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enhance or impede a firm’s dynamic capabilities. The development of new products or capabilities or the opening of new markets can either enhance or destroy the value of complementary assets. Microsoft’s installed base in the old MS-DOS (“Microsoft disk operating system”) was a valuable complementary asset when it developed Windows in the late 1980s. By contrast, the development of the basic oxygen furnace in the steel industry reduced the value of American steel firms’ existing capabilities in the open hearth process. A proposed change in an organizational routine that undermines the value of a complementary asset can give rise to the sunk cost effect discussed earlier, thereby reducing the likelihood that a firm will adopt the change.
“Windows of opportunity” can also impede the development of dynamic capabilities. Early in a product’s development, its design is typically fluid, manufacturing routines have not been developed, and capital is generally nonproduct specific. Firms can still experiment with competing product designs or ways of organizing production. However, as time passes, a narrow set of designs or product specifications often emerge as dominant. At this point, network externalities and learning curve effects take over, and it no longer becomes attractive for firms to compete with established market leaders. This variant of the sunk cost effect implies that firms that do not adapt their existing capabilities or commit themselves to new markets when these uncertain windows of opportunity exist may find themselves eventually locked out from the market or competing at a significant disadvantage with early movers.
THE ENVIRONMENT
In The Competitive Advantage of Nations, Michael Porter argues that competitive advantage originates in the local environment in which the firm is based.28 Despite the ability of modern firms to transcend local markets, competitive advantage in particular industries is often strongly concentrated in one or two locations: the world’s most successful producers of high-voltage electrical distribution equipment are in Sweden; the best producers of equipment for tunneling are Swiss; the most successful producers of large diesel trucks are American; and the leading microwave firms are Japanese.
Porter views competition as an evolutionary process. Firms initially gain competitive advantages by altering the basis of competition. They win not just by recognizing new markets or technologies but by moving aggressively to exploit them. They sustain their advantages by investing to improve existing sources of advantage and to create new ones. A firm’s home nation plays a critical role in shaping managers’ perceptions about the opportunities that can be exploited; in supporting the accumulation of valuable resources and capabilities; and in creating pressures on the firm to innovate, invest, and improve.
Porter identifies four attributes in a firm’s home market (which he collectively refers to as the “diamond”) that promote or impede a firm’s ability to achieve competitive advantage in global markets:
1.Factor conditions
2.Demand conditions
3.Related supplier or support industries
4.Strategy, structure, and rivalry
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Factor Conditions
Factor conditions describe a nation’s position with regard to factors of production (e.g., human resources, infrastructure) that are necessary to compete in a particular industry. Because general-purpose factors of production are often available locally or can be purchased in global markets, the most important factors of production are highly specialized to the needs of particular industries. For example, since the 1950s, Japan has had one of the highest numbers of engineering graduates per capita. This, according to Porter, has had much more to do with its success in such industries as automobiles and consumer electronics than the low wages of its production workers.
Demand Conditions
These conditions include the size, growth, and character of home demand for the firm’s product. Sophisticated home customers or unique local conditions stimulate firms to enhance the quality of their products and to innovate. For example, in air conditioners, Japanese firms such as Panasonic are known for producing small, quiet, energy-efficient window units. These product characteristics are critical in Japan, where air conditioning is important (summers are hot and humid), but large, noisy units would be unacceptable because houses are small and packed closely together, and electricity is expensive.
Related Supplier or Support Industries
Firms that operate in a home market that has a strong base of internationally competitive supplier or support industries will be favorably positioned to achieve competitive advantage in global markets. Although many inputs are mobile, and thus firms do not need geographic proximity to make exchanges, exchanging key inputs, such as scarce production know-how, does require geographic proximity. Companies with skillful home-based suppliers can be early beneficiaries of newly generated production know-how and may be able to shape innovation in supplying firms. For example, Italian shoe manufacturers have established close working relationships with leather producers that allow the shoe manufacturers to learn quickly about new textures and colors. Leather producers, in turn, learn about emerging fashion trends from the shoe manufacturers, which helps leather producers to plan new products.
Strategy, Structure, and Rivalry
The final environmental determinant of competitive advantage, according to Porter, is the context for competition in the firm’s home market. This includes local management practices, organizational structure, corporate governance, and the nature of local capital markets. For example, in Germany and Switzerland, most shares in publicly traded firms are held by institutional investors who do not trade frequently, and capital gains are exempt from taxation. As a result, day-to-day movements in share price are not significant, which, according to Porter, creates a stronger propensity for companies in these industries to invest in research and innovation than is true of their counterparts in the United States and Britain.
Rivalry in the home market is another important part of the competitive context. According to Porter, local rivalry affects the rate of innovation in a market far more than foreign rivalry does. Although local rivalry may hold down profitability in local markets, firms that survive vigorous local competition are often more
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that fly international routes are far more cost efficient than many of the international airlines they compete with and rely on profits from international routes to offset losses domestically.
CHAPTER SUMMARY
Under the dynamic of perfect competition, no competitive advantage will be sustainable, and the persistence of profitability over time should be weak, because most firms’ profits will converge to the competitive level.
Evidence suggests that the profits of high-profit firms decline over time, while those of low-profit firms rise over time. However, the profits of these groups do not converge to a common mean. This lack of convergence cannot be ascribed to differences in risk between high-profit and low-profit firms. More likely, it reflects impediments to the operation of the dynamic of perfect competition.
The resource-based theory of the firm emphasizes asymmetries in the resources and capabilities of firms in the same business as the basis for sustainable competitive advantage. Resources and capabilities must be scarce and immobile—not tradable on well-functioning markets—to serve as the basis of sustainable advantage.
Competitive advantages must also be protected by isolating mechanisms to be sustainable. An isolating mechanism prevents competitors from duplicating or neutralizing the source of the firm’s competitive advantage. Isolating mechanisms fall into two broad classes: barriers to imitation and early-mover advantages.
Specific barriers to imitation are: legal restrictions, such as patents or copyrights, that impede imitation; superior access to scarce inputs or customers; economies of scale coupled with limited market size; and intangible barriers to imitation, including causal ambiguity, dependence on historical circumstances, and social complexity.
Sources of early-mover advantages include: the learning curve, brand-name reputation when buyers are uncertain about product quality, and consumer switching costs. Early-mover advantages are also possible in markets with network effects.
Creative destruction is the process whereby old sources of competitive advantage are destroyed and replaced with new ones. Economist Joseph Schumpeter wrote that the essence of entrepreneurship is the exploitation of the “shocks” or “discontinuities” that destroy existing sources of advantage.
A dominant established firm’s incentive to innovate may be weaker than that of a smaller firm or a potential entrant. The sunk cost and the replacement effect weaken the established firm’s incentive to innovate. The efficiency effect, by contrast, strengthens the dominant firm’s incentive to innovate as compared with a potential entrant’s incentive.
Evolutionary economics sees the firm’s decisions as determined by routines— well-practiced patterns of activity inside the firm—rather than profit maximization. Firms typically need to engage in continuous search for ways to improve their existing routines.
Dynamic capabilities are a firm’s ability to maintain the bases of its competitive advantage.