Theories of Competitive Advantage

Strategy is the plan of action that allocates resources and activities and aims at dealing with the environment, achieving a competitive advantage and attaining the organisation’s goals. Competitive advantage refers to what sets the organisation apart from others and provides it with a distinctive edge for meeting customer needs in the marketplace. The choice that will make the organisation different is the essence of formulating strategy. In order to remain competitive, companies need to focus on core competencies, develop synergy and create value.

Competitive advantage is a company’s ability to perform in one or more ways that competitors cannot or will not match. A competitive advantage is said to be sustainable when it has the means to edge out rivals when competing for the favors of customers. Although sustainability is the ideal case for advantages, the most common competitive advantages are leverageable, which means that a company can use them as a catalyst to new ones. The competitive advantages that companies develop will fail if the costumers do not value them as important. Therefore companies must focus on building customer advantages.

Porter argues that competitive advantage results from a organisation’s ability to perform the required activities at a collectively lower cost than rivals, or perform some activities in unique ways that create buyer value and hence allow the organisations to command a premium price. Four different theories of competitive advantage will be examined in this article: The SCP paradigm, Porter’s generic strategies, the resource-based approach and the core competences model.

1. The SCP Framework

In the Structure Conduct Performance (SCP) framework, the way in which the organisation acts is determined by external forces in the industry (market or industrial structure). This school of thought argues that the structure of an industry will determine the strategies (conduct) and that this in turn will determine performance.

  • Market structure: the degree of market concentration, product differentiation, barriers to entry and exit, vertical integration and diversification.
  • Conduct: goals of the organisations, strategies, anti-competitive practices, research and innovation, advertising etc.
  • Performance: a number of performance indicators, output growth, sales revenue growth, profitability, technical progress, employment, efficiency, added shareholder value, added economic value.

Therefore, the structure of the industry is the key parameter in the formation of strategy. Not all strategies are appropriate for all industries, Successful strategies may fail (not produce the intended outcome) if applied as-is in a different environment.

However, this linear paradigm proves itself too deterministic. When strategic managers apply this approach, they take the industrial structure as a given. In this way, their job is to respond to the external forces and plan their strategies in an automated way by analyzing the competitive environment. However in many industries the environment follows turbulence change. Strategists tend to change the environment by designing strategies that will shape it to their needs and their advantage, instead of being spectators to the change. In these cases, the industry structure is being shaped by the strategies, and not the other way round as the SCP paradigm argues.

2. Porter’s Five Forces and Generic Strategies

Michael Porter’s work is organizationally rooted in the SCP paradigm. According to his approach, two factors underlie the choice of competitive strategy.

  1. Industry attractiveness and the factors that determine it.
  2. The determinants of relative competitive position within an industry.

In order to analyse the industry attractiveness, Porter developed the Five Forces model. According to that, in any industry competition is mutually influenced by five forces: The entry of new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers and the rivalry amongst the competitors.

Although the Five forces model roots within the SCP approach, Porter differentiates in that he argues that an organisation is not a prisoner of its industry structure. Through their strategies, organisations can shape industry by influencing the competitive forces. For example, industry leaders can influence buyers, suppliers and other competitors, and subsequently shape the underlying industry structure.

Competitive strategy is also influenced by the specific relative position within the industry. Through positioning, organisations can possess two basic types of competitive advantage: low cost and differentiation. These types of competitive advantage result from the ability to cope with the industrial forces better than the competitors. Porter introduces three ‘generic competitive strategies’ for achieving above-average performance in an industry.

  1. Cost leadership, when the organisation tries to become the low-cost producer or operator of the industry.
    • Risks associated with cost leadership include:
    • Changes in technology allow new entrants to become themselves the cost leaders. This risk is minimised by constant research and development, but obviously such investments require rise of costs.
    • Margins fall when costs rise (by internal or external factors). In such scenarios, the differentiation advantage may overcome the cost leadership one.
  2. Differentiation, when the organisation seeks to be unique within the industry along some dimensions that are valued by buyers (higher quality, more functions etc). If it succeeds, it is then rewarded for its uniqueness with a premium price. However, when choosing to differentiate, companies should seek appropriate ways that lead to a price premium greater than the cost of differentiating.
    • Risks of this strategy include:
    • Consumers may choose another differentiated product which they value more, or their needs change over time.
    • Consumers may choose the low-cost products, especially when the price difference tends to be high.
    • Other competitors may imitate the chosen differentiation.
  3. Focus, which rests on the choice of a narrow competitive scope within an industry and the optimization of the strategy for the target segment. In cost focus an organisation seeks a cost advantage in the target segment. In differentiation focus, the organisation seeks differentiation in the narrow segment.
    • Risks associated with focus are:
    • The focus strategy is imitated. In order for this to be avoided, entry barriers are required (e.g. assets valued by the costumers such as customer care services, reputation, etc).
    • The target segment becomes unattractive.
    • Broadly targeted competitors dominate the segment. Again, entry barriers will sustain the competitive advantage experienced.

Organisations that try to position on more than one generic strategy but fail to achieve any of them are “stuck in the middle”. Not only they do not possess a competitive advantage, but they are in a disadvantage situation, since the cost-leader, the differentiators or the focusers are already better positioned.

Although Porter’s positioning framework is an industry standard for more than twenty years, Mintzberg (1998) argues that it constrains creative thought. Strategists do not think outside the box and the given options (cost leadership, differentiation and focus) tend to minimize the process of strategic thinking.

3. Resource Based View (RBV)

According to Barney, the environmental models of competitive advantage have assumed that organisations within an industry are identical in terms of the resources they control and the strategy they pursue. Further, they assume that if resource heterogeneity develops within an industry, it will not last long since strategic resources are highly mobile (they can be bought and sold). The proposed resource-based view substitutes these assumptions. The resource based view model assumes that strategic resources can be heterogeneous and that these resources may not be perfectly mobile. Organisation’s resources include all assets, capabilities, processes, attributes, information, knowledge, etc, controlled by an organisation that enable it to implement strategies that promote efficiency.

In order for a resource to hold the potential of sustained competitive advantage, it must have four attributes.

  • It must be valuable, exploiting opportunities and neutralizing threats.
  • It must be rare among existing and potential competitors. A valuable resource cannot be considered as a source of competitive advantage if it is shared amongst a large number of organisations, because all organisations will have the capability to exploit it and will be lead to a common strategy.
  • It must be imperfectly imitable. Valuable and rare resources can only be sources of sustained competitive advantage if competitors that do not possess them cannot obtain them.
  • There cannot be strategically equivalent substitutes. Organisation resources are strategically equivalent when they can be exploited separately to implement the same strategy. That is, an organisation may be able to substitute a similar resource that enables it to conceive and implement the same strategy. Further, very different resources may also be strategic substitutes.

The proposed resource based view framework reasons that resources heterogeneity and immobility within an industry allow organisation resources to be valuable, rare, imperfectly imitable and not easily substitutable. Such resources will then lead to exploiting opportunities and neutralizing threats, in order for sustained competitive advantage to be achieved.

It should be noted that a distinction is drawn in the literature between resources (tangible) and capabilities (less tangible). The framework of Barney unites both resources and capabilities under the umbrella of “resources”.

4. Core Competences

There are some capabilities that are much less visible and they are more difficult to imitate and establish competitive advantage. These are referred to as core competences. Phahalad and Hamel (1990) take the resource-based approach one step further, through the notion of core competencies. They argue that in the long run, competitive advantage depends on the ability to build core competencies at lower cost and more speedily. Management should consolidate corporate-wide technologies and production skills into competencies that empower individual businesses to adapt promptly to environmental changes.

Three criteria are being used in order to categorize a capability as a core competence. A core competence should provide potential access to a wide variety of markets. It should make a significant contribution to the perceived customer benefits of the end-product. Finally, it should be difficult for competitors to imitate. Examples of core competencies include Apple’s ability to create from scratch and innovate and Sony’s ability to miniature.

According to this framework, the common mistake that companies do is to outsource and finally lose their core competences, led to this by the strict perception of competitiveness in terms of price/performance. Although a more competitive product may result, competitiveness cannot be sustained as core competences will be surrendered. Another common mistake is that companies often miss opportunities to establish competences that are evolving in existing business. At the Strategic Business Unit level, existing core competencies are often being sabotaged by under-investment and improper allocation, which may result in atrophy and missing opportunities.

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