Source:
E-mail dt. 25.11.2012
What
is Competitive Advantage?
Mr.
M.B. Eswaran
Doctoral Fellow Student
XLRI, Jamshedpur, India
Why
this question?
The term “Competitive Advantage” became
a term of art in business strategy with Michael Porter’s 1985 insightful book
of that title. Warren Buffett has said that he evaluates a company by looking
for “Sustainable Competitive Advantage.”The heart of the matter of strategy is
usually advantage. Just us a lever uses mechanical advantage to multiply force,
strategic advantage multiplies the effectiveness of resources and/ or
activities. In simple language, strategy is how you get from where you are now
to where you want to be - and with real and sustainable competitive advantage.
Statements about competitive advantage
abound, but a precise definition is elusive. According to one school of
thought, competitive advantage is unique value, which is created by favorable
terms of trade in product markets. That is, sales in which revenues exceed
costs. However, scrutiny of the concept of “cost” quickly reveals problems.
What is the “cost” of a scarce resource? Another
school of thought holds that advantage is revealed by “super-normal” returns.
Again, questions quickly arise. Internal returns are normally measured by some
type of market-book ratio. Such ratios include return on capital, return on
assets, market-to-book value, and Tobin’s Q. Given such a measure, are
supernormal returns “super” relative to the expectations of owners, the economy
as a whole, or the rest of the industry? A third school of thought ties
advantage to stock market performance. According to financial economics,
superior stock market performance stems from surprising increases in
expectations. Thus, after 9/11, the stocks of defense companies rose
dramatically. Does this signal competitive advantage?
In reviewing the use of the term
competitive advantage in the strategy literature, the common theme is value
creation. However, there is not much agreement on value to whom, and when and
about how value is to be conceptualized or measured (gains to trade, value to
owners, increases in value to owners). There is disagreement or confusion about
the meaning of rents, the appropriate use of the opportunity cost concept, whether
competitive advantage means winning the game or having enough distinctive
resources to maintain a position in the game. There is no known reconciliation
of these conceptual difficulties in strategy literature. As Richard P Rumelt aptly describes in his paper, “the strategy area is
in need of a clear definition of competitive advantage, or it needs to stop employing
a concept that cannot be defined. The
question, “What is Competitive Advantage?” needs an answer”. (August 5, 2003).
What the
existing theories say?
The
three beliefs that inform all existing theories of competitive advantage are;
(1) intra-industry performance is highly variable across firms; (2) performance
variability persists in the long run; and (3) performance variability is largely
attributable to the inimitable advantages of high-performing firms.
We give bellow the summary of various
thoughts on competitive advantage in strategy literature by important
contributors.
·
The fundamental
concept of competitive advantage can be traced back to Chamberlin (1939), but
Selznick (1957) can be attributed with linking advantage to competency. The
next major development came when Hofer and Schendel
(1978, p.25) described competitive advantage as "the unique position an
organization develops vis-a-vis
its competitors through its patterns of resource deployments." In this,
they are suggesting that competitive advantage ensues from competencies. They
also viewed competitive advantage as something that can be used within the
firm's strategy. As such, competencies and competitive advantage are
independent variables and performance is the dependent variable.
·
Day (1984) and
Porter (1985) provided the next generation of conceptualization. Rather than
being something that is used within strategy, they saw competitive advantage as
the objective of strategy, the dependent variable. The rationale behind this is
that superior performance is correlated with competitive advantage, and
achieving an advantage will automatically result in higher performance. Porter
says “competitive advantage is at the heart of a firm’s performance in
competitive markets” and goes on to say that purpose of his book on the subject
is to show “how a firm can actually create and sustain a competitive advantage
in an industry—how it can implement the broad generic strategies.” Thus, competitive advantage means having low
costs, differentiation advantage, or a successful focus strategy. In addition, Porter argues that “competitive
advantage grows fundamentally out of value a firm is able to create for its
buyers that exceeds the firm’s cost of creating it.”
·
Besanko, Dranove, and Shanley (2000) say “When a firm earns a higher rate of economic
profit than the average rate of economic profit of other firms competing within
the same market, the firm has a competitive advantage in that market.”They also
carefully define economic profit (1999) as “the difference between the profits
obtained by investing resources in a particular activity, and the profits that
could have been obtained by investing the same resources in the most lucrative
alternative activity.”
·
Peteraf (1993) defines competitive advantage as “sustained
above normal returns.” She defines imperfectly mobile resources as those that
are specialized to the firm and notes that such resources “can be a source of
competitive advantage” because “any ricardian or
monopoly rents generated by the asset will not be offset entirely by accounting
for the asset’s opportunity cost” (i.e., its value to others).
·
Barney (2002)
says that “a firm experiences competitive advantages when its actions in an
industry or market create economic value and when few competing firms are
engaging in similar actions.” Barney goes on to tie competitive advantage to
performance, arguing that “a firm obtains above-normal performance when it
generates greater-than-expected value from the resources it employs. In this final case, the owners of resources
think they are worth $10, and the firm creates $12 in value using them. This positive difference between expected
value and actual value is known as an economic profit or an economic rent.
·
Dierickx and Cool (1989: 1059) have echoed Barney (1986) in
arguing that competitive advantage is not obtainable from freely tradeable assets. “if a privileged
product market position is achieved or protected by the deployment of scarce
assets, it is necessary to account for the opportunity cost of those assets.
Many inputs required to implement a strategy may be acquired in corresponding
input markets. In those cases, market
prices are indeed useful to evaluate the opportunity cost of deploying those
assets in product markets. However, the deployment of such assets does not
entail a sustainable competitive advantage, precisely because they are freely
tradable.”
·
Saloner, Shepard and Podolny (2001) say that “most forms of competitive
advantage mean either that a firm can produce some service or product that its
customers value than those produced by competitors or that it can produce its
service or product at a lower cost than its competitors.” They also say that
“In order to prosper, the firm must also be able to capture the value it creates. In order to create and capture value the firm
must have a sustainable competitive advantage.”
·
John Kay (1993:
14) defines distinctive capabilities as ones derived from characteristics that
others lack and which are also sustainable and appropriable. “A distinctive
capability becomes a competitive advantage when it is applied in an industry or
brought to a market.”Kay [p. 194] measures the value of competitive advantage
as valued added, with the costs of physical assets measured as the cost of
capital applied to replacement costs.
·
Brandenberger and Stuart (1996) discuss multi-agent games
(industries) and examine the conditions under which players can appropriate a
portion of the total gains to trade. Agents include buyers, suppliers, and
producers. Total gains to trade are
maximum available from the assignments among agents. They conclude that the maximum value
appropriated is limited by the agent’s value added to the game—the amount the
game’s total value is increased by the agent’s presence. In addition, “To have a positive added value
it must be ‘different’ from its competitors . . . . . enjoying a favorable
asymmetry . . .”
Existing theories of competitive advantage conclude
that firm heterogeneity or inimitable
advantages persist due to one or many of the following reasons:
(1)
Firms earned
monopoly rents by adopting profitable market positions in attractive
industries, and protected these rents by creating or exploiting barriers to
mobility and market entry (Positioning School of thought)
(2)
Performance
variations are attributable to variability in firm specific resources and
capabilities, protected from imitation by “isolating mechanisms” such as social
complexity and causal ambiguity. RBV’s emphasis on internal and intangible
sources of firm heterogeneity thus represents a significant advance over purely
structural theories of competitive advantage derived from the structure-conduct-performance
model of industrial economics (RBV school of thought)
(3)
Firms sometimes
fail to capture opportunities, fail to imitate perfectly-imitable resources,
and do not solve their solvable problems, and fail to execute fundamental
strategies. These failures need not be due to bounded rationality, causal
ambiguity, isolating mechanisms, mobility barriers or other cognitive or market
failures. Even the most powerful, highly-resourced, and fully-informed firms
allocate resources inefficiently and neglect sound business practice. As a
result, firms are always heterogeneous and they always perform differently,
even in the absence of sustainable competitive advantages (Behavioural
School of Thought)
Where the
existing theories fail?
Firms fail to imitate imitable
resources, fail to solve solvable problems; this will lead to intra-industry
performance variation attributed mainly competitive advantages of the
successful firm. Firms compete on two axes, the axis of competitive advantage,
where performance is driven by the inimitable resources and capabilities; and
the axis of errors, where performance is driven by failures to attend to the
activities, resources and opportunities that are equally available to all
firms. These errors produce performance variation not attributable to
competitive advantages.
Resources can be classified either as
sustainable competitive advantages (valuable and barrier-protected),
unsustainable competitive advantages (valuable and not barrier-protected), or
competitive disadvantages (not valuable).
Theories of competitive advantage allow
for the existence of unsustainable competitive advantages and competitive
disadvantages – if the theories are true, such resources clearly must exist,
and they must be relatively abundant. However, because the theories are
grounded in standard economic models, their primary concern is with firm
heterogeneity in market equilibrium. In equilibrium, rational firms have had
sufficient opportunity to divest non-valuable resources (competitive disadvantages)
and to imitate valuable resources that are not protected by diffusion barriers
(unsustainable competitive advantages) – and firms that fail to behave this way
have become inconsequential or bankrupt. Errors may remain, but they approach
an irreducible minimum, and are not a significant source of heterogeneity. In
equilibrium, all remaining heterogeneity derives from value-generating,
barrier-protected factors (sustainable competitive advantages), and neither the
failure to adopt unsustainable competitive advantages (errors of omission) nor
the persistence of competitive disadvantages (errors of commission) has
intra-industry performance consequences.
Under Competitive Disadvantage, firm
heterogeneity is caused by avoidable errors. Theories of competitive advantage
share the same logical structure, derived by extension from standard
microeconomic models of product and factor markets. This structure is perhaps
best described as “barrier-driven”: intra-industry performance variation is
caused by valuable characteristics that are distributed non-uniformly across
firms, and that resist diffusion to uniform distribution due to market
imperfections. In theories of competitive advantage, relatively few resources
are protected by diffusion barriers. Most resources either do not generate net
economic value or are not subject to the market imperfections that impede
resource diffusion. Hence, most resources cannot act as sustainable competitive
advantages. When a firm does have sustainable competitive advantages, these are
generally few in number, or comprise highly idiosyncratic alignments of a few
underlying resources.
What new
understandings are required?
(a) Understanding the concept of firm is a pre-requisite
to understand competitive advantage - In the Industrial Organization paradigm, a firm is a ‘processor of
information’, the behaviour of which can be
understood as an optimal reaction to external signs and factors which are
detected. The main results of the processing of information by firms are
precisely those activities that emerge from the positioning of an end product
within an industry structure. For Porter, once activities are shaped and
defined by processing information, then these activities may drive competencies
(accumulation of collective knowledge and learning in the firm). Processing
information is thus the core of the economic decisions of the traditional
firms, while creating and exchanging knowledge is just a by-product of the
current activities.
The RBV looks upon firms as bundles of resources. Just
as every product requires several resources for its creation so is a resource
capable of creating several products. It follows, therefore, that a firm can be
either viewed as a player in the product-markets that it serves or a bundle of
resources.
According to Kusonoki, Nonaka and Nagata (1998), the organizational schemes of the
firms related to knowledge creation can be categorized in three types:
·
Knowledge base
(distinctive individual units of knowledge, functional knowledge, elemental
technologies, info-processing devices, patents),
·
Knowledge frames
(capture linkages of individual units of knowledge and their priorities),
·
Knowledge
dynamics (interaction between knowledge base and knowledge frame).
Based on the above three types, our view is that the
resource based theory deals with the first category (knowledge base), the
Industrial Organization Paradigm (common competencies) and core-competence
approach deals with the second category (knowledge frames), while the dynamic
capability/evolutionary approach deals
with the third category (knowledge dynamics). Thus, each approach brings a
specific insight on the organization of knowledge in the I/O, RBV and CCA
approaches of the firm. And, it follows that all these challenging approaches
should be essentially considered as complementary ways of dealing strategically
with knowledge within the firm.
The firm is thus conceived as ‘a processor of
knowledge’, as a locus of setting up, construction, selection, usage and
development of knowledge. The firm is more sensitive to the sharing and
distribution of knowledge than it is to the distribution of information. In fact, considering the firm as a processor of knowledge leads to
the recognition that cognitive mechanisms are essential, and that routines play
a major role in keeping the internal coherence of the organization. In other terms, the governance of the firm is
not focused on the resolution of informational asymmetries but on the
co-ordination of distributed pieces of knowledge and distributed learning
processes.
(b) Next let us understand how industry analysis help in
pursuing competitive advantage - Within
industry performance differences are larger than performance differences across
industries. However, industry analysis is critical in creating competitive
advantage for several reasons. Companies that generate competitive advantage by
devising strategies that neutralize the unattractive features of the industry
and capitalize the attractive ones. Industry conditions appear to have large
influence whether competitive advantages are even possible. Incumbent firms
often face a tension between managing industry structure and pursuing an
advantage within the industry structure. In the definition of what is a firm,
industry structure analysis is considered as knowledge frames (common
competencies)
(c) Now we should know how the knowledge within and
without is organized and intelligently directed in a firm - The firm fixes its attention first on a closed subset
of activities that define the “core” domain of resources and competencies, and
then rank other activities (the “periphery”) along a decreasing index of
attention from the core domain. Such an order implies that the firm manages
resources, competencies and transactions simultaneously, but as it does so
according to a specific lexicographic order of priorities.
Within its set of resources and competencies, the firm
functions as a knowledge processor giving full priority to the creation of
resources. The firm’s domain of competencies is not considered to be tradable
on the market: activities belonging to the domain of competencies are
‘disconnected’ from the make-or-buy trade-off suggested by transaction-cost
theory. More precisely, two subsets can be distinguished in this domain: the
zone of core competencies which correspond to the sets of activities with the
higher focus of attention, that the firm aims to be ahead of the competition,
and the zone of competencies that encompasses the activities which the firm
‘knows well how to do’, but which are not necessary for a competitive advantage
over others.
Once the set of activities that belong to the set of
competencies has been chosen, the other activities that do not belong to the
core (the ‘periphery’ or ‘non core activities’) are
then managed under traditional methods which may rely on the transaction cost
approach .These activities are necessary to support core activities, and they
generally correspond to the larger number of activities and employment
positions in the firm. These activities do not require by definition a strong
commitment in terms of knowledge management. The firm just needs to ‘be
informed’ of best practice among other firms and of organizations that can
offer equivalent support services and if it appears that these activities are
too costly to be run within the firm compared to market mechanisms (according
to transaction costs criteria), they will be outsourced.
(1) To sum-up, the building and management of resources
and competencies drive the management of transactions, and thus shape the structure
of activities of the firm.
(2) To create competitive advantage, the firm must
configure itself to do something unique and valuable.
(d) We must also understand that all firms are subject to
“the theory of errors” - All
firms, successful and unsuccessful alike, make mistakes, and their errors may
persist unchecked for years or decades. If a firm lapses severely or often then
it may fail utterly. This does not imply that performance variation can be
attributed to the “competitive advantages” of successful survivors, or that
firms with competitive advantages are free from significant errors of omission
or commission. If anything, advantaged firms are more susceptible to avoidable
errors and must show even greater vigilance toward error.
Theories of competitive advantage provide an evocative
account of the performance of successful firms, and have survived intense
competition among rival performance theories. These are important achievements
and should be taken seriously. However, as a general account of intra-industry
performance heterogeneity, we believe these theories are incomplete. By
focusing on great firms, they fail to address the performance of more typical
firms and industries; they neglect the effects of organizational errors.
Theories of competitive advantage are correct in
claiming that the difference between a resource that can be imitated and one
that cannot is essential, both in theory and practice. If firms fail to imitate
valuable, barrier-free resources, then the resulting performance variance is
remediable by the short-term actions of managers or consultants. If industry
performance variation declines over time, it need not be due to the increasing
loss of competitive advantages, but may instead be due to error-reduction, or
“economizing behaviours”. Unsuccessful firms
eliminating errors (e.g., imitating unsustainable advantages) is not the same
thing as successful firms losing competitive advantages. If remediable errors
are a significant source of heterogeneity, then managers have endogenous
opportunities to enhance firm performance. These opportunities may not entail
firm transformation or industry revolution, but in most industries the
“mundane” fundamentals of sound management practice probably account for the
greater proportion of performance variability. In our view, a theory of errors
provides an essential corrective to theories of competitive advantage, and
offers promising new directions for empirical research in strategy.
(e) What in the world is “position”? - Position is achieved by organized and intelligently
directed knowledge. Position is essential for making and retaining economic
profit. Economic profit or economic rent is defined as the excess of accounting
profit of a firm over its cost of equity. The wider the excess of accounting
profit over cost of equity is better. A firm’s command over a position ensures
sustainability of the competitive advantage. A firm gains organized knowledge
by accumulated experience, by continuous investments in the underlying
resources, capabilities and competencies, by co-ordination of different
activities, by experiment and research and by creative imagination.
(f) When the competitive advantage is sustainable? - A competitive advantage is sustainable; (a) when the
competition finds it difficult to imitate the underlying knowledge that creates
the unique value. The firm must ensure that the competitive advantage is
difficult to imitate perfectly. Competitive Advantage usually comes from an
integrated set of choices that distinguishes the firm from its rivals. Creating
and sustaining the competitive advantage are not two separate things. The
choices that create the competitive advantage will also influence to sustain
the competitive advantage. (b)The competitive advantage would be resistant to
re-capitalization and not be subject to the factor-price fallacy.
(g) Can the customer value be conceptualized? - Customer value is inherent in or connected through
the use to some product/service. Customer value is something perceived by
customers rather than objectively determined by a seller. Customers’
perceptions involve trade-off between what the customer receives (e.g.,
quality, benefits, worth, utilities) and what he or she gives up to acquire and
use off a product/service (e.g. price, sacrifices). Customer Value relies on
the proper understand or misunderstanding of terms such as utility, worth,
benefits , and quality, that are themselves not well defined. For example, is
customer value as quality the same thing as customer value as worth or
benefits? Is a benefit built into and part of a product, or is it something
that customers experience as a result of using a product in a use situation? We
cannot answer these questions without examining exactly what these secondary
concepts mean. On the positive side exploring these differences may lead to a
deeper understanding of customer value.
For this paper , we define customer value as
“customer’s perceived preference for and evaluation of those product/service
attributes, uniquely tailored activities to deliver those products/services ,
attribute performances , and consequences arising from use that facilitate (or
block) achieving customer’s goals and purposes in use situation “.
(h) Let us now see how customer value can be measured? - A customer’s willingness to pay is the maximum
amount of money that a customer would be willing to part with in order to
obtain the product or service. The concept of supplier opportunity cost is
precisely symmetrical to willingness to pay. Total value created by a transaction is the difference between customer’s
willingness to pay and the supplier’s opportunity cost. The actual value that
the firm captures is determined by its added value. The added value of a
firm is the maximal value created by all participants in a transaction minus the
maximal value that could be created without the firm. In essence, it is the
value that would be lost to the world, if the firm disappeared. The larger the
firm’s added value, the greater it’s potential for economic profit. A firm can
increase its added value by widening the gap
it achieves between customer willingness to pay and supplier opportunity cost
beyond what rivals attain. We say that a firm with such a wider gap has a
competitive advantage in its industry.
Can it be
defined now?
·
Competitive advantage
is not about beating rivals; it's about creating unique value for customers.
·
However,
Competitive Advantage is more than marketing. If the unique value doesn't
require configuration of a firm into something unique and valuable and a
specifically tailored value chain to deliver it, it will have no strategic
relevance.
·
The essence of
competitive advantage is finding an integrated set of choices that
distinguishes a firm from its rivals.
·
It is not
possible to "delight" every possible customer out with the unique
value. The sign of a Competitive Advantage is that it deliberately makes some
customers unhappy.
·
No Competitive
Advantage is meaningful unless it makes clear what the firm will not do. Making
trade-offs is the linchpin that makes competitive advantage possible and
sustainable.
·
A core competence
or resource or activity alone will rarely produce a sustainable competitive
advantage but with the “mundane” fundamentals of sound management practice.
·
The importance of
execution cannot be overemphasized. Execution is unlikely to be a source of a
sustainable advantage, but without execution even the most brilliant strategy
will fail to produce superior performance.
·
If a firm has a
competitive advantage, it should show up on its P&L. There is no honour in size or growth if those are profit-less.
Competition is about profits, not market share.
·
Superior economic
profits are achieved by choosing to compete in or build a great industry, by
keeping the margin high and by avoiding avoidable errors and by competing well
Thus we define,
“Competitive advantage is about creating unique value
for customers by organized and intelligently directed knowledge to achieve
superior economic profits”
References
·
Barney, Jay B.
(2002). Gaining and Sustaining Competitive Advantage, 2nd ed. Reading, Mass.:
Addison-Wesley.
·
Besanko, David, David Dranove, and
Mark Shanley (2000). Economics of Strategy. 2nd Ed.
John Wiley & Sons, New York.
·
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·
Chamberlin, E.
(1939) The theory of monopolistic competition.
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·
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·
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·
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·
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·
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·
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·
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(1980). Competitive strategy, The Free Press, 1980.
·
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·
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·
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·
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