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REV: FEBRUARY 25, 2006

PANKAJ GHEMAWAT JAN W. RIVKIN

Creating Competitive Advantage
Some companies generate far greater profits than others. The pharmaceutical maker ScheringPlough produced an economic profit of more than $10 billion during the period 1984-2002. That is, the accounting profit it generated exceeded its cost of equity capital by that amount. Over the same period, U.S. Steel produced an economic loss of nearly $500 million; its cost of capital exceeded its accounting profit by a wide margin. Such large differences in economic performance are commonplace. Understanding their roots is crucial for strategists. Differences in industry structure shed some light on such differences in performance. To a certain extent, Schering-Plough has generated more economic profit than U.S. Steel because the pharmaceutical industry is structurally more attractive than the steel industry. Rivalry in the pharmaceutical market is muted by factors such as patent protection, product differentiation, and expanding demand; in contrast, rivalry in the steel industry is fierce—fueled by excess capacity, limited differences across products, and slow growth. Many pharmaceutical users hesitate to switch among products or brands, while steel customers are usually willing to switch among producers to get a better price. Many pharmaceuticals are made from commodities with little labor input, while unions exercise such power in the steel industry that labor costs often account for a quarter of total revenue. Such contrasts in industry-level competitive forces are one reason that the profit levels of firms in different industries differ. Figure 1 shows, for each of many industries, the spread between the industry’s return on equity and its cost of equity (the vertical axis) and the average equity in the industry (the horizontal axis) for the period 1984-2002. Reflecting