I/O Model of Above-Average Returns

Examples of different industries, firms, and by using research published in academic peer reviewed journals. The I/O Model of Above-Average Returns and (2) The Resource-Based Model of Above-Average Returns. Why should firms earn above average returns? And which of the two models is advantageous in generating above average returns under current economic conditions, this needs to be supported and explained.

Definitions: The I/O Model of Above-Average Returns-specifies that the choice of industries in which to compete has more influence on firm performance than the decisions made by managers inside their firm.The I/O model is based on the following four assumptions:

  • The external environment—the general, industry and competitive environments impose pressures and constraints on firms and determines strategies that will result in superior returns.  In other words, the external environment pressures the firm to adopt strategies to meet that pressure while simultaneously constraining or limiting the scope of strategies that might be appropriate and eventually successful.
  • Most firms competing in an industry or in an industry segment control similar sets of strategically relevant resources and thus pursue similar strategies.  This assumption presumes that, given a similar availability of resources, most firms competing in a specific industry (or industry segment) have similar capabilities and thus follow strategies that are similar. In other words, there are few significant differences among firms in an industry. 
  • Resources used to implement strategies are highly mobile across firms.  Significant differences in strategically relevant resources among firms in an industry tend to disappear because of resource mobility.  Thus, any resource differences soon disappear as they are observed and acquired or learned by other firms in the industry.
  • Organizational decision-makers are assumed to be rational and committed to acting only in the best interests of the firm.  The implication of this assumption is that organizational decision-makers will consistently exhibit profit-maximizing behaviors.

According to the I/O model—which was a dominant paradigm from the 1960s through the 1980s—firms must pay careful attention to the structured characteristics of the industry in which they choose to compete, searching for one that is the most attractive to the firm, given the firm’s strategically relevant resources.  Then, the firm must be able to successfully implement strategies required by the industry’s characteristics to be able to increase their level of competitiveness. The five forces modelis an analytical tool used to address and describe these industry characteristics.

Based on its four underlying assumptions, the I/O model prescribes a five-step process for firms to achieve above-average returns:

  • Study the external environment—general, industry and competitive—to determine the characteristics of the external environment that will both determine and constrain the firm’s strategic alternatives.
  • Select an industry (or industries) with a high potential for returns based on the structural characteristics of the industry.  
  • Based on the characteristics of the industry in which the firm chooses to compete, strategies that are linked with above-average returns should be selected. 
  • Acquire or develop the critical resources—skills and assets—needed to successfully implement the strategy that has been selected.  
  • The I/O model indicates that above-average returns will accrue to firms that successfully implement relevant strategic actions that enable the firm to leverage its strengths (skills and resources) to meet the demands or pressures and constraints of the industry in which they have elected to compete.  

The I/O model has been supported by research indicating:

  • 20% of firm profitability can be explained by industry characteristics· 36% of firm profitability can be attributed to firm characteristics and the actions taken by the firm
  • Overall, this indicates a reciprocal relationship—or even an interrelationship—between industry characteristics (attractiveness) and firm strategies that result in firm performanceThe Resource-Based Model of Above-Average Returns-is grounded in the uniqueness of a firm’s internal resources and capabilities. The five-step model describes the linkages between resource identification and strategy selection that will lead to above-average returns.· Firms should identify their internal resources and assess their strengths and weaknesses. The strengths and weaknesses of firm resources should be assessed relative to competitors.
  • Firms should identify the set of resources that provide the firm with capabilities that are unique to the firm, relative to its competitors. The firm should identify those capabilities that enable the firm to perform a task or activity better than its competitors.· Firms should determine the potential for their unique sets of resources and capabilities to outperform rivals in terms of returns. Determine how a firm’s resources and capabilities can be used to gain competitive advantage.
  • Locate and compete in an attractive industry. Determine the industry that provides the best fit between the characteristics of the industry and the firm’s resources and capabilities.
  • To attain a sustainable competitive advantage and earn above-average returns, firms should formulate and implement strategies that enable them to exploit their resources and capabilities to take advantage of opportunities in the external environment better than their competitors.

Resources and capabilities can lead to a competitive advantage when they are valuable, rare, costly to imitate, and non-substitutable. · Resources are valuable when they support taking advantage of opportunities or neutralizing external threats. · Resources are rare when possessed by few, if any, competitors. · Resources are costly to imitate when other firms cannot obtain them inexpensively (relative to other firms). non-substitutable

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