THE TWO SIDES OF COMPETITION AND THEIR IMPLICATIONS FOR STRATEGY

Transcription

1 THE TWO SIDES O COMPETITION AND THEIR IMPLICATIONS OR STRATEGY J. GANS, G. MACDONALD, AND M. D. RYALL Abstract. We analyze value appropraton under competton usng cooperatve game theory and demonstrate that competton embodes two competng rvalres: to approprate value on the one hand and to create t on the other. The management of ths tenson s central to strategy. We present a new noton of compettve ntensty, show where the tradtonal vew of competton leads one astray and ntroduce a new quanttatve method by whch practtoners may assess ther strategc optons. Date: August 18,

2 2 1. Introducton In three decades of strategy research, few n the lterature dspute the premse that competton s central to frm performance. Indeed, a major share of strategy s foundatonal work contemplates the dynamc nteracton between competton and performance on the sustanablty of advantage. In order to analyze whether an advantage s sustanable, of course, one must typcally understand what caused t to arse n the frst place. Hence, much has also been wrtten on the contemporaneous effects of competton on performance. The standard analyss frames competton as rvalry to approprate value; that s, as a vgorous, zero-sum combat among market actors, each one strvng to maxmze ts own take of the avalable economc proft. Under ths concepton, the effect of competton on performance s unambguously negatve. Thus, t s not surprsng that much of the dscourse n strategy s organzed around barrers to competton. Take for example, the three domnant streams of research devoted to explanng the determnants of frm performance heterogenety. These nclude: () frm postonng (Caves and Porter, 1977; Porter, 1979); () transacton cost economcs (Wllamson, 1971); and, () the resource-based vew (Wernerfelt, 1984; Barney, 1991). 1 The frm postonng lterature examnes moblty barrers between ndustry groups. The transacton cost lne consders barrers arsng from transactons costs and bounds on manageral ratonalty. The resource-based vew studes barrers to the moblty of resources between rvals. 2 Today, the compettve-threat/barrer/performance logc s a central letmotf n many popular MBA textbooks on strategy. 3 Our thess s that, whle competton certanly nvolves rvalry of the type descrbed above, t smultaneously nvolves another: rvalry to create value. Ths latter contest s about attractng the partners one needs for value-producng transactons over the alternatves presented to them by others. Taken together, these two sdes of competton create an nterestng tenson the ntensty and balance of whch have major, often surprsng, mplcatons for strategy. To contrast our vew aganst the tradtonal logc, consder the canoncal work on frm postonng by Porter (1979, 1980), n whch ths logc s so sharply llustrated. Porter mantans that the defnton of competton as the fght for market share among drect ndustry compettors s too 1 Gven the magntude of the lteratures assocated wth each of the prmary streams, we lmt our ctatons to ther early, foundatonal papers. See the dscusson n, e.g., Prem (2007). 2 We are careful to note that there are, of course, varatons on these themes (e.g., Porter, 1996; Esenhardt and Martn, 2000; Prem, 2007) dfferent themes (e.g., Kogut and Zander, 1996; Moran and Ghoshal, 1996; Rvkn, 2000), and some attempts at cross-thematc ntegraton (e.g., arjoun, 2002; Hunt and Lambe, 2000). 3 See, for example,colls and Montgomery (1997); Saloner et al. (2000); Grant (2002); Besanko et al. (2003); Gans (2005).

3 THE TWO SIDES O COMPETITION 3 narrow. Instead, he argues (Porter, 1980, p. 6), Customers, supplers substtutes, and potental entrants are all compettors to frms n the ndustry and may be more or less promnent dependng on the partcular crcumstances. Competton n ths broader sense mght be termed extended rvalry [emph. n orgnal]. Ths percepton of competton has a long, venerable tradton datng back to the orgnal neoclasscal economsts (a theme upon whch we elaborate below). It bolsters the noton that, Competton n an ndustry contnually works to drve down the rate of return on nvested captal, Porter (1980, p. 5, emph. added), an dea echoed n not just the frm postonng stream, but throughout the strategy lterature. or example: In compettve envronments when one frm gans some advantage over others, that advantage becomes a target for all other frms to emulate or to overcome. The advantage begns to erode wth competton, Grant (2002, p. 235, emph. added); and, Once establshed, compettve advantage s subject to eroson by competton, Moran and Ghoshal (1996, p. 44, emph. added). We, thus, arrve at the concluson that a frm enjoys a stable flow of approprated value only n the presence of barrers to ths essentally corrosve force. The nterplay between competton and ts barrers mples a spectrum of compettve ntensty. Accordng to Saloner et al. (2000, p ), At the lower end of the spectrum, where competton s least ntense, s the monopoly structure: ndustres that have a sngle frm... Perfect competton s at the other extreme of compettve ntensty... A perfectly compettve ndustry has many small frms. urthermore, each frm sells the same product that all other frms n the ndustry sell; there s no product dfferentaton [emph. added]. Ths spectrum s consdered mportant because, followng from the ntal premse about the nature of competton, t naturally correlates wth frm proftablty. As explaned by Grant (2002, p. 70), A sngle frm protected by barrers to the entry of new frms forms a monopoly n whch t can approprate n proft the full amount of the value t creates. By contrast, many frms supplyng an dentcal product wth no restrctons on entry or ext consttutes perfect competton: the rate of proft falls to a level that just covers frms costs of captal [emph. added]. Hence, the tradtonal logc leads us to conclude that the core strategc problem facng a frm s how to create a defensble poston aganst competton s relentless push toward the eradcaton of economc proft. Porter (1980, p. 34) says that successful solutons to ths problem are myrad but, at the broadest level, can be categorzed nto three nternally consstent generc strateges: 1)

4 4 J. GANS, G. MACDONALD, AND M. D. RYALL cost leadershp, 2) dfferentaton, and 3) focus. To the best of our knowledge, ths asserton was uncontroversal n ts tme and remans so to ths day. In ths paper, we take a dstnct path based upon a balanced noton of competton. Our analyss rests on the observaton that before the economc value from a transacton can be approprated, the requste partes must frst consent to partner n ts creaton. If an actor has vable alternatves to a gven busness proposal, then obtanng such consent s not a forgone concluson. Potental collaborators must be jontly persuaded to produce economc value together rather than n some alternatve confguraton. The actual process by whch such persuason occurs can vary wdely. At one end of the spectrum, the partes to a deal may engage n extensve dscussons desgned to dentfy everyone s alternatves and assess ther mplcatons. At the other, alternatves may already be known or mpled by market condtons (e.g., average nput prces) and thus requre no more dscusson than an offered payment for servces. Regardless of how t actually happens, we refer to ths entcement of collaborators as rvalry to create value. The recept of economc value s a prmary reason market actors agree to partcpate n the actvtes requred to create t. Therefore, persuason to collaborate takes the form of gvng up suffcently large shares of the value to be produced va collaboraton. There s a fundamental tenson here. Snce the value assocated wth any transacton s fxed, every dollar gven up to partcpant A s not only a dollar unobtanable for oneself, but also a dollar unavalable for use to entce partcpants B, C and D to jon n as well. Ths addng-up, or feasblty, constrant s what gves competton ts darker, zero-sum sde, the one spotlghted n the tradtonal lterature. It s what nduces rvalry to approprate. What makes competton nterestng s ths essental tenson. When the partes to a deal have no vable alternatves, then there s no such tenson. In ths case, any splt of the avalable value s consstent wth competton. At the other extreme s when ths tenson reaches a vrtual breakng pont. In ths case, the actors mutually exclusve productve alternatves are so rch that there s one, and only one, value dstrbuton among the partes that succeeds n holdng the transacton together. Thus, the full effect of competton s to determne, for each market partcpant, a range of appropraton outcomes consstent wth the resoluton of both types of rvalry. The greater the essental tenson, the narrower the range of possble outcomes. Ths suggests a dfferent way to thnk about compettve ntensty, wth the spectrum runnng from stuatons n whch competton has no effect on who gets what, to those n whch t fully determnes each actor s share.

5 THE TWO SIDES O COMPETITION 5 Seen n ths way, competton loses ts nherently malevolent appearance. Consstent wth the standard vew, competton can lmt the maxmum value obtanable through the market. At the same tme, however, t can also work to guarantee a mnmum. Whether competton has a good, bad, or lttle effect depends upon the constellaton of value-producng alternatves avalable throughout the market. Ths shft n perspectve leads to the concluson that the core strategc problem of the frm s how to manage these competng rvalres. Because ths essental tenson can manfest tself n an abundance of ways, the use of the generc strategy concept as an analytc organzng devce s hghly questonable. Rather, as we demonstrate below, there s another, more refned approach to strategc analyss that properly accounts for both sdes of competton. Ths paper s one n a growng lne n strategy that use cooperatve game theory (hereafter, CGT) to analyze value appropraton under competton. Because the approach s formal, all of our assumptons, defntons and results are stated unambguously. We show the precse sense n whch competton s conceved as an nherently neutral force, actng smultaneously to rase and to lmt the amount of value an economc actor can approprate. New to ths paper s the reformulaton of compettve ntensty as a spectrum rangng from pure barganng to pure competton. In partcular, the formal defnton of pure competton ntroduced here generalzes early, neoclasscal notons of perfect competton as well as more recent ones found n the economcs lterature. We analyze varous generc strateges that the strategy lterature advances to gude practtoners n the creaton of compettve advantage and demonstrate where the standard ntuton supportng these strateges goes awry. nally, n place of generc strateges, we ntroduce a novel, quanttatve approach to dentfyng promsng strategc optons that arses qute naturally from the CGT formalsm. The remander of the paper s organzed as follows. In the next four ntroductory subsectons, we revew the relevant lterature, explan why CGT s well-algned wth the study of foundatonal ssues n strategy, carefully enumerate the key assumptons underlyng the methodology, and present a complete verson of the model. Snce many readers wll be unfamlar wth ths admttedly abstract approach, we take the lberty of dscussng these areas as carefully and throughly as possble. Those who are famlar wth CGT may safely skm these sectons (.e., wth an eye toward understandng how we wsh to nterpret the mathematcs n the context of compettve strategy). In Secton 2, we dscuss the orgns of tradtonal vew of compettve ntensty and then move on to develop a new characterzaton consstent wth CGT. Secton 3 follows n the sprt of Brandenburger and Stuart (1996), by usng smple, numercal examples to llumnate some key mplcatons of competton

6 6 J. GANS, G. MACDONALD, AND M. D. RYALL and to clearly demonstrate where tradtonal thnkng sometmes fals. In Secton 4, we apply the theory to develop a new quanttatve procedure by whch to assess a frms s strategc optons. The last secton presents our concludng thoughts Revew of CGT n strategy. CGT has a dstngushed hstory datng back to the famous book by von Neumann and Morgenstern (1944) (the dea that the exchange alternatves avalable to groups of agents nfluence the appropraton of ndvduals was frst suggested by Edgeworth, 1881). 4 The ntroducton of CGT to strategy occurs wth a practtoner-orented text by Brandenburger and Nalebuff (1996) and a contemporaneous scholarly artcle by Brandenburger and Stuart (1996). Both works focus prmarly upon the noton of ndvdual added value (defned below). Brandenburger and Nalebuff (1996) challenge the conventonal wsdom by rejectng the vew of drect compettors purely as proft-destroyng substtutes. Instead, they demonstrate that, n some stuatons, drect compettors are actually complementors (.e., enhance a frm s proftablty). A canoncal example s the case of smlar ethnc restaurants competng n the close geographcal proxmty of a specfc cty dstrct. Brandenburger and Stuart (1996) make numerous contrbutons, ncludng: 1) descrbng market nteracton as the actve search for value creaton and appropraton opportuntes; 2) showng that, under certan crcumstances, a frm that enjoys a favorable asymmetry wth respect to ts added-value must also enjoy superor proft; 3) advocatng a symmetrc treatment of buyers and supplers; and, 4) explanng why CGT s deal for analyzng the free-form nature of market nteractons. At the same tme, ths ground-breakng paper leaves several ssues open to future study. or example, because t restrcts attenton to stuatons n whch all the acton s n ndvdual value added, the exact meanng of favorable asymmetry n the general case s left to future work. Smlarly, the stuatons analyzed do not fully llumnate the nherent tenson between rvalry to create vs. approprate value. Thus, the precse mpact of ths tenson on appropraton remans unexplored. nally, followng Porter (1980), the paper prescrbes four generc valuebased strateges. Agan, because the analyss s lmted to those stuatons n whch value added s the sole determnant of appropraton, practtoners cannot be confdent of the effcacy of such strateges n more general settngs. 4 Industral organzaton economcs reles heavly on noncooperatve market games;.e., Cournot quantty and Bertrand prce competton games.

7 THE TWO SIDES O COMPETITION 7 The general, formal work n strategy usng CGT begns wth MacDonald and Ryall (2004), who ntroduce the noton of an actor s mnmum total value and use t to derve a necessary and suffcent condton for a frm to be guaranteed strctly postve appropraton by force of competton alone. 5 Adner and Zemsky (2006) study the nteracton between consumer versus resource heterogenetes to derve, among other thngs, the condtons requred to support strategc dversty n a market. MacDonald and Ryall (2006) characterze how the entry of an arbtrary agent nto a market affects the lower bound on a frm s compettve range of appropraton. Ryall and Sorenson (2007) explore the formaton of and value appropraton n productve socal networks and characterze the condtons under whch competton guarantees network brokers a share of value. Brandenburger and Stuart (2007) ntroduce the noton of a bform model n whch an ntal, non-cooperatve stage, n whch agents make strategc moves desgned to alter ther compettve landscape, s followed by a CGT stage, n whch the consequences of these moves are determned. 6 Chatan and Zemsky (2007) study strategc ssues n supply chan management. de ontenay and Gans (2008) examne how outsourcng changes value appropraton and asset value. Adegbesan (2008) extends factor market theory to show that frms can proft when they exhbt superor complementarty to target resources, even n the absence of asymmetrc expectatons Why CGT?. A CGT model takes as nput the value-creatng optons avalable to a set of economc actors through ther jont productve actvtes. In the context of strategy, these optons are determned by the actors resources, preferences, technologes, skll, knowledge, etc. The output of the model s a precse descrpton of the way competton shapes an actor s ablty to capture value from the actual transactons n whch t engages. One of CGT s useful features s ts generalty. or example, ndustral organzaton economcs reles heavly on market games (.e., Cournot quantty and Bertrand prce competton games) to derve theoretcal results. Stuart Jr (2005) demonstrates that Cournot (and, by mplcaton, Bertrand) can be set up as specal cases of the bform model. Ths s sgnfcant as t mples that any results demonstrated usng a general bform game also apply to stuatons satsfyng the assumptons of these market games. Conversely, results proven usng Cournot or Bertrand do not necessarly hold n the more general compettve settngs that can be modelled wth CGT. 5 It should be mentoned thatclppman and Rumelt (2003) provde some addtonal nformal speculaton on possble connectons between CGT and strategy. 6 The frst verson of ths paper appeared n 1996, postoned for an economcs audence. However, as t ganed ncreasng recognton as an enormously useful analytc framework for strategy, t was eventually revsed wth that audence n mnd.

8 8 J. GANS, G. MACDONALD, AND M. D. RYALL Unlke the more famlar market games of economcs, CGT focuses on agents and appropraton rather than on products and prces. Thus, CGT delvers on the orgnal speculaton by Wernerfelt (1984, p. 171), or the frm, resources and products are two sdes of the same con. 7 CGT tells us who approprates how much ndependent of the specfc mechansm by whch that value s transferred. The transfer mechansm may well be prce, but s not restrcted to t (e.g., exchanges of goods-n-knd between busness, non-monetary benefts for employees, etc., are also covered). When terms of trade are mportant, they can be ncorporated explctly (e.g., Byford, 2007). Ths shft n focus has mportant mplcatons. In the standard noncooperatve market models, frms are smply handed barganng power n the form of prce-settng authorty. Appropraton n a CGT model s due to two explct sources: a mnmal amount guaranteed by competton and an addtonal quantty due to extra-compettve factors (such as ndvdual barganng skll). Ths makes clear that what a frm ndeed, any agent gets s crtcally dependant upon ts relatve exchange alternatves. rms are not automatcally endowed wth the power to dctate the terms of trade. A capacty-constraned monopolst facng a large group of small, homogeneous buyers may very well enjoy a hgh level of appropraton guaranteed by competton: ts alternatve ways to employ fxed capacty are rch relatve to those of ts customers. However, that same monopolst facng a sngle buyer (e.g., a defense contractor transactng wth the government) must rely entrely upon ts barganng ablty: here, the monopolst has no alternatves by whch to leverage ts appropraton. In addton to these benefts, the mathematcs nvolved convex analyss s smple and elegant. Moreover, convex analyss s the body of math from whch lnear programmng arses. Hence, t s often a short leap from theoretcal propostons to practcal applcatons, the development of whch s, for now, largely unplowed ground. We provde an example later n the paper. There are, of course, downsdes to these technques. Perhaps the greatest s that the approach s techncal and, presently, unfamlar. Ths s a serous barrer to adopton and dssemnaton. In addton, generalty comes at the prce of abstracton. Thus, how one should nterpret the math s rarely a trval consderaton. The fact that CGT comes burdened wth a tradton of non-descrptve jargon (e.g., core, nucleolus, cooperatve, kernel and so on) does not help matters. Another ssue s the exstence of an analytcal soluton. In most strategy applcatons, 7 Makowsk and Ostroy (1995) make the dualty between the product-prce and agent-appropraton vews explct by usng CGT to prove the Second Welfare Theorem of economcs from the agent-appropraton vew. As Lppman and Rumelt (2003) conclude, applcaton of CGT s especally well-suted to those nterested n the RBV.

9 THE TWO SIDES O COMPETITION 9 the core s the approprate soluton concept (more on ths below). Useful though ths s, some coaltonal games have no core and, as a result, cannot be analyzed n ths way. 8 nally, some (e.g., Lppman and Rumelt, 2003) complan that workng wth ntervals s problematc;.e., n the sense that competton typcally narrows appropraton to a nontrval range rather than a unque pont. However, we take the contrary poston that n the context of strategy ths feature of CGT s actually one of ts strengths. Identfcaton of an agent s range of compettve outcomes s what allows us to decompose appropraton nto a compettve part and a extra-compettve part. or example, a frm facng weak competton (and, hence, a wde compettve range) mght best be advsed to nvest n resources geared toward persuadng others to part wth value (e.g., a hgh-qualty sales force) rather than n those desgned to add value (e.g., a capacty expanson) Key Assumptons. One of the essental features of usng mathematcs to derve theoretcal propostons s that t requres the full explcaton of all crtcal assumptons. Our results requre the followng three assumpton. Assumpton 1. All agents measure the value of ther transactons n the same way (typcally, money). In the context of frms and markets, ths assumpton s a mld one. However, t does have two mportant consequences. rst, t allows us to make apples to apples comparsons between agents n terms of what they approprate. Absent ths, the asserton that one frm consstently outperforms another would be mpossble to nterpret. Second, t mples that f one unt of value s transferred from one partcpant to another, the total value they share s unchanged;.e., a buyer must gve up exactly $1 to transfer $1 to the frm. Of course, dfferent partcpants are free to value the same thngs dfferently ndeed, that they do so s what creates gans from trade. Ths assumpton merely requres that these values can be expressed n the same unts. Assumpton 2. Gven a feasble set of transactons, agents transact voluntarly. 8 The condtons for core exstence are well understood (Bondareva, 1962; Shapley, 1965) and, moreover, are not an ssue n a wde range of market settngs (Stuart, 1997). 9 The multplcty complant s, n any event, rendered moot wth the ntroducton of the appropraton factor (Brandenburger and Stuart, 2007) whch permts us to assgn specfc values to agents compettve appropraton ranges.

10 10 J. GANS, G. MACDONALD, AND M. D. RYALL That s, n order for a feasble transacton to occur, all partes to t must freely decde to partcpate n t. By feasble we mean the set of transactons that are technologcally, nsttutonally and ratonally avalable. or example, a transacton prohbted by law (e.g., colluson) s not feasble. Smlarly, transactons that are beyond the actual abltes of agents to delver or of whch, say, boundedly ratonal agents are unaware, are not feasble. The pont s that, n order to be nduced to engage n a partcular set of feasble transactons, each tradng partner must vew ther nvolvement as provdng the best personal beneft over some other set of transactons n whch they can freely engage. Assumpton 3. Partcpants nvolved n an economc exchange agree on the total value expected to be created by that actvty. Ths last assumpton s the strongest of the three. It does not say that expectatons need be correct; e.g., there s nothng preventng the antcpated value of an exchange beng assessed on the bass of bad subjectve expectatons. What ths assumpton does s allow us to speak of the value of a group s economc opportuntes wthout ambguty. In settngs consstent wth assumptons 1-3, agents face few exogenous restrctons wth respect to how they are allowed to produce value and arrange ts dstrbuton. As a result, competton s a front-and-center ssue. Agents agree upon the feasble set of transactons, they measure value the same way, and they are free to partcpate n the actvtes that leave them best off. Thus, f we conclude that a frm s mnmum level of appropraton s strctly greater than ts lqudaton value, the result s not due to an accdent, or because rvals are prohbted from competng, or as a result of dsagreements over the values of outsde optons. Rather, t s that competton and competton alone has generated ths outcome The ormal Setup. CGT requres the specfcaton of two essental components. The frst s a lst of all the agents n the stuaton of nterest. The second s an assessment of ther jont opportuntes to create economc value. ormally, these are respectvely defned as: () a set N {1, 2,..., n} of agents; and, () for every nonempty subset G N an economc value, v G 0, that members of G would generate should the transactons nvolve only the agents n G. We refer to a subset G as a group of agents; The set of agents can be as small as two and as large as everyone n the world economy (the only restrcton s that n be fnte). Typcally, N ncludes all the agents n an ndustry (ncludng buyers,

11 THE TWO SIDES O COMPETITION 11 supplers, employees, frms, etc.). However, the scope need not be so large. One may, for example, wsh to analyze a specfc ssue nvolvng a small number of partcpants; e.g., the proftablty of a new technology development allance (n whch case, the analyss mght be lmted to the set of potental partners). In large retal markets, customers can often be abstracted out of the analyss by estmatng demand n the standard way and then analyzng how the revenue approprated from consumers gets dstrbuted up the ndustry value chans. The element of CGT most subject to msnterpretaton s the value assocated wth a group, v G. Therefore, some dscusson about ths s warranted. v G s the amount of economc value the actors n G would be expected to generate were they only to transact among themselves condtonal upon the nsttutonal, knowledge and technologcal constrants of ther envronment. In some settngs, the producton of v G mght mply central coordnaton or cooperaton across all group members; e.g., f cartels are legal, agreeng to capacty lmts. However, such an nterpretaton s not requred. Transactons beyond the knowledge of the actors or that volate the law are not feasble. In most settngs of nterest to strategy, v G s the value that could be created were the members of G ndependently free to engage n any of the feasble transactons avalable wthn that group. nally, the meanng of value can vary dependng upon what s approprate for the analyss at hand: v G s a scalar that can represent a determnstc cash value, a net present value, or an expected value. Thus, for each agent n N, v {} s the value that agent would receve were to declne partcpaton n transactons nvolvng any other agents n N. or example, f N contans all the agents n frm s global markets, then v {} mght be ts lqudaton value. If N represents a new market that frm s thnkng about enterng, then v {} s the value t would expect to capture were t to deploy the resources requred to enter that market to ther next-best use. At the other end of the spectrum, v N s the value generated when all agents are free to engage n any combnaton of feasble transactons. Of all the values, v N s the one produced wth the fewest restrctons on who can deal wth whom. We nterpret t as the actual value that the agents n N antcpate producng and use a specal symbol, V v N, to hghlght ths fact. or example, suppose Bob owns a TV that he s ndfferent between keepng and sellng at a prce of $500. Kate has seen Bob s TV, whch she consders much ncer than her current model. She fgures that ownng Bob s TV herself s worth $1000. Alternatvely, she can contnue watchng her set, an opton she values at $200. In ths case, N = {Bob, Kate}. Bob and Kate s outsde alternatves are smply to keep ther current TVs. Therefore, v {Bob} = 500 and v {Kate} = 200. If

12 12 J. GANS, G. MACDONALD, AND M. D. RYALL Bob and Kate agree to exchange, they have to negotate how to splt the $1000 worth of value such an exchange creates. Thus, V = In ths example, V s the actual, monetary value of the contemplated transacton. Hence, appropraton here refers to the utlty, denomnated n dollars, drectly enjoyed by each partcpant to the transacton. Gross monetary value can always be converted to economc value va a normalzaton that accounts for the agent s outsde alternatves. or example, n the precedng example, there s $300 n economc value avalable from the transacton (.e., the gross value less reservaton values, = 300). Thus, an alternatve specfcaton s v {Bob} = v {Kate} = 0 and V = 300. Under ths specfcaton, appropraton s n terms of net economc proft. Alternatvely, suppose lexo Products, Inc. has one unt of ts propretary lexomatc avalable to sell. Bob and Kate both value a lexomatc at $1 above-and-beyond ther next-best alternatve to buyng t. lexo Products, Inc. has no alternatve use for ts product. In ths case, the outsde alternatves are all zero-value. Left to themselves, lexo Products and Bob can create $1 n value by transferrng ownershp of the lexomatc to Bob. The same s true for Kate. Taken as a whole, the group can stll only create $1 n value (.e., lexo Products, Inc. wll sell ts lexomatc ether to Bob or to Kate). Bob and Kate cannot create value together. Thus: V = 1; v { P I,Bob} = v { P I,Kate} = 1; v {Bob} = v {Kate} = v { P I} = v {Bob,Kate} = 0. Note that ths setup does not mply the absence of transacton costs. or example, t could be that, other thngs equal, Bob and Kate each value a lexomatc at $5 but that the process of transactng s so resource consumng for the usual reasons that all but $1 of value s used up by transactng. What we wsh to know s how the $1 n net economc value s, ultmately, splt up between PI, Bob and Kate. Smlarly, the approach does not rule out nformaton asymmetres n the producton of value. or example, the precedng parameters could summarze a stuaton n whch the contemplated transactons are whch of Bob or Kate to hre as CEO of PI. Consstent wth the concerns of agency theory, pror to hrng everyone knows that managers are prvy to better nformaton than the shareholders, that they wll use ths nformaton to ther own advantage and that the board wll mplement some ncentve scheme desgned to keep such behavor n check. Then, the $1 s the economc value everyone expects the manager wll create gven the approprate ncentve scheme, antcpated self-nterested behavor and so on.

13 THE TWO SIDES O COMPETITION 13 Ths setup allows a precse defnton of an agent s added value. rst, when agent s a member of group G, we adopt the notatonal conventon of wrtng G to ndcate the group G wth agent removed. Then, formally, agent s value added s av V v N. Value added s the dfference between the actual value created and the value that could be created should transactons wth be removed from the mx. In strategy applcatons, what we wsh to know s, gven a set of agents and ther exchange alternatves, how much value gets created and how t s dstrbuted. To descrbe what agents approprate, defne a dstrbuton of value as a lst π (π 1,..., π n ) n whch π ndcates agent s specfc level of appropraton. Thus, from the perspectve of an outsder, the observables are V, the value produced, and π, each agent s share of that value approprated. The alternatve values, the v G s, whle known to the partcpants, are not necessarly seen from the outsde. The followng defnton connects the avalable value (V ) and the agents varous productve alternatves (the v G s) to how much each agent approprates (π). Defnton 1. A dstrbuton of value π s sad to be compettve f the followng two condtons are met: (1) easblty: N π V, (2) Consstency: or all G N, G π v G. The dea behnd Defnton 1 s that, when agents are free to select among ther feasble productve opportuntes, the avalable value must be dstrbuted n such a way that no subset of actors can approprate more by engagng n some alternatve transactons. Specfcally, Condton 1 (easblty) says that the total amount of value approprated by all the actors cannot exceed the amount actually avalable (V ). 10 Condton 2 (Consstency) says that, for every group G, the aggregate share of V approprated by ts members must be at least as much as they could generate were they to restrct themselves to transactons wthn the group (.e., v G ). When the consstency condton s not met, the actors n G can abandon ther roles n the creaton of V, produce v G nstead, and dstrbute t n a way that makes everyone n the group better off. or any specfcaton of actors and exchange opportuntes, there may be many dstrbutons that satsfy condtons (1) and (2). Tradtonally, the set of all such dstrbutons s referred to 10 The notaton P N π s shorthand for the sum of the appropraton of every actor n N;.e., π1 + π2 + + πn.

14 14 J. GANS, G. MACDONALD, AND M. D. RYALL as the core. 11 It can be shown that, from the perspectve of agent, (1) and (2) mply a range of competton-consstent appropraton levels: anythng between a compettve mnmum, denoted π mn, and a compettve maxmum, denoted π max. Thus, each pont n the nterval [π mn assocated wth at least one dstrbuton of value that meets the condtons of Defnton 1., π max ] s Recallng our ntroductory dscusson, condtons (1) and (2) generate the two rvalres that, together, defne the full effect of competton. The feasblty constrant mples rvalry to approprate value n the sense that each unt of V approprated by actor s a unt that cannot be approprated by anyone else. Ths s zero-sum sde of competton that appeals to our ntuton and garners so much attenton. What Defnton 1 makes explct s that there s another sde to competton, the one assocated wth the consstency constrants of Condton (2). These mply rvalry to create value n the sense that, n order to persuade any subset of actors to partcpate n the producton of V, they must be offered an aggregate amount of value at least as great as they could produce on ther own. Notce that an mmedate mplcaton of a dstrbuton of value π beng compettve s that, for every agent, v {} π mn π max av. That s, no agent can be forced to partcpate for an amount less than what they could get f they freely chose not to partcpate (hence, v {} π ). Smlarly, all the other agents cannot be forced to transact wth under terms that leave them wth less than they could get f they freely chose not to (hence, π av ). Contnung wth the lexomatc example, suppose the actual transacton s: PI sells a unt to Bob at a prce of 90/c. The prce allocates value: of the $1 n value generated by ths transacton, PI earns a cash flow of 90/c and Bob enjoys consumer surplus of 10/c. We wrte π = (π P I, π Bob, π Kate ) = (.9,.1, 0). Unfortunately for Bob, ths dstrbuton s not compettve. Clearly, condton (1) s satsfed (exactly $1 s dstrbuted). However, π P I + π Kate =.9. Ths s a problem gven that v { P I,Kate} = 1. Therefore, condton (2) fals: π s not consstent wth the alternatve transactons avalable to these three agents. Rather than accept the trade wth Bob at 90/c, PI could offer to sell to Kate at any prce strctly greater than 90/c and less than $1 such a deal s strctly preferred by both partes to the alternatve transacton (PI and Kate). Thus, π = (.9,.1, 0) s not a compettve dstrbuton of value. Ths example s qute specal n the sense that competton 11 We assume V s large enough that the set of compettve dstrbutons s not empty. Stuart (1997) demonstrates that compettve dstrbutons exst for a broad range of market stuatons. However, there are exceptons (see, e.g., Telser, 1978).

15 THE TWO SIDES O COMPETITION 15 fully determnes what each agent approprates: π P I = 1, π Bob = π Kate = 0. In ths case, Bob and Kate are exactly ndfferent between partcpatng n ths market or ther next-best alternatve. 2. Value appropraton under competton We begn to buld ntuton about competton by frst presentng the case n whch t has zero effect on the dstrbuton of value, pure barganng (formally descrbed n Defnton 2). We then turn to the opposte case, pure competton, n whch the force of each actor s alternatves fully determnes how value s dstrbuted (Defnton 3). Whle both defntons are, as far as we can ascertan, new to ths paper, Defnton 3 s of specal nterest because t generalzes concepts of perfect competton used both n economcs and strategy. We magne that the lon s share of real world markets le somewhere between these two extremes. Later, we present a method (due to Brandenburger and Stuart, 2007) by whch to assess ndvdual appropraton when an actor s range of compettve outcomes s an nterval (.e., when π mn π max ) Pure Barganng. Let us consder a two agent example (lke Bob & Kate) but ths tme nvolvng a hypothetcal transacton between General Dynamc Electrc Boat Corporaton (EB) and the U.S. Navy (USN). The transacton under contemplaton s the delvery of 10 Vrgna Class submarnes from EB to USN over a 10 year perod. Assume that the resources EB would use to produce the subs meet condtons for sustaned compettve advantage asserted by Peteraf (1993);.e., they are unque, nmtable, known to be nmtable, and mmoble. Based upon ts ft wth exstng weapons systems, perceved threats to natonal securty, etc., the present value of benefts per boat to USN s $1.8 bllon. Make an extreme assumpton that EB s resources have no alternatve use (ncludng beng sold, due to ncomplete markets) and, hence, zero economc cost. If EB declnes the transacton, then t does not ncur producton costs of $1.2 bllon per boat. Thus, the economc value created by ths transacton s, n bllons, $1.8 $1.2 = $0.6. Stated n terms of the model, V =.6, v {USN} = v {EB} = 0. It should be easy to see that any splt of the $600 mllon consttutes a compettve dstrbuton of value. If the USN pays a prce of $1.2 bllon, thereby capturng $600 mllon n value, EB s just ndfferent to a resource redeployment. Gven the scope of the analyss, USN s the only avalable transacton partner. Other than extng the market for advanced fast attack submarnes, EB has no alternatves. Of course, the same s true for USN. At a prce of $1.8 bllon, the government s just-ndfferent to consummatng the deal. Any

16 16 J. GANS, G. MACDONALD, AND M. D. RYALL splt of the $600 mllon (.e., any prce between $1.2 and $1.8 bllon) consttutes a compettve dstrbuton of value. 12 Ths leads to the followng defnton. Defnton 2. A market nteracton descrbed by a coaltonal game s pure barganng f, for every partcpant n N, π mn = v {} and π max = V. In other words, the agents productve alternatves do not shape ther compettve ranges n any way: any level of economc proft between v {} and V s consstent wth every agent s feasble alternatves. Clearly, the precedng example meets ths defnton. EB and USN must resort to whatever means they can thnk of to persuade each other to part wth some porton of the $600 mllon n economc value (e.g., arguments about farness, hghlghtng employment mplcatons n key congressonal dstrcts, and so on). If EB does approprate value, t wll not be due to USN s need to persuade t not to engage n alternatve transactons freely avalable wth other actors.e., competton. Recall, EB s resources were assumed to meet all the condtons tradtonally thought to endow a frm wth a sustaned compettve advantage. Yet, n ths case, no advantage s assured n the frst place, much less sustaned. Dependng upon extra-compettve factors (e.g., relatve barganng sklls or nsttutonal norms), EB mght wnd up wth anythng from none of the economc proft to all of t (nether extreme may be the most lkely outcome, but both are vable possbltes just the same) Pure Competton. Let us move from pure barganng to ts polar opposte by ntroducng a new noton we term pure competton. Ths concept generalzes the noton of perfect competton mported from economcs n ways that are helpful to strategy. In order to understand what s new and useful about t, we begn wth the more famlar dea of perfect competton. In strategy, the conventonal take on perfect competton s consstent wth the standard model of economcs, by whch we mean a homogeneous product market wth free entry of dentcal frms. 13 In ths model, a perfectly compettve market s one n whch: ) the product s standardzed; ) frms are prce-takers; ) factors of producton are perfectly moble; and, v) consumers and frms have perfect nformaton (rank, 2006, p. 364). 14 Takng nput prces as gven, the mplcaton s a 12 Ths outcome does not depend upon the fact that n = See Vner (1933). 14 One of the frst versons of ths model s due to Walras (1874) (Walras, 2003, n Englsh) who, along wth hs contemporares Jevons (1879) and Menger (1871), fathered neoclasscal economcs. Debreu (1959) represents the pnnacle of ths lne of thnkng.

17 THE TWO SIDES O COMPETITION 17 perfectly elastc supply curve and zero economc proft for frms. Many strategy researchers would agree wth Knght (1946, p. 102) that perfect competton of ths knd exhbts few features n common wth real world markets: 15 The perfect market, of theory at ts hghest level of generalty, s conventonally descrbed as perfectly or purely compettve. But use of ths word s one of our worst msfortunes of termnology. There s no presumpton of psychologcal competton, emulaton, or rvalry, and ths s rather contrary to the defnton of economc behavor. Market relatons are mpersonal, between persons and goods; and persuason or barganng s also excluded. The perfect compettor of the standard model s one who behaves as a passve prce-taker and, wth zero entrepreneural creatvty, as a passve market-taker as well. As Makowsk and Ostroy (2001, p. 484) add Neoclasscal economsts borrowed from ther classcal predecessors the vew that, n a producton economy, perfect competton s the smple, nescapable concluson of free entry. And wth free entry comes zero profts. Almost to the same extent as prce-takng, the common dentfcaton of perfect competton wth a free entry/zero proft equlbrum elmnates the space needed for the expresson of market creatvty. Much that has been wrtten n strategy stems from a basc dssatsfacton wth the standard model: beyond the theoretcal lmtatons already dentfed by Knght (1946), frms n real markets exhbt a degree of heterogenety and rchness that s n stark contrast to ts mplcatons. It s nterestng that although much of the work n strategy rejects the conclusons of the standard model, t yet contnues to embrace ts essental logc. Thus, n seekng to explan the gap between the predctons of the standard model and realty, each prmary stream n strategy focuses upon certan barrers to competton (resource moblty, knowledge, ndustry poston, etc.) that are thought to styme the nescapable concluson of the neoclasscal vew. A fundamental flaw n ths thnkng s that t consders only the zero-sum sde of competton and, as a result, presents a profoundly ncomplete characterzaton of ts effect. Ths pont s not lost on modern economsts. In the modern vew, a perfect compettor s an economc actor who pursues the capture of economc value wth creatve zeal, barganng vgorously wth others for a better deal, nnovatng new products f he sees a proft to dong so, strategcally msrepresentng 15 Ths comment was frst brought to our attenton n Makowsk and Ostroy (2001, p. 484).

18 18 J. GANS, G. MACDONALD, AND M. D. RYALL hs prvate nformaton f ths s proftable, Makowsk and Ostroy (2001, p. 480). In ths vew, perfect competton s defned as any allocaton of resources at whch each partcpant receves the full contrbuton t makes to the total gans from trade;.e., each partcpant approprates ts added value. Thus, whle the zero-proft ndustry of the standard model meets the more general, modern defnton of perfect competton (because, there, frms have added values of zero), so do others ncludng some n whch frms nnovate, dfferentate, and proft. To llustrate, consder three arlnes, say, Qantas (Q), Amercan Arlnes (A), and Brtsh Arways (B), who are contemplatng the formaton of a UnfedWorld allance. These arlnes beleve that by sharng frequent fler programs, establshng jont tcketng optons, and so on, they wll create operatng effcences, ncrease customer loyalty and mprove overall profts. Keepng thngs smple, suppose any two of these arlnes can form an allance that ncreases jont profts by $20 mllon. A three-way allance generates $30 mllon n addtonal proft. ormally: V = 30; v {QA} = v {QB} = v {AB} = 20; v {Q} = v {B} = v {A} = 0 (where the outsde values are the proftabltes of the non-alled arlnes normalzed to zero). The set of feasble, arm s-length alternatves guarantees that each arlne receves precsely $10 mllon n return for ther partcpaton n the 3-frm allance no more, no less. To see ths, notce that f Q attempts to negotate a larger share one that leaves A and B wth less than $20m between themselves A and B smply pont to ther own ablty to generate and share $20m wthout Q (an opton they strctly prefer to any 3-frm allance that leaves them wth less). Ths argument holds dentcally for all three frms. Thus, the 3-frm allance forms wth each partcpant gettng $10m of the $30m generated, an amount exactly equal to ts added value ($10 = $30 $20). Here, competton actually guarantees that every agent s a full-approprator: each has added value of $10 and ths s precsely what each receves. Hence, ths stuaton meets the modern economcs defnton of perfect competton. Notce how ths turns the neoclasscal vew of competton on ts head: now, competton s a force actng to guarantee that every frm approprates the full measure of ts productve contrbuton to the economc nteractons n whch t partcpates. Moreover, ths postve state of affars comes about as a result of (presumably, heterogeneous) managers actvely seekng nnovatve opportuntes by whch to create and approprate value. What could be better? At ths pont, some mght argue that the essental normatve message of strategy should be reversed: Managers, seek perfect competton! To ths concluson, we demur. In our vew, competton s an essentally neutral force. rom the strategy perspectve, the key

19 THE TWO SIDES O COMPETITION 19 feature of the precedng example s not that every agent s a full approprator but, nstead, that the dstrbuton of V s entrely determned by the agents feasble alternatves. That s, t s the polar opposte of pure barganng. Ths naturally leads to the followng defnton. Defnton 3. A market nteracton descrbed by a coaltonal game s purely compettve f, for every partcpant n N, π mn = π max. Our noton of pure competton emphaszes the true role of competton as an essentally neutral force that determnes the bounds of agent appropraton. In stuatons of pure competton, barganng plays no role n what agents approprate. In stuatons of pure barganng, competton plays no role. The symmetry s complete. In addton, Defnton 3 generalzes exstng notons of perfect competton. Perfect competton n the neoclasscal sense meets ths defnton (a sngle equlbrum prce dstrbutes value n a unque way) as does the modern, full-appropraton sense (where, for all agents, π mn = π max stuatons beyond ether of these. = av ). However, Defnton 3 encompasses a wder range of To see a case of pure competton n whch agents do not get ther added values, consder a dfferent example nvolvng productve socal networks. Suppose the nvestment bankng market contans four frms. It does no harm to assume these frms are heterogeneous on many key dmensons; e.g., specalzed ndustry know-how, clent contacts, reputaton, dstrbuton channels, and so on. Assume further that as a result of nformaton complementartes, scale economes and transacton costs there are dmnshng returns to socal network sze. Specfcally, assume that: ) ndvdually, banks cannot generate a proft; ) any network of two produces jont proft of $20; and, ) addng more to a two-frm network s not proftable. Then, V = 40 (two dstnct networks form producng $20 each). Sngle-frm groups produce value of $0 and two- and three-frm groups produce $20 (n the latter, two frms create a network and the thrd frm s left to produce zero). The drvng feature of ths example s that value s created by ntermedate-szed groups. By Defnton 3, ths nteracton s purely compettve each frm approprates exactly $10. However, because each agent s added value s $20, none s a full approprator; thus falng the modern economcs defnton of perfect competton (and, obvously, the condtons of the standard model as well). Thus, Defntons 2 and 3 dentfy two ends of a contnuum, nether of whch are lkely to arse n any real world settng. Ther usefulness, s not n ther emprcal descrptve power but n

20 20 J. GANS, G. MACDONALD, AND M. D. RYALL what they say about a frm s overarchng strategc stuaton. The knds of resources, knowledge, technologes and nsttutonal structures that cause superor performance n ndustres closer to the pure barganng end of the spectrum are lkely to be qute dstnct from those at the pure competton end. Ths dstncton s potentally crucal both n terms of normatve and postve strategy theory. rst, t elmnates the dead-end perfect competton of the standard model as an nterestng focal pont: we see no obvous argument n favor of ndustres beng nvarably pushed toward one end of the contnuum or the other. Second, the rch dversty observed n real markets arses as a natural mplcaton of the economc motvaton nduced by competton. Thrd, agents nhert all the attractve features of the perfect compettor of modern economcs (.e., are actve, unque, potentally nnovatve, value-seekers). nally, competton s conceved of as nether nherently good nor bad; e.g., sometmes pure competton mples full appropraton, sometmes the opposte The general case. Defntons 2 and 3 are clearly specal, wth most real world cases probably fallng somewhere n-between;.e., v {} < π mn < π max < V. Suppose partcpant consders takng some costly strategc acton that wll alter the compettve envronment by both lowerng π mn and ncreasng π max. How should t evaluate ths opton? At ths pont n the development of our theory, we have only the nterval of compettvely consstent possbltes rather than a specfc pont-estmate. In order to compute the proftablty of strategc nvestments, we requre pontestmates. Brandenburger and Stuart (2007) ntroduce a method of valung compettve ntervals that has the character of a subjectve expectaton (and, hence, an nterpretaton we choose to emphasze). When facng [π mn, π max ], a frm s subjectve expected level of appropraton can be assessed as π = α π max + (1 α )π mn, where π s frm s antcpated level of of appropraton wth α [0, 1] summarzng ts subjectve belefs about the effects of extra-compettve factors. Thus, π can be nterpreted as the frm s subjectve expected appropraton level, takng these factors nto account. The parameter α s referred to as frm s appropraton factor (A). Rearrangng terms, π = π mn + α ( π max π mn ), (1) whch emphaszes that what a frm gets s the mnmum appropraton guaranteed by competton (π mn ( ) plus an addtonal amount as a result of extra-compettve factors (α π max π mn ) ). or example, when α = 1, the frm expects appropraton of π = π max and, when α = 0, t expects