Porter’s five forces and dynamic capabilities in strategy

In the last two decades, one of the most fundamental questions emerging in strategic management is how firms achieve and sustain competitive advantage. In a simplified world, understanding how firms achieve and maintain superior or abnormal returns means comprehending how firms position themselves in a certain market, what they produce and how they use resources at their disposal to do so. In this sense we may distinguish between the positional perspective, developed by Michael Porter, according to which achieving competitive advantage is the result of exploitation of imperfections in the market, the resource based perspective, which states that competitive advantage lies in the ownership of valuable resources, and the dynamic capabilities view, which follows the resource based view but also adds the dimension of time in the equation. In this essay, I will compare and contrast these three views after having described them, and will end by illustrating how they can all be brought together.

According to Michael Porter, operational efficiency (OE) as measured for example by financial management tools is necessary but not sufficient for firms to sustain viable superior returns. Firms that compete on OE can quickly imitate new technologies and management techniques of rivals, and feasibly reorient themselves when competition shifts the productivity frontier outwards. As Porter notes: “Although such competition produces absolute improvement in OE, it leads to relative improvement for no one.” (Porter 1996, HBR, p.63) The dominant idea emerging from Porter’s competitive forces approach developed in the 1980’s is that superior returns are achieved when a company positions itself within its environment in way that creates a quasi-monopoly.

By “environment” we refer to the industry in which the firm chooses to compete and by “position” we mean how the firm decides to compete in this industry. This framework provides a systematic way of thinking about how competitive forces determine the profitability of different industry segments. In the pursuit of a viable competitive advantage, a firm is confronted with a two dimensional consideration: it must identify an attractive industry and additionally it has to make a trade-off between alternative generic strategies in order to assume a clear position in the market. (Porter, 1980)

Industry attractiveness is determined by Porter’s five industry-level competitive forces, namely the power of suppliers and buyers, the rivalry amongst existing firms, the entrance of new competitors and the development of substitute products. The way value is appropriated among suppliers, existing rivals and buyers is determined by their bargaining power. Other constraints on profitability include the threat posed by new entrants, which partly depends on the expected retaliation by existing firms, and the threat of substitute products. When many firms compete in the industry core, there is little product differentiation and no dominant players, excess capacity and low growth increase rivalry and dissipate profitability to others. To defend itself, a firm can raise appropriate barriers to entry or create unique competencies, which often represent different sides of the same coin. (Porter, 1980)

Once an attractive industry is identified, the firm must create a competitive advantage by assuming a unique and valuable position within it. This is sometimes called the “loose brick” strategy, because it refers to a section of the market that is somewhat neglected. Strategic positions mainly emerge from two distinct sources, which are not mutually exclusive and often overlap. Positioning may be variety-based, resting on the choice of products or services that the company will choose to offer rather than the customer segment, or it may be needs-based, resting on the choice to serve a particular segment of customers with differing needs. (access-based is also a third source of positioning that segments customers accessible in different ways, such as rural vs. urban) (Porter, 1996)

As stated earlier, being on an industry efficient frontier and having operational efficiency is not enough to guarantee a sustainable advantage. For a strategic position to be sustainable, the company must also make trade-offs in terms of the way with which it will choose to compete. It must decide both on the source of the competitive advantage it will develop and the competitive scope it will adopt. In this light, Porter provides two strategies for competitive positioning: cost leadership and differentiation. As he notes “Strategy is the creation of a unique and valuable position involving a different set of activities.” (Porter 1996, HBR, p.68)

It is essential that a firm choose to be either a cost leader or a differentiator, because in attempting both it would become a “straddler” and fall below the efficient frontier. Eventually it will become dominated by competitors that have made clearer strategic choices and appeal to a distinctive set of customers. An example of a “straddler” would be Continental Airlines, a company that maintained its full service airline status but tried to imitate Southwest’s “no frills” business model by competing against it on certain routes. Positioning trade-offs become essential to strategy by deterring straddling and repositioning, because competitors that follow those approaches lower the value of their existing activities and undermine their own strategy. (Porter, 1996)

The resource-based view (RBV) approaches strategy from a different perspective. While Porter assumes a firm finds an attractive industry, decides to become a cost leader or differentiator, and acquires the necessary resources to achieve competitive advantage, the RBV is “inside out”. Its basic principles have their roots in the classic approach of strategy formulation, which begins with an appraisal of organizational competencies and resources. Those that are distinctive or superior relative to those of rivals may become the basis for competitive advantage if they are matched appropriately to environmental opportunities. (Peteraf, 1993)

The RBV views the company as a set of physical (inputs) and intangible (reputation) resources and organizational capabilities embedded in the company’s routines, processes and culture, and claims that it is the ownership of these resources that enables a firm to perform activities better or more cheaply than competitors, thus creating superior returns by deploying these competitively distinct resources through strategy. In practice however, it is difficult to identify and evaluate both physical and intangible resources in terms of their market value. In this sense, the RBV links internal capabilities to the external industry environment. To qualify as the basis for an effective strategy, a resource has to pass a number of external market tests that check its inimitability (how hard is it to copy the resource), durability (how long does the resource last), appropriability (who capture the value created by the resource), substitutability (how unique is a resource) and competitive superiority (whose resource is really better). (Collins and Montgomery, 1995)

Similarly, Peteraf has defined four conditions that have to be met for resource and capabilities to qualify as sources of competitive advantage. Heterogeneity ensures that firms at least breakeven, at best earn rents, as firms with more efficient productive factors/resources earn rents above their marginal cost. These rents are Ricardian, meaning that some firms possess superior productive factors in limited supply that cannot be expanded to satisfy demand – they have inelastic supply curves. This leads to other companies entering the market with inferior resources that produce as long as price exceeds marginal cost. Thus, efficient firms can sustain this type of competitive advantage only if their resources are not imitable and expandable freely by other firms.

Heterogeneity is also consistent with the concept of monopoly rents, where profits result from a deliberate restriction of output relative to competitive levels. Heterogeneity then results mainly from product differentiation and positioning. Ex post limits to competition, usually dependent on imperfect imitability and imperfect substitutability, serve as barriers that prevent rents from being competed away. (property rights, patents) Imperfect mobility allows valuable resources to remain a source of sustained advantage because they are specialized to firm-specific needs, and although possibly tradable they are simply more valuable within the firm. (sunk costs) Ex ante limits to competition ensure that the costs incurred to establish a superior resource position do not offset the rents earned. (Peteraf, 1993)

The RBV perspective focuses on strategies that exploit existing firm-specific resources. However, it also invites consideration of strategies for developing new capabilities. In facing an ever-changing economy and global market, managers are forced to look beyond the current competitive advantage held by their firm. Management needs to effectively coordinate and redeploy internal and external competencies to face the changing business environment. Resources, no matter how valuable, eventually become eroded by time and competition. Effective corporate strategies require continual investment to maintain and build valuable resources. The dynamic capabilities view (DCV) developed by Teece, Pisano and Shuen, also an efficiency-based approach, criticizes the positional and resource-based views for being static, in that they do not address the strategic issue in light of rapidly changing environments.

“Dynamic” refers to the capacity to renew competences so as to achieve congruence with a changing environment, while “capabilities” emphasize the key role of management in appropriately adapting, integrating and reconfiguring internal and external organizational resources and skills to this environment. Competitive advantage lies the firm’s processes (such as routines or patterns of current practice), shaped by its specific asset position (resources such as technological or structural assets) and the paths available to it (trajectories). Strategic alternatives available to the firm depend on the past, and the path it has traveled, recognizing that history matters. Like with the RBV, these competencies provide competitive advantage and generate rents only if they are difficult to imitate. (Teece, Pisano and Shuen, 1997)

In terms of focus, the positional perspective is market power oriented, whereas the RBV and DCV are more efficiency oriented. Their disparity essentially lies in how each defines the sources of profitability. According to Porter, the sources of monopoly rents stem from strategizing in such a way that a firm becomes unique within an industry. Competitors become limited by entry barriers and high costs. Such a perspective views strategy as “outside in”, because it is shaped at the industry level. In so far as the entry process is concerned, firms identify an attractive industry, choose a strategy based on conjectures about competitors’ rational moves, and acquire the necessary resources to support the entry.

On the other hand, the RBV suggests that profits come from developing routines and processes that lead to achieving firm-level efficiency advantages. The process here is “inside out”, conceptualized at the firm level. Here, the entry sequence is inversed; firms first identify unique resources, choose the markets in which these resources are likely to earn the highest rents, and turn to these markets to assess how these rents can be optimally utilized. Finally skills, know-how, and general competencies are path dependent, implying that they must be built, and cannot be simply acquired. Strategic change is costly and hard, and occurs incrementally.

Although the resource-based and positional views seem very different, they may be reconciled by identifying elements of each framework in the other. As Collins and Montgomery note in their 1995 article “The RBV combines the internal analysis of phenomena within companies with the external analysis of the industry and competitive environment”. Both frameworks suggest that for a competitive advantage to be sustainable, it must be unique and difficult to imitate. Also, both agree that certain conditions have to be met for resources to qualify as competitive, and use the same language to address these conditions: inimitability matches Porter’s barriers to entry, substitutability matches the threat of substitute products, appropriability is captured by bargaining power and durability is implicit in the sustainability of competitive advantage concept. Similarly, both approaches agree that competitive advantage is likely to be eroded, and the DCV addresses this issue. Finally, the heterogeneity aspect of the RBV is also consistent with the positional view, in that it results from differentiation and positioning.

In reality, even though all three perspectives differ in several ways, it can be suggested that in order for a strategy to be competitively sustainable managers must consider all of them. Managers must have an integrated conception of their business that takes into account the arenas, staging, differentiators, vehicles and economic logic underlying their strategy. Strategy should be viewed as a coherent whole, a central, integrated and externally oriented concept. (Hambrick and Fredrickson, 2001) In his 1996 article, Porter discusses the need for “fit” and mentions that “[…] operational effectiveness is about achieving excellence in individual activities […] strategy is about combining activities.” He agrees that internal core competencies must match external goals. Consistency between activities and processes ensures that competitive advantage cumulates and makes strategy easier to communicate and implement.

Porter mainly distinguishes between first order fit (simple consistency between activities) and second order fit (when activities are reinforcing), which both reduce costs or increase differentiation. In this sense industry positioning, operational efficiency and renewing one’s advantages to adapt to changing times all matter. The same concept is brought up by Prahalad and Hamel in their 1990 article, when they mention that companies need to fully leverage core competencies in order to succeed against competitors, which means harmonizing and combining productive forces across SBUs.

Although the three paradigms discussed above are quite different, we have shown that in some ways they are similar and often complementary. According to some authors like Amit and Shoemaker, the resource perspective complements the industry analysis framework. In today’s rapidly changing business environment, Porter acknowledges in his 1996 paper that firms need to leverage their resources in a way that resembles the core competencies framework in order to maintain competitive advantage. Canon’s attack against Xerox in the plain paper copy market segment is exemplary of a firm that combined all three strategic views in order to succeed. Canon strategically positioned itself by slowly entering the U.S, Xerox’s home market, and appealing to personal copiers, a section of the market Xerox was not interested in. Canon developed new technologies to produce a cheap and small personal copier, but could not have done so without its already developed skills and knowledge in optics, thus leveraging its existing competencies in the way suggested by Prahalad and Hamel and the RBV.

Bibliography:

Collins, D., and Montgomery, C., “Competing on Resources: Strategy in the 1990’s”, Harvard Business Review, July-August (1995) pp119-128

Hambrick, D.C, and Fredrickson, J.W., “Are You Have a Strategy?”, Academy of Management Executive, Volume 15 (2001), pp48-59

Peteraf, M.A, “The Cornerstones of Competitive Advantage: A Resource Based View”, Strategic Management Journal, Volume 14 (1993) pp179-191

Porter, M.E., “What is Strategy?”, Harvard Business Review, November-December (1996) pp61-78

Prahalad, C.K., and Hamel, G., “The Core Competencies of the Corporation”, Harvard Business Review”, May-June (1990) pp79-91

Teece, D.J., Pisano, G., and Shuen, A., “Dynamic Capabilities and Strategic Management”, Strategic Management Journal, Volume 18 (1997) pp509-533