Title: Markets Organization and Corporate Strategy
1Markets Organization and Corporate Strategy
- George Norman
- Cummings Professor of Entrepreneurship and
Business Economics
2Some Introductory Comments
- Textbook The Economics of Strategy
- Grading
- Two sets of essays 20 and 25 respectively
- Research paper 30
- Industry analysis and presentation 25
- Syllabus not a legally binding description
- Web-site http//www.tufts.edu/gnorman/cmba344.htm
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3Objectives
- Focus on strategic decision-making
- Application of economic reasoning to develop
insights necessary for a firm to deal effectively
with its operating environment - The central role of strategic decision-making in
determining a firms success
4Strategy and Economics
- The definition of strategy
- no single definition
- different from tactics - essentially short-term
5Strategy Definition
- The determination of the basic long-term goals
and objectives of an enterprise, and the adoption
of courses of action and the allocation of
resources necessary for carrying out these goals.
(Chandler, 1962)
6Strategy Definition
- The pattern of objectives, purposes or goals, and
the major policies and plans for achieving these
goals, stated in such a way as to define what
business the company is in or should be in and
the kind of company it is or should be. (Andrews,
1971)
7Strategy Definition
- What determines the framework of a firms
business activities and provides guidelines for
coordinating activities so that the firm can cope
with and influence the changing environment.
Strategy articulates the firms preferred
environment and the type of organization it is
striving to become. (Itami, 1987)
8Why an Economic Perspective?
- Other approaches are possible
- game theory
- psychology
- how motivation and behavior of individuals shape
organizations - sociology
- social structures, peer networks, routines and
their effects on organizational decisions and
decision-making
9Economics
- Requires that we be explicit about the elements
that generate strategies - decision-makers
- goals
- choice of strategic variables
- relationships between choices and outcomes
- Provides a clear linkage between conclusions and
assumptions - Cost lose some detail
10The Need for Principles
- What makes a profitable, successful business?
- Can general lessons be drawn from the behavior of
successful organizations? - Reasons for success often unclear and complex
- No list of characteristics that guarantee success
- Partial data
- Success stories bias interpretation
- No automatic or general recipe for success
- Trek outsourcing and brand-management (Raleigh)
- Usiminas excellence in manufacturing (Bethlehem)
- Wal-Mart initiative of local managers inventory
management (Kmart)
11Principles (cont.)
- Successful firms adopt strategies that exploit
potential profit opportunities. - Adapt to changing environments
- Need to analyze decision making using consistent
principles of market economics and strategic
action
12A Framework for Strategy
- The big issues
- boundaries of the firm
- markets and competitive analysis
- position and dynamics
- internal organization
13The boundaries of the firm
- These extend in three directions
- horizontal how much of the product market the
firm serves - vertical the set of activities that the firm
performs itself and those it purchases from other
firms - corporate the set of distinct businesses in
which the firm operates
14Markets and competitive analysis
- Understand the markets in which the firm operates
- Industry-specific effects constrain profitability
and must be understood - high-tech e.g. pharmaceuticals or low-tech e.g.
airline travel - determinants of entry
- mistakes can be made e.g. major pharmaceutical
companies attempts to move into production of
generics
15Position and dynamics
- How and on what a company competes
- cost
- advertising
- product positioning
- RD
- Dynamics
- how the firm accumulates resources
- how the firm adjusts to changing circumstances
16Internal organization
- How should a firm organize itself to give effect
to its strategies? - Organizational structure determines information
flows and alignment of individuals with the
objectives of the firm - decentralized versus centralized
- incentives versus culture
17An Economics Primer
18Some Introductory Ideas
- Objectives need well-defined strategies that are
under the control of the decision-maker - Success is determined by the economic environment
within which the firm operates - Strategies must be consistent with the
environment - law of demand
- size and profitability of price-matching
- is it reasonable to match a small competitors
price cut? - Price and cost can additional volume be sold at
a profit?
19Costs
- How do costs change as output changes?
- This is the total cost function - TC(Q)
- Describes the efficient relationship between
output and total cost - Total cost increases with output
TC(Q)
Total Cost
Output
20Fixed and variable costs
- Variable costs increase with output
- labor costs
- materials costs
- Fixed costs are independent of output
- general administration costs
- property taxes
- The distinction is fuzzy
- some costs have fixed and variable components
- costs may be fixed over one range and vary over
another
21Fixed and variable costs (cont.)
- Fixed costs are invariant with output but are
affected by other decisions - Whether costs are fixed or variable depends upon
the time period
22Average and marginal costs
- Average cost is total cost divided by output
AC(Q)TC(Q)/Q. - Marginal cost is the additional cost of producing
one more unit of output MC(Q)dTC(Q)/dQ. - They are related as follows
MC(Q)
AC(Q)
Cost
Output
23The importance of time
- Distinguish between short-run and long-run costs
- In the long-run choose plant size that is
adjusted to anticipated output
SACM(Q)
SACS(Q)
The long-run cost curve is the lower envelope
of the short-run cost curves
Average Cost
If expected output is Q1 but actual output is Q4
then short-run costs will be on SACS(Q)
SACL(Q)
If expected output is Q3 install the large scale
plant
If expected output is Q1 install the small scale
plant
If expected output is Q2 install the medium
scale plant
- In the short run may have to live with wrong
plant
Q1
Q2
Q3
Q4
Output
24Sunk costs
- When assessing the costs of a decision consider
only those costs the decision affects - Distinguish between sunk costs and avoidable
costs - inventory already existing is a sunk cost
- additions to inventory are avoidable costs
- Sunk costs are not the same as fixed costs
- some fixed inputs can be redeployed from their
existing use if conditions change
25Sunk costs (cont.)
- Sunk costs affect strategy - particularly on
entry and exit - change of technology with existing production
versus adoption of new technology with greenfield
site - existing firms generally more reluctant to adopt
new technologies - The existence of sunk costs makes it difficult to
eliminate a competitor - The existence of sunk costs is a barrier to entry
26Demand and Revenues
- The demand function describes the relationship
between quantity demanded and variables that
affect demand - income
- tastes
- advertising
- price
- The relationship between quantity and price is
generally negative
Price
At price P1 the quantity demanded is Q1
At price P2 the quantity demanded is Q2
P1
P2
Quantity
Q1
Q2
27Demand and Revenues (cont.)
- There are exceptions to this law of demand
- prestige goods price confers prestige
- goods where quality is not directly observable
price is taken as a signal of quality - Where this is true then a cut in price may damage
sales by damaging the goods image
28Price elasticity of demand
- An increase in price
- generally reduces the quantity sold
- has an ambiguous effect on sales revenue
- The relationship between a price change and sales
revenue is determined by the elasticity of demand
(or the sensitivity of demand to price) - definition
m change in quantity
change in price
29Price elasticity of demand (cont.)
- If price elasticity of demand is greater than
unity then an increase in price reduces sales
revenue - If price elasticity of demand is less than unity
then an increase in price increases sales revenue
Increase in sales revenue from increased price
Increase in sales revenue from increased price
Reduction in sales revenue from increased price
Reduction in sales revenue from increased price
Price
Price
Quantity
Quantity
Elastic demand
Inelastic demand
30Price elasticity of demand (cont.)
- Demand is inelastic if
- comparison is difficult
- complex product
- little experience
- buyers pay only a small proportion of total cost
- insurance coverage
- switching costs exist
- complementary with other products
- Demand is elastic if
- close substitutes
- buyers expenditures are a large proportion of
total expenditure - product is an input to another product with
elastic demand
31Pricing Decisions
- If firm aims to maximize profit then the pricing
and output rule is simple - choose output such that marginal revenue equals
marginal cost - get price from the demand function the price
that clears the market - Use the standard pricing formula
P(1 - 1/m) MC
32Game Theory
- Firms not in competitive markets must make
strategic decisions - When there are few firms these decisions are
interdependent - game theory is a particularly useful tool for
analyzing such interdependence and strategic
choice - assumes rationality
33Matrix form and Nash equilibrium
- Simple example of capacity choice by two firms
Dominant strategy for Beta
Dominant strategy for Alpha
18, 18
15, 20
20, 15
16, 16
16, 16
Nash Equilibrium
34Nash equilibrium
- Need not be attractive
- generally does not maximize joint profits
- Prisoners dilemma
- But it is compelling
- neither firm would choose to change strategy if
its rival does not - Timing is important
- simultaneous (or non-observable)
- sequential (or observable)
35Game trees and equilibrium
- Consider a modified and expanded example
18, 18
15, 20
9, 18
8, 12
20, 15
16, 16
16, 16
8, 12
0, 0
18, 9
36Sequential choice
- If choices are sequential the first mover can
- anticipate rivals choice
- manipulate rivals choice
- With sequential choice use game tree
37A game tree
Do not Expand
Beta
(18, 18)
Do not Expand
Small
Small
(15, 20)
Large
(9, 18)
Do not Expand
Beta
(20, 15)
Small
Small
Small
Alpha
(16, 16)
Large
(8, 12)
Do not Expand
Do not Expand
Beta
(18, 9)
Large
Large
Small
(12, 8)
Large
(0, 0)