Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 14
Sustaining Competitive
Advantage
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 John Wiley  Sons, Inc.
Sustaining Competitive Advantage
 Sustaining competitive advantage over time is not
easy.
 Rivals can imitate the formula for success.
 Rivals can use new technologies, products and
business practices to erode the competitive
advantage of industry leaders.
 Yet Some firms have been successful in sustaining
their competitive advantage (Coca-Cola, Dell
Computers) for long periods of time.
Perfect Competition & Competitive Advantage
 In a perfectly competitive industry where
firms are price takers, competitive
advantage does not exist.
 Even when the product varies on a cost-
quality continuum dynamics of perfect
competition can work.
The Perfectly Competitive Dynamic
 The efficient frontier is the boundary with the best
feasible price-quality combinations.
 A price-quality point such as (PA, qA) is not
sustainable if there is free entry since a rival can
enter at (PB, qB).
 Free entry and costless imitation will force all the
firms to move to the tangency point and the
economic profit will be zero.
The Perfectly Competitive Dynamic
Sustainability with Monopolistic Competition
 In monopolistic competition, firms sell
horizontally differentiated products to consumers
who differ in their tastes.
 Each seller faces a downward sloping demand
curve due to product differentiation
 Sellers get to set the price above marginal cost but
there is no guarantee of economic profits.
Sustainability with Monopolistic Competition
 Entrants can slightly differentiate their products
from the incumbents’ and create their own niche.
 Free entry will cut into the market share of the
incumbents and make the economic profit become
zero.
 Profitability cannot be sustained unless entry is
deterred
Threats to Sustainability
 Even when incumbents can deter entry economic
profits may not be sustainable.
 Sometimes good performance may be simply due
to luck.
 Over time profits regress to the mean.
Threats to Sustainability
 Good performance is not always attributable to
luck.
 A firm might develop advantages that are hard to
imitate.
 Yet if the suppliers/buyers are powerful they can
extract the profits.
Effect of Competitive Forces on Profitability
 Entry, imitation and price competition will force
economic profits to eventually go to zero
 Competitive forces will make return on assets
(ROA) to equal the cost of capital
 Regardless of where a given firm is today, with
passage of time its profits will converge to
competitive levels.
Evidence on the Persistence of Profitability
Dennis Mueller’s study of U. S. manufacturing firms
finds that:

Firms with abnormally high ROA will experience a
decline over time

Firms with abnormally low ROA will experience an
improvement over time and

high ROA firms and low ROA firms do not converge to a
common mean
Evidence on the Persistence of Profitability
 Mueller’s results indicate that there are some
forces that push markets towards the competitive
rate of return and other forces that impede that
dynamic.
 The net result is a persistent ROA gap between
firms that start out as high ROA firms and firms
that start out as low ROA firms .
The Persistence of Profitability in Mueller’s Sample
Competitive Advantage of Firms
and Industry Profitability
 A firm in a fiercely competitive industry may
continue to have an edge over its rivals if its
competitive advantage is difficult to imitate.
 Firms within an industry with high entry barriers
may earn economic profits but may all be equally
profitable.
Sustaining Competitive Advantage
 Competitive advantage is sustainable if it persists
despite competitors’ efforts to duplicate it or
neutralize it.
 Sustainability can occur in two ways.
 Firms may differ with respect to resources and
capabilities and the differences persist.

Isolating mechanisms (analogous to barriers to entry)
may work to protect the competitive advantage of firms.
Resource Based Theory of the Firm
 Resource based theory of the firm explains
sustained competitive advantage in terms of
heterogeneity in resources and capabilities.
 To support competitive advantage resources and
capabilities have to be

scarce

imperfectly mobile and

unavailable in the open market.
Resource Based Theory of the Firm
 Immobile resources may be inherently non-
tradable (Example: Reputation for toughness)
 Immobile resources may be relationship specific
(Example: Landing slots in an airline’s hub)
Isolating Mechanisms
 Isolating mechanisms limit the rivals from eroding
a firm’s competitive advantage.
 Isolating mechanisms are to firms what entry
barriers are to industries.
 Two distinct types of isolating mechanisms are
 Impediments to imitation
 Early mover advantage
Impediments to Imitation
 These mechanisms impede the potential entrants
from duplicating the resources and capabilities of
the incumbent firm
 Five important types of impediments are
 legal restrictions
 Superior access to inputs/customers
 Market size and scale economies
 Intangible barriers
Intangible Barriers to Imitation
 Barriers to imitation will be intangible if the firm’s
advantage lies in distinctive organizational
capabilities.
 Three such barriers to imitation can be identified.
 Casual ambiguity
 Historical circumstances
 Social complexity
Casual Ambiguity
 A firm’s superior ability to create value may be
obscure and imperfectly understood, even by those
in the firm.
 Casual ambiguity may become a source of
diseconomies of scale because the firm may be
unable to replicate its success from one plant to the
next.
Historical Circumstances
 Distinctive capabilities may be bound up with the
history of the firm
 Dependence of the capabilities on historical
circumstances may limit the firm’s growth
potential
 Historical dependence may also mean that the
strategies may be viable for only a limited time
Social Complexity
 Competitive advantage may be hard to replicate if
the advantage is rooted in socially complex
processes
 Such processes include interpersonal interactions
among managers, suppliers and customers.
 Complex social interactions are not easily imitated
even when understood.
Intangible Barriers & Organizational Change
 When major organizational changes are
undertaken, it is easy to overlook intangible
sources of competitive advantage.
 Major organizational changes are more likely to
achieve the desired results in “greenfield” plants
than in established ones.
Early-Mover Advantage
Four different isolating mechanisms fall
under the category of early mover advantage
 Learning
curve
 Reputation and buyer uncertainty
 Switching costs
 Network Effects
Networks and Standards
 Many networks are based on standards (telephone,
railroads)
 Established standards are difficult to replace
 Two key questions:
 Should a firm compete “for the market” or “in the
market?”
 What does it take to topple the existing standard?
“For the Market” or “In the Market”?
 Monopoly in a smaller market may be more
valuable than competing as a small player in a
large market.
 If the standards war is going to be too costly, it
may be better to accept a common standard.
 It is critical to attract early adopters to build the
installed base of customers.
“For the Market” or “In the Market”?
 Standards war may discourage the production of
complementary products, hurting the entire
industry.
 To win the standards battle manufacturers of
complementary products may have to be offered a
greater share value added.
Fighting a Dominant Standard Successfully
 Installed base gives the incumbent the edge.
 To challenge the dominant standard the rival
should offer superior quality or new options.
 The rival should also tap into the complementary
goods market.
Early Mover Disadvantages
 Early movers may lack the complementary assets
to make their products succeed
 Early movers can lock themselves into inferior
technologies and rivals can learn from these
mistakes (Example: Wang Laboratories)
Imperfect Imitability & Industry Equilibrium
 With imperfect imitability, but otherwise
competitive conditions, some firms consistently
earn economic profits.
 Yet to potential entrants the industry appears to
offer zero expected profits
 Lippman and Rumelt explain this outcome using
entrants’ uncertainty regarding their costs.
Imperfect Imitability & Industry Equilibrium
 Competition makes entrants’ pre-entry (ex-ante)
expected economic profit zero
 Entrants are uncertain about their post-entry cost
structure.
 Ex-post if an entrant turns out to be a high cost
producer it quits.
 Observed average profits for the industry will be
positive due to survivorship bias.