Subject

An investigation into alternative explanations of the market share-profitability relationship.

Type of Report

Conceptual development, presentation and empirical test of hypotheses, discussion of results, and implications for marketing strategists and

Objective

To present theory and empirical research outlining how popular measures of business performance are related to competitive advantage and are affected by discontinuities in the environment.

Method

Develops a view of competitive advantage based upon superior value delivery to customers and outlines linkages among value delivery, competitive advantage, discontinuities, market share and profits; summarizes framework via hypotheses which are tested using longitudinal data from over 1400 businesses represented in the FTC Line of Business and PIMS data; presents results and implications.

Audience

Marketing strategists and strategy researchers.

Main Ideas

It has become fashionable in recent years to question the curious addiction of marketing scholars and practitioners to so-called strategic concepts and fundamental laws of the marketplace. Nowhere has this dissenting commentary been more evident than in the attacks launched against a fundamental tenet of strategic management thought, the presumed law-like, positive relationship between a business’ market share and its profit rate. Criticisms of the relationship have taken many forms, including evidence indicating that small share competitors can experience high rates of return; that the relationship might be spurious in that both share and profits are jointly determined by some third factors such as product quality, marketing expenditures, stage of product life cycle, management skill, luck, or other disturbances of fate; that there exists reciprocal causation in the relationship such that the causal effect of profits on share accounts for much of the association; that even if the relationship does exist, the magnitude of effect is relatively small.

In spite of these criticisms, there are at least two issues concerning the share-returns controversy that remain unresolved. First, if market share is not causally related to profits via mechanisms of scale economies, learning, or market power as traditionally believed, what forces or explanations are responsible for the consistent share-return associations observed? Ascribing the association to shocks, luck, management skill or other third factors does not offer much in the way of guidance to practitioners. Second, the majority of evidence marshaled for or against the share-returns hypotheses has been derived from a single data base, namely the PIMS data. Numerous authors have called for validation studies using other data sources.

This paper presents theory and empirical research that addresses these unresolved issues in the share-returns association controversy. First, we sketch a simple theory of competitive advantage based on the concept of value delivery, indicating the critical role of institutional skills at value delivery in creating competitive advantage and the linkages among institutional skills, competitive advantage, market share, and profits. Next, we detail the mechanisms by which discontinuities in the business environment, such as changes in technology, competition, regulation, and relative prices impact the value delivery systems of incumbent businesses, alter the nature of competitive advantage, and transform the market shares and profit rates of broad classes of businesses. We then summarize our views in the form of testable hypotheses about the relationships between the vulnerability of an industry to discontinuities and the market share and profit rates of established businesses in the industry. Finally, we present a preliminary test of our hypotheses using data from the Federal Trade Commission (FTC) Line of Business (LB) data. We then contrast results achieved with these data with results obtained from comparable models estimated using the more commonly utilized PIMS data set.

Conceptual Framework

Our value delivery theory of competitive advantage may be summarized in seven basic points, namely:

1. Sustainable competitive advantage is rooted in the abilities of a business to deliver superior value to customers at a profitable cost, not in structural barriers to competition as commonly believed. This skill-based advantage may manifest itself in one or more areas of a business’ value delivery system, i.e., in its abilities to choose, provide, and communicate a superior value proposition to target customers. Skill(s) may reside in individual workers, functions, or may even become institutionalized and possessed by the business unit as a whole. Once institutionalized, these skill-based advantages become difficult for competitors to easily replicate, forming the basis for truly sustainable advantage.
2. Market share reflects the ability of a business to deliver superior value to customers.
3. Projects which deliver superior value to customers will inevitably do so at a profitable cost, since those which do not will be abandoned by the business, and those which do will benefit further from numerous scale-related advantages.
4. High market share is not a cause of supranormal profitability but is itself an outcome of the same forces that also affect profitability, these being institutional skills at superior value delivery.
5. Discontinuities alter the basis of competitive advantage by altering customers’ value hierarchy and/or the skills necessary to deliver superior value to customers at a profitable cost. In turn, discontinuities will predictably have an adverse impact on the profit and share positions of established businesses, requiring them to devote considerable time and resources to realign their value delivery system and build new capabilities consistent with the new environment.
6. Businesses are affected by two sources of change when industry discontinuities occur: selection by the environment of those businesses whose value delivery systems are consistent with the new market environment, and adaptive learning, whereby old value delivery systems are rejuvenated by businesses to be consistent with the new environmental context.
7. Rational adaption to discontinuities by a business is an inverse function of the level of inertia in the organization. Inertia may be related to the size of a business, although competing explanations exist as to whether large size and resource scale facilitate or inhibit flexible response to changing circumstances.

Method

These tenets have a number of testable implications. To test hypotheses, models of business unit market share and profitability are developed. In the models, key strategy variables are hypothesized to affect each other in a cause-effect fashion over time, in order to permit a clearer establishment of the temporal priority of variables such as market share and discontinuities on others such as profits. The models are estimated using annual data on 1,046 businesses operating in 141 different markets between 1974 and 1977 from the FTC Line of Business Program. The results are contrasted to those obtained from comparable estimation with data on 396 business from the PIMS program. Separate models are estimated for three business types: Consumer Durables, Consumer Non-Durables, and Capital Goods.

Summary of Key Findings

Market share never had a significant, positive, and temporally prior impact on profits. The conventional wisdom that high market share leads to high profits, as it was tested, was rejected. The findings are consistent with recent evidence questioning the profit-enhancing value of increasing market share.

Industry discontinuities had negative and usually significant impact on market share and profits. Each time discontinuity variables significantly contributed to explaining market share and profitability, their magnitude of effect was quite large.

Discontinuities do not appear to interact with business size to have a predictable relationship with profit performance. The level of inertia that may hinder a business in adapting successfully to change does not vary systematically with the size of a business. Thus, the depiction of large share firms as tortoises in the race of adaption are vivid but not representative.

A correlate of business size, financial resources available, does appear to facilitate adaption. Discontinuities did interact with profits to improve share performance, but this relationship is not one that occurs regularly for all businesses.

Higher profits may point to the availability of larger pools of funds that can be redeployed to realign business strategy when change occurs.

In five of the six samples of business studied, some form (and sometimes multiple forms) of significant discontinuity effect on market share and/or profits was observed. Thus, discontinuities do appear to be very important strategic events affecting business performance.

Implications

Some of the key managerial implications of the study are:

1. The intrinsic value of market share has been overstated. The frequently reported association between market share and profits does not appear to be attributable to a direct, positive, and causal effect of share. If our conceptualization is accurate, then it is not in market share that profit-yielding capacity primarily resides, but in the products, management, and marketing capability that create superior value, and the discontinuities that create opportunities for share gains.
2. While market share and profile are not connected via a law-like, linear relationship, the two variables may be correlated at any one point in time. This is so because they are both measures, albeit different ones, of a business’ skills at superior value delivery. A business’s market share indicates its ability to deliver superior value, given the tastes of consumers at that point in market evolution. In contrast, profits measure the extent to which superior value is delivered at a low cost relative to price.
3. While market share may be a good indicator of contemporaneous profits, it is less likely to be a good indicator of future profit success. This is so because unexpected discontinuities may impact consumers’ perception of value and the value delivery systems of businesses. In turn, a redistribution of sales and/or profits across competing businesses may result.
4. The chance to improve one’s comparative advantage and in turn one’s competitive position arises out of recognition of change when discontinuities occur. At that time, management must realign its value delivery sequence in accordance with the new environmental context. How well management responds and how quickly management responds will affect the distribution of sales, share, and profits.
5. Some businesses may be “luckier” than others when discontinuities occur in that they may already have the skills and resources in place to deliver the value proposition consistent with the new environment. “Unlucky” businesses must move quickly to acquire or develop them.
6. Market leaders are not necessarily immune to discontinuities. If the basis for success shifts, businesses that have been successful in the past may now be at a disadvantage relative to other businesses possessing skills and resources related to new, required competencies. Similarly, smaller businesses equipped with appropriate value delivery systems can be catapulted to success.
7. If recognition of change is a key to long-term success, then it follows that maintaining peripheral vision and scanning the environment for changes in customers, technology, regulation, competition, etc., is one routine component of strategic analysis. A related second routine component is the constant search for ways in which all elements of a business’ value delivery sequence can be redeployed or enhanced to achieve maximum consistency with the requirements of the current environment as well as foreseeable environments.

Authors’ Comments

The authors offer the following observations:

“With regard to the substantive issues addressed in this research, we believe that the nature of marketing planning and strategy formulation should be expected to vary across businesses and industries, depending in part on the frequency and intensity of discontinuities experienced. The diversity across these possible marketplace scenarios suggests to us that marker analysis and strategy formulation should be situation-specific. Furthermore, we think that a belief in law-like patterns of marketplace performance generalizable to the population of businesses should be relinquished, and the idea that certain patterns of behavior and outcomes reveal themselves on a contingency basis should be embraced. Understanding what those contingencies are, and how value delivery, competitive advantage, market share, and profits can vary under each, is a current challenge for both strategy researchers and managers. There is no single, foolproof way, no algorithm, to set strategy. The only constants are anticipation, flexibility, and the willingness to develop new skills at value delivery.,

“This study was among the first on marketing strategy topics to incorporate data from both the PIMS and FTC programs. The interest in doing so was to investigate whether consistent results are obtained when one tests strategic hypotheses using extremely different sources of business unit information. The analysis suggests that this is indeed the case. The results that emerged from each of these information sources questions the profit-enhancing value of increasing market share, an outcome that converges with other recent strategy studies.”

About the Authors

Cathy Anterasian is a Consultant with McKinsey and Company. Lynn W. Phillips is Associate Professor of Marketing, Stanford University.