information is necessary to identify and anticipate external changes. This is dependent on a firms environmental scanning capability. As the pace of change has accelerated, environmental scanning activities have changed with it: firms are less dependent on conventional analysis of economic and market research data and more dependent on early warning systems through direct relationship with customers, suppliers, and competitors

Flexibility Flexibility of response requires that a firm swiftly redeploys its resources to meet changes in external conditions. Traditionally associated with plant and equipment, information systems, and other aspects of organizational hardware, flexibility is now viewed as primarily, dependent on organizational software- organizational structure,decision-making systems, job design, and culture

Flexibility Flexibility typically requires fewer levels of hierarchy, greater decentralization of decision-making, and informal patterns of cooperation and coordination. The greater a companys flexibility in responding to changing market circumstances, the less dependent it is on its ability to forecast Dell Computer is the epitome of the current trend toward speed and agility. A custom order placed at 9a.m. on Monday can be on a delivery truck by 9p.m Tuesday

Competitive Advantage From Innovation Internal change is generated by innovation. Innovation is typically thought of in its technical sense: the embodiment of new ideas and knowledge in new products or processes. In a business context, however, innovation also embodies new approaches to doing business. Innovative strategies tend to be the basis of most outstanding success in most industries - far more so than product innovation alone.

Competitive Advantage From Innovation Southwest Airlines built a business system that differs radically from that of the established airlines: it offers point-to-point route, provides no in-flight meals, operates a single type of plane and does not utilize either of the industrys main computerized reservation systems. Southwests unique approach has given it some of the lowest unit costs in the industry. Dell computer established its direct-sales model initially over the telephone and subsequently the internet

Sustaining Competitive Advantage Once established, competitive advantage is subject to erosion by competition. The speed with which competitive advantage is undermined depends on the ability of competitors to challenge either by imitation or innovation.

Imitation Imitation is the most direct form of competition, thus, for competitive advantage to be sustained over time barriers to imitation must exist. The more effective these isolating mechanisms are, the longer competitive advantage can be sustained against the onslaught of the rivals.

Imitation For one firm successfully to imitate the strategy of another, it must meet four conditions : Identification. The firm must be able to identify that a rival possesses a competitive advantage. Incentive. Having identified that a rival possesses a competitive advantage, the firm must believe that by investing in imitation, it too can earn superior returns.

Imitation Diagnosis. The firm must be able to diagnose the features of its rivals strategy that give rise to the competitive advantage Resource acquisition. The firm must be to acquire through transfer or replication the resources and capabilities necessary for imitating the strategy of the advantaged firm. Figure:Sustaining competitive advantage:types of isolating mechanism

Identification: Obscuring Superior Performance A simple barrier to imitation is to obscure the firms superior profitability The most direct means of obscuring competitive advantage in order to discourage would-be competitors is simply to forgo short-term profits. The theory of limit pricing postulates that a firm in a strong market position sets prices at a level that just fails to attract entrants

Obscuring Superior Performance A more attractive means of avoiding competition is for the firm to withhold information about its profitability. –Private companies and unincorporated forms of business have an advantage in this respect: they are not obliged to make public their financial results The recent trend to take public companies private has been motivated, in part, by the advantages of nondisclosure.

Incentives to Compete: Deterrence and Preemption If a firm can persuade rivals that by imitating its strategy they will not achieve comparable profitability, it may be able to avoid competitive advantage. Deterrence involves making threatening signals toward competitors that encourage the competitor to believe that a strategy of imitation will not prove profitable.

Deterrence The key to deterrence is the promise of retaliation against a competitor that encroaches on the firms strategic niche For a threat to be effective in deterring a competitive advantage, it must be credible The credibility of a threat also depends on the reputation of the firm that issues it Microsofts aggressiveness in office software has given it a reputation that inhibits many weaker rivals from doing battle with it.

Preemption A firm can also deter imitation by preemption - occupying existing and potential strategic niches in order to reduce the range of investment opportunities open to the challenger. Preemption can take many forms:

Preemption Proliferation of product varieties by a market leader can leave new entrants and smaller rivals with few opportunities for establishing a market niche. Large investments in production capacity ahead of the growth of market demand also preempt market opportunities for rivals Patent proliferation can protect technology-based advantage by limiting competitors technical opportunities.

Diagnosing Competitive Advantage :Causal Ambiguity and Uncertain Imitability If a firm is to imitate the competitive advantage of another, it must understand the basis of its rivals success. In most industries, there is a serious identification problem in linking superior performance to the resources and capabilities that generate that performance. It s easy for Kmart to point to the differences between Wal-Mart and itself. The difficult task is to identify which differences are critical to the profitability differential between the two retailers.

Causal Ambiguity and Uncertain Imitability The more multidimensional a firms competitive advantage and the more each dimension of competitive advantage is based on complex bundles of organizational capabilities rather than individual resources, the more difficult it is for a competitor to diagnose the determinants of success. The outcome of causal ambiguity is uncertain imitability: Where there is ambiguity associated with the causes of a competitors success, any attempt to imitate that strategy is subject to uncertain success.

Acquiring Resources and Capabilities Having diagnosed the sources of an incumbents competitive advantage, the imitator can mount a competitive challenge only by assembling the resources and capabilities necessary for imitation. A firm can acquire resources and capabilities in two ways: it can buy them or it can build them Transferability,Replicability – Chapter 5

Acquiring resources and capabilities Even if resources are mobile, the market for a resource may be subject to transaction costs – costs of buying and selling arising from search costs, negotiation costs, contract enforcement costs, and transportation costs The alternative to buying a resource or capability is to create it through internal investment.Businesses that require the integration of a number of complex, team-based routines may take years to reach the standards set by industry leaders.

Acquiring resources and capabilities Conversely, where a competitive advantage does not require the application of complex, firm- specific resources, imitation is likely to be easy and fast. Imitation of financial innovations is swift.

First-mover Advantage: success breeds success The idea of first-mover advantage is that the initial occupant of a strategic position or niche gains access to resources and capabilities that a follower cannot match. Where the resources required for competing are scarce, first movers can simply preempt these scarce resources. Initial competitive advantage offers a profit flow that permits the firm to invest in extending and upgrading its resource base

Success breeds success The first mover in a market establishes a reputation with suppliers, distributors,and customers that cannot be initially matched by the follower. Where proprietary standards in relation to product design and technology are important to competitive advantage, the first mover may have an advantage in setting the standard. Economies of learning suggest that the first mover can build a cost advantage over followers as a result of greater experience.

Competitive Advantage in Different Market Settings Two types of value-creating activity: trading and production /Chapter 1/ These different types of business activity correspond to different market types: trading markets and production markets Figure:Competitive advantage in different industry settings: trading and production

Efficient markets: the absence of of competitive advantage Perfect competition exists where there are many buyers and sellers, no product differentiation, no barriers to entry or exit, and free flow of information. An efficient market is one in which prices reflect all available information. Because prices adjust instantaneously to newly available information, no market trader can expect to earn more than any other.

Efficient markets: the absence of of competitive advantage The absence of competitive advantage in efficient markets can be linked to resource availability. If finance and information are equally available to all traders, there is no basis for one to gain competitive advantage over another

Competitive Advantage in Trading Markets Imperfect Availability of Information. Competitive advantage is dependent on superior access to information Transaction Costs. If markets are efficient except for the presence of transactions costs, then competitive advantage accrues to the traders with the lowest transaction costs. Systematic Behavioral Trends. In markets where systematic behavioral trends occur, competitive advantage is gained by traders with superior skill in diagnosing such behavior.

Competitive Advantage in Trading Markets Overshooting. Inefficiencies can also arise in trading markets due to the propensity of market participants to overact to new information, with the result that prices overshoot. On the assumption that overshooting is temporary and is eventually offset by an opposite movement back to equilibrium, then advantage can be gained through a contrarian strategy: acting in the opposite direction to market swings.

Competitive Advantage in Production Markets Production activities require complex combinations of resources and capabilities, and these resources and capabilities are highly differentiated – each producer possesses a unique combination of resources and capabilities. The greater the heterogeneity of firms endowments of resources and capabilities, the greater the potential for competitive advantage. –

Types of Competitive Advantage A firm can achieve a higher rate of profit over a rival in one of two ways : either it can supply an identical product or service at a lower cost, or it can supply a product or service that is differentiated in such a way that the customer is willing to pay a price premium that exceeds the additional cost of the differentiation. The two sources of competitive advantage define two fundamentally different approaches to business strategy

Types of Competitive Advantage Reconciling differentiation with low cost has been one of greatest strategic challengers of the 1990s. Common to the success of Japanese companies in consumer goods industries has been the ability to reconcile low costs with high quality and technological progressiveness.