Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 15
The Origins of Competitive Advantage:
Innovation, Evolution and
the Environment
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 John Wiley  Sons, Inc.
Competitive Advantage
Acquiring a competitive advantage involves
 anticipating
unmet and unarticulated consumer
needs deep into the future
 investing development of new products
 investing in capabilities to produce and
distribute these products and
 be the first to do so
Entrepreneurship and Competitive Advantage
 Competitive advantage arises from a firm’s
entrepreneurial ability to exploit market shocks
and discontinuities
 New sources of competitive advantages displace
established ones (Schumpeter’s creative
destruction)
Creative Destruction
 Markets have periods of comparative quiet
punctuated by shocks and discontinuities
 During the period of quiet firms that posses
superior products and technology earn economic
profits
 Entrepreneurs who exploit the opportunities
created by the shocks enjoy economic profits
during the next period of quiet
Creative Destruction and Growth
 Schumpeter considered static efficiency - allocative
efficiency at a point in time - to be less important
than dynamic efficiency
 Society benefits much more from competition
between new products, new technologies and new
forms of organization than from price competition
Creative Destruction and Monopoly
 Schumpeter’s ideas have been used to defend
monopoly.
 Presumably monopoly leads to greater investment
in innovation and higher long term growth.
Creative Destruction & Competitive Advantage
 Creative destruction implies that the isolating
mechanisms that protect a firm’s competitive
advantage will not be permanent
 The life expectancy of a competitive advantage
shrinks as technology and tastes change rapidly
Disruptive Technologies
 Many of the disruptive technologies have higher
perceived benefits and lower costs
 Some times disruptive technologies can have lower
benefits and much lower costs (example:
Downloadable MP3 recordings versus higher
resolution in CDs)
Sustainability and Creative Destruction
 Access to ongoing scientific expertise is essential
for riding the wave of creative destruction.
 Biotech and pharmaceutical firms stay in close
touch with the scientific and academic community.
 They reward scientists for generating general
scientific knowledge.
Strategic Intent and Strategic Stretch
 According to Hamel and Prahalad, successful firms
like CNN, SONY and Honda tend to have strategic
intent - an obsession with global dominance in
their industries
 For these firms, there is a gap - strategic stretch -
between their strategic intent and their current
resources and capabilities
Hypercompetition
 Firms are said to enter a state of
hypercompetition state when competitive
advantages can only be sustained for very short
periods.
 According to Richard D’Aveni, several industries
are in this state.
 Firms in these industries continually seek new
sources of competitive advantage.
Hypercompetition Strategies
 A firm’s chief strategic goal should be to disrupt
the existing sources of advantages including its
own.
 A firm that relies solely on its existing source of
advantages will be displaced by more innovative
rivals.
 Firms may be able to create shocks on their own
rather than waiting for them to occur.
Incentives to Innovate
 Established firms face certain incentives to refrain
from innovation.
Sunk cost effect
 Replacement effect

 They also face certain incentives to become
innovators.

Efficiency effect
The Sunk Cost Effect
 For established firms, costs incurred to commit to
a particular technology are sunk costs.
 Investment in resources and capabilities specific to
the technology will be less valuable with another
technology.
 Established firms tend to favor the current
technology.
Replacement Effect
 The opportunity to innovate is assumed to be
available to either an incumbent monopolist or a
potential entrant.
 The innovation will lower the average variable cost.
 If the entrant gets to innovate it can displace the
monopolist and its incentive to do so depends on the
value of becoming the monopolist.
Replacement Effect
 Monopolist’s incentive to innovate will be less
since it will be replacing itself.
 Established firms will be less willing to innovate
that potential entrants.
Efficiency Effect
 If the monopolist anticipates that the entrant may
get an opportunity to innovate, its incentives to
innovate will be stronger.
 If the monopolist can continue to be monopolist by
innovating, its incentives will greater than the
potential entrants.
The Incentive to Innovate
 All three effects (sunk cost, replacement and
efficiency) will work simultaneously to determine if
the incumbent will innovate or not.
 Replacement and sunk cost effects may dominate if
the probability of innovation by entrants is low.
 Efficiency effect will dominate if the potential
entrants are likely to capitalize on the incumbents
failure to innovate.
Innovation Competition
 Competition to innovate can be like a “winner take
all” contest
 When firms compete to develop the same product,
the firm that does it first will enjoy a significant
advantage
 The winner may be able to get a patent and/or the
advantages of a first mover
Innovation and the Market for Ideas
 If there is a market place for ideas, the incumbent
can acquire the technology of the entrant.
 The entrant can sell its ideas for full value.
 Incumbent has incentive to invest in R & D to
improve its bargaining position.
 Incumbent may also skip R & D investment to avoid
duplication.
Market for Ideas
 For the innovator to realize the full value of the
innovation
technology should be protected by patents and
 the required expertise in production and marketing of the
innovative products is not scarce

 The balance of power shifts away from the
innovator to the established firms if such expertise
is scarce.
Market for Ideas
 Incentives in allocating capital to innovation differ
between small and large firms.
 Small firms face the external capital market with
uninformed investors.
 Large firms use internal capital markets where
allocation can shift away from faltering projects
quickly.
Innovation Competition
 Staying even slightly ahead of the rivals will produce
disproportionate benefits
 First innovator will benefit from



patent protection
network externalities (even when there is no patent protection)
and
consumer perceptions.
Patent Race
In a “winner take all” race to obtain a patent, a firm
should look at the following factors before deciding
whether or not to increase its R & D investment

Effect of additional investment in R & D productivity

Response by the rivals to increased investment by the
firm

The number of competitors in the field
Choosing the Technology
When multiple R & D methodologies are available, a
firm should consider the following characteristics

Riskiness of each methodology (uncertainty about the
anticipated completion date)

Correlation between methodologies (when the
uncertainties are resolved, how often are the outcomes
similar?)
Riskiness of R&D
 A monopolist will be indifferent about risk as long
as the expected completion date is the same for all
methodologies
 When firms compete, each firm will end up
choosing a high variance strategy over a low
variance strategy, if the expected completion date
is the same
Riskiness of R&D
 If all the other firms follow a low variance
methodology, a firm that follows a high variance
methodology improves its odds of being the first to
reach the desired outcome
 Every firm faces the same incentive to switch to a
high variance methodology and no firm will choose
a low variance methodology
Correlated Research Strategies
 Society benefits more if firms pursue uncorrelated
methodologies (compared with correlated ones)
since the probability of any one firm reaching the
goal is higher with uncorrelated methodologies
 It turns out that firms left to decide on their own
will choose uncorrelated strategies
Correlated Research Strategies
 If many firms pursue the same methodology, each
firm will have a small probability of success.
 Any one firm will benefit by pursuing an
uncorrelated methodology and increase its chance
of winning.
 A niche R & D strategy (uncorrelated) can be
valuable even when the probability of success is
small.
Evolutionary Economics and
Dynamic Capabilities
 In traditional economics, a firm is assumed to
make decisions to maximize economic profit.
 Evolutionary economics views decisions made by a
firm as determined by established routines.
 Routines include methods of production, hiring
policies, etc.
Evolutionary Economics
and Dynamic Capabilities
 Usually a firm’s routines change slowly over time
(if they do change).
 To ensure survival, firms need to continuously
improve their routines.
 Firms with dynamic capabilities can adapt their
resources and capabilities and exploit
opportunities created by market shocks and
discontinuities.
Factors that Limit Dynamic Capabilities
A firm’s dynamic capabilities are inherently limited
because of

the path dependence of sources of competitive advantage

limited availability of complementary assets

“windows of opportunity” that do not stay open for long
Path Dependence
 Firm’s routines can only change incrementally and
cannot have a clean break from the past
 The new source of advantage will be path
dependent
 With threats from new entrants, even small path
dependencies can have major implications for the
firm’s competitiveness
Complementary Assets
 Complementary assets are assets that are valuable
only with a product or technology.
 If changes in a routine lowers the value of
complementary assets, the firm will be reluctant to
adopt the changes.
Windows of Opportunity
 Early in a product’s life, its design and
specifications will be fluid and firms will have
room for experimentation.
 Over time a narrow set of design and specifications
emerge as dominant and it is hard for new firms to
challenge market leaders.
 Those who do not exploit the window of
opportunity get shut out.
The Environment
 Michael Porter suggests that the firm’s local
environment is a major influence on its
competitive environment.
 Even as a modern firm transcends local markets,
the source of its competitive advantage remains
localized.
The Environment
A firm’s home nation and home markets play an
important role in its ability to sustain its competitive
advantage

by supporting the accumulation of valuable resources and
capabilities and

by exerting pressure on the firm to innovate, invest and
improve
Managing Innovation
 A firm has to contend with two opposing forces in
trying to manage innovation.
 To foster innovation, creativity and
entrepreneurship, the organization should be
sufficiently flexible.
 However, coordination of innovative activities will
require formal structure and controls.