So once again, the fundamental principle

of business strategy is that in perfectly competitive markets, no firm

realized economic profits or rents. This suggest that the existence
of economic profits suggests some type of market
inefficiency and our task as strategists is to identify ways in which firms may
capitalize on these market imperfections. Now as obvious question is, are these
markets actually perfectly competitive? How often are markets
perfectly competitive or not? So here's some empirical data for you. Fact, average
industry returns vary
even after controlling for risk. In other words when we look across
industries, even controlling for the different risk profiles
we might see in industries, we see that the returns vary
across these industries. Even more interestingly, we find that returns across
companies
within an industry vary even more. So in other words, the variance of profitability
within
a given industry tends to be very high. And then third, the returns to individual
companies and the structure of these industries tends to vary over time so
that the returns that a company might get one day might be very different than
what it gets 20 years from now. Think about examples like
I mentioned with Kodak. Very profitable company who fell on hard
times when the market shifted there. So, to just give you some data, and
this is a stylized example here, this data has been smoothed and made to
look nice with a normal distribution, but it illustrates
the fundamental concept here. Here we have three different sectors,
computers, textiles, and pharmaceuticals. The straight lines represent
the central tendencies of those industries in terms of
their return to profitability. What you see is arguably pharmaceuticals
are more profitable than textiles, more profitable than computers. More
importantly, we also see a distribution of
profitability within those segments. So there'll be some firms
that are doing very, very well and others who are doing poorer,
in fact, not even making positive returns. So we get variability both across
industries and then within industries. And then we have this dynamic perspective,
that say these curves are constantly
shifting and moving over time as well. So this suggests again that what we're
doing here is we're trying to analyze these economic profits. And here's a quote
from Brealey and Myers,
who has one of the central corporate finance textbooks called
Principles of Corporate Finance, in a chapter where they talk about
where positive net value comes from. I think this quote does an excellent job
highlighting what the roll
of the strategist is. So what they say is when you are presented
with a project, think of a firm even, that appears to have a positive NPV, don't
just
accept the calculations at face value. They may reflect simple estimation
errors in forecasting cash flows. Probe behind cash flow estimates and try
to identify the source of economic rents. A positive NPV for
a new project is believable only if you believe the company
has some special advantage. So, highlight here,
the source of economic rents. The company has some special advantage. That is, in
essence,
what we're trying to do as strategists. Is identify those underlying
sources of competitive advantage. So, there are two perspectives in
the strategy literature on economic rents. But first, is what it's often
referred to is Monopoly Rents. The idea of Monopoly Rents comes
out of a branch of economics referred to as industrial
organizations economics or we'll call it the industrial
organization view. The idea of Monopoly Rents is that
there's something that prevents That shift in the supply curve that
we talked about previously, here. Some barrier to entry that
prohibits this competition to our perfectly competitive outcome. What could create
that? Consider our t-shirt vendor case. A barrier to entry there might
be a license to operate. Maybe the university gives a limited
number of licenses to sell t-shirts outside the stadium. That would limit entry,
prevent that
supply curve from shifting out all the way, and allow for the potential for
profitability within the segment. The key from the Monopoly Rents
perspective here is that industry structure matters. How do we think about and
analyze the industry structure to understand when there
are these barriers to competition. The second perspective is whats often
referred to the Ricardian Rents perspective named after David Ricardo,
who is a famous 19th century economist. Ricardo is probably most famous for
his theory of comparative advantage. This idea that there are certain nations
that have things that they are better at doing than others. In essence,
this notion of competitive advantage. This is sometimes referred
to in the strategy literature as the Resource Based View. Unlike the Monopoly Rents
perspective, there might actually be
no barriers to entry. There might be numerous firms
entering into the segment but what's critical that there
are various barriers to imitation. So what you see in the graph
here are two firms. One and two, represented by
the two sets of cost curves. AC1, MC1 versus AC2 and MC2. What you see is that firm
one has
a lower cost structure than firm two. At any given quantity or any given price,
their costs are lower than their rivals'. As a result of that both, as price
takers, the second firm actually has a higher
cost structure than the first. And what's critical that as long as what's
called the marginal producer in the market is able to survive, in other words
they cover their opportunity costs. Anyone who has a lower cost structure
than them could actually thrive and survive within the industry and
perhaps do quite well by themselves. Another way to think about Ricardian Rents
is in terms of differentiation. So maybe, in our t-shirt vendor case,
we have different designs. And my design is more
valuable than your design. It's more valued by
customers than your design. As a result, I might have a higher
what we call willingness to pay for my product than you have for yours. What's
critical in both these examples,
both the cost and differentiation example, is that there are some
barriers to imitation. By this we mean other competitors
can't copy what you do. So in the cost example,
maybe it's a trade secret. Maybe you know better than your
competitors how to produce low cost t-shirts. In the differentiation case, maybe
there's some legal barrier to protection, like a copyright that
you have on your design. That prevent someone else
from imitating your design. The key though once again is there's
some barrier to imitation so competitors can't copy what you do. And critical to
this
Ricardian Rents perspective is that firm structure matters. It's not just the
industry structure, but we have to dive into the level
of the firm as well. And understand firm structure. So together these two
perspectives on
rents provide us a way of thinking about how firms achieve superior performance and
help us understand how to
analyze their strategy.