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Transcript of Managerial Economics:Economics of Strategy Economics of Strategy Patrick McNutt wwww wwww wwww.......
Managerial Managerial Economics:Economics Economics:Economics
of Strategyof Strategy
Managerial Managerial Economics:Economics Economics:Economics
of Strategyof StrategyEconomics of StrategyEconomics of Strategy
Patrick McNuttPatrick McNuttwww.patrickmcnutt.comwww.patrickmcnutt.com
Abridged Abridged ©©
Workshop Lesson plan….
• Plan is to follow Besanko’s Economics of Strategy 5th Edition
• Day 1 : Revision of Chapters 3 and 5 (Agency and Co-ordination) and Introduce Chapter 2 (Economies of Scale and Scope)
• Day 1 Workshop Study Groups & Case Analysis• Break-out Sessions at 330-530pm Day 1 and Day 2 with group
Presentation Day 3 at 2pm start• Day 2 & 3: Focus on Chapters 8,9,10 and 11 and link into
Units 3 and 4• Day 1: Introduction and setting the scene using McNutt’s
Game Embedded Strategy Chapters 1 and 2
Workshop Focus
• Management type and relevance of TCE..Unit 1. Besanko Ch 3 and 5, McNutt Ch 1
• Cost leadership and economics of capacity..Unit 2. Besanko Ch 2 and McNutt Ch 5
• Market-as-a-game…market structure, oligopoly, and dynamic games…Units 3 and 4. Besanko Ch 8,9,10 and 11 and McNutt Ch 6,7,8 and 9
• Real Time case Analysis…go to Page 45 of colour-coded Storybook
Why the focus?At the frontier of economic
analysis…..• Understand management as ‘they are’ not as theory
hitherto ‘assumed them’ to be• Management can be ranked (by type) and are faced
with trade-offs => something must come ‘top of the menu’
• Firms are conduits of information flows (vertical chain)• Supply chain capacity constraints and technology-lag• Reducing price does not necessarily lead to an increase
in revenues (elasticity)• Prices are primarily signals (observed behavior)• Companies understand the competitive threat as
(recognised) interdependence (zero-sum and entropy)
The competitive threat!• Traditional Analysis is biased
towards answering this question for Company X: what market are we in and how can
we do better?• Economics of strategy (GEMS) asks:
what market should we be in?
Co-ordination• Coase asked in ‘ The Nature of Firms’ in 1937:
• Transaction costs: costs of negotiating, monitoring and enforcing contracts.• Behavioural assumptions: bounded rationality & opportunism.• The relative cost of organising transaction through different forms of
governance determined by:• Extent to which complete contracts are possible. Where contract refers to
agreement between two parties which could be explicit or not.• Extent to which there is a threat of opportunism by parties in the
transaction.• Degree of asset specificity in the transaction.• Frequency with which the transaction is repeated.
Storybook p.12
Why are not all economic transactions coordinated by markets?
When transaction costs are too high, exchange to be coordinated by organisations
Organisation vs. Market
division of labour Adam Smith
Specialisation
Co-ordination
market organuisation
Transaction cost
economics
Hybrid
Companies as Players in a Market-as-a-game?
• Principal-agent relationship• Shareholders as principals and
management as agents• Who are decision makers?Management ≈ firms ≈ companies
=PLAYERS (key decision makers)
Costs of not being a Player
• Agency costs can accrue..across the shareholders (esp institutional)..changing CEOs
• Bounded rationality and opportunity costs with trade-offs
• Make or Buy dilemma• First Mover Advantage (FMA) v Second Mover
Advantage (SMA)• Play to win v Play not to loose!• Follower status ‘behind the curve’• Technology lag and failure to differentiate ‘fast enough’
to sustain a competitive advantage
Bridging Unit 1 and Unit 3: Game analysis
• Binary reaction; Will Player B react? Yes or No?
• If YES, decision may be parked
• If NO, decision proceeds on error
• Surprise
• Non-binary reaction: Player B will react. Probability = x%
• Decision taking on conjecture of likely reaction
• No Surprise
Lets’ begin! Unit 1: Why the emphasis on behaviour (of
players)?• The Firm as a ‘nexus of contracts’• Vertical chains and agency costs• Shareholders and management-as-agent• GHM Theory (Besanko pp158-161) and
incomplete contracting• Type of management and Bounded
rationality
Management Models• Understand Penrose effect• Understand Bounded Rationality• Go to Table 1.2 pp14 McNutt
Game Embedded Strategy Compare with Next Slide where
you add in Williamson/TCE
Behavioural Baumol Marris Williamson
Objective Multiple goals TR:Sales Growth:gd Managerial Utility or Value
Approach Satisficing – subject to Profit
Constraint
Maximisation– subject to
Profit Constraint
Maximisation - subject to
Security Constraint
Maximisation - subject to Profit Constraint
Principal Agent Issue
Yes Yes Yes Yes
Short v Long Term
Varies Short and also dynamic
Long Short
Reaction & Interaction
Yes Partial Partial Partial
Decision Making Coalitions
Yes Management and zero-sum
Relevance of shareholders
Yes,..TCE
Baumol strategy or Maximising Market
Share: MMS• Recognise zero sum constaint and
entropy (redistribution within market shares)
• Market Shares (before): 40+30+20+10• Zero-sum (after): 30+40+20+10• Entropy (after): 30+35+25+10• Iff {∆qi/∆Q} > 0 market exhibits non-
price competition:• Check {∆qNOKIA/∆QSmartphones} < 0
Total Revenue
Total Cost
Profit/LossSales driven beyond the point of max profit but within the minimum profit constraint
Min Profit Constraint
Output
£
MMS-strategy
• Entropy when the industry elasticity is less than the firm-specific elasticity: ηp < єp
• MSa = [ηp + σ.MSb]/єp
• Market Penetration: єp < σ.MSb and Market poaching σ < 1
Precis on a Marris model…
• McNutt Ch 4: Understand balanced equation gc = gd to identify parameters of profitability
• Supply of capital: debt v equity• Demand for capital: R&D exp v dividends• Instrumental variables influencing growth
– visit Diageo case in Kaelo v2.0• KFIs: profits/output and output/capital• Tobins q and Marris v ratio
U1 U2 U3 U4Valuation ratio Shareholders perference
xBest to management
V2 Valuation curve
G1 G2 Growth rate
V1
V(min)
y
0
Marris equations/dividends paradox
• Calculating share price by DCF formula
• P = eps/r : Static firm no growth opportunities• P = eps/r + PV(GO): Dynamic firm with growth
opportunities…this is a Marris firm
• Common denominator is the plough-back ratio (PBR) = 1 – divs/eps…This is a Marris equation
• More dividends can signal an absence of R&D growth• But more R&D from G1 to G2 can accrue an agency
cost as Bayesian shareholders SELL as value falls V1 to V2.
Unit 2: Cost leadership as a type (of player)
• Profitabiltiy v scale and (size and scope)• Production as a Cost-volume constraint
• Understanding the economcis of productivity as exemplar for incentives
• Normalisation equation• Sources of Cost Efficiency [next slide]
• Cost leadership checklist..McNutt p61
Sources of cost efficiency
• Measure of the level of resources needed to create given level of value
Production-cost relationship
Production-cost relationship
Capacity utilisation
How much to produce given capital size?
Capacity utilisation
How much to produce given capital size?
Economies of scale
How big should the scale of the operation be?
Economies of scale
How big should the scale of the operation be?
Other
X-inefficiencies, location, timing, external environment, organisation discretionary policies
Other
X-inefficiencies, location, timing, external environment, organisation discretionary policies
Transaction costs
Which are the vertical boundaries of the firm?
Transaction costs
Which are the vertical boundaries of the firm?
Economies of scope
What product varieties to produce?
Economies of scope
What product varieties to produce?
Learning and experience factors
How long to produce for?
Learning and experience factors
How long to produce for?
£
Q0,0
SAC1SAC2
SAC3 LAC
q1q2
Lower per unit cost for more units sold
qt
Current plan of plant closures to lower cost base not completed
Av.Cost = marginal cost
MES Point: Production - demand - productionto attain cost leadership
Capacity Constraints: Why ?
• Case A: Unexhausted economies of scale due to prodcut differentiation
• Case B: Firm-as-a-player does not produce large enough output to reach MES
• Case C: Firm-as-a-player restraints production (deliberate intent)..McNutt’s dilemma as production drives demand…(Veblen monopoly type)
• Convergence of technology increases the firm-specific risk of Case C..avoid Case C or not?
Bridge Unit 1 and Unit 2
• Shareholder as principals expect max value• Management to minimise the agency costs• Positive Learning Transfer, PLT• Nomenclature on type: Baumol type (signal =
price), Marris type (signal = dividends).• Cost leadership type (link into Besanko Ch
13 on stategic cost advantage)
Unit 3: Game type and signalling
• Decisions are interpreted as signals• Observed patterns and Critical Time
Line.see Nissan example pp20 in McNutt• Recognition of market interdependence
(zero-sum)• Price as a signal v Baumol model of TR
max• Scale and size: cost leadership• Dividends as signals v Marris model
Oligopoly and Game TheoryT3 + GEMS
• Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour
• Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players.
• Key elements:• Players. Company or manager.• Strategies.• Payoffs
• Equilibrium. Every player plays her best strategy given the strategies of the other players.
• Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective.
• The use of T3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow oligopolists to better predict the likely strategic response of competitors when analysing competition from game embedded strategy perspective.
Describe (prices as signals) game
dimension• Players and type of players• Prices interpreted as signals• Understand (price) elasticty of demand and
cross-price elasticity• Patterns of observed behaviour• Leader-follower as knowledge• Accomodation v entry deterrence• Reaction, signalling and ‘best you can do,
given reaction of competitor’
Link Units 3 and 4: Game Dimension
• What is a game – loss of independence?• Nash premise: Action, Reaction and Reply• Non-cooperative sequential (dynamic) games• Introduce oligopoly and players (companies) n
< 5• TR Test and Elasticity McNutt pp36• Single shot price reduction: (i) fail TR test and
revenues fall; (ii) near rival misreads the price as a signal
Type of Players• Incumbent type v entrant type• Dominant type v monopoly incumbent • De novo entrant type and geography of
the market• Potential entrant type and the threat of
entry• Newborn players and extant
(incumbent) type
Limit Pricing Model in Besanko pp310-318 and McNutt
pp71-76• Outline the game dimension:
dominant incumbents v camuflaged entrant type
• Define strategy set for incumbents• Allow entry and define the equilbrium• Preference - entry deterrent strategy
v accomodation [next slide]
1
2
Enter
0,10
-7,2
5,8
Do Not Enter
Agressive
Accommodating
Entry Deterrent Strategy• Reputation of the incumbents• Entry function of the entrant• De novo and entry at time period t• Potential entrant and forces reaction
at time period t from incumbent• Coogans bluff strategy (classic
poker strategy)
Continuing with Unit 4: Define a price war
• Determine the Bertrand reaction function• Signalling• Compute a Critical Time Line (CTL)from
observed signals..Examples of CTL in McNutt pp 20 Figure 2.1 and pp94 Fig 7.4
• Find a price point of intersection• Case Analysis of Sony v Microsoft at
McNutt pp 114-116 and also in Kaelo v2.0
Visit Kaelo v2.0 and Games/Signalling
• Example: Critical Time Line in Sony v Microsoft in Kaelo v2.0, Apple v Nokia game dimension McNutt pp92
• Play a PD game and investment game in Kaelo v2.0
• Altruism, fairness, selfish gene, dominant strategy
• Understand the ‘husband and wife’ payoff matrices [next slide]
The husband and wife payoffs
• Simultaneous game between husband & wife who must decide on how to spend the
evening.
• Problem of coordination where players have different preferences but common interest in coordinating strategies.
• One key application includes the battles for standards: • VHS by JVC vs Betamax by Sony in the 1980s• BlueRay DVD by Sony vs HD DVD by Toshiba in 2008
• Effect of sequentialisation? Solution. Commitment? Signalling?
wife
in out
husband
in 10,5 2,4
out 0,1 4,8
Nash Equilibria• Define the Nash equilibria [next slide]• Analyse the Payoff matrix
(B,Y) > (A, X)• Commitment and chat• Punishment strategy• Strategic ToolBox in terms of credible
mechanisms
10,10
8,-50,0
-5,8
Strategy A
Strategy B
Strategy X Strategy Y
Player 1
Player 2
Prisoners’ Dilemma
•Apply Prisoners’ Dilemma to Pricing Policy
Player 2
Confess Don’t Confess
Player 1 Confess 8 8 0 20
Don’t confess 20 0 3 3
Firm 2
High Price
Low Price
Firm 1 High Price 8 8 0 20
Low Price 20 0 3 3
•Would outcome change if the game is repeated? The Folk Theorem
Application of ‘husband and wife’
game• Two pharmaceutical companies must
simultaneously decide which products to research.
• This example does illustrate the concept of ‘first mover advantage’.
• How could companies sequentialise? Signing contracts with leading universities, hiring expert.
A O
A -2,-2 20,10
O 10,20 -1,-1
Games as Strategy: Strategic ToolBox
• Segmentation strategy to obtain FMA• Relevance of chain-store paradox• Dark Strategy and 3 Mistakes in
McNutt pp95-97• Second Mover Advantage• Strategic ToolBox in terms of identfying
the competitive threat v cartel coordination on (High. High)..Cheating
10,10
13,02,2
0,13
Low Prices
High Prices
Low Prices High Prices
Player 1
Player 2
Absence of price wars?Link into the HBR
articles• Hypothesis: Price Wars occur due
to a mis-match in price signals.• Mismatch can occur due to (i)
declining volumes ∆qi/∆Q < 0; (ii) uncompetitive cost structure; (iii) decreasing productivity; (iv) mangement type (predator)
GEMS and Strategic Analysis
•Knowledge of the identity of near rival:
Actionyou -> Reactionrival
-> NashReplyyou
Locate Your Company in the Next SlideScenario A?Scenario B?Scenario C?
GEMS and Tn=3 Framework [next slide]
pp 130-132 in McNutt
Industry Analysis
Play-out Game Scenario B
e.g. change the gamenew
product development
Strategic Options (Identify the Games)
Play-out Game Scenario A e.g. market
entrycompetitors reactions
Play-out Game Scenario C
e.g. change the game
Consolidation
Strategic Decisions
Porter’s 5 Forces BCG Value Net
S.W.O.T. P.A.R.T.S. McKinsey
Game theory
Organizational Goals
Game theory Insights
GEMS and Strategic Analysis• Knowledge of likely reaction of
near rival• Binary reaction; Will Player B
react? Yes or No?• Non-binary reaction: Player B will
react. Probability = x%
Game Embedded Strategy: GEMS:
Complete the Diagram
What Market should Your Company be in?
Games & Feedback
Final Scenarios for YOUR Company……
• The RationaleMarkets evolve
• The RationaleType, Technology
and Time• The RationaleKnow your market
• The StrategyNon-binary
• The StrategyGame metrics and
analytics• The Strategy
GEMS
Thank you for participating………
Sapere aude
‘That which one can know, one should dare to know’