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Strategic Management II
In the course we will be talking about competition and performance between industries.
Or we could also analyse the companies that are in the same industry. Equal market, similar product but different profitability (benchmark comparison).
What is Business strategy? Bundle comprising long term goals aimed at maximizing firm value, and major courses of action, policies and plans for achieving these goals. This implies:
- Determining the boundaries of current and future business activities.
- Generating and allocating substantial resources to achieve these goals.
- (^) Shaping the organization and the environment it operates in.
Warning required / assumptions: In this course we will assume the existence of relatively free markets. If we have large deviations from a free market environment would drastically change the behavior of firms.
Why the economics perspective? Strategy is a multidisciplinary field with contributions from economics, psychology, sociology, political sciences or anthropology.
The economic perspective is the most widespread in the field, and the one which has developed the most in recent decades. The differential characteristics of the economic perspective is that it is based on analytical analysis.
Are principles universal?
Total revenue (TR) = P(Q) x Q Marginal revenue (MR) is equal to the change in TR for a given production level:
- Pricing and Output Decisions
Profits are maximized when MR = MC If MR < MC the firm can increase profits by increasing output. If MR > MC the firm can increase profits by decreasing output.
- Perfect competition
Perfect competition is a special case in the theory of the firm -uses a benchmark case. Industry has many firms that produce an identical product. Firms can enter and exit at will. Each firm must charge the same price. Firm level elasticity of demand is infinite. Firm level demand curve is flat.
- Supply and demand
Industry supply is the horizontal sum of the individual firm’s supply functions. Normally the elasticity of the INDUSTRY is more elastic than the COMPANY’s supply. Supply and demand of the industry determine the price. If prices exceeds AC, more firms enter and shifts supply to the right.
Industry supply
With these graphs we can see and study how firms get profits. In the first one we can see the profit per unit with the price given by the demand and supply of the market.
q (quantity of ONE firm), Q (quantity of all the market, all firms)
As seen in last graph the company gets unitary profits, so the market for the business will grow (supply increases SS’) and the profits of the market are once again zero. No one will enter the market now that the profits are null.
Part 2: Horizontal
boundaries
Fundamental Question in Strategy: “What explains heterogeneity in firm performance?”
Corporate strategy: the way a company creates value through the configuration and coordination of its multi market activities. Focus on the multimarket scope of the firm (configuration) and how the firm manages the activities and business that lie within the corporate hierarchy. There are several dimensions to corporate strategy including:
- Horizontal firm boundaries: Industry scope, geographic scope
- Vertical firm boundaries:vertical scope.
Horizontal Firm Boundaries Industry scope ⇒ what to sell? Geographic scope ⇒ Where to sell?
- Average fixed cost are reduced once the production increases. FC are constant as a absolute value. Scale:
Scope:
Fixed costs can arise at the product level (advertising) , plant level (assembly line) or multi plant level. Example: An online supermarket. To distribute the products, they incurred high fixed costs. The average variable costs were low. They need a high scale of sells. If they distribute more products in the same trucks or refrigerators, the unitary average cost will be lower. Example II: An airport hub. Where there are a lot of flights from that place. It is cheaper to have all international direct flights form the hub and not from ALL the connections from the hub. Here the hub is Z. Imagine all the black are part of the hub and G wants to go to B. It would be expensive if all D, F, G, H, E and C have a direct flight to B. It is cheaper to have a flight from Z to B and all the others form the hub.
- Technology adoption decisions in production, or invest in R&D to improve their efficiency. Relevant in the long term. Example: imagine two alternative production technologies: You go from the continuous line to the … one, where the average costs are lower.
- Specializatio n of labor, that involves a substantial investments to develop special expertise or to achieve scale economies. In the long term, the optimal level of specialization will be determined by the size of the market.
- Other: Inventories stock out, cube-square rule, large volume purchases, advertising and umbrella branding, R&D is an ambiguous case.
Inventories Firms carry inventories to avoid stock outs. Bigger firms can afford to keep smaller inventories compared with smaller firms.
- Similar hedging in finance
- Two firms may not experience stock outs at the same time
- If two firms merge, they would have lower probability to have a stock out.
Cube-square Rule Double the diameter of a hollow sphere and the volume will increase eightfold, whereas the surface area will increase only fourfold. The cost of the sphere is likely to increase by less than eight times.
Purchasing
If you are a big firm you can purchase by a lower price (because of the #of products I buy). My elasticity if I am a big firm is very elastic, each cent matters to me, I am very price sensitive. Big firms have bigger purchase power. Small firms can join purchasing alliances.
Advertising Large firms have lower cost of sending a message (negotiation costs are lower). Large firms can convert a larger proportion of potential customers into actual customers.
Umbrella branding Brand maintenance is lower if the firm has different products under the same brand. New products are easier to introduce when there is an established brand with the desired image. The main limitations are the conflicting brand images that may cause diseconomies of scope.
Research and development Economies of scale in R&D and also economies of scope in R&D (ideas from one project can help another project). ⇒ under some conditions firms can pool their resources and joint for a joint venture. Big firms have a lower average cost of innovations. Small firms may be more suitable for motivated researchers.
Sources of scales and scope DISECONOMIES Labor costs are higher in bigger companies. Agency costs increase with size (more costly to controlate and coordinate). Conflicts of interests. may not be able to capture customers is you already deal with their competitors. Difficulty in replacing unique specialized inputs. If you cannot replicate them, expanding output may decrease their production.
3. Economies of learning
-Win the market share battle -highest market share has the highest volume and cumulative volume growing at fastest rate, descending the learning curve fastest to the lowest cost. May lead to losses in the short term but ensure long term profitability. Early entry provides potentially long term cost advantages. Learning facilities fighting the entry of rivals (learning curves deter entry when they are not too steep or too flat.
a. Success In 1972 Texas Instruments use the learning curve strategy in the calculator market. Unit costs falls from thousands of dollars to single figures in less than a decade. Texas Instruments go to be the cost leader in the market since the learning curve was very steep. b. Failure
Before implementing a learning curve strategy, we must ask questions such as:
- Does my industry exhibit experience curve?
- Precise cost of reduction?
- Is cumulated output doubling fast enough?
- etc
Different strategic implication of the economics of learning: 1- Incentive systems, bonus plans, zero defect programs, etc. 2-Engineering effort 3-Teamwork 4-Employee retention strategies 5-R&D technology transfer practices
4.Diversification There are many multi business firms. For example sony that fabricates DVD, TV, PS, movies, music, etc. What is importance of diversified firms in the economy? To measure the degree of diversification, we use “relatedness” concept.
Two business are related if they share the technological characteristics, production characteristics and/or distribution channels. -Single business: 95% of revenues are from a single activity or line of business. -Dominant business: 70-95% of revenues from the principal activity.
-Related business: less than 70% comes from the primary activity, but its other lines of business are related to the primary one. -Conglomerate: derives less than 70% of its revenues from its primary area and has few activities related to the primary area.
Example:
Why do firms diversify? To gain economies of scale and scope ⇒ optimal horizontal boundaries. Financial synergies ⇒ shareholder’s diversification, identifying undervalued firms, internal capital markets. Managerial reasons for diversification ⇒ Empire building, increase compensation, less chance of high loss in any given quarter.
Diversification reduces the firm’s risk and smoothes the earnings stream -accordingly, shareholder's risk is reduced. Do shareholders benefit from such strategy? NO. Shareholders can themselves diversify their portfolio at near zero cost (investing in the capital markets (stock exchange) themselves).
- Identifying and acquiring undervalued firms Some potential acquirers believe they are skilful at identifying undervalued firms- and then they buy them ⇒ without expecting efficiency gains.
Reasons to be skeptical: it is necessary that market value be incorrect and that no other investor noticed → it is very hard to know the value of the firm, CEO’s are overconfident - maybe in a related business there can be competition to buy the firm.
Takeovers or merger proposals call attention (this means there is competition in the acquisition process) other firms also bid, other firm’s can also see the value of the firm and want to buy it → then the winner is the one that pays more (normally the price is overvalued) because if not there could not have bought it. Winner’s curse.
Part 3: Vertical boundaries
Strategic implications Strategic decision : define the firm’s vertical boundaries. Intuition : the firm will integrate an activity instead of resorting to the market (by outsourcing it to subcontractors) when integration maximizes productive efficiency. Example of vertical chain production in furniture production:
Which is more efficient: several specialist firms linked by markets, or the combination of these specialist firms under common ownership?
Common issue: What are TRANSACTION COSTS of markets compared with administrative costs of the firm? Types of Vertical Integration (VI) Strategy of acquiring control over additional links in value chain of producing and delivering products/services.
- Backward integration (Upstream)
- Forward Integration (Downstream)
Some make-or-buy fallacies: Firms should buy, rather than make, to avoid incurred costs in the activity. Fimes should make, rather than buy, to avoid paying a profit margin to subcontractors. Firms should make, rather than buy, to avoid fluctuations in the price of the input. Firms should make, rather than buy, to control the distribution channel and exclude competitors.
Oliver E. Williamson Winner of the 2009 Nobel prize in Economics. The transaction cost approach to the study economic organization regards the transaction as the basic unit of analysis.
The approach applies both to the determination of efficient boundaries, as between firms and markets, and to the organization of internal transactions.
Choices of how to structure transactions
Economics of transactions
When is VI more attractive than Outsourcing?
Can-Maker is afraid that Red-Cola may behave opportunistically once the investment cost is sunk. After one year, Red-Cola could exploit incomplete contracting and renegotiate the agreed price down to 0,19$, claim that the quality of cans is low and should be priced accordingly. in this scenario, Can-Maker’s best option is to continue selling the cans to Red-Cola, but the NPV of building the plant becomes negative:
Conclusion: Can-Maker fears being held up but Red-Cola and therefore prefers not to invest.
Hold-up implications The elements that give rise to the hold-up are the following:
- Incomplete contracts : open the door to opportunistic behavior, they are not complete contracts with not all specifications of a normal contract.
- (^) Relationship-specific assets : the value of the assets is lower outside the relationship, in their best alternative use (the source of specificity can be geographical, physical, of dedicated assets, or human specificity). Something that can only be used by specific suppliers, specific transactions.
- The hold-up problem increases transaction costs. Parties will dedicate more time and effort to negotiating market contracts. In the worst case scenario, investment in assets with a high-degree of specificity will need to be integrated inside the firm. Integration as a solution to the “hold-up” problem Why does integrating the activities inside the firm solve the hold-up problem which arises in the marketplace? Differences in the governance mechanism: Disagreements are solved inside organization, without resorting to courts. Long term relationships are foreseen within a firm, unlike in the case of market transactions.
- V. Double marginalization : when both firms contracting through the vertical supply chain have market power in their respective activities, price formation is suboptimal( price is bad for everyone). By independently setting their prices, firms obtain lower profits than under full integration. Firms do not internalize the negative externality that increasing their price has in the remaining stages of the supply chain.
Example of double marginalization:
specialized can producer, and the remaining production of cans is done by coca cola itself. Advantages: better information and incentives over the market and internal process, flexible and control of risk. Disadvantages: coordination problems, not exhausting economies of scales/scope.
- III. Alliances and joint ventures: is when two or more firms collaborate on a project, share information and/or production assets: adequate for activities in which there are reasons both to outsource and to integrate. Flexible and dynamic collaboration, disagreements are solved by internal negotiation not in court. In the joint venture, cooperation is established through a new organization of shared property. This reinforces the alignment of incentives among participants. Potential problems are the disclosure of confidential information, coordination problems, misalignment of incentives.
- IV. Subcontractor networks: firms pertaining to the network from semi- formal long-term relationships. Implicit contracting. The repeated nature of transactions inside the network reduces transaction costs, allowing subcontractors to execute more complex processes and facilitating the exchange of information and the investment in assets with a higher degree of specificity. A spanish case Mercadona: The supermarket chain Mercadona has over 1300 stores and large sales. mercadona establishes privileged relationships with over one hundred selected suppliers, called inter proveedores. An open book policy is established between the two parties: Mercadona and the suppliers share their financial statements, and agree on the return rate that shall be enjoyed by the supplier. The interproveedores jointly invest 700M€, a fifth part of the total investment in the Spanish food producing sector.
Market power in the vertical chain The structure of the vertical chain of production determines: · Distribution of market power among firms, within the vertical chain. · How much surplus is appropriated in each stage of the chain (how much of the possible profit for each firm).
- Market power can be exerted form a single stage of the vertical chain. · When there is market power in several stages, however, double marginalization provides a rationale for integration or collusion through the vertical chain. In this case we do not have market power, that is P=MC → Each producer increases price by their marginal cost.
- Consider the introduction of a new production technology that intensifies the economies of scale present in the second stage of production. Assume this stage remains perfectly competitive after consolidation.
The only thing that changes now is the marginal cost of c2, it is lower here. The firms in stage 2 can charge more (receive more profits)
- Consider forward integration by firms operating in the first stage. ·Firms acquire and integrate firms operating in the second stage. ·Assume integration is efficient -it reduces production costs:
·Integration does not affect the intensity of competition between firms.
- This is equivalent to backwards integration by second-stage firms.
- To analyze the impact of market power in the vertical chain, consider first the case where one stage of the production chain is monopolized by a single firm and there is no market power in the remaining stages. · How are the profits of the monopolist affected by upstream suppliers and downstream intermediaries? · Can the monopolist benefit from integrating forwards or backwards in order to exert market power?
