The resource-based view revisited - SSRN

European Management Review (2010) 7, 91–100

& 2010 EURAM Macmillan Publishers Ltd. All rights reserved 1740-4754/10 palgrave-journals.com/emr/

The resource-based view revisited: Comparative firm advantage, willingness-based isolating mechanisms and competitive heterogeneity Anoop Madhok1, Sali Li2, Richard L Priem2 1

Schulich School of Business, York University, Toronto, Canada; Lubar School of Business, The University of Wisconsin–Milwaukee, Milwaukee, Wisconsin, USA

2

Correspondence: Anoop Madhok, Schulich School of Business, York University, 4700 Keele Street, Toronto, ON L4S 1S8, Canada. Tel: þ 416 736 2100, Ext. 20578; Fax: þ 416 736 5687; E-mail: [email protected]

Abstract We take a step beyond the resource-based view that resource characteristics (i.e., valuable, rare, inimitable and non-substitutable) are the sole basis for isolating mechanisms. Instead, we apply Ricardo’s principle of Comparative Advantage in a two-firm, two-product scenario to show how additional isolating mechanisms can result from economic incentives that provide managers with distinct strategic choices. Specifically, our analysis indicates that managers’ strategic decisions based on comparative firm advantage (CFA) affect their willingness to imitate competitors, even when their firms are fully capable of such imitation. This willingness, in turn, helps to determine the direction of firm expansion. We discuss how Ricardo’s CFA logic can provide specific guidance for managers regarding effective firm strategies in specific comparative advantage situations by factoring in both internal efficiencies and competitive pressures when designing and implementing rent-seeking strategies. European Management Review (2010) 7, 91–100. doi:10.1057/emr.2010.6; published online 29 April 2010 Keywords: comparative firm advantage; competitive heterogeneity; resource-based view; isolating mechanisms

Introduction omparative advantage and competitive advantage are two important concepts in the economics and management literatures. Scholars typically have used comparative advantage to predict trade patterns between nations and competitive advantage to predict a firm’s superior performance relative to competitors. Recently, however, these level-of-analysis boundaries have begun to blur. For instance, Porter (1990) has applied the competitive advantage rationale at the nation level in establishing his dynamic, ‘diamond’ model: namely, that a nation’s demand conditions, rivalry conditions, factor conditions, and supporting industries determine its competitive advantage in a particular industry relative to other nations. In going beyond the more static factor conditions (such as land) that provided the basis for David Ricardo’s landmark work, Porter has enriched, extended and reformulated Ricardo’s (1821) theory of comparative advantage, offering

C

a more comprehensive explanation for why some nations advance and prosper in certain industries while others do not. Moreover, Porter’s nation-level work has since stimulated research examining the competitive advantage of ‘industry clusters’ at the sub-national level (e.g., Storper, 1993; Maskell and Malmberg, 1999). This successful application of competitive advantage concepts upward to the nation level begs two exploratory questions: Can we likewise apply Ricardo’s concepts of comparative advantage downward to the firm level? And if we do, might new implications result for theory in strategic management? For example, the issues of why firms differ and the durability of such differences have been fundamental to strategy research associated with the resource-based view (RBV). We show in this paper how comparative advantage concepts can be applied at the firm level of analysis, and how this application produces novel insights into such elemental

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strategy issues as the determinants (sources) of heterogeneity among competing firms and the sustainability of firm-level competitive advantages. Resource inimitability – due to the inability of rivals to replicate a focal competitor’s rare and valuable resources – is central to the RBV’s explanations of sustainable competitive advantage. In contrast to this ability-based argument, we use the logic of comparative advantage to demonstrate situations wherein a focal competitor’s resources are imitable, yet potential rivals are unwilling to make the investments necessary to replicate or imitate those resources because the rivals’ current resource configurations can be applied more profitably elsewhere. That is, even if they are able to imitate, some rivals or potential rivals choose to refrain from imitation (i.e., are unwilling to imitate) based on their internal logics of comparative advantage. We term this comparative firm advantage (CFA). Moreover, we show how this previously unexamined source of competitive heterogeneity can lead to sustainable advantage in contexts where either: (1) the rivals continue to have more profitable opportunities elsewhere; or (2) when delay by rivals pursuing other opportunities allows the focal competitor time to convert ‘second class’, imitable resources into ‘first class’, inimitable resources. Thus, we demonstrate how comparative advantage-based reasoning complements the RBV in its current form and has important implications for the capture of rents – a key aspect of strategy theory (Rumelt et al., 1994) – by factoring in both internal efficiencies and competitive pressures when designing and implementing rent-seeking strategies. Our paper is organized as follows. We first investigate what constitutes comparative advantage in the context of strategic management. In the process of doing so, we link firms’ rent-earning capacities with their resource deployment and accumulation decisions in a novel manner that revisits the role and functioning of (comparative) opportunity costs in this decision. In contrast to past work in the RBV, we combine both use- and user-based opportunity costs as the underlying basis for such decisions. Having established the theoretical basis of our argument, we then relate managers’ resource allocation decisions to ability and willingness-based isolating mechanisms (WIM) and to the sustainability of competitive advantage. We then discuss the implications of these ideas. The comparative advantage of firms McGraw-Hill’s Dictionary of Modern Economics (1983: 88) defines comparative advantage1 as ‘the special ability of a country to provide one product or service relatively more cheaply than other products or services. This concept is generally used in international trade theory, although it also applies to cost comparisons among firms in an industry and among individual workers’.2 Unlike the notion of competitive advantage – which before Porter (1990) had been strictly applied at the firm level – comparative advantage can be broadly applied at multiple levels of analysis (Ricardo, 1821). To better examine firms’ comparative advantage, however, we must take one step beyond the dictionary definition and place the concept within the context of strategic management.

The RBV views firms as collections of resources and evolving capabilities ‘that are managed dynamically for the purpose of earning rent’ (Williams 1994: 229). In line with this logic, firms deploy strategies to serve the ends of creating, enhancing and capturing economic rents (Barney, 1991; Peteraf, 1993; Makadok, 2001; Peteraf and Barney, 2003), with rents defined as ‘returns to a factor in excess of its opportunity costs’ (Peteraf and Barney, 2003: 315). Opportunity costs underpin many important theoretical issues in the strategic management literature. As Coase (1973: 108) claimed, ‘opportunity cost would seem to be the only one which is of use in the solution of business problems because of its focus on the alternative courses of action which are open to the executive’ (emphasis added). The alternative courses of action, embedded in the concept of opportunity costs, acknowledge managers’ options and liberties in making strategic choices (Child, 1972), with managers being economically motivated to pursue that strategy and to choose that course of action among alternatives which further enhances their firms’ search for rents. Despite the importance of opportunity costs, researchers have yet to reach a consensus on what they really entail. The conventional approach treats opportunity costs as the value (for a focal resource user) of a resource in its alternative best use (Coase, 1973; Chiles and McMackin, 1996). Consider this to be use-based opportunity costs. As a corollary, for use-based opportunity costs rent would be the excess in value of a resource in a particular use relative to its next best use. Notably, this treatment is primarily focused on resource use, but it implicitly neglects the role of competition in determining resource value and rent-earning capacity. In contrast, Peteraf (1993) cited Klein et al. (1978) in her influential article to distinguish between use-based and user-based opportunity costs, with user-based opportunity costs determined by the value of a resource to its second-highest valuing potential user. As a corollary, for user-based opportunity costs rent would be the excess in value of a resource in a particular use relative to its value in such use by its next best user.3 The distinction between use-based and user-based opportunity cost is subtle but significant. In the first case, the next best use refers to the application of the particular resource by the same firm to another use. In the second case, it refers to the application of the particular resource by another firm for the same or similar use. The key difference between these two approaches is that the former is about what can be done better within a firm as it seeks to earn rents, whereas the latter focuses on who can do it better between two firms. In this latter sense, the marginally productive resource refers to the resource held by the inferior user/producer. We illustrate these two logics, and the limitations of considering only one of the two in strategic analysis, through the following stylized scenarios. Types of opportunity costs and strategic choice Consider a single-firm, two-product case following the conventional approach – that is, a focal firm can employ its internal resources in making two products – and assume for simplicity that these two products have the same level of

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perceived consumer value. If the firm can produce one product more efficiently than it can produce the other, then Ceteris paribus it should choose to produce the product that it can produce most efficiently. This is because the firm’s use-based opportunity costs are greater if it forgoes producing the more efficient product than if it forgoes producing the less efficient one. Thus, for conventional, use-based logic the emphasis is on efficiency in resource utilization between two products, and a firm can capture greater rents by producing one than it can by producing the other. This is hardly controversial. More recently RBV scholars such as Peteraf and Barney (2003) have questioned the conventional argument of rent creation above. They instead take inter-firm competition into consideration and view opportunity costs from a more user- and competitor-focused perspective. From this perspective even if the firm can produce one product more efficiently than another, choosing a strategy depends also on the productivity ratios of potential rivals. In other words, can the focal firm discussed above still earn rents by producing its most efficient product given the existence of competition? In contrast to the conventional view, where the focus was on the difference between two uses within a particular firm, the focus of user-based opportunity cost logic is on the difference between two competitors (or resource users) in their efficiency in making a particular product. In this two-firm, single-product case the difference between the efficient use of a productive resource by one particular user over another becomes the source of rent (Peteraf, 1993; Peteraf and Barney, 2003); that is, rent represents a return to efficiency differences between two firms with respect to resources in a particular use. Given the definition of competitive advantage as a firm’s ability ‘to create relatively more economic value’ (Peteraf and Barney, 2003: 314) that ‘is an indicator of a firm’s potential to best its rivals in terms of rents y ’ (p. 313), we can determine Ceteris paribus that the more efficient firm holds a competitive advantage in the two-firm, single-product case. Again, this is hardly controversial. Both of these approaches to opportunity costs clearly have contributed to the development of strategic management theory. Yet, the lack of integration between them hinders a more comprehensive understanding of appropriate strategies for firms as they deploy and accumulate resources in the search for rents. On the one hand, the conventional argument overlooks the role of competition. On the other hand, although the second argument highlights the competitive dimension in the rent-earning process it neglects the possibility for firms to take alternative courses of action with their productive resources. By assuming ‘two single-business firms competing in a production market, one of which has a competitive advantage over the other’ (Peteraf and Barney, 2003: 315; italics added)4 and that ‘(t)he use to which the potential user may wish to put it may be exactly the same (as the focal firm)’ (Peteraf, 1993: 184; italics added), the RBV argument over-simplifies competitive processes. As Lippman and Rumelt (2003) point out, without considering the alternative courses of action the single-product market model jeopardizes the operational meaning of opportunity

cost, because opportunity cost only has meaning when firms have multiple options for creating and capturing value through different resource allocation strategies. To begin integrating these two perspectives, we next turn to a two-firm, two-product world5 wherein the notion of CFA can naturally be introduced. Extending the previous discussions, consider a situation in which both firms can produce the same product more efficiently than the other product, and one firm can produce each of the two products more efficiently than can the other firm. In that case, the more efficient firm will make the strategic choice based on its internal efficiency advantage, but the situation is a little more complicated for the second firm. Specifically, the second firm may choose the product at which it is less efficient if its relative advantage for that product is greater when compared to the other firm. Thus, both efficiency advantage and comparative advantage should be considered by the second firm in making the product decision. Moreover, as we will discuss, if the first firm has an efficiency advantage both internally and relative to competitors, it will apply conventional thinking and, Ceteris paribus, choose to produce the product where it has the internal efficiency advantage and will forgo production of the second product in order to achieve the greatest possible profitability. The second firm is then protected in producing the second product, even though it is less efficient with the second product than is the first firm, by the first firm’s unwillingness (due to insufficient economic incentive) to produce the second product. This is the essence of WIM. A recent example illustrates this argument. When Ebay entered the Korean market it acquired AuctionCo, one of the online auction leaders in Korea for both business-toconsumer (B-to-C) and consumer-to-consumer (C-to-C) auctions. Ebay soon learned, however, that with AuctionCo it had a sharper edge over other Korean competitors in the C-to-C auction market than it did in the B-to-C market. Given limited managerial resources, Ebay chose to abandon the B-to-C market in Korea and largely focus on the C-to-C market. Consistent with the two firm–two product arguments in this paper, we see that Ebay has competitive advantages over its Korean competitors for both B-to-C and C-to-C models, but Ebay found its greatest CFA in its C-to-C business. On the other hand, although a local online business site like Lycos Korea may not have a competitive advantage in either the B-to-C or C-to-C markets over Ebay’s AuctionCo, Lycos Korea has a relative CFA in the B-to-C market and can be successful there due to willingness-based mechanisms isolating it from Ebay. Thus, there are many differences that can be found among our three stylized scenarios. Table 1 summarizes some key differences between the conventional view, the RBV and CFA reasoning. The conventional view, as in the first scenario, is based on a one firm-two product model; accordingly, the greatest interest is in the issue of what can be done better in a firm, and the focus is on how to enhance a firm’s internal efficiency with respect to resource utilization. In contrast, the second scenario as put forward by Peteraf and Barney (2003) in their elaboration of the RBV is based on the situation of two firms and one product; accordingly, its interest is on the issue of which one of the two firms can

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The conventional view

The RBV

The comparative firm advantage (CFA) view

Basic model Key approach towards opportunity costs Key area of focus

One firm two products Use based

Two firms one product User based

Two firms two products Both

Internal efficiency; Within a firm

Both; within and between firms

Key question

What can be done better inside a firm? Not applicable

Efficiency relative to competition; between two firms Which firm can do it better?

Key argument on inter-firm heterogeneity

produce the product in a more efficient manner and thereby capture more value. In the third scenario, CFA reasoning is based on a two firm–two product model that better reflects the complexity and dynamics of business competition; accordingly, the interest is in the issue of what can be done better by which firm. CFA reasoning goes one step beyond extant approaches – it looks both within and across firms and thus incorporates both use- and user-driven criteria in its calculus regarding product production choices. CFA is a more comprehensive approach because it recognizes that firms have alternative opportunities for utilizing their specific resources in their search for rents, and that firms can and should make optimal choices among these alternatives by factoring in both internal efficiencies and competitive pressures when designing and implementing rent-seeking strategies. The resulting strategic choices, based on both use- and user-driven compulsions, can affect a firm’s resource accumulation and allocation processes and thus with time can cause durable differences across firms. CFA reasoning can therefore complement the RBV by helping to better explain managers’ strategic choices and actions and how these choices contribute to inter-firm heterogeneity. In the next section, we introduce some variations to our basic argument to further elaborate on how firms’ economic incentives in rent-seeking affect managers’ resource accumulation and allocation decisions. We also show how CFA reasoning identifies an important but as yet unaddressed aspect of competitor heterogeneity. Specifically, by extending the concept of isolating mechanism beyond ability to also include willingness, we use CFA reasoning to address the issue of inter-firm heterogeneity across rivals more comprehensively than does the current RBV. In this process, we also extend current understanding of sustainable competitive advantage and identify the type(s) of advantage (comparative, competitive, or both) that are truly sustainable. Re-examining competitive heterogeneity The question of why firms differ can be subdivided into two component parts. First, when and why are firms unable to imitate one another effectively? Second, and equally important, when and why would rivals or potential rivals

Ability to imitate

What can be done better by which firm? Willingness to imitate

that are able to imitate instead choose to refrain from imitation (i.e., be unwilling to imitate)? The RBV has focused largely on the first part of the question. Traditionally, three general isolating mechanisms have been identified that prevent the imitation of resource allocations: property rights, learning and developmental costs, and causal ambiguity (Rumelt, 1984; Hoopes et al., 2003). All three mechanisms focus on the fact that competitors lack the ability to imitate; thus, they can be considered as ability-based isolating mechanisms (AIM). However, as Hoopes et al. (2003: 891) pointed out in their discussion of competitive heterogeneity, ‘if resources or capabilities associated with sustained performance heterogeneity are not protectable, then its persistence must be due to something other than costly imitation’. Supporting this line of thought, Knott (2003) found in her study that close but able rivals did not copy superior but imitable franchise routines that they recognized as important. She therefore questioned whether the RBV has been overly (and too narrowly) concerned with resource imitability, since there may be other factors reducing the incentive of rivals to imitate. Similarly, Christensen (1997) highlighted a number of different cases where incumbents chose not to (i.e., were not willing to) imitate a potential future rival because the incentives to do so were weak. This line of argument underlines the existence of what we term as WIM, characterized by firms’ different economic incentives as they pursue rent-seeking strategies. In other words, WIM exists as a consequence of firms’ economic incentives to profit logic. The CFA rationale we have described functions as a WIM. Consider again Ebay’s strategy in the Korea market. Although Ebay has the capabilities to employ its resources in a similar way as its Korean competitors in the B-to-C business model, Ebay’s decision makers foresee greater profit potential from focusing their resources on the C-to-C business framework and thus differentiating the firm from its competitors. This represents a WIM from the perspective of the firms operating in the B-to-C market. Both types of isolating mechanisms are clearly important in competition between firms. To better illustrate how the traditional RBV reasoning and CFA reasoning – and therefore correspondingly AIM and WIM – can work together in the two-firm, two-product case, we use the simple two-by-two matrix shown in Table 2. For clarity, we

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No WIM

WIM exists

No AIM

AIM exists

1 A has no advantage in widgets (neither comparative nor competitive advantage) 3 A has a temporary advantage in widgets (comparative but not competitive advantage)

2 A has a temporary competitive advantage in widgets (competitive but no comparative-based advantage)

1

4 A has a sustainable competitive advantage in widgets (both competitive and comparative advantage)

2 Gadget

Gadget

A B

A B Widget

3 Gadget

Widget 4 Gadget

B

B

A

A

Widget

Widget

Figure 1 Willingness- and ability-based isolating mechanisms in combination. (a) Situation 1. A has neither competitive nor comparative advantage in widgets over B. (b) Situation 2. A has competitive but not comparative advantage in widgets over B. (c) Situation 3. A has comparative but not competitive advantage in widgets over B. (d) Situation 4. A has competitive and comparative advantages in widgets over B.

focus our discussion solely on a situation where Firm A is producing widgets, and we then evaluate the nature of the competition Firm A might be expected to face in widgets (over gadgets) under different combinations of AIM and WIM. We also illustrate the relative efficiency advantages for Firm A relative to potential competitor Firm B in Figure 1 for each situation, with each numbered diagram in Figure 1 corresponding to the situation with the same number in Table 2. For instance, Cell 1 in Table 2 represents Figure 1’s Situation 1; Cell 2 represents Figure 1’s Situation 2; and so on. Figure 1 graphically presents the scenarios in a series of typical comparative, two-firm, two-product analyses. Given equivalent inputs, each firm’s total production if all its resources are allocated solely for one product is represented by a point on that product’s axis. The line connecting these points (i.e., the points of full production volume where all of a firm’s resources are allocated exclusively to one or the other product) represents the

‘budget line’ indicating the tradeoff facing that firm if it should shift some production from one product to the other. The slope of this budget line represents the relative production efficiency of the firm for the two products and, when shown for both firms, the two budget lines allow us to more clearly evaluate the comparative advantage situation for the two potentially competing firms and the two products in question under each of the scenarios in Table 2. In the case of Cell 1 Situation 1, Firm A has neither comparative nor competitive advantage in producing widgets. Thus, it cannot be protected from Firm B by either AIM or WIM in producing widgets; should Firm A choose to produce widgets in this situation, Firm B is both able and willing to compete with Firm A. This situation can be considered as the classic multipoint competition, where rivals are aware of each other’s existence and trying to eliminate competitors from the market segment. Scholars such as Chen (1996), Gimeno (1999), and Boyd (2004) have used the airline industry to illustrate how firms with

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superior resources in multiple markets tend to either push competitors out from the markets or relegate the competitors to very small secondary or niche positions. Now take the case (Cell 2 Situation 2) where only AIM exists and WIM does not exist for Firm A to produce widgets. Firm A has competitive but no comparative advantage in producing widgets. Traditionally, AIM has been considered a necessary and sufficient condition for the existence of sustainable competitive advantage. However, when only AIM exists but WIM does not, competitors lack the capability to imitate in the short-to-medium run but they do not lack the motivation. This is a situation wherein Firm A has would-be and motivated imitators who at some point may attempt imitation. Once the situation allows it, these imitators will make the investments necessary to catch up with the Firm A, and Firm A may lose its competitive advantage. Scholars such as Mitchell (1991) and Giarratana (2008) argue that in high-tech industries, despite the fact that start-up firms tend to dominate in newly emerged market segments, the start-ups’ success and first mover advantage cannot prevent large firms that were incumbents in the previously dominant segments from entering the new market segments. In this situation, the start-ups’ advantageous positions are only temporary, and depend upon the speed with which previous incumbents can imitate and catch up. From a dynamic perspective, we may find that with time and environmental change the competitive relationship between Firm A and Firm B in producing widgets easily could evolve from Cell 2 to Cell 1. For instance, the holder of a unique patent is protected by an AIM, and has sustainable competitive advantage due to the legal protection that prevents potential competitors from imitating. Such competitive advantage is limited by calendar time, geographic scope and institutional or technological changes, however. More important to our argument, as evident from the short period within which most patents are circumvented (Levin et al., 1987), is that concerted effort by a motivated imitator can result in cultivation of the desired capabilities over time. This implies that with the protection of AIM many firms can only achieve temporary competitive advantages which could be overcome by would-be and well-motivated competitors. In Cell 3 Situation 3, only WIM exists and AIM does not. Firm A has comparative but no competitive advantage in producing widgets. Here, suppose that Firm A specializes in widgets. Even though as a result of competitive advantage Firm B has the ability and knowledge to produce widgets, given its limited managerial resources (Penrose, 1959) Firm B’s managers will not be economically motivated (i.e., will be unwilling) to attempt imitation and compete in widgets, because their greatest potential profit is in gadgets. That is, even though AIM does not exist and hence cannot prevent Firm B from imitating Firm A, WIM can still protect Firm A because Firm B can achieve higher rents by pursuing CFA-based rents, which in this scenario is represented by gadgets. Arora et al.’s (2009) recent research on the US drug industry provides an excellent example for this situation. They analyzed more than 3000 drug R&D projects in the US during 1980–1994, and found that pharmaceutical firms are superior to biotech firms in both the discovery of new

compounds and in the clinical development of those compounds. Yet because pharmaceutical firms have a greater comparative advantage in clinical development than in the discovery of new compounds, they tend to specialize downstream in clinical developments and leave biotech firms to conduct upstream discoveries. Thus, pharmaceutical firms are analogous to Firm B, and clinical development is what we have called ‘gadget’ in our example; and biotech firms are analogous to Firm A and compound discovery is ‘widget’. Unless strategic decision making is distorted by other factors (e.g., to spread investment risk, better strategic positioning, etc), or unless there is an increase in available managerial services (Penrose, 1959), Firm B’s managers will be unwilling to launch an attack in the widget market. To put it differently, if only WIM exists, Firm A’s competitors may have the ability to attack its market segment but may choose not to do so because that would be a suboptimal resource allocation. Under this market situation the WIM is not a strategic failure of Firm B; rather it is a ‘natural’ side effect of Firm B pursuing a maximization-based rent-seeking strategy in its production choices. From this CFA perspective we can further explain the dilemma proposed by Pisano (2006) – why is it that biotech firms usually only achieve near zero profitability, yet have survived for more than 30 years? CFA suggests that biotech survival may be due to the fact that pharmaceutical firms have an absolute advantage, but not a comparative advantage, in new compound discovery. On the one hand, if biotech firms try to increase revenues by selling compounds at higher prices to the pharmaceutical firms, the pharmaceutical companies will move into the discovery arena given that they have an absolute advantage if they do so. On the other hand, biotech firms are allowed enough profits to survive by the pharmaceutical firms precisely because the pharmaceutical firms can more profitably focus their resources on clinical development. Thus, Pisano’s (2006) biotech–pharmaceutical question is consistent with Cell 3 Situation 3; we can say using our terminology that Firm A enjoys a temporary competitive advantage in producing widgets due to WIM until Firm B chooses to attack for some other strategic reason. In Cell 4 Situation 4, both AIM and WIM exist. Firm A has both comparative and competitive advantage in making widgets. Only when both WIM and AIM work together can a competitive advantage be sustained for a long term. In this scenario, potential rivals are limited in their abilities to imitate and have little incentive to do so. It is only this ‘double protection’ that results in a truly sustainable competitive advantage. We once again can use a dynamic perspective to show competitive evolution, this time from Cell 3 to Cell 4. Suppose in Cell 3 Firm B chooses to specialize in gadgets. Through lack of use, its routines and capabilities in producing widgets likely would erode with time (i.e., the intercept of Firm B on the widget axis will shift inwards from the original position in Situation 3 towards the position in Situation 4). On the other hand, by specializing in widgets Firm A will benefit from a learning-by-doing process that is unavailable to Firm B (i.e., the intercept of Firm A on the widget axis will shift outwards from its

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original position in Situation 3 towards the position in Situation 4). As a result of experiential learning and pathdependence, even though the initial condition for Firm A was inferior to Firm B for producing widgets, Firm A may become more efficient in producing widgets than Firm B in a later stage (Penrose, 1959). Moreover, once Firm A becomes more efficient in producing widgets, even if Firm B were to attempt to duplicate the greater efficiency of Firm A in producing widgets, this would be difficult for Firm B due to the firms’ different historical paths (Teece et al., 1997). This indicates that the early stage WIM due to comparative advantage later will be augmented by AIM that also will begin to protect Firm A (i.e., an evolution to Cell 4), thus making the competitive position between Firm A and B more sustainable. This dynamic overall process is illustrated well by Adner and Snow’s (forthcoming) recent argument concerning the efficacy of ‘graceful technological retreats’ by dominant incumbents when they face a new entrant possessing a dramatically-improved new technology. This work also can help illustrate the potential for transition from Cell 3 to Cell 4 that we just discussed. Adner and Snow (forthcoming) argue that incumbents under threat from new technology need not try to imitate the new technological breakthrough, even when they have the capabilities and resources to do so. Instead, another strategic option is to cede the customers for the new technology to the entrant while focusing instead on those existing customers whose preference is to stay with the familiar-but-less-effective older technology. According to Adner and Snow (forthcoming), this focus on continuing to dominate the older technology can be the most effective response for an incumbent when the customer segment favoring the older technology – due to inertia, lack of investment, or occupying a niche requiring special use characteristics – is sufficiently large. This would be another Cell 3 case wherein the incumbent firm may have the ability but not the willingness to choose to compete with the new technology. Following CFA logic, as time passes the new entrant and the incumbent will gain further experience with their respective technologies. As this experience increases the ability-related barriers for each firm, should they later wish to expand into the other’s technology, their AIM-based competitive advantage will increase and the competitive situation will shift into Cell 4. The example from Adner and Snow (forthcoming) also helps to illuminate an important but as yet ignored factor that works in concert with CFA reasoning when managers are making strategic decisions. For Ricardo’s (1821) nationlevel analysis of production decisions, the motivation for a particular product focus is the potential for ‘gains from trade’ that may accrue to both nations, and the mechanism through which this occurs is trade among nations. The analogous motivation for comparative advantage analysis at the firm level is profit for each firm individually, but there is no corresponding direct product transfer or benefit sharing among competing firms. Instead, the additional factor necessary for CFA reasoning to be useful is the presence of consumer segments with heterogeneous preferences for the products available in our two-firm, two-product scenarios. That is, as Adner and Snow (forthcoming) note, for a ‘graceful technological retreat’

to make economic sense there must be a sufficiently large segment of consumers whose preferences can be satisfied – or perhaps even be best satisfied – by the incumbent’s previously dominant technology. Absent this – that is, with homogenous consumers or buyers who all prefer one product over the other – then it becomes a two-firm, single-product model, where CFA logic would not apply for the firms’ strategic decisions. Discussion Ricardo’s seminal work ‘On the Principles of Political Economy and Taxation’ (1821) has left two major legacies for economic and managerial thought: the theory of rent and the theory of comparative advantage (Sraffa, 1981). Although deeply embedded and well integrated in Ricardo’s original work, the two theories have evolved rather divergently. On the one hand, comparative advantage theory has with some exceptions been applied rather narrowly to the domain of international economics, despite Ricardo’s intention that it be applied to other levels of analysis as well (Ricardo, 1821). On the other hand, the theory of rent has reached well beyond Ricardo’s original intention – which was to explain how countries can enhance their wealth – and has permeated microeconomics and strategic management. In strategic management, for example, Ricardian rents provide the foundation of the RBV, which has become over the past 20 years one of the most influential theories in the field (Lockett et al., 2009). In the words of one of its foremost proponents, the RBV is ‘simply an extension of Ricardian economics but with the assertion that many more factors – besides land – are inelastic in supply’ (Barney, 2001b: 645), and shares Ricardo’s basic assumption that (some) resources are heterogeneous, valuable, rare and imperfectly mobile (Barney, 1991, 2001a; Peteraf and Barney, 2003). Despite having experienced divergent development paths, the two legacies of Ricardian economics nevertheless share the same roots; they can and should be reintegrated. Given the commonalities, integrating Ricardo’s comparative advantage theory with the RBV likely can improve our understanding of both rents and sustainability of advantage at the firm level. We have revisited Ricardo’s work on comparative advantage, for example, and used it in addressing one of the most fundamental issues in strategy: inter-firm differences and competitive heterogeneity (Rumelt et al., 1994; Hoopes et al., 2003). CFA and the sustainability of competitive advantage Barney defines a sustainable competitive advantage as occurring when a strategy that creates value for the firm is ‘not simultaneously being implemented by any current or potential competitors and when these other firms are unable to duplicate the benefits of this strategy’ (1991: 102). This suggests that not all competitive advantages can or will become sustainable. The key, then, is to identify those situations that have the attributes and thus potential for firms to achieve sustainable advantage. Through our discussion of Table 2 and Figure 1 we have distinguished scenario types and paths of evolution among types that can lead to truly sustainable competitive advantage. When an economic activity has both comparative and competitive

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advantage, both WIM and AIM function together to result in a more robust sustainability. Our scenarios have shown how CFA reasoning can complement the RBV to provide a more comprehensive understanding of isolating mechanisms. By emphasizing managers’ decisions to structure their activities in line with comparative opportunity costs, CFA logic shows that firm managers may have rational incentives not to imitate other firms and that systematic differences in preferences across managers may be caused by the incentives to pursue CFA rent-seeking strategies. Extant study on the RBV has not yet recognized and built upon this distinction. CFA and the RBV Lippman and Rumelt (1982: 419) contend that ‘a theory explaining the dispersion of firm efficiencies within an industry must address both the origins of inter-firm differences and the mechanisms that impede their elimination through competition and entry’. With respect to the RBV framework our most direct focus and contribution is on the dimension of inimitability, which we have partitioned into two aspects: ability and willingness. We question the RBV’s nearly exclusive emphasis on AIM; given resource value, AIM is considered a necessary and sufficient condition for sustainability in the RBV. Yet, if mechanisms exist that make able competitors unwilling to imitate, then inimitability via ability is no longer the sole necessary condition or sufficient condition for sustainable advantage. In contrast to Oliver (1997), who demonstrated firms’ unwillingness to imitate because of institutional constraints, our argument rests on an economic logic. The challenge to RBV scholars is the integration of WIM into the theoretical framework of the RBV. Our introduction of CFA reasoning and WIM into the strategy conversation is a step toward a more holistic and realistic view of competitive heterogeneity. This step is notable for RBV scholars in part because Peteraf and Barney have stated that ‘so fundamental is the condition of heterogeneity, that it is the sine qua non of this [RBV] theory’ (2003: 311; italics in original). In a sense, AIM and WIM as we have proposed it are complementary to one another in determining firms’ resource allocations and deployments. That is, they in part co-determine the competitive heterogeneity phenomena in an industry. CFA and other approaches to strategy Besides extending the RBV’s view of competitive heterogeneity, our CFA argument also can be applied to dynamic capabilities that center around firms’ routines, inertia and path-dependence (Nelson and Winter, 1982; Teece et al., 1997; Eisenhardt and Martin, 2000). In short, routines are developed through experience and tend to differ in their efficiency and effectiveness. Nelson and Winter (1982) demonstrated through simulation the conditions wherein some routines are more conducive to sustainable advantage than are others. By placing the firm along different experiential paths based on relative opportunity costs, the CFA argument provides an additional and novel set of conditions that can further strengthen sustainable competitive advantage. This in turn contributes to a more

comprehensive and robust framework for inter-firm heterogeneity than do conventional RBV arguments. CFA also has potential to add to the literature on the boundaries of the firm. When a firm is no longer able to organize a new economic activity in-house because the associated costs do not justify doing so, the firm will limit its scope/boundaries (e.g., Coase, 1937; Williamson, 1975). The following question arises from CFA reasoning, however: Before firms reach their ability limitations (i.e., where the incremental cost of adding a new economic activity exceeds the potential benefits), are their managers always willing to expand? CFA logic emphasizes the willingness aspects of firms’ activities, and potentially can lend new insight into the question: ‘[Given limited resources], why does a firm organize a particular economic activity internally and not any other?’ Finally, CFA also may be useful in bringing customers back more directly into the strategy equation. As shown earlier during our discussion of the Adner and Snow (forthcoming) paper, CFA-based decisions by managers often must take into account market segments and consumer preferences. Such demand side considerations of course are not new to either strategy or entrepreneurship scholars; Edith Penrose (1959) asserted 50 years ago that companies realize successful business growth when they attend to consumers. More recently, arguments are resurfacing that ‘resources gain economic value from their use by customers’ (Kor et al., 2007: 1198). Some strategy scholars have begun using customer-focused approaches in examining strategic issues such as: the influences of consumer demand on technological innovation and competitive advantage (Adner and Levinthal, 2001; Adner, 2002; Adner and Zemsky, 2006; Tripsas, 2008); consumer-focused strategies for value creation and appropriation (Zander and Zander, 2005; Priem, 2007; Gans et al., 2008; Adner and Snow, forthcoming); and users’ roles in entrepreneurial innovation (Sawhney et al., 2005; Shah and Tripsas, 2007; Faulkner and Runde, 2009). As shown by our earlier discussion of Adner and Snow (forthcoming), CFA reasoning may represents one step toward a needed integration of demand side and producer side approaches to strategic management. The managerial usefulness of CFA Because CFA and WIM shift the frame from the ability to imitate to the managerial incentives to do so, we have moved beyond the idea that the characteristics of resources in and of themselves (i.e., valuable, rare, inimitable and nonsubstitutable) are the sole isolating mechanisms that contribute to competitive heterogeneity. Instead, additional isolating mechanisms like WIM also may be found within the domain of managerial choice (Child, 1972). The currently accepted RBV and the dynamic capabilities approach to strategic management have been criticized repeatedly as being singularly lacking in actionable prescriptions for managers (e.g., Priem and Butler, 2001a, b; Ambrosini and Bowman, 2009; Lockett et al., 2009). Consistent with these criticisms, Birger Wernerfelt noted in a recent interview that the capital asset pricing model in finance has considerable utility for managerial problem-solving, but went on to say: ‘I think the RBV is not that. Instead I think

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it just says okay, here are some of the resources that are important, but it doesn’t tell you what to do with them really. So I think unfortunately it is not that’ (Lockett et al., 2008: 1133). Recent RBV-based studies still fall prey to the ‘lack of prescription’ problem (e.g., Holcomb et al., 2009); these studies reconfirm that great managers are important and that managers’ heterogeneous ability (in this case, at bundling resources) explains more variance in outcomes when there is resource parity (see Thomas (1988) for an earlier empirical demonstration), but they have little to say about specific actions that should be taken by ‘great’ managers in different contexts. CFA studies may illuminate one path for moving beyond this problem, because CFA logic can indicate what strategies are likely to be effective alternatives in specific comparative advantage situations, as we have shown in our explanations of Table 2 and Figure 1. Conclusion Rumelt et al. (1994) have argued that a comprehensive understanding of inter-firm heterogeneity requires different streams of theories. The CFA reasoning we have introduced extends strategy scholars’ current understanding of competitive advantage and isolating mechanisms in a distinctive manner and sheds new light on the phenomenon of inter-firm heterogeneity. This matter is important because competitive advantages, when sustainable, potentially culminate in performance differences across rival firms. The implication for managers is that they should analyze comparative opportunity costs when deciding which rent enhancing strategies to pursue. One potential avenue for future research is to uncover other sources of WIM based on managerial choices, which in turn would further enhance our understanding of interfirm heterogeneity. With respect to CFA reasoning, additional questions that might be addressed could include: How does the relationship among alternative products (e.g., are they complementary or supplementary) affect firms’ strategic choices and resource allocations? Or with respect to firms’ search for rents: What is the substitutability attribute of the RBV (Priem and Butler, 2001a)? We hope that CFA-related issues such as these will be picked up by other scholars in future research. Notes 1 A detailed illustration of comparative advantage using Ricardo’s original example is shown in the Appendix. 2 There is an implicit ceteris paribus assumption in this definition: that all these products or services render a similar level of perceived consumer benefit. That is, the profit margin of a product or service is determined solely by costs. Otherwise firms/nations need not provide the relatively lower cost product or service but instead can pursue the ones that promise the largest difference between perceived benefits and cost (i.e., value creation, Peteraf and Barney, 2003). 3 Later, Peteraf and Barney (2003) define rent as a return above the opportunity cost of the marginally productive resources, the latter referring to the value generated by the resources held by the inferior producer/user. 4 Note that Peteraf and Barney (2003: 313) consider competitive advantage as a ‘fundamental type of competitive edge y an indicator of the firm’s potential to best its rivals in terms of

rents, profitability, market share, and other outcomes of interest’. To keep our argument consistent with the RBV, we subscribe to this interpretation of competitive advantage herein. Moreover, this interpretation is also applied to the later discussion of comparative firm advantage. 5 Of course resources can be applied to multiple products and face multiple competitors. Our model, however, is concerned only with the next best use and the next best competitor.

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Appendix First, Let us look at Portugal. If with 80 men, Portugal can produce 1 unit of wine in a year. However, with the same number of men, Portugal can produce only 80/90 (0.88) unit of cloth in a year. If Portugal chooses to produce 1 unit of wine, she is giving up the opportunity to produce 0.88 unit of cloth. On the other hand, if Portugal chooses to produce 1 unit of cloth, she is giving up 1/.88 (1.125) units of wine. Now, let us look at England. If with 120 men, England can produce 1.2 units of cloth in a year. However, with the same number of men, England can produce only 1 unit of wine in a year. If England chooses to produce 1 unit of wine, she is giving up the opportunity to produce 1.2 units of cloth. On the other hand, if England chooses to produce 1 unit of cloth, she is giving up 1/1.2 (0.833) unit of wine. As shown in Table A1, we can see that the opportunity cost of producing one unit of cloth is lower for England (0.8333) than for Portugal (1.125). On the other hand, the opportunity cost of producing one unit of wine for Portugal (0.88) is lower than for England (1.2). Therefore, Portugal has comparative advantage in producing wine; while even though England does not have any absolute advantage in producing either cloth or wine, but she has comparative advantage in producing cloth. Table A1 Comparative advantage

1 unit of cloth 1 unit of wine

England

Portugal

0.833 unit of wine 1.2 unit of cloth

1.125 unit of wine 0. 88 unit of cloth