Strategy & Economics:
Introduction to Economic Rents and
Competitive Advantage
MANEC 387
Economics of Strategy
David J. Bryce
David J. Bryce
What is Strategy?
• A 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 others
• A pattern in a stream of decisions
David J. Bryce
What is the Goal of Strategy in
Business?
• To secure sustained profit for the firm
• In economics, profit is defined as
π = R – C – OC
(Profit = Revenue – Costs – Opportunity Cost of assets)
• Contrast to Accounting Profit:
πacc = R – C
David J. Bryce
How to Secure Profit? Exploit the
Conditions of Imperfect Competition
Perfect Competition
• Numerous sellers and
buyers unable to affect price
• Perfect Information
• Homogenous products
• No barriers to entry or exit;
mobile resources
Zero Economic Profits
Imperfect Competition
•
•
•
•
Few competitors, numerous
suppliers and buyers
Asymmetric Information
Heterogeneous Products
Barriers to entry
Positive Economic Profits
(also referred to as supernormal
profit)
David J. Bryce
The Structure of Industries
Threat of new
Entrants
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David J. Bryce
Bargaining
Power of
Customers
Barriers to Entry
What factors keep potential competitors out?
• Scale economies
– e.g., aerospace industry
• Scope economies
Industry
– e.g., retailing
• Capital requirements
A
– e.g., aerospace industry
B
C
D
• Switching costs
– e.g., Windows operating system
• Access to distribution
– e.g., soft drinks
• Product Complexity
– e.g., supercomputers,
microprocessors
• Entry deterring regulations
– e.g., Tobacco
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Nature and Focus of Rivalry
Why industries are more or less “competitive”?
• Factors
Industry
– Industry growth rates
• Where to secure growth
A
– Exit barriers
• e.g., specialized assets, emotional barriers
B
C
– Fixed costs
• e.g. capacity increments
Competitive rivalry can focus on
many factors, including price, quality,
technology, features, service, etc.
David J. Bryce
– Lack of product
differentiation
• e.g. differences in functionality, performance
– Switching costs
– Number of competitors
Threat of Substitutes
What alternatives are available to customers
Industry
A
C
B
D
• Direct substitution with
the same functionality
– diesel vs gas engines
– DirecTV vs cable
Customers
• Eliminating need for
product
– water meters vs flat rate
David J. Bryce
Supplier or Buyer Power
How can my suppliers or customers extract value?
Supplier Power
Buyer Power
• Supplier concentration
– Few vs many suppliers
• Supplier volume
– Large vs small purchase
• Buyer concentration
– Few vs many customers
• Volume of purchases
– Large vs small purchase
• Product differences
– Dependence on unique
• Available alternative products
– Competitive products
• Threat of backward integration
– Ability to become a
decisions
features
• Threat of forward integration
– Ability to become competitor
• Switching costs
– Limitations on ability to
change suppliers
David J. Bryce
decisions
competitor
• Switching costs
– Threat of switching suppliers
How Industry Structure Influences
Profitability
100
80
Percent
of
Market
60
99
Others
(>10,000)
40
20
0
1
Farmers
5-10% ROE
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20
Others (>10)
4
Green Giant
17
Campbell
25
Swanson
34
Stouffer
ConAgra
Frozen Entree Makers
20-25% ROE
90
3 2
Others
(>1000)
American
Kroger
4 Safeway
Food Retailers
8-12% ROE
Successful strategies should:
• Minimize buyer power
– (e.g., build customer loyalty)
• Offset supplier power
– (e.g., alternative source(s))
• Avoid excessive rivalry
– (e.g., attack emerging vs entrenched
segments)
• Raise barriers to entry
– (e.g., make preemptive investments)
• Reduce the threat of substitution
– (e.g., incorporate their benefits)
David J. Bryce
Economic Rents
• Strategists especially seek a kind of profit called
economic rent
• Economic rent is the excess received over the
minimum amount that justifies (or pays for) the
resource, operation, function, activity, or asset
• Economic rent may be positive when economic
profits are zero due to the opportunity cost of rent
earning assets (but only when OC is producing actual
returns)
• A portion of accounting profit is usually economic
rent
David J. Bryce
Example
• Suppose 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.
• 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 land
David J. Bryce
Example (continued)
Revenue
Firm A
Firm B
R
R
Cost
– (C – $10,000)
–C
Accounting Profit
R – C + $10,000
πacc
Opportunity Cost
– $10,000
–0
Economic Profit
π
π
Economic Rent
$10,000
0
David J. Bryce
The Relationship between Rent and
Economic Profit
• When a valuable asset can be sold, the opportunity
cost of its use is its sale price (less costs incurred)
– Thus, OC = Economic Rent and
– The firm earns normal economic profit
π + rent = R – C – OC + OC
π = R – C – OC
• When an asset cannot be sold, it has no OC
– Thus, rents increase the revenue of the firm (or reduce its
costs) and positive economic profit ensues
π + rent = (R + Rent) – C – (OC=0)
π = R –C
David J. Bryce
Rent Recap
• When 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?
• Answer: When assets (or resources) cannot be sold
• But when can resources not be sold?
• Answer: When markets for rent-earning assets are
inefficient or fail
David J. Bryce
Why Markets for Assets May Fail
• The 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 value
• 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 rents
David J. Bryce
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 discovery
• The 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’ resources
• Wal-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
David J. Bryce
Definition: Competitive Advantage
• When a firm earns positive economic profit, the
firm possesses a competitive advantage
• Reminder: How is positive economic profit
secured?
• Answer: 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) markets
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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 advantage
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The Cornerstones of Competitive
Advantage
Four conditions must be met:
1. Resource Heterogeneity
2. Ex Post limits to competition
3. Imperfect resource mobility
4. Ex Ante limits to competition
Following discussion draws liberally from M. Peteraf, 1992, The Cornerstones of Competitive Advantage
David J. Bryce
Ex Post Limits
Heterogeneity
to Competition
Rents
Rents Sustained
Sustained
Competitive
Advantage
Rents sustained
within the firm
Imperfect
Mobility
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Rents not offset by
costs
Ex Ante Limits
to Competition
Appendix
• Detailed descriptions of the
cornerstones of competitive advantage
David J. Bryce
Resource Heterogeneity
• Resources are the tangible and intangible assets of
the firm:
– Tangible: Plant, equipment, fax machines, human
resources, etc.
– Intangible: Employee knowledge, goodwill,
patents, team-embodied skills, etc.
• To be the source of SCA, these resources must be
substantively different from other resources and must
be limited in supply
• The way the firm “gets things done” must also differ
from others; firms must perform different activities
than rivals or perform similar activities in different
ways
David J. Bryce
Two types of rent may be earned on
heterogenous resources
• Ricardian Rent
– Rents earned on scarce resources—those that are
insufficient to supply all the demand for their services;
– Resources may be “fixed” (e.g. land), or “quasi-fixed” (e.g.
unique team skills)
• Monopoly Rent
– Rents earned by restricting the output produced from
resources; the full supply of the resource is not utilized
– Resources must nevertheless be heterogenous and
unavailable or inaccessible by others to earn monopoly rents
David J. Bryce
Ex Post Limits to Competition
• Regardless of the type of rent earned, the condition of
heterogeneity must be preserved to maintain SCA
• How? After a firm gains a superior position and is
earning rents, there must be limits to competition for
those rents
• There are two primary limiting factors:
– Imperfect Imitability
– Imperfect Substitutability
• Mechanisms that limit imitation include property rights,
causal ambiguity, producer learning, buyer search
costs, buyer switching costs, reputation, etc.
• We’ll talk much more about substitutability later
David J. Bryce
Imperfect Resource Mobility
• This is the market failure idea—resources are immobile
or imperfectly mobile when markets are inefficient
– Immobile: Markets completely fail—assets are of no value
outside the firm
– Imperfectly Immobile: Value is lessened when assets are
transferred but not obliterated
• We provided examples of the types of assets that are
subject to market failure earlier; these resources may
also be considered imperfectly mobile
• Remember—opportunity costs on these assets are
lower than the value of the asset to the firm, which
creates positive economic profit
David J. Bryce
Ex Ante Limits to Competition
• Prior to any firm’s establishing a superior resource
position, there must be limited competition for that
position
• To conceptualize this, consider the alternative:
– Suppose a large number of firms simultaneously perceive a
new opportunity;
– By competing amongst themselves to acquire the resources
needed for that opportunity, they will bid up the cost of
entering until post-entry economic profit is zero
• Thus, firms must either be systematically better
informed than others about the future value of
opportunities or be lucky enough to stumble upon an
opportunity before its value is widely known
David J. Bryce