Last week we took a quick look at the competitive advantage. This week we will take a closer look at the idea of competitive advantage and how it relates to the whole concept of competitive markets and the existence of market power. First, we need to add some empirical content to the definition. Bruce Greenwald and Judd Kahn in their book Competition Demystified provide some useful parameters for us to use in such an effort. Starting out, they argue, care must be taken to define the industry/market that a firm works within. This is important for two reasons: measurement of market share and calculation of performance of a firm. The measurement of market share is important because one of the criteria for identifying companies with market power is that market shares within an industry must be relatively stable. That is, real competitive advantage must be sustainable. In more competitive industries, market share is less stable and changes can take place relatively frequently.
The second reason that industry/market definition must be reasonable is that evidence of sustainable competitive advantage can be discerned in situations where a firm earns an after-tax rate of return on invested capital that is in excess of the firms cost of capital. To Greenwald and Kahn this means that a firm that possesses competitive advantage must earn an after-tax rate of return in the 15% to 25% range. (This can be translated into a pre-tax rate of return in the range of 23% to 38% if one assumes a tax rate of 35%.) One problem in finding firms that have competitive advantage is that the firms operate may operate in several market or industry spaces. As a consequence, the ‘company’ rate of return may be rather average whereas they may operate in one or more markets or industries where they really do possess competitive advantage. Internally, it is important for a management (as well as investors) to understand the different market segments or industries that a firm works in so as to be able to identify exactly how the company is performing and why. Note that firms that do not possess competitive advantages will earn in the range below 10% after-tax rates of return.
The important question, of course, is what accounts for sustainable competitive advantage. Michael Porter has identified five elements that a firm must consider when looking for and achieving sustainable competitive advantage. These five forces are labeled barriers to entry, demand advantages, supply advantages, industry rivalry, and the existence of substitute or complementary products. In this posting we will follow Greenwald and Kahn and just focus on barriers to entry and demand advantages. Greenwald and Kahn argue that these two forces tend to be the predominant cause of competitive advantage. Barriers to entry pertain to all those advantages that exist that limit the ability of potential competitors to enter an industry whether they be government rules and regulations, economies of scale, knowledge or specialized resources. Demand advantages are related to customer captivity that result from things like habit, search costs, or switching costs.
Porter has been accused of providing instructions to firms on how to reduce competition. And, in reality, the five forces analysis is a recipe for finding out how a firm can achieve and maintain market power, which is basically the power to set prices at optimal levels. Firms that don’t possess market power are said to be price takers whose primary decision is the quantity that the firm will produce. Thus, the Porter approach is a methodology for creating market power and reducing price competition.
Historically, economists have presented a picture of industry rivalry as a continuum going from perfect competition, say on the left end, to monopoly, on the right end of the spectrum. (In between we list monopolistic competition, to the right of perfect competition but to the left of oligopoly, the latter being to the left of monopoly.) The two extreme models are the most completely defined and hence serve as the starting point for understanding different market structures. (Milton Friedman would only discuss these two extremes because they were the two models that were most rigorously constructed and logically consistent.) The primary assumptions behind the model of perfect competition are as follows: the market is made up of small, identical participants, both on the buy and sell side of the market; all producers supply a product/service that is exactly the same; there are no barriers to entry to or exit from the industry; there are no transaction costs; complete information; and all firms operate under constant costs of production. The primary assumptions behind the model of the monopolist are: one producer; one differentiated product/service; barriers to entry and exit exist; there may be transaction costs; information may be incomplete; and there may and probably are economies of scale. In the perfectly competitive case all buyers and sellers are price takers: no matter how much they buy or sell in the market they cannot affect the price posted in the market. The monopolist is a price maker.
In between there are all sorts of different combinations of characteristics of firms and industries. One can strongly argue that distinctions are not two-dimensional, but multi-dimensional, and the concepts of the oligopolistic industry and the monopolistically competitive industry are just models that were historically relevant at one time or another. What is crucial in the Greenwald and Kahn analysis is that firms tending to have market power or competitive advantage tend to earn after-tax rates of return on invested capital that are in excess of their cost of capital and exhibit relatively stable market shares. Firms that tend to lack market power or competitive advantage tend to be smaller, find that their market share is relatively unstable and earn after-tax returns on invested capital that are around their cost of capital.
It is crucial to understand that competitive pressures are constantly pushing firms with market power or competitive advantage to the left (in terms of the competitive continuum). If there are excess returns being earned, and there are no barriers to entry, firms will compete vigorously to participate in those excess returns. Thus, market power or competitive advantage must be continuously defended and efforts must constantly be made to enhance or expand it. (Microsoft is an obvious choice for an example of this latter behavior. Tiger Woods is another.) This approach must be intentional it doesn’t just happen.
But, you must be realistic. The market and competitive conditions may be such that you cannot maintain competitive advantage and even intentional efforts to sustain it or enlarge it may not be successful. In such case, management must be realistic about their situation and accept the fact that their firm and their industry is moving more toward the competitive end of the spectrum. In such cases, Greenwald and Kahn argue that strategies to attain market power must be abandoned and emphasis must be placed upon tactics such as improving operational efficiencies and cutting costs.
An example relating to this latter case is that of General Electric. When GE evolved into a company where competitive advantages had been lost it needed to head in another direction. Jack Welch was brought in and his early years were spent in improving operational efficiencies and cutting costs. GE companies that didn’t perform up to goals were then spun off and sold. Many now argue that GE is at the stage where it is worth more as separate companies. GE’s days of exceptional earnings may be over.
Last week we examined the financial services industry and discussed the problems in the subprime market. Here financial innovation relating to mortgage-related securities developed products in which there were no barriers to entry and customer captivity never existed. Competition reduced returns and banks, in order to keep up revenues, cut corners in an effort to generate large volumes. Another example of vanishing market power can be found in energy. Energy markets had been regional in nature up until the 1990s. When energy markets became national, there appeared the opportunity to arbitrage between regions where energy costs were low and regions where energy costs were high. Enron became a leader in these arbitrage activities. But, there were no barriers to entry and no customer captivity. In order to try and earn acceptable returns, the company resorted to extra-legal means rather than finding a business model that was more appropriate to the existing market. Lesson learned: be realistic about your markets.