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Strategy: Key Concepts and Open Questions

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Title: Strategy: Key Concepts and Open Questions


1
Strategy Key Concepts and Open Questions
  • As in finance, the goal of the firm is value
    maximization
  • Strategy may be defined as the way the firm
    deploys its resources and capabilities within its
    environment to maximize its value
  • The strategy literature typically takes a less
    quantitative approach than finance or industrial
    organization analyses are more descriptive and
    somewhat less analytical

2
Key Concerns
  • Key concerns
  • Industry Attractiveness Which industries should
    the firm be in?
  • Competitive Advantage How should the firm
    compete? What does it have that its competitors,
    suppliers, buyers, potential entrants, and
    complementors do not?
  • Boundaries of the Firm What should the firm do,
    how large should it be (make vs. buy scope)
  • Internal Organization How should the firm
    organize its structure and systems internally?

3
Relation to Other Fields
  • The strategy literature borrows heavily from
    finance, industrial organization, and the theory
    of the firm
  • Value maximization and the associate computations
    (after-tax cash flows, net present values) are
    key concepts from finance
  • The frameworks for analyzing industry
    attractiveness emerged from industrial
    organization
  • Work on the boundaries of the firm follows the
    theory of the firm transaction costs are
    referred to frequently in the strategy literature

4
Relation to Other Fields
  • The concept of competitive advantage is directly
    related to the notions of positive economic
    profits in economics and profits in excess of
    the opportunity cost of capital in finance
  • Competitive advantage can be defined as A firm
    possesses a competitive advantage when it earns a
    persistently higher rate of profit than its
    competitors

5
Industry Attractiveness
  • Porter Competitive Strategy (1980)
  •  
  • The Five Forces Framework for Industry Analysis
  •  
  • Buyers
  •  
  • Entrants Competitors Substitutes
  •  
  • Suppliers

6
The Five Forces Framework
  • The Five Forces Framework is primarily used to
    assess the profitability of different industries,
    not the profitability of specific firms, but it
    is useful for both
  •  
  • Estimates vary, but most suggest that 10 to 20
    of the variation in firm profitability is
    accounted for by the industries firms operate in
  • Rivalry among existing firms is the main focus of
    industrial organization and strategy, but the
    other forces cannot be ignored

7
Applying the Framework
  • Strategy texts provide long lists of factors that
    affect industry profitability in the five forces
    framework
  • For any particular analysis, it is useful to
    focus on a small number of key factors determined
    on a case-by-case basis
  • Most of the factors are based on findings in the
    industrial organization literature
  • For example, the main factors that affect the
    threat of entry and the threat from substitutes
    are barriers to entry and the cross-price
    elasticities of demand

8
Factors
  • Factors that Affect Rivalry Between Existing
    Competitors
  •  
  • 1. Brand Identity
  • 2. Concentration the number of competitors and
    their variation in size
  • 3. Fixed Costs
  • 4. Industry Growth
  • 5. Intermittent Overcapacity
  • 6. Product Differentiation
  • 7. Switching Costs

9
  • Factors that Affect the Bargaining Power of
    Buyers
  •  
  • 1. Ability to Backward Integrate
  • 2. Buyer Concentration
  • 3. Information
  • 4. Price-sensitivity
  • 5. Product Differentiation
  • 6. Switching Costs
  •  
  • Factors that Affect the Bargaining Power of
    Suppliers
  •  
  • 1. Differentiation of Inputs
  • 2. Impact of Inputs on Cost or Differentiation
  • 3. Size of Purchase
  • 4. Supplier Concentration
  • 5. Switching Costs
  • 6. Threat of Forward/Backward Integration

10
  • The Five Forces Framework is incomplete because
    it does not recognize the role of allies,
    collaborators, and other partners
  •  
  • Brandenburger and Nalebuff Coopetition (1996)
  •  
  • The Value Net adds Complementors
  •  
  • Customers
  •  
  • Competitors The Firm Complementors
  •  
  • Suppliers
  •  
  • Complementors are the mirror image of
    competitors they increase
  • buyers willingness to pay for the firms
    products and decrease the
  • price that suppliers require for their inputs 

11
Examples of Complementors
  • Doctors Doctors influence the success of
    pharmaceutical products by
  • prescribing drugs, but they are not buyers
  •  
  • Intel/Microsoft Microsofts software runs on
    computers equipped with
  • Intel microprocessors, and its more valuable
    when combined with
  • better processors
  •  
  • Drug/Biotech Allies Small biotechnology
    companies form alliances
  • with large drug companies to develop and market
    products
  •  
  • Any given firm may play multiple roles in the
    value net this is
  • particularly important for large firms. For
    example, in its relationship
  • with small software companies Microsoft may be a
    supplier, potential
  • competitor, complementor, and buyer 

12
Dynamics
  • Key features of the environment change over time
  • 1. Buyers and their needs
  • 2. Regulations
  • 3. Relationships between players
  • 4. Suppliers and their products
  • 5. Technology

13
Competitive Advantage is Temporary
  • Ghemawat Commitment (1991) analyzes return on
    investment (ROI) reported over a ten-year period
    by 692 business units
  •  
  • Splitting the sample into two equally sized
    groups based on ROI revealed that the top groups
    ROI in year 1 was 39 and the bottom groups ROI
    in year 1 was 3
  •  
  • After ten years over 90 of the 36 point gap
    between the two groups was eliminated
  • Thus, most of competitive advantage depends on a
    temporary firm or business unit effect

14
Industry vs. Firm Effects
  • McGahan (.) assesses the relative importance of
    the following types of effects in explaining
    variation in firm profitability
  • Permanent industry effects 11
  • Temporary industry effects insignificant
  • Permanent firm effects 24
  • Temporary firm effects 57
  • Her study uses Compustat, which is not as
    disaggregated as possible, but the results still
    suggest that firm effects are more important

15
Firm Effects Resources and Capabilities
  • The basic finding that industry effects appear to
    account for little of the variation in firm and
    business unit profitability has led strategy
    researchers to focus more on firm effects
  • Achieving superior profitability within an
    industry is emphasized more than finding
    profitable industries
  • This has led to increasing focus on firm-level
    resources and capabilities

16
Resources and Capabilities
  • Strategy can be oriented around demand or
    internal resources and capabilities
  • In environments with rapid change, it is better
    to formulate strategies around resources and
    capabilities
  • For example, when PCs began to replace
    typewriters in the early 1980s, typewriter firms
    that attempted to follow their customers by
    trying to enter the PC market generally failed
  • Typewriter firms that pursued other products
    where their existing skills could be useful were
    more successful (small electronic appliances,
    etc.)

17
Resources and Capabilities
  • Establishing a competitive advantage is concerned
    with formulating and implementing a strategy that
    recognizes and exploits the unique features of
    each firm
  • Basic units of analysis are the resources of each
    firm
  • Items of capital equipment, skills of individual
    employees, patents, brands, and so on
  • Resources work together to create capabilities,
    which are basically what the firm is good at

18
Establishing and Sustaining Competitive Advantage
  • In order to establish a competitive advantage, a
    resource or capability must be scarce if every
    firm can acquire the resource or capability then
    the outcome is much like perfect competition
  • In order to sustain a competitive advantage,
    their must be barriers to imitation
  • Are the resources or capabilities transferable
    (can they be traded or spread through employee
    mobility?)? Can they be replicated?
  • Intangible resources become important brands,
    reputation
  • Plants and equipment and even patents become
    obsolete relatively quickly
  • Capabilities based on complex organizational
    routines are less vulnerable to imitation (like
    FedExs next-day delivery service)

19
Emergence of Competitive Advantage
  • Dynamics are important for explaining the
    emergence of competitive advantage
  • Some firms have greater innovative capabilities
  • Some firms are better able to respond to change,
    either because of intrinsic change management
    capabilities or because their resources or
    capabilities are well-suited for the particular
    type of change occurring
  • External sources of change include changing
    tastes, prices, and technological change
  • Competitive advantages emerge when firms innovate
    or benefit from external change

20
First Mover Advantages
  • First movers accept the risk that the market may
    not materialize, but if the market materializes
    the first mover may acquire resources and
    capabilities
  • Resources like store locations may be scarce
  • A reputational asset is created with suppliers
    and buyers
  • Where standardization is an issue, the first
    mover may be able to set the standard
  • The first mover can learn by doing and move down
    the learning curve ahead of followers

21
Industry Evolution and the Life Cycle
  • Competition is a dynamic process in which firms
    attempt to obtain competitive advantages only to
    see them eroded by imitation, innovation, and
    external change
  • The industry environment is reshaped by the
    forces of competition
  • The industry life cycle is a common pattern of
    industry development industries can be
    classified according to their stage, and we can
    determine which strategies are appropriate in
    each stage

22
Product Life Cycles
  • Products are born, their sales grow, they reach
    maturity, they go into decline, and they
    eventually disappear
  • The industry life cycle follows the product life
    cycle and thus depends on how broadly defined the
    product is
  • 64-bit video games have a relatively short life
    cycle but video games in general have a long life
    cycle
  • Strategy researchers generally divide the life
    cycle into four stages introduction, growth,
    maturity, and decline
  • Demand growth and the production and diffusion of
    knowledge varies over the life cycle

23
Demand Growth
  • Think of an S-shaped growth curve
  • In the introduction stage, quality and sales are
    low and costs and prices are relatively high
    customers tend to be high-income innovation
    oriented risk accepting individuals
  • In the growth stage, quality improves, costs and
    prices come down and sales increase dramatically
    the product obtains mass market appeal
  • In the maturity stage market saturation increases
    and increasingly demand is replacement demand
  • In the decline stage the industry is threatened
    by a replacement

24
Diffusion of Knowledge
  • Knowledge diffusion drives the industrys
    evolution
  • In the introduction stage, there may be no clear
    standard and product improvements and changes
    occur rapidly
  • Standardization often leads to the growth stage
    mass market appeal requires a product that is
    unlikely to become obsolete quickly
  • In the growth stage, obtaining scale and access
    to distribution is key
  • Product and process innovation depend on
    technological opportunities and may persist or
    vary throughout the life cycle, but in the
    maturity stage there may be a shift to process
    innovation if opportunities for further product
    improvements diminish
  • In the decline stage the orderly exit of capacity
    is important to prevent price wars industry
    consolidation is critical

25
Key Open Questions
  • Understanding resource, capability, and strategic
    heterogeneity in dynamic environments could use
    much additional work
  • In depth studies of particular firms in their
    industry context could provide additional
    insights about how particular resources,
    capabilities, and strategies are advantageous at
    different points in the life cycle
  • For example, I have a working paper that uses a
    simple model to study mergers in declining
    industries
  • Few other studies have even bothered to
    investigate mergers in this environment, although
    consolidation is a critical strategic objective

26
Key Open Questions
  • The key insights from the strategy field have not
    been fully incorporated into industrial
    organization
  • Dynamic models of industry evolution should
    incorporate greater differences between firms in
    terms of their resources, capabilities, and
    strategies
  • Models should be consistent with the result that
    the vast majority of profitability depends on
    firm effects and that most of profitability is
    transitory
  • Key resources, capabilities, and strategies
    should also affect firm valuations studies of
    stock prices and returns can investigate these
    relationships
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