Integrated Strategy: Residual Market
Imperfections as the Foundation of
Sustainable Competitive Advantage
Felix Oberholzer-Gee
Dennis A. Yao
Working Paper 17-074
Integrated Strategy: Residual Market
Imperfections as the Foundation of
Sustainable Competitive Advantage
Felix Oberholzer-Gee
Harvard Business School
Dennis A. Yao
Harvard Business School
Working Paper 17-074
Copyright © 2017 by Felix Oberholzer-Gee and Dennis A. Yao
Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may
not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.
Integrated Strategy:
Residual Market Imperfections as the Foundation of Sustainable Competitive
Advantage1
Felix Oberholzer-Gee and Dennis A. Yao2
February 1, 2017
Market imperfections are central to understanding the mechanisms that permit firms to
capture value. Through competition leading firms often reduce these imperfections,
making markets more efficient. The remaining imperfections become a primary impetus
for government intervention. Hence, understanding residual market imperfections –
those imperfections that persist after market competition and regulation are accounted for
– must undergird any assessment of the long-term attractiveness of firm strategies. Our
proposed framework provides an integrated view of competition and government
intervention, two of the principal forces that influence variation in firm profitability.
1. Introduction
Early in his first term, President Obama signed the Credit Card Accountability
Responsibility and Disclosure Act of 2009. The CARD Act required disclosures that
provided consumers with additional information about the cost of using credit cards, and
it sharply limited the fees that banks could charge. The regulation reduced banks’
revenues and net income significantly, saving consumers more than $20 billion annually.
The largest decline in income occurred in the most profitable card segment: fees from
consumers with low credit scores (Agarwal et al., 2014).
This example illustrates two features of market economies.
First, profits vary
significantly across both market segments and between firms within those segments.
1
We thank David Baron, Robert Grant, Hillary Greene, Rebecca Henderson, David Primo and conference
participants at the Strategy and the Business Environment conference held at Duke, the LBS Ghoshal
conference, and the Strategic Management Society for helpful comments. This paper is a substantially
revised version of a paper entitled “Integrated Strategy.” Some of the ideas in this paper are also described
in our course note “Strategies Beyond the Market” HBS 9-707-469 (rev. 2/2/2012).
2
Harvard Business School, Boston, MA 02163; [email protected] and [email protected].
Oberholzer and Yao – Integrated Strategy
Banks that had focused on customers with limited access to credit earned a higher (riskadjusted) return than banks that targeted wealthier consumers. 3 Even over an extended
period of time, competition did not fully dissipate the greater profitability at the lower
end of the market. Second, the attractiveness of markets and the financial performance of
companies are both potentially vulnerable to government intervention. For example, the
CARD Act’s requirement that banks warn consumers before they exceeded their credit
limit wiped out a substantial portion of the fees that contributed to the superior
profitability of the subprime market.
The two questions that emerge from these features—what is the source of sustained
supra normal profitability and why does government intervention often undermine it—
turn out to have a single answer: residual market imperfections. These are the market
imperfections that persist notwithstanding competition among firms and intervention by
the government. They soften competition and allow firms to capture a greater fraction of
the value that they create. As such, this paper’s two goals are, first, to provide a
parsimonious characterization of the conditions under which firms attain such supra
normal profits and, second, to better understand why governments frequently target
precisely those markets exhibiting superior profitability.
Our framework is based on the economic theory of market failures (Bator 1958). The
theory specifies a set of conditions that interfere with effective competition. A wide
range of firm strategies—arguably nearly all of them—depend on the presence of market
imperfections to yield supra normal profits (Yao 1988, Oberholzer and Yao 2013,
Mahoney and Qian, 2013). Identifying the mechanisms through which a strategy avoids
competition is a valuable starting point for analyzing the source of competitive
advantage. But this analysis is incomplete. Market imperfections are often reduced
when firms compete to create and capture value (see, e.g., Chatain and Zemsky 2011). In
our introductory example, prior to the 2009 legislation, some banks provided consumers
with better information to attract a larger share of the highly profitable lower-income
households. Others competed by charging lower fees when consumers exceeded their
3
Charge-offs are higher among customers with lower credit scores, but higher interest rates and
incremental fees more than make up for the difference (Agarwal et al. 2014).
2
Oberholzer and Yao – Integrated Strategy
credit limits.
These strategies reduced the importance of the initial information
asymmetries. Government intervention through the CARD Act then further limited the
market imperfections that had survived competition.
Many forms of government
intervention seek to preserve or enhance competition, putting the savvy strategist in
tension with the determined regulator.
Residual market imperfections are the
imperfections that remain once both market competition and the public policy response to
soft competition are taken into account.
In the market for credit cards, some
imperfections persist even today, after the implementation of the CARD Act. These
residual imperfections constitute the true building blocks of longer-term strategic success.
One might think that market imperfections help companies and hurt consumers and
that government regulation generally limits business opportunities in the interest of
protecting consumers. Despite the CARD Act’s conformity to this pattern, the intuition
is misleading more generally. Market imperfections often hurt business, government
interventions can increase firm profits, and residual imperfections are not necessarily
smaller than the imperfections that survived market competition.
Laws to protect
intellectual property provide a striking example of these varied relationships. In the
absence of patents, copyrights, and trademarks, firms earn socially suboptimal returns on
innovative activity because rival firms can easily appropriate their intellectual property.
In environments without intellectual property rights, some firms are able to keep their
innovations secret which, in turn, creates informational frictions that enhance their
profitability. If governments then create formal IP protection, innovative firms gain even
greater market power and the value of the residual market imperfections increases. As a
result, companies that rely on IP often earn returns far in excess of their cost of capital.
Figure 1 illustrates for the credit card and innovation examples how, from a firm
perspective, the value of market imperfections changes with market competition and
government intervention. In the credit card example, the value of market imperfections to
firms is greatest if little competition exists among banks for lower-income households
and there is no government intervention. As banks begin to compete on fees, the value of
the market imperfection is reduced. In a final step, the CARD Act further undermines the
value of the market imperfection. We observe the opposite pattern within the context of
3
Oberholzer and Yao – Integrated Strategy
intellectual property.. Without a means to protect their intellectual property, firms are on
average worst off. As some firms begin to learn how to keep intellectual property secret,
profits increase. But innovative firms fare better if government creates and enforces
intellectual
ectual property rights, the lowest bar in figure 1.
Figure 1
Competition and Government Intervention Influence the Value of Market Imperfections
Our framework contributes to the literature and to current management practice in
two ways. Similar to other frameworks in strategic management―
management―e.g., industry analysis
(Porter 1980) and the Resource
Resource-based View (Wernerfelt 1984)―we
―we identify a small set
of forces that account for a substantial portion of the variation in profitability across
firms. Following Yao (1988)
88) and Oberholzer and Yao (2013
(2013), we contend that three
imperfections―market power, asymmetric information, and transactions
transaction costs―are
particularly important to our understanding of the variation in firm profitability.4
Our framework also helps integrate competitive strategy and regulatory concerns
(Stigler 1971, Posner 1974, Baron 1995).
While executives and academics alike
recognize the importance of political and legal factors for a firm’s financial
4
We discuss the relationship between these imperfections and the industry analysis and RBV perspective in
Section 5.
4
Oberholzer and Yao – Integrated Strategy
performance,5 both communities lack an integrated framework that links market
competition and government intervention (Durand et al. 2017). By providing an
integrated framework to understand competition and government intervention, we hope
to link classic strategic management with political and legal analysis. In so doing, we
seek to provide an intellectual blueprint for a closer integration of these concerns. 6
This paper proceeds as follows: In the next section, we provide another example that
illustrates the value of integrated strategic thinking. Section 3 then discusses market
imperfections and their effect on profitability. Next, we address government intervention
and residual market imperfections. Section 5 briefly focuses on the opportunities offered
by strategies that exploit market imperfections and the competition to exploit them. We
also distinguish our framework from current strategy theories. Finally, we conclude by
considering how our framework can be used to formulate and implement sustainable
strategies.
2. The Transformation of Market Failures
The market for automobile tires illustrates the value to considering both market forces
and government activity in tandem. Consumers typically have imperfect information
when they purchase replacement tires for their automobiles. Inspection does not allow
them to observe the underlying performance characteristics of a tire, nor can their own
experience provide much guidance regarding tire reliability and durability. Some firms
capitalized on this market imperfection by establishing a reputation for quality tires.
Brand reputation not only addressed the consumer information problem, it also allowed
companies such as to earn higher premiums on their tires relative to companies with
lesser reputations.
While competition among brands reduced Goodyear’s ability to
capture the value it created, scale economies in brand building and first-mover
advantages allowed the company to attain supra normal profits (Breyer 1982;
Oberholzer-Gee, Yao and Raabe 2006).
5
Traditionally, strategic and unit planning has been separated from legal affairs (Schulz 1990). However, in
recent years there is a strong trend towards including legal departments in a firm’s strategic planning
conversations (Association of Corporate Counsel 2016, p.6).
6
By limiting our examination to government interventions we exclude an examination of the “private
politics” (Baron 2001) dimension of nonmarket strategies.
5
Oberholzer and Yao – Integrated Strategy
The government response is not difficult to predict. In 1966 the U.S. Congress
passed legislation that required the Department of Transportation to develop a tire
grading system.
The proposed system had the potential to reduce the information
problem consumers faced and, therefore, threatened to reduce the value of the reputation
strategies through which some firms sought to capitalize on this information problem.
The grading of tire quality, however, turned out to be technically difficult for the
government to implement. In 1979, after a long struggle between the regulators and the
tire industry, Uniroyal, a tire company with a relatively weak brand but decent quality
tires, broke ranks with its industry brethren and helped the government develop the
necessary testing procedures and standards. It is perhaps only mildly surprising that
Uniroyal’s products scored among the top tires on the new government rating. And it is
of no surprise that Uniroyal subsequently built an advertising campaign around its
impressive ratings performance. 7
The example illustrates how profitable strategies can be built around market
imperfections. The first imperfection (i.e., information asymmetry) made brands extra
valuable, and the second imperfection (i.e., scale economies in brand building) prevented
smaller companies from competing away the brand advantage. As will become apparent,
it is often the transformation of different types of market imperfections that leads to
sustainable supra normal profits.
3. The Core Framework
The intellectual basis for our approach is the economic theory of market failures. The
approach categorizes failures as relating to market power, information imperfections, and
transactions costs.8 Gerard Debreu (1959) and Kenneth Arrow and Frank Hahn (1971)
showed that fully competitive markets would not allow companies to earn returns in
excess of their cost of capital. Economists refer to this result as the First Welfare
Theorem. From this glass-mostly-empty economic perspective we learn that a market
failure, what we term a market imperfection, is necessary, though not sufficient, to
sustain above-normal profits (Yao 1988; Oberholzer and Yao 2012).
7
8
See, e.g., advertisement in Popular Mechanics, July 1981, p.99.
A fourth category, externalities, is of lesser significance in our context and is, therefore, not addressed.
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Oberholzer and Yao – Integrated Strategy
Each of the three market imperfections discussed below reveals a specific reason why
a company’s profit margin is not eroded by competition and represents a fundamental
mechanism through which companies can obtain or maintain supra normal profits. As
these imperfections also identify the main sources of market inefficiency, they directly
provide the public interest justification for welfare-enhancing government intervention
(Musgrave and Musgrave 1989).
3.1. Three Market Imperfections
Although our inspiration is drawn from the economic theory of market failures, we
adapt the theory to accommodate the strategy context. We focus on three classic market
failures: production economies, information imperfections, and transactions costs.
Production Economies
Production economies are an important source of market power, the ability of a firm
to price above the level that would prevail under perfect competition. Economies of scale
are a classic example of a production economy. If a larger scale decreases costs and the
scale economy exists at levels that are substantial fractions of overall market demand,
then economies of scale result in a reduced number of competitors and softer
competition. Other types of production economies are associated with product scope
(Baumol, Panzar, and Willig 1982), cumulative learning (Rapping 1965), or network size
(Tirole 1994). Production economies can yield different types of competitive advantage.
Network externalities increase consumer willingness-to-pay while economies of scale
lower costs.
Firms pursue numerous strategies to take advantage of scale. Prominent examples
include the underpricing of initial offerings and heavy investing in advertising (Sutton
1991), building capacity in advance of short-term demand (see, e.g., U.S. v. Alcoa, 146
F.2d 416 (2d Cir.) (1956)), and altering one’s location strategy to gain scale advantages
(Ghemawat 2007).
From a societal perspective, production economies create an
interesting tension between increased efficiency (and potentially lower prices to
consumers) and reduced competition (and potentially higher prices).
7
For example,
Oberholzer and Yao – Integrated Strategy
competitive pressures animate firms to exploit economies of scale, leading to a more
efficient use of resources. As in our previous examples, market competition serves to
increase the economic surplus. At the same time, economies of scale can reduce the
number of viable competitors, which may hurt consumers and prompt government
intervention.
This tension between the more efficient use of resources and softer
competition is reflected in the government’s policy response to production economies.
For example, antitrust law allows internal expansion; firm size is not itself deemed
anticompetitive (ABA Section of Antitrust Law 2007).
By contrast, the authorities
regularly intervene in M&A activities to prevent the artificial creation of market power.
Where economies of scale effectively create natural monopolies (e.g., electric utility
distribution), it is common for governments to regulate pricing (Griffen and Puller 2005,
Armstrong and Sappington 2006).
production.
Sometimes, the authorities even resort to public
Consistent with the spirit of these interventions, electricity prices, for
example, tend to be lower under public ownership (Fiorio and Florio 2013).
Information Imperfections
In the presence of information imperfections, buyers or sellers lack the information
that is necessary for efficient exchange. Instances of asymmetric information in which
one party lacks material information that is known to the other are particularly common
(Ippolito 1986). Information imperfections can help soften competition if buyers are
unaware of near-equivalent products offered by a rival firm (e.g., Chatain and Zemsky
2011). For example, a company with a superior product may have difficulty breaking
into existing buyer-supplier networks because buyers are unaware of (Butters 1977) or do
not trust the new entrant. As a result, current suppliers are able to charge higher prices.
A common intuition is that firms tend to benefit from information imperfections
while customers tend to lose because, for example, firms benefit from increased search
costs. However, as the tire industry example illustrates, this view is too simplistic.
Reducing asymmetric information, for instance by building brands, can benefit
consumers and firms with strong brands (Shapiro 1982) while harming firms that lack a
strong brand. In the hopes of gaining competitive advantage, companies also employ
8
Oberholzer and Yao – Integrated Strategy
other types of quality assurance such as warranties or money-back guarantees. In each of
these instances, competition reduces existing market imperfections. Unfortunately, such
solutions can be unattractive to a firm if performance depends not only on the quality of
the product but also on the way the customer uses it. The problem is particularly grave
when the seller cannot observe customer behavior, another information imperfection.
With respect to warranties, for example, inability to observe consumer behavior raises
costs.
The competitive forces also reduce market imperfections when third parties such as
credit ratings agencies and Consumer Reports alleviate information asymmetries. While
markets for analysis and review help overcome information problems, they often face
their own market imperfections. For instance, hotels regularly post negative reviews on
nearby rivals, thereby reducing the value of online evaluations (Mayzlin, Dover, and
Chevalier 2014, see also Faulhaber and Yao 1988).
Because information imperfections can weaken competition and reduce consumer
welfare, regulatory actions to correct asymmetric information problems are common.
Information regulation seeks to improve market efficiency by mandating disclosures.
Examples include nutrition labeling, credit term disclosures, and energy efficiency labels.
In the presence of severe information imperfections, governments sometimes resort to
minimum standards to protect consumers (Fung, Graham, and Weil 2009). Finally,
trademark law is designed to prevent consumer confusion and preserve firm incentives to
reduce information asymmetries (Merges, Menell, and Lemley 2012).
Transactions Costs
Transactions costs are the costs of drafting, negotiating, and safeguarding agreements.
They include the costs of governing transactional relationships and securing
commitments. Williamson (1985) argues that transactions costs are a particular concern
when the proposed exchange is complex, uncertain, and when it requires transactionspecific investments. If the transactions costs exceed the value of the exchange, no
market will exist for that exchange. More commonly, market frictions alter the nature
and level of market activity (see, e.g. Joskow 1987 for a discussion of how contracting is
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affected by the need to invest in relationship-specific assets). Search costs are a good
example of a transaction cost which alters equilibrium price levels (Stahl 1989).
Transactions costs can also make it difficult to implement solutions to other market
imperfections. For example, the transactions costs of returning faulty products reduce the
value of product warranties.
As in the case of production economies and information imperfections, there are
private and public actions directed towards reducing transaction costs. Mechanisms that
speed settlement (e.g., third-party arbitration) or facilitate the enforcement of contracts
(e.g., litigation) are particularly important. Patents, which allow companies to control the
use of information about an innovation that is embedded in novel products or services,
are another example.
3.2. Private Responses to Market Imperfections
Firms respond to market imperfections in diverse ways. At its simplest, a firm might
choose to exploit its market power.
When faced with poorly informed buyers, for
instance, the firm might raise its prices. Bayer aspirin is a good example. Sold at three
times the price of its private-label equivalent, the Bayer product has the same active
ingredient and dosage as the generic versions. The power of Bayer’s brand primarily
reflects the uncertainty of consumers with limited medical knowledge. Doctors and
pharmacists, by contrast, devote 90% of their aspirin purchases to private label aspirin. If
everyone was as well informed as pharmacists, the market share of branded aspirin would
fall by more than one half (Bronnenberg et al., 2015).
The case of aspirin is no
exception. U.S. consumers spend $166 billion annually on branded products for which
nearly identical private-label substitutes exist. In other instances, firms exploit scale
economies to capture consumer surplus: Wal-Mart raises prices in sparsely populated
markets where it faces little competition (Ghemawat et al. 2003); U.S. cable companies
charge significant mark-ups and oversupply quality in response to scale advantages that
benefit incumbent firms (Crawford et al. 2015).
In all these instances, firms exploit market imperfections at the expense of consumers
and at the cost of efficiency. In other situations, however, competition among firms
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Oberholzer and Yao – Integrated Strategy
transforms market imperfections, creating potential gains for firms and consumers. Here,
market imperfections represent market opportunities whose mitigation creates value. As
discussed previously, better credit card terms, investments in tire branding, and online
reviews constitute examples of this second type of response. Firms often use
complementary measures to create a competitive advantage in exploiting market
imperfections. For example, risk-averse travelers find positive reviews of well-known
travel brands particularly helpful (Casalo et al. 2015). Lesser-known brands do not
benefit as much from online reviews, enhancing the advantage of travel providers with
strong brands.
Uber and similar ride-sharing services provide another example of the mitigation of
market imperfections that can benefit firms and consumers. The market for taxi services
was traditionally plagued by information asymmetries. For example, supply and demand
is mismatched in most markets most of the time. And industry regulations often had the
effect of softening competition. For example, taxi drivers were frequently prohibited
from picking up passengers in specific areas in many cities. Uber and similar services
use technology to better match drivers and passengers, thereby making the market more
efficient (Hall and Krueger 2016, Moon 2017). At the same time, the Uber business
model benefits from (local) network externalities that give rise to market power because
the matching technology is specific to a company’s platform.
One imperfection is
competed away; but a new imperfection has the potential to sustain supra-normal profits.
4. Government Intervention
While competition can reduce the value of market imperfections to firms, the
persistence of imperfections even in fairly competitive environments prompts
government intervention.9 Some interventions wipe out much of the value of the existing
9
The importance of market failures as a rationale for regulation is reflected in the primary purposes of large
U.S. federal regulatory agencies. An examination of the purposes of regulatory agencies with spending over
$100 million show that the large majority of those agencies have purposes that link to market failures of
production economies (market power), information imperfections, transactions costs, or externalities. Other
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Oberholzer and Yao – Integrated Strategy
imperfections. The telecommunications industry provides a few striking examples. For
years, the non-portability of individual cell phone numbers discouraged customers from
switching telecom providers. Individuals who changed their carrier had to notify friends,
acquaintances, and business contacts, a time-consuming task that made customers “loyal”
to their providers.
Not surprisingly, regulators eventually forced the portability of
numbers in many countries, making markets far more competitive (Shi et al. 2006).
Similarly, consumers in the United States (and in many other markets) incurred hefty
charges when they used cell phone services that exceeded contractual limits. These
“overage” fees were an important contributor to firm profitability (Miravete 2002, 2003;
Herweg and Mierendorff 2013). Pressured by the Federal Communications Commission,
the industry eventually agreed to send alerts to customers who were close to their service
allowances.
It is rare, however, that government interventions magically produce fully
competitive markets. Typically, some market imperfections persist post intervention and
the effects of these imperfections will frequently vary across firms. Regulations that
impose a fixed cost on firms, for example, will have asymmetric competitive
consequences because they have smaller unit cost implications for larger firms.
Table 1 provides some examples that illustrate residual strategic opportunities that
result from firm and government actions intended to mitigate various types of market
imperfections.
purposes include protection of rights (e.g., EEOC), protection of market boundaries (e.g., DEA), and
macroeconomic policy (e.g., Federal Reserve).
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Table 1: Examples of Market Imperfections, Responses, and Strategic
Opportunities
General
Category
Example
of
Market
Imperfection
Response of Firms
Response of
Government
Residual
Strategic
Opportunity
Production
Economies
Large
economies of
scale results in
strong market
power or even
natural
monopolies in
portions of the
value chain
Firms expand
geographically
and across
product markets
to take
advantage of
aggregate global
production in a
few locations
Regulation
of access
prices to
portions of
value chain
Implementation
via regulatory
rules may have
asymmetric
competitive
consequences
Information
Buyers cannot
Imperfections evaluate
quality of
product
Firms build
brands which
assure
consumers of
quality
Government
mandates
quality rating
system
Firms compete
to shape rating
system to gain
competitive
advantage;
lesser brands
market using
government
rating system
Transaction
Costs
Firms vertically
integrate to
reduce
information
leakage
Government
provides
patent
protection
for
intellectual
property
IP protection is
uneven; R&D,
licensing, and
alliance
strategies adapt
to patent laws;
IP litigation
becomes useful
tactical tool
Extremely
costly to
prevent rivals
from learning
critical pieces
of IP or
imitating and
reverse
engineering
innovations
The observation that governments do not typically restore full efficiency is not a
coincidence. Figure 2 illustrates two of the main obstacles to achieve full efficiency:
second-best considerations and the inherent messiness of government intervention.
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Oberholzer and Yao – Integrated Strategy
Figure 2
Paths to Residual Market Imperfections
As figure 2 illustrates, residual market imperfections, the building blocks of longterm competitive advantage, result from both private and public action. Private responses
are the firm strategies that seek to exploit market imperfections. When private responses
produce close-to-efficient outcomes, the likelihood of a public response decreases
substantially. Public responses are government interventions. These are shaped by
existing distortions in the economy and by the practical difficulties of implementing
government programs.
4.1. Second-Best Considerations
In a world in which many markets are distorted, even an optimal government
intervention often leads to further distortions. Economists refer to this insight as the
theory of the second best (Lipsey and Lancaster 1956).
For example, if a natural
monopoly dominates one sector of the economy while another is competitive, it is
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Oberholzer and Yao – Integrated Strategy
optimal for the government to raise prices above marginal cost in the competitive sector.
Optimal innovation policy provides another example of a second-best intervention.
Markets for innovation are prone to failure because new information, once created, can
be shared at almost no cost. Governments correct this market imperfection by granting
innovators temporary exclusive use positions in the form of patents and copyrights. This
second-best response allows the patent holders to raise prices and benefit from residual
market imperfections for considerable periods of time (Jaffe and Lerner 2004). Another
consequence is that these exclusive-use positions may be awarded to undeserving
inventions because patent offices economize on the resources devoted to patent
evaluation, a problem that is compounded by the costs associated with litigation which
would be needed to “undo” or “limit” that award. For our purposes, the key insight of the
theory is that even a perfect government would choose to distort the economy, thereby
providing a basis for the superior profitability of some firms (Spence 1975, Train 1991).
4.2. Messy Solutions
Real-world governments are less than perfect, of course.
Residual market
imperfections also persist because lawmakers and regulators find it difficult to design and
implement interventions.
This is particularly true in environments that allow
stakeholders to influence policy (Baron 2001).
4.2.1. The Design of Interventions
Experts within the fields of economics, law, and policy—let alone across those
fields—frequently disagree over the appropriate design solutions to market imperfection
problems. With respect to controlling market power, for example, voluminous literatures
exist arguing for and against various ways to regulate pricing by natural monopolists
(Joskow 2007).
Experts also disagree about which mergers to block to preserve
competition (see, e.g., Scherer 1980). And while most observers agree that information
imperfections can be reduced through the provision of more information, considerable
debate exists regarding crucial details of what and how that additional information should
be provided (Fung, Graham, and Weil 2009). If experts disagree, it is likely that at least
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some government interventions leave markets imperfect, opening avenues to sustained
superior profitability.
4.2.2. Influence Seeking
Expert disagreement is not the only force affecting governmental design of efficient
interventions. Private parties, including firms, consistently use their influence to achieve
their own as opposed to social gains. Groups with significant resources and focused
interests are particularly influential (Stigler 1971). For example, adoption of regulations
whose costs intensely affect one group but whose benefits are widely diffused will be
more difficult to pass owing to the challenge of mobilizing diffuse interests (Wilson
1980). In these instances, it is especially likely that significant market imperfections will
survive government intervention.
While documenting the influence of well-organized interest groups is easy (AustenSmith, 1997; Rodrik, 1995; Yackee, 2006), important forces prevent policy outcomes
from being entirely inefficient. One such force is competition among interest groups
(Becker 1983). For every group that wants less regulation, there is often an opposing
group that represents the interests of those who stand to gain from regulation. 10
Another reason that efficiency considerations influence political decisions is electoral
competition (Baron 1994, Grossman and Helpman 1996, Besley and Coate 2001,
Riezman and Wilson 1997). Lawmakers who support policies and programs that hurt
their constituents require compensation, typically in the form of campaign contributions
or political favors. Organized interests employ two tactics to keep the cost of political
favors limited. When choosing between policies with similar private but different public
benefits, the interests choose the policy that is better for the electorate. Another tactic is
to couch the arguments for private benefits in terms of the public interest. Groups often
make claims regarding market efficiencies (e.g. price and investment planning effects),
distribution (e.g., employment, fairness, support of small business or entrepreneurship),
10
Insead and Chatain (2008) examine actions that a firm can take against a rival’s resources in both factor
and political markets which increase the focal firm’s profits and conditions under which competitor
responses will influence the longevity of that profit increase.
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Oberholzer and Yao – Integrated Strategy
and implementation challenges (e.g., unreliability of regulatory procedures).
While
private interests may motivate such arguments, debate couched in public interest terms
raises the costs to those who attempt to influence outcomes against the public interest
(Grossman and Helpman 1994). Disguising private interest in public interest clothing
requires expensive tailoring which might still split at the seams when subjected to the
pressure of public interest scrutiny. Arguably, the tactic is likely to be more successful in
the legislative arena – lawmakers often have a difficult time sorting out the public interest
– than in administrative proceedings where experts better understand the public interest.
Design difficulties and influence seeking activities often combine to limit the
efficiency gains from government intervention. While regulation might diminish or even
eliminate some market imperfections, other imperfections are likely to persist and new
ones might even emerge as a result of government activity.
4.2.3. Implementation
Even when there is agreement regarding policy design and only limited influence
seeking by special interest groups, implementation of a given policy still has the potential
to introduce additional inefficiencies (Tirole 1994; Prendergast 2007). All governmental
action requires some administration either by a government agency or the courts. For
example, merger interventions, while limited in the sense that they generally involve a
one-time intervention (as opposed to an on-going regulatory presence) into the market,
result from a process involving settlement negotiations with antitrust agencies and
sometimes rulings by courts with limited antitrust law experience. Information disclosure
interventions such as tire grading, discussed previously, may depend on an underlying
testing procedure as well as monitoring and enforcement of such procedures and
disclosures. And government interventions to reduce transactions costs raise collateral
problems. Patents which confer time-limited exclusive rights are granted and enforced
within a system that is expensive, error prone, and arguably insufficiently flexible to meet
society’s needs regarding the myriad technologies at issue (Bessen and Meurer 2008).
Administration is of even greater importance when legislation addressing particular
market imperfections is vague and open-ended (e.g., antitrust law guidance for the courts)
17
Oberholzer and Yao – Integrated Strategy
or delegates implementation to administrative agencies (e.g., corporate average fuel
economy regulations to EPA).11 Such delegation allows decision makers with the
administrative or judicial some responsibility to shape residual market imperfections
subject to budget and organizational imperatives or political ideologies (Wolf 1979).
5. Integrated Strategy and Residual Market Imperfections
This section explores the market opportunity and sustainability implications of the
residual market imperfections framework.
We first argue that residual market
imperfections offer opportunities for a firm to create value rather than merely being
mechanisms that facilitate value capture. Second, we address the question of competition
to exploit these imperfections and connect our framework to the positioning and RBV
schools of strategic thought. Finally, we examine sustainability from the viewpoint of
regulatory threats and different approaches of firms to counter those threats.
5.1 Strategic Opportunities
Companies whose strategies do not exploit one or more market imperfections face the
full force of competition and, therefore, will find it difficult to attain sustained
profitability.
Hence, in evaluating a strategy, it is valuable to understand (1) what
residual imperfections, if any, characterize the market, (2) how one’s strategy (and the
strategies of rival firms) exploit such imperfections, and (3) how residual market
imperfections may change over time. The third element in the evaluation involves not
only projecting future market strategies, but also anticipating potential government
intervention.
11
Because laws are not always clear-cut and need to be enforced to truly have bite, the mechanisms
through which legal actions are brought and enforced are another critical component to understanding the
non-market environment. Laws specify which parties have “standing” to bring legal actions. For the
purpose of this paper, it is interesting that buyers and sometimes third parties (e.g., public interest groups)
who seem somewhat removed from the direct effect of the action being challenged are sometimes given
legal standing. This situation allows such parties to target particular firms with lawsuits that can be viewed
as raising the transactions costs of doing business for individual firms.
18
Oberholzer and Yao – Integrated Strategy
While the analysis of residual market imperfections directly addresses value capture,
strategies that build on these imperfections are opportunities for firms to create value.
Our framework, therefore, has the additional contribution of suggesting fertile targets for
business development and innovation.12 Consider, for example, a few of the many ways
in which innovative firms reduce transactions cost: Apple’s extensive use of vertical
integration to avoid compatibility issues (Yoffie and Baldwin 2015); Toyota’s close
collaboration with suppliers (Williamson 2008); and Tata’s creation of more efficient
firm-internal labor and capital markets (Khanna and Palepu 1997, 2000). In each of these
cases, competition among firms encourages the innovators to share the transactions costs
savings with consumers. More generally, the market imperfections analysis facilitates
identifying customers that are most effectively targeted by a particular strategy:
customers who would most suffer from the market imperfection that underlies the
strategy.
5.2 Competition to Exploit Residual Market Imperfections
All perspectives on the sources of firm performance require some explanation for
why created value will not be competed away (Rumelt 1979, Barney 1986). Both the
positioning school (Porter 1979, 1980, 1996) and the resource-based view (Wernerfelt
1984) identify circumstances under which the number of firms that compete for
customers remains limited. In a classic five forces analysis, for instance, markets are
deemed attractive if the firm faces few rivals and a multitude of suppliers and customers.
The key to longer-term profitability, then, depends on the number of competitors in the
relevant markets. The positioning school relies heavily on the idea that each strategic
position involves trade-offs, implicitly suggesting that in many markets the number of
firms that compete in exactly the same way for the same group of customers is limited.
Trade-offs reduce the willingness of current rivals to imitate the positions of other firms.
Entrants, which lack such pre-existing trade-offs, are deterred for other reasons,
economies of scale and other examples of high barriers to entry playing a critical role
(Mahoney 2001).
12
Jia and Mayer (2016) suggest that a firm’s market capabilities could be a source of political capabilities.
19
Oberholzer and Yao – Integrated Strategy
Similarly, the resource-based view of enduring competitive advantage ultimately
turns upon the number of firms in a market. Because resources are not tradable, they
qualify as a source of rents that stay with the firm (Peteraf 1993). In the RBV view also,
firms are intrinsically different and do not compete in exactly the same way. Superior
resources for creating value lead to superior performance.
One contribution of the residual market imperfections framework is that it speaks
directly to the question of why the number of firms remains limited.
Production
economies, information imperfections, and transactions costs, a subset of which have
been addressed by Mahoney (2001) and Chatain and Zemsky (2011) as market frictions,
all serve to keep limited the number of firms vying for a segment of customers. In the
aspirin example, the effective number of competitors is small because consumers are
unaware of the benefits of private-label products. The cost of identifying and contracting
with potential suppliers typically limits the number of firms that customers would
consider. As these examples make clear, our framework incorporates the classic reasons
for a limited number of competitors (e.g., productions economies), but we emphasize that
the effective number of rivals is often smaller than government statistics or Yelp would
suggest.
Because the residual market imperfections framework is squarely focused on
understanding why the number of competitors remains limited despite attractive returns,
the approach has the potential to lead to deeper insights and sharper recommendations.
For instance, substantial capital requirements are sometimes used to illustrate high
barriers to entry in the positioning school (Bain 1956). While financing constraints can
be an impediment to entry, capital markets will have little difficulty supporting even very
large projects in the absence of information asymmetries (McAfee et al. 2004).
Information imperfections are the true source of competitive advantage. The difficulty of
obtaining finance is a mere manifestation of the underlying imperfection.
We also see residual market imperfections as underlying the RBV analysis.
Resources remain unique to firms because they cannot be easily identified and traded
20
Oberholzer and Yao – Integrated Strategy
(Itami and Roehl 1987, Dierickx and Cool 1989).13
Market imperfections are the
impediments to trade. For example, outsiders often have difficulty understanding why a
rival has greater capability. Meta-capabilities such as dynamic capabilities that involve
an entire system of learning are particularly difficult to penetrate (Rivkin 2000, Teece,
Pisano, and Shuen 1997, Helfat 2007). In fact, these capabilities may be so hard to
understand and implement that even replication inside the firm can be a problem (Winter
and Szulanski 2001).
Whether within a single firm or across rivals, competitively
relevant differences persist because of market imperfections.
To understand how our framework can lead to more precise strategy prescriptions,
consider the power of brands. Brands can constitute a valuable resource (Grant 1991).
But it is not difficult to find firms with widely recognized brands that fail to achieve
supra-normal profits. The market imperfections framework suggests that brands are
particularly valuable in markets with substantial uncertainty. Where brands serve as a
valuable signal for quality, firms are more likely to experience attractive returns to brandbuilding activities.14 While the positioning school, the resource-based view, and the
market imperfections framework are close cousins – each approach treats the number of
competitors in a market as a key determinant of profitability – the market imperfections
framework is arguably the most closely focused on the reasons why superior returns do
not lead to perfect competition.
Overlaying this snapshot of firms and markets is the question of timing and
recognition of profitable strategies. Even if imitable, innovative business ideas that
create value or increase value capture may give the innovator first-mover advantages
(Lieberman and Montgomery 1988) which can be leveraged into a sustainable
competitive advantage if, for example, the first-mover advantage is linked to a market
13
Market imperfections also may be the mechanism through which a given resource is valuable.
Our framework focuses primarily on the functional value offered by brands to consumers. Brands, of
course, frequently offer emotional and self-expressive benefits (Aaker and Joachimsthaler 2000) which
serve to differentiate offerings and soften competition. Like the case of investments in innovation,
investments in brand are affected by residual market imperfections relating to the ability of the firm to
overcome the transactions costs (and also asymmetric information problems) associated with preventing
other firms from free-riding on branding investments. Here, trademark law protection functions in a similar
way as patent protection to mitigate the market imperfection.
14
21
Oberholzer and Yao – Integrated Strategy
imperfection.15
For example, Toyota gained a significant cost and performance
advantage over other automobile manufacturers through its extensive field experience
with its hybrid automobile engine systems because it had the dominant market share of
such vehicles (Reinhardt et al. 2006). These advantages, of course, depend on a wide
range of considerations including pioneering costs, the tolerance of early adopters, as
well as the growth rate of the market. Another intriguing barrier to imitation involves
cognitive failures. They may not only impede the occurrence of the initial creative jump,
but also the recognition of the strategic importance of a rival’s new strategy (Gavetti
2012).
Strategies that exploit one or more imperfections through an implementation that
involves nontrivial development, then, would seem to offer the best opportunity for
sustained profitability. The market imperfections intrinsically reduce competition while
nontrivial development, especially when it involves some business innovation or
underappreciated opportunity, would slow rival recognition of that development and
reduce the attractiveness of late imitation.
5.3 Sustainability and Integrated Strategy
The previous subsection focused on classic sustainability threats from market
competitors, we now broaden our discussion to include government action.
We begin by examining three approaches that firms take when they consider the
effect of the political and legal environment on their strategy (see Dorobantu et al. 2017
for a closely related argument).16 One approach is to take the regulatory environment as
given. Such firms treat government and legal institutions as providing exogenous “rules
of the game.” They consider the sustainability of a given strategy as dependent on the
current and future set of rules. Essentially, these firms are “rule takers” as they do not
15
Early movers can acquire critical resources at below market value (e.g. intellectual property) or can lock
up such resources through long-term contracts. Of course, these advantages would amount to rents on
prescient forecasting rather than ongoing rent streams.
16
Baron (1995, 2013) emphasizes the value to a firm of having its top managers consider both the market
and nonmarket strategies when making overall “integrated” strategy choices. See, also, Shotts (2016) who
analyzes a game-theoretic model of a firm’s investment choices in an environment where government
expropriation is a serious risk and uses the results of the analysis to underscore the importance of the
integration of a firm’s political risk management with its operating units.
22
Oberholzer and Yao – Integrated Strategy
expect their actions to influence government. A deeper level of integration occurs when
firms anticipate that their market strategies might elicit a government response. These
companies account for the likelihood that changes in the rules of the game will influence
returns from their market strategy. Companies in this group, which we term “passive rule
shapers,” anticipate government action but are not directly involved in the public policy
process. A third group, the “active rule shapers,” simultaneously consider market
strategies and opportunities to actively shape the rules of the game (Bonardi et al. 2005,
Bonardi et al. 2006, Henisz et al. 2014, Holburn and Vanden Bergh 2014). 17 These firms
align their political and regulatory strategies to benefit their market strategy and thus take
an endogenous view of rules when assessing the sustainability of their strategic choices. 18
Firms within each category, even rule-takers, benefit from anticipating possible
regulatory changes. A valuable precondition to effective anticipation is the firm’s ability
to identify which aspects of the governmental environment are strategy relevant. But
doing so is challenging without a clear sense of how the source of profits and the sources
of regulatory action are related.19 This connection is one of the advantages of the residual
market imperfections framework: in a given market the market imperfections that a firm
attempts to exploit are the imperfections that a regulator (and consumer activists) would
like to fix.
The framework, as applied to the sustainability threat posed by governmental action,
suggests that the actual size of the residual market imperfections will be the dominant
17
There is a rich literature that describes how firms engage political actors, influence the rules of the game,
and reap private benefits in return (see, e.g., Blumentritt 2003, Shaffer et al. 2000, Bonardi 2004, Cho et al.
2006, Cooper at al. 2010, Hillman and Hitt 1999, Jia, 2014, Macher and Mayo 2015, Meznar and Nigh
1995). The resulting tensions inside the organization are analyzed by Shaffer and Hillman (2000).
18
For a skeptical view of the performance consequences of firms’ political engagement, see Aggarwal et al.
2012, Faccio 2006, and Hadani and Schuler 2013.
19
For any given firm there is a plethora of environmental forces that may impact its profitability. A
manager contemplating the sea of possible factors to consider is likely to feel adrift. A difficulty with
current strategic models (e.g., the Five Forces) is that they generally do not help managers identify which
nonmarket factors are important. For example, sometimes government is treated as an additional force. In
other approaches, government influences the various market forces and, through these forces, ultimately the
attractiveness of an industry itself. Obviously there are many other factors that impact the five forces: new
technology, evolving consumer tastes, market fragmentation, switching costs, overcapacity and so on.
Because there are so many factors, managers are forced to work with long and unwieldy lists of possible
influences on profitability, without clear guidance as to when they need to pay attention to non-market
forces.
23
Oberholzer and Yao – Integrated Strategy
factor determining governmental intervention into particular markets. Another factor is
the extent to which those market imperfections are perceived as harming consumers. This
latter dimension affects both the overall political impetus for regulatory change and the
intensity with which various interest groups will engage in the political process.
The matrix in Figure 3 combines the residual market imperfections and perceived
consumer harm dimensions and is useful for anticipating regulatory action.
Understanding possible regulatory interventions in terms of their impact on market
imperfections and mapping the reliance of existing firm strategies on the market
imperfections illuminates each firm’s true interests vis-à-vis possible rule changes and
provides insight into the likely outcomes from a political contest over such rules. When
market imperfections and consumer harm are minimal (“no market problem”), regulatory
intervention is least likely.
When residual market imperfections are high and the
perceived consumer harm is substantial (“market problem”), regulatory intervention is
most probable and will be arguably directed towards mitigating the imperfection.
Somewhat less straightforward are the other two cases. When imperfections are high
but perceived consumer harm is low (e.g., business-to-business settings), business interest
group competition may address the imperfections, though the parochial interests of the
players and the legislators may play a larger role, especially regarding legislative action,
because the policy decisions are more removed from the public eye. The fourth and final
case, characterized by high perceived consumer harm and low market imperfections, is
interesting because regulatory actions might actually worsen the residual market
imperfections.20
Thus far, Figure 3 has been discussed in terms of the anticipation of outcomes. Rule
shapers, of course, would consider possible regulatory action as both a threat and an
opportunity and would take political actions to affect the outcomes in each box. A rule
shaper’s governmental or nonmarket strategy derives directly from their market strategy
20
The political entrepreneur setting and the interest group competition setting are related to two of
Wilson’s (1980) categories in his politics of regulation, though he focuses on concentration of benefits and
harms across affected groups.
24
Oberholzer and Yao – Integrated Strategy
and that market strategy anticipates the firm’s ability to shape regulatory outcomes. 21
Firms that fully integrate market and nonmarket strategies not only anticipate
governmental actions but they also try to influence those actions. Such firms also choose
their market strategies by taking into account the impact their actions will have on
residual market imperfections and perceived consumer harm. Both factors will influence
the sustainability of their market strategy. Consider, for example, an action that provides
value to consumers by mitigating a market imperfection (“Competition A” in Figure 3).
The strategy will directly reduce the public interest demand for a governmental
intervention. Such actions are more temporally robust than those that merely exploit such
imperfections and profit streams emerging from such actions would seem easier to
sustain. For example, if firms selling products in a market prone to information
imperfections build high-quality reputations and provide customer friendly return
policies, the residual information imperfection and consumer harm is reduced, lowering
the likelihood of regulatory intervention. In contrast, a tactic which exploits information
imperfections as well as some decision-making biases on the part of consumers would
likely induce quick imitation and government intervention.22
For example, some
telecommunications firms have arguably profited by getting consumers to buy the
“wrong” plan. Such a tactic has at least two weaknesses—competitors can attempt to fix
the information imperfection by offering use-based automatic adjustment plans and the
government can compel greater transparency regarding information about plans and
usage.
Another manner in which pressure for governmental action may be reduced emerges
directly from the competition to exploit a market imperfection. As described in the
CARD Act example, competition (“Competition B” in Figure 3) can sometimes result in
price pressure that mitigates some of the potential costs imposed on consumers from the
exploitation of the imperfection, even though the underlying imperfections are left
unaffected.
Finally, firms may engage in self-regulatory activities to preempt
21
See, e.g., Keim and Zeithaml (1986) and de Figueiredo (2009) for discussions of corporate political
strategies.
22
There is a debate over whether consumers make rational choices or not. See, e.g., Miravete (2003) and
Grubb (2009).
25
Oberholzer and Yao – Integrated Strategy
government regulations (see, e.g., King and Lenox 2000, Delmas and Montes-Sancho
2010).
Figure 3: Likelihood of Government Intervention and Forces of Competition
Perceived Consumer Harm
High
Low
High
Market Problem:
Interest Group
Competition
(possible)
Market Problem
(most likely)
Competition (B)
Competition (A)
Residual Market
Imperfection
Low
No Market Problem No Market Problem:
(unlikely)
Political
Opportunity
(possible)
6. Conclusion
The residual market imperfections framework serves two purposes: it helps identify
the source of value capture which facilitates an understanding of a firm’s competitive
advantage and the animating factors that initiate and guide regulatory interventions into
the market. If a strategy depends on exploiting one or more market imperfections—and
most do—then potential government interventions that alter the nature of the
imperfection are first-order threats to a firm’s competitive advantage. Seeing the market
opportunities and the nonmarket threats through the lens of the residual market
imperfection framework sharpens the relationship between market and nonmarket
strategy. It better pins down the mechanism by which value is dynamically captured and
26
Oberholzer and Yao – Integrated Strategy
directs attention to governmental action as a key boundary condition; it offers a filter
through which managers can focus on strategy-relevant nonmarket forces; and it makes
clearer how nonmarket forces can be harnessed by firms to affect relative competitive
advantage.
But residual market imperfections also present value creation opportunities.
By
partially or fully solving an existing market imperfection, a firm creates value while
setting itself up to capture some portion of that value. 23
Thus, a residual market
imperfections perspective points the way towards sustainable strategies that allow a firm
to be compensated for improving net social value.
These strategies contrast with
strategies that only exploit market or residual market imperfections to capture value. 24
Any strategy that increases individual firm profits is likely to come under market attack
by one’s competitors. Likewise, strategies that increase profits while not improving
consumer benefits are also likely to attract nonmarket attacks.
Thus, our analysis
provides a natural way for firms to consider how and when their strategies have win-win
characteristics for both themselves and society.
Finally, transcending the individual firm perspective, our integrated analysis of the
interaction of firm strategy and government action also suggests that market outcomes
can be highly path dependent. When the underlying market imperfections are significant,
firm actions may transform the residual market imperfection. If they mitigate the
problem, less severe or no regulation is likely to follow. But if they do not, a stronger
regulatory response is more likely. The response will, in turn, alter the residual market
imperfections that shape subsequent firm strategies.25 Hence, even putting political
economy considerations aside, markets with similar underlying market imperfection
characteristics may evolve to distinctly different end points.
23
A cost-leadership strategy that is built around exploiting economies of scale is one in which the valuecapture component—reduced market competition—is indivisible from the value creation component—
efficiencies that lower the costs of production. This indivisibility makes it difficult for non-market actors to
undermine value capture without engaging in direct market intervention.
24
Enron, for example, made substantial profits by exploiting arbitrage opportunities that were created as a
result of early attempts to organize and run the California energy market.
25
Path dependency is exacerbated because the regulatory process exhibits significant inertia. Not only is
the passage of regulation often difficult (see, e.g., Kingdon 1984), but the process of adjusting extant
regulations to reflect modest reductions in the degree of consumer harm that might result from new firm
solutions is also challenging.
27
Oberholzer and Yao – Integrated Strategy
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