Markets Organization and Corporate Strategy

George Norman

Cummings Professor of Entrepreneurship and Business

Economics

Some Introductory Comments

Textbook: The Economics of StrategyGrading:

Two sets of essays: 20% and 25% respectively Research paper: 30% Industry analysis and presentation: 25%

Syllabus: not a legally binding descriptionWeb-site

http://www.tufts.edu/~gnorman/cmba344.html

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 firm’s success

Strategy and Economics

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

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)

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)

Strategy Definition

What determines the framework of a firm’s business activities and provides guidelines for coordinating activities so that the firm can cope with and influence the changing environment. Strategy articulates the firm’s preferred environment and the type of organization it is striving to become. (Itami, 1987)

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

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

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)

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

A Framework for Strategy

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

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

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

Position and dynamics

How and on what a company competes cost advertising product positioning R&D

Dynamics how the firm accumulates resources how the firm adjusts to changing circumstances

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

An Economics Primer

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 competitor’s price cut? Price and cost: can additional volume be sold at a profit?

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

Tot

al C

ost

Output

TC(Q)

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

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

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:

Cos

t

Output

AC(Q)

MC(Q)

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

In the short run may have to live with “wrong” plant

SACS(Q)SACM(Q)

SACL(Q)

Q1 Q2 Q3

Ave

rage

Cos

t

Output

If expected output is Q1 install the small scale plant

If expected output is Q2 install the medium scale plant

If expected output is Q3 install the large scale plant

Q4

If expected outputis Q1 but actual

output is Q4 thenshort-run costs

will be on SACS(Q)

The long-run cost curveis the lower envelope ofthe short-run cost curves

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

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

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

Quantity

P1

P2

Q1 Q2

At price P1 thequantity demanded

is Q1

At price P2 thequantity demanded

is Q2

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 good’s image

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:

= % change in quantity

% change in price

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

Pri

ce

Quantity

Pri

ce

Quantity

Reduction in salesrevenue from increased

price

Increase in salesrevenue from increased

price

Reduction in salesrevenue from increased

price

Increase in salesrevenue from increased

price

Elastic demand Inelastic demand

Price elasticity of demand (cont.)

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

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

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 marketUse the standard pricing formula:

P(1 - 1/) = MC

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

Matrix form and Nash equilibrium

Simple example of capacity choice by two firms

Alpha

Do Not Expand

Expand

Beta

Do Not Expand Expand

$18, $18

$20, $15 $16, $16

$15, $20

Dominantstrategyfor Beta

Dominantstrategy

for Alpha

$16, $16$16, $16

NashEquilibrium

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)

Game trees and equilibrium

Consider a modified and expanded example

$18, $18

Alpha

Do Not Expand

Large

Beta

Do Not Expand LargeSmall

Small

$15, $20

$8, $12

$8, $12 $0, $0

$9, $18

$20, $15

$18, $9

$16, $16$16, $16$16, $16

Sequential choice

If choices are sequential the first mover can anticipate rival’s choice manipulate rival’s choice

With sequential choice use game tree

A game tree

Do not Expand

Do not Expand

Do not Expand

Do not Expand

Small

Small

Small

SmallLarge

Large

Large

Large

Alpha

Beta

Beta

Beta

($18, $18)

($15, $20)

($9, $18)

($20, $15)

($16, $16)

($8, $12)

($18, $9)

($12, $8)

($0, $0)

Small

Small

Do not Expand

Large