2 - Competence Explanations of Economic Profits in Strategic Management: Some Policy Implications

Summary

Economics offers at least two classes of explanations of the existence of economic profits (Demsetz 1973). The first, which can be described as a monopoly theory of economic profits, suggests that economic profits emerge as a result of firms acting to reduce output below and increase prices above the competitive level. Several large theoretical and empirical literatures on topics such as tacit and explicit collusion, industry concentration, oligopolies, and vertical and horizontal exclusive agreements (to name just a few) all fall within this broad category of monopolistic theories of economic profit (Scherer 1980).

The second class of explanations, which can be called the capability theory of economic profits (Rumelt 1984; Barney 1986a), suggests that economic profits emerge because some firms are more capable than others. If the cost of developing these capabilities is less than the value they create, they can be a source of economic profit. Though not having spawned as extensive an empirical and theoretical literature as monopolistic theories of economic profits, capability explanations of these profits have received some attention – for example, from evolutionary economists (Nelson and Winter 1982) and some information economists (e.g., Demsetz 1973).

There is little doubt that both these explanations of economic profits are valid in at least some circumstances. Some firms gain economic profits by engaging in monopolistic activities, others by exploiting their superior capabilities. Indeed, a single firm's economic profits might reflect both monopolistic actions and superior capabilities.