Q.

2 What does the I/O mode, and resource-based model suggest a firm
should do to earn above-average returns?
The I/O Model of Above-Average Returns
From the 1960s through the 1980s, the external environment was thought to
be the primary determinant of strategies that firms selected to be successful.
The industrial organization (I/O) model of above-average returns explains the
external environments dominant influence on a firms strategic actions. The
model specifies that the industry in which a company chooses to compete
has a stronger influence on performance than do the choices managers
make inside their organizations. The firms performance is believed to be
determined primarily by a range of industry properties, including
1. Economies of scale
2. Barriers to market entry,
3. Diversification,
4. Product differentiation,
5. Degree of concentration of firms in the industry
Grounded in economics, the I/O model has four underlying assumptions.
1. The external environment is assumed to impose pressures and
constraints that determine the strategies that would result in aboveaverage returns.
2. Most firms competing within an industry or within a certain segment of
that industry are assumed to control similar strategically relevant
resources and to pursue similar strategies in light of those resources.
3. Resources used to implement strategies are assumed to be highly
mobile across firms, so any resource differences that might develop
between firms will be short-lived.
4. Organizational decision makers are assumed to be rational and
committed to acting in the firms best interests, as shown by their
profit-maximizing behaviors.

The
I/O
model
challenges firms to
locate
the
most
attractive industry in
which to compete.
Because most firms
are assumed to have
similar
valuable
resources
that
are
mobile
across
companies,
their
performance generally
can be increased only
when they operate in
the industry with the
highest profit potential
and learn how to use
their
resources
to
implement
the
strategy required by the industrys structural characteristics
The five forces model of competition is an analytical tool used to help firms
with this task. The model encompasses several variables and tries to capture
the complexity of competition.
The five forces model suggests that an industrys profitability (i.e., its rate of
return on invested capital relative to its cost of capital) is a function of
interactions among five forces:
1. Suppliers
2. Buyers
3. Competitive rivalry among firms currently in the industry
4. Product substitutes
5. Potential entrants to the industry.
Firms can use this tool to understand an industrys profit potential and the
strategy necessary to establish a defensible competitive position, given the
industrys structural characteristics.
Typically, the model suggests that firms can earn above-average returns by
1. Manufacturing standardized products, or
2. Producing standardized services at costs below those of competitors (a
cost leadership strategy)
3. Manufacturing differentiated products for which customers are willing
to pay a price premium (a differentiation strategy).
As you can see, the I/O model considers a firms strategy to be a set of
commitments, actions, and decisions that are formed in response to the

characteristics of the industry in which the firm has decided to compete.

The Resource-Based Model of Above-Average Returns
The resource-based model assumes that each organization is a collection of
unique resources and capabilities. The uniqueness of its resources and
capabilities is the basis for a firms strategy and its ability to earn aboveaverage returns.
Resources are inputs into a firms production process, such as
1. Capital equipment,
2. the skills of individual employees,
3. patents,
4. finances,
5. and talented managers.
In general, a firms resources are classified into three categories:
1. physical,
2. human, and
3. organizational capital.
resources are either tangible or intangible in nature. Individual resources
alone may not yield a competitive advantage. In fact, resources have a
greater likelihood of being a source of competitive advantage when they are
formed into a capability.
A capability is the capacity for a set of resources to perform a task or an
activity in an integrative manner. Capabilities evolve over time and must be
managed dynamically in pursuit of above-average returns. Core
competencies are resources and capabilities that serve as a source of
competitive advantage for a firm over its rivals.
Core competencies are often visible in the form of organizational functions.
For example, the preceding Strategic Focus suggests that even though
Netflix operates in a turbulent competitive environment, its strong
capabilities in technology and tracking customer preferences for movies
allow it to remain competitive, while others such as Blockbuster continue to
lose money in the online movie rental businesseven though they are
gaining market share.
According to the resource-based model, differences in firms performances
across time are due primarily to their unique resources and capabilities
rather than to the industrys structural characteristics.
This model also assumes that firms acquire different resources and develop

unique capabilities based on how they combine and use the resources; that
resources and certainly capabilities are not highly mobile across firms; and
that the differences in resources and capabilities are the basis of competitive
advantage.
Through continued use, capabilities become stronger and more difficult for
competitors to understand and imitate. As a source of competitive
advantage, a capability should be neither so simple that it is highly imitable,
nor so complex that it defies internal steering and control.
The resource-based model suggests that the strategy the firm chooses
should allow it to use its competitive advantages in an attractive industry
(the I/O model is used to identify an attractive industry). Not all of a firms
resources and capabilities have the potential to be the basis for competitive
advantage.
This potential is realized when resources and capabilities are
1. valuable,
2. rare,
3. costly to imitate,
4. and nonsubstitutable
Resources are valuable when they allow a firm to take advantage of
opportunities or neutralize threats in its external environment. They are rare
when possessed by few, if any, current and potential competitors. Resources
are costly to imitate when other firms either cannot obtain them or are at a
cost disadvantage in obtaining them compared with the firm that already
possesses them. And they are non-substitutable when they have no
structural equivalents. Many resources can either be imitated or substituted
over time. Therefore, it is difficult to achieve and sustain a competitive
advantage based on resources alone. When these four criteria are met,
however, resources and capabilities become core competencies.
Research shows that both the industry environment and a firms internal
assets affect that firms performance over time. Thus, to form a vision and
mission, and subsequently to select one or more strategies and to determine
how to implement them, firms use both the I/O and the resource-based
models. In fact, these models complement each other in that one (I/O)
focuses outside the firm while the other (resource-based) focuses inside the
firm.