Welcome to Foundations of Business Strategy module three, analyzing firm capabilities. In this module we're gonna discuss how you identify those distinctive capabilities that might provide competitive advantage for a firm or organization. We'll also discuss how capabilities fit together as in a system, and try to think about how they align with one another both internally and externally. We'll also discuss the sustainability of a competitive advantage. And then last but not least, we'll discuss how one actually acquires these valuable capabilities. Let me begin with a story of a company, Southwest Airlines, in the US airline market. We've discussed before how the US airline market is one of the most competitive markets in the world. In fact, we see it as being one of the least profitable industries over the last couple decades. It is an industry that has seen numerous bankruptcy and tends to have a lot of turnover, with companies entering the market, exiting the market or merging and acquiring with one another. Throughout this whole period, Southwest Airlines has been perhaps the one lone success story in the airline market. They've been a profitable company going on nearly 40 years. How do they do it? At the end of the day it's clear that they have some distinctive capabilities that seem to differentiate them from their peers. They're well known for being a low-cost carrier, for having quick turnaround times, and also for having superior service in terms of on-time flights and lack of loss of baggage. So how do they do this? How do we understand these capabilities that they have and how these capabilities might provide them a competitive advantage? Well, let's evoke again our fundamental principle of business strategy. If everyone can do it, it's difficult to create and capture value from it. Or alternatively, in a perfectly competitive market, no firm realizes economic profits or rents. At the end of the day, Southwest's advantage is in part because others have failed to be able to imitate what they do. And many have tried over the years. So let's think again about our two perspectives on rents. Last module, we talked about monopoly rents, this idea that there are various barriers to entry that create the opportunity for a firm to succeed and not go to our competitive outcome in which we have a perfectly competitive market and no economic rents. The key to this perspective is the idea that industry structure matters. Today we're gonna turn to our attention to this idea of Ricardian rents. At the heart of this perspective is the role of firm capabilities. The premise here is that these firm capabilities matter most in understanding competitive success. Put another way, these economic rents are due at the end of the day to barriers to imitation, what we referred to before as these Ricardian rents after the economist David Ricardo. So if we look at our graph here, it's the idea again that two firms operating in the same industry might have, for example, different cost structures. Some firms, then, are simply more profitable than others because of these underlying capabilities and the inability of others to imitate them. We can think about these types of advantages in two ways, a cost advantage and a demand advantage, in the simplest of terms. In the first graph we see a cost advantage. Here we have two firms operating in the same market where they're charging the same price for their goods or services. Firm number one has a lower cost structure than firm number two. As a result of this, they can profit in an industry even though the second firm is a marginal producer within the industry. And by this we mean the last entrant into the industry who stays in the industry, covers their opportunity cost, but really isn't that successful or profitable. If you have a lower cost structure than the marginal producer, you can do very well. Compare that to a demand advantage. In a demand advantage what we have are two firms operating in the same industry and, for argument's sake, we're gonna say they have the exact same cost structure. However, the one firm, firm two in this case, gets a higher willingness to pay. Customers are basically willing to pay more for their product or service than the other company, company one. So though they have identical cost structure, the fact that they're able to charge more for their product gives them the ability to achieve some of these economic rents that we're interested in. It's interesting to consider Southwest Airlines. They seem to have, in a lot of people's estimation, perhaps both a cost advantage and a demand advantage. A cost advantage to the extent that they're able to get quick turnaround times, get high utilization and lower their costs. And a high demand advantage to the extent that they have these aspects of quality, such as, again, the ability to have low loss of baggage and the ability to have on-time flights, that might actually command a price premium. Now it might be odd to think about a low-cost carrier having a price premium, but it's important to think of that relative to other other low-cost carriers. And perhaps people are willing to pay a little more for their product or service. So at the end of the day, we're very interested in trying to understand how do these advantages come about, and what are the underlying capabilities to generate them. So let's start first with analyzing the underlying capabilities and trying to identify what they are. The first step in a capabilities analysis, we being with what we call a value chain analysis, where we identify specific resources and capabilities. Next we want to assess the alignment of these capabilities both internally and externally together. Third, we want to then determine the degree to which any capability provides an advantage that is sustainable over time. These three elements make up basic capabilities analysis. Now there are many different versions of how to do a capabilities analysis out there. Our tool kit provides one particular template. But I would argue that all effective capabilities analyses, at the end of the day, have these three elements. So we're gonna discuss, as we go through the rest of the module, how to do each of these steps.