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Economics of Strategy – Chapter 11: Industry Analysis Industry analysis frameworks

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1. Assessment of industry and firm performance 2. Identification of key factors affecting performance 3. Determination of how changes in the business environment may affect performance 4. Assessing generic business strategies Brandenberger & Nalebuff: Value Net
value net often enhances firm profits Porter: Five Forces
how suppliers, distributors and competitors detract form a firm’s profits Limits of Porter: 1) limited attention to factors affecting demand other than availability and prices of substitute/complement; 2) focus on industry; 3) government as regulator disregarded; 4) only qualitative – best for assessing trends

Performing a Five-Forces Analysis -

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is only a tool for assuring systematic use of economic principles key question is if any force is sufficiently strong to reduce or eliminate industry profits internal rivalry (can be heated up by all other 4 forces also) should be seen in light of product market and geographic market; firms compete on price and nonprice dimensions
price competition heated up when: o many sellers in market o stagnant or declining industry o firms have different costs o excess capacity o undifferentiated products/low switching costs o large/infrequent sales orders o industry does not use “facilitating practices”/has history of cooperative pricing o strong exit barriers entry (structural and strategic barriers)
threat of entry affected by: o significant sales economies / minimum efficient scale large relative to the market o consumers highly value reputation / are brand loyal o access of entrants to key inputs o experience curve o network externalities o government protection o expectations about postentry competition substitutes and complements (substitutes reduce demand, complements boost demand) – can affect rivalry, entry and exit
factors to consider: o availability of close substitutes/complements o prive-value characteristics of substitutes/complements o price elasticity of industry demand supplier power (can erode industry profits if concentrated or firm gets locked-in) o relative concentration of industry and upstream and downstream industries o purchase volume of downstream firms o availability of substitute inputs o relationship-specific investments by the industry and its suppliers o threat of forward integration by suppliers o ability of suppliers to price discriminate buyer power (their ability to extract profit form firm partly linked to internal rivalry) – form factors see supplier power coping with the five forces: 1) position to outperform rivals; 2) identify industry segment in which the five forces are less severe; 3) try to change the forces

Coopetition and the Value Net -

adds to five forces analysis, in that it assesses threats and opportunities by performing an analysis of suppliers, customers, competitors and complementors
firm interactions may be positive, not only negative (as assumed by Porter) e.g. standards facilitate industry growth; cooperation to improve quality or efficiency; cooperation with buyers/suppliers to reduce inventories (JIT)

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Economics of Strategy – Introduction: Strategy and economics -

Strategy
ultimately determines success or failure, revealed in terms of consistent behavior, shapes firm’s competitive persona to successfully formulate and implement strategy, a firm must confront 4 broad classes of issues: o boundaries of the firm
horizontal (product market), vertical (make/buy), corporate (set of businesses the firm competes in) o market and competitive analysis o position (basis for competition) and dynamics (adjustments) o internal organization

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Economics of Strategy – Chapter 12: Strategic Positioning for Competitive Advantage Competitive Advantage -

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five-forces framework shows how induct conditions determine firm profitability across industries profitability, however, also varies within a particular industry competitive advantage = firm (or business unit) earns a higher rate of economic profit than the average of other firms competing within the same market o same market (except for perfectly competitive markets) = one firm’s production, pricing and marketing decisions materially affect the prices that others in the group can charge framework (page 389) for competitive advantage takes market economies and value-created relative to competitors into account o value-created relative to competitors is dependent on benefits position and cost position relative to competitors – a higher value-created can simultaneously achieve higher profits and higher net benefits to consumers o study showed that industry is responsible for 18% variation, competitive position 32%, unexplained are 43%

Competitive Advantage and Value Creation: Analytical Tools and Conceptual Foundations Perceived Benefit and Consumer Surplus -

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consumer surplus = perceived benefit (B) – monetary price (P) o perceived benefit (consumer’s maximum willingness-to-pay) = perceived gross benefit – user costs – transactions and purchasing costs o consumer surplus is analogous to the profit of a firm o purchase will only occur if the surplus is positive, at a choice between competing products, that with the largest consumer surplus will win indifference curve = combinations of price-quality that yield the same consumer surplus (for a given consumer) o price-quality combinations below a given curve provide superior value, above inferior value o surplus parity = when firm’s price-quality positions line up along the same indifference curve o surplus parity in markets in which consumers have identical preferences
market shares will be stable, if all offer the same quality, they have to charge same price o slope of indifference curve = tradeoff willingness between price and quality

Value-Created -

value-created (on a per unit basis) = perceived benefit to final customer (B) – cost of inputs (C) = consumer surplus (B – P) + producer’s profit (P – C) price (P) determines how much of the value-created sellers capture as profit and buyers capture as consumer surplus

Value Creation and “Win-Win” Business Opportunities -

positive economic value is a requirement for production whenever B > C, entrepreneurs can make deals to leave all parties better of (suppliers, themselves, customers)
gains from trade

Value-Creation and Competitive Advantage -

a positive value creation (B – C) is no guarantee for positive economic profit, as in competitive markets P is bid down to C and zero economic profit results, the share of consumer surplus increases To achieve a competitive advantage – to outperform the competitors in its markets – a firm’s product must not only create positive value, it must create more value than its competitors.
firm can match consumer surplus “bids” and end up with a higher profit on the sale.

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first step in diagnosing firm’s potential for achieving competitive advantage: understand how economic values is created (drivers for consumer benefits and costs) & evolution of the business (market demand, conditions of technology…)

Value Creation and the value chain (Fig. 12.8, p. 405) -

value chain = firm as a collection of value-crating activities, each having the potential to add to both B and C value-added analysis = determining incremental benefit of an activity by using market prices of finished or semifinished goods analyzing competitive advantage also involves the entire vertical chain of production, as value can also be created through make-or-buy decisions that are sensitive to conditions of technology and transaction costs

Value-Creation, Resources and Capabilities -

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to perform better at some or all of the value-chain activities, a firm must possess resources and capabilities that competitors lack (otherwise copying would occur) resources = firm specific assets (e.g. patents trademarks, brand-name reputation, installed base…) capabilities = activities that a firm does especially well compared with other firms
key characteristics: o valuable across multiple products or markets o embedded in organizational routines
persistent o tacit – difficult to reduce to algorithms or procedure guides distinct are key success factors (skills and assets needed to achieve profitability in a particular market), as they are market level characteristics every firm must possess; they are not sufficient for a competitive advantage often there are limits to manageability of capabilities and resources

Value-Creation versus Value Redistribution -

diversification activity of 70s and 80s was based on view that skills in bargaining or acquiring undervalued firms was enough to succeed, however, these skills have rather to do with value redistribution than with creating new value

The role of Industry structure -

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value-created = value-created by average firm in industry + differential between firm’s value-created and average industry value-created o industry average has a great impact, even if firm greatly outperforms its industry, it can still have low profits in an absolute sense opportunities for retaining value-created can vary substantially along the vertical chain – partly due to differences in the structure of the industry at each point

Strategic Positioning: Cost Advantage and Benefit Advantage -

2 broad approaches to achieve competitive advantage: o cost advantage = attain lower C, maintaining B comparable to competitors o benefit advantage = offer higher B, maintaining C comparable to competitors

The Economic Logic of Cost Advantage -

to create a cost advantage, a company has to create a C advantage that is larger than (a possible) B disadvantage
simultaneous increase in consumer surplus and profit possible - 3 possible ways: o offer same B through e.g. economies of scale o offer slightly reduced B that allows for automation, less expensive components, lower quality control standards, to underprice rivals by more than enough to offset the lower B o offer different quality by redefining the product

The Economic Logic of Benefit Advantage -

to create a benefit advantage, a company has to create a B advantage that is larger than (a possible) C disadvantage
simultaneous increase in consumer surplus and profit possible

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in markets with no horizontal differentiation (identical preferences) pricing is influenced as follows: o cost advantage: lower price just below unit cost of next most efficient competitor to capture entire market o benefit advantage: rise price just below unit cost C plus additional benefit compared to the next highest B offered horizontal differentiation = product possesses attributes that increase its value for some, but decrease it for others
strong when many attributes and consumers disagree about desirability; weak when product is simple and buyers are more knowledgeable (as business customers usually are) margin strategy (for low price elasticity of demand) = firm maintains price parity with competitors and profits from cost advantage (cost advantage) / increases price and benefit from premium (benefit advantage) share strategy (for high price elasticity of demand) = underprice competitors to gain market share at their expense (cost advantage) / maintain price parity and profit from increased market share (benefit advantage) usually mixed strategies are employed always the reactions of competitors have to be regarded!

Comparing Cost and Benefit Advantages -

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cost position is relatively more attractive when: o economies of scale and learning economies are potentially significant and competitors are not exploiting them o nature of the product limits opportunities to enhance B (commodities) o consumers are price sensitive (indifference curves are flat) o search good = objective quality attributes are easily accessible (reducing costs and imitating competitors is easier) superior benefits position is relatively more attractive when: o typical consumer is price insensitive (steep indifference curves) o economies of scale/learning are already exploited
niche markets become more attractive o experience good
image, reputation or credibility are difficult to imitate/neutralize

Implications for Functional Area Strategies -

choice for the basis for competitive advantage is guided by demand and technological product characteristics choice for competitive advantage in turn guides operating strategies in all functional areas
See Table 12.4, page 420

Stuck in the Middle -

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Porter argued that pursuing cost and benefit strategies at the same time does not work because of the tradeoff involved however, practice has shown that it is well possible – several factors that might weaken the observed tradeoff: o offering high-quality products can increase market-share, which then reduces average costs because of economies of scale or the experience curve o rate at which accumulated experience reduces costs is greater for higher-quality products than for lower-quality products o inefficiences muddy the relationship between cost position and differentiation position
TQM is geared at improving production processes to increase B and reduce C efficiency frontier = shows lowest level of cost that is attainable to achieve a given level of differentiation given the available technology and know how what matters is the value-created, not providing the higherst B or lowest C pursuit of strategic positioning requires deep understanding of how value is created
what drives costs, what attributes create benefits, and how do the drivders vary across different segments of the market

Targeting and Market Segmentation -

choosing the target market is itself a key strategic decision that often cannot be separated from the approach to value-creation market segment = group of consumers within a broader market who possess a comon set of characteristics and thus respond to market miex ariables in much the same way
(e.g. characteristics for consumer goods markets: demographics, geography, knowledge of product, willingness to trade off quality and price…) targeting: selection of segments that the firm will serve and the development of a product line strategy in the light of those segments
2 categories: focus and broad coverage

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broad coverage strategies – try to serve all segments offering a full line of related products making use of economies of scope (production, distribution, marketing…)
can either be in the form of a one-size-fits-all strategy (economies of scale allow for cost advantage) or a customization strategy (benefit advantage) focus strategies
make use of economies of scale that could not be achieved by expanding – 1) product specialization (several market segments); 2) geographic specialization (variety of related products in a narrowly defined area); 3) customer specialization (related products to particular class of customers); 4) niche strategy (single product for single market)

Appendix – Cost Drivers -

cost drivers related to firm size or scope o economies of scale – average costs go down as scale of operations increases (e.g. due to indivisible inputs, properties of processing units, increases in productivity of variable inputs, economies of inventory management) o economies of scope – average costs go down as firm produces greater variety o capacity utilization - cost drivers related to cumulative experience o learning curve (distinct from economies of scale!) - cost drivers independent of firm size, scope or cumulative experience o input prices o location o economies of density (cost savings arising with greater geographic density of customers) o complexity/focus o process efficiency (fewer inputs for given amount of output utilized) o discretionary policies o government policies - cost drivers related to the organization of transactions o organization of the vertical chain (e.g. vertical integration can reduce costs in some markets through better coordination) o agency efficiency
cost of each activity in the firm’s vertical chain may be influenced by a different set of cost drivers – 2 possible ways to achieve a cost advantage: o control key cost drivers within various activities better than competitors o fundamentally alter activities in the value chain (process reengineering)

Appendix – Benefit Drivers -

perceived benefit depends on the attributes the customers value and the ones that lower the transaction costs benefit drivers can be classified along 5 dimensions: o physical characteristics o quantity and characteristics of service and complements o characteristics associated with the sale or delivery of the good o characteristics that shape consumers’ perceptions or expectations of product’s performance/cost in use o subjective image of the product

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Economics of Strategy – Chapter 13: Sustaining Competitive Advantage How hard is it to Sustain Profits? Threats to sustaianability in competitive markets -

in perfectly competitive markets (costless imitation and free entry), firm profit is driven down to zero economic profit sales occur at the quality/price level, at which the efficiency frontier (most efficient cost-quality positions), is tangent to an indifference curve – at any other point, where economic profit would be positive, the pricequality position would have to lie above the efficiency frontier triggering imitation/entry

Threats to sustainability in Monopolistically competitive markets -

sellers are horizontally differentiated in distinct niches, demand curve is downward sloping, so optimal to set a price above marginal costs nevertheless entry will continue until incremental profits just cover fixed costs

Threats to sustainability under all market structures -

regression to the mean = one should not expect firms to repeat extreme performances for long, as they might have benefited/lost from good/bad luck genuine advantages might be inimitable, but if strong buyers/suppliers (most likely in oligopolistic or monopolistic markets) exist, they might bargain away the profits

Evidence: The persistence of profitability -

Dennis Mueller has shown that the extremes persist, they do converge, but not towards a common mean
some forces push markets toward perfectly competitive outcomes, others impede this the forces are distinct from Porter’s 5 forces, as we are concerned with the individual firm

Sustainable Competitive Advantage The resource-based theory of the firm -

competitive advantage is sustainable if it persists despite efforts by competitors or potential entrants to duplicate or neutralize it to support a sustainable competitive advantage, the market must be characterized by persistent asymmetries in terms of firms’ resources and capabilities resource-based-theory of the firm: sustainability needs scarce (acquired before supplier could bargain economic profit to zero) and imperfectly mobile resources immobile resources
due to cumulative experience, reputation, relationship-specific value, cospecialization o cospecialization = assets are more valuable when used together than when separated

Isolating mechanisms -

scarcity and immobility are necessary, but not sufficient
also needed are isolating mechanisms isolating mechanisms = forces that limit the extent to which a competitive advantage can be duplicated or neutralized through the resource creation activities of other firms (similar to entry barriers for the industry) o 2 groups: 1) impediments to imitation; 2) Early-mover advantages competitive advantage might be initially achieved by: process or product innovations; discoveries of new sources of consumer value/market segments, shifts in demand or tastes, changes in regulatory policy

Impediments to imitation -

legal restrictions
patents, copyrights, trademarks, governmental control over entry (licensing, certification, quotas…) – can however be highly mobile (sold or bought), if so, a buying firm needs to have superior information about how to best utilize the asset or complementary resources to enhance its value in order not loose profitability to the seller

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superior access to inputs or customers
inputs – through ownership, long-term exclusive contracts; customer – through exclusive dealing clauses
but vulnerable to changes in technologies or tastes, or the opening up of new input or product markets (also to have the competitive advantage the resources must be secured at “below-market” prices) market size and scale economies
imitation may be deterred by a large minimum efficient scale relative to the market demand, of which a firm has already secured a large share (although the entrant my imitate the source of the other firm’s advantage, it may nevertheless be unprofitable, as the price might then be below the LAC (long-run average cost) intangible barriers to imitation
not only hard to imitate, but also hard to consciously redesign o causal ambiguity: causes of competitive advantage are obscure and only imperfectly understood, typically due to tacit knowledge o dependence on historical circumstances: unique experiences in adapting to the business environment o social complexity: interpersonal relations of managers, with managers of supplierer or with customers strategic fit (Porter) = a firm’s activities form a coherent, mutually-reinforcing whole
to succeed in positioning, an entire system of activities has to be implemented correctly as choices among a whole set are tightly linked and reinforce one another (to successfully imitate, a rival has to align an entire system of activities – the odds of failure rise exponentially when a firm has to imitate simultaneously on multiple dimensions)

Early-Mover Advantages -

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learning curve
firms with the greatest cumulative experience can profitably underbid rivals due to lower unit costs, further increasing the learning effects network externalities: individual consumer’s benefit form purchasing the product is greater the larger the installed base is
thus those establishing the base earlier have an advantage reputation and buyer uncertainty
sale of experience goods relies heavily on the reputation for quality – the first mover has the advantage as it can gain reputation and has reduced the uncertainty of consumers
pioneering brands often also heavily influence customer preferences o endogenous sunk costs
while with market growth exogenous sunk costs become lesser of a barrier, endogenous sunk costs can create important early-mover advantages fro firms (e.g. due to escalation in advertising and related scale efficiencies) buyer switching costs
areise for buyers from specific know-how that is not fully transferable or if the seller develops customer specific know-how about the buyer other sellers cannot quickly replicate

Early-Mover advantages and competition for market share -

although early-mover advantages may suppress competition once they are acquired, competition to achieve it might be intense anticipated switching costs by consumers might however lead to relatively price inelastic demand curves and firms end up setting higher prices leading also to reduced competition in the earlier phases

Early-Mover Disadvantages -

early movers can fail due to a lack of complementary assets, by betting on the wrong technologies, by “bad luck or trivial circumstances” which lead to a different standard

Imperfect imitability and industry equilibrium The most efficient firms earn positive economic profits because no firm can be certain that it can imitate their competitive advantage. Average entrants earn subpar returns relative to active firms because the least efficient firms will not survive. As price declines toward the equilibrium level, these firms will exit the industry. If an average entrant survives, it will be at the bottom end of the distribution of remaining firms. - ex ante economic profitability = each firm’s expected economic profit before entering (zero) - ex post economic profitability = each firm’s expected economic profit after entering, may be positive or negative

Oster – Chapter 5: Groups within industries -

strategic groups = clusters of firms within an industry that have common specific assets and thus follow common strategies (e.g. branded / generic) in setting key decision variables
may play an important role in understanding performance differenes among firms

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differences in assets and strategies create e.g. pioneering-brand advantages or learning-curve advantages
groups may react very differently to changes in environment o for analysis, a strategic groups is a middle ground between the industry and the firm captive production = firms producing entirely for another organization in the same corporation merchant firms = firms producing strictly for the open market change in the environment can help to precipate a major strategic change among firms in the industry, however, do the strategic groups may have quite different abilities to take advantage of changes in the environment
relative profitability of particular strategic groups may change o

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Barriers to entry and barriers to mobility -

entering an industry with fairly well-defined strategic groups is more difficult to analyze, as barriers may be specific to a group
differences in profitability when analyzing forces that push towards a common level, mobility between groups and entry into the different groups has to be analyzed (sometimes a second layer, similar to industry analysis is needed) risk-adjusted profit differences will persist among strategic groups only if there are barriers to mobility among those groups existence of large specific assets (physical or organizational) can have a substantial effect on a firm’s choices
if firms in an industry differ substantially in their portfolio of these assets, they will also differ in their response to environmental change

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Economics of Strategy – Chapter 2: The horizontal boundaries of the firm: Economies of scale and scope -

horizontal boundaries = quantities and varieties of products and services a firm produces
depend on economies of scale and scope

Formal definitions of economies of scale and scope Definition of Economies of Scale -

economies of scale = exist over range of output where average cost declines – thus marginal cost (MC) must be less than the overall average cost diseconomies of scale = average cost is increasing average cost curve
often U-shaped due to an initial spread of the fixed costs and later due to capacity constraints, bureaucratic and agency problems; if L-shaped, average costs decline up to the minimum efficient scale (MES)

Definition of Economies of Scope -

economies of scope = savings that manifest as the variety of goods and services is increased in a firm, usually defined in terms of relative total cost of producing a variety of goods and services together in one firm versus separately in 2 firms
TC (Qx,Qy) < (TC (Qx,0) + TC (0,Qy)

Where do economies of scale come from? -

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indivisibility and the spreading of fixed costs
at the product, plant and multiplant level 1. spreading of product-specific fixed costs: may include special equipment, R&D, training expenses, costs necessary to set up a production process… 2. tradeoffs among alternative technologies: economies of scale do not only arise because of more efficient capacity utilization, but also due to tradeoffs between technologies with low fixed and high variable costs or reverse  short-run economies of scale = reductions in average costs due to increases in capacity utilizations  long-run economies of scale = reduction due to adoption of a technology/larger plant that have high fixed costs but lower variable costs  long-run average cost curve = lower envelope of curves of alternative technologies/plant sizes 3. substantial product-specific economies of scale are more likely when production is capital intensive and minimal product specific economies of scale are more likely when production is materials or labor intensive 4. exogenous fixed costs = fixed costs that are necessitated by production (technology) 5. endogenous fixed costs = fixed costs not related to production, rather R&D, advertisement… increased productivity of variable inputs (mainly having to do with specialization) inventories 6. need to carry inventories creates economies of scale, as the higher the volume of business, the lower can the ratio of inventory to sales be while achieving a similar level of stock-outs
reducing the average costs of goods sold 7. queuing theory = shows that as arrival rate increase, the seller need carry a smaller excess inventory in percentage terms to maintain a fixed rate of stock outages the cube-square rule = as the volume of a vessel (tank, pipeline) is increased by a given proportion, the surface area increases by less than this proportion
in many production processes, production capacity is proportional to the volume, whereas total cost of producing at capacity is proportional to the surface area of the vessel

Special sources of economies of scale and scope (other than production) -

economies of scale and scope in purchasing
discounts for volume purchasing are given because of less costs to sell to a single buyer, the price sensitivity of bulk buyers and the necessity to assure a steady flow of

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business, however purchasing alliances can also achieve this and sometimes the largest buyer might not get the largest discounts economies of scale and scope in advertising 8. costs of sending messages per potential customer (cost of sending a message / number of potential receivers): larger firms enjoy lower advertising costs per potential consumer, mainly because of the fixed costs associated with placing an ad 9. advertising reach and umbrella branding  number of actual consumers may, even if costs of sending messages per potential customer are the same, differ due to a differing size of outlets  umbrella branding – effective when consumers use information in an ad about one product to make inferences about others, thus reducing advertising costs per effective image (also reduces risk of new product introduction economies of scale and scope in R&D
R&D involves significant indivisibilities (minimum feasible size of projects and departments) and also economies of scope from spillovers, however there is no clear relationship between size and innovativeness, as large firms can reduce average costs of innovation, but small firms may be better able to motivate researchers and may have different incentives to innovate

Sources of diseconomies of scale -

labor costs and firm size
larger firms generally pay higher wages due to unionization and a compensating differential for less attractive workplaces and greater distances, however, their worker turnover is lower incentive and bureaucracy effects
divergence between productivity and payment, hard to monitor and communicate, work rules stifle creativity and commitment spreading specialized resources too thin
if a specialized input is a source of advantage and a firm tries to expand its operations without duplicating the input, expansion may overburden the specialized input conflicting out (mostly for professional services) – problems arise if clients have difficulties with the firm also serving their competitors

The learning curve -

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learning curve (experience curve) = depicts the cost advantages that flow from accumulating experience and know how (though lower costs, higher quality, more effective pricing an marketing) 10. magnitude of benefits is the slope of the change in unit costs over cumulative production, usually calculated for a doubling in cumulative production
median slop appears to be about 0.8 (= 20% savings) learning curve strategies
firms produce seemingly more than is optimal in the short run, to reap the benefits of experience see also growth/share matrix (page 94) learning occurs at different rates for different organizations and processes, when it rests with individuals it is important to take account of it

Scale and scope economies, firm size and profitability -

scale and scope economies set limits to the number of firms competing in a market firms can expand output through 1) internal strategies, relying on retained earnings, equity and debt, or 2) external strategies, relying on formalized relationships with other firms (synergies = economies of scale/scope) although there is a positive correlation between market share and profitability, there is no causal mechanism whereby market share leadership automatically translates to profits

Economics of Strategy – Chapter 6: Diversification -

diversified firm = a firm producing in multiple output markets
successful diversification combines businesses that can exploit scope economies; diversification for other reasons tends to be less successful

The extent of diversification -

history has seen 5 merger waves in the US, all with a different character: 1. 2. 3. 4.

1883-2000 after worldwide depression, some corporation were able to monopolize their industries after WW1, antitrust law prohibited monopolies, but oligopolies build up, involving vertical integration 1960s/70s, increased levels of unrelated diversification due to antitrust laws 1980s, failure of the many conglomerates resulted at firms being offered at “bargain” prices

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mid-1990s, motivated by (1) desire to establish dominant market share or (2) access to international markets
mergers too usually place in related industries

relatedness (by Richard Rumelt) = measured according to how much of firm’s revenues are attributable to product market activities that have shared/related technological or production characteristics, or distribution channels o 3 characteristics: proportion of revenues from (1) largest business, (2) largest group of related businesses, (3) stages of a vertically integrated production process o single business: 95% in single activity o dominant business: 70-95% from principal activity o related business: >70% from principal activity, but other lines of business are related to it o unrelated business (conglomerate)

Rationales for diversification -

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economies of scale and scope
needed are either related products or markets: o operational synergies
increased market share (mergers are more likely when there is a positive expectation of market share change and in fact this expectation usually is achieved) o to pursue economies of scope a related set of products for a narrow population of consumers would be necessary, however this is rare in reality – economies of scope can also come form other sources (see resource-based view of the firm)  e.g. by spreading a firm’s underutilized managerial and organizational resources (however, the farther away the news business, the more resource the firm will need to expand)  dominant general management logic = managers of diversified firms may spread their own scarce resources across nominally unrelated businesses (however, it is a difficult claim) financial strategies: argument runs that long-term success requires development of a portfolio of businesses that assure an adequate and stable cash flow to finance activities, however: o can shareholders diversify themselves usually less expensive o value creation through this “firm-as-banker” view is only reasonable for related diversification where the firm has more skills in evaluation an investment o acquiring target firms at a bargain is difficult, as the winner in an auction pays more than all others are willing to pay
financial synergies are plausible, but do not justify a merger, in combination with economies of scope they can be strong economizing on transaction costs: goal is to minimize transaction costs, a diversification is efficient when the transaction costs are lower than in a coordination among independent firms o diseconomies of scale also arise due to diversification: influence costs
through internal lobbying resource allocations may be inefficient (capital markets can allocate resources more efficiently than corporate managers) o control and incentive systems have to be set up managerial reasons for diversification (best single explanation for unrelated diversification): o oriented toward maintaining or enhancing the position of executives making diversification decisions, rather than efficiency or enhancing shareholder wealth
 pursuit of growth (for unrelated higher in firms with limited internal growth)  managers avoid to get fired (diversified operations = average performance) o however, managers can also be motivated by an unrelated diversification

The market for Corporate Control -

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managerial reasons for diversification are countered by the threat of hostile takeovers Market for Corporate Control (MCC) = Manne argued that the main purpose of a merger is to replace one management team with another, as the control of corporation is a valuable asset (capital market observers must have intimate knowledge about efficiencies of management teams)
this threat disciplines current managers; however, for a successful takeover, also specialized knowledge or resources are necessary, as in the takeover process the price is bid up to a level, where if these are not present the winner has overpaid often successful takeovers end in de-diversification (selling off of unrelated parts) there is little support that corporate raiders can actually identify and eliminate ineffective boards of directors and entrenched management teams
unclear whether disciplining management accounts for more than a small number of mergers

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if gains from replacing management teams come from improving operating economies, all stakeholders can gain if takeovers occur without a basis in operating synergies, gains may largely accrue to the new owners as they redistribute wealth from other stakeholders that have made relationship specific investments and whose quasi-rents are then extracted o short term: gain for the new owner o long-term: stakeholders will be unwilling to further invest in relationship (but problems can be foreseen by raider), however it can also adversely influence the industry when others see their jobs/investments jeopardized o but: firms do not necessarily have to be acquired to extract quasi-rents from stakeholders

Evidence on the performance of diversified firms -

ultimately, diversity can only be worthwhile if corporate management adds value in some way and the test of a corporate strategy must be that the businesses in the portfolio are worth more than they would be under any other ownership diversification up to a certain point can be efficient, the sources however are unclear, realizing the efficiencies can be difficult and extensive diversification is often associated with poor performance

Studies of diversified firm performance using accounting data: -

relationship between performance and corporate diversity is unclear; profits are more likely to be determined by industry profitability and how the firms related old and new businesses moderately diversified firms have higher capital productivity, but the higher the level of diversification and the more unrelated it is, the lower productivity

Stock price studies of diversified firms -

divsifying mergers and acquisitions can be associated with performance gains, however, to create value (increased stock returns and reduced risk) diversification must involve related businesses

Long-term performance of diversified fims: -

2 major studies have shown that merger performance over time has generally been poor – the merger wave of the 1980s can be seen as a correction of the unrelated merger wave of the 1960s Tobin’s q = market value of firm / cost of replacing its tangible assets
higher for specialized firms


Diversification can create value, though its benefits per se relative to non-diversification are unclear due to industry effects and other factors. Firms that diversify according to a core set of resources and with an eye toward integrating old and new businesses tend to outperform those that do not work toward building interrelationships among their units (there needs to be some basis in scope economies with transaction cost conditions).

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Economics of Strategy – Chapter 3: The vertical boundaries of the firm -

vertical boundaries = define the activities that a firm performs itself as opposed to purchases from independent firms in the market vertically integrated firms = hierarchical firms that perform many of the steps in the vertical chain themselves (contrary: disintegrated firms – they outsource)

Make versus buy -

make-or-buy = decision of a firm to perform activity itself or purchase form independent firm
can lead to back- or forward integration (if decision is make); however not only the extremes exist, solutions can capture some of the benefits and costs of both, the make and buy extremes firms are said to be upstream or downstream from another (relative – up earlier in the process, down later) vertical chain of modern industrial enterprise also comprises a large variety of support services (usually placed outside the chain, as they support each step) market firms = firms selling their own processing, handling or support activities using the market = firm buys activities or inputs form market firm vertically integrated = firm provides activity or makes input itself

Defining the boundaries: -

buy benefits: 1) economies of scale of market firms; 2) market firms are exposed to the competition and thus must be efficient and innovative buy costs: 1) coordination of production flows; 2) private information may leak; 3) transaction costs

Some make-or-buy fallacies -

generally buy/make
choice should depend on efficiency and should look at economic profitability make to obtain input at cost, not fluctuating market value
fluctuation can be countered by hedging, risk is even exacerbated by investing in industry with fluctuating prices

Reasons to “BUY” -

-

market firms are often more efficient (can either perform activity at lower cost or higher quality) tangible efficiencies: o economies of scale and learning economies through aggregation of production
if market is competitive, buyer gains, if limited competition persists, both buyer and seller gain o division of labor (specialization) is limited by the extent of the market (magnitude of demand)
increased demand is accompanied by increased specialization
high degrees of specialization lead to economies of scale intangible benefits of using the market: o agency costs = costs associated with slack effort and with the administrative controls to deter slack efforts  usually market competition controls these costs, but in a vertically integrated firm where these are not present (or reduced) and divisional performance may be hard to determine, these costs may become substantial (especially if the in-house division is a cost center = performs solely for the firm of which it is part)  agency cost can also arise in the form of a lack of innovativeness  incentive based pay tied to performance or other measures can help, but the right use is difficult (e.g. to induce long-term innovations, instead of short-term-) o influence costs = costs of activities to influence internal capital markets (direct costs of influence activities, e.g. for internal lobbying + costs of bad decisions that arise)
large, vertically integrated firms may be more prone to such costs

Costs of using the market -

coordination of production flows through the vertical chain
when players must make decisions that depend, in part, on those of others, thy need to protect against coordination problems, either through contracts or middlemen clauses

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design attributes = attributes, where small errors can lead to large costs
coordination is especially important, thus it often makes sense to integrate all critical upstream and downstream activities and rely on administrative control (vertical integration) o look at marginal benefit of producer of exploiting the design attribute and look at the buyers marginal costs; fees might help, but steep marginal cost curves might give rise to handle it rather internally leakage of private information
loss can be costly; can sometimes be countered by contracts (e.g. noncompete clauses in employment contracts) transactions costs = costs of using the market; arise when one or more parties to a transaction can act opportunistically
contracting costs, costs of adverse consequences of opportunistic behavior and costs of trying to prevent it o

-

Technological change and evolving firm boundaries -

new technologies (computer, telecommunications, inventory management) have reduced many of the advantages of make decisions

Economics of Strategy – Chapter 4: The Transactions Cost of Market Exchange -

arm’s-length market transaction = one in which autonomous parties exchange goods or services with no formal agreement that the relationship will continue into the future
governed by contract law long-term contracts/strategic alliances
obligations are less precisely defined, less likely to be resolved through litigation

Contracts and market exchange -

contracts define conditions of exchange
promote economic efficiency in that they make sequential performance of obligations possible however, their ability to facilitate exchange depends on: o completeness of the contract
a complete contract stipulates each party’s responsibilities and rights for each and every contingency that could arise during the transaction and also determines what constitutes satisfactory performance and how to measure it, in total it must be enforceable  incomplete contracts (not fully specifying the mapping of possible contingencies to rights responsibilities and actions) are the rule in the real-world
3 factors: o bounded rationality = limits on the capacity of individuals in processing information, dealing with complexity and pursue rational aims
parties cannot contemplate or enumerate every contingency o difficulties specifying or measuring performance o asymmetric information = parties do not have equal access to all contract-relevant information o available body of contract law
well developed body of contract law makes it possible for transactions to occur smoothly when contracts are incomplete, in that they specify a set of standard provisions applicable to wide classes of transactions  however, 1) broad phrasing raise costs of transaction; 2) litigation can be a costly way to complete contracts and can weaken or destroy business relationships

Transactions with relationship-specific assets
transaction costs with incomplete contracting -

relationship-specific assets = investments made to support a given transaction
create switching costs and thus lock the parties into the relationship to some degree fundamental-transformation: before the relationship, competitive bidding occurs, but once costs have been sunk for relationship-specific assets, bilateral bargaining between the parties to the transaction occurs (often a climate of distrust and noncooperation arises) forms of asset specificity: o site specificity - economize on transportation/inventory costs or processing efficiencies o physical asset specificity – inhibits customers from switching suppliers o dedicated assets = investment made to satisfy a particular buyer

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human asset specificity – skills, know-how and intangible assets that are more valuable inside a particular relationship than outside rents and quasi-rents: o relationship-specific investment (RSI) = amount of investment that cannot be recovered if business is not done with the original partner o rent = profit expected from investing in production, assuming all goes as planned o quasi-rent = extra profit that you get if the deal goes ahead as planned, versus the profit you would get if you had to turn to your next best alternative holdup problem: o if assets are not relationship specific, quasi-rents are zero, however, when they are large, the trading partner could try to exploit this o holding up = partner attempts to renegotiate the terms of a deal to extract part of the quasi-rents for himself transaction costs resulting from the holdup problem: o contract negotiation and renegotiation: time consuming and costly; renegotiations may delay or disrupt exchange and impede deliver of products to customers
difficult in sequential production o investments to improve ex-post bargaining positions
e.g. second source or standby facilities, nevertheless, this creates excess capacity or results in lost economies of scale o distrust
give rise to costs contracting and costs from lost sharing of information or ideas which could improve efficiency or quality o reduced investment
underinvestment in either the form of reduced scale or general-purpose assets instead of more specific ones
lower productivity and higher production costs o

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Transactions costs and vertical integration -

vertical integration is an alternative to the market exchange to avoid the inefficiencies listed above 3 reasons why vertical integration may be preferable: o differences in governance: management has more flexibility in the choice of mechanisms for conflict resolution and those are less costly, both in time and disruptive effects; additionally, also the decision base is broader and much more detailed (less information asymmetry) o repeated relationship: more incentives to make relationship-specific investments and reduced likelihood of opportunistic behavior (but agency problems) o organizational influences: common purpose and culture of organizational members gives rise to cooperative systems

Economics of Strategy – Chapter 5: Organizing Vertical Boundaries: Vertical integration and its alternatives Technical efficiency versus agency efficiency technical efficiency = degree of usage of the least-cost production process
aimed at process of production - agency efficiency = extent to which the exchange of goods and services in the vertical chain has bee organized to minimize the coordination, agency and transactions cots
aimed at process of exchange - economizing = balancing of technical and agency efficiencies
Oliver Williamson argues that the optimal vertical organization minimizes the sum of technical and agency inefficiencies
ee figures 5.1 (p. 171) and 5.2 (p. 173) o scale and scope economies: firm gains less from vertical integration the greater the ability of outside market specialists to take advantage of economies of scale and scope relative to the firm itself o product market scale and growth: firm gains more from vertical integration the larger is the scale of its product market activities o asset specificity: firm gains more from vertical integration when production of inputs involves investments in relationship-specific assets -

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Vertical Integration and Asset Ownership -

Grossman, Hart & Moore (GHM)
focus on importance of asset ownership and control in make-or-buy decisions with incomplete contracting, the pattern of asset ownership affects the willingness of parties to invest in relationship-specific assets
3 alternatives to organize the transaction: nonintegration, forward integration, backward integration vertical integration is desirable, when one unit’s investment in relationship specific assets has a significantly greater impact on the value created in the vertical chain than the other’s investment does explains also why there are different degrees of vertical integration physical and human-asset specificity can have different implications (physical is transferable, human often not
also form of asst is important)

Process Issues in Vertical Mergers -

merging on the vertical chain is more than a simple make-or-buy decision, but a matter of buying an opportunity to make
efficiency depends on how governance arrangements between the 2 merging firms develop; thy will not necessarily reflect the transaction-cost requirements suggested by GHM path dependence = past circumstances could exclude certain possible governance arrangements in the future
can also affect vertical relationships by affecting the capacity of the firm to sell the products of a unit to other downstream buyers besides itself

Alternative to Vertical Integration -

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tapered integration = firm both makes and buys a given input o benefits: 1) expansion of input/output channels w/o substantial capital outlays; 2) internal channels provide cost/profitability data for use in contract negotiations; 3) internal supply capabilities protect from holdup of independent input suppliers o disadvantage: 1) impedes scale advantages; 2) coordination problems concerning specifications/delivery times; 3) monitoring problems may be exacerbated; 4) maintain inefficient internal capacity that had formerly been critical to the firm strategic alliances and joint ventures: o strategic alliance = 2 or more firms agree to collaborate on a project or to share information or productive resources o joint venture = 2 or more firms create and jointly own a new independent organization
firms stay independent; rely on norms of trust and reciprocity o candidates for alliances have all or most of the following features: 1) transaction involves impediments to comprehensive contracting; 2) are complex, not routine; 3) requires buildup of relationship-specific assets by both; 4) excessively costly for one to develop all necessary expertise; 5) market opportunity is transitory; 6) opportunity requires local partner o drawbacks: 1) risk of loosing control over proprietary information; 2) lack of formal mechanisms fro making decisions/resolving disputes; 3) agency and influence costs (
free-rider problem) collaborative relationships
long-term, semiformal relationships o subcontractor networks: close long-term relationships with a high degree of collaboration, more sophisticated and comprehensive tasks being conducted by subcontractors, more asset specificity o keiretsu = network of firms with cross-ownership with a bank at the core that facilitates the relationships among members; also informal personal relationships implicit contracts and long-term relationships: implicit (= unstated understanding) means that the contract is generally not enforceable – however the threat of losing future business can be a powerful mechanism that makes implicit contracts viable

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Economics of Strategy – Chapter 7: Competitors and Competition Competitor identification and market definition -

qualitative & quantitative methods needed for identification
force managers to think of the nature of the competition markets need to be analyzed separately (firms often operate in several input and output markets)

Identifying competitors by identifying substitutes -

-

substitute = if price for X increases and price for Y remains, demand for X goes down and for Y up o degree measured by the cross-price elasticity of demand: ηyx = (∆Qy/Qy) / (∆Qx/Qx) o a positive ηyx reveals substitutes direct competitors = strategic choices of one directly affect performance of other (large cross-price elasticity) indirect competitors = firms affect each other only through strategic choices of a third party products tend to be close substitutes when: 1) same/similar product performance characteristics; 2) same/similar occasions for use; 3) sold in same geographic market qualitative analysis by comparing product performance characteristics has shortcomings: 1) subjective and imprecise; 2) degree of substitution is difficult to determine quantitative approach can be pursued by e.g. 1) obtaining cross-price elasticities; 2) observing price changes over time; 3) using Standard Industry Classifications (SICs), this is however limited

Market definition -

market = set of suppliers and demanders whose trading establishes the price of a good
2 firms are in the same markets if they constrain each other’s ability to raise prices DOJ test: if all firms collectively would set prices to maximize combined profits and this rise would be at least 5%, then there must be few firms outside the candidate market to constrain pricing and thus the market is well defined own-price elasticity of demand: ηx = (∆Qx/Qx) / (∆Px/Px)
DOJ test uses same formula for the collective own-price elasticity which should be, if it is a market, rather low this approach yields direct, as well as indirect competitors (when they are sufficiently strong to constrain prices)

Geographic competitor identification -

Elizinga and Hogarthy definition of geographic market: a geographic market is properly identified if 1) the firms in that market draw most of their customers from that area and 2) the customers residing in that area make most of their purchases from sellers in that market

Measuring market structure -

characterizing a market as concentrated/unconcentrated helps assessing the likely nature of competition market structure = number and distribution of firms in a market N-firm concentration ratio = combined market share of N largest firms in the market (usually based on sales revenue Herfindahl index = sum of squared market shares of all firms in the market (= ∑i (Si)²) Numbers-equivalent of firms = reciprocal of Herfindahl index – conveys more information than the N-firm concentration ratio, as it accounts also for the sizes of the largest firms!

Market structure and competition -

-

firms may faced a continuum of pricing possibilities, depending on the nature of the competition
4 broad categories: o perfect competition
intense price competition (Herfindahl: < 0.2) o monopolistic competition
price competition dependent on degree of differentiation (H. < 0.2) o oligopoly
price competition dependent on degree of differentiation ( 0.2 < H. < 0.6) o monopoly
light price competition (H. >= 0.6) don’t take Herfindahl figures as given, always assess the circumstances surrounding the competitive interaction

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Perfect competition -

perfect competition: many sellers, homogeneous good, costless searching, single market price beyond anyone’s control
individual firms face infinitely elastic demand market conditions tend to drive down prices if 2 or more of the following conditions are present: o many sellers (due to diverse pricing preferences; unwillingness to cut production and assigning who should be the one; if collusive pricing is achieved, cheaters will always break through) o homogeneous product – customers switching represents the largest source of sales gain in homogeneous product markets o excess capacity – as long as sales contribute to cover fixed costs the sale is made

Monopoly -

monopoly power = ability to act in an unconstrained way monopolist – faces little or no competition, if any it comes from fringe firms collectively accounting for more than 30-40% or market
sets price at point where marginal revenue from last unit sold equals marginal cost; thus price is above marginal cost and output below competitive level antitrust
consumers loose; counter argument
monopolies arise from discoveries of more efficient production and new products fulfilling unmet consumer needs (thus restricting monopoly profits may hurt consumers by limiting innovativeness) monopsonist – faces little or no competition in one of its input markets (discussion is then about ability to reduce input prices)

Evidence on market structure and performance -

theory suggests that price-cost margins should be higher in more concentrated markets
with few exceptions validated; studies have shown that on average 3 sellers need to be present in a market to make price competition as intense as it can get link between economies of scale and market structure weak, if any, link between concentration and profitability

Economics of Strategy – Chapter 9: The dynamics of pricing rivalry Dynamic Pricing Rivalry: Intuition -

-

-

basic assumption is that firms would prefer prices to be close to their monopoly levels when can cooperative pricing (no formal collusion) be achievable although the pricing decisions are made noncooperatively
undercutting rival’s prices leads to a trade-off between short-term profits from an increased market-share, sustainable in the long run as long as there is no retaliation and a loss in profits from a steady market share and reduced margins if the competitors retaliate
in markets with two or few sellers, no one has an incentive to cut prices, as he knows there will be retaliation when he is able to influence the market profoundly with his own actions price increases in a 2 firm market (as long as the price stays below the monopoly price) by one producer should reasonably be followed by the other, when it is apparent that the party rising the price would undo the change if the others are not following as they could only gain from that
needs to be signaled tit-for-tat strategy – announcing that you will follow all price decreases by other players tit-for-tat with many firms
if each firm believes that its competitors will raise the price from the current to the monopoly price in the current period and thereafter will follow a tit-fot-tat strategy, each firm will find it in its self-interest to charge the monopoly price, as long as the single-period benefit from cooperating divided by the difference in individual per-period profit at monopoly price levels opposed to the current level is larger than the discount rate: o see formula on page 295 folk theorem = for sufficiently low discount rates, any price between the monopoly price Pm and marginal cost can be sustained as an equilibrium in the infinitely repeated prisoners’ dilemma game (however for prices below Pm other strategies than tit-for-tat are necessary) o implies that cooperative pricing behavior is possible in an oligopolistic industry, but there can be many other equilibria o coordination problem – to attain the cooperative outcome, firms in the industry must coordinate a strategy, which makes it in each firm’s self-interest to refrain from aggressive price cutting
this strategy must be a focal point, so compelling that a firm would expect all other firms to adopt it

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especially difficult in competitive environments that are turbulent and rapidly changing; traditions and conventions that stabilize the environment make it easier

Why is tit-for-tat so compelling -

grim-trigger strategy = we will charge Pm, but in each subsequent period if anyone deviates from Pm, drop the price to marginal cost and keep that forever (also results in monopoly price) tit-for-tat is a robust strategy, in that it is 1) nice (is never first to defect from cooperation), 2) provocable (immediately punishes), 3) forgiving (returns to cooperation when rival returns) however, when misreads are possible, less provocalbe and more forgiving strategies might be desirable to avoid a vicious cycle of uncooperative moves (thus carefully ascertain the details of the competitive initiative!)

How market structure affects the sustainability of cooperative pricing -

pricing cooperation is harder to achieve under some market structures than others
2 reasons: o ability/inability to coordinate on a focal equilibrium o market structure conditions systematically influence the benefit-cost ration

Market concentration and sustainability of cooperative pricing -

-

benefit-cost ratio goes (see page 295) goes up as number of firms goes down
cooperative pricing is more likely in concentrated than in fragmented market o reasons: market share is larger and thus a larger fraction of benefit is captured + temporary increase in profit by undercutting prices is relatively smaller, as it is more difficult to steal market share the more firms, the more unlikely that competitors think alike (focal point)

Reaction speed, detection lags and sustainability of cooperative pricing -

speed with which firms can react to rival’s pricing moves affects sustainability in that the threshold is affected
holding the discount rate fixed, the faster the reaction speed, the lower the threshold (for immediate retaliation, cooperative pricing will always be sustainable) firm may be unable to react due to: 1) lags in detecting; 2) infrequent interactions with competitors; 3) difficulties in detected who is cutting price; 4) difficulties attributing lost sales to price cuts or decreased market demand
reduce speed and efficiency of retaliation (if it comes late) structural conditions affecting the importance of factors influencing reaction time: o lumpiness of orders
infrequent, large sales reduce the frequency of competitive interactions, making price a more attractive competitive weapon o information about sales transactions
public transactins facilitage cooperative pricing, however secrecy, especially if other dimensions besides list or invoice price or customized products are involved creates problems  business practices that facilitate secret price cutting create a prisoners’ dilemma
each firm prefers to use them, but industry collectively is worse off  misreadings become more likely o number and size of buyers – number of buyers dramatically affects likelihood that secret price cuts will be detected – easier to detect deviations if each firm sells to many small buyers o volatility of demand and cost conditions – the higher the fixed costs and the more variable the demand (even more if it is difficult to observe prices and volume of rivals), the more problematic the problem of coordination on the monopoly equilibrium as firms are chasing a moving target  demand changes cause monopoly price to fluctuate  with high fixed costs, excess capacity is problematic as marginal costs decline rapidly and thus the temptation to cut price to steal business is high

Asymmetries among firms -

firms are not identical
different cost structures/qualities give rise to different monopoly prices the firms would like to charge differences in costs also create asymmetric incentives for firms: e.g. smaller firms have more incentive to defect from cooperative pricing, as they benefit less (in absolute terms) from the more toward cooperative pricing than the large ones and they often perceive the incentives of the large firms to punish them as weak you should not always match a price cut though, but may want to create a price umbrella
it is not desirable to match lower prices if: o price cut is relatively large, but the price cutter does not seal much market share o the percentage price cut is small – margins are relatively small to begin with

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smaller firms also have incentive to lower price of goods where repeat purchases are common – they can do it temporarily (if there is a lag) and make customers sample (and then perhaps stick to) their product

Facilitating Practices -

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ways to either facilitate coordination among firms or diminish their incentives to cut price: price leadership – one firm leads all others follow
overcomes problem of coordinating on a focal equilibrium by giving up pricing autonomy and giving it to a single firm; should be distinguished with barometric price leadership (= in competitive markets price leader just acts to represent changes in market conditions) advance announcement of price changes – reduces uncertainty and allows for multiple corrections beforehand most favored customer clauses – provision in a sales contract that promises a buyer that it will pay the lowest price the seller charges: 2 types o retroactive – for a given period of time also after the actual delivery, if producer cuts prices he has to refund the former buyer the difference o contemporaneous – only for the time of the contract o soften price competition in the future and penalize firms for selective price cutting for customers with highly price-elastic demands uniform delivered pricing – firm quotes a single delivered price for all buyers and absorbs any freight charges itself (easier to engage in selective price cutting then when a uniform FOB pricing approach is used)
facilitates cooperative pricing

Quality competition -

quality – all nonprice attributes that increase the demand for the product at a fixed price quality choice in competitive markets
either all goods are identical or exhibit pure vertical differentiation lemons market = uninformed customers + low-quality products cheaper to produce than high-quality
seller has incentive to sell only low-quality, buyer is all the time suspicious and only willing to pay a low price, thus high-quality offerings have a hard time (need money-back guarantees, etc.) underinvestment in information is likely, when uninformed can quickly infer information from the behavior of those people seeking the information

Quality choices of sellers with market power -

demand curve becomes more inelastic as quality increases and more customers are attracted
the quality to choose should be that where the marginal cost of the quality increase equal the marginal revenue that results when consumers demand more of the product quality enhancements tend to be incrementally more costly as quality nears perfection marginal benefit of improving quality: 1) increase in demand; 2) incremental profit on each additional unit sold to increase demand, there need to be marginal customers (horizontal differentiation) and they have to perceive that quality has increased (thus often focus on observable attributes) conveying quality information is especially critical for experience goods seller with the higher price-cost margin has stronger incentive to increase quality

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Meeting 8

Week 5

Economics of Strategy – Primer: Game Theory -

in monopolistic and oligopolistic markets, key is to anticipate how rivals may react game theory – all decision makers are presumed to be rational and each is attempting to anticipate the actions and reactions of its competitors Nash equilibrium = each player is doing the best it can, given the strategies of the other players (a dominant strategy is one where the decision is the same for all of the other player’s moves) – however this does not necessarily lead to the outcome that maximizes aggregate profits Game matrix
represents decisions where players make moves simultaneously Game trees
represent sequential decision making (here we calculate the subgame perfect Nash equilibrium) – the outcome can differ significantly from a simultaneous-move game o subgame perfect Nash equilibrium = each player chooses an optimal action at each stage in the game that it might conceivably reach and believes that all other players will behave in the same way (use fold-back method)

Economics of Strategy – Chapter 8: Strategic commitment -

-

strategic commitments = decisions that have long-term impacts and are difficult to reverse
can significantly influence competition by shaping competitors’ expectations and change their behavior beneficial to the firm making the commitment, however does the loss of flexibility pose a high risk o preempting vs. flexibility tactical decisions = decisions that are easily reversed and whose impact persists only in short term

Why commitment is important -

-

preemptive aggressive moves can transform a simultaneous move game into a sequential game strategic commitments that seemingly limit options can actually make a firm better off
inflexibility has value when competitors’ expectations can be influenced so that they make decisions that benefit the already committed firm
however, such a commitment must be: o visible o understandable o credible
key is irreversibility (contracts can also facilitate commitment), public statements can sometimes have commitment value, if management is putting something at risk if it fails to match words with actions however, previous commitment can limit a firm’s ability to take advantage of new commitment opportunities theory on process innovations: if 1) innovation is nondrastic; 2) is likely to make adaptor tough as opposed to soft; 3) returns form process are certain, then a large incumbent firm has stronger incentive to adopt the technology than a new entrant

Flexibility and option value -

beneficial strategies are often rooted in inflexibility, but strategic commitments are almost always made under conditions of uncertainty (market conditions, costs, competitor’s goals/resources)
thus preserving flexibility has value as it gives firms options option value of delay = difference between expected NPV of investment today and investment after delay; arises because delay allows to tailor decision to underlying circumstances, however, factors like preemptive moves by competitors limit the option value

A framework for analyzing commitments -

strategic investments are durable, specialized and untradable
sunk costs Ghemawat: strategy is manifested in a few commitment-intensive decisions – getting them right is essential 4-step framework for analyzing commitment-intensive choices: o positioning analysis – direct effects of commitment  analyze likelihood of position of delivering superior benefits or lower costs  provides basis for determining revenues and costs associated with each alternative o sustainability analysis – determine strategic effects of commitment  analyze potential responses and how market imperfections help protecting a competitive advantage  provides basis for determining time horizon

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first 2 culminate in NPV analysis of alternative strategies o flexibility analysis – incorporates uncertainty into the framework by the option value  key determinant is learn-to-burn ratio = learn rate, rate at which new information is received, divided by burn rate, rate at which firm invests in sunk assets
high ration implies high degree of flexibility  many commitment-intensive choices have potential for high learn-to-burn ratios (tests, pilot programs…) o judgment analysis – looking at organizational/managerial factors that might distort incentive to choose optimal strategy:  decentralized decision making: accept more investment opportunities (both good and bad) – Type II errors  centralized decision making: rejecting too many opportunities: Type I errors

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Meeting 9

Week 6

Economics of Strategy – Chapter 10: Entry and Exit -

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entry = beginning of production and sales by a new firm in a market
affect incumbent firms in 2 ways: 1) take market share and 2) intensify competition o comes from wither new or diversifying (product or geography) firms – should be treated distinctly as e.g. costs of entry differ for them exit = a firm ceases to produce in a market or shuts down completely

Evidence on Entry and exit -

entry and exit is on average pervasive, in an average industry there is a relatively high turnover of firms entrants and exiters tend to be only 1/3 in size of typical incumbents, however a few firms that enter by diversification are of equal size - most entrants do not survive 10 years, but those that do grow precipitously - entry and exit rates vary by industry
Thus managers have to take unknown competitors into account and know the entry and exit conditions of their industry.

Entry and Exit Decisions: Basic Concepts -

profit-maximizing, risk-neutral firm should enter a market if the sunk costs of entry are less than the net present value of expected postentry profits postentry profits depend on (1) demand / cost conditions and (2) nature of postentry competition barriers to entry = factors that allow incumbents to earn positive economic profits
either: o structural: natural cost or marketing advantages o strategic: active deterrence of entry by incumbent

Bain’s topology of entry conditions -

blockaded entry – incumbent needs to do nothing (structural entry barriers shield it) accommodated entry – structural entry barriers are low and (a) entry-deterring strategies are ineffective or (b) cost more than company can gain
entry is so attractive that the incumbent should not waste resources to prevent it deterred entry – use of entry deterring strategy, only viable if benefits exceed costs

Structural entry barriers -

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control of essential resources o controlling key inputs is however risky as new input sources may emerge and owners of scarce resources may hold out for high prices, regulatory risk o patents give protection, but they have a limited lifetime and can be invented around economies of scale and scope – important is the minimum efficient scale o to overcome a cost disadvantage an entrant must increase market share, however this may lead to intensivied price competition o incumbents also can have economies of scope o what is also important is entering at large scale or scope is disadvantageous only to the extent that the entrant cannot recover its up-front entry costs if it subsequently decides to exit marketing advantages of incumbency – stem largely from umbrella branding that can offset uncertainty with customers and also helps in negotiations with the vertical chain o umbrella branding effectively reduces the sunk costs of introducing a new product

Barriers to exit -

profit-maximizing, risk-neutral firm will exit if value of assets in best alternative use exceeds the present value from remaining in the market, however exit barriers limit incentives to stop production arise from obligation that must be met whether or not operations are ceased
1) obligations to input suppliers; 2) relationship-specific productive assets; 3) government restrictions

Entry-deterring strategies -

entry-deterring strategies can only succeed if (1) incumbent earns higher profits as a monopolist and (2) entry-deterring strategies change entrants’ expectations about the nature of postentry competition

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Week 6

perfectly contestable market = monopoly, in which monopolist cannot raise prices above competitive levels
occurs when hit-and-run entry is possible (quick entry with low sunk or zero sunk costs and a delayed retaliation so that entering party can reap profits from lower pricing before he enters before retaliation occurs) contestability theory = thereat of entry can keep monopolists from raising prices, however few markets are perfectly contestable
possibility to reap additional profits by keeping out entrants limit pricing = incumbent discourages entry by charging a low price before entry occurs – use game theory to find out whether or not it really pays off o in general it does not pay of if pricing is made irrationally, as it has to be used constantly to deter entry and monopoly profits can never be reached, additionally, the equilibrium is not subgame perfect
don’t do it o for limit pricing to pay off, entering firms need to be uncertain about some characteristic of the incumbent firm (especially the cost structure and level) or the level of market demand o limit pricing may influence entrant’s estimates of incumbent’s costs and thus also its expectations of postentry profitability (high-cost incumbent would lower price to disguise costs, low-cost incumbent needs to make sure cost advantage is recognized
the lower the incumbents costs, the lower the price that it sets) predatory pricing = setting a price below costs (average or short-run marginal) to drive entrant out of the market to recover the losses after the exit of the entrant when the firm can again exercise market power o in a world in which all entrants can accurately predict the future course of pricing, predatory pricing would not deter entry and is thus irrational (as predatory pricing in the last market is irrational, it also irrational in all markets before
chain-store paradox o chain-store paradox = despite predatory pricing to deter entry is irrational, many firms are commonly perceived to engage in it – can be explained by uncertainty o if entrants lack certainty of future course of pricing, price cutting by an incumbent can affect expectations; also a reputation of toughness can be created, e.g. by committing to maintain or increasing market share excess capacity o market forces arguments
only possible to increase production in large increments; downturns in general economic business cycle; entrants increasing industry capacity o strategic purposes
credible commitment of increasing output should entry occur – signal to fight aggressively (uncertainty helps, but even if entrant possesses complete information about the strategic intentions, the possible expansion at a relatively low costs can substantially reduce the entrant’s postentry profits)

“Judo Economics” and the “Puppy Dog-Ploy” -

small firms and potential entransts can also use the incumbent’s size to their own advantage by convincing the incumbent that the loss in profitability through the entrant does not justify price cuts, through which the incumbent would loose, due to the large market share, a lot however, this “Puppy Dog-Ploy” can only work, if the firm can credibly commit not to grow and resource constraints or patents deter future entrants

Exit-promoting strategies -

firms occasionally contend that their rivals are slashing pricing to drive them from the market and by that would put customers, despite the lower prices, at a disadvantage in the long-run a price war harms all firms in the industry and one firm can only win if the other actually exits the market – means one player needs to have deep pockets from which it can finance the price ware, this is however also with increased size difficult wars of attrition – resource battle where survivor claims reward, while looser gets nothing, however if the war lasts too long, even the winner may be worth of firms with exit barriers are better positioned to win a war of attrition

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IB 3-1

Meeting 10

Week 6

The multinational enterprise as an economic organization -

multinational enterprice (MNE) = controls and manages production establishments located in at least 2 countries to assess and explain existence and prevalence of MNEs, we need models predicting where multiplant firms enjoy advantages in the make decision 3 categories of multiplant firms: o horizontal multiplant enterprise – broadly same line of goods in each geographic market o vertical multiplant enterprise – some plants produce input for others o unrelated, diversified company

Horizontal multiplant enterprises and the MNE -

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horizontal MNE = multiplant firms with plants in several countries
needed are 1) locational forces justifying dispersed production; 2) governance or transaction-cost advantages of common administrative control MNEs will exist only if the plants they control and operate attain lower costs or higher revenue productivity than same plants under separate managements
2 explanations: 1) production and logistical advantages; 2) efficiency gains in complementary nonproduction activities Dunning’s framework – 3 necessary conditions for the appearance of horizontal foreign investments: o firm can appropriate some value-creating proprietary assets o production is efficiently dispersed among several national markets o decentralized application of proprietary asset is more efficiently managed by ownership than arm’s length transactions (problem with information goods
public character and thus underprovided; asymmetric information; difficult to contract for) in the service sector, firms become MNEs also to benefit from the parent’s ties to customers, themselves having become MNEs – they follow their customers because they have transaction-specific assets longevity of proprietary assets is another explanation to foreign investments

Vertically integrated MNEs -

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vertically integrated MNE = vertically integrated firm, whose production units lie in different nations
again locational pressures and advantages from common administration are necessary; internalizes a market for intermediate products, just as horizontal MNEs internalize markets for proprietary assets proprietary-assets model not necessary as explanation, but it could explain which producer operating at one stage undertakes an international forward or backward vertical integration transaction-cost economics as explanation: vertical integration occurs, because the parties prefer it to the ex ante contracting costs and ex post monitoring and haggling costs that would mar the alternative state of arm’s-length transactions; another explanation is information asymmetries and the time-lag associated with information sharing under contracts vertical integration is also often involved in horizontal foreign investments – many foreign subsidiaries do not just produce the parent’s good, but process semifinished units of that good or package/assemble it according to local specifications
complementing horizontal international diversification with some vertical diversification allows the investments to become complements

Portfolio diversification and the diversified MNE -

primary driver is the spreading of business risks
maximum can be reached by not only diversifying across products, but also geographically with ability of shareholders to diversify in a low cost way, value-maximizing firm management should select a risk/return trade-off that values risk at the market price of residual (systemic risk) – however agency conflicts are common and managers have motives to keep risk level low

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IB 3-1

Meeting 10

Week 6

Oligopolistic reaction and foreign direct investment: The case of the US tire and textiles industries -

paper tests impact of oligopolistic reaction and firm-, as well as host country-related factors on FDI activities
by combining the 2 streams of research they hope to more fully explain FDI - in oligopolistic industries, firms are mutually interdependent
tend to follow a pattern of action-reaction – cooperation/collusion can improve joint as well as individual profits o with only 2 leading firms coordination is easier
may ration the world market o with more than 10-12 firms, influences on each other can likely be ignored
firms invest independently o oligopolistic reaction is most probable when there are 3 to 10 or 12 firms with approximately equal market power
entry concentration in a specific international market should increase with market concentration up to a certain point and then decline; imitative behavior should occur in moderately concentrated industries - firm related factors: 1) frim size, 2) R&D expenditures, 3) advertising - host country-related factors: 1) market size, 2) political stability, 3) geographical proximity (implying cultural similarity and thus lower monitoring and communication costs)
Result: Followers in oligopolistic industries are not following the leader just because the leader is in the market – they also base their decisions on economic factors, like other investors in non-oligopolistic industries

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