Background
Neoclassical economic theory (Traditional economics)
Assumes equilibrium and perfect competition. Focus on individual decision-making (consumers and firms)
● Assumes Equilibrium; a stable state, where supply equals demand in a market
● Assumes perfect competition (in baseline models). Assumptions in the model of perfect competition;
○ Large numbers: decreasing returns; a large number of buyers and ellers; firms are price
takers
○ Homogeneity: demand is homogeneous; standardized products
○ Mobility: Resources are perfectly credible mobile; free entry and exit
○ Rationality: buyers and sellers have complete information and maximize their utility and
profit
○ Transaction cost: transactions are costless
● More idealized theory of markets
Industrial Organizations economics (IO)
Focus on market structure in imperfect markets, but still assumes equilibrium
● Builds on neoclassical foundations, but adapts them to analyze strategic competition
● It studies how market structure affects firm behavior and market outcomes
○ Instead of individual decision making of consumers and firms, like neoclassical
● Focuses on imperfect competition: monopoly, oligopoly, barriers to entry, strategic behavior.
○ Few firms, differentiated products, strategic interaction
● Still assumes stable equilibrium states
● Uses Game theory
● Structure-Conduct-Performance: characteristics of the industry (structure; e.g. number of firms,
entry barriers) cause how firms behave (conduct) and therewith cause performance (market outcomes)
Porter’s five forces
● Based on IO and directly links to SCP
● Adapted IO thinking to strategy by turning it into a practical tool
● External forces that shape competition and firm performance; explain why industries differ in
profitability
Porter’s Five Forces: Determine the profitability of firms in an industry
● Rivalry Among Existing Competitors: The intensity of competition between firms in the industry.
● Threat of New Entrants: The ease or difficulty with which new firms can enter the industry and
challenge established companies.
● Bargaining Power of Suppliers: The ability of suppliers to influence the price of inputs, thereby
affecting the firm's cost structure.
● Bargaining Power of Buyers: The influence customers have on prices, which can affect a firm's
profitability.
● Threat of Substitute Products or Services: The extent to which alternative products or services can
replace those offered by firms in the industry.
Resource Based View
● Focus on internal firm resources as key to sustainable competitive advantage
● VRIN (valuable, rare, inimitable, non-substitutable)
● IO focus on external market structure, but RBV focus on internal firm differences
, Week 1 - Course Introduction
Learning objectives:
● Be able to explain what competitive advantage is (not)?
● Be able to account for the main assumptions of neoclassical economic theory of perfect competition
● Be able to distinguish other key economic schools of thought in terms of how they explain performance
differences among firms
Q: What are the economic foundations of competitive strategy?
1. Besanko et al., (2000), Economics of Strategy
Economic costs and profitability
● Accounting costs: Reflect historical costs based on accrual accounting (used for external reporting to
lenders and investors). Objective and verifiable
● Economic costs: based on opportunity cost, the value of the best alternative use of resources
○ Economic costs consider all relevant opportunity costs, unlike accounting costs, so
accounting costs may exclude valuable alternatives - Economic costs provide a better basis
for strategic decision making
● Accounting Profit: Sales revenue minus accounting costs
● Economic Profit: Sales revenue minus economic costs
○ A firm can have positive accounting profit but negative economic profit, which suggests the
firm is not utilizing its resources efficiently compared to the next best alternative.
○ The revenue you make, minus the revenue you could have made (given all the options you
have)
Theory of the firm: Pricing and Output Decisions
● The firm's goal is to maximize profit by setting prices and quantities optimally.
● Marginal Revenue (MR) and Marginal Cost (MC):
○ The firm maximizes profit when MR = MC
○ If MR > MC, the firm should increase output; if MR < MC, the firm should reduce
output.
➢ Firms should use marginal analysis to make pricing and output decisions that maximize profit. This
involves adjusting output levels based on the relationship between marginal revenue and marginal cost.
➢ Firms need to consider the price elasticity of demand and the contribution margin (PCM) when
deciding whether to raise or lower prices.
Perfect Competition
● In a perfectly competitive market, firms produce identical products and compete only on price. Firms
have no control over market price.
● In perfect competition, where products are identical, firms only compete on price; and produce at the
point where price equals marginal cost (P = MC). Firms cannot earn a profit above their opportunity
cost, and new firms enter when there is profit.
● Long-Term Equilibrium: In the long run, firms in a perfectly competitive market will earn zero
economic profit because any short-term profits attract new entrants, increasing supply and lowering
the price.
● Zero economic profit: investors are earning returns on their investments that are equal to what they
could earn from their next best opportunity. This does not mean zero accounting profit, as firms may
still have positive accounting profits even at zero economic profit.
, ● Firms that rely on easily imitable products or resources are at risk in perfectly competitive markets,
where profits are eroded by competition. To achieve sustainable competitive advantage, firms must
protect their position from imitation.
● The key to long-term success is managing resources in a way that consistently leads to positive
economic profit, which reflects a firm’s ability to generate value beyond its opportunity cost.
2. Conner, Kathleen R. (1991), A Historical Comparison of Resource-based Theory and Five
Schools of Thought within Industrial Economics
Article compares RBT with Five Schools of Thoughts from Industrial Organization Economics. Found that RBT
focusing on firms internal resources, is contrasted with IO’s emphasis on market structure and external forces.
● RBT differs from IO schools by focusing on internal firm differences, rather than just market
structure (like IO does)
○ Assumptions of IO are:
■ Firms operate under various market structures
■ Firm behavior and performance depend on industry characteristics
■ Focuses on external forces and market-based explanations of performance
○ Assumptions of RBV are:
■ Firms are heterogeneous (varying) in their resource endowments
■ Resources are imperfectly mobile (not easily traded or transferred)
■ Competitive advantage stems from unique, firm-specific resources
Theory of the firm
● A theory of the firm should explain:
○ Why firms exist instead of just market contracts
○ Why firms differ from each other
○ What determines firm boundaries and internal organization
● Conner evaluates each IO school and RBT against this standard
IO School of Thoughts
● Bain-type: advantage comes from Market power (positioning, Porter), not from resources
○ Performance depends on industry structure (e.g. entry barriers, market concentration)
○ Doesn’t explain why firms exist or how they differ internally
○ Firm-level differences are less important
● Chicago school of thought focus on efficiencies
○ Assumes markets are efficient and firms don’t sustain long-term profits without superior
efficiency
○ Entry barriers rarely exist
○ Any firm advantage is competed away over time
○ Like neoclassical economics, assumes homogeneous firms and perfect information
● Schumpeter school of thought focus on innovation
○ Innovation is the key driver of economic growth and competitive advantage
○ Emphasizes innovation, entrepreneurship, and creative destruction
■ "creative destruction"—replacing old ways of doing business with new ones
■ First mover advantage
○ Firms compete by developing new products and technologies (innovation)
○ Accepts that firms differ in capabilities and outcomes
○ Closer to RBT in recognizing firm-level innovation and change over time
○ Entrepreneurs play a central role by combining resources in new ways to create new
business models, products, or markets
○ Competitive advantage is temporary, because innovation is followed by imitation
● Williamson Transaction Cost Economics (TCE)
○ Firms exist to reduce transaction costs (e.g. costs of contracting, bargaining, monitoring)
Neoclassical economic theory (Traditional economics)
Assumes equilibrium and perfect competition. Focus on individual decision-making (consumers and firms)
● Assumes Equilibrium; a stable state, where supply equals demand in a market
● Assumes perfect competition (in baseline models). Assumptions in the model of perfect competition;
○ Large numbers: decreasing returns; a large number of buyers and ellers; firms are price
takers
○ Homogeneity: demand is homogeneous; standardized products
○ Mobility: Resources are perfectly credible mobile; free entry and exit
○ Rationality: buyers and sellers have complete information and maximize their utility and
profit
○ Transaction cost: transactions are costless
● More idealized theory of markets
Industrial Organizations economics (IO)
Focus on market structure in imperfect markets, but still assumes equilibrium
● Builds on neoclassical foundations, but adapts them to analyze strategic competition
● It studies how market structure affects firm behavior and market outcomes
○ Instead of individual decision making of consumers and firms, like neoclassical
● Focuses on imperfect competition: monopoly, oligopoly, barriers to entry, strategic behavior.
○ Few firms, differentiated products, strategic interaction
● Still assumes stable equilibrium states
● Uses Game theory
● Structure-Conduct-Performance: characteristics of the industry (structure; e.g. number of firms,
entry barriers) cause how firms behave (conduct) and therewith cause performance (market outcomes)
Porter’s five forces
● Based on IO and directly links to SCP
● Adapted IO thinking to strategy by turning it into a practical tool
● External forces that shape competition and firm performance; explain why industries differ in
profitability
Porter’s Five Forces: Determine the profitability of firms in an industry
● Rivalry Among Existing Competitors: The intensity of competition between firms in the industry.
● Threat of New Entrants: The ease or difficulty with which new firms can enter the industry and
challenge established companies.
● Bargaining Power of Suppliers: The ability of suppliers to influence the price of inputs, thereby
affecting the firm's cost structure.
● Bargaining Power of Buyers: The influence customers have on prices, which can affect a firm's
profitability.
● Threat of Substitute Products or Services: The extent to which alternative products or services can
replace those offered by firms in the industry.
Resource Based View
● Focus on internal firm resources as key to sustainable competitive advantage
● VRIN (valuable, rare, inimitable, non-substitutable)
● IO focus on external market structure, but RBV focus on internal firm differences
, Week 1 - Course Introduction
Learning objectives:
● Be able to explain what competitive advantage is (not)?
● Be able to account for the main assumptions of neoclassical economic theory of perfect competition
● Be able to distinguish other key economic schools of thought in terms of how they explain performance
differences among firms
Q: What are the economic foundations of competitive strategy?
1. Besanko et al., (2000), Economics of Strategy
Economic costs and profitability
● Accounting costs: Reflect historical costs based on accrual accounting (used for external reporting to
lenders and investors). Objective and verifiable
● Economic costs: based on opportunity cost, the value of the best alternative use of resources
○ Economic costs consider all relevant opportunity costs, unlike accounting costs, so
accounting costs may exclude valuable alternatives - Economic costs provide a better basis
for strategic decision making
● Accounting Profit: Sales revenue minus accounting costs
● Economic Profit: Sales revenue minus economic costs
○ A firm can have positive accounting profit but negative economic profit, which suggests the
firm is not utilizing its resources efficiently compared to the next best alternative.
○ The revenue you make, minus the revenue you could have made (given all the options you
have)
Theory of the firm: Pricing and Output Decisions
● The firm's goal is to maximize profit by setting prices and quantities optimally.
● Marginal Revenue (MR) and Marginal Cost (MC):
○ The firm maximizes profit when MR = MC
○ If MR > MC, the firm should increase output; if MR < MC, the firm should reduce
output.
➢ Firms should use marginal analysis to make pricing and output decisions that maximize profit. This
involves adjusting output levels based on the relationship between marginal revenue and marginal cost.
➢ Firms need to consider the price elasticity of demand and the contribution margin (PCM) when
deciding whether to raise or lower prices.
Perfect Competition
● In a perfectly competitive market, firms produce identical products and compete only on price. Firms
have no control over market price.
● In perfect competition, where products are identical, firms only compete on price; and produce at the
point where price equals marginal cost (P = MC). Firms cannot earn a profit above their opportunity
cost, and new firms enter when there is profit.
● Long-Term Equilibrium: In the long run, firms in a perfectly competitive market will earn zero
economic profit because any short-term profits attract new entrants, increasing supply and lowering
the price.
● Zero economic profit: investors are earning returns on their investments that are equal to what they
could earn from their next best opportunity. This does not mean zero accounting profit, as firms may
still have positive accounting profits even at zero economic profit.
, ● Firms that rely on easily imitable products or resources are at risk in perfectly competitive markets,
where profits are eroded by competition. To achieve sustainable competitive advantage, firms must
protect their position from imitation.
● The key to long-term success is managing resources in a way that consistently leads to positive
economic profit, which reflects a firm’s ability to generate value beyond its opportunity cost.
2. Conner, Kathleen R. (1991), A Historical Comparison of Resource-based Theory and Five
Schools of Thought within Industrial Economics
Article compares RBT with Five Schools of Thoughts from Industrial Organization Economics. Found that RBT
focusing on firms internal resources, is contrasted with IO’s emphasis on market structure and external forces.
● RBT differs from IO schools by focusing on internal firm differences, rather than just market
structure (like IO does)
○ Assumptions of IO are:
■ Firms operate under various market structures
■ Firm behavior and performance depend on industry characteristics
■ Focuses on external forces and market-based explanations of performance
○ Assumptions of RBV are:
■ Firms are heterogeneous (varying) in their resource endowments
■ Resources are imperfectly mobile (not easily traded or transferred)
■ Competitive advantage stems from unique, firm-specific resources
Theory of the firm
● A theory of the firm should explain:
○ Why firms exist instead of just market contracts
○ Why firms differ from each other
○ What determines firm boundaries and internal organization
● Conner evaluates each IO school and RBT against this standard
IO School of Thoughts
● Bain-type: advantage comes from Market power (positioning, Porter), not from resources
○ Performance depends on industry structure (e.g. entry barriers, market concentration)
○ Doesn’t explain why firms exist or how they differ internally
○ Firm-level differences are less important
● Chicago school of thought focus on efficiencies
○ Assumes markets are efficient and firms don’t sustain long-term profits without superior
efficiency
○ Entry barriers rarely exist
○ Any firm advantage is competed away over time
○ Like neoclassical economics, assumes homogeneous firms and perfect information
● Schumpeter school of thought focus on innovation
○ Innovation is the key driver of economic growth and competitive advantage
○ Emphasizes innovation, entrepreneurship, and creative destruction
■ "creative destruction"—replacing old ways of doing business with new ones
■ First mover advantage
○ Firms compete by developing new products and technologies (innovation)
○ Accepts that firms differ in capabilities and outcomes
○ Closer to RBT in recognizing firm-level innovation and change over time
○ Entrepreneurs play a central role by combining resources in new ways to create new
business models, products, or markets
○ Competitive advantage is temporary, because innovation is followed by imitation
● Williamson Transaction Cost Economics (TCE)
○ Firms exist to reduce transaction costs (e.g. costs of contracting, bargaining, monitoring)
