What Is Competitive Advantage?
Competitive advantage refers to factors that allow a company to produce goods or services better or more cheaply than its rivals. These factors allow the productive entity to generate more sales or superior margins compared to its market rivals.
Competitive advantages are attributed to a variety of factors including cost structure, branding, the quality of product offerings, the distribution network, intellectual property, and customer service.
- Competitive advantage is what makes an entity's products or services more desirable to customers than that of any other rival.
- Competitive advantages can be broken down into comparative advantages and differential advantages.
- Comparative advantage is a company's ability to produce something more efficiently than a rival, which leads to greater profit margins.
- A differential advantage is when a company's products are seen as both unique and higher quality, relative to those of a competitor.
Understanding Competitive Advantage
Competitive advantages generate greater value for a firm and its shareholders because of certain strengths or conditions. The more sustainable the competitive advantage, the more difficult it is for competitors to neutralize the advantage. The two main types of competitive advantages are comparative advantage and differential advantage.
The term "competitive advantage" traditionally refers to the business world, but can also be applied to a country, organization, or even a person who is competing for something.
A firm's ability to produce a good or service more efficiently than its competitors, which leads to greater profit margins, creates a comparative advantage. Rational consumers will choose the cheaper of any two perfect substitutes offered. For example, a car owner will buy gasoline from a gas station that is 5 cents cheaper than other stations in the area. For imperfect substitutes, like Pepsi versus Coke, higher margins for the lowest-cost producers can eventually bring superior returns.
Economies of scale, efficient internal systems, and geographic location can also create a comparative advantage. Comparative advantage does not imply a better product or service, though. It only shows the firm can offer a product or service of the same value at a lower price.
For example, a firm that manufactures a product in China may have lower labor costs than a company that manufactures in the U.S., so it can offer an equal product at a lower price. In the context of international trade economics, opportunity cost determines comparative advantages.
Amazon (AMZN) is an example of a company focused on building and maintaining a comparative advantage. The ecommerce platform has a level of scale and efficiency that is difficult for retail competitors to replicate, allowing it to rise to prominence largely through price competition.
A differential advantage is when a firm's products or services differ from its competitors' offerings and are seen as superior. Advanced technology, patent-protected products or processes, superior personnel, and strong brand identity are all drivers of differential advantage. These factors support wide margins and large market shares.
Apple is famous for creating innovative products, such as the iPhone, and supporting its market leadership with savvy marketing campaigns to build an elite brand. Major drug companies can also market branded drugs at high price points because they are protected by patents.