Competition and Performance

Contributed by Michael Ryall



In this section, we trace the development of ideas in strategy about competition and its effect on firm performance. Perhaps not too surprisingly, strategy inherits much of its thinking about the workings of competition from economics. Our purpose is, first, to explore the traditional conceptualization of competition that underpins several central ideas in strategy and, then, to highlight recent work that aims to provide a more precise theoretical foundation for analyzing these issues.
The thesis developed here is that many of strategy’s principal claims are built upon a notion of competition that is implicitly rooted in the ideas of the original neoclassical economists (Jevons, 1879; Menger, 1871; Walras, 1874). Paradoxically, even as much of the work in strategy seeks to distance itself from the bogeyman of neoclassical economics, it yet proceeds to incorporate the essential logic of that paradigm in its analysis of firm performance under competition. This typically leads to an overly simplistic intuition of how competition works. Recent theoretical contributions based upon coalitional game theory expand and refine the traditional view.

Makowski and Ostroy (2001) reviews the history of economic thought with respect to “perfect” competition and, in particular, summarizes a rich, innovative line of work on this subject by these two authors (Ostroy, 1980; Makowski & Ostroy, 1987; Makowski & Ostroy, 1993). The starting point is the “Standard Model” (SM) of economics -- the one commonly found in microeconomic textbooks, featuring price-taking, market-taking, and free entry. The SM traces its origin directly to the founders of neoclassical economics, who viewed “perfect competition” as the inexorable outcome of a production economy -- an equilibrium state of zero profits induced by free entry. Alternatively, this paper updates the definition of “perfect competition” to be a situation in which the “added values” of a market’s agents add up to the aggregate economic value produced in that market. Under this definition, it quickly follows that a firm’s economic profit in a “perfectly competitive market” is equal to its individual marginal product. That is, competition at its most intense guarantees every actor economic profit equal to its added value.1 This is a complete inversion of the traditional intuition regarding the effect of competition on performance.

Next, it is instructive to consider a founding paper from two of strategy’s primary streams: Porter (1979) on industry positioning and (Wernerfelt, 1984) on the resource-based view. Common to each of these is the conclusion that firms enjoy economic profit only in the presence of barriers to competition. This conclusion is consistent with the neoclassical SM, with competition conceptualized as a persistent force of performance erosion.

In (Porter, 1979), the logic of the SM is explicit (p. 137): “In the economists’ `perfectly competitive’ industry, jockeying for position is unbridled and entry to the industry very easy.” This leads to the conclusion (p. 137): “The weaker the forces collectively, however, the greater the opportunity for superior performance.” (Wernerfelt, 1984) extends this logic to firm resources (p. 172): “For purposes of analysis, Porter’s five competitive forces will be used, although these were originally intended as tools for analysis of products only.” Similarly (p. 172), “One can identify types of resources which can lead to high profits. In analogy to entry barriers, these are associated with what we will call resource position barriers.” The thinking of the original neoclassicists is, thus, deeply embedded within both the industry positioning and resourced-based views.2

Brandenburger and Stuart (1996) is the first (and, hence, ground-breaking) paper to advocate the use of cooperative game theory (CGT) in strategy. Although positioned (p. 5) as “following Porter (1980),” this paper represents a marked departure from mainstream thinking up to that point. In particular, the cases examined here meet Makowski and Ostroy (2001)’s definition of perfect competition. As mentioned above, this guarantees that every agent is a full-appropriator. This, in turn, implies the normative conclusion that firms maximize their value-added (“value-based” strategy). It is worth pointing out that the analysis stops short of using the full CGT formalism to derive mathematical propositions, opting instead to illustrate its ideas with specific numerical examples. Thus, the efficacy of value-based strategies in other than perfectly competitive markets is left as an open theoretical question.3

MacDonald and Ryall (2004) focuses upon the “positive” side of competition, characterizing the conditions under which competition alone guarantees strictly positive economic profit (not necessarily an amount equal to its added value). This paper represents a technical advance in the sense that it uses a complete version of the CGT setup to derive formal propositions. The main result demonstrates that the existence of a particular tension between the aggregate value actually produced in an industry and the values of the alternative, arm’s-length transactions available to a specific firm is both necessary and sufficient to guarantee that firm appropriates strictly positive economic profit. In both positive and normative terms, this suggests that superior performance may be associated with resource and industry positions that intensify this tension.

Brandenburger and Stuart (2007) makes a number of significant theoretical advances. Two innovations are especially important: i) the concept of a “biform” game; and, ii) the introduction of an individual “confidence index.” A biform game is a hybrid in which agents take strategic actions (represented in an initial noncooperative stage) the interactive consequence of which is to change the joint competitive landscape (represented by a second, cooperative, stage). The individual confidence index summarizes managerial assessments regarding relative performance on super-competitive dimensions (e.g., bargaining skill). This allows one to associate a specific level of value appropriation with each agent’s competitive interval.4 Taken together, we now have a complete formal setup with which to analyze -- in very refined ways -- how strategic decisions at the firm level alter the balance of competitive and super-competitive factors that affect performance.

In summary, many of strategy’s early conjectures followed from the view that, sans effective barriers, competitors fly into a market like a hail of bullets and drive economic profit to zero. This is consistent with the SM of the early neoclassicists. Recent applications of CGT demonstrate that competition is an inherently neutral force, with both positive and negative effects. This distinction matters. When unbridled competition implies full appropriation, superior performance is associated strategies that lower barriers and raise added value. When the negative effect of competition dominates, ideas in the earlier mainstream literature rest on a much firmer foundation. Typically, economic performance is determined by a combination of competitive and super-competitive factors. Presently, the interplay between these determinants and the types of policy levers widely explored in the extant literature (e.g., resource deployments) remains largely unexplored.

Bibliography



1 An agent’s “added value” is the incremental amount of economic value that agent contributes, by virtue of her presence, to the aggregate economic value created.
2 Note the remarkable correspondence between Wernerfelt and the work of Makowski & Ostroy. Wernerfelt opens with the assertion that, “For the firm, resources and products are two sides of the same coin.” Makowski and Ostroy (1995) provide an explicit demonstration that the product-market and firm-resource views are, in a precise technical sense, dual to one another.
3 The answer to which is no; see Gans et al. (2008).
4 Typically, agents face a nontrivial range of payoffs that is consistent with competition.