STR 421
Economics of
Competitive Strategy
Michael Raith
Spring 2007
Today’s class
2. Value creation and competitive advantage
2.1 Value creation and positioning
2.2 Sustainability of a competitive
advantage
Sustainability of competitive
advantage
 Efficient markets principle: if you have a competitive
advantage, others will try to imitate what you’re doing
 What will prevent them?
Sources of sustainability
 a.k.a. “Isolating mechanisms”, “Sources of market
power”
 All of these are also barriers to entry
1. Impediments to imitation
= Reasons why others cannot imitate you
= Loosely speaking, returns from unique resources and skills
2. First (or early)-mover advantages
= Reasons why it would be uneconomical for others to imitate you
= Loosely speaking, returns from market power
 Distinction not clear-cut: how much does it cost to
replicate an incumbent’s advantage?
1. Impediments to imitation: (a)-(f)
(a) Regulatory restrictions
–
–
Broadcasting rights, taxis, import tariffs and quotas
Not just given situation: companies spend $$$ to influence regulation
(b) Patents = legally protected monopoly rights, exist to encourage
innovation
–
Example: Patent protection important in pharmaceuticals, weaker in
medical devices. Depends on
 Ability to innovate around existing patents
 Speed of innovation: new devices quickly become obsolete
(c) Secrecy about production process
–
Often chosen when obtaining patent protection is difficult and product
is difficult to reverse-engineer
(d) Superior access to inputs or
customers
 Inputs:
– De Beers until 1990
– Alcoa’s backward integration into bauxite in early 20th century
 Customers: e.g. through exclusive-dealing contracts
 What about talented employees (=inputs)?
– Can be hired away if worth as much or more elsewhere
– Cannot if they stand to lose human capital specific to the firm
(or to a set of other employees, “cospecialized assets”)
 “Unique resources” must be scarce and immobile
(e) Unique capabilities
 Examples:
–
–
–
–
Honda in engines
3M in adhesives and thin-film coating
Bombardier in trains
Canon: integration of microelectronics, fine optics and precision
engineering
= Capabilities that
– are result of organizational learning over time, corporate
culture, organizational structure
– do not depend on individuals
(f) Strategic fit
 Examples: Southwest Airlines, Ikea, Dell; we’ll see
others
 Good internal fit can be
1. Source of competitive advantage
2. Reason for its sustainability
 Hard for others to get all components of the system right at
the same time.
 But successful imitation may only be question of time
– E.g. pressure on airlines like Southwest, JetBlue
2. First-mover advantages:
basic logic
 Suppose A has discovered a market opportunity and is making a
profit
 B considers imitating A. Assume B can do so without any
technological disadvantage (no impediments to imitation)
 What would happen? Upon entry, B might find itself
– Sharing a limited market with A
– Engaged in a price war with A
– Without customers because for some reason customers stick with A
 As long as A is committed to staying, A can make profit if alone, but
B as second mover cannot, and hence should stay out
 A then has a first-mover advantage
(a) Scale economies relative to
size of market (segment)
 Basic logic:
– A and B can share market if market > 2 MES
– But if market smaller, competition will lead to losses
– If A is more likely to stay because of sunk costs, B should not
enter in the first place
 Examples:
– Wal-Mart in small towns
– Coors in West in 70s, A/B & Miller in East in 80s
 Closely related: Geographic or positional preemption in
markets with differentiated goods
– CC&S in its niche of the market
(b) Reputation
 Established reputation for quality raises buyers’ WTP
– What matters is perceived quality
 Competitors w/o reputation can only sell at lower price
 Reputation must often be maintained through
advertising or R&D
 Endogenous sunk-cost markets
– E.g. Coke, Intel, Apple
Special case: brand image
 Perceived quality often more matter of brand image
than based on tangible things
 Companies spend $$$ to advertise brands
 Importance of advertising depends on who
makes/influences purchase decision
– Beer: consumers
– Cans: companies
– PCs: resellers, Consumer Reports, corporate/educational etc.
(c) Network effects
 Direct network effects: value to buyers increases with # of users
– Fax machines, Word, eBay
 Indirect network effects: link through a complementary product
– The more people use PCs & Windows,
 the more software for PCs is developed
 the greater the value of PCs to buyers
– Another example: DVDs/players and Blockbuster
 If a firm owns technology that customers are locked into, it has
market power because rivals’ products will be less valuable to
customers.
– PC industry is competitive, but Microsoft is monopolist
 Ask: how strong are network effects?
(d) Switching costs
 A firm has market power if its customers incur some cost if they
switch to a different product
– Synergies with other products in same family, e.g. Microsoft Office
– Familiarity with existing product, e.g. WordPerfect
– eBay, NetFlix
– Yahoo vs. Google: lock in users through personalized searches?
 Creating switching costs is powerful way to build customer loyalty
and market power
– But rational customers must be willing to be locked in!
 Ask: How difficult is it really for customers to switch?
– E.g. cell phones: regulation that allows customers to transfer home
phone number to cell phone
(e) Learning effects
(“experience curve”)

lower AC as a result of higher cumulative output
 First-mover advantage through experience
– E.g. aircraft

Strategic consequences
–
–

Being first important if you know there will be learning effects
BCG in 70s: invest in early stages of product life cycle to secure
learning economies. Problems:
1. Existence of learning effects often known only afterwards
2. You may be investing in losing products
Internal fit matters: union contracts at Lockheed diminished
learning effects in producing the L-1011 TriStar (BDSS Ch. 2)
Sustaining a competitive
advantage is hard
 Don’t assume any of these barriers exist for a
particular firm; ask to what extent they may exist:
1. Having certain resources and capabilities does not mean
they’re unique
 Imputed “unique capabilities” often used as shortcut to
explain a firm’s success without careful analysis
 Firms often fool themselves by claiming to have certain
unique capabilities
2. Moving first does not by itself confer a first-mover advantage
 “Sustainability” is not yes-no matter, often only matter
of time