In answering the essential question of strategic management (why do some firms c

Question

In answering the essential question of strategic management (why do some firms consistently outperform others?) we know that we need to understand both industry and firm effects.

Industry Effects: What is the theory that helps us to understand industry effects and according to this theory, what is the essential source of competitive advantage? Explain the analytical framework used to assess the source of industry effects.

Firm Effects: What is the theory that helps us to understand firm effects and according to this theory, what is the essential source of competitive advantage? Explain the analytical framework(s) used to assess the source of firm effects.

How do these two theories relate to each other?

Explanation / Answer

Firm performance is determined primarily by two factors: Industry and Firm effects

Industry effects describe the underlying economic structure of the industry. They attribute firm performance to the industry in which the firm competes. The structure of an industry is determined by elements common to all industries, elements such as entry and exit barri-ers, number and size of companies, and types of products and services offered. In a series of empirical studies, academic researchers have found that about 20 percent of a firm’s profitability depends on the industry it’s in.

Firm effects attribute firm performance to the actions managers take. The key point is that managers’ actions tend to be more important in determining firm performance than the forces exerted on the firm by its external environment.

Although a firm’s industry environment is not quite as important as the firm’s strategy within its industry, they jointly determine roughly 75 percent of overall firm performance. The remaining 25 percent relates partly to business cycles and other effects.Competition-the ongoing struggle among firms to gain and sustain competitive advantage does not take place in isolation. Managers therefore must understand the relationship between strategic management and the role of business in society, which we will turn to next.

Analytical framework used to access the source of industry and firm effects is Porter's Five Forces of Competitive Position Analysis.

Porter 's Five Forces analysis is based on the concept that there are five forces that determine the competitive intensity and attractiveness of a industry or a market. This helps to identify where power lies in a business situation and is useful both in understanding the strength of an organisation’s current competitive position, and the strength of a position that an organisation may look to move into.
Five forces are :

1. Power of the Supplier
2. Power of the buyer
3. Threat of substitution
4. Threat of new entrants
5. Competetive Rivalry

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