david bryce © 1996-2002 adapted from baye © 2002 strategy & economics: introduction to...

David Bryce © 1996-2002Adapted from Baye © 2002


Strategy & Economics:Introduction to Economic Rents and Competitive Advantage

Strategy & Economics:Introduction to Economic Rents and Competitive Advantage

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



What is Strategy?What is Strategy?

• A planned sequence of actions to A planned sequence of actions to achieve a goal or resultachieve a goal or result

• Sequences of moves and Sequences of moves and countermoves among competitors countermoves among competitors where each is trying to achieve a where each is trying to achieve a more favorable position relative to more favorable position relative to othersothers

• A pattern in a stream of decisionsA pattern in a stream of decisions

• A planned sequence of actions to A planned sequence of actions to achieve a goal or resultachieve a goal or result

• Sequences of moves and Sequences of moves and countermoves among competitors countermoves among competitors where each is trying to achieve a where each is trying to achieve a more favorable position relative to more favorable position relative to othersothers

• A pattern in a stream of decisionsA pattern in a stream of decisions



What is the Goal of Strategy in Business?What is the Goal of Strategy in Business?

• To secure sustained profit for the firmTo secure sustained profit for the firm• In economics, profit is defined asIn economics, profit is defined as

ππ = = RR – – CC – – OCOC (Profit = Revenue – Costs – Opportunity Cost of assets)(Profit = Revenue – Costs – Opportunity Cost of assets)

• Contrast to Accounting Profit:Contrast to Accounting Profit:

ππaccacc = = RR – – CC

• To secure sustained profit for the firmTo secure sustained profit for the firm• In economics, profit is defined asIn economics, profit is defined as

ππ = = RR – – CC – – OCOC (Profit = Revenue – Costs – Opportunity Cost of assets)(Profit = Revenue – Costs – Opportunity Cost of assets)

• Contrast to Accounting Profit:Contrast to Accounting Profit:

ππaccacc = = RR – – CC



How to Secure Profit? Exploit the Conditions of Imperfect Competition

How to Secure Profit? Exploit the Conditions of Imperfect Competition

• Numerous sellers and Numerous sellers and buyers unable to affect pricebuyers unable to affect price

• Perfect InformationPerfect Information• Homogenous productsHomogenous products• No barriers to entry or exit; No barriers to entry or exit;

mobile resourcesmobile resources

Zero Economic Profits Zero Economic Profits

• Few competitors, numerous Few competitors, numerous suppliers and buyerssuppliers and buyers

• Asymmetric InformationAsymmetric Information• Heterogeneous ProductsHeterogeneous Products• Barriers to entry Barriers to entry

Positive Economic ProfitsPositive Economic Profits (also referred to as supernormal (also referred to as supernormal

profit)profit)

Perfect Competition Imperfect Competition



The Structure of IndustriesThe Structure of Industries

Competitive Rivalry

Threat of newEntrants

BargainingPower of

Customers

Threat ofSubstitutes

BargainingPower of Suppliers

From M. Porter, 1979, “How Competitive Forces Shape Strategy”



How Industry Structure Influences Profitability

0

20

40

60

80

100

Farmers5-10% ROE

Frozen Entree Makers 20-25% ROE

Food Retailers 8-12% ROE

Percent ofMarket

Others(>10,000)

ConAgra

Stouffer

Swanson

Campbell

Green Giant

Others (>10)

SafewayKrogerAmerican

Others (>1000)

34

25

17

4

20

90

2341

99



Economic RentsEconomic Rents

• Strategists especially seek a kind Strategists especially seek a kind of profit called economic rentof profit called economic rent

• Economic rent is the excess Economic rent is the excess received over the opportunity cost received over the opportunity cost of an assetof an asset

• A portion of accounting profit is A portion of accounting profit is usually economic rentusually economic rent

• Strategists especially seek a kind Strategists especially seek a kind of profit called economic rentof profit called economic rent

• Economic rent is the excess Economic rent is the excess received over the opportunity cost received over the opportunity cost of an assetof an asset

• A portion of accounting profit is A portion of accounting profit is usually economic rentusually economic rent



ExampleExample

• Suppose two firms in an industry own their Suppose two firms in an industry own their land outrightland outright

• Firm A is located near a major railroad and can Firm A is located near a major railroad and can ship products for $10,000 a year less than ship products for $10,000 a year less than Firm B, which is 100 miles distant.Firm B, which is 100 miles distant.

• Economic Rent on the land is $10,000 per year Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to pay for its land this period—the rent goes to Firm A in lower costs)Firm A in lower costs)

• Thus, Firm A earns rent of $10,000 on its landThus, Firm A earns rent of $10,000 on its land

• Suppose two firms in an industry own their Suppose two firms in an industry own their land outrightland outright

• Firm A is located near a major railroad and can Firm A is located near a major railroad and can ship products for $10,000 a year less than ship products for $10,000 a year less than Firm B, which is 100 miles distant.Firm B, which is 100 miles distant.

• Economic Rent on the land is $10,000 per year Economic Rent on the land is $10,000 per year ($10,000 is what Firm B would be willing to ($10,000 is what Firm B would be willing to pay (OC) for the land less Firm A’s zero cost to pay (OC) for the land less Firm A’s zero cost to pay for its land this period—the rent goes to pay for its land this period—the rent goes to Firm A in lower costs)Firm A in lower costs)

• Thus, Firm A earns rent of $10,000 on its landThus, Firm A earns rent of $10,000 on its land



Economic Rent (continued)Economic Rent (continued)

• When opportunity costs are persistently lower When opportunity costs are persistently lower than the rents earned on assets, positive than the rents earned on assets, positive economic profit can be sustainedeconomic profit can be sustained

• But how can opportunity costs be lower than But how can opportunity costs be lower than rents? rents?

• AnswerAnswer: When assets (or resources) cannot be : When assets (or resources) cannot be soldsold

• But when can resources not be sold?But when can resources not be sold?• AnswerAnswer: When markets for rent-earning assets : When markets for rent-earning assets

are inefficient or failare inefficient or fail

• When opportunity costs are persistently lower When opportunity costs are persistently lower than the rents earned on assets, positive than the rents earned on assets, positive economic profit can be sustainedeconomic profit can be sustained

• But how can opportunity costs be lower than But how can opportunity costs be lower than rents? rents?

• AnswerAnswer: When assets (or resources) cannot be : When assets (or resources) cannot be soldsold

• But when can resources not be sold?But when can resources not be sold?• AnswerAnswer: When markets for rent-earning assets : When markets for rent-earning assets

are inefficient or failare inefficient or fail



Why Markets for Assets May FailWhy Markets for Assets May Fail

• The source of the rent cannot be precisely The source of the rent cannot be precisely identified by external or sometimes even identified by external or sometimes even internal observersinternal observers

• Separating the assets from the context of the Separating the assets from the context of the firm renders them useless or significantly firm renders them useless or significantly impairs their usefulness or valueimpairs their usefulness or value

• The assets encounter Arrow’s Information The assets encounter Arrow’s Information (knowledge) Paradox: (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 Therefore, the “assets” never go up for sale (OC is near 0), but they earn positive rents(OC is near 0), but they earn positive rents

• The source of the rent cannot be precisely The source of the rent cannot be precisely identified by external or sometimes even identified by external or sometimes even internal observersinternal observers

• Separating the assets from the context of the Separating the assets from the context of the firm renders them useless or significantly firm renders them useless or significantly impairs their usefulness or valueimpairs their usefulness or value

• The assets encounter Arrow’s Information The assets encounter Arrow’s Information (knowledge) Paradox: (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 Therefore, the “assets” never go up for sale (OC is near 0), but they earn positive rents(OC is near 0), but they earn positive rents



Examples of ‘Assets’ that May be Subject to Market FailureExamples of ‘Assets’ that May be Subject to Market Failure

• A A complex social processcomplex social process among scientists at a among scientists at a pharmaceutical firm that, along with good pharmaceutical firm that, along with good science, leads to consistent innovation in new science, leads to consistent innovation in new drug discoverydrug discovery

• The The knowledgeknowledge that Intel applies at its wafer that Intel applies at its wafer fabrication facilities to keep defects lowfabrication facilities to keep defects low

• The The exclusive relationshipsexclusive relationships that Coca-Cola that Coca-Cola Company has with its bottlers that keep others Company has with its bottlers that keep others from utilizing the bottlers’ resourcesfrom utilizing the bottlers’ resources

• Wal-Mart’s Wal-Mart’s locationlocation in small, rural communities in small, rural communities in which no other entering competitors could in which no other entering competitors could attract a remaining market large enough to be attract a remaining market large enough to be profitableprofitable

• A A complex social processcomplex social process among scientists at a among scientists at a pharmaceutical firm that, along with good pharmaceutical firm that, along with good science, leads to consistent innovation in new science, leads to consistent innovation in new drug discoverydrug discovery

• The The knowledgeknowledge that Intel applies at its wafer that Intel applies at its wafer fabrication facilities to keep defects lowfabrication facilities to keep defects low

• The The exclusive relationshipsexclusive relationships that Coca-Cola that Coca-Cola Company has with its bottlers that keep others Company has with its bottlers that keep others from utilizing the bottlers’ resourcesfrom utilizing the bottlers’ resources

• Wal-Mart’s Wal-Mart’s locationlocation in small, rural communities in small, rural communities in which no other entering competitors could in which no other entering competitors could attract a remaining market large enough to be attract a remaining market large enough to be profitableprofitable

We refer to such “assets” as Strategic Assets



Definition: Sustainable Competitive Advantage (SCA)Definition: Sustainable Competitive Advantage (SCA)

• Earning positive economic profit Earning positive economic profit in the presence of attempts by in the presence of attempts by others to imitate or substitute the others to imitate or substitute the firm’s source of competitive firm’s source of competitive advantageadvantage




Definition: Competitive AdvantageDefinition: Competitive Advantage

• When a firm earns positive economic profit, When a firm earns positive economic profit, the firm possesses a competitive advantagethe firm possesses a competitive advantage

• Reminder: How is positive economic profit Reminder: How is positive economic profit secured?secured?

• Answer: By earning rents on assets that are Answer: By earning rents on assets that are subject to market failuresubject to market failure

• Thus, strategy is about creating assets that Thus, strategy is about creating assets that are subject to market failure or otherwise are subject to market failure or otherwise exploiting the conditions of failed (imperfect) exploiting the conditions of failed (imperfect) marketsmarkets

• When a firm earns positive economic profit, When a firm earns positive economic profit, the firm possesses a competitive advantagethe firm possesses a competitive advantage

• Reminder: How is positive economic profit Reminder: How is positive economic profit secured?secured?

• Answer: By earning rents on assets that are Answer: By earning rents on assets that are subject to market failuresubject to market failure

• Thus, strategy is about creating assets that Thus, strategy is about creating assets that are subject to market failure or otherwise are subject to market failure or otherwise exploiting the conditions of failed (imperfect) exploiting the conditions of failed (imperfect) marketsmarkets



Definition: Sustainable Competitive Advantage (SCA)Definition: Sustainable Competitive Advantage (SCA)



david bryce © 1996-2002 adapted from baye © 2002 strategy & economics: introduction to...

Documents