BUSI 103 - Introduction to Business (Chapter 12)
August 5, 2026
Everything this book has taught - creating value, pricing it, investing in it, marketing it - happens in a world full of competitors who want the same customers, so the last question is the hardest one: how do you keep the profits you have built from being competed away?
Read time ~44 min - ~6,532 words - problems ~40 min
Why this matters. If you build something profitable, other people will notice - and they will come for it. Strategy is the discipline of sustaining an edge in the face of that pressure, and it is where every tool in this book finally has to work together.
What you’ll be able to do.
The big ideas.
Key terms. strategy, sustainable competitive advantage, moat, Porter’s Five Forces, substitutes, barriers to entry, switching costs, resource-based view (RBV), VRIO, indifference principle, where to play / how to win.
ADD CASE EXAMPLE HERE. The class case for this lesson is kept out of the book deliberately, so it can stay swappable in class. Suggested areas this anchor case could cover: - A focused regional company deciding whether to grow fast - franchise, take investment, expand - or protect the discipline and culture that made it special. - A company whose once-strong advantage got competed away, and the moment it could have seen the erosion coming. - A company whose choices about where to play and how to win visibly reinforce one another - and a tempting move that would break the coherence.
Everything a business does to create value happens alongside competitors trying to serve the same customers - strategy is how you think about that.
So business, it’s about value creation. Strategy is basically nothing more than an intent, a plan: look forward, how are we gonna create value? Part of that is for whom, right? Who we’re creating value for and how we do that better than everybody else. Everything else - cost, growth, profit - it only makes sense if we have this grounded truth of how we create value.
Through this book we talk a lot about what specific firms do to deliver value and communicate value with customers - that was the work of the value creation chapter (Chapter 2) and the marketing strategy chapter (Chapter 9). One thing to understand is we do this in a competitive context, right? There are lots of firms doing this, competing with us. Strategy helps build a context for us to understand not just that we’re interacting in the world ourselves, or that we’re interacting in the world with other customers. We’re doing this in a large context of customers and potential customers and competitors who are also looking to serve needs for people that we might also be looking to serve needs for.
High profits attract competitors, and the competition that follows pushes those profits back toward the average.
One thing that’s important to note is that, according to economics, there’s this idea that competition takes all profits and dissipates it away. The way this kind of works is if there are customers we start with and we say, “Oh I could do something to be valuable for a customer.” Let’s just say I could do something that would be quite valuable, to the extent where it would be quite profitable. Well here’s the thing. If I’m making a lot of profits and this customer is really delighted, other people are going to look around and say, “Hey maybe I could do that too.” If you’re making a lot of money, your profits are going to attract the attention of other people who are also interested in making profits, so they get into the business too.
Once they get into the business, it could be one of two things. They can learn, actually, “Oh this is really hard. I’m not actually good at creating this value and what this guy is doing is pretty difficult, so I can’t do this anymore. It’s not worth my time,” and they drop out.
But it turns out if you’re making really high profits, it’s going to pay for someone to figure out how to compete with you - and to compete with you for your customers and say, “Well let’s offer the service, but let’s just offer it a little bit cheaper.” Now you’re not going to be outdone by them, so maybe you can afford to offer a little cheaper. That’s going to be kind of just a race to the bottom on prices, which customers are going to love, until you can’t go any further.
The person who can compete the best is going to be somebody who is going to be so efficient that their costs are so good that they can afford to lower prices just a bit more than the other person can. What’s going to happen is you never lower your price without needing to. Once we kind of reach the lowest point before another competitor gets kicked out, if you don’t kick them out of the market, that’s where it is. You’re making this profit margin and they’re making kind of a smaller profit margin, almost nothing. Customers are delighted, and now they’re busy at work trying to figure out how they could cut their costs so they could also be competitive.
Basically all this says is there’s a big long competition that unfolds over time where profits are always under pressure to get competed away. This is mean reversion of profitability. When a company is really profitable, it tends to be that somehow they’re going to get less. For companies that are not profitable, eventually if they stick around, they are going to make more, because there’s this constant tug of war at work where the profitable ones are under competition from the less profitable ones, right? People are always trying to figure out how to do this better. If you have a lot of profits, it’s going to get competed away.
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Mean reversion of profitability: the most and least profitable firms both drift back toward the middle over time.
So in a large macro sense we can say, “Hey what’s the point of getting good?” - because if you’re good, eventually you’ll have those things competed away. At any given point in time companies are striving to compete, and I wouldn’t say that it’s useless, but it’s really hard. Being good consistently is hard in the face of competition, because if you’re doing well and thriving, people want a piece of that action, until the point where you’re no longer doing as well and thriving, because the competition is going to bring you down.
There’s a related picture in the historical equity risk premium. That just shows how much people are earning on their investment, and that kind of bounces around at a very specific percentage point, around 5%, not a lot higher, not a lot lower. This is to say that when we think about profits and return on equity, we have put money in some ventures. Some of them are risky, some of them are less risky. The question is, how much would we have to put in? How much have you got out? How much profit do we have to get to put that stuff at risk?
When it comes to that, in general, if you could make money you might get involved, but you’re not sure you can, so it’s risky. In order to get involved you’re going to have to make a certain level of profits to get into that venture - to take the risk that you may or may not be able to do it. If you’re sure you’re going to make profits, you’d be willing to invest a lot, because it’s guaranteed, all the way up to just about making just a little bit of profits. When you’re not sure, you need to have a buffer of safety. This is why some companies, some industries are really profitable: because they’re also really risky. They have to justify the risk of getting in, whereas the others have smaller margins. It’s often tied to us not adding as much value, or to us attracting a lot of people to enter this market because there’s not a lot of risk in getting these returns. It’s a pretty sure thing, so you’re willing to invest more in order to capture that.
Strategy is about sustaining profits over time - and that means making focused choices about what you will and will not do.
So, key things with strategy. Strategy is about sustaining profits over time, not just short-term wins. There’s the external view, the internal view, and then what I call the playing-to-win view, that is from Roger Martin. These are frameworks from others that I think are valuable for understanding strategy.
The idea is that what we’re always looking for is a source of sustainable competitive advantage - what some will call a moat. What’s going to protect your business model from being imitated by others, and therefore entering a form of competition where your profits go away? Strategies are about making choices, right? It’s about picking specific things to be really strong in. We have to decide what we are not going to do, so we can remain focused, because to get good at something requires focus. You have to decide where you’re going to play and how you’re going to win, and focus on that. That has to be the right decision - there has to be enough profitability in that specific zone that you choose. The narrower you play, the easier it is to get good, and the easier it is to build a sustainable competitive advantage.
Strategy matters because profit margins are always under pressure from competitors, from substitutes, and even your customers. Customers, if they know that you’re making a lot of money off them, they themselves can figure out, “Can I do this for myself?” You’re always under pressure to compete - from your customers, from direct competitors, or potentially other substitutes. Strategy is about how you maintain your edge in this constantly competitive environment, and how you grow your source of competitive advantage.
Even a great product struggles in a hostile industry - profitability is tied to the structure of the industry around you.
The core idea from Michael Porter, who created Porter’s Five Forces, is that profit really depends on your position in the industry. It’s about external forces, not just your product. They’re going to shape how much profit you can have, and these forces push against you. The more they push against you, the harder it is to sustain profits. Even successful firms are going to struggle if the industry is really competitive.
Profitability differs quite a bit by different kinds of industries. Michael Porter started thinking maybe profitability is tied to something about the industry - and, in particular, the structure of the industry. It turns out that pharmaceuticals and semiconductors have very high profitability, airlines and car making very low profitability, and the question is what kind of insight we can get from that.
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Average profitability varies widely and persistently across industries.
Rivalry sits at the center; buyers and suppliers squeeze from either side; new entrants and substitutes threaten from above and below.
The five-forces exhibit has rivalry in the center and the four pieces around the side. When we talk about competition being like these five forces, the most immediate competition is what we put at the center of this framework.
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Porter’s Five Forces: competitive rivalry at the center, with supplier power, buyer power, the threat of new entrants, and the threat of substitutes around it.
If you have competition among existing competitors that look very much the same, and your offering is very much the same, there’s not a lot of ways to differentiate. That’s the structure of what’s going to define competition now. What’s going to drive that? Surely the number of competitors. If there are a lot of competitors, the competition is going to be more intense, because everyone’s competing against each other. If you’re all the same, there’s not a lot of differentiation, and the price competition can be intense because there’s not a lot of ways we could differentiate. If we have a lot of diversity, then it’s going to soften the competition - it could be that while we’re competing with each other, we’re just a better fit for certain customers. You kind of draw out and pick and choose what customer segments you’re competing in, which might be different from the customer segments that I’m competing in.
If the industry is really concentrated - there’s just a small number of players - it could affect competition in different ways. If there are not that many players, maybe it’s not that competitive, because there are only a few people left. If we have very different segments, that could also soften competition. At the same time, there could be very intense competition when there are few players, especially if we’re not differentiated. Industry growth is the big one. When everything is growing, everyone’s happy, everyone’s investing, and we’re worried less about competing over the existing customers, because there are more customers to win. When there’s not a lot of growth and there are not a lot of new customers, we start getting really intense over fighting for who gets what share of the customers. That can make competition more intense.
If there are a lot of differences in quality among the things we offer, we could be differentiated, and the market could be less intense, because we’re focusing on different quality levels, different customer types. If customers are really loyal to our brand, we’re not always fighting over defecting and stealing customers from each other.
The other thing is around barriers to exit and switching costs. From the barriers-to-exit standpoint, if we can’t get out - we’re invested in this and we’re going to lose a lot if we leave - we are more prone to compete than if it’s easy to leave. And if our own customers have what they call switching costs - you have a customer, but switching to another provider would be really expensive for them - then they tend to be more loyal to you. That might also soften competition. But if they can very easily switch to another place, we’re always competing, at every moment, for the next customer.
If we look at the east-west part of this framework, we talk about the bargaining power of buyers and the bargaining power of suppliers. If our own customers can pit us against each other, the competition is going to get really high, and profits are going to be bid down to be really low. If we’re easy to switch between, or if there are not that many customers, every single customer really matters a lot, and that gives more power to those buyers. And if they are able to find something else that they could use instead of you or a direct competitor, the more alternatives they have, the more that’s going to put pressure on our profits.
Then we go upstream. Everybody is a buyer, but we are also the customers of, let’s say, our suppliers. If we can be squeezed on that side as well - if there are not that many suppliers, and all of us have to buy from a very small group of people - those people have more power, and that’s going to make the profits in our given industry a lot lower. If we are able to benefit from a ton of very competitive suppliers, or we can substitute and do something else, that gives our suppliers less power. That’s going to help us protect our profit margin instead of being squeezed by our suppliers. Along the east-west side: we are competing with our rivals, but we are also affected upstream and downstream. Downstream, if our own buyers have a lot of negotiating power, that’s going to put pressure on our profits. Upstream, if our suppliers have a lot of negotiating power over us - which has a lot to do with basically “can we live without them, or are there other people that we can go to?” - that’s going to have an impact on our profit margins as well. So much about how much profit we make is defined by this context of who has more power and how competitive it is within that circle.
If we look at the top and bottom of this framework, we’re talking about the threat of new entrants and the threat of substitutes. One thing that can change competition is whether or not we’re going to get more competitors in here. If there’s a high barrier to entry just to get into this game - you have to spend a lot - probably fewer people are going to be prepared to do that. If we’re in an industry that requires a lot of upfront fixed costs, people really have to think before they get in, because it’s a big commitment. That means we have fewer rivals, and that’s going to make competition a little bit less intense. Otherwise we’re always worried about people coming in - you’re always competing against the newest entrant, and that’s going to intensify the competition.
Other things can keep people out. Economies of scale: you have to be a certain size in order to be efficient, so small players can’t get in. If there are strong economies of scale, existing players probably only have to worry about the existing players, with few people coming in. If there’s a lot of brand loyalty, getting customers is going to be hard for new players. That tends to keep the club exclusive, keep that market smaller, and we don’t worry so much about the threat of new people coming in. And anything about requirements or regulation: if you have to clear a lot of bars just to get into this game, then to the extent that we can keep people out, that is going to make competition less intense, because we’re basically barring the entrance of new competition.
That’s competition from people who do what we do. There’s another form of competition, which is the substitute product. What’s different from a competing product? A competing product is somebody else producing what we produce. A substitute is somebody producing a different product, but that product could be used instead of our product. If you’re a burger place, you think about all these other burger places - you hope that your burger is better than their burger, and you watch whether your customers are going for them or for you. But in the market of lunch, people could eat burgers, pizza, or hot dogs. These are other products that are not what you’re doing, but could be consumed in lieu of your products - so they are substitutes. If there are a lot of substitutes available, that’s going to make competition really intense, because you’re not just competing against the people who produce your product. Producing cars, you might be competing against other car manufacturers, but you’re also competing against other forms of transportation - rail transportation, bike transportation, or just moving around on feet. Those are things that you have to think about as a broader form of competition. And if the price and performance of substitutes are really, really good for customers - even if their product is worse than yours, it’s just way cheaper - this is something that you have to compete with.
All of these factors are the five forces that Porter talks about:
Industry structure matters - but most of the explainable difference in performance sits inside firms, not between industries.
Porter’s Five Forces was a real innovation when it comes to strategy, but there’s another way of thinking about it. Where do the profitability differences really come from? There were some people who said, “Look, maybe it really comes from industry structure, and the best way to get profits is just to pick the right type of industry.” But researchers started analyzing: where does this stuff really come from? Does it come from the business unit? Does it come from what industry you’re in? Does it come from company-specific things, or is it just about time and trends? What they found, doing a variance decomposition across all these observations of different companies, was that industry effects are there - around 8% - and it matters, but it doesn’t explain the biggest share. One of the biggest explanatory factors, besides just random noise and luck, is the business unit: specific businesses have very firm-specific advantages and resources and capabilities, and this seems to be a driver of performance. Of course there are other things, like corporate effects - being owned by a specific type of company - or just year-to-year trends, but the business unit is a big piece. This would suggest that the thing that really explains performance is something specific to a business, not just its industry. (Decomposition: business-unit effects ~46%, industry ~8%, corporate ~1-2%, year ~2%, unexplained ~40%. Source: Rumelt, “How much does industry matter?”, Strategic Management Journal, 1991 - lesson deck.)
So this is a look inward. Maybe the real holy grail of understanding what drives sustainable competitive advantage is about something that makes your firm special, even if you’re in the same industry.
Firms outperform their industry when they hold resources that are valuable, rare, hard to imitate - and that the organization is built to exploit.
These scholars found that even within an industry there’s variation in profitability. What could be driving that? The theory - the resource-based view (RBV) - goes that there are specific resources that you have within your firm, and other people may not. This could be what drives whether you have an advantage.
The acronym here is VRIO. We ask four questions about a resource:
If a resource is valuable - it helps you create or capture value with your customer - and it’s rare, a comparative advantage that not everybody has, and other people can’t copy it, and you build an organization around this to take advantage of it, then this might be a source of sustainable competitive advantage.
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The VRIO model: each additional test a resource passes moves it from competitive parity toward sustained advantage.
Here’s how the result works out. If you’ve got something that’s valuable, but other people have it - it’s not rare - this is just what everybody has. It’s just table stakes for the game. Now if you have something that’s valuable and rare, but it’s not difficult to imitate, you have a temporary competitive advantage - but pretty soon people are going to build something that works just as well, and then your gains will be gone. Now if you’ve got something that’s valuable, it’s rare, it is also difficult to imitate, but you’re not organizing yourself to take really good advantage of it, then this is a potential competitive advantage - you just didn’t find a way to convert on it. Everything has to be there: we’ve got the right stuff in place, it’s valuable, not everybody has it, people cannot produce a substitute for this, and we are organizing ourselves to really take advantage of it. That is the source of long-term competitive advantage. It’s a resource that’s internal - that is the locus, versus the external industry environment. This is the idea of the resource-based view.
Some examples of this:
Assets flow to whoever can use them best - so it is not enough to hold a valuable asset; you have to be its most valuable user.
Sustainable competitive advantage is really hard to maintain. Why? Because assets are what we call mobile. To the extent that people are where you get your advantage, people can leave. Ideas can leave. People can find out what you know. People leave your company, and those insights leak out to other places.
This gets us down to the indifference principle: assets don’t care who utilizes them. They’ll just find their way into the hands of the most valuable player. For example, take LeBron James - great basketball player, and a lot of people think a source of winning games, a source of advantage. If you’re thinking about basketball as a business, winning allows you to be a more famous team, allows you to make more money. If we all know LeBron would be great anywhere he goes, you’re gonna have to pay him a lot to attract him to your team. Other people know that they would also like that advantage, so they would bid this up, and pretty soon everyone’s bidding up a contract to possibly attract LeBron James to their team. If that is your source of advantage - having this great player who could go anywhere - the bidding war is going to be such that the only person who wins this competition is LeBron. Everybody else is willing to pay up to the marginal benefit they would get by having him on their team, because everybody would be able to utilize this.
Assets kind of don’t care who owns them - it’s just about who the highest bidder is going to be. And it also works for inanimate things, not people but other objects. If you have a machine that can really produce this product, in the hands of somebody who makes less profit on it, they’re willing to pay a certain amount for it. Somebody who can make more profit with it is willing to pay even more, so they’re going to compete it away from them. The indifference principle is that assets - people, talent, physical assets, capital - tend to flow to where the highest return is, because those are the asset owners who can pay the most for them. If you have an asset, it is not enough to have one. It is not enough to have a competitive asset, a valuable asset. You also have to be the most efficient utilizer of that asset and generate the most value with it, or else somebody else is gonna give you an offer you can’t refuse, where it’ll be worth it for you to sell.
You might say, “Well, I would just stop them from buying it - I’ll just keep it and refuse.” But if you think about it, why would you do that? If you’re producing a certain amount of value over a number of years, and count all of that up, but somebody else can produce more value than you, they’re gonna be able to offer you a price where it will be too good for you to say no.
Strategy and competitive advantage is something where it is not enough to just be the lucky possessor. You have to kind of earn that - to win all the time.
A strategy answers two questions - where will we play, and how will we win there - and you need both.
The last framework is one from Roger Martin, who was a scholar at the University of Toronto and also a practitioner for P&G. He says strategy can be broken out into two questions:
You’ve got to answer both these questions to have a good strategy.
On the “where do we play” side, you’ve got to choose your segment, your region, your geography, your product or channel. You’re defining the arena in which you compete, and the idea here is that defined boundaries help us get focus and avoid distractions. Once you know what the place is, it’s got to be big enough to be worth going after - and then you have to get to the next question: how do we win? What collection of assets, advantage, and know-how do we have to be really compelling in this space? We’re always kind of going back and forth between these two things. We should be in a place where we have the greatest advantages, and once we’re in a place, we always have to figure out how we do better than the alternatives.
Winning - there’s a finite group of ways we can do that. We can win because we are great on costs. We have superior quality. We have access to those customers, or we have a very strong brand. Winning must reflect what our real strengths are: strengths relative to anybody else competing in that space, where other people can’t compete and preferably don’t want to replicate the kind of advantage you have. That is the source of sustainable competitive advantage.
Martin’s five questions are not a menu worked through one at a time - they are an integrated set of choices that have to cohere.
There’s a picture of this - reverse engineering competitive strategy as a cascade of five different questions:
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Martin’s cascade: winning aspiration, where to play, how to win, must-have capabilities, management systems.
These choices are not chosen in sequence - they’re an integrated set of choices. There has to be some coherency among them; it has to make sense together. Once you make one choice, all the other choices are somehow bound to that, so all of these choices have to work together.
You cannot compute a strategy from data - it is a story about how you win, tested by whether it works.
I think Roger Martin really emphasizes that strategy is a hypothesis. It’s an idea of how we can win. This is not something that necessarily has been done before. It cannot be isolated and derived from data. It is, in some sense, a set of beliefs.
Some people will say, “Well, if it’s as easy as that and there are no facts, maybe everyone can do it - every idea is as good as another.” Not quite, because it has to be internally consistent. These decisions, when they are internally consistent, harmonize and reinforce one another, and then we get good at particular things, and it kind of becomes a self-fulfilling prophecy.
If it’s misaligned, we have problems: our how-to-win doesn’t work in this particular area, so we’re in the wrong place. We’re not going to have advantages if we have a really good idea of how to win but we don’t have the capabilities to deliver. Or we have these capabilities, but we’re not organized - we don’t have the management systems to really deploy them. That’s also going to be a problem.
Then the proof is in the pudding. If this works, you will see it work. The best players have a coherent play that does win. When it doesn’t, it gives clues about what has to change, what has to be tweaked in order to recover - and you’re able to react in an efficient, fast, and effective way.
You can read a good strategy off a company’s choices - including what they are choosing not to do.
Some of the highlights of a strategy are knowing not just what a company is doing, but what they’re not doing. Take Trader Joe’s. Where do they play? They’re always in dense urban or suburban neighborhoods. They’re looking at value-oriented shoppers - not super rich, but shoppers who are looking at value, more adventurous, interested in new things. How do they win? They have curated private-label products that allow them to keep the costs down. The variety is interesting. They have a friendly store culture that’s really important - they’re not just making it super low price, super efficient; that’s not the vibe that customers want. They maintain low prices, partially reinforced by their own private label, and they don’t have to spend a lot on promotions to get people in.
You can imagine what would happen if they were in a very rural neighborhood. They might not have enough people of this particular segment who would be interested, and that wouldn’t work. If they decided to carry a lot of name brands, they would lose some specialness that’s specific to this store. People wouldn’t find it as compelling, because they can get those name brands at any store. These are choices that they make together, and they reinforce one another - the best strategies are choices that reinforce, not choices at odds with one another.
The external view, the internal view, and strategy-as-choice work together - and they ask for judgment, not just analysis.
When it comes to understanding strategy, it’s helpful to have a handful of good lenses, and we’ve talked about three of them:
Some important things to keep in mind:
Whatever company ends up in the anchor slot - or whichever one you carried in your head through this chapter - run it through the three lenses. What do the five forces say about how hard its industry squeezes? What does it hold that passes the VRIO test, and is it still the most efficient utilizer of those assets, or is the indifference principle already at work? And can you state its strategy as choices - where it plays, how it wins, what it has deliberately decided not to do - that visibly reinforce one another? A business that clears all three lenses is worth defending - and defending it is the job. Profits attract competition, advantage erodes, and the companies that stay good do it by choice, coherence, and constant revision, not by luck.
12-1 Two Industries, One Dollar. [LO1, LO2] An investor is choosing between two businesses seeking the same investment: a regional airline and a specialty pharmaceutical firm. Both project similar revenue. Using the five forces, explain why the same dollar of revenue might convert to very different sustained profit in these two industries. Name the two or three forces that differ most sharply, and say which business would need the stronger firm-specific story to be worth backing.
12-2 The VRIO Audit. [LO3] A family-owned bakery is famous for a sourdough recipe, a head baker of twenty years, and a corner location it rents near campus. Run each of the three “assets” through the four VRIO questions. Which, if any, could support a sustainable advantage? For each that falls short, name the failing test and what the indifference principle predicts will happen to that asset over time.
12-3 Where to Play, How to Win. [LO4] A student team wants to launch a meal-prep service. Draft their strategy as Martin’s cascade: a winning aspiration, a where-to-play choice (segment, channel, scope), a how-to-win choice, the two must-have capabilities, and one management system. Then run the coherence check: find the one choice in your own draft most at odds with the others, and fix it.
© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 103 - please do not repost or redistribute without permission.