CHAPTER 2 LITERATURE REVIEW
2.1 WHAT IS STRATEGY?
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LITERATURE REVIEW
2.1 WHAT IS STRATEGY?
The term “strategy” traditionally has a very strong root in military, originally used by generals in battles as an elaborate plan to achieve a specific goal under uncertain conditions or environments. In the history of China, work can be found as early as 500 B.C. by the famous Sun Tzu, who wrote the renowned military strategy book, The Art of War. As business competition began to incorporate more and more of the principles of military strategies, “strategic management” had brought about the attention of scholars.
Nevertheless, the definitions of “strategy” have been constantly debated.
A distinguished professor of business history at Harvard Business School, Alfred Chandler (1962) argued that strategy is “the determination of the basic long-term goals and objectives of an enterprise, and the adoption of course of action and the allocation of resources necessary for carrying out these goals” (p. 13) Coinciding with Chandler’s view, Michael Porter also supports the deliberate strategy with his Three Generic Strategies and Five Forces Model, which describes how a firm pursues competitive advantage within its chosen industry.
As opposed to deliberate strategy, however, Henry Mintzberg and James Waters (1985) advocate the importance of emergent strategy, which is a “realized pattern” of actions, or decisions that was “not expressly intended.” It is of the view that strategy emerges over time as the result of a stream of smaller decisions that accommodates to changing reality. As Figure 2-1 illustrated, emergent strategy is realized despite absence of deliberate planning whereas intended strategy may or may not be realized.
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Figure 2-1. Relationship Between Intended and Realized Strategies
Source: Mintzberg and Waters (1985, p. 140).
Although the relevance of these strategies changes over time, both perspectives have their merits. Since a firm’s performance is inevitably tied to its strategic actions, we can define strategy as “a pattern of decisions and actions that enables an organization to improve or maintain its performance” (Hill and Jones, 1998, p. 3).
This draws us to the question on what constitutes a good strategy and what constitutes a bad one. While the industry-based view such as the Five Forces Model emphasizes the importance of a firm’s external opportunities (O) and threats (T), the resource-based view calls for the analysis of a firm’s internal strength (S) and weakness (W). Therefore, according to Barney, a good strategy is one that “neutralizes threats and exploits opportunities awhile capitalizing on strengths and avoiding or fixing weaknesses”
(1997, P. 27) The result is the prevalence of SWOT analysis throughout business schools’
syllabi and companies seeking to gain competitive advantages. However, as the
boundaries between industries become thinner and firms begin to operate internationally, managers have found that industry-based view and resource-based view together cannot explain certain phenomenon. For instance, why do some firms continue to underperform albeit the level of industry competition seems ideal for their operations? Also, why are some firms unable to utilize their competitive advantage in different environments? In seeking these answers, a professor from the University of Texas Dallas, Mike Peng proposed a new idea called the “institution-based view” of strategy. In short, the institution-based view suggests that context is important, and both formal and informal institutions play a crucial role. Combined with the industry-based view and resource-based view, it forms a “strategy tripod” that paints a complete picture for a firm’s direction. I will explain in detail below what each one of the views entails.
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2.2 WHAT IS THE INDUSTRY-BASED VIEW?
Porter came up with the Five Forces model in 1980 on how to identify keys to profitability in a company’s local environment, namely, the industry in which it operates.
The model predicts the average level of firm performance in the industry based on the intensity of competition between organizations and their task environments. However, the model was not without faults. In 2008, Porter published an updated version of his
framework to clarify the common misconceptions of his model and extended upon it.
Here we will mainly be talking about the updated model.
The Five Forces model identifies the five most common threats that decrease a firm’s profitability and their determinants. These threats are: (1) the threat of entry, (2) the threat of rivalry, (3) the threat of substitutes, (4) the threat of suppliers, and (5) the threat of buyers. See Figure 2-2 for a summary of the five forces model.
Figure 2-2. The Five Forces Model of Competition
Source: Porter (2008).
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2.2.1 The Threat of Entry
New entrants hurt the profitability of the industry by bringing in additional capacity, subsequently causing an imbalance between supply and demand. The main determinant of the threat of entry is the height of entry barriers, which are defined by Porter as “advantages that incumbents have relative to new entrants” (Porter 2008, p. 26).
Economies of scale are important sources of entry barriers. They force new entrants to enter in a large scale in order to compete with the incumbents in the industry, consequently putting new entrants at a cost disadvantage. Similarly, industry with
learning curve also allows incumbents to have lower cost per unit without requiring firms to size up. Cost decline with experience because workers become more efficient at their jobs as times passes, and it is particularly significant in labor-intensive industries.
Consumer switching costs are also another sources of entry barriers. The higher the customer switching costs, the more expensive it is for new entrants to acquire existing customers from incumbents. Additionally, established brand identification can also raise customer switching costs.
Large capital requirements also discourage new entrants, especially when they cannot be recovered or when investment capital is difficult to obtain.
Finally, government policies have the ability to either increase or decrease entry barriers by imposing more stringent regulations or granting more subsidies, which affects the costs for new entrants.
2.2.2 The Threat of Rivalry
Rivalry can be intense when numerous competitors are equal in size and power.
Since the capacity of the industry is limited, firms will be forced to encroach on one another’s customers to secure profit. Furthermore, when competitors are similar in firm attributes or offer undifferentiated products or services, competition is also fierce because firms attract the same segments of customers.
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When industry growth is slow, a firm wishing to expand will also have to take market share from existing incumbents. As a consequence, incumbents will engage in higher level of competition to avoid being pushed out of the market or eliminated.
Lastly, the intensity of rivalry is great when exit barriers are high. Sometimes a firm will choose to stay in the market because exiting is simply too costly. However, the excess capacity usually causes the profitability of the industry to dip as a whole.
In order to combat against the aforementioned factors, firms often engage in a price war. Moreover, they might also be inclined to spend a lot on advertisement to stand out. However, both of these actions hurt the profitability of firms. Porter (2008)
mentioned “rivalry is especially destructive to profitability if it gravitates solely to price because price competition transfers profits directly from an industry to its customers” (p.
32)
2.2.3 The Threat of Substitutes
Substitutes threaten the profitability of the industry when they offer lucrative trade-off to the industry’s products or services, on the condition that they provide similar functions. Likewise, low customer switching costs also allow substitutes to create more threats. It is important to pay attention to change in other industries’ products or services when switching costs are low in case technological improvement causes them to become substitutes.
2.2.4 The Threats of Suppliers
Suppliers have the ability to take away profitability of the industry when they are powerful. Suppliers are powerful when a significant of their revenue does not depend on the industry and when they are larger in scale. Hence, they have little to lose from charging the highest price they can.
In addition, suppliers also have more bargaining power when they are more concentrated compared to the firms in the industry because the firms only have a limited number of options to choose from.
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A firm also faces more threats from suppliers if the products or services offered by the suppliers are highly differentiated or if there are no substitutes for them. Since a firm cannot get such supplies elsewhere, suppliers command a great degree of power.
Finally, if a firm has invested extensively to particular suppliers, it would find it difficult to bargain with the suppliers since its switching costs have become very high.
Nevertheless, sometimes a firm has no choice but to cooperate with suppliers in order to survive, as most of the factors affecting supplier bargaining power are beyond a firm’s control.
2.2.5 The Threat of Buyers
Powerful buyers are able to decrease the profitability of the industry by demanding price reductions and asking for better quality products and more services.
Buyers are able to make these demands based on a few factors. First, when they are relatively few in numbers or when their purchased volume represents a significant portion of the industry’s outputs. Since the buyers’ businesses are very attractive in these cases, rivalry among firms would be more intense and buyer would have more leeway.
Moreover, when buyers have the ability to integrate backward and produce the products or services themselves, firms also face more pressure to lower their prices, consequently causing the profitability to be squeezed out.
Buyers also command great bargaining power when the industry’s products or services are undifferentiated or standardized. When buyers are able to find equivalent alternatives easily and there are no switching costs, it is in their best interests to play firms against one another in order to achieve the maximum cost reduction.
Buyers have more intention to negotiate down price when they are not earning significant economic profits as consumers do during economic downturn. The same can be said when the products or services represent a huge portion of the buyers cost structure.
Obviously buyers would want to save as much as possible when opportunity costs are high.
Finally, assuming buyers eventually plan to sell the outputs they purchase from the industry, they can be especially price sensitive when the impact of the industry’s
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products or services do not affect the quality of their own products much. Since the buyers do not depend heavily on the industry, their main focus would be on price.
In conclusion, the five forces model predicts the average level of firm performance within an industry and elucidates the root causes of competition and profitability.
2.2.6 Other Industry Dimensions
In line with Porter’s popular five forces model, Dess and Beard (1984) inspected different dimensions of organizational task environments under the assumption that resources available in the task environments have a significant effect on the populations and characteristics of organizations, similar to that of resource-dependence theory and population-ecology theory developed by Aldrich and Pfeffer (1976) and others. Using the inter-item and factor analyses on resource transactions of organization, they found that survival rate of organizations can be contributed to at least three dimensions –
munificence, dynamism, and complexity.
Comparable to Aldrich’s codification of environmental capacity, environmental munificence as a dimension refers to the degree to which the environment allows for the growth and persistence of organizations. In this regard, it can be understood why industry sales growth is a crucial determinant of not only an organizations’ future outlook, but also its profitability as demonstrated by Dess and Beard (1981).
Environmental dynamism as a dimension reflects the unpredictability and uncertainty brought about by environmental change. Generally seen as a sign of
instability, environmental change has the potential of generating unwanted consequences to organizations and affects their performances. Furthermore, environmental change also becomes more difficult for organizations to manage as interconnectedness among
organizations increases, by virtue of contingent factors multiplying (Pfeffer and Salancik 1978).
Environmental complexity involves the diverse range of operations that organizations must deal with in their environment, with organizations facing more heterogeneous environment having more complex operations and structures. Complexity
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may rise as organizations diversify their scope of operations or as organizational density increases (Chandler 1962, Starbuck 1976).
Dess and Beard’s Dimensions of Organizational Task Environments provides a compelling evidence on dimensions that affect organization’s performance and internal structure; however, similar to Porter’s five forces model, the research focuses on factors in organization’s external environments. Since these analyses all assume the average level of organization profitability in the industry predicts the bulk of organizational performances, their findings may be misleading when an organization’s industry is not the primary determinant of its overall performance, especially in the late 90s.
Additionally, these analyses are only appropriate when the industry already preexists.
They offer no value to firms facing new and undiscovered industries. It was thus argued that the attractiveness of an industry could not be viewed independently, but must be combined with analysis of organizations’ resources and capabilities. Although Dess and Beard’s (1984) research incorporates the resource-dependence theory, it was mainly concerned with the input and output exchange between organizations and their task environments.
2.3 WHAT IS THE RESOURCE-BASED VIEW?
Whereas the industry-based view focuses on a firm’s external environments to find opportunities and eliminate threats, the resource-based view focuses on a firm’s internal assets to build strengths and reduce weaknesses. In the second edition of Strategic Management and Competitive Advantage, Barney and Hesterly describe the resource-based view as a “model of firm performance that focuses on the resources and capabilities controlled by a firm as sources of competitive advantage” (74).
Resources used to build strength can be either tangible or intangible. Physical assets such as manufacturing plants or financial assets all count as tangible resources. In contrast, team chemistry among employees and brand recognition by consumers count as intangible assets. Moreover, as a subcategory of resources, capabilities such as innovation or technical skills also enable a firm to use its resources efficiently in carrying out it strategies.
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In A Resource-based View of the Firm, Wernerfelt investigated the relationship between resources and profitability and proposed strategies for managing the firm’s resources in the long run. Expanding on Porter’s five competitive forces (1980),
Wernerfelt (1984) further argued that a firm must establish a “resource position barrier”
in addition to an entry barrier in order to secure its position from diversifying entrants.
With this objective in mind, a firm should be able to identify resources that generate high returns. Moreover, by considering resources that are jointly produced with products, he came up with the idea of “resource-product matrix,” which helps a firm choose its most optimal strategies when growing its pool of valuable resources sequentially. For instance, the improvement in production skills supported by increasing domestic contacts may allow a firm to expand into international markets, leading to the development of resources such as international contacts. Figure 2-3 illustrates this pattern.
Figure 2-3. Resource Development
Source: Wernerfelt (1984, p. 177).
Although Wernerfelt’s simple economic tool can help a firm identify valuable resources that may subsequently become competitive advantages, he did not mention whether these competitive advantages are sustainable. By examining the possibility of
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finding sources of sustained competitive advantages under the conditions of resource homogeneity and immobility, which are the underlying assumptions in Porter’s five force model, Barney (1991) verified the impracticality of such assumptions and concluded that research must focus on resource heterogeneity and immobility. Based on these two new assumptions, he further suggested that in order for firm resources to possess the potential of sustained competitive advantages, they must satisfy the requirements of being valuable, rare, inimitable, and non-substitutable.
According to Barney, resources are attributes that help a firm “exploit
opportunities and neutralize threats in a firm’s environment,” and valuable resources are those that improve the efficiency of a firm’s strategy implementation (1991). While valuable resources and can enhance a firm’s competitive position in the form of
generating more revenue streams or minimizing costs, they are unlikely to be sources of competitive advantages when they are possessed by a large number of firms. On the other hand, if the number of firms possessing a particular resource is less than the number of firms required in an industry with perfect competition dynamics, that particular
resource may be considered a competitive advantage (Hirshleifer, 1980). Nonetheless, even when they are not rare, certain valuable resources and capabilities are still essential for a firm to maintain competitive parity and survive.
Even though valuable and rare resources may be of sources of competitive
advantages, they only become sources of sustained competitive advantages when they are imperfectly imitable. The 3 reasons that Barney (1991) deducted for making resources difficult to imitate are (1) unique historical conditions, (2) causal ambiguity, and (3) social complexity.
Due to the unique path each firm takes, a firm may be able to acquire and exploit resources in a particular space-time along its history that makes it costly for other firms to imitate, consequently imperfectly imitable. Likewise, causal ambiguity has the highest probability of causing imperfect imitability when the firm cannot even understand the link between the resources it controls and the competitive advantages they generate, otherwise competing firms can just acquire people with knowledge of such link to
implement imitation. Finally, socially complex resources such as company culture, brand
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identification, and the personal network of a firm’s manager can all be impossible for competing firms to systematically recreate even when causation is obvious.
While a firm has a great chance of creating sustained competitive advantages due to the aforementioned reasons, Barney (1991) suggests that there also must be no
strategic equivalent substitutes for the firm’s valuable and rare resources. When competing firms can use different resources and capabilities to implement the same strategy, a firm’s sustained competitive advantages will cease to be inimitable and rare.
Eventually, it will lose its edge if competing firms are able to do it a lower cost. Barney’s framework is summarized below in Figure 2-4.
Figure 2-4. The Relationship Between Resource Heterogeneity and Immobility, VRIO, and Sustained Competitive Advantage
Source: Barney (1991, p. 112).
After Barney’ resource-based view made its introduction in 1991, it has since made a vast impact in the field of strategic management. In an attempt to assess the development of the RBV in the 10-year time span, Barney, Wright, and Ketchen (2001) briefly summarized papers analyzing the contribution of the RBV specifically on human resource management, economics, entrepreneurship, marketing, and international
business. In addition, to accommodate for new developments in strategic management, they suggested further research of the RBV in areas such as corporate governance,
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organizational behavior, ethics and corporate social responsibility, and information management. While acknowledging potential methodological issues, they conclude that the resource-based view has indeed improved our knowledge about management.
In Managing Firm Resources in Dynamic Environments to Create Value: Looking inside the Black Box, Sirmon, Hitt, and Ireland (2007) argued that the link between
In Managing Firm Resources in Dynamic Environments to Create Value: Looking inside the Black Box, Sirmon, Hitt, and Ireland (2007) argued that the link between