Strategic Management and the I/O Model of Above-Average Returns

Learning Objectives

  • Use the Industrial Organization (I/O) model to explain how firms can earn above-average returns.

The I/O Model of Above-Average Returns

  • Period of focus: 1960s through 1980s.
  • Key idea: External environment influences strategy choice significantly more than internal organization.

Key Characteristics of the I/O Model

  • The I/O model explains that:
    • A set of industry characteristics determine the profitability potential of an industry or segment, including:
    • Economies of scale
    • Barriers to market entry
    • Diversification
    • Product differentiation
    • Degree of concentration among firms in the industry
    • Market frictions
  • These characteristics influence the actions firms should take to operate profitably.
  • Detailed examination of these characteristics is provided in Chapter 2.

Underlying Assumptions of the I/O Model

  1. External Environment's Influence: The I/O model posits that the external environment imposes constraints that shape strategies leading to above-average returns.
  2. Resource Similarity: Firms within the same industry or segment are assumed to control similar strategically relevant resources and pursue similar strategies.
  3. Resource Mobility: Resources are highly mobile; thus, resource differences among firms are expected to be temporary.
  4. Rational Decision Makers: Organizational decision-makers are viewed as rational individuals motivated to act in the best interests of the firm, exemplifying profit-maximizing behaviors.

Competitive Industry Selection

  • The I/O model encourages firms to identify the most attractive industry based on:
    • Similar resource types among firms.
    • Mobility of resources across companies.
  • Performance enhancement occurs when a firm competes in a high profit potential industry and adeptly utilizes its resources to implement the necessary strategy shaped by the industry's characteristics.

Competitive Strategies Based on the I/O Model

  • The model suggests firms can achieve above-average returns through:
    • Cost Leadership Strategy: Producing standardized products at lower costs than competitors.
    • Differentiation Strategy: Producing unique products that command a price premium from customers.
  • These strategies are explored in depth in Chapter 4.

Five Forces Model of Competition

  • An analytical tool for finding attractive industries. It considers five forces:
    1. Suppliers
    2. Buyers
    3. Competitive rivalry among existing firms
    4. Product substitutes
    5. Potential new entrants
  • This model helps firms understand industry attractiveness in terms of profitability potential and determines a firm's advantageous position in the industry.

Process According to the I/O Model

  • Steps for firms to earn above-average returns include:
    1. Study the External Environment: Focus on both the general and industry environments, as well as competitor environments.
    2. Locate an Attractive Industry: Identify industries whose structural characteristics suggest a high potential for above-average returns.
    3. Identify Strategy for Above-Average Returns: Formulate strategies that align with the identified attractive industry conditions.
    4. Develop Required Assets and Skills: Acquire or develop the necessary assets and skills to implement the chosen strategy.
    5. Use Strengths for Implementation: Leverage the firm's strengths—developed or acquired assets and skills—to execute the strategy effectively.

Anticipated Outcomes

  • Superior Returns: The goal is to achieve above-average returns through strategic actions that respond to external conditions.

Integration with Research Findings

  • Research shows a firm's industry accounts for approximately 20% of profitability, while firm resources and capabilities account for 36% of profitability variance.
  • Hence, both external environmental factors and internal resources and strategic actions significantly impact a firm's performance.
  • The I/O model depicts strategy as a set of commitments and actions derived from the characteristics of the industry in which the firm competes.

Contrast with the Resource-Based Model

  • The resource-based model, discussed in the following sections, offers an alternative perspective on the determinants of strategic choice, emphasizing different factors than those highlighted by the I/O model.