Once again, the fundamental principle of business strategy is that in perfectly competitive markets, no firm realizes economic profits or rents. This suggests 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, an obvious question is, are these markets actually perfectly competitive? How often are markets perfectly competitive or not? 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. 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 may be very different than when it gets 20 years from now and you think about examples like I mentioned with Kodak, very profitable company who fell on hard times when the market shifted there. To just give you some data and this is a stylized example here, this data has been smooth and made it 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 returns or 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 well and others who may or doing poor, in fact, not even making positive returns. We get variability both across industries and then within industries and then we have this dynamic perspective, they say these curves are constantly shifting and moving over time as well. 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 and a chapter where they talk about where positive net value comes from. I think this quote does an excellent job highlighting what the role of the strategist is, so what did they say? They say, "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." Highlight here the source of economic rents, the company has some special advantage, that is in essence what we're trying to do as strategist, is identify those underlying sources of competitive advantage. There are two perspectives in the strategy literature on economic rents, the first is what's often referred to as monopoly rents. The idea of monopoly rents comes out of a branch of economics referred to as industrial organizations economics or we 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 a perfectly competitive outcome. What could create that? Consider a 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 what's often referred to as the Ricardian rents perspective named after David Ricardo who was a famous nineteenth-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 base 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 and that there are various barriers to imitation. What you see in the graph here are two firms, 1 and 2 represented by the two sets of cost curves AC_1, MC_1 versus AC_2 and MC_2. What you see is that firm 1 has a lower cost structure than firm 2. 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 the, 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 for themselves. Another way to think about Ricardian rents is in terms of differentiation. Maybe, in our t-shirt vendor case, we have different designs and my design is 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's 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 there once again is there 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. 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.
