Markets Organization and Corporate Strategy

1
Markets Organization and Corporate Strategy

• George Norman
• Cummings Professor of Entrepreneurship and
  Business Economics

2
Some 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
  l

3
Objectives

• 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

4
Strategy and Economics

• The definition of strategy
• no single definition
• different from tactics - essentially short-term

5
Strategy 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)

6
Strategy 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)

7
Strategy 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)

8
Why 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

9
Economics

• 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

10
The 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)

11
Principles (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

12
A Framework for Strategy

• The big issues
• boundaries of the firm
• markets and competitive analysis
• position and dynamics
• internal organization

13
The 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

14
Markets 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

15
Position 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

16
Internal 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

17
An Economics Primer
18
Some 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?

19
Costs

• 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
20
Fixed 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

21
Fixed 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

22
Average 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
23
The 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
24
Sunk 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

25
Sunk 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

26
Demand 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
27
Demand 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

28
Price 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
29
Price 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
30
Price 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

31
Pricing 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
32
Game 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

33
Matrix 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
34
Nash 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)

35
Game 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
36
Sequential choice

• If choices are sequential the first mover can
• anticipate rivals choice
• manipulate rivals choice
• With sequential choice use game tree

37
A 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)