PDF Summary:Competition Demystified, by Bruce Greenwald and Judd Kahn

In business, sustainable competitive advantage is what separates thriving companies from those that struggle to survive. But many executives misunderstand where true competitive advantages come from and how to identify them. In Competition Demystified, Bruce Greenwald and Judd Kahn explain that lasting competitive advantages are typically rooted in local markets rather than global dominance, and they outline the specific barriers that protect companies from competition.

Greenwald and Kahn examine the three primary sources of market superiority—supply advantages, demand advantages, and economies of scale—and explain how these create barriers that new competitors struggle to overcome. They also provide a framework for evaluating whether a company possesses genuine competitive advantages by analyzing market stability, profit consistency, and the sustainability of entry barriers. This guide offers a practical approach to identifying and protecting competitive advantages in an increasingly competitive business landscape.

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Diligent companies can progress through these learning curves faster than their competitors, allowing them to maintain a competitive edge on expenses that outlasts most patents. However, these proprietary cost benefits rooted in learning are only sustainable up to a certain point. A rapid rate of technological development can erode process-specific advantages as they turn obsolete. Additionally, as industries mature and technology evolves more slowly, competitors will eventually learn the efficiencies of the leading companies.

(Shortform note: The authors’ use of the term “learning curves” refers to the process of accumulating tacit knowledge and process know-how within a firm. This knowledge is often difficult for competitors to replicate, giving the firm a temporary advantage. However, rapid technological development can render these routines obsolete, while industry maturity allows competitors to catch up through mechanisms like labor mobility, benchmarking, and imitation.)

Basic products and processes don't provide an environment for exclusive technological benefits. Patenting them is difficult, and they can be easily copied and shared with other companies. If several workers can fully understand a certain production or service method, competitors may hire them to learn the core processes involved. When the technology is straightforward, it can be hard for the developer to argue that intellectual property was stolen, because a lot of the technology will seem like "common sense."

(Shortform note: While it’s true that basic products and processes are easy to copy, there are exceptions. For example, the economist David J. Teece argues that in industries with strong trade-secret protection, even “common sense” processes can’t be legally replicated by hiring a few employees. He explains that when crucial knowledge is deeply embedded in specialized skills, organizational routines, and co-specialized assets, rivals can’t reliably reproduce the innovation merely by hiring some of the innovator’s employees.)

This restriction is especially significant in the large and expanding service sector—covering healthcare, transaction processing, finance, education, and retail. In these fields, the technology is often either basic or created by specialized external companies. To be genuinely proprietary, technology must be internally developed by the company. Markets where external experts or vendors handle the majority of innovations in products or processes cannot significantly cut costs using technology, as anyone can purchase the benefits. If cost benefits derived from exclusive technology are uncommon and fleeting, those grounded in lower input expenses are even less common.

(Shortform note: Since the book’s publication, the rise of cloud computing and AI has transformed service industries. While the authors argue that externally supplied technology can’t provide a cost advantage, many service firms have gained proprietary benefits by combining cloud platforms with unique data and digital workflows. In Competing in the Age of AI, Marco Iansiti and Karim R. Lakhani explain that competitive advantage now comes from integrating data, algorithms, and digital processes across the organization. Even when using widely available cloud infrastructure, companies that develop proprietary data and embed machine learning into their operations can create self-reinforcing advantages that are hard to replicate.)

Human resources, all kinds of capital, primary resources, and midstream inputs are typically sold in competitive marketplaces. Some businesses must contend with strong unions capable of increasing labor expenses. They might also deal with an excess of insufficiently funded pension and retiree healthcare obligations. However, if an organization joins the market using low-cost, nonunion labor, others may follow, and this entry process will eradicate any surplus profits gained from reduced labor expenses. Unionized companies might decline or fail, and the ones that remain have no edge over their competition. The first company to find a lower cost of labor in a country such as China may gain a temporary benefit over competitors who are slower to move, but the benefit soon disappears as others follow.

The Declining Importance of Low-Cost Labor

The authors’ discussion of surplus profits from low-cost, nonunion labor in a country such as China was written before the country’s wages began to rise rapidly. In Global Inequality, Branko Milanovic notes that over the last three decades, real wages in China—especially for urban manufacturing workers—have increased at a very fast pace, narrowing the gap with workers in rich countries and transforming China from a reservoir of extremely cheap labor into a middle-income economy. At the same time, technological change and automation have reduced the importance of low-skilled labor costs in manufacturing, so that global production is now driven less by the search for the lowest possible wages and more by considerations such as productivity, skills, infrastructure, and proximity to large markets.

Barrier Dynamics & Sustainability

Greenwald and Kahn highlight that the scale of an economy can provide a competitive edge when combined with customer captivity. Economies of scale take place when a business's per-unit costs decrease as it produces more and has a larger market share than its competitors. Here, the company can make a profit with pricing that leaves its competitors losing money. However, if competitors can reach the same customers, they can match the scale. Therefore, economies of scale only serve as an advantage over competitors when combined with customer captivity.

(Shortform note: Some experts disagree with Greenwald and Kahn’s assertion that economies of scale only serve as an advantage when combined with customer captivity. In Competitive Strategy, Michael Porter argues that economies of scale can be a powerful barrier to entry on their own. He explains that when the minimum efficient scale is large relative to the size of the market, new entrants face a dilemma: They must either enter at a large scale and risk strong retaliation from established firms or enter at a small scale and accept a cost disadvantage.)

If a company aligns its marketing and pricing with its rivals, it will maintain its leading market share. Rivals can't equal its operational scale, leading to consistently higher average costs for them. The company can reduce prices until it's the only one making a profit, either boosting its market share or removing any profit for competitors who set similar prices.

(Shortform note: Reducing prices until competitors stop making profits can lead to antitrust lawsuits for predatory pricing. This strategy can result in hefty fines, legal fees, and even forced changes to business practices. For example, in 2017, Qualcomm faced a $773 million fine in Taiwan for predatory pricing, and in 2019, the European Union fined Qualcomm $272 million for similar practices.)

Additionally, Greenwald and Kahn assert that market growth can reduce the advantages provided by economies of scale. As the market grows, the difference in fixed costs relative to sales between the incumbent and the entrant decreases. This helps the entrant become competitive.

(Shortform note: This idea is part of the industrial-organization tradition of economic theory, which focuses on how the size of the market affects the strength of advantages tied to the size of the firm. This tradition was started by Joe Bain, who we’ll discuss later.)

Strategic Application: Identifying and Utilizing Advantage

The authors believe that identifying and leveraging strategic edges is crucial to crafting strategies that work well. They emphasize that market-specific advantages aren't aligned with the goals of CEOs fixated on growth. To begin strategizing, evaluate the existing and prospective markets' competitive benefits for a company.

In some markets where there aren't any competitive advantages and none are expected, the only option is to focus on operational efficiency. In another set of markets, where established, attentive businesses have competitive advantages, potential new entrants should avoid entering, and less dominant established companies should exit. In some sectors, a company will have an edge over the competition. Here, its strategic approach should involve overseeing and safeguarding them.

The Limitations of the Authors’ Recommendations

The authors' recommendations may not be universally applicable, especially in rapidly evolving or disruptive markets. For instance, in The Innovator's Dilemma, Clayton M. Christensen argues that established companies often fail to innovate because they focus too much on operational efficiency and existing competitive advantages. He explains that in emerging markets, companies may need to enter without clear competitive advantages to learn and adapt. He writes, “Markets that do not exist cannot be analyzed: suppliers and customers must discover them together.” This suggests that in some cases, entering a market without immediate advantages can be a strategic move to gain insights and shape the industry's future.

In the next sub-section, we will discuss how market analysis should focus on pinpointing long-term competitive edges.

Evaluating Marketplaces to Attain an Advantageous Position

Greenwald and Kahn argue that market analysis should focus on pinpointing long-lasting competitive edges. These can be measured by the stability of profits and market share. If a business leads the market and has consistently high profits, it likely enjoys a competitive edge. The subsequent step is to determine the source of this edge, such as proprietary technology, consumer retention, scale economies, or government intervention. This helps predict how long the edge will last. If a business lacks advantages over competitors, the sole plan is to concentrate on operational effectiveness.

(Shortform note: The authors’ claim that stable profits and market share indicate a long-lasting competitive edge is supported by research on companies with “economic moats.” These are companies with structural features that are hard to replicate, such as strong brand identity, cost advantages, or network effects. In his book, Pat Dorsey explains that companies with economic moats tend to maintain high profitability and relatively stable market share over long periods. This suggests that identifying these patterns can indeed reveal a long-lasting competitive edge.)

The following sub-sections will discuss how to identify competitive barriers and value a business according to its sustainable advantage.

Recognizing Obstacles to Competitors

Greenwald and Kahn assert that entry barriers are the primary factor in determining a company’s competitive environment. These are structural features of a market that prevent new competitors from entering or existing companies from expanding. They are synonymous with advantages over competitors.

Obstacles to entering the market are crucial because they determine whether a company can earn profits above the cost of invested capital. If entry barriers don't exist, any company that earns high profits will attract new competitors. As additional competitors join the market, demand is split between them, per-unit costs increase, prices fall, and profits disappear. In a sector with no obstacles to new competitors, a firm can only endure through maximum efficiency. If entry is restricted, incumbent companies can act in ways new competitors can't.

Counterpoint: Entry Barriers Aren’t Everything

Some strategists have argued that entry barriers are not synonymous with competitive advantages. In Capitalism, Socialism and Democracy, Joseph Schumpeter argued that extraordinary profits can be earned even in markets that are open to entry. He explains that when a company introduces a new product or technology, it can temporarily enjoy a monopoly position and earn high profits, even if there are no structural barriers preventing others from entering the market. This is because it takes time for competitors to imitate the innovation and catch up. Schumpeter argues that this process of creative destruction, where new innovations disrupt existing markets, is a key driver of economic progress.

Valuation Using Sustainable Advantage

Greenwald and Kahn suggest that valuation should consider both asset value and the company's EPV to assess lasting competitive edges. Asset value refers to the expense needed to reproduce the company’s assets. EPV is the company's current net cash flow, assuming it will be sustained forever without growing or shrinking.

Comparing asset value and earnings power reveals the company’s competitive position. If earnings power value exceeds asset value, the company has a lasting competitive edge. If the values of assets and EPV are equal, the company lacks a competitive edge. If the business's asset value exceeds its EPV, it's not generating enough earnings to justify its assets.

Origins of the Asset Value and Earnings Power Comparison

The idea of comparing asset value and earnings power value to assess a company's position has roots in Benjamin Graham and David Dodd's 1934 book Security Analysis. They contrasted asset-based and earnings-based valuations, arguing that both approaches are necessary for a complete picture. They argued that asset value provides a floor for valuation, while earnings power reflects the company's ability to generate profits. Graham and Dodd's framework, like Greenwald and Kahn's, suggests that when earnings power significantly exceeds asset value, it indicates a strong competitive position. Conversely, when asset value exceeds earnings power, it signals potential problems. This two-pronged approach to valuation has influenced generations of investors, including Warren Buffett, who has emphasized the importance of both asset quality and earnings power in his investment decisions.