Organisation Summary Block 5, 2009-2010

Part One: Economic foundations of strategy

Chapter 1 Basic microeconomic principles
---

Chapter 2 Economies of scale and scope
The horizontal boundaries of a firm depend on the strategy of the firm and the cost structure. The
strategy includes deliberately choosing a different set of activities to reach a firms goals: focus,
differentiation or overall cost leadership. Theres need to distinguish between strategic (long-term)
and operational (short-term) decisions, whereas these strategy depends on your mission and vision.

Further, the firms strategy is influenced by the cost structure. Cost structures differ because of scale
advantages, synergy, experience advantages and network advantages.
Economies of scale occur when the average cost declines when volume increases. In this case, fixed
costs have to be high compared to variable costs. Firms with scale advantages, have higher average
costs than marginal costs. They have to be aware that the average cost can increase when capacity
reaches its limit (diseconomies of scale). Firms have to find the smallest volume for which average
cost is lowest, the so called Minimum efficient scale.
Economies of scale have four reasons to come from:
1. Indivisibilities and spreading of fixed costs; Spreading of product-specific fixed costs and capital
intensive versus labor intensive production.
2. Increased productivity of variable inputs; The Division of Labor Is Limited by the Extent of the
Market (Adam Smith): specialization leads to reduced average cost if the market is large enough
to allow specialization.
3. Inventory; Small inventory can lead to products that are sold out. Optimal inventory is larger for a
large firm, but is smaller as % of total sales. Therefore, the cost of inventory is relatively smaller
for large firms
4. Cube-square rule; If we double the volume of a container, the surface area less than doubles.
Important for breweries, tanks, vessels, pipes, etc.
We measure economies of scale with the output elasticity (MC/AC): If MC/AC<1, then economies of
scale, if MC/AC>1, then diseconomies of scale.
Economies of scope occur when the cost of the joint production of different goods is lower than the
cost when producing the goods separately. So, in other words: TC( Q
1
,Q
2
) < TC( Q
1
,0 ) + TC( 0,Q
2
).
Experience advantages yields that the cost per unit of production decreases if volume increases. So,
a new firm with low cost of input can have higher cost than existing firm with high cost of input. If
there are significant experience effects, new firms with lower cost than incumbent firms must run
short term losses. Therefore, governments give financial support to new (loss making) firms using the
argument infant industry argument.
Network advantages yields that the demand for a good increases if more people use the good.
Thats why the liberalization of the phone market must ensure that other firms have access to the
network and that the abuse of monopoly is punishable.

The discussed advantages (economies of scale and scope, experience and network advantages) are
exogenous and industry specific. Following Porters 5-forces model, horizontal boundaries depend on
Internal rivalry; Competition for market share, relevant to
market and related to cost structure.
Potential entrants; Entry barriers, structural (discussed above)
and strategic (differentiation).
Threat of substitutes; Determining (cross-)price-elasticity and
strategic patenting.

Internal
Rivalry
Supplier
Power
Entry Substitutes
Buyer
Power
Porters 5-forces model
Chapter 3 Agency and coordination
As firms grow large, they face two problems: How to motivate the employees to take actions that
further the firms goals, and how to coordinate employees actions to achieve the best results for the
firm. When the principal hires an agent to take actions that affect the payoff to the principal, a
principal-agent relationship occurs. Agency problems arise when the objectives of the principal and
the agent are different or when the actions of the agent are not observable by the principal and vice
versa.

Within in a firm, shareholders want maximum profits, while managers could be interested in
enhancing their personnel health, boosting their prospects for the next job, etc. Therefore,
separation of ownership and control (supervisory board) is a key feature in a corporation.
Firms can use several measures to combat the agency problems:
Monitoring; Expending resources on monitoring employees can mitigate the agency problems.
But, monitoring can be expensive, imperfect or add an extra layer in the agency relationship.
Pay-for-performance incentives; The principal can link agents performance to the payoff to the
agent. Examples are sales commission, stock options for executives and non-monetary rewards.
Firms can increase the commission rate and lower the base pay to increase profits, whereas this
base pay can even be negative. Some complexities in a performance-based model could be:
Sales outcomes may be affected by factors not under the sales persons control;
With uncertainty, risk averse employees will demand risk premiums in contracts;
If employee is engaged in multiple tasks he/she may focus on task that brings more reward.
Bureaucracy; Bureaucracy limits the set of actions an employee can take. An example is limits on
discounting by the sales force. Discounting by one sales person may increase his compensation,
while lowering the overall profits for the firm.

Often the best action for one person may depend on actions by others and/or information held by
others. To coordinate all employees actions, organizations can be centralized or decentralized:
Centralized organizations; In centralized organizations, decision-making authority is
concentrated. Centralized organization may not be effective in responding to localized
information. As the organization becomes large, coordination problems become more severe.
Decentralized organizations; In decentralized organizations, decision making authority is
dispersed. Agency problems may lead to coordination opportunities to be missed (resulting in
agency costs).

Related to the size of the firm, influence costs become more substantial when an organization
expands. When an organization expands, there exist more and more divisions and all these divisions
want more and more resources. Resources consumed by influence activities represent influence
costs. This can explain the conglomerate discount: the value of the conglomerate is lower than the
value of the separate divisions of the firm.

Chapter 4 The power of principles
---

Part Two: The Firm Boundaries
Chapter 5 The vertical boundaries of a firm
Whereas the horizontal boundaries of a firm depend on the strategy and the cost structure, the
vertical boundaries depend on the value chain. In other words, the firm has to check which activities
will be undertaken by the firm itself and which activities will be outsourced?
Firms are vertically integrated if they undertake most of their activities by themselves, such as Shell.
This can be measured by the firms added value. Firms who are vertically disintegrated outsource
many activities, for example Nike and Benetton. Vertical integration can be distinguished in forward
integration and backward integration. Forward integration is the expansion of activities downstream
(to the consumer), for example opening own stores. Backward integration is the expansion of
activities upstream (to the supplier), for example buying own resource houses.

Porter developed the 5-forces model to analyze the sector, but he also developed the value chain, to
analyze the firm itself. The value analysis identifies the competitive advantages within the value
chain (Cost leadership, differentiation or focus) and it describes make-or-buy (outsourcing) decisions
within the value chain. Make-or-buy (Outsourcing) decisions depends on:
Scale advantages; Suppose the minimum efficiency scale (MES) is large for an intermediate good.
Then the main producer will not produce it by himself, but he will outsource the intermediate.
Agency costs and influence costs; Agency costs arise when the employer and employee have
different objectives. Higher agency costs will increase the probability of outsourcing. Influence
costs occur when in-house suppliers use this money to shield against pressure from the board to
become more competitive. Large, vertically integrated firms often have more influence costs.
Incomplete contracts; Complete contracts stipulate each partys responsibilities and right, foresee
all possible circumstances, dont allow different interpretations and they eliminate opportunistic
behavior. Incomplete contracts are not able to foresee all circumstances and contain asymmetric
information, which can lead to different interpretations.
Transaction costs; Transaction costs are all costs involved in creating and maintaining a market
relation between partners. With vertical integration, there are less transaction costs. Transaction
costs include the costs of searching for a partner, deal negotiation, writing a contract and
enforcing a contract. Explanations for transaction costs are:
o Idiosyncratic investments (relationship-specific investments); Investment tied to a certain
transaction that cannot be redeployed to another transaction without (productivity) loss.
o Quasi-rent and hold-up; Suppose X makes a profit of
1
with a relation-specific investment to
supply a good to Y. Suppose X can sell the good also to Z for
2
. Then the quasi-rent is the
profit X makes for making the relation-specific investment:
1
-
2
. If quasi-rent is high and
contracts are incomplete, there is the risk of hold-up: Y can threaten to pay X only
2
instead
of
1
.

Recently a trend in disintegration occurs. This can be explained by a growth in the ICT-sector (which
reduces transaction costs), by economies of scale (which increases advantages of outsourcing) and by
institutional changes: Asian countries have undergone significant economic liberalization.

Chapter 6 Alternatives to Vertical Integration
In short terms, outsourcing decisions depends on technical efficiency and agency efficiency.
Therefore, specialized components of a product are often produced in-house, while standard
components are often outsourced. Further, if a firm serves a larger market, its more likely to be
vertically integrated.

A make-or-buy decision is essentially a decision regarding ownership, which brings the residual
control rights with it. Residual rights are rights that are not explicitly stipulated in a contract and they
are for the owner, not for the firm to which the activity is outsourced.
Backward or forward integration affects the incentives to invest in such a relationship-specific asset.
If the investments by the upstream player and the downstream player are of comparable
importance, market exchange is preferred. Or, if the investment by one player is more important in
value creation, vertical integration is preferred and this player will be allocated ownership.
So, decision rights between firms are determined with a contract. But within a firm, decision rights
are also determined, with governance. Actually, its not clear what happens to governance when two
firms merge. Due to the theory of Grossman, Hart and Moore can be applied to divisions within a
firm.
A firm can integrate backward or forward through greenfield investments, merger or acquisition.
Alternatives to vertical integration are:
Tapered integration (make-and-buy); Firm produces part of the inputs and outsources the rest,
which is really common in R&D, or firms sells part of its products through own retail channels and
the rest through independent retailers. Some advantages of make-and-buy are smaller
investment, reduction of asymmetric information and protection against uncertainty in demand.
Some disadvantages are possible coordinating/monitoring problems and splitting production can
increase average cost of their economies of scale.
Joint-ventures and strategic alliances; With a joint-venture, a firm is owned by two or more
parent firms for research, production, marketing, etc. Sometimes firms can only enter a market
through a JV. A strategic alliance is an explicit coordination between two or more firms. These
firms remain independent. It can take several forms, such as license agreements, quality labels
and purchasing pools. Advantages of JVs and SAs are risk reduction, scale advantages and
knowledge exchange. Disadvantages are distrust, free-rider problem and coordination problems
between two different cultures. Instead of contracting, JVs and SAs are primarily based on trust.
Implicit contracts and collaborative relationships; Especially in Japan firms are less vertically
integrated than in Europe or USA. Therefore, Japanese firms organize production with long-run
collaborative relationships with other firms. This gives large subcontracting networks. Within
such a network, an implicit contract exist: these participating firms exchange equity shares and
place individuals on each others board of directors. So, these firms act cooperatively. A
disadvantage is the threat of losing future business if one party breaks the implicit contract.

Chapter 7 Diversification
Diversification across products and across markets can exploit economies of scale and scope.
Diversification that occurs for other reasons tends to be less successful. Diversification can be
measured with the relatedness concept. This concept looks in which degree different businesses
share technological, production and distributional characteristics. Four different types of firms are:
Single; More than 95% of revenue comes from primary activities.
Dominant; 70% till 95% of the firms revenue comes from primary activities.
Related; Less than 70% of revenue comes from primary activities.
Conglomerate; Also, less than 70% of revenue comes from primary activities.
Another measurement of diversification is the entropy measurement, which is -p
i
*ln(p
i
), where p
i
is
the proportion of firms sales in segment i. If a firm is exclusively in one line of business (pure play),
its entropy is 0. For a firm, spread into 20 different lines equally (so, p
i
=5%), the entropy is about 3.

There exist six different efficiency-based reasons for diversification:
Economies of scale; If a merged firm is motivated by scale economies, the market share of the
merged firm should increase immediately, leading to declining average costs.
Economies of scope; If firms pursue economies of scope through diversification, large firms should
be expected to sell related set of products in different markets. But, firms that produce unrelated
products and serve unrelated markets could be pursuing scope economies in other dimensions:
o Resource based view of the firm; Organizational resources of the firm are not fully utilized in
its current product markets. Applying them in other markets, creates economies of scope.
o Dominant general management logic; Seemingly unrelated business may need specific skills,
which are especially developed by managers.
Economizing on transaction costs; If transactions costs complicate coordination, merger may be
the answer. Transactions costs can be a problem due to specialized assets such as human capital.
Diversifying shareholders portfolios; Diversification reduces the firms risk and smoothes the
earnings. When shareholders are unable to diversify, they benefit from such risk reduction.
Identifying undervalued firms; When the target firm is in an unrelated business, the acquiring firm
is less likely to value the target correctly. Winners curse could wipe out any gains from synergies.
Internal capital markets; In a diversified firm, some units generate surplus funds that can be
channeled to units that need the funds (internal capital market). This is more easy than lending
money from a bank, because there are no monitoring costs and no asymmetric information.
There can be costs for diversification, too. Diversified firms may incur substantial influence costs.
Also, diversified firms may need elaborate control systems to reward or punish managers. And, at
last, internal capital markets might not function well in practice (cross subsidization).

There are also managerial reasons for diversification. Managers may prefer growth (even
unprofitable) since it adds to their social prominence, prestige and power. Also, managers may be
able to enhance their compensation by increasing the size of their firm. At last, managers may feel
more secure if the firms performance mirrors the performance of the economy.
The market for corporate control is an important constraint on the managers. If managers undertake
unwise acquisitions, the stock price drops, reflecting overpayment for the acquisition. Acquirers
profit by buying shares at the depressed levels and raising their value by imposing some changes.

In short-run, no real relation exists between performance and diversification. Moderately diversified
firms may have higher capital productivity and unrelated diversification may harm productivity. In
long-run, it looks even poorer: around half of all acquisitions are eventually divested.

Part Three: Market and Competitive Analysis
Chapter 8 Competitors and competition
Competition occurs, when one firms strategic choice (adversely) affects the performance of another
firm. Within direct competition, the strategic choice of one firm directly affects the performance of
another firm. Firms are direct competitors when they produce products that are substitutable, which
means that these products have similar characteristics and are sold in the same geographical area.
Within indirect competition, the strategic choice of one firm affects the performance of another,
because of a strategic reaction by a third firm.
Competition can be identified with the cross-price elasticity:
yx
=(Q
y
/Q
y
)/(P
x
/P
x
). If
yx
>0, the
products are substitutes; If
yx
<0, the products are complements. Another way to identify
competitors are Standard Industrial Classification (SIC) codes, which are numbers for the
identification of products and services.
A market consists of buyers and sellers of a good/service. Theres a difference between perfect and
imperfect competition. Perfect competition consists of many firms, which are all working as efficient
as possible, do not make abnormal profits and which produce homogeneous products. Imperfect
competition contains monopolistic competition, oligopolies and monopolies.

The Structure-Conduct-Performance (SCP) says that an high concentration is bad for consumers.
Forward causation with that is that the market structure affects conduct, which in turns affect
performance. Structure can be measured by the market concentration, which can be measured with
the N-firm concentration ratio (the combined market share of the N largest firms) and with the
Herfindahl index (sum of the squared market shares). Also, entry barriers must be measured. Entry
barriers, such as minimum efficient scale, advertising and R&D, carries out new suppliers. Conduct
can be measured by looking at a firms pricing, product choice, investments, etc. Performance can be
measured with the price-cost margin (Lerner (market power): L=(P-c)/P), profitability (return on
equity/assets), production efficiency and innovative performance (number of patents). The ending
hypotheses of SCP are that market power increases when market concentration increases and that
the larger the entry barriers, the higher the exercise of market power.
So, SCP showed a positive correlation between market concentration and market power. Therefore,
antitrust law came up. This law restrict prices and price agreements (market sharing, price fixing, etc)
and it prohibits the forming of cartels. So, it prevents the effective competition in the common
market. After Chicago school emphasized that economic efficiency, such as cost-reducing innovation,
can lead to dominant positions as well, the antitrust law was declining a bit.
Chapter 9 Strategic commitment and competition
There is a explicit distinction between tactics and strategy. Tactics are short-term and easy to
reverse, while strategy are long-term implications with difficulty to reverse (or even irreversible).
Strategic commitment are the decisions or strategies of the firm that have long term impact and are
difficult, if not impossible, to reverse. Due to this long-term and irreversibility, there is risk and
uncertainty involved. But on the other hand, commitment can have a profound effect on the
decisions of competitors, or the firm has to anticipate changes in terms of market rivalry. So, the
importance of commitment is that it limits the options of the firm, but affects the expectations of
competitors. Commitment is only valuable if its visible, understandable and credible. To be credible,
systematically bluffing doesnt work. Principles of credibility are changing payoffs of the game,
limiting ability to back out of the commitment and using others to help maintain the commitment.

How a competitor reacts on tactical decisions (short-term) depends on whether its a strategic
complement or strategic substitute. Strategic complements occur when a firms action induces a
rival to take the same action. Bertrands model stated that a price decrease of firm X is likely to be
followed by a price decrease of firm Y. In this model, aggressive behaviour leads to more aggressive
behaviour of competitors. Strategic substitutes occur when a firms action induces a rival to take the
opposite action, for example the model of Cournot: an increase in output of firm X is likely to be
followed by a decrease in output by firm Y. This model yields that aggressive behaviour leads to less
aggressive behaviour of competitors.

On strategic commitment, competitors react differently than on tactical decisions. The reaction
depends on whether is a tough or soft commitment. A tough commitment is a commitment with an
adverse effect on competitors of the firm, a soft commitment is a commitment with a beneficial
effect on competitors of the firm. Commitment can result in two effects:
1. Direct effect: The impact on the net present value (NPV) of the firms cash flows, assuming that
the firm adjusts its own tactical decisions in light of this commitment.
2. Strategic effect: The effect of the tactical decisions of competitors on the NPV of the firms cash
flows after the commitment is made.
When committing to a strategy, a firm should not only take the direct effect into account, but also
the reaction of competitors, the strategic effect! In general, commitments that lead to less aggressive
behavior from rivals will have a beneficial strategic effect.

The value of commitment refers to creating inflexibility. However, strategic commitments are made
under uncertainty about market conditions, cost and strategies and goals of competitors. Therefore,
preserving some flexibility can be valuable for the firm. Flexibility can be retained by adjusting
commitment when changes occur, or by postpone commitment till there is more information
available, or by holding the option open for investment in the future, instead of at this moment.
A real option is the choice to adjust an (investment) decision based on future information. Potential
actions in the future can be assigned financial value; the value of flexibility.

Chapter 10 The dynamics of pricing rivalry
---

Chapter 11 Entry and exit
The number of players in a market is likely to change over time, so entry and exit will occur:
Entry is the beginning of production and sales by a new firm in a market. Entry can be done by a
brand new firm or by an established firm that is diversifying into a new market, so a new market
for a new product or a new geographical market. The effect of entrants is that the market shares
of incumbent firms (firms already in the market) reduces, which intensifies competition.
Exit occurs when a firm ceases to produce and sell in a market. Causes for exit could be a simply
fold up of the firm (DSB Bank), the firm may discontinue a particular product or product group
(Sega exits the hardware market) or the firm may leave a particular geographic market segment
(Google in China). Exit on the market leads to an increasing market share of incumbent firms,
which will lower competition.
A firm will enter a market when the sunk cost of entry are lower than the net present value of the
post-entry profit stream, which depends on demand and cost conditions as well as post-entry
competition. And the fact that there are such large differences in entry per industry, is concerned
with entry barriers. Entry barriers reduce the likelihood of entry and affect the returns of both the
incumbent and the entrant. Entry barriers can be distinguished into structural entry barriers and
strategic entry barriers. Structural entry barriers are natural advantages of incumbent firms.
Structural entry barriers are entry barriers such as:
Control of essential resources; Natural resources are really likely to be controlled by incumbents.
Patents can also prevent rivals from imitating a firms products. At last, there might be special
know-how, which is hard to replicate for rivals (the learning curve effect).
Cost advantages (economies of scale and scope); If economies of scale are significant, entrants
may face cost disadvantages (high sunk costs), which is common in capital-intensive industries. If
economies of scope exist, entrants may face cost disadvantages, too. Incumbents may, for
example, produce multiple product lines in the same plant or upfront costs of brand awareness
may be high for entrants.
Marketing advantages; Incumbents can exploit the brand umbrella to introduce a new product
more easily. Further, its easier to negotiate in the vertical chain for incumbents (networks).
Strategic entry barriers are incumbents actions to deter entry. For these strategies, incumbents must
earn higher profits as a monopolist than as a duopolist and the strategy should change the entrants
expectations regarding post-entry performance. With strategic entry barriers, you can think of:
Expanding capacity; By holding excess capacity, the incumbent can credibly threaten to lower the
price if entry occurs. It deters entry, because the incumbent now has a cost advantage and it
cannot back-off from the investment in excess capacity.
Limit pricing; The incumbent sets the price sufficiently low to discourage entrants. If entrant infers
that post-entry price will be low, entry may not be likely. But, limit pricing may lead to sacrifice of
profits or inability to meet market demand. So, over multiple periods, the incumbent may be
better of being a duopolist then limit pricing forever as monopolist.
Predatory pricing; The incumbent sets the price below short-run marginal cost expecting to
recoup the losses via monopoly profits once the rival exits. But, if all entrants can perfectly
foresee the future course of incumbents pricing, predatory pricing will not work. So, predatory
pricing, limit pricing as well, only works if theres asymmetric information for the entrant.
These entry barriers make up the entry conditions of a market, which can be distinguished in
blockaded, accommodated or deterred entry. If theres a blockaded entry, incumbents dont take
any action to deter entry, because existing structural barriers are sufficiently effective. If theres a
accommodated entry, incumbents should not bother to deter entry, because structural barriers to
entry may be low and strategic barriers may be ineffective or not cost effective. If theres a deterred
entry, incumbents deter entry, because strategy to deter entry is (cost-) effective.

Next to entry barriers, there exist also exit barriers. Possible exit barriers are sunk costs (marginal
cost stays low), relationship specific assets may have low resale value and government regulations.

Chapter 12 Industry analysis
---

Part Four: Strategic Position and Dynamics
Chapter 13 Strategic positioning for competitive advantage
A firms ability to create value and enjoy a competitive advantage over other firms depends on how it
positions itself within its industry. A firm has to try to position itself in such a way that it is able to
Focus Group
Uniqueness
Low cost
Value created
relative to comp.
Market
economics Economic
profitability
produce more value relative to its competitors. The difference between the value that resides in the
finished good and the value that is sacrificed to convert inputs into the finished product, is a
competitive advantage. In other words, the sum of the consumer (B-P) and producer surplus (P-C),
which is called the created value (B-C). But, consumers demand the same surplus from the firm as
from its rivals. Even with superior value creation, the firm can still offer as much consumer surplus as
its rivals. Therefore, to achieve competitive advantage a firm must produce more value than its rivals,
which can be done by a value chain analysis. Each activity in the value chain can potentially add to
the perceived benefits, but also to the costs. So, to create more value than its competitors, a firm can
configure the value chain differently or it can perform more efficiently. However, in practice its very
difficult to isolate the benefits and costs of each activity.

A firms generic strategy describes how it
positions itself to create value. We distinguish
three different strategies, the so called Porters
positioning strategies:
Low cost leadership; A cost leader creates a larger value (B-C) by achieving a lower C than its
rivals. The firm can undercut rivals prices and sell more than they do or it can match rivals prices
and attain higher price cost margins than they can. A cost advantage is a suitable strategy when
the nature of the product doesnt allow benefit enhancement, consumers are quite price-
sensitive or when it concerns a search good, so the product quality is known before purchase.
Uniqueness (benefit); A benefit leader creates a larger B C by achieving a higher B than its rivals.
Such a firm can match rivals prices and sell more than they do or charge price premiums and
attain higher price cost margins than rivals can. A benefit advantage is suitable when consumers
are willing to pay a premium, economies of scale and learning are significant or when it concerns
an experience good, so the product quality is only known after purchase and using period.
Focus group; Within focus group, we can distinguish three types of focus strategies:
Customer specialisation: Offer a wide range of products to a narrow customer group.
Product specialisation: Offer limited product variety for a wide range of customers.
Geographic specialisation: Exploit the unique conditions of the region.

Chapter 14 Sustaining competitive advantage
A competitive advantage and a sustainable competitive advantage differ. Competitive advantage
occurs when a firm outperforms competitors. But these rivals can erode the competitive advantage
of industry leaders by imitation or innovation. So, sustaining a competitive advantage over time is
not easy! Sustainable competitive advantage is long-term competitive advantage that is not easily
duplicable or surpassable by competitors. To differentiate, there are two important possibilities:
Differences between firms are persistent because of superior resources and capabilities; This
theory explains sustained competitive advantage in terms of heterogeneity in resources and
capabilities. To support advantage, these resources and capabilities have to be scarce, imperfectly
mobile and unavailable for open market. Else, any other firm could replicate a successful strategy.
Resources are a firms assets, including people and the value of its brand name and represent
inputs (tangible and intangible) into a firms production process. Capabilities are the firms
capacity to deploy resources that have been purposely integrated to achieve a desired end state.
They emerge over time through complex interactions among tangible and intangible resources
and are often based on developing and exchanging information through the firms human capital.
Isolating mechanisms may work to protect competitive advantage; Isolating mechanisms limit the
rivals from eroding a firms competitive advantage. These mechanisms are to firms what barriers
to entry are to industries. There exist two groups of isolating mechanisms:
o Impediments to imitation; These impede potential entrants from duplicating the resources and
capabilities of the incumbent firm. Impediments are legal restriction (patents), superior access
to inputs or customers (vertical integration), market size and economies of scale (specialized
Knowledge
Absorptive capacity:
Absorb information &
turn into knowledge.
Innovation
Absorb knowledge &
turn into innovation.
Information
Explicit (formalized)
Implicit (experience)
products) and intangible barriers, which exist if the firms advantages lies in distinctive
organisational capabilities.
o Early mover advantages; These are advantages of which the economic power increases over
time. Four important types of advantages are learning curve (more experienced from the
beginning), switching costs (costs of switching to other supplier), reputation and buyer
uncertainty (reputation can provide quality) and network effects, which exist if customers
value the product, depending on how many others are using the product.
Most networks are based on standards, which are difficult to replace. Therefore, replacing a standard
can be done by attracting early adopters or offering superior quality and new options. But, a firm can
also accept the standard to avoid high costs of replacing the standard.

Chapter 15 The origins of competitive advantage: innovation, evolution and the environment
To acquire competitive advantage, a firm has to anticipate on unmet and
unarticulated consumer needs somewhere in the future. This can be done by
investing in development of new products and capabilities to produce and
distribute these products, so in general by innovation. Innovation has two
dimensions: product innovation is the introduction of a new product or a product
of improved quality, while process innovation is the introduction of a new method
of production. Furthermore, innovation can be characterised in three groups:
Radical innovation: The development of new products or production processes
that are based on new operational or scientific principles.
Organisational innovation: The introduction of a new way to assemble existing components.
Incremental innovation: Relatively small improvements of an existing product or process.
Innovation enlarges consumer surplus, for example by quality improvement and lower product costs.

Innovation can be considered a shock (fundamental change that lead to shifts in competitive
positions in a market). So, competitive advantage arises from a firms ability to exploit market shocks.
A market have periods of comparative quiet punctuated by shocks and discontinuities. Creative
destruction arises when new sources of competitive advantage displace established ones. Due to
creative destruction, disruptive technologies arise. These technologies clear the market and displace
less efficient products, processes and organisational forms. Therefore, life expectancy of competitive
advantage shrinks as technology and tastes change rapidly. During periods of comparative quiet,
firms that possess superior products and technology earn economic profits. In particular industries,
competitive advantages can only be sustained for very short periods. Firms in these industries
continually seek new sources of competitive advantage. Such an industry has a hypercompetition.
On the economy, technological improvement and long term economic growth is more important
than optimal allocation of resources at a given point in time. Also, society benefits more from
competition between new products, new technologies and new forms of organisation than from
price competition. These arguments are also used to defend monopolies.

Established firms face certain incentives to refrain from innovation:
Sunk cost effect: Profit maximizing firm sticks with its current technology even though the profit
maximizing decision for a firm starting from scratch, would be to choose a different technology.
Replacement effect: Despite equal innovative capabilities, an entrant is more willing to spend
more to develop an innovation. Therefore, a monopolist can only replace itself.
But, sometimes these monopolistic firms do innovate:
Efficiency effect: A monopolist usually has more to lose from another firms entry than that firm
has to gain from entering the market. Therefore, the monopolist has to try being more efficient.
All three effects will work simultaneously to determine if the incumbent will innovate or not. If the
probability of innovation by entrants is low, replacement and sunk cost effects may dominate. If the
potential entrants will capitalize on incumbents failure to innovate, the efficiency effect is dominant.
Ideas and technologies can also be bought. The innovator has bargaining power and can realise the
full value of the innovation whenever the technology is protected by patents and the necessary
knowledge to market the product is not scarce. Otherwise, the balance of bargaining power shifts
away from the innovator to the established firm that possesses this scarce expertise.

Part Five: Internal Organization
Chapter 16 Performance measurement and incentives in firms
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Chapter 17 Strategy and structure
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Chapter 18 Environment, power and culture
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