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Levinthal (1995) found out that the principal mission of strategic management is the analysis of performance variety within the firms. Two prime theories explained and have heavily influenced the answer to the question of performance differences within firms. One theory's focus is on differences in the performance of industries-and in addition, firms-are characteristic to the economic attractiveness of the structural features of the industries within which they are associated. This line belongs to the school of economic explanations of performance heterogeneity, primarily subjected to performance differences between industries.
Illustrating upon economic heredity but changing the centre of attention away from industry structure, another stream has conceived that differences in firm success are characteristic to internal or firm-level factors. This stream contemplates on resources as the unit of analysis in determining performance heterogeneity within firms. Consequently, two leading explanations of the sources of competitive advantage have surfaced in the literature, mainly in the last 30 years. The first main group follows the structure-conduct-performance (SCP) paradigm of traditional industrial organization (IO). The second group is known as the resource-based view of the firm (RBV), based on a firm's factor tradition.
Conventional Industrial Organization Economic Theory
Economic theory has a stretched and rich practice and includes a range of 'schools' to which individual theorists have contributed over the last 75 years. Though a number of schools seek to understand the determination of performance variance within firms with a level of focus on firm-level factors, strategic management has been mainly influenced and grounded by industrial organization economics (Porter, 1981). Industrial organization economics mainly concentrates on industry structure as the main determinant of performance within industries, while paying no attention to the importance to intra-industry heterogeneity. The external environment is quarreled to be a central subject matter within traditional IO (Mauri and Michaels, 1998).
Mason (1939) was within the first to suggest that there is a deterministic connection between industry structure and firm's performance. Later on, Bain (1959), one of Mason's students at Harvard University, presented his seminal work which focused on the structure-conduct-performance (SCP) model. The SCP model confirms the importance of industry structure as one of the key determinant of the performance variance between firms competing within different industries.
In the Bain-type industrial organization (IO), conduct can largely be ignored as performance is determined solely by structure (Porter, 1981) because industry structure determines firm conduct. In fact, most of the intellectual work has observed the structure-performance association, efficiently ignoring behavior (Scherer, 1980). Phillips (1974) proposes that a firm's performance depends on industry structure alone, therefore, behavior is determinable. Summarizing the SCP, Porter (1981) states:
"The essence of the [Bain] paradigm is that a firm's performance in the marketplace depends critically on the characteristics of the industry environment in which it competesâ€¦Industry structure [Bain proposed] determined the behavior or conduct of firms, whose joint conduct then determined the collective performance of the firms in the marketplace".(p. 610, 611)
Within the structure-performance model, the roles of firm size and industry
concentration are predominantly emphasized. Bain (1954, 1956), for example, highlights
that industry concentration and barriers to entry act together to increase the performance of
large firms. Also, Martin (1993) claims that, economies of scale, product differentiation, and absolute capital requirements act as barriers to entry. In this regard, larger firms lean to be the benefactors of such structural occurrence.
The formation of high levels of industry concentration, on the other hand, tends to
encourage collusive and even monopolistic conduct, which allows firms to experience
market power while purposively confining competition (Conner, 1991; Jacobson, 1992;
Martin, 1993; Grant, 2002).
Firms who hold back output can then charge higher prices, thus gaining a profit through a synthetically high market price. In addition, the restriction of rivalry, forces customers to accept inferior quality products because the benefits of innovation are controlled in the market (Jacobson, 1992).
The capability to build strong barriers to entrance and the chase of monopoly control tends to support larger firms, given the postulation of relatively stable, stagnant market environments within the Bain-type IO theory (Porter, 1981; Sampler, 1998; Jacobson, 1992; Makadok, 1999). Applying IO rational to the development of a competitive strategy, the key then, is to select a field whose structure is beneficial to imperfect competitive dynamics whereby monopoly fees can be taken out.
From a resource point of view, whereas neoclassical perfect rivalry theory proposes that firm resources are fundamentally homogeneous and thus entirely mobile and transferable among firms, Bain-type IO theory calms down this assumption in those levels of firm resource heterogeneity may exist; i-e in the form of lawfully protected assets such as patents, those are unique to individual firms (Bain, 1959). However, while levels of firm resource heterogeneity may be standardized in Bain-type IO theory, these variations do not matter as the economic strength or weakness of industry structure eventually determines the possible profit of firms within a given industry (Phillips, 1974; Porter, 1981).
Though much of the theoretical groundwork of the traditional IO model was prepared in the 1930s through the 1950s, Michael Porter's work in the 1980s indicated a
foremost 'revival' of the Bain-type IO model in that he applied IO principles to the field of
strategic management, mainly in the areas of corporate strategy and competitive
benefit (Porter, 1980, 1985). Mostly referred to as the 'five forces' framework.
Porter's early research has conquered the teaching and practice of strategy for more than
30 years and is deep-rooted in the traditions of Bain-type IO economics.
Porter's Five Forces Framework
As with IO economics, Porter emphasized much of his attention on industry structure. Inspecting the level of competition within an industry based on five forces, he
suggests that it is the mutual strength of the five forces that conclude the profit potential
of any industry and thus firms' relative chance for higher performance (Porter,
It is the first structural force is hazard of new entrants that focuses on the strength of an industry's barriers to entry. The first force focuses on the favorability of industry
barriers that may restrict the arrival of new entrants, therefore protecting the industry's
potential profit. Barriers to entry can comprise of economies of scale, product differentiation, and customer loyalty to recognized brands (Hill and Deeds, 1996; Mintzberg et al., 1998).
The higher the barriers/ obstacles to entry, the more probable it is that firms within the industry will look for tacitly collude to uphold those barriers, as a result making it difficult for outsiders to gain entry, which ultimately preserves industrial performance (Hill and Deeds, 1996; Grant, 2002).
The second structural force is the threat of alternate/substitute products and services that focuses on the quantity and level of competition between industries. In industries where
a few products or services substitutes are available, industrial profitability is protected. In
industries where there are many products or services substitutes are easily available, industrial
profitability will for sure suffer. Competition then, depends on the degree to which products or
services in one industry can be replaced by products or services from another industry (Mintzberg et al., 1998; Digman, 1999).
The third structural force is the bargaining authority of suppliers/dealers that focuses on the relative power and control that suppliers/dealers may or may not impose within an industry. If we assume that suppliers would wish to take advantage of their own profits, achieving the highest price for their
products or services is desirable. If there are a few suppliers and strategic, the bargaining power
of firms in that particular industry is then voiceless, so pricing advantage can be attained by
suppliers/dealers which in turn negatively impacts the overall industrial performance and vice versa (Bennett, 1996).
The fourth structural force is the bargaining authority of buyers that focuses on the
customers of that firm and their purchasing power. Buyers always try to bargain for lower
prices with higher quality. In order to do so the firms give concessions to the buyers with bargaining powers necessarily increases
rivalry within the industry, which ultimately eats away the industrial profit margins (Brandenburger and Nalebuff, 1995; Digman, 1999). This is a serious problem in industries where the threat of substitute is high.
The fifth structural force is rivalry amongst the existing competitors that focuses on the competition of firms within an industry to extreme. The other four forces converge on rivalry, that is likened to competition as a 'war' (Mintzberg et al., 1998; Hax and Wilde, 2001). fundamentally, the fifth force looks for, to explain the conduct of firms engaged in this battle for bigger market share and higher performance.
It is important to keep in mind that the five forces are a function of industry and because of this industrial strcture industrial profitability is determined (Digman,
1999). Similar to Bain's structure-conduct-performance (SCP) model, the five forces of industrial structure affects the overall industry performance, and therefore the performance of firms within the industry.
Porter's (1980; 1985) work, however, does set special emphasis on firm's conduct, mostly with respect to strategy development and strategic choice within the framework of industrial structure.8 Known as 'generic' strategies, Porter (1980) argues that firms must choose between three standard strategies:
Cost or differentiation focus
Porter (1985) looks at the external environment as partially exogenous and partially subject to
the influences of firm actions. Porter (1985, p. 7) states, "a firm is usually not a prisoner
of its industry structure. Firms, through their strategies, can influence the five forces. If a firm can shape structure, it can fundamentally change an industry's attractiveness for better or for worse."
in addition, Porter's framework visibly identifies the position of firm conduct in persuading its own destiny. i.e. Firms have to choose a strategy with which they can create an exclusive, invulnerable position against industry rivals. Last but not least, Porter (1985; 1996) does identify the importance of internal activities but this identification does not place the same importance on resources as does the resource-based view of the firm (Wernerfelt, 1984; Barney, 1991).
Condemnation of industry structure:
In a broadly cited study, Schmalensee (1985) scrutinizes the accounting profits of
American manufacturing firms that are enclosed in the Federal Trade Commission Line
of Business Report (FTC LBR) for the year 1975. He comes to know that industry effects explain 19.46 % of the difference in firm profitability of firms while firm effects account for only 0.62 % of the difference.
Hansen and Wernerfelt (1989), by means of a sample of 600 Fortune 1000 firms, study
the relative significance of economic factors such as industrial profitability, market share,
and size of the firm effects and organizational factors (firm-level factors) such as goal
importance and human resources importance. Using data from the Compustat and the Survey of
Organizations (SOO), developed by the Institute for Social Research at the Michigan University, they find that firm-level effects account for just about twice as much of
the profitability variation as industry effects, 38 % to 18.5 %.
Rumelt (1991), confronting Schmalensee's (1985) findings and using FTC LBR data for the years 1974 to1977, argues that the differences in firms' profitability are based unique endowments of resources found in independent firms or single business units rather than on the structural characteristics of an industry. Rumelt discovers that industry effects account for only 4 % of the variance in profitability while firm-level effects account for 46 % of the variance.
McGahan and Porter (1997), also study the earlier work of Schmalensee (1985), Rumelt (1991), sample including manufacturing & services industries in America and a longer time period, including the years 1981-1994. The outcomes show that the industry effects account for 19 % of the business section profitability variance while firm-level effects account for 36 % of the variance in profitability across all the industries.
Hawawini et al. in (2003), reinvestigated the work and study of Schmalensee (1985), Rumelt (1991) and McGahan and Porter (1997), scrutinize 562 firms across 55 industries over a period of ten years, 1987 to 1996. They found that the firm effects account for 36 % in the explained variance in return on the assets while the industry effects account for just over 8 % of the variation in accounting profits.
naturally, firm's success is accomplished by an appropriate fit of internal resources to the external competitive environment. thus, research that compares the firm's factor and the industry structure will probably continue to be a fruitless effort because both the resources and the industry structure are important for shaping strategy and performance (Henderson and Mitchell, 1997). lastly, though studies that compare industry factors with firm level factors may then provide empirical value, such studies do not successfully isolate which of the resources contribute most to the success of the firm.