While accounting measures and stock market returns provide a sense of how well a firm is performing, these indicators may not be ideal if the intent is to understand which firms perform well systematically over the long term. One limitation of those indicators is that they may reflect random perturbations in market outcomes. A firm may have a stroke of good luck that leads it to capture exceptional profits, even if the strategic position of its business is poor. A firm may also have a stroke of bad luck that leads it to have underwhelming profits, even if the strategic position of its business is healthy. A second limitation of these indicators is that firms are not always attempting to carry profits on their books. For example, there are several publicly traded firms that rarely earn profits but are considered healthy, and even thriving, because they use much of their “would be” profits to invest in further improving their businesses.
At a conceptual level, strategic management scholars are often less concerned with specific accounting and stock market performance indicators and more concerned with the idea of competitive advantage. Before offering a formal definition of competitive advantage, it is useful to recall the more familiar concept of economic value creation. Economic value creation (EVC) is the difference between what a customer is willing to pay (WTP) for a product and the cost incurred to produce the product.
EVC = WTP – Cost
The customer’s WTP is also referred to as their reserve price—the maximum they are willing to pay for the product. In this equation, cost reflects the cost incurred by the producer, rather than the cost to the consumer of purchasing the product, which is referred to instead as the price of the product.
Economic value creation may vary across firms. Firms that sell the same product may each incur a different cost of production. Further, consumers may be willing to pay one price when purchasing the good from one firm, but willing to pay another price when purchasing the good from the firm’s competitor. This all implies that the economic value created will differ from firm to firm.
With this in mind, we can now say that a firm has a competitive advantage over a competitor if it has a larger economic value creation than that competitor. For example, if we have two firms, A and B, A has a competitive advantage over B if the economic value created by A exceeds the economic value created by B. The magnitude of A’s competitive advantage is given by the difference between the economic value created by each firm.
The concept of competitive advantage is useful for several reasons. First, unlike measures such as profits and stock price, competitive advantage does not change based on random perturbations. If a firm’s competitive advantage increases, that means that either its economic value creation increased, or its competitor’s economic value creation decreased. These changes, in turn, reflect relative shifts in the cost structure, or relative shifts in consumers’ willingness to pay. Second, the notion of competitive advantage better reflects the strategic health of firms that reinvest in their business, and therefore are healthy, but do not observe profits. For instance, if firm A earns a profit of $100, but then re-invests $98 of that profit into the business to improve the product, then the accounting profits are $2, but the actual health of the company may have improved because the consumers willingness to pay for the product may have increased. Such a firm would still display a large economic value creation measure, and therefore may still hold a competitive advantage.
What is Competitive Advantage? [07:58]
The video for this lesson further explains competitive advantage.
You can view this video here: https://youtu.be/PeCCT7CKpYA.
WolvesandFinance. (2018, February 11). What is Competitive Advantage? [Video]. YouTube. https://youtu.be/PeCCT7CKpYA.