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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.

· Brandenburger, A. and G. Stuart (1996). “Value-based business strategy”, Journal of Economics and Management Strategy, 5, pp. 5-24.

· Chamberlin, E. (1939) The theory of monopolistic competition. Cambridge, MA: Harvard University Press.

· Day, G. S. (1984) Strategic market planning: The pursuit of competitive advantage. St. Paul, MN: West.

· Dierickx, I. and K. Cool (1989). “Asset stock accumulation and sustainability of competitive advantage”, Management Science, 35, pp. 1504-11.

· Ghemawat, Pankaj and Jan Rivkin (1999). Strategy and the Business Landscape. Addison-Wesley, Reading, PA.

· Hofer, C. W., & Schendel, D. (1978) Strategy formulation: Analytical concepts. St. Paul, MN: West.

· Kay, John. (1993). Foundations of Corporate Success. Oxford University Press.

· Nonaka I., Konno N., (1998), The Concept of Building for Knowledge Creation, California Management Review, vol. 40.

· Peteraf, M. A. (1993). “The cornerstones of competitive advantage: A resource-based view”, Strategic Management Journal, 14, pp. 179–191.

· Porter, M. E. (1980). Competitive strategy, The Free Press, 1980.

· Porter, Michael, Competitive Advantage, The Free Press, NY, 1985.

· Richard P. Rumelt, (August 5, 2003), What in the World is Competitive Advantage? Policy Working Paper 2003-105.

· Saloner, Garth, Andrea Shepard, and Joel Podolny (2001), Strategic Management, John Wiley & Sons, New York.

· Selznick, P. (1957) Leadership in administration. New York: Harper & Row.