Section 2: Porters 5 Forces and Intro Game Theory

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Section 2 Porters 5 Forces and Intro Game Theory

• MBA 299 Strategy
• Rob Seamans Richard Wang
• 4-4-2007

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Announcements

• Round 2 of CSG has run and results are posted
• Round 3 strategies due on Monday 4/7 at noon

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Agenda for today

• Strategic framework Porters 5-forces
• Strategic framework Game Theory
• Quantitative Analysis Financial statement
  analysis and benchmarking

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Industry Analysis

• Systematic search for economic leverage

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Porters Five Forces
Threat of New Entry

• Economies of scale
• Proprietary product differences
• Brand identity
• Switching costs

• Capital requirements
• Access to distribution
• Absolute cost advantages
• Government policy
• Expected retaliation

Bargaining Power of Suppliers

• Differentiation of inputs
• Switching costs
• Presence of substitute inputs
• Supplier concentration
• Importance of volume to supplier
• Cost relative to total purchases
• Impact of inputs on cost or differentiation
• Threat of forward integration

• Buyer concentration
• Buyer volume
• Buyer switching costs
• Buyer information
• Ability to integrate backward
• Substitute products
• Price / total purchases
• Product differences
• Brand identity
• Impact of quality / performance
• Buyer profits

• Switching costs
• Concentration and balance
• Informational complexity
• Diversity of competitors
• Corporate stakes
• Exit barriers

Threat of Substitutes

• Relative price performance of substitutes
• Switching costs
• Buyer propensity to substitute

Source Michael E. Porter, Competitive
Advantage (New York Free Press, 1985)
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Correlates of high rivalry

• Numerous Competitors
• Industry growth is low
• Fixed/sunk costs are big, particularly with
  several players currently in the market
• Overcapacity, particularly with several
  players..
• Switching costs are low

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Forces creating high barriers to entry

• Economies of scale
• High Minimum Efficient Scale
• Need to compare MES to total size of the market
• Absolute cost advantages
• Learning curve after producing X cumulative
  units, average costs decline by Y
• Proprietary inputs or distribution channels
  (e.g. of inputs/distribution locked up)
• Government Regulation
• e.g. Bus in Berkeley, Taxi in NYC

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Indicators of high buyer power

• High buyer concentration
• Demand by top 5 buyers / total demand
• Few sales sales long-lived
• Time between sales, bunched orders
• Presence of backwards integration
• Number of buyers who act as own supplier
• Ease of buyer switching
• Lack of specific investments by buyers

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Indicators of high supplier power

• High supplier concentration
• Supply of top 5 suppliers / total supply
• You have high COGS
• Useful to look at a single unit
• Presence of forward integration
• Number of competitors who act as own supplier
• High investments required to use product from
  supplier
• Difficulty of switching suppliers
• Lack of specific investments by buyers
• Importance of your firms volume to your
  suppliers

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Indicators of high substitution threat

• High price elasticity of demand
• If my product price rises X, demand falls by
  more than X
• Or, if price of substitute product falls, demand
  for my product falls
• Inverse correlation of my sales with sales in
  substitute market
• Our markets sales fell by 200mn substitutes
  sales grew by 180mn

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Agenda for today

• Strategic framework Porters 5-forces
• Strategic framework Game Theory
• Quantitative Analysis Financial statement
  analysis and benchmarking

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Examples of Game Theory Applications

• Areas where game theory can (has) been fruitfully
  applied
• Price competition in oligopolies
• Entry decisions
• Areas that are not game theory
• Optimizing factory line performance

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Why is game theory useful?

• Formulating your strategy in a dynamic
  environment
• Taking account of your competitors actions in
  your strategy formulation process
• Provides predictions for what should happen
• This means using estimates of payoffs to deduce
  behavior in advance
• Provides a method of comparison across different
  scenarios

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A Simple Simultaneous Game Prisoners Dilemma
B
Players
Confess Dont Confess
0,0
4,-3
Confess Dont Confess
A
1,1
-3,4
Action Choices
Payoffs
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Nash Equilibrium of the Prisoners Dilemma
B
Confess Dont Confess
0,0
4,-3
Confess Dont Confess
A
1,1
-3,4

• Nash Equilibrium
• Given what the other player is doing, you cant
  do better by deviating

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Application of Prisoners Dilemma Price War
B
Fight Accommodate
0,0
4,-3
Fight Accommodate
A
1,1
-3,4
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A simple variation
B
Fight Accommodate
-5,-5
-3,4
Fight Accommodate
A
1,1
4,-3
Equilibrium Strategy can differ if payoffs
changes!
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A few comments caveats

• Equilibria are not necessarily socially
  efficient they are just in some sense stable
• Better outcomes for the players could be achieved
  through coordination and commitment
• Mergers
• Collusion
• Repeated plays

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Other topics in game theory

• In future sections we will cover more game theory
  topics including
• Sequential games
• Repeated games
• Signaling games

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Agenda for today

• Strategic framework Porters 5-forces
• Strategic framework Game Theory
• Quantitative Analysis Financial statement
  analysis and benchmarking

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Financial statement analysis

• Can be critical when assessing the two
  fundamental strategies cost leadership vs.
  differentiation
• Consider the three accounting statements Balance
  Sheet, Statement of Cash Flow, Income Statement
• Remember your accounting and finance ratios and
  use this to back in to missing values of interest
• Look at within-firm trends over time
• Remember to deflate them
• CPI data at the Bureau of Labor Statistics
  http//data.bls.gov/cgi-bin/surveymost?cu

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Common Terms

• Sales Price/unit x units sold
• COGS Product cost/unit x units sold
• Production cost Raw materials cost direct and
  indirect labor costs depreciation
• Gross margin Sales COGS
• Net income Gross margin SGA
• P/E current share price/earnings per share
• Market value Share price x shares outstanding
  market value of debt (usually approximated by
  book value of debt)

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Income statement

• Think hard about the top line
• Is it possible to estimate average price/unit?
• Can you use product mix information to push
  deeper?
• COGS and SGA per unit and as a of sales are
  useful data points
• Find the appropriate level of granularity
• Look at P/E ratios and use the imputed growth
  rate to consider plausible scenarios consistent
  with market expectations
• Where will the growth in earnings come from - top
  line growth or from efficiencies?

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Balance sheet statement of cash flows

• How is the company financing its operations?
• Debt or Stockholders Equity
• Does anything you see make you wonder about
  revenue recognition?
• What might a large accounts receivable indicate?
• Working capital matters in many industries
• WCAP - AR - Inventory /- other deferred
  assets/liabilities as appropriate
• Get a sense for earnings management
• Big bath accounting in year X make earnings
  look better at year X1 . . . observe this in
  the cash flows

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External Benchmarking

• Compare financial statement measures across firms
• Unit prices and sales
• Unit COGS and SGA as a fraction of total revenue
• Market cap and P/E
• Look for granular market or operating data to
  understand firms better
• Can be strong evidence for existence of cost or
  differentiation strategy
• Cost compare various cost drivers across firms
• Differentiation compare various willingness to
  pay/customer value drivers across firms

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High-level internal benchmarking

• Compare the financial metrics you just calculated
  within a firm over time
• Look for more detailed market or operational data
  to help explain changes in key metrics over time
• Ask yourself what these comparisons tell us about
  firm strategy

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Detailed benchmarking

• Detailed benchmarking requires lots of data
• Compare plants, divisions, regions, products etc.
• Create PLs for the relevant unit of analysis
• Often a great way to find growth opportunities
• Tip regression analysis might impress your
  client/boss and is pretty easy to do

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Useful tips Units are key!

• Think carefully about your units often
  normalizing by an appropriate unit can really
  help clarify your argument (and your thinking)
• XX/sales (overall performance)
• XX per unit produced or sold (suggests economies
  of scale, over/under-investment in marketing,
  etc)
• XX per customer (important in repeat-purchase or
  consumer goods environments)
• XX as a of industry profits (useful for BTE,
  rivalry, etc)