Strategy & Economics: Introduction to Economic Rents and Competitive Advantage

1. Strategy & Economics:Introduction to Economic Rents and Competitive Advantage MANEC 387 Economics of Strategy David J. Bryce

2. What is Strategy? • A planned sequence of actions to achieve a goal or result • Sequences of moves and countermoves among competitors where each is trying to achieve a more favorable position relative to others • A pattern in a stream of decisions

3. What is the Goal of Strategy in Business? • To secure sustained profit for the firm • In economics, profit is defined as π = R – C – OC (Profit = Revenue – Costs – Opportunity Cost of assets) • Contrast to Accounting Profit: πacc = R – C

4. Numerous sellers and buyers unable to affect price Perfect Information Homogenous products No barriers to entry or exit; mobile resources Zero Economic Profits Few competitors, numerous suppliers and buyers Asymmetric Information Heterogeneous Products Barriers to entry Positive Economic Profits (also referred to as supernormal profit) How to Secure Profit? Exploit the Conditions of Imperfect Competition Perfect Competition Imperfect Competition

5. Threat of new Entrants Competitive Rivalry Bargaining Power of Suppliers Bargaining Power of Customers Threat of Substitutes The Structure of Industries From M. Porter, 1979, “How Competitive Forces Shape Strategy”

6. How Industry Structure Influences Profitability Others (>10) 20 Green Giant 4 Percent of Market Others (>1000) 17 Campbell 90 Others (>10,000) 99 25 Swanson 34 Stouffer 2 American 3 Kroger 4 ConAgra 1 Safeway

7. Economic Rents • Strategists especially seek a kind of profit called economic rent • Economic rent is the excess received over the opportunity cost of an asset • A portion of accounting profit is usually economic rent

8. Example • Suppose two firms in an industry own their land outright • Firm A is located near a major railroad and can ship products for $10,000 a year less than Firm B, which is 100 miles distant. • Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to Firm A in lower costs) • Thus, Firm A earns rent of $10,000 on its land

9. Economic Rent (continued) • When opportunity costs are persistently lower than the rents earned on assets, positive economic profit can be sustained • But how can opportunity costs be lower than rents? • Answer: When assets (or resources) cannot be sold • But when can resources not be sold? • Answer: When markets for rent-earning assets are inefficient or fail

10. Why Markets for Assets May Fail • The source of the rent cannot be precisely identified by external or sometimes even internal observers • Separating the assets from the context of the firm renders them useless or significantly impairs their usefulness or value • The assets encounter Arrow’s Information (knowledge) Paradox: • A potential buyer of information must know what the information is in order to assess its worth. But once the buyer knows enough to assess its worth, he is in possession of the essentials, which he has acquired without cost. • Therefore, the “assets” never go up for sale (OC is near 0), but they earn positive rents

11. Examples of ‘Assets’ that May be Subject to Market Failure • A complex social process among scientists at a pharmaceutical firm that, along with good science, leads to consistent innovation in new drug discovery • The knowledge that Intel applies at its wafer fabrication facilities to keep defects low • The exclusive relationships that Coca-Cola Company has with its bottlers that keep others from utilizing the bottlers’ resources • Wal-Mart’s location in small, rural communities in which no other entering competitors could attract a remaining market large enough to be profitable We refer to such “assets” as Strategic Assets

12. Definition: Sustainable Competitive Advantage (SCA) • Earning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantage

13. Definition: Competitive Advantage • When a firm earns positive economic profit, the firm possesses a competitive advantage • Reminder: How is positive economic profit secured? • Answer: By earning rents on assets that are subject to market failure • Thus, strategy is about creating assets that are subject to market failure or otherwise exploiting the conditions of failed (imperfect) markets

14. Definition: Sustainable Competitive Advantage (SCA) • Earning positive economic profit in the presence of attempts by others to imitate or substitute the firm’s source of competitive advantage