MKT 450 Strategic Management
Mishari Alnahedh
LECTURE 5: COMPETITIVE ADVANTAGE
The Nature and Sources of Competitive Advantage
Mishari Alnahedh
Learning Objectives:
o What is the value of strategic flexibility?
o Under what conditions are strategic commitments
more likely to lead to sustainable competitive
advantage?
o How can game theory tools and cash-flow analyses
be used together?
o When are first-mover advantage and second-mover
advantage applicable?
Strategic Flexibility
Mishari Alnahedh
What is the value of strategic flexibility?
 Responsiveness to the opportunities provided by external
change requires


Information (a key resource)
Flexibility (a key capability)
 Information is necessary to identify and anticipate external
changes.


This is dependent on a firm’s environmental scanning capability
through “early warning systems”
Largely based on relationships with customers, suppliers, and
competitors
Strategic Flexibility
Mishari Alnahedh
What is the value of strategic flexibility?
 Flexibility of response requires that a firm swiftly redeploys
its resources to meet changes in external conditions.


This is dependent on “organizational software”
Largely based on organizational structure, decision-making
systems, job design, and culture.
Strategic Flexibility
Mishari Alnahedh
Strategic Flexibility
Mishari Alnahedh
Benetton’s responsiveness
 Flexibility typically requires:



Fewer levels of hierarchy
Greater decentralization of decision making
Informal patterns of cooperation and coordination
 Responding to emerging market trends and changing
customer preferences

Benetton uses a vertically integrated network
● At the retail level, a system of country and regional agents who
coordinate the franchised retail outlets
● At the production level, more than 2,000 subcontractors, but no
formal contracts
Strategic Flexibility
Mishari Alnahedh
Strategic Flexibility
Mishari Alnahedh
Dell’s Responsiveness
 The greater a company’s flexibility in responding to changing
market circumstances, the less dependent it is on its ability
to forecast
 Dell operates with under 14’s days’ inventory

This not only cuts costs, but also permits Dell to adjust rapidly
and effortlessly to fluctuations in market demand and upgrade
its products quickly to take advantage of technical advances in
components
 Dell’s entire logistics are outsourced

Some components (e.g., monitors) are delivered to customers
without passing through Dell’s hands
Strategic Flexibility
Mishari Alnahedh
Strategic Flexibility
Mishari Alnahedh
IKEA’s responsiveness
 Strategic flexibility depends on core competencies for
repositioning product offerings
 IKEA uses computer-based coordination to organize its
1,800 “loosely-coupled” suppliers of modular ready-toassemble furniture components
 A 50-country global product creation and production
network
Strategic Flexibility
Mishari Alnahedh
Strategic Commitment vs. Flexibility
 Commitment

Game Theoretic preemption strategy
 Flexibility

Real (Strategic) Options Analysis
 Flexibility is analogous to “having options” and
commitment is analogous to the “exercise of an option”
 The greater the uncertainty the firm faces, the more
valuable are its strategic options.
 The resolution of uncertainty over time is the catalyst
which induces a manager to make (sunk cost)
commitments.
Game Theory and Cash-Flow Analysis
Mishari Alnahedh
Traditional Evaluation of Financial Projects

Net Present Value (NPV) or Discounted Cash Flow Analysis
CF
+
time
-
The Value of Time: Commitment vs. Flexibility
Mishari Alnahedh
Cost to Build Plant = $1600
Cost of Capital = 10%
Price(t=1) = $300
Price = $300
.5
Price(t=0) = $200
.5
Price(t=1) = $100
Price = $100
The Value of Time: Commitment vs. Flexibility
Mishari Alnahedh
Time
Expected Cash
Flow
(Traditional NPV)
Expected Cash
Flow
(Scenario 1)
Expected Cash
Flow
(Scenario 2)
0
1
2
3
4
5
6
7
8
Infinity
$
$
$
$
$
$
$
$
$
$
(1,400)
200
200
200
200
200
200
200
200
200
$
$
$
$
$
$
$
$
$
$
(1,300)
300
300
300
300
300
300
300
300
$
$
$
$
$
$
$
$
$
$
(1,500)
100
100
100
100
100
100
100
100
NPV
$
600
$
1,545
$
(455)
The Value of Time: Commitment vs. Flexibility
Mishari Alnahedh
Build now (classic NPV) versus value of waiting
•
•
•
•
NPV calculation
($1400) in year 0
.5($300) + .5($100) = $200
for each year after
Value of $200
perpetuity=$2000
Expected NPV ($1400) +
$2000=$600
Waiting
• Year 0 = $0
• Scenario 1 (price = $300)
– Yr. 1=($1300)
– Perpetuity of $300
– NPV =$1545
• Scenario 2 (price = $100)
– Yr. 1=($1500)
– Perpetuity of $100
– NPV =($455)
• NPV of waiting:
– .5($1545) + .5(0) = $773
What is the value of the option to wait a year ?
Waiting in a real option
Mishari Alnahedh
An increase in the variance, increases the value of the option.
better
Outcome
ABC Corp is planning to establish four new plants to make rubber bands, each for a
different type of rubber bands. The investment costs of the four plants are known.
The future prices of rubber bands, however, are unknown. Two possible scenarios of
the future prices of rubber bands are shown in tables 1 and table 2 below for the four
plants or projects. If ABC Corp can buy a real option to delay the decision of which
plant to invest in, which project will have a real option with the highest value?
Table1. The Up Scenario
Cost of the plant
Price in year 1
Price in year 2
Price in years 3-10
Project A
$55,000
$ 5.00
$ 5.00
$ 5.00
Project B
$55,000
$ 10.00
$ 15.00
$ 25.00
Project C
$1,000,000
$ 50.00
$ 55.00
$ 60.00
Project D
$25,000
$ 10.00
$ 15.00
$ 25.00
Table2. The Down Scenario
Cost of the plant
Price in year 1
Price in year 2
Price in years 3-10
Project A
$55,000
$ 5.00
$ 5.00
$ 5.00
Project B
$55,000
$ 5.00
$ 10.00
$ 20.00
Project C
$1,000,000
$ 45.00
$ 50.00
$ 55.00
Project D
$25,000
$ 1.00
$ 2.00
$ 4.00
Strategic Commitment
Mishari Alnahedh
Game-theoretic Approach to Strategy
Mishari Alnahedh
 What prior strategic commitments
has the competitor made?
 How “reversible” is your action or
the competitor’s potential
response?
 credible threat
 Does the potential market fit with
the competitor’s existing strategy?
 What are the payoffs relative to
other actions the competitor could
take?
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
Under what conditions are strategic commitments more
likely to lead to sustainable competitive advantage?




When the commitments are credible (sunk investments);
When you understand what strategic investments are
important in your business and how “sunk” those
investments are.
When you pay attention to how your competitors’
returns vary under different strategic scenarios;
When you communicate the commitment to the other
firms (for both competition and cooperation);
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
How Can “Commitment” Affect a Competitor’s Response?
Commitment (sunk costs) can be used to pre-commit to
a certain strategy and, thus, influence competitor
response


Preemption of Strategically Valuable Assets
- Access to raw materials (e.g., Alcoa; Royal Dutch Shell)
Reduce incentives for imitation
Commitment (sunk costs) can be used to achieve
cooperation
Game Theory and Cash-Flow Analysis
Mishari Alnahedh
How can game theory tools and cash-flow analyses be
used together?
Strategy: Games against other people

Our actions affect the payoffs we are likely to experience
(Game-theoretic analysis)
Finance: Games against “Nature”

Payoffs are determined exogenously or by chance
(Decision-theoretic analysis)
Game Theory and Cash-Flow Analysis
Mishari Alnahedh
Strategic Commitment : First-mover Advantage
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
Speed of response: First-mover vs. second-mover
Sources of first-mover advantages




Economies of Scale
Experience or Learning Curve Effects
Brand Equity and customer loyalty
“Network Externalities”
First-mover disadvantages



High risk
High development costs
High demand uncertainty
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
A second mover : is a (second, third, fourth, etc.) firm that
responds to a first mover’s competitive action often through
imitation or a move designed to counter the effects of the initial
action.
New Bala is a successful second
mover in the athletic shoe industry.
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
Speed of response: First-mover vs. second-mover
Second-mover advantages




Reduction in demand uncertainty
Market research to improve satisfying customer needs
Learn from the first mover’s successes and shortcomings
Gaining time for R&D to develop a superior product
Strategic Commitments and Competitive Advantage
Mishari Alnahedh
First Mover Disadvantages May Lead to Second Mover
Advantages
 The Costs of Early Adoption
 The “Bleeding Edge” of Technology
 Changing Technology
 Product Technology
 Process Technology
 Changing Consumer Tastes
 Saturn & Chrysler
 Given that a second mover’s product development costs can
be much lower than the first mover’s product development
costs, first-mover advantages must be substantial to justify
first moving as a strategy
Competitive process in different market settings
Mishari Alnahedh
 For competitive advantage to exist, there must be some
imperfection (or inefficiencies) of competition
 What types of resources and capabilities are necessary to
compete?
 What are the circumstances of the availability of the
resources and capabilities?
 Trading markets vs. Production markets
 Trading involves arbitrage across space (trade) and time
(speculation)
 Production involves the physical transformation of inputs
into outputs
Competitive advantage and imperfections in the
competitive process
Mishari Alnahedh
MARKET
TYPE
SOURCE OF
IMPERFECTION
OF COMPETITION
TRADING
MARKETS
•None (efficient markets)
•Imperfect information availability
•Transactions costs
•Systematic behavioral trends
•Overshooting
•Barriers to imitation
PRODUCTION
MARKETS
•Barriers to innovation
OPPORTUNITY
FOR COMPETITIVE
ADVANTAGE
None
Insider trading
Cost minimization
Superior diagnosis
(e.g.... chart analysis)
Contrarianism
Identify barriers to imitation
(e.g. deterrence, preemption,
causal ambiguity, resource
immobility, barriers to resource
replication) & base strategy
upon them.
Difficult to influence or exploit.
Sources of imperfections to the competitive process
Mishari Alnahedh
Trading markets




Imperfect availability of information
Transaction costs
Systematic behavioral trends
Overshooting as a result of imitation
Production markets


Barriers to imitation
Barriers to innovation
Barriers to Imitation
Mishari Alnahedh
How long will it be before the first rival imitates
the first mover?
How fast does new imitation occur once it starts?
These two factors determine “appropriability”
Barriers to Imitation
Mishari Alnahedh
REQUIREMENT FOR IMITATION
Identification
Incentives for imitation
ISOLATING MECHANISM
- Obscure superior performance
- Deterrence--signal aggressive
intentions to imitators
- Pre-emption--exploit all available
investment opportunities
Diagnosis
- Rely upon multiple sources of
competitive advantage to create
“causal ambiguity”
Resource acquisition
- Base competitive advantage upon
resources and capabilities that are
immobile and difficult to replicate
Barriers to Innovation
Mishari Alnahedh
The more complex an industry in terms of multidimensionality of customer choice criteria and the
number of value chain activities, the greater the
potential for creating “new game” strategies

New rules of the game
• Value chain reconfiguration such as disintermediating
• Innovative business models to create value for customers
from novel experiences, products, product delivery or
bundling, process technologies, and organizational
formats
Generating and Sustaining Competitive Advantage
Mishari Alnahedh
How does one generate competitive advantage?
How does one sustain competitive advantage?
Consider the following three strategies

Market Share

Learning curves

Corporate Culture
Does market share generate competitive advantage
Mishari Alnahedh
The computer industry is an excellent example of the
lack of correspondence between market share and
profit rates.
IBM was a clear market leader in terms of market share,
but had only mediocre profit performance relative to its
rivals.
Market share is no guarantee of success.
- Remember Kodak ?
Does market share generate competitive advantage
Mishari Alnahedh
Perhaps high market share causes high profit rates.
But it could equally well be that there is a third factor
(e.g., good service capabilities), unobserved by us, that
causes both high profitability and high market share.


In this case, we would see a correlation between
profitability and market share, but no causal explanation.
Costs of acquiring market share offset the returns to
market share.
Market share can generate advantage when there are
significant economies of scale.
Does Market Share Generate Competitive Advantage?
Mishari Alnahedh
When can market share work to generate and sustain
and advantage?
Scale economies, combined with high exit costs, may
show a defensible advantage.
High exit costs:


Invest in large and specialized assets (commitments) that
make exit difficult.
These “exit barriers are entry barriers.”
Learning curve and competitive advantage
Mishari Alnahedh
How does a learning curve effect generate an
advantage?
To the extent that the firm is first in the market, it
may, through the operation of the learning curve,
have lower costs than new rivals.

Thus, learning curve effects may meet our first
criterion of giving initial relative advantage.
Learning curve and competitive advantage
Mishari Alnahedh
What about the imitation issues for sustaining
advantage?
Learning curve effects can lead to sustained
competitive advantage:


If the learning curve effects remain within the firm;
and
If the learning curve effects persist in the face of
technological change.
Corporate culture and competitive advantage
Mishari Alnahedh
Organizational culture refers to the complex set of
ideologies, symbols, and core values shared throughout the
firm and that influences the way it conducts business. It is
the social energy that drives --- or fails to drive --- the
organization.
Corporate culture and competitive advantage
Mishari Alnahedh
How can corporate culture generate advantage?
An organization’s culture creates value, because it
allows that organization to strike deals with its
suppliers, customers, and employees that are not
available to other firms.

Thus, culture is an organizational asset.
Corporate culture and competitive advantage
Mishari Alnahedh
How can corporate culture be a source of sustained
competitive advantage?
Corporate culture is hard for another firm to imitate.
In fact, an organization may have difficulty in
replicating its own culture in other geographic areas.

“Invisible” or intangible assets like corporate culture
are often the only sustainable source of competitive
advantage, primarily because such advantages are so
difficult to imitate.
Today’s Main Takeaway
Mishari Alnahedh
 A firm can earn a rate of profit in excess of its cost of capital either
o by locating in an attractive industry or
o by establishing a competitive advantage over its rivals
 Of these two sources of superior profitability, competitive
advantage is the more important
 Two primary components of the analysis of competitive advantage
are:
o External sources of competitive advantage
o Internal sources of competitive advantage
 In this session, we focused on the relationship between
competitive advantage and the competitive process