What are competitive advantages?
According to Rumelt (2003), the question on a precise definition of competitive advantages
is elusive, since there is a lot of confusion about the ambiguous concept. Specifically, some
of the definitions of competitive advantages are problematic as they are reasoning in circles.
Economics
Because the definition of a competitive advantage is elusive, scholars within the strategic
management field took a look at the field of economics and benchmarks to sharpen their
thinking on what competitive advantages.
Neoclassical economics and perfect competition concept
One of the main concepts in economics to produce a clear answer on the question what
competitive advantages precisely are, is the concept about the model of perfection
competition and the neoclassical economics. This perfect competition concept is a model
within a theoretical world in which there are no differences in performance between firms
and all firms make zero economic profits (read: there are no better performance
alternatives left for any of the firms as there are no differences between the performances
of firms in this theoretical world).
That is, all the possible resources are being used at their most optimal way within the
perfect competition model, suggesting that everybody is getting what their best alternative
option would deliver.
Important to note is that this theoretical model is based on certain assumptions:
- The large numbers assumption: there are a large number of buyers and sellers,
saying that no single buyer or seller have market power and can affect the price,
meaning that all firms are price-takers
- The homogeneity assumption: firms are producing standardized goods or services,
saying that buyers have no reason to prefer the product of one seller to another
- The mobility assumption: it is easy to exit and entry the industry, saying that there
are no hindrances on firms by entry or leaving the industry.
- The rationality assumption: there is complete information and knowledge about the
(commodity) prices in the market and everybody wants to maximize their profits
- The transaction cost assumption: transactions are costless
Allocative efficiency (maximization of welfare)
The idea of this theoretical model of perfect competition is that in a world where all existing
markets are perfect competitive, and every rational agent is after their self-interest, both
maximum individual freedom and maximum collective welfare arise. We call this
maximization of both the individual and collective welfare the allocative efficiency. This
allocative efficacy stands for the situation in which all resources in the system are allocated
,to the most productive use, which is the cause of all firms earning zero economic profits (as
there cannot be alternative economic costs)
What is competition about in this perfect competition model?
If we take a closer look at the perfect competition model and theoretical world of
assumptions, competition within this world and model is about free competition:
- Price competition: first, competition within the perfect competition model is about
price competition since rational agents interact with each other by responding to
price signals (although buyers and sellers all are price-takers)
- Entry and exit; second, there is the idea that when there is a positive economic profit
in a certain part in one industry, that will immediately attract entry; and when there
are negative outcomes in one port that will trigger exists.
What does this model of perfect competition bring the definition of competitive
advantages?
To sum up, the beauty of this perfect competition model is that we now have a theoretical
benchmark in which there are zero economic profits (read: no competitive advantages) that
can be used as a very powerful benchmark for situations in which there are profits made by
differences in performances between firms. Namely:
“Any deviation from the assumptions of the perfect competition model, or in other words,
anything that makes sure that there are differences in performances between firms instead
of zero economic profits, can be a source that leads to performance difference and
explanation of what a competitive advantage is”
,Additional schools of thought in economics that influenced the strategic management field
Whereas the neoclassical economics and theoretical model of perfect competition are the
basic starting point of the use of economics within strategic management, they certainly are
not the only economic school that influenced the field of strategic management. There are
also other schools that have their own ideas about the role of economics and influenced the
strategic management field.
Important to note is that each of these economics’ schools are different ways of thinking and
all step away from certain assumptions of the neoclassical world of perfect competition that
may cause performance differentials and can be sources of competitive advantages.
- Positioning school & Bain type IO school (market power as source)
- Resource based school (resources as source)
- Chicago School (process efficiencies as source)
- Ricardian School (costly to copy resources as source)
- Schumpeterian school (innovation as source)
, The positioning school of Michael Porter
Michael Porter builds on the economic thinking of the Bain-type industrial organization
school by translating the findings from the Bain-type industrial organization (IO) economics
into managerial frameworks for lowering competition instead of increasing competition. The
Bain-type IO economics recognized that above normal profitable industries existed and tried
to understand where these deviations from the perfect competition model were coming
from to inform governments with anti-trust policies to counter the market power in these
industries and make these industries more competitive again to increase social welfare.
More specifically, the Bain-type IO started to look at the differences in performances of
industries and tried to understand why some industries have greater profits than other
industries. They did this by looking at the market power that was related to the
characteristics of the industry structure and the conduct of the firm as potential
explanations of the differences in performances between industries (S-C-P paradigm)
- structure: structural characteristics of industries such as concentration and barriers
to entry (main focus)
- conduct key decisions and the strategy of firms such as collusion and predatory
pricing
The link between Bain-Type IO economics and the positioning school of M. Porter
Michael Porter turned this Bain-type IO policy-thinking, in terms of increasing social welfare
and competition by anti-trust policies against market power, on its head by focusing on
strategic management objectives such as profit maximization and decreasing competition.
Porter did this by a paper that presented a theory of determinants of profits of firms
(similar to the scp-model) which, according to Porter, rests on:
1. Total Industry structure: industry-wide traits and variables (five forces)
2. Inter-industry structure: the structure within an industries (strategic groups)
3. Firm conduct: the conduct of induvial firms (generic strategies)
So, for explaining the profitability of industries and firms, according to Porter, (1) first the
structure of the total industry is relevant that can be explained by using the five forces
model, (2) then the inter-industry structure must be explained by the so-called strategic
groups and (3) last the conduct of individual firms could be explained by analyzing their
generic strategies.
1. Total Industry structure: industry-wide traits and variables by five forces model
If we apply this total industry, inter-industry, firm conduct approach of Porter of above, the
first step is to use the five forces model of Porter to analyze the average profitability of a
certain total industry. In other words, the five forces model tells us something about the
attractiveness of a particular industry by looking at how strong the forces of each type of
competition are that can possibly reduce the profitability within that industry
- Strong forces of competition -> more competition -> less profitability of the industry
