Ricardian Rents & Comparative Advantage

1. Ricardian Rents & Comparative Advantage Paul C. Godfrey Mark H. Hansen Marriott School of Management

2. What strategists need to know: What’s the difference between efficiency and market power? (Ricardian rent vs. monopoly rent) What is the difference between absolute advantage and comparative advantage? How can managers use the principles of comparative advantage and efficiency to create competitive advantage?

3. The Market Efficiency Hypothesis Market leaders earn higher profits because they are more efficient • Efficiency here could mean productive • efficiency and/or consumer preference • for the product • Microsoft earns high profits because they • are more ‘efficient’ at producing software • and operating systems

4. The Source of Efficiency Ricardian rents flow from resources that are relatively more productive than competitors’ resources • Ricardian rents are earned by firms that • have resources that meet the VRIO criteria, • where the cost of imitation is not due to • some contrived barrier to entry • sometimes referred to as efficiency rents • or even less precisely, economic rents

5. The Market Power Hypothesis Market leaders earn higher profits because they can behave monopolistically due to contrived barriers to entry  contrived barriers to entry include:  government granted protection  size that results in price setting power • exclusive contracts that shut out • competition • Microsoft earns high profits because they • are so large they dictate the terms of trade • and/or buy up potential competition

6. Absolute Advantage Adam Smith made this concept famous in international trade theory (specialize where you have the low cost) • a firm has an absolute advantage if it has lower • absolute costs than others (including the cost of • capital) • a Ford dealer has a lower absolute cost of doing • oil changes than a Jiffy Lube because of size • and cost of capital

7. Absolute Advantage Ford Dealer Jiffy Lube Oil Changes profit/hr. $65 $60 Engine Repair profit/hr. $80 $55

8. Comparative Advantage Ricardo made this concept famous in international trade theory (Robert Torrens was the first) • a firm has a comparative advantage if it can • produce a good at a lower opportunity cost • than others (including the cost of capital) • a Jiffy Lube faces a lower opportunity cost of • doing oil changes than a large Ford dealer • because the dealer has to give up higher-profit • capacity (engine repair) to do the oil changes

9. Comparative Advantage Ford Dealer Jiffy Lube Oil Changes profit/hr. $65 $60 Engine Repair profit/hr. $80 $55 9

10. Management Implications Ricardian Rents & Comparative Advantage 1) know the source of your rents – Ricardian or Monopoly • know the source of competitors’ rents – Ricardian or • Monopoly • figure out who has an absolute advantage and who • has the comparative advantage  Competitors  Suppliers  Buyers  guide decision-making in entry, exit, positioning, supply chain structure, pricing, product, etc.