Competitive Advantage
August, 2002
Gordon Walker
Professor
Cox School of Business
Southern Methodist University
Dallas TX 75275
Introduction
The essence of strategy is achieving a sustainable advantage over competitors.
Competitive advantage therefore constitutes the goal of strategic thinking and the primary
focus of successful entrepreneurial action. To achieve this goal, firms develop value and
cost drivers that lead to sustainable, superior economic performance. Intel’s success in
the microprocessor industry and Walmart’s dominance in mass-market retailing are due
in large part to their abilities to provide products and services that offer value to
customers at costs rival firms cannot imitate.
The two major elements of competitive advantage are:
o Positioning the product line more effectively than competitors
o Defending the sources of this market position against rivals.
Both are necessary for achieving high, sustainable performance, but neither alone is
sufficient.
Effective positioning in a market first means offering a product whose value
matches buyer preferences. We can think of the product’s value as the price a buyer is
willing to pay in the absence of a competing product and in the context of other
purchasing opportunities. At a higher price, the customer simply refuses to buy. Thus, in
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the absence of fraud or extortion, the customer, not the seller, always determines the
product’s value.
When buyers define value differently in a market, matching the product to their
preferences can be quite complex. Widely varying customer preferences create an array
of overlapping market segments with varying degrees of profitability and rates of growth.
Profitability differs across segments because they vary in factors such as buyer power and
competition, which influence prices and costs and change over time as the industry
evolves. In turn, segment growth rates vary as new market trends emerge and old ones
stagnate.
But effective positioning involves more than just satisfying customers: they must
be satisfied efficiently. Within an industry, firms vary both on what kind of value they
offer and on what it costs them to make the contribution. Firms that have achieved
enduring success in their industries offer more value per unit cost compared to
competitors, consistently over time. The difference between the product’s value and its
cost is the economic contribution produced by the firm. The larger the economic
contribution, the stronger the firm’s market position and, if this position can be sustained,
the greater the firm’s competitive advantage.
Delivering value at a cost that consistently produces profitability above the
industry average depends on the firm’s resources and capabilities. A resource is a
relatively stable, observable asset, such as a brand or geographical location, that
contributes to the firm’s performance. Resources can usually be valued in a market and
traded by their owners. A capability, on the other hand, denotes the firm’s ability, using
its organization and people, to accomplish tasks at a high level of expertise continuously
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over time. One example is reducing costs through superior learning as volume increases;
another example is shortening the design-to-production cycle. These capabilities are
developed and maintained through the coordinated efforts of the firm’s employees and
are impossible to trade without selling the whole company or at a minimum the units
containing the capability.
Resources and capabilities are developed over time within the firm or bought with
more or less accurate foresight for their strategic value. Since they define the kind and
amount of value the firm offers as well as the cost at which this value is produced, they
determine the firm’s market position and must be defended from competitors. Developing
and protecting resources and capabilities are thus essential for significant economic
performance over the long term.
To defend its advantage from erosion by industry forces, a successful firm must
prevent rivals from copying its core assets and practices and must induce customers not
to switch to comparable or substitute products. Firms employ a variety of means to
protect their resources, capabilities and customers from competitors. These “isolating
mechanisms” range from exercising property rights to maintaining a high rate of
innovation to increasing customer costs in searching for new products.
Figure 1 shows how competitive advantage arises from developing and protecting
resources and capabilities.
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Figure 1
Building Competitive Advantage
Competitive Positioning with Customers
Defending Against Competitors
Isolating mechanisms
Value
Drivers
Resources
Cost
Drivers
Capabilities
Superior Economic Contribution
Retain
Customers
Prevent
Imitation
Sustainable Market Position
Competitive Advantage
Other Sources of Firm Performance
Competitive advantage is one of three factors that determine a firm’s economic
performance. The other two are macroeconomic and industry forces. Macroeconomic
influences, such as the business cycle and monetary policy, influence nation-wide
patterns of demand and supply. Lower interest rates, for example, lower a firm’s cost of
capital, increasing the number of projects that can be funded and therefore the firm’s
potential earnings. Industry-specific forces include the power of buyers to force a
reduction in prices and the power of suppliers to force a rise in costs. The average
profitability of newspapers, for example, is reduced by the increasing cost of newsprint.
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Industries differ in terms of how much these three factors affect firm
performance. In some industries, macroeconomic factors are powerful. For example, the
business cycle affects the retailing and construction industries more than energy or
military contracting. Likewise, industry forces can be strong or weak. Structural
influences, such as the level of competition and buyer power, are stronger when
businesses have roughly similar strategies based on common inputs and resources, as in
the salt and sugar industries. However, where firms differ widely in their costs and in the
value they provide customers, industry factors are less important than the abilities of the
firms themselves. It is in these industries that the idea of competitive advantage is most
powerful.
Financial markets assess all three factors in determining the market value of a
firm. In many cases, strong macroeconomic and industry forces mask the importance of
competitive advantage. In a performance-rich industry, with high average growth and
profitability, such as IT consulting in the late 1990’s, competitive advantage may have
less of an effect on a firm’s market value than industry trends. But in an industry with
lower overall returns, such as IT consulting in 2001 and 2002, the firm with a competitive
advantage is likely to stand out. Achieving competitive advantage always produces better
economic outcomes compared to rivals and thus increases the relative value of the firm.
Competitive Positioning with Customers
Customers rarely pay for the full value of the product because competition drives
the market price down. For example, consider a firm thinking about improving its market
position by buying a new machine that would reduce costs. In a non-competitive market,
the supplier of the new machine might ask the firm that is buying the machine to pay a
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price close to, if not equal to, the amount of the reduction in costs, since this price reflects
the machine’s full value to the buyer. In a competitive market, however, with more than
one supplier offering comparable machines, prices decline as the suppliers compete to get
the customer’s business. The more prices go down, the more money the customer makes
from the transaction and the less the supplier makes. Note that even as prices are reduced,
the value of the machine to the buyer, in terms of its contribution to the buyer’s
efficiency, remains the same. Thus, through its effect on price, rivalry in an industry is a
central influence on both the supplier’s and the buyer’s economic performance.
Thus in competitive markets, buyers capture part of the overall economic
contribution the firm produces. The part the buyer captures is the difference between the
product’s value and its market price. The firm captures the rest, which is its profit - the
difference between the price and unit cost (see Figure 2).
Figure 2
The Distribution of Economic Contribution
Between Buyer and Supplier
Product Value
Economic
Contribution
Generic
Produced by
the Supplier
Buyer’s
Surplus
Market Price
Supplier’s
Profit
Product Cost
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Generic Strategies. A common argument is that a successful firm must have one
of two generic strategies, which reflect its value and cost profile. A firm should be either
a “differentiator” or the “cost leader.” A differentiator invests in offering high value, and
the cost leader has the lowest costs. These strategies can be applied to a broadly defined
market or to a market niche. In the case of a niche, the strategy is called “focus.” If a firm
is neither a differentiator nor the cost leader, it is called “stuck in the middle.”
In this approach, a firm must make an essential tradeoff: it must choose between
investing in higher value or investing in lower cost. The differentiator’s investments in
producing value are typically expensive, raising costs. In turn, cost leaders emphasize
reducing costs by reducing investments in value. For example, compare Rolex to Swatch
in watches, or Mercedes to Hyundai in automobiles.
Figure 3 shows a simple depiction of this tradeoff. The figure presents the
economic contribution of three firms: D for differentiator, LC for low cost, and SIM for
stuck in the middle. SIM lies between D and LC on the high value – low cost continuum.
Their contributions are simply the amount of value they offer minus the cost incurred to
achieve this value.
SIM provides more value than LC, the cost leader, but has higher costs; the firm
also has lower costs than D, the differentiator, but produces less value. Also, since the
tradeoff SIM makes between value and cost bulges downward, this firm produces a
smaller surplus than either D or LC and therefore has a competitive disadvantage.
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Figure 3
Tradeoff Between Differentiation
and Low Cost Generic Strategies
Higher
Value
D
Value D
Value SIM
SIM
LC
Value LC
Lower Cost
Cost D Cost SIM Cost LC
There are two important assumptions behind the argument that firms in the middle
do poorly. The first is that because the resources and capabilities of a firm like SIM are
not dedicated to achieving either high value or low cost, the firm cannot compete on
value with the differentiator or on cost with the cost leader. In essence, a company cannot
pursue both high value and low cost at the same time and in fact suffers when it tries to
do so since its economic contribution is lower than the firms specializing at the two ends
of the market. The lower value and higher cost of the firm in the middle are thus due to
problems of strategy execution. The second assumption is that the customer base of the
firm in the middle is insufficient to allow it to improve its abilities, given competition
with the other firms. That is, customers gravitate towards the higher value of the
differentiator and are willing to pay the price it charges, or they buy the lower value
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product at the cost leader’s lower price. There is little opportunity for a firm in the middle
to improve its position.
A classic example of a firm that is stuck in the middle is Sears, the venerable allpurpose retailer. In many of the products it sells, Sears is caught between more upscale
department stores, such as Nordstroms and Bloomingdales, and the expanding low-cost,
discount segment led by Walmart. The national expansion of regional department stores
with branded goods, such as Foleys and Macys, has also increased competition in the
mid-market group, forcing Sears to change its private label strategy. In addition, Target’s
aggressive entry into the market between Walmart and Sears has hurt its performance.
Marks and Spencer in Great Britain has faced a similar problem in market positioning.
Yet these two assumptions regarding the disadvantage of the firm in the middle
do not generalize to all industries by any means. Cost drivers may be powerful for any
level of value, and value drivers for any level of cost. A more innovative firm may be
able to achieve higher margins in the middle, even though the firm’s value to the
customer is not the highest, and its costs are not the lowest. A good example is Charles
Schwab in the internet brokerage business during the bull market of the late 1990’s (see
the short case study below). Schwab’s process innovations as a low-cost firm in the
traditional brokerage business enabled it to provide a more attractive mix of value and
price than its competitors in internet trading. As a firm in the middle, Schwab increased
its value to customers through improving service levels, while simultaneously holding
costs and therefore prices down. Consequently, buyers gravitated towards the firm,
increasing its ability to improve the difference between its value and cost through further
innovation.
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***********************************************************************
Short Case Study: The Internet Brokerage Industry
In the internet stock brokerage industry, the dimensions on which firms compete
are price and service. Almost all firms offer trading in the same array of financial
instruments – equity, bonds, IRAs, options. So there is no additional value associated
here. However, there is a clear positive correlation between price and both the size of a
customer’s account and the quality of the services offered. Customers with higher
deposits are charged higher prices and get better service in terms of research information
provided by the firm (and probably the expertise of its agents on the phone). Large full
service incumbents occupy the high price – high service end of the market, and discount
brokers and entrants specializing in internet trading are located at the low end. The Midmarket group lies between these two ends. It seems clear that no firm is able to offer the
lowest price with the best service. The reason is simply that better service is costly, and to
make adequate profits higher service firms charge more for broker-assisted trades and
only offer expensive, high-level in-house expertise to high-dollar traders.
Figure 4 shows Fall, 2000 data on eleven firms separated into three groups based
on their price structures and research services offered. At the high end is the Premium
Group: three firms – Prudential, Salomon and Paine Webber – that require substantial
deposits and charge asset management as well as trading fees. Next the Mid Market
Group, composed of Merrill Lynch, Fidelity, CSFB, Morgan Stanley Dean Witter and
Charles Schwab – offers lower rates for trades than the Premium Group, has much lower
minimum deposits, and less in-depth research except for high-dollar customers. At the
low end are firms – such as Ameritrade, and E-Trade – that offer a much lower price for
both internet and broker-assisted trades, no minimum and only generic research.
It is clear that both Schwab and Fidelity have more accounts than either the firms
in the Premium and Price Leader groups. In fact, internet brokerage for the Premium
Group appears to be an ancillary service offered customers with high net worth rather
than a separate business that the firms are expanding aggressively, as is the case with the
firms in the other groups. Additional data not shown indicate that Schwab – in the middle
– has relatively strong earnings, while the firms at the low end, with the exception of TD
Waterhouse, are losing money. (Data on Fidelity and Datek are unavailable since these
firms are privately held, and the other firms in the middle – MSDW and Merrill Lynch –
do not report information on internet brokerage separately from their non-internet
business.) So, although we do not have complete cost and value data for these firms, what
information we have strongly suggests that there is a large customer base for some of the
firms in the middle of the market and that among them Schwab is making money in this
market position. In this industry, being in the middle can clearly be economically
advantageous. Note, however, that not all firms in the middle are doing well – CSFB is
not profitable; so, although we can infer that Schwab has a higher economic contribution
than the other firms, being the middle offers no guarantee of higher returns.
***********************************************************************
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Figure 4 – The Internet Brokerage Industry (Fall, 2000)– Selected Firms
Broker Assisted,
<1000
Minimum deposit
Online Research
PaineWebber
$1250/year
min.
$1250/year
min.
$100000
PaineWebber
Number of Accts
On-line acct assets
Avg no. of trades/day
<1M
unk
<49K
Merrill Lynch
CSFB Direct
Elec Order, <1000
Broker Assisted,
<1000
Minimum deposit
Online Research
$29.95 per trade
$50-120 + .25 to
.06/share
$2000
ML global investor
network
$20
$20
Number of Accts
On-line acct assets
Avg no. of
trades/day
735K
3.1B
<49K
Elec Order, <1000
TD Waterhouse
Elec Order, <1000
$12
Broker Assisted,
$45
<1000
Minimum deposit
$1000
Online Research
S&P, 1st Call,
Vickers
Number of Accts
2.2M
On-line acct assets
114B
Avg no. of
111K
trades/day
$0
zacks, lipper,
csfb if
>$100K
430K
24B
23K
Quick&Reilly
$14.95
$37.50 to
$49+.5*shares
$0
Zacks, Vickers
219K
10B
7K
Premium Group
Prudential
Salomon
.25-1.5% of assets +
.75%-1.5% of assets annually
24.95/trade
.25-1.5% of assets +
.75%-1.5% of assets annually
24.95/trade
$50000
$50000
Prudential
Salomon Smith Barney
Research
<1M
<1M
Unk
unk
<49K
<49K
Mid Market Group
Morgan Stanley Dean Witter
$29.95
$39.95
zacks,
$2000
homson, msdw if
>$100k
<1M
Unk
<49K
Datek
$9.99
$25
$0
charts and news
only
623K
14B
97K
Schwab
Fidelity
$29.95
$39 or .09* share
$5000
advanced if >$100k
$25 per trade
$59 to 120 + up to
$.14/share
$2500
Lehman Bros.
4.2M
419B
207K
4.7M
333B
98K
Price Leaders
E*Trade
$14.95/19.95 NASDAQ
$29.95 + .01*>5000/34.95
NASDAQ
$1000
S&P
11
3M
61B
114K
Ameritrade
$8
$18
$0
marketguide, zacks
1M
36B
94K
Positioning in terms of economic contribution. Ultimately, it is the difference
between value and cost, not their levels, relative to competitors, that determines superior
market positioning. Competitive advantage is not about differentiation or cost leadership.
It is about producing and then protecting a greater economic surplus than rivals.
Consider two firms that produce products that have the same value to customers.
But one firm has lower costs than the other. The firm with lower costs can charge the
same price as its competitor and earn a higher return. The buyer is indifferent since it
receives the same amount of surplus from both firms. Alternatively, the lower cost firm
can reduce its price, thereby increasing the buyer’s surplus and attracting customers to the
firm’s product. Either way, the firm that creates the larger economic contribution by
having the lower cost has a competitive advantage, which is sustainable if the firm can
protect its cost advantage from competitors.
Similarly, when two firms produce different levels of value but at the same cost,
the firm with the higher value, and therefore the greater economic contribution, has a
competitive advantage. This is so because this firm can increase its price and increase its
profit while still allowing the buyer to capture the same surplus. Or it can charge the
same price as its competitor, thereby offering a higher surplus to the buyer and making its
product more attractive.
It is common for competitors to offer products at different levels of value and
produce them at different levels of cost, as in the example of the internet brokerage
industry. Figure 5 shows the market positions of Schwab and representative firms from
the Premium and Low Price groups. For convenience, the Premium and Low Price firms
have the same economic contribution, which is less than Schwab’s.
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Schwab’s profile shows that it has neither the highest value nor the lowest cost,
but its economic contribution is greater than its competitors. The additional surplus
Schwab produces is shown in Figure 5 as the checked area. Schwab can offer the buyer
more value than its competitors and earn a profit. To offer the same economic surplus as
Schwab, the Low Price firm could price below cost, expecting to increase its volume and
therefore its efficiency. This appears to be what Etrade and Ameritrade are doing.
Alternatively, the Low Price competitor could add services to increase its value, but it
must do so without adding costs. In either case, the Low Price firm must address the
problem of higher value at lower cost that Schwab has already solved. Similarly, the
Premium firm has the highest value and needs to lower cost without reducing value in
order to compete with Schwab. Or the Premium firm could increase its value even more.
However, in doing so, it cannot increase its costs if it wants to remain competitive. In
sum, to take customers away from Schwab, both the low price firm and the premium firm
must become more productive.
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Figure 5
The Internet Brokerage Industry
$
Premium Firm
Value
Schwab
Value
Low Price Firm
Value
Typical
competitor’s
economic
contribution
Schwab’s
economic
contribution
Cost
Cost
Cost
Value or Cost Advantage. Even though it is incomplete as a source of
competitive advantage, the concept of product differentiation does highlight how firms
compete through increasing customer value rather than through reducing costs.
Investments in raising customer value are typically directed at achieving a value
advantage over rivals. In some situations, this strategy can produce substantial gains in
economic performance.
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Investments in value improve the firm’s market position when they are focused on
attracting the customer, whether an existing one or a new one, who is most ready to
switch to the new product. When these customers are more sensitive to value, such as
service or brand enhancements, higher value induces them to change products. If the
investment is directed at the more entrenched customer, it may be too limited or too
focused on value drivers that are ineffective in inducing switching behavior.
Increased volume due to higher value must be sufficient to justify the firm’s
investment. Investments in value are more effective when the proportion of marginal
customers that are value-sensitive is high. This is typically the case in emerging markets
where performance and quality vary substantially across products. However, achieving an
innovative value advantage also represents a major type of positioning in mature markets,
as Apple Computer has repeatedly tried in the PC market.
Pursuing a value advantage is more reasonable when it produces a higher return
than the opportunities to reduce costs. Cost reduction is less attractive when all firms in
an industry have access to the same process innovations to increase efficiency or to the
same sources of lower cost inputs. In this case, although a firm must invest in efficiency
to remain competitive, the value this investment creates is inevitably passed on to
customers through lower prices as the costs of all firms fall.
Alternatively, investing in cost drivers gives the firm two ways to increase
economic performance. First, without lowering its margins, the firm can reduce its price.
This tactic raises the amount of surplus captured by the customer and thus the demand for
the product. Second, the firm can continue to charge the same price and have higher
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margins. Either way, if the firm’s lower cost position can be protected from competitors,
the firm develops a competitive advantage.
Cost reduction provides a greater return when the marginal customer is price
sensitive, since the firm can lower its price and keep the same margin. Walmart’s success
as a low-cost retailer has been based on attracting an untapped pool of price-conscious
buyers worldwide. Price sensitivity is common in economies with low growth rates
where customers have diminished expectations regarding future income. Japanese buyers
in the late 1990’s became markedly more oriented towards price, as their economy
continued to stagnate, allowing low-cost retailers such as Costco to enter the market
successfully.
Cost reduction programs are also more likely to be initiated when improvements
in value are difficult or costly. For example, major enhancements in value often become
more expensive in the later stages of a technologies’ life cycle, as Intel found in the
development of its 8086/8 microprocessor. As its technology platform matures, efficiency
has become more important for Intel both to maintain low prices and to develop the
financial resources necessary for the increasingly costly iterations of technological
innovation.
Value and Cost Drivers. What should firms focus on to improve productivity
compared to competitors? The case of the internet brokerage industry shows that rivals
can invest in improving value or reducing costs or both. To achieve competitive
advantage in positioning with customers, a company must strengthen its resources and
capabilities related to improving the difference between the value offered and the cost
incurred. These investments focus on value drivers and cost drivers (see Figure 6).
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Figure 6
Value and Cost Drivers
Value Drivers
Cost Drivers
Quality
Delivery
Service
Technology
Breadth of Line
Customization
Geography
Risk Assumption
Brand/reputation
Network Externalities
Environmental Policies
Complementary Products
Scale Economies
Scope Economies
Learning Curve
Low Input Costs
Vertical Integration
Organizational Practices
Value Drivers. In all markets firms compete in part on the value they add to
customers. This value varies across firms depending on their resources and capabilities.
The more firms vary in the value their products provide customers, the more significant
the determinants of value as a source of competitive advantage. A good example of a firm
that builds strong value drivers is Cisco Systems (see sidebar).
************************************************************************
Short Case Study – Cisco Systems
Since its inception in 1984, Cisco Systems has been one of the clearest examples
of strong market positioning based on two major value drivers – customer service and
breadth of product line. Cisco sells telecommunications equipment to four types of
customer – telecommunications companies, large businesses (over 500 employees), small
businesses, and consumers. Its product line consists of four segments or types of product:
1) routers, which move digital voice, data and video transmissions from one network to
another across the internet; 2) switches, which are used to send transmissions in local
networks (e.g., LANs); 3) access devices, which allow remote users, such as home
workers, to connect effectively with the internet; and 4) other products such as services
and network management software. As the chart below shows, overall revenue has
increased about 125% over 1998-2000. Gross margins have held roughly constant at
about 70%.
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Cisco has focused on providing outstanding customer service and a very broad
line of compatible products. John Chambers, Cisco’s CEO, demands excellent customer
service from his employees. Service increases the value of the firm since downtime in
telecommunications equipment causes an immediate economic loss for the customer.
Cisco’s service processes are driven by its use of information technology, especially the
internet. Significantly, not only is the internet an efficient means of solving customer
problems, it is also Cisco’s core business. So Cisco’s use of the internet is both a key
capability supporting its market position and a demonstration to firms in general of why
the internet is so useful, which is why they should buy Cisco’s products. Through the
internet Cisco connects its customers with the companies that manufacture its products.
(Cisco is a devout outsourcer of manufacturing.) Customers are also connected directly to
any Cisco unit that can help solve problems. And Cisco units are connected to each other.
To the extent Cisco can assure customers that their needs will be met quickly and
effectively with up-to-date technology, Cisco is well positioned to increase demand for
its products, relative to competitors whose promises of better service may not be as
credible.
Given its dominant market share (about 80%) in the core router market, Cisco has
been able to introduce a range of compatible products that together tie customers to
Cisco’s technology. Cisco has been vigorous in licensing and promoting the technical
standards underlying these products so that its customers benefit from a larger market of
firms selling compatible technology. Breadth of line increases value to the customer by
providing an integrated system of telecommunications hardware, reducing search and
maintenance costs as well as the danger of problems in communication at the interface
between system components.
But by far the most important capability for broadening its product line is Cisco’s
expertise in acquiring and integrating other firms. In an industry with a very high rate of
innovation, Cisco has developed a marked skill in identifying, acquiring and integrating
startup firms whose technology is at the leading edge of an emerging subfield, such as
optical switching equipment and wireless technologies, and whose management and
culture fit well with Cisco’s organization. Between January, 1994 and January, 2001,
Cisco made over seventy acquisitions to bring new products and engineering talent inhouse. Twenty-three acquisitions were made in 2000 alone. It is reported that some
engineers and venture capitalists designed their startups specifically to be attractive to
Cisco. One reason has been the high price Cisco paid for the startup, almost always in
stock. Since Cisco’s stock has traditionally traded at a very high multiple to earnings,
reflecting its strong growth potential, the venture capitalists and engineers receive an
excellent return on their shares in the startup. However, since the decline in internet
stocks during 2001, it is harder for Cisco to leverage its market value as easily. A second
reason is that the startup would probably be unable to compete successfully against Cisco
over the long term, given Cisco’s continuing investments in new products and in
processes to improve customer service. In this light, the experience and long-term
reputation benefits of working for Cisco may outweigh the personal satisfaction of being
an entrepreneur. At any rate, there is nothing to prevent the entrepreneur from starting
another venture with new technology, which Cisco again might find attractive.
Cisco thus positions itself with customers by emphasizing service and breadth of
line, both of which provide high value given the degree of technological change and
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complexity of telecommunications equipment, and its criticality for the customer’s
business. The firm’s capabilities are mapped effectively onto this position – specifically
its use of information technology, especially the internet, and its expertise in acquisitions
of other high-technology firms.
The major threats to Cisco in 2001 were 1) a decline in the U.S. and global
business cycles that lowers demand for telecommunications equipment and therefore
Cisco’s stock price and 2) a rate of technological innovation in the market that exceeds
the company’s ability to acquire and integrate startup firms. Both of these challenges are
related to Cisco’s product line breadth. A lower share price makes Cisco a less attractive
acquirer to entrepreneurs, perhaps limiting its acquisition scope, especially for more
promising technologies. A higher rate of innovation by technology focused firms – for
example in optical networking by Juniper Networks and Sycamore Networks - means that
Cisco would be unable to find and absorb startups fast enough to keep its product line
technologically current. Of course, neither challenge need be permanently damaging. At
some point, the market will recover, raising Cisco’s stock; and Cisco could reestablish
the currency of its product line by acquiring new firms with state-of-the-art technology.
Whether customers will continue to value the breadth of line and service Cisco offers, in
comparison with the technology-based functionality of competitors, remains an open
question.
***********************************************************************
The major dimensions on which firms position themselves to attract demand on
the basis of value are the following:
Quality. A product’s quality entails its durability and reliability, as well as its
aesthetic effect. In many industries, customers will not accept quality below a relatively
high level, either because of safety concerns, as in automobiles and airplanes, or the high
cost of downtime, as in business telecommunications equipment. In other industries, there
is significant room for a moderate quality producer. There is high variety in the quality of
different wines, for example. Quality sensitivity is therefore an important market
characteristic.
Delivery. In some industries, the delivery of the product within a specified time
frame is a key performance attribute. The diffusion of just in time logistics procedures
has increased expectations about delivery times in many industries, especially durable
goods. Customers in growing industries especially value a firm’s ability to deliver goods
quickly or a project within the specified timeframe, since without on-time delivery
downstream market share may be lost to faster competitors.
Service. Many products require ancillary services to provide customers with
information and fix unexpected problems. The value some products offer customers can
decline quickly if effective service cannot be provided. Service expertise can also
compensate for poor customer experience with a product early in its life cycle, as bugs
20
are identified and fixed. Further, an enhanced service capability can build customer
loyalty.
Technology. Positioning with superior technology entails better design, features
and functionality than competitors. Customers typically vary in their preferences for more
advanced or better technology. Some buyers require higher functionality and features so
that a broader range of tasks can be performed with higher quality outcomes. Others trade
off technology for a lower price. In this case, the customer’s tasks are less demanding or
can be performed at adequate quality levels. The interplay between technological
innovation and customer buying patterns is central to competition in technological
intensive industries. For example, when technological change is rapid, some customers
will avoid investing in the most advanced technology in the expectation that it will be
supplanted in the near future.
Breadth of line. A firm may offer a broad product line for several reasons. A
broader line provides customers with one stop shopping to fill a greater variety of needs
and potentially one source for product service. Some firms, such as Ryobi in garden
appliances, sell modular products with interchangeable parts, lowering the customers’
costs. Also, when the customer uses the products together, such as telecommunications
equipment, buying from one supplier insures better compatibility at the interfaces
between products. Also, demand for the product line may increase through cross-selling,
a benefit from shared customer information, or through trading up, a benefit from selling
across customer segments with different income levels and levels of product experience.
Customization. Customized products frequently provide the buyer with greater
value since they are tailored to a greater degree to the buyer’s needs. However, custom
goods typically command a higher price reflecting their higher costs. With the advent of
mass customization, driven by process innovations originating in Japan, the prices of
customized products in durable goods industries have declined, as the growth of Dell
Computer demonstrates. Standardized goods can also drive out custom products, as has
happened in applications computer software. In this case custom solutions have rarely
been designed following best practice, which standard software purports to embody.
Standardized software is therefore cheaper and more current than older specialized
solutions.
Geography. There are two types of competitive advantage based on geography –
location and scope. Location adds value when the firm is close enough to its customers to
lower the cost of coordination in handling logistics or other activities. Large durable
goods assemblers - for example, the big three car companies, Ford, General Motors and
DaimlerChrysler – frequently encourage their parts suppliers to set up their factories near
the assembly plants in order to benefit from lower coordination and logistics costs.
Geographic scope is an extension of the location advantages to multiple regions. In this
case, firms with facilities in multiple locations are better positioned to serve customers
with a comparable geographical reach. Citibank, for instance, benefits substantially from
the global reach of its banking network in serving large multinational corporations.
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Risk assumption. A firm may signal the quality or performance of its product by
assuming a large part of the risk of product failure. The type of risk assumption depends
on what the product is supposed to do for the buyer. Warranties regarding product failure
are common for durable goods, for instance automobiles or stereo equipment. Here the
more extensive the guarantee, the higher quality the product is assumed to be. Thus top
line car producers, such as Mercedes and BMW, offer more extensive warranties on their
automobiles than mid-range companies.
Brand/reputation. Brand and reputation are both resources that signal product
quality or performance. The effect of the signaling on customer behavior ties the firm to
its market position. In some cases, such as Walmart, the brand indicates adequate quality
and low price, attracting price sensitive buyers. In other cases, the brand signals high
quality or cachet, attracting price insensitive buyers with social ambitions. Reputation
pertains more to firm performance, for example in executing cooperative agreements.
Firms with reputations for effective cooperation, for example Motorola in
semiconductors and Amgen in biotechnology, are positioned differently in markets where
complex contracting is the norm than firms with histories of failed partnerships.
Network externalities. In many markets there are economies of scale in demand
– that is, the benefit each customer receives from a product increases as new customers
are added. The basis of these economies is often the adoption of a standard
communication technology, as can be found in telephone switches, word processing
programs or simply languages in general. In the early stages of such a market, many
standards typically compete. Eventually, one often becomes dominant, as Microsoft has
with its Windows operating system. Firms in these markets will therefore position their
products according to the standard they follow – which may have many or few users.
More users indicates a greater the “network externality,” which means a higher benefit to
new users when they adopt the technology.
Environmental policies. Some buyers prefer to purchase from firms with
progressive environmental policies. Although customers perceive an indirect rather than
direct contribution to value from social and environmental programs, their effect on
buying behavior can be significant. Interface, a Georgia carpet company, has built a
strong image as a developer of operating practices linked to the concept of sustainability,
which means not harming the natural environment. The company initiated this program
in response to customer concerns about the company’s environmental policies and has
benefited from buyer perceptions of its commitment to sustainable operations. Ford and
British Petroleum are notable industry leaders in improving the environmental impact of
company products and operations.
Complementary Products. The value of many products is increased by the
availability of complements. Two products are complements when they are functionally
enhance each other and their demand curves are therefore positively correlated. There is a
host of examples: The value of DVD players rises as more movies and other types of
entertainment are available on DVD disks. Extensive road systems make motor vehicles
more useful. Sailboats need sails. In many cases, complements are produced by the same
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firm. But this need not be so since the resources and capabilities required to compete in
two complementary industries can be quite different. For example, Intel does not write
operating system software, and Microsoft does not make semiconductors. Yet the Intel
Pentium chip and Microsoft’s Windows are highly complementary.
Cost Drivers. Firms compete on cost as well as value. The more firms vary in
their cost structures in an industry, the more important the determinants of cost as a
source of competitive advantage. But opportunities to improve costs relative to
competitors are present whether firms differ widely or narrowly in efficiency.
An interesting example is the Vanguard Group, a mutual fund company. One of
Vanguard’s product lines is money market mutual funds, a type of fund which invests in
short term securities and therefore has a low yield but also low risk. Because of their low
risk, these funds are often seen as a substitute for cash. The main component of value to
the buyer is the net yield on the fund, which is determined both by the ability of the fund
to forecast government interest rates, which drive the returns on the securities the fund
invests in, and by the costs the fund incurs to administer its operations. It turns out that
although funds differ in their forecasting ability, on average they do not pass along their
forecasting earnings to customers. So net yields differ across funds primarily because of
variation in their expenses, and Vanguard has low costs compared other firms. The
company’s cost structure thus allows it to have higher profitability in a very competitive
market and greater flexibility to provide higher yields to customers through charging
them less for administrative expenses. Higher yields in its money funds attract more
customers, which increases the size of Vanguard’s assets. Greater size reduces costs
further through economies of scale. So Vanguard’s competitive advantage due to its
superior cost structure can endure.
The major determinants of lower costs are the following:
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Scale economies. In their basic form, scale economies are related to the decline in
a firm’s average costs with higher volume over the long term, as fixed costs are spread
across a larger number of units produced. Firms with high fixed costs cannot be
profitable unless they produce beyond the volume at which they break even. The shape of
the decline in average costs depends on whether fixed costs are recurring or nonrecurring.
Firms with recurring fixed costs must reinvest in new capacity in a stepwise
fashion as volume grows. In this case, the average cost curve is shallow at higher volume
as new facilities are initiated. In contrast, for many firms, for example those producing
information goods such as movies or software, the cost of designing and producing the
product is a large up front investment that cannot be recovered (i.e., sold to another firm)
independently of the sale of the product itself. Further, this investment dwarfs other costs.
In these industries, the average cost curve declines rapidly with higher volume, and the
profits made on sales beyond the break-even point are substantial.
A common assumption regarding larger scale is that it allows the firm to invest in
more efficient processes so that variable costs per unit are lower. Higher volume enables
more standardized, usually automated procedures, which are associated with lower labor
costs. One of the most famous examples of this phenomenon is Ford’s assembly line,
which revolutionized cost-based competition in the automobile industry in 1923. Ford’s
innovation, which was enabled by higher car sales as the industry expanded in the U.S.,
wiped out many higher cost competitors. Scale efficiencies are thus ultimately tied to
ongoing process innovation as the firm grows.
While it is common to identify a minimum efficient size in an industry at which
firms begin to achieve economies of scale, competitors typically vary in the volumes at
which these economies are reached. The reason is that, although similar, the technologies
of these firms vary sufficiently to create different cost structures. This variation is driven
by the development of unique cost-reducing capabilities and by differences among firms
in the effective implementation of standard practices. These differences create the
opportunity for more efficient firms to achieve a competitive advantage at every size
level. But such an advantage is not guaranteed, since a firm may not be able to extend its
cost-reducing capabilities beyond a certain size.
Scope economies. Another source of lower costs is economies of scope. A firm
achieves economies of scope when the cost of producing two products using shared
assets and practices are less than the costs of producing the products separately. The
concept also applies to lowering costs through sharing assets across geographical
locations. For example, it is not uncommon for a firm entering a new geographical
market to invest in an infrastructure to support several facilities, but to open these
facilities sequentially, as Walmart typically does. The firm begins to achieve economies
of scope in the regional system when enough facilities have been opened to cover the
costs of the initial infrastructure investment.
A cost advantage over competitors through economies of scope can be achieved
in two ways. First, two products may share a specialized resource that is more efficient
than competitors. For example, Nucor has developed highly efficient mini-mills, each of
which manufactures many steel products at low cost in part because of shared production.
Second, economies of scope may be based on the practices a firm uses to coordinate asset
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sharing. More efficient coordination practices, relative to competitors, contribute to a cost
advantage for each product.
The learning curve. A third source of lower costs with the expansion of the firm
is the refinement of practices due to learning within and across activities. Originally
observed in aircraft assembly, the learning curve has long been recognized as a key
contributor to making production systems more efficient, especially in technically
complex processes such as semiconductor manufacturing. Complex processes have more
steps to coordinate and more complicated activities within each step. Initial production
designs cannot identify the most efficient mechanisms for managing each interface in the
overall process. So as products are made, line workers and engineers experiment with
new practices directed at cost reduction.
The effect of cumulative volume on costs is commonly represented by an
exponential function. As the amount produced doubles, cost declines by a fixed
percentage. This percentage, and therefore the shape of the learning curve, varies
according to the activity involved.
To achieve a cost advantage through the learning curve, a firm must learn faster
and longer than rivals, typically through producing more volume first. Differences in
learning rates across firms in an industry are determined by their capabilities, which are
based on patterns of investment in learning as a critical asset. These investments are
made in employee expertise and training. Companies also invest in organizational
policies to exploit learning benefits once they are identified. For example, Intel has a
policy, called CopyExactly, of building identical manufacturing facilities so that process
innovations can be diffused to all plants without problems in implementation.
Low input costs. A firm can also have lower costs than its rivals through lower
cost inputs, such as materials, labor, capital, information, and technology. In global
markets, cheaper manufactured inputs are available from low cost operations in
developing or newly developed nations, such as China. However, if this opportunity
expands and is available to all firms, then those firms that move early to exploit it will
experience a temporary cost advantage. The source of lower cost inputs must be protected
from competition for an enduring advantage to be achieved.
A firm also benefits from lower capital costs. Larger firms with strong balance
sheets typically have lower capital costs than smaller independent competitors. A lower
cost of capital raises the number of projects that have positive economic returns and thus
allows the company to invest in more opportunities for growth. Smaller businesses that
are part of a diversified corporation may benefit from its superior balance sheet.
Partnerships between firms can be a source of lower cost information and
technology. Reciprocal agreements between companies lower transaction costs and
smooth the transfer of proprietary assets that would be costly to acquire in the open
market. Partners may provide information on common customers, for example; and
cross-licensing agreements for technology can lower acquisition costs for both partners.
Vertical integration. In many circumstances, vertical integration can lower the
cost of coordinating transactions between adjacent activities in the design and
commercialization of the firm’s product. Transaction costs in the market are higher when
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the adjacent activities are specialized to each other. Specialization limits the availability
of market benchmarks for performance and of viable alternative suppliers. However,
achieving lower transaction costs within the firm in managing the interface between
specialized activities depends critically on how the firm is organized. The more
centralized the control over the interface, the more efficient coordination is likely to be.
The more control over the interface is decentralized, the more it resembles a market, and
the less the firm benefits from vertical integration.
Organizational practices. Firm specific process innovations, based in
organizational practices, are a major source of lower costs relative to competitors. Firms
that focus on lowering costs continuously tend to develop a range of efficiencies in all
activities, but especially operations and logistics. To provide a persistent cost advantage,
these programs must be resistant to imitation. An excellent example of a firm that
emphasizes innovation to lower costs is Southwest Airlines, which has pursued cost
reduction programs since its inception. Also, Japanese automobile manufacturers, such as
Toyota, are legendary for their ability to reduce costs in operations as the yen strengthens
in value compared to the currencies of other countries.
Defending against competitors
To achieve a competitive advantage, it is not enough to produce a high economic
contribution. The successful firm must defend the sources of value from attack by
competitors. The central means of protecting these sources are the prevention of imitation
and high customer switching costs.
The specific factors that reduce imitation and increase switching costs are
isolating mechanisms (see Figure 7). To defend its market position, the firm aligns these
mechanisms with its value and cost drivers, and with its resources and capabilities that
produce these drivers. Without these mechanisms, competitive forces would quickly eat
up the firm’s profit.
Figure 7
Isolating Mechanisms
Increasing Customer Retention
Preventing Imitation
Search Costs
Transition Costs
Learning Costs
Property Rights
Dedicated Assets
Causal Ambiguity
Learning Costs
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Preventing the imitation of resource and capabilities. Because a valuable
resource is generally observable, the firm must shield it from being copied by
competitors. There are two means of preventing imitation. First, if the firm owns the
resource, it can establish and enforce property rights regarding how the resource is used.
Second, if the resource is external to the firm, it can turn the resource into a dedicated
asset by absorbing its capacity, thereby excluding competitors from using it.
A resource that can be protected through rights of ownership is among the most
durable sources of a superior market position. Trademarks and patents, for example, are
crucial legal safeguards against the imitation of brands and technologies, respectively. In
the absence of these protections, the returns of entrepreneurs to the development of these
resources would be significantly lower.
Resources vary in the degree of security legal protection offers them. This is
especially true in the case of technological assets. Biotechnology patents, for example,
usually can be designed around in several years, as competitors create new compounds
that resemble the patented substance but not enough to constitute an infringement of the
innovator’s rights. In some cases, firms avoid patenting a core resource because the
process exposes details about the substance, design or procedure that competitors can
observe, thus making it easier to imitate.
In addition, property rights are especially hard to enforce across borders. Many
countries, such as China before its entry in the World Trade Organization, have legal
systems that do not impose strict, consistent sanctions on copying technologies, brands or
other strategic assets that contribute to strong market positions. This inattention to
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property rights weakens the motivation of firms within the country to innovate as well as
the incentive of foreign firms to compete in the country’s markets.
The second way to protect a strategically important asset from competitors is to
tie up its capacity. To use up the asset’s capacity, the firm must effectively absorb the
asset’s ability to produce goods or services, as can occur for a dedicated distribution
channel or supplier of specialized inputs. Firms can also tie assets up through
partnerships and long-term contracts. Rupert Murdoch’s expansion of Fox’s global
franchise is to a great extent based on locking in key communications channels,
especially satellite systems, early in the development of a market, as in the United
Kingdom and Australia.
The economic worth of a dedicated asset depends on its contribution to the firm’s
value and cost drivers. For instance, tying up suppliers of low cost inputs helps a firm
protect its cost advantage. Similarly, locking in a supplier of advanced technology can
help sustain a value advantage.
A dedicated asset preserves the firm’s market position as long as building a
substitute is so costly that entry is deterred. When the market growth rate is high and the
expected size of the market is large, absorbing the capacity of a critical asset is not
sufficient to protect the firm’s competitive advantage. In this case, rivals may attempt to
invest in assets that compete with the firm’s dedicated source. For example, new
distribution channels may be built, or new sources of specialized inputs developed.
Dedicated assets are also vulnerable to self-interested behavior by the asset
owners. When asset owners attempt to capture a significant increase in the economic
value they contribute to the firm’s market position, the firm’s competitive advantage
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declines. Potential solutions are to acquire the asset from the owner, develop a
proprietary alternative to the asset in-house, or change the firm’s strategy to remove its
dependence on the asset.
Unlike a resource, which can generally be observed, valued and traded, a
capability is typically based in organization-specific routines that cannot be separated
from the firm itself. When Southwest Airlines found in the early 1970’s that it was
possible to turn a plane around at the gate in less than 20 minutes, thereby increasing the
number of short haul flights the plane could make each day, many competitors rushed to
Houston to observe how the company did it. But, even though the practices could be
observed, they were based on a set of conditions the other airlines could not replicate:
flexible labor rules, employee commitment, the absence of baggage transfers, no assigned
seating, and standardized boarding passes. Beneath the observable procedures were
hidden rules among pilots, baggage handlers, ground crew and others, that speeded up the
process. So even if a competitor was able to organize its personnel along the lines of
Southwest, the interactions of the rival’s employees would not be as effective.
There are therefore two major impediments to copying capabilities. The first is
causal ambiguity regarding how the capability is executed. In many instances, it is simply
not feasible for an outsider to model the procedures that underlie a capability. The second
impediment involves the learning costs a rival must incur to replicate the capability. In
the absence of a well-defined model, a rival may attempt to learn the capability through
experimentation. However, when the capability is complex or its execution requires
knowledge that can only be developed over time, the costs of learning may be
prohibitive.
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To the extent competitors can’t understand how a firm’s capability works, the
capability is protected from imitation. Its causes are hidden from view and so cannot be
replicated by rivals. Causal ambiguity forces firms to develop capabilities that are
approximations of each other, leading to different firm performance levels. Moreover,
these differences in performance among firms will persist over time, as each firm
develops its practices along a relatively unique path. Causal ambiguity therefore acts as
both a barrier to improvement for the poor performing firm and a shield against imitation
for the firm with a competitive advantage.
Causal ambiguity is prevalent in the capabilities that underlie value drivers such
as delivery, quality, service and customization, which are based on organizational
practices. These practices evolve through process innovations that rivals are hard put to
model effectively. However, as powerful buyers insist on industry performance
standards, such as the ISO series of quality certification protocols, the ability of any firm
to achieve a value advantage on the basis of these drivers is reduced. The exception may
be customization, which as a value driver is inherently difficult to create metrics for
across firms.
Two cost drivers for which causal ambiguity is strong are the learning curve and
organization-specific practices. Although industries have benchmarks for the cost
benefits of the learning curve in specific activities, competitors vary systematically
around these benchmarks according to differences in capabilities. Causal ambiguity about
these capabilities protects them from imitation and thus allows more able firms to sustain
their cost advantage. More generally, causal ambiguity protects firms that have
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established a cost advantage due to superior coordination practices or continuous costbased process innovation, as the Southwest Airlines example shows.
There is an obvious close relationship between causal ambiguity and a rival’s
costs in learning a capability. The greater the ambiguity, the higher the costs. But even
when ambiguity is not high, learning and development costs may be substantial.
Dierickx and Cool have called the cost of trying to develop a capability in less
time than the original firm, a time compression diseconomy. Diseconomies are stronger
when the stock of knowledge enabling the capability is more organization- than
individual- specific. They are also larger when the capability’s contribution to value or
cost drivers is dependent on characteristics of its developmental path.
If the stock of knowledge resides in an individual, then it would be possible
simply to hire him or her to capture it. For example, Amazon tried to capture Walmart’s
expertise in logistics by hiring the Walmart senior logistics executive. Unfortunately, it is
rarely the case that one individual or even a group of managers can quickly replicate in a
new firm a valuable capability that existed at an earlier employer, even when there is
little ambiguity regarding execution. More often, building the key organizational assets
that support the original capability takes time, as Amazon experienced. How long this
process takes obviously depends on the size of the task and the resources dedicated to it.
The greater the task and the more resources required, the higher the costs of learning and
development.
Development costs are also high when a capability is tied to complementary
practices within an organization. For example, the effectiveness of Lincoln Electric’s
piece-rate compensation system, which is a key contributor to the firm’s low cost
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structure, is tied to human resource, marketing, and production policies. It would be
difficult for a competitor to copy the piece-rate system and receive the same benefit from
it as Lincoln without also adopting the supporting policies. But adopting these
complementary policies and practices increases the cost of imitation.
History-dependent capabilities are also expensive for a rival to develop. A
capability is history-dependent when it is based on perceptions or practices developed
over a unique period of time that has passed. A useful analogy is the scaffolding that is
used to construct a building and then removed. The scaffolding is gone, but the building
could not have been built without it. To replicate the capability, each firm must simulate
the historical event, increasing costs. This problem is endemic in benchmarking exercises
between intense competitors, such as Bao Steel and Posco in sheet steel, which have
different manufacturing histories but attempt to match value and cost in the present.
Learning and development costs are always considered sunk, since the learning
process is irreversible. The costs are recouped only through the returns that are produced
by what has been learned. Since these returns are uncertain, the higher the costs, the less
likely are rivals to attempt imitation, especially against a firm that has already developed
the value driver. Citibank’s broad geographical scope in global commercial banking and
Intel’s position as the dominant standard in PC microprocessors are examples of value
drivers that are formidably costly for rivals to replicate.
Increasing customer retention. Firms are threatened by substitution as well as
imitation. Substitute products have value-cost profiles based on resources and capabilities
that differ substantially from those of the products that are substituted for. For example,
different modes of transportation – car, train, airplane - are obvious substitutes. To
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prevent the erosion of its competitive advantage by substitutes, and by new products
produced by competitors, the firm can either lower its price to increase the customer’s
surplus relative to substitutes, or raise buyer’s costs of switching.
Switching costs are related to three types of cost. First, the more a buyer must
search for an alternative to its current product, the higher its search costs and the more
expensive it is to switch to a new supplier. Second, the more extensive and complex the
process of switching from one product to another, the higher the transition costs. Last,
the more new information and skills the buyer must learn in adopting a new product, the
greater the learning costs, which make switching more expensive. These three
components of switching costs – search, transition and learning – are a function of the
supplier’s value drivers and so can be manipulated to increase customer retention. In
addition, search costs are determined by inherent characteristics of the product,
specifically whether its value can be assessed without the product actually being used.
A product whose value cannot be measured accurately without a trial is called an
experience good. Experience goods have higher switching costs because the buyer must
try them out to find out whether one can serve as an adequate replacement for another. A
bottle of wine with an unknown vintage is a reasonable example of an experience good
since it cannot be appreciated until it is consumed. An experienced wine drinker will
have less uncertainty regarding the wine’s value, however, as he or she can calibrate the
year, winery, appellation, and so on. Yet ultimately the proof is in the tasting. A branded
soft drink, such a Coca-Cola or Pepsi-cola, is not an experience good, simply because
these vendors strive to produce a uniform product in every bottle or can, no matter where
it is produced world-wide. So once a buyer has tasted the soft drink, there should be no
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uncertainty regarding the value of any bottle in the future. Thus, a product is more or less
an experience good depending on buyer experience and product standardization, both of
which reduce the uncertainty regarding its value.
A broad range of value drivers are directly related to increasing switching costs.
Customization locks buyers in by providing the supplier with deep knowledge of the
customer’s business. This knowledge reduces communication costs in the supply
relationship and perhaps increases flexibility, as long as the supplier does not exploit the
buyer’s dependence on it by reducing service levels or raising prices. The customer’s
transition costs are substantial whether it shifts to a new customized product or a standard
input, simply because in either case it must throw out the old customized protocols and
redesign the interface with the supplier.
As a value driver, reputation and brand contribute significantly to customer
retention. Reputation acts as a signal of quality that reduces uncertainty for the buyer.
Switching away from a major brand entails high search costs since a comparable promise
of value from a new supplier must be made. IBM in its prime period of selling
mainframes to large corporations understood very well the value its brand offered as a
certification of quality and service.
Firms competing on service expertise can create high switching costs since
service quality is inherently an experience good. It is difficult for a buyer to assess the
quality of service without directly observing it in the context of the specific problems.
One needs only to reflect on the aversion to switch from suppliers of good service to
understand how costly searching for alternatives can be.
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Network externalities also increase switching costs, as the recent antitrust suit
against Microsoft argues. These costs are caused by the time and expense of making a
transition from the protocols of one standard to those of an alternative. Learning costs are
also incurred in adopting the new standard.
As a value driver, product line breadth may allow the customer to communicate
seamlessly across products through standard interfaces, such as Cisco has established in
its switches and routers. This benefit of interoperability creates a cost of switching to a
competing supplier. The cost is associated with the difficulty of designing a compatible
interface between the old and new supplier’s products. The buyer is more likely to
replace the entire product line, which is much more expensive.
A similar argument can be made regarding the costs of switching from a supplier
with an extensive geographical scope that matches the buyer’s operations. Although there
is no firm-specific standard that ties regions together technologically, communication and
coordination across regions are more efficient within a single supplier than among several
vendors, each from separate regions.
Summary
We have discussed how competitive advantage is built and sustained. At its core,
competitive advantage means producing a larger economic contribution than competitors
and defending the sources of that contribution from rivalry. To establish a dominant
market position, the firm must invest in value and cost drivers. It is the difference
between value and cost, not their absolute value, relative to competitors, that determines
the firm’s advantage. The higher this difference, the more productive the firm and the
stronger its position in the market.
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Protecting a firm’s economic contribution from competitors produces a larger and
longer-lived financial return. By retaining customers and preventing the imitation of
important resources and capabilities, a firm can reduce price competition and sustain
margins. Without a defense against rivals, competitive advantage is either short-lived or
cannot be achieved at all.
But no advantage is permanent. Ultimately, increased rivalry is inevitable. As
competition beats down market prices, buyers capture more surplus than suppliers,
reducing the resources available for improving the firm’s contribution. Further,
innovation by competitors and shifts in customer perceptions of value will eventually
erode any market position.
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Summary Points
 Competitive advantage is a combination of effective market positioning and defense
against competitors.
 Market position is characterized by the difference between the value the customer
receives from a product and the cost the firm incurs in producing this level of value.
 The firm’s resources and capabilities determine the value and cost drivers on which it
competes.
 The customer, not the seller, always determines the value of the product.
 The value of a product is the price at which a buyer would purchase it in the absence
of alternatives or close substitutes and given the buyer’s other purchasing
opportunities.
 Competition drives the market price below the product’s value.
 Two generic strategies, differentiation and cost leadership, are related to achieving
higher value and lower cost, respectively.
 Generic strategies do not explain superior market positioning.
 A firm can occupy a superior market position without having the lowest cost or
highest value.
 Defending against competitors is necessary to sustain a superior market position.
 Defense against rivals entails establishing isolating mechanisms to prevent imitation
and retain customers.
 Imitation is reduced by strong property rights, dedicated assets, high causal
ambiguity, and high learning and development costs.
 Customers are more likely to stick with the firm’s product when their search costs,
learning costs and transition costs are high.
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Central References
Amit, Raphael. Schoemaker, Paul J H, 1993, “Strategic assets and organizational rent,”
Strategic Management Journal, 14(1): 33-46.
Barney, J. B, 1991, “Firm resources and sustained competitive advantage” Journal of
Management, 17: 99-120.
Dierickx, Ingemar and Karel Cool, 1989, “Asset Stock Accumulation and Sustainability
of Competitive Advantage,” Management Science, 35(12): 1504-1514.
Ghemawat, Pankaj, 1991, Commitment: The Dynamic of Strategy, New York: The Free
Press.
Lippman, Steven and Richard P. Rumelt, 1982,“Uncertain Imitability: An Analysis of
Interfirm Differences in Efficiency Under Competition,” Bell Journal of Economics,
13:418-438.
McGahan, Anita M. Porter, Michael, E, 1997, “How much does industry matter, really?”
Strategic Management Journal. 18 (Special Issue Supplement): 15-30.
Peteraf, Margaret, 1993,A The cornerstones of competitive advantage: A resource-based
view, Strategic Management Journal. 14(3): 179-191
Porter, Michael, 1980, Competitive Strategy, New York: Free Press.
Porter, Michael, 1996, “What is Strategy?” Harvard Business Review,
Postrel, Steven, 2000, “Notes on Strategic Advantage,” mimeo, Cox School of Business,
Southern Methodist University.
Rumelt, Richard, 1984, “Towards a Strategic Theory of the Firm,” in Competitive
Strategic Management, Robert Lamb (ed.), pp. 557-570.
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