Theories of Strategy
Lecture 1.1: Economic foundations of strategy
Research question lecture 1.1:
How can the neoclassical theory of perfect competition inform theories of competitive advantage?
- Theories of competitive advantage are best understood as highlighting deviations from the model of
perfect competition that is the theoretical benchmark in neoclassical economics.
o Because perfect competition specifies a (purely theoretical) environment in which there is no
room for competitive advantage. Therefore, competitive advantage can only occur in
environments that deviate from perfect competition.
2. Competitive advantage
Theories of Strategy course
- Theme: Competition
- Research question: How can we explain differences in performance among firms?
A short overview of the strategy field
- Five schools of thought (Stoelhorst, 2008)
o 1960s: The design school
o 1970s: The planning school
o 1980s: The positioning school
o 1990s: The resource-based school
o 1980s and onwards: The process school
- Focus for this course is on the positioning school and the resource-based school
o These two schools focus more on the content of strategy: what is good strategy?
Focus on competitive strategy:
- How to compete
- SBU level
o Strategic business unit: A part of a larger business that can have its own strategy, relatively
independent of other parts of the business
o The focus is on how the firm in that particular line of business can have a competitive
advantage.
Three layers of theory
Economics strategic management (competitive advantage/schools of thought is here) management
- Schools of thought like to give practical guidelines to manager
- They do so by underlying economic principles
Competitive advantage (Rumelt, 2003)
- Competitive advantage is an ambiguous concept
- An example of a problematic definition:
o Ghemawat and Rivkin (1999): “A firm such as Nucor that earns superior financial returns
within its industry (or it strategic group) over the long run is said to enjoy a competitive
advantage over its rivals”.
This is problematic because the idea of competitive advantage should be to help us
explain these superior financial returns.
Competitive advantage – A first start
,
,3. Perfect competition
What will be the performance of firms in a perfectly competitive market?
- Zero economic profit
The model of perfect competition: 5 assumptions
- The large numbers assumption
o Decreasing returns; a large number of buyers and sellers; firms are price takers
- The homogeneity assumption
o Demand is homogeneous; standardized products
- The mobility assumption
o Resources are perfectly mobile; free entry and exit
- The rationality assumption
o Buyers and sellers have complete information and maximize their utility and profit
- The transaction cost assumption
o Transactions are costless
Some basic concepts (Besanko et al., 2000)
- Economic profit (versus accounting profit)
o Accounting profit: what comes in minus what goes out
o Economic profit: take into account opportunity costs.
- Economic costs (versus accounting costs)
- Opportunity costs
o There may be an additional cost in the form of an income that you did not get
These concepts are important because of the model of perfect competition:
- The model is about a world of ‘perfect decentralization’ in which rational agents (homo economicus)
interact exclusively through price-mediated exchange
- The model formalizes an intuition going back to Adam Smith: that free market competition will
maximize collective welfare despite (or even because of) the fact that individual economic agents are
self-interested.
- What the model considers as maximization of welfare is allocative efficiency: the most efficient
allocation of given scarce resources given a certain level of productive knowledge (‘in perfect
competition, there are no opportunity costs left on the table’).
o Each scarce resource will end up in its most efficient use.
Competition in the model of perfect competition
- Competition is:
o Price competition
Agent respond to price signals. Because of the large numbers assumption there is
nothing they can do about the price.
o Entry and exit
If there is temporarily a positive economic profit in a certain industry, that will
immediately attract entry and vice versa.
- Because of this the whole system comes into a general equilibrium
o Because of competition there are no opportunity costs left and social welfare is maximized.
Firms in the model of perfect competition
- Firms are:
o Black boxes
Something goes in, something comes out. What happens in between is not
something that economists care about (in these sorts of models)
o Unitary agents
Firms are seen as one (rational) individual
, Theoretical benchmark (perfect competition)
Principles of strategy: Perfect competition
- Principle 1: When the assumptions of the model of perfect competition are met, there is no room for
performance differences: all firms earn zero economic profit
- Corollary: Any deviation from the assumptions of the model of perfect competition is a possible source
of competitive advantage that can lead to performance differences
Limitations of the neoclassical model
- The firm is treated as a unitary agent
- The firm is treated as a black box
- Preferences are seen as given
- Technology are seen as given
- Agents are seen as fully rational (and entirely self-interested)
- There is no room for increasing returns
4. Schools of thought in economics (Conner, 1991)
Schools of thought View of the firm Central concept Source of performance Role of management
differentials
Neoclassical Input combiner Price mechanism (Market imperfections) Adjust price and
economics production volume
Bain-type industrial Output restrainer S-C-P (industry Market power Develop
organization (IO) structure) advantageous market
position
Chicago school Efficiency seeker Information costs Efficiency Look for efficiencies
in production and
distribution
Schumpeter Seeking new Creative Innovation Make competitors’
combinations destruction positions obsolete
Resource-based view Resource combiner Firm heterogeneity Costly-to-copy Acquire, develop and
resources maintain unique
resources.
The layers of theory
Lecture 1.1: Economic foundations of strategy
Research question lecture 1.1:
How can the neoclassical theory of perfect competition inform theories of competitive advantage?
- Theories of competitive advantage are best understood as highlighting deviations from the model of
perfect competition that is the theoretical benchmark in neoclassical economics.
o Because perfect competition specifies a (purely theoretical) environment in which there is no
room for competitive advantage. Therefore, competitive advantage can only occur in
environments that deviate from perfect competition.
2. Competitive advantage
Theories of Strategy course
- Theme: Competition
- Research question: How can we explain differences in performance among firms?
A short overview of the strategy field
- Five schools of thought (Stoelhorst, 2008)
o 1960s: The design school
o 1970s: The planning school
o 1980s: The positioning school
o 1990s: The resource-based school
o 1980s and onwards: The process school
- Focus for this course is on the positioning school and the resource-based school
o These two schools focus more on the content of strategy: what is good strategy?
Focus on competitive strategy:
- How to compete
- SBU level
o Strategic business unit: A part of a larger business that can have its own strategy, relatively
independent of other parts of the business
o The focus is on how the firm in that particular line of business can have a competitive
advantage.
Three layers of theory
Economics strategic management (competitive advantage/schools of thought is here) management
- Schools of thought like to give practical guidelines to manager
- They do so by underlying economic principles
Competitive advantage (Rumelt, 2003)
- Competitive advantage is an ambiguous concept
- An example of a problematic definition:
o Ghemawat and Rivkin (1999): “A firm such as Nucor that earns superior financial returns
within its industry (or it strategic group) over the long run is said to enjoy a competitive
advantage over its rivals”.
This is problematic because the idea of competitive advantage should be to help us
explain these superior financial returns.
Competitive advantage – A first start
,
,3. Perfect competition
What will be the performance of firms in a perfectly competitive market?
- Zero economic profit
The model of perfect competition: 5 assumptions
- The large numbers assumption
o Decreasing returns; a large number of buyers and sellers; firms are price takers
- The homogeneity assumption
o Demand is homogeneous; standardized products
- The mobility assumption
o Resources are perfectly mobile; free entry and exit
- The rationality assumption
o Buyers and sellers have complete information and maximize their utility and profit
- The transaction cost assumption
o Transactions are costless
Some basic concepts (Besanko et al., 2000)
- Economic profit (versus accounting profit)
o Accounting profit: what comes in minus what goes out
o Economic profit: take into account opportunity costs.
- Economic costs (versus accounting costs)
- Opportunity costs
o There may be an additional cost in the form of an income that you did not get
These concepts are important because of the model of perfect competition:
- The model is about a world of ‘perfect decentralization’ in which rational agents (homo economicus)
interact exclusively through price-mediated exchange
- The model formalizes an intuition going back to Adam Smith: that free market competition will
maximize collective welfare despite (or even because of) the fact that individual economic agents are
self-interested.
- What the model considers as maximization of welfare is allocative efficiency: the most efficient
allocation of given scarce resources given a certain level of productive knowledge (‘in perfect
competition, there are no opportunity costs left on the table’).
o Each scarce resource will end up in its most efficient use.
Competition in the model of perfect competition
- Competition is:
o Price competition
Agent respond to price signals. Because of the large numbers assumption there is
nothing they can do about the price.
o Entry and exit
If there is temporarily a positive economic profit in a certain industry, that will
immediately attract entry and vice versa.
- Because of this the whole system comes into a general equilibrium
o Because of competition there are no opportunity costs left and social welfare is maximized.
Firms in the model of perfect competition
- Firms are:
o Black boxes
Something goes in, something comes out. What happens in between is not
something that economists care about (in these sorts of models)
o Unitary agents
Firms are seen as one (rational) individual
, Theoretical benchmark (perfect competition)
Principles of strategy: Perfect competition
- Principle 1: When the assumptions of the model of perfect competition are met, there is no room for
performance differences: all firms earn zero economic profit
- Corollary: Any deviation from the assumptions of the model of perfect competition is a possible source
of competitive advantage that can lead to performance differences
Limitations of the neoclassical model
- The firm is treated as a unitary agent
- The firm is treated as a black box
- Preferences are seen as given
- Technology are seen as given
- Agents are seen as fully rational (and entirely self-interested)
- There is no room for increasing returns
4. Schools of thought in economics (Conner, 1991)
Schools of thought View of the firm Central concept Source of performance Role of management
differentials
Neoclassical Input combiner Price mechanism (Market imperfections) Adjust price and
economics production volume
Bain-type industrial Output restrainer S-C-P (industry Market power Develop
organization (IO) structure) advantageous market
position
Chicago school Efficiency seeker Information costs Efficiency Look for efficiencies
in production and
distribution
Schumpeter Seeking new Creative Innovation Make competitors’
combinations destruction positions obsolete
Resource-based view Resource combiner Firm heterogeneity Costly-to-copy Acquire, develop and
resources maintain unique
resources.
The layers of theory
