Chapter 12 Sustaining Competitive Advantages

Chapter Contents 1) Introduction 2) How Hard Is It to Sustain Profits? Threats to Sustainability in Competitive and Monopolistically Competitive Markets Evidence: The Persistence of Profitability 1) Sustainable Competitive Advantage Example 12.1: Exploiting Resources: The Mattel Story The Resource-Based Theory of the Firm Example 12.2: American versus Northwest in Yield Management Isolating Mechanisms Impediments to Imitation Example 12.3: Cola Wars: Slugging It Out in Venezuela Example 12.4: Maintaining Competitive Advantage in the On-Line Brokerage Market Early-Mover Advantages Example 12.5: Switching Costs for the Newborn Set: Garanimals Example 12.6: The Microsoft Case Early-Mover Disadvantages 4) Imperfect Imitability and Industry Equilibrium Chapter Summary Questions

1) 2)

Chapter Summary Competitive advantage in a competitive market is not sustainable indefinitely. The resource-based theory of the firm demonstrates how profits are reduced through competition, new market entrants and imitation among other reasons. The resource-based theory states that for a firm to maintain long run excess profits, its resources must meet four conditions: Resource heterogeneity: the resources and capabilities underlying firm production are heterogeneous across firms. In a particular industry, since firms are all different, there must be some whose resources are superior to other firms for competing in the industry. These firms with superior resources are able to produce their output more efficiently (lower costs) and/or are able to product goods that satisfy consumers more than the goods offered by other firms. Ex-ante barriers to competition: other firms cannot recognize the value that the resource creates up front. If the value of the resource were common knowledge, competition to acquire the resource would have driven up the price of acquiring it initially perhaps up to the point where the rents are completely dissipated. In other words, ex-ante barriers to competition presume imperfect information in market. Imperfect mobility: generally means that the superior resource cannot be traded (or if the resource can be traded, there are reasons it wouldnt be as productive in the hands of another producer). If a resource could be used just as effectively or more effectively by a competitor, the opportunity cost of utilizing the resource offsets the profits generated by the resource. Imperfect mobility implies the existence of cospecialization. Ex-post barriers to competition: insure that the competitive advantage associated with heterogeneity is preserved. Subsequent to a firm gaining a superior position and earning rents, there must be forces that limit the competition for those rents. If another firm can obtain the same resources, there is no ex post limit. Examples include patents, experience curves, and ownership of scarce inputs. Although the above suggests that there is a high hurdle to generating economic rents in the long run, research has shown that although high performance firms profits do decline in the long run, and those of low performance companies increase, they do not converge. This lack of convergence could arise from the fact that there are few true competitive markets in the world or the presence of some degree of resource-based advantage.

Definitions Regression to the Mean (Reversion to the Mean): In the case of extremely good (or poor) performance by a company, there is a high probability of this company returning to a less extreme (or average) performance in subsequent periods. This implies that firms will sometimes have the ability to generate extraordinarily high (or low) rents through unspecifiable factors, such as luck, but in the long run will revert back to average performance. Cost of Capital: A firm specific rate of return, specified by the markets view of a firms riskiness, which determines the cost of raising capital. If the firm is unable to exceed this expected return, they will be unable to attract investors capital. Competitive Advantage: The ability of a firm to outperform its industry average and earn higher rents than the norm. A firms competitive advantage is subject to issues of sustainability, otherwise the firms exceptional performance will be vulnerable to a regression to the mean. Resource-Based Theory of the Firm: Theory that sustainable competitive advantage exists only if resources and capabilities are scarce and imperfectly mobile. In a well-functioning market, where resources are plentiful, competitively priced, and not specific to a company, competitive advantages do not exist. Imperfectly Mobile: Resources are imperfectly mobile when they are cospecialized and therefore derive higher rents for the firm with ownership of cospecialized assets, since these assets will be worth less to any other firm. The owning firm will have these quasi-rents. (Current rents less the next best option.) Co-Specialized Assets: Assets that are more valuable and derive more rents, when used together. Isolating Mechanisms: Mechanisms that limit the extent to which a firms competitive advantage can be duplicated or neutralized by competitors. They are to companies what barriers to entry are to an industry. Causal Ambiguity: Exists if the cause of a firms ability to create value is obscured and only imperfectly understood. External observers, competitors, find it difficult to know why one firm can create an advantage and therefore cannot duplicate the companys ability to extract rents. Social Complexity: Source of a firms competitive advantage may lie in its interpersonal capability (such as trust with suppliers, relationships with clients). The ability to create or manage this advantage may be too complex and expensive to replicate easily, thereby leading to increase sustainability of their competitive advantage.
Network Externalities: Exist when the benefits of a product to a consumer grows as the community of users of this product increase in size. The example in the chapter is QWERTY keyboard.

Conceptual Applications

Choose a Profitable Company and Investigate Students are familiar with dozens of companies that seem to have sustained profitability for more than a handful of years. Instructors could assign short reports about individual firms to verify and explain why profits were sustained or why sustainability changed. Which of the mechanisms discussed in the chapter were key to this profitability? How long does the student believe the firm will be able to maintain that advantage? Choose a Barrier and Explore None of the barriers to imitation are immutable. Technological, legal, regulatory and cultural factors continually redefine the extent and power of these advantages. Instructors might want to have the students investigate one barrier and how it has evolved in recent history. With an understanding of historical changes, the students might be able to predict what future changes would mean for industry competition. For example, if the average length of patents and copyrights were shortened by the government, which companies would win, which would lose? If changing technology dramatically reduced the economies of scale in automobile production, how would you expect the industry dynamics to change? Talk about Industries in which Barriers Occur Students may also investigate competition from an industry level. Which barriers occur in which industries? Does historical profitability of companies match student expectations based on the availability of these impediments? How quickly are specific industries changing? An example from the computer software world: if a universal software recognition system were to be developed that allowed seamless recognition of all software programs irrespective of operating system (such as Sun's Java 'applets' might turn out to be), how would this change Microsoft's Windows network externality advantage? Would Apple be able to gain share in this altered environment? Students could also compare industries. For example, why is imitation more of a problem for biotechnology companies than for semiconductors?

Suggested Harvard Case Studies De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters) Nucor at a Crossroads HBS 9-793-039 (see earlier chapters) Intel Corp.--1968-2003 Product Number: 9-703-427 Publication Date: Nov 21, 2002 Revision Date: Nov 22, 2005 Author(s): Ramon Casadesus-Masanell, David B. Yoffie, Sasha Mattu Type: Case (Field) Length: 25p Description: Describes three stages in Intel's history: the initial success and then collapse in DRAMs and EPROMs, its transition to and dominance in microprocessors, and its move to become the main supplier of the building blocks for the Internet economy. Allows a rich discussion of industry structure and transformation in DRAMs and microprocessors, creation of competitive advantage and value capture, and sustainability. Learning Objective: An introduction to basic ideas on corporate strategy, using Intel's internet strategy. Also introduces industry analysis and transformation, competitive strategy, and competitive dynamics. Subjects Covered: Competition, Corporate strategy, Industry analysis, Internet. Teaching Notes: Intel Corp.: 1968-2003; Intel Corp.: 2005, Teaching Note (5-704-465) 29p Ramon Casadesus-Masanell, David B. Yoffie, Sasha Mattu

Extra Readings The sources below provide additional resources concerning the theories and examples of the chapter. Brock, G. W. The US Computer Industry. A Study of Market Power. Cambridge, MA: Ballinger,1975. Carroll, P. Big Blues: The Unmaking of IBM. New York: Crown, 1993. DeLamarter, R. Big Blue: IBM's Use and Abuse of Power. New York: Dodd, Mead, 1986. Ferguson, C.H. and C.R. Morris. Computer Wars: The Fall of IBM and the Future of Global Technology. New York: Times Books, 1994. Ghemawat, P. Commitment.- The Dynamics of Strategy. New York: Free Press, 1991. Greer, D. F. Industrial Organizations and Public Policy. 3rd ed., New York: Macmillan, 1992. Mueller, D. C. Profits in the Long Run. Cambridge: Cambridge University Press, 1986. Nelson, R. and S. Winter. An Evolutionary Theory of Economic Change. Cambridge, MA: Harvard University Press, 1982. Penrose, E. T. The Theory of the Growth of the Firm. Oxford: Blackwell, 1959. - the pioneering work underlying the resource-based theory. Peteraf, M. A. The Cornerstones of Competitive Advantage: A Resource-Based View. Strategic Management Journal, 14, 1993.Polanyi, M. The Tacit Dimension. Garden City, NY: Anchor, 1967. Scherer, F. M. and D. Ross. Industrial Market Structure and Economic Performance. 3rd ed., Boston, MA: Houghton Mifflin, 1990. Grant, Robert M. The Resource-Based Theory of Competitive Advantage: Implications for Strategy, California Management Review; Spring 1991; 33, 3

Answers to End of Chapter Questions 1. An analysis of sustainability is similar to a five forces analysis. Comment. Clearly, a five forces analysis identifies many of the threats to sustainability. A five forces analysis identifies the factors which impact overall industry profits. However, the five forces does not explain why some firms in an otherwise perfectly competitive market may be able to sustain positive economic profits over long periods, even though the industry on average earns zero profits. The five forces framework is not appropriate for analyzing the differential in performance across firms. A complete analysis of sustainability must address the differences in resources and capabilities possessed by each firm. 2. Muellers evidence on profit persistence is 30 years old. Do you think that profits are more or less persistent today then 30 years ago? Justify your answer. Muellers results suggest that firms with abnormally high levels of profitability tend, on average, to decrease in profitability over time, while firms with abnormally low levels of profitability tend, on average, to experience increases in profitability over time but high profitability firms and low profitability firms do not converge to a common mean. Muellers work implies that market forces are a threat to profits, but only up to a point. Other forces appear to protect profitable firms. While Muellers work is 30 years old, it is likely a similar study performed currently would yield analogous results. Many of the forces that acted to protect profits 30 years ago are still very relevant (for example, economies of scale in manufacturing and/or branding). High profit industries still currently attract entry, but many of these industries also enjoy forces that inhibit the degree of competition firms face. 3. Coke and Pepsi have sustained their market dominance for nearly a century. General Motors and Ford have recently been hard hit by competition. What is different about the product/market situation in these cases that affects sustainability? One problem facing the auto industry is even the most popular of cars, such as Fords1960 Mustang faces a limited technological as well as a general product life cycle. That is, changes in technology and taste force automakers to eventually phase out even the most popular models. Coke and Pepsi, on the other hand, face no real pressure to change their formula. In short, automakers must incur huge recurring capital outlays in order to product, while Coke and Pepsi only need to continually invest in their brands. Second Pepsi and Coke have successfully created brand equity unmatched by Detroit. Studies show that people do not necessarily think that Coke tastes better than RC. However, the image and brand equity that Pepsi and Coke have built up over the years has created a loyal following because consumers apparently value this brand equity and reward the firms with repeat purchases. GM and Ford, on the other hand, have not been able to do that with their own products. An individuals choice of soft drink is an ad hominem decision. Once consumers have chosen a brand of beverage, they exhibit a significant amount of inertiathey are unlikely to switch brands. Individuals are more likely to choose their automobile analyticallytrading off features and price. Third, General Motors and Ford have the issue that any technological advantages or advantages rooted in economies of scale that they have are difficult to keep proprietary because of imitability or employee Ford and GM rely. Car manufacturers can easily proliferate dealerships. Foreign carmakers can enter and easily open dealerships. Carmakers can sell their products over the Internetinfinite shelf space. Entrants into the beverage industry (and this applies to many consumer nondurables) are hard pressed to find available shelf space among retailers. 4. Provide an example of a firm that has co-specialized assets. Has the firm prospered from them? Why or why not? Assets are cospecialized when they are more valuable when used together than when separated. For example, sports analysts have suggested that John Stockton and Carl Malone of the Utah Jazz basket ball team create more value as a pair then the sum of their values would be if each played for other teams. If their contracts expire at different times, it would be difficult for either of them to

negotiate in salary the value they create for the Jazz. The reason is, when one contract expires the other player is still under contract and so the Jazz owns the other half of the dynamic duo. The player can only negotiate his value to the team who values that player the most after the Jazz. Since the players are worth more to the Jazz than the sum of their values to other teams, the Jazz gets to retain a portion of the value the players create. If the players had contracts that expired at the same time and the players were not cospecialized with the other players or with the state of Utah, they could negotiate away from the team their full value. 5. Often times, the achievement of a sustainable competitive advantage requires an investment and should be evaluated as such. In some cases, the benefits from the investment may not be worth the costs. Rather than trying to build a sustainable position, the firm should cash out, for example, by exiting the industry, selling the business assets to another firm, or refraining from investing additional capital in the business for future growth. Evaluate this statement keeping a focus on two questions: a) in light of the factors that help a firm sustain a competitive advantage, explain in what sense achieving a sustainable advantage requires an investment. b) Can you envision circumstances under which the such an investment would not be beneficial to the firm. a) Gaining a competitive advantage requires an investment in a factor or factors that allow the company to make profits in excess of those of their competition. However, a simple investment does not guarantee competitive advantage. Investments in factors that do not provide excess profits are a waste of money. For example, if a company wants to buy a factor and there is perfect information as to the factors future value, the purchaser will have to pay the owner the net present value of future cash flows from the factor, or even more. Thus while the company makes accounting profits, it does not make economic profits and thus has no competitive advantage. Furthermore, competitive advantage is not a guarantee of profits. Having a competitive advantage in a shrinking or tiny market could mean that the companys advantage is not paying off in excess profits or a positive net present value. b) Managers and shareholders often have different goals and ideas of what is best for the company. For example, a shareholder may realize that investing in order to create or maintain a competitive advantage in a small industry is a waste of capital while the manager may be undertaking the project for self-aggrandizement or empire-building. Equity holders may hold the companys stock for reasons other than claiming a share of the companys future income, such as diversification and risk-hedging and thus may be unwilling to shift the focus of the company. 6. Do you agree or disagree with the following statements about sustaining advantage? A. In a market with network externalities, the product that would potentially offer consumers the highest B-C inevitably comes to dominate. In a market with network externalities, it is not necessarily true that the product that would potentially offer consumers the highest B-C comes to dominate. For some products, such as computer software or consumer electronics, a consumers benefit from purchasing the product is greater the more consumers currently use the product or are expected to use it in the near future. When a network externality exists, a firm that has made more sales than its competitors in early periods and has thus developed a large installed base has an advantage when competing against firms with smaller installed bases. B. Usually high performing firms may get that way either by outpositioning their competitors, belonging to high performing industries, or both. High performance in the long run requires that the company outperform their competition through inimitable strategies or use of factors, such as outpositioning ones competition. This is true for all industries, not just high performing ones. C. If the sunk costs of entering industry A exceed the sunk cost of entering industry B, there will certainly be fewer firms in industry A than in industry B. Higher suck costs of entering an industry will make new comers hesitate to enter the market. If

all conditions other than the sunk costs are the same, the higher the sunk cost, the fewer the new entrants. However, if the net present value of entering an industry is positive, firms will enter. In other words, we cannot conclude that the level of sunk costs is perfectly negatively correlated with the number of firms in the industry without accounting for other factors such as the level of overall demand in the industries. Furthermore, if an industry has high sunk costs, firms are less likely to exit the industrysunk costs act as a barrier to exit that may positively impact the number of firms in the industry.

D. The Kronos Quartet (a popular classical string quartet) provides an example of cospecialized assets. If the members of the quartet produce more value together than they do as soloists or as members of different groups, then they could be viewed as co-specialized assets. However, each member of the Kronos Quartet is considered tradable. If any player can quit the Kronos Quartet and join another group and the same (or more) total value is generated, then the members would not be examples of co-specialized assets. 7. Which of the following circumstances are likely to create first mover advantages: A. Maxwell House introduces the first freeze dried coffee. There are no network externalities or switching costs with freeze-dried coffee. A case may be made for possible reputation and buyer uncertainty effects, that is if Maxwell house can pioneer a product and establish a reputation for quality, preexisting customers may be unwilling to switch and new customers will seek out the pioneer because of its reputation. However, this effect is very uncertain. If another brand comes along that tastes better, consumers can easily switch. If Maxwell house can patent the freeze-drying process and it cannot be invented around, the patent may offer a sustainable first mover advantage. It is also possible that the product would offer first mover disadvantages. If Maxwell House invests all its money in one process, but another company free-rides on its marketing and creates a better product, Maxwell house could face a first mover disadvantage. B. A consortium of US firms introduces the first high-definition television. There is a potential first mover advantages to the introduction. The invention might be patentable. It is also possible that the introduction will offer the consortium the network externality advantage in that it can become the base for the complementary software (TV programming, providing that these programs must meet the consortiums standard) and for future home-entertainment opportunities. Consumers will want to buy hardware that meets the standard so they can receive the TV programs and tie in to future complementary hardware, if it comes about. Another possible advantage is the learning curve effect. If the consortium successfully introduces the technology, they may be able to produce larger volumes earlier than their competition. A disadvantage could arise if the high definition television was the wrong bet, i.e. its the wrong technology, or a different consortium introduces a different standard that dominates the US consortiums. C. Smith Kline introduces Tagamet, the first effective medical treatment for ulcers. The first possible advantage would again be legal, i.e. patent protection. If Smith Kline markets the Tagament as a pioneer they may be able to gain customers and keep them through reputational effects and the fact that switching costs would be high. If physicians learn how to treat patients using Tagament and patients prefer to purchase a product with which physicians are experienced, Tagament may secure a first mover advantage. A customer who had used Tagament successfully for years may be unwilling to switch for a newer, less tested product, unless offered a strong incentive to switch. Smith Klines several year head start could also give them an insurmountable advantage in terms of the learning curve. However, it is possible that substitute products can free ride on Smith Klines marketing efforts. D. Wal-Mart opens a store in Nome, Alaska. This can be a sustainable first mover advantage if the market dynamics of Nome, Alaska are such that there are not enough potential customers in Nome to let two or more stores operate at an efficient scale. This assumes that Wal-Mart is the first store to open. 8. Each of the following parts describes a firm that was an early mover in its market. In light of the information provided, indicate whether the firms position as an early mover is likely to be the basis of a sustainable competitive advantage.

A. An early mover has the greatest cumulative experience in a business in which the slope of the learning curve is one. The learning curve is the decreasing marginal costs of production corresponding with an increase in volume over time. A learning curve of one means that costs do not decrease or increase as a function of volume over time and thus show that there is no learning curve advantage for this particular firm. B. A bank has issued the largest number of automated teller cards in a large urban area. Banks view their ability to offer ATM cards as an important part of their battle for depositors, and a customers ATM card for one bank does not work on the ATM systems of other banks. This potentially is a sustainable advantage. Issuing a large number of cards does not give a sustainable advantage unless there is a correspondingly large number of ATMs to use them at and if all other ATM cards dont work at them. Having the largest number of ATMs might grant a economy of scale advantage that other banks cannot afford to duplicate. Having the largest number of ATMs and ATM cards might also create a network externality in that firms with installed bases larger than their competitors has an advantage when competing with competitors with smaller basis. This advantage could be easily lost. For example if customers want to use their ATMs out of the geographic area the bank services, the bank may have to use services like Cirrus to provide this service. Thus, the externality advantage could be undermined. C. A firm has a 60 percent share of T3MP, a commodity chemical used to make industrial solvents. Minimum efficient scale is thought to be 50 percent of current market demand. Recently a change in environmental regulations has dramatically raised the price of a substitute chemical that indirectly competes with T3MP. This change undermines the market for the substitute, which is about twice the size of the market for T3MP. This question is about first move advantage and minimum efficient scale. A firm does possess a first mover advantage if it achieves minimum efficient scale and no other firm can do so. This describes the firm in question, until the market for the substitute collapses. When the T3MP market expands, more firms can achieve economies of scale, and the first mover advantage may be lost. If, however, the firm has a well-developed brand name, it will have an advantage as these new customers launch their initial purchases of T3MP. 9. In defending his company against allegations of anticompetitive practices, Bill Gates claimed that if someone developed an operating system for personal computers that was superior to Microsofts Windows 95 operating system, it would quickly become the market leader, just as Gates DOS system became the market leader in the early 1980s. Opponents countered that the market situation in the late 1990s was different than in the early 1980s, so even a markedly superior operating system might fail to capture significant market share. Comment. This is a great example of the power of network externalities. The installed base of Microsoft Windows operating systems increased precipitously between early 1980 and late 1990. Each of these users has purchased and learned to use software that is compatible with the Windows operating system. Each of these users has constructed worksheets and documents in their Windows compatible softwares. Furthermore, most of these users network with other individuals, at least on some level, who, in all likelihood, are Windows operating system users. If a user changed operating systems, and that operating system was not backward compatible with Windows and all the software that operates in Windows, that user would probably have limited software choices, would have to convert all his files into new programs and would be unable to network with many other users. Even an operating system with phenomenal features would be hard pressed to attract many users. 10. Super Audio CD (SACD) and DVD Audio (DVDA) are new digital audio formats. Both offer surround-sound music at a quality that approaches the original studio master

recordings from which they are made. (Standard compact discs degrade sound quality due to format limitations.) Although there are few dedicated SACD or DVDA players, it is possible to manufacture DVD players with SACD and/or DVDA circuitry for an additional for an additional $50-$500 per format, depending on the quality of the playback. SACD is supported by Sony, which offers the format on some of its mid-priced DVD players. It has also won support from several classical music and jazz labels, and has released recordings from several popular acts including the Rolling Stones. DVDA is backed by the DVD consortium, and is included as a low-cost added feature in mid-priced DVD players from Denon, Panasonic, and Pioneer. However, few recording studios have embraced the format thus far. Which format do you think is most likely to survive the nascent format war? Should Sony compete for the market or in the market? A product is said to be standardized when some protocol is followed in its production such that users of the same product can interact with each other and/or with some set of complementary goods that follow that protocol. If a firm is considering entering a market in which a standard does exist (or is likely to emerge) there is much the firm needs to considermore than can be addressed in answering this question! As is the case with any firm, there is a share that enables the firm to achieve sufficient profitability to continue operation. In the case of a firm whose product complies with a standard and the good is consumed with a complementary good (PC and software), the level of market share required to achieve profitability is affected not just by the firms own minimum efficient scale, but the minimum efficient scale in the production of the complementary goods. Within a product function, there are multiple possible standards that might emergesometimes only one survives (as in PCs, since Apple is really delegated to a ever decreasing niche) and sometimes multiple standards coexist for many, many years (cassettes and CDs or DVDA and SACD). When we see multiple standards, the following is often the case: o Alternative standards are not substitutable enough for many customers. That is, there is meaningful differentiation among the offeringswhereby one standard dominates for one set of occasions of use and another standard dominates for another set of occasions of use (for example, cassettes are portable and CDs have better sound quality). Sufficient product performance differences could justify coexistence. Sometimes these alternative standards sell to difference segments of consumers and sometimes the consumer segments overlap. Producers of the complementary goods can cover all their costs. That is, the consumers are willing to pay for the redundant costs of producing the complementary goods for multiple standards because the consumers value the differentiation between the standards. Whether entering a new or existing product market for which a complementary product is required the firm needs to consider the minimum efficient scale of the complementary good in setting its market share target. The good described in the question does not seem likely to be dominated by one standard. While Sony has done a good job of getting some traction, the fact that other hardware manufacturers are currently including the feature in their products suggests that Sonys lead will be contested.