Porters model Still effective in evaluating competitive strategy

Strategic management is continuously evolving as both an academic discipline and as a reflection of management practice. No one can deny the contribution of Michael Porter to the development of the discipline in the context of the advances that have taken place since the publication of his seminal work Competitive Strategy in 1980. A firm’s competitive behavior has become an important topic for practitioners, theorists, and policy makers since then. Among the explanations of firms’ behavior is Michael Porter’s model, there are several alternative new approaches developed, such as the New Industrial Organization and Game Theory and the Resource-Based Perspective. Those approaches may have some extent of relationships, similarities, and differences relative to Porter’s model. Is Porter’s model still effective in evaluating competitive strategy relative to those approaches?

Objectives of the Research Paper:

The objective of this research paper is to evaluate the use of Porter’s model comparing with those approaches. The criteria are based on popularity, well-defined structure, feasibility, clarity, simplicity and generality.

Literature Review:

Given the importance of competition, many literatures focused on the identification of the most successful competitive strategies that firms pursue. A famous framework within this literature, especially among business strategists and industrial economists, is Porter’s model (1980, 1998, and 2004).

Porter proposes that firms can outperform competitors if they pursue any of his three recommended generic competitive strategies. His recommended strategies are “lower cost” or “cost leadership,” “differentiation,” and “focus.” “Focus” can be found in three variants-“cost focus,” “differentiation focus,” or “cost and differentiation focus.”

Porter’s model of generic competitive strategies is an important synthesis of Porter’s research and teaching experience within strategy and industrial economics. From the firm’s point of view, the most relevant and important aspect of the competitive environment is the industry in which the firm competes. Industries are comprised of firms that produce close substitutes. However, the firms’ competitive environment has a common structure, consisting of five competitive forces. These forces that are viewed as the determinants of the industry’s overall competitiveness and profitability are:

potential entry of new competitors

intensity of rivalry among existing firms

potential development of substitute products

bargaining power of consumers

bargaining power of suppliers

According to Porter, it is the joint influence of these forces that determines the intensity of competition of each industry, where the strength of each competitive force is industry-specific. Profitability, considered as the “rate of return on investment,” is negatively correlated with the overall strength of these forces. Hence, the greater the strength of these forces that affect firms, the lower the expected profitability in the industry.

In Porter’s research, analyzing an industry with respect to these five competitive forces would help the firm identify its strengths and weaknesses relative to the actual state of competition. If the firm knows the effect of each competitive force, it can take corresponding defensive or offensive actions in order to place itself in a appropriate position against the pressure exerted by these five forces. Even though a firm defends itself against the competitive forces first, firm can affect the competitive forces by its own actions. This view of competition holds that not only the existing firms in the industry are actual or potential competitors but also additional competitors may arise from “extended rivalry” customers, suppliers, substitutes, and potential new entrants.

Given this context, firms should pursue in order to position themselves against the pressure of the main competitive forces and achieve higher profitability than the industry’s average. These strategies are presented in the so-called model of generic competitive strategies (Porter, 1980). The term “generic” would refer to the broadest level of the strategic approach that the firm chooses to pursue, regardless of its business, be it manufacturing, service, etc.

The two dimensions in this framework are strategic advantage and strategic target. Strategic or competitive advantage is of two kinds, differentiation or lower cost. Strategic target or competitive scope can be in terms of geographic targets, customer segments served, and the range of products. The combination of these two dimensions creates the three main strategic alternatives: “differentiation”, “cost leadership” (or “lower cost”), and “focus”, where focus can be of three kinds, “cost focus,” “differentiation focus,” or “cost and differentiation focus.”

A cost leadership strategy requires a firm to become the lowest cost producer of a product or service so that above-average profits are earned even though the price charged is not above the industry average. A differentiation strategy involves creating a customer perception that a product or services is superior to that of other firms, based on brand, quality, and performance, so that a premium price can be charged to customers. A focus strategy involves the use of either a differentiation or cost leadership strategy in a narrow market segment.

While explaining his three main strategic alternatives, Porter emphasizes that total commitment and supporting organizational arrangements are required to implement the strategy effectively. A firm must choose between a differentiation or a cost leadership strategy. He also reinforced that being the lowest cost producer and being truly differentiated and commanding a price premium are rarely compatible.

The success of a generic strategy in delivering competitive advantage is dependent on ensuring that the firm’s value chain successfully supports its generic strategy in adding greater value to its products and services than competitors. The value chain includes all those activities that contribute to the final value of an organization’s product. Value added, or margin, is “the difference between the total value and collective cost of performing the value activities” (Porter, 1985a). Value chain analysis is Porter’s technique for understanding an organization’s ability to add value through its activities, and their internal and external linkages, and allows managers to identify where value is currently added in the system and where there is potential to create further value in the future by reconfiguration and improved coordination of activities.

The development of the five forces, generic strategy, and value chain frameworks was fundamental to the emergence of strategy as recognized academic discipline and, as well as forming the centerpiece of the competitive positioning paradigm, also provided the major analytical tools of the planning school.

New Industrial Organization and Game Theory

The new industrial organization approach is closely linked to the concepts of game theory in analyzing firm’s strategic behavior. The term “strategic” in the terminology of game theory implies interdependence-firms’ behavior affecting each other’s performance, such as profits. From a game-theoretic perspective, competitors solve a specified game that has an equilibrium condition in the form of Nash equilibrium or its refinements (sub-game perfection). In the context of firm strategy, the need for this refinement is that while the Nash equilibrium specifies equilibrium conditions based on ex ante evaluations, some of these conditions do not imply rationality (or sub-game Nash equilibrium) in ex post situations.

An industry analysis is represented as a simple game in the figure, where a potential entrant, “E”, and an incumbent, “I”, decide on their strategic moves. In this game “E” decides whether to enter the industry or not and “I” decides whether to retaliate by engaging in a price war. The outcomes, say profits, are given on the right of the arrows that end the game, where the first outcome is for “E” and the second one for “I.”

Given the setting in the figure, there are two Nash equilibriums, Eq1: (“Not Enter”; “Retaliation”), and Eq2: (“Enter”; “No Retaliation”). Once “E” has entered the industry, both “E” and “I” would prefer to be in Eq2, which specifies “Enter” for “E” and “No Retaliation” for “I”, as opposed to a position where “E” chooses “Enter” and “I” chooses “Retaliation.” Hence, in ex post situations, Eq2 involves rational choices for both players.

On the other hand, it might not always be straightforward to see what Eq1 implies for firms’ behavior. Eq1 specifies ex ante evaluations, where “E” stays out of the industry with the belief that “I” will retaliate by engaging in a price war. In the case of the belief that “I” will choose “Retaliation” the rational choice for “E” is to choose “Not Enter” as opposed to “Enter.” However, if “E” would indeed enter the industry, the choice of “Retaliation” by “I” would be based on an irrational behavior because in such case “I” would be better off by choosing “No Retaliation.” For “I”, while “Retaliation” would be rational in ex ante evaluations (or in one-shot game settings), it is not so once “Enter” by “E” is in place since it is “No Retaliation” that is the rational choice in such ex post situations (or in dynamic game settings). This also means that only Eq2 is a sub-game perfect Nash equilibrium.

Resource-Based View (RBV)

In the resource-based view, firms are considered to differ in terms of efficiency because of the differences in their competitive advantage due to endowed or acquired resources. Since imitation would diminish part of the competitive advantage that firms have, “the very concept of sustained competitive advantage is often defined in equilibrium terms: it is that advantage which lasts after all attempts at imitation have ceased. So, (zero imitation) equilibrium is utilized as a yardstick to define and understand sustained competitive advantage” (Foss and Mahnke, 1998, p. 9). More generally, referring to Demsetz (1973), Barney (1986, 1991), Rumelt (1987), Dierickx and Cool (1989) and Peteraf (1993), a firm’s competitive advantage would be sustained if these criteria are met:

resources are heterogeneous enough to account for differences in efficiency

resources are ex ante economical

resources are ex post non-imitable

resources are not perfectly mobile across firms

Findings and Analysis:

Porter’s Five-Forces Model versus Game Theory

In relation to Porter’s analysis, the first type of equilibrium (Eq1) in the figure could be the case when existing firms are credible in their threats to retaliate against the potential entrants, which is relates to his discussion of one of the five competitive forces, i.e. the “potential entry of new competitors.” More generally, Eq1 type of equilibrium would hold if the structure of entry barriers is such that in the event of entry firms believe that everybody, or at least the potential entrant, is worse off. However, when it comes to ex post situations and entry has been made, the second type of equilibrium (Eq2) is likely to be the case.

If Porter’s model holds, as long as firms pursue his recommended strategies, for example, “E” and “I” could pursue “lower cost,” but without necessarily engaging in a fierce price war. This would imply Eq2 as the sub-game Nash equilibrium. As long as “E” is able to earn profits when entering the industry, the game illustrated can be easily extended to allow for firms to choose among the other Porter-recommended strategies. In case Porter’s model holds, the pursuit of these strategies would reward firms with higher than average profitability (which directly relates to profits assuming equal capital/investment requirements), though not necessarily with equal profit levels.

With entry, Eq2 would be stable for as long as both firms earn more than in a retaliatory situation, which, in another example of Porter’s analysis, could happen if one firm has chosen “differentiation” and the other one “lower cost.” In the case of more than two firms, referring to Porter’s analysis, the situation would translate into choices among the recommended and non-recommended strategies. If Porter is right, those firms that choose recommended options are better off, as long as all firms do not simultaneously choose “Retaliation” type of choices. With firm heterogeneity, firms with superior performance based on Porter’s prescription choose their unit costs, degrees of differentiation, or relevant strategic targets, but not necessarily the same for each firm.

While Foss and Mahnke acknowledge the advancement that game theory has brought into the analysis of firms’ competitive behavior through its tools based on logical reasoning, they do criticize this approach on the grounds of the specification of equilibrium. According to their study, since equilibrium is given from the outset (given that games consist of sophisticated players who anticipate each other’s actions) it leaves no room for disequilibrium situations, such as entrepreneurial discoveries or managerial change to create new opportunities. Explicitly, they state that: “Most notably, there is no notion of an entrepreneurial discovery procedure (Kirzner 1973), in the sense that firm managers are not supposed to discover and act on new opportunities in the market. Everything is essentially given from the beginning and specified by the analyst” (Foss and Mahnke, 1998, p. 6).

Based on this description of the role of game theory as the core of the new industrial organization, Porter’s model of generic strategies is viewed as an attempt to explain firm competitive behavior at a less aggregate explanatory level. In other words, while game theory explains why some firms are in and some others out of the industry, Porter’s model (1980) tries to provide a more detailed analysis of why some of the firms already in the industry are more successful than others.

Porter’s Five-Forces Model versus Resource-based view

In RBV, a firm’s competitive advantage would be sustained if these criteria are met:

resources are heterogeneous enough to account for differences in efficiency

resources are ex ante economical

resources are ex post non-imitable

resources are not perfectly mobile across firms

In relation to Porter’s model, the first two criteria would appear to be met in the efforts that firms make to achieve lower cost or differentiation positioning in the industry. This, when combined with a broad or lower target, is supposed to yield a higher than average performance. Requirements of the “lower cost” or “differentiation” as well as “focus” strategies illustrate such affinity, as, for example, is the case of sufficient spending on advertising and R&D or efforts to secure favorable inputs (low price or high quality) that lower-cost producers and differentiators would have to make in order to successfully pursue their recommended strategies.

The third and fourth criteria are not so straightforwardly related to Porter’s analysis, but they also could be considered as being indirectly present there. If the firm’s resources-or its requirements (Porter’s definition) and efforts-are being imitated or are perfectly mobile across firms, there would be no differences across firms in terms of their competitive advantage on cost or differentiation.

Provided these features of the RBV and the discussion above, Porter’s model is viewed as an attempt to explain firm competitive behavior at a more aggregate explanatory level. Hence, the concept of the firm’s competitive advantage in Porter’s model would represent the aggregation of differences in firms’ resources.

Foss and Mahnke criticize the RBV on similar grounds to their critique of game theory. They view it as lacking disequilibrium explanations. For instance, they state that: “… sustained competitive advantage exists only in (zero imitation) equilibrium (cf. Lippman and Rumelt, 1982); it simply makes no sense to speak of sustained competitive advantage outside of equilibrium, because equilibrium is defined as the absence of imitation. … much of the important structure of the resource-based perspective is solidly founded on equilibrium methodology” (Foss and Mahnke, 1998, p. 10). Another critical point in Foss and Mahnke is that Porter explains firm differences by relying on a given context (industry) or endowment of resources (factors). They do not account for other forms of firms’ differences, such as learning and entrepreneurship (managerial change, innovation, etc.), which are explained endogenously. A firm’s absorptive capacity could be the explanation for the degree of learning and entrepreneurship if three conditions are met.

innovation occurs as a result of cumulative knowledge and learning.

as long as learning helps to build knowledge-based capacity-learning and knowledge-based capacity are important elements that lead to innovation.

there is a strong correlation between innovation and entrepreneurship, and such interpretations of innovation could similarly extend to entrepreneurship.

Since entrepreneurship is a more abstract concept than innovation, the last condition might come in handy in empirical analysis by giving one the ability to make use of measures of innovation in deriving conclusions about entrepreneurship as well.

At one level, it is important that looking at the firm as a collection of activities and the value chain is a way of organizing those activities. The nature and cost of those activities give rise to competitive advantage. There is a direct line between activities, cost, price, and profitability. Resources and competences are one step back in the chain from this. Presumably, if firm has a lot of competence in sales, it will be allowed to conduct its sales activity more efficiently. When looking at an organization’s activities, it is useful to look at the balance sheet of competences and capabilities. That will be an important determinant of how effective the activity will be, which then has a direct link to competitive advantage. The problem is its nagging imprecision: What is a competence? What is a capability? What makes a firm unique? Why is it that a firm is going to receive superior returns rather than the resource holder who could bargain up the price? It often comes across as vague and allows companies to make exaggerated claims about their resources and competences without validating those claims with proper analysis. For example, how will a firm become more profitable, through higher price or lower cost or some combination of the two? How can lower cost and/or higher price be achieved? How do resources and competences connect to these questions? The RBV has imploded that the more that people have investigated the underlying assumptions, the more they question this approach. Finally, it loses its operational significance.

Advantages of using Porter’s model:

Popularity:

Porter has had a major impact on the area of business strategy and on the field of industrial economics. For instance, Miller and Dess (1993) found that over 1986-1990, Porter’s 1980 work was referred in almost half of the papers in the Strategic Management Journal. in July 2005, there were a total of 896 references to Porter, of which 807 had cited his 1980 model in the journals using the “Business Source Premier’s database.

Well-defined structure:

By looking at the framework of three generic strategies, the concept of competitive advantage and strategy has been explained within a well-structured setting. The model presents a “general rule” for a firm’s strategy. It is contended that firms that follow the rule or the recommended strategy will attain competitive advantage and perform better than firms that do not. The benefit of using a well-structured model for analyzing the competitive advantage of firms is that it provides some criteria or benchmarks against which firms can be easily analyzed and compared in ex post situations.

Feasibility:

The application of such a model to real life situations becomes feasible since identifying and selecting those firms that have achieved competitive advantage and chosen the relevant strategic targets becomes a fairly straightforward process. One can simply place these firms within the framework and assess whether they fall within the recommended alternatives or not. The more feasible a model is, the easier the comparison of firms can be made; and consequently, the easier conclusions about competitive advantage and performance are reached. This may be especially helpful in empirical settings where problems with data quality are prevalent. A feasible model gives the researcher a useful tool to quickly see whether the information from the observations fits the model’s dimensions or not, discarding those observations with ambiguous information.

Clarity:

The model of generic strategies presents a clear and easily comprehensible way of analyzing how a firm can attain competitive advantage and perform better and also when it fails to do so. The concept of competitive advantage can be understood without difficulty by theorists, practitioners and the lay audience because the meanings of lower cost and differentiation (in terms of quality at least) are relatively straightforward. In a world of many different cultures, languages and firms’ practices, the terminologies used, especially those in theory and business, can sometimes be far from consistent. This is particularly true when a theory is translated into other languages for research and/or teaching purposes. Furthermore, differences in terminology can also pose serious problems to fully absorb what a theory suggests for real-life business practices, especially where they are applied in contexts that differ substantially from those in which the theory first originated. Where researchers and professionals need to engage in interpreting and adapting theoretical concepts into comprehensible and practicable terms, a model that possesses clarity in its original format is a valuable asset.

Simplicity and generality:

Porter has presented his 1980 model in such general terms that it can encompass any type of industry and firm. Moreover, the model has a notable simplicity in terms of the main elements that make up the competitive strategies. Since efforts to reach simplicity are sometimes associated with the reduction of the number of details or elements of a model, the accuracy of representation may inevitably be put into question. The trade-off between simplicity and representation is a subject of debate in every science, but the relatively low confidence in finding universal and permanent laws governing the nature of social phenomena can make this issue more debatable in economics, and even more so in business studies. Although it is through empirical analyses that models are assessed in terms of their ability to capture the essence of a more complex reality, a simple and general model remains desirable in every field.

Complementary:

Porter’s model represents a rather high degree of detail in the specification and explanation of firms’ competitive behavior. While game theoretic models are concerned with even broader consideration of strategy, they do not generally engage in a detailed explanation of the specific actions of firms while choosing one action in the tree of the game. There are, of course, studies within game theory that do consider detailed actions of firms’ competitive behavior, but as an overall approach to strategy, it is more concerned with the context of competition rather than competitive actions, per se.

Porter’s model describes the competitive behavior of firms more specifically than game theory, though such behavior is still viewed as generic at the broadest level of a firm’s strategy planning and implementation process. In order to be successful in the pursuit of one of the recommended generic strategies, firms should meet a number of requirements. However, the model itself is reasonably general since it incorporates a myriad of factors and conditions for firms into a three-generic-strategy approach with five recommended strategic options. On the other hand, as noted in the discussion of the previous section, the resource-based perspective specifies firms’ competitive behavior in more detail by looking at how the resources should be used in order for firms to be able to reach and maintain competitive advantage.

Given this interpretation, Porter’s model has a complementary feature to game theoretic models and the RBV. The advantage of starting with Porter’s model is that the knowledge gained from its applicability can provide a useful basis for further investigations along the lines of a broad contextual approach based on game theory or a more detailed intra-firm approach based on the RBV.

Critics on Porter’s model

Despite the advantages of using Porter’s model, there have been criticisms of a number of aspects of his work. The five forces concept has been attacked on the basis that the principal unit of analysis is the industry rather than the individual firm. Porter argues that the framework makes it possible to assess the potential profitability of a particular industry, and Porter and McGahan (1997) provide some evidence to support this claim, whereas Rumelt (1991) argues that firm-specific factors are more important to the profitability of a business than industry-wide factors. The framework also implies that the five forces apply equally to all firms in an industry. However, the strength of the forces may differ from business to business on the basis of firm size and/or the strength of their brand name in reality. Finally, five forces analysis can be regarded as rather static at a time when the business environment is increasingly dynamic. Despite these possible limitations, the framework is the most powerful tool available for analysis of the business environment to this day.

The generic strategy framework has been the focus of far more than criticism (Miller, 1992; Mintzberg, Quinn, & Ghoshal, 1995). There is considerable evidence that many companies consciously operate a hybrid strategy combining low cost with differentiated products or services and, rather than being stuck in the middle, they are highly successful businesses. Toyota is an example. Similarly, low cost, and low price, alone do not sell products and services. They must possess qualities that are perceived by customers as desirable and of value. Furthermore, Mintzberg et al. (1995) argued that price, together with image, after sales support, quality, and design, can be used as the basis of product differentiation. The resource-based school has more fundamentally questioned the view that generic strategies cannot be the basis of competitive advantage and they suggest that organizations must develop unique firm-specific core competences that will allow them to outperform competitors by doing things differently and better (Prahalad & Hamel, 1990). This uniqueness precludes general recipes for competitive advantage such as those implied in the generic strategy framework. Nevertheless, differentiation of products and services remains fundamental to the means by which organizations seek to gain competitive advantage.

Pretorius (2008) stated that Porter’s generic strategy matrix often proves inadequate for use by distressed firms because of assumption that ventures operate “normally” in competitive environments. Leaders of troubled ventures facing turnaround situations need to interpret the complex factors involved, as generic strategies alone prove inadequate.

E. Conclusion:

Porter’s model along with some other alternatives, the New Industrial Organization and Game Theory and Resource-Based Perspective to the firm’s competitive behavior were reviewed.

The context of firms’ competitive strategies in Porter’s analysis consists of five competitive forces: potential entry of new competitors, intensity of rivalry among existing firms, potential development of substitute products, bargaining power of consumers and bargaining power of suppliers. According to Porter, the joint influence of these forces determines the industry’s intensity of competition and average profitability. Porter’s model of generic strategies encompasses the main strategic options that firms pursue regardless of the type of industry and the firm’s business. There are two main dimensions in this model: competitive advantage, which can be in the form of lower cost or differentiation; and strategic target(s), which can be found in terms of geographic areas, market segments served, or range of products offered.

Porter’s three recommended strategies are “lower cost,” “differentiation,” and “focus.” Focus can be of three kinds: “cost focus,” “differentiation focus,” or “cost and differentiation focus.” The non-recommended option is “stuck in the middle.” According to Porter, the recommended strategies reward firms with higher than average profitability, and the “stuck in the middle” strategy inevitably yields poor performance. In relation to the other approaches reviewed, Porter’s model is considered as an insightful and convenient approach to analyzing the firm’s competitive behavior for a number of reasons. These reasons are its popularity, well-defined structure, feasibility, clarity, simplicity and generality, and complementary role to two other main approaches to analysis at the aggregate level.

Although insightful and convenient, whether Porter’s model is also a useful approach to predict superior performance is another issue and an important research topic. The knowledge of the usefulness of Porter’s model would be enhanced if a number of studies that relate to this model are critically reviewed. It would be best not only to point out the findings of the studies reviewed, but also-more importantly-to assess their conceptualization of Porter’s model as well as the methodologies deployed.