Beyond the Reach of the Invisible Hand: Impediments to Economic Activity,

Market Failures, and Profitability

Dennis A. Yao

Strategic Management Journal, Vol. 9, Special Issue: Strategy Content Research. (Summer, 1988), pg. 59-70.

By Amit Jain

MARKETS ARE EFFICENT

Basic Relationships

1. Entry barriers as operational combinations of IEAs

2. IEAs cause market failure

3. Absent IEAs, entry barriers may not cause market failure

Shortcomings of Economic Theory

The Efficient Market:◦Consumers and producers act as price takers◦Markets exist for all commodities◦Buyers and sellers have complete information◦Thus, all firms will make normal (average) profits

Perfectly competitive markets lead to long-run profits that are average

Good strategy leads to survival, not excess profits

So why do we observe companies making excess profits?◦ Market failure has created ‘supra-normal’ profitability◦ Strategists are interested in identifying factors that

create an imperfect market (i.e. imperfect competition)

Industrial Organization – Barriers to Entry: A source of market failure

Industrial Organization (IO) Literature◦Barriers to Entry (Bain 1956, Caves and Porter

1977), such as product differentiation or capital requirements

Example of product differentiation◦The perception of a product as being different works

only if the buyer is uninformed about the products in the market Absence of cost-effective credible information Imperfect information

Therefore, there is more to market failure (and more sources) than B2E

Impediments Theory – another source of market failure

Transaction Costs

Production Economies

Sunk Costs

Imperfect Information

Transaction CostsTwo relevant types

◦Free-rider problem: Costs of excluding non-buyers from use of a product or service Excluding non-subscribers from benefits of product

review◦Costs of communication and information

Writing long-term contracts when all future contingencies cannot be predicted

Strategies for dealing with transaction costs◦Vertical integration◦Culture change: match employee’s goals with

organization’s goals◦Develop long-term relationships with outside

organizations

Production Economies, Sunk Costs, Imperfect Information

Production Economies◦ Economies of Scale, Learning Curve, Economies of Scope

Sunk Costs◦ In absence of sunk costs, entry and exit become costless

(‘contestible’ markets)Imperfect Information

◦ Absence of perfect buyer information leads to above average price-cost margins

◦ Ways to exploit: provide information oriented strategies Reputations: brand loyalty. Product differentiation through advertising Signaling quality through warranties “Price reflects Quality” – high price, high quality.

Concluding Thoughts and Comments

The paper integrates B2E with IEA.However, the paper’s implications on transaction

costs is limited.◦ Here’s an extended definition: The firm exists by

minimizing transaction costs, which includes costs associated with opportunism, complexity, and uncertainty.

Can transaction costs theory encompass impediments theory?◦ Since production economies (quasi-rents), sunk costs

(sunk investments), and imperfect information (uncertainty) are handled within the boundaries of the firm, then transaction costs may be sufficient.