article title
On the Path towards a Competence-based
Theory of the Firm
Jörg Freiling, Martin Gersch and Christian Goeke
Abstract
Jörg Freiling
University of Bremen,
Germany
Martin Gersch
Freie Universität
Berlin, Germany
Christian Goeke
Freie Universität
Berlin, Germany
Exploiting the potential and tackling the problems of resource-based and competencebased research, this paper develops a proposal for a competence-based theory of the firm
(CbTF). The CbTF is based on the fundamentals of market process theory and is independent of existing approaches to explaining the nature of the firm. The paper addresses
the basics of the theory in terms of the philosophy of science by referring to the Lakatos
model and the position of CbTF in organization theory. The fundamental question of the
nature of the firm is approached by the notion of an organizational ‘ambiente’ and by
using findings of entrepreneurship research.
Keywords: theory of the firm, philosophy of science, market process theory, competence-based view, organizational ‘ambiente’
Introduction
Is the resource-based view useful? The response from academics is ambiguous.
Some researchers argue that the objections made are so basic that the resourcebased view should be discarded (e.g. Priem and Butler 2001). Others (e.g.
Barney 2001) still promote the utility of this view by pointing out some of its
strengths and comparable weaknesses of other ‘established’ theories. The debate
continues with many open questions, e.g.:
1 Is the resource-based view fatally flawed?
2 Does the resource-based view provide a theoretical framework or at least
pave the way to such?
Organization
Studies
29(08&09):
1143–1164
ISSN 0170–8406
Copyright © 2008
SAGE Publications
(Los Angeles,
London, New Delhi
and Singapore)
www.egosnet.org/os
3 What are the minimum requirements for establishing a framework in
resource-based research that realizes an enduring approach for management
and organization theory?
This paper argues that, despite some promising progress, the serious problems
of the resource-based view can only be resolved through a solid grounding in
the philosophy of science. Many of the justified objections call for an approach
that re-engages with the fundamentals of scientific thinking. The purpose of this
paper is to locate a reconfigured version in the landscape of organization theory
DOI: 10.1177/0170840608094774
1144
Organization Studies 29(08&09)
in order to identify (in)commensurable approaches and to avoid problematic
eclectic work. Having positioned its approach, this paper intends to analyse one
of the most basic questions of business research in circumstances of incomplete
information, uncertainty and dynamism in markets: to explain the very nature
of the firm — in a particular manner that sets it apart from other theories in use.
The paper is organized as follows: firstly, state of the art, resource-based
research is analysed in order to illustrate the most fundamental criticisms. These
represent the core of any further consideration and the basis of a re-conceptualization introduced in the second step. Accordingly, a suggestion for a so-called
‘competence-based theory of the firm’ (CbTF) is introduced, stressing the role
of entrepreneurship, dynamic capabilities and competences. The discussion
within the scope of the philosophy of science takes the different existing concepts into account and is finally guided by the methodology of Lakatos (1970),
pointing out elements of the ‘hard core’ as basic assumptions of the theory. The
derivation of a consistent terminology, based on the phenomena to be explained
and what is considered to account for them (‘explanandum’ and ‘explanans’,
referring to Hempel and Oppenheim 1948), is subject to subsequent considerations. These prepare the ground for an outline of the basic causal structures of
a refined resource-based theory.
In order to understand the fundamental position of this approach, the location
of CbTF in management and organization theory is the subject of the third step.
It transpires that CbTF belongs to the approaches of evolutionary economics
that are positioned far from the traditional mainstream of economic theories,
namely the functionalist paradigm according to Burrell and Morgan (1979). In
particular, the CbTF appears as a part of market process theory with an interesting aspect: market process theory, as developed by Mises (1949), Hayek
(1978) and Kirzner (1973), addresses the market level and does not represent a
management theory. Accordingly, researchers still lament a ‘missing chapter’ in
market process theory, namely a chapter that would fill the ‘concreteness gap’
concerning intra-organizational processes (Boettke 1994; Loasby 2002). The
other way round, embedding CbTF in market process theory facilitates further
progress towards a ‘new IO approach’: by combining considerations on the
micro level (firm) and the macro level (market/industry), the opportunity arises
to address the dynamics of competition from a particular, co-evolutionary point
of view. In this sense, this paper makes a contribution to the metamorphosis
debate triggered by Penrose (1995) and Pitelis (2002). Finally, the paper
attempts to explain the very nature of the firm by extending some of the contributions of, for example, Conner (1991), Foss (1993), Madhok (1996) and
Hodgson (1998).
Historical Background and State of the Art in Resource-based
Theory
Resource-based and competence-based thinking can be traced back to the early
steps of economic theory. Adam Smith (1776/1904) pointed out the opportunities of division of labour and coordination. Promising further steps were made
Freiling et al.: Towards a Competence-based Theory of the Firm
1145
by Charles Babbage (1832/1963) and Friedrich List (1841). They stressed
asymmetrically distributed skills and capabilities among individuals more than
had Smith, pointing to the necessity of resolving the coordination problem of
the division of labour. In particular, List (1841) formulated the ‘law of the confederation of productive forces’ by referring to the fact that productivity not
only depends on the division of labour but also on linking the different activities. This unification of the productive forces, carefully monitored by the entrepreneur, is in List’s view the only way fully to exploit the opportunities offered
by the division of labour, while simultaneously opening a road to the competence discussion of the 1950s (e.g. Penrose 1959), and the 1990s (e.g. Prahalad
and Hamel 1990; Teece et al. 1997), and most recent discussions on entrepreneurial issues of the theory of the firm (e.g. Langlois 2007). Notably, these
streams in classical theory indicate that, in the beginning, entrepreneurship and
entrepreneurial functions on the one hand and initial capability-based considerations on the other were part of the same nucleus. Incidentally, this same link
can be identified in the work of Edith T. Penrose (1959: 77).
There has been much progress in resource and competence research in the
meantime and capability-based approaches continue to inform strategic management theory (e.g. Helfat et al. 2007). Why is this? The competence perspective acknowledges the importance of time and historicity in economic decision
making by referring to organizational paths. It explains why every organizational entity is equipped with specific resources and an identity, and sheds interesting light on internal factors such as tacit knowledge, social complexity,
organizational routines and competences (Dierickx and Cool 1989).
There remain, however, some fundamental problems of resource-based and competence-based research that obstruct the path of an affirmed theoretical approach:
• The ‘house’ of resource-based approaches in strategic management theory is
neither a homogeneous nor a coherent one (Knudsen 1996; Acedo et al.
2007). Within the scope of a resource-based view we can identify: a
resource-based theory (e.g. Barney 1991), a resource-advantage theory —
rooted in no less than 11(!) research traditions of a different kind (Hunt
2000) — and a resource-endowment view (Mahoney 1995). A competencebased view consists of at least the core competence debate (Prahalad and
Hamel 1990), the dynamic capabilities approach (Teece et al. 1997) and
competence-based strategic management (Sanchez et al. 1996) — not to
mention the huge number of knowledge-based approaches. Knudsen (1996:
13) points out: ‘it is probably not reasonable at this point to describe the
competence perspective as a coherent research programme, or paradigm,
characterized by a common hard core and positive heuristic’. The lack of
coherence is accompanied by considerable problems:
–
There is still no declarative statement on basic assumptions in use
(Knudsen 1996). The terminology is confusing in many respects. Most
important is the fact that terminological considerations are not aligned
with the underlying ‘explanandum’ and ‘explanans’ of competencebased research. Moreover, there is still confusion about the object of
explanation.
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Organization Studies 29(08&09)
–
Closely connected with the explanandum debate and this kind of reasoning, the tautology critique (e.g. Priem and Butler 2001) is still justified
and represents a key challenge for further research.
• Different research traditions frequently find themselves combined with competence research. Many of them are simply incommensurable and end up in
problematic kinds of eclecticism from the viewpoint of the philosophy of
science, while others are at best misleading. For example: is the often practised extension of transaction cost economics (TCE) with time-oriented
aspects (e.g. Langlois 1992, 2006) or the combination with competence theory really useful if we consider that TCE belongs to the neoclassical research
tradition and is equilibrium-oriented, whereas competence research claims to
be a market process approach belonging to evolutionary theory? Referring to
a debate on another level: is there any virtue in making use of biological
analogies when analysing organizational issues? It was Penrose who had
triggered this discussion more than 50 years before, when she remarked:
‘(E)ven as a metaphor it [biological evolution] is badly chosen … (I)n seeking fundamental explanations of economic and social phenomena in human affairs the economist
… would be well advised to attack his problems directly and in their own terms rather
than indirectly by imposing sweeping biological models upon them’ (1952: 819).
In confronting these fundamental problems, the question of how to proceed arises.
Regarding the numerous deficiencies of transaction cost theory, Sydow (1992) in
a similar situation outlined four alternatives: (1) fast forgetting, (2) improving, (3)
combining or (4) re-conceptualizing. Rejecting alternative (1) in face of the considerable explanatory power of resource-based research, alternatives (2) and (3)
do not come into play, because minor improvements are unable to overcome the
deficiencies mentioned and combination is not a primary route, as many fruitless
trials have already shown (Schneider 1997). Re-conceptualization thus remains,
and is the subject of our next section.
Competence-based Theory of the Firm: First Steps in Responding
to Recent Problems
It is clear that competence research lacks foundation in the philosophy of science
(Foss 2005). In particular, there is no solution to the problem of eclecticism.
Feyerabend (1975) raises a plausible claim for theoretical pluralism. As long as
pluralism is not understood the ‘anarchic’ way introduced by Feyerabend, this
goes along with appropriate criteria to connect insights from different theories.
Unfortunately, these criteria do not yet exist. In order to respond to this problem,
to avoid a too long discussion on meta aspects of the philosophy of science and
to establish a reliable grounding, a framework is useful in order to derive the
research basics systematically. Lakatos (1970) developed such a framework of
conceptualizing the ‘hard core’ of a scientific programme. Lakatos (1970:
132–138) argues that every theory can be described by a hard core consisting of
incontestable basic assumptions. These hard-core assumptions are accompanied
by a number of further assumptions and auxiliary hypotheses that should serve
Freiling et al.: Towards a Competence-based Theory of the Firm
1147
as a ‘protective belt’ against falsification. This protective belt is subject to adjustments and replacements helping to defend the hard core (as far as possible) and
to reveal new facts, and is accompanied by positive and negative heuristics. To
define such basic cornerstones of a theory, it is argued, is vital for giving order
to the chaos of observable phenomena and thereby facilitating the generation of
new insights (Smith, according to Loasby 1999: 8).
In order to conceptualize CbTF’s hard-core elements, as claimed for example by
Foss (2005), it is necessary to summarize the fundamental modus of competencebased thinking. Based on prior research contributions, which can be regarded as
frame-forming and generally accepted among competence researchers, the following aspects are to be considered:
• The whole research stream is an economic one.
• Economic agents are equipped with scarce and in many cases not perfectly
mobile factors (Barney 1991).
• They make decisions under circumstances of incomplete, asymmetrically
dispersed information.
• They reflect, learn and exercise by each decision. The results are idiosyncratic
capabilities and ‘entrepreneurial theories’ (Harper 1995) in every point in time.
• Former decisions are often dependent from later decisions. Accordingly, not
only history matters (Dosi 1982) but also individual and organizational paths
evolve.
• The factors that are available to firms are not totally homogeneous (Barney
1991). By means of bundling and specification processes they become heterogeneous so that every firm can be regarded as a unique bundle of factors
(Penrose 1959), in particular of resources and competences.
• Although the firm as an entity is embedded in a constraining business environment, there is still leeway for entrepreneurial action and for shaping outer
conditions according to firm-specific goals. The opportunities to shape
depend on the organizational development, the commitments made and the
resources and competences available.
The challenge now is to transform these cornerstones into a hard core in the
sense of Lakatos (1970). This requires the formulation of basic assumptions
derived from the above-mentioned considerations and their integration into a
cohesive whole (a ‘hard core’). The commonalities of market process theory and
competence-based research are an anchor point for the derivation of the assumptions. Such an explicit hard core is no end in itself — it is rather considered very
useful for aligning relevant research in a theoretically robust way. Due to reasons
mentioned below, we suggest calling the research programme on this common
ground ‘Competence-based theory of the firm’. The CbTF offers the opportunity
to build a consistent theoretical framework backed by the philosophy of science.
Designed as an evolutionary approach of the economic kind, the elements of the
hard core (HCE) are arranged according to the fundamental work of Backhouse
(1998) as follows:
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Organization Studies 29(08&09)
Figure 1
Knowledge and
Radical Uncertainty
(based on Rese
2000: 70)
Knowledge relevant for the market
1
... that a player
already has.
2
... of which the
player knows
but does not
long for.
3
... of which the
player does
not know.
4
... that does
not exist yet.
Competence-based Theory of the Firm:
Experience and alertness
determine a player’s cognition
of what knowledge exists.
The knowledge attained by a player
at a certain point of time: knowledge
on knowledge.
Radical ignorance
The player does not have all relevant
knowledge. New knowledge is created
constantly.
HCE 1: Subjectivism. This construct, well known from the market process theory of the New Austrian Economics (Mises 1949), points to the fact that economic agents differ in what they know, what they want, what they do and what
they are equipped with (e.g. skills). Individuals make decisions from their own
points of view and their respective interpretations. In this sense, every individual is equipped with specific knowledge, motivation, expectations and abilities.
These endowment items are subject to changes over time (learning, training,
etc.) with the result that new asymmetries evolve. Subjectivism plays a crucial
role in explaining the idiosyncratic nature of the firm, in accord with resourcebased and competence-based thinking.
HCE 2: Radical uncertainty. HCE 1 implies the incompleteness of information and knowledge in the actions and decisions of individuals. HCE 2 goes
further (Shackle 1972): ‘The history-to-come which will flow from men’s
decisions is nonexistent until those decisions themselves are made. What
does not yet exist cannot now be known’ (Shackle 1972: 3). CbTF presumes
radical uncertainty, just like the market process theories, as demonstrated in
Figure 1.
HCE 3: Methodological individualism. Decisions are made by individuals. Also
in harmony with market process theory, methodological individualism means that
all decisions in organizations can be traced back to single individuals and their
contributions to aggregated phenomena (e.g. organizational learning, culture —
cf. Spender 2006). In literature, there is no uniform concept of methodological
individualism. Kincaid (2004) coined the term ‘varieties of individualism’ and
identified five modes. In particular, ‘explanatory individualism’ asserts that social
phenomena can be fully explained in individualistic terms. In order to address
organizational phenomena at best without giving up the individualistic viewpoint,
we refer to the moderate methodological individualism according to Foss (2005).
This implies that ‘at least metaphorically … institutions exert influence on individual behaviour … in the sense that ‘they’ structure incentives and therefore
impact behaviour’ (Foss 2005: 10). Similarly, organizational competences can be
explained by analysing intra- (Teece 2007) and inter-personal behaviour. This
understanding is chosen due to the economic character of CbTF. In case of sociological considerations, concepts such as methodological interactionism
(Nooteboom 2006) are able to highlight the relationships among agents.
Freiling et al.: Towards a Competence-based Theory of the Firm
1149
HCE 4: ‘Homo agens’. In face of the HCEs mentioned, the traditional ‘homo
oeconomicus’ model of economic theory does not fit. Mises (1949) modelled
human action by referring to the ‘acting man’ (‘homo agens’) as a proactive
player, permanently looking for new opportunities to improve his situation
(Lachmann 1986). Combinations of objectives, means and alternatives are given
but are subject to entrepreneurial action and modifications in order to bring things
to a favourable outcome. In particular, two basic features are required in order to
model the ‘homo agens’: alertness, being relevant only in settings of radical
uncertainty, and economizing, which implies making (limited) rational choices
within the scope of the surroundings mentioned. The notion of the ‘homo agens’
seems to fit perfectly with resource-based and competence-based thinking.
HCE 5: Moderate voluntarism. Closely connected with the ‘homo agens’ and in
combination with radical uncertainty, moderate voluntarism implies that the
agents’ moves might have some impact on their relevant environment in such a
way that favourable conditions can be shaped in a desirable manner through
proactive, creative management (Prahalad and Hamel 1990; Teece 2007).
Nevertheless, the power of an agent is restricted, bringing the embeddedness
argument into play: the given legal system, market standards and power constellations in competition indicate that, even for alert entrepreneurs, not everything is possible.
HCE 6: Time matters. Time plays a prominent role in competence research in
general and in CbTF in particular due to historicity and the non-consummatory run of events (i.e. no definable outcomes of actions). Historicity implies
possible irreversibilities in decision making which cause lock-ins as well as
lock-outs and affect the path-oriented organizational development (Dosi
1982). Path relatedness has an ambiguous impact. On the one hand, it confines the development options of individuals and organizations. Not every
action in the future is possible, as past decisions and developments might still
influence what is conceivable for the future and what is not: events are intertemporally connected. On the other, path effects enable agents and organizations to trigger accumulation processes, for example those regarding resource
and competence building. In this context Dierickx and Cool (1989) coined the
term ‘asset mass efficiencies’. Moreover, events are not only inter-temporally
connected but also to a certain degree self-energizing (Arthur 2000). Actions
are not only surrounded by other actions (which form a sequence together
with the initial action: Rizzo 1994) but also go along with time lags as regards
their effects. This thinking is deeply embedded in competence research, as
revealed in the discussion on isolating mechanisms or flexibility and inertia
(Rumelt 1984). The run of events and final result are open (Arthur 2000: 112).
The irreversibility argument applies.
These six elements of the hard core make up the foundation of CbTF.
Comparing the different HCEs to corresponding work under the umbrella of
market process theories, in particular the New Austrian Economics (Vaughn
1994), one can say that CbTF is compatible in terms of basic assumptions with
these research programmes. Even Hunt (2000) affirms a strong backing of
resource-based theory in Austrian Economics.
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Organization Studies 29(08&09)
Based on this hard core, the question about CbTF’s epistemological aim (the
explanandum) arises, which goes along with further terminological considerations. It is argued that, without aligning the terminology with the epistemological intention, no adequate response to the tautology objection (Priem and
Butler 2001) can be found and no consistency in reasoning is possible.
One issue that competence research and CbTF have in common is that differences among firms are not primarily explained by factors belonging to market structure and business environment but by the availability and usage of
resources and competences. The predominant epistemological aim of resource
and competence research is to explain inter-firm performance differences by
attributing them to the availability and usage of competences and resources
(Barney 1991). Such a procedure is not unproblematic for at least two reasons:
(1) it focuses on the performance that was actually realized in markets and thus
suggests that only successful players have competences; (2) it makes use of an
ex-post view because, due to uncertainty (HCE 2), ex ante no one can know
which player will be more successful than the other. The aspects point to the
roots of the tautology debate (Priem and Butler 2001). In face of these arguments, this paper proposes a modified explanandum.
What can a modified explanandum look like if the HCEs and the tautology
critique are to be considered? It is argued that addressing ‘striving for competitiveness’ rather than ‘observable competitive advantages’ as the object of
explanation is useful in order to proceed. In particular, in the area of the theory
of the firm the most fundamental aspect is the existence of institutions.
Competitiveness as a construct is therefore conceptualized as the firm’s ability to remain in markets under conditions of — or at least almost — free competition. More precisely, according to Schneider (1998: 68), the firm’s
competitiveness as a non-failure in the market process consists of two components: (a) the ability to prove itself in market processes with parties from the
market’s counter-side (vertical component); and (b) the ability to withstand the
menacing forces of rivals or third-parties in the business environment (horizontal and lateral component). Thus, a longing for competitiveness is merely the
way to ensure today’s and tomorrow’s subsistence.
Striving to avoid tautological reasoning and primarily intending to explain why
firms exist, CbTF’s epistemological aim is therefore the explanation of current
and future firm competitiveness in markets due to inhomogeneous availability of
competences and resources. The reason for choosing this explanandum is
twofold: (1) According to HCE 2, when longing for competitiveness, players act
under radical uncertainty. Thus they cannot know in advance whether they will
achieve competitive advantage based on their resources and competences. (2)
Referring to HCE 6, time matters. Each player will paint his/her own specific,
more or less visionary picture of later market requirements. In this context he/she
will set up a value-added system, backed up by heterogeneous potentials
(resources and competences) and guided by the available entrepreneurial forces
(HCE 4, homo agens), in order to provide a competitive input to the market which
is — hopefully, but not necessarily — the root of competitive advantage (‘striving for competitiveness’). This argument can even be strengthened with regard to
the parallels between CbTF and the Austrian business cycle and capital theory
Freiling et al.: Towards a Competence-based Theory of the Firm
1151
(Foss and Ishikawa 2007). Constraining forces will work, based on historicity (HCE 6) and embeddedness (HCE 5). This process is ongoing and pathdependent — as long as a firm remains competitive.
The shift from ‘competitive advantage’ to ‘striving for competitiveness’ has
considerable impact on the definition of the main terms in competence research.
Firstly, as long as resources (and competences) explain the roots of competitiveness and the uncertain development of competitive advantages, it is not sufficient
to understand them as ‘anything which could be thought of as a strength or a
weakness of a given firm’ (Wernerfelt 1984: 172). Resources and competences are
an outcome of the firm’s combination and refinement processes, enabling it to be
better prepared for proving itself in market processes with customers/suppliers
and withstanding the pressure of competitors. As Penrose (1959: 75–76) stated:
‘The fact that most resources can provide a variety of different services is of great importance for the productive opportunity of a firm. It is the heterogeneity, and not the homogeneity, of the productive services available or potentially available from its resources
that gives each firm its unique character.’
Accordingly, the following differentiation is required and in accord with the
HCE debate and the epistemological aims of CbTF:
Assets are homogeneous external or internal factors that can usually be procured
in markets, serving as input for value-added/upgrading processes.
Resources can be understood as those assets that have undergone a firm-specific
upgrading process. Therefore they should (in face of HCE 2, without any certainty) contribute to the actual and future competitiveness of a firm and thus
account for the firm’s heterogeneity.
Competences mean a repeatable, non-random ability to render competitive output. This ability is based on knowledge, channelled by rules and patterns. The
more competences that are applied, the less room there is for windfall profits.
Competences direct goal-oriented processes for surfacing future performance
potential while offering concrete input to the market.
The role of the above-mentioned terms is depicted in Figure 2. In particular, it
is not necessarily the case that the activation of competences guarantees success
in the market process. The better the whole value-added system is synchronized
with actual and potential market requirements based on visionary shaping of the
external conditions, however, the more promising the presumptions are.
The outcome is that CbTF delivers a platform to overcome the tautology critique. In particular, the argument can be made without referring to the rent discussion anchored in equilibrium-based thinking (Foss 2002: 152). To go one
step further, the dynamic character of CbTF will be delineated.
All the assets, resources and competences representing the firm’s potential
are variable. The left-hand side of Figure 3 shows that the potential (readiness
for action) at one point in time is the basis for a specific action. This action,
which is also based on intention and expectation, can also yield new insights,
for example via customer feedback in the market process. In this way, the
potential at the next point in time will be modified so that the readiness for
action later on will change: time matters (HCE 6). The right-hand side of Figure 3
1152
Organization Studies 29(08&09)
Figure 2
CbTF's Chain of
Reasoning
‘Meta competences’
Shaping of market input processes
Shaping of
readiness for action
Market processes
Visionary shaping
Transaction?!
Offering of
products/services
Processes
(Market input)
competences
Resources
(Asset upgrading)
competences
Assets
Market feedback
Upgradability
Upgrading
Ability of
activation
Activation
Offer to market
highlights the accumulation processes over time. By taking a number of actions
into account, the helix structure indicates shifts in the firm’s readiness for
action. Due to similar action of rivals and uncertainty (HCE 3), it is not possible to state whether or how far these processes will contribute to a higher level
of competitiveness. On the other hand, an invalidation of such processes is possible, for example if competitors are able to trigger innovative processes with
creative–destructive impact (Schumpeter 1934).
It is apparent that the focused theoretical programme of CbTF offers a starting point for addressing the nature of the firm. Before analysing this topic, a
debate on the positioning of CbTF in organization theory will help in locating
the paradigm that embraces CbTF.
Locating CbTF in Management and Organization Theory
Primarily in the 1970s and 1980s, many proposals were made in order to structure the considerable heterogeneity of organization theory (e.g. Burrell and
Morgan 1979; Astley and Van de Ven 1983). Such taxonomies are useful for
identifying streams of organization research that fit into one — existing or
evolving — paradigm (Kuhn 1962) and make use of similar and compatible
assumptions, research principles, laws and scientific methods (Chalmers 1999).
More important, regarding problematic kinds of eclecticism, is the identification of the ‘boundaries’ of a paradigm or a research programme.
Bearing in mind the cornerstones of CbTF based on the HCEs, the taxonomy
developed by Burrell and Morgan (1979) appears to be useful in understanding
CbTF’s fundamental position and the all-encompassing paradigm. Figure 4
demonstrates that Burrell and Morgan (1979: 1) deal with the basic ontological
dimension, whether the reality under investigation is external or internal to the
Freiling et al.: Towards a Competence-based Theory of the Firm
Figure 3
Action and
Readiness for
Action
(Ortmann 2008)
1153
R5
R4
A4
Readiness
for action
X1 in t1
Action
(application and
creation of new
readiness)
R3
Readiness
for action
X2 in t2
R2
A3
A2
A1
R1
individual — a question directly mirrored in the HCEs mentioned above.
Fundamentally, the subjectivist approach to social science is to be separated
from the objectivist approach. As to the ontological question, subjectivism is
expressed by a position of nominalism, and objectivism by realism. According
to HCE 1, CbTF follows nominalism and assumes that reality is not a given, but
a product of the mind. Furthermore, the assumption concerning human nature
reflects CbTF’s roots in subjectivism: HCE 5 points to moderate voluntarism,
which implies that human action is to a large extent not a strict consequence of
environmental conditions, as suggested for example by traditional IO. The position is not an extreme one, however, the agent’s free will being restricted by
embeddedness. Subjectivism reveals interesting methodological consequences:
the subjective position tends towards ideographic methodology, favouring qualitative analysis governed by the subject matter under investigation (Burrell and
Morgan 1979: 2–7). As they argue:
‘The ideographic approach to social science is based on the view that one can only
understand the social world by obtaining first-hand knowledge of the subject under
investigation. It thus places considerable stress upon getting close to one’s subject and
exploring its detailed background and life … The ideographic method stresses the
importance of letting one’s subject unfold its nature and characteristics during the
process of investigation.’ (Burrell and Morgan 1979: 6)
The second dimension in use addresses the ‘order versus conflict’ debate,
triggered in particular by Dahrendorf (1959). Whereas the sociology of order
touches upon the explanation of structures, the sociology of conflict addresses
change and its implications. CbTF takes an intermediate position. Change happens, due to the entrepreneurial action (HCE 4: homo agens) of individuals —
either individually or together with others acting in organizations — according
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Organization Studies 29(08&09)
Figure 4
Paradigms for the
Analysis of Social
Theory
(Burrell/Morgan
1979: 22)
the sociology of radical change
‘radical humanist’
‘radical structuralist’
subjective
objective
‘interpretive’
‘functionalist’
the sociology of regulation
to HCE 3 (individualism). Change is possible, however, though at the same time
restricted by prior decision making and the embeddedness of the firm in the
environment. Due to the historicity argument (HCE 6) and the relevance of
organizational inertia in social and economic life, scepticism towards radical
change is part of CbTF thinking.
To summarize, in terms of the Burrell and Morgan taxonomy, CbTF belongs
to the interpretive paradigm — but without radical positioning. Thus CbTF is
located near to the border with the radical humanist paradigm. The diversity of
approaches belonging to the interpretive cluster (e.g. Weick 1995; Choo 1998)
reminds us to be wary of the mutual exchange of constructs and findings:
although similar in nature, the assumptions are not necessarily the same.
Moreover, CbTF does not follow thinking in terms of radical subjectivism — as
HCE 5 (moderate voluntarism) suggests. These considerations indicate that
central debates in organization theory do not end up as ‘either/or’ categorizations (implicitly suggested by the given taxonomy) but rather as ‘as well
as’ considerations, such as pointed out by Astley and Van de Ven (1983). Nevertheless, in order to understand the idiosyncracies of a theoretical perspective
with its commonalities and differences when compared to other research
streams, the taxonomy of Burrell and Morgan is useful: in a nutshell, many of
the organization theories in use belong to the functionalist paradigm, including
IO, new institutional economics and neoclassical theory. Regarding the fundamental viewpoint, the assumptions and methodology of those theories are so
different from theories belonging to the interpretive cluster that incommensurability is inevitable. This is one basic outcome of this section: in terms of the
philosophy of science it does not make sense to combine theories of the functionalist (e.g. TCE) and the interpretive paradigm (e.g. CbTF; but not RBV in
general, cf. Foss 2002, who bemoans the heterogeneity problem of the RBV)
due to incompatibility. This holds true regardless of the fact that important constructs (e.g. specificity) can be evolutionarily re-conceptualized in CbTF.
Moreover, it leads to an educated guess that the explanations of the nature of the
firm will differ from, for example, transaction cost theory if CbTF thinking is
Freiling et al.: Towards a Competence-based Theory of the Firm
1155
applied. An explanation that goes beyond opportunism is possible. This string
of thoughts directly links with resource and competence research (e.g. Conner
1991; Foss 1993; Madhok 1996).
Another outcome is that commensurable theories can be identified. The
CbTF, as a theory belonging to the tradition of evolutionary economics, is
deeply rooted in market process theory. Hunt (2000) and Foss and Ishikawa
(2007) come to similar conclusions. Incidentally, in this regard this paper lies
very close to the work of Penrose (1959), whose entrepreneurial and discovery
process-based touch was stressed by Foss (2002). When one considers basic
assumptions, the way of reasoning and the methodology in use, the compatibility becomes apparent. Market process theory, in particular that formulated by
the New Austrian Economics (Mises 1949; Kirzner 1973; Hayek 1978), deals
with trial and error processes resting upon entrepreneurship, knowledge and
skills (such as alertness) as the cutting edge in competition. The same applies to
CbTF, whereupon CbTF goes one step further and addresses the aligned interplay of skills by the competence construct.
Following the evolutionary logic, market process theory explains how new
ideas/actions and innovative impulses evolve (variation), to what extent they
succeed or fail in competition (selection) and whether they become part of
future market processes (retention). Although market process theory has proven
indispensable in understanding markets and industries, it still faces the abovementioned problem of a ‘missing chapter’, namely, that the explanation of
value-added processes in the firm in connection with individual (and organizational) action is insufficient (Boettke 1994; Loasby 2002). CbTF, however, is in
a position to finally bridge this gap, for at least two reasons. Firstly, CbTF is
compatible with market process theory, as outlined above. One can regard
CbTF not only as belonging in the same paradigm as market process theory, but
as an integral part of market process theory. Secondly, CbTF offers a variety of
causal structures which are part of the explanans. These causal structures open
the road to understanding the very nature of the firm — a question of such a fundamental nature that the corresponding findings can simultaneously be used in
order to explain effects in competition.
Stepping Ahead: The Competence-based Nature of the Firm
Why do firms exist? What are firms made up of? These questions represent the
start of a theory of the firm and are the subject of the considerations of this
section. Follow-up questions would relate to the firm’s development over time,
its possible downfall, its boundaries, and internal organization (Foss 1993;
Langlois and Robertson 1995).
In order to address the issue of the nature and essence of the firm, apart from
established theories such as the transaction cost approach (Williamson 1985), the
work of Penrose once more comes into play: ‘A firm is more than an administrative unit; it is also a collection of productive resources the disposal of which
between different uses and over time is determined by administrative decision’
(Penrose 1959: 25). In order to understand the firm, she points out: ‘The essential
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Organization Studies 29(08&09)
difference between economic activity inside the firm and … in the “market” is that
the former is carried on within an administrative organization, while the latter is
not’ (1959: 15). The following considerations shed additional light on the internal
conditions of firms, helping to explain why firms as institutions are indispensable
modes of economic coordination facing alternative governance designs.
Transaction cost theorists argue that, in the case of specific environmental
conditions, firms are required in order to overcome the transaction-related problems connected with opportunistic behaviour and information impactedness.
The explanation rests to a great extent upon the negative consequences of uncertainty. CbTF gives rise to additional arguments. In reference once again to the
classical pedigree of competence research, the argument of List (1841) is
invoked. Clearly, the opportunities provided through division of labour are not
independent of the underlying institutional design. Admittedly, division of
labour works in markets as wells as in firms and cooperatives but not in the
same way. List (1841) and his ‘law of the confederation of productive forces’
shows a promising modus by referring to the necessity of orchestrating the
processes of divided work — thoughts that recur in Penrose (1959). This leads
to the question of what really differs if we compare markets and firms à la
Penrose. The answer is close to her proposal of the ‘area of (administrative) coordination’ (Penrose1959: 20): the firm offers a specific ‘ambiente’. This ambience, representing a fertile background for firm-specific coordination, resource
and competence usage as well as development, is required in order to unveil the
productive forces of the firm and to contribute to competitiveness as conceptualized above. Moreover, and with regard to the entrepreneurial touch of CbTF,
it helps to generate new productive forces.
Why does this take place differently in firms than in markets or loosely coupled systems of cooperation? The answer can be given by referring to the causal
structures of CbTF, borrowed from resource-based research and, if possible,
adapted to CbTF. What does prior research suggest in this context?
Based on a system of different assumptions, Kogut and Zander (1992) refer
to so-called ‘higher order organizing principles’ of the firm, which is a first indication that coordination in firms differs from that in other institutions. These
higher-order organizing principles rest upon procedures by which social relations among employees are recreated and coordinated. With the help of these
principles, knowledge can be used in a structured way to facilitate value-added
activities and to enable voluntary action. Similarly rooted, Hodgson (1998: 189)
makes an interesting suggestion by pointing out the firm’s capacity to protect
and develop competences in the organization. Although we need arguments as
to how this might occur, a fertile background triggering these development
processes seems to make a difference between the firm and alternative modes
of governance. Hodgson recognizes a capacity of the firm as an institution to
mould and integrate the individual perceptions, preferences, abilities and
actions of its personnel.
Foss (1996: 18) states that firms exist due to a more efficient coordination of
learning activities compared to other institutions. This is worth taking up, by
tackling the question of what is different in the case of organizing learning
within firms compared to within other institutions. Helfat and Peteraf (2003)
Freiling et al.: Towards a Competence-based Theory of the Firm
1157
conclude that, under the cover of causally ambiguous relations among individuals in organizations, joint interpretations emerge that lead to collective minds.
Finally, the point of Penrose (1959) is taken into consideration: firms offer
outstanding opportunities for production thanks to the system of productive
resources that constitutes the firm. In this context, Ravix (2002: 167) concludes that production requires a certain environment, which is a given in the
case of firms as institutions. Accordingly, we should pay attention to the way
in which this combination of productive assets, resources and competences is
formed.
All these findings are useful for a preliminary understanding of the specific
‘ambiente’ of a firm and its raison d’être. In contrast to TCE, these considerations not only focus on coordination/transaction but also production/transformation. CbTF tries to integrate the two economic challenges into a cohesive
whole by acknowledging the aspect of time and evolution. Understanding the
fertile background offered by firms as institutions requires going some way
further.
It is argued that the answer can be given by referring once again to the
division and unification of labour and the role of entrepreneurship (List
(1841; Penrose 1959). In face of the moderate voluntarism of CbTF (HCE 5)
and the homo agens notion (HCE 4), entrepreneurial motives are important
in order to address the very nature of CbTF more comprehensively. Taking
the subjectivism argument (HCE 1) seriously, entrepreneurs are equipped
with different entrepreneurial spirits, minds and skills. Some of them might
be powerful people, others less so. Nevertheless, two points are important
when conditions of radical uncertainty (HCE 2) and historicity and nonergodicity (HCE 6) apply. Firstly, the power of every entrepreneur is
restricted due to embeddedness. To unveil power, as in the case of ‘creative
destruction’ (Schumpeter 1934), a ‘division of entrepreneurial labour’ is as
necessary as a ‘unification of the entrepreneurial forces’. However, the problem of limited power of individuals is not internalized in Schumpeter’s world
of pure voluntarism and power exerted by elitist entrepreneurs. Therefore,
our proposal refers to List (1841) as well as Penrose (1959) where interpersonal alignments between people play a decisive role. Responding to
Witt’s (1999) interesting question of whether entrepreneurs need firms, the
CbTF position is an unambiguous one: entrepreneurs very often need firms
because they believe in a world of radical uncertainty (HCE 2), to attain their
goals sooner, better or more comprehensively with the help of the institution
and the specific mode of coordination accompanying it. They expect to pool
influential forces to shape outer conditions and to be better prepared regarding upcoming challenges in future markets. Such a way of thinking is far
from TCE and similar theories.
Secondly, it is questionable whether entrepreneurship is restricted to one
person or those few in the roles of owners or senior management. To unveil the
creative potential of a firm requires triggering entrepreneurial thinking and action
in every part of the firm. Accordingly, CbTF’s understanding of the firm takes into
account what Mises (1940: 246) noted when he touched on the entrepreneurship
issue in the context of methodological individualism (HCE 3): as long as the term
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Organization Studies 29(08&09)
‘entrepreneur’ is discussed in economic studies, the reference is not to a single
person but rather to a function to be performed by people. The viewpoint of Mises
(1940) is useful in many ways: leaders with formal authority have to align their
entrepreneurial activities, which presupposes the existence of structures. The
same applies with regard to the notion that everyone within a firm has at least
some discretion to perform entrepreneurial functions, as mentioned earlier.
Among these, structures, routines and competences play a prominent role.
Separated from other constructs, however, they are not sufficient to enable understanding of what constitutes the ambience of the firm. We will address this idea
later when considering the isolating mechanisms of the RBV.
To continue the entrepreneurship debate within the scope of CbTF, the question arises as to how entrepreneurship is relevant in explaining the existence and
nature of the firm. Sanchez and Heene (1996) develop the framework of the
firm as an open system (see Figure 5). This view, also reinterpretable in terms
of methodological individualism, points to the importance of governing system
elements. The strategic logic comprises rationales employed and entrepreneurs’
minds (Sanchez et al. 1996: 10). The strategic logic of a single person is often
restricted by past events and experiences. The firm as a stable institution ties
entrepreneurial forces together and helps to overcome individual mental barriers. Identifying business opportunities and developing ideas about how to generate completely new opportunities is therefore a matter of entrepreneurial
division and unification of labour. Paths can be created or opened up by pooling ideas and other kinds of assets within the scope of the firm.
Taking a look inside the firm in order to understand the ambience more
comprehensively, Figure 5 demonstrates the importance of a well-structured
value-added net, consisting of a multitude of different assets and governed by
management processes that find themselves in recursive relationship to the
strategic logic. This structure is subject to permanent adaptations triggered
internally or externally, for example by absorbing firm-addressable assets, by
learning in the market process with respective feedback loops, or by a consultant’s advice. That asset mass efficiencies of firms differ from similar
effects of other institutions (Dierickx and Cool 1989) can well be explained
by these internal and market processes. In order to understand why the firm
might offer a fertile ambience, more isolating mechanisms (Rumelt 1984)
come into play.
Regarding the isolating mechanisms, the roles of interconnectedness of assets
as well as social complexity become apparent. Firms offer an environment where
a multitude of relations among people and links among assets and resources
evolve. Notably, the same holds true for other institutions. There are considerable
differences, however, as to the quantity and quality of these couplings. In respect
of the term ‘complexity’, a usual conceptualization encompasses the multitude of
elements, including the quantity, density, and variety of relations between them.
Transferring this conceptualization to our context, the complexity of asset networks within firms differs significantly from that within markets. Colleagues find
themselves in regular and intense personal interaction. Day by day, employees
become better used to available systems and technologies (HCE 6: time matters).
Awareness of the opportunities of the firm as an institution grows over time so that
1159
Freiling et al.: Towards a Competence-based Theory of the Firm
Figure 5
The Firm as an
Open System
(Sanchez and
Heene 1996: 41)
Environment:
Scanning, benchmarking,
consultants, new managers...
Boundaries of the firm as
open system
Strategic Logic:
operating rationale for goal attainment
Management Processes:
process for coordinating deployments of assets
and capabilities
Data
Intangible Assets:
e.g. knowledge, reputation, relationships ...
Data
Tangible Assets:
physical assets, e.g. machines, buildings
Data
Operations:
production, marketing, distribution
Firm addressable resources:
available external resources
Fading transparency and
increasing oranizational inertia
Decisions,
procedures
Product Offerings
Product Markets
Competition
Information by the market
the notion of asset mass efficiencies applies due to synergies — in just the way
that market process theory suggests (Hayek 1978).
By scrutinizing the asset (re-)configuration activities in this tightly coupled
context, it emerges that, due to the stability and the long-term horizon of firms,
certain action-oriented structures evolve that are considered as routines in evolutionary theories (Pentland and Rueter 1994). Those action sequences, containing mental blueprints of how to proceed and deeply embedded in people’s
minds, are channelled by the organizational goals as well as the explicit and
implicit rules that are the result of interaction processes among individuals
(HCE 3). Such a background, preparing the employees for specific action in
contextual value-added activities, is significantly different from the more or less
anonymous ‘arm’s-length’ context of markets. These couplings can well explain
the immobility of certain resources — which might be associated with inflexibility. How far these specification processes are useful in order to increase the
firm’s competitiveness remains open in a world of radical uncertainty (HCE 1).
Nevertheless, the firm is prepared regarding certain situations that might arise,
in a different way to those of other institutions.
Whereas rules and routines add some flesh to the bones of the ‘ambiente’
notion, the role of tacit knowledge is also important. Beside the fact that tacit
knowledge fuels routines to a great extent, implicit knowledge represents a core
challenge of coordination. Whereas tacit knowledge is almost permanently in use
by its bearer, the outcome of a group of people depends on the extent to which
tacit knowledge is transferred among individuals and skilfully put to use by the
team. In the context of institutions, the question arises why a single person
should transfer tacit knowledge to others — considering that the transfer is
costly, indeterminate and time-consuming. In markets, this kind of transfer will
1160
Organization Studies 29(08&09)
not take place, due to a lack of incentive structures. In firms, however, the situation is quite different (Freiling 2004): transfer is not only possible due to permanent ‘training on the job’ by the potential recipients, but is positively aimed for,
due to mutual understanding and the belief that it will ‘pay off’ in terms of successful outcomes for the firm, which depend on skilful workers and their efficient interaction.
All the isolating mechanisms mentioned above explain a coordination difference of firms vis-à-vis other institutions. Isolating mechanisms can work in different ways: they can contribute to developing the ambience of the firm as well
as protecting the causally ambiguous asset network in face of appropriation
strategies by rivals
Finally, the pressing question arises again as to what differentiates the ambience of firms from those of alternative institutions. Do the mechanisms mentioned work only in firms or also in other institutions? The response is twofold:
it seems likely that similar forces might appear in other institutional contexts.
Particularly from a non-evolutionary point of view, there is no real difference.
When an evolutionary perspective is applied, however, the situation changes.
Time matters, in many ways, and causes accumulation effects that are institution-specific. The enduring character of the firm creates favourable conditions
in order to develop coordination modes that differ from other institutions in
terms of quality. This seems to be a core argument and indicates that not only
was there something like a paradigm shift (Kuhn 1962) from IO to RBV in
strategic management, but that we are over halfway towards another paradigm
shift, from non-evolutionary, functionalist theories to evolutionary theories,
with market process theory as one prominent representative.
Outlook
The approach chosen in this paper is different from prior attempts. Many scholars have favoured the connection of new institutional economics with the
resource-based and competence-based perspective (e.g. Conner 1991; Langlois
and Robertson 1995; Hodgson 1998). In the case of making adaptations among
different research streams and testing commensurability, this procedure is possible from the perspective of the philosophy of science. The proposal of this
paper, contributing to the metamorphosis of the theory of the firm, is to focus
the enormous scope of resource and competence research and to investigate the
opportunities for explanation on this platform rooted in market process theory.
The approach we have proposed indicates the need to take some steps back in
order to move forward. With regard to the fundamental problems of resource
and competence research, however, it seems to be worth a try to confront the
opportunities presented in order to address these issues.
Moreover, this research approach appears to be able to close a long-lasting
gap in market process theory on the one hand, while benefiting from the advantages of market process theory on the other. In this respect, embedding entrepreneurial thinking deeper in competence research is one opportunity that
presents itself, tying together the work of classical theorists, that of Penrose and
Freiling et al.: Towards a Competence-based Theory of the Firm
1161
more recent strands of management theory, in order to combine entrepreneurship theory and strategic management. Another opportunity presented by this
theory is that it leads to an understanding of the interplay between the ontological levels of the firm and industry/the market.
Note
References
We gratefully acknowledge the support of Christos Pitelis and helpful comments by three anonymous reviewers.
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1994 Austrian economics in America.
Cambridge: Cambridge University
Press.
Weick, K. F.
1995 Sensemaking in organizations.
Thousand Oaks, CA: Sage.
Wernerfelt, B.
1984 ‘A resource based view of the firm’.
Strategic Management Journal 5/2:
171–180.
Williamson, O. E.
1985 The economic institutions of
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1999 ‘Do entrepreneurs need firms?’
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Jörg Freiling
Jörg Freiling has a PhD in Business Administration and is a Full Professor at the University
of Bremen. He is Director of the SCOUT Institute for Competence-based Strategic
Management and holds the LEMEX Chair for Small Business and Entrepreneurship. His
research interests include the theory of the firm, the management of organizational competences, the impact of entrepreneurship on organizational performance, change management and SME management in international business.
Address: LEMEX Chair for Small Business and Entrepreneurship, Faculty of Business
Studies & Economics, University of Bremen, Wilhelm-Herbst-Strasse 5, D-28359
Bremen, Germany.
Email: freiling@uni-bremen.de
Martin Gersch
Martin Gersch has a PhD in Business Administration and Business Informatics. He is a
Full Professor at the Freie Universität Berlin (Germany) and head of the Competence
Centre E-Commerce. His research interests include evolutionary theories, resource and
competence research, strategic and information management, industry transformation,
change processes, e-business, innovative business models, e-learning, and competitive
(dis)advantages and traps.
Address: Freie Universität Berlin, School of Business & Economics, Garystrasse 21,
14195 Berlin, Germany.
Email: martin.gersch@fu-berlin.de
Christian Goeke
Christian Goeke is a Research Associate at the School of Business and Economics at the
Freie Universität Berlin (Germany). He received his PhD in economics and business
administration from the Ruhr-University Bochum (Germany). His current research
focuses on strategic challenges of industry transformation, with a special focus on the coevolution of objects on different levels of analysis, alliance strategies, and competencebased strategic management.
Address: Freie Universität Berlin, School of Business & Economics, Garystrasse 21,
14195 Berlin, Germany.
Email: christian.goeke@fu-berlin.de
www.hbrreprints.org
Awareness of the five forces
can help a company
understand the structure of its
industry and stake out a
position that is more
profitable and less vulnerable
to attack.
The Five Competitive
Forces That Shape
Strategy
by Michael E. Porter
Included with this full-text Harvard Business Review article:
1 Article Summary
The Idea in Brief—the core idea
The Idea in Practice—putting the idea to work
2 The Five Competitive Forces That Shape Strategy
18 Further Reading
A list of related materials, with annotations to guide further
exploration of the article’s ideas and applications
Reprint R0801E
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The Five Competitive Forces That Shape
Strategy
The Idea in Brief
The Idea in Practice
You know that to sustain long-term profitability you must respond strategically to
competition. And you naturally keep tabs
on your established rivals. But as you scan
the competitive arena, are you also looking
beyond your direct competitors? As Porter
explains in this update of his revolutionary
1979 HBR article, four additional competitive forces can hurt your prospective profits:
By understanding how the five competitive forces influence profitability in your industry, you can
develop a strategy for enhancing your company’s long-term profits. Porter suggests the following:
• Savvy customers can force down prices
by playing you and your rivals against
one another.
• Powerful suppliers may constrain your
profits if they charge higher prices.
• Aspiring entrants, armed with new capacity and hungry for market share, can
ratchet up the investment required for
you to stay in the game.
COPYRIGHT © 2008 HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.
• Substitute offerings can lure customers
away.
Consider commercial aviation: It’s one of
the least profitable industries because all
five forces are strong. Established rivals
compete intensely on price. Customers are
fickle, searching for the best deal regardless
of carrier. Suppliers—plane and engine
manufacturers, along with unionized labor
forces—bargain away the lion’s share of airlines’ profits. New players enter the industry in a constant stream. And substitutes
are readily available—such as train or car
travel.
By analyzing all five competitive forces, you
gain a complete picture of what’s influencing profitability in your industry. You identify game-changing trends early, so you can
swiftly exploit them. And you spot ways to
work around constraints on profitability—
or even reshape the forces in your favor.
POSITION YOUR COMPANY W HERE THE
FORCES ARE WEAKEST
Example:
In the heavy-truck industry, many buyers
operate large fleets and are highly motivated to drive down truck prices. Trucks are
built to regulated standards and offer similar features, so price competition is stiff;
unions exercise considerable supplier
power; and buyers can use substitutes such
as cargo delivery by rail.
To create and sustain long-term profitability
within this industry, heavy-truck maker Paccar chose to focus on one customer group
where competitive forces are weakest: individual drivers who own their trucks and
contract directly with suppliers. These operators have limited clout as buyers and are
less price sensitive because of their emotional ties to and economic dependence
on their own trucks.
For these customers, Paccar has developed
such features as luxurious sleeper cabins,
plush leather seats, and sleek exterior styling. Buyers can select from thousands of
options to put their personal signature on
these built-to-order trucks.
Customers pay Paccar a 10% premium, and
the company has been profitable for 68
straight years and earned a long-run return
on equity above 20%.
EXPLOIT CHANGES IN THE FORCES
Example:
With the advent of the Internet and digital
distribution of music, unauthorized downloading created an illegal but potent substitute for record companies’ services. The
record companies tried to develop technical
platforms for digital distribution themselves,
but major labels didn’t want to sell their
music through a platform owned by a rival.
Into this vacuum stepped Apple, with its
iTunes music store supporting its iPod music
player. The birth of this powerful new gatekeeper has whittled down the number of
major labels from six in 1997 to four today.
RESHAPE THE FORCES IN YOUR FAVOR
Use tactics designed specifically to reduce
the share of profits leaking to other players.
For example:
• To neutralize supplier power, standardize
specifications for parts so your company
can switch more easily among vendors.
• To counter customer power, expand your
services so it’s harder for customers to leave
you for a rival.
• To temper price wars initiated by established rivals, invest more heavily in products that differ significantly from competitors’ offerings.
• To scare off new entrants, elevate the fixed
costs of competing; for instance, by escalating your R&D expenditures.
• To limit the threat of substitutes, offer better value through wider product accessibility. Soft-drink producers did this by introducing vending machines and
convenience store channels, which dramatically improved the availability of soft drinks
relative to other beverages.
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Awareness of the five forces can help a company understand the
structure of its industry and stake out a position that is more profitable
and less vulnerable to attack.
The Five Competitive
Forces That Shape
Strategy
by Michael E. Porter
COPYRIGHT © 2007 HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.
Editor’s Note: In 1979, Harvard Business Review
published “How Competitive Forces Shape Strategy” by a young economist and associate professor, Michael E. Porter. It was his first HBR article,
and it started a revolution in the strategy field. In
subsequent decades, Porter has brought his signature economic rigor to the study of competitive strategy for corporations, regions, nations,
and, more recently, health care and philanthropy.
“Porter’s five forces” have shaped a generation of
academic research and business practice. With
prodding and assistance from Harvard Business
School Professor Jan Rivkin and longtime colleague Joan Magretta, Porter here reaffirms, updates, and extends the classic work. He also addresses common misunderstandings, provides
practical guidance for users of the framework,
and offers a deeper view of its implications for
strategy today.
In essence, the job of the strategist is to understand and cope with competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s
harvard business review • january 2008
direct competitors. Yet competition for profits
goes beyond established industry rivals to include four other competitive forces as well:
customers, suppliers, potential entrants, and
substitute products. The extended rivalry that
results from all five forces defines an industry’s
structure and shapes the nature of competitive interaction within an industry.
As different from one another as industries
might appear on the surface, the underlying
drivers of profitability are the same. The global auto industry, for instance, appears to
have nothing in common with the worldwide
market for art masterpieces or the heavily
regulated health-care delivery industry in Europe. But to understand industry competition
and profitability in each of those three cases,
one must analyze the industry’s underlying
structure in terms of the five forces. (See the
exhibit “The Five Forces That Shape Industry
Competition.”)
If the forces are intense, as they are in such
industries as airlines, textiles, and hotels, almost no company earns attractive returns on
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The Five Competitive Forces That Shape Strategy
investment. If the forces are benign, as they are
in industries such as software, soft drinks, and
toiletries, many companies are profitable. Industry structure drives competition and profitability, not whether an industry produces a
product or service, is emerging or mature, high
tech or low tech, regulated or unregulated.
While a myriad of factors can affect industry
profitability in the short run—including the
weather and the business cycle—industry
structure, manifested in the competitive forces,
sets industry profitability in the medium and
long run. (See the exhibit “Differences in Industry Profitability.”)
Understanding the competitive forces, and
their underlying causes, reveals the roots of an
industry’s current profitability while providing
a framework for anticipating and influencing
competition (and profitability) over time. A
healthy industry structure should be as much a
competitive concern to strategists as their company’s own position. Understanding industry
structure is also essential to effective strategic
positioning. As we will see, defending against
the competitive forces and shaping them in a
company’s favor are crucial to strategy.
Forces That Shape Competition
Michael E. Porter is the Bishop William Lawrence University Professor at
Harvard University, based at Harvard
Business School in Boston. He is a sixtime McKinsey Award winner, including for his most recent HBR article,
“Strategy and Society,” coauthored
with Mark R. Kramer (December 2006).
harvard business review • january 2008
The configuration of the five forces differs by
industry. In the market for commercial aircraft, fierce rivalry between dominant producers Airbus and Boeing and the bargaining
power of the airlines that place huge orders
for aircraft are strong, while the threat of entry, the threat of substitutes, and the power of
suppliers are more benign. In the movie theater industry, the proliferation of substitute
forms of entertainment and the power of the
movie producers and distributors who supply
movies, the critical input, are important.
The strongest competitive force or forces determine the profitability of an industry and become the most important to strategy formulation. The most salient force, however, is not
always obvious.
For example, even though rivalry is often
fierce in commodity industries, it may not be
the factor limiting profitability. Low returns in
the photographic film industry, for instance,
are the result of a superior substitute product—as Kodak and Fuji, the world’s leading
producers of photographic film, learned with
the advent of digital photography. In such a situation, coping with the substitute product be-
comes the number one strategic priority.
Industry structure grows out of a set of economic and technical characteristics that determine the strength of each competitive force.
We will examine these drivers in the pages that
follow, taking the perspective of an incumbent,
or a company already present in the industry.
The analysis can be readily extended to understand the challenges facing a potential entrant.
Threat of entry. New entrants to an industry bring new capacity and a desire to gain
market share that puts pressure on prices,
costs, and the rate of investment necessary to
compete. Particularly when new entrants are
diversifying from other markets, they can leverage existing capabilities and cash flows to
shake up competition, as Pepsi did when it entered the bottled water industry, Microsoft did
when it began to offer internet browsers, and
Apple did when it entered the music distribution business.
The threat of entry, therefore, puts a cap on
the profit potential of an industry. When the
threat is high, incumbents must hold down
their prices or boost investment to deter new
competitors. In specialty coffee retailing, for
example, relatively low entry barriers mean
that Starbucks must invest aggressively in
modernizing stores and menus.
The threat of entry in an industry depends
on the height of entry barriers that are present
and on the reaction entrants can expect from
incumbents. If entry barriers are low and newcomers expect little retaliation from the entrenched competitors, the threat of entry is
high and industry profitability is moderated. It
is the threat of entry, not whether entry actually occurs, that holds down profitability.
Barriers to entry. Entry barriers are advantages that incumbents have relative to new entrants. There are seven major sources:
1. Supply-side economies of scale. These economies arise when firms that produce at larger
volumes enjoy lower costs per unit because
they can spread fixed costs over more units,
employ more efficient technology, or command better terms from suppliers. Supplyside scale economies deter entry by forcing
the aspiring entrant either to come into the
industry on a large scale, which requires dislodging entrenched competitors, or to accept
a cost disadvantage.
Scale economies can be found in virtually
every activity in the value chain; which ones
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The Five Competitive Forces That Shape Strategy
are most important varies by industry.1 In microprocessors, incumbents such as Intel are
protected by scale economies in research, chip
fabrication, and consumer marketing. For lawn
care companies like Scotts Miracle-Gro, the
most important scale economies are found in
the supply chain and media advertising. In
small-package delivery, economies of scale
arise in national logistical systems and information technology.
2. Demand-side benefits of scale. These benefits, also known as network effects, arise in industries where a buyer’s willingness to pay for
a company’s product increases with the number of other buyers who also patronize the
company. Buyers may trust larger companies
more for a crucial product: Recall the old
adage that no one ever got fired for buying
from IBM (when it was the dominant computer maker). Buyers may also value being in a
“network” with a larger number of fellow customers. For instance, online auction participants are attracted to eBay because it offers
the most potential trading partners. Demandside benefits of scale discourage entry by limiting the willingness of customers to buy from a
newcomer and by reducing the price the newcomer can command until it builds up a large
base of customers.
3. Customer switching costs. Switching costs
are fixed costs that buyers face when they
The Five Forces That Shape Industry Competition
Threat
of New
Entrants
Bargaining
Power of
Suppliers
Rivalry
Among
Existing
Competitors
Threat of
Substitute
Products or
Services
harvard business review • january 2008
Bargaining
Power of
Buyers
change suppliers. Such costs may arise because
a buyer who switches vendors must, for example, alter product specifications, retrain employees to use a new product, or modify processes or information systems. The larger the
switching costs, the harder it will be for an entrant to gain customers. Enterprise resource
planning (ERP) software is an example of a
product with very high switching costs. Once a
company has installed SAP’s ERP system, for
example, the costs of moving to a new vendor
are astronomical because of embedded data,
the fact that internal processes have been
adapted to SAP, major retraining needs, and
the mission-critical nature of the applications.
4. Capital requirements. The need to invest
large financial resources in order to compete
can deter new entrants. Capital may be necessary not only for fixed facilities but also to extend customer credit, build inventories, and
fund start-up losses. The barrier is particularly
great if the capital is required for unrecoverable and therefore harder-to-finance expenditures, such as up-front advertising or research
and development. While major corporations
have the financial resources to invade almost
any industry, the huge capital requirements in
certain fields limit the pool of likely entrants.
Conversely, in such fields as tax preparation
services or short-haul trucking, capital requirements are minimal and potential entrants
plentiful.
It is important not to overstate the degree to
which capital requirements alone deter entry.
If industry returns are attractive and are expected to remain so, and if capital markets are
efficient, investors will provide entrants with
the funds they need. For aspiring air carriers,
for instance, financing is available to purchase
expensive aircraft because of their high resale
value, one reason why there have been numerous new airlines in almost every region.
5. Incumbency advantages independent of
size. No matter what their size, incumbents
may have cost or quality advantages not available to potential rivals. These advantages can
stem from such sources as proprietary technology, preferential access to the best raw material sources, preemption of the most favorable
geographic locations, established brand identities, or cumulative experience that has allowed
incumbents to learn how to produce more efficiently. Entrants try to bypass such advantages.
Upstart discounters such as Target and Wal-
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The Five Competitive Forces That Shape Strategy
Mart, for example, have located stores in freestanding sites rather than regional shopping
centers where established department stores
were well entrenched.
6. Unequal access to distribution channels.
The new entrant must, of course, secure distribution of its product or service. A new food
item, for example, must displace others from
the supermarket shelf via price breaks, promotions, intense selling efforts, or some other
means. The more limited the wholesale or retail channels are and the more that existing
competitors have tied them up, the tougher
entry into an industry will be. Sometimes access to distribution is so high a barrier that new
entrants must bypass distribution channels altogether or create their own. Thus, upstart
low-cost airlines have avoided distribution
through travel agents (who tend to favor estab-
lished higher-fare carriers) and have encouraged passengers to book their own flights on
the internet.
7. Restrictive government policy. Government
policy can hinder or aid new entry directly, as
well as amplify (or nullify) the other entry barriers. Government directly limits or even forecloses entry into industries through, for instance, licensing requirements and restrictions
on foreign investment. Regulated industries
like liquor retailing, taxi services, and airlines
are visible examples. Government policy can
heighten other entry barriers through such
means as expansive patenting rules that protect proprietary technology from imitation or
environmental or safety regulations that raise
scale economies facing newcomers. Of course,
government policies may also make entry easier—directly through subsidies, for instance, or
Differences in Industry Profitability
The average return on invested capital varies markedly from industry to industry. Between 1992 and 2006, for example, average return on invested capital in U.S. industries ranged as low as zero or even negative to more than 50%. At the high end are industries like soft drinks and prepackaged software, which have been almost six times more profitable than the airline industry over the period.
Profitability of Selected U.S. Industries
Average Return on Invested Capital
in U.S. Industries, 1992–2006
50
10th percentile
7.0%
25th
percentile
10.9%
Median:
14.3%
75th percentile
18.6%
Average ROIC, 1992–2006
90th percentile
25.3%
Number of Industries
40
30
20
10
0
0%
or lower
5%
10%
15%
20%
25%
30%
ROIC
35%
or higher
Return on invested capital (ROIC) is the appropriate measure
of profitability for strategy formulation, not to mention for equity
investors. Return on sales or the growth rate of profits fail to
account for the capital required to compete in the industry. Here,
we utilize earnings before interest and taxes divided by average
invested capital less excess cash as the measure of ROIC. This
measure controls for idiosyncratic differences in capital structure
and tax rates across companies and industries.
Source: Standard & Poor’s, Compustat, and author’s calculations
harvard business review • january 2008
Security Brokers and Dealers
Soft Drinks
Prepackaged Software
Pharmaceuticals
Perfume, Cosmetics, Toiletries
Advertising Agencies
Distilled Spirits
Semiconductors
Medical Instruments
Men’s and Boys’ Clothing
Tires
Household Appliances
Malt Beverages
Child Day Care Services
Household Furniture
Drug Stores
Grocery Stores
Iron and Steel Foundries
Cookies and Crackers
Mobile Homes
Wine and Brandy
Bakery Products
Engines and Turbines
Book Publishing
Laboratory Equipment
Oil and Gas Machinery
Soft Drink Bottling
Knitting Mills
Hotels
Catalog, Mail-Order Houses
Airlines
40.9%
37.6%
37.6%
31.7%
28.6%
27.3%
26.4%
21.3%
21.0%
19.5%
19.5%
19.2%
19.0%
17.6%
17.0%
16.5%
16.0%
15.6%
15.4%
Average industry
15.0%
ROIC in the U.S.
13.9%
14.9%
13.8%
13.7%
13.4%
13.4%
12.6%
11.7%
10.5%
10.4%
5.9%
5.9%
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The Five Competitive Forces That Shape Strategy
indirectly by funding basic research and making it available to all firms, new and old, reducing scale economies.
Entry barriers should be assessed relative to
the capabilities of potential entrants, which
may be start-ups, foreign firms, or companies
in related industries. And, as some of our examples illustrate, the strategist must be mindful of the creative ways newcomers might find
to circumvent apparent barriers.
Expected retaliation. How potential entrants
believe incumbents may react will also influence their decision to enter or stay out of an
Industry Analysis in Practice
Good industry analysis looks rigorously at the structural underpinnings
of profitability. A first step is to understand the appropriate time horizon.
One of the essential tasks in industry
analysis is to distinguish temporary or
cyclical changes from structural
changes. A good guideline for the appropriate time horizon is the full business
cycle for the particular industry. For
most industries, a three-to-five-year horizon is appropriate, although in some industries with long lead times, such as
mining, the appropriate horizon might
be a decade or more. It is average profitability over this period, not profitability
in any particular year, that should be the
focus of analysis.
The point of industry analysis is not
to declare the industry attractive or unattractive but to understand the underpinnings of competition and the root
causes of profitability. As much as possible, analysts should look at industry
structure quantitatively, rather than be
satisfied with lists of qualitative factors.
Many elements of the five forces can be
quantified: the percentage of the buyer’s
total cost accounted for by the industry’s
product (to understand buyer price sensitivity); the percentage of industry sales
required to fill a plant or operate a logistical network of efficient scale (to help assess barriers to entry); the buyer’s switching cost (determining the inducement an
entrant or rival must offer customers).
harvard business review • january 2008
The strength of the competitive
forces affects prices, costs, and the investment required to compete; thus
the forces are directly tied to the income statements and balance sheets of
industry participants. Industry structure defines the gap between revenues
and costs. For example, intense rivalry
drives down prices or elevates the costs of
marketing, R&D, or customer service, reducing margins. How much? Strong suppliers drive up input costs. How much?
Buyer power lowers prices or elevates the
costs of meeting buyers’ demands, such
as the requirement to hold more inventory or provide financing. How much?
Low barriers to entry or close substitutes
limit the level of sustainable prices. How
much? It is these economic relationships
that sharpen the strategist’s understanding of industry competition.
Finally, good industry analysis does
not just list pluses and minuses but
sees an industry in overall, systemic
terms. Which forces are underpinning
(or constraining) today’s profitability?
How might shifts in one competitive
force trigger reactions in others? Answering such questions is often the source of
true strategic insights.
industry. If reaction is vigorous and protracted
enough, the profit potential of participating in
the industry can fall below the cost of capital.
Incumbents often use public statements and
responses to one entrant to send a message to
other prospective entrants about their commitment to defending market share.
Newcomers are likely to fear expected retaliation if:
• Incumbents have previously responded
vigorously to new entrants.
• Incumbents possess substantial resources
to fight back, including excess cash and unused
borrowing power, available productive capacity, or clout with distribution channels and customers.
• Incumbents seem likely to cut prices because they are committed to retaining market
share at all costs or because the industry has
high fixed costs, which create a strong motivation to drop prices to fill excess capacity.
• Industry growth is slow so newcomers can
gain volume only by taking it from incumbents.
An analysis of barriers to entry and expected
retaliation is obviously crucial for any company contemplating entry into a new industry.
The challenge is to find ways to surmount the
entry barriers without nullifying, through
heavy investment, the profitability of participating in the industry.
The power of suppliers. Powerful suppliers
capture more of the value for themselves by
charging higher prices, limiting quality or services, or shifting costs to industry participants.
Powerful suppliers, including suppliers of labor, can squeeze profitability out of an industry that is unable to pass on cost increases in
its own prices. Microsoft, for instance, has contributed to the erosion of profitability among
personal computer makers by raising prices on
operating systems. PC makers, competing
fiercely for customers who can easily switch
among them, have limited freedom to raise
their prices accordingly.
Companies depend on a wide range of different supplier groups for inputs. A supplier
group is powerful if:
• It is more concentrated than the industry it
sells to. Microsoft’s near monopoly in operating
systems, coupled with the fragmentation of PC
assemblers, exemplifies this situation.
• The supplier group does not depend
heavily on the industry for its revenues. Suppliers serving many industries will not hesitate to
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The Five Competitive Forces That Shape Strategy
Industry structure drives
competition and
profitability, not whether
an industry is emerging
or mature, high tech or
low tech, regulated or
unregulated.
harvard business review • january 2008
extract maximum profits from each one. If a
particular industry accounts for a large portion
of a supplier group’s volume or profit, however,
suppliers will want to protect the industry
through reasonable pricing and assist in activities such as R&D and lobbying.
• Industry participants face switching costs
in changing suppliers. For example, shifting
suppliers is difficult if companies have invested
heavily in specialized ancillary equipment or in
learning how to operate a supplier’s equipment
(as with Bloomberg terminals used by financial
professionals). Or firms may have located their
production lines adjacent to a supplier’s manufacturing facilities (as in the case of some beverage companies and container manufacturers).
When switching costs are high, industry participants find it hard to play suppliers off against
one another. (Note that suppliers may have
switching costs as well. This limits their power.)
• Suppliers offer products that are differentiated. Pharmaceutical companies that offer
patented drugs with distinctive medical benefits have more power over hospitals, health
maintenance organizations, and other drug
buyers, for example, than drug companies offering me-too or generic products.
• There is no substitute for what the supplier group provides. Pilots’ unions, for example, exercise considerable supplier power over
airlines partly because there is no good alternative to a well-trained pilot in the cockpit.
• The supplier group can credibly threaten
to integrate forward into the industry. In that
case, if industry participants make too much
money relative to suppliers, they will induce
suppliers to enter the market.
The power of buyers. Powerful customers—
the flip side of powerful suppliers—can capture more value by forcing down prices, demanding better quality or more service (thereby
driving up costs), and generally playing industry
participants off against one another, all at the expense of industry profitability. Buyers are powerful if they have negotiating leverage relative to
industry participants, especially if they are price
sensitive, using their clout primarily to pressure
price reductions.
As with suppliers, there may be distinct
groups of customers who differ in bargaining
power. A customer group has negotiating leverage if:
• There are few buyers, or each one purchases in volumes that are large relative to the
size of a single vendor. Large-volume buyers are
particularly powerful in industries with high
fixed costs, such as telecommunications equipment, offshore drilling, and bulk chemicals.
High fixed costs and low marginal costs amplify
the pressure on rivals to keep capacity filled
through discounting.
• The industry’s products are standardized
or undifferentiated. If buyers believe they can
always find an equivalent product, they tend to
play one vendor against another.
• Buyers face few switching costs in changing vendors.
• Buyers can credibly threaten to integrate
backward and produce the industry’s product
themselves if vendors are too profitable. Producers of soft drinks and beer have long controlled the pow...
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