Strategy & Competition: Why Some Firms Keep Their Profits

In Damodaran's January 2026 dataset of listed companies, the whole market kept about 9.7 cents of net profit from each dollar of sales. Software firms kept about 25 cents. Tobacco firms kept about 27. Airlines kept about 2.5 and food retailers about 1.3. Airlines carry passengers across oceans and fly them safely; grocers feed whole cities. They are no less useful than software. They are just in a game where profit is competed away.

Why? One company makes cola and another makes steel, and both work hard. Strategy asks what lets a firm keep earning above the average, and competition policy asks what society should do when a firm keeps too much.

Why some industries are more profitable: Porter's five forces

In a 1979 Harvard Business Review article, "How Competitive Forces Shape Strategy", Michael Porter made a plain claim: profit depends less on how clever a firm is than on the structure of the industry it is in. He named five forces that squeeze or protect profit:

1. Threat of new entrants. If anyone can start, profits are copied away.
2. Threat of substitutes. Something different that does the same job caps your price.
3. Power of buyers. Big, informed buyers who can switch bargain your price down.
4. Power of suppliers. If your inputs come from one source, they take your margin.
5. Rivalry. Many equal rivals with high fixed costs fight on price.

A weak force is good for the firm and a strong one is bad. A graduate looks at an industry and scores the five before saying anything about the managers.

The model has critics, and they are worth knowing. Kevin Coyne and Somu Subramaniam argue that it assumes buyers, suppliers and rivals never collude or interact, that value comes only from structure, and that uncertainty is low. Adam Brandenburger and Barry Nalebuff added complementors (the makers of things that make your product more valuable) as a sixth force. Others argue that the model ignores what each firm itself is good at, which the resource-based view puts first. Porter himself updated the framework in a 2008 article. All sides agree that both the industry and the firm matter.

Competitive advantage: cost, differentiation and the value chain

Inside an industry, a firm that earns more than its rivals has a competitive advantage. Porter's Competitive Strategy (1980) said there are two basic kinds. Cost advantage: you make the same thing for less, and can either undercut rivals or keep the difference. Differentiation: you make something buyers will pay more for. He also warned of being "stuck in the middle", with neither; economists and managers still argue about how often that is true.

A neat way to see the two together is to ask what a rival's cost lets you charge. If your product is as good as the rival's, a price war drags the price down to the rival's cost, and your margin is your cost gap. If buyers value yours more, you can charge that premium on top.

Porter's value chain (Competitive Advantage, 1985) tells you where to look: inbound logistics, operations, outbound logistics, marketing and sales, service, supported by technology, procurement, people and infrastructure. An advantage hides in one link or in how links fit. Ikea's cost advantage lives in design and flat-pack logistics, not in cheap wood. A luxury brand's lives in marketing and service. The question is always: which activity do we do better, and can they copy it? A copyable advantage lasts about as long as it takes to copy.

Economies of scale and the learning curve

Bigness helps in two plain ways. Fixed costs spread out: a factory costs the same whether it makes a thousand units or a million, so the average cost per unit falls with volume. And experience teaches: the more a firm makes, the better it gets. T. P. Wright noticed in 1936 that the labour per aeroplane fell by a steady percentage each time cumulative output doubled; consultancies later called this the experience curve.

The catch: scale only helps if demand is large enough to use it. A giant plant sitting half-empty has higher average costs than a small full one. And a learning curve is not automatic; it comes from deliberate work, and rivals can also learn.

Network effects and platforms

Some goods get more valuable as more people use them. A telephone is useless alone and valuable with millions. Economists call this a network effect (a demand-side economy of scale): it raises what buyers are willing to pay, rather than lowering the seller's cost. Direct effects come from other users of the same thing (messaging, a phone network). Indirect or two-sided effects link groups: more drivers make a ride app better for riders, and more riders make it better for drivers. A platform is a business built to host such a market, and the economics of pricing two sides at once was set out by Jean-Charles Rochet and Jean Tirole (2003).

Robert Metcalfe's law says a network's value grows with the square of its users, since n users have about n(n−1)/2 possible connections. Andrew Odlyzko, Bob Briscoe and Benjamin Tilly argued in 2006 ("Metcalfe's Law is Wrong") that later users are worth less than early ones, so growth is nearer n × log n. Studies of Facebook and Tencent have fitted n², and a European internet-usage study found n² for small and n log n for large networks. The data haven't settled it; the main point survives either way.

Three cautions. Tipping is not automatic: it needs network benefits to outweigh product differences and costs of switching or using several services at once. Some networks congest (more users can make it worse). And data advantages are often weaker and shorter-lived than classic network effects. The famous cases, such as VHS beating Betamax, are told with different details by different historians.

Entry, price wars and the economist's view of competition

Strategy books ask how to win. Industrial organization asks the opposite: how many rivals does it take for a market to behave competitively? The classic model is the French economist Antoine Cournot's (1838): firms choose how much to make, and the price falls as total output rises. With one firm you get the monopoly price. With two, a lower price. As the number of firms grows, price slides toward cost. Prices fall quickly at first and then slowly.

Notice what the model leaves out, and what strategists add. Real firms also enter and exit, and an incumbent may threaten a price war to deter entry. Game theory (34/45) shows that a threat to fight is only believable if fighting is in the incumbent's own interest when the time comes; otherwise entrants call the bluff. Firms avoid price wars when they can: in the Cournot picture profit falls fast as rivals multiply, which is why firms prefer differentiating products to matching prices.

Market power and antitrust

Firms that keep profits by being better are doing what the system rewards. Firms that keep them by shutting rivals out are doing something else. Telling them apart is the job of competition law (called antitrust in the United States), and the regimes differ.

Regime	Main rules	Notes
United States	Sherman Act (1890), Clayton Act (1914), Hart-Scott-Rodino (1976)	Sherman §2 bars monopolisation. Mergers are reviewed by the DOJ and FTC.
European Union	Articles 101 (agreements) and 102 (abuse of dominance); Merger Regulation 139/2004	Digital Markets Act applies since 2023 to designated "gatekeepers", fines up to 10% of worldwide turnover.
China	Anti-Monopoly Law, in force since 2008	Enforced since 2018 by the State Administration for Market Regulation (SAMR).
India	Competition Act, 2002	Enforced by the Competition Commission of India.

Recent examples, each dated. On 5 August 2024 a US federal judge, Amit Mehta, found that Google had illegally maintained a monopoly in general search; in a remedies decision of 2 September 2025 he declined to break the company up, barred exclusive contracts for search and ordered some data sharing, and both sides appealed. In April 2025 the European Commission imposed the first fines under the Digital Markets Act: €500 million on Apple and €200 million on Meta. In April 2021 China's regulator fined Alibaba about $2.8 billion, around 12% of its 2020 net profit, for anticompetitive practices.

The tools differ in what they measure. A common first screen is the HHI (the widget above). The US 2010 guidelines treated a market above 2,500 as highly concentrated; the 2023 revision tightened the threshold, so check the current text. The deeper argument is about the goal. The consumer welfare standard, associated with Robert Bork, asks whether prices rise or output falls for buyers. Critics (sometimes called "neo-Brandeisian") say this is too narrow and misses power over workers, suppliers and politics. Defenders say it is the only standard that can be measured and tested. Most jurisdictions now treat consumer welfare as one factor among several.

What a graduate just sees

• Industry structure explains a lot of profit before you look at the managers: score the five forces.
• An advantage is only as good as it is hard to copy.
• Your margin = rival's cost + your premium − your cost: an advantage is a gap.
• Average cost falls with volume, but only if demand fills the factory.
• Network effects create winners by tipping; critical mass is the whole game, and expectations decide it.
• In a market with few rivals, prices drift up; each extra rival helps, with diminishing force.
• A merger changes the concentration number, and regulators look at both the level and the change.
• "Dominant because better" and "dominant because blocked everyone else" can look the same from outside, and the law tries to tell them apart.

Where it shows up next

• Pricing (34/61): once you know your cost and your rival's cost, pricing is choosing where in that gap to sit.
• Marketing Management (34/57): positioning is differentiation seen from the customer's side.
• Entrepreneurship (34/56): a new venture's first question is which force it can beat and for how long.
• In the world: why airlines and grocers earn thin margins, why a "winner takes most" app market forms, what a merger review asks, and every news story about a company being sued by a regulator.

If you want to go deeper

• 📘 Textbook. Robert Grant, Contemporary Strategy Analysis (Wiley). The standard strategy text for business students, with industry analysis, resources and cases.
• 📘 Textbook. David Besanko, David Dranove, Mark Shanley and Scott Schaefer, Economics of Strategy (Wiley). The economist's version, with game theory throughout. For the pure theory, Jean Tirole's The Theory of Industrial Organization (MIT Press, 1988).
• 📘 Gentler. Michael Porter, Competitive Strategy (1980), for the originals; Carl Shapiro and Hal Varian, Information Rules (1999), for networks and standards; Tim Wu, The Curse of Bigness (2018), for the antitrust story and the argument against consumer welfare.
• 🌐 Free course. MIT OpenCourseWare 15.902 Strategic Management I (Fall 2006, Hax and Sahani), a graduate Sloan course on analytical methods and strategic practice.