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So returning back to the fundamental principal.
The existence of these economic profits suggest there's some type of market
inefficiency. So our draw as strategic analysts, our
task is to identify ways in which these market inefficiencies arrive, and how
firms might be able to capitalize on them to gain these economic profits.
That were interested. Now an obvious question would be: Were our
markets perfectly competitive? Is that what we observe in practice?
Well, the facts are, and this is good for business, is that in fact markets aren't
perfectly competitive. And that there are often various
inefficiencies that allow for firms to profit in the economic profit terms.
If we just look at the facts, average industry returns vary across industries,
even controlling for risk. What this basically means is some
industries are simply more profitable than others.
Not surprising. Interestingly, returns among companies
with industries vary even more. So in other words, even within an
industry, we see even greater variance than we see.
Across industries. And then finally, returns for individual
companies vary over time. We talked about Kodak last session.
Kodak, a highly profitable firm for many, many years.
Now with a technological shift, find themselves going bankrupt.
And the chart you see on the slide is a very stylized representation of three
different industries here. You see the density here, the distribution
of the companies within those industries and the returns on the x axis.
And the point is the following We'll see differences in terms of average industry
profitability. Pharmaceuticals on average are more
profitable than computers. And we'll also see differences in terms of
their variance. Textiles has a very high variance where
there's some very, very profitable firms on one end, and then some firms who are
really struggling and often fail and go out of business.
Computers, on the other hand, we might see a much more narrower distribution of
profitability with. Within that industry.
So at the end of the day our job as strategic analysts is really analyzing the
sources of these economic profits. There's a great quote in Brealey and Myers
seminal textbook Principles of Corporate Finance where they talk about exactly this
issue in the context of measuring economic rents as we talked about before.
When you're presented with a project that appears to have a positive NPV net present
value, don't just accept the calculations at face value.
They may reflect simple estimation errors in forecasting future cash flows.
Put/g behind cash flow estimates and try to identify the source of economic rents.
Positive NPV for a product is believable only if you believe that company has some
special advantage. Now I've highlighted this side/g notion,
I've tried to identify the source of Economic rents.
That's what we're going to try to do here as strategic analysts.
And really where we're going for a number of sessions here is diving deeper into
potential generic sources of economic rents.
And in particular, we're going to talk about three different types of economic
rents that can be created. Monopoly rents, Ricardian rents, and
Schumpeterian rents. Let me describe each in turn.
The notion of monopoly rents comes from a branch of economics referred to as
industrial organization economics. Industrial organization economics is very
interested in the potential for firms to have market power, and actually is very
informative to issues around antitrust and the like.
In the industrial organization view, monopoly rents exist when there are some
barriers to entry. In essence, that industry structure
matters. So let's go back to our T-shirt vendor
case. How could our T-shirt vendor avoid the
fate of a competitive market? Well, one possibility is perhaps you need
a license to be able to sell T-shirts outside the stadium.
To the extent that there's licenses are a scarce good that then restricts entry to
the market. And allows for firms that are able to get
one these licenses to very well and to profit from that.
So the ability to stop that entry and to stop that shift out of the supply curve
will allow firms who are within the industry to profit from playing there in
the terms of economic profits. The second perspective we'll talk about
are what as sometimes referred to as Ricardian Rents after Ricardo, a famous
economist from the 19th century. What David Ricardo and others have talked
about is the notion that there might be barriers to entry Imitation.
In the strategy lecture we refer to this as the resource base view.
Unlike structural barriers to prevent entry, the idea here is that, while there
might be entry into the industry, there are things that prevent companies from
copying one another. So let's go back to our T-shirt vendor
case here. In the T-shirt vendor case perhaps you
have some type of copyright or some type of trade mark on the design on your
T-shirt that prevents others from copying you.
So that while others might enter the industry and start selling T-shirts, they
can't sell exactly the same T-shirt as you.
And as a result, you can continue to do very well despite the fact that entry is
occurring. This is in essence this idea of
competitive advantage that we talked about in the last session.
Being able to do things better than those within your industry segment.
Geographically, you see it represented here in terms of a cost advantage.
Imagine two firms, firm one and firm two, that simply have different cost
structures. For the same level of price, we might find
one firm just barely profitable if not profitable at all, whereas another might
find their cost structure lower. In this case, firm number 1 and be able to
profit still from selling, despite the fact that others are struggling in the
market. So the essence of the resource based view
here is that one again, once again there are barrier to imitation and that firm
capabilities and firm structure. Really matter here in terms of achieving
these economic rents. A third perspective we'll talk a little
later, is what is sometimes referred to as Schumpeterian rents, after Joseph
Schumpeter, an Austrian economist who was a professor at Harvard for many years.
And Schumpeter's probably most famous for coining the phrase the gales of creative
destruction. This is what in sometimes referred to in
the strategy literature as the dynamic capabilities view of strategy or economic
rents. There's a recongition that markets are
dynamic, that innovation matters. What you see illustrated here is the idea
that technologies evolve. That over time technologies are replaced
as new technologies come along that are better and replace those technologies.
And you see these different stages over time within industry segments.
If you take our T-shirt vendor case, it may very well be that you come up with a
novel design. You have no protection on it.
There's no way to prevent others from copying you.
But because you're the first to market, you ahve at least a brief window in which
you can achive these economic rents before others copy you.
Perhaps you have an innate ability to do these types of designs and so while
everybody copies your design in the next time, the next game, you come out with yet
another new design that's even better, that attracts even more customers.
And it's kind of this idea of constantly staying ahead of the masses here as they
imitate you and copy you, that allows you to get the economic rents that we're
interested in. Some might point to Apple as a company,
who's been very good about this in recent years of coming up with new products, and
new product classifications. That are constantly ahead of those
imitating what they introduced to the market.
Perhaps a few months or a few years before.
So let me end with, a couple of lessons here that I want you to take away .
If there's only one thing you remember from this series of lectures, it is the
fundamental principle. In perfectly competitive markets, no firm
realizes economic profits. This is a critical principle for business
strategy. It's something I find is sometimes missed
in the popular business press. We get so enamored with markets and
demand. That we forget about competition.
Going back to the mypets.com example. It wasn't that there wasn't a market
demand for online pet supplies. There most definitely was.
It was the competitive aspect and the inability to prevent others from doing
exactly the same business model that ultimately doomed the likes of pets.com.
The second thing I'd like you to remember is this notion of economic profits.
This idea that they are returned in excess of the opportunity cost of capital.
This is kind of above and beyond just your normal accounting profits.
Finally we want to remember that in the real world product markets are rarely
perfect and the firms often have competitive damage and thankfully this is
true or there'd be no reason to have business strategist or perhaps even
business schools, it is this idea that we can capitalize on these inefficiencies
that allows us to have competitive damage and has something that really interesting
and interesting to analyze. Finally, broadly speaking firms may
capture these economic profits in one of two ways.
Either there are barriers to competition. This industrial organization viewpoint.
Or there are barriers to immitation. This resource based viewpoint.
And I'll highlight once again, that over the next couple sessions, we're going to
take a deeper dive Into each of these perspectives and talk about how industry
structure affects profitability, and then how firm capabilities affect
profitability. Thank you very much.