The purpose of any business is to create value by producing goods or services that are worth more than the cost of the necessary inputs. This value can be distributed in any number of ways, of course, exclusively to shareholders at one extreme or completely to employees at another. In any case, to survive and thrive, every firm must create value. This observation raises a fundamental question: How do companies create value?
Economic theory predicts what every manager knows – it’s hard to make a profit let alone sustain margins over time. Success attracts competitors who imitate your strategy and woo your customers. Important clients demand price reductions while suppliers push for price increases. Substitute products or services threaten to render your offerings irrelevant. Then, of course, there are shifts in the legal or regulatory context that can fundamentally alter the rules of the game. Given these difficulties, how can firms grow revenues, earn profits, and survive?
Economic theory describes three distinct ways that firms create value: establishing and defending a positional advantage, building and leveraging superior resources, and seizing fleeting opportunities.
Creating value through superior position
The first approach emphasises establishing and defending a desirable position. The underlying logic is to identify an attractive market, establish a secure position, and erect defences to prevent competitors, customers, and suppliers from appropriating your profits. To use military imagery, this resembles finding a high hill, building a secure fortress with barbed wire and machine gun turrets, and defending it against attacks from all sides.
An attractive position, according to this viewpoint, has two components. First, a company should identify a profitable industry. Numerous studies have demonstrated that industry is an important predictor of a company’s profitability. Firms in the pharmaceutical industry, for example, generally earn higher returns than companies in the steel sector. This is not always the case, of course. Companies such as Ispat International and Nucor have managed to create value in structurally unattractive industries like steel.
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