Imperfect Imitability and Industry Equilibrium • 383

384 • Chapter 11 • Sustaining Competitive Advantage

building a factory if it comes into the industry. This factory costs $36 million to build and (for simplicity) never depreciates and cannot be converted to another use. Investors expect a return of 5 percent on their capital, so the annualized cost of the factory is 0.05 3 $36,000,000 5 $1,800,000, or $1.8 per unit of capacity.

What will the equilibrium price be? In equilibrium, firms in the market will have positive operating profits while a potential entrant’s expected operating profit will be equal to or below the cost of entry. In this example, the price that makes a prospective entrant just indifferent between entering and not entering is $6.17 At that price, firms that enter and learn that their AVC is $7 or $9 will immediately exit. Firms with an AVC of $1, $3, or $5 will produce up to capacity and earn a per-unit operating profit of $5, $3, and $1, respectively.

A potential entrant’s expected operating profit per unit of capacity, when the price is $6, is thus:

(0.2 3 5) 1 (0.2 3 3) 1 (0.2 3 1) 1 (0.2 3 0) 5 $1.8

This expected operating profit equals the entry costs of $1.8 per unit, so a price of $6 leaves potential entrants just indifferent between entering or not. Put another way, at a price of $6, each firm’s expected rate of return on its invested capital (ROIC) is equal to its cost of capital of 5 percent. This is illustrated in Table 11.1.

The example illustrates the distinction between ex ante and ex post economic profitability. Before entering (i.e., ex ante), each firm’s expected economic profit is zero; that is, each firm expects to earn its 5 percent cost of capital (see Table 11.1). After entering (i.e., ex post), a firm’s economic profit may be positive or negative; that is, a firm may earn more or less than the competitive return of 5 percent. This yields a fundamental insight: to assess the profit opportunities available in a particular business, managers should not just focus on the performance of the most successful firms (i.e., those firms that are still in the business). In the preceding example, the average ROIC of active producers is (13.89 1 8.33 1 2.78)/3 5 8.33 percent, yet ex ante profitability is just 5 percent. The reason for this is that a simple average of the profitability of active firms ignores unsuccessful firms that have lost money and exited the industry.

This example offers another fundamental insight about profitability. If one takes an “ex ante” perspective and entry is free, then it is impossible to have positive expected profits without unique resources and capabilities. Before entering the market, firms in this example all have the same expected profits. The same can be said more generally about entrepreneurs before they sink investments into their new business ideas. Unless they

TABLE 11.1

Summary Statistics for Imperfect Imitability Example