The Four Theories of Profit and Their Joint Effects - CiteSeerX

The Four Theories of Profit and Their Joint Effects - CiteSeerX

Special Issue: Twenty Years of Resource-Based Theory Journal of Management Vol. XX No. X, Month XXXX xx-xx DOI: 10.1177/0149206310385697 © The Author...

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Special Issue: Twenty Years of Resource-Based Theory

Journal of Management Vol. XX No. X, Month XXXX xx-xx DOI: 10.1177/0149206310385697 © The Author(s) 2010 Reprints and permission: http://www. sagepub.com/journalsPermissions.nav

The Four Theories of Profit and Their Joint Effects Richard Makadok Emory University

As a theory of profit, resource-based theory is focused on a single causal mechanism—competitive advantage. Although this focus has been useful in helping to understand some sources of interfirm profit differentials, it is nevertheless highly limiting because competitive advantage is not the only causal mechanism by which profit can be generated. Three other mechanisms, labeled here as rivalry restraint, information asymmetry, and commitment timing, have also been extensively studied as sources of profit. Rather than continuing to examine each of these four mechanisms’ main effects on profit in isolation, and thereby generate increasingly incremental knowledge over time, the author proposes an alternative agenda for future research—namely, to synthesize multiple mechanisms in order to focus on their relatively unexplored interaction effects on profit. This article reviews the small but emerging literature of research that has already begun to pursue this agenda and outlines some logical next steps for further development. Keywords: competitive advantage; rivalry restraint; information asymmetry; commitment timing; collusion; resource-based view; flexibility; preemption; interaction effects; mediating effects; moderating effects

At its core, the strategic management field asks two intertwined “big picture” questions about business: Why (or perhaps how) do some companies persistently earn substantial profit, while others do not? And what, if anything, can managers actually do about it? Basic economics teaches that, under price competition, profit is expected to trend toward zero, so in a competitive capitalist economy, any large sustained profit should be rare. In the big Acknowledgements: Thanks to the special issue coeditors, and to Russell Coff and David Gaddis Ross, for their helpful comments and other related discussions. Thanks also to research assistants Jay Rughani and Nadine A. Virani for their outstanding help, and to Carol Gee for her meticulous copy-editing assistance. All remaining errors are my own. Corresponding author: Richard Makadok, Goizueta Business School, Emory University, 1300 Clifton Road, Atlanta, GA 30322, USA E-mail: [email protected] 1

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picture, this is certainly true: In the United States, over half of all new businesses fail within their first four years (Phillips & Kirchhoff, 1989), and even among businesses that do not fail outright, most operate at only a basic subsistence level—barely eking out enough profit to survive. Indeed, out of the 23 million U.S. businesses in 2002, only about 25% had achieved enough success to expand beyond the proprietors themselves and hire one or more employees (U.S. Census Bureau, 2006). And among the many millions of U.S. businesses that have existed over the past century, only a tiny fraction of a percent—just a few thousand—have ever succeeded enough to become publicly traded companies. Out of those, far fewer sustain large profits over an extended period of time (Wiggins & Ruefli, 2002). So, when we ask the question of why or how profit persists in a competitive capitalist economy, we are focused on a rare “outlier” phenomenon—a small number of companies that beat some rather long odds. Research on the resource-based theory (RBT) has made a substantial contribution toward answering these questions by highlighting how profit can arise as a consequence of competitive advantage. Yet if the strategy field’s ultimate goal is to develop and test an overall integrated theory of profit, then both RBT and its close cousin, activity-system analysis (Porter, 1996), must be judged as woefully incomplete. After all, these are theories of competitive advantage, and competitive advantage is only one of several possible ways to create sustained profit. In particular, virtually every theory proposed in the economics or strategy fields to explain profit relies on one or more of four basic causal mechanisms, labeled here as competitive advantage, rivalry restraint, information asymmetry, and commitment timing. Each of these mechanisms draws upon a different intellectual heritage from economics, relies on different underlying theoretic assumptions, affects profit in different ways, and has been applied to different problems and phenomena in strategy (for a summary, see Table 1 in Makadok, 2010: 370). With relatively few exceptions, research on each of these profit-generating mechanisms has largely taken place in separate silos, with little cross-pollination between them. As a result, we know a lot about how these four mechanisms operate in isolation from each other, but little about how they jointly operate when combined together, and especially little about their interaction effects: Do they reinforce and amplify each other’s impact on profit? Or do they undermine and dampen each other? Is it beneficial or counterproductive for firms to pull more than one of these levers simultaneously? Our knowledge about the answers to these questions is currently very limited. Over time, as each separate mechanism becomes more thoroughly and rigorously understood in isolation, further research within each silo tends to become more incremental and tends to offers less new insight. At this point, the best remaining opportunities to discover major new fundamental insights are no longer within each mechanism but rather at their intersections—bridging and synthesizing across multiple mechanisms. The time has come to shift attention and effort from the exhaustively studied main effects to the relatively unexplored interaction effects. The purpose of this article is to propose such cross-mechanism synthesis as an agenda for future development of the strategy field, with the ultimate goal of developing and testing a complete theory of profit encompassing all of their joint effects, including main, mediating, and moderating (interaction) effects. The next section provides a cursory overview of past research that has been done on each of these four mechanisms in isolation. Then, the section

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that follows reviews research that has begun to synthesize across multiple theories of profit and also offers some speculative conjectures intended to help fill some gaps where such syntheses between mechanisms have not yet been studied. This review then leads to a discussion of ways in which the mechanisms may be inherently self-reinforcing and/or self-limiting.

Retrospective Overview of the Mechanisms in Isolation Competitive Advantage: “To the Victor Go the Spoils” The key insight of RBT and other competitive-advantage-based theories of profit is that firms often differ systematically in the extent to which their processes for transforming inputs into outputs can create economic value, where value is defined as the difference between what customers are willing to pay for the firm’s product and the firm’s cost to produce and deliver that product to those customers (Brandenburger & Stuart, 1996). Competition dissipates that value, allowing it to be captured by customers in the form of lower prices, but competition from any given firm cannot dissipate more value than that firm creates in the first place. So, if a firm has an advantage that allows it to create value that no rival can match, then no rival can fully compete away that value, thereby leaving some portion of the value available for the advantaged firm to capture, regardless of how competitive the industry may be (Demsetz, 1973, 1974). Based on this insight, and later building on Ricardo’s (1817) theory of scarcity rents, RBT has developed a theoretical logic (Barney, 1991; MacDonald & Ryall, 2004; Peteraf, 1993; Peteraf & Barney, 2003) and an empirical base (Barney & Arikan, 2001; Crook, Ketchen, Combs, & Todd, 2008) to help pinpoint both the kinds of resources that can confer such a value creation advantage and the required conditions that can sustain it.

Rivalry Restraint: “If You Can’t Beat Them, Join Them” Whereas RBT is about how firms can win in the face of aggressive competition, theories based on rivalry restraint are about how that competition can be avoided in the first place, or at least mitigated in its intensity. Ever since Bertrand’s (1883) critique of Cournot’s (1838) model of oligopoly behavior, it has been recognized that some forms of competition are more intense than others and that restraints on the intensity of competition can boost the overall profitability of the firms in an industry. Some rivalry restraints, like price fixing, bid rigging, market division, and cartels, may arise endogenously as a result of tacit or explicit collusion among rivals, while other restraints are exogenously imposed—for example, government regulation of pricing and market entry, or structural barriers to competition or entry, such as brand loyalty, switching costs, transportation, or tailoring costs for horizontally differentiated products. In either case, whether endogenous or exogenous in origin, rivalry restraints affect profit the same way—by artificially raising output prices (or lowering input prices) from their competitive levels to benefit firms at the expense of their customers and/or suppliers. In industrial economics, both the conventional structure-conduct-performance paradigm (Bain,

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1959) and newer research on supergames (Shapiro, 1989) have focused on pinpointing the conditions and behaviors that help create and sustain these restraints. Within the strategy field, rivalry-restraint logic has been applied to industry analysis, including the “five-force” framework (Porter, 1979), co‑opetition (Brandenburger & Nalebuff, 1996), and mutual forbearance via multimarket contact (Gimeno, 1999; Karnani & Wernerfelt, 1985).

Information Asymmetry: “You Can Fool Some of the People Some of the Time” Whereas RBT is based on differences in the ability to create value by transforming inputs into outputs, information asymmetry theories are based on differences in the ability to assess the value of either inputs or outputs. Some market participants may have better information than others about the value-in-use of the goods, services, or resources that they trade with each other. This information asymmetry may create hazards for the transaction since the better informed party may exploit its informational advantage at the expense of less informed parties—that is, buying something for less than its true value and/or selling it for more than its true value. When one party, usually the seller, has superior information ex ante, before the parties have agreed to a contract, the hazard is known as adverse selection (Akerlof, 1970). When the information asymmetry occurs as a result of one party, again usually the seller, being able to privately influence the value ex post, it is known as moral hazard (Grubel, 1971). These hazards may be severe enough to undermine less informed parties’ willingness to participate in a transaction at all, so research in information economics has focused on mitigating these hazards enough to avoid such market failure by employing mechanisms like signaling (Spence, 1973), screening (Rothschild & Stiglitz, 1976), incentives (Grossman & Hart, 1983), and monitoring. However, because these mechanisms offer only incomplete “second-best” solutions, they may still leave some opportunity for one transaction partner to profit from an informational advantage at the other’s expense, as in a semi– strongly efficient market (Fama, 1970). Most applications of information-asymmetry logic in the strategy literature have focused on moral-hazard problems in either corporate (Daily, Dalton, & Cannella, 2003) or transactional (David & Han, 2003) governance. These governance issues are actually negative applications of information asymmetry, insofar as they are mainly about preventing the erosion of profit by mitigating informational disadvantages. By contrast, relatively little strategy research has focused on affirmative applications of information asymmetry, wherein a firm captures profit by exploiting informational advantages—for example, by ex ante misrepresenting the quality of its products to customers before the sale (adverse selection) or by ex post underinvesting in providing customer services after the sale (moral hazard). One notable exception is research on strategic factor markets (Barney, 1986; Makadok, 2001, 2002; Makadok & Barney, 2001), which focuses on how firms can exploit informational advantages when they play the role of buyer rather than seller, especially in markets for corporate acquisitions (Capron & Shen, 2007; Nayyar, 1990, 1993) and for other assets whose future value may be difficult to forecast (Durand, 2003; Makadok & Walker, 2000).

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Commitment Timing: “The Early Bird Gets the Worm, but the Second Mouse Gets the Cheese” Even if competing firms have the same value-creating resources and the same valuepredicting information, their profits may still differ due to differences in the timing of their strategic commitments. This occurs for two reasons: On one hand, a firm making an early commitment gains the benefit of preemption—that is, being able to shape the incentives, and hence the behavior, of later-moving rivals in ways that block, discourage, or deter them from making aggressive moves. Yet this preemption benefit may come at the expense of having to make commitments to actions under greater uncertainty, since it may not yet be clear what the demands of the market environment will be and how those demands can best be served. So, early commitment entails a risk of getting stuck with an approach that serves the wrong demands or serves them in a suboptimal way. On the other hand, a firm that delays its commitment gains the benefit of retaining flexibility—that is, being able to more clearly observe the demands of the market environment before committing and thereby allowing it to tailor its approach to serve those environmental demands more precisely and more effectively. However, this flexibility benefit may come at the expense of making the firm more vulnerable to the preemptive actions of earlier-moving rivals, thereby blunting its ability to move as aggressively as it might like. So, preemption may let the early bird get the worm, but delay lets the second mouse get the cheese—that is, after observing how the first mouse met its fate by springing the mousetrap. These divergent effects of preemption and flexibility counteract each other because commitment timing often combines two intertwined games—a game against unresponsive nature and her exogenous environmental shocks (e.g., to demand or to technology) and a game against rational rivals who respond to incentives. The flexibility effects of delayed commitment provide benefits in the game against nature, but the preemption effects of early commitment provide benefits in the game against rivals (Ghemawat & del Sol, 1998; Lieberman & Montgomery, 1988). Optimum commitment timing involves a trade-off between these effects. Both effects draw upon intellectual heritage from economics—notably, von Stackelberg’s (1934) leader–follower oligopoly model for preemption and Black and Scholes’s (1973) option-pricing model for flexibility. In the strategy field, the logic of preemption has been central to the study of innovation (Kessler & Chakrabarti, 1996) and first-mover advantage (Lieberman & Montgomery, 1988), while the logic of flexibility has been central to research on real options (McGrath, 1997) and dynamic capabilities (Teece, Pisano, & Shuen, 1997). Indeed, the flexibility-versus-preemption trade-off may explain why innovation can be either highly profitable or highly unprofitable (Lieberman & Montgomery, 1988; Teece, 1986).

Cross-Mechanism Integration There are two ways to think about how any pair of profit-creating mechanisms might be combined—either as mediating effects or as moderating effects (i.e., interaction effects). In a mediating effect, the independent variable from one mechanism influences the independent

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variable of a second mechanism so that the first independent variable has both a direct effect on profit and an indirect effect through the second mechanism. Under this mediating scenario, the value of the second mechanism’s independent variable is constrained by the first, so the two mechanisms cannot be freely manipulated as separate “levers” for generating profit. In a moderating effect, the independent variable from each mechanism influences the magnitude (and possibly even the direction) of the other mechanism’s effect on profit, but without influencing the actual value of the other mechanism’s independent variable. Under this moderating scenario (in contrast to the mediating scenario), each mechanism’s independent variable can be freely manipulated as a separate lever, independent of the other mechanism’s independent variable.

Moderating Effects Across the Mechanisms Since interaction effects are sequence independent and therefore symmetric, there are six possible pairwise interaction effects between the four mechanisms, as shown in Table 1. As in a correlation matrix, only the lower half of the table (below the main diagonal) is shown, since the upper half is symmetric. These interactions can be seen as motivators or demotivators to a profit-maximizing firm, insofar as they examine how each mechanism’s use either raises or lowers the profitability of using the other mechanism. Interaction effect between competitive advantage and rivalry restraint. In a series of four theoretical economic models using different representations for the concept of rivalry restraint, Makadok (2010) predicts that rivalry restraint reduces the profitability of a competitive advantage by requiring the advantaged firm to cede market share to weaker rivals, which reduces the total amount of value that its advantage can create for its customers. A slight variation on this same result has been replicated, using a coalitional game theory approach, in a recent working paper by Chatain and Zemsky (2009: 16, Proposition 4.2). Anecdotal evidence for this negative interaction effect is provided by the natural experiment of deregulation. When rivalry-restraining regulations have been removed from industries like air travel, trucking, telecommunications, and financial services, competitive advantage has become a much more important driver of performance than it had been during the regulated period (Bleeke, 1990). Likewise, firms in low-rivalry industries are much more amenable to accepting the labor market practice of pattern bargaining, wherein a union negotiates virtually identical contracts with competing firms and thereby precludes any firm from having a competitive advantage on labor costs. Such pattern-bargaining schemes tend to break down as industry rivalry becomes more intense (Freedman & Fulmer, 1982). Although no large-sample empirical study has directly tested the interaction effect of competitive advantage and rivalry restraint on profit, some indirect large-sample empirical evidence is provided by McGahan and Porter (1997: 24, 27), who report a “remarkably robust” negative covariance between the industry and corporate parent effects that “is consistent with the idea that corporate parents have a greater positive influence when they participate in unattractive industries.” If the corporate parent effect captures competitive advantages at the corporate level, and

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Table 1 Pairwise Moderating Effects (interaction effects) Across the Causal Mechanisms Competitive Advantage

Rivalry Restraint

Rivalry restraint

Rivalry restraint reduces the profitability of a competitive advantage by requiring advantaged firm to cede market share to weaker rivals, which reduces the total amount of value that the advantage can create (Makadok, 2010).

Information asymmetry

Private information is most Conjecture: Rivalry valuable when competing restraints artificially firms are evenly matched, as depress input prices and this is when there is most inflate output prices, uncertainty about which which reduces the competitor would benefit most potential returns to trading from doing a given transaction. on private information The value of private about which inputs are information is reduced by undervalued or which either a competitive advantage outputs are overvalued. or disadvantage, since either one reduces this uncertainty (Makadok, 2001).

Commitment Compared to its weaker rivals, a timing firm with a competitive advantage in its complementary resources is hurt less by delaying commitment since it can more easily stage a comeback later—i.e., its relative strength makes rivals’ preemptive efforts less effective (Narasimhan & Zhang, 2000; Teece, 1986)

Information Asymmetry

Conjecture: A preemptive Conjecture: Private information firm benefits less from is more valuable for any subsequent rivalry preemptive firms that make an restraint since followers early commitment at a time have already been deterred when uncertainty about from behaving demands of the environment is aggressively toward it. still high. Firms that delay commitment until this uncertainty is reduced have less to gain from private information.

if industries become unattractive because they lack restraints on rivalry, then this empirical finding could be interpreted as evidence of a negative interaction effect between rivalry restraint and competitive advantage. Further indirect evidence for this interaction effect can be seen in Berger and Hannan’s (1998) finding that U.S. commercial banks operating in less competitive (i.e., more concentrated) local markets were more efficient and in Baggs and de Bettignies’s (2007) finding that Canadian businesses facing more intense competitive pressure engaged in more cost reduction and quality improvement.

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Interaction effect between competitive advantage and information asymmetry. Using a theoretical strategic factor market model, Makadok (2001, 2002) makes the point that a firm’s expected profit from having private information about the potential value of a transaction is greatest when this information can make a difference by tipping the scales in the firm’s decision about whether or not to do the transaction. When firms compete for scarce opportunities to do a transaction, private information is most likely to make such a scale-tipping difference when there is most uncertainty about whether the firm would benefit more than its rivals from doing the transaction. Such uncertainty is highest when the firm and its rivals are evenly matched in the strength of their complementary assets—that is, when they are at competitive parity. By contrast, if the firm is at either a big competitive advantage or a big competitive disadvantage in the relative strength of its complementary assets, then there would be less uncertainty about whether it has more to gain from the transaction than its rivals do, and so there would also be less benefit to any private information about the potential value of the transaction. So far, this proposition remains untested. Interaction effect between competitive advantage and commitment timing. Delaying commitment to a particular market, to a particular business model, to a particular product design, or to a particular way of doing things allows a firm to make these choices in the way that best satisfies the demands of its environment. However, this benefit comes at the cost of allowing rivals to make preemptive moves that may deter the firm from making aggressive moves later to capture market share. Teece (1986) argues that this threat of being preempted is less serious and less severe for a firm with a competitive advantage in its complementary resources, since it can more easily stage a comeback later, as in the case of General Electric’s resurgence in the CT scanner industry against the disadvantaged pioneer EMI, as well as IBM’s resurgence in the PC industry against the disadvantaged pioneer Apple Computer. In other words, a firm with a competitive advantage is hurt less by delaying commitment because its relative strength makes rivals’ preemptive efforts less effective. This type of complementarity between flexibility and competitive advantage is also predicted in the game-theoretic model of Narasimhan and Zhang (2000) and is consistent with the empirical results of Mitchell (1991) and Robinson, Fornell, and Sullivan (1992). Interaction effect between rivalry restraint and information asymmetry. Although there is considerable research, which is discussed later in this essay, on mediating effects between these two mechanisms (i.e., ways in which one affects the ability to use the other), I am nevertheless unaware of any research on moderating effects between them (i.e., ways in which each one affects the incentive to use the other). Yet there is a natural logic that one might use to think about their interaction effect, which I offer as a speculative conjecture: Private information boosts a firm’s profit by taking advantage of the ignorance of trading partners in order to buy undervalued inputs for less than they are worth and/or sell overvalued outputs for more than they are worth, but in an industry with rivalry restraints, input prices will already be artificially depressed and output prices will already be artificially inflated as a result of the restrained rivalry. So, the incremental benefit of having more price-distorting private information will be reduced in an industry where rivalry restraints have already underpriced the inputs and overpriced the outputs. Conversely, this same logic works in reverse:

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A firm that can already use private information to buy underpriced inputs and sell overpriced outputs will have less to gain from the price-distorting impact of any rivalry restraint. Interaction effect between rivalry restraint and commitment timing. Here again, mediating effects between this pair of mechanisms have been studied and will be discussed later, but there is a dearth of research on moderating effects. Yet, here again, there is some natural logic to inform another speculative conjecture: Rivalry restraint boosts profit by ensuring that competing firms mutually refrain from behaving aggressively toward each other, but if a firm makes an effective preemptive move, then it has already deterred later-moving rivals from behaving aggressively toward it, in which case the preemptive firm has less to gain from any subsequent rivalry restraint. The mutual prevention of firms’ aggressive moves toward each other is less helpful to a firm that has already preemptively precluded its rivals from moving aggressively. Conversely, this same logic works in reverse: When firms are mutually restrained in their rivalry, each firm has less to gain from moving preemptively to deter aggressive moves from its rivals, since such aggression has already been forestalled by the rivalry restraint. Interaction effect between information asymmetry and commitment timing. As with the previous two pairs, a dearth of research on this interaction effect leaves only logic to inform a speculative conjecture here: Private information has greater value as a guide for decisions when uncertainty is high than when uncertainty is low. The purpose of flexibility is to delay decisions until uncertainty is reduced, and the disadvantage of preemption is the requirement to commit to a course of action while uncertainty is still high. So, private information should be more valuable to preemptive firms, which make an early commitment at a time when uncertainty is still high, and less valuable to firms that delay commitment. A prime example of this phenomenon is Apple Computer’s extraordinary pursuit of secrecy about the features of its pioneering new products prior to launch (Coff, 2010), compared to its later-moving competitors, who share much more prelaunch information with producers of complementary products and with the public.

Known Mediating Effects Across the Mechanisms The preceding moderating effects, as profit motivators or demotivators, were about how using one mechanism can shape a profit-maximizing firm’s incentives to choose to use another mechanism as well. By contrast, the mediating effects in Table 2 are not about the firm’s incentives or choices at all. Rather, they are activators or deactivators— ways that one mechanism can directly activate or deactivate another mechanism, either forcing or preventing its actual use. Also, whereas the moderating effects were sequence independent and thus symmetric, mediating effects are inherently sequence dependent, with one mechanism serving as the antecedent and another as the mediator, as shown in the asymmetric Table 2. In general, these mediating effects have been studied more extensively than the moderating effects.

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Table 2 Known Pairwise Mediating Effects Across the Causal Mechanisms Mediating Mechanism Antecedent Mechanism

Competitive Advantage

Competitive advantage

Rivalry Restraint

Information Asymmetry

Dominant firm may enable sustained collusion by either aggressively disciplining (Markham, 1951) or accommodatively counteracting (Eswaran, 1997; Olson, 1971) any cheating by rivals.

For knowledge-based competitive advantages, absorptive capacity (Cohen & Levinthal, 1990) or asset mass efficiencies in knowhow (Dierickx & Cool, 1989) enables advantaged firms to learn more effectively.

Competitive advantage may impede flexibility through a competency trap (Levitt & March, 1988) or core rigidity (LeonardBarton, 1992).

None?

Sustaining collusion may require rapid imitation (Lieberman & Asaba, 2006), thereby precluding differences in commitment timing.

Rivalry restraint

Under restrained rivalry, income effects may demotivate a firm’s managers from pursuing competitive advantage (Hermalin, 1992).

Information asymmetry

Private information Private information allows firms to impedes enforcement selectively of collusion (Stigler, acquire strategic 1964), but collective resources from delegation restrains which rivalry (Bonanno & competitive Vickers, 1988). advantages can be created (Barney, 1986).

Commitment Timing

First-mover advantages (Lieberman & Montgomery, 1988) and time compression diseconomies (Dierickx & Cool, 1989) parlay early commitment into competitive advantage.

Precommitment to punish defection makes collusion more stable (Jacquemin & Slade, 1989: 422-423). Conversely, flexibility lets firms renege on collusive arrangements.

Commitment Timing

Private information enables opportunity recognition, which in turn enables preemptive moves (Fiet, 2002).

Learning/experience effects may allow early commitment to generate better information in both adverse-selection (Greenwood & Nagel, 2009) and moral-hazard (Mayer & Argyres, 2004) scenarios.

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Mediating effects between competitive advantage and rivalry restraint. Using an agencytheoretic model, Hermalin (1992) predicts that as industry rivalry becomes more restrained, income effects will tend to demotivate a firm’s managers from pursuing cost reductions. This occurs because managers expect higher income as a result of the rivalry restraint’s beneficial impact on firm performance, and this higher expected income causes them to work less and take more leisure. Although Hermalin’s model focused on managers’ efforts to reduce costs, similar logic would also apply to any type of managerial effort to gain competitive advantage, so rivalry restraint should reduce competitive advantage. The most comprehensive empirical evidence in support of this income effect comes from Baggs and de Bettignies’s (2007) survey-based study of a broad cross-section of Canadian businesses, where the interaction of the intensity of product market competition with the severity of agency problems was found to have a positive effect on the performance sensitivity of compensation, the amount of employee effort motivated, and the resulting impact of that effort on both cost reduction and quality improvement. In the reverse direction, however, competitive advantage may increase rivalry restraint. Research suggests two different ways—indeed, contradictory ways—that having a dominant firm may help enable an industry to sustain tacit collusion, by either aggressively disciplining cheating (Markham, 1951) or accomodatively counteracting cheating (Olson, 1971). An example of the former is the role played by R. J. Reynolds Tobacco Company in enforcing price discipline on the cigarette industry during the 1920s and 1930s (Markham, 1951; Scherer & Ross, 1990: 249-251), while an example of the latter is the role played by Saudi Arabia in maintaining cartel unity in OPEC (Eswaran, 1997). Mediating effects between competitive advantage and information asymmetry. There is a fine line between information asymmetry and any form of competitive advantage that is based on superior knowledge. On one hand, information asymmetry generates profit by taking advantage of the ignorance of buyers or suppliers: By knowing more about the value of the goods or services that they buy or sell, the firm can appropriate some of that value from them. On the other hand, knowledge-based forms of competitive advantage generate profit by taking advantage of the ignorance of competitors: Knowing more than rivals do about how to create value allows the firm to capture more value. This fine line between the two mechanisms can become blurred in at least three ways: First, the possibility of vertical integration means that buyers and suppliers may also be potential rivals, and vice versa. Second, even if there were a clear boundary between rivals and the buyers and suppliers, information may still flow between them, so keeping rivals ignorant may also require keeping buyers and suppliers ignorant, and vice versa. Third, some private information may benefit a firm in relation to both its rivals and its buyers and suppliers (e.g., knowing the cost structure of a proprietary production process) and so may inextricably create profit via both mechanisms. Yet even where the fine line between competitive advantage and information asymmetry is not blurred in any of these preceding ways, it is still possible for each of these mechanisms to mediate the other’s impact on profit. As Barney’s (1986) strategic factor market theory argues, any strategic resources that a firm acquires cheaply as a result of its private information may subsequently become the source of a competitive advantage. Perhaps the most striking

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example of this phenomenon was Microsoft’s 1980 acquisition of all rights to QDOS (“quick and dirty operating system”), the precursor to PC‑DOS and MS­‑DOS, for the paltry sum of $75,000 from its original developer, Seattle Computer Products. This resource, which subsequently generated countless billions of dollars of profit for Microsoft, had such a low initial acquisition price because, under the terms of its nondisclosure agreement with IBM, Microsoft was not permitted to disclose to the seller its private information about the secret development and impending launch of the IBM PC, for which Microsoft had been contracted to license the operating system (Freiberger & Swaine, 2000). Conversely, if the knowledge underlying a firm’s ability to create superior value also gives it private information about the value of resources, goods, and services that it buys and sells, then competitive advantage may also enable information asymmetry. For example, res­earch on absorptive capacity (Cohen & Levinthal, 1990) and asset mass efficiencies in know-how (Dierickx & Cool, 1989) suggests that firms with a knowledge advantage may be able to acquire new information more effectively. Cohen and Levinthal (1990: 135) cite the special role of Bell Labs in AT&T as an example of this point. Mediating effects between competitive advantage and commitment timing. The classic leader–follower oligopoly model of von Stackelberg (1934) with symmetric firms (i.e., sharing the same cost structure and the same demand curve for an undifferentiated product) shows how preemption can generate superior profit, even in the absence of any competitive advantage, simply by shaping the incentives of later movers in ways that block, discourage, or deter them from making aggressive moves. But in addition to this “pure preemption” benefit, early commitment may also enable a firm to create competitive advantage. Indeed, research on first-mover advantages (Lieberman & Montgomery, 1988) and research on time compression diseconomies (Dierickx & Cool, 1989) both focus on how early commitment can be parlayed into competitive advantage. Lieberman and Montgomery offer numerous scenarios where this can happen, including the creation and exploitation of customer switching costs, for example, via airline frequent-flier programs, as well as other sources of customer inertia like brand loyalty, and preemptive acquisition of advantage-creating physical or intellectual resources through patent races (as in the pharmaceutical industry) or through control over mineral rights (as has occurred in nickel mining). Conversely, having a competitive advantage may impede a firm’s flexibility through a competency trap (Levitt & March, 1988) or core rigidity (Leonard-Barton, 1992). LeonardBarton examines five case studies where a leading firm’s core competency in one area actively impeded its ability to innovate new products and technologies in other areas. Perhaps her best example is the contrast between Hewlett Packard’s success in developing a low-cost spectrum analyzer and its failure in developing the Model 150 personal computer. What had made HP so successful in developing measurement instruments like the spectrum analyzer was its “next-bench” design capability, wherein an engineer would design a new product to meet the needs of other nearby engineers (at the proverbial “next bench”) who could provide instant feedback on specifications, designs, and prototypes. While this approach made sense for measurement instruments, because the neighboring engineers were representative of the product’s target market, it failed badly when applied to a personal computer, where the target market had very different skills and needs.

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Mediating effects between rivalry restraint and information asymmetry. Stigler (1964) argues that private information about prices charged to customers (or paid to suppliers) impedes, and may prevent, enforcement of collusive rivalry restraints in product markets (or in factor markets). This is true regardless of whether the enforcement arises endogenously through the tit-for-tat reactions of the rivals themselves or is exogenously imposed by a governmental regulatory authority or by a cartel’s central office. Whoever is doing the enforcing must be able to observe prices for all transactions in order to know whether a defection has occurred. For example, depression-era state procurement laws requiring the publication of winning bids had the unintended consequence of facilitating collusion among cement producers, since each firm knew that selling cement to the government at low prices would lead its rivals to retaliate with price cuts on nongovernmental sales (Scherer & Ross, 1990: 528). If the product is a homogeneous undifferentiated commodity, then the story ends there— private information about pricing must be prevented, but not other forms of information asymmetry. However, if the product is vertically differentiable or heterogeneous in its quality or value in use, then collusion requires coordinating on an entire schedule of different prices for different versions of the good or service, and defection can occur either by undercharging on price or by overdelivering on quality (Scherer & Ross, 1990: 279-284). In that case, private information about quality or value-in-use can impede or prevent the enforcement of rivalry restraint just as much as private information about pricing. Interestingly, there is also at least one scenario where firms may be better able to restrain rivalry as a result of having subjected themselves to an informational disadvantage: If all rivals in a market jointly delegate decision-making authority to their own self-interested managers with private information, then this may serve as a credible commitment to restraining rivalry (Bonanno & Vickers, 1988). Although Stigler’s (1964) argument suggests that information asymmetry impedes rivalry restraint, I am not aware of any separate theory or logic about causality in the opposite direction—that is, how rivalry restraint might reciprocally affect the degree of information asymmetry, either positively or negatively. Mediating effects between rivalry restraint and commitment timing. As the prisoner’s dilemma reminds us, collusion is an inherently unstable arrangement since each party has an incentive to unilaterally defect. However, precommitment to punish defection makes collusion more stable, while conversely, flexibility may let firms renege on collusive arrangements (Jacquemin & Slade, 1989: 422-423). The classic example of this phenomenon is the use of best-price contractual clauses, such as meet-or-release and most-favored-customer clauses, which were ruled by the Federal Trade Commission to be anticompetitive in the Ethyl case against manufacturers of lead-based gasoline additives (Holt & Scheffman, 1987). In the opposite direction of causality, Lieberman and Asaba (2006) review a variety of theories suggesting that, under certain circumstances, collusion may cause rival firms to move in parallel, or at least to quickly imitate each others’ competitive moves, thereby ensuring that their commitments are nearly simultaneous. They cite two examples of this phenomenon: the agreement by automobile manufacturers to share any newly adopted pollutioncontrol technology, which was alleged to be anticompetitive, and the nearly instantaneous imitation of calculator innovations between Casio and Sharp, which stabilized their rivalry and raised entry barriers. Such parallel, nearly simultaneous moves preclude either the

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preemption of markets via early commitment or the observation of exogenous shocks via delayed commitment. Mediating effects between information asymmetry and commitment timing. While most research on learning curves and experience curves (Ghemawat, 1985) focuses on how early commitment can help a firm gain and exploit superior knowledge relative to its competitors, learning and experience may also improve the firm’s informational advantages, or at least mitigate its informational disadvantages, vis-à-vis its transaction partners as well. With respect to the adverse-selection information asymmetries that arise in strategic factor markets for new resources, Greenwood and Nagel (2009) find that less experienced mutual-fund managers exhibit more trend-chasing behavior in technology stock investments, making them more vulnerable to bubbles and crashes. With respect to moral-hazard information asymmetries that arise when firms buy or sell services, Mayer and Argyres (2004) discover a learning process in which technology firms become increasingly skillful at writing contracts with each other that aim to reduce information asymmetries or mitigate their potentially hazardous effects. Regardless of whether the information asymmetry is of the adverse-selection or moral-hazard type, these learning effects would, in principle, provide greater benefit to firms that have gained greater experience as a result of earlier commitment. In the opposite causal direction, the essence of “opportunity recognition” or “opportunity discovery” in entrepreneurship research is that private information can facilitate opportunity recognition, which in turn may enable preemptive moves (Fiet, 2002). Incumbent firms may have all of the necessary resources and capabilities to serve a potential market and yet fail to recognize the existence of this potential market, in which case an upstart challenger with inferior resources and capabilities but superior information may recognize its potential and therefore pioneer the new market in a preemptive way. For example, Bevan (1974) recounts how Golden Wonder, a tiny regional Scottish producer of potato chips, entered the broader U.K. market in 1960 and, within 6 years, had dethroned the near-monopolist, Smith’s Potato Crisps, to become the national market share leader. In the United Kingdom prior to 1960, the vast majority of potato chips were purchased and consumed by men in pubs, while almost none were sold in supermarkets. Avoiding the pub market, Golden Wonder’s key insight was recognizing the potential market for selling potato chips to women and children in supermarkets for household consumption. Smith’s continued to fail to recognize this new market for five more years and did not even consider competing against Golden Wonder until 1966, by which time its loss of market share was irreparable.

Self-Reinforcing and Self-Limiting Features of the Causal Mechanisms The mediating effects from the last section can combine to form feedback loops, either positively self-reinforcing or negatively self-limiting each profit mechanism. However, even if these mediating effects did not occur, it is still possible that these mechanisms could, by themselves, have self-reinforcing or self-limiting characteristics. For example, it has long been understood that rivalry restraint contains the seeds of its own destruction: For collusive

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forms of rivalry, the more successful the collusion is at raising prices above the competitive level, the greater the incentive for individual firms to cheat and thereby undermine the collusive outcome (Jacquemin & Slade, 1989: 420-421). Furthermore, even if rivalry were restrained without collusion and without threat of cheating, there would still be an inherent upper limit on the degree of rivalry restraint that firms can profitably pursue. Rivalry restraint involves increasing a firm’s profit margin at the expense of decreasing its output, but as rivalry restraint increases, the detrimental impact of decreased output will eventually overwhelm the beneficial impact of increased margin, at which point further rivalry restraint would become incentive incompatible (Chatain & Zemsky, 2009; Makadok, 2010). The pursuit of competitive advantage involves an interesting combination of both selfreinforcing and self-limiting features. On the self-reinforcing side, competitive advantage can increase both a firm’s output and its profit margin, and since profit is output multiplied by profit margin, the magnitude of competitive advantage will tend to have a quadratic effect on profit. Therefore, the stronger a firm’s competitive advantage is, the more profit it can gain by further increasing its competitive advantage. On the self-limiting side, as increasing the magnitude of a firm’s competitive advantage causes its output to grow, this growth of the firm usually necessitates more severe agency problems, as more work gets delegated to more employees, across more levels of hierarchy and in more remote locations. The resulting increase in agency costs detracts from the profitability of the competitive advantage. In addition, the increased agency costs are further exacerbated by income effects: As increased competitive advantage gives managers (and perhaps other employees) an expectation of higher income, they increasingly prefer to work less and take more leisure (similar to the effect of rivalry restraint predicted by Hermalin, 1992).

Discussion: Toward a Unified Theory of Profit It is often said that strategy distinguishes itself from other related fields through its focus on total firm performance as its primary dependent variable (e.g., Barney, 1997: 20). The basic social science disciplines of economics and sociology focus on performance outcomes at a higher level of analysis—for example, the efficiency, welfare, or equity of an entire economy or society. Other business disciplines like finance, accounting, marketing, operations, and organizational behavior focus on performance outcomes at a lower level of analysis— for example, revenues, capital raised, operational efficiency, team effectiveness, or turnover rates. Strategy is supposed to fill this gap by focusing on firm-level performance. If the strategy field wants to define itself in this way, then it ought to move more deliberately toward the ultimate goal of building and testing a complete unified theory of total firm performance encompassing all four of the causal mechanisms, their self-reinforcing or self-limiting features, and their mediating and moderating (i.e., interaction) effects. The purpose of this article is to review the initial steps that have already been taken toward this destination and to provide a general road map for the rest of the journey. As Table 2 shows, most of the mediating effects have been theorized. So, further progress on them requires better empirical testing, as well as more careful examination of their boundary conditions, since many are focused on special cases—for example, collusive forms of

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rivalry restraint or knowledge-based forms of competitive advantage. It would be useful to know whether these boundary conditions can be relaxed. By contrast, Table 1 shows that far less work has been done on moderating effects, where more pieces of the puzzle are missing. Only half have been well theorized, with the others merely being conjectured here, and empirical testing of them has been indirect, scant, or nonexistent. Another gap in these moderating effects is that they have been limited to twoway interactions. Higher order interactions (e.g., three-way or four-way) may exist but are difficult to even envision due to their intricacy. For example, if the conjecture that rivalry restraint makes information asymmetry less relevant to profit is correct, then it might also make information asymmetry’s interaction with competitive advantage less relevant to profit. If each main, mediating, and moderating effect discussed here is a piece of the puzzle, then fitting those pieces together to form a complete, coherent, systemic picture will require more complicated methods for both theory and empirics. On the theoretical side, the pairwise approach used in current research—that is, studying the joint effects of two causal mechanisms at a time—has allowed for predictions to be made with closed-form solutions of formal mathematical models. But when three or four mechanisms are combined into a single model, the increased number of “moving parts” may make it intractable, in which case predictions may have to be made on the basis of approximate solutions, numerical methods, or even simulation. Likewise, on the empirical side, the data collection challenges will likely increase geometrically with the number of causal mechanisms that are being studied simultaneously. Because the mechanisms operate at different levels of analysis, tests of their joint effects will require empirical settings and data that also span across levels of analysis. Rivalry restraint is a property of industries or markets, so it requires data from multiple industries or markets. Competitive advantage is a property of firms, so it requires data from multiple competing firms. Information asymmetry is a property of transactions, so it requires data at the transaction level. Finally, the dynamic effects of commitment timing require data from multiple time periods. The more mechanisms that are involved, the more demanding the data requirements become, and it is currently unclear what empirical setting might generate such multifaceted, multidimensional data.

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