Sustainability

Contributed by Peter Zemsky



The sustainability of competitive advantage has come to have a central place within the strategy field. Sustainability is of interest in contexts where firm heterogeneity is allowing some firm to outperform rivals at some point in time and concerns the extent to which the underlying heterogeneity and the resulting performance differences endure over time. There are a variety of threats to sustainability including mismanagement of organizational strengths and external shifts in the market that undercut the rents from a firm’s position. The focus in these readings, as in much of the strategy literature, is on the treats to sustainability coming from imitation by rivals and entrants that reduce or eliminate the heterogeneity that is the basis for the superior performance. We limit ourselves to the theoretical development of this topic. For closely related empirical work, see Industry and Firm Effects.

The “invasion” of economic concepts from industrial organization into the strategy field in the 1980s, which was spurred by the work of Michael Porter (1980, 1985), gave rise to considerable creative tension in the field. The new industry-level of analysis and the emphasis of economic drivers of superior performance, threatened to shift attention away from the traditional concerns of the field with internal business policies. To a large extent, the literature on sustainability comes directly from attempts to push back against the IO perspective.

Lippman and Rumelt (1982), in the first formal theoretical paper inspired by the distinctive concerns of the strategy literature, demonstrate how superior performance can arise without assumptions of imperfect competition and market power, which are the defining features of the IO approach. In their model there are a large number of potential entrants that can pay a fixed cost to enter an industry. The key assumption is that there is imperfect imitability so that each entrant’s cost function is determined by an independent draw from a known distribution. In equilibrium, firms with bad draws exit and the remaining firms on average must have abnormal returns even when in the case where the firms are all small and have no market power. Ex ante however expected profits from entry are zero. The paper remains an outstanding example of high quality theorizing in strategy. Barney (1986) in his paper on strategic factor markets applies the same reasoning in his verbal argument that from an economics perspective superior performance must be the result of luck.

The “resource-based” alternative to IO economics crystallizes in Barney (1991), one of the most cited papers in strategy. The paper brings together a variety of ideas that were circulating in the field at that time, including the concept of barriers to imitation from Lippman and Rumelt (1982). Important too is the idea from the classic paper by Wernerfelt (1984) that firms can be viewed not just as a collection of product market positions as in an IO approach, but as a collection of underlying resources. Finally, there is an emphasis on sustainability, which was the focus in Dierickx and Cool (1989). Reacting to Barney’s (1986) paper on strategic factor markets. They point out that many firm resources are not purchased but must be built up over time and that there are a variety of mechanisms that sustain asymmetries in resource stocks. All of this comes together in the resource-based perspective where firms as endowed with rent earning resource bundles and to the extent that a firm has valuable, rare and inimitable resources then it will enjoy superior performance. The issue of ex ante creation of the resources from Lippman and Rumelt (1982) and Barney (1986) is dropped and as in Dierick and Cool (1989). The emphasis is shifted to analyzing the extent to which resource asymmetries can be sustained in the face of imitation.

While the resource-based view provided a powerful rallying point for strategy scholars, as a platform for strategy scholarship it became clear over the ensuing decade that the received theory was not living up to the original high expectations. Priem and Butler (2001) forcefully argue that the core argument in Barney suffers from the potential failing of verbal theorizing of being a tautology, with the definition of competitive advantage being too close to the possession of the valuable and rare resources. In addition, the resource-based view has suffered from taking the Wernerfelt (1984) argument too far and viewing firms as only bundles of resources and ignoring the fact that ultimately these resources generate rents by creating competitive advantages in actual product markets. There is a danger that such a one-sided view allows empirical researchers in this tradition to ignore important complexities and endogeneities that arise from the fact that performance data is almost always generated from competitive interactions in product markets.

Both Priem and Bulter (2001) and Barney (2001) in his response, suggest that more formal theory is a promising avenue for advancing resource-based research. Indeed, almost two decades after Lippman and Rumelt (1982) there is a return to formal work on resources and sustainability, starting with Makadok and Barney (2001), who formally study strategic factor markets.1 Pacheco-de-Almeida and Zemsky (2007) study both the sustainability and the creation of competitive advantage. In their model, a leader firm first decides how fast to develop a resource and then a follower decides whether and how fast to imitate the resource. There are time compression diseconomies as in Dierckx and Cool (1989) so that the faster a firm develops the resource, the greater the cost. The paper formalizes two notions of sustainability: whether the follower has an economic incentive to develop the resource and, if it does, how long it takes it to neutralize the leader’s advantage. The paper shows how competitive advantage need not be equivalent to superior performance: Although the leader enjoys a period of competitive advantage for at least some interval of time, the net present value of its profits flows may be lower once one takes into account the differential cost of resource development. Finally, although the strategy literature often suggests that barriers to imitation are good for leaders and bad for followers, here the follower can be hurt by an increase in spillovers that aid imitation because the resulting fast imitation demotivates the leader to develop the resource in the first place.2

Turning to the IO tradition, a useful counter weight to the focus on internal, hard to imitate resources coming out of the strategy literature is provided by the large body of theory on network externalities, as well summarized by Katz and Shapiro (1994).3 When consumer willingness to pay is an increasing function of a firm’s market share due to network externalities, initial advantages are easily amplified and sustained. It is interesting to note the extent to which the concerns of the IO literature on network externalities overlap with those in strategy. Predictions about the outcomes of competition between standards and the existence of winner-take-all corner solutions are highly relevant, while issues of social welfare and pricing are more peripheral. There has been a recent resurgence of this literature with recent work on “two-sided” markets such as ebay and other platforms. However, as the survey by Rochet and Tirole (2006) makes clear, the primary concern here is on pricing decisions and hence this work is of more relevance to marketing than to strategy.

Although the effect of positive feedback where success breeds success is especially powerful when there are strong network externalities that give rise to winner take all markets, these effects are in fact pervasive and operate in many markets with high concentration. Sutton (1991) does a brilliant job of rigorously exploring how the escalation of advertising expenses underlies some of the most sustainable positions, those in the consumer packaged goods industries. Especially inspiring is his integration of game theory modeling, large sample empirical work and detailed case studies. The key theoretical predication is that in advertising intensive markets, concentration is sustained above a minimal threshold even as market size becomes large. The case studies show how the theory developed using simple two-stage games gives rise to positive feedbacks that can play out over time in real markets. Sutton (1998) extends the analysis from advertising to R&D intensive settings.

All of the above literature approaches sustainability from a neoclassical economics perspective of rational optimizing actors. Rivkin (2000) studies imitation using firms that engage in local search among a set of business policies. The paper makes use of NK simulation, which were first brought to strategy in Leventhal (1997). In this tradition, firm heterogeneity arises and is sustained because firms find locally optimal policies and are assumed to stop experimentation. This simulation approach delivers on the original promise in Nelson and Winter (1982) to rigorously study how idiosyncratic organizational routines arise and evolve using simulations, as well as providing micro-foundations for the idea of uncertain imitability from Lippmann and Rumelt (1984). Like the RBV, most NK models suffer from abstracting away from product market competition, although see Lenox at al. (2006) for a notable exception. For more on fit and imitation see Fit.

Although the tension between an IO perspective and a resource-based perspective has provided some impetus to the development of the strategy literature, research on the theory of sustainability has the potential to help better integrate the study of firm resources and product market competition.

Bibliography




1 Other recent formal work on resources are Makadok (2001), which considers the interaction between resource picking and capability building, and Adner and Zemsky (2006), which follows up on the proposal in Priem and Bulter (2001) to elucidate how the ability of resources to create value in product markets may shift over time.
2 Pacheco-de-Almeida and Zemsky (2008) extend the analysis to show that the leader may benefit from reducing barriers to imitation when this can cause a follower to shift from a strategy a developing the resource in parallel to the leader to a strategy of waiting and imitating.
3 A classic paper on network competition of interest to strategy scholars is Katz and Shapiro (1992). For a good overview of the phenomenon see Chapter 7 on networks and positive feedback in Shapiro and Varian (1999).