University Notes - Senior Year, 2nd Semester

Table of Contents Keith Parker’s Notes from USC

Volume 5 of 5

Senior Year, Second Semester Page Content BUAD-497: Strategic Management 1 Syllabus 11 Course Documents 25 Assignments 37 Class Notes 63 Group Project 89 Powerpoint Slides FBE-440: Trading and Exchanges 179 Syllabus 190 Course Documents 214 Assignments 228 Class Notes 243 Exam Things FBE-462: International Trade and Commercial

Trade 272 Syllabus 277 Course Documents 282 Handouts 286 Homework 300 Class Notes 315 Group Project 356 Powerpoint Slides MOR-492: Global Strategy 401 Syllabus 412 Discussion Help 413 Reading Notes 417 Class Notes 435 Projects 493 Powerpoint Slides

University of Southern California Marshall School of Business

BUAD 497: STRATEGIC MANAGEMENT

Spring 2007 Instructor: Peer C. Fiss, Ph.D. Office: Bridge Hall 303-B Phones: Office: 1-213-821-1471 Email: [email protected]: Section 15102R – T/TH 12-1:50pm ACC 201 Section 15107R – T/TH 2-3:50pm HOH 304 Section 15112R – T/TH 6-7:50pm ACC 201 Office Hours: Wed 2:00pm – 4:00pm and by Appointment Prerequisites: Successful completion of all core business requirements COURSE DESCRIPTION This course introduces the concepts, tools, and first principles of strategy formulation and competitive analysis. You will learn about why some firms survive and prosper while others do not, and develop the critical analysis and communication skills necessary to create and implement firm strategy. The course focuses on the information, analyses, organizational processes, and skills and business judgment managers must use to design strategies, position their businesses and assets, and define firm boundaries, to maximize long-term profits in the face of uncertainty and competition. Strategic Management (BUAD 497) is an integrative and interdisciplinary course in two important respects:

1. The course assumes a broad view of the environment that includes buyers/consumers, suppliers, technology, economics, capital markets, competitors, government, and global forces and it assumes that the external environment is dynamic and characterized by uncertain changes. In studying strategy, this course draws together and builds on all the ideas, concepts, and theories from your functional courses such as Accounting, Economics, Finance, Marketing, Organizational Behavior, and Statistics. However, it is much more than a mere integration of the functional specialties within a firm.

2. The course takes a general management perspective. It views the firm as a whole, and examines how

policies in each functional area are integrated into an overall competitive strategy. We designed this course to develop the “general management point of view” among participants. This point of view is the best vantage point for making decisions that lead to sustainable business performance. The key strategic business decisions of concern in this course involve determining and shaping organizational purpose to evolving opportunities, creating competitive advantages, choosing competitive strategies, securing and defending sustainable market positions, and allocating critical resources over long periods. Decisions such as these can only be made effectively by viewing a firm holistically, and over the long term.

This course is intended to help you develop skills for formulating strategy. These skills will help you in whatever job you take after graduation as well as in your personal investing and choice of employment. The strategy formulation process demands the mastery of a body of analytical tools and the ability to take an integrative point of view. You will develop these skills through:

• In-depth analysis of industries and competitors • Prediction of competitive behavior • Techniques for analyzing how firms can develop and sustain competitive advantages over time

NOTE: BUAD 497 is a core course taught by several instructors. Policies regarding assignments and grading may be different for each instructor. Be sure to refer ONLY to this syllabus.

BUAD-497: Syllabus

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EDUCATIONAL OBJECTIVES Theory and Concepts. The central concept of this course is that of competitive strategy. Definitions abound, but they all share some sense of the allocation of critical resources over relatively long periods in pursuit of specific goals and objectives. Successful strategies exploit external conditions, entrepreneurial insights, and internal resources, seeking configurations of prices, preferences, technologies, and information that offer opportunities for sustainable competitive advantage. Strategy can be usefully thought of as the comprehensive alignment of an organization with its future environment. Success, however, depends not only on the soundness of the strategy, but also on its effective implementation through appropriate organizational and administrative choices. In the end, unforeseen external factors may cause a well-conceived and executed strategy to fail, in spite of its initial wisdom -- but a poor strategy badly executed increases the chances of failure. Opportunities to act strategically often do not come labeled as “strategic” and occur infrequently. If missed, or mismanaged, they can prove disastrous for any firm. Understanding the concept of competitive strategy formulation is a primary educational objective of this course. This will involve mastering an array of economic, strategic, and organizational concepts and theories, and acquiring an integrative general manager’s point of view. The course will cover theories for in-depth industry and competitor analysis, for anticipating and predicting future industry developments, and for examining the impact of change (in technologies, tastes, government regulations, global competition, and other important environmental forces) on competition and industry evolution. The course will also examine the economic underpinnings of competitive advantages, and the fundamental conditions that allow firms to conceive, develop, and sustain, advantageous strategic positions. While our primary focus will be on mastering strategy formulation at the business unit or competitive level, the course will also examine corporate and global strategy issues such as diversification, vertical integration, economies of scope across related businesses, the transfer of technology and core competencies, and international expansion and growth. Analytical Skills. Theoretical concepts are a great aid to understanding, but by themselves, they do not help resolve real business problems or challenges. Also needed are analytical skills and techniques that can be applied to the data to "fill in" the facts and premises assumed in the theories. A second educational objective is further to increase each student’s inventory of useful analytical skills and tools. Some of the tools are quantitative -- analyzing financial statements, computing comparative buyer costs, and calculating the effects of scale and learning on production costs, for example -- while others are qualitative. Learning how to apply these techniques, and, more importantly, when to apply them is a key objective of the course. In learning to size-up a business and its problems or opportunities, this course will require you to conduct "full blown" strategic analyses. That is, identifying firms’ strategies and testing them for consistency, recognizing potential entrepreneurial opportunities and strategic challenges/problems, selecting and establishing competitively protected market niches, identifying competitive advantages and shaping defenses to circumvent the advantages of rivals, formulating and implementing internally consistent business strategies, and designing efficient and effective organizations. Rhetorical Skills. The best analysis in the world will have little effect if it cannot be communicated to others. Managers must be able to articulate their views coherently and persuasively, and they must be skilled at understanding and analyzing other points of view. Management is a "verbal sport;" perhaps 90% of a typical manager's day is consumed by oral communication. Time is often scarce. You must learn to make convincing arguments and to make them quickly, or the merits of their ideas are likely to become simply irrelevant. This skill takes practice, and we will place a great deal of emphasis on it in class. Wisdom. Much of the knowledge that successful managers and consultants employ consists of "rules of thumb" about what issues are likely to be important in certain kinds of business situations. These rules of thumb, or heuristics, are often implicit in the thinking of people who have never bothered to articulate them explicitly. A fourth goal of this course is to help you build up your set of useful "stories" and heuristics for your future managerial careers. In this course, we are as much interested in developing an appreciation for the art of management as we are in understanding the science of management. Tools alone will not a strategist make. While the ability to master

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analytical models, frameworks, and tools is essential, ultimate success is more strongly predicated on prescient judgment, entrepreneurial insight, iconoclastic vision, and a willingness to act forcefully with conviction. COURSE FORMAT AND THE CASE DISCUSSION METHOD In order to achieve the objectives of the course, we will devote the majority of our class time to the analysis and discussion of selected management, competitive strategy, and business policy cases. I will use lectures to elaborate on key theoretical models and frameworks or to reinforce crucial concepts. These lectures, however, will be subordinate to the case analysis. Cases provide a natural "test-bed" for theory and provide vivid examples that aid memory of concepts. While nothing can surpass first hand personal industry and managerial experience as a basis for analysis and decision-making, case analysis is an indispensable proxy for the kind of knowledge that can only be gained through years of experience and research. I have selected a mix of old and new business cases on a range of companies from a variety of industry settings. Each case is intended to teach us something specific, yet each can teach many things. We will not attempt to exhaust each case of all its learning experiences, but rather build up a "tool kit" of analytical tools, skills and insights, progressively over all the selected cases. There are other reasons for employing the case discussion method of instruction. First, it allows you to develop skills at problem definition in addition to problem solving. Cases typically do not have an obvious set of tasks whose performance will lead to mastery. Rather, they force you to sift through a mass of information, some of it irrelevant or contradictory, in order to identify the important or strategic issues. Second, the case method gives you a chance to deal with ambiguity. Most cases do not have obvious "right" answers. Managers must be able to function in situations where the right answer is not known, without falling into the trap of assuming that any answer is as good as another. Some analyses and proposed strategies are clearly wrong, and some are clearly better than others are. A popular phrase in case analysis classes is "There are no right answers, but there are wrong answers." Case discussion techniques provide a chance to learn the meaning of analytical rigor in situations other than open-and-shut problems. These rationales are offered because the case method is unfamiliar to most of you and frequently causes initial confusion. There will be many times when I will not reveal my own opinions about a particular issue, and there will be many cases that do not end up neatly packaged with an "answer." You may discover that your preparation "misses" key points of a case, especially at first. This is a normal part of the learning experience. While we will direct class discussions, the quality of your learning experience will be directly determined by: (1) your degree of preparation, active listening, and participation, and (2) your classmates' preparation, listening, and participation. Some will not agree with you, and you may be asked to defend your argument or change your mind. So long as criticism is directed at arguments and not at individuals, is relevant to the issues at hand and coherently argued, it is very much welcomed. Case Preparation Because this course relies heavily on case material, extensive before class preparation and in class participation are required to ensure the class' success. (1) Preparation for a case discussion should begin with a rapid reading of the assigned case and other materials. (2) Then, it is worthwhile to review the discussion questions provided for clues as to what issues require special attention. (3) The next step is normally to re-read the case carefully, taking notes which sort information, facts, and observations under a number of relevant headings. Try to formulate theories or hypotheses about what is going on as you read ("the company loses money on small orders"), modifying or rejecting them as new information surfaces ("Table 2 shows that shipping costs per unit are higher for small orders, but only for long-distance shipments"). Push yourself to reach definitive conclusions before you come to class. (4) You should perform quantitative analyses, “crunching” whatever numbers are available. It is also very important to provide quantitative support wherever possible, particularly when exploring various hypotheses as to the nature and importance of certain phenomena. (If the requisite data are not available in the case, a precise description of what data are missing often triggers ideas for making creative use of the information that is available.) It is usually worthwhile to identify trends in the firm or industry, preferably with a quantitative measurement. Some of these trends, often very important ones, will not be flagged in the text of the case. (5) Finally, preparation will include notes that can be used to guide your interventions in class discussions. You will probably want to, and I strongly encourage you to form study groups that regularly meet to share insights and ideas about the assigned cases. While this is voluntary, experience shows that satisfactory performance in this course, and a good grade, depend on it.

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WARNING! There is a good chance that you will feel a bit confused or overwhelmed during the first module, or two, of the course. This is a byproduct of the peculiar structure of the strategy course that does not build up linearly by successively adding components of knowledge week by week. Rather, every case in a sense contains all the material in the entire course. Furthermore, the early theoretical concepts will gain in meaning to you once you have worked through a few cases. As a result, there is no logical way to begin except by immersion. So remember: SOME CONFUSION IS NORMAL AT FIRST. You will gain experience as we progress through the course. COURSE EVALUATION Course grades will be determined by individual and group activities: Course contribution and participation 15% Individual mini case analysis 10 Individual midterm exam 20 Group project presentation 10 Group project writeup 20 Individual final exam 25 100% In order to pass this course successfully, a passing grade (> 50%) must be achieved in the group and in the combined average of the individual components. Please note that if your individual performance in the course is unsatisfactory, it will not be brought up by a good group grade. The distribution of grades will closely follow the guidelines of the Marshall School of Business (an average class GPA of 3.0 for required courses). Course Contribution and Participation. Managers must often “sell” their ideas to others in order to get their acceptance and support. In this course, the classroom provides a laboratory in which you can test your ability to convince your peers of the appropriateness of your approach to complex management problems. Furthermore, it tests your ability to carefully listen to others’ perspectives and understand why they may reach a different conclusion. Before you can effectively sell your ideas to others, you must understand what is motivating them, what issues they feel are important, and what assumptions they are making that may be different from your own. When evaluating your contribution to the class discussion, then, I will consider how effectively you put forth your own arguments, as well as how well you listen to, understand, and build upon (or refute) the arguments of others. In all cases, I will look for high quality (which is frequently not the same as high quantity) arguments, analyses and questions that improve the class’ collective understanding of the case issues. While I encourage you to speak up at any time, keep in mind that comments that are redundant, tangential or seemingly irrelevant to the case discussion at hand or attempts to dominate class discussion will have a negative impact on your participation grade. I will use the following criteria when determining class contribution grades: • Has the student attended and made significant contributions to each class discussion? • Does the student show evidence of careful case analysis by using facts and evidence from the case? • Does the student draw valid conclusions from the facts presented in the case? • Does the student contribute interesting examples? Does the student make effective comparisons among

different cases situations, as well as between case situations and real life cases? • Do the ideas suggested by the student push us to consider an aspect of the case that is not necessarily obvious at

the outset? Do they go beyond the surface and get into core issues? • Is the student is an active listener? Do his/her comments fit in with the flow of the class discussion? Do his/her

comments demonstrate listening to and reflection on points suggested by others? Does the student interact with, challenge, question, and extend comments of other participants, or are all comments directed towards the instructor?

• Does the student engage in constructive debate that challenges the opinions expressed by others without diminishing the value of their contribution?

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I realize that some of you may be shy about speaking up in a large class like this. Therefore, I offer you the opportunity to somewhat compensate by participating in the class’s online discussion group. The same evaluation criteria apply here as for in-class discussion. However, keep in mind that this can never fully substitute for in-class discussion. Please remember that your classmates and I expect you to attend and be well prepared for each class, having read the required conceptual material and analyzed the assigned case study ahead of time. We also expect you to play an active role in class discussion. If all class members prepare for and actively participate in each class discussion, your experience will be all the better for it. I will ask you to speak even if you have not volunteered, so please be ready for discussion every class. Individual Mini Case Analysis. For this assignment, I will ask you to analyze a recent event in the business press using the tools we have discussed in class. The analysis should not exceed four (4) double-spaced pages with 1" margins and 12 point font. I will post more information on this assignment on the course website. This assignment will be due on Tuesday, February 6. Individual Midterm Exam. For this assignment, I will provide you with specific questions regarding a company case, and your answers should be confined primarily to the facts as presented in the case. You are expected to use both the concepts and the terminology presented in this course in your write-ups. For the mid-term analysis, the analysis should not exceed six (6) double-spaced typewritten pages, with 1" margins and 12 point font). Your analysis will be evaluated equally on the following criteria: • How well (i.e., thoroughly and concisely) do you describe the environmental context and internal factors that

are important to the problem? • Accurate and thorough use of course concepts • Integration of course concepts with information about the company and problem • How well do you integrate course concepts with information about the problem to illuminate the problem in a

way that leads to solutions? • Extent to which recommendations are consistent with analysis • Feasibility and specificity of recommendations • Quality of written analysis The individual midterm exam will be a take-home exam. It will be due on Tuesday, March 6, at the beginning of class. Please put your name and student number ON THE BACK OF YOUR EXAM ONLY, NOT ON THE FRONT. I don’t want to see your name while I grade these assignments. As always, you should not discuss the case itself with any other student. Group Project Presentation and Writeup. For this group project, you will self-select into groups of 4-6 members. It is your responsibility to form teams. All team members must be from the same section. The project requires you to examine strategic challenges or an issue of concern at real organizations. The purpose of the project is to give your team an opportunity to apply what has been learned in the course to strategic problems faced by real-world organizations. In terms of the topics for your analysis, groups can choose from a menu of topics including the organizational development of a firm over its entire history, an analysis of a firms’ responses to the internet, an analysis of the growth pattern of a successful and an unsuccessful firm, or a successful and unsuccessful radical repositioning of two companies. Your team should identify one or more public, private, or not-for-profit organizations to study. You may select an organization in which one or more of the team members has worked or been a member. I would suggest that you be selective in choosing an issue or problem to analyze, as a lack of background on the issue itself will not be an acceptable excuse for a lack of depth in the analysis. 1. an e-mail with the names an addresses of your group members, a team name, and a brief statement that

outlines your proposed project (see below)

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2. a written analysis and data appendix (20% of course grade) and 3. an oral presentation to the class (10% of course grade) 4. completing a peer evaluation form within 24 hours of the presentation You will conduct original research on your organization(s) and will supplement this information with data from the media, the organization(s)’ own literature, and other secondary sources. You should focus your analysis on applying concepts from the course. Although it is acceptable to incorporate several concepts from the course, please aim for depth rather than breadth regarding the use of course concepts. In my experience, papers that aim to apply a bunch of concepts end up being shallow in their analysis and don’t do well. The project proposal e-mail will be due by midnight on Wednesday, January 31. This e-mail should include: 1. The team name and names of all team members 2. A brief description (roughly 400 words) of your topic. The written analysis should not exceed fifteen (15) double-spaced typewritten pages, with 1" margins and 12 point font. I will only read the first 15 pages of text, so please stay within the page limit. The limit does not include appendices, which you can use to provide charts, figures, or other background material, but should be no longer than five (5) pages. Appendices which are not directly referenced in the text will not be read. The appendix is not a catch-all for anything that might be relevant, but is to be used carefully to support your points. Always include page numbers. Staple papers only, (no binding, folders, clips, or anything other than plain paper). This written document is due at noon on Friday, April 6 for all teams. Oral presentations will be given during the final 4 class sessions. Each presentation should be 25-30 minutes in length, and additional time will be set aside for questions from other teams after the presentation. Both the oral presentation and written document should cover all of the key elements of your analysis. For grading purposes, it will not be sufficient to orally present an aspect of your analysis that does not appear in the written document. The in-class presentation of your paper is worth 10% of the course grade. Half of these 10% will come from your peers, who will attend your presentation and afterwards score it, while the other half will come from my evaluation. It is therefore imperative that you both do well on these presentations and also attend the presentations of your peers, as you will have to post grades for them online. Also, I do not expect but welcome non-traditional forms of presentation. I expect that at this time of your USC career, you know how to give a professional presentation, so this may be a good opportunity to play around with the format. However, please remember that presentations that neglect content in favor of form are not likely to score well. Finally, each team is free to structure itself as it wishes. However, at the conclusion of the project, each member of the group will be asked to evaluate every other group member anonymously on the last day of class using a peer evaluation form that will be available on the course website. All team members must complete the form within 24 hours of their presentation. The goal of this evaluation is to discourage free-riding. If any students receives unsatisfactory ratings from their group, their grade will be marked down accordingly. Individual Final Exam. A final exam will be given during the exam time specified by the University. The exam will consist of questions on an exam case passed out to you one week prior to the exam. The format is similar to case presentations and discussions (e.g., you will be asked to diagnose the problem and make recommendations for action based on all the materials covered in this course). The anticipated times are listed in the course schedule attached at the back of the syllabus. However, you are responsible for confirming this date and time in the university schedule of classes. COURSE POLICIES Attendance. Attendance at all class sessions is expected. Because learning in this course occurs primarily through interactions with other participants during class, every effort should be made to attend each class. There is no substitute for being present, prepared, and participating in the class discussion. While I recognize that from time to time absences may be unavoidable, absences necessarily limit your class contribution (you can’t gain participation points if you are not there…) and hence can influence your grade. Please notify me by email at least a day in

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advance if you must miss a class. If you do miss class, it will be your responsibility to get notes, find out what was discussed, etc. from one of your classmates. Participation Cards. At the end of each case discussion, students who actively participated in the discussion should turn in a Participation Card. These cards should list your name, the date, the case discussed that day, and a synopsis of your contributions during that day’s discussion. The Participation Cards will be used in combination with my own daily evaluations to determine your participation grade for the day. For this purpose, please purchase a package of 3x5 index cards and bring them to each class. Please turn off all Communication and Entertainment Devices. Your classmates and I expect your full attention, so please keep your laptops closed unless we use them for an assignment. Also, please be sure your cell phones, pagers, Blueberries, phasers, tricorders, or other devices are turned off during class. Other Stuff: • Do not wait until the end of the semester to see me regarding problems with your performance. Your

performance in this class is important to me, so please see me early. • Written assignments must be submitted on time. As managers, you will not be afforded the luxury of missing

deadlines (think of deadlines as “windows of opportunity”). The discount rate for late assignments is steep. • If you can convey your thoughts more succinctly in your written assignments, please do so! Suggested paper

lengths are only upper limits. • Like managers executing actual strategies, we may find that the course syllabus must be amended slightly as the

semester progresses. Please be sure to check the course webpage before class for study questions and further information on the readings and cases!

COURSE MATERIAL Case Package: The assigned cases for this course are available from the University Book Store. When

necessary, I will place additional materials on the course website for you. Text: There is no required textbook for this course. However, if you would like to use a textbook to

extend your understanding, you are welcome to come by my office and browse my collection and pick my brain about them (i.e. which ones to buy, which ones to avoid…)

3x5 Cards: Please bring a deck of 3x5 cards to every class to record your participation (see above

description). COURSE COMMUNICATION: BLACKBOARD SYSTEM I have posted the course syllabus to the 497 folder for your section in Blackboard. I will also post additional course lecture notes/materials, further details on assignments, and general course announcements to this folder throughout the semester. You should develop the habit of checking the course folder on a daily basis. You can access Blackboard either by going to http://totale.usc.edu/webapps/portal/frameset.jsp or by going through the “My Marshall” portal http://mymarshall.usc.edu. You will need your UNIX password for either site. IMPORTANT: (1) Since e-mails sent to the class originate from the Blackboard system, it is your responsibility to make sure your e-mail is set up to forward your messages to your preferred internet provider (IP) account such as EarthLink, AOL, Hotlink, etc. (2) Be certain that you include a recent digital color photograph of yourself within the personal information section, as I will use these to learn your names (important for your participation grade). ACADEMIC INTEGRITY

The following information on academic integrity, dishonesty, and the grading standard are placed here at the recommendation of the School of Business Administration Faculty and are taken from the Faculty Handbook.

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Additional statements about academic integrity may be found in SCampus handbook available at the Topping Student Center and online at http://www.usc.edu/go/scampus. Further information may be obtained from the Office of Student Judicial Affairs and Community Standards at http://www.usc.edu/student-affairs/SJACS/index. “The University, as an instrument of learning, is predicated on the existence of an environment of integrity. As members of the academic community, faculty, students, and administrative officials share the responsibility for maintaining this environment. Faculty has the primary responsibility for establishing and maintaining an atmosphere and attitude of academic integrity such that the enterprise may flourish in an open and honest way. Students share this responsibility for maintaining standards of academic performance and classroom behavior conducive to the learning process. Administrative officials are responsible for the establishment and maintenance of procedures to support and enforce those academic standards. Thus, the entire University community bears the responsibility for maintaining an environment of integrity and for taking appropriate action to sanction individuals involved in any violation. When there is a clear indication that such individuals are unwilling or unable to support these standards, they should not be allowed to remain in the University.” (Faculty Handbook, 1994: 20) Academic dishonesty includes: (Faculty Handbook, 1994: 21-22) 1. Examination behavior - any use of external assistance during an examination shall be considered academically

dishonest unless expressly permitted by the teacher. 2. Fabrication - any intentional falsification or invention of data or citation in an academic exercise will be

considered a violation of academic integrity. 3. Plagiarism - the appropriation and subsequent passing off another’s ideas or words as one’s own. If the words

or ideas of another are used, acknowledgment of the original source must be made through recognized referencing practices.

4. Other Types of Academic Dishonesty - submitting a paper written by or obtained from another, using a paper or essay in more than one class without the teacher’s express permission, obtaining a copy of an examination in advance without the knowledge and consent of the teacher, changing academic records outside of normal procedures and/or petitions, using another person to complete homework assignments or take-home exams without the knowledge or consent of the teacher.

The use of unauthorized material, communication with fellow students during an examination, attempting to benefit from the work of another student, and similar behavior that defeats the intent of an examination or other class work is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions accompanying examinations. Where a clear violation has occurred, however, the instructor may disqualify the student’s work as unacceptable and assign a failing mark on the paper. STUDENTS WITH DISABILITIES

Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me as early in the semester as possible. DSP is located in STU 301 and is open 8:30 a.m. – 5:00 p.m., Monday through Friday. The phone number for DSP is (213) 740-0776.

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BUAD-497: Syllabus

Porter’s 5-force framework: • Assesses competitive position of a firm within an industry • 5 variables measure competitive advantage • Assumes continuous downward pressure of competition • Points to interdependencies between factors (i.e. interaction, substitution)

Competition… Threat of entry: ease of ability to enter new markets

Impacted by: absolute cost advantages, government policy, economies of scale, and brand identity (minimum efficient scale) Patents, tariffs, quotas, licensing, geographical locations, language/cultural

Buyer power: size and concentration of customers Impacted by: concentration, switching costs, backwards integration Powerful…large and concentrated, backwards integration Weak…fragmented, producer’s supply critical parts Supplier power: differentiation and switching costs Impacted by: # of suppliers, switching costs and presence of substitute inputs Powerful…concentrated and significant switching costs Weak…standard product and concentrated purchasers Rivalry: intense rivalry reduces average profitability

Impacted by: growth, differentiation, # of competitors, diversity and exit barriers Concentration ratio, Herfindahl Index (monopoly, perfect competition)

Threat of substitutes: price/performance ratios, switching costs and sub. improvement Impacted by: products in other industries ability to constrain the raising of prices

*Great framework for industry dynamics…but complimentors and government influence missing!

PEST: Political: tax policy, employment laws, environmental regulations, trade restrictions, tariffs and political stability. Economic: growth, interest rates, exchange rates and inflation. Socio-cultural: health consciousness, population growth rate, age distribution, career attitudes and safety. Technological: barriers to entry, MES and outsourcing decisions (R&D, automation). *Useful for understanding market growth/decline, business positions, potential direction for operations. Overview of various macroenvironmental factors in firm’s particular environment. These factors = external opportunities and threats in SWOT !!!

SWOT: Strengths: internal asset Weaknesses: internal liability Opportunities: external asset Threats: external liability *Unfortunately, most strengths have corresponding weaknesses and all future events are both opportunities and threats…thus, SWOT = introspective analysis of company, not the industry or competitive environment

Porter’s Generic Strategies: Strategy: unique position for a firm

not doing the same activities better, rather doing them differently or doing different activities. Strategy involves trade-offs

Due to incompatible product features, inconsistencies in image, limits of coordination, motivation, management, etc.

Strategy = achieving high degree of fit between internal activities and external environ. Operational effectiveness is not strategy

*Strategy key tension…control and flexibility!!!

BUAD-497: Course Documents

Hambrick and Fredrickson: Strategy: central, integrated, externally oriented concept of how to achieve objectives. Arenas: where will we be active? (geographically, industry, markets, segments/positions) Vehicles: how will we get there? (joint ventures, subsidiaries, LLP, corporations) Differentiators: how will we compete? (quality, quantity, cost, service, efficiency, safety) Staging: what speed and sequence of moves? (monthly, quarterly, annually, saturate markets, slow introduction, across entire continents, select countries) Economic Logic: where will profits come from? (premium prices, superior product, etc.)

*does strategy…fit environment? Exploit key resources? Sustain differentiators? Internally consistent? Enough resources to pursue in long term? *Elements of firm must reinforce strategy!!!

Boston Consulting Group Matrix: Stars: (high Market share, high Growth) Aggressive investment to support continued growth and consolidate competitive position of firm Question Marks: (low Market Share, high Growth) Selective investments: divestitures for weak firms or those with uncertain prospect for strategic fit.

Cash Cows: (high Market Share, low Growth) Investments sufficient to maintain competitive position: excess cash used to nurture stars and select question marks. Dogs: (low Market Share, low Growth) Divestiture, harvesting or liquidation and exit. *Measures market share against growth

McKinsey Matrix: Industry Attractiveness (comp. position-good, medium, poor): Low: profit producer, loser, loser Medium: winner, average business, loser High: winner, winner, question mark

Core Competencies: Core competencies combine resources and capabilities to create a competitive advantage.

Resources: tangible (factories, products) and intangible (reputation, loyalty) assets to firm in the form of: financial, physical, human, org. Capabilities: proficiencies enabling firm to take full advantage of resources (marketing and cooperative relationships).

Portfolio of Competencies: existing and new Existing: opportunity to improve existing position in markets by leveraging current core competencies…new products to be created from a different configuration of existing resources. New: new products required to protect and expand brand in current markets…the markets of the future.

Resource Based View (RBV) of Corporation: 2 critical assumptions: Resource Heterogeneity (differences in resources among existing firms) and Resource Immobility (costly for firms to acquire)…have something someone doesn’t and can’t get, then a sustainable competitive advantage is created. *Internal focus on idiosyncratic strategies (not external with identical)…resources not highly mobile, therefore possession directly correlated to competitive advantage.

VRIO: Value: resource enables firm to exploit opportunity (increase revenue) or neutralize threat (decrease costs). Rare: if not rare, perfect competition observed: no competitive advantage…must have scarcity among firms to enjoy rarity and competitive advantage. *Valuable and rare…competitive advantage *Valuable and not rare…competitive parity


*not Valuable…competitive disadvantage Imitability: cost disadvantage in imitating valuable and rare resources = sustainable competitive advantage: intangible and bundles of resources more costly to imitate.

• Unique historical conditions: first mover advantage, path dependence • Casual ambiguity: bundling fogs actual casual links • Social complexity: unable to duplicate relationships exactly • Patents: periods of legal protection

Organization: align structure and control mechanisms to exploit resources and compliment other resources within firm (3M rewards innovation and risk taking). * Valuable, Rare, Imitate, Organized resources = sustainable competitive advantage.

Greiner’s model of Org. Growth: Phase 1: growth by creativity…crisis by style of management Phase 2: growth by tight management…crisis by autonomy Phase 3: growth by delegation…crisis by control Phase 4: growth by coordination…crisis by bureaucracy Phase 5: growth by team spirit…crisis by unknown factors *Firm grows as organization evolves…each new phase sparked by revolutionary infusion

Organizational Structures: Simple: low revenue base, simple product-market scope. Functional: increase in revenues, engage in vertical integration.

Cost Leadership: operations = main function. Process engineering > R&D. Large centralized staff, formal procedures, and highly structured job roles. Differentiation: marketing = main function. R&D, decentralization emphasized. Foster change and promote new ideas with organic, less structured job roles.

Divisional: expand into new/related product markets and/or geographic areas. More autonomy for divisions: corporate staff relegated to logistical and general strategic oversight. Divisions are solely responsible for functionality. *Decentralized structure (i.e. Nucor).

Matrix: expand internationally: extension of divisional concept to project level.

Mintzberg’s Organizational Theory: 5 Basic Elements Operating Core: employees perform basic work related to organization’s product. Strategic Apex: corporate executives responsible for running entire organization. Middle Line: managers transfer information between higher and lower levels of organizational hierarchy. Technostructure: organizational specialists responsible for standardizing various aspects of organization’s activities. Support Staff: individuals provide indirect support services to organization.

5 Organizational Structures: The Simple Structure: young, small; nonsophisticated technical system; simple, dynamic environment. (Key: strategic apex) Machine Bureaucracy: old, larger; regulating, nonautomated technical system; simple, stable envir. (Key: technostructure) The Divisionalized Form: diversified markets (esp. products & services); old, large. (Key: Market grouping, performance control, limited vertical decentralization) The Professional Bureaucracy: complex, stable envir. Nonregulating, nonsophisticated technical system: (Key: Operating Core). The Adhocracy: complex, dynamic envir.; sophisticated and often automated technical system (Key: Support Staff) *The Idea Organization: Value-based organizations, public/religious organizations…Jehovas Witnesses, Greenpeace, Al-Qaeda, IRA

Activity Systems:


Configurations exhibit high degrees of internal fit. Interplay of complementarities and trade-offs across multiple activities is critical to success...equifinal (different, yet equally effective methods). Must extend and strengthen fit among activities according to strategic position.

What is strategy? Unique position, tailored activities, clear tradeoffs, continuity of position with consistent improvement and integrated system of activities with fit. What is not strategy? Best practices, learning, agility, flexibility, restructuring, mergers/consolidation, alliances or the Internet.

Game Theory:

1. Structure of games: • Players – any number of persons • Rules – determined by the number of options/alternatives in the play of the game. Structure of

play off matrix is a function of the rules of the game. • Payoff Structure

1. Zero sum: one side must get less if the other gets more 2. Non-zero sum: not an equal trade off of +/-

• Strategies 1. Minimax – to minimize the maximum loss; defensive strategy 2. Maximin – to maximize the minimum gain; offensive strategy 3. Tit-for-Tat – always respond in kind 4. Tat-for-Tit – always respond conflictually to cooperation and cooperatively towards

conflict

2. Moves to change the game played: • Players: can bring in customers, bring in suppliers, bring in complementors, or bring in

competitors. • Added Value: can limit the supply, raise amount of consumers are willing to pay, or lower

competitors’ value. • Rules of the Game: can change the rules to benefit you • Tactics employed: can make the game more transparent or opaque, depending on which

benefits you • Scope of the Game: you can link games to other games or de-couple the game from other

games.

3. Basic games: Prisoners’ Dilemma – The result of using a minimax strategy. It assumes no communication. Strategies can be altered if there is sufficient trust between the players. Both confess at the saddle point. Characterized by T > R > P > S

• Temptation: desire to double- cross other player • Reward: cooperate with the other player • Punishment: from playing it safe • Sucker’s pay off: for the player who is double-crossed

Chicken – there is no saddle point. No matter what one player choose, the other player can change for some advantage. It is unstable and the outcome cannot be predicted, but credible commitment can persuade the other player to back down

Dilemma of the Commons – the problem of the unregulated use of a public good. Someone takes advantage of a shared good and profits himself but reduces the overall capacity of the market, hurting the rest of the group.

Competitor profiling


Complements game theory w/ competitor profiling to work around restrictive assumptions on which game theory is built

Behavioral perspective • Focus on competitors’ predispositions • What competitors really want given beliefs, blind spots, and historical gathering

Why Competitor Profiling Matters • Goals may not be fully rational

• Differences in an organizations’ charter (public, non-profit, family-owned) • Beliefs—see the world differently

• Mental models may differ (diff. in functional backgrounds) • Agency problems (top-management’s interests may be different) • Irrationality (pride, jealousy, fairness)

• Routines may constrain opportunities for action • inertia due to size/family/maturity/complexity/strong culture/bureaucratization

Integrating game theory and competitor profiling • Think Broadly about the set of strategic options

• Variables (organization, customers, pricing) • Asymmetric • Commitment postures • Information

• Augment your toolkit for dynamic Analysis • Scenario analysis (role-playing/devils advocate) • Market testing • Sequenced rollout

• Match analytics and industry/company context • Do general assumptions hold in the industry/company? • But: question industry logics/orthodoxies

Value chain analysis, including value creation, value division, value added, the value net

Value added chain analysis (Harnishfeger Case)

• Why Value Creation? • Before who gets what, determine what there is to get

• Assessing= • Who are the players? • Customers willing to pay? • Suppliers’ opportunity costs?

Value Chain • Production Flow

SUPPLIER resource or input BUSINESS product/output CUSTOMER

• Monetary flow ($) CUSTOMER BUSINESS SUPPLIER

Value Creation

SELLER (indifferent) Opportunity cost


Cost (profit) Price Willingness to pay BUYERS

Value Created = buyer’s willingness to pay – supplier’s opportunity costs

• Price measures the division between business and the customer • Cost measures the division of value between business and supplier

Value Added = total value with you – total value w/o you • What you bring to others

| Cost | Price | (positive bargaining zone) | Willingness to pay

Size of the pie = willingness to pay – opportunity cost

Division of the pie = value added

Value net

Customers

/ | \

Competitors Company Complement

\ | /

Suppliers

Standards/network externalities and their role in strategy (open/closed, tactics etc..)

Standards matter whenever products depend on compatibility

Strategies • Hold back product launch • Adopt a simple, undifferentiated, standard design • Encourage imitation by other manufactures • Lower prices to maximize early sales

• Sony vs. JVC


• Standards introduce network effects • Benefits that come from having a large installed base of users • Classic examples are literal networks

• Telephone • Fax • Internet

• Number of possible connections grow rapidly w/ number of users – “network externalities” • System w/ one user is of little users • System w/ all customers on is very valuable

• Windows vs. Mac

Wins and looses • Consumers

• Better off • Reduced uncertainty • More users, more value • Decrease in variety

• Complementars • Generally better off • Brokering role

Key Points • Understand the positions and interests of all pates involved in the standards competition • Strength of position – 7 key assets

1. Control over an installed based 2. Intellectual property rights 3. Ability to innovate 4. First-mover advantages 5. Manufacturing 6. Strength in complements 7. Reputation and brand name

• Preemption • New technologies require champions to invest early to build • Being first can back fire if there are better technologies arriving soon

Expectations Management • Engage in aggressive marketing, make early announcements of new products, assemble allies, make visible

commitments to your technology • Self-fulfilling prophecies can overrule technical advantage

• Leapfrogging

Open • No one firm controls • Specs are public – anyone can build compatible products • May require license fee • May not help firm that invented

Closed • One firm • Systems can be controlled, so benefits don’t flow to a competitor • Leapfrogging may occur •


Dynamic industries and their effect on strategy

• Competitive advantages erode quickly • Established rules are broken • Industry boundaries are breached • Customer loyalty is fickle • Sustainable competitive advantages becomes a series of shorter unsustainable competitive advantages

• Internet Explorer vs. Netscape • Internet Explorer vs. Mozilla

Judo and Hardball strategies

Judo Strategy Target your opponents weakness and use it as leverage

Hardball Strategy Use “unfair” advantage

Design vs. Learning schools in strategy (fallacies, deliberate vs. emergent etc..)

Design School • Ex-ante analysis, thinking and reasoning • Assumes all relevant factors can be objectively analyzed • Assumes that this analysis precedes and dominates action – implementation follows as a separate stage • Separates thinking from doing and often implies a hierarchy – senior managements thinks – others implement • Option appraisal is conducted logically on the basis of analysis

Learning School • Strategy making takes place w/in an unpredictable world

• Creates the necessity for the flexible strategic approaches • Serendipity (accidental discoveries, luck, etc) is required for effective performance • Strategy is often made by lower-level managers – strategy evolves through autonomous action • Strategy has both intended and emergent components

Mintzberg’s 3 fallacies of strategic planning 1. fallacy of predetermination – future is unknown 2. fallacy of detachment – impossible to detach formulation from implementation 3. fallacy of formation – inhibits flexibility, spontaneity, intuition, and learning

= GRAND FALLACY – “because analysis is not synthesis, strategic planning is not strategy formulation”

Deliberate vs. Emergent Strategies Intended Strategy + unrealized strategy Deliberate realized strategy + emergent strategy = sustained superior strategy

Robust action

Allows a company to rapidly take advantage of opportunities as they occur Enables various levels and functions w/in the organization to contribute to the emerging strategies


The public company and its strengths/weaknesses

The public company faces pressure from various angles including: Wall Street – investor expectations, earnings growth, and quarterly pressures Executive Compensation – increase in overall level, use of stock options Economic Cycles Cyclical Industry

The above pressures are offset by the following methods of control: Compliance Department Disclosure Governance Ethics and integrit of participants

Strengths/Weaknesses of the Public Company Strengths Ability to raise enourmous amounts of capital and spread risk

Transparency – financing acitivites are visible and information readily available. Poor performance results in lower share values Corporation are disciplined both by their internal governance systems and by competition in product and factor markets.

Weaknesses Separation of ownership and control results in an agency problem

Lack of powerful and informed monitors results when the shareholders are widely dispersed Entrenchment incentives – management may invest in protecting their jobs rather than creating value Excessive mandated information disclosure lowers value of proprietary product and strategic information.

Agency Theory

Risk bearking specialist (principal) pays compensation to a managerial decision-making specialist (agent)

“The essence of the Agency Theory is that the Principal has inferior information to the Agent.

Moral Hazzard: the principal and agent share the same information up to the point at which the agent takes an action, but thereafter the principal is only able to observe the outcomes. Adverse Selection: the principle does not know some information which is relevant to the action (such as the ability of the agent to perform the task), whereas the agent can make use of this information to his own advantage.

Example: any time someone hires an outside consultant or contractor to perform a service for which the principal has no real input/influence that can alter the outcome aside from the directions given to the Agent. Financial Advisor or contractor (construction),

Diversification and differences in risk preferences

…. The role of the board of directors (formally and actually)

The Board of Directors is responsible for hiring, firing, monitoring, and setting compensation of the firm’s managers. They have broad discretion to direct the company’s affairs and is supposed to ensure that the firm in managed in the best interest of shareholders.


Shareholder votes are also required to approve corporate mergers, to authorize the sale of major assets, to amend the firm’s bylaws, and to authorize the issuance of new equity issues. Directors are frequently selected by management and are beholden to them for their jobs CEO’s are often on the Board which can create accountability problems. Boards too often have poor procedures of evaluation in place, both regarding management and their won performance. As a result, Board’s of Directors often exercise rather little control.

Disclosure and shareholder control (formally and actually)

Publicly-traded companies are required annually to disclose a great deal of information about corporate earnings, executive compensation, and the ownership of the company’s voting shares. Firms are also required to hold annual shareholders’ meetings that are open to all owners of common stock Prior to these meetings, corporations send out proxy statements to shareholders that describes: The meeting agenda Spells out precisely which issues are to be voted on by shareholders

Provides a form for shareholders to use either to vote personally at the meeting or to assign their right to vote to someone else.

How corporate control is really exercised… Most corporate elections are usually staid affairs where shareholders are asked to vote for or withhold their vote for single slate of company directors Proxy fights occur when a rival group of shareholders nominate a slate of alternative directors who do not support the current management team.

-This is relatively rare due to the expense to shareholders As a result, shareholders often have little opportunity or incentive to actively engage in corporate control.

Compensation and stock options (formal and actually)

In 2006, avg total compensation of chief executives of S&P 500 companies was $14.78 million. This represented a 9.4% increase in CEO pay over 2005 Performance and compensation have a cloudy connection when it comes to CEO’s Compensation on average was comprised of: Salary (cash): 20%

Short term incentive plans (bonus): 20%....usually tied to specific performance measures such as ROI or net profits

Long term incentive plans (stock options): 60% Other benefits (insurance, legal, pension…)

Underwater options and indexed options

Underwater option: an option in which the strike price (price you can purchase stock at) is higher than the current stock price. No reason to exercise option until this situation is reversed.

Indexed Options: Indexed options balance a company's relative stock market performance against its absolute gains. Because indexed stock options pay primarily for out performance, they are highly leveraged. This means they require more shares to deliver the same value as traditional stock options Indexed Options strip out market effects. They link an option's strike price to a benchmark such as the S&P 500 or an industry index. Executives are rewarded only for beating the benchmark


The Market for Corporate Control and Takeover Defense • Board of directors is supposed to act in the interest of shareholders; they decide things such as the

hiring and firing of upper-level management. Shareholders must vote on things such as major sales of assets, mergers et cetera

• How the corporation controls this: Directors are selected by management, and owe them for their jobs; CEO are very often the head of the boards of directors, causing accountability problems

• Boards of directors therefore usually have very little power over companies • Stockholder meeting are usually set up by companies to be intimidating, hard for stockholders to ask

questions or make any comments • Voting for directors is usually ‘yes or no’ for a proposed slate of new directors • Shareholders are too fragmented to really put up any fight against current management • The market thus operates when firms face the risk of takeover when they are operated inefficiently.

Many firms begin to operate more efficiently as a result of the “threat” of takeover. Hence, the market allegedly acts as an important source of discipline over managerial incompetence and waste

• However, it’s an expensive last resort...and often doesn’t work!

Predictable Surprise • The learning school theory: remember that you can’t just depend on one core competency and ignore

changes in the environment, things change • Externalities will have many effects on business operations, predicting these surprises is an important

part of strategic thinking

Corporate Crime and Strategic Control Systems, Warning Signs, and how to control it (KPMG guidelines) • White collar crime is a very big problem, yet it is seldom investigated • Most companies aren’t doing very much about the threat of fraud in the business world • Managers often feel enormous pressure to meet financial expectations, and will do a lot to try to meet

these numbers, even if some of it is unethical • Company culture has a large effect on the amount of white-collar crime going on • Some warning signs: Kill the messenger attitude in the company; low confidence in accounting

statements; employees seldom refer to ethical conduct codes when making decisions; top management ethical statements seem to be just for the public; people who ignore ethics but produce good numbers are promoted

• How to control crime: find out what the risks are in your company, address these specifically; make views on fraud known; create a culture that looks down on corporate crime; ensure that internal controls are effective; develop a response plan when fraud comes up; be strict on fraud when it is found

• Good news: The majority of consumers will switch to brands/ stores when they are found to be ethical

BUAD 497 Final Study Guide- Scott Exner

I. 7-S Framework The 7-S framework is a management model used for internal analysis describing the 7 interconnected factors to:

• Organize a company in a holistic and effective way (create alignment among depts.) • Determine “doablility” of strategies • Examine the effects of change on the Org. • Examine functional/dysfunctional aspects of the Org.

• Strategy – a plan of action to maintain competitive advantage over the competition • Systems – measures and actions which accommodate the execution of daily activities • Structure – the way the organization is structured, who reports to whom • Style – how do you lead? Personal style? • Shared Values – company culture, work ethics etc


• Staff – company employees and their capabilities • Skills – core competencies of the company as well as that of its staff

• Successful strategy implementation requires the alignment of all the seven S’s—fit is just as important inside as outside!

II. Beer’s formula for organizational change and…

Δ = f(D•M•P) – C

Δ is the effectiveness of change, a positive function of D (dissatisfaction), M (model, or vision), and P (change process) that need to be greater than C (cost of change).

III.…Leading organizational transformations

When implementing a new strategy, start with the hard part of operational improvement! Only then make the transition to improving the work environment.

IV.Five forces of management and strategy execution

I couldn’t find any info relevant to the graphic provided by Peaches in slides of online.

• Many excellent strategies fail because of poor execution • Good execution accepts the role of communication and politics • Good execution is flexible enough to roll with the punches and builds options into the process è

robust action

V. Small world effects, direct/indirect ties, strong/weak ties, and the strength of weak ties

• Small World Effects: People know neighbors, distant people, and people at random Small World of Connections (i.e. 6 degrees of Kevin Bacon). The first five random links reduce the path length of the network by half!--> Small World Networks should be everywhere!!!

• Can be seen in Al Qaeda, Marketing, Connections amongst industry leaders • We tend to use “weak ties” (Granovetter) and also friends-of-friends, because they are more

likely to have non-redundant information • Direct and indirect ties are positively related to innovation • Alliance Networks: Access to know-how, contacts, resources expands the size of radar screen

and make you detect technological discontinuities, emergent markets, new designs. The position of the firm in the alliance network also determines the propensity to collaborate.

VI.Network foundations of social capital Social capital is a “useful metaphor,” explaining “how people do better because they are somehow better connected with other people- What mechanisms form foundations of?

• When focused on a single person, the network is fragile! • As structural cohesion increases, fewer nodes are able to control resource flow within the

network. • Power, Information, Norms and Values, Informal Social Control is more uniform for better

foundation, less freeriding (Community Character)


VII.Structural holes, brokerage and closure, strategic network expansion Structural Holes are contact disconnects- create social capital via brokerage opportunities. Structural holes provide important benefits.

• Brokers occupying structural holes earn bigger bonuses • Managers located in structural holes are promoted earlier in their careers • People located in structural holes often have “better ideas” than others

Combine Brokerage and Closure:

Strategic Network Expansion was just this lame graphic, basically means build contacts from contacts in different industries I think…

Takeaways: • It is the diversity of contacts that generates social capital—strength in weak ties • Network centrality and structural holes are important for determining power and knowledge flows—

both for firms and for your personal experience. Brokers do better! • Social capital and power come from bridges that person can build between others!


BUAD 497: Strategic Management Informal Cheat Sheet for the Final Exam Spring 2007

Listed in chronological order: Porter’s 5-Force framework, PEST and SWOT frameworks Porter’s Generic Strategies Hambrick & Fredrickson framework (from “Are you sure you have a strategy?”) BCG and McKinsey matrices Core competency and resource-based view of the corporation VRIO framework Greiner’s model of org. growth and classic growth patterns of firms Organizational structures (simple, functional, divisional etc.) and their relation to strategy Mintzberg’s approach to org. structure Activity Systems and strategy as positioning/configuration/fit Complementarities, tradeoffs, equifinality, fit Game theory, the structure of games, moves to change the game played Basic games such as PD, Chicken, the Dilemma of the Commons Competitor profiling Value chain analysis, including value creation, value division, value added, the value net Standards/network externalities and their role in strategy (open/closed, tactics etc..) Dynamic industries and their effect on strategy Judo and Hardball strategies Design vs. Learning schools in strategy (fallacies, deliberate vs. emergent etc..) Robust action 7-S Framework Beer’s formula for organizational change and leading organizational transformations Five forces of management and strategy execution Small world effects, direct/indirect ties, strong/weak ties, and the strength of weak ties Network foundations of social capital Structural holes, brokerage and closure, strategic network expansion The public company and its strengths/weaknesses Agency theory, moral hazard, adverse selection (think of examples!) Diversification and differences in risk preferences The role of the board of directors (formally and actually) Disclosure and shareholder control (formally and actually) Compensation and stock options (formal actually) Underwater options and indexed options The market for corporate control and takeover defenses Predictable surprise Corporate crime and Strategic control systems Warning signs of deviant org. cultures KPMG’s recommendations on deterring employee fraud


BUAD-497: Assignments

Professor Fiss Individual Mini Case Analysis

BUAD-497: Tuesday-Thursday 12-1:50 PM ID#6390.4899.77



1) The sales growth in McDonalds Coffee of thirty percent over the past year since the

introduction of McCafe has reinforced Sgro’s belief that a bold move into a more dedicated

retail coffee offering in McDonalds’ restaurants provides value. Nonetheless, this is not to say

that the current success of McCafe has completely solved the problem of McDonald’s

lackluster breakfast offering. First, to tackle the issues facing McDonald’s breakfast sales, one

must look at the value that these breakfast items bring to the quick-serve breakfast industry.

Clearly, McDonalds is an industry leader in providing good-quality products quickly at a low

price. The restaurant had continued to offer this value in their breakfast menu, but hadn’t

vigorously sought innovative new breakfast items or changes in the menu to match changes

occurring in the industry. As a result of this oversight in McDonald’s product management,

the fast-food leader was quickly losing ground in breakfast sales to its competitors, namely

Tim Hortons. As McCafe brings value to McDonald’s breakfast menu by turning McDonalds

into a one-stop-shop for breakfast and coffee, something valued in the industry as seen by the

melding of Wendy’s and Tim Hortons as well as others, McCafe does not solve the

McDonalds’ breakfast menu’s lack of dynamism.

2) If McCafe were to be introduced years before the case date, it may have been much

more rare than it actually was at its introduction. The ‘McCafe’ concept had become more of

an industry trend than an exception, with many major quick-service retailers offering similar

value to McDonald’s McCafe integration. At the time, Tim Hortons had already begun to

broaden its breakfast offerings, essentially offering similar value to that provided by a

McDonald’s with a McCafe. The advantage McDonalds would have over Tim Hortons in this

arena would have been its historically efficient operations; Tim Hortons, though, has

challenged this advantage after being purchased by Wendy’s, another quick-service chain that



has brought its operating efficiency to Tim Hortons coffee houses. Furthermore, Tricon Global

Restaurants, which includes KFC, Pizza Hut, and Taco Bell, had already begun to offer menus

from these three restaurants in different combinations under one roof, the success of which has

further strengthened the idea that combination restaurants are appealing to consumers.

Concurrently, there is strong evidence that multiple offerings under one roof, such as

McDonalds and McCafe, are more attractive to consumers than a restaurant that serves only a

menu similar to McCafe’s. Nonetheless, McDonalds is not a first mover in implementing this

idea, as the industry has already been busy making a trend out of this concept.

3) McCafe is imitable, to an extent. For the most part, as mentioned in the above

paragraph, Tim Hortons in collaboration with Wendy’s has largely already implemented this

concept in their international operations. Other restaurants in the quick-serve industry cannot

imitate McDonald’s strategy in a very important way, though. McDonald’s brand image is

arguably stronger than any other restaurant, especially the “Mc” branding. Further, McCafe

has attempted to differentiate itself with its coffee delivery. While its competitors take a few

minutes to make each cup of specialty coffee, McCafe’s machines take only seconds to brew

up the same coffee. While this speedy delivery may prove to differentiate McCafe enough for

some gain in market share, its competitors are sure to react quickly to this strategy. Other

coffee and breakfast providers, such as Tim Hortons, are likely to either switch to these faster

machines or advertise that their coffee is made the ‘right’ or ‘original’ way, and that it is

somehow more genuine than the mass-produced McCafe coffee. Further, Wendy’s may

further promote the strategy they have been using largely in their international restaurants,

melding Tim Hortons and Wendy’s together in one restaurant, by bringing this strategy to the

Canadian market. While McDonalds’ McCafes may help the restaurant chain to regain some



market share in the quick-serve breakfast market, competitors are likely to respond with similar

offerings or strong product differentiation.

4) The McCafe concept falls directly in line with McDonald’s organizational structure.

McDonalds has been organized to depend on low-cost largely unskilled labor, quick service, a

strong brand image, and overall low product cost to consumers. Further, McDonalds allows

consumers to enjoy their orders in a variety of ways: take-out, eat-in, and drive-through. The

new McCafes took advantage of these operating efficiencies by utilizing new coffee

technology that allows for unskilled workers to quickly brew premium coffee at a low cost to

the consumer as per McDonalds’ trademark efficiency. In tandem, customers can order their

premium coffee with take-out, drink-in, and drive through, all on the same receipt as their

McDonalds breakfast order. As McCafe so closely follows McDonalds organizational

structure, the restaurant will have the knowledge in operating efficiency to be a cost leader in

the premium coffee industry in Canada. While others, such as Tim Hortons and Wendys, may

have similar restaurant structures with menus similar to McDonalds and McCafe, they may not

be able to achieve the operating efficiency of McDonalds that allows for such low prices.

Therefore, McDonalds will be able to achieve a sustainable competitive advantage in the low-

cost quick-serve premium-coffee market that also serves a breakfast menu as a result of its

historically strong operating efficiency and strong brand image. Nonetheless, competitors may

be able to capture market share by differentiating themselves as more genuine premium coffee

servers that don’t use mass-produced machine-made coffee. Further, if Wendy’s were to

further integrate Tim Hortons into its operations, it may be able to achieve the operating

efficiency of McDonalds and McCafe, therefore diminishing the McCafe competitive

advantage.



Professor Fiss Take-Home Midterm

BUAD-497: Tuesday-Thursday 12-1:50 PM ID#6390.4899.77



2

1) An analysis of the steel industry based on Porter’s five forces model reveals that

rivalry is high, due not only to the basic five forces in the industry but also to powerful

changes in the global steel market. To begin, the threat of entrants into the steel industry

is low. The primary reason for this threat level is due to the high costs of entry. Steel

manufacturing mills are extremely expensive to build and maintain, leading to a low level

of new entrants into the market, especially given the state of the industry today. Namely,

the industry has been blanketed with over-capacity in the United States while it has been

experiencing little growth. Therefore, there is little incentive for new players to enter the

market, as providing more capacity in the industry would be of little value to buyers.

Buyer power, alternatively, is relatively high in some respects but low in others.

Overall, buyer power is rated to be medium. On one hand, there are few possibilities for

differentiation in the steel industry, lending buyers the power to bid competing steel

manufacturers against each other for the lowest possible price. Further, buyers arrive one

at a time for purchases, in a sense. In other words, when a buyer is interested in placing

an order for steel, steel manufacturers line up all at the same time to bid on supplying the

product to the buyer. Therefore, buyers can easily force these undifferentiated steel

manufacturers into a bidding war that drives margins down for manufacturers. As H.

Aycock, former Nucor chairman and CEO, said, “The key to making a profit when

selling a product with no aesthetic value, or a product that you really can’t differentiate

from your competitors, is cost.” On the other hand, some companies in the industry have

shown an ability to differentiate their steel product in some ways. Although this has been

limited, manufacturers such as Nucor have offered services along with their product such

as in-house engineering that provides the buyer with a product that is uniquely designed



3

for their use of the product. Conversely, the high transportation costs of steel products

lowers buyers ability to bid manufacturers against each other, as the number of

manufacturers that can be bid against each other is limited to those within a reasonable

proximity of the buyer. Finally, the ability of buyers to backward integrate is limited due

to the high barriers to entry into the steel manufacturing industry mentioned earlier.

The threat of substitutes in this industry is relatively high. The largest threats are

lighter metals and stronger alloys as well as plastics and synthetics. As technology

develops, these types of products have been used more and more in applications typically

reserved solely for steel, such as the side paneling of new cars. Further, many other

consumer products, such as bicycles, are being made from these new materials. While

the steel industry clearly has a future with stable purchasers, such as the construction

industry, technology has allowed substitute products to become more of a threat to the

steel industry than what the industry has seen in past decades.

The power of suppliers, like buyers, is rated at a medium level. First, suppliers of

the minerals and scrap steel required for steel production aren’t able to demand a very

high margin on their products. While the steel itself makes up a significant portion of

costs in this industry (sixty percent in the case of Nucor), the mini-mill developed by

Nucor has allowed backward integration to eliminate suppliers in some cases and cause

low supplier margins in other cases due to the threat of backward integration. The

industry’s other primary supplier, employees, have high bargaining power. Many of

those employed in this industry are members of unions that demand high wages and

benefits, while others who aren’t unionized are paid high wages and given steep benefits

in order to compensate for harsh working conditions. The power of employees in this



4

industry becomes clear after reviewing their incredibly high wages, which is usually

double the average wage in the manufacturing industry in the United States.

Rivalry among firms is very high. There are a variety of reasons for this. First,

foreign competition made a strong entrance onto the US steel-manufacturing scene and

had more of an impact on domestic competitors than it should have. It was found that

many of these new entrants were being unfairly subsidized by foreign governments or

were ‘dumping’ into the United States. Secondly, the industry has been burdened with

overcapacity, leading to intense rivalry among firms. Further compiling on top of this

overcapacity are barriers to exiting the industry. These barriers of exit keep firms in the

industry that are under bankruptcy protection or that aren’t making a profit on their goods

sold. Third, the industry growth rate has been slow in many of the developed nations of

the world that are home to competitive multi-national steel manufacturers, leading to

intense global competition. All of these factors contribute to the intense rivalry seen in

this industry. Overall, the industry is not very attractive in the state that it is currently in.

To compete in this type of industry, a firm will do best to challenge the tough

powers working against it. Namely, in order to combat supplier power a firm can

backwards integrate and automate the production process to reduce necessary manpower.

In order to combat threat of substitutes and buyer power, a firm might find a way to

differentiate its product by bundling other services with it. To combat intense rivalry, a

firm could take advantage of its excess capacity by expanding into developing markets

with a higher industry growth rate.

2) Central to Nucor’s activity system is low cost. As mentioned in the previous

pages, H. Aycock can be directly quoted in saying that cost leadership is essential to the

Nucor activity system. Leading to this low cost advantage first is Nucor’s lean



5

organizational structure. Nucor puts a very strong emphasis on keeping executive

management limited, with a total corporate staff of less than twenty-five when 1999

began. This is achieved by having a decentralized management system, where very little

corporate oversight is present. Managers of individual mills and manufacturing plants

are given nearly full autonomy of operations, and operations such as engineering and

software development are operated independently in each facility. Further, executives

within the company don’t receive the traditional perks usually associated with their

position, such as private jets and plush corporate offices. This lends to employee loyalty,

lower costs, and a lean company culture.

Also important to Nucor’s activity system is their unique incentive-based

employee compensation system. With this system, employees are given bonuses based

on the amount of production that is reached in a week that is above a standardized

production rate. This system leads to increased employee loyalty, decreased employee

turnover rates, and more satisfied employees who don’t demand unionization. Although

they pay their employees more per hour than the industry average, Nucor’s incentive

system leads to a more productive employee base and a strong company culture. This

productivity leads to lower product costs, and their more self-reliant employees are able

to self-manage in Nucor’s decentralized management structure.

Further strengthening Nucor’s activity system, technological innovation adds

value to the entire organization. Nucor’s emphasis on technological innovation is

strengthened by in-house engineering in each individual facility that caters to the

different demands of customers in different regions and industries, which is supported by

the decentralized management structure explained earlier. Further, innovation in the firm

led to the development of he mini-mill system of manufacturing, which allowed for



6

backwards integration and lower costs. Other technological innovations included the

placement of electric arc furnaces in their mini-mills to increase efficiency and, again,

lower costs.

In an industry where low costs and local innovations are key to success, Nucor’s

activity system has provided these values enough to become a major competitor in the

steel manufacturing industry. The four core elements of Nucor’s activity system, an

incentive-based employee structure, technological innovation, a lean organizational

structure, and low costs, lend to a product that provides a great value to buyers. (See

Appendix #1: Nucor Activity System)

3) One change in Nucor’s organizational structure involved the overcapacity of the

steel manufacturing industry in the United States. As capacity utilization was about

seventy-five percent, opening new plants and adding to this over-capacity would not be

beneficial. Although Nucor had traditionally opened Greenfield plants, this structure had

lost its effectiveness in the current state of the industry. Thus, the firm’s executives

decided that they would move towards mergers and acquisitions.

The other relevant move by the management of Nucor was the decision to add a

level of management to the corporate office staff: four new Executive Vice Presidents

and two specialist jobs in strategic and steel technology. The reasoning for this change,

as stated by Aycock, was to enable corporate headquarters to get back in touch with

independent facilities. Although this move appears to be a clear departure from the

companies tried-and-true activity system, it actually falls neatly into their strategy.

Specifically, as competition increased and Nucor grew in size, the small corporate office

staff began to lose touch with independent facilities. Thus, the entire organizational

structure was deteriorating, which led the organizational structure to be not lean but,



7

more accurately, non-existent. In order to keep the ‘lean organizational structure’

element of their activity system intact, it was necessary for Nucor to keep communication

intact and expand the number of employees in corporate operations.

4) Nucor’s options for future strategies include the option of doing more of the same.

That is, keeping their newly altered organizational structure with a slightly larger

corporate staff. Further, mergers and acquisitions would lead their development in the

United States. Yet another option for Nucor would be to focus more on expansion

overseas, in markets where the steel industry is growing much quicker than in developed

markets. This option would allow for Nucor to utilize some of its excess capacity

without trying competing in the over-saturated US market. A third option would be to

focus on technological innovations that would lower costs and allow for a lower cost to

the buyer.

I would recommend a combination of two of these strategies. The best option for

Nucor is to continue with mergers and acquisitions of other steel-manufacturing firms in

the United States, but place more of an emphasis on technological development that

would reduce their costs of steel manufacturing. This is best because it allows Nucor to

sustain one of its primary and more important competitive advantages as a company: a

very productive self-reliant workforce that is able to manage itself. This advantage might

not travel internationally, thus Nucor must focus on the domestic market. In order to

compete in the domestic market, price must be lowered by technological innovation.

Further, in order to grow as a company, mergers and acquisitions must continue in order

to develop the company but not add to the over capacity of the US market.



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BUAD-497: Class Notes

1

1: Extremist Religious Ideology Al-Qaeda Defined

Al-Qaeda is a radical political group driven by an interpretive religious ideology.

Literally meaning “the base,” al-Qaeda is the core of an international network of Islamic

terrorist organizations. Its goals include eliminating foreign influence in the Muslim

world, especially American forces in Saudi Arabia, eradicating those deemed to be

infidels, recapturing Jerusalem, and establishing a new Islamic caliphate. Ultimately, it

hopes to create Islamic states and build a formidable army with nuclear capabilities to

wage war on the Western world.1 Led by Osama bin Laden and Ayman al-Zawahiri, the

evolution from a brick and mortar organization to a decentralized global network is

transforming terrorism. Appendix ‘A’ provides a timeline of al-Qaeda’s significant

events. Their popular ideology makes them a performance and networking leader.

Technology is the vehicle inspiring believers to become recruits, willing to sacrifice

everything because of a steadfast dedication to the message of al-Qaeda’s ideology.

Radical Influence

Al-Qaeda’s ideology is a Sunni Islamist movement using the mujahadeen to

pursue jihad against the influence of the West. Although the literal meaning of jihad is

not directly correlated with the popularized definition as a holy war, the influence of

radical religious factions removes all but this military context from the word. The six

rules of jihad and the Koran clearly state that deliberate killing of noncombatants is

forbidden unless they are conspirators.2 However, modern Islamists, including bin Laden

and al-Qaeda’s ideological leader, al-Zawahiri, extend the religious boundaries of

interpretation to generate support for their political agenda. They select elements of

tradition and modernity to create a unique religious perspective. Al-Qaeda’s leadership

BUAD-497: Group Project

2

understands the significance of its ideology as the fundamental core of its global strategy.

Implementing a broad platform that appeals to the greater cause of martyrdom rather than

targeting specific rules is instrumental to understanding why al-Qaeda is the world’s

leader in terrorism.

It is important to note that al-Qaeda was conceptualized by Abdullah Azzam, not

bin Laden. Azzam was not a proponent of resorting to terrorist tactics because of the

grave implications on future negotiations and hopes of peace.3 After his assassination, an

act some believe to have been ordered by bin Laden himself, al-Qaeda was free to

broaden the appeal of their ideology to attract the widest possible support base. With al-

Zawahiri and other religious scholars at his side, bin Laden used Qutbism and takfir to

create an indiscriminate brand of Islam closely resembling the unifying philosophy of

Salafism.4 Strong anti-US and anti-Israeli rhetoric engenders a vast support structure

across all spectrums of radical Islam, including the second largest Islamist group

Hezbollah, a Shia organization. While many terrorist organizations have short life spans

due to their specific convictions and confinement to territorial campaigns, al-Qaeda’s

underlying goal to bridge the ethnic, cultural and secular divides between Shia and Sunni

Muslims for the greater good applies to every Islamist struggle.5 Uniting Muslims as one

coherent force fighting the tyranny of the West, al-Qaeda is instilling a locally rooted, yet

globally inspired attitude to develop its global influence.

Religious Justification Al-Qaeda engenders support from non-radical Muslims because it establishes

religious justification for its actions. Bin Laden constantly refers to the will of Allah in

both his writings and speeches, leading many to believe that he is carrying out His divine


3

requests. As the loudest voice in many areas of the Muslim world, he maximizes

effectiveness through expansive awareness of al-Qaeda’s mission. Bin Laden released

two fatwa’s, one in 1996 and another in 1998 that clearly describe his disgust of

American occupation in several Muslim countries and their unilateral support of Israel.

More importantly, he provides religious authorization for the indiscriminate killing of

Americans and Jews everywhere. 6 Although bin Laden is not a religious scholar worthy

of issuing such official Islamic decrees, he rejects the authority of contemporary Islamic

leaders and assumes responsibility for directing the jihad against the West.

The strength of this ideology lies in its overwhelming acceptance by Muslims of

all social classes. Al-Qaeda is the best at reinforcing the glory of martyrdom because of

the time and effort spent on training and preparing its operators for the reward of

sacrifice. Believing that sacrifice is the ultimate act of allegiance, suicide operators view

death as an appealing opportunity to drive fear into the enemy.7 The robust capacity for

regeneration is directly attributable to the widespread sympathy and belief in their

ideology. However, the most compelling aspect of their religious legitimization is the

danger it poses to civilization at large. Widespread politicization of radical ideas allows

al-Qaeda to dramatically influence both non-radical Muslims and the West.

Spectrum of Islamist Groups

The Spectrum of Islamist Groups is a framework separating terrorist organizations

by their goals and methods. It highlights the role al-Qaeda’s ideology plays in making it

the most feared and powerful terror network in Islamism.8 Unlike other terrorist

organizations, al-Qaeda is evolving from segment to segment as it increases its global

capabilities and presence. While their core values are revolutionary and ideological, its


4

progression from a utopian to an apocalyptic group following the attacks on 9/11 leaves it

the world’s foremost authority of terror. The only other group exhibiting such force is the

Armed Islamic Group of Algeria (GIA), an organization even bin Laden denounces for its

extreme methods. But al-Qaeda’s leveraging its ideology to validate the dramatic

escalation of violence opposed to the sheer terror the GIA is inflicting intentionally.9 Just

as Hezbollah politicized its popular national movement in Lebanon, al-Qaeda is doing so

on the global stage through its complex organization and operations. This carefully

crafted ideology threatens both Western and Islamic societies on a scale that reaches far

beyond that of traditional terrorism.

2: Decentralized Organizational Structure Vertical Leadership

Al-Qaeda’s decentralized organizational structure is guided by strong leadership,

the only vertically integrated segment. Bin Laden is al-Qaeda’s emir-general, or head of

operations. He provides spiritual council, financial governance and oversees all strategic

objectives. Next is the shura majlis who act as the organization’s board of directors. With

twenty to thirty members, including the chief lieutenant al-Zawahiri, they monitor

strategic, operational and religious issues.10 Al-Qaeda’s leadership are the lines of

authority responsible for coordination and guidance. Their insight keeps the organization

on a goal-oriented, big picture approach focusing on furthering their ideology.

Compartmentalized Operational Committees

Below the council are the four operational committees, each led by an emir who

reports directly to the shura majlis. These groups include: military, finance and business,

Islamic study and fatwa, and media and publicity. It is the duty of the committees and


5

regional networks to oversee day-to-day operations and implement al-Qaeda’s specific

operations

Military The military committee trains, recruits and acquires military resources without

disrupting their decentralized structure. Current estimates indicate Al Qaeda camps have

trained more than 100,000 Islamist militants, with over 120 camps operating in

Afghanistan at the time of 9/11, although they retain only “a small number of militants

under direct orders.”11 Organizational success requires constant attention to internal and

external changes within an organization’s environment. As Al Qaeda grows, its

leadership has reconciled the challenges faced by expansion through self-sufficient and

independent terrorist cells. Al-Qaeda created precise training resources, namely the Al

Qaeda Field Manual, Encyclopedia of Afghanistan Jihad and the Declaration of Jihad

Against the Country Tyrant’s.12 These comprehensive training manuals cover everything

from doctrinal values, military principles, recruiting and the importance of teamwork.

Discussing issues ranging from assassinating enemy personnel to qualifications for

becoming members, these manuals lay out exact directions for how to live a life free from

conceptual problems and full of religious principle.

Finance/Business

Although al-Qaeda is popularly seen as an illegitimate organization, much of its

financing is quite legitimate. With many terrorist organizations resorting to illegal

activities, including kidnapping and drug trafficking, al-Qaeda focuses on genuine

businesses like diamond trading, import/export, construction, manufacturing, transport

and financial services. Nonetheless, some funding has been tracked to fraud, currency


6

counterfeiting, document forging and wealthy individual supporters through infiltration

of various charities and non-governmental organizations (NGO’s). Al Qaeda's financial

network is valued at approximately three-hundred million dollars, with annual dispersion

between thirty and forty million a year. Organizing collection and distribution are

members of al-Qaeda’s finance committee. Professional bankers, accountants, and

financiers control the large and diverse supply of funding. An operational doctrine

teaches operatives frugal financial behavior, self-sustaining financial tools, deception and

denial.13 The entire financial network is built on a base of operationally strong terrorists

and networked financiers, allowing it to be extremely adaptive and flexible. Its means of

sourcing, hiding, and distributing funds are numerous and complex. Although the US has

had some success in freezing funds, the complexity of the organization minimizes the

pervasive effect on al-Qaeda as a whole. As of 2004, every Al Qaeda cell carrying out a

successful terrorist attack has received its funding from a different source.14

Al-Qaeda’s primary objective is to carry out financial activities that limit record

keeping and potential tracking. Focusing on discretion and decentralization, operatives

are trained to manage finances, forge documents, participate in credit card scams and

hack into accounts. Many cells are expected to be almost fully self-reliant in terms of

funding, a slight change in structure that followed the World Trade Center bombing of

1993.15 Al Qaeda cells were required to be too self-sufficient; the operative involved in

this attack didn't have sufficient funds for buying enough explosives to do substantial

damage to the trade center, nor did they have the funding needed to fly out of America

(leading one of the operatives to foolishly return to the dealership for a deposit refund on

the van carrying the explosives). Thereafter, a portion of funds raised by individual sects


7

is pooled for redistribution to groups planning major attacks. As described in Al Qaeda's

military training manual Declaration of Jihad Against the Country's Tyrants, the

commander of each cell also divides remaining funds into those needed for operational

activity and those to be invested for financial return.

Through international banking, the Islamic banking system and the underground

hawala network, al-Qaeda easily hides funding sources and distribution channels.

International banking does not have heavy regulations or authorities to pursue potential

terrorist activity. The Islamic banking system suffers from even weaker oversight due to

the poor economic state of most developing countries using this construct. Finally, the

hawala network is widespread, even in the US, and has no records of transactions or

financial systems. The business environment in which Al Qaeda operates contributes

greatly to their ability to conceal their methods. 16 Through these frameworks, al-Qaeda

raises substantial amounts of funding and redistributes them across the globe, all under

the watchful eye of seemingly powerless anti-terrorist organizations and governments.

Islamic Law The Islamic Law committee serves as the lightning rod for growth and creating

cohesion between its decentralized units. Combining their intangible ideology with

various resources, especially human capital, has far reaching effects on expansion. The

many “loosely-organized and widely-disbursed movement or ideology comprised of

many small and localized "self-generating" terrorist cells and individuals”17 responsible

for the bulk of al-Qaeda activities are linked by religious foundations in Islamic Law. Al-

Qaeda roots its battle on the West in the Sharia, or Islamic Divine Law, illustrated by the

fatwas placed upon the West. Maintaining a low profile in its role in global terrorism


8

without wavering its ideology allows al-Qaeda to maximize its effectiveness. 18

Legitimizing their actions as a struggle for social justice in combination with the power

of religious indoctrination is providing al-Qaeda with both rapid growth and continued

success.

Media and PR This committee molds al-Qaeda’s public image, aiming to garner support

throughout the Muslim world and further insight ill-will against the West. Their strategy

and methods are discussed in detail in Part 3: Strategic Use of Digital Technologies.

Expansive Global Network

The remainder of al-Qaeda exists in an intricate global network of independent

cells and affiliates. Al-Qaeda’s strong leadership provides financial, logistical, and

strategic guidance to an estimated six to seven million radical Muslims worldwide,

roughly 120,000 of them willing to resort to violence.19 The ability to draw on countless

independent operators at any time makes their options limitless. Using an arms-length

network with some strong ties, al-Qaeda’s decentralized structure acts like that of a

consulting firm or holding company facilitating communications with its subsidiaries.

Most members of al-Qaeda are actually associates without inside access to the

organization. Only a special few whose devotion is constantly tested make up the strong

ties within the network. Maintaining maximum security and integrity within the

organization is the driving force behind this specialized arms-length approach.

Much like the compartmentalized committees, cells are designed to be completely

self-sustaining and independent of one another. The “family” idea developed in their

training camps is the basic construct for members. Each family represents a separate


9

nationality. From these families, cells ranging from two to twenty people are organized

for specific missions. Whether its surveillance, active reconnaissance or a suicide

bombing, these teams are well prepared and fully aware of their objectives. The level of

trust remains high even among members from different families because of their common

bond of being strict believers in the brotherhood of Islam above all else.20 With a

horizontally integrated global network, dissemination of information through different

groups is done only on a need to know basis, making it very difficult for intelligence

agencies to procure tangible amounts of reliable information. As globalization diversifies

the world, al-Qaeda understands the need for interconnectivity, but does so only when

necessary to maximize efficiency and effectiveness without sacrificing protection.

Appendix ‘B’ illustrates al-Qaeda’s organizational structure in a flow chart.

3: Strategic Use of Digital Technologies Technological Web of al-Qaeda

Al-Qaeda’s strategy is continuous reinforcement of their ideology while

remaining decentralized and anonymous. Utilizing advances in modern technology, al-

Qaeda delivers an unweaving devotion to a universal brand strategy: communicating a

single message to all myriad units. They are ahead of the curve in using digital media,

namely the internet and satellite broadcasting. Computer technologies and the internet

allow the jihadist networks to communicate, spread their ideology, and recruit new

members.21 “Terrorist websites have exploded in numbers from a dozen in 1998 to more

than 4,800 today. Modern terrorist organizations exploit the internet to raise funds, recruit

members, and execute attacks.”22 Because al-Qaeda is so decentralized with vast

networks, the use of the internet explains their superior functionality. They stay

connected in complicated webs of networks with minimal risk. Many encrypted internet


10

sites facilitate communication and interaction with security and privacy, leaving little to

no paper trail.

As the internet and digital media are developing a 360º approach, making it

available everywhere, on every device, at anytime, it is becoming the cornerstone of

modern strategic implementation. Such versatile vehicles, al-Qaeda is constantly pushing

their ideology on users at every level. Only a computer with internet access is needed to

watch and listen to bin Laden himself. The ease and speed of communication is

remarkable, especially when considering they are able to raise funds, spread propaganda,

recruit members, and execute attacks online. Be it financing, active involvement or mere

sympathy, al-Qaeda’s militaristic strategy is deeply impeded in an ideology successfully

communicated through digital media. Adoption of these digital communication networks

and methods greatly enhance al-Qaeda’s capabilities. Trying to connect an organization’s

strategy and structure through a virtual system is an abstract concept. Al-Qaeda is

currently deeply rooted in social networking sites, portable programs, and Massively

Multiplayer Online Role-Playing Games (MMORPGs).

Social Networking

Social networking sites enable al-Qaeda to recruit through propaganda of their

ideology. Children growing up with computers and the internet are exposed to jihadist

sites dedicated to rearing them on violence and hatred towards the US. They also show

graphic images of war casualties, video executions, and leader statements. This

generation of internet users is more likely to believe in conspiracies and the ideologies of

al-Qaeda because of the psychosomatic interaction between the internet and the jihad


11

ideology.23 Furthermore, user accessibility is increased through free communication

services on the internet like Skype and Voice-Over-Internet Protocol (VoIP).

Portable Programs

Al-Qaeda’s use of technology is nothing short of staggering, especially with the

recent discovery of Mujahadeen Secrets by iDefense/VeriSign. Mujahadeen Secrets is a

portable program utilizing USB and pen drive technology that does not require

installation of applications, allowing them to operate at internet or computer cafés. 24 It is

nearly impossible to trace usage of such programs beyond the café itself. The programs

are very popular because they are written in native languages, rather than English based

sites like YouTube.com. This language system increases user comfort, trust, and

understanding, ultimately allowing for easier acceptance of al-Qaeda’s ideology.

MMORPGs

Extensive research is developing the functionality of MMORPGs in business and

military arenas. MMORPGs are a virtual world where users can live in the game almost

as realistically as in real life: design their own characters, team with groups, purchase

land and other goods, and socialize through VoIPs. Popular MMORPGs are World of

War Craft and Second Life. Second Life is more “realistic” than the fantasy-warrior

planet of War Craft. “Second Life is a 3-D virtual world entirely built and owned by its

residents. Since opening to the public in 2003, it has grown explosively and today is

inhabited by a total of 5,231,598 people from around the globe.”25 The threat comes from

virtual terrorism. Extreme activists can connect online and implement 3D plans of

attacks, gather intelligence, recruit more members, and perform other aspects of

communication and networking. Essentially, Second Life allows for an entire world


12

without law or prosecution. Extremist groups “activity has included attempts to infiltrate

[other] groups, use of virtual weapons, and mass protest rallies.”26 Al-Qaeda seeks to

gain the advantage of this technology’s massive global networking capabilities and

virtual scenario executions.

Al-Zawraa TV

On November 14, 2006, al-Zawraa, a 24-hour insurgent station began

broadcasting throughout the Middle East.27 This strategically important information

outlet is overloaded with propaganda, audio messages from leaders, violence against the

Iraq government, and military footage. It is broadcast on a satellite owned by Egypt as a

“purely commercial arrangement.”28 On January 26, the signal started broadcasting from

a satellite somewhere in Saudi-Arabia. With these types of satellite collaborations,

shutting down this station is highly unlikely making the jihad ideology difficult to tune

out. The stations long term effects have yet to be measured however its content is viewed

as highly credible.29 Importantly, this is another strong communication of al-Qaeda’s

ideology and unifying strategy.

Craigslist and Decentralization

An interesting parallel is the United States concentration on Craigslist as a model

for al-Qaeda. Craigslist is merely an online bulletin board that astonishingly receives over

five billion hits a month with only 24 employees.30 This is an exemplary model of a

decentralized agency whose unifying-internal-message statement has led to vast success.

Founder Craig Newmark states: “Decentralized organizations can be more effective and

resilient. People who are passionate and can work independently can get more done than

a centralized organization.” Key to al-Qaeda’s operations, the leadership does not require


13

sub cells to report back, rather they are given a strong up front mission (ideology) and are

expected to perform independently. The combination of ideology and devotion is so

strong that each sub cell functions extraordinarily well. Bin Laden’s message to

followers: “I want to kill people and wreak havoc. Don’t check with me, or they will find

me. We’ll send money.” Not reporting back also ensures more secrecy and confidentiality

of the leaders.31 Like Craigslist, other user-generated sites provide interesting leverage

for communication between strangers. Groups sharing an ideology can develop wikis,

post videos, and join blogs. There is almost no limit to the ability of a small group to

communicate. With the extensive decentralization of Al-Qaeda, they have truly advanced

the art of military communication borrowed from innovative business models.

4: Countering al-Qaeda’s Strategy Western Response

Following 9/11, the West intensified efforts to capture and destroy al-Qaeda. The

invasion of Afghanistan left the Taliban and al-Qaeda’s infrastructure destroyed.

Although nearly two-thirds of al-Qaeda’s leadership has been neutralized, failure to

capture bin Laden or al-Zawahiri combined with al-Qaeda’s technological prowess leaves

them a major threat. The West’s inability to secure quality counterintelligence through

state-of-the-art technology underscores the need for a more inclusive strategy. A military

campaign alone will not destroy al-Qaeda. The use of satellite imagery, intercepting

communications and direct countermeasures to the digital media devices being employed

by al-Qaeda is inadequate because of their decentralization, popular ideology and

technical abilities. Focusing on these core elements rather than the peripherals of how

they spread their ideology is the only way to defeat them. A successful strategy must be a


14

fluid and dynamic approach that challenges their ideology and attacks their financial

supporters directly.

Challenge the Ideology

Discrediting their ideology is the most essential element to destroying al-Qaeda.

Undercutting their religious legitimacy by revealing their political motivations and

hypocritical actions will tarnish their movement. Damaging their reputations as religious

figures fighting for Islam will weaken their massive global support structure and create

widespread dissension. By working with legitimate leaders of Islam to inform the Muslim

world of the true extent of al-Qaeda’s actions, the West will be able to use Islam against

them. Unable to undermine their technology, al-Qaeda’s ideology is becoming deeply

engrained into the Muslim world. Western forces must challenge this key differentiator in

the global arena in order to halt this rapid progression. Until their fundamental ideology

is attacked, their cause will always have believers carrying on the fight.

Attack Financial Supporters

Attacking those that sponsor terrorism through financing or protection is the next

phase of reducing al-Qaeda’s global strength. As Colonel Gadaffi told the American’s

post 9/11, “If you want to combat terrorism, bomb London and Riyadh.”32 With various

individuals donating over $1.6 million a day to Islamic causes via charities and

investments in Saudi Arabia, the time to go after those behind terrorism is now. London

is the home to many Islamist offices and anonymous financial contributors. Moreover,

support from the governments of Iran, Syria and the Sudan to name a few, must be

stopped in order to achieve substantial military success. Al-Qaeda must be destroyed

from within by attacking their core strengths. Challenging al-Qaeda’s ideology and


15

eliminating their major financing and protection sponsors will erode their global network,

not to mention helping locate bin Laden and al-Zawahiri. With technology helping to

further their decentralization and spread their ideology, a cohesive strategy confronting

these crucial aspects simultaneously is the path leading to the ultimate destruction of al-

Qaeda in its entirety.


16

Appendix ‘A’: Timeline of Significant Events ‘80s: Maktab al Khadamat (MAK), led by Abdullah Azzam and Osama bin Laden, is a

mujahadeen financing organization used during the anti-Soviet revolt in Afghanistan begins evolving into the organization al-Qaeda.

’88: al-Qaeda is officially formed under Azzam and bin Laden in response to an outcry

for expanding assistance to Islamist struggles throughout the world. ’89: Azzam is assassinated and al-Qaeda consolidates remaining MAK members that

share bin Laden’s point of view. ’90: bin Laden returns to Saudi Arabia to find the country’s wealthy oil fields

vulnerable to Saddam Hussein’s military, who recently invaded Kuwait. Bin Laden offers his mujahadeen army to protect these natural resources, but the Saudi royal family instead allows American forces to deploy from Saudi Arabia.

’91: bin Laden’s public outcry against the Saudi royal family for allowing them to

profane the sacred soil in the land of the two mosques forces him into exile to the Sudan.

’92: al-Qaeda builds a solid financial infrastructure through legitimate business

(construction firms, import/export companies, and farms) and through banking operations to facilitate unfettered growth for several years.

’93: World Trade Center (WTC) bombing kills six and injures over one thousand. ’96: bin Laden returns to Afghanistan amidst heavy foreign pressure on the Sudanese

government to extradite him. This is when al-Qaeda establishes alliance with Taliban, whose similar outlook on world relations and isolation from the Western world provides them safe haven for training recruits and solidifying the organization’s operations. Issues first fatwa denouncing the American occupation of Saudi Arabia and their support of Israel.

’98: bin Laden creates World Islamic Front Against the Jews and Crusaders to issue a

fatwa authorizing the indiscriminate killing of Americans and Jews across the globe. US embassy bombings in Tanzania and Kenya kill over three hundred.

’00: suicide attack on the USS Cole stationed in Yemen kills seventeen. ’01: suicide attack on WTC and the Pentagon on 9/11 kill three thousand people. US

led coalition enters Afghanistan and begins attacking Taliban and al-Qaeda. ’04: over two-thirds of al-Qaeda leadership has been either captured or killed and much

of their physical infrastructure is destroyed, but bin Laden and al-Zawahiri remain at large.


17

Shura-Majlis Advisory Council

Finance and Business Committee

Fatwa and Islamic Study Committee

Military Committee Media and Publicity Committee

Training Subcommittee

Camp Administration Subcommittee

Osama bin Laden Emir-General/Senior

Operations Chief

Islamic Army (Affiliate Organizations)

Appendix ‘B’: Organizational Structure Flow Chart


18

Appendix ‘C’: Glossary Terms: Caliphate: the only form of government fully approved by Islamic theology. It represents the political unity and leadership of the Muslim world. Emir-general: high title of nobility traditionally used in Islamic nations; literally meaning commander or general. Fatwa: a legal pronouncement made by a mufti, a scholar capable of making judgments on Islamic law. Usually made when fiqh (Islamic jurisprudence) is unclear. Families: each family denotes a different country. At the basic level, cells are organized by nationality. Recruitment is made through family, friends or trusted acquaintances. However, for specific operations, families sometimes merge or recruit outside their nationality (i.e. the 9/11 attacks predominantly used the Saudi family, but were led by Muhammad Atta of the Egyptian family). Hawala: informal value transfer system based on performance and honor of a huge network of money brokers. Via a network of hawaladars, or money brokers, customers transfer a sum of money to recipients is other cities under a promise to repay the debt at a later date. There is no legal interference (or protection) and no records of individual transactions. Infidel: one who denies Allah or the Islamic prophet Muhammad; literally meaning “unbeliever” or “one without faith.” Islamism: the idea that Islam is also a political system, as well as a religion. It also refers to groups violently opposed to Western encroachment on their way of life. Jihad: the exertion of one’s utmost effort in order to attain a goal or to repel something detestable in a variety of contexts, ranging from personal to military conflicts. Mujahadeen: term for Muslim fighting in a war or involved in any other struggle; literally meaning “struggler.”

Qutbism: radical strain of Islamic ideology and activism inspired by Sayyid Qubt, a leading Egyptian ideologue who believed only followers of his strain of Islam were true Muslims and that furthering the Middle East required the removal of Israel and the Jews. Salafism: a universalistic vision of classic Islam. Viewing Islam in totality, it has no bias against conflicting sects. Its goal is to return Islam to the sublime nature described in the Koran. Sharia: body of Islamic law, it’s the legal framework within the public and some private aspects of life are regulated for those living in a legal system based on Muslim principles of jurisprudence. Shura majlis: a term used by many Sunni terrorist organizations for their top leadership; literally meaning consultative council. Six rules of jihad:

1. jihad is for the sake of Allah, not for the sake of wealth, goods, fame, glory or power 2. obedience to the imam (Arabic for “leader”) 3. avoid misappropriating booty 4. respect pledges of protection 5. manifest endurance under attack 6. avoid corruption


19

Spectrum of Islamist Groups: 4 segments of radical Islamic factions:

1. Revolutionary – seek to legitimize violence by advocating and practicing collective decision making, drawing selectively on the Qutbist ideology. (i.e. Egyptian Islamic Jihad, Hamas)

2. Ideological – have a coherent discourse of political violence. (i.e. Hezbollah) 3. Utopian – seek to destroy existing order. (i.e. Abu Sayyaf Group, Libyan Islamic Fighting Group) 4. Apocalyptic – use collective violence but are indiscriminate. (i.e. GIA)

Takfir: in Islamic law, the practice of declaring those previously known as Muslims as actual kafirs, or non-believers. People/Organizations: Abdullah Azzam: Palestinian by birth, he was a central figure in the global development of the Islamist militant movement. As a religious scholar, he created an ideology and paramilitary operation to further the cause of oppressed Muslims. His practical approach to recruitment and training combined with his ideology left a lasting impression of bin Laden and was instrumental in establishing al-Qaeda. Armed Islamic Group of Algeria (GIA): Islamic terrorist organization that seeks to replace the existing Algerian government with an Islamic state. Notorious for extreme violence, their methods during the ‘90s resulted in many fellow terrorist organizations, including the Libyan Islamic Fighting Group, Egyptian Islamic Jihad and bin Laden to denounce their overly aggressive actions. However, they stop short of denouncing their ambitions for an Islamic Algerian state. Ayman al-Zawahiri: Egyptian by birth, he is a poet, physician, author and former head of the militant group Egyptian Islamic Jihad. Fluent in English, French and Arabic, he merged his organization with al-Qaeda in ’98 and is a high ranking member of the shura council. It is believed he is the chief lieutenant to bin Laden and also his physician. Al-Zawahiri is credited with much of al-Qaeda’s ideological ideas and military operations. Colonel Gadaffi: although he holds no public office, he is the de facto leader of Libya. Government officials refer to him as the “Brother Leader and Guide to the Revolution.” Hezbollah: a Shia Islamic political and paramilitary group based in Lebanon. It shares similar goals with al-Qaeda, including the eradication of Western influence and the establishment of an Islamic government in Lebanon. As the second largest recognized terrorist organization, their expertise in bombing buildings has been tapped by al-Qaeda through their unique and truly rare tactical alliance. Osama bin Laden: Saudi Arabian by birth, he is the leader of al-Qaeda. As a member of the prestigious and wealthy bin Laden family, he inherited between $25-30 million following his father’s death. A careful financial planner and shrewd businessman, bin Laden’s skills have guided al-Qaeda to become a powerful multinational organization. His methods are revolutionary, changing the Islamist movement to pursue a global strategy against the West that is justified by two fatwa’s he issued in ’96 and in ’98. One of the FBI’s Ten Most Wanted, bin Laden remains the most renowned terrorist in the world.


20

Notes 1 "Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007

<http://en.wikipedia.org/wiki/Al-Qaeda>. 2 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,

2002), p.120-122 3 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,

2002), p. 134 4 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,

2002), p.124 5 Hayes , Laura. "Al Qaeda: Bin Laden's Network of Terror." infoPlease. 29 Mar 2007

<http://www.infoplease.com/spot/al-qaeda-terrorism.html>. 6 "fatwa." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007

<http://en.wikipedia.org/wiki/fatwa>. 7 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,



2002), p.72 10 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,

2002), p.55 11 "Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007

<http://en.wikipedia.org/wiki/Al-Qaeda>. 12 Sympathy for al-Qaeda Soars in Pakistan, Frontier Star, January 23, 2006. Monday, 350 words 13 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.60-69 14 Basile, Mark, ‘Going to the Source: Why Al Daeda’s Financial Network is Likely to Withstand the Current War on Terrorist Financing’, Studies in Conflict & Terrorism, 27:3, 169-185 15 Committee on Banking, Housing, and Urban Affairs, Subcommittee on International Trade and Finance, Hawala and Underground Terrorist Financiang Mechanisms: Hearing before the Subcommittee on International Trade and Finance. 107th Congress., 1st sess., 14 November 2001 16 Schramm, Matthias and Markus Taube, Evolution and institutional foundation of the hawala financial system, International Review of Finincial Analysis, Vol. 12 Issue 4, Pages 405-420 17 Signs Point To a Surviving Terror Network, The Washington Post, August 11, 2006 Friday, Final

Edition, A Section; A01, 1214 words, Karen DeYoung, Washington Post Staff Writer <LexisNexus>


21

18 "Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007

<http://en.wikipedia.org/wiki/Al-Qaeda>. 19 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press,


2002), p.21-71 21 Bernard, Jerome. "Weakened Military, al-Qaeda Fights On-line." Agence France Presse 19 Feb 2007 22 McKenna, Brian. "Sinister Links to a Deadly Network." Times Higher Education Supplement 06 Oct

2006: 25. 23 McKenna, Brian. "Sinister Links to a Deadly Network." Times Higher Education Supplement 06 Oct

2006: 25. 24 Cochran, Andrew. "Internet Security Company Cracks Special Jihadist Software." Internet Blog 26 Jan

2007 02 Apr 2007 <http://counterterrorismblog.org/mt/pings.cgi/3583>. 25 "What is Second Life?." Second Life. 2 Apr 2007 <http://secondlife.com/whatis/ >. 26 Cochran, Andrew. "Part II of ‘MetaTerror: The Potential Use of MMORPGs by Terrorists”." Internet

Blog 12 Mar 2007 02 Apr 2007 <http://counterterrorismblog.org/mt/pings.cgi/3583>. 27 Grace, Nick. "Al Qaeda TV." Daily Standard 03 Jan 2007: 28 Cochran, Andrew. "Arabsat Begins to Broadcast Insurgent Propaganda Station." Internet Blog 12 Mar

2007 02 Apr 2007 <http://counterterrorismblog.org/mt/pings.cgi/3754>. 29 Cochran, Andrew. "Arabsat Begins to Broadcast Insurgent Propaganda Station." Internet Blog 12 Mar

2007 02 Apr 2007 <http://counterterrorismblog.org/mt/pings.cgi/3754>. 30 Jones, Del. "Can Small Businesses Help Win the War?." USA Today - Final Edition 3 Jan 2007: 1B. 31 Jones, Del. "Can Small Businesses Help Win the War?." USA Today - Final Edition 3 Jan 2007: 1B. 32 Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.192


1

AL QAEDADecentralization and the Technological

Evolution of Global Terrorism

Scott Exner · Lizzy Friedman · Keith ParkerMark Kimbrough · Bryan Neff · Matt Zimmerman

5: PEACHES


2

AGENDA

1: Extremist ReligiousIdeologyAl-Qaeda DefinedRadical InfluenceReligious JustificationSpectrum of Islamist Groups

2: DecentralizedOrganizational StructureVertical LeadershipExpansive Global NetworkCompartmentalizedOperational Committees

3: Strategic Use of DigitalTechnologiesTechnological Web of al-QaedaSocial NetworkingPortable ProgramsMMORPGsAl-Zawraa TVCraigslist andDecentralization

4: Countering al-Qaeda’sStrategy

1: EXTREMIST RELIGIOUS IDEOLOGY

Al-Qaeda: a radical political group driven by aninterpretive religious ideology.

Goals: eliminate foreign influence in the Muslim

world eradicate those deemed to be infidels establish a new Islamic caliphate


3


Extremist Ideology: Sunni Islamist movementpursuing jihad against the West.

Core of Ideology Locally rooted…globally inspired Fundamental rhetoric Extend religious boundaries


Maximize effectiveness through expansiveawareness

Fatwas, video messages, etc.

Robust capacity for regeneration glory ofmartyrdom

Spectrum of Islamist Groups

2: DECENTRALIZED ORGANIZATIONALSTRUCTURE

Vertical Leadership Emir-General = Osama bin Laden Shura Majlis (20-30 members)

– Includes: Ayman al-Zawahiri– Oversees strategic, operational, and religious

issues

Lines of authority = goal-oriented


Compartmentalized Operational Committees Finance/Business Military Islamic Law Media and PR


Expansive Global Network Intricate global network of independent cells

and affiliates Arms-length network with some strong ties

– “family” construct


Finance and Business Sophisticated financial network

– Professional Finance Committee– Strict operational doctrine; self-reliant– Adaptive and flexible

Limit record keeping and potential tracking– Frugal financial behavior– Self-sustaining financial tools– Deception and denial– Limited upward communication/ financing– Difficulties with this structure


4


Finance and Business Redistribution Channels

– International banking: fewer regulations &policing authorities

– Islamic banking system: weaker thaninternational banking

– Hawala network: no records! Purposefully make unnecessarily high number

of money transfers


Military Military Committee Trains, recruits and acquires military resources Decentralized management through Literature

and Ideology Self-sufficient and independent terrorist cells


Islamic Law Rooted in “Sharia”- Islamic Divine Law Lightning rod for growth Cohesion between decentralized units

Media and PR Molds public image of itself and the West Garner support in Muslim populations

STRATEGIC USE OF DIGITALTECHNOLOGIES

Technological Web of al-Qaeda

Unified BrandStrategy

AlignmentIdeology

NetworksAutonomy

SocialNetworking

Craigslist &Decentralization

MMORPG’sAl-Zawraa TV

PortablePrograms

SOCIAL NETWORKING

Propaganda of Ideology

Graphic images, videos, and leaderstatements

Skype &Voice-Over-Internet Protocol (VoIP)

Children target sites

PORTABLE PROGRAMS

“Mujahadeen Secrets”

Program on USB –No installation required

Impossible to trace

Native language

Internet cafés


5

MMORPG’S

5,231,598+ global users

Virtual Terrorism

Scenario Executions

Recruiting

World without laws

AL-ZAWRAA TV

November 14, 2006, al-Zawraa, a24-hour insurgent station

Violence against the Iraqgovernment & military footage

January 26, 2007 – satellitesomewhere in Saudi-Arabia

Long term effects have yet to bemeasured however its content isviewed as highly credible

CRAIGSLIST &DECENTRALIZATION

Decentralized internet organizationwith a strong internal message

Online bulletin board - five billionhits a month with 24 Employees

User-generation: build wikis andblog

Autonomy – no reporting back

4: COUNTERING AL-QAEDA’SSTRATEGY

Western Response thus far Strategy for Future Success

– Challenge the Ideology– Attack Financial Supporters

QUESTIONS?


1

BUAD 497: Strategic Management

Prof. Peer C. FissOffice: Bridge Hall 303-BTelephone: (213) 821-1471Email: [email protected] Hours: Wednesdays 2-4 pm, or by

appointment

Sections 15102, 15107, 15112

Class 1: Introduction to Strategy

Class Introductions Who am I

Why this class What will you learn How will we operate

What is Strategy?

My Own Background

German citizenWorked for a number of companies, including

Mannesmann and DPDPh.D. in Management and Sociology from Northwestern

University (Kellogg School of Management)Appointments at Queen’s University and USCPublished in a variety of top academic journalsTaught courses on strategy and corporate governance at

the undergraduate, MBA, and executive levelSome of my research interests

Corporate governance Executive compensation Strategic change

Where I grew up…

Why this class?

Strategic Management is intended to be achallenging and exciting capstone

The primary objective of this course is tointroduce you to the analysis and formulation ofstrategic problems and decisions facing managersand leaders.

The material in this course is designed to be as“real world,” relevant, and interesting as possible.

I hope this course will be one of the most usefulyou have ever had and that it will be instrumentalin helping to make you more successful in yourcareer

What will I teach?

This class will focus both on themaking and implementation ofbusiness strategy

How will we operate?

Mix of theory and casesCurrent events Performance evaluation

Contribution to class discussion (15 %) Individual mini case analysis (10%) Individual midterm case analysis (20 %) Group project presentation (10%) Group project writeup (20%) Individual final exam (25%)

Course packet available from Campus Bookstore– there is no textbook

Come prepared

BUAD-497: Powerpoints

2

Other Administrative Stuff… What is Strategy…?

A preliminary definition:

A company‘s strategy is the ‚game plan‘management has for positioning thecompany in its chosen market arena,competing successfully, pleasingcustomers, and achieving good businessperformance. (Thompson/Strickland 1998)

Strategy-making efforts must aim atproducing a good fit between acompany‘s resource capability and itsexternal situation

Basics of Strategic Management

Four aspects that set strategicmanagement apart

Interdisciplinary capstone course

External focus Competition and the nature of the business landscape

Internal focus Firm competencies, strengths and weaknesses

Future direction Where are we going and how is the marketplace developing?

Why is strategic managementimportant?

Makes a difference in performance levels

Provides systematic approach touncertainties and business challenges

Coordinates and focuses employees

Who does strategy?

The Role of the Board of Directors Elected representatives of the company’s stockholders Legally obligated to represent and protect

stockholder’s

The Role of Top Management Responsible for decisions and action of every

employee Providing effective leadership

Other Organizational Employees Implement—put the strategies into action and

monitor performance Evaluate—do the actual evaluations and take

necessary actions

A Short History of Strategy

HBS requires a class in Business Policy in 1912Adam Smith’s “invisible hand” (the market) gives

way to Alfred Sloan (GM CEO from 1923-1946)concept of the “visible hand”—middle manager

Chester Bernard influential book “The Executive”argues that managers should pay attention to“strategic factors”

Ronald Coase’s 1937 article “why firms exist”(Nobel Prize in economics) and JosephSchumpter’s concept of “disruptive technologies”written in 1942 bring in organizational economics


3

Historical Overview:From Planning to SM

Phase: Planning (1945-1960) Only budgeting. If you focus on financial

aspects and controlling, you will be able toplan and forecast.

Order optimization Operations research


2. Phase: Long-Range Planning(1960-1973)

Operations researchers aim to integrate thefirm into one single model

But then…main external shock: Oil crisis of1973, increases demand for forecasts


3. Phase: Strategic Planning (1973-1980) Before: Main focus on past and extrapolation

to the future. Now: What can we learn from the oil crisis? Do

we have to accept such external shocks? Arewe able to predict them?

Change of perspective: How can we analyzefuture chances and risks?

Oil shock was located outside the company,therefore main focus changed to theenvironment. What is the environment askingfor?

Are we able to handle and to meet theserequirements?

Important Research: Strategic IssueManagement, Strategic Surprise Management(Early Warning Systems by Krystek/Müller-Stewens / Weak Signals by Ansoff)


4. Phase: Strategic Management (1980- aboutnow)

Globalization strengthens the customer‘sposition.

Interconnections between firm and environmentare getting more and more intensive. In manyindustries, there is a necessity for permanentchange and innovation.

Focus on social sciences and “human factor”: Acompany can only implement a strategy if it isaccepted by all members.

So called “soft factors” are more Important:personnel, organization, culture.

The organization has to be more open forcooperation and integration. Congruence modelbecomes dominant.

(1980: Strategic Management Journal and Journal of Business Strategy)


5. Phase: New OrganizationalTypes…?

“Knowledge workers” “Complexity science” “Virtual organizations” “Network forms of organizing” “Adaptive teams” “Virtual markets” “Boundariless organizations”


A Central Idea of Strategic Management: “Fit” between the elements of the system

(Intra-System-Fit), focus on structure, culture,and behavior.

Chandler (1962): Strategy and Structure >„Structure follows strategy“

Ansoff (1965): Corporate Strategy > “System-Environment-Fit“

Basic hypothesis: environment, externalstrategic behavior, and the internal ‚structure‘are interrelated


4

Strategic Management Process

AnalyzingCurrentSituation

Decidingon

Strategies

PuttingStrategiesin Action

Evaluating andChangingStrategies

SituationAnalysis

StrategyFormulation

StrategyImplementation

StrategyEvaluation

Key Takeaways

Fast Paced Class…come prepared!Where strategy came fromWhat strategy isKnow the basic strategic management

process

Preview for Class 2

Preview Case of interaction between firmactions and industry landscape

Prepare the assigned readings (Porter, Intelcase; see syllabus and course website)

Fill out the personal information sheet onthe course website


1

BUAD 497: Session 2

Preview Case

Agenda for today

• Administrative items• Case Discussion: Intel Corporation

Learning goals for this session

• Understand how the industry landscapeinfluences a firm’s opportunities for growth

• See how strategic choices at the firm levelmatter

• Examine the nature of the competitivelandscape and how it can be shaped

• Connect strategy and the creation of value forfirms

Intel Corporation: 1968-1997

• What was Intel’s strategy in DRAMs?

• What accounts for Intel’s dramatic decline inmarket share in DRAMs between 1974- 1984?


• What strategy did Intel use to gain acompetitive advantage in microprocessors?

Up Through 286 386 and Later

IBM IntelIntel

Licensee

Licensee

Licensee

Licensee

PCManufacturer

PCManufacturer

PCManufacturer

PCManufacturer

PCManufacturer


2


• What threats has Intel faced in sustaining thiscompetitive advantage?

• How did Intel deal with each threat?


• Why has Intel been able to sustain itsadvantage in microprocessors, but not inDRAMs?


• Intel and Internet: New Challenges

Key Takeaways

• Industry landscape strongly influences a firm’sopportunities for profit—microprocessors are a morefertile landscape to achieve high profits

• Strategic choices at the firm level matter—Intelexploited that landscape to its benefit

• Firms can shape the landscape—Intel shows how firmscan affect the competitive landscape

• Strategy is about value appropriation as well as valuegeneration—you have to capture value or someoneelse will

• Capabilities as a source of sustainable competitiveadvantage

Next session: Industry Analysis I

• Prepare Porter “The structuralanalysis of industries”

• Prepare Hambrick and Fredrickson“Are you sure you have a strategy?”


1

BUAD 497: Session3

Industry Analysis I

Industry Analysis: Issues andTools

Learning goals for this session Know how industry analysis fits into strategy formulation Know the general tools for industry analysis— be an informed consumer Know Porter’s model for industry analysis and be able to apply it on your own Understand Hambrick & Fredrickson’s model of strategy and be able to apply it on your own

Industry and competitive analysis

“When an industry with a reputationfor difficult economics meets amanager with a reputation for

excellence, it is usually the industrythat keeps its reputation intact.”

(Warren Buffet)

Profitability Differences AcrossSelected Industries (Ghemawat, Rivkin, 1999)

Profitability Differences Within thePharmaceutical Industry(Ghemawat & Rivkin, 1998)

Profitability Differences Within theAirline Industry(Ghemawat & Rivkin, 1998)


2

A Three-Dimensional BusinessLandscape (Ghemawat, 2001)

What is causing the industry tochange? An Example

"An Update on Moore’s Law“

The observation made in 1965 byGordon Moore, co-founder of Intel,that the number of transistors persquare inch on integrated circuitshad doubled every year since theintegrated circuit was invented. Thisis the current definition of Moore'sLaw, which Moore himself hasblessed. Most experts, includingMoore himself, expect Moore's Lawto hold for at least another twodecades.

Moore’s Law Industry Importance: Empirical Evidence

Rumelt, R. (1991). How much does industrymatter? Strategic Management Journal, 12: 167-185.

"To the extent that accounting returns measure thepresence of economic rents, the results obtained hereimply that by far the most important sources of rents in… manufacturing businesses are due to resources ormarket positions that are specific to particular business-units rather than to corporate resources or tomembership in an industry. Put simply, business unitswithin industries differ from one another a great dealmore than industries differ from one another.”

How much does industry matter?Rumelt (1991)

46.4%Stable Business-Unit Effects

8.3%Stable Business Effects

0.8%Corporate Effects

% of VarianceExplained

Variable

Approximate Effects on Variance inReturn on Capital:

Industry Importance: EmpiricalEvidence

McGahan, A., Porter, M. (1997). How muchdoes industry matter, really? StrategicManagement Journal, v18, pp. 15-30.

“We also find that the importance of the effectsdiffer substantially across broad economic sectors.Industry effects account for a smaller portion ofprofit variance in manufacturing but a larger portionin lodging/ entertainment, services, wholesale/retailtrade, and transportation.”


3

How much does industry matter?Porter & McGahan (1997)

32%Business Specific Effects

4%Corporate Parent

19%Industry

2%Year

% of Variance ExplainedVariable

Approximate Effects on Variance inReturn on Capital:

Industry Analysis: Basic Issues

What does this industry look like? What are the major competitive forces? What are the trends?

What does it take to do better than averagein this industry? What are the sources of sustainable competitive

advantage?

Michael E. Porter is the Bishop WilliamLawrence Professor Professor, basedat Harvard Business School where heleads the Institute for Strategy andCompetitiveness

(1980): Competitive Strategy, Free Press, NewYork

(1990): What is Strategy?, Harvard BusinessReview

Porter’s Five Forces

Framework used to assess the competitiveposition of a firm within an industry

Uses five forces or variables to measurecompetitive advantage

Assumes continuous downward pressure ofcompetition

Points to interdependencies between factors Interaction Substitution

Porter’s Five Forces Model

Rivalry

Threat of Substitutes

Threat of Entry

Buyer PowerSupplier Power

Industry Rivalry

Intense rivalry among firms in an industryreduces average profitability.

Rivalry is impacted by industry growth product differentiation number of competitors competitor diversity exit barriers


4

What causes rivalry to be strongor weak?

Number and relative size ofcompetitors

Concentration ratio = % of total industry salesaccounted by the 4 largest firms

Logging = 18% Cigarettes = 85%

What causes rivalry to be strongor weak?

Herfindahl Index - a measure of thebalance in an industry

Example: 3 firms with market shares of 0.50, 0.25, 0.25

H = ((0.50)2+(0.25)2+(0.25)2) = 0.25 + 0.0625 + 0.0625 =0.375

H of 0 ➔ Perfectly Competitive H of 1 ➔ Monopoly H > 0.18 ➔ Relatively high concentration, i.e. industries with

reduced rivalry

2. Buyer Power

Size and concentration of customers

Buyer Power

The power of buyers is determined by factorssuch as buyer concentration, switching costs,and backward integration

Buyers are powerful if Buyers are large and concentrated (government

purchases from defense contractors) Credible threat of backward integration (large auto

manufacturers and small parts suppliers—classic Fisherauto body case)

Buyers are weak if Buyers are fragmented (most consumer products) Producers supply critical parts (Intel’s relationship w/

PC manufacturers)

3. Supplier Power

Differentiation Switching Costs

Supplier Power

Bargaining power is based on factors such asnumber of suppliers, switching costs, andpresence of substitute inputs

Suppliers are powerful if Suppliers are concentrated (drug industry’s relationship

with hospitals) Significant cost to switch suppliers (Microsoft’s

relationship with PC manufacturers) Suppliers are weak if

Standardized product with many competitive suppliers(tire industry’s relationship with auto manufacturers)

Concentrated purchasers (garment industry’srelationship to major department stores)


5

4. Threat of Substitutes

Price to Performance Ratios Switching Costs


In Porter’s model, substitute products refer toproducts in other industries (Pepsi is not asubstitute for Coke!)

A close substitute constrains the ability of firmsto raise prices (e.g. aluminum can maker isconstrained by price of glass bottles, steel cans,and plastic containers)

Factors that affect substitutes: Price/Performance tradeoff Switching costs Substitute improvement

5. Threat of Entry Threat of New Entrants

Ability of new firms to enter market isdetermined by factors such as: absolute cost advantages government policy economies of scale brand identity

Minimum Efficient Scale

Volume

UnitCosts

MESEntryPoint

Entry Barriers

Patents - pharmaceuticals Licensing - physicians, lawyers physicians,

lawyers Laws - product standards, corporate crime Tariffs Geographic advantages - Panama or Suez

canal Language or culture - publishing in many

countries


6

Rivalry


Threat of Entry

Buyer PowerSupplier Power

So, what’s missing from Porter’smodel…?

A Toolkit fir Industry Analysis(from Macro to Micro)

PEST (or STEP) Political/Economic/Socio-cultural/Technological

Porter’s Five ForcesSWOT Strengths/Weaknesses/Opportunities/Threats

Value Chain Analysis

SWOT

SWOT stands for Strengths,Weaknesses, Opportunities, and Threats

ThreatWeaknessLiabilities

OpportunityStrengthAssets

Future/ExternalNow/Internal

But how well does SWOT work?

Research has shown that managers viewopportunities and threats differently

But almost any future event can be framedas either an opportunity or a threat.

Likewise, most strengths entailcorresponding weaknesses, and vice versa.

Thus, SWOT mostly tells you aboutyourself, not your environment…

Hambrick & Fredrickson: Do youhave a strategy?

Strategy: “central, integrated, externallyoriented concept of how we will achieveour objectives”

Five elements: Where will we be active? (arenas)

How will we get there? (vehicles)

How will we compete? (distinctive properties)

What speed and sequence of moves? (staging)

Where will profits come from? (economic logic)

An Example: GE Transportation Systems --Locomotives

Arenas

Differentiators

Vehicles Staging EconomicLogic

Arenas

• Diesel• Emphasize long and heavy hauls (including industrial and mining)· Americas, Asia, Middle East, Africa· Limited defensive position in Europe

Vehicles

• Wholly-owned subs with extensive service sites• Selective JVs in Europe (including Eastern/Central)

Differentiators

• Service• Mileage/operating efficiency• Safety• Operator comfort/ergonomics

Economic Logic

• Premium prices for superior product and service• Lowest diesel manufacturing costs (Erie factory)

Staging

1: • New Model X by Year 2 • Push very aggressively in Latin America and Asia • Sign Eastern Europe JVs

2: • New Model XX by Year 4 • Push aggressively in Africa

Throughout: • 5% annual productivity gains • Wait-and-see in Western Europe

9


7

Hambrick & Fredrickson: KeyEvaluation Criteria

1. Does your strategy fit with what’sgoing on in the environment?

2. Does your strategy exploit your keyresources?

3. Will your envisioned differentiatorsbe sustainable?

4. Are the elements of your strategyinternally consistent?

5. Do you have enough resources topursue this strategy?

Key takeaways – Industryanalysis

Industry matters; know your toolkit forunderstanding the constraints it poses uponyou

Porter’s model is useful for making sense ofindustry dynamics, but it has importantshortcomings; know the blind spots

Don’t take your industry for granted—thedefinition matters!

Make sure you have a strategy and that itselements reinforce each other

Next class

Prepare CF Motorfreight Case Be sure to have handed in the complete

personal information sheet (w/ yourpicture…)


1

BUAD 497: Session 4

Industry Analysis II

Administrative Stuff

Group projects Other stuff…


Apply the tools for industry analysisto a classic industry

Build a deeper understanding ofindustry dynamics

Connect this to strategy formulation

CF MotorFreight in 1992

Why is it so difficult to make money in theLTL trucking business?


How well positioned is CFMF in the LTLbusiness? How should we evaluate theirstrategy for this industry?


As Bob Lawrence and Don Moffitt, whatare your options for solving thesecompetitive problems?


2

CF MotorFreight: Update

CF spun off its unionized trucking business andcalled it CFC

Performance continued to deteriorate CFC’s competitors such as Roadway Express,

Yellow, and Arkansas Best remained profitable The regional trucking units kept cannibalizing

CFC’s business In May 2002, the board replaced the CEO with a

turnaround specialist CFC filed for bankruptcy September 3, 2002

Price

Cost

Market Share

Market Size

Unit Margins

Unit Volumes

Net Income

AssetsManaged

Return On Investment

DividedBy

Times

What mattersmost…!

Product Innovation

Process Innovation

Functional Efficiency

Marketing Effort

Customer Value

New Products

Barriers to Entry

New Markets

More Useage

Integration

Marketing Effort

Product QualityPrice Strategies

Cost Strategies

Market Share Strategies

Market SizeStrategies

Margin

Volume

Net Income

Your Essential Choice of Strategies

Key Takeaways

Industry analysis is a powerful tool for analyzingstrategy; it can show what opportunities exist inthe environment

A deeper understanding of industry dynamicsprotects you from simplistic strategies that oftenget you into trouble

Next session: Industry Analysis III

Prepare Apple Inc.: iPods and iTunes case Begin planning for your group projects


1

BUAD 497: Session 5

Industry Analysis III


Use several tools for industry analysisin a dynamic industry

Examine factors that contribute todynamic industry change

Begin to think about strategyformulation under uncertainty

Apple Computer Inc: iPods and iTunes Apple Computer Inc: iPods and iTunes

How attractive was the music industrytraditionally for the recording companies?

Apple Computer Inc: iPods and iTunes

How has the attractiveness of the industrychanged with the entry of Napster?


What was Napster’s strategy and how didit evolve over time?


2


What was Apple’s strategy as it relates tothe music industry?


As Apple, what should be your strategygoing forward?

Entry into theRussian marketin 1992

Entry intoemergingmarkets suchas India

Entry intoderegulatedlocal phonemarket

Strategy againstentrant in themining industry

Examples

Analogies andpatternrecognition;Nonlineardynamic models

Latent-demandsearch;Scenarioplanning

Decisionanalysis; GameTheory; Optionvaluationmodels

Classic industryand strategyanalysis tools

AnalyticTools

No basis toforecast thefuture

A range ofpossibleoutcomes, butno naturalscenario

A few discretesolutions thatdefine thefuture

A single,forecast preciseenough forstrategy

What canbe known?

TrueAmbiguity

A Range ofFutures

AlternateFutures

Clear-EnoughFuture

Four Levels of Uncertainty in Strategic Planning

Source: Courtney et al, Strategy under Uncertainty, HBR 1997

Key Takeaways

Companies must look broadly at the economics andforces of the industry. Think about the powerconstellations and how they are likely to change

Good strategies are coherent, build on existingadvantages, and exploit industry landscape. That’swhat Apple did

There is a big difference between having a productadvantage and having a competitive advantage.Product advantages alone are difficult to sustain

Uncertainty is critical to strategy making, and thereare tools to deal with different levels of uncertainty

Next session: Firm Competencies I

Prepare Hill and Jones chapter “InternalAnalysis”

Go to the USC and Marshall homepagesand study the strategic framework forUSC and the Dean’s message for Marshall


1

BUAD 497: Session 6

Firm Competencies I


Examine the RBV and role of corecompetencies in building competitiveadvantage

Understand how a Resource-based View(RBV) of the firm works and how it differsfrom the IO view

Apply both frameworks to conduct astrategic analysis of USC and Marshall

A Comparison: GTE vs. NEC in1980

GTE Sales 9.98B Active in

telecommunications Positioned in

display technologies Net cash flow 1.73B

NEC Sales 3.8B No telecom

experience Comparable

technological base

And eight years later… GTE vs.NEC in 1988

GTE Sales – 16.46B Closed down semi-

conductors Divested much of

their display business Telephone operating

company Moved other areas

into joint ventures

NEC Sales – 21.89B World leader in semi-

conductors First tier player in

telecommunications Included lifestyle

products – mobilephones, fax,notebooks

GTE’s Strategy: A Portfolio ofBusinesses

No clear strategic intent or commitment Significant work to identify key

technologies, but little coordinationamong business units

Decentralization and outsourcing madeGTE increasingly dependent on outsidersfor critical skills

NEC’s view of changes in the1980s

NEC identified three interrelated streams oftechnological and market evolution Computing would evolve from Main Frame to

distributed processing Components from ICs to VLSI Communications from mechanical to digital

→ Semi-conductors would become the ‘Core Product’


2

NEC’s Strategy: A Portfolio ofCompetencies

Exploit the convergence of computing andcommunications – C&C

Communicated its intent to the wholeorganization

Shifted resources between units to supportcomponents and processors

GTE vs. NEC

Portfolio of Businesses

Portfolio of Competencies

vs.

The BCG Portfolio Matrix The Strategic Implications of the BCGMatrix

Stars Aggressive investments to support continued growth and

consolidate competitive position of firms

Question marks Selective investments; divestiture for weak firms or those

with uncertain prospects and lack of strategic fit

Cash cows Investments sufficient to maintain competitive position.

Cash surpluses used in developing and nurturing stars andselected question mark firms

Dogs Divestiture, harvesting, or liquidation and industry exit

The McKinsey/GE Matrix The Corporation as a Portfolioof Core Competencies

Source: G. Hamel and C. K. Prahalad, Competing for theFuture (Cambridge, Mass.: Harvard Business School Press,1994), p. 227.


3

Two Concepts of the Corporation

SBU is a potential reservoir ofcore competencies

Autonomy is central; the SBU“owns” all resources other thancash

Status of the business unit

Building strategic architectureand competencies to securethe future

Optimizing corporate returnsthrough capital allocation trade-offs among businesses

Value added of topmanagement

Businesses and competenciesare the unit of analysis; topmanagement allocates capitaland talent

Discrete businesses are theunit of analysis; capital isallocated business by business

Resource allocation

Portfolio of competencies, coreproducts and businesses

Portfolio of businesses relatedin product-market terms

Corporate structure

Interfirm competition to buildcompetencies

Product competition based ontoday’s products

Basis for competition

Portfolio of CompetenciesPortfolio of Businesses

Core Competencies and the RBV:What is the company good at?

Core competencies are a source of competitiveadvantage They make a company distinctive

Competencies = Resources and Capabilities Resources

tangible and intangible assets of a firm» tangible: factories, products intangible: reputation

four general categories: financial, physical, human, organization

Capabilities proficiencies that that enable a firm to take full advantage of

other resources » marketing skills, cooperative relationships

Examples:Distinctive Competencies

Toyota, Honda, Nissan Low-cost, high-quality manufacturing capability and

short design-to-market cycles

Intel Ability to design and manufacture ever more powerful

microprocessors for PCs

Motorola Defect-free manufacture (six-sigma quality) of cell

phones

Competencies At Marks & Spencer

Adapted from Exhibit 3.5 Marks & Spencer: How Resources and Capabilities Lead to Advantages, with permission of Harvard BusinessReview: Exhibit from “Competing on Resources: Strategy in the 1990’s” by D. J. Collis and C. Montgomery, 73, no. 4 (1995).

Marks &Spencer

The Resource Based View (RBV)

Two critical assumptions of RBV: Resource Heterogeneity

differences in resources among similar firms

Resource Immobility costly for firms to acquire

What do these assumptions mean? If one firm has resources that are valuable and

other firms don’t AND if other firms can’t imitatethese resources without incurring high costs, THENthe firm possessing the valuable resources will likelygain a sustained competitive advantage

IO vs. RBV

Firms have idiosyncratic,not identical strategicresourcesResources are notperfectly mobile andtherefore heterogeneous

Firms within an industry haveidentical strategic resources

Resources are highly mobile(easily bought and sold) andtherefore homogeneous

Assumptions:

Internal—describesfirm’s internalcharacteristics andperformance

External—describesenvironmental conditionsfavoring high levels of firmperformance

Focus:

Barney, WernerfeltPorter, RumeltSomeAuthors:

Resource Based View(RBV)

Industrial Organization (IO)


4

The VRIO Framework

If a firm has resources that are…

• valuable,• rare, and

• costly to imitate, and…• the firm is organized to exploit these resources,

…then the firm can expect to enjoy a sustainedcompetitive advantage

Applying the VRIO Framework

The Question of Value

In theory: Does the resource enable the firmto exploit an external opportunity or neutralizean external threat?

The practical: Does the resource result in anincrease in revenues, a decrease in costs, orsome combination of the two?

Levi’s reputation allows it to charge a premium for its Docker’s pants


The Question of Rarity

A resource must be rare enough that perfect competition has not set in

If a resource is not rare, then perfect competitiondynamics are likely to be observed (i.e., nocompetitive advantage, no above normal profits)

Thus, there may be other firms that possess theresource, but still few enough that there is scarcity

Several pharmaceuticals sell cholesterol-lowering drugs, but the drugs are still scarce—look at prices


Valuable and Rare

If a firm’s resources are… …the firm can expect:

Not Valuable Competitive Disadvantage

Valuable, but Not Rare Competitive Parity

Valuable and Rare Competitive Advantage(at least temporarily)


The Question of Imitability The temporary competitive advantage of valuable

and rare resources can be sustained only ifcompetitors face a cost disadvantage in imitatingthe resource

intangible resources are usually more costly to imitate than tangible resources and bundles of resources are more costly than single resources

Harley-Davidson’s styles may be easily imitated,but its reputation cannot

Costs of Imitation

Unique Historical Conditions First mover advantages Path dependence

Causal Ambiguity Causal links between resources and competitive advantage may not

be understood Bundles of resources fog these causal links

Social Complexity The social relationships entailed in resources may be so complex that

managers cannot really manage or replicate them

Patents Offer a period of protection if the firms is able to defend its patent

rights Can be a two-edged sword as firms disclosure may decrease costs of

imitation by other firms


5


The Question of Organization

A firm’s structure and control mechanismsmust be aligned so as to give people abilityand incentive to exploit the firm’s resources

Examples: formal and informal reporting structures,management controls, compensation policies,relationships, etc.

These structure and control mechanisms complementother firm resources—taken together, they can help a firm achieve sustained competitive advantage

3M Company – rewards innovation and risk-taking

The VRIO Framework

Valuable? Rare?Costly toImitate?

Exploited byOrganization?

CompetitiveImplications

No

Yes

Yes

Yes

Yes

Yes Yes Yes

No

No

No Disadvantage

Parity

TemporaryAdvantage

SustainedAdvantage

EconomicImplications

BelowNormal

Normal

AboveNormal

AboveNormal

Source; Adapted from J. Barney, “Firm Resources a Sustained Competitive Advantage, ‘ Journal ofManagement 17 (1991), pp. 99-120.

Competitive Dynamicsof Resource Imitation

Competitive Dynamics The strategic decisions and actions of firms in

response to the strategic decisions and actionsof other firms

Firm A(strategy decisionslead to competitive

advantage)

Firm B’s Possible Responses

No Response

Change Tactics

Change Strategy

Case Study: USC/Marshall

Key Takeaways

While traditional factors used to be important,knowledge-based core competencies are increasinglyimportant in the new business landscape

Internal strategic analysis aims to integrate the firm’sspecific strengths to maximize advantage

Know the VRIO framework for understanding how toachieve and sustain competitive advantage

Core competencies can become core rigidities

Next class: Firm Competencies II

Examine the role of corporateheadquarters in acquiring anddeveloping competencies

Prepare PepsiCo case


1

BUAD 497: Session 7

Firm Competencies II

Learning goals for this case

Use the RBV to understand what PepsiCoshould do

Examine how we can achieve coordinationamong businesses to exploit competencies

Examine the relationship betweencorporate vs. business unit strategy andtrade-offs between autonomy andcoordination

PepsiCo’s Restaurants PepsiCo’s Restaurants

Should PepsiCo acquire CoC and CPK?

PepsiCo’s Restaurants

Given PepsiCo’s strategic goals, whereshould CoC and CPK be placed in thePepsiCo structure?

PepsiCo’s Restaurants

How could PepsiCo be re-structured toimprove coordination and synergy?


2

PepsiCo Restaurants: Update

Pepscio made both acquisitions. They took a51% ownership with agreements to buy out therest over time, conditional on performance.

CPK and CoC were left as independentcompanies reporting to VP Strategic Planning(Ken Stevens) and one or two restaurantpresidents

CoC was reconceived as a design and marketingcompany, with production outsourced

CPK has rolled out more stores nationwide, usingthe funding from PepsiCo

PepsiCo Restaurants: Update (Cont’d)

However, 1994 operating profits from restaurants fell 6% Pepsico Vice-Chairman Roger Enrico’s goals are to return

to profitable growth by tying together business functionsacross the chains, including accounting, billing, andpurchasing to cut costs, and reducing the number ofcompany owned stores.

In 1997, PepsiCo spun off its restaurants as Tricon,renamed Yum! in 2002.

Yum! focused on generating concentrated efficienciesunder a single brand, sometimes placing two or threebrands into a single restaurant; sales have increasedconsiderably, though still less than at McDonalds

Growth has been impressive in China, with operatingprofits rising from $20m to $200m from 1998 to 2005

Key Takeaways

Be able to analyze what actions createcompetencies and how they affect corporatestrategy

PepsiCo: clear example of benefits of sharing andcoordination at the corporate level (you can’t getmuch more related than three fast foodrestaurants…!)

But even here: tradeoff between autonomy andgrowth!

You can create value through fairly independentdivisions—the question is, can coordinationcreate even more?

Next class: Firm Competencies III

Prepare Wal-Mart Case and skim the businesspress on current developments around Wal-Mart

Remember that group emails are due bymidnight on Wednesday, the 31st


1

BUAD 497: Session 8

Firm Competencies III


Continue analyzing the sources of a firm’scompetitive advantage and how they relateto competency

Examine the sustainability of thiscompetitive advantage

Analyze the transferability of competitiveadvantage and what factors matter whenmoving into different environments

Wal-Mart Stores Inc. Wal-Mart Stores Inc.

What are Wal-Mart’s sources ofcompetitive advantage?

Wal-Mart Stores Inc.

How sustainable is Wal-Mart’s position?

Wal-Mart Stores Inc.

What are the issues involved with Wal-Mart diversifying into foreign countries?


2

Next class: Complementarities and Fit

Prepare readings Milgrom and Roberts, “Complementarities

and Design Decisions” Grant, “Alternative Structural Forms”

Mini case analysis due at beginning ofclass


1

BUAD 497: Session 9

Fit and Complementarities

Learning Goals

Understand the importance of organizationalstructure and configurations for designing and inimplementing strategies

Understand the tension between differentiationand integration in organizing

Know the relative advantages and disadvantagesof the most common organizational structures(functional, divisional, matrix)

Examine different views of organizations, such asMintzberg’s approach and a view of firms asactivity systems

Why Understand OrganizationalConfigurations and Structure?

Internal fit of organizational configurations isessential for achieving sustainable competitiveadvantage

Understanding configurations and structures isimportant for your career. What activities arecore? Where do you fit in? What organization doyou want to be in? Formal vs. informal?Centralized vs. decentralized? Entrepreneurial vs.rule-guided?

Organizational Structure and Design

Organizational Structure The formal configuration between individuals

and groups with respect to the allocation oftasks, responsibilities, and authorities withinorganizations

Organizational Design The process of coordinating the structural

elements of an organization in the mostappropriate manner

Three approaches: Classical Organization Design Mintzberg’s Framework Activity Systems

Part I: The Classical Approach The history of a hostel that grewtoo fast…

Chef

WaiterCleaning aid

It-technician Dishwashers

Receptionist

Caretaker

Midlevel manager Midlevel manager Midlevel manager

Husband

WifeChildren

Guests


2

Graphic Description

= Evolution = Revolution

Age of Organisation

Size

of O

rgan

isat

ion

Crisis by Style of Management

Phase 1

Growth by Creativity

Phase 2

Growth byTight Management

Phase 3

Growth by Delegation

Crisis by Autonomy

Crisis by Control

Crisis by Bureaucracy

Crisis by what?

Phase 4

Growth by Coordination

Phase 5Growth byTeam Spirit

Greiner’s Model of OrganizationalGrowth

”After the task has been divided into specialist subtasks, the problem isto integrate the subtasks around the completion of the global task. Thisis the problem of organisation design.”

Jay Galbraith (1974), Organization Design – An Information Processing View

Control Flexibility

The circularity of formalisation

The problem is how to find the right balance and not let the organisation drown in complexity

The Basic Problem of Organizing

Growth Patterns of Firms

Phase 1Strategy: Low revenue base; simple product-market scopeStructure: Simple

Phase 2Strategy: Increase in revenues; engage in vertical integrationStructure: Functional

Phase 3Strategy: Expand into new, related product-markets and/or

geographical areasStructure: Divisional

Phase 4Strategy: Expand into international marketsStructure: International Division, Geographic Area, Worldwide

Product Division, Worldwide Functional, orWorldwide Matrix

Functional Structure

Chief ExecutiveOfficer or President

ManagerProduction

ManagerEngineering

ManagerMarketing

ManagerR&D

ManagerPersonnel

ManagerAccounting

Lower-level managers, specialists, and operating personnel

Advantages Pooling of specialists

enhances coordinationand control

Centralized decisionmaking enhances anorganizational perspectiveacross functions

Efficient use of talent Career paths and

professional developmentin specialized areas arefacilitated

Disadvantages Differences in functional

orientations impedecommunication andcoordination

Tendency for specialiststo develop a short-termperspective and a narrowfunctional orientation

Functional area conflictsmay overburden top leveldecision makers

Difficult to establishuniform performancestandards

Functional Structure

Office of the President

Centralized Staff

Marketing Personnel

Engineering Operations Accounting

• Operations is main function• Process engineering is

emphasized over R&D• Large centralized staff• Formalized procedures• Structure is mechanical, job

roles highly structured

Structure for Cost LeadershipStrategy


3

Operations HumanResources

President andLimited Staff

Marketing

New ProductR&D

• Marketing is the main function for tracking new product ideas• New product R&D is emphasized• Most functions are decentralized• Formalization is limited to foster change and promote new ideas• Overall structure is organic; job roles are less structured

R&D

FinanceMarketing

Structure for a Differentiation Strategy Divisional Structure

Chief ExecutiveOfficer orPresident

Corporate Staff

Division A

General Manager

Division B

General Manager

Division C

General Manager

ManagerProduction

ManagerEngineering

ManagerMarketing

ManagerR&D

ManagerPersonnel

ManagerAccounting

Organizedsimilarly toDivision 1

Organizedsimilarly toDivision 1

Lower-level managers, specialists, and operating personnel

Advantages Increases strategic and

operational control,permits executives toaddress strategic issues

Quick response toenvironmental changes

Increased focus onproducts and markets

Minimizes problemsassociated with sharingresources across functions

Facilitates development ofgeneral managers

Disadvantages Increased costs incurred

through duplication ofpersonnel, operations,and investment

Dysfunctionalcompetition amongdivisions may detractfrom corporateperformance

Difficulty in maintaininguniform corporate image

Overemphasis on short-term performance

Divisional Structure

A structure based on geographic lines usuallyimplies a multi-domestic international strategy

NorthAmerica Australi

aEurope Asia Latin

AmericaAfrica

Product A Product B Product C Product D

Chief Executive Officer

Corporate Office (Staff)

Multi-Divisional Structure (A)

Multi-Divisional Structure (B)

Product A Product B Product C Product D

A structure based on product lines usuallyimplies a global international strategy

Chief Executive Officer

Corporate Office (Staff)

Matrix Structure

Chief ExecutiveOfficer orPresident Corporate

Staff

ManagerAdministration

and HumanResources

ManagerProjects

ManagerManufacturing

ManagerEngineering

ManagerMarketing

Manager PublicRelations

Project A

Project B

Project C

Project D


4

Advantages Increases market

responsiveness throughcollaboration andsynergies

Allows more efficientutilization of resources

Improves flexibility,coordination, andcommunication

Increases professionaldevelopment throughbroader responsibilities

Disadvantages Dual reporting relationships

can result in uncertaintyregarding accountability

Intense power strugglesmay lead to increasedlevels of conflict

Working relationships maybe more complicated andresources duplicated

Excessive reliance onteamwork may impedetimely decision making

Matrix Structure Restructuring Leo Burnett

Part II: Mintzberg’s Approach Henry Mintzberg: Five Basic Elements

Operating Core: Employees who perform thebasic work related to an organization’s product orservice.

Strategic Apex: Top-level executives responsiblefor running an entire organization.

Middle Line: Managers who transfer informationbetween higher and lower levels of theorganizational hierarchy.

Technostructure: Organizational specialistsresponsible for standardizing various aspects ofan organization’s activities.

Support Staff: Individuals who provide indirectsupport services to an organization.

Mintzberg’s Five Organizational Forms


5

Five Organizational Forms (1)

The Simple Structure: young, small;nonsophisticated technical system;simple, dynamic environment.Key: strategic apex

Machine Bureaucracy: old, larger;regulating, nonautomated technicalsystem; simple, stable envir.Key: technostructure

The Divisionalized Form: diversifiedmarkets (esp. products & services); old,large.Key: Market grouping, performancecontrol, limited vertical decentralization

Five Organizational Forms (2)

The Professional Bureaucracy:complex, stable envir. Nonregulating,nonsophisticated technical system:Key: Operating Core.

The Adhocracy: complex, dynamicenvir.; sophisticated and often automatedtechnical systemKey: Support Staff

The Idea Organization: Value-basedorganizations, public/religiousorganizations…Jehovas Witnesses,Greenpeace, Al Quada, IRA

Summary of Mintzberg Part III: Organizations as ActivitySystems

The Underlying View: Strategy asPositioning (Porter, 1996)

Operational effectiveness is not strategy Operational effectiveness is a given

Strategy is a unique position for the firm Strategy is not doing the same activities better, rather

doing them differently or doing different activities

Strategy involves trade-offs Due to incompatible product features, inconsistencies

in image, limits of coordination, motivation,management, etc.

Strategy means achieving a high degree of fitbetween internal activities/resources and theexternal environment

A Different View:Firms as Activity Systems

Activity Systems form configurations thatneed to exhibit a high degree of internal fit

Interplay of complementarities and trade-offs across multiple activities is critical tosuccess

Different configurations can be equifinal,i.e. equally effective (“many best ways toorganize”)


6

LimitedCustomer

Service

Self-selectionby Customers

ModularFurniture

Design

LowManufacturing

Cost

SuburbanLocation

With ampleparking

LimitedSales

staffing

IncreasedLikelihood of

Futurepurchase

In-houseDesign focused

On cost ofmanufacturing

ExplanatoryCatalogues,Informative

Displays andlabels

Ease ofTransport and

assembly

“ knock-down”Kit packaging

Wide varietyWith ease of

manufacturing

MoreImpulsebuying

MostItems in

inventory

Year-roundstocking

100%Sourcing from

Long-termsuppliers

Self-Transport by

customers

High-trafficStore layout

Self-assemblyBy customers

AmpleInventoryOn site

IKEA’s Activity System

Robert Mondavi Premium wine producer Long-term contracts with

outside growers, also ownsvineyards

Established relationships,extensive knowledge-sharing

Extensive use of hand-methods to ensure highestquality

Aging in small oak barrels Heavy use of tastings, PR,

wine tours

E.&J. Gallo Large-volume, low-price

producer Grapes purchased at arms-

length from outside growers,often also imported

Highly automated productionmethods

Aging in stainless steel tankfarms

Heavy use of advertising(leading advertiser amongCalifornia wineries)

Equifinal Activity Systems withInternal Fit: Wine Industry

Home Depot Huge stores with no-frills

design Widest selection of items High ceilings allow large

inventories on store shelves No warehouses or distribution

centres; direct deliveries fromlimited number of vendors

Goods delivered go directly onselling floor on palettes

Well-trained employees toadvise mostly DIYs and smallcontractors

Low prices

Lowe’s Slightly smaller, more

attractive stores Greater emphasis on

fashion, kitchen, decorating Lower ceilings with more

attractive shelving Regional distribution

centres with hub-and-spoke system

Contractors are served byseparate corporate divisions

Higher proportion ofunique and fashion itemsw/ higher prices

Equifinal Activity Systems withInternal Fit: Home ImprovementRetailing

Implications: Strategy and Fit

Taylor many activities to the strategicposition

Strengthen the fit among activities The strategic value of outsourcing depends

on fit Outsourcing tends to make activities generic Tailor suppliers to strategy

Improve the strategy (and counter yourrivals’ moves) in ways that extend andstrengthen fit


7

What is a Strategy? Unique position Tailored activities Activities fit together in an

integrated system Clear tradeoffs Continuity of position but

consistent improvement

What is not a Strategy? Best practice improvement Learning Agility Flexibility Restructuring Mergers/Consolidation Alliances/Partnering The Internet

Summary: Strategy as Configuration Key Takeaways

Structure and configuration need to follow strategy There is a key tension in organizational structures

between control and flexibility; know which one ismore important for your situation

Organizations go through growth cycles; knowwhich one you are in and recognize the symptoms

Know the main organizational structures and theiradvantages and disadvantages

Formal structures are only half the story—knowhow a firm’s activity systems are configured andhow this supports/hinders the firm’s strategy

Next Session: Fit Applied

Prepare Progressive Case


1

BUAD 497: Session 10

Fit Applied I

Learning Goals

Get experience applying the activitysystem framework

Examine trade-offs of strategic positions Understand the model of strategy that

underlies the configurations approach

Progressive Corporation Average Industry Ratios 1995-1998

Strategy as “OneBest Way”

One ideal competitive position inthe industry

Benchmarking of all activitiesand achieving best practices

Aggressive outsourcing andpartnering to gain efficiencies

Advantages rest on a few keysuccess factors, criticalresources, core competencies

Flexibility and rapid responses tocompetitive and market changes

Strategy as Fit

Unique competitive positionfor the company

Activities tailored to the firm’sstrategy

Clear trade-offs and choicesvis-à-vis competitors

Advantages arise from fitacross activities

Sustainability comes from theactivity system, not the parts

Alternative Views of Strategy Key Takeaways

Competitive advantage emerges out of the entiresystem of a firm’s activities

Fit among activities reduces cost or increasesdifferentiation

Relying on complex activity systems decreasesthe threat of imitation by competitors

The most viable strategic positions are thosewhose activity systems are incompatible becauseof tradeoffs


2

Next Session: Fit Applied II

Continue with analysis of activitysystems

Prepare Airborne Express case


1


Fit Applied II

Learning Goals

Compare different positions within anindustry and understand the strategiesthat go with them

Examine the effect of cost position onstrategy

Be able to identify priorities based ontotal and marginal relative costs

Airborne Express Airborne Freight Stock Price

Update

Airborne continued to prosper in 1997 and 1998(net income 1996: $28m, 1997: $120m, 1998:137m).

However, in 1999 Airborne began to falter. FedExmoved further into ground operations. BothFedEx and UPS exploited the online shoppingboom of the late 1990s, but Airborne struggled.

After 1999, Airborne’s profits were meager withlosses in some quarters

Update (cont’d)

In March 2003, DHL announced it would acquireAirborne for about $1.2 billion.

Since 2003, DHL has committed extensive fundsto catch up with FedEx and UPS in the US. DHL’sbrand has replaced Airborne’s and is trying toestablish itself as a “third force” in the expressmail industry


2

Key Takeaways

Greater interactions between decisions tend tolead to internally consistent but mutuallyexclusive positions

Even a small firm can carve out a long-viableposition in an inhospitable environment byexploiting a distinct position

Successful strategies tailor a large number ofactivities in mutually reinforcing ways to createthis position

However, even the best fit is not invulnerable tocompetitive moves that take away positionaladvantages

Next Session: Fit Applied II

Continue with analysis of activitysystems

Prepare Airborne Express case


1


Competitor Analysis

Learning Goals

Understand how game theory applies to businessand helps us to analyze strategic moves by ourcompetitors

Know the main elements of games and their basicforms

Examine how firms can change the rules of a gameto capture more value for themselves

See how competitor profiling can complement gametheory

What is Game Theory?

“No man is an island”

Analysis of rational behavior in interactive or interdependent situationsThe bad news…

…knowing game theory does not guaranteewinning

The good news……very useful framework for thinking about

strategic interaction

Games We Play

Group projects Free riding and reputationPoker CredibilityTraffic CongestionDating Information manipulationDining out Coordination

Decision Theory vs. Game Theory

Ten of you go to a restaurant

If each of you pays for your own meal……this is a decision problem

If you all agree to split the bill...…now, this is a game

Restaurant Decision-Making

A check splitting policy changes incentives:they depend now on the moves of other players…

May I recommend that with theBleu Cheese for ten dollars more?

Sure!

It is onlya dollarmore

for me!


2

Games Businesses Play

Market entry CommitmentSupply chains AuctionsCorporate takeovers Winner’s curseFishing CongestionPatent races Game of chickenOPEC output Collusion & enforcement

Components of a Game

Games have the following characteristics:

Players Rules Payoffs Strategies

Games as Defined by the Numberof Players

1-person (or game against nature)2-personn-person (3-person & up)

Games as Defined by the Rules

Rules determine the number of options/alternativesin the play of the game.

The payoff matrix has a structure (independent ofvalue) that is a function of the rules of the game

Thus many games have a 2x2 structure due to 2alternatives for each player

Games as Defined by the PayoffStructure

Zero-sumClassic games: Chess, checkers, tennis, poker.Business games: Sales negotiations (often)

Non-zero sumClassic games: MonopolyBusiness games: Market entry, research investment

Generic Strategies

In simple games, it is natural to suppose that oneplayer will attempt to anticipate what the otherplayer will do

Minimax: to minimize the maximum loss; a defensivestrategy

Maximin: to maximize the minimum gain; anoffensive strategy

Games can also have sequential play, which leadsto more complex strategies

Tit-for-tat: always respond in kind Tat-for-tit: always respond conflictually to

cooperation and cooperatively towards conflict


3

Game or Nash Equilibria

Games also often have solutions or equilibriumpoints

These games, owing to the selection of particularreasonable strategies, will result in a determinedoutcome

A Nash Equilibrium is that pointwhere it is not to either player’sadvantage to unilaterallychange his or her mind

John F. Nash (1928-)

(1) The Prisoner’s Dilemma

Two years

Two years

Ten years

Free

Confess

Free

Ten years

Six months

Six months

~ Confess

Prisoner B

Confess~ Confess

Prisoner A

Should youconfess?

What makes a Game a Prisoner’sDilemma?

We can characterize the set of choices in a PD as: Temptation (desire to double-cross other player)

Reward (cooperate with other player)

Punishment (play it safe)

Sucker’ pay off (for the player who is double-crossed)

A game is a Prisoner’s Dilemma whenever: T > R > P > S

Free > Six months > Two years > Ten years

What is the Outcome of a PD?

The saddle point is where both confessThis is the result of using a minimax strategy.Two aspects of the game can make a difference.

The game assumes no communication The strategies can be altered if there is sufficient

trust between the players

Examples in Business: two companies deciding onwhether to start an advertising campaign; Boeingvs. Airbus in VLAs; research investments, …

(2) The Game of Chicken

0

0

+1

-1

Swerve

-1

+1

-20

-20

~ Swerve

Driver B

Swerve~ Swerve

Driver A

Chicken is an Unstable game

There is no saddle point in the game.No matter what one player chooses, the other

player can unilaterally change for some advantageChicken is therefore unstableWe cannot predict the outcomeBUT: Credible commitment can persuade the other

player to back down

Examples in Business: Patent races, Microsoft vs.Linux, etc.


4

(3) Tragedy of the Commons

Describes the problem of the unregulated use of apublic good

Take a village with 10 familiesEach family has 10 cows which just exactly provide

the food they needThe village commons

has a carrying capacityof 100 cows

Cow Carrying Capacity

Each cow produces 500 lbs of meat & dairy per yearup to or at carrying capacity of the pasture.

10 families X 10 Cows X 500 lbs = 50,000 lbs offood at carrying capacity

…and then Farmer Symthe’s wife has triplets…

One more cow…

So Farmer Smythe decides he really needsone more cow

And there is no one to tell him “No!” becausethe commons is an unregulated public good Some modern commons are forests, oceans,

public roadways, air quality, Internet (nospamming), markets with limited carryingcapacity, etc..

Reduced Capacity

With the overgrazing, each cow will now produceonly 490 lbs of food.

101 Cows X 490 lbs = 49,490 lbs of food at carryingcapacity

Each family gets 4900 lbs of meat & dairy, insteadof 5000

Except Farmer Smythe, who gets 5390 lbsEven with the reduced carrying capacity,

it is still to his advantage toadd the extra cow

Looks familiar…?

Look at the situation: N players Equilibrium solution is to ~cooperate Joint optimal outcome is to cooperate This is an n-person, collective Prisoner’s dilemma

Applying Game Theory toBusiness: Toys “R” Us

Competitive Landscape Toy & department stores

Do not compete with TRU on price (50% markups)

General discounters (Wal-Mart, Target) Cannot compete with TRU on selection (9% markups) Toys exhibit high product differentiation

Specialized discounters (only TRU) Enjoyed 20% market share nationally

Warehouse clubs (Costco, Pace) Introduced in the 1980s By 1989, about 200 items in competition

Cause of concern for Toys “R” Us!


5

Toys “R” Us (continued)

Market research into the future of warehouseclubs Manufacturers estimated 3-5% annual growth rate Toys “R” Us conducted comprehensive but proprietary

study Manufacturers were aware of the study, but not its

results Toys “R” Us expected warehouse clubs to grow quite

fast…

Idea! Issue statement to manufacturers: “You may not sell to warehouse clubs without losing

Toys “R” Us as a customer.” Effectively, choose between a $5 billion market (TRU) and a

less than $500M market (warehouse clubs)

Toys “R” Us (continued)

Manufacturers agreed to TRU deal Really they had little choice given the uncertainty about

the future

Warehouse club toy sales decreased Pre-agreement growth of 51% per year Overall growth of clubs of over 10% per year

Toys “R” Us kept its market

The Toys “R” Us Example

Sequential timing Threat of Manufacturer’s decisions

How will my opponents react?

Simultaneous timing Manufacturer’s decisions

What is my opponent doing right now?

Information Future profitability of warehouse clubs

What can I infer from the actions of others?

Agreements Enforceability of contracts & agreements

What happens if someone breaks the agreement?

Changing the Game…

What game is being played?

Who are the key players? duopoly game; oligopoly game; etc…

What options are open to the players? pricing game; advertising game; etc.

What goals are the players pursuing market share? profits?..

Are goals complementary or conflicting? issues the players agree on, sources of conflict, etc..

What is the time structure of the game? one shot, repeated, simultaneous, sequential…

How can the game be changed?

The game can be changed by changing…

Players Added value Rules of the game Tactics employed Scope of the game


6

Changing the players

Bring in customers Pay customers (esp. early adopters) to play (Samples, Netscape) Subsidize some customers, other full paying customers will follow

(Initial discount to lower risk)

Bring in suppliers Holland Sweetener Co./NutraSweet and Coca-Cola

Bring in complementors Do it yourself. Nintendo - both h/w & s/w Pay complementors to play (at least initially)

Bring in competitors Create a second source to encourage buyers to adopt technology

Limit your supply DeBeers and diamonds; Nintendo & video games Downside: Shrinks the pie today; leaves entry opportunity open

Raise amount consumers are willing to pay Policies that build loyalty (frequent flier miles) increase willingness

to pay - GM / Ford credit cards

Lower competitors’ value Softsoap - by cornering the supply of pumps

Change the added value

Changing tactics

Make the game more transparent or opaque depending on which benefits you

To establish credibility (clear the fog) Absorb uncertainty (e.g. accept a pay-for-performance contract) Offer guarantees or advertise Ask others to demonstrate their credibility to you

To establish uncertainty (preserve the fog) Create complexity (long distance calling rates) Bluff: Ask yourself whether you will be believed and under what

circumstances Ask what others stand to gain by preserving the fog, and what they

could be bluffing about

Changing the scope

What is the current scope of the game? Games are often linked across geographic and product

markets

Do you want to link the game to other games? Would a multi-market contract be beneficial to you?

Do you want to de-couple the game fromother games? Leave a market to stop competing head-on with

another firm

Beyond Game Theory:Competitor Profiling Why Competitor Profiling?

Game Theory takes an economic perspective Focus on incentives and interactions among moves Assumption of rationality; what competitors should do

if they behaved rationally

Competitor Profiling takes a behavioralperspective Focus on competitors’ predispositions What do competitors really want given their beliefs,

blind spots, and historical tendencies


7

Why Competitor Profiling Matters

Goals may not be fully rational due to- Difference in an organizations’ charter (public, non-

profit, family-owned…)- Agency problems (top management’s interest may be

different)- Irrationality (pride, jealousy, fairness…)

Beliefs may lead them to see the world differently- Mental models may differ (e.g. due to differences in

functional backgrounds)

Routines may constrain opportunities for action- Inertia due to size/maturity/complexity/strong

culture/bureaucratization etc.

How to Integrate Both GameTheory and Competitor Profiling

Think broadly about the set of strategic options Variables (organization, customers, pricing…) Asymmetries Commitment postures Information

Augment you toolkit for dynamic analysis Scenario analysis (role-playing/devil’s advocate) Market testing Sequenced rollout

Match analytics and industry/company context Do general assumptions hold in this industry/company? But: question industry logics/orthodoxies

Key Takeaways

Game theory is a powerful tool for analyzingcompetitive moves—know the typical games andbe able to anticipate your rival’s response

Logics can often be changed so a new game isplayed—use this to your advantage

Never assume your opponent’s behavior is fixed!Predict their reaction to your behavior

Complement game theory with competitor profilingto work around the restrictive assumptions onwhich game theory is built

Next Session

Get experience applying gametheory and competitor analysis

Prepare Ryanair case


1


Competitor AnalysisApplied I

Learning Objectives

Get experience applying competitoranalysis

Examine market entry and the threat ofretaliation

Ryanair Ryanair: What Happened…

Even before Ryanair initiated service in May1986, Air Lingus and BA reduced their lowest,restricted round-trip fare to £95!

Ryanair countered with an unrestricted fair of£94.99

By 1989, customers could find fares as low as £70 Ryanair’s initial performance was promising

almost 100% seats sold great PR for “taking on the big guys”

Ryanair: What Happened…(Con’d)

Ryanair soon grew to serve 27 routes (Dublin,Manchester, Liverpool, Glasgow etc.)

Passenger volume grew rapidly But…the company began to accumulate large

losses I£6 Million in 1988, I£4.5 Million in 1989

Expansion strained the firm’s management system January 1991, Ryanair was hours away from

bankruptcy…

Ryanair reborn!

The airline cut costs radically dropped all loss-making routes removed all in-flight amenities (coffee, snacks, etc.) promoted duty-free sales renegotiated labor contracts

Ryanair remodeled itself completely on SouthwestAirlines

2002-2003: 30% operating profit margin vs.British Airway’s 3.8%

2003: market capitalization of $5b – compared to$3b for BA and $2.7b for Air France


2

Key Takeaways

Combining game theory analysis with competitorprofiling is essential; you need to examine bothsides of the story

Retaliation is extremely unattractive when theentrant is small, the incumbent large, and across-the-board price cuts necessary to retain customers

But: the ability to retaliate in a targeted waymakes retaliation more attractive and likely

Credible commitment is often difficult

Mini Case Analysis Notes andComments

Next Session

Continue with applying competitor analysis Case: Leadership Online—Barnes and

Nobles vs. Amazon


1


Competitor AnalysisApplied II

Learning Objectives

Examine competitive moves in the neweconomy of online selling

Understand how positioning analysis—theanalysis of willingness to pay and ofcost—matters in the context of onlineselling

Explore the substitution threat tocompetitive advantages in this newbusiness landscape

Leadership Online

vs.

Cost Comparison of Online vs. OfflineBusiness Models

What B&N brings to the table…

The B&N annual report of 1996 read as follows:

“The competitive advantages we bring to thisbusiness are enormous, as is our ability toleverage pre-existing assets. They include [the]distribution center, [the] 2.5 million title database, special order processing, direct marketingexpertise, name recognition and franchise value,international reputation, excellent partnerships(Firefly, AOL, etc), [and] bookselling expertise.”

Amazon vs. Barnes & Noble


2

Update on the Online Battle

Amazon in 2004: $588m net income on revenues of $6,921m about 70% of the online book market market cap of $18 billion

Barnes & Noble in 2004: $143m net income on revenues of $4,874 about 15% of the online book market market cap of $2.3 billion

By 2005, Amazon had become the world’s largest onlineretailer with 47 million accounts. It had moved frombooks into other media (CDs, DVDs…) and then intoelectronics and a dozen other categories

Amazon added operations in the UK (1998), Germany(1998), France (2000), Japan (2000), Canada (2000), andChina (2004)

Key Takeaways

Competitor analysis is valuable across variousbusiness landscapes and can show the differencesresulting from differing ability to digitize products

There is usually a continuum of competitiveresponses—consider all and select the one thatbest works with your capabilities and is hardest toimitate

The sustainability of competitive advantage isoften complicated in virtual contexts. Online andoffline competition can coexist and interact

The threat of imitation for online business modelsis frequently overblown, but such business likelyhave to deal with new threats to sustainability

Next Session

Focus on creating value and competitiveadvantage

Case: Harnischfeger Industries


1


Creating CompetitiveAdvantage

Learning Objectives

Enhance our understanding of value creation,value appropriation, and value added

See how value creation and appropriationrelate to competitive moves

Apply these concepts to the Harnischfeger case

Why Care About Value Creation?

In any market, before consideringwho gets what it is important tounderstand what there is to get

What determines total value created?

Assessing Value Creation

Who are the players? What are customers willing to pay for

the good or service? What are suppliers’ opportunity costs

of providing the good or service?

The Value Chain Value Creation


2

Value Creation

Value created =Buyer’s willingness-to-pay

minusSupplier’s opportunity cost

This is the value that can beappropriated

Value Division

Value Added

Price measures the division of valuebetween business and customer

Cost measures the division of valuebetween business and supplier

What determines these divisions ofvalue?

Added Value

Value Added - A Simple Game

Imagine there are 30 students in this class. A blackcard is passed out to each student.

Added Value - A Simple Game

Imagine the instructor holds 30 red cards.


The Dean has agreed to pay $100 for each pair (1black + 1 red) of cards.

$100


3


How much would you be willing to accept for yourblack card? Imagine the instructor offered you$20. Would you accept this offer?

Added Value –A Slight Modification

Imagine the same game except now the instructoronly has 27 red cards. There are still 30 blackcards for 30 students. How much would youaccept for your black card?

Added Value in the card game =

When the instructor is in the game, the valueof the game is $3,000. When theinstructor is not in the game the value ofthe game is $0.

When there are 30 black and 30 red cards,each student has an added value of $100because without each student a matchcannot be made and $100 is lost.

Added Value in the card game =

When there are 30 black and 27 red cards,the instructor has an added value of$2,700 and an individual student has anadded value of $0. Since 3 students willend up without a match, no one student isessential to the game.

The total value of the game with 30 studentsis $2,700.

The total value of the game with 27 studentsis also $2,700.

What you get is based on youradded value

Added value =total value with you

minustotal value without you

It’s what you bring to others

(Brandenburger and Nalebuff, Coopetition, 1996)

What is your added value?

Ask yourself the following question:

If I enter this game, what do I add?

That is how much you can bargain for…


4

Summary

The size of the pie Willingness-to-Pay minus Opportunity Cost

The division of the pie: Added Value

The next step: what happens if youcannot cooperate to maximize valuecreated?

Harnischfeger Industries

Update on Harnischfeger…

Bob Hale of Harnischfeger chose to do battle withKranco

In July 1992, Kranco filed for Chapter 11bankruptcy after its biggest lender cut off the funds

In January 1993, Kone announced that it hadacquired Kranco’s operating assets, including therights to designs and trade names, for $3.5 million

This was about the worst possible outcome fromHarnischfeger’s perspective

In January 1998, Harnischfeger sold its crane unitto an investment firm and left the market foroverhead cranes

The Value Net

Key Takeaways

Value creation and value division are bothimportant aspects of strategy

If you only consider the competitive battle,you may miss the larger opportunities thatcome from creating value!

Added value largely determines the divisionof the pie

Expanding the game by bringing in newplayers may frequently be your best bet atcapturing more value (i.e. more of the pie)

Next Session

Move from creating to sustainingcompetitive advantage

Case: Saturn—A Different Kind of CarCompany


1


SustainingCompetitive Advantage

Learning Objectives

Examine how to create competitive advantageas a de novo entrant in a mature industry

Understand the challenges of sustainingcompetitive advantage

See how Saturn has used the configuration ofits value chain to secure its competitive position

Saturn: A Different Kind of Car Company Key Takeaways

As a de novo entrant in a mature industry, youcan only achieve competitive advantage bycreating value in a new way

The likely way of creating new value is throughreconfiguring the value chain to achieve novelproduct attributes

Sustaining competitive advantage may rest on anarrow set of interlinked activities

Taking actions to secure and protect competitiveadvantage can be a two-edged sword: it canprevent imitation but may also make knowledgetransfer to the corporate parent more difficult

Next Session

Strategy in a world of standards andnetwork externalities

Reading: Shapiro and Varian, “The Art ofStandard Wars”

Also: Check out the Blue-Ray/HD-DVDbattle going on right now


1


Standards and NetworkExternalities I

Learning Goals

Understand the role of standards instrategy and implementation

Know the rules of standards strategy andthe politics of standard setting

Apply these concepts to a current real-life example

Winning with Standards

Standards are central to business strategy,yet are often not well understood

Standards matter wherever productsdepend on compatibility (software, CDs, videotapes, lamp batteries, razor blades, typewriter keyboards,ski bindings, credit card systems…)

Standards change the game and therequired different strategies

Standards Require DifferentStrategies

The elements of the generic “Porter Style”strategy:

get in the market early differentiate the product protect it from imitation charge premium prices

With standards, successful strategies oftenwork differently. It may be smarter to…

hold back the product launch adopt a simple, undifferentiated, standard design encourage imitation by other manufacturers lower prices to maximize early sales

An Example…

versus

Sony vs. JVC

Sony launches its Betamax videotape recording system in1974

Two years later, JVC introduces its Video Home System(VHS), an incompatible alternative to Betamax

By that time, more than 100,000 Betamax machines hadalready been sold

BUT: JVC adopts a more “open” policy for partners,sharing information about the technology…

By 1984, the JVC “family” has 40 companies, includingGrundig, Hitachi, Matsushita, Philips, RCA, and Sharp,some of the biggest manufacturers in Japan, Europe, andNorth America. The Betamax group has only about adozen members


2

Sony vs. JVC: Number of Units Sold Sony vs. JVC: Share of VCR Market

Sony vs. JVC

Sources of JVC’s success: “Bandwagon” of supporting firms

Consumer confidence Faster pace of product improvement at moment of choice

Larger scale lowers costs Network externalities for consumers

The Result: by 1988, Sony conceded and beganproduction of VHS recorders; the war wasofficially over

Understanding Standards andNetwork Externalities

How Standards Change the Game

Standards introduce network effects “Demand side Economies of Scale”

Benefits that come from having a large installedbase of users

Classic examples are literal networks telephone network (“natural monopoly”) fax machines Internet

Number of possible connections grows rapidlywith number of users – “network externalities”

system with one user is of little use system with all customers on is very valuable

How Standards Change the Game

Positive feedback strengthens widely usedplatforms

Example: Windows vs. Mac Windows has more users, therefore

More retailers sell Windows PCs More software producers write for Windows Windows documents can easily be exchanged with

others More IT staff specialize in Windows

Therefore, still more people switch to Windows


3

Microsoft products are not necessarily better Some quality benefits from huge sales, but not crucial “Popularity adds value”

Switching costs can be considerable Legacy systems can create path dependencies

Where no clear winner exists yet Customer expectations for future will decide winner Need to lure developers and users in early stages

(win “mindshare”)

Network effects are not based onefficient production The Evolution of a Standard War

Who Wins and Who Loses FromStandard Adoption?

Consumers Generally better off Reduced uncertainty; no need to wait More users, more value But variety may decrease

Complementors Generally better off May serve in a brokering role (DVD)

Incumbents May be a threat Strategies

Deny backward compatibility Introduce its own standard Ally itself with new standard

Open versus Closed Standards

Some technological standards are open (WiFi networks,Ethernet, TCP/IP)

no one firm controls them specifications are public, anyone can build compatible products may require license fee

Some standards are closed, controlled by one firm (e.g.most of Windows)

Important tradeoffs here: Openness helps technology become dominant But success of a technology may not help the firm that devised

it (e.g. IBM and desktops) Closed systems can be controlled, so benefits don’t flow to a

competitor But development may be stifled and leapfrogging may occur

Discontinuity(Many vendors)CD audio, 3.5” disks

PerformancePlay

Palm Pilot,Iomega Zip

Incompatible

Open Migration(Many vendors)Fax machines,

some modems

ControlledMigration

Windows 98,Pentium,Softwareupgrades

Compatible

OpenControl

Strategies for New Standards:Open vs. Closed

Part One: Tactics in FormalStandard Setting

Don’t automatically participate If you do you have to license

Keep up momentum Continue R&D while negotiating

Look for logrolling Trading technologies and votes


4

Part One: Tactics in FormalStandard Setting

Be creative about deals Second sourcing, licensing, hybrids, etc.

Beware of vague promises Definition of “reasonable royalties”

Search carefully for blocking patents Also patents held by non-participants

Preemptively build an installed base

Part Two: Tactics in StandardWars

Standard wars emerge when twoincompatible technologies struggle tobecome a de facto standard

These wars usually end in truce (56 k modems) duopoly (video games) fight to death (VCRs)

Key Assets for Standard Wars

Control over an installed base Intellectual property rights Ability to innovate First-mover advantages Manufacturing Strength in complements Reputation and brand name

Two Basic Tactics forStandard Wars

Preemption New technologies require champions willing to invest

early to build an installed base Being first to market can backfire if superior technology

will soon arrive

Expectations management Engage in aggressive marketing, make early

announcements of new products, assemble allies,make visible commitments to your technology

Blu-ray vs. HD-DVD

vs.

Strategies after you win a war

Staying on your guard Offer your customers a migration path to fend off

challenges from upstarts

Leverage your installed base andcommoditize complementary products But enter adjacent markets only if integration adds

value for consumers

Competing with your own installed base You need improvements to drive upgrade sales


5

Strategies after you win a war

Protecting your position Offer ongoing attractive terms to important

complementors

Stay ahead Develop proprietary extensions to improve your

technology

Strategies if you fall behind

Adapters and interconnection Target a market niche or interconnect with the larger

network (American Express with Visa)

Survival pricing It doesn’t work

Legal approaches If all else fails, sue!

Key Takeaways

Understand the positions and interests of allparties involved in a standards competition

The strength of your position in standardscompetitions depends on seven key assets

Preemption is a critical tactic, but there are waysaround it

Expectations management is critical; self-fulfillingprophecies can overrule technical advantage

Once you’ve won the war, don’t rest; beware ofleapfrogging

Next Class

Apply standard strategy to themarketplace

Prepare Browser Wars Case


1


Standards and NetworkExternalities II


Analyze fast-moving competition in anindustry with network externalities

Understand the dynamics of a small firmtaking on a much larger rival

Competition in Dynamic IndustryEnvironments

Competitive advantages erode quickly Established rules are broken Industry boundaries are breached Customer loyalty is fickle Sustainable competitive advantages

becomes a series of shorter unsustainablecompetitive advantages

New Rules of CompetitiveEngagement

Don’t cling to competitive advantages—createnew ones

Entry barriers are easily overcome Consistency and logical thinking make your firm

predictable, so think outside the box Long term planning only prepares you to sustain

and exploit existing advantages, so work to createnew competencies and advantages

Consistently attacking your competitor’s mainweakness forces them to become stronger, soattack a range of weaknesses

(D’Aveni--Hypercompetition)

The Browser Wars

vs.

Mike Homer—Netscape

Held Senior Positions atNetscape as well asother firms such asApple and AOL

Graduate of Universityof California at Berkeley


2

Usage Share of Major WebBrowsers

Source: Wikipedia.org

The Next Challenger: Firefox

vs.

Current Market Share Key Takeaways

The winning strategy in the Browser War Get market share (give the product away) Innovate constantly Adopt open standards; but not too open

“Judo Strategy”: target your opponents weaknessand use it as leverage Netscape exploiting its competitors’ retail sales and

revenue streams Microsoft doing the same to Netscape

“Hardball Strategy”: use “unfair” advantage Microsoft exploiting its Windows advantage

End of the course’s first part

Move on to strategy implementation Prepare Honda (A) case

Have a great break!


1


Strategy Formulation andImplementation I

Second Part of the Course

How do good strategies get implemented? What can managers do to foster good

strategies?

The Honda Case (A) Next Class

Prepare Honda (B) case Read Eccles and Nohria: “Strategy as a

Language Game”


1


Strategy Formulation andImplementation II

Understanding Strategy

Honda (A) and (B): Two versions of a story that

emphasize the differences betweenplanned and emergent strategies

Where we left off…

Whatmotorcyclesused to beabout in the1950s…

July 21st, 1947 LifeMagazine Photo

Where we left off…

…and what Honda didwith it!

Changed marketperception of thedefinition of a motorcycle

Drove rapid increase inoverall U.S. market formotorcycles

Grew from ~ 0% in 1959to 43% of total market in1974

BCG’s View of Honda’s Entrance intothe US Motorcycle Market Honda (A)

Made strong investments in R&D Used extensive vertical integration Aggressive low price strategy for entry into USA. Market strategies expanded and redefined the market

segment – “You meet the Nicest People on a Honda”,through pricing, distribution and advertising.

Progressive expansion of market from region to region(West to East) over a six year period

Construction of plant with a capacity 10x demand Low cost producer with high volumes and high

productivity based on capital intensive automatedtechniques to exploit economies of scale; focus on long-term profitability & share

The Inside View of Honda’sEntrance Honda (B)

Soichiro Honda onthe assembly line(circa 1950s)


2

Two Views of Strategy The Design School in Strategy

Ex-ante analysis, thinking and reasoning. Assumes all relevant factors can be objectively

analysed Assumes that this analysis precedes and

dominates action – implementation follows as aseparate stage.

Separates thinking from doing and often implies ahierarchy – senior management thinks – othersimplement.

Option appraisal is conducted logically on thebasis of analysis

The Classic Planning Process

IdentifyMission,Goals, &

Strategies

Analyze theEnvironment

AnalyzeResources

Opportunitiesand Threats

Strengths andWeaknesses

ReassessObjectives

FormulateStrategies

ImplementStrategies

EvaluateResults

The Learning School in Strategy

Strategy making takes place within anunpredictable worldCreates the necessity for flexible strategic approaches

Serendipity (accidental discoveries, luck, etc.) isrequired for effective performance

Strategy is often made by lower-level managersStrategy evolves through autonomous action

Strategy has both intended and emergentcomponentsRealized strategies are combinations of intended andemergent strategies


3

Mintzberg’s Three Fallacies ofStrategic Planning

Fallacy of predeterminationThe future is unknown

Fallacy of detachmentImpossible to detach formulation from implementation

Fallacy of formalizationInhibits flexibility, spontaneity, intuition, and learning

All three contribute to the “Grand Fallacy”:"Because analysis is not synthesis, strategic

planning is not strategy formation"(Mintzberg 1994, “The Rise and Fall…”, p. 321)

Deliberate versus Emergent Strategies

IntendedStrategy

RealizedStrategyUnrealized

Strategy

Deliberate Strategy

Emergent Strategy

Adapted from: Mintzberg, H. “The Strategy Concept I: Five Ps for Strategy” California Management Review. Volume 30Number1, Fall 1987.

SustainedSuperior

Performance

Eccles and Nohria

Strategy as Robust Action

Robust Action is…

Acting without certitude Constantly preserving flexibility Being politically savvy Having a keen sense of timing Judging the situation at hand Using rhetoric effectively Working multiple agendas

Eccles & Nohria, Beyond the Hype

What, then, is the role ofstrategic planning?

1. Provide a structured mechanism for analysis andthinking about complex strategic problems

2. It involves people in strategy process giving themownership

3. Planning helps communicate the strategy4. Planning assists control by requiring regular

review of performance5. Assist in presentation of alternative and possible

radical ways of considering strategic issues–“thinking outside the box”

Key Takeaways

Effective strategies combine both deliberate andemergent elements; both are important

Strategic planning processes should really beviewed as strategic learning processesUse strategy language to build consensus on mission,objectives, and strategic alternatives

Plans and processes must be robust enough to… …allow a company to rapidly take advantage ofopportunities as they occur

…enable various levels and functions within theorganization to contribute to the emerging strategies


4

Next Session

Continue with implementation andchange inside the firm

Prepare Lehman Brothers (A) case


1


Implementationand Change I

Session Objectives

Examine strategy implementation upclose and personal

Understand the key ingredients insuccessful strategy implementation

Understand what it takes tosuccessfully manage change

Lehman Brothers (A) The Rise of Lehman Brothers’ EquityResearch Department, 1987-1990

The 7-S Framework The 7-S Framework

A tool for determining the “doability” of strategies

Used for internal analysis of a company

Analyze strategic characteristics of a company

Aims to create alignment among variousdepartments of an organization

Allows to examine the effect of change on acompany

Analyze the successful and dysfunctional aspectsof an organization


2

The 7-S Framework: “Hard S”

Strategy – a plan of action to maintaincompetitive advantage over the competition

Systems – measures and actions whichaccommodate the execution of daily activities

Structure – the way the organization isstructured, who reports to whom

The 7-S Framework: “Soft S”

Style – how do you lead? Personal style?

Shared Values – company culture, work ethicsetc

Staff – company employees and their capabilities

Skills – core competencies of the company aswell as that of its staff

Beer’s Formula of OrganizationalChange

Δ = f(D•M•P) - C

Δ is the effectiveness of change, which is apositive function of D (dissatisfaction), M(model, or vision), and P (change process)that need to be greater than C (cost ofchange).

(Michael Beer, “Leading Change,” HBS Press, 1988)

Leading OrganizationalTransformation

Desired State

Existing State

Effective transformation path

Ineffective transformation path

Wor

k en

viro

nmen

t

Operational efficiency

The Five Forces of Management

Down

Up

Across OutSelf

Down

Key Takeaways

Successful strategy implementation requires the alignmentof all the seven S’s—fit is just as important inside asoutside!

Know Beer’s formula of organizational change: it’s afunction of Dissatisfaction, Model, and Process

When implementing a new strategy, start with the hardpart of operational improvement! Only then make thetransition to improving the work environment. But domake it!

Success in playing a game changes the game. Failure toappreciate the consequences of one’s success and tenacityin playing the old game are what tragedies are made of!


3

Next Session

Continue with implementation andchange

Prepare Lehman Brothers (B) case


1


Implementationand Change II

Session Objectives

Examine the factors that lead to thedecline of Lehman Brothers

Understand the challenges of strategyimplementation and staying on top

The role of leadership in strategyexecution

Lehman Brothers (B): The StoryContinues…

The Rise and Fall of Lehman Brothers’Equity Research Department, 1987-1995

The 7-S Framework: What’s notaligned now…?

Leading OrganizationalTransformation

Effective

IneffectiveGlo

bal C

oord

inat

ion

Local Autonomy

Ineffective


2

“More than anything else,management cut the analysts’emotional ties by ejecting thenucleus of the department, Jackand Fred” (Dean Eberling, 1993)

How Much Do You Want to Rely onPeople?

What Happened Next…

Firm-wide change, 1997-2001: Employees up more than44% since 1997, as Lehman bulks up in banking, equityresearch, and sales & trading− 2001: 2/3 of Lehman’s revenues from trading and underwriting,

with the balance from bonds; in 1997, it was opposite− 2001: Lehman’s 150th anniversary; average tenure of upper

ranks: 22 years; “no splashy acquisitions, no managerial coups,no lay-offs; employees own 35% of the firm

“2001 was Lehman’s year…” Posted the best ROE of anysecurities firm; top tier of corporate debt underwriting;almost doubled its equity underwriting market “It wasn’t what happened in 2001. It takes years to create

change” (Fuld) No plans to downsize; “Now is the time to build market share”

(Fuld, 2002)

Back on top…but at what price?

How They Did It Again

In 1999, analyst Steve Hash is Lehman’s newequity research head

Hash gets senior leadership’s mandate to rebuildthe equity research department

He consults with Fraenkel and reintroducesseveral of Rivkin & Fraenkel’s processes to thedepartment Training sessions Weekly meetings

Hash later reflects that he had taken “all thatJack and Fred had done” and did it again—andthe formula had again succeeded

Back on top…but at what price?

An industry expert estimated it cost Lehman close to$100 million in additional expenses to get back to #1


3

Why Many Strategies fail…theImportance of Execution

“We had a failure in communication and execution, not inplanning…” (Chris Pettit, August 1995)

Common mistakes in execution: The strategy is not made by those responsible for its execution Pursuing too many initiatives concurrently Failure to appreciate the weaknesses of the assumptions and

develop contingency plans Successful execution involves both communication and

politics. It entails… Jointly setting goals Following through and holding people accountable Learning from how reality deviates from the plan.

“Execution…it’s the leader’s most important job.” (Bossidyand Charan, 2002)

Effective leadership is key to execution

John Chambers and Jack WelchLeadership Styles

Seven Critical Aspects ofSuccessful Execution

1. Know your people and your businessCan you trust the information you get or has itbeen extensively filtered?

2. Insist on realismCan you clearly articulate the organization’sproblems and weaknesses?

3. Set clear goals and prioritiesAre the business priorities few in number andfocused in a constructive way?

4. Follow throughHow many meetings have you attended in whicha good idea surfaced, but never got done?

Seven Critical LeadershipAttributes

5. Reward the doersDo you have a process in place that rewards high-performers objectively, fairly, and openly?

6. Expand people’s capabilitiesDo you spend enough time directly coaching,providing feedback, and cultivating people?

7. Know yourselfCan you be honest with yourself, deal objectivelywith business and organization realities, and givepeople direct and forthright assessments?

Key Takeaways

Many excellent strategies fail because of poorexecution

Good execution keeps the 7 S’s aligned—fitrules!

Good execution accepts the role ofcommunication and politics

Good execution is flexible enough to roll withthe punches and builds options into the process robust action

Next Session

Managing with networks and power Burt, “Structural Holes: Introduction” Reading: Cross, Borgatti, and Parker,

“Making Invisible Work Visible”


1


Managing withNetworks and Power I

Learning Goals

Understand how and why networks matter Know the different characteristics of

networks and network positions Know the basic concepts tools for analyzing

your firm’s and your own position in anetwork

What is “Six Degrees”?

“Six degrees of separation between us and everyone else on this planet”

John Guare (1990)

The Kevin Bacon Game

Invented by Albright Collegestudents in 1994

Goal: Connect any actor toKevin Bacon, by linking actorswho have acted in the samemovie.

Oracle of Bacon website usesInternet Movie Database(IMDB.com) to find shortestlink between any two actorshttp://oracleofbacon.org/

The Kevin Bacon Game:An Example

KevinBacon

TimRobbins

Om Puri

Amitabh Bachchan

Yuva (2004)

Mystic River (2003)

Code 46 (2003)

Rani MukherjeeBlack (2005)

Source: Kentaro Toyama, Microsoft Research India

Not Quite theKevin Bacon Game…

KevinBacon

TeriHatcher

Larry Shaw

Peer Fiss

Is the brother of…

The Big Picture (1989)

Desperate Housewives (2004)

Lynda ManssonIs the aunt-in-law of…


2

Another Fun Example: The ErdősNumber

Number of links required toconnect scholars to Paul Erdős,via co-authorship of papers

Erdős wrote 1500+ papers with507 co-authors.

Jerry Grossman’s (Oakland Univ.)website allows mathematicians tocompute their Erdos numbers:

http://www.oakland.edu/enp/

Connecting path lengths, amongmathematicians only: average is 4.65 maximum is 13

Paul Erdős (1913-1996)

The Science Behind “Six Degrees”

The Small World Experiment (Milgram, 1967)

A single “target” (stock broker in Boston) Random ”senders” chosen in Nebraska Each sender asked to forward a packet to a

friend who was “closer” to the target All friends got the same instructions 64 packets reached the target via different

“chains” Typical length of chain?

Stanley Milgram (1933-1984)

Six…

Society as a Graph

People arerepresented asnodes

Society as a Graph

People arerepresented asnodesRelationships arerepresented asedges (lines)(Relationships may befriendship, colleagues,business contacts etc.)

Ring graphFully Connected graph

Random graph

Power Law Graph

The Small World EffectWatts and Strogatz (1998)

b = 0 b = 0.125 b = 1

People knowothers atrandom.

Not clustered,but “small world”

People knowtheir neighbors,

and a few distant people.

Clustered and“small world”

People know their neighbors.

Clustered, butnot a “small world”


3

First five random links reducethe average path length of thenetwork by half, regardless ofN!

So what would it take for anyworld at all to be small?It turns out: not much…Some source of “order”The tiniest amount of randomness

So: Small World Networksshould be everywhere!

Clu

ster

ing

coef

ficie

nt /

Nor

mal

ized

pat

h le

ngth

Clustering coefficient (C) and average path length (L) plotted against b

The Small World EffectWatts and Strogatz (1998)

But Who Cares…?

Why do networks matter?

Why is Six Degrees interesting?

The 9/11 Hijackers and TheirAssociates

Nodes: investment pharma research labs public

biotechnology

Source: http://ecclectic.ss.uci.edu/~drwhite/Movie

Business ties in US Biotech-Industry: 1988

Links: financial R&D collab.

Source: http://ecclectic.ss.uci.edu/~drwhite/Movie

Business ties in US Biotech-Industry: 1991

Nodes: investment pharma research labs public

biotechnology

Links: financial R&D collab.

black: opinion leaderspurple: influencedgreen: uninfluencedgrey: undecided

Viral and Buzz Marketing

Source: http://www.orgnet.com


4

Typical Small Interfirm ProductionNetwork in NYC Garment Industry

Source: Uzzi, ASQ 1997

Example 1: Finding a Job

Contrary to economic theory, many labormarkets rely on personal contacts

We ask family, friends, colleagues for help In particular, we tend to use “weak ties”

(Granovetter) and also friends-of-friends,because they are more likely to have non-redundant information

Hence, the “Strength of Weak Ties”

Example 2: Making BusinessContacts

PeterJane

Sarah

Ralph

Example 3: Mapping Email Flow to Find„Hidden“ Communities of Experts

colors refer todepartment affiliation

source: http://www.orgnet.com

Example 4: Alliance Networks

Access to know-how, contacts, resources expands thesize of radar screen and make you detecttechnological discontinuities, emergent markets, newdesigns

Direct and indirect ties are positively related toinnovation (Ahuja 2000)

Experience and centrality in the network are related tosuccess—the relevant knowledge is widely distributedoutside the firm (Powell et al. 1996)

The position of the firm in the alliance network alsodetermines the propensity to collaborate (Stuart 1998)


5

Networks and Social Capital

Ron Burt argues that social capital is a “usefulmetaphor,” explaining “how people do betterbecause they are somehow better connectedwith other people,” and that we need to “cutbeneath the metaphor to reason from concretenetwork mechanisms responsible for socialcapital” (Burt 2005)

What are the “concrete network mechanisms” that create advantage for communities & organizations? How do individual membership patterns shape

community cohesion?LOW Cohesiveness

Network Foundations of Social Capital

A collectivity is structurally cohesive to the extent thatthe social relations of its members hold it together

Add more ties ….


But when focused on a single person, the network is fragile!


Remove that one person and the whole networkdisintegrates… Problem!


Solution: Spreading relations around the structure makes it robust to node removal



6

As structural cohesion increases, fewer nodes are able tocontrol resource flow within the network

Power is more evenly distributed because nobodycontrols access to network resources

Information flows more uniformly across the network Norms & values tend to be more uniform Informal Social Control is uniform as there are fewer

opportunities to free ride

The collectivity should take on a community character

Network Foundations of Social Capital A Key Feature: Structural Holes(Burt 1992)

Structural Holes are disconnects between contacts thatcreate social capital via brokerage opportunities

Ego actor gains earlier access to flows of valuableinformation

Ego fills structural holes by forging new ties linking itsunconnected alters, extract “commission” or “fee” forproviding brokerage services

Information and control benefits mean better performance,which mean higher return on human capital

Ego maximizes its self-interests by controlling & exploitinginformation, playing one actor against another (“tertiusgaudens”)

A

YOU B

D

C

Structural Holes Filled by “You”

Redundant contact

Non-redundant contact

Structural Holes and the SocialStructure of Competition

?

How Network Position Matters

Structural holes provide important benefits.For example…

Brokers occupying structural holes earn biggerbonuses

Managers located in structural holes arepromoted earlier in their careers

People located in structural holes often have“better ideas” than others

(Burt 1992; 2003)

How Network Position Matters

You

Network A’

You

Network B’ Network C’

You

Strategic Network Expansion


7

Combining Brokerage and Closure

© 2004 Ronald Burt. Brokerage and Closure, Cambridge University Press 2005.

Exercise: Assessing YOURNetwork

Ask yourself the following questions…

Academic matters Who are the people with whom you have discussed important

projects and assignments?

Job Search What people have been most helpful in your job search so far?

Friends Who are your closest friends?

Professional development during your time at USC What people have contributed most significantly to your professional

development during the last year?

Key Takeaways

Network centrality and structural holes areimportant for determining power and knowledgeflows—both for firms and for your personalexperience. Brokers do better!

Social capital and power come from the bridgesthat a person can build between others

It is the diversity of contacts that generates socialcapital—strength lies in weak ties

Network effectively; what does a new contactadd to your network? What do YOU contribute totheir network?

Next Session

Prepare case: Abelli and Savotti atBanca Commerciale Italiana (A)


1


Managing withNetworks and Power II

Learning Objectives

Get experience applying tools of networkanalysis

Examine the role of power and influence ininterorganizational and interpersonalnetworks

Abelli & Saviotti at BCI Another Example: The GermanNetwork of Crossholdings

Italmobil iare

HdP

SAI

Burgo

Pirel l i

Banca Intesa

Banca d’Ital ia

Lazard

Unic reditoItal iano

Banca diRoma

Commerzbank

General i

Paribas

Compart

Banca Commerc iale Ital iana

Deutsche BankFIAT

Mediobanca

6%

3.2% 8.1%

2%

3.4%

1.2%

4.5%

0.6%4.9%

5.7%

21%

6.2%

13.2%

1%

3.3%0.4%

4.5%0.8%

9.2%

4.9%

1%

3.3%

0.7%

9.4%

2.9%

2%

3.1%

2%

12.5%

8.2%

4.7%

1.7%

7.6%

14.5%

2%

3%

2.2%

2%

4.5%

1.4% 2.2%

1.9%

13.1%3.1% 2%

2.1%

14.2%

0.4%

11.7%

2.7%

10%4.8%

5%5%

Cross-shareholdings—March 1999

12.5%

4.9%

Italmobil iare

HdP

SAI

Burgo

Pirel l i

Banca Intesa

Banca d’Ital ia

Lazard

Unic reditoItal iano

Banca diRoma

Commerzbank

General i

Paribas

Compart

Banca Commerc iale Ital iana

Deutsche BankFIAT

Mediobanca

6%

3.2% 8.1%

2%

3.4%

1.2%

4.5%

0.6%

5.7%

21%

6.2%

13.2%

1%

3.3%0.4%

4.5%0.8%

9.2%

4.9%

1%

3.3%

0.7%

9.4%

2.9%

2%

3.1%

2%

8.2%

4.7%

1.7%

7.6%

14.5%

2%

3%

2.2%

2%

4.5%

1.4% 2.2%

1.9%

13.1%3.1% 2%

2.1%

14.2%

0.4%

11.7%

2.7%

10%4.8%

5%5%

Cross-shareholdings—March 1999


2

Italmobiliare

HdP

SAI

Burgo

Pirelli

Banca Intesa

Banca d’I talia

Lazard

UnicreditoItaliano

Banca diRoma

Commerzbank

Generali

Paribas

Compart

Banca Commerciale Italiana

Deutsche BankFIAT

Mediobanca

Sav iotti

Gutty

Lucchini

LucchiniGutty Desiata

Rondelli

v Ruedorf err

F.-PoncetRondelli

Gutty

Sozzani

Director Interlocks—March 1999

LucchiniGutty

Sav iotti

Influence Matrix for BCI Case

BCI: What Happened Next…

May 12, 1999: BCI chairman Luccini calls a generalshareholders meeting for June 21

May 15, 1999: Under pressure from the Mediobancacoalition, the BCI board rejects the Unicredito proposal

June 17, 1999: The BCI board convenes to asses BancaIntesa’s offer (70% stake, BCI to remain a separate entitywithin Banca’s group)

June 20, 1999: Abelli and Saviotti resign with the entireBCI board except for Luccini and one other board member

What Happened Next… (Cont’d)

• June 21, 1999: The general assembly the next dayappoints a new board that duly reflects Mediobanca’scontrol over BCI. Fausti is appointed honorary chairman

• June 23, 1999: The governor of Banca d’Italia (thecentral bank) publicly states his approval of the BancaIntesa deal

• End of June, 1999: BCI and Banca Intesa seal atakeover deal; by September, Banca Intesa has completecontrol of BCI

A Comparison of the BancaIntesa and Unicredito ItalianoOffers

Source: Morgan Stanley Dean Witter Researchestimates, MSDW Equity Research, 09/01/1999

What Happened Next… (Cont’d)

So Mediobanca seems to have prevailed…?

April 2000: Banca Intesa severs its ties withMediobanca! Moreover, the reorganization of IntesaBCIturns BCI into a direct competitor of Mediobanca

June 2000: Mediobanca Honorary Chairman, EnricoCuccia, dies

2001 and after: Mediobanca’s influence over Italy’scorporate world continues to decline. By 2003, itsshareholders agree to restrain the banks managementfrom using its holdings as a means of control overcorporate Italy


3

(Some) Key Takeaways

Understanding power and influence in complexnetworks is an important advantage; as both A&Sand Cuccia found out, you have to know theterritory

There is a lot more to power than authority andcompetence; often power is best exercisedindirectly through intermediaries

There is considerable value in buildinginterdependent relationships with key playersover time that can be leveraged when needed inthe future

Next Week

Last topic relating to strategyimplementation: Performance andGovernance

Sharon Oster “Organizational Goals:Politics and Power in Organizations”

Prepare Monks and Minow on “ArthurAndersen”


1


Performance andGovernance I

Goals for this Session

Examine challenges to implementingstrategy and the essential problem of thepublic company

Know the various mechanisms forexercising corporate governance

Examine problems at Arthur Anderson

Strategy, Performance, andIntegrity

A critical function of managers is to create strongcompetitive strategies that enable the company tomeet financial goals without compromisingintegrity

BUT: Today’s business environment isextraordinarily complex Less staff forces organizations to do more with less Expense reductions continue to be major way

companies increase EPS Earnings growth continues to be core focus Unrealistic performance goals can pressure those who

must make them work Reward and compensation systems can expose

employees to ethical compromises

Arthur Andersen’s HoustonBranch Office

“…perhaps nothing can bring a company down with suchamazing speed as misconduct.”

M. Ingebretsen, Why Companies Fail: The 10 Big Reasons Businesses Crumble, and How toKeep Yours Strong and Solid. (2003)

The Paradox of Operating as aPublic Company

Pressures

Wall Street Influence Investor expectations Earnings growth Quarterly pressures

Exec. Compensation Increase in overall level,

stock options

Economic Cycle Cyclical Industry

OffsettingControls

Compliance (Enron)

Disclosure (Worldcom)

Governance (Tyco)

Ethics and integrity ofparticipants (ArthurAndersen)

An Example: The “Walk-down toEarnings Game”

Analysts are “systematically optimistic” regarding earningsforecasts at the beginning of the fiscal reporting period

Aware of these tendencies, company financial officers give“guidance” to analysts (usually in the form of discretionaryinformation disclosures” suggesting the analysts lowertheir estimates)

As analysts lower their estimates towards the end of theperiod

The company releases its official reported earnings at alevel that “beats” the analyst estimates

The analysts issue “strong buy” recommendations If the game is played right, the company’s stock

will rise sharply on the day it announces its earnings


2

The Public Company Conundrum

Strengths Ability to raise enormous amounts of capital and spread risk Transparency - financing activities are visible and information

readily available / Poor performance results in lower share values Corporations are disciplined both by their internal governance

systems and by competition in product and factor markets

Weaknesses Separation of ownership and control results in an agency problem Lack of powerful, informed monitors results when the

shareholdings are widely dispersed Entrenchment incentives - management may invest in protecting

their jobs rather than creating value Excessive mandated information disclosure lowers value of

proprietary product and strategic information

A historical example…

On a boat trip up China’s Yangtze River in the 19th

Century, a titled English woman complained to her hostof the cruelty to the oarsmen. One burly coolie stoodover the rowers with a whip, making sure there were nolaggards.

Her host explained that the boat wasjointly owned by the oarsmen, andthat they hired the man responsiblefor flogging!

Why would such an organizational arrangement arisevoluntarily?

Agency Relationship: Owners andManagers

• Risk bearing specialist(principal) pays compensation to

• A managerial decision-makingspecialist (agent)

An AgencyRelationships

Managers(Agents)

Shareholders(Principals)

• Decision makers

• Firm owners

Basic Problems of InformationAsymmetry

Moral Hazard: the principal and agent share thesame information up to the point at which the agenttakes an action, but thereafter the principal is only ableto observe the outcomes

Adverse Selection: the principal does not know someinformation which is relevant to the action (such as theability of the agent to perform the task), whereas theagent can make use of this information to his ownadvantage

The essence of the Agency Theory is that thePrincipal has inferior information to the Agent.

The Tradeoff Between Profitabilityand Revenue Growth Rates

Manager and Shareholder Risk andDiversification

Ris

k

Diversification

DominantBusiness

UnrelatedBusinesses

RelatedConstrained

RelatedLinked

Managerial(employment)

risk profile

B

Shareholder(business)risk profile

A


3

How is Corporate ControlExercised

The Board of Directors The elected B of D is responsible for hiring, firing,

monitoring, and setting the compensation of the firm’smanagers

The B of D has broad discretion to direct the company’saffairs and is supposed to ensure that the firm is managedin the best interest of shareholders

Shareholder votes are also requiredto approve corporate mergers,to authorize the sale of majorassets, to amend the firm’s bylaws,and to authorize the issuanceof new equity issues

How is Corporate ControlExercised (really…)

Directors are frequently selected by managementand are beholden to them for their jobs

CEOs are all to often also the chairs of the boards,which creates all kinds of accountability problemsThis is the case in about 75% of S&P 500 firms in theUS (McKinsey & Company US Directors Survey,2002)

Boards too often have poor procedures ofevaluation in place, both regarding managementand their own performance

As a result, BoDs often exercise rather littlecontrol…


Disclosure and Shareholder Meetings Publicly-traded companies are required to annually disclose

a great deal of information about corporate earnings,executive compensation, and the ownership of thecompany’s voting shares

Further, these firms are also required to hold annualshareholders’ meetings, which is open to all owners ofeven a single share of common stock

In announcing these meetings, corporations send everyshareholder a proxy statement that describes: the meeting agenda, spells out precisely which issues are to be voted on by shareholders, and provides a form for shareholders to use either to vote

personally at the meeting, via www, via telephone or to assign theright to vote the shares they own to someone else

How is Corporate ControlExercised (really…)

Most corporate elections are usually staid affairswhere shareholders are asked to vote for orwithhold their vote for single slate of companydirectors

“Proxy fights” occur when a rival group ofshareholders nominate a slate of alternativedirectors who do not support the currentmanagement team.

However, these are relatively rare due to expenseto shareholders

As a result, shareholders often have littleopportunity or incentive to actively engage incorporate control

Flow of Authority in CorporateGovernance

© 2006 The McGraw-Hill Companies


4


Compensation and Incentives In 2006, the average total compensation of chief

executives of S&P 500 corporations was $14.78 million,including salaries, bonuses, and incentive plans

That’s a 9.4% increase in CEO pay over 2005 The connection between superior performance and pay is

rather tenuous CEOs Henry McKinnell of Pfizer and Robert Nardelli of Home Depot

both received exit packages of more than $200 million. Both firmsunderperformed during their tenures

Compensation on average consisted of Salary (cash): ~20% Short term incentive plans (bonus): ~20%, usually tied so specific

measures (ROI, net profits…) Long term incentive plans (stock option plans etc): ~60% Other benefits (insurance, legal, pension etc.)

Compensation and CorporateEarnings (Bebchuck & Grinstein, 2006)

Source: Bebchuck & Grinstein, The Growth of Executive Compensation (2005)

Market Downturn and theDilemma with Stock Options

The problem of “underwater” options…

Why take action?

Why NOT take action?

An External Mechanism: TheMarket for Corporate Control

To the extent that managers do not act in the bestinterest of shareholders, the stock price of the firm will beless than what it would have been if the managersfocused on maximizing shareholder wealth.

The market thus operates when firms face the risk oftakeover when they are operated inefficiently. Many firmsbegin to operate more efficiently as a result of the“threat” of takeover.

Hence, the market allegedly acts as an important sourceof discipline over managerial incompetence and waste

However, it’s an expensive last resort…and oftendoesn’t work!

Impediments to the Market forCorporate Control

Entrenched insider groups frequently fight these bidsusing: Various court actions Staggered boards Poison pills Amendments to the corporate charter Greenmail Selling off “crown jewels” (aka “scorched earth”) Searching for white knights Any other strategy designed to discourage the bidder from

pursuing the target further

Firms frequently succeed in fending off takeover bids evenwhen they would yield the target firm shareholders verylarge share premiums

The Full Picture on CorporateControl…

Boards of Directors have a fiduciary duty toshareholders to monitor management, but…

Principals (i.e. shareholders) may engage inmonitoring behavior to assess the activities anddecisions of managers, but…

Executive Compensation can be used to alignthe incentives of managers and owners, but…

The Market for Corporate Control candiscipline ineffective management, but…


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Arthur Andersen Arthur Andersen Background Info

Arthur Andersen was an accounting andconsulting service that operated businessesthroughout the US & world.

The 89 year old company was part of the “Big 5”accounting firms.

Main headquarters in Chicago, Illinois andHouston, Texas.

Enron, the large energy corporation, was a clientof Andersen’s for 16 years up until Enron’s 2001bankruptcy.

Timeline of the Scandal

In the summer and fall of 2001, Arthur Andersenforesaw government litigations and investigationsagainst Andersen and Enron.

October 16th,2001- Enron issued a press releaseannouncing the company’s $618m net loss for the3rd quarter of 2001.

On the same day, Enron reduced shareholder’sequity in the stock and the stock priceplummeted.

Timeline (cont’d)

October, 2001- Enron informs Andersen todestroy all paper documents and emailsconcerning Enron.

Shortly after, the SEC starts an investigation ofthe two companies.

Lawyers defending Arthur Andersen argued thatshredding documents was a routine practice.

Eventually, Andersen was charged withobstruction of justice for destroying thedocuments before the collapse of the energygiant.

August 31, 2002- Arthur Andersen dissolves

Key Takeaways

Know (and be able to “speak”) Agency Theory;it is the most dominant theory today incorporate governance and likely to remain so inthe future

Also know the limits of Agency Theory; it haslittle to say about trust, dominant social,political, or organizational culture. Thesematter! (and may differ considerably…)

All the different mechanisms of internal andexternal governance as currently on the bookshave their weaknesses—know and avoid them!

Next Session

Prepare Bausch & Lomb Case


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Performance andGovernance II

Session Goals

Examine what factors contribute tounethical conduct in organizations

Understand what went wrong at Bausch& Lomb

Corporate or “White Collar” Crime

“…crime committed by a person of respectability and highsocial status in the course of his occupation” (Sutherland1939)

Encompasses a variety of non-violent crimes usuallycommitted in commercial situations for financial gain,including

antitrust violations, computer/internet fraud,credit card fraud, phone/telemarketing fraud,bankruptcy fraud, healthcare fraud, environmentallaw violations, insurance fraud, mail fraud,government fraud, tax evasion, financial fraud,securities fraud, insider trading, bribery,kickbacks, counterfeiting, public corruption,money laundering, embezzlement, economicespionage, trade secret theft etc…

Corporate or “White Collar” Crime

In the U.S., the cost of corporate crime such as price-fixing and unsafe or illegal practices is estimated at up to$200 billion annually

Employee theft is 10 times as big a problem as streettheft, white collar crime is 2-10 times as big a problem asemployee theft

White collar criminals are far less likely to be investigated,arrested or prosecuted than other types of offenders

White-collar crime is especiallydangerous because of opportunitiesfor large-scale thefts; large enoughto sink even a large company

Companies reporting fraud byindustry sector (Global)

Source: PWC Global Economic Crime Survey 2005

45% of companiesworldwide

reported beingvictims of

economic crime inthe last 2 years

Fraudster’s relation to thecompany


Typical profilemale (80%), between 31 and

41 years (34%), educated withdegree or higher (48%)


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Almost a quarter of actscommitted by senior

management

Reasons for committing fraud How are companies respondingto the threat of fraud…?

KPMG’s survey of large companies in 2002found that

10% admitted fraud is “something we have not reallythought about”

17% said fraud risk management is not adequatelyaddressed

55% said they needed to improve channels for reportingsuspicion of fraud

More than 80% said the person with overall responsibilityfor fraud prevention and detection is either the CEO or CFO

KPMG Fraud and Misconduct Diagnostic Survey 2002

Bausch & Lomb: Pressure to Perform Bausch & Lomb: Missing the Mark

Essential Elements of StrategicControl Systems

Boundaries

Culture Rewards

Between 1994 and 1995, the value of the company’sshares sank by about a third

Daniel Gill retired in late 1995 in response to increasinglyangry shareholders

A later SEC inquiry cleared Gill personally but stated that“Bausch & Lomb violated the anti-fraud, reporting andrecord keeping, and internal control provisions of theExchange Act.”

Bausch & Lomb struggled to develop a viable long-termstrategy, resulting in the restructuring of the company inlate 2001 and early 2002, which included the loss of some700 jobs.

Update: Bausch & Lomb


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In October, 2005, Bausch & Lomb disclosed that anaccounting fraud problem in its Brazilian subsidiary mayrequire the company to postpone filing its quarterlyfinancial report due to problems with its books and records

On March 17, 2006, B&L announced it would delay its2005 annual report by about 6 weeks to make adjustmentsfollowing internal investigations

Bausch & Lomb also said its ongoing investigation intoSouth Korean vision joint venture BL Korea has foundevidence of improper sales practices from 2002 to 2005.

On March 23, 2006, Moody's Investors Service announcedit considering lowering its "Baa3" rating on B&L’s $544million of unsecured debt (that’s just one notch above junk)

Bausch & Lomb is currently still working on its 2006financial statements and plans to file them by April 30

Update: Bausch & Lomb Again inTrouble (cont’d)

Managers often feel enormous pressure to do whatever ittakes to deliver good financial performance

Actions often taken by managersCut costs wherever savings show up immediatelySqueeze extra sales out of early deliveriesEngage in short-term maneuvers to make the numbersStretch the rules further and further, until

limits of ethical conduct are overlooked

Executives feel pressure to hit performance targets sincetheir compensation depends heavily on companyperformance

Fundamental problem with a “make the numbers”syndrome: The company does not serve its customers orshareholders well by placing top priority on the bottom line!

Bausch & Lomb: Not theException…

Warning Signs of a DeviantOrganizational Culture

1. There is a "kill the messenger" ethos in theorganisation -- justifies distortion andconcealment of information

2. There is a low degree of confidence in theaccuracy of internal reports

3. Despite claims to doing the right thing, in the lastanalysis, top management does the mostexpedient thing

4. Employees do not know ofor refer to written ethics policies

5. The operative value of the organisationis: if it's legal it's ethical

Warning Signs of a DeviantOrganizational Culture (con’d)

6. Top management's stated concern for ethicsappears to be mainly for public relations

7. Managers (while basically truthful) are willing todeceive in order to accomplish organizational orpersonal goals

8. Managers do not believe there is an obligation tobe candid where it could harm personal ororganizational goals

9. People who ignore ethicsbut produce bottom line resultsget promoted

KPMG: How to Deter EmployeeFraud

Know the risks in your business What areas are most at risk? Where do you need to concentrate

your efforts?

Make your views on fraud known Set the tone, establish clear guidelines, make clear your intention

to investigate vigorously. Nothing is a better deterrent than ahistory of investigation

Create a culture that frustrates fraud Lead by example and avoid gray areas in rules, including receiving

or giving gifts, entertainment, commissions, conflict of interest

Ensure that your internal controls areeffective Be alert for indicators of fraud. Develop a fraud response plan so

you know what to do. Set up an audit committee or expand therole of the BoD’s audit committee

KPMG: How to Deter EmployeeFraud

Make certain that personnel policies areeffective Check applicant’s information and references thoroughly,

particularly for risk areas. Establish an employee hotline forreporting fraud.

Review disciplinary policy Be tough on fraud; it can put your entire

business at risk and damage its reputationas well as yours. A firm response to fraud willbe your best protection against future fraud.


4

But there’s also good news..!

76% of customers will switch to brands orstores based on ethics & societal issues(Cone/Roper, 1997)

88% of consumers are more likely to buyfrom a socially responsible firm (WalkerResearch, 1998)

Sales growth, profits, and ROI arecorrelated with corporate citizenship(Maignan, 1997)

Ethical strategy and business = profits!

Next Class

Next….YOUR Turn Presenting!


Professor Larry Harris FBE 440 Marshall School of Business Courses 15355R (MW) & 15356R (TTh) University of Southern California Spring 2007

TRADING AND EXCHANGES Course Syllabus

Course Objectives This course will introduce you to the theory and practice of securities and contract trading at exchanges and in dealer networks. We will examine

• why and how people trade, • the principals of proprietary trading, • why market institutions are organized as they are, • how markets are changing in response to innovations in information technologies, • the origins of liquidity, volatility, price efficiency, and trading profits, and • the role of public policy in the markets.

To address these questions, we must understand why and how institutions, dealers, and individuals trade. Understanding trader behavior thus is a primary course objective.

At the end of this course, you should be able to

• solve various trading problems, • recognize various trading styles, • judge whether you would be a successful trader, • evaluate and motivate brokers, • design markets, and • effectively lobby policy-makers on market issues.

Target Audience I designed this course for anyone who wants to understand how markets work and how traders trade. The reading assignments and the class lectures are appropriate for students who have no market experience.

Experienced traders will also find this course to be valuable. Although you may already know much about market institutions, the economic perspectives that you will learn in this course will greatly improve your understanding of why some people make money while others lose money. Many brokers and dealers have greatly appreciated taking this course.

Students with substantial market experience have little advantage over other students other than initial familiarity with the jargon and institutions.

Prerequisites This course has no prerequisites. Familiarity with Investments, Microeconomics, Corporate Finance, Information Technologies, and Statistics is helpful but not necessary.

FBE-440: Syllabus

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You will not be lost if you have not yet studied these subjects, but you may have to work harder than students who are already familiar with their principle concepts.

Addresses and Telephone Numbers Professor Larry Harris (213) 740-6496 office Fred V. Keenan Chair in Finance (323) 933-0888 home USC Marshall School of Business (323) 244-1154 mobile Hoffman Hall 600G Los Angeles, CA 90089-1427 [email protected] LarryHarris.com

You may call me at home or on my cell, but not before 7:00 AM, after 9:30 PM, on Friday night, or on Saturday.

How to Reach Me 1. Drop in during office hours—no appointment is necessary. My office is in Hoffman

600G. My office hours this semester are:

Mondays 1:00-2:00 PM Thursdays 9:45-10:45 AM

2. Arrange to meet me by appointment.

3. Just drop in. I am in my office most days. It is best (but not necessary) to call ahead to make sure I am available and not occupied. I am obviously unavailable when I am teaching. I teach MW 10-12, TTh 8-10, and TTh 11-12:30.

4. Call me on the telephone. If you leave a message, please speak slowly and clearly when you give your phone number. You may call me at home or on my cell phone, but please not before 7:00 AM, after 9:30 PM, on Friday night, or on Saturday.

5. Arrange to dine with me before or after class. Consider inviting your classmates too.

6. Send me e-mail at [email protected]. While I am always happy to take questions about course topics, I prefer to respond orally rather than by e-mail. The opportunity to listen and respond generally produces more effective learning.

Electronic Notices I post assignments and information of interest to this class on Blackboard. The web address for BlackBoard is http://blackboard.usc.edu.

I may use a password to protect some documents. If so, the password will be TradeOn. The password is case sensitive.

FBE-440: Syllabus

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Grades and Examinations I will base the course grade on two midterm examinations, many small homework projects (see below) and on a final examination. Their relative weights in the course grade are as follows:

2 midterm examinations at 20 percent per midterm 40% Homework projects / class participation 25% Final examination 35%

Total 100%

The examinations are scheduled as follows:

MW Class TTh Class Midterm 1 Wednesday, February 14 Thursday, February 15 Midterm 2 Wednesday, April 4 Tuesday, April 3 Final Exam Monday, May 7, 8:00 - 10:00 AM Wednesday, May 9, 8:00 - 10:00 AM

The midterm and final examination dates will not change. Please check now to see that you do not have any conflicts.

The second midterm will cover primarily topics covered since the first midterm. Since you cannot fully understand some topics without understanding earlier topics, you may wish to review earlier topics before the second midterm.

The final examination will be a cumulative examination. Topics covered after the second midterm, however, may be somewhat over-represented.

When assigning grades, I compute the weighted sum of examination and homework numeric scores using the weights above. Since the in-class variance of scores typically varies across exams and homework, the influence of a given score may be different from the weights presented above. In the past, the greatest in-class variation has been in homework scores and in essay exam scores. These exercises therefore have had a greater influence on the final grade than the above weights would suggest.

Grading Standards The Marshall School uses (and I adhere to) the following standards for undergraduate grading:

A Excellent quality work B Good quality work C Fair quality work D Work of minimum passing quality F This grade is awarded to any undergraduate student failing to meet the

minimum standards for passing the course. The grade of F indicates that the student failed at the end of the semester or was doing failing work and stopped attending the course after the twelfth week of the semester.

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Plus/minus grading (A, A-, B+, B, B-, C+, C, C-, D+, D, D-, F) increases the basic five grades to a total of twelve possible levels of performance.

I interpret these standards as follows:

A Mastery of course concepts, tools, and techniques, plus a solid understanding of implications, applications, and interrelationships. Ability to apply and express that understanding with meaningful oral and written language.

B Solid understanding of course concepts, tools, and techniques, plus

knowledge of or awareness of implications, applications, and interrelationships. Capability to converse effectively in the terminology of the course.

C Knowledge of course fundamentals. Basic understanding or awareness of

finer points of course and discipline. Meets normal expectations of course input criteria.

D Barely grasps the essentials of the course with little or no understanding of

the finer points. F Unable to communicate an understanding of the basic concepts, tools, or

techniques of the course. A failure to measure up to the basic course output goals.

Class Participation and Homework Projects Class participation is an important part of the learning experience of this course. The richness of the learning experience depends upon the degree of preparation by all students before each class session. Your classmates and I expect you to prepare for all classes and to actively participate in class discussions. I may call upon you at any time during class discussions to summarize insights from readings and class discussions, to analyze problems, or to opine on the value of what you are learning.

Many concepts that we will discuss in the class sessions do not appear in the textbook. We also will discuss many topics more thoroughly and from different perspectives than does the textbook. Accordingly, class attendance also is an important component of the learning experience for this course.

I generally will assign a short homework project for you to do before each class session. The homework usually will challenge you to think deeply about topics of interest to this course. It often will provide a foundation for an in-class discussion.

The project will be due at the beginning of the class session. To encourage on-time attendance, I do not accept late projects. You must personally turn-in your homework projects. On days when no homework is due, I may pass an attendance signup sheet which will serve as a substitute for the homework.

FBE-440: Syllabus

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To encourage you to attend the entire class session, I may call upon you at anytime until I dismiss the class. If you do not respond when I call your name, you will not receive credit for the homework assignment, even if you turned it in.

I designed these homework collection procedures to encourage you to attend class. I have taught this course without these procedures and have observed that students who did not attend class typically learned much less than those who did. Since I adopted these procedures, I have observed that students come to class better prepared and that they learn more.

Take the homework assignments seriously. You may fail the course if you do not receive credit for enough assignments. Regrettably, I have failed students who did not obtain credit for enough homework assignments.

To ensure that these policies are not too burdensome to you, you may miss three homework assignments during the semester with no negative effect on your grade. For example, if I assign 25 homework projects during the course, you will have a perfect homework/participation score if I accept at least 22 adequately prepared assignments from you. Although I will not award extra credit if you complete all the assignments, I strongly encourage you to do so.

After you have missed three assignments, you may request permission to be absent. I will grant permission entirely at my discretion and only under the most severe circumstances. You should avoid missing homework assignments early in the semester because you may need to miss them later if you get sick or need to attend an interview or a funeral.

Since I expect that missing homework will be a rare occurrence, and since you will always know when you have missed an assignment or have left class early, I will not post my records of completed assignments. I will notify you if your work has not been acceptable.

To obtain complete credit for a homework project, • it must be turned in on time, as noted above, • you must be present if I call your name, as noted above, • your paper must represent your sincere effort to address the assignment, • the paper should be properly formatted, and • your name and social security number must be legibly written in the upper right hand

corner of the paper.

I will judge the sincerity of your effort by whether your written presentations are thoughtfully prepared and/or by your ability to discuss your work in class. If I have accepted your homework and I have not contacted you to tell you that your assignment was not adequately prepared, you may assume that you obtained full credit for the assignment.

Given the very large number of homework papers that I will receive, our time would be poorly spent returning your homework papers to you in class. I therefore will not return your homework papers to you unless I have specific comments to give you. You therefore may want to keep a copy for yourself.

Adequately completing the homework assignments will primarily require that you be disciplined and that you make an honest effort to complete the assignment. To trade

FBE-440: Syllabus

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effectively requires good personal discipline. In a course about trading, asking you to exercise personal discipline is very reasonable.

The Fine Print on Grades These rules protect you and me should unexpected events occur.

You generally will receive no credit for tests that you miss. If you secure prior permission from me to miss a test, or if you have a valid medical excuse, I will make a special arrangement for you. At my sole discretion, I will allow you take the test (or a similar test) at another time, or I will arrange to give more weight to your other test results.

To prove illness, you must submit your doctor’s note stating the nature of the illness and your doctor’s name, address, and telephone number. To prove that you were sent out of town on business, you must submit a copy of your airline and motel receipts, plus the name, address, and telephone number of your superior. I will not excuse you unless I receive all documentation listed above. I reserve the right to contact your doctor, superior, etc.

USC strongly discourages incomplete grades, except in dire circumstances. Consequently, I will not give a grade of “Incomplete.” I will only make an exception to this rule if you have taken the examinations when scheduled, but missed the final examination due to illness or to a required out-of-town business trip for which you give prior written notice. You cannot pass the course without taking the final examination. Students who do not complete all required work, and do not receive a grade of “incomplete” will fail.

To receive a final grade in the unlikely event of an “Incomplete,” you may either take the final exam that I administer to my next “Trading and Exchanges” class (which could be years from now) or take the final of another professor teaching an equivalent class (which is not likely as I have been the only professor teaching this class).

Register in this class only if you are willing to abide by these rules. Your registration will be your confirmation that you agree to abide by these rules.

Academic Integrity Academic integrity is an important component of the optimal learning environment that USC seeks to maintain. General principles of academic integrity include the concept of respect for the intellectual property of others, the expectation that individual work will be submitted unless otherwise allowed by an instructor, and the obligations both to protect one’s own academic work from misuse by others as well as to avoid using another’s work as one’s own. All students are expected to understand and abide by these principles. SCAMPUS, the Student Guidebook, contains the Student Conduct Code in Section 11.00; recommended sanctions appear in Appendix A. http://www.usc.edu/dept/publications/SCAMPUS/gov/

I do not expect academic dishonesty to be a problem in this course. However, should any suspicion of academic dishonesty arise, students will be referred to the Office of Student Judicial Affairs and Community Standards for further review. The review process appears at: http://www.usc.edu/student-affairs/SJACS/.

FBE-440: Syllabus

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Disability Services Any student requesting academic accommodations based on a disability must register with Disability Services and Programs (DSP) each semester. You can obtain a letter of verification for approved accommodations from DSP. Deliver the letter to me as early in the semester as possible. DSP is located in STU 301 and is open 8:30 AM - 5:00 PM, Monday through Friday. The phone number for DSP is (213) 740-0776.

Returned Papers To protect the confidentiality of your work, you must pick up your own graded paperwork. I will not give your papers to anyone else. Students who miss class sessions when paperwork is returned must arrange for an appointment to retrieve the material. I will discard graded paperwork unclaimed by a student after four weeks.

Disputes over graded material must be brought to my attention as soon as possible.

Technology Use in Class Sessions Communication devices such as cell phones, Blackberries, etc. capable of sending or receiving electronic communication and all entertainment devices such as iPods or other MP3 players must be turned off and kept off throughout the class session. Receiving or sending communication or entertainment during class disrupts the learning environment and is rude to those around you.

You may use laptops for taking notes, but I may revoke this privilege on an individual or global basis if I find that it is disruptive. You may use laptops for other purposes only with my expressed permission. In all events, you may not connect to the Internet unless I specifically permit it. You may not use laptops during examinations.

Your Responsibilities • Read assigned readings before coming to class and come prepared to discuss them.

If you are uncertain of the assignment, consult the course web pages at http://blackboard.usc.edu. The readings and our discussions are an integral part of the course.

• Read the financial press every day. Come to class prepared to discuss current events in the markets. At a minimum, read the front page of the Money & Investing section of The Wall Street Journal. You also should read the Los Angeles Times business section. The business sections of the New York Times, The Financial Times and Investor’s Daily are even better. Try reading the finance section of The Economist and any relevant special reports. Best of all, read Traders Magazine or Securities Week, if you can get a copy. Serious professionals follow current events in their industry. Be a securities industry professional, if only for the next seventeen weeks. Reading the news will help you get more out of this class.

FBE-440: Syllabus

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• Come to class on time. If you are late, enter quietly. If it is raining, remember that you will need more travel time. If you are habitually late, think about why you are not excited about coming to class. If I can improve things, please tell me. If you are simply not interested, drop the class for your sake—you must have better things to do than to attend a class that does not interest you.

• Help your classmates study and prepare for class. The best way to learn is to teach. Teach each other, and you will learn quickly and thoroughly. Also, your classmates may become your professional colleagues. Start forming your professional networks by getting to know them now.

• Express yourself. This is your class. Express your opinions, your problems, your reservations, your suggestions, and your interests. Make this class work for you. Help me improve the course. There are no dumb questions. If you do not understand something, many of your classmates also probably do not understand it either. Please ask the question.

• Initiate. Do not limit yourself only to the resources I assemble for the course. If you want to learn something we do not cover, find a source (I can help) and study.

Required Text Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003.

I am offering a one-dollar bounty for each new error in the book that you bring to my attention. To earn this reward, you must be the first to identify the error. I am interested in typos, grammatical problems, factual inaccuracies, and any other objective issues that are the responsibility of the author. I will be the sole arbiter of what qualifies and I reserve the right to cancel this offer at anytime. An errata sheet appears at http://www.tradingandexchanges.com.

A Very Useful Book John Downes and Jordan Elliot Goodman, editors, Dictionary of Finance and Investment Terms, 7th Edition (New York: Barron’s Educational Series, 2006, ISBN 978-0764134166)

This inexpensive dictionary is very useful for quickly defining financial jargon and concepts.

A Strong Recommendation Edwin Lefèvre, Reminiscences of a Stock Operator, (New York: John Wiley and Sons, Inc., Reprinted 1993, ISBN 0-47105970-6, first published in 1923)

Reminiscences is a ghostwritten autobiography of Jesse Livermore. Livermore was a very successful stock and commodity speculator who traded in the late 19th and early 20th centuries. The author, Edwin Lefèvre, was a financial reporter who spent two months interviewing Livermore for this project. The result is presented as a first-person narrative by a character called Larry Livingston, who clearly represents Jesse Livermore. The book is full of market wisdom and human wisdom. It is easy to read, engaging, and covers many of the topics of this course.

FBE-440: Syllabus

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Rev: 1/4/07

FBE-440: Syllabus

Professor Larry Harris Trading and Exchanges USC Spring 2007

FBE 440 TTh Class Schedule

The examinations indicated on this schedule will take place as scheduled. Otherwise, this is a tentative schedule that I may modify in response to the needs and interests of the class. As the course evolves, I will post the topics to be covered in the next lecture (and associated reading assignments) on BlackBoard. The topics below correspond to chapters in the textbook. Please read them before coming to class.

I will not attend class on March 27 (Q Group Conference) and April 10 (Passover holiday). I hope to arrange for outside speakers on those days.

Date Topic

Jan 9 Tu 1 Introduction

Jan 10 Th 2 Trading Stories 3 The Trading Industry 4 Orders and Order Properties

Jan 16 Tu 5 Market Structures

Jan 18 Th 6 Order Driven Markets

Jan 23 Tu 6 Order Driven Markets (continued)

Jan 25 Th 7 Brokers

Jan 30 Tu 8 Why Do People Trade?

Feb 1 Th 9 Good Markets

Feb 6 Tu 10 Informed Traders and Market Efficiency

Feb 8 Th 11 Order Anticipators

Feb 13 Tu 12 Bluffing and Price Manipulation

Feb 15 Th Midterm Examination

Feb 20 Tu 13 Dealers

Feb 22 Th 14 Bid/Ask Spreads

Feb 27 Tu 15 Block Trading

Mar 1 Th 16 Value-motivated Traders

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Date Topic

Mar 6 Tu 17 Arbitrageurs

Mar 7 Th 18 Buy-side Traders

Mar 13 Tu Spring Recess Holiday

Mar 15 Th Spring Recess Holiday

Mar 20 Tu 19 Liquidity 20 Volatility

Mar 22 Th 21 Liquidity and Transaction Cost Measurement

Mar 27 Tu No Class

Mar 29 Th 22 Performance Evaluation and Prediction

Apr 3 Tu Midterm Examination

Apr 5 Th 23 Index and Portfolio Markets

Apr 10 Tu No Class

Apr 12 Th 24 Specialists

Apr 17 Tu 25 Internalization, Preferencing, and Crossing

Apr 19 Th 26 Competition within and among Markets

Apr 24 Tu 27 Bubbles, Crashes, and Circuit Breakers

Apr 26 Th 28 Floor versus Automated Trading Systems 29 Insider Trading

May 9 W Final Examination, 8:00 AM - 10:00 AM

May 11 F University Commencement

FBE-440: Syllabus


Techniques for Learning Efficiently You will learn more in less time if you learn efficiently. You then will have more time for other activities. Consider the following suggestions to make your learning quicker and more effective.

The General Principle You learn most effectively when you force yourself to use what you must learn. You must put new information and concepts into your own words. Then you must organize, manipulate and use them.

Specific Suggestions When studying, imagine that you will have to teach others what you have learned. Think carefully about how you would do this. This objective is more real than you might imagine. When people hire you for what you know, they expect you to share your knowledge. You soon will be educating your supervisors, colleagues and employees.

Practice teaching the course material to your classmates in study sessions.

If you have a copy of a speaker’s lecture notes, do not use them when you attend the lecture. You will learn most effectively if you take notes yourself and then later compare your notes to the speaker’s notes. If no speaker’s notes are available, trade lecture notes with your classmates and discuss the differences among them. Do this even if the speaker’s notes are available.

Highlighting and underlining may help you identify what you need to learn, but they are not efficient learning techniques. At best, they help you understand what other people have written. To remember your studies, you must put them into your own words. People like to highlight and underline because these tangible activities make them feel productive. Do not mistake activity for productivity. If you ever catch yourself highlighting and underlining on autopilot, you know what I am talking about.

You learn most effectively by taking notes. If you do not feel like writing, consider dictating your notes into a tape recorder. Both methods work well. In either event, do it in your words. Do not copy what others have written. You learn more from composing your notes than from studying them. Spend more time composing.

Compose notes after you finish reading a section or a chapter. It is best to wait a few hours. Recompose your lecture notes after a lecture, preferably without looking at your original notes. To remember something, you have to practice remembering. If you know that you will later compose and recompose, you will remember more.

When you review your studies, start by trying to remember what you want to review. Then go back to your notes, see what you forgot, and study just that. It is inefficient to study what you already know. If necessary, return to the original sources.

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To prepare for tests, practice taking old tests if they are available. Take the tests before you read the answers. Being able to recognize a correct answer is not the same thing as being able to provide the correct answer. Practice providing, not recognizing.

If you cannot understand an important passage in your readings, go back and review. Good texts are organized so that you should not have to read forward to understand an earlier passage. You accomplish little by plowing through confusion. Unlike snow, confusion usually piles up in front instead of being pushed to the side. Not all texts are well written, however, and even the best texts may have some weak sections. Sometimes it is best to do a quick first pass over the material so you can see where it is going. Then go back and read it carefully.

If you are lost in a lecture, tell your instructor. Many others may be lost too. The true object of a lecture is to transmit knowledge, not to finish a set of topics. Instructors that finish their lectures without conveying information have wasted your time and their time. Come to class prepared to minimize the chance that you will get lost.

Everyone gets frustrated when they are confused about something that they believe they must know. Frustration is an emotion that makes learning less effective. It can cause you to overestimate the time necessary to accomplish your objectives and lead to feelings of failure that would become self-reinforcing if you quit. Managing frustration therefore is essential to effective learning.

You can prevent frustration by not allowing yourself to get confused. When you do not understand what you are reading, go back and review. When you do not understand a point made in lecture, ask the instructor to explain it again differently.

When you do become frustrated (everyone does at some point), deal with it immediately by taking action to control this emotion instead of letting it control you. If you are studying, stop and do something else for a while. If you are in a lecture or a meeting, ask a question. Do not waste time in an emotional state that is not productive. Instead, recognize your emotion and deal with it.

Do not eat a heavy meal before you attend class or plan to study. It is easier to learn when you do not have to fight the natural inclination of your body to doze on a full stomach.

Most peoples’ minds slow down in the early afternoon (if they keep normal sleeping hours). Try to avoid studying and taking classes when your mind is not active.

If you are too tired to learn effectively, get some sleep and return to your studies when you are more rested. Otherwise you will waste your time and be even more tired.

Study somewhere where you will have few distractions. You only have one CPU in your head. Multitasking is inefficient because keeping track of tasks and switching among them consumes energy and time. You can accomplish more in less time by devoting your full attention to one task at a time than if you try to do several at the same time.

If you review a little bit every now and then, you will learn more than if you spend the same amount of time cramming before an exam.


3

A Final Note of Encouragement Although these suggestions may seem as though they are difficult, they will allow you to learn more in less time. Learning effectively will give you more time to do other things. Time is our most scarce resource. Use it wisely.


Name_____________________________ Last, First


FBE 440 MW Midterm 1 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar.

Since knowing that you do not know something is a valuable form of knowledge, I give half credit for blank answers. A completely wrong answer, of course, will receive no credit.

Good luck!

Very Short Answers (five points each) 1. What kind of option does a buy limit order

represent? __________________________

2. What common order type has the greatest market impact? __________________________

3. What benefit do commodity hedgers expect to obtain from trading? __________________________

Simple One Sentence Answers (5 points each) 4. In what sense are exchanges and brokers the same?

5. What is the primary conflict of interest within an SRO?


6. What is the main advantage of a call market over a continuous trading market?

7. Why is price priority self-enforcing?

8. The pricing rule used in the bucket and bucketering shops that Jesse Livermore traded in is a derivative pricing rule. Why have I classified it as such?

Slightly Harder One Sentence Answers (10 points each) 9. Why do mutual fund management companies like soft dollars commissions?


Name_____________________________ Last, First

10. Of what benefit is orthogonality to a well-informed trader?

11. Consider a sealed bid auction in which the highest bidder wins and pays the average of the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction.

12. Provide one example of how informative prices in the secondary capital markets (trading of seasoned securities) help make production in our economy more efficient.


Computation Questions (10 points each) 13. Suppose that the following orders are submitted to a call market that conducts a single

price auction using price-time precedence rule at 10:15. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.)

Trader Arrival time Side Price Size

A 9:30 Buy 11 10 B 9:40 Sell 11 10 C 9:45 Buy 9 20 D 9:50 Sell 9 10 E 10:00 Buy 12 5

Price _____________ Volume _____________ 14. Mark submits a market order to sell 9 to a continuous market with the following order

book: Trader Bid Size Price Offer Size Ann 15 80.0 Jack 3 80.3 Steve 80.4 5 Beth 80.6 10 At what average price will Mark’s order be filled? __________________________


Name_____________________________ Last, First


FBE 440 TTH Midterm 1 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar.

Since knowing that you do not know something is a valuable form of knowledge, I give half credit for blank answers. A completely wrong answer, of course, will receive no credit.

Good luck!

Very Short Answers (5 points each) 1. Price is currently at 50. What order should a trader

use if she wants to sell if the price falls to 30? __________________________

2. What limits the trading profits of informed traders? __________________________

Simple One Sentence Answers (5 points each) 3. Who or what is on the “buy-side?”

4. What is the difference between a broker and a dealer?


5. What benefit do members of an SRO obtain by subjecting themselves to its regulation?

6. Ignoring labor costs, what is the most important argument against opening the NYSE an hour earlier to accommodate European traders?


8. Rational investors expect to lose on average to well-informed traders. Why are they still willing to trade?


Name_____________________________ Last, First

Slightly Harder One Sentence Answers (10 points each) 9. Consider a sealed bid auction in which the highest bidder wins and pays the average of

the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction.

10. Why is a large tick (minimum price variation) necessary to make secondary precedence rule such as time precedence economically meaningful?

11. How do informative prices in the primary (new issue) capital markets help make production in our economy more efficient?

12. How might gamblers in the financial markets benefit the economy as a whole?


Computation Questions (10 points each) 13. An ECN that organizes a continuous pure price-time auction opens with an empty limit

order book. It then receives the following orders: Trader Arrival time Side Pric

e Size


List the trades, if any, that the ECN arranges:

Trade # Time Buyer Seller Price Size

1

2

3

4

5

14. Consider the following order book for a single price auction:

Aggregate Bid Sizes

Price

Aggregate Offer Sizes

15 12.0 35 12.1 15 12.2 5

5 12.3 10 5 12.4

12.5 12.6 10 12.7 15 12.8 12.9 15 13.0 10

What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.)


Name_____________________________ Last, First

Price _____________ Volume _____________



FBE 440 MW Midterm 1 Answers

Very Short Answers (five points each)

1. What kind of option does a buy limit order represent? A put option.

2. What common order type has the greatest market impact? Large market orders

3. What benefit do commodity hedgers expect to obtain from trading? Risk reduction

Simple One Sentence Answers (5 points each)

4. In what sense are exchanges and brokers the same? They both arrange trades for their clients.

5. What is the primary conflict of interest within an SRO? An SRO is managed by the members that it regulates. The SRO thus may place the members’ interests before the public’s interests.

6. What is the main advantage of a call market over a continuous trading market? The call market reduces search costs by concentrating liquidity at a single point in time and space.

7. Why is price priority self-enforcing? Traders always seek the best prices.


Bucket and bucketering shops obtain (derive) their contract prices from prices printed at other venues.

Slightly Harder One Sentence Answers (10 points each)

9. Why do mutual fund management companies like soft dollars commissions? Soft dollar commissions allow fund management companies to pay for goods and services with their customers’ assets.


10. Of what benefit is orthogonality to a well-informed trader? Orthogonality increases the liquidity available to well-informed traders by decreasing the probability that they will compete with other informed traders for the same liquidity.


Bidders should bid slightly less than their reservation prices because their bids determine to some extent the prices that they will pay if they win.

12. Provide one example of how informative prices in the secondary capital markets (trading of seasoned securities) help make production in our economy more efficient.

Informative secondary prices help allocate managers to existing capital by pricing how well they use the resources available to them. Informative secondary prices also allow shareholder to motivate their managers with stock options.


Computation Questions (10 points each) 13. Suppose that the following orders are submitted to a call market that conducts a single

price auction using price-time precedence rule at 10:15. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.)

Trader Arrival time Side Price Size


The sorted order book is

Bid Size

Price Offer Size

20 9 10 10 11 10 5 12

The 5 to buy at 12 are matched with 5 of the 10 to sell at 9 leaving 5 to sell at 9. The remaining 5 to sell at 9 are matched with the 10 to buy at 11 leaving 5 to buy at 11. The remaining 5 to buy at 11 are matched with 5 of the 10 to sell at 11. No further trades can be arranged because the next best buyer is only willing to pay 9. The single price is 11 and the volume is 15. 14. Mark submits a market order to sell 9 to a continuous market with the following order

book: Trader Bid Size Price Offer Size Ann 15 80.0 Jack 3 80.3 Steve 80.4 5 Beth 80.6 10

At what average price will Mark’s order be filled? 3 trade at 80.3 and 6 trade at 80.0 so that the average price is 80.1.



FBE 440 TTH Midterm 1 Answers

Very Short Answers (5 points each)

1. Price is currently at 50. What order should a trader use if she wants to sell if the price falls to 30?

A stop order at 30.

2. What limits the trading profits of informed traders? Liquidity


3. Who or what is on the “buy-side?” Institutions and individuals that manage money.

4. What is the difference between a broker and a dealer? A dealer trades for his own account whereas a broker trades as agent for other accounts. A dealer fills orders from his own account whereas a broker fills orders by finding a trader to take the other side.

5. What benefit do members of an SRO obtain by subjecting themselves to its regulation? SROs regulate their members to decrease the costs that members may impose upon each other. The costs may result from bad business practices or from the loss of reputation suffered by all when some members cheat the public.

6. Ignoring labor costs, what is the most important argument against opening the NYSE an hour earlier to accommodate European traders?

It will dilute liquidity by further spreading it through time.


Bucket and bucketering shops obtain (derive) their contract prices from prices printed at other venues.

8. Rational investors expect to lose on average to well-informed traders. Why are they still willing to trade?

They benefit by using the markets to move money from the present to the future.


Slightly Harder One Sentence Answers (10 points each)


Bidders should bid slightly less than their reservation prices because their bids determine to some extent the prices that they will pay if they win.

10. Why is a large tick (minimum price variation) necessary to make secondary precedence rules such as time precedence economically meaningful?

A small tick allows traders to cheaply obtain precedence through price priority.

11. How do informative prices in the primary (new issue) capital markets help make production in our economy more efficient?

They make it impossible or expensive for entrepreneurs to obtain capital for bad investment projects and make it easy for entrepreneurs to obtain capital for good projects.

12. How might gamblers in the financial markets benefit the economy as a whole? They make prices more efficient in the long run by making markets more liquid for informed traders.

Computation Questions (10 points each) 13. An ECN that organizes a continuous pure price-time auction opens with an empty limit

order book. It then receives the following orders: Trader Arrival time Side Price Size


List the trades, if any, that the ECN arranges:

Trade # Time Buyer Seller Price Size

1 9:50 A D 10 10 2 9:50 C D 9 5 3

4

5


14. Consider the following order book for a single price auction:

Aggregate Bid Sizes

Price


15 12.0 35 12.1 15 12.2 5

5 12.3 10 5 12.4

12.5 12.6 10 12.7 15 12.8 12.9 15 13.0 10

What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.) Match 5 bid at 12.4 with 5 offered at 12.2. Match the 5 bid at 12.3 with 5 of the 10 offered at 12.3. No more trades are possible. The only price that works for all is 12.3. The total volume is 10.



Homework Assignment 7 - Answers Using the following orders, please complete the following tables taken from Chapter 6.

Table 6-1-New. Example Orders

Time Trader Order side Size Price

10:01 Bea Buy 3 30.0 10:05 Sam Sell 2 30.1 10:08 Ben Buy 4 30.2 10:09 Sol Sell 2 30.3 10:10 Stu Sell 5 30.3 10:15 Bif Buy 4 market 10:18 Bob Buy 3 30.2 10:20 Sue Sell 4 30.0 10.27 Sun Sell 3 30.2 10:29 Bud Buy 3 30.3

Assume that Bif’s true reservation price is 30.5.

Table 6-2. Example Order Book

Sellers Buyers

Trader Size Order price Size Trader

30.0 3 Bea Sue 4 30.0 Sam 2 30.1 Sun 3 30.2 30.2 3 Bob 30.2 4 Ben 30.3 3 Bud Sol 2 30.3 Stu 5 30.3 Market 4 Bif


2

Please conduct a single price call market auction and present the results:

Table 6-3. Call Market Trades

Match Seller Buyer Quantity

1 Sue Bif 4 2 Sam Bud 2 3 Sun Bud 1 4 Sun Ben 2

Total: 9

What is the single uniform price? 30.2

Table 6-7. Trader Surpluses in the Single Price Auction Example

Trader Order Filled sales

Filled buys

Trade price

Assumed value Trader surpluses

Sue Sell 5 limit 30.0 4 30.2 30.0 (30.2 − 30.0) × 4 = 0.8 Sam Sell 2 limit 30.1 2 30.2 30.1 (30.2 − 30.1) × 2 = 0.2 Sun Sell 3 limit 30.2 3 30.2 30.2 (30.2 − 30.2) × 3 = 0.0 Bif Buy 4 at market 4 30.2 30.5 (30.5 − 30.2) × 4 = 1.2 Bud Buy 3 limit 30.3 3 30.2 30.3 (30.3 − 30.2) × 3 = 0.3 Ben Buy 4 limit 30.2 2 30.2 30.2 (30.2 − 30.2) × 2 = 0.0 Totals 9 9 2.6


3

Please conduct a continuous market auction using the same orders from Table 6-1-New above and present the results:

Order Book after First Order Arrives

Sellers Buyers


30.0 3 Bea

The market is 30.0 bid for 3

Order Book after Two Orders

Sellers Buyers


30.0 3 Bea Sam 2 30.1

The market is 30.0–30.1 3 x 2.

Order Book after Three Orders

Sellers Buyers


30.0 3 Bea 30.2 2 Ben

The market is 30.2 bid for 2


4

Order Book after Four Orders

Sellers Buyers


30.0 3 Bea 30.2 2 Ben Sol 2 30.3


Order Book after Five Orders

Sellers Buyers


30.0 3 Bea 30.2 2 Ben Sol 2 30.3 Stu 5 30.3


Order Book after Six Orders

Sellers Buyers


30.0 3 Bea 30.2 2 Ben Stu 3 30.3



5

Order Book after Seven Orders

Sellers Buyers


30.0 3 Bea 30.2 3 Bob 30.2 2 Ben Stu 3 30.3


Order Book after Eight Orders

Sellers Buyers


30.0 3 Bea 30.2 1 Bob Stu 3 30.3


Order Book after Nine Orders

Sellers Buyers


30.0 3 Bea Sun 2 30.2 Stu 3 30.3



6

Order Book after Ten Orders

Sellers Buyers


30.0 3 Bea Stu 2 30.3


Table 6-8. Trades in the Continuous Auction Example

Time Seller Buyer Price Quantity

10:08 Sam Ben 30.1 2 10:15 Sol Bif 30.3 2 10:15 Stu Bif 30.3 2 10:20 Sue Ben 30.2 2 10:20 Sue Bob 30.2 2 10:27 Sun Bob 30.2 1 10:29 Sun Bud 30.2 2 10:29 Stu Bud 30.3 1 Total: 14

Table 6-9. Trader Surpluses in the Continuous Auction Example

Trader Order Filled sales

Filled buys

Average trade price

Assumed value Trader surplus

Sam Sell 2 limit 30.1 2 30.1 30.1 (30.1 − 30.1) × 2 = 0.0 Sol Sell 2 limit 30.3 2 30.3 30.3 (30.3 − 30.3) × 2 = 0.0 Sue Sell 4 limit 30.0 4 30.2 30.0 (30.2 − 30.0) × 4 = 0.8 Sun Sell 3 limit 30.2 3 30.2 30.2 (30.2 − 30.2) × 3 = 0.0 Stu Sell 5 limit 30.3 3 30.3 30.3 (30.3 − 30.3) × 3 = 0.0 Ben Buy 4 limit 30.2 4 30.15 30.2 (30.2 − 30.15) × 4 = 0.2 Bif Buy 4 at market 4 30.3 30.5 (30.5 − 30.3) × 4 = 0.8 Bob Buy 3 limit 30.2 3 30.2 30.2 (30.2 − 30.2) × 3 = 0.0 Bud Buy 3 limit 30.3 3 30.233 30.3 (30.3 − 30.233) × 3 = 0.2 Totals 14 14 2.0


Keith Parker ID#6390.4899.77 [email protected] WSJ Article Summary From Tuesday, January 9th, Print edition of the WSJ “Same Crowd Behind Oil Rise Now Sells Out” Many people expected investors to continue to put more money into crude oil and to

continue to buy futures in the commodities market. Many analysts don’t believe this to

be completely true, as returns have slowed and the costs of holding investments in this

market have increased significantly. If the large cost of holding onto an investment in the

crude oil market continues, investors may not be willing to buy. Further, oil futures have

fallen 27 percent since their peak in July of last year. This article is important to the class

largely because it demonstrates that an investment that provides a return may not be

attractive to investors if the cost of holding onto said investment is too high.

FBE-440: Assignments

Keith Parker ID#6390.4899.77 [email protected] Discussion on SRO’s self-regulation and its implications For Thursday, January 18th While there are clearly ways in which for-profit stock exchanges that list

themselves on their own exchange could manipulate the regulations applicable to buying

and selling stock, I do not believe that this would happen in today’s market. The most

prominent reason for this is the industry’s focus on such a thing happening. Further,

because the idea that a for-profit organization regulating itself seems to many to be ill-

fated, there follows the idea that there will be intense scrutiny of discrepancies and

manipulations of self-imposed regulations that might be aimed at the increase of profits

for said exchange. As a result of this scrutiny that is likely to occur over these

organizations’ self-regulations, it would be too risky for such exchanges with long-

standing reputations (such as the NYSE or NASDAQ) to take part in self-regulation

manipulations for fear of being caught.

As far as regulatory problems that could occur go, there are a few possibilities.

First, an exchange such as the NYSE or NASDAQ could manipulate the time it takes for

their own stock to update in electronic trading systems to work in their advantage when

trading of their stock is taking place. Further, when buyers purchase their own stock at

low prices, these exchanges could artificially make it appear that prices are low for a

period of time; this would result in more stocks being sold than if the price were allowed

to rise, as regulations require.


Keith Parker ID#6390.4899.77 [email protected] WSJ Article Brief The Most Important Traders in the Stock Market For Tuesday, January 30th In the stock market the most important traders are speculators, particularly the

informed traders within this group. This is true because the price of stock for a certain

company in the stock market should represent as best it can the true value of that firm.

Informed traders act on information about the fundamental values of a firm, thus their

trades balance out to an equilibrium price that is the nearly true value of the firm,

according to what is known in the market. This ‘close-to-true’ value is based on trades

from value traders who extensively research the worth of the company, as well as news

traders who keep the stock price up-to-date by acting on the most recent news relevant to

the organization. Nonetheless, the price of a stock usually doesn’t represent the true

worth of a firm, as noise traders whose trade is based on factors outside of standard

information and news cause the price of a stock to vary widely from its real value.

Essentially, informed traders are important to the stock market because they act as a

counter-balance to the noise created by ‘noise traders’ (essentially all traders who are not

‘informed traders’).


Keith Parker ID#6390.4899.77 [email protected] What Is The Optimal eBay Bidding Strategy? For Thursday, January 25th In order to receive an item for the lowest possible price through the online bidding

site eBay, a user is best served by not bidding at all until as close to the auction end as

they can get, then entering their bid limit. EBay is essentially an English auction.

Further, the eBay system automatically enters a bid for one’s item at a set bidding

increment above the previous bidder’s bid limit, up to the price of one’s bid limit. As a

result of this, a user needs not constantly sit at his or her computer outbidding somebody

else up to their bid limit, they can merely enter their bid limit and let the eBay system do

the rest. Secondly, it is best to enter one’s bid limit as close to the end of the auction as

possible. The reason for this is as follows. If users enter their bid limits early in the

auction, the current bid price will rise and other users may reconsider their bid limit,

raising their limit to a higher amount than it would have previously been. This will result

in a higher cost of the item. The exception here is an item with many substitutes or listed

by many sellers. In this case, bidding early will raise the bid price enough to cause other

users to look elsewhere and not bid on the item at all.


Keith Parker ID#6390.4899.77 [email protected] WSJ Article Brief The Most Important Traders in the Stock Market For Tuesday, January 30th In the stock market the most important traders are speculators, particularly the

informed traders within this group. This is true because the price of stock for a certain

company in the stock market should represent as best it can the true value of that firm.

Informed traders act on information about the fundamental values of a firm, thus their

trades balance out to an equilibrium price that is the nearly true value of the firm,

according to what is known in the market. This ‘close-to-true’ value is based on trades

from value traders who extensively research the worth of the company, as well as news

traders who keep the stock price up-to-date by acting on the most recent news relevant to

the organization. Nonetheless, the price of a stock usually doesn’t represent the true

worth of a firm, as noise traders whose trade is based on factors outside of standard

information and news cause the price of a stock to vary widely from its real value.

Essentially, informed traders are important to the stock market because they act as a

counter-balance to the noise created by ‘noise traders’ (essentially all traders who are not

‘informed traders’).


Keith Parker ID#6390.4899.77 [email protected] New York Times Article Brief S.E.C. is Looking at Stock Trading For Thursday, February 8th The SEC has begun an investigation that will attempt to reveal which banks on

Wall Street, if any, have been engaging in front running. Front running is when a bank

tells valuable clients about a major trade before the trade actually happens. This allows

the client to make a risk-free trade on said stock. Some banks may have been allowing

front running a little differently than it has happened in the past; banks may be giving

their valuable clients information about trades in advance of large trades, after which

these clients would go to a different bank to make the trade. The SEC has demanded all

stock and option trading data for the last two weeks of September from Major Wall Street

Banks. Concerns have arisen from studies that show unusual amounts of trading

occurring before major deals are carried out. Further, the growing dominance of Hedge

funds on Wall Street, which now account for 30 to 50 percent of trading on most major

markets, has fed concerns of insider trading. The SEC has reported that any information

regarding insider trading will be immediately investigated as usual.


Keith Parker ID#6390.4899.77 [email protected] Bidding for CBOT For Thursday, March 23rd Although ICE may be offering a higher bid price for CBOT (over one billion

dollars higher), the shareholders will benefit more from the acceptance of the CME bid.

The underlying reason for this is compatibility. The nature of the futures trading markets,

that futures can only be traded within their exchanges (unlike stocks which can be moved

from exchange to exchange), it is important to build market share. Most importantly, a

merger between CBOT and CME will provide customers with more liquidity. CBOT

should accept the lower bid offer and through this provide a better service with more

liquidity, thus providing more value to their shareholders.


Keith Parker ID#6390.4899.77 [email protected] Jim Cramer on Market Manipulation For Thursday, March 29th It seemed to me that Jim Cramer, when speaking of things that would manipulate

the market illegally, wasn’t as concerned as much about the legality of such moves as he

was whether or not such actions were commonplace and accepted as standard in the

market. His insights into the way in which markets could be manipulated were

interesting though. His comments in regards to short-selling companies such as Apple

and RIM (Research in Motion), then leaking rumors that the near futures of those

companies weren’t looking very good in order to lower stock price in order to make a

profit were also a clear indication that market manipulation and corruption were more

routine than many people might think. Some comments in the video, such as it ‘only’

costing 10 or 15 million dollars to manipulate the market in some ways, made it clear that

market manipulation is often a very expensive game to play.


Keith Parker, University of Southern California

FBE-440: Class Notes

FBE-440 Review 2/9/07 2:13 PM

Traders often use whole numbers more often than fractions, et cetera Some questions will come from boxes in the book What are the benefits of a call market?

• Bring people together at the same place and time, creating and offering more liquidity

• What’s the role of time and place when we think about Call markets? Liquidity

How do order-driven markets arrange trades

• Market uses a set of rules, order precedence rules, to match buyers to sellers, and use pricing rules to determine price

Do brokers work for their clients or for themselves? Obviously, they work for themselves, though the nature of their work is that they are working for other people Of what value is a large entertainment budget to a broker?

• Brokers are most valuable when they have many clients Soft dollars, what are they? Soft dollars paid towards research from one account might benefit another account, this could be a problem here What agency regulates options trading? The SEC Find out what a deep-discount broker is Activities that may appear in the back office of a brokerage firm? Why is it important to have a poker face in a physically convened market? This is negotiating prices face-to-face Why do traders care about trustworthiness? Don’t ramble on when answering questions like these, just answer it very straightforward

FBE-440: Exam Things

Things from the book that weren’t in class? • Does it appear in the list of important points in the chapter? • Was it highlighted in some way in the book? • Was an example provided to make it more clear? • Were there questions on it at the end of the book?

Will get more credit for not writing something on the exam that you know you don’t know, rather than making something up What do brokers do?

• Help their clients arrange trades, provide more value when they have more clients

Figure out what payment for order flow is

• What is payment for order flow, why are regulators concerned about it, and what affect does it have on commissions?

What markets would you expect to see the greatest market efficiency? What makes prices informative? In what way is market structure like the rules of the game? It determines who has power, et cetera Lecture notes on blackboard represent at least one outline for going through the course; basically an abbreviated form of the book with the important stuff; often professor looks at lecture notes when writing exam A couple of questions might be on current events in the trading arena


Continuous AuctionTime Trader Order Side Size Price

10:01 Bea Buy 3 30Sam Sell 2 30.1Ben Buy 4 30.2Sol Sell 2 30.3Stu Sell 5 30.3Bif Buy 4 MarketBob Buy 3 30.2Sue Sell 4 30Sun Sell 3 30.2

10:29 Bud Buy 3 30.3

TradesBuyer Seller Price QuantityBen Sam 30.1 2Bip Sol 30.3 2Bif Stu 30.3 2Ben Sue 30.2 2Bob Sue 30.2 2Bob Sun 30.2 1Bud Sun 30.2 2Bud Stu 30.3 1

Order BookBuyer side Sellers sideBuyer Price Quantity Seller Price QuantityBen 30.2 2 Sam 30.1 2Bob 30.2 3 1 Sun 30.2 2Bea 30 3 Sol 30.3 2

Stu 30.3 5 3 2

Buyers' Surplus Seller SurplusSurplus Reservation Surplus Reservation(30.2-30.1)2 30.2 Ben (30.1-30.1)2 30.1 SueList goes on List goes on

When calculating suplus for Bud, who traded at two prices, you have to calculated his weighted average trading price





1. Suppose the market is 100 bid, offered at 101. What would be the limit price of a limit buy order if it were placed at the market?

100

2. The following orders are in a market: Order A: Buy 10 for 18 Order B: Buy 15 for 19 Order C: Buy 5 for 20 Order D: Sell 5 at 21 Order E: Sell 25 at 22 Order F: Sell 20 at 23 What is the best bid?

Order C: Buy 5 for 20 (The highest priced buy order.)

3. An order book in a continuous auction contains only one limit order. It is a buy order with a limit price of 5. A limit sell order with a limit price of 4 arrives. At what price will a trade be arranged, if any?

5

4. In the extreme, a market sell order is like what kind of limit order? A limit order with a zero price.

5. In what direction is price moving when a limit sell order placed at the market fails to execute?

Down

6. What do you expect will happen to bid/ask spreads if volatility increases? Spreads will increase.

7. Suppose a buyer buys 5 contracts for 40 using a limit order priced at 42. Given this information only, what is a reasonable lower bound for his trader’s surplus?

(42-40)*5=10

8. Who makes payments for order flow? Dealers



9. How can a buyer who does not have time-precedence at $25 acquire order precedence?

Raise her bid.

10. The market in a continuous trading auction is 100 bid, offered at 101. An IOC order to buy, limit 100.5 arrives. What happens?

Nothing. The order does not fill and it cancels automatically.


11. Why do traders only want to trade with creditworthy counterparts? They want to be sure that their counterparts are able to settle their trades.

12. Why would it be difficult to enforce the uniform pricing rule in a continuous trading market?

Traders will break their orders into pieces to price discriminate.

13. In this course, what is the difference between an investor and a speculator? An investor trades to move money from one point in time to another. A speculator trades to profit from unique information.


Computation Questions (10 points each)

14. Consider the following summary order book for a single price auction.

Aggregate Bid Sizes

Price


Market Sell 2 15 12 20 12.1 2 15 12.2 10 12.3 7

7 12.4 4 5 12.5 4 1 12.6 10 1 12.7 15

12.8 30 12.9 15 13 10

4 Market Buy

At what price should the single price auction be conducted?

What total quantity will trade? The single price auction price will be 12.4. The market buy orders are matched with the market sell orders leaving 2 unmatched on the buy side. These are matched with the sell orders placed at 12.1. The sell orders placed at 12.3 are matched with the buy orders placed at 12.7, 12.6 and 12.5. The sell orders place at 12.4 are matched with 4 of the buy orders placed at 12.4, leaving 3 unfilled on the buy side. No further trade is possible. The clearing price of 12.4 maximizes the total volume. The volume, counted on the buy side is 4 + 1 + 1+ 5 + 4 = 15. Counted on the sell side it is 2 + 2 + 7 + 4 = 15.

15. Mark submits a market order to buy 9 to a continuous market with the following order book:

Trader Bid Size Price Offer Size Ann 15 80.0 Jack 3 80.3 Steve 80.4 6 Beth 80.7 10




Very Short Answers (5 points each)

1. In what direction is price moving when a limit buy order placed at the market fails to execute?

Up

2. Whose trading would a public order precedence rule restrict? The members of an exchange

3. The following orders are standing in a market: Order A: Buy 10 for 18 Order B: Buy 15 for 19 Order C: Buy 5 for 20 Order D: Sell 5 at 21 Order E: Sell 25 at 22 Order F: Sell 20 at 23 What is the best offer?

Order D: Sell 5 at 21 (The lowest priced sell order).

4. Suppose a seller sells 8 bonds for 95 using a limit order priced at 93. Given this information only, what is a good lower bound for her trader’s surplus?

(95-93)*8=16 or 1600 if you remember the bond pricing convention.

5. An order book in a continuous auction contains only one limit order. It is a buy order with a limit price of 5. A limit sell order with a limit price of 4 arrives. At what price will a trade be arranged, if any?

5

6. Which type of informed trader typically profits when values change but prices do not change?

News trader


7. The market at a continuous trading auction is 100 bid, offered at 101. A day order to buy, limit 100.5 arrives. What happens?

The order is placed into the book on the buy side at 100.5 to await execution.


8. What makes a market transparent? A transparent market publishes its quotes, orders and trades in a timely fashion.


9. Why is a large tick (minimum price variation) necessary to make secondary precedence rules such as time precedence economically meaningful?

A small tick allows traders to cheaply obtain precedence through price priority.

10. Why would it be difficult to enforce the uniform pricing rule in a continuous trading market?

Traders will break their orders into pieces to price discriminate.

11. What effect does liquidity have on price efficiency? Prices should be more efficient in liquid markets because informed traders need liquidity to profit.

12. Why are uninformed traders willing to lose to informed traders? Uninformed traders are willing to lose to informed traders because they obtain some other benefit from trading besides trading profits. These benefits may come from investing, hedging, gambling or asset exchanging.


Computation Questions (10 points each)

13. Suppose that the following orders are submitted to a call market that conducts a single price auction using price-time precedence rule at 11:00. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.)

Order Arrival Time Side Limit Price Size A 9:30 Sell 50 25 B 10:00 Buy Market 25 C 10:15 Buy 51 10 D 10:31 Sell 50 5 E 10:35 Buy 49 10 F 10:38 Sell 51 20

What is the market clearing price?

First sort the orders into an order book as follows: Order Arrival Time Side Limit Price Size A 9:30 Sell 50 25 D 10:31 Sell 50 5 F 10:38 Sell 51 20 B 10:00 Buy Market 25 C 10:15 Buy 51 10 E 10:35 Buy 49 10

In a single price auction, all of Order A (25) is first matched with Order B and both are completely filled. All of Order D is then matched with 5 of Order C. The remaining 5 of Order C are matched with part of Order F. No further trades are possible because Order E is only willing to pay 49 but Order F wants 51.

The uniform price for this auction is 51 since 51 is the only price at which a trade can be arranged between Order C and Order F.

What total quantity will trade? The total volume is 25 + 5 + 5 = 35.


14. Mark submits a market order to buy 9 to a continuous market with the following order book:

Trader Bid Size Price Offer Size Ann 15 80.0 Jack 3 80.3 Steve 80.4 6 Beth 80.7 10



Midterm #2 Review FBE-440 3/30/07 2:17 PM

Arbitragers provide liquidity – connects people who arrive in different places and time, provide an example of a speculative arbitrage Recognize pure and speculative arbitrages It is speculative for sure if you can image some factor that would cause the arbitrage spread to forever move apart All arbitragers are risky Discuss the risks of doing an arbitrage, implementation risks, risks of engaging in a speculative arbitrage Market manipulation

• Potential for bluffing imposes a discipline • The price impact per share, when your buying you typically raise

prices • If the price impact per share of buying is higher, than you could

just buy a bunch to push prices up and then sell them Understand that brokers end up staking their reputation on the quality of information that they produce Order anticipation chapter, if you go around telling everybody that you’re going to trade, people will front run you- control the exposure of your order Dark liquidity pool: a trading system where people can’t see who is willing to trade Explain why firms with crummy ideas have a hard time selling capital

• If you have a bad idea, you have to sell a lot of shares and this dilutes the values of the shares, which is just transferring the cost of the new venture to the shareholders, which isn’t good

Know a lot about adverse selection, and where it arises in trading markets

• Bid-Ask spreads, et cetera


What determines a bid-ask spread? Why is it unlikely that a liquid market would ever develop around somebody’s pizza parlor? There would be too much asymmetric information Two models of the bid-ask spread: the equilibrium spread model talked about in class should be known

• The implications of free entry and exit • People are deciding whether to, if you are selling, to take a bid or

make an offer, and, if you are buying, whether to take a bid or make an offer

Who is going to be doing the best with arbitrage? The arbitrage portfolio, the high frequency arbitrage is going to tend to be done with high something Fundamental volatility is due to changes in actual value; transitory volatility is the volatility due to everything else (effects of uninformed traders, et cetera) Transitory volatility has a strong link with transaction costs When is a value motivated trader able to trade?

• If price is below (or above) fundamental value o This can happen for two reasons: prices changed and values

didn’t (uninformed traders), or vice versa (news trader) o Value motivated trader is a supplier of liquidity

Winner’s curse • Why it arises (valuation errors) • When bidding in an auction, must be careful because, as a buyer,

the highest bidder is the one who wins. It is likely that the highest bidder is the guy who probably overvalued the thing being bid on



FBE 440 MW Midterm 2 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar.

Since knowing that you do not know something is a valuable form of knowledge, I will give 40 percent credit for blank answers. A completely wrong answer, of course, will receive no credit.

Good luck!

Short Answers: These questions can be answered with one or two sentences. (10 points each)

1. Order anticipators, informed traders, and dealers all profit from other traders. Which of these traders are parasitic traders and why?

2. Why are momentum traders especially vulnerable to bluffers?

3. How do dealers learn about value from their order flow?


2

4. Under what conditions would you expect adverse selection spreads to be large?

5. Why do block brokers prefer to serve uninformed traders rather than informed traders?

6. How do we know that value traders are the ultimate suppliers of liquidity?

7. Arbitrageurs and dealers both match buyers to sellers. How do their methods differ?


Name_____________________________ Last, First

3

8. How do exchanges simplify bilateral searches?

9. What distinguishing characteristics of fundamental volatility and transitory volatility allow us to discriminate between them?

10. Suppose that transaction costs for a trader are evaluated relative to an opening price benchmark. The trader fills orders for a portfolio manager who trades on momentum. Will the trader’s estimated transaction costs be unbiased?


4



FBE 440 TTH Midterm 2 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar.

Since knowing that you do not know something is a valuable form of knowledge, I will give 40 percent credit for blank answers. A completely wrong answer, of course, will receive no credit.

Good luck!

Short Answers: These questions can be answered with one or two sentences. (10 points each)

1. How do the strategies used to front-run a market order and a standing limit order differ? (Assume the orders are buy orders.)

2. Why do bluffers fear value traders?

3. Suppose that an uninformed trader trades only with dealers who only know about market values but nothing about fundamental values. Do the uninformed trader’s trading profits depend on the number of informed traders in the market? Why or why not?


2

4. If the value of all traders’ time increased, what would you expect would happen to bid/ask spreads? Why?

5. Why do large liquidity suppliers want to know whether the traders who seek to trade with them will want to trade more of the same security in the future?

6. You plan to bid in an auction for an item for which the value is uncertain. You set your bid assuming that there will only be ten bidders. Before submitting your bid, you learn that 100 people will bid on the item. Should you change your bid? Why?

7. Do arbitrageurs and dealers compete with each other for trading profits? Why or why not?


Name_____________________________ Last, First

3

8. What is liquidity?

9. How is transitory volatility related to transaction costs?

10. Suppose that transaction costs for a trader are evaluated relative to a closing price benchmark. The trader fills orders for a portfolio manager who tends to be well informed. Will the trader’s estimated transaction costs be unbiased?




Short Answers (10 points each)

1. Order anticipators, informed traders, and dealers all profit from other traders. Which of these traders are parasitic traders and why?

The order anticipators are parasitic traders because their trading neither makes markets more liquid nor prices more informative.

2. Why are momentum traders especially vulnerable to bluffers? Since momentum traders follow trends, bluffers can cause them to trade unwisely by manipulating prices.

3. How do dealers learn about value from their order flow? A surplus of buy order volume over sell order volume suggests to them that informed traders may be present so that values are probably higher then current prices, and vice versa for a surplus of sell order volume.

4. Under what conditions would you expect adverse selection spreads to be large? When many informed traders are in the order flow or when the information that informed traders tend to have is highly material (i.e. price is very different from value).

5. Why do block brokers prefer to serve uninformed traders rather than informed traders? The clients with whom the block brokers match block initiators do not want to lose to informed traders. If they burn these clients, they won’t be able to do more business with them.

6. How do we know that value traders are the ultimate suppliers of liquidity? Value traders trade when price departs from value, which usually happens when uninformed traders are moving prices away from values. They thus supply liquidity in response to the demands from these uninformed traders.


2

7. Arbitrageurs and dealers both match buyers to sellers. How do their methods differ? Arbitrageurs use their hedge portfolios to match buyers to sellers at the same time but in different places. Dealers use their inventories to match buyers to sellers in the same market buy who arrive at different times.

8. How do exchanges simplify bilateral searches? They reduce the costs of searching by creating systems that allow buyers and sellers to quickly find the best trading opportunities.

9. What distinguishing characteristics of fundamental volatility and transitory volatility allow us to discriminate between them?

Price changes due to fundamental volatility are unpredictable whereas those due to transitory volatility tend to reverse (are mean-reverting).

10. Suppose that transaction costs for a trader are evaluated relative to an opening price benchmark. The trader fills orders for a portfolio manager who trades on momentum. Will the trader’s estimated transaction costs be unbiased?

The estimated transaction costs will be upward biased because momentum managers buy when prices are rising and sell when prices are following so that the trader will tend to buy when price is above the open and sell when price is below the open.





1. How do the strategies used to front-run a market order and a standing limit order differ? (Assume the orders are buy orders.)

To front run the market order, you buy first and then sell when the price impact of the market order moves prices up. To front run a standing limit order, you buy first. You then sell to the standing limit order if you believe that prices will fall.

2. Why do bluffers fear value traders? Value traders can stop a bluff by supplying all the liquidity that the bluffer is demanding when the bluffer is trying to move prices.

3. Suppose that an uninformed trader trades only with dealers who only know about market values but nothing about fundamental values. Do the uninformed trader’s trading profits depend on the number of informed traders in the market? Why or why not?

The uninformed trader’s profits are reduced by adverse selection spreads that the dealers must charge to recover from them what the dealers lose to the well informed traders.

4. If the value of all traders’ time increased, what would you expect would happen to bid/ask spreads? Why?

Bid/ask spreads would widen to compensate traders who offer liquidity for the additional value of their time committed to do so.

5. Why do large liquidity suppliers want to know whether the traders who seek to trade with them will want to trade more of the same security in the future?

They do not want to offer liquidity to price discriminators.

6. You plan to bid in an auction for an item for which the value is uncertain. You set your bid assuming that there will only be ten bidders. Before submitting your bid, you learn that 100 people will bid on the item. Should you change your bid? Why?

You should lower your bid because if you win the auction, you will learn that your estimate was higher than 100 people rather than just 10—you probably over estimated value.


2

7. Do arbitrageurs and dealers compete with each other for trading profits? Why or why not?

Arbitrageurs and dealers compete to match buyers to sellers. If either were not in the market, the other would be more profitable.

8. What is liquidity? 1. The ability to trade quickly when you want at low cost. 2. The successful outcome of a bilateral search in which buyers look for sellers and vice versa.

9. How is transitory volatility related to transaction costs? The price impacts of trades are both transaction costs and contributors to transitory volatility.

10. Suppose that transaction costs for a trader are evaluated relative to a closing price benchmark. The trader fills orders for a portfolio manager who tends to be well informed. Will the trader’s estimated transaction costs be unbiased?

The estimated transaction costs will tend to underestimate the actual transaction costs because the trader will tend to buy at a price below the close because his manager is well informed.





1. Which type of informed trader typically profits when prices change but values do not change? Value-motivated trader

2. When deliberately moving prices, bluffers hope that other traders will identify them as what kind of trader? Informed trader

3. When selling has more price impact than buying, should a bluffer buy first or sell first? Sell first.

4. Name an important way that dealers attract order flow. Quote aggressive prices Quote substantial sizes Purchase order flow Advertise

5. Dealer Jack quotes a market of 20 bid, 21 offered. Dealer Jill quotes 20.5 bid, 21 offered. Dealer Julia quotes 20 bid, 20.75 offered. What is the inside market quote? 20.5 bid, offered at 20.75

6. Name the two most important risks that concern traders who offer liquidity to large traders. Risk of trading with an informed trader (Adverse selection risk) Risk that the large trader will trade more size

7. Name an important risk that an arbitrager faces when he engages in a pure arbitrage. Poor implementation (poor trading) Model risk (winner’s curse)- Failure to properly understand the relative value relation.

8. Is the outside spread generally wider or narrower than a typical dealer’s spread? Wider


2

Very Short Essays (20 points each)

9. In what sense can we identify arbitrageurs as producers and recyclers of financial instruments? Many arbitrages involve trading of nearly identical risks that appear in different forms. When an arbitrageur buys one instrument and sells the others, he or she in effect transforms the risk from one from to another. The process can be viewed as producing or recycling financial instruments. For example, when an arbitrageur buys the 500 S&P 500 stocks and sells the S&P 500 futures contract, the arbitrageur effectively creates the futures contract. The arbitrageur would do this when the futures contract gets expensive relative to the cash index, which typically will happen when demand for the futures form of the S&P 500 equity risk rises relative to demand for the cash form of the risk.

10. What causes the winner’s curse and how do traders avoid it when bidding for an item? The winner’s curse arises because traders cannot perfectly value the instruments that they trade. When they overvalue them, they tend to bid too high and win the auctions at prices above values. Traders avoid the winner’s curse by considering what they learn when they are the highest bidder. In particular, if they are the highest bidder, they likely overvalued the item. They avoid the winner’s curse by lowering their bids to reflect the fact that, if they win, they will learn that everyone else likely had a lower valuation. The amount that they lower their bid increases with the number of other bidders and with the uncertainty in their estimates of value.

11. Describe how a sentiment-oriented technical trader might identify profitable trading strategies. A sentiment-oriented technical trader tries to anticipate the trades that uninformed traders will do. He or she would do this by considering why uninformed traders trade. If the reasons can be predicted, the technical trader can front-run the uninformed traders. For example, suppose that uninformed traders tend to buy whatever stocks are featured on CNBC. A sentiment-oriented technical trader would watch CNBC and immediately buy on the first indication that a stock will be featured on the show.





1. When buying has more price impact per contract than selling, should a bluffer buy first or sell first? Buy first.

2. To which type of trader do bluffers most commonly lose? Value-motivated traders

3. Name an important way that dealers attract order flow. Quote aggressive prices Quote substantial size Purchase order flow Advertise

4. What do you expect would happen to bid/ask spreads if gamblers traded more often in the instruments in which dealers make markets? Spread would narrow because gamblers are uninformed traders.

5. How does large trade size affect the adverse selection spread component? It increases it because people fear that large traders are well informed.

6. Name the two most important risks that concern traders who offer liquidity to large traders. Risk of trading with an informed trader (Adverse selection risk) Risk that the large trader will trade more size

7. What trader type can ultimately supply the most liquidity to a market? Value-motivated traders

8. In a pure order-driven market, how would an increase in the value of all traders’ time affect bid/ask spreads? Bid/ask spreads would increase.


2

Very Short Essays (20 points each)

9. Why do we expect a liquid market to have more informative prices? The liquidity would make informed trading more profitable since the informed traders would have less impact on price when trading. They then would acquire more costly information and put it into the price.

10. A slow trader has issued a large standing buy limit order at the market. How could a clever fast trader profit from this situation? Place a buy order at a slightly better price and hope that it executes. If values subsequently rise, the clever trader profits without bound. If values fall, the clever trader will sell to the large buyer for a small loss. This strategy is profitable if the slow trader is not likely to cancel his order after the clever trader’s order is filled. This strategy effectively extracts the option value of the put that the buyer granted to the market.

11. How do arbitrageurs and dealers compete with each other? Dealers use their inventories to move liquidity through time by connecting a buyer who arrives at one point in time with a seller who arrives at a different point in time, both in the same market. Arbitrageurs use their hedge portfolios to move liquidity from one market to another by connecting a buyer who arrives at one market to a seller who arrives at a different market, both at the same time. Since dealers and arbitrageurs both can satisfy demands for liquidity, they are competitors.


Fall 2007 Professor Baizhu Chen 740-7558 HOH701C email: [email protected] http://www-rcf.usc.edu/~baizhu/ Office Hours: M 4:00 – 6:00pm

TTH 2:00 – 3:00pm or by appointment The post-war period has been a remarkable era of growth in trade. As a result economies in general have become more open. Countries are more interconnected through international trade. Firms are now more and more facing competitions from other countries. Many aspects of trade relations are now headline news - for example the bilateral trade conflict between U.S. and Japan; alleged unfair trading practices of Japan, Korea, Taiwan, and now increasingly China and others; the Super 301 provisions; restrictions on U.S. multinationals; newly negotiated voluntary restraint agreements; liberalization in Eastern Europe and other formal socialist countries; Human rights and trade; the Uruguay Round of GATT negations; NAFTA，WTO and so on. U.S. policy on these and other issues is of crucial importance to global prosperity in the 1990s. Firms' competitive strategies are increasingly influenced by the trade policies of U.S. and other countries. A firm without a global view will not be competitive in a global economy in which competitions come not only from domestic competitors but also from competitors located in different countries. COURSE OBJECTIVES: This course surveys the major topics in the theory of international trade. Like all branches of economics, this course is concerned with decision making with respect to the use of scarce resources to meet desired economic objectives. It is consequently concerned with how international transactions influence such things as social welfare, income distribution, employment, growth, and the possible ways public policy can affect the outcomes. We will focus on such questions as: (1). What determines the basis for trade? (2). What are the effects of trade? (3). What determines the value and the volume of trade? (4). What factors impede trade flows? (5). What is the impact of public policy that attempts to alter the pattern of trade? We will cover most basic trade theories and their policy implications. In this course, we will analyze various trade and industrial policies, for instance, tariff, quota, VER, anti-dumping, customs union. We will also discuss the U.S. trade law, institutional framework of WTO/GATT, the Uruguay Round negotiations, the Multi-Fiber Agreement, and NAFTA. This course is concerned mainly with the non-monetary aspect of international economics. The monetary and balance of payments issues are only marginally discussed. COURSE REQUIREMENTS:

International Trade and Commercial Trade

(FBE 462) Department of Finance

Marshall School of Business University of Southern California


FBE-462: Syllabus

Thomas A. Pugel, International Economics, 12th edition, Irwin McGraw-Hill, 2004 Reading Packet Wall Street Journal is required Lecture notes will be posted in the BLACKBOARD system under the course number for downloading. You should be able to access the BLACKBOARD by typing your userid and password of your UNIX account. For more information of the BLACKBOARD, please contact the Keck Center. COURSE EVALUATION: Requirements for the course include one project (25%), three examinations (45%), three homework assignments (each 5%) and class participation (15%). Class participation may alter your grade by as much as one level. The final grade is based on a “curve.” I adhere roughly to the school guidelines: An average grade of 3.30 out of 4.00 for undergraduate elective courses. This translates loosely into something like 30-35% A, 45-50% B, 15-20% C, and 0-10% D&E. I do not assign letter grades to individual exams and homework assignments. However, I will give you complete distributions for each grade and you can apply the scale indicated above. Project 25% Examinations 45% Homework 15% Class Participation 15% Examinations will consist of multiple choice questions, numerical problems, and in some cases short essays. All exams are closed-book, closed-notes. Each exam will cover the required readings from the text and all the material covered in class. Students should turn in their homework assignments before the due dates. Generally the homework assignment should be turned in at the beginning of the lecture on the due date. Should he or she for any reasons turn in the homework assignment after the due dates, his or her scores will be discounted 10% for every hour the homework is overdue up to a maximum of 50% discount. Violations of academic integrity standards will be treated seriously. "The use of unauthorized materials, communication with fellow students during an examination, attempting to benefit from the work of another student, and similar behavior that defeats the intent of an examination or other class work is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions that accompany examinations. Where a clear violation has occurred, however, the instructor may disqualify the student's work as unacceptable and assign a failing mark on the paper." Make-up Exams: Current department policy to which I adhere is “No makeup midterm and final exams will be allowed.” If you have an extenuating circumstance that prevents you from taking the exams, discuss your reasons with me BEFORE the time of the exam. Current department policy is that a student may not be given a make-up exam unless he or she has obtained written permission from the course instructor in advance. In addition, you must be able to document your extenuating circumstance. Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me (or my TA) as


FBE-462: Syllabus

early in the semester as possible. DSP is located in STU 301 and is open 8:30 a.m. - 5:00 p.m. Monday through Friday. The phone number for DSP is (213) 740-0776 Team Project: We will arrange a field trip to Maquiladoras of Mexico. The trip date is tentatively scheduled on March 1-4, 2005. We will leave in the evening of March 1, Thursday, and return on March 4, Sunday. We will visit several Maquiladoras in Tijuana and other places in Mexico. Students are asked to conduct preliminary research on these Maquiladoras before the trip. After the field trip, students are required to complete a team research paper, which is to be presented at the end of the semester. Disclaimer This syllabus is an invitation to you to engage in an exciting and interactive study international trade. It is my goal to provide a collaborative and supportive learning environment where students will learn from one another both inside and outside of the classroom. To that end, modifications to this syllabus may be warranted as I assess the learning needs of this particular class. This is a contract for this course between you and me. If you want a grade from this class, implicitly you have to follow this contract. COURSE OUTLINE: 1/9 Introduction 1/11 Global Trade Overview International Economics (TP), ch. 1, p1-11, p33 1/16 Is Trade A Zero-Sum Game? International Economics (TP), ch. 2, p15-28 1/16- Why Nations Trade (I)? International Economics (TP), ch. 3, p31-43 /18

“The Halo Effect”, The Economist, Sept. 30, 2004 “Trade Disputes,” The Economist, Sept. 16, 2004 Case Discussion: Free Trade vs. Protectionism: the Great Corn Laws Debate, HBR Case 9-701-080, Feb. 20, 2001

1/23 Why Nations Trade (II)? International Economics (TP), ch.3, p48-57, ch.4, p68-72 1/25 “A forbidden fruit in Europe: Latin bananas face hurdles”,

The New York Times, April 5, 1993 “Working Man’s Dread”, The Economist, October 1, 1994. “The Sucking Sound from the East”, the Economist, July 26, 2003

1/25 Why Nations Trade (III) ? International Economics (TP), 5 1/30 2/1 Growth and Trade International Economics (TP), ch.5 “Korea is overthrown as sneaker champ”,


FBE-462: Syllabus

the Wall Street Journal, October 7, 1993 2/6 Examination 1 2/8 Tariff International Economics (TP), ch. 7 2/13 Tariff Case Discussion: Can Florida Orange Growers Survive

Globalization?, HBR Case 9-904-415, March 8, 2004 2/15 Non-tariff Barriers International Economics (TP), ch. 8 “U.S. import rights: going once, going twice...”

Business Week, March 9, 1997 “China Trade Policy’s Ripple Effect,” the Washington Post, November 11, 2003

2/20- Protect or Not To Protect International Economics (TP), ch. 9 2/22 “Argument against free trade when market fails,” Notes (to be

provided in class) “How Countries Go High-tech,” the Economist, November 8, 2001 Case Discussion: Brazil on Wheel, HBR Case 9-804-080, May 25, 2004

2/27- Pushing Exports International Economics (TP), ch. 10

“How to beggar your neighbor” the Economist, February 3, 1996

3/1 No Class (Preparation for Mexico trip) 3/1-4 Trip to Mexico 3/6 Pushing Exports International Economics (TP), ch. 10

“How to beggar your neighbor” the Economist, February 3, 1996

3/8 Examination 2 3/12- No Classes (Spring Break) 3/16


FBE-462: Syllabus

3/20- Trade Blocs and Trade Blocks International Economics (TP), ch. 11 3/22

“Regionalism and trade, the right direction?” the Economist, September 16, 1995 “Building blocks or stumbling blocks”, the Economist, October 31, 1992 “Everybody’s Doing It,” the Economist, February 26, 2004

3/27- GATT/WTO, US Trade Laws Case Discussion: 3/29

Creating the International Trade Organization, HBS, Case, 9-798-057, Feb. 1998

David Moss and Nick Barlett, The World Trade

Organization, Sept. 2002, HBR Case, 9-703-015 4/3- Trade and Environment International Economics (TP), ch. 12 4/5 “Trading Hot Air”, the Economist, October 17, 2002 “Tax or Trade”, the Economist, February 14, 2002

Case Discussion: the Sweat Serpent of the South-East Asia, the Economist, Dec. 30, 2003

4/10 Trade in Factors International Economics (TP), ch. 14 4/12 Review/Catch up 4/17 No Class (Preparation for Project) 4/19 Project Due Project Presentation 4/24 Project Presentation 4/26 Examination 3


FBE-462: Syllabus

Spring 2007 Professor Baizhu Chen 740-7558 HOH701C II. Please answer each question in the space provided. Do not feel compelled to fill the entire space.

Complete but concise answers are appreciated. 1. (8 points) The following table shows the labor costs of producing cloth and wheat in England and Poland

Poland England Wheat 4 1 Cloth 2 1.5

Both countries use only labor to produce each product. Labor can move between the two industries. Each country is endowed with 100 units of labor.

a. Which country is more productive in producing wheat? What is its labor productivity in wheat? Which country is more productive in producing cloth? What is its labor productivity in cloth?

Answer: England more productive in both wheat (productivity: 1) and cloth (productivity: 2/3)

b. Write out the full employment condition for each nation. Draw it in the following diagram. What is the autarky relative price of cloth in Poland?

Midterm Examination International Trade and Commercial Policies

(FBE 462)

50 C

W W

Poland England

25

C

100

66.7



4W+2C=100 W+1.5C=100

c. Which country has a higher wage? Why? 1*WE = Pw 2*WP=Pc Pw = Pc => WE =2*WP



2. (5 points) The following table shows the factor endowments of several countries. 3. (4 points) In article "Working Man's Dread" published in The Economist, October 1, 1994, in the

reading packet, it says:

- Trade => price of skilled labor intensive goods goes up and price of unskilled labor intensive goods

goes down => unskilled labor wage goes down while skilled labor wage goes up => gap increases

- technological change => demand for skilled labor increases while demand for unskilled labor decrease

4. (11 points) In the great Corn-Laws debate, many arguments have been made to support or against the repeal of Corn Laws in Britain in the mid-19 century. These arguments are listed in the following table. In the column “Effect”, enter R if you believe that the argument is for repealing the Corn Laws. Enter N if the argument is not for repealing.

5. (4 points) BANANA question (a). Answer: these factors are possibly the reasons – weather, cheaper land and cheaper labor (b). Answer: benefiting American consumers



International Trade and Commercial Policies, FBE 462

Group Project

This group project is to be completed by a group of no more than 5 students. It is due on April 19, 2007. The project needs to be typed with double space. Total pages should not exceed 20, including tables, reference, footnotes, executive summary and title page. You will present your findings at the end of this term. Any report exceeding the page upper limit will be penalized. There is no minimum page requirement. Each group will choose one of the companies visited as your target company. One company can be selected by multiple groups. Discussions between different groups are not allowed. Your project write-up should contain an executive summary, a body of analysis, and a conclusion. You should also include references and footnotes, if necessary. You should collect as much data/evidence as possible to support your statements in your project. Ideally, you should utilize as much as possible in your report the knowledge, terms, models/frameworks, and techniques that you have learnt in this class. You should use your target company as a sample to study the industry. You should address the broad question if the industry in Mexico has a comparative advantage. The overall aim of your report is to develop a detailed industry report, focusing on the strategic challenges and opportunities in your industry in Mexico today and in the next five or so years. It should emphasize analyses instead of description. Descriptive information should be discussed to set the stage and context for the situation facing your industry but the analyses of the situation should receive much greater emphasis. Your team should think critically about the industry and should develop your own perspective on the situation facing the industry now and in the future.

The intended audience should be managers in the industry who are interested in Mexico, both local and foreign managers. Thus, it should read like a report prepared for an industry association or set of players in the industry. Any company in the industry, foreign or local, should be interested in the report as it should discuss the basic structural information of this industry.

In analyzing your industry, think back to frameworks, concepts, tools, theories, models, and other material learned in this class, as well as in other classes of your undergraduate curriculum. Use appropriate frameworks, concepts, tools, theories, and models you learned earlier in the undergraduate program for analyzing and drawing conclusions about your industry. A well developed industry analysis is interdisciplinary in nature, drawing upon strategic, marketing, operational, financial, economic, and management perspectives. Therefore, you should apply and integrate appropriate material from earlier courses in preparing your industry report. Issues to Address

1) Conclusions and recommendations about opportunities for foreign companies to compete in the industry in Mexico over the next five years

2) Conclusions and recommendations about opportunities for local Mexican companies to compete domestically and globally over the next five years



In analyzing your industry, the following are some possible areas you may wish to consider. However, the following list is NOT meant to be a template of areas that you must cover for the report. You should think about what kinds of analyses are appropriate to analyzing the situation facing your industry in your target country and include those relevant analyses in your report. You should define the areas of analyses that are relevant to your report.

1) Evolution of the industry over time – forecasts of growth, future trends, upcoming opportunities and challenges, etc.

2) Competitive analysis of local players in the industry in Mexico – strengths and weaknesses of domestic participants in the industry, the strategies pursued by various players, the relative levels of success and profitability of various players, the likelihood of new domestic entrants into the industry over the next five years, etc.

3) Competitive analysis of foreign players in the industry in Mexico – strengths and weaknesses of foreign participants in the industry, the strategies they are pursuing, the relative levels of success and profitability of these players, the likelihood of new foreign entrants into the industry over the next five years, the relative comparative advantages of foreign vs. local players in this industry, etc.

4) Strategic marketing analysis – assessment of the dynamics of customers, viable target segments, market potential in the target country, marketing opportunities and challenges, etc.

5) Cost structures of the industry – what are the major components of the cost? Is it mainly the labor cost, or capital cost? How does regulations affect the cost structure?

6) Strategic operational analysis – assessment of the challenges, opportunities, and critical success factors for carrying out effective operations in the country, advantages and disadvantages of local production, etc.

7) Environmental analysis of Mexico – assessment of the impact of the economic, political, cultural, and technological environment of Mexico on the industry, the implications of these environment factors for being successful in the industry, etc.

8) Policy analysis – assess the impact of various government policies on your industry. You may want to address how NAFTA or China’s entry of WTO influences the competitive structure of this industry.

9) Ethical issues confronting companies in your industry in Mexico – assessment of the ethical challenges faced by managers in your industry doing business in Mexico, the implications of these ethical challenges for competition and for being successful in the industry, etc.

10) Comparison of the characteristics and strategic challenges of the industry in Mexico with that of the industry in other countries, particularly the U.S. or China – assessment of the similarities and differences in your industry Mexico and other countries in areas such as competitive environment, customer environment, opportunities and challenges, key success factors, etc.

11) Strategic importance of the country in regard to global competition in the industry – importance of the country in the global context of the industry in terms of market opportunities, access to factors of production, access to new innovations, competitive positioning, as a base for exporting to other countries, etc.

12) Conclusions and recommendations about opportunities for foreign companies to compete in the industry in Mexico – motivations for foreign companies to participate in the industry in Mexico, likelihood of new foreign entry into the industry, etc.

13) Conclusions and recommendations about opportunities for local companies domestically and globally




FBE-462: Handouts


FBE-462: Homework

FBE-462 1/11/07 10:12 AM

Globalization and global trade overview • People same • Communicate (transaction cost goes down) • Trade freer

o Goods and services o Capitals and labors

• Interdependence o Factors of production

• Technology • Conflict • Trade is more regional

o 49% of Asian exports go to Asia, if you add 20% to that (the amount that goes to North America), you see that over 70% of Asian trade is within Asia



FBE-462 1/16/07 10:01 AM

Basic mercantilist idea assumes that the more precious metals a country has, the wealthier it is

• This promotes exports, and dissuades from high imports • Agriculture was always the heavily protected industry protected

back then, during this period Is trade a zero-sum game?

• Barriers still exist in trade among countries • As long as there are barriers, there is arbitrage • Globalization process creates winners and losers, more social

stratification, some countries are becoming worse off than they were before

Wealth of a nation should be measured by the amount of goods and services that can be produced, not by the amount of gold

• This is less convenient than gold, but better • Today, we see gold as just another good, like anything else • Many people still think that export is better than import, without

any preconditions • Section 301 is a trade law that says that any foreign country that

has an excessive trade imbalance with the US, the US will enter into trade negotiations with that state to attempt to eliminate this imbalance

o This was targeted at Japan when it was first introduced • Consumer surplus • Utility curve for consumers, indifference curve, the shit learned last

semester in Econ for business – the more of a good one has, the less it is worth to them

• Marginal willingness to pay for a good or service • Consumer surplus is $2 if the consumer is willing to pay $8 for a

service, but only has to pay $6 • Selling Apples, market price is $10 but you are willing to sell them

for $8, producer surplus is thus $2 Autarky to open economy

• Supply equals demand



• What is the total wealth of this country? • Total welfare of a nation is consumer surplus plus producer surplus

(CS+PS=Total Welfare) • North Korea is a close example of this, China before 1978 • In the slide, the difference (e) is exports, when price is above the

market equilibrium of demand and supply • CS=c, PS=d • Total welfare in this case is c=d=e, so by engaging in trade, a small

country will benefit (the total welfare of that country is higher with trade)

• Consider two countries, one is the home country the other is foreign o One is importing the other is exporting o World market price is determined by the equilibrium of the

export supply and the import demand o The smaller the country is, the more relative gains you will

receive from trade from other countries o We see this, small countries have applied more free trade

policies because of the benefits that come to these countries from this free trade

o NAFTA set up an emergency fund to compensate those countries that will be negatively affected by the opening of trade

o In exporting country, consumers will suffer and producers will gain, while this is vise-versa in importing country

General Equilibrium Approach

• Production possibility frontier • There is a line tangent to the production frontier that shows world

relative price, this line meets consumer utility curve • Relative price of cloth, versus relative cost of wheat • Suppose in a world market, cloth is more expensive than wheat • The world market price line (in the slide) will be steeper • Price of exports divided by Price of imports = relative price of

exports or TOT (terms of trade) • When terms of trade increases, line gets steeper and country can

get more of relative product for each product being exported



• China, long history of China • Chinese have small bananas, while the US has very big bananas



FBE-462 1/18/07 10:06 AM

Why nations trade? Going over handout given in class “The halo Effect” article from the economist Benefits

• Change in relative prices will be good for developed countries Downsides

• Hurts developing countries who are competing with China in industries attractive to developing nations

For a developed country, TOT (terms of trade) will improve because of this effect in China, with 200 million unskilled workers “One man’s junk is another man’s treasure” article for today

• Scrap metals, papers • Trash is the number one export from the US to China • This is based on relative prices, exports of scrap metals, papers, et

cetera are cheaper as raw materials in China than getting these products in others ways from within China

Another example of how demand affects imports and exports

• Chicken breast exported to the US from China, more demand for it here than there

• Chicken slaughtering in China Case Analysis

• Corn law- protecting agriculture industry within the UK (not just corn, many other agricultural products as well)

• Case is about Britain thinking about appealing the corn law and opening free trade of agriculture

• Pros of this proposition o Price of agricultural goods in the UK will go down



o Trade relations with countries supplying these goods might be improved

o Better usage of land within the UK, instead of subsidized agriculture

o Shifting resources to other industries, reduce strain on government funds to subsidize farmers

o Solve certain food shortage problems o More varieties of goods available in the country

• Cons o Farmers’ wages will decrease o Increase dependence on other countries for agricultural

products o Other countries may not reciprocate o Will the economy be able to absorb the shock? o Losing political support from farmers o Loss of revenue and fairness



FBE-462 1/23/07 10:01 AM

Why Nations Trade? • What determines supply and what determines demand? • Substitutes, et cetera • Article brings up concerns of Southeast Asian countries of whether

or not they will have a competitive advantage over China in industries that might benefit these nations

• Ricardo’s Theory of Competitive Advantage Both productivity and wage are very important

• Outsourcing • Starting to outsource white-collar jobs has caused dispute

Ricardo model

• Requires a high degree of specialization • Competitive advantage

o If a country has a lower opportunity cost of producing good A, the country has a comparative advantage in that trade

• The line in the graph is usually not straight in the real world, it is curved

• Japan is smaller than the US in all respects



FBE-462 1/30/07 10:01 AM

Dogswell presentation Why nations trade Resource-based trade Labor-based trade Chile trade article

• Farming products, most notably fruits, made in Chile (their summer is our winter)

• Chilean wines are now becoming more competitive in other countries

• In their winter, we sell them fruits Brazilian article

• Covering the agriculture sector in Brazil o Oranges are very competitive, especially orange juice o Sugar, Coffee, Soy beans

Growth rate of soy bean exports in Brazil is very high • Why do they have a competitive advantage in growing?

o Good growing conditions, tropical weather o Vast amounts of land, it’s a land-abundant country

• Prices of these commodities have gone up (such as orange juice prices)

Who wins and who loses?

• Everybody doesn’t always win, creates larger income gaps • For simplicity, assume that production technologies are constant

Article “Working Man’s Dread”

• What happened to the real wage in America since 1973? o It has gone up at a slower rate than other wages

• Wage is price for labor • Demand is determined by labor productivity • Labor for tech jobs has increased, as demand for technology

increases



Article “The Sucking Sound From The East”

• Mexico • Low-skilled manufacturing demand has gone down in Mexico • They are less competitive, can’t compete with labor costs in China • Also, Mexico has high energy costs • Energy sector in Mexico is a monopoly, and has reduced the

competitiveness of their low-skilled work force • This work force isn’t as productive as China’s work force • Unions of labor forces in Mexico makes them less competitive



FBE-462 2/1/07 10:15 AM

Exam on Tuesday will be similar to class discussions and homework • There will be a couple of questions on the articles read for the class,

but these questions will be preceded by an excerpt from the article • Structure of exam will be similar to homework, but a bit longer and

with questions from cases and articles Who is most likely to benefit from free trade and who is most likely to be hurt from free trade?

Labor C W Price of cloth relative to wheat will go up

Land • Exporting cloth

o Labor will be better off and land owner will be worse off (as cloth is labor intensive, and price relative to wine will increase as the country exports cloth)

• US is capital abundant, US will export capital o Capital owners will likely vote for free trade, and will benefit

from it, labor will be worse off from free trade as labor prices relative to capital will go down

• Will the two groups always vote against each other on the issue of free trade?

o It depends on which industry one is in, those in industries who don’t have a competitive advantage will be protectionist, those in industries with an advantage will be pre-free trade

o Boeing all voted for a most-favored nation status for China Section 5: Economies of Scale and Trade

• Intra-Industry trade o US imports and exports cars o US sells soybeans, buys shoes from China

Economies of scale

• External economies of scale (EES) o Prices go down when the entire industry gets bigger



• Internal economies of scale (IES) o Prices go down as the size of operations within the firm

increases • C = F + a*X • AC = (C/X) = (F/X) + A • The more a firm produces, the less the fixed costs per unit are Perfect Competition Monopoly Monopolistic Competition Oligopoly • Companies often merge if the fixed costs factor is high enough, this

way Internal Economies of Scale come into effect o Examples here are car manufacturers and banks

• Monopolistic competition: Each firm is a monopoly in its own product, but competes with similar products

Scale economies and product differentiation

• Two countries that are exactly the same o Instead on each country making some expensive cars and

some cheap cars, these nations will benefit from economies of scale if one nation produces cheap cars only and the other country produces expensive cars only



FBE-462 2/13/07 10:19 AM

Dutch disease • Currency appreciation • Direct result of the resource-based trade model • Immiserizing growth: Even though there is a harvest of coffee,

because of price drops some coffee producers are worse off than if they had not increased production

o In a small country, growth is always good o Balanced growth for a large country is usually good o Growth biased towards export sector of a large country, may

be worse off- prices of export drop, country gets less of import product for each unit of export product

• Economic growth can also affect the TOT • When export growth occurs in a large country, world price may

decrease and effect TOT so much that the country is worse off (with a small country, world price may not be affected as much)

• ISI strategies (He calls is Import Substitution Strategy) Product cycle theory

• Dynamics of comparative advantage • Comparative advantage changes over time because of economic

growth o South Korea and the shoe-making market

• Countries will gain competitive advantage, and other will lose it, its all part of a cycle

• Difficult to figure out when a country will lose its competitive advantage, took about 20 years for South Korea to lose its competitive advantage in sneakers

Tariffs – Section 7



FBE-462 2/15/07 10:03 AM

Tariffs – Basics • NAFTA- trade should be duty free by 2015 • Preferential duties • GSP (Generalized System of Preferences) • Weighted average of tariff rates- weighted average based on dollar

amount of trade of each product/service Welfare of import duty

• Small nation: its TOT is given • Tariff has no effect on its TOT • Gain or loss? • For large countries, when tariff is imposed the world market price

drops and P-star (P*) declines, making the Tariff more than it would be for a small country



FBE-462 3/20/07 10:17 AM

Dumping and Anti-dumping • The product is sold in another country at lower than the fair market

value o How does one determine the fair market value? o Compare to other similar products or prices of same or similar

products in other countries o If you can’t do this, base it on the cost of production

• The case of China and shrimp dumping o There is a 112% import duty on shrimp from China o Even though price is lower in China, this can’t be used for

comparison in determining fair market price because Chinese are commies

o The US just makes excuses why it can’t use local price for comparing shrimp prices in the US (i.e., in Thailand they eat fresh shrimp so its OK that the price for shrimp there is lower than the price for Thai shrimp in the US)

• Conditions for dumping to occur o Imperfect markets o Segmented markets

• Types of dumping o Predatory dumping

Very difficult to do this, because after you raise prices back up, more competitors will enter

o Cyclical dumping Dumping Christmas trees at low prices after Christmas

is over o Persistent dumping

Export subsidy and countervailing duties

• China is the largest cotton producer, with US coming in second and India coming in third

• US cotton subsidy is $2 billion • Divide that out, you get $120,000 to produce cotton in the United

States



FBE-462 3/22/07 10:07 AM

Export subsidies • Consumers lose welfare • Producers gain welfare • Government must pay for subsidy • Results in a deadweight loss • Country will always lose if implementing a export subsidy, whether

the country is large or small • European agricultural industry

o Agriculture goods are more expensive in Europe o Land for farming is limited in Europe, makes it hard for them

to compete in the world market o World price is $10 for farm goods, EU set a price floor at $15,

at one point 75% of the EU budget was for buying Europe’s excess supply

o EU implemented an export subsidy of $5, so farmers had incentive to export their excess production to foreign countries (this way they wouldn’t have to spend so much buying and storing excess production)

o Many reasons for the original protection of the agriculture industry



Mexican Wine Industry Analysis

Prepared by: Eric Chen

Cyrus Chini Alex Daly

Shelley Goto Keith Parker

FBE 462 – International Trade and Commercial Policy

April 19, 2007


FBE-462: Group Project

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Executive Summary

This report on the Mexican wine industry is intended to serve as a resource for both domestic wineries and foreign wine companies considering Mexico as a potential investment opportunity. As a truly global industry, we had to center our analysis of Mexico’s wine industry within the context of this international market. What we found on a global level is a $90 billion industry undergoing a serious transition, with New World producers reinventing the way that wine is produced, distributed, and marketed, and challenging the traditional vintners of Europe worldwide. Scale economies and cost efficiency, consistent quality, and aggressive branding campaigns have replaced esteemed terroir as the success factors for wineries. Tariff barriers and regulations are falling, allowing almost any wine-producer to compete worldwide.

Turning to Mexico, we will examine the $230 million wine industry in terms of its factor endowment advantages and infrastructural and customer base shortcomings. There is very little foreign investment in the industry, and the largest domestic wineries have done little to break into export markets. An analysis of the environment facing Mexican wineries highlights the favorable political and economic policies in place but also the striking lack of experience with viticulture and interest in wine within the country.

Looking ahead to opportunities and challenges, wineries worldwide will continue to compete aggressively for the sole growth segments of premium and super-discount wines. Innovative branding and access to solid distribution channels will continue to be essential. In the end, we offer the following recommendations:

o Mexican wineries must place much more emphasis on these marketing concepts and strongly push the export of their premium and super-premium wines.

o Due to existing global oversupply and the many challenges impeding successful

operations in Mexico, we do not believe that any foreign wine companies should look to invest in the Mexican industry.



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Mexican Wine Industry Analysis

A Global Overview

The global wine industry is currently undergoing a drastic transition. In the past 30 to 40 years,

this $90 billion industry has changed from a European agricultural product based on centuries of

tradition to a globally competitive, marketing-centric industry. New World producers in

Australia, the United States, and South America have turned the conventions of wine-making

upside down, utilizing huge plots of fertile land, implementing advanced agro-industrial

techniques, and aggressively pushing the exports of strongly branded wines.

Major Players

Though their hold over the market is declining, the largest wine exporters are still the traditional

countries of France, Italy and Spain, followed by the United States and Australia. However,

even though France and Italy produce far more wine than New World countries, the two largest

wine companies are from the U.S. and Australia. A 2003 merger between Constellation of the

U.S. and BRL hardy from Australia formed the world’s largest wine producer, just passing E&J

Gallo of California. These conglomerates have achieved economies of scale in both production

and distribution that far exceed any current competitors in Europe.

Consumption Patterns

Wine consumption is still concentrated in Europe, with France, Italy and Spain being the three

largest wine markets in the world, but per capita consumption is rapidly declining in these

traditional wine regions – from over 100 liters per capita in 1966 to under 60 liters today. At

the same time, wine consumption is steadily increasing in North America, Australia, and most

rapidly in totally new markets such as Asia and Africa. Across all markets, demand for higher

quality wine is actually still growing, leading to an emphasis on quality, not quantity. Trend-



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wise, red wines are on the upswing, and younger consumers especially look for new, more

exciting wines than the traditional Chardonnays of the 1980s. With their open acreage for

planting and more consistent production, New World wineries are much more capable of

adjusting to these changing trends than European competitors.

New World Innovations

Australian, American, and South American entrepreneurs have fully taken advantage of their

ability to carve a domestic industry out of nothing – to completely reinvent wine-making.

Utilizing resource factors such as abundant land, a warmer climate, and capital intensive

technology, New World producers are now challenging European wine makers in almost every

market and at every price segment. The use of irrigation, trellis growing systems, scientific

experimentation, stainless steel fermentation tanks has all but eliminated the annual quality

variations that affect the consistency of European wines. New marketing techniques such as half

gallon bottles, screw off tops, and boxed wines have also proven very attractive to consumers, in

addition to reducing shipping and storage costs.

The Rise of Australian Wines

“Australia is the driving force in the global wine industry.”1 This quote would have been

unheard of just 30 years, but since Australia is now the largest wine exporter to the United

Kingdom, it is probably fitting. Due to their relatively small domestic market, Australian

wineries had to combine their new production methods with an aggressive marketing campaign

to establish themselves on the international stage. Companies such as BRL Hardy and Southcorp

vastly improved the accessibility of wine by simplifying their denomination systems and

1 The Economist. “Blended.” http://economist.com 23 June 2003.



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establishing strong brand identities that could carry over from one varietal to the next. Their

methods have obviously worked, as Britain, long considered a key import market due to its lack

of domestic production, now sells more Australian wine than French wine. Showing how much

the industry has changed, a recent study shows that British consumers choose their wines based

on previous purchases, price, country and occasion, in that order – nothing to do with the region

or variety, which are two areas often focused on by traditional wine-makers. 2

South American Experiences

Of particular interest to the Mexican winemakers may be the successes of the wine industry in

Chile and Argentina. Argentina is the world’s fifth biggest wine producer, most of which is

consumed domestically, and Chile is one of the most competitive wine exporters. Argentina has

all the natural endowments necessary for wine production, and its exports have increased

dramatically during the past seven years of domestic stability – many of its signature varietals

are especially popular with American consumers.3 Chile, on the other hand, has followed

Australia’s model of strongly branding its wines and even promotes its exports through the use

of overseas wine trade groups. Chile has been further aided by its existing free trade agreements

with countries including the United States, Japan, and South Korea.

Cost Structure of the Industry

New World wine producers launched their immensely successful growth based on their

efficiency and ability to essentially mass produce what was once considered an artisan’s product.

While the quality of wine exported by countries such as Australia and Chile has greatly

2 Campbell, Gwyn and Nathalie Guibert. “Introduction.” The British Food Journal 108:4 233-39. 3 The Economist. “Vino’s Twin Peaks.” http://economist.com 15 Mar 2007.



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improved, a large part of their competitive advantage still stems from lower production costs, of

which there are four major components:

• Grape costs per case

• Crush and Capitol costs

• Barrel Costs (corks, labels, etc.)

• Dry goods costs per case

Grape Costs

Depending on the quality of wine produced, this cost sees the most variability. For Basic quality

wines, grape costs are usually around 8% the total cost of production. On the other end of the

spectrum, for Ultra-Premium quality wines, the cost of grapes range from around 65%-85% of

the total cost of production. Of greater importance, however, is the fact that the amount of

grapes needed for a 9L case of Ultra-Premium Australian wine can be produced for $45.45 as

opposed to $104.55 in France.

Crush and Capitol Costs

This category includes the cost of the machinery and labor used to produce the wine. These costs

are usually fixed and do not see much variability between the different qualities of wine nor

between the different wine-producing countries. Costs range from $13-20 for each 9L case

produced.

Barrel Costs

These costs are relatively 0% for lower quality wines and only reach up to about 2% of the total

cost of producing higher quality wines.



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Dry Goods Costs

The costs remain less than 1% of the production per case regardless of the quality of the wine or

the country. But when all of the production costs are added together, New World wineries are

able to achieve significantly higher margins than European producers across every market

segment and most notably with their Super-Premium and Ultra-Premium wines. In these

segments, Australian winery margins of 17% and 50%, respectively, far outshine the 4% and

18% of their French counterparts. Further downstream profits are also available for companies

who have vertically integrated enough to own their own marketing and distribution channels.

Regulations

The historical status of wine production in Europe plays a major role in the cost structure of the

wine industry. Heavy fines may be imposed if guidelines are not properly met, and many

countries that produce wine, mostly in Europe, have restrictions placed on grape varieties in

particular regions. Other regulations may include the amount of sugar content in the wine, the

amount of time spent aging the wine, and the geographic origin of the oak used for barreling.

These sorts of limits hurt certain countries when there are shifts in demand. For example, if the

market demand shifts to a drier red wine, there may be restrictions holding back wineries in

certain German regions from producing what the market demands. With their non-traditional,

more market-based approach, New World producers are largely free from these constraints and

can quickly adapt to market preferences.

Tariffs

The tariffs applied to the imports of wine vary greatly from country to country. The United

States charged a tariff of $0.063 per liter of wine in 2002, which is one of the lowest in the



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world.4 Other import tariffs range from $0.11 per liter in Europe, to 4% ad valorem in Mexico,

to 60% ad valorem in Hong Kong. A 2002 Mutual Acceptance Agreement (MAA) on

Oenological Practices signed by the U.S., Canada, Chile, Australia, and New Zealand sought to

promote the international wine trade and ease barriers.5

Strategic Market Analysis

Wineries have two main customers:

Wholesalers

Retailers such as grocery stores, liquor stores, etc. obtain the wine they sell from their

wholesalers or wine merchants, who have previously purchased cases from the wineries

themselves. Wine retailing has undergone a shift in recent years, as large, powerful grocery

chains or wholesale stores such as CostCo have exerted more influence on their distributors.

These chains are able to demand a large scale and scope from their distributors, meaning the

most successful wine producers will often be those who are able to provide their distributor (or

retailer if the winery owns their distribution) with enough variety to stock an entire grocery shelf.

And of course, the wine conglomerates of Australia, Chile and the United States are in a much

better position to do this than the independent vintners of Bordeaux.

End Consumers

Wine drinkers can also purchase their wine directly from the winery but this method is often

inconvenient, and largely relegated to small, local wineries that are unable to gain access to

broader distribution channels. End consumers are much more likely to purchase their wine at a

local retailer. To reach more consumers, producers strive to create a diverse product line to

4 Penn, Cyril. “Wine Gaining Ground in US Trade Outlook.” Wine Business Monthly 5 Penn.



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appeal to all palates. For example, German wineries do their best, with respect to regulations, to

respond to the market demand in sweeter wines by producing their own brand of dessert wine.

These shifts in ‘fashion’ are one of the biggest challenges wineries are faced with. Strict

regulations prohibit many Old World wineries from quickly meeting the new demands.

Competitive Analysis of Mexico’s Wine Industry

With this understanding of the global wine industry, we can now turn specifically to Mexico. In

2005 the Mexican wine industry generated revenues of $230.2 million, and growth is expected to

accelerate in the coming years, with the market reaching $313.6 million by 2010.6 The industry

centers around the city of Ensenada in Baja California, which accounts for 90% of the quality

wine produced in the country. Other major winegrowing regions include Guadalupe, Calafia,

San Vicente and Santo Tomas Valleys. Although Mexico is not a global leader in the wine

industry, one advantage it has over many other countries is its weather. Baja California lies

above the 30th parallel on the Pacific Coast and has the perfect climate of hot days and cool

nights needed for winegrowing, allowing grapes to develop their sugar without a corresponding

drop in acidity.

Challenges for the Industry

Even though Mexico has this ideal weather for producing high quality grapes, the Mexican wine

industry still faces many barriers, one of which is the relative shortage of wine drinkers.

Traditionally, wine is not the primary choice of alcoholic beverage for Mexican people, who tend

to prefer beer and tequila. Domestic consumption is further discouraged by the fact that the

Mexican government put a 40% tax on each bottle of wine, making it harder for wine to compete

with the more traditional Mexican beverages. A more complicated challenge for the Mexican 6 Datamonitor Industry Market Research. “Mexico – Wine.”



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wine industry is the water supply, specifically the management of water use in the winegrowing

areas. Controlled water stress has worked well for Mexican wineries in the past, but due to the

proliferation of new wineries, many Mexican vineyards that require irrigation are not getting

enough water supply. On top of that, the fact that the city of Ensenada is growing rapidly results

in even less water available for the vines, leading Josef Backhoff to argue that “if the region were

to have no problem with water, without a doubt we would be growing 10 times faster."

The Market Leader – L.A. Cetto

There is very little foreign involvement in the Mexican wine industry, but there are a few

domestic companies that have enjoyed some success both domestically and internationally. The

largest producer is L.A. Cetto. L.A. Cetto is a family owned company that has a large vineyard

in the Guadalupe Valley and Sonora and annual sales of 1.8 million liters. The winery divides its

wine into three different levels, commercial blends, the single varietal series, and the "Limited

Reserve". In addition to the more common wines, it also sells wines that acknowledge their

Italian heritage, such as Nebbiolo and Passito dessert wine, as well as the Californian specialties

of Zinfandel and Petite Syrah. Overall, L.A. Cetto enjoys a great deal of success; it has a large

market share of 9.9% within Mexico, and exports about 40% of its total wine production.

Other Mexican Wineries

The second biggest producer in Mexico is Bodegas de Santo Tomas, with an 8.8% market share

and sales of 1.6 million liters in 2005. Another winery that is doing fairly well is Monte Xanic.

Monte Xanic is smaller than L.A. Cetto, but it is a proud winner of numerous prizes, including

the bronze medal at the 2000 Challenge International Du Vin in Blaye-Bourg, France for the

1998 Monte Xanic Chardonnay. Strategically speaking, Monte Xanic chooses to differentiate

itself by concentrating on Bordeaux varietals and Chardonnay.



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Environmental Analysis for Mexico’s Wine Industry

Economic Environment

Despite primary and secondary education being free and mandatory, 47% of the population live

below the poverty line.7 This provides an abundance of cheap, disposable labour, which is

especially useful in a seasonal, labor-intensive industry as is wine. Since the growing and

harvesting season only comprises about a third of the year, the ability to pick up seasonal

workers is very important to the industry, and Mexico can provide that. The relative abundance

of labor along with the shortage of available jobs for low-skilled employment allows the winery

to freely hire and fire as many workers as it needs, allowing them to keep wages down and profit

maximized.

The second important dimension of the economic environment is overall macroeconomic

stability. While the economic and financial crises that Mexico experienced in the 1980s and

1990s may seem to be distant memories, in terms of wine-growing this really is not that long at

all. To produce top quality wines, vintners must wait as long as 20 years to really see their

investment mature, which helps explain why wine production and exports in the more stable

Chile have grown so much more rapidly than in Argentina.

Cultural Environment

From our first-hand experiences in Mexico, it was apparent that Mexico has a very small

domestic market for wine. The alcohol sector is dominated by beer and tequila, because those

are the more traditional drinks. This means that if wineries and the industry want to expand, they

will have to export a good portion of their product.

7 Ed. Starr, Pamela K.. Challenges for a Postelection Mexico: Issues for US Policy. Council on Foreign Relations. Council special report no. 17, November 2006



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Political Environment

Mexico is very open to trade; they have free trade agreements with about 40 different countries.8

Also, as the NAFTA transition periods progress, and US-Mexico trade becomes more and more

open, whatever tariffs exist on liquors and wines will be dropped along with the rest of the agri-

business sector.9 This will give Mexican wineries a large market in the US that allows low

transportation costs, and a favorable market. This would give them a larger target market and

allow them to expand beyond the capacity of the domestic market.

Technological Environment

Mexico, unlike the more traditional wine-producing regions like France and other European

states, lacks the rules and regulations regarding the traditions in wine production. Therefore, it

can utilize technological advances like steel vats for brewing white wines, as we observed at L.A.

Cetto. This gives the Mexican wineries an advantage in the cheaper-grade or boxed wine

industries that can be produced en masse.

Policy Analysis

NAFTA’s effect on the industry

About 90% of all Mexican imports go to either the US or Canada, both of which have an

appreciation for imported wine and cheap wine.10 Also, the lower trade barriers allow for the

Mexican wineries to take advantage of lower transportation costs to the US and Canada as

opposed to overseas. Also, as the NAFTA countries continue to integrate, Mexico will have

8 Ed Starr. 9 Adams, John A., Jr.. Bordering the Future: The Impact of Mexico on the United States. Praeger Publishers: Westport, Connecticut. 2006 10 Starr.



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freer and freer access to the North American markets, allowing them to expand their wine

exports.

Border Control

Since there is a 1 liter limit on how much alcohol private citizens can bring across the border

from Mexico to the US, Mexican wineries can mark up the prices of wine they import based on

supply and demand. Since the US consumers can therefore really only get Mexican wines

domestically as opposed to buying in bulk while south of the border and bringing it back, the

wineries can up the price that they charge distributors in the states to reflect that exclusivity.

In addition to this, the increased security at the border is draining California wineries of their

supply of seasonal workers. The migrant workers that used to pick the wineries’ grapes during

the relatively short harvesting season can no longer go to the US from Mexico as easily. This

restriction on the international mobility of labor gives Mexico a comparative advantage over the

US wineries, since the labor is much cheaper and more readily available in Mexico.

China’s Effect on the Industry

Although China is the world’s sixth largest producer of wine, it consumes most of it domestically,

and does not rank among the top ten wine exporting countries.11 In the future, however, China

may become a threat to the Mexican wine industry, especially as the country becomes more open

to western cultures and consumables. Analytically speaking, China has the climate, the

resources and the land for wine production, it just hasn’t taken off because wine in the

conventional sense is not traditionally a part of Chinese culture. Right now, in the wine and beer

sectors, Mexico exports over 200 times as much as China does to the US.12 Mexico, as well as

11 FAOSTAT. Food and Agriculture Organisation of the United Nations. http://faostat.fao.org. 12 April 2007. 12 USDA Foreign Agricultural Service (FAS). United States Department of Agriculture: Foreign Agricultural Service. http://www.fas.usda.gov. 12 April 2007



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any other wine-producing country, will continue to benefit from China staying out of this export

market.

Competitive Environment

The domestic array of wine producing competitors in Mexico is very limited, due to its status as

a relatively under-developed market for wine production. Competition from imports poses a

very strong risk to any potential wineries in Mexico, though. Established foreign wine producing

markets have years of experience in making high quality wine in bulk at low prices, most notably

the California and Australian markets. Further, European wineries have long produced premium

wine brands and still hold a large portion of the world wine market, despite the problems they

have had in recent decades. In order to develop as an effective world wine-producing competitor,

Mexico would first have to develop its own domestic wine market. Currently, Mexico makes

up .7 percent of the wine market for the Americas.13 With such a small market, it would be

difficult to establish the image of desirability so needed in this competitive industry. Further,

wine making has been making a move from a labor-intensive business to a capital intensive

business, as evidenced by the emergence of very large mass-producing wine companies such as

E&J Gallo, who recently posted a US$4 Billion revenue intake. While California is known for

its abundance of Capital, Mexico is not.14 These conditions paint a clear picture of the

difficulties Mexico would face in emerging as a competitive force in the world wine industry.

13 “Wine Industry Overview.” Business and Company Resource Center, 11 April 2007 14 “Business: Blended; Wine Industry Mergers.” The Economist, 25 January 2003



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Customer Environment

When looking at consumer trends in the wine industry in Mexico, the picture is a little brighter.

While US wine sales growth has slowed from its record-breaking numbers in the 90s, Mexican

consumers’ demand has seen recent sharp increases. Wine sales in Mexico are expected to have

a compound annual growth rate of 6.2 percent, compared with similar markets such as Brazil

who have seen growth slide to 1.9 percent.15

Opportunities and Challenges

The vast majority of growth in the wine industry has been in the premium wines and super-

discount wines. The market for wines between these two extremes has seen very little growth,

and often market shrinkage. As the Mexican wine industry is fairly under-developed, wine

producers in this market have little opportunity to achieve the scale needed for the production of

super-discount wines, the opportunity in this market lies in premium brands. This actually

coincides nicely with the wine-growing conditions in Mexico, as the Mexican climate and soil

are said to be very conducive to premium grape growing. Also, when looking at the target

market for wine consumption in Mexico, the focus will quickly fall to the upper-middle to higher

income population. This segment, and specifically urban professionals with travel experience

and greater discretionary spending, will be the people most likely to venture away from the

traditional choices of beer and tequila. An opportunity for Super-Premium and Ultra-Premium

wines exists here as a status symbol.

Furthermore, as mentioned earlier, the lack of domestic competitiveness leads to a lack of

pressure for innovation and improvement in quality; conversely, the highly developed wine

producing regions around the world are constantly under pressure from competitors to improve 15 “Wine Industry Overview.” Business and Company Resource Center, 11 April 2007



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quality and to rapidly innovate. A major boost from foreign investors with agricultural,

technological, and most importantly marketing experience would probably be needed to really

raise the Mexican wine industry up to the standards of even Chile or Argentina, but the problem

lies in attracting these investors.

Conclusions and Recommendations

With this understanding of the global wine industry, the economics of wine production, the

history of the industry in Mexico, the overall business environment in Mexico, and the ongoing

development of the wine market in Mexico, it is possible to make some concluding

recommendations for both local wineries and foreign companies considering expanding to

Mexico.

Domestic Producers

For a domestic winery such as LA Cetto to be grow and be successful both domestically and

internationally, we strongly believe the emphasis must be placed on quality and branding, due to

the fact that the only segments that continue to grow in sales on a global basis are the premium

wines. The primary challenge in entering the market as a high quality brand is the development

of a strong brand image. In order to compete in the premium wine segment, a Mexican wine

producer would need to develop a brand image that could compete with well established and

respected brand name labels from Australia, California, France, Italy, and others. Given the fact

that Mexico has no history of wine-making, this could prove especially challenging. However,

since there have already been a few wineries such as Monte Xanic experiencing success

internationally, perhaps the Mexican government could consider export subsidies for the wine



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industry, or at least looking into MAA’s such as the one signed in 2002 to promote their

involvement in the international wine trade.

Foreign Companies

In the final evaluation, we do not believe that the Mexican wine industry is a desirable

investment opportunity for foreign wine companies looking to expand. As mentioned above, the

infrastructure in Mexico is still lacking, especially in regards to irrigation and water supply, but

also concerning financial and economic stability. The domestic market for wine is also very

small, meaning a new foreign producer would have to focus almost entirely back on their home

market, limiting the advantages to be gained from economies of scale. This need to focus almost

entirely on exports would cause problems of its own due to the fact that there is very little

recognition of Mexican wines worldwide. With no wine heritage, it would be very hard for a

new Mexican wine to compete with the established vintners of Europe, the US, Australia, or

even Chile. Furthermore, success in the wine industry is currently being driven by marketing

and quality, and while foreign investors could bring their branding experience to Mexico, they

would have a very difficult time establishing a competitive image for Mexican wines. Finally,

and perhaps most fundamentally, there is currently a huge global oversupply of grapes for every

type of wine except specialties such as champagne and port. In the face of declining global

consumption and falling prices for grape growers, there is simply no reason for a foreign firm to

make the huge investment necessary to jumpstart the Mexican wine industry.



Comparison of markets

Competitive Environment

The domestic array of wine producing competitors in Mexico is very limited, due

to its status as a relatively under-developed market for wine production. Competition

from imports poses a very strong risk to any potential wineries in Mexico, though.

Established foreign wine producing markets have years of experience in making high

quality wine in bulk at low prices, most notably the California and Australian markets.

Further, European wineries have long produced premium wine brands and still hold a

large portion of the world wine market, despite the problems they have had in recent

decades. In order to develop as an effective world wine-producing competitor, Mexico

would first have to develop its own domestic wine market. Currently, Mexico makes up

.7 percent of the wine market for the Americas.1 With such a small market, it would be

difficult to establish the image of desirability so needed in this competitive industry.

Further, wine making has been making a move from a labor-intensive business to a

capital intensive business, as evidenced by the emergence of very large mass-producing

wine companies such as E&J Gallo, who recently posted a US$4 Billion revenue intake.

While California is known for its abundance of Capital, Mexico is not.2 These conditions

paint a clear picture of the difficulties Mexico would face in emerging as a competitive

force in the world wine industry.

Customer Environment

When looking at consumer trends in the wine industry in Mexico, the picture is a

little brighter. While US wine sales growth has slowed from its record-breaking numbers

1 “Wine Industry Overview.” Business and Company Resource Center, 11 April 2007 2 “Business: Blended; Wine Industry Mergers.” The Economist, 25 January 2003



in the 90s, Mexican consumers’ demand has seen recent sharp increases. Wine sales in

Mexico are expected to have a compound annual growth rate of 6.2 percent, compared

with similar markets such as Brazil who have seen growth slide to 1.9 percent.3


The far majority of growth in the wine industry has been in the premium wines

and super-discount wines. The market for wines between these two extremes has seen

very little growth, and often market shrinkage. As the Mexican wine industry is fairly

under-developed, wine producers in this market have little opportunity to achieve the

scale needed for the production of super-discount wines, the opportunity in this market

lies in premium brands. This actually coincides nicely with the wine-growing conditions

in Mexico, as the Mexican climate and soil are said to be very conducive to good grape

growing. The primary challenge in entering the market as a premium brand is the

development of a strong brand image. In order to compete in the premium wine segment,

a Mexican wine producer would need to develop a brand image that could compete with

well established and respected brand name labels from Australia, California, France,

Italy, and others. Further, as mentioned earlier, the lack of domestic competitiveness

lends to a lack of pressure for innovation and improvement in quality; conversely, the

highly developed wine producing regions of the world are constantly under pressure from

competitors to improve quality and to rapidly innovate.

3 “Wine Industry Overview.” Business and Company Resource Center, 11 April 2007



1

Entering the MexicanWine Industry

Professor ChenFBE-462Yu Chen

Cyrus ChiniAlexander DalyShelley GotoKeith Parker

Agenda

• Global Wine Industry Overview• Industry Cost Structure• Overview of Mexican Wine Market• Analysis of market externalities• Opportunities and Challenges• Conclusion and Recommendations

Global Wine Industry Overview

• $90 billion industry in 2002• Largest national producers and exporters

– France, Italy, Spain, United States, Australia

• Key import markets– Germany, United Kingdom, United States, France

• Major wineries/conglomerates– Constellation, LVMH, E&J Gallo, Southcorp,

Seagram

The Reshaping of the CompetitiveEnvironment

• The decline in Europeandominance– Falling consumption rates– New World production methods and

innovation– Oversupply of grapes

• The rise of Australian exports• The South American experience

Cost Structure of the Industry

• Production– Grape Costs– Crush and Capitol Costs– Barrel Costs– Dry Goods Costs

• Non Production– Regulation Fines– Tariffs– Marketing, Shipping, and Distribution

Market Analysis

Winery Wholesaler Retailer End Consumer



2

• Centered in Ensenada

• Guadalupe, Calafia, San Vicente andSanto Tomas Valleys

The Mexican Wine Industry Advantages and Disadvantages ofthe Mexican Wine Industry

Weather

Water Supply

Number of Wine Lovers

Main Wine Producersin Mexico

L.A. Cetto

Monte Xanic

Environmental Analysis

• Economic– Abundance of cheap, low-skilled labor– Favors the seasonal nature of the wine

industry– Possibility of macroeconomic instability

• Political– Free trade agreements– NAFTA

Environmental Analysis

• Cultural– Small domestic market– Expansion opportunities lie in exports– Marketing necessary to increase domestic

consumption• Technological

– Lacks traditional wine-making regulations– Cheap mass production possible

Policy Analysis

• Border Control: mobility of goods– Limited amounts may be brought across the

border– Can sell for a higher price to reflect exclusivity

• Border Control: mobility of labor– US lack of cheap seasonal labor– Give Mexican producers an advantage



3

Policy Analysis

• NAFTA– Take advantage of US markets– Continuing integration promises less profit

loss to tariffs• China

– Large producer, but not exporter– Has the resources to take market share

away, but less cultural incentive

Competitive Analysis

• Domestic Wine Competition– Very Limited

• International Wine Competition– Very large and established– Have reached Economies of Scale and Scope– Competitors have established images

• Very hard to develop• Mexico currently doesn’t have the right image


• Overall Industry Growth– On the extremes– Mexican entrants should focus on Premium

• Establishing a Premium Brand– Good Terroir in Mexico– Would compete with established name brands– Lack of significant domestic competition

• Less innovation• Less pressure for higher quality

Conclusions and Recommendations

• Domestic Firms– Focus on branding – creating a Mexican identity– Expand exports, especially within premium segments

• Foreign Companies – NOT attractive– Infrastructure not in place– Domestic market too small– Lack of a national wine heritage, limited branding

possibilities– Global oversupply

Thank You

Questions?



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Business & Company Resource Center

Datamonitor Industry Market Research, Nov 15, 2006 pNA

Mexico - Wine.

(L.A. Cett)(Industry overview)

Full Text: COPYRIGHT 2006 DatamonitorMarketDefinition

The wine market consists of fortified wine, sparkling wine and still wine. The market is valued according to retail selling price (RSP) and includes any applicable taxes. Any currency conversions used in the creation of this report have been calculated using constant 2005 annual average exchange rates.

For the purpose of this report, the Americas comprises the US, Canada, Brazil and Mexico.

ResearchHighlights

*The Mexican wine market generated total revenues of $230.2 million in 2005, this representing a compound annual growth rate (CAGR) of 5.6% for the five-year period spanning 2001-2005.

*Market consumption volumes increased with a CAGR of 2.5% between 2001-2005, to reach a total of 18.2 million liters in 2005.

*The performance of the market is forecast to accelerate, with an anticipated CAGR of 6.4% for the five-year period 2005-2010 expected to drive the market to a value of $313.6 million by the end of 2010.

MarketAnalysis

The Mexican wine market has posted steady rates of growth throughout 2001-2005 and is expected to grow at an even faster pace in the forthcoming five year period. Similarly to wine markets in Brazil and Canada, Mexico benefits primarily from the sale of still wines.

The Mexican wine market generated total revenues of $230.2 million in 2005, this representing a compound annual growth rate (CAGR) of 5.6% for the five-year period spanning 2001-2005. In comparison, the Canadian and Brazilian markets grew with CAGRs of 4.1% and 1.9% over the same period, to reach respective values of $4257.8 million and $2235.7 million in 2005.

Market consumption volumes increased with a CAGR of 2.5% between 2001-2005, to reach a total of 18.2 million liters in 2005. The market's volume is expected to rise to 19.4 million liters by the end of 2010, this




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representing a CAGR of 1.3% for the 2005-2010 period.

Still wines sales proved the most lucrative for the Mexican wine market in 2005, generating total revenues of $183.7 million, equivalent to 79.8% of the market's overall value. In comparison, sales of sparkling wines generated revenues of $33.4 million in 2005, equating to 14.5% of the market's aggregate revenues.

The performance of the market is forecast to accelerate, with an anticipated CAGR of 6.4% for the five-year period 2005-2010 expected to drive the market to a value of $313.6 million by the end of 2010. Comparatively, the Canadian and Brazilian markets will grow with CAGRs of 3.4% and 3.8% respectively over the same period, to reach respective values of $5026.1 million and $2,697.7 million in 2010.

Value

The Mexican wine market grew by 5.1% in 2005 to reach a value of $230.2 million.

The compound annual growth rate of the market in the period 2001-2005 was 5.6%.

Mexico Wine Market ValueUnit: USD Year Value Growth2001 1853000002002 197100000 6.4%2003 207200000 5.1%2004 219000000 5.7%2005 230200000 5.1%CAGR 2001-2005 5.6%

Volume

The Mexican wine market grew by 2.1% in 2005 to reach a volume of 18.2 million liters.

The compound annual growth rate of the market volume in the period 2001-2005 was 2.5%.

Mexico Wine Market VolumeUnit: Liters Year Volume Growth2001 165000002002 17000000 3.3%2003 17400000 2%2004 17800000 2.5%2005 18200000 2.1%CAGR 2001-2005 2.5%




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Segmentation

Sales of still wine accounts for 79.8% of the Mexican wine market's value.

In comparison, sparkling wine generates a further 14.5% of the market's revenues.

Mexico Wine Market SegmentationYear: 2005 Category PercentageStill wine 79.8%Sparkling wine 14.5%Fortified wine 5.7%

Segmentation

The Mexican wine market accounts for 0.7% of the Americas market value.

In comparison, Brazil generates 7.3% of the market's value.

Mexico Wine Market SegmentationYear: 2005 Geography PercentageUnited States 78.1%Canada 13.9%Brazil 7.3%Mexico 0.7%

Share

L.A. Cetto accounts for 9.9% of the Mexican wine market's volume.

In comparison, Bodegas de Santo Tomas generates a further 8.8%.

Mexico Wine Market ShareYear: 2005 Company PercentageL.A. Cetto 9.9%Bodegas de Santo Tomas 8.8%Pernod Ricard 1.1%Serena 0.5%Other 79.7%

CompetitiveLandscape

L.A. Cetto leads the Mexican wine market, with sales in 2005 amounting to 1.8 million liters, this accounting for 9.9% of the markets volume. Other significant players include: Bodegas de Santa Tomas, whose sales of 1.6 million liters comprise 8.8% of the markets volume, and Pernod Ricard, which has sales of 0.2 million liters and a volume share of 1.1% of the market.




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Supermarkets & hypermarkets form the most significant distribution channel for wine sales in Mexico, accounting for 35.7%. On-trade sales account for an additional 28% of the market.

This section contains brief overviews of the leading companies in the Mexican wine market.

Company

L.A. Cett

L.A. Cetto is based in Chapultepec, Mexico. It primarily produces Cava and exports to 27 countries.

No recent financial data is available.

Company

Pernod Ricard

Pernod Ricard is the second largest manufacturer of spirits and fourth largest manufacturer of wines globally. It manufactures and distributes wines and spirits under more than 65 brand names. The company operates in the Americas, Europe and the Asia Pacific. It is headquartered in Paris, France and employed about 12,250 people as of December 2003.

The company recorded revenues of $6.5 billion during the fiscal year ended December 2005, an increase of 46.9% over 2004. The operating profit of the company during fiscal 2005 was $1.3 billion. The net profit was $800.5 million during fiscal year 2004, an increase of 22% over 2004.

Supermarkets & hypermarkets are the most important distribution channel, with 35.7% of the market's volume distributed via this channel.

On-trade accounts for a further 28%.

Mexico Wine Market DistributionYear: 2005 Channel PercentageSupermarkets/hypermarkets 35.7%On-trade 28%Specialist Retailers 24.7%Other 11.6%

ForecastValue

In 2010, the Mexican wine market is forecast to have a value of $313.6 million, an increase of 7.3% since 2005.

The compound annual growth rate of the market in the period 2005-2010 is predicted to be 6.4%.

Mexico Wine Market Value Forecast




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Unit: USD Year Value Growth2005 230200000 5.1%2006 242100000 5.2%2007 255900000 5.7%2008 275500000 7.7%2009 292200000 6.1%2010 313600000 7.3%CAGR 2005-2010 6.4%

ForecastVolume

In 2010, the Mexican wine market is forecast to have a volume of 19.4 million liters, an increase of 6.6% since 2005.

The compound annual growth rate of the market volume in the period 2005-2010 is predicted to be 1.3%.

Mexico Wine Market Volume ForecastUnit: Liters Year Volume Growth2005 18200000 2.1%2006 18400000 1.3%2007 18600000 1.1%2008 18900000 1.4%2009 19200000 1.4%2010 19400000 1.3%CAGR 2005-2010 1.3%

MacroeconomicData

Population

Mexico Size of PopulationUnit: Population Year Value Growth2001 1012000002002 102500000 1.2%2003 103700000 1.2%2004 105000000 1.2%2005 106200000 1.2%

GDP

Mexico GDPUnit: Real GDP (1995=100) Year Value Growth2001 130.22002 131.5 1%




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2003 133.4 1.4%2004 137.7 3.2%2005 142.6 3.5%

Inflation

Mexico InflationUnit: Inflation Rate % Year Value2001 0.0442002 0.0572003 0.042004 0.042005 0.033Exchange RateUnit: Exchange Rate Year Value2001 0.0012002 0.0012003 0.0012004 0.0012005 0.001

Article A156814249

© 2007 by The Gale Group, Inc.



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Business & Company Resource Center

Wines, Brandy, and Brandy SpiritsSIC Code(s) Covered

2084-Wines, Brandy & Brandy Spirits

NAICS Code(s) Covered

312130-Wineries

Industry Snapshot

Although the first commercial wine venture in the United States was in Pennsylvania in 1793, the majority of modern American wineries have been located in California, with Washington and New York coming in a distant second and third, respectively. California and its 1,300 wineries has accounted for more than 90 percent of all U.S. wine production and more than 70 percent of all wine sold in the United States. If viewed as a nation, California would rank fourth in worldwide wine production, following Italy, France, and Spain. In the mid-2000s Gallo was the dominant wine producer in the country, as well as the leading exporter.

In the mid-2000s Americans purchased 627 million gallons of wine, with a retail value of approximately $23 billion. Eighty-eight percent of the total was table wine, 7 percent was dessert wine, and 4 percent was sparkling wine or champagne. Table wine has been the most popular kind of wine sold in the United States. Varietals, table wines made predominately of one kind of grape, grew in popularity in the past decade. In 2004, 40.5 percent of wine sold in supermarkets was red, 40.4 percent was white, and 19.1 percent was blush.

Organization and Structure

All winemakers must sell their products through wholesalers and retailers to accommodate various federal, state, and local regulations regarding the sale of alcoholic beverages. The Federal Alcohol Administration Act (FAA) was established after the 13-year Prohibition Era ended in 1933. The Bureau of Alcohol, Tobacco, and Firearms (ATF) is responsible for administering and enforcing the FAA, including qualifying winemakers, collecting producer and wholesaler occupational taxes, and regulating trade practices, advertising, and labeling. Beyond the uniformity of the FAA, regulations vary greatly among the 50 states.




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States can sell wine in one of two ways, either in a controlled environment or using an open, licensed method. "Open" states have licensed retailers and wholesalers that handle the distribution and sale of alcoholic beverages. Thirty-two states and the District of Columbia are open states. The other 18 states operate under the control method, in which each state government buys and sells alcoholic beverages at the wholesale and retail levels. In addition to federal regulations, some states have set up their own independent agencies that are responsible for the administration, licensing, and enforcement of state laws and the collection of state revenues. Some state legislatures even have created their own alcoholic beverage control (ABC) agencies with rule-making power, and 32 states allow their citizens to vote for or against the sale of liquor on a city or county-wide basis.

Background and Development

California winemaking began in 1769 when Father Junipero Serra planted vines at Mission San Diego. In September 1772, the grapes were harvested and pressed, creating California's first vintage. These early wines were produced for sacramental purposes and personal consumption at the missions.

The commercial era of wine production began in 1830 with the efforts of Frenchman Jean Louis Vignes from Bordeaux, France. His vineyard was located in what is now downtown Los Angeles. The wine industry boomed as an ancillary result of the discovery of gold in California in 1848. A surge of Europeans came to the state seeking their fortune. Immigrants from Italy, France, and Germany who had no luck finding gold turned to a trade they already knew--winemaking.

Between 1860 and 1880, the industry grew rapidly as numerous wineries were established. By 1890, several of the state's famous wine regions already had taken shape and the industry was producing 25 million gallons of wine per year. After suffering losses from a vine pest called phylloxera, the industry virtually disappeared with the passage of Prohibition in 1919. The repeal of Prohibition in 1933, however, prompted the industry to rebuild. Growth was steady between 1949 and 1960, with annual output increasing from 117 million gallons to 129 million gallons. By the 1970s, the demand for California table wines had doubled.

As the industry evolved, so did consumer preferences. From 1933 to 1967, dessert wine was the most popular kind of wine in the United States. During the 1970s, generic table wines, like California Chablis and California Burgundy, dominated sales. By the late 1980s, varietal wines, those labeled with the name of the grape, had taken over.

After posting a 6.5 percent loss in 1993, wine sales in the United States continued to rise, while per capita consumption remained steady at 1.8 gallons. According to the San Francisco-based Wine Institute, consumer demand for premium varietal wines spurred a 5 percent increase in California table wine sales in 1994--the strongest performance in more than a decade.

While most of the largest wine producers reported record sales, and consumer tastes moved upscale to more expensive wines, 1994 was noted as the best year for the wine industry since the late 1980s. "The end of the drought, the waning of phylloxera root




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louse problems and increased consumer demand all have winemakers singing a new tune," reported Clifford Carlsen of The San Francisco Business Times.

Total U.S. production again rose in 1995, up 10.3 percent at 437 million gallons. According to wine industry analyst Jon Frederickson of San Francisco-based Gomberg, Fredrickson and Associates, wine sales increased 8 percent in 1995 to a record $4.4 billion. Increased consumer demand and a relatively strong supply of fruit contributed to the industry's continued strong growth.

Following record wine sales and all-time high prices for grapes in 1995, the industry experienced another banner year in 1996. In fact, many North Coast wineries, with sales increases of 30 to 40 percent, did not have enough wine to meet the staggering demand.

The improved economy and continuing news reports about the health benefits of moderate wine consumption fueled the continued growth of the industry. A 1991 broadcast of 60 Minutes reported a link between moderate wine consumption and a reduced risk of heart attack. Called the French Paradox, two scientists found that despite similar fat intake, France's heart attack rate was one-third that of the United States. A key factor they attributed to this was the French custom of drinking wine with meals. Red wine sales increased more than 75 percent after that 1991 report.

Champagne sales continued to drop despite increases of specific brands. From a peak of 18.2 million 9 liter cases of sparkling wine and champagne in the United States in 1986, consumption fell to 12.3 million 9 liter cases in 1995. Causes for the decline were high prices for champagne, high taxes, high cost of shipping, and lack of consistent, high-profile marketing programs.

Wine sales were expected to continue their increase as the federal government took an unprecedented step in advocating moderate consumption. When the U.S. government issued new dietary guidelines in 1996, it acknowledged, for the first time, the benefits of moderate wine consumption. Previously, the government had warned that even small amounts of alcohol had "no net health benefit."

"Writing that language into the dietary guidelines was an extraordinary statement of public policy change in the United States. It's a foundation we can build on into the next century," said John De Luca, president of the Wine Institute, the trade association for the wine industry. He added that the revised guidelines culminated five years of work to redefine the image of wine, "putting it back on the dining room table where it's been for 2,000 years."

Leading the pack in wine sales have been the varietals. Relatively new to the industry, a "fighting" varietal has been defined as a value-priced, cork-finished, 750 ml varietal wine. The leader in fighting varietals has been Glen Ellen, followed by Fetzer's Bel Arbors, Sebastiani's Country Wines and Swan Cellar label, Beringer's Napa Valley, and Robert Mondavi's Woodbridge. Tim Wallace, a Glen Ellen executive, told Beverage Dynamics that "fighting varietals are the foundation for the American wine industry in the future."

In the late 1990s, fruit-flavored varietal wines became popular. Canadaigua introduced Arbor Mist in 1998 in flavors such as peach and tropical fruits chardonnay and exotic fruits and sangria zinfandel. Other producers followed suit, including Sutter Home's Portico, Earnest & Julio Gallo's Wild Vines, and the Wine Group's Lyrica.




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The introduction of fruit-flavored varietals caused a minor uproar among wine purists in the industry. Because these wines contain less than 7 percent alcohol, they are regulated for the Federal Drug Administration (FDA), which does not issue designation requirements for varietals.

At the end of the twentieth century, U.S. producers of champagne and sparkling wine commanded a 70 percent share of the domestic market. Growth continued to be slow. In 1997, shipments of champagne rose 1 percent for the first time since the 1980s, but they fell by 3 percent the following year. These losses were attributed to consumers' abandonment of the less expensive charmat producers in favor of the higher-end method champenoise varieties.

The good news was that the quality of champagne, both domestic and imported, was rising. Those producing champagne began to make a product that was more suited to American tastes. Improvements in champagne production were forged mainly in Carneros, Mendocino County, California, as well as on the central coast. In return, these domestic producers saw consumers move to brands that offered high quality at affordable prices.

The sale of wine over the Internet stirred a heated debate between the U.S. Congress and the wine industry. Spurred by a rash of student-led violence in the nation's schools, legislators created a bill on youth crime and gun control. An amendment to the bill gave states the power to use federal courts to enforce local laws governing the interstate alcohol trade. Proponents said that the amendment's purpose was to prevent underage drinking. Many in the wine industry believed that it would restrict their business. A survey of 176 California vintners, conducted by the Wine Institute, found that nine out of ten shipped their products to out-of-state customers and 50 percent used Web sites to sell their products.

Production.

The making of wine begins with the grape harvest, which generally occurs from August through November, depending on the grape variety and the weather. The grapes are placed in a crusher that separates the stems from the fruit and breaks up the berries. The stems are then discarded, leaving a combination of juice, seeds, pulp, and skins, called "must." Juice from red or white wine grapes is colorless.

To make white wine, the skins and seeds usually are removed from the must after a few hours. The remaining juice is called "free-run." The discarded skins also are pressed to extract the "press juice." Both juices then are filtered, placed in storage, and given yeast to facilitate the fermentation process. White wine fermentation can last anywhere from three days to three weeks. Upon completion, the wine is filtered for solids or remaining yeast. The wine then is aged for a period of one week to a year in stainless steel, oak, or redwood containers. It also can be aged in the bottle. After aging, the wine can be blended with other wines to create a desired style or can be sent to be finished, a process that stabilizes and filters the wine before bottling.

Production of red wine is slightly different than the process of making white wine. Red wine is fermented at warmer temperatures than white wine. For red wine production, the skins are fermented with the crushed juice to give it color and flavor. The skins float to the top and are moistened regularly with juice to extract color and flavor. Red wine usually is fermented for five to ten days and then is filtered, clarified, and preserved with sulfites. Red wine commonly is aged in oak barrels for one to two years.




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Champagne is made in one of two ways: by method champenoise or the charmat process. In method champenoise, still wine is blended with a mixture (called triage) of still wine, yeast, and a sugar substance. This blend is resealed in bottles where it is fermented for a second time and aged. Carbon dioxide collects in the bottles, which is released in a rush of bubbles when the bottles are uncorked. In the charmat, or bulk, process, the still wine, yeast, and sugar are fermented in a pressurized tank rather than in bottles.

Types of Wines.

Wines sold in the United States generally are divided into the following categories: champagne, aperitif, dessert wine, table wine, and varietal wine. Also included in this discussion are brandy and other fortified wines. Wines can be named one of four ways: by variety, which tells the predominant type of grape; by a generic name describing the color, such as blush; by the region that originally inspired the wine, such as Chablis; or by a proprietary name, which is a label created by the winery.

Champagne and sparkling wines are names used interchangeably in the United States for wines with effervescence. These wines range from very dry (natural), to dry (brut), to slightly sweet (extra dry), to sweet (sec and demi-sec). Aperitifs are appetizer wines usually served prior to a meal and can include champagnes and sherries. Dessert wines are officially classified as those with an alcohol content of 17 percent to 21 percent. They can be sweet or dry and include sherries and ports.

Table wine is a term commonly used to describe all red, white, blush, and rose wines that contain 7 to 14 percent alcohol. These wines are still rather effervescent and are served mainly with meals. Table wines can be made from any grape or combination of grapes and in any style that the winemaker chooses. Varietal wines are table wines that are made from a minimum of 75 percent of a particular grape variety; they carry the name of the grape variety from which they are produced, such as Chardonnay or Merlot.

The red table wine category has been led by Cabernet Sauvignon, a full-bodied, rich, intense wine with noticeable tannins. A leading prestigious varietal, Cabernet Sauvignon has been one of the most widely available wines from California. Other red varietals include Merlot, Petite Sirah, and Zinfandel. Merlot is a medium- to full-bodied wine that originally was made for the sole purpose of blending with Cabernet Sauvignon. Petite Sirah is a wine with deep color, full body, and a fresh-berry taste. Zinfandel, known as the classic California wine, is known too for its versatility, range of style, and raspberry-spicy aroma and flavor.

White table wines have been dominated by Chardonnay, which is the most widely planted variety of grape in California, making up more than 56,000 acres. It is a dry wine that has a balance of fruit, acidity, and texture. Depending on what the winemaker uses for storage, Chardonnay can range from clean and crisp wines to rich, complex, oak-aged wines.

Other white varietals include French Columbard, Sauvignon Blanc, Johannisberg Reisling, Gewurztraminer, and Pinot Blanc. French Columbard is generally fresh and fruity, ranging from light to medium in body. Sauvignon Blanc has been one of the fastest growing varietals in California; sometimes called Fume Blanc, it is best known for its grassy, herbal flavors and is often consumed with fish and shellfish. Johannisberg Riesling, from the German Riesling grape, is aromatic, delicate, and slightly sweet. Late Harvest Rieslings are good accompaniments for dessert.




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Gewurztraminer offers spicy aromas and flavors and a slight wisp of residual sweetness. Often this wine goes well with Asian food. Pinot Blanc is a unique, dry white wine, with styles ranging from bold, oak-aged to crisp and medium-bodied.

Brandy is "burnt wine" or fruit wine that is boiled and aged in wood. Virtually any type of fruit can be used to make brandy, although grapes have been the most common. Brandy has been produced primarily in Spain, Italy, and France, and most recently in the United States. Cognac has been considered to be the best of all brandies. Cognac's discerning characteristic has been its blending, often created from a number of different cognacs coupled carefully to achieve an appropriate mixture.

Fortified wines were the creation of the Spanish and Portuguese and included port, sherry, and Madeira. Sherry is made by blending younger sherries with older sherries in oak casks. It varies in dryness levels and in hues. Harvey's Bristol Cream, imported by Hiram Walker & Sons, has been the top-selling sherry in the United States, with a nearly 41 percent market share. The best-seller is a blend of aged oloroso, a fortified full-bodied sherry, and Pedro Ximines grapes, which sweetens the mixture.

Port is red wine fortified with grape brandy. It was created unintentionally in the seventeenth century when Portugal tried to ship its table wine to England. In order to stabilize the wine during its voyage across the Atlantic, the wine needed the addition of grape brandy. England has remained the most popular market for port.

Madeira comes from a tropical island of the same name and is a raisiny, sweet wine. Madeira has been closely linked with the history of the United States, according to the New York Times Magazine. It was considered to be the wine of choice for American Revolutionary notables such as Thomas Jefferson, George Washington, and Ben Franklin. Unlike other wines that soured during the long, hot voyage across the Atlantic, Madeira was the only wine known to improve dramatically with the introduction of heat.

After a time of record growth throughout the 1990s, U.S. winemakers began seeing wine sales flatten in the early 2000s. With a shaky economy made all the more so by the attacks of September 11, 2001, the wine industry, like many U.S. industries, was affected by the decrease in consumer spending on travel and recreation, which is tied in to wine drinking. Another factor in the state of the wine industry from 2000 to 2003 was the overproduction of grapes and the ensuing drop in grape prices by as much as 75 percent in 2001 and 2002. Wine prices dropped during this time while sales flattened. Retail sales of wine in the United States were $19.8 billion in 2001, a 4 percent increase over 2000's sales of $19.0 billion. By 2002, sales of California wine dropped in all categories for the first time in more than a decade. Finally, the proliferation of high quality, inexpensive imported wine caused further woes for U.S. winemakers. Imports rose 17 percent in 2002, accounting for 25 percent of total wine sales in the United States.

White wine continued to be popular, owning 40 percent of the wine market in 2001, with red not far behind, growing from 17 percent in 1991 to a strong 37 percent of market share in 2001. The MKF Wine Trends Report noted that the leading California table wine varietals, Chardonnay, Cabernet Sauvignon, Merlot, and White Zinfandel/Blush, accounted for about 76 percent of all retail sales by value of California wine in 2001. Chardonnay continued its leading spot with a 29 percent dollar market share, followed by Cabernet with 19 percent, Merlot with 15 percent, and White Zinfandel/Blush holding 13 percent of the market by value. Secondary red varietals, including Syrah, Pinot Noir, and Red Zinfandel, all were up more than 30 percent in




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revenues for California wineries. There was a surge in popularity of Pinot Grigio, which the Wine Spectator reported had sales increasing faster that any other white wine in supermarkets. Wine coolers, once popular in the late 1990s, were less so as the new millennium dawned.

In a climate of more cautious consumer spending, wines priced at $50 and higher were selling far less than in the robust 1990s, noted Charles Krug Winery co-proprietor Peter Mondavi in a July 2002 interview with Beverage Industry. "The wines that are $35 or so are still going through the roof. So we're having great success in that category," he added. With prices falling to record lows, consumers were indeed enjoying bargains in the early 2000s. Indeed, California chain Trader Joe's seemed to be leading the bargain trend, offering the Charles Shaw line of Merlots, Cabernets, and Chardonnays for $1.99 in late 2002 and early 2003. In those six months, wine industry analysts Jon Fredrikson estimates the company sold about 1 million cases of the generally good quality wine that was dubbed, "Two-Buck Chuck."

Current Conditions

By the mid-2000s the U.S. wine industry was picking up. California wineries shipped a record amount of products, with approximately 428 million gallons shipped domestically, from a total 522 million gallons shipped worldwide. While so-called "extreme value" varieties continued to sell well, the expensive premium wines also were seeing increases, accounting for 64 percent of industry revenues. Following the trend across nearly all American retail industries, the middle variety sales were flat, with the majority of the industry growth occurring at either extreme end of the price spectrum. In 2004 sales of red outpaced white for the first time in years.

To ensure that California sustained its fertile winegrowing land, the Wine Institute and the California Association of Winegrape Growers launched the "Code of Sustainable Winegrowing Practices" in 2002, which in 2004 received a $475,000 USDA grant for support of sustainable winegrowing practices. The program for vintners and growers was a voluntary and helpful tool for conserving natural resources, protecting the environment, and enhancing relationships with neighbors, local communities, and employees.

A new trend in the mid-2000s was that of bringing winemaking to the masses with make-your-own wineries and classes springing up in Florida, New York, California, and Texas, to name just a few of the locations. While the majority of these operations, which were not affiliated with any particular winery, allowed customers to simply choose grapes, add yeast, and design labels, some of the larger operations, such as the Bacchus School of Wine, were truly teaching the winemaking process in less than a year, starting students from the very beginning.

Other relevant trends included more vintners moving to plastic corks. Although considered "tacky" by some, more and more winemakers worldwide were seeing the benefits to the move, as costlier, traditional corks were increasingly blamed for ruining bottles with sediment, mustiness, or leakage. This negative cork performance costs vineyards money, as they absorb the cost of returned bottles. Other winemakers made a move to organics, as Fetzer Vineyards announced that it intended to grow and use 100 percent organic grapes for all of its wine by the 2010 harvest.




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Industry Leaders

As dominant as the state of California is in the wine industry, so too are the wineries of California winemakers Ernest & Julio Gallo (E & J Gallo). Controlling nearly 40 percent of the U.S. wine market, E & J Gallo Wineries led every wine category in which it competed. According to the Wine Spectator, one out of every three bottles of wine made in America is a Gallo product. The world's largest winemaker, E & J Gallo Wineries had annual sales of more than $3 billion in 2004.

In 1933 the original Ernest and Julio Gallo brothers winery was founded in Modesto, California. Unable to obtain bank financing, the company bought crushing and fermenting equipment on 90-day terms and rented a warehouse to make its first commercial wine. Using pamphlets on winemaking from the local library and grapes bought on a promise to pay from eventual sales, the two brothers made their first batch of wine. By 1993 Gallo owned five separate vineyards totaling more than 2,000 acres. The company remained a private, family-owned business (two of Julio Gallo's great-grandchildren, Matt and Gina, are actively involved in the company's winemaking operations) and was one of the largest organic farms in the United States.

The company's success was due in part to the partnership of the Gallo brothers; Ernest marketed the wine that Julio made. Another part of Gallo's success was its quest for improving the quality of the wine it produced. To this end, Gallo replanted its vineyard in Livingston in 1946 using grape varieties that had not been previously grown in the area. Various viticultural techniques were experimented with, and in 1947 a formal research program was established to evaluate the results. Specific standards were developed for winemaking and were used thereafter.

In 1965 Julio Gallo established the first Growers Relations Department and shared research findings with area growers. In 1967 Gallo offered long-term contracts to selected growers, giving economic security and incentive to replant vineyards with the better grape varieties recommended by Gallo. During the 1970s, the winery shifted to producing premium varietal wines, and in 1991 it introduced its first ultra-premium wine, 1991 Sonoma Estate Chardonnay. Leading brands for E & J Gallo Wineries have been Gallo, Andre, Bartles & James, and Carlo Rossi.

Constellation Brands, the former Canadaigua Wine Company, became the number-two seller in the U.S. wine market in 1995 with the acquisition of the Almaden and Inglenook wine labels (in 1994) from Heublein for $130.5 million. Although the company name may not be well known, its products such as Almaden, Inglenook, Taylor California Wines, and Paul Masson Wines are household names. Constellation had sales of $3.6 billion in 2004.

The company is a father-and-son operation located in upstate New York, started in 1945 by Marvin Sands, who bought a sauerkraut factory and turned it into a winery for $60,000. For ten years, Canandaigua Industries sold fruit wines in bulk to local bottlers who then sold them under their own brand names. In 1954 Sands turned away from bulk wines and created a brand for himself--Richards Wild Irish Rose, a blended red dessert wine. During the 1960s Wild Irish Rose represented nearly all of the company's sales.




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Working from that base, Sands slowly expanded, acquiring 11 small wineries through 1984. Then the company entered the wine cooler market with its Country Wine Coolers. Although the company suffered an operating loss of $20 million in 1987 and 1988 due to expensive advertising, Sands realized the power of the company's distribution network and began looking for established brands.

In 1991 Canadaigua made its first major purchase with Cook's Champagne for $60 million. Then came additional purchases in 1993, 1994, 1998, and 1999. By the end of the twentieth century, Canadaigua was posting annual sales of $740 million. In 2004, the company had more than 200 brands of wine, beer, and spirits on the market.

Workforce

In 2003, the beverage manufacturing industry as a whole employed more than 169,000 workers. In total, as of the early 2000s, the winemaking industry employed more than 17,000 workers. The majority of wineries were family-owned, were located in California, and had a tremendous impact on that state's economy. Los Angeles-based Recon Research Corporation reported that the California wine industry contributed nearly $1.5 billion annually to the Sonoma County economy, employing more than 3,600 people and creating secondary industrial employment of an additional 2,500 jobs.

America and the World

U.S. wine companies' efforts to establish joint ventures in Europe were not as successful as they had hoped. Controlled by small producers and cooperatives, experiences there led U.S. companies, in the early 2000s, to the more successful, growing trend of teaming with Australian companies, who were more than willing to establish a greater foothold in the United States. However, overseas planting of premium varietals elsewhere had been growing at a fast pace and was expected to be a significant new source of wine for U.S. consumers. In fact, California wineries bought unprecedented amounts of overseas wine to meet consumer demand for low-priced everyday wine and to expand their existing line of products in the mid-1990s.

For example, in 1996 Robert Mondavi began importing a Chilean line of wines, the Caletara brand, priced in the $6 to $9 range. A second brand, Edwardo Chadwick, was introduced in the $12 to $15 range, followed by a brand in an even higher price range. In 1995 the winery also launched a line of Italian varietals.

Demand for Australian wine in the United States skyrocketed as American consumers enjoyed the Australian style of wine. Its worldwide trademark of generous flavors, soft tannins, and accessible fruit made this wine easier to like when young, a perfect style of wine for Americans. In 1990 the Australians shipped only 578,000 cases of wine to the United States. By the decade's end, the Australian Wine Bureau reported that more than 4 million cases of Australian wine would be shipped to the United States by 2001, and by 2026 shipments should total more than 10 million cases with an estimated value of




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$440 million. Chilean wine became popular in the late 1990s and early 2000s as well, with Chilean exports up 15.6 percent, but falling prices earned them only 1.4 percent more money. Exports of Chilean wine to the United States fell 1.8 percent in 2001. South African wines, meanwhile, grew faster than projected, growing by 29 percent and increasing 133 percent in value, based on 1999 sales figures.

In late 2001, the United States, Canada, Australia, Chile, and New Zealand signed the Mutual Acceptance Agreement on Oenological Practices. The wine trade agreement was a significant development in promoting international wine commerce and would loosen trade restrictions for U.S. wines. John De Luca, president and CEO of the Wine Institute in San Francisco exclaimed, "This agreement is a breakthrough for the world wine trade that recognizes the effectiveness of other country's regulatory and enforcement systems for assuring that producers comply with its country's standards." Argentina and South Africa had the option to sign the agreement prior to March 2002.

According to the Department of Commerce, U.S. wine exports totaled $541 million in 2001. The largest market was the United Kingdom, which grew by 32 percent in volume with values of exports rising 20 percent to $170 million in that market. Other leading markets included Canada, with $95 million; the Netherlands, with $69 million; Japan, with $57 million; Belgium, with $28 million; the Federal Republic of Germany, with $14 million; Ireland, with $14 million; France, with $7.1 million; Sweden, with $6.6 million; and Denmark, with $6.2 million. Champagne and sparkling wine exports totaled 25 million gallons valued at $31 million, down from a high of 37 million gallons in 1999 due to consumers stocking up for millennium celebrations. Dessert wine exports were $31 million, and grape must and other fermented beverage exports stood at $22 million in 2001. In total, the United Stats shipped 1 percent less wine in 2001 than the previous year. Mexico was expected to be an important market in the twenty-first century because, according to the North American Free Trade Agreement (NAFTA), the 16 percent tariff on American wine sales to that country would be lifted around the year 2004.

Further ReadingsBaker, Deborah J., ed. Ward's Business Directory of U.S. Private and Public Companies. Detroit: Thomson Gale, 2003.

"Bottled Perfection." Entrepreneur, February 2005.

"Business: Blended; Wine Industry Mergers." The Economist, 25 January 2003.

"California Vintners Getting Stomped After a Decade of Growth." The San Diego Union-Tribune, 7 January 2003.

Carlsen, Clifford. "Full-bodied Sales Make 1994 Vintage Year for Wineries." San Francisco Business Times, 4 August 1995.

------. "Robust Year of Sales Gives Wine Makers a Healthy Glow." San




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Francisco Business Times, 15 November 1996.

Ceausu, Joel. "US: Winegrowing Study Results Revealed." Entrepreneur,February 2005.

Cioletti, Jeff. "Three Markets in One." Beverage World, 15 February 2005.

"Crisp Pinot Grigio at Last Gets Chance to Sparkle as Chardonnay Alternative." Nation's Restaurant News, 10 February 2003.

"Fetzer Vineyards." Beverage Industry, 18 November 2002.

George, Jason. "An Italian Tradition Moves from the Cellar to the Classroom." The New York Times, 27 September 2004.

"GP Life: Drink." GP, 5 July 2004.

Hallett, Vicky. "Vintage Me, 2004." U.S. News & World Report, 27 September 2004.

"Hoover's Company Capsules." Hoover's Online, 2005. Available from http://www.hoovers.com.

Lazich, Robert S., ed. Market Share Reporter. Detroit: Thomson Gale, 2005.

"Plastic Corks Coming of Age; Low Cost Appeals to Vintners." South Florida Sun-Sentinel, 6 February 2003.

"Seeing Red: Changing Preferences Make U.S. Wineries Happy to be 'In the Red.'" Beverage Industry, July 2002.

"Too Many Bottles, Not Enough Buyers; Wine Industry Souring." Seattle Times,24 January 2003.

"Up Close with Peter Mondavi, Jr." Beverage Industry, July 2002.

U.S. Department of Labor. Industry-Specific Occupational Employment Statistics, 17 February 2005. Available from http://www.bls.gov.




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Whitley, Robert. "Big Cult Is Swallowing $1.99 Wine." The San Diego Union-Tribune, 25 February 2003.

Wine Institute. "California Vintners and Growers Introduce Code of Sustainable Winegrowing Guidelines," October 2001. Available from http://www.wineinstitute.org.

------. "California Wine Industry Statistical Highlights," December 2004. Available from http://www.wineinstitute.org.

------. "Despite Economic Conditions, September 11 and the Strong Dollar 2001 California Wine Shipments Up One Percent," April 2002. Available from http://www.wineinstitute.org.

------. "New Ground-Breaking Report Documents California Sustainable Winegrowing Practices," 6 October 2004. Available from http://www.wineinstitute.org.

------. "Strong Sales Growth in 2004 for California Wine as Shipments Reached New High," 5 April 2004. Available from http://www.wineinstitute.org.

------. "United States, Canada, Australia, Chile and New Zealand Sign Mutual Acceptance Agreement on Oenological Practices," December 2001. Available from http://www.wineinstitute.org.

------. "U.S. House and Senate Approve Limited Direct Wine Shipments for Winery Visitors," October 2002. Available from http://www.wineinstitute.org.

------. "U.S. Wine Exports Up Three Percent in Volume, Strong Dollar Contributes to One Percent Decrease in Revenues," May 2002. Available from http://www.wineinstitute.org.

Source Citation: "Wines, Brandy, and Brandy Spirits." Encyclopedia of American Industries. Online Edition. Thomson Gale, 2006. Reproduced in Business andCompany Resource Center. Farmington Hills, Mich.:Gale Group. 2007.http://galenet.galegroup.com/servlet/BCRC

Document Number: I2501400038




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© 2007 by The Gale Group, Inc.



1

1

Section 1. Globalization &Global Trade Overview

Professor Baizhu ChenFBE462

Marshall School of Business

2

Overview Questions

Discussion of Globalization List some stylized facts about the world

trade What is Mercantilism?

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1. Globalization

Product Market – Trade FlowWorld Merchandise export as % of GDP

0

1

2

3

4

5

6

7

8

9

1889 1913 1929 1950 1960 1970 1980 1990 20004

Globalization

International Interdependence, % import of GDP Export of G&S 1970 1998 United States 6% 12% United Kingdom 23 29 Japan 11 10 Netherlands 42 56 Germany 21 27 Singapore 102 170 China 3 22 Belgium 52 73 Korea 14 28

5

Globalization

6

Globalization

22.62.72.24.941.74.419.8World49.93.01.71.716.82.222.5Asia48.67.33.50.816.00.915.5Middle East17.71.510.20.648.42.518.9Africa

7.62.31.124.556.81.74.6C.E Europe/CIS

7.92.62.56.867.71.89.5Western Europe7.61.21.41.213.615.657.8Latin America

22.02.11.20.818.115.440.5North America

AsiaMiddleEast

AfricaCIS/CE Europe

WesternEurope

LatinAmerica

NorthAmerica

destinationorigin

Destination of Merchandise Export, 2003


FBE-462: Powerpoints

2

7

Globalization

8

Globalization

transaction costs are lower but still exist

Bald

win

& M

artin

NBE

R 69

04

9

Globalization

Bald

win

& M

artin

NBE

R 69

04

10

Pr

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ket –

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Globalization

10.6107.96.28.16.28.57.2US29.128.323.821.9151538.552.3UK6.54.76.93.31.91.29.90.8Japan14.411.19.29.75.31.10.811.1Germany13.6129.262.76.827.821.1France

19971995199019851980196019381914

Outward FDI Stock as a % of GDP

Factor Market – FDI

12

Globalization

World FDI Stock as a % of World Output



3

13

Globalization

Correlation between domestic savingsand domestic investment

14

Globalization

Foreign securities held by Pension, % of total assets

US Japan UK

15

Globalization

1900 1920 1960 1980 200019400

5

10

15

20percentage

Share of U.S. Population That is Foreign-Born1900-2000

Source: Department of Commerce Historical Statistics of the US Colonial Times to 1970, USStatistical Abstract 2000

Factor M

arket – Labor

16

Overview of World Trade

17


2003, leading merchandise exporters and importers

$7.7TTotal World$7.5TTotal World3.0Belgium3.4Belgium3.2Canada3.6Canada3.4Netherlands3.9Italy3.7Italy3.9Netherlands4.9Japan4.1UK5.0France5.2France5.0UK5.8China5.3China6.3Japan7.7Germany9.6US

16.8US10.0GermanyImport ShareCountryExport ShareCountry

18


$1.8TWorld Total$1.8TWorld Total2.8Canada2.5HK, China2.8Ireland2.6China3.1China3.5Netherlands3.6Netherlands3.9Japan4.2Italy4.0Italy4.7France4.2Spain6.2Japan5.5France6.6UK6.4Germany9.6Germany8.0UK

12.8US16.0USImport ShareCountryExport ShareCountry

2003, leading service exporters and importers



4

19


8.59.76 Econom ies in E. A sia

1.10.8India

0.71.1B razil

5.96.5C hina

30％34.6％D eveloping N ations

1.41.2A ustralia/N ew Zealand

4.86.4Japan

44.845.3Europe

19.012.5U S & C anada

70％65.4％D eveloped N ations

进口占全球比例出口比例占全球Merchandise/2004

20

Overview of World TradeShare of China and other Asian countries in US merchandise imports, 1990-03 (%)

21


Intra-regional trade of major RTAs, share in world exports

22


Foods & Beverage 45

Industry Supplies 148

Capital Goods 300

Auto & Parts 69

Consumer Goods 83

Others 32

Total 676

Meat 7Soybeans 5

Corn 5Chemicals 26

plastic 13others 13

semiconductor 42Computer accessories 34Telecom equipment 26

Civilian aircraft 25

Pharmaceutical preparations 15Apparel, textiles7

US Export (Jan – Nov 2001, billion)

23


Foods & Beverage 43

Industry Supplies 258

Capital Goods 276

Auto & Parts 174

Consumer Goods 262

Others 44

Total 1057

fish 9meat 6wine 4

Crude oil 70Chemical 18

Natural gas 16

Computer accessories 57Semiconductor 29

Telecom equipment 22Electronic apparatus 22

Apparel 64Pharmaceutical preparations 30

Toys 20

US Import (Jan – Nov 2001, billion)24

US Trade Deficits (Quarterly)



5

25 26

2. Mercantilism

Assumption: the wealth of the nation ismeasured by the nation’s stock of preciousmetals export goods to other nations => receive

precious metals from other nations import goods from other nations => pay

precious metals to other nations

27

- Mercantilism

If a nation’s export exceeds its import =>its stock of precious metals increase => wealth increases

If a nation’s export exceeds its export =>its stock of precious metals decrease => wealth decreases

28

- Mercantilism

Policy implication based on Mercantilism: a nation’s wealth can be accumulated through

export rather than import trade is a zero-sum game trade policy should be used to promote export trade policy should be used to restrict import



1

1

Section 2. Is Trade A Zero-Sum Game?



2

1. Overview Questions

What is consumer’s surplus? What is producer’s surplus? Will a small nation gain from trade? Is trade a zero-sum game?

3

2. Demand

Consumer decision: max U(q1,q2) Budget constraint: F(q1,q2, p1, p2, I) = 0 Demand function: qi=qi(p1, p2, I)

p

q

4

- Demand

Consumer surplus: measures the amount a consumer gains from a

purchase by the difference between the pricehe actually pays and the price he would havebeen willing to pay

5

- Demand

In the diagram, the consumer surplus ofconsuming 10 units of apple is given by a

12

10

a

b

p

q

6

- Supply

Producer’s decision: max pq-c(q) the cost function c(q) depends on factor

prices and techniques of production (# offactors required to produce one unit output)

supply function: qs=qs(p, …)p

q



2

7

- Supply

Producer surplus: measures the amount a producer gains from a

sale by the difference between the price heactually receives and the price he would havebeen willing to accept

8

- Supply

In the diagram, the producer surplus ofselling 10 units of apple is a

p

p

a

b

10

9

3. From Autarky To Open Economy

Autarky total welfare of this nation = ?

p

q

D

S

a

b

10

- From Autarky To Open Economy

Small country: price is taken as given welfare with trade = ? gains = ?

p* c

de

11


Large country: price is endogenous Two countries: Home and Foreign

p c

de

Hp* c*

d*e*

F

F exportsupply

H importdemand

12


world market price: determined by the worlddemand and supply

==> gains from trade In Home country, anyone worse off? Income distribution: across nations, within

the same nation



3

13

4. General Equilibrium Approach

P

Cloth

Wheat

A

General equilibriumanalysis Two goods Autarky equilibrium – A Relative price of cloth - p

14

General Equilibrium Approach

General equilibriumanalysis World relative price – p* Production – B Consumption – C Country gains from trade Gains are not distributed

evenly Trade creates winners

and losers

Cloth

P

Wheat

A

B●

●

C

P*

15

Gains From Trade

Terms of trade (TOT) Relative price of

export to import When TOT improves,

the country is betteroff

P*

Wheat

A

B

●

●

C

D

Cloth



1

Section 3. Why Nations Trade (I)?



2

Overview Questions

Know the determinants of trade pattern What is comparative advantage? What is absolute advantage?

3

Determinants of Trade

Countries trade with each other becausethey are different Demands are different

(Dc/Dw)h

(Sc/Sw)h= (Sc/Sw)f

(Dc/Dw)f

C/W

Pc/Pw

(Pc/Pw)f

(Pc/Pw)h

4


Supplies are different

(Sc/Sw)h

(Sc/Sw)f

(Dc/Dw)h= (Dc/Dw)f

Pc/Pw

C/W

(Pc/Pw)f

(Pc/Pw)h

5


Demands are different because tastes differ it is hard to explain the difference in tastes

What cause the difference in supply? labor cost or labor productivity factor endowments

6

Ricardo’s Theory ofComparative Advantage

Consider a simple situation: two countries, two goods produced by labor, labor fully mobile domestically not

internationally, full employment no trade barrier, perfect competition

Will Mexico be able to export?

Labor cost to make In Mexico In the US1 bushel of Wheat 4 hours 1 hours1 yard of cloth 2 hours 1.5 hour



7


If no trade between them, the opportunitycost of producing cloth in Mexico: 0.5 bushel of wheat per yard in US: 1.5 bushel of wheat per per yard

Mexico USOne bushel of wheat

One yard of cloth

Save 0.5 bushelof wheat

Get 0.5 morebushel of wheat

8


Comparative Advantage: If a country has a lower opportunity cost of

producing good A, the country has acomparative advantage in producing A

A country will export the good in which ithas a comparative advantage In Ricardo’s Theory: opportunity cost of

production is determined by the relative laborcost

9


If each country has 100 labor hour still assume the free-trade relative price of

wheat is one per yard of cloth (terms of trade)

50

25

wheat

Cloth 66.7

100wheat

Cloth

Mexico US

C2015

20 30

76

16 20

80C*

S0

S*0

S1

S*1

50

10


Countries gain from trade if trade is basedon comparative advantage

Trade is a positive sum game Mercantilism: Trade is a zero sum game

Direct comparison of the absolute laborcost of production is irrelevant for trade

The country that has an absolute advantagein labor cost has a higher wage

11


Ricardian model implies extremely highdegree of specialization

Ricardian model implies that trade willbenefit everyone

12

Extension from Ricardo

wheat

Cloth

C

S1

wheat

Cloth

C

S1

S0

S0



13

Extension from Ricardo

wheat

Cloth

C

S1S0

Cloth

CS1

S0

Gains from trade with increasing cost ofproduction

wheat



1

1

Section 4. Why Nations Trade (II)

2

Module Objectives

To explain why countries with similartechnologies trade

Income distribution effect of trade

3

Factor Endowments

How to explain this trade pattern?

4

Factor Endowments

Consider a simple situation: Two factors of production: labor and capital factors can freely move domestically but not

internationally, full employment technologies of production are the same for all

countries (two countries) no trade barriers, perfect competition countries differ in their endowments

5

They Have the Same Technology

Japan endowments: Land=10, Labor=8 US endowments: Land=20, Labor=10

Wheat Cloth

Land

Labor

3

1

1

3

3W + C =10W + 3C = 8

3W + C = 20W + 3C = 10

US

Japan

6

Will A Less Resource Nation BeAble to Export?

US is said to be land abundant and Japan islabor abundant

Cloth is said to be labor intensive, andWheat is land intensive

Will Japan be able to find anything toexport?



2

7

Production Possibility Frontier

10/3

W

C

10

20/3

20

10/3

10

W

C

8

8/3

3W + C = 10W + 3C = 8

Japan

3W + C = 20W + 3C = 10

US

8

Which Country RelativelySupply More?

More general, production possibilityfrontiers in these countries which country relatively supply cloth more at

any given relative price?

W

C

JapanW

C

US

9

Factor Endowments Determine

Countries export the products that use theirabundant factors intensively Heckscher-Ohlin Theory

To know your advantage: Which factors are abundant? Does your industry use the abundant factor

intensively?

10

Comparison of Factor Endowments

11

Who Wins and Who Loses?

For simplicity, assume that productiontechnologies are constant

W is land intensive, C is labor intensive capital-labor ratio:

W: 1/3 C: 3 W C

Land

labor

3

1

1

3

12

- Who Wins and Who Loses?

Assume the prices are: Wheat: Pw = $14 Cloth: Pc = $10

Perfect competitive conditions: MC of producing cloth = MR of selling cloth MC of producing wheat = MR of selling wheat



3

13


3r + w = $14 r+ 3w = $10 ==> equilibrium factor prices

r = $4 w = $2 r

w

Pc

Pw14


Suppose Pc increases by 20% 3r + w = $14 r + 3w = $12

r = $3.75 w = $2.75

r

w

Pc

Pw

15


==> %Δr = -6.25% ==> %Δw = 37.5% %Δr < 0 = %ΔPw < %ΔPc =20% < %Δw those factors intensively used in sectors

with prices increase will be better off those factors not intensively used in sectors

with prices increase will be worse off Stolper-Samuelson Theorem

16


Application: Suppose U.S. has export andimport sectors. Assume export sector ishigh-skill labor intensive and import is low-skill labor intensive. U.S. is high-skill laborabundant

who will support freer trade in U.S.?



1

1

Section 5 Economies of Scaleand Trade

2

Module Objectives

To explain the scale economies To explain trade that is not based on the

standard assumptions

3

Patterns of Trade of US

4

Inter- versus Intra-Industry Trade

How to explain intra-industry trade? A country exports and imports goods of the same

industry Can difference in labor cost and factor

endowments explain intra-industry trade? Inter-industry trade

a country exports goods in some industries andimports goods in other industries.

5

Economies of Scale

External economies of scale (EES) average production cost of a firm is lower if

the whole industry at a particular location islarger but does not depend on the size of thefirm

Internal economies of scale (IES) average production cost of a firm is lower if

the firm size is larger

6

Economies of Scale

Examples of EES? What kinds of market structures are

consistent with EES? If EES is significant, history, luck,

coincidence, or government policy playimportant role in determining the pattern oftrade

Policy implications?



2

7

Economies of Scale

What can lead to Internal Economies of Scale? What kinds of market structures are consistent

with IES?

8

Scale Economies andMonopolistic Competition

Consider differentiated product - products that are

seemingly the same good but that are perceived byconsumer to have real or imagined difference

consumers value varieties monopolistic competition - a producer has a

monopolistic power on his brand; but competewith other brands

scale economies - size of the firm increasesreduces the cost of production (two types of scaleeconomies)

9

Scale Economies and ProductDifferentiation

Two nations: US and UK, two types of car cheap car expensive car labor output labor output 10 5 20 5 15 10 25 10 20 15 30 15 25 20 35 20 30 25 40 25 35 30 45 30

10

Countries Are Identical

Assume U.S. and UK were identical, andeach has 35 labors

Assume in autarky, each produce 10 cheapcars and 5 expensive cars

11

Gains From Trade

If U.S. and UK can trade with each other,consider the following two situations: U.S. uses 35 labors produce cheap car and UK

uses 35 labors produce expensive car => howmany cheap and expensive cars total?

12

Gains From Trade, Again

U.S. uses 35 labors produce expensive car andUK uses 35 labors produce cheap car => howmany cheap and expensive cars total?



3

13

Why Trade Benefits?

With economies of scale and productdifferentiation, nations with similarcharacteristics will still trade with eachother to explore the scale of the market to satisfy the diversified needs of consumer

14

Scale Economies andMonopolistic Competition

How to describe the pattern of trade? Japan - capital abundant Canada - land abundant Two goods: manufacturing (capital intensive)

and food (land intensive) differentiated products in manufacturing with

increasing returns to scale

15

Patterns of Trade

Canada

Japan

Food Manufacturingproducts

16

What If Market Sizes Differ?

If nations have different sizes of marketsand trade has to incur transportation costs,what kind of pattern of trade will it be? => country with a larger demand for a good

will likely to be the export of this good, if scaleeconomies are present



1

Section 6. Growth and Trade

2


What is the Rybczynski Theorem? What is the “Dutch Disease”? Under what circumstances the

immiserizing growth will more likelyoccur?

What is the product cycle theory?

3

2. Rybczynski Theorem

Two factors of production: labor and capital factors can freely move domestically but

not internationally all factors are fully employed technologies of production are the same for

all countries no natural and man-made trade barriers perfect competition

4

- Rybczynski Theorem

Consider only two goods: wheat and cloth

W C

L

K

5


For simplicity, first assume that productiontechnologies are constant

W is labor intensive, C is capital intensive capital-labor ratio:

W: 1/3 C: 3 W C

L

K

3

1

1

3

6


Home country endowments: Labor: 10 capital: 14

full employment condition: 3W + C = 10 W + 3C = 14 A: (W,C)=(2,4) 10/3

10

W

C

14

14/3

A

K

L



7


Suppose L increases by 20% A: (W,C) = (2.75, 3.25) W↑by 37.5%, C↓ by 18.75%

10/3

10

W

C

14

14/3

A

K

L

8


If one factor endowment increases, the industryuses the factor intensive will grow, the otherindustry will decline

“Dutch Disease” The deindustrialization of an economy as a result of the

discovery of a natural resource. So named because itoccurred in Holland after the discovery of North Sea gas; ithas also been applied to the UK since the discovery ofNorth Sea oil. The discovery of such a resource lifts thevalue of the country's currency, making manufacturedgoods less competitive; exports therefore decline andimports rise.

Ÿ Dictionary of Business, Oxford University Press

9

3. Immiserizing Growth

For a small country, growth is always good.

W

C10

- Immiserizing Growth

Balanced growth for a large country The country tends to be better off

W

C

11


Growth biased toward to the import sectorfor a large country => better off

W

C12


Growth biased toward to the export sectorfor a large country => maybe worse off

W

C



13


Two effects when a large country grows growth effect => tends to make it better off TOT effect

if growth biased toward to import sector =>TOTimproves

if growth biased toward to export sector => TOTworsens

If TOT worsens so much that dominates thegrowth effects => growth is immiserizing

14


Conditions that growth causes TOT worsenssuch that immiserizing growth occurs: growth strongly biased toward to the export sector world demand for the export good is very inelastic the country is heavily dependent on the export

sector (heavily involved in trade) before growth the country must be a large economy

15

4. Product Cycle Theory

Dynamics of Comparative Advantage comparative advantage changes overtime

because of economic growth

16

Product Cycle Theory

New Product Stage high income countries (US) produce and

consume new product firms need to familiarize the products and to detect

consumer response high R&D cost, high cost in advertising, sales

promotion, marketing, etc. demand is local almost no international trade

17


Maturing Product Stage standards begin to emerge and large-scale

production is adopted economies of scale begin to realize first high income countries (US) exports to medium

income nations (Spain) later medium income nations (Spain) export to high

income countries (US) foreign direct investment occurs, and MNCs emerge

18


Standardized Product Stage product is familiar to consumers production processes can be easily learnt

labor costs play an important role developed countries busy introducing other new

products production shifts to developing counties developed countries become the importer



19


t0 t1 t2New productstage

Maturingproduct stage

Standardizedproduct stage

Production,consumption ofa product

U.S. Production

U.S.Consumption

exportsimports



1

Section 7. Tariff

2


What are different types of tariffs? What happens to terms of trade when a

small country imposes a tariff? a largecountry?

What is the effective rate of protection? What is the optimal tariff rate?

3

2. Basics of Tariff

tax on import or export ad valorem tariff: P = P* (1+t) specific tariff: P = P* + t

4

Basics of Tariff

Source: http://www.usitc.gov/tata/hts/bychapter/index.htm

5

Basics of Tariff

Tariff structures can be quite complicated wristwatches with case of precious metal or of

metal clad with precious metal: withmechanical display only, having no jewels oronly one jewel in the movementMFN: 51c each +6.25% on the case & strap, band

or bracelet +5.3% on the batteryNon-MFN: $2.25 each +45% on the case+80% on

strap, band or bracelet +35% on the battery

6

Basics of Tariff

Tariff Rates in China, 1995



7

- Basics of Tariff

Preferential duties tariff rates applied to an import according to its

geographical source; a country that is givenpreferential treatment pays a lower tariff

e.g., British Commonwealth, EU, NAFTA GSP (generalized system of preferences)

developed countries permit duty-free entry of aselected list of products if those products areimported from particular developing countries

8

- Basics of Tariff

Measurement of tariff rates unweighted average tariff rate

10% on Good A, 15% on good B, 20% on good C unweighted average tariff rate = 15% overstate the height of the country’s average tariff if the

country imports mostly good A

weighted average tariff rate value of A import $500, B $200, C$100 weighted average tariff rate = 12.5% What is the problem of using weighted average tariff rate as a

measure of degree of protection?

9

3. Welfare of Import Duty

small nation: its TOT is given tariff has no effect on its TOT gain or loss?

P

Q

DS

P*

P*+ t

a

b

fc d e

10

- Welfare of Import Duty

large nation: tariff affects its TOT gain or loss?

P

Q

DS

P*

P*+ t

P*

a

b

c

ed

fi

g h

11


Effects of tariff consumption effect production effect trade effect revenue effect redistribution effect terms of trade effect

12


tariff=consumption tax+production subsidy e.g. $10 shirt, 50% tariff => P = $15,

government collects $5 This is equivalent to a 50% consumption tax +

50% production subsidy



13


Optimal tariff the tariff rate that maximizes the welfare of the

tariff-imposing nation what is the optimal tariff of a small nation? what is the optimal tariff of a large nation? Why U.S. does not impose the optimal tariff?

14


A country has both tariffs on its car importsand auto engine imports. The countryproduces cars using imported auto engine.As the pressure of trade liberalization rises,the country pledges to move toward freertrade by eliminating the tariff on engineimports. Evaluate the country’s policy.

15


effective rate of tariff when there are different levels of production,

and at each level, there is a tariff imposed, howto measure the degree of protection?

16

4. Welfare of Export Duty

examples of export tax: cocoa (Ghana) coffee (Brazil and Colombia) jute (Pakistan) rice (Burma and Thailand) timber (Ivory Coast and Liberia) tea (Sri Lanka) tin (Malaysia)

17

- Welfare of Export Duty

small country: export duty $25

Pw=60

D

S

20

P=35a

bc

d



1

Section 8. Non-tariff Barriers

2


What are the effects of an export tariff? What are the differences and similarities of

a tariff, quota, and VER? Name some other non-tariff barriers

3

2. Quota and VER

Tariff, Quota and VER What if it is a large nation?

P

Q

10

12

q1 q2

a b c d

q3 q44

- Quota and VER

Quota versus Tariff With increasing foreign competition, quota

offers more protection to domestic industriesthan tariff

Quotas provide bureaucrats more power quotas are more likely to create a domestic

monopoly than tariff

5

- Quota and VER

MFA: multifiber arrangement (1974) iron and steel sugar (quota + tariff)

1989, US sugar price $0.2281/lb, World price$0.1445, equivalent tariff rate of 58%

Japanese car 1981, 1.68 million cars (VER) to U.S. 84-85, increased to 1.85 million cars

6

3. Other Barriers

Local content requirement technical, administrative and other

regulations health and technical regulations

Government procurement policies “Buy America” act

Fed government agencies must buy from home U.S.firms unless the price is 6% abover foreigners’

for Department of Defense, this figure is 12%



7

- Other Barriers

Reclassification Restrictions on services trade

restrictions on foreign insurance companies foreign ships not allowed from carrying cargo

between purely domestic ports (U.S., etc.) landing rights for foreign aircraft limited (open

space? Canada, EU versus US)

8

- Other Barriers

Foreign exchange controls exporters are required to sell their foreign

exchange earnings to the central bank, whichin term parcels out to importers selectively

Advance deposit requirement license to import is awarded only if the

importing firm deposits with the governmentspecific funds

9 10



1

Section 9 Protect or Not to Protect

2


What is market failure? What is the implication to trade when

market fails What is the Coase Theorem? What is the industrial policy?

3

2. For and Against Free Trade

Arguments for free trade efficiency scale economy transfer of technology reducing social cost (e.g. rent-seeking cost)

4

-For and Against Free Trade

Arguments against free trade optimal tariff theory Revenue Income Distribution/welfare policy Political and strategic objectives market failure

free trade no longer optimal=> policy need to beused to correct market failure

5 6



7 8

9

3. What if market fails?

Market fails if there is monopoly, orincreasing returns to scale, or, …

When market fails, the price no longerreflects the opportunity cost of producingthis good

When market fails, producer’s surplus orconsumer surplus does not fully capture thebenefit of producing or consuming a good

10

- What if market fails?

If the market fails to compensate theproducer for the extra benefits generated

p

Q

Sso =MCso

Spr=MCpr

11


What is the first-best policy to correctmarket failure? - a positive externality

p

Q

Sso

Spr

pw=10

q1 q3 q4

12

q2

a b c de

12


What is the first-best policy to correctmarket failure? - a negative externality

p

Q

SprSso

pw=10

q1 q3 q4

8

q2

ab

cd e f

gh



13


The first-best policy is always the onewhich can directly correct the market failure

The second-best policy is the one which ismost closely targeted to the market failurethough cannot directly correct it.

A general rule: The closer a policy is targeted to the problem,

the better it is (requires to identify theproblem!)

14


An alternative to impose policies, specifythe property rights Coase Theorem

If costless negotion is possible, rights are well-specified, and redistribution does not affectmarginal values, thenŸ the allocation of resources will be identical whatever the

allocation of legal rights, andŸ the allocation will be efficient, so there is no problem of

externality, further moreŸ if additional policy (tax/subsidy) is imposed in such a

situation, efficiency will be lost.

15


Purse-seine fishing of tuna fish results indrowning of dolphin (similarly the seaturtles killed trapping in the nets withshrimp)

What is the source of problems? What are the policy options?

16


The African elephant population was cut inhalf within a span of 8 yrs in 1980s due topoaching

Public pressure from affluent countries tosave the elephants intensified in late 1980sand early 1990s

What is the source of problem? What are the policy options?

17

4. Industrial Policy

Government policy to channel resources toparticular industries, generally thoseindustries that government views asimportant to future economic growth

Instruments used to channel resources: tariff, direct production subsidy, government

procurement, free R&D, cheap credit, etc... Should or should not use industrial policy?

18

- Industrial Policy

Consider using industrial policy for thefollowings: industries with high value-added per worker upstream industries industries with future growth potential high-tech industries



1

Section 10. Pushing Export

2


What is dumping? What is countervailing duty? Explain the strategic trade policy

3

2. Dumping and Anti-dumping

The product is sold in another country at aprice less than fair value. less than the price of the like product in the

exporting country or (in the absence of such domestic price) less

than the highest comparable price of the likeproduct selling in any third country

or less than the cost of production in thecountry of origin

4

- Dumping and Anti-dumping

dumping if the good is selling below “fairmarket value”

how to calculate the “fair market value” Conditions for dumping to occur:

imperfect market segmented markets

5


types of dumping predatory dumping cyclical dumping persistent dumping

6


Persistent Dumping perfect competition in foreign market monopoly domestic

MC

Ddom

Dfor=MRfor

MRdom

P

Q



7


antidumping duty can be imposed if dumping occurred (selling at less than fair

value) ITA of Commerce Dept. determines if dumping

occurs

dumping causing material injury to plaintiff ITC determines if material injury occurs

8


Petition

ITA

Casedismissed

If not belowLTFV

ITC

Casedismissed

If no injury

ITA

Negotiatesettlement

Imposepenalty

9


Numbers of antidumping investigations inU.S. 1980 37 1985 63 1981 15 1986 71 1982 65 1987 15 1983 46 1988 42 1984 74 1989 23 Total 1980-1989: 451

10


Target industries of U.S. antidumpinginvestigations Chemicals 58 Food 16 Iron and Steel 201 Machinery 8 Textiles and apparel 15 others 153 Total 1980-1989: 451

11


Target countries of U.S. antidumpinginvestigations, 1980-1989 Japan 58 Brazil 24 Germany 29 France 22 Korea 27 UK 18 Italy 26 China 17 Canada 25

12


U.S. cases 1980 1982 1985 total(80-85)

duties 10(27%) 13(20%) 25(40%) 82(27%)

rejected 9(24%) 21(32%) 20(32%) 104(35%)

withdrawn 18(49%) 31(48%) 18(29%) 114(38%)

total cases 37 65 63 300

U.S. International Trade Commission Annual Report



13

3. Export Subsidy and Countervailing Duty

welfare cost of export subsidy what if it is a large nation?

P

a b c dPw

ps

14

- Export Subsidy and Countervailing Duty

European Common Agriculture Policy(CAP) EC members: Germany, France, Italy,

Belgium, Netherlands, Luxembourg, UK,Ireland, Denmark, Greece, Spain, Portugal.

15


Million T Million T

16


According to GATT/WTO, export subsidyis to be condemned (except farm subsidy)

Countervailing duty is permitted if export subsidy is found if the subsidized export cause or threaten to

cause material injury to domestic firms

17


Numbers of CVD investigations in U.S. 1980 69 1985 63 1981 17 1986 71 1982 116 1987 15 1983 8 1988 42 1984 26 1989 23 Total 1980-1989: 301

18


Target countries of U.S. CVDinvestigations, 1980-1989 Japan 17 Brazil 36 Germany 18 France 28 Korea 17 UK 18 Italy 24 China -- Canada 18



19

4. Strategic Trade Policy

Government may encourage exporters toform cartel to extract rents from foreigncountries OPEC, MITI

An importing country facing a foreigncartel may tax the import to extract backpart of the monopoly rents.

20

- Strategic Trade Policy

Airbus v.s. Boeing If Boeing starts produce first

Boeing

AirbusP NP

P

NP

-5

-5

0

100

100

0

0

0

21


Airbus v.s. Boeing If Europe subsidizes Airbus $25

Boeing

AirbusP NP

P

NP

20

-5

0

100

125

0

0

022


Airbus v.s. Boeing If Europe and US both subsidy their firms

Boeing

AirbusP NP

P

NP

20

20

0

120

120

0

0

0

23


Suppose the payoff matrix is the following What if EC $25 subsidy

Boeing

AirbusP NP

P

NP

-20

5

0

125

100

0

0

024


What lessons we learn from these? strategic trade policy is a beggar-thy-neighbor

policy strategic trade policy could be used to increase

the welfare of the nation imposing the policy it is not clear that strategic trade policy will

always increase the welfare of the nation if foreign nation retaliates, all nations may be

worse off in this non-cooperative game



1

Section 11. Trade Blocs andTrade Blocks

2

1. Trade Blocs

Free-trade-area countries abolish all import duties on their

mutual trade in all goods, but each country hasits own tariffs for the rest of the world

Andean GroupŸ Bolivia, Colombia, Ecuador, Peru, Venezuela

European Free Trade Association (EFTA)Ÿ Austria, Finland, Iceland, Liechtenstein, Norway,

Sweden and Switzerland

NAFTA transshipment and rules of origin

3

- Trade Blocs

Customs Union a free-trade-area with a common external tariff

toward the rest of the world Benelux (1947, later absorbed into EC in 1958)

Ÿ Belgium, Netherlands, and Luxembourg

ASEAN (loose association-moving towardcustoms union)Ÿ Brunei, Indonesia, Malaysia, Philippines, Singapore,

Thailand

no transshipment problem

4

- Trade Blocs

Common Market a customs union with mobility of factors of

production EC (European Community, 1958, Treaties of Rome) MERCOSUR (Southern Cone Common Market)

Ÿ Argentina, Brazil, Paraguay, Uruguay

Central American Common MarketŸ Costa Rica, El Salvador, Guatemala, Honduras,

Nicaragua

5

- Trade Blocs

Economic Union a common market with unified fiscal,

monetary and socioeconomic policies European Union

Ÿ Belgium, Denmark, France, Germany, Greece, Ireland,Italy, Luxembourg, Netherlands, Portugal, Spain and UK

6

- Trade Blocs

Is a FTA always welfare improving? tariff $4

10

12

1415

SK

SUS

SM



7

- Trade Blocs

If U.S. and Korea form a FTA, US betteroff?

If U.S. and Mexico form a FTA, U.S. betteroff?

10

12

1415

SK

SUS

SM

ab c

ed f

ihg j

15

A CB D 8

- Trade Blocs

FTA improves welfare if Trade Creationdominates Trade Diversion

What kind of FTA likely improves welfare? more trade originally (large trade partner) low tariffs among members before FTA

relative to external tariff member nations complement with each others more members and larger size of economies if transportation => closer geographically

9

- Trade Blocs

NAFTA Benefits of being in NAFTA for each of the

following nations? U.S., Mexico, and Canada

EC Difference between EC and NAFTA?

PAFTA? (Pacific-Asia Free Trade Area) APEC

10

- Discuss:When Can SanctionsSucceed

Give some successful examples ofeconomic sanction

Give some unsuccessful examples ofeconomic sanction

Under what conditions economic sanctionswill be more successful?



1

Section 12. WTO

2

History of WTO

1944 Bretton Woods IMF, World Bank and ITO (GATT) GATT suppose to be temporary GATT function

lists code of conduct dispute settlement multilateral negotiation

3

Principles of WTO

non-discrimination (MFN, Article I) trade liberalization

reciprocity any new tariff or increase in tariff must be offset by

cuts in other tariffs no unilateral quotas on imports, except threaten

“market disruption”

no unfair encouragement for exports no export subsidy, except agricultural goods

transparency protect through tariff 4

GATT/WTO negotiations

yr nations $ Kennedy Round: 62-67 48 40b Tokyo Round: 73-79 99 155b Uruguay Round: 86-93 108 1,000b

5

US Tariff Rates

Smoot-Hawley (1930)

% of of dutiable

% of total import

Kennedy RoundTokyo Round

6

Exemptions

Exemptions from GATT/WTO rules antidumping and countervailing duties (VI) safeguard arrangements (XIX) BOP and Economic Development (XII, XVIII) free trade areas (XXIV) general exemptions (XX, XXI)



7

GATT problems

“gray area”: VER abuse antidumping and CVD exemptions traditional issues: agriculture, T&C new issues: service, & IPR free-trade-area weak GATT institution

8

US Tariff and Non-tariffBarriers

Tariff (% of dutiable)

Equivalent tariff rate of non-tariff barriers

9

- GATT negotiations

GATT Rounds resulted tariff reduction % of nations’ trade subject to nontariff

barriers 1966 1986 US 36% 45% EU 21% 54% Japan 31% 43% All DC 25% 48% Laird & Yeats, Weltwirtschaftliches Archiv, 1990, 126, 2:299-326

10

The Uruguay Round

Accomplishment of Uruguay Round 40% reduction in tariffs agreement of all nations to recognize IPR agreement among developed nations on starting to

convert nontariff to tariff barriers on Textile &Clothing (over 10 years) and then cut tariff rate

Subsidies in agriculture be cut over six years by 20%,non-tariff barriers be converted to tariffs and cut by36%

more formalized institution (WTO) to monitor tariffreductions and resolve disputes

No agreements on financial services andtelecommunications yet, but talks continue

11 12

Achievement of WTO

Dispute settlement mechanism is working 104 disputes submitted in less than 2 years (compare

with 196 cases to GATT in 50 years) Case of Kodak v.s. Fuji Case of Costa Rica lingerie case v.s. US

Telecommunications Agreements (Feb. 1997) 68 nations (account for 90% of the revenue) pledged US, EU, and Japan fully liberalized by Jan 1, 1998

Financial Service Agreement (Dec. 1997) 102 nations (over 95% market) pledged US, EU fully open to foreign banks, insurance and

securities with minor exceptions



13

Unresolved Issues

Substantial trade barriers remain in some sectors Financial, entertainment, and publishing

Environmental concerns Worker’s rights Foreign Direct Investment

Local content requirement, local ownership rules,outright prohibition

Abusive use of antidumping

14

Some U.S. Trade Policies

US Trade Laws

15

Case: China’s Entry of WTO

Agriculture average tariff reduced to 17%, duty on US

major agri-export to 14.5% grace period to 2004 accept USDA certification tariff once lowered, cannot be increased tariff-rate quota (TRQ)

low tariff rate if within quota (1-3%), but high tariff exceedingthe quotaŸ soybean oil: TRQ currently 1.7 million cubic ton, increases to

3.3 million cubic ton in 2005, TRQ to be abolished in 200616


17


18


Export from US to China



19


Industrial Products average duty lower from 24.6% to 9.44% after WTO,

key products to 7.1% high tech products duty lower from 13.3% to 0, no

requirement of technological transfer lowered duty cannot be adjusted 2/3 of products grace period to 2003, majority of others

to 2005 no quotas on major US products (fertilizer, fiber

optical cable, etc.), grace period 5 years if there is a quota, increase 15% per year car quota 6 million, abolish by 2005 20


Services permitting grandfathering the provincial

agreement abolish restrictions on domestic distribution

within 3-5 years restrictions on leasing, warehouse, advertising,

packaging, air shipping, inspections abolishedwithin 3-4 years

21


Telecommunication abolish geographical restriction

paging - within 4 years mobile - within 5 years

foreign investment after 4 years can be 49%(51% in paging)

adopt CDMA protocol

22


Insurance abolish geographical restriction with 5 years foreign insurance firms can do group

insurance, health insurance and pension life insurance firms can choose their own

domestic venture partner, can take 50% shareafter WTO and increase to 51% after one year

non-life firm can take 51% share after WTO,can be WOFE after 2 years.

23


Banking and Security retail banking will be opened for WOFE banks

by 2005 banking on RMB business allowed by 2005 only joint venture is allowed in security,

foreign firms can take up to 33% (???)



1

Section 13. Environmental andLabor Standards

2

What are the differences?

Income(1999)

Numbers Population (b) Income Rangeper person ($)

AverageIncome perperson ($)

Low 58 2.4 100-754 410

Lowermiddle

49 2.1 755-2995 1200

Uppermiddle

27 0.6 2996-9265 4900

High 27 0.9 9266+ 25730

3

Income(1999)

Infant Deathsper 100,000birth

% childrenof 10-14yworks

CO2EmissionsMetric Tonsper person

Annual deforest.square kilom per100,000 person

Low 68 19 100-754 1.8

Lowermiddle

35 7 755-2995 1.2

Uppermiddle

26 6 2996-9265 7.2

High 6 <1 9266+ -1.3

What are the differences?

4

Setting Standards

Harmonization of standards Mutual recognition of standards Separate standards

5

Labor Standards

International Labor Organization (ILO) Prohibition of forced labor Freedom of association The right to organize and bargain collectively An end to the exploitation of child labor Nondiscrimination in employment

6

Child Labor

US Child Labor 300,000 – 800,000

40%

20%

18%

% of its children



7

Trade and Environmental Issues

Non Transboundary Environmental Issues Difference in environmental standards Pollution havens

Transboundary Environmental Issues

8

How to attack externalities?

impose tax to force producer to pay extrasocial cost

Problems? second-best

P

80

400

A

B

C

D

Germany’s MB ofdumping waste

MC of wastedumping to Austria

9

- How to attack externalities?

Coase Theorem if costless negotiation is possible, property

rights are well-specified, and redistributiondoes not affect marginal values, then the allocation of resources will be identical,

whatever the allocation of legal rights the allocation will be efficient, so there is no

problem of externality if a tax is imposed in such a situation, efficiency

will be lost10

Cases

CFC’s and Ozone what is the policy used? is the policy working? why the policy is (or not) successful?

11

- Cases

Dolphins and Tuna what is the policy for U.S? Is the policy working? why the policy is (or not) successful?

12

- Cases

Elephants and Ivory what is the policy? Is the policy working? why the policy is (or not) successful?



13

- Cases

Brazilian Rain Forests what is the policy? Is the policy working? why the policy is (or not) successful?



1

Section 14. Trade in Factors



2

International Capital Flow

foreign portfolio investment Stocks and bonds No direct management and control

foreign direct investment Often involves control and management In the U.S., owns more than 10% shares to be

counted as FDI for accounting purpose.

3

Inbound FDI

4

FDI

Firm factors What unique advantage the firm has over local firms?

Local factors What factors in local are attractive? Is it cheaper labor

or land? Or is it the market? Or else? Policy factors

Is the local policy encouraging FDI? Legal structuresare favorable?

Competitive factors Scale economy? Competitors there already? Can we

keep our competitiveness?

5

FDI

6

FDI



7

FDI – China Case

8

FDI – China Case

9

FDI – China Case

0.144Zambia100.151Thailand090.165Singapore080.235Korea070.416Australia060.446Macau050.502U.S.040.533Virgin Is033.691Cayman Is0224.63HK01

Accumulated $BNation2003

10

FDI – China Case

55%

56%46% 74%

4% 57%

15% 26% 16% 2% 10% 1%

% of asset overseas

Source: UNCTAD

11

FDI – China Case

130BurgCIMC2006

18500*UnocalCNOOC20051275*MaytagHaier2005520Ssangyong MotorsSAIC20051750IBM PCLenovo2005

7000*NorandaMinmetals2004650Hynix TFT-LCD unitBOE20039.8Schneider Electronics AGTCL2002262Devon’s oil fieldPetrol China2002

275BP’s refinery assetsCNOOC2002

3205% interests Northwest Shelf VentureCNOOC2002394Oil fields AlgeriaSinoPec2002592Repsol-YPECNOOC20027Menghetti SpaHaier2001

US$ millionTargetCompany

12

FDI – Why Go Global?

Domestic competition Diversification v.s. globalization

Technology & know-how Global brand Protectionism Exchange Rate Government policies



13

Immigration

14

Immigration

0R0S L1LE

MPLS

MPLR

DS DR

A

B

C

E

WS WS

WR WR

WE WE

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b

c

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Immigration

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MPLS

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University of Southern California Marshall School of Business

MOR 492: GLOBAL STRATEGY Spring 2006

Professor: Carl W. Voigt, Ph.D. Office: Bridge Hall 303-E Phone: Direct: (213) 740-0764 Department of Management and Organization Office: (213) 740-0728 Email: [email protected] [Note: I do not check email sent to [email protected]!!!] Office Hours: MW 11:00-12:00 noon, 1:30-2:00 pm, immediately after class, and by appointment COURSE DESCRIPTION Business enterprise in today’s environment increasingly involves crossing national borders and, more generally, engaging in business activities in numerous countries that are often very different from each other. Changes in technology, transportation, communications, and political alliances have significantly internationalized business. Increasingly, firms are required to compete in multiple foreign markets at both the product and supply-chain levels. Understanding the management, marketing, financial, and operational challenges associated with global business activity, and developing skills in these areas, have become essential requirements for success. The Global Strategy course is designed to provide students with the skills, knowledge, and sensitivity required to create, maintain, and renew sustainable competitive advantage within a global environment. Global Strategy will explore international business issues from an integrated firm-level perspective. The course will adopt a strategic perspective and will highlight the following topics from this perspective: the analysis of industry and environmental forces, the competitive context in which companies operate in global industries, creating and sustaining global competitive advantage, the characteristics of global, multi-domestic and transnational strategies, international entry strategies, global strategic alliances, the role of global organizational structures, and the importance of global strategic control. Case studies used in this course will help you develop your analytical and decision-making skills and also highlight the reality of environmental uncertainties influencing decision making in the global context. Cases also seek to develop your capacity to identify issues, to reason carefully through various options and improve your ability to manage the organizational process by which decisions get formed and executed. In addition to case analyses we will also read and discuss additional articles on strategic issues relevant to operating in a global context. Thus, students will develop both, historical and current, and theoretical and practical, perspectives on operating in a global context. This course has two broad objectives and will be taught simultaneously at two levels. First, this course is designed to teach students “about” international business issues. That is, the course intends to help students understand how business practices vary widely across regions and countries. Secondly, this course is designed to teach students “how to” formulate and evaluate winning global strategies. In a very real sense, this course is designed for students who seek to work in, or with, firms that operate in many different countries, or which operate outside the US. By the end of the course, students should be able to: perform country, region, industry and firm analyses in an international setting, evaluate the effectiveness and sustainability of international and global corporate strategies, analyze the benefits and shortcomings of various multinational organizational structures, compare the relative merits of different modes of global market entry, and understand the underlying conditions of the international economy that influence global competitive behavior activity such as economic, legal, political and cultural differences, exchange rates, comparative national advantage, national economic policy, the role of international agreements and customs unions, and balance of trade and payments.


MOR-492: Syllabus

MOR 492 Syllabus

MOR 492 GLOBAL STRATEGY Spring, 2006

2

COURSE EVALUATION Course grades will be determined by students’ relative performance on the following course components: Course Contribution (participation and unannounced quizzes) 20% Individual Case Analysis (one) 10 Group Case Analysis (one) 10 Doing Business with Mexico Group Project and Presentation 25

First Mid-term Exam 15 Second Mid-term Exam 20 100% In order to successfully pass this course, a passing grade (> 50%) must be achieved in each individual course component. Missed mid-terms and/or assignments severely reduce a students grade. Plus and minus shades will be assigned to those immediately above or below grade cutoff points. The distribution of grades will closely follow the guidelines of the Marshall School of Business (an average class GPA of 3.3). ATTENDANCE POLICY Class attendance is absolutely essential. All missed classes will be noted. The policy on missed classes is to allow each student three (3) absences, no questions asked, no penalty. All further absences over the limit will reduce the student's participation grade, no questions asked, no excuses of any kind expected or accepted. Students with an excessive number of absences are at risk of failing the course. Only Official University engagements, such as scheduled debating events, sports events, are excepted from this policy. Job interviews, etc., are not excused, so choose your absences carefully. Habitual lateness (and leaving class early), for whatever reason, will be noted as evidence of low course commitment, and penalized. Simply put, you cannot learn for our class discussions, and your classmates cannot learn from you, if you are not present. COURSE CONTRIBUTION Since this course is principally a case and seminar class, your overall commitment and attitude toward this course, and your daily active verbal participation (speaking and listening) in classroom discussions, will be closely monitored. In grading class participation, we will look at both the quantity and quality of your class contributions/interventions. Class participation is obviously a function of preparation, skills, attitude, and a willingness to actively commit yourself in front of your instructor and colleagues. A classroom is a cost-free environment for experimenting and learning to "play the game." Make use of it. Shyness is no excuse. With regard to quality, the dimensions that we look for include: Relevance -- does the comment bear on the subject at hand? Comments that do not link up with what the discussion is focusing on can actually detract from the learning experience. Causal Linkage -- are the logical antecedents or consequences of a particular argument traced out? Comments that push the implications of a fact or idea as far as possible are generally superior. Responsiveness -- does the comment react in an important way to what someone else has said? Analysis -- is the reasoning employed consistent and logical? Evidence -- have data from the case, from personal experience, from general knowledge been employed to support the assertions made? Importance -- does the contribution further our understanding of the issues at hand? Is a connection made with other cases we have analyzed? Clarity -- is the comment succinct and understandable? Does it stick to the subject or does it wander? All students will be formally called on, at random, to take the lead in various aspects of class discussions at least once or twice during the semester. If the student called upon is not present, is late, or is not sufficiently prepared to make a substantial contribution to the class discussion, he/she will lose points for class contribution. If the student makes helpful comments, he/she will accumulate points for class contribution. Since it is unlikely that there will be


MOR-492: Syllabus

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3

enough opportunities to call on each student more than once or twice, be warned that failure to be thoroughly prepared, on all occasions, can be devastating to your overall grade. Each student will receive a score for participation at the end of each lecture/discussion and case discussion session. No Credit Students, though present, who make no contributions, will receive no credit. A Little Credit The simple recitation of facts from the case will receive some credit toward the student’s class contribution score. More Credit Comments that do more than simply recite case facts will receive significantly greater credit towards a student’s class contribution score. For example, comments that provide synthesis or raise counterintuitive points, will add much more to a student’s class contribution score. Gold-Star Credit Students who substantially advance the learning of the whole class by providing non-intuitive analyses, profound insights, or “over the top” quantitative analyses, will receive maximum credit. Negative Credit Comments that contain factual misstatements, demonstrate lack of adequate preparation, or are distracting because they come too late in the discussion, will be penalized. Attempts to dominate class discussion rarely result in consistent and significant contributions. Participation Cards: At the end of each case discussion, students who actively participated in the discussion will be asked to turn in a “Participation Card”. These cards should list your name, the date, the case discussed that day, and a synopsis of your contributions during that day’s discussion. The Participation Cards will be used in combination with the instructor’s own daily evaluations to determine your participation grade for the day. For this purpose, please purchase a package of 3x5 index cards and bring them to each class. Group Article Presentations and Critiques: On days when additional articles have been assigned one group will be given the task of reviewing and critiquing each article. Groups should creatively think of ways to help the other students in class learn the assigned materials. These presentations will be evaluated and will factor into determining a students overall course contribution grade. Unannounced Quizzes: Short unannounced quizzes may be given at any time during the course to test the level of student preparation for lecture and case discussions. Multiple choice and short answer questions may be given at the beginning of classes where a case is assigned for class discussion. No make-up opportunities will be given to students who are absent or late. Student performance on these pop-quizzes will be used to determine a student’s participation grade. INDIVIDUAL CASE ANALYSIS Students must select a case and prepare a comprehensive external, competitive, and internal analysis, and provide appropriate strategic recommendations and implementation plans. The individual case analysis should include a “consulting format” report with a carefully prepared one page executive brief (attached to the front) containing the essence of the critical issues, analysis and strategic recommendations which have detailed in your report. A “consulting format” report should contain powerpoint slides which are essentially visual in appearance. Examples of reports will be presented in class. Please note carefully those cases which can be prepared as an individual analysis. They are designated by an “ica.” More detail will be given in class. The individual case analysis is 10 percent of the course grade. Students must be present in class to submit individual assignments, and they must be submitted at the beginning of class. Unfortunately, late individual assignments will not be accepted. Students may submit a second individual case assignment if they are not satisfied with the first grade received. The better of the two individual assignments will be used in determining your final course grade. GROUP CASE ANALYSIS I will assist all students in forming groups. I will attempt to ensure a proportional distribution of women and men in each group. In forming groups I will also ensure that no group has more than two non-native English speakers. Additionally, international students will be distributed across groups so as to ensure within-group diversity.


MOR-492: Syllabus

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4

The group case analysis should include a carefully prepared report with a two-page executive brief. Your report should be in “consulting format”. Please note carefully those cases that can be prepared as a group case analysis. They are designated by a “gca” on the course schedule. More detail will be given in class. The group case analysis is 10 percent of the course grade. Note: Each group must submit a GCA, in Modules I or II, before the first Mid-term Exam which is scheduled for Wednesday, February 14th. Late group case analyses will not be accepted. Groups may submit a second group case assignment if they are not satisfied with the grade received on the first. The better of the two grades will be used in determining the final course grade for all group members. INTERNATIONAL FIELD TRIP TO MEXICO This course includes a MANDATORY field trip to Tijuana and Ensenada, Mexico. The dates and length of the international field trip are still to be determined but are likely to be March 1-3. We are planning a two-day trip (Friday and Saturday) where we will study local Mexican businesses, Maquiladoras (multinational companies with facilities in Mexico which benefit from free trade agreements), meet with local Mexican government officials, and study local culture and business practices. The cost of the trip will be subsidized by USC’s CIBER (Center for International Business Education and Research) and the USC Marshall Undergrad Program, but will require students to contribute to the cost of the trip. The trip will require students to make arrangements to miss classes, and/or work obligations on those days. You should ask your professors and employers for permission to be absent now. Participation on the field trip to Mexico is mandatory. You must have a valid passport for this trip. If you DO NOT have a passport, you must apply for one IMMEDIATELY. DOING BUSINESS WITH MEXICO GROUP REPORT AND PRESENTATION Assignment: If you were advising a global company not already present in Mexico (or another country such as China), would you advise them to enter the “x” business sector? Why or Why not? If yes, How? If not, what would change your decision? Your analysis should consider how you would enter and market products to the lowest tiers for the consumer sector. [Where “x” represents an industrial, retail, financial, or service sector of your choice. For example, automotive sector, textile sector, tourism sector, electronics, retail, etc.] Creativity in framing your project is encouraged. While the primary assignment is to take a U.S. business (not currently doing business in Mexico) to Mexico and enter all segments of the Mexican market, you may structure your assignment differently. You could consider bringing a Mexican company to the US. Or you could consider taking a U.S. company to another global market instead of Mexico. Or you could consider bringing a non-US business to Mexico. Any variation on the topic should be outlined in a short memo and be presented in advance of all deadline to me for feedback and acceptance. Assess the opportunity for an existing global corporation, typically a U.S. firm in the same sector but not already present in Mexico. Prepare your report as if you were going to present your findings to the top management executive team of the global company. Your report should examine the challenges of entering all segments of the Mexican market place. You must consider how to enter the fourth and “fifth” tiers of the consumer market place. If you choose to enter, why and how do you enter this sector, i.e., a recommended entry strategy for the global firm including an analysis of which segment of the sector you would enter, the mode of entry you would choose. If not, why not? Is this decision contingent on some factors, and what are these factors? Regardless of whether you chose to enter or not to enter, what would make you change your decision? What indicators do you look for to change your decision?


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5

To support your recommendation, the following key dimensions should be addressed

(Whenever possible, you should collect data and use statistical analysis to support your arguments. These data should be presented clearly in tables and figures both in the report and the presentation):

1) Market Potential: For example: Importance of sector to economy in terms of absolute size and percentage of

the sector in the economy, employment and any other dimensions, growth rate of sector, profitability in then sector, foreign investment in sector, sources of foreign investment.

2) Competition in the Sector: For example: who are the players, their market shares, what types of strategies are they following, domestic players and multi-national players, countries of origin of key multi-national players, who are the major investors in the sector—domestic and multi-nationals, what are the primary ways in which they compete, sources of competitive advantage of key players, value chain configurations of key players.

3) Strategic Importance to Mexico of the Sector: For example: does Mexico have factor endowment advantages in this sector, is Mexico a lead market for trends and developments in the sector, are there related and supporting industries that support the development of this industry in the country, how important is Mexico in the global competitive battles among major international players in this sector, how important is this market as a platform for expansion into surrounding countries.

4) Profitability and Growth rates: For example: current profitability of the sector as a whole, differences in the profitability of different strategies of competitors, attractive competitive positions of incumbents, potentially attractive strategic positions for new entrants.

5) Key Institutional Forces / Institutional Voids (Economic, Political, Legal, Technological, and

Social Context) affecting Sector including any barriers to entry: For example: Economic policies, Political forces, Regulatory framework, Technological forces, Social changes; focus should be on laying out the current context and what is changing; focus should be on only the major issues not a laundry list; in particular, you should address key impediments or barriers to entry faced by foreign firms seeking to enter Mexico especially with respect to this particular sector.

6) Marketing Analysis: For example: what are the primary target markets, what are the needs and preferences

of the target markets regarding the sector, what are customer attitudes and perceptions of the sector, what are the key trends in customer demand and behavior impacting the sector, how satisfied are customers with the sector, what products and services are typically offered, and how are the products and services priced, promoted and positioned relative to the competition. How is the consumer market segmented? What are lowest tiers of the consumer market like?

7) Comparison of Key Characteristics of Sector with Same Sector in the U.S. Economy: For example: a comparison of the key characteristics and features of the sector with the same sector in the U.S.; in particular, you may compare the structure of the industry, key operating characteristics, cost and quality competitiveness of the sector or key players in the sector; value chain configurations and so on.

8) Sector Evolution: For example: How is the sector likely to evolve in the future and why so; what key

indicators of evolution should an analysis focus on to understand the changes in the industry; how is the structure of the sector likely to change?

9) Entry Strategy: For example: If you choose to enter the market, how does your entry strategy address the

entry barriers described in section 5 and the evolution of the sector described in section 8? If you chose not to enter the market, come up with a strategy that would reduce the risk of entry if a U.S. company decided to enter the market in spite of your recommendations.

Page Limit You should limit your report to 2 pages of executive summary, and up to 10-15 pages of appropriate “consulting format” presentation slides. Fewer pages would be better if you can more effectively present the data in


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6

diagrams and tables (and Powerpoint slides). Make use of tables and charts to present as much information as parsimoniously as possible. You will not have enough time to be able to provide a full comprehensive treatment of the assignment, so focus on the most important issues in each area outlined above. Please note: Cases are not good models for your group project because they are intendedly descriptive, and, on purpose lack substantive analysis. Your project should be long on analysis and short on description. The report and presentation is 25 percent of the course grade. Late projects will be penalized 10 percent per day late, including weekends. The 25 percent report grade will be divided into 15 percent for the written report, which I will assign, and 10 percent for the class presentation. The class presentation grade will be determined by the class as a whole. Member of the class will be required to rank all the group presentations. Your average presentation ranking will determine your presentation grade. The top ranked group will receive an A, the bottom ranked group will received a B-. In preparing your Doing Business in Mexico presentation you should carefully consider your audience; your classmates. Be sure to prepare your verbal/oral presentation in a way that teaches them something new and interesting. It is difficult to educate without entertaining, although it is easier to entertain without educating. Be careful to get the education part right. Your written reports should necessarily be more comprehensive, including all appropriate detailed analyses. However, an oral presentation, to your classmates who have also prepared similar reports, will necessarily be different than your written report.

MID-TERM EXAMS Two mid-term exams have been scheduled for this course. These mid-terms will cover all the assigned readings, course lectures, and case studies in the modules preceding the mid-terms. The mid-term exams will consist of multiple choice questions, short answer and short essay questions on all assigned readings and cases. Students who miss mid-terms without prior arrangement will receive a grade of zero. See Course Schedule for the dates of the mid-term exams. COURSE MATERIAL A series of cases and readings have been assigned for this course. They are available through University Partners in the University Book Store. When necessary, your instructors may place additional materials in the bookstore for you to purchase. COURSE COMMUNICATION: BLACKBOARD An “Electronic Folder” has been created for this course in BLACKBOARD. You should begin the habit of checking the BLACKBOARD folder on a very regular basis. The course syllabus, case discussion and assignment information have been posted to the MOR 492 folder. Additional course lecture notes/materials, further details on assigned cases and the group projects, and general course announcements, will be posted to the folder throughout the semester. STUDENT REPRESENTATIVE You will be asked to elect a Section Representative during our first session. The selected student representative will act as a liaison between the section and the instructor to provide informal feedback and communication, particularly on issues that individual students may not wish to raise personally with the instructor. OFFICE HOURS AND APPOINTMENTS


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7

I have set aside the hour before lunch on Monday and Wednesday for “open” office hours, and 30 minutes before the afternoon class, for those who would like/need to discuss specific issues related to the course. I will also make appointments for those who cannot meet me during the “open” office hours. ACADEMIC INTEGRITY

The following information on academic integrity, dishonesty, and the grading standard are placed here at the recommendation of the School of Business Administration Faculty and are taken from the Faculty Handbook. “The University, as an instrument of learning, is predicated on the existence of an environment of integrity. As members of the academic community, faculty, students, and administrative officials share the responsibility for maintaining this environment. Faculty have the primary responsibility for establishing and maintaining an atmosphere and attitude of academic integrity such that the enterprise may flourish in an open and honest way. Students share this responsibility for maintaining standards of academic performance and classroom behavior conducive to the learning process. Administrative officials are responsible for the establishment and maintenance of procedures to support and enforce those academic standards. Thus, the entire University community bears the responsibility for maintaining an environment of integrity and for taking appropriate action to sanction individuals involved in any violation. When there is a clear indication that such individuals are unwilling or unable to support these standards, they should not be allowed to remain in the University.” (Faculty Handbook, 1994: 20) Academic dishonesty includes: (Faculty Handbook, 1994: 21-22) 1. Examination behavior - any use of external assistance during an examination shall be considered academically

dishonest unless expressly permitted by the teacher. 2. Fabrication - any intentional falsification or invention of data or citation in an academic exercise will be

considered a violation of academic integrity. 3. Plagiarism - the appropriation and subsequent passing off of another’s ideas or words as one’s own. If the

words or ideas of another are used, acknowledgment of the original source must be made through recognized referencing practices.

4. Other Types of Academic Dishonesty - submitting a paper written by or obtained from another, using a paper or essay in more than one class without the teacher’s express permission, obtaining a copy of an examination in advance without the knowledge and consent of the teacher, changing academic records outside of normal procedures and/or petitions, using another person to complete homework assignments or take-home exams without the knowledge or consent of the teacher.

The use of unauthorized material, communication with fellow students for course assignments, or during a mid-term examination, attempting to benefit from work of another student, past or present, and similar behavior that defeats the intent of an assignment or mid-term examination is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions accompanying examinations. Where a clear violation has occurred, however, the instructor may disqualify the student’s work as unacceptable and assign a failing mark on the paper. STUDENTS WITH DISABILITIES Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me as early in the semester as possible. Your letter must be specific as to the nature of any accommodations granted. DSP is located in STU 301 and is open 8:30 am to 5:00 pm, Monday through Friday. The telephone number for DSP is (213) 740-0776.


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8

RETURNED COURSEWORK Returned paperwork, unclaimed by a student, will be discarded after 4 weeks and hence, will not be available should a grade appeal be pursued following receipt of his/her grade. ABOUT YOUR PROFESSOR Carl Voigt is an Associate Professor of Strategy (Clinical) in the Management and Organization Department. He also received his Ph.D. from the Anderson School at UCLA in strategy and organization. He is a native New Zealander, although he completed his undergraduate work at Avondale College in New South Wales, Australia. Dr Voigt specializes in teaching competitive and global strategy, and management courses in both the undergraduate and MBA programs here at USC. His academic interests are in business, corporate and global strategy, and in particular in entrepreneurship. Dr. Voigt has consulted with firms and organizations in the entertainment, food processing, tourism, health care, engineering, telecommunications, defense, and not-for-profit sectors. He has also conducted numerous seminars for teams of managers in the areas of management and strategy. He is an academic consultant with the F.T.C. Line of Business program. Initially, Dr. Voigt began his career as a high school teacher. His first job was teaching high school business subjects on Guadalcanal in the Solomon Islands. During that time he also served as Chair of the Business Studies Curriculum Development Committee and a member of the National Secondary School Curriculum Committee for the Solomon Island government. Dr. Voigt has been awarded two Marshall’s Golden Apple teaching awards: one from the Marshall MBA students in 2001, and one from the Marshall undergrads in 2005. Dr. Voigt has previously been an Associate Dean of our Marshall Undergrad Program, MBA.PM and EMBA Programs, and Marshall MBA Program. He has also successfully coached several teams of Marshall undergraduates to world prominence in different case competitions. In April 2001 he helped coach four Marshall undergraduates to first place in McGill’s international case competition. In February 2000 he coached Marshall’s team to first place in the Marshall International Case Competition. And he also coached Marshall undergraduate teams to a second place finish in 1998, and a final four finish in 1999. In a “past” life, he was heavily involved in coaching basketball; having coached at the high school, college and international levels. While in the Solomon Islands he coached their national basketball team for 2 ½ years. Today, he is first and foremost a father. He spends most of his free time, now, organizing and coaching and refereeing in recreational programs for his children (He has three sons: 22, 17 and 13 years old, and a 12 year old daughter). Dr. Voigt’s wife, Diane, teaches grades 7-10. TENTATIVE COURSE SCHEDULE** ** Please note that this is a tentative course schedule. Changes may be necessary relative to coordinating our International Field Trip to Mexico. Additionally, some cases may be changed by the instructor. For those without a current valid passport, you must apply for a Passport. You will need

this for our field trip to Mexico in March. You must expedite your passport Session Date Case / Topic Course Deliverable


MOR-492: Syllabus

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9

1 1/8 Course Introduction Lecture/Discussion: What is Globalization and the Global Marketplace, really? Read: Gupta and Govindarajan. “Managing Global Expansion: A Conceptual Framework” I. COMPETING IN THE GLOBAL MARKETPLACE 2 1/10 Review/Introduction: First Principles and Core Concepts of Strategy Photo and Bio Read: Siegel, Introduction to Global Strategy 1/15 M L K H O L I D A Y 3 1/18 Case: Jollibee Food Corporation: International Expansion Immigration Documents

4 1/22 Case: Global Wine Wars: New World Challenges Old (A) gca/ica 5 1/24 Case: BRL Hardy: Globalizing an Australian Wine Company gca/ica Read: Ghemawat, “Regional Strategies for Global Leadership” II. GLOBALIZATION IN CONTEXT 6 1/29 Lecture/Discussion: Global Environmental Analysis: Frameworks for Analyzing Global Regions, Countries, Industries and Markets Read: Ghemawat, “Distance Still Matters: The Hard Reality of Global Expansion Note on Political Risk Analysis 7 1/31 Case: Toys “R” Us Japan ica Read: Prahalad and Lieberthal, “The End of Corporate Imperialism” 8 2/5 Lecture/Discussion: Country Analysis: Analyzing Opportunities and Challenges Case: Mexico: Unfinished Business Read: “Country Analysis” Selection of economic sector and focal company for doing business in Mexico project due *** 9 2/7 Case: The Competitive Advantage of China Read: Porter, “The Competitive Advantage of Nations” 10 2/12 Case: AmorePacific: From Local to Global Beauty gca/ica 11 2/14 FIRST MID-TERM EXAM 2/19 P R E S I D E N T S’ D A Y H O L I D A Y III. CREATING GLOBAL COMPETITIVE ADVANTAGES 12 2/21 Lecture/Discussion: Global Strategy: Creating Global Advantages and Building Strategic Multinational Capabilities Read: Ghemawat, “The Forgotten Strategy” 13 2/26 Case: S.A. Chupa Cups ica


MOR-492: Syllabus

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Read: Bartlett and Ghoshal, “Going Global: Lessons from Late Movers” 14 2/28 Case: The Globalization of CEMEX gca Read: MacMillan, van Putten, McGrath, “Global Gamesmanship” 3/1-3 I N T E R N A T I O N A L T R I P T O M E X I C O Mandatory 15 3/5 Case: Haier: Taking a Chinese Company Global ica IV. GLOBAL ENTRY STRATEGIES AND STRATEGIC ALLIANCES 16 3/7 Lecture/Discussion: Global Entry Strategies: Exporting, Foreign Direct Investments, Joint Ventures and Strategic Alliances Read: Hamel, Doz and Prahalad, “Collaborate with Your Competitors – and win” Working Outline, with designation of individual responsibilities, of “Doing Business in Mexico” course group project due. *** 3/10-18 S P R I N G B R E A K 17 3/19 No Class Work on your “Doing Business in Mexico Project” 18 3/21 Case: Louis Vuitton Moet Hennessy: Expanding Brand Dominance in Asia ica 19 3/26 Case: Hong Kong Disney (A): The Walt Disney Perspective ica 20 3/28 Case: Flextronics International, Ltd. gca V. MANAGING AND ORGANIZING MULTINATIONAL CORPORATIONS 21 4/2 Lecture/Discussion: Global Business Management: Designing and Managing Multinational Corporations Read: Bartlett and Ghoshal, “What is a Global Manager?” 22 4/4 Case: P&G Japan: The SK-II Globalization Project ica 23 4/9 Case: Timberland: Commerce & Justice 24 4/11 SECOND MID-TERM EXAM 25 4/16 No Class: Work on Doing Business in Mexico Group Assignment ** VI. DOING BUSINESS IN MEXICO PROJECT PRESENTATIONS 26 4/18 Final Presentations: Doing Business in Mexico Report Due 27 4/23 Final Presentations 28 4/25 Final Presentations FINAL EXAM PERIOD (see Spring Schedule of Classes for date)


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Scheduled Feedback Sessions on Presentations and Report Please Note: Submitting Group Case Analyses All groups must submit a group case analysis (gca) before the first Mid-Term Exam. I will assist you with a within-group peer performance appraisal. You should plan on using this group peer evaluation intervention to give open, honesty, and constructive feedback to each other based on performance to this point in our class. It is better to deal with within-group issues earlier rather than later! Submitting Individual Case Analyses ica/gca: In modules I & II, you may submit an individual case analysis (ica), if your group choose not to prepare and submit a gca. Note, however, that you may not submit an ica at the same time your group submits a gca. Submit Photo and Bio by January 10 (Session 2) Please prepare a 5 x 7 inch card with a picture of yourself (depicted anyway you like so long as you are recognizable), with some brief information about yourself such as country of origin, languages you speak, your major, your short-term and long-term career goals, hobbies, eccentricities, and anything else that is interesting about yourself that you would like to share with me. Immigration Documents by January 18 (Session 3) You will need legal documents for our trip to Mexico in October. A current passport is required and/or alien resident card. As of January U.S. citizen must travel to and from Mexico with a valid passport. Please turn in a clear photocopy of your passport, alien resident card, or a copy of you application for a passport, on Wednesday, January 18th. Note: All cases and articles are in the Case Package available from the University Book Store.


MOR-492: Syllabus

Session 3: International Expansion: Global Strategy & Management Challenges Wednesday, 1/18 The Jollibee case traces the international expansion of Jollibee Foods Corporation, a Philipines based fast food company led by entrepreneur Tony Tan Caktiong (or TTC) that is expanding within Asia, and now beyond. The case begins with Noli Tingzon, the new general manager of the international division, facing three investment decisions. He has opportunities to expand into Papua New Guinea (PNG), Hong Kong, or the United States, and recognizes that his decision on which project to back will probably shape the broader strategic agenda and organizational model that the company’s international operations will follow. The Jollibee case will also give us practice at identifying a competitive strategy, drawing a business model, evaluating the sustainability of competitive advantages, and thinking critically about how far a company’s strategy can “travel” without modification. Read Gupta and Govindarajan. “Managing Global Expansion: A Conceptual Framework” Seigel “Introduction to Global Strategy” Case Jollibee Foods Corporation: International Expansion Discussion Questions 1. How was Jollibee able to build its dominant position in fast food in the Philippines? What sources

of competitive advantage was it able to develop against McDonald’s in its home market? 2. How would you evaluate Tony Kitchner’s effectiveness as the first head of Jollibee’s international

division? Does his broad strategic thrust make sense? How effectively did he develop the organization to implement his priorities?

3. As Noli Tingzon, how would you deal with the three options described at the end of the case?

How would you implement your decision? 4. Provide advice to the top management team at Jollibee. What should Tingzon do to ensure global

success? Which option should he select? What competitive advantages does he have to build on? What global competitive advantages can Tingzon exploit to improve its global position?

No formal turn-in assignment This is our first case and we will use it to get used to doing a case analysis. Reminder: Immigration Documents Please bring to class one of the following: (1) a clear photo copy of the information page from your passport (the copy of your photo should be recognizable), or (2) a copy of your birth certificate and one government issued photo ID. If you are an international student or an international exchange student (that is, a student on any type of visa), we need a copy of your visa, too.


MOR-492: Discussion Help

The Forgotten Strategy By Pankaj Ghemawat

• In many if not most cases, companies see globalization as a matter of taking a superior business model and extending it geographically, with necessary modifications, to maximize the firm’s economies of scale

• The key strategic challenge is simply to determine how much to adapt the business model – how much to standardize from country to country versus how much to localize to respond to local differences

• Many companies have moved toward more localization and less standardization • All companies that view global strategy in this way focus on similarities across countries, and the potential

for the scale economies that such commonalities unlock, as their primary source of added value • In their rush to exploit the similarities across borders, multinationals have discounted the original global

strategy: arbitrage, the strategy of difference • If they are to get their global strategies right in the long term, many companies will have to find ways to

combine the two approaches, despite the very real tensions between them The Strategy of Differences

• Arbitrage has been around for a very long time • Many of the industries in which arbitrage has historically been applied – farming, mining, and textiles – are

regarded as low-tech and mature • There is also the sense that well-run global enterprises have already reaped what competitive advantage

they can from arbitraging such generic factors of production as capital or labor, which, as one leading management guru has put it, can now be sourced efficiently with the click of a mouse

• The scope of arbitrage is as wide as the differences that remain among countries, which continue to be broad and deep

o Cultural Arbitrage Claims that the scope for cultural arbitrage is decreasing over time are clearly not true for

all countries and product categories Reduction in other dimensions of difference – tariffs or transport costs, for instance – can

also increase the viability of cultural arbitrage o Administrative Arbitrage

Legal, institutional, and political differences from country to country open up a host of strategic arbitrage opportunities

Tax differentials are an obvious example (NewsCorp) Few managers explicitly treat tax or other administrative arbitrages as a strategic tool,

despite their potential Executives are reluctant to draw attention to such arrangements for fear that they might

be outlawed In some cases, administrative arbitrageurs are actually breaking the law Many forms of administrative arbitrage involve working with or around given rules In some cases, companies can leverage political power to try and change the rules The potential for using government influence to create administrative arbitrage

opportunities remains high o Geographic Arbitrage

Transportation and communication costs have dropped sharply in the last few decades But the drop does not necessarily translate into a decrease in the scope of geographic

arbitrage strategies Although communication costs have dropped more sharply than transportation costs,

there are cases in the telecom sector where returns earned by focusing on residual distance have been higher than those gained by building or exploiting global connectivity

The geographic arbitrageurs that have lost some ground in recent decades are the great general trading companies of the past, which traditionally took advantage of large international variations in prices for a broad array of products by getting them from market A to market B


MOR-492: Reading Notes

o Economic Arbitrage Refers to the exploitation of specific economic factors that don’t derive directly from a

country’s culture, geography, or administrative context These factors include differences in the costs of labor and capital, as well as variations in

more industry-specific inputs such as knowledge or the availability of complementary products, technologies, and infrastructures

The best-known type of economic arbitrage is the exploitation of cheap labor, which is common in labor-intensive, capital-light industries like clothing

Labor arbitrage can be applied to R&D as well as to ongoing operations, as Emraer also demonstrates

One might argue that labor arbitrage is an unsustainable strategy in knowledge industries because labor costs quickly rise to match demand

Capital cost differentials would seem to offer slimmer pickings than labor cost differences; they are measured in single percentage points rather than multiples of ten or twenty

The subtlest forms of economic arbitrage involve the exploitation of knowledge differentials

Reconciling Difference and Similarity

• One would think that companies that try to exploit differences would not find it easy to exploit similarities as well

• Fundamental tensions between pursuing scale economies and playing the spreads exists • The data indicates that there is some merit to classifying companies according to the primary way they add

value through their international operations over long periods of time • For a start, it’s possible to apply different strategies to different elements of a business • The branded business grew to significant volumes but continued to generate losses because the competitive

environment was particularly tough for a late mover • The future of globalization process is by no means obvious • Markets may integrate further once economic conditions improve • Some argue that the process could actually shift into reverse, toward even greater economic isolation, if the

experience between the two World Wars is any precedent • The differences that make arbitrage valuable as well as the similarities that create scale economies will

remain with us for the foreseeable future



Going Global: Lessons from Late Movers By Christopher A. Bartlett and Sumantra Ghoshal

• Companies from developing countries have entered the game too late • They don’t have the resources; they can’t hope to compete against giants • There is plenty of evidence that the above is not true • The writers studied 12 emerging multinationals in depth

o They operate in wide range of businesses, but they are all based in countries that have not produced many successful multinationals

• The evolution into more-profitable product segments can be clearly tracked on what we call the value curve o All industries can be seen as a collection of product market segments o The value curve is a tool used to differentiate the various segments o The more profitable the segment, the more sophisticated are the capabilities needed to compete in

it – in R&D, distribution, or marketing A Model of Success

• Indian pharmaceutical company Ranbaxy o Moving into large markets like China and Russsia – required building new customer relationships,

a strong brand image, and different distribution channels o U.S. and European markets – the company needed to meet much more stringent regulatory

requirements o Their immediate challenge was to break out of the mind-set that they couldn’t compete

successfully on the global stage o Once freed of that burden, they had to find strategies in which being a late moves was a source of

competitive advantage rather than a disadvantage o They had to also develop a culture of continual cross-border learning

Breaking Out of the Marginal Mind-Set

• Companies from peripheral countries can fall into several traps, which we call liabilities of origin • Some companies feel as though they are locked in a prison of local standards because of the gap between

technical requirements and design norms at home and world-class standards abroad • If demand at home is strong, managers then can reasonably postpone the investments needed to comply

with international standards • Sometimes, management is either unaware of the company’s global potential or too debilitated by self-

doubt to capitalize on it • There are a few companies for which the liability of origin derives from a limited exposure to global

competition, leaving them overconfident in their abilities or blind to potential dangers • Our emerging multinationals started to overcome them by creating a push from home and a pull from

abroad o Push from home

Management’s greatest challenge is to shock or challenge the company to push it from its nest

Samsung example Another way to create a push from home requires a leap of faith more than a shock of

recognition These leaps can be dramatic, and they are always risky, like performing on a trapeze

without a net Some CEO’s do this by investing far ahead of demand, even if doing so reduces the

company’s responsiveness to its successful home market o Pull from abroad

Organizations need an engaged trading post, not just a passive listening post



Companies need offshore champions who can provide the young, overseas organization with credibility and confidence, both internally and externally

Singh from Ranbaxy created an organization in which managers from other parts of the world had a seat at the table on key corporate decisions

Devising Strategies for Late Movers

• The next major challenge is to choose a strategy to enter the global marketplace • Benchmark and sidestep

o Emerging multinationals can learn how to compete against the players in foreign markets simply by adapting and responding to those players as they enter the home market

o They benchmark the established global players and then maneuver around them, often by exploiting niches that the larger companies have overlooked

o Jollibee example • Confront and challenge

o When companies use their newcomer status to challenge the rules of the game, capitalizing on the inflexibilities in the existing players’ business models

o A more radical strategy is to introduce new business models that challenge the industry’s established rules of competition

o Though risky, this approach can be very effective in industries deeply embedded with tradition or comfortably divided among an established oligopoly

o The typical business model in these industries has become inflexible o BRL Hardy example

Learning How to Learn

• The global marketplace is information based and knowledge intensive • To survive in this environment you must learn how to learn: its is the central skill that allows a company to

move up the value curve • Protect the past

o Too many companies become so focused on where they are going that they forget where they are coming from

o With the Jollibee example, the new manager broke down the barriers between the international and domestic organizations and began building relationships that acknowledged his respect for their success and dependence on the home country’s expertise

• Build the future o Entering a new market requires considerably more than simply tweaking the home-market formula o Often companies lack the expertise needed to tailor the product or strategy to the new environment o So many emerging multinationals try to take a shortcut to learning by entering into a partnership

with a foreign company o In theory, companies can sidestep the disadvantages of partnering by buying the necessary

capabilities o After the false start, Hardy realized that in international business new capabilities cannot simply

be installed; they must be developed and internalized Having the Right Stuff

• Moving from the periphery into the mainstream of global competition is such a big leap that it was always led from the top

• The emerging multinationals always have leaders who drive them relentlessly up the value curve • Their commitment to global entrepreneurialism was rooted in an unshakable belief that their company

would succeed internationally • Their operation expanded, they all exhibited a remarkable openness to new ideas that would facilitate

internationalism – even when those ideas challenged established practice and core capabilities • These leaders are models for the heads of thousands of marginal companies in peripheral economies that

have the potential to become legitimate global players



MOR-492 1/10/07 2:04 PM

General Strategy

• Managing the future

Risk premiums, sustainable/renewable above normal returns

• ROA: Return on Assets

• ROIC

• EVA: Economic Value added

• Government no risk

• More risks with businesses

Willingness to buy

• Marketing, placement of staples in grocery stores

• Willingness to pay: Hospitals, we don’t shop around for the

cheapest emergency room

• Harley Davidson tattoos, you can charge them whatever you want

Cost minimization

• Fixed costs stay the same, economies of scale doesn’t affect fixed

costs

• Economies of scope, sharing fixed costs, so one item carries less of

a burden

o Trucking, want to fill up lorries so there is less cost on each

product

Not often is it possible to have both high volume and high margins

• It’s not true at all that high market share equals high profit

• There are two winning strategies

• One emphasize low price and high volume

Business Models

• Very important to know the business model, for direction in

decisions

• Investment goes into uniqueness

o Usually, some exceptions (R&D to lower costs)

When you have a good thing in business, people will try to copy you


MOR-492: Class Notes

• Rivals

o Entrants

o Buyers

o Substitutes

o Supply

• If there are many of these in some market, it is not attractive

• To solve this

• Barrier to entry to block entrants

Targeting

• Low Cost – Broad market focus: Ivory, Dial et cetera

• Low Cost – Focused market focus: The stuff you get in a hotel

• Differentiated – Broad:

Drug industry can charge a lot, because insurance covers it

• Most Pharmaceuticals are patent protected

• Huge barrier to entry when getting into this industry

Shocks and trends can have enormous affects on industries

Attractive products

• Valuable

• Rare

• (non)Imitable

• Organization

Strategy is your idea for making money

• How to sustain it over time

• Competitive threats, how to build up a defensible market position



Global Expansion

Nan WangWhitney Stambler

Keith ParkerKerry MacDonald

Gary LilardiChen Kang “CK” Hsu

Mark DavenportFebruary 12, 2007Group 5 “The Seven Samurai”

Decision Tree - Strategic Approach

Vision: To become a top 10company with $4 billion insales by increases overseassales from $100m to $1.2b.


MOR-492: Projects

Cosmetics – An Expanding Industry

Expected expansion ofcosmetics industry by 2009:

$180 Billion

• AmorePacific is involved in 49%of the potential cosmetics productscope (green shaded slices).

•Europe makes up the largestmarket followed by Asia with theUS closely behind in third.

Projected Performance

Threat ofNew Entrants

- High

Threat ofSubstitutes -

Low

Bargainingpower of

Suppliers -Low

Bargainingpower ofBuyers –

High/Medium

Rivalryamong

competitors -High

• Large selection of otherlabels• Low switching costs•Fragmented market• Some degree of customerloyalty

• Low barriers to entry•Low restrictive regulation(FDA)• Low capital requirements

• Many suppliers• Fragmented• Low switching costs

• Oral supplements• Tattooed make-up• Plastic/dermatology surgery• Spa treatments

• L’Oreal, The Procter & Gamble, UnileverPLC, Shiseido Co. Ltd., The Estee LauderCos. Inc., Avon Products, Beiersdorf AG,Johnson & Johnson, Alberto-Culver Co.,Kao Corp.•Similarity among brands•Increasing global concentration

From this analysis, AmorePacific is facing an overall medium competitive global cosmetic industry.

Porter’s 5 Forces


MOR-492: Projects

CAGE FrameworkDistance between Korea and other countries

Korea vs. China

Culture Distance

•Different languages

•Korean herbal medicine system was based on China’s

•Common Confucian tradition, colonial ties

Administrative Distance

•World Trade Organization

•China open to foreign investment and competition

Geographic Distance

•Land borders

•Northeast China is accessible from Korea, and shares

much history and culture

Economic Distance

•Korea is a developed country, China is a developing

country

Korea vs. U.S

Culture Distance

•Different languages

•Different religions and Value, Norms, and ethnicity

•Korean based business on personal contact

Administrative Distance

•World Trade Organization

•Korean government has heavy influence on economy

•Relatively unstable political climate due to North Korea

Geographic Distance

•Long Distance

•Korea has multiple American military bases

Economic Distance

•Rich-Rich: Replication

•Korea has complicated social and distribution network

Korea vs. FranceCulture Distance : - Different languages

- Different religions and Value, Norms, and ethnicity

- France has a relatively lax work environment

Administrative Distance - World Trade Organization

- France has strict socialist labor laws

- France has relatively unfriendly political environment for commerce

Geographic Distance - Long Distance

Economic Distance - Rich-Rich: Replication

Macro-Environment Analysis

P.E.S.T. AnalysisTechnological EnvironmentUnited States:• High cosmetics R&D• Rapidly expanding Internet based economy

China:•Evolving e-commerce

France:• Advanced cosmetic industry R&D infrastructure

Political EnvironmentUnited States:• Open trade• FDA approval required for most cosmetic products

China:•Law banning door-to-door sales in 1996•Shares much history and culture with Korea

France:• Labor Union activity can affect production costs

Economic EnvironmentUnited States:• Capitalist Economy

China:•1980s and 1990s became more open to foreigninvestment and competition• High GDP growth rate

France:•Strong currency (EU)

Social EnvironmentUnited States:•Mixed cultural environment

China:•Common Confucian tradition, colonial ties, and Koreanherbal medicine systems comes from China•Growing popularity on South Korean culture

France:•Prefer “Made in France” products•“the home of cosmetics”

AmorePacific wants to expand their product line internationally. Therefore, the company needs todetermine the right place to sell the maximum amount of their products to earn the highest profit. Eventhough there are cultural gaps between Korea the United States, China , and France, AmorePacificshould be able to make a profit in these different regions through thorough research of where to enter themarket in order to reach the widest consumer base.


MOR-492: Projects

Business Model

Loyal

Consumers

Premium

Prices

Increased

Margins

R&D

Brand

Marketing

Reputation Extra

Profits

Quality

As a cosmetics company, AmorePacific relies on Differentiation-based model to attract customers and build

consumer loyalty.

Door to Door

Personal Selling

Value Chain

R&D Raw Materials Manufacturing Distribution Marketing Retail

•Experience

•Knowledge

•Designated

national

research lab

by Korean

government

•Nano

structure

technologies

•Location

•botanicals

•chemicals

•location

•technology

•consolidation

•Differentiatio

n

•Brand

marketing

•Scope of

production line

•transportation

•Customer

relationship

•Changing of

consumer’s

taste

•Door to door

personalized

selling

•High-end

retail

distribution

AmorePacific serves a wide range of customers by offering products of different quality and levels of

innovation. Furthermore, AmorePacific’s unique culture of adaptability and unity has given more market

sensibility. Combined with their strong home base, high levels of innovation, successful marketing

strategy, expansive knowledge base, and a wide range of personalized products, AmorePacific is able to

obtain its current success.


MOR-492: Projects

ChinaFrance

USB

enefit

sC

ost

sR

isks

• Market Size and Growth

• Growth potential, unsaturated

• Joined the WTO

• Political stability

• Economic freedom lacking

• Unemployment levels high

• Access to majority ofpopulation is limited

• Door-to-door sales illegal

• World center for cosmeticproduct development

• Strong demand for cosmetics

• Reluctance to buy from newlydeveloped country

• Trouble reaching mid-pricedpharmacy channel

• Different cosmetic productpreferences

•Flagship product, a fragrance,has low loyalty levels

• Entry costs are high,especially in high profiletargeted locations

• Overcoming association with‘newly developed country’origins

• Brand confusion, with low-endproducts and high end offerings

• Reaching the non-immigrantmarket

• Highly regulated market

• Another world leader incosmetic product development

• Large number of Koreanimmigrants

• High discretionary income

Opportunities & Attractiveness

Well Equipped for High-End Market

DIFFERENTIATION

STRATEGY

Exclusive Ingredients

•Only available in Korean farms

•Hand picked rare ginsengaged precisely 6 years

•Unmatched perfectmicroclimate

•Green tea extract harvested byhand during 1st week of April

Unique Packaging

•Designed in multiple layers

•Protect products from light,heat, cold, and time

•Packaging is the “shape ofdevotion”

R&D Center

•Among the largest of anycosmetics company worldwide

•Exclusive “Nano DeliverySystem”, 1/1000th the size of a

skin cell

•Maximizes nurturing at thecellular level

•First in sector designated“National Research Lab”

New Products

•Quick launch of high-endbrands

•Innovative and research-basedproducts

Distribution

•Single brand booths

•High-tech door-to-door sales

•Hue Place


MOR-492: Projects

Success FactorsAmore Pacific’s success is the contribution of several factors that helped them establish their brand in

the Korean cosmetics market. Factors such as product quality, their market familiarity, and luck enables

them to become Korea’s leading producer of skin-care and cosmetic producs.

Market Familiarity Product Quality

Reputation

•Understand Korean

women and their

needs.

•AmorePacific is a

local Korean company

with majority of their

employees Korean.

Hence, they are able to

better understand their

market’s needs.

• High quality products

that works.

•Access to rare and

quality ingredients.

•Beauty professionals

to provide customer

service through spas,

department store

booths, etc.

Luck•AmorePacific is the first company to provide skin-care and cosmetic products to the

Korean market.

•Korean Economic crisis and depression creates a larger entry barrier for large

international competitior to enter Korea and enables AmorePacific to take advantage of their

market dominance.

Global StrategyIn order to understand AmorePacific’s strategy for going global, and what they wanted to achieve in their

global businesses, close attention should be paid to their levels of local responsiveness and global

coordination through this model.

Global

International

Glo

balC

oo

rdin

ati

on

Local Responsiveness

Transnational

Multi-Domestic

AmorePacific

(Tomorrow)

AmorePacific

(Now)

AmorePacific’s goal is tocompete with the bestinternational brands in the globalcosmetic market. To do this,they must appeal to the differentglobal consumer needs whilekeeping their costs at a minimum

One solution for this is to moveinto a Transnational-typecompany. This would mean highproduct differentiation for eachregional market (scope) whilekeeping high global coordinationto take advantage of economiesscale.

High

Low High


MOR-492: Projects

Initial Entry StrategyAmorePacific’s entry strategy for each of their global market were different to suit the heterogeneousity of

consumer preference. These differentiations included: Marketing strategy (target market and entry market),

Product lines, and Distribution/retail points.

Entry Market: High-MediumIncome

Products: Exclusive to Fragrances

Marketing Strategy:

•“M ade in France” Fragrances tocreate an exclusive image

•Different brand name to betterappeal to the local’s preference

Entry Market: Low-MediumIncome

Products: Skin-care and Cosmetics

Marketing Strategy:

•“Bottom-up” strategy

•Used Korean marketing strategybecause of similar marketenvironmet. (eg.Korean Models)

Entry Market: High-Medium Asianmarket

Products: Full line Skin-care andCosmetics

Marketing Strategy:

• Target the Asian market within theUS because they had more brandawareness

•High priced skin-care products topromote youthfulness

Recommendations

UnitedStates

France

China

• Strongest emphasis on the US market, largepotential for high investment returns.

•Top Down Approach.

•Focus on High-End department stores andretailers.

•Diversify marketing towards non-Asian andKorean consumers in US.

• Second strongest push for development in theFrench market, strategically necessary location forcosmetic companies.

•Retain separation from Corporate to allow localdecision making for the French market.

•Expand product line to build from the foothold offragrances. Bundle skincare products.

• Emerging market offers strong potential for high marketshare, but many barriers still exists low-end targetingcould influence global brand image

•Retain “Made in Korea” to ride the “Korean Wave.”

•Introduce higher-end products but retain accessibility toTier 3 consumers.


MOR-492: Projects

Implementation

France

•Exploit strong perfume market, but avoid cosmetics forthe near-term

•Sophisticated demand in perfume market can provideknowledge for introducing quality products for marketsin other countries

•Avoid “Made in Korea” concept

•Emphasize quality

United States

•Potential for highest returns because of profit premiums on high-end product lines with emphasis on research & technology

•Resources should be dedicated to securing premium distributionchannels for market introduction (i.e. Saks Fifth Avenue, Bergdorf-Goodman, Neiman Marcus, etc.)

•Penetrate top � down by catering to 1st & 2nd tier customers

All Global Markets

•Management should avoid reducing resourcecommitments because this will hinder goals toincrease worldwide market share. The strongfinancial position currently doesn’t necessitatereductions.

•Continue to pursue organic growth. Inorganicgrowth through acquisitions or joint ventures canlead to inconsistencies in operations anddamage AmorePacfic’s global image.

•Diverse entry strategies are necessary becauseof differences between cosmetic market maturityand consumer preferences by country.

China

•Continue bottom � up penetration

•Huge mass market opportunities in the lower tiersthrough low-end niches

•Emphasize “Made in Korea” to appeal toyoung popular culture

Conclusion• The United States would offer the highest returns on investments of

resources and managerial emphasis.

• France is strategically important in the global cosmetics market, as anindustry focal point.

• By moving from the multi-domestic to transnational approach, SuhKyung-Bae should be concerned with maintaining localresponsiveness and increasing global coordination.

• Joint ventures and acquisitions could be considered, but not at theexpense of losing control or sacrificing the company image.


MOR-492: Projects


MOR-492: Projects

4 N Q\ r UFu k» u D

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[email protected]

Tuesday, February 06, 2007 Tuesday, February 06 07 Tue, Feb 6 Tue, Feb 6, 2007

02/06/2007 06/02/2007 2007/02/06 02/2007 02-06-2007 06-02-2007 2007-02-06 02-2007 02/06/07 06/02/07 07/02/06 02/07 02-06-07 06-02-07 07-02-06 02-07

[MOR 492] White Board


MOR-492: Projects

P&G in Japan: The SK-II Globalization Project

Individual Case AnalysisKeith Parker

ID#6390.4899.77


MOR-492: Projects

In deciding upon which markets to enter, two factors are important to consider.

First, the individual country factors must be analyzed and compared with the core

competencies of the P & G organization. Second, and just as important, one must

understand the effects that entering either or both of these countries will have on the

newly created strategic organizational structure of P & G’s entire group.

In analyzing a potential move into the English market, it has become clear that

many of the core competencies that SK-II holds in Japan do not travel to the European

market. First, the four to six-step face washing program might be too intense for the

casual European woman. Further, service at the point of sale, one of AK-II’s strong

points, must be able to travel in order to ensure success. England, with its high minimum

wage, does not provide the most attractive market for such a sales model.

The consideration of entering the high-end Chinese market appears to be much

more appealing than the entry into the English market. While the overall Chinese market

may not be able to afford such expensive luxuries as the SK-II product line, the more

sophisticated inner-city markets with a high discretionary income appear to be a great

match for entry by SK-II. Olay has already done some of the work in testing the waters

by borrowing the service-based sales model and putting it into practice in China. This

model was highly successful, which lends to the idea that one of SK-II’s most important

core competencies will travel to the Chinese market.

Moving into the Chinese market seams to be a good move from most angles.

When taking into account the new organizational structure of P & G, which emphases the

firms’ ability to take successful products from separate GBUs and spread them across the

globe, a move into the English market seems to be a good test of this organizational

structure and may help newly appointed managers find their place in the organization.


MOR-492: Projects

Brin

gin

g S

K-II in

toB

ring

ing

SK

-II into

Eu

rop

eE

uro

pe

an

d C

hin

aa

nd

Ch

ina

Ke

ithP

ark

er

ID#

63

90

.48

99

.77


MOR-492: Projects

Ove

rvie

wO

ve

rvie

w•

Th

e c

ore

co

mp

ete

ncie

s o

f SK

-II trave

l be

st to

the

Asia

nM

ark

et

•T

he

Eu

rop

ea

n m

ark

et h

as d

iffere

nt p

refe

ren

ce

s th

an

the

Asia

n m

ark

et a

nd

ve

ry d

iffere

nt c

om

pe

titive

co

nd

ition

s

•M

ark

et s

ha

re o

f SK

-II is s

till low

in A

sia

, an

d w

ith its

pro

mis

e o

f su

cce

ss a

s s

ho

wn

by la

rge

gro

wth

in J

ap

an

,th

e m

ark

et in

Asia

tha

t mig

ht b

est b

ekn

ow

n fo

r be

ing

ho

me

to s

om

e o

f Asia

’s m

ost s

op

his

tica

ted

be

au

typ

rod

uct c

on

su

me

rs, s

o g

row

th s

ho

uld

be

focu

se

d in

this

reg

ion

•N

on

eth

ele

ss, w

ith th

e n

ew

org

an

iza

tion

al s

tructu

re o

fP

rocto

r an

d G

am

ble

su

pp

ortin

g th

e w

ide

sp

rea

d s

ale

of

su

cce

ssfu

l P &

G p

rod

ucts

, aw

ea

ry e

ntry

into

the

En

glis

hm

ark

et m

igh

t pro

vid

eclu

es a

s to

the

po

ten

tial fo

r furth

er

exp

an

sio

n in

to o

the

r we

ste

rn m

ark

ets


MOR-492: Projects

SK

-II So

urc

es o

f Su

cce

ss

SK

-II So

urc

es o

f Su

cce

ss

Re

se

arc

ha

nd

De

ve

lop

me

nt

Ad

ve

rtisin

gM

an

ufa

ctu

ring

Dis

tribu

tion

Se

rvic

ea

tC

ou

nte

r

Will

Lik

ely

trave

lsu

cce

ssfu

llyto

bo

thC

hin

aa

nd

Eu

rop

e

Will

Lik

ely

trave

lto

Ch

ina

,w

he

rep

refe

ren

ce

sa

resim

ilar.

InE

uro

pe

,th

ou

gh

,p

refe

ren

ce

sd

iffer

toth

ee

xte

nt

tha

tp

rod

ucts

ma

yn

ot

trave

lw

ell

toth

isa

rea

Ad

ve

rtisin

gm

eth

od

ssh

ou

ldtra

ve

lw

ell

toC

hin

a,

bu

tm

ay

req

uire

diffe

ren

tm

ed

ium

s.

InE

uro

pe

,T

Va

ds

are

too

exp

en

siv

e-

ma

yb

eto

od

ifficu

ltto

esta

blis

hre

co

gn

ition

an

db

uild

ma

rke

tsh

are

Dis

tribu

tion

me

tho

ds

ma

yn

ee

da

dju

stm

en

tfo

rE

uro

pe

,b

ut

P&

G’s

kn

ow

led

ge

with

dis

tribu

tion

inth

ism

ark

et

sh

ou

ldm

ake

for

asm

oo

thtra

nsitio

n

Hig

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bo

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sts

inth

eU

Kw

illm

ake

this

ve

ryd

ifficu

ltto

trave

l,th

ou

gh

inC

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ath

eo

pp

osite

istru

e,

as

lab

or

ism

uch

ch

ea

pe

rth

an

inJa

pa

n

•We

llre

se

arc

he

da

nd

de

ve

lop

ed

pro

du

ct;

pro

vid

es

the

mu

lti-ste

pp

roce

ss

de

sire

din

the

so

ph

istic

ate

db

ea

uty

pro

du

ct

ma

rke

to

fJa

pa

n

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rvic

ea

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eco

un

ter

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ng

,le

ad

ing

tocu

sto

me

rlo

ya

lty

•Inn

ova

tive

ad

ve

rtisin

ga

pp

ea

led

toJa

pa

ne

se

ma

rke

t


MOR-492: Projects

Ind

ustry

An

aly

sis

Ind

ustry

An

aly

sis

Th

rea

t of E

ntry

•Mo

stly

am

ark

etin

g-b

ase

din

du

stry

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hic

hre

qu

ires

he

avy

use

of

ca

pita

lto

ga

ina

sig

nific

an

tm

ark

et

sh

are

•La

rge

am

ou

nt

of

ca

pita

la

lso

req

uire

dfo

rre

se

arc

ha

nd

de

ve

lop

me

nt

•Bo

utiq

ue

en

tran

tsm

ay

find

nic

he

ma

rke

ts,

bu

tin

ord

er

tog

ain

asig

nific

an

tm

ark

et

sh

are

itis

imp

orta

nt

tob

ee

sta

blis

he

da

nd

ha

ve

ala

rge

ca

pita

lb

ase

Su

bs

titute

s•D

ep

en

din

go

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em

ark

et,

su

bstitu

tes

ma

yb

eco

mm

on

or

rare

InC

hin

a,

wo

me

nm

ay

ch

ose

toin

ste

ad

use

sim

ple

so

ap

an

dw

ate

r.In

Ja

pa

n,

tho

ug

h,

co

nsu

me

rso

ph

istic

atio

nle

nd

sto

the

ide

ath

at

the

reis

littlesu

bstitu

tion

for

be

au

typ

rod

ucts

Su

pp

lier

Po

we

r•S

up

plie

rsa

ree

mp

loye

es

alo

ng

the

en

tireva

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ch

ain

,ch

em

ica

lsu

pp

liers

,a

nd

su

pp

liers

of

se

lling

sp

ace

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ose

inco

ntro

lo

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sp

ace

ha

ve

ala

rge

am

ou

nt

of

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we

ra

sth

ere

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ited

sp

ace

an

dm

an

yp

eo

ple

co

mp

etin

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rit

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er

su

pp

liers

do

n’t

ha

ve

ve

rym

uch

po

we

r

Riv

alry

Hig

h

Lo

w

Hig

h

Me

diu

m

Me

diu

m-

Hig

h

•Firm

sco

mp

ete

he

avily

for

ma

rke

tsh

are

•Th

ere

are

ma

ny

pla

ye

rsin

the

be

au

typ

rod

ucts

ga

me

,in

cre

asin

griv

alry

;th

isis

esp

ecia

llytru

ein

sa

tura

ted

ma

rke

ts

Bu

ye

r Po

we

r•B

uye

rsa

recu

sto

me

rsa

tth

ee

nd

of

the

line

•Th

ese

cu

sto

me

rsh

ave

afa

irlyla

rge

am

ou

nt

of

bu

yin

gp

ow

er,

as

be

au

typ

rod

ucts

are

usu

ally

so

ldn

ea

rco

mp

etin

gb

ea

uty

pro

du

cts

so

itis

ea

sy

for

the

cu

sto

me

rto

wa

lka

wa

y


MOR-492: Projects

Po

ssib

le E

ntry

Co

nsid

era

tion

sP

ossib

le E

ntry

Co

nsid

era

tion

sL

oc

atio

n D

rive

rsC

os

t an

d V

olu

me

Driv

ers

By

exp

an

din

go

pe

ratio

ns,

mo

ve

me

nt

alo

ng

the

lea

rnin

gcu

rve

will

incre

ase

eco

no

mie

so

fre

plic

atio

nAs

initia

le

xp

an

sio

nin

toth

ese

ma

rke

tsw

illo

nly

inclu

de

on

ep

rod

uct

line

(SK

-II),o

pe

ratio

ns

will

no

tb

eb

en

efite

db

ye

co

no

mie

so

fsco

pe

As

with

eco

no

mie

so

fre

plic

atio

n,

an

din

cre

ase

into

tal

un

itsso

lda

fter

en

terin

ge

ithe

ro

fth

ese

ma

rke

tsw

illle

ad

tob

en

efit

from

eco

no

mie

so

fsca

le

Na

tion

al

diffe

ren

ce

sw

illb

elim

iting

inE

uro

pe

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ut

no

so

mu

ch

ine

nte

ring

Ch

ina

No

n-m

ark

et

stra

teg

ies

are

no

tsu

bsta

ntia

lin

this

ca

se

Glo

ba

lle

arn

ing

will

be

se

en

mo

st

ine

nte

ring

Eu

rop

e,

an

dw

illb

ea

nim

po

rtan

tte

st

of

the

ne

wo

rga

niz

atio

na

lstru

ctu

reo

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&G

With

the

siz

eo

fP

&G

’so

pe

ratio

ns

ino

the

ra

nd

sim

ilar

ind

ustrie

s,

the

firmw

illb

ea

ble

top

rovid

eso

me

of

the

flexib

ilityn

ee

de

din

en

terin

gE

uro

pe

an

dC

hin

a


MOR-492: Projects

Re

gio

n a

na

lysis

Re

gio

n a

na

lysis

En

gla

nd

Ch

ina

Ja

pa

n

Cle

arly

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ere

are

larg

ecu

ltura

ld

iffere

nce

sb

etw

ee

nth

eA

sia

nb

ea

uty

ma

rke

ta

nd

the

Eu

rop

ea

nb

ea

uty

ma

rke

t.W

hile

Ja

pa

nm

ay

be

the

so

ph

istic

ate

dm

ark

et

of

Asia

,w

he

rela

rge

am

ou

nts

of

de

ve

lop

me

nt

with

inth

ein

du

stry

occu

r,F

ran

ce

isth

ee

qu

iva

len

to

fE

uro

pe

.W

itho

ut

be

ing

inF

ran

ce

,S

K-

IIw

on

’tb

ea

ble

toe

ffectiv

ely

co

mp

ete

with

oth

er

Eu

rop

ea

nB

ea

uty

su

pp

liers

inE

ng

lan

d.

Ch

ina’s

top

-tier

ma

rke

tis

mo

resim

ilar

toJa

pa

n’s

ma

rke

t.A

ltho

ug

hth

eo

ve

rall

ma

rke

tm

ay

diffe

r,th

eta

rge

tm

ark

et

(I.e.

tho

se

inth

eb

igcitie

sw

ithla

rge

dis

cre

tion

ary

inco

me

)w

illm

ost

like

lyb

uy

SK

-IIp

rod

ucts

.E

vid

en

ce

of

this

ha

sa

rise

nfro

mO

lay’s

use

ofS

K-II’s

Ja

pa

ne

se

tactic

sin

Ch

ina

ino

rde

rto

justify

the

pric

ep

rem

ium

for

the

irp

rod

ucts

.T

his

ha

sb

ee

nw

ildly

su

cce

ssfu

l.

Ja

pa

n’s

ma

rke

tis

so

ph

istic

ate

d,

ha

so

na

ve

rag

ea

rela

tive

lyla

rge

am

ou

nt

of

dis

cre

tion

ary

inco

me

,a

nd

ha

sp

rove

nth

at

SK

-II,a

lon

gw

ithth

ese

rvic

es

an

dm

ark

etin

gth

at

acco

mp

an

yth

ep

rod

uct,

ca

nsu

cce

ed

inm

ark

ets

sim

ilar

toth

is


MOR-492: Projects

En

terin

g E

ng

lan

dE

nte

ring

En

gla

nd

•A

lthough

Euro

pe

may

notbe

ideally

suite

das

apote

ntia

llo

catio

nfo

rexpansio

nofth

eS

K-II

line,entry

into

this

mark

etm

ay

pro

vid

estra

tegic

benefit

•A

sm

ostla

rge

beauty

pro

ductcom

panie

sare

glo

balin

scale

,S

K-II

can

reap

the

benefits

ofknow

ledge

transfe

r,econom

ies

ofscope,

etcete

ra

•If

SK

-IIis

tobecom

ea

glo

bally

com

petitiv

ebra

nd,it

mustte

stth

ew

ate

rsand

make

apre

sence

inth

ew

este

rnw

orld

•E

ngla

nd,w

ithits

concentra

ted

departm

entsto

rechannels

thatw

ould

allo

wlim

ited

hig

h-c

ostserv

ice

sta

ffbutsim

ilar

serv

ice

quality

,w

ould

be

agood

choic

e

•W

hile

losses

may

occur,

this

isnecessary

inord

er

togain

astra

tegic

positio

nin

the

world

mark

et

•F

urth

er,

alth

ough

SK

-II’sp

rem

ium

positio

nin

gd

oesn’t

fitw

ell

with

P&

G’s

volu

me-b

ased

stra

tegy,it

will

com

plim

entO

lay’s

low

er-c

ostvolu

me

stra

tegy

and

pro

vid

eeconom

ies

ofscope

as

well

as

stro

nger

barg

ain

ing

pow

er

with

Engla

nd’s

very

pow

erfu

lconcentra

ted

reta

ilers

•F

urth

er,

as

bra

nd

image

and

serv

ice

quality

are

essentia

lto

the

success

ofS

K-II

inth

eB

ritish

mark

et,

ow

ners

hip

ofth

ese

com

ponents

should

be

as

full

as

possib

le.

Apartn

er

inente

ring

this

mark

et

would

be

agood

idea

for

the

oth

er

com

ponents

ofbusin

ess

opera

tion,th

ough,so

as

tom

inim

ize

risk

and

pro

vid

efo

ra

sm

ooth

er

exit

stra

tegy


MOR-492: Projects

En

terin

g C

hin

aE

nte

ring

Ch

ina

•T

he

Ch

ine

se

ma

rke

t,th

ou

gh

on

ave

rag

eq

uite

ab

itd

iffere

nt

from

the

Ja

pa

ne

se

ma

rke

tin

term

so

fp

ers

on

alsp

en

din

gp

ow

er

an

dso

ph

istic

ate

dp

refe

ren

ce

s,

ca

nstill

pro

vid

eS

K-II

with

ala

rge

am

ou

nt

of

su

cce

ss

inth

eA

sia

nm

ark

et

•In

the

larg

est,

we

alth

ies

citie

so

fC

hin

are

sid

eth

ose

wh

oh

ave

pre

fere

nce

ssim

ilar

toth

eJa

pa

ne

se

an

dth

eb

uyin

gp

ow

er

top

urc

ha

se

item

sm

ark

ed

up

as

hig

ha

sS

K-II

•A

sse

rvic

eis

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ch

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rge

pa

rto

fS

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rall

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ring

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y,

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ab

ilityto

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at

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me

lylo

wp

rice

inC

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aa

dd

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ta

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•O

lay

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rrow

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rvic

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ase

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ea

from

SK

-IIa

nd

pu

tit

tow

ork

inC

hin

a,

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ug

esu

cce

ss;

this

alo

ne

isp

roo

fth

at

on

eo

fS

K-II’s

stro

ng

est

co

reco

mp

ete

ncie

sw

illtra

ve

lin

toth

eC

hin

ese

ma

rke

ta

nd

me

et

su

cce

ss

•C

hin

a’s

po

ten

tialfo

rg

row

tha

nd

pro

fitis

stro

ng

en

ou

gh

for

on

eto

su

gg

est

tha

tP

&G

en

ter

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the

ma

rke

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er

ino

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rto

ma

xim

ize

pro

fit(I.e

.C

hin

ais

no

ta

ve

ryris

ky

en

try)


MOR-492: Projects

Ho

w D

oe

s T

his

Fit In

to T

he

Ho

w D

oe

s T

his

Fit In

to T

he

Org

an

iza

tion

al S

tructu

re?

Org

an

iza

tion

al S

tructu

re?

•As th

is c

ase

an

aly

sis

ma

yh

ave

pro

vid

ed

mo

reco

ncre

tere

aso

ns to

NO

T e

nte

r En

gla

nd

tha

n v

ice

vers

a, w

hen ta

kin

g in

to a

ccount P

& G

’s n

ew

org

an

iza

tion

al s

tructu

re o

ne

find

s th

at th

is is

cle

arly

no

t the

ca

se

•On

e o

f the

co

re c

om

pe

ten

cie

s o

f the

ne

wo

rga

niz

atio

na

l stru

ctu

re o

f P &

G is

its a

bility

to ta

ke

a g

oo

d id

ea

from

on

e G

BU

an

d m

ass m

ark

et th

esa

me

tech

no

log

y in

diffe

ren

t wa

ys th

rou

gh

ou

t the

wo

rld; S

K-II is

the

pe

rfect p

rod

uct to

ch

alle

ng

e th

isn

ew

org

an

iza

tion

al s

tructu

re a

nd

allo

wa

ll of th

en

ew

ly a

pp

oin

ted

ma

na

ge

rs to

esta

blis

hth

eir ro

le in

the

org

an

iza

tion


MOR-492: Projects

Me

xic

an

Exp

an

sio

n

Pre

sente

dby

Mark

Davenport

,C.K

.H

su,

Gary

Lilard

i,Kerr

yM

acD

onald

,

Keith

Park

er,

Whitney

Sta

mble

r,N

an

Wang

Th

e W

ahah

a G

rou

p


MOR-492: Projects

Executive

Sum

mary

Wahaha’sCompanyBackground

Wahaha

isth

ele

adin

gbevera

ge

pro

ducer

inC

hin

a.

Founded

by

Zong

Qin

gou

in1989,

the

com

pany

has

gro

wn

into

abillion

dollar

industr

y.

Wahaha

has

begun

alim

ited

expansio

nabro

ad

by

ente

ring

the

United

Sta

tes

and

putt

ing

its

pro

ducts

on

shelv

es

inN

ew

York

and

Los

Angele

s.

Part

of

Wahaha’s

str

ate

gy

isto

find

mark

ets

with

hig

hgro

wth

opport

unitie

s.

Mexico’sAttractivenesstoWahaha

The

Mexic

an

soft

dri

nk

mark

et

isan

extr

em

ely

att

ractive

mark

et

for

Wahaha.

Curr

ently,

Mexic

ois

ranked

the

worl

d’s

second

larg

est

soft

dri

nk

mark

et.

Within

the

soft

dri

nk

industr

y,

carb

onate

dbevera

ge

cate

gory

dom

inate

sw

ith

huge

revenues

repre

senting

over

60%

of

the

mark

et.

Carb

onate

sare

part

icula

rly

popula

rin

Mexic

odue

toth

ehot

clim

ate

,com

patibility

with

Mexic

an

food,

and

the

wid

em

ark

et

penetr

ation.

Infa

ct,

carb

onate

ddri

nks

have

becom

epart

of

Mexic

an

culture

;“m

any

Mexic

ans

would

find

itdifficult

toim

agin

ea

gath

eri

ng

with

frie

nds

without

carb

onate

s.”

[1]

Over

the

next

few

years

,th

esoft

dri

nk

mark

et

isexpecte

dto

be

valu

ed

at

$20.3

billion,

an

incre

ase

of

27%

sin

ce

2005.

Meanw

hile,

sale

svolu

me

isexpecte

dto

incre

ase

by

28.6

%to

49.6

billion

lite

rs.

Wahaha

should

take

advanta

ge

of

the

opport

unity

toente

rin

this

gro

win

geconom

y.

Wahaha’s

targ

et

custo

mers

are

sim

ilar

tow

ho

the

com

pany

appeals

toin

Chin

a.

The

com

pany

willaim

at

the

low

er

tiers

of

the

mark

et

(tie

rs3

and

4)

where

consum

ers

are

more

pri

ce-s

ensitiv

e.

InM

exic

o,

this

targ

et

mark

et

repre

sents

ala

rge

perc

enta

ge

of

the

overa

llM

exic

an

mark

et

(appro

xim

ate

ly64%

).

HowtoEnterintoMexico

There

are

many

options

for

Wahaha

toconsid

er

befo

reente

ring

Mexic

o.

How

ever,

out

of

the

many

possib

lepath

sth

ebest

choic

eis

tojo

int

ventu

rew

ith

Gro

upe

Danone.

Wahaha

and

Danone

have

an

exis

ting

rela

tionship

that

was

form

ed

in1996.

Curr

ently,

Danone

ow

ns

51%

of

Wahaha.

With

Danone's

assis

tance,

Wahaha

was

able

toin

vest

inadvanced

pro

duction

lines,

impro

ve

eff

icie

ncy,

and

pro

duction

double

dfr

om

1996

to1997.

Danone

has

been

opera

ting

inM

exic

ofo

rover

30

years

.W

ith

Danone’s

experi

ence

inM

exic

o,

Wahaha

can

use

its

know

ledge

of

the

mark

et

tohave

agre

ate

rchance

at

success.

Wahaha

willneed

tobuild

abott

ling

pla

nt,

but

with

the

hig

hgro

wth

of

the

mark

et,

the

bre

akeven

should

occur

duri

ng

the

second

year.

Als

o,

Danone

alr

eady

has

aw

ide

dis

trib

ution

and

manufa

ctu

ring

netw

ork

that

can

be

used

todis

trib

ute

Wahaha

pro

ducts

.W

ahaha

willbe

able

toente

rM

exic

oand

know

that

they

have

atr

ustw

ort

hy

part

ner

with

them

.

When

ente

ring

into

this

new

mark

et,

Wahaha

should

imple

ment

its

old

busin

ess

model,

but

make

som

enecessary

sm

all

adapta

tions.

InC

hin

a,

Wahaha

targ

ets

the

low

er

tiers

inru

ralre

gio

ns,

but

inM

exic

o,

these

are

as

are

not

as

popula

ted

and

popula

tion

inru

ralare

as

continues

todecline

There

fore

Wahaha

willneed


MOR-492: Projects

Executive

Sum

mary

Continued

CompetitorsWahahaWillFace

Wahaha

faces

majo

rcom

petition

inM

exic

o.

The

larg

est

are

Coke

and

Pepsiw

ho

dom

inate

the

mark

et

with

63%

com

bin

ed

mark

et

share

.H

ow

ever,

Wahaha

willnot

be

dir

ectly

com

peting

with

these

two

com

panie

s.

Inste

ad,

Wahaha

willlo

ok

togra

bsom

eof

the

mark

et

that

the

sm

aller

bra

nds

reach.

Big

Cola

isone

of

the

sm

aller

bra

nds

that

Wahaha

willbe

com

peting

with

and

matc

hin

gth

epri

ce

they

put

on

its

pro

ducts

.M

ark

et

trends

indic

ate

that

much

of

the

incre

ase

inconsum

ption

volu

mes

inM

exic

ois

dri

ven

by

low

-pri

ce

carb

onate

sth

at

are

more

aff

ord

able

for

consum

ers

.In

this

sense,

Wahaha

willnot

bestealing

mark

et

share

from

com

petito

rsas

much,

butexpanding

the

mark

et.

BarrierstoWahaha’sSuccessinMexico

While

Mexic

ohold

sgre

at

pote

ntialfo

rW

ahaha,

there

are

facto

rsth

at

may

hin

der

the

success

of

the

com

pany.

There

are

rela

tively

hig

hpoliticalri

sks

and

corr

uption

within

Mexic

o.

There

are

als

ocultura

ldis

tances

because

of

the

diffe

rence

inla

nguage

and

Mexic

ans

do

not

favor

Asia

npro

ducts

.H

ow

ever,

by

join

tventu

ring

with

Danone,

Wahaha

can

mitig

ate

these

cultura

ldis

tances

by

learn

ing

from

Danone’s

experi

ence

and

respondin

gto

these

diffe

rences

inth

em

ark

et.

HowtoSucceedinMexico

Inord

er

tosucceed

inth

eM

exic

an

carb

onate

ddri

nks

industr

y,

Wahaha

needs

tobuild

its

glo

balcom

petitive

advanta

ge.

Inord

er

todo

this

,th

ecom

pany

can

take

advanta

ge

of

its

know

ledge

incre

ating

econom

ies

of

scale

and

scope

that

impro

ved

trem

endously

with

their

join

tventu

rew

ith

Danone.

Additio

nally,

the

way

that

Wahaha

advert

ises

willhelp

spre

ad

its

bra

nd

image.

Wahaha

willre

plicate

the

mark

eting

str

ate

gy

that

ituses

inC

hin

aand

use

com

merc

ials

,pri

nt

ads,

and

cele

bri

tyendors

em

ents

.D

anone’s

30-y

ear

experi

ence

inM

exic

ow

illals

ohelp

Wahaha

succeed

inth

isnew

mark

et

and

captu

rea

port

ion

of

the

soft

dri

nk

industr

y.

[1]

“Soft

Dri

nks

–M

exic

o.”

Euro

monit

or

Inte

rnati

onal.

August

20

06.


MOR-492: Projects

Com

pany

Info

rmation


MOR-492: Projects

Who

isW

ahaha?

�“W

ahaha”

inChin

ese

refe

rsto

the

sound

kid

sm

ake

when

they

are

happy

and

laughin

g

�Found

by

Zong

Qin

ghou

in1989

�Private

-ow

ned

com

pany

and

big

gest

bevera

ge

pro

ducer

inChin

a

�M

anufa

ctu

res

non-a

lcoholic

bevera

ges

and

non-b

evera

ge

goods

inclu

din

gclo

thes,

snacks,

etc

.

�Responsib

lefo

r15.6

%ofChin

a's

tota

lbevera

ge

pro

duction

�RM

B4.6

5billion

into

talassets

�JV

ow

ners

hip

:Zong

Qin

ghou

hold

s49%

and

Danone

hold

s51%

�Lookin

gfo

rgro

wth

opport

unitie

s


MOR-492: Projects

There

are

severa

lentr

ystr

ate

gy

opti

ons

available

for

Wahaha

for

their

move

into

Mexic

o.T

he

most

capit

alin

tensiv

ein

vestm

ent

would

be

aw

holly-ow

ned

subsid

iary

.A

lthough

this

would

giv

eth

ecom

pany

com

ple

tecontr

olover

their

opera

tions,th

ism

ode

ofentr

yis

not

advis

able

as

Wahaha

lacks

experi

ence

inexpandin

git

sbusin

ess

inte

rnati

onally.

Rath

er

than

buildin

gth

eir

opera

tions,W

ahaha

could

acquir

ea

Mexic

an

bra

nd

that

isa

dir

ect

com

peti

tor

toW

ahaha,but

this

com

es

wit

hth

eri

sk

offa

ilin

gto

inte

gra

teth

ecom

panie

sor

overp

ayin

gfo

rth

ecom

pany.

Wahaha

could

consid

er

astr

ate

gic

allia

nce

such

as

ajo

int

ventu

rew

ith

Danone

or

apart

ners

hip

wit

ha

localbott

ler/

dis

trib

uto

rsuch

as

AR

CA

.

All

ofth

ese

are

via

ble

entr

ystr

ate

gie

s.

How

ever,

Wahaha

needs

tocare

fully

weig

hth

epro

sand

cons

ofeach

opti

on

toensure

successfu

lentr

yin

toM

exic

o.

Me

xic

oJointVenturewith

existingfirmin

Mexico

(Danone)

Partnershipwith

localbottler

ordistributor

(ARCA)

Acquisitionofa

localbrand

Directinvestment

withoutany

strategicalliances

Aft

er

consid

eri

ng

all

ofth

eopti

ons,w

ere

com

mend

that

Wahaha

ente

rth

eM

exic

an

mark

et

thro

ugh

ajo

int

ventu

rew

ith

Danone.W

ahaha’s

exis

ting

rela

tionship

wit

hD

anone

mit

igate

sm

uch

ofth

eri

sk

ofa

part

ner

hold

ing

up

Wahaha

because

Danone

isfinancia

lly

tied

toW

ahaha’s

success.Furt

herm

ore

,W

ahaha

could

take

advanta

ge

ofD

anone’s

alr

eady

esta

blished

dis

trib

uti

on

channels

inM

exic

o.

Danone

firs

tente

red

Mexic

oin

the

70

’sas

aw

holly

ow

ned

inte

rnati

onalsubsid

iary

,and

now

has

an

exte

nsiv

enetw

ork

ofdis

trib

uto

rs,re

tailers

,and

support

ing

industr

ies

under

its

belt

.T

his

would

,in

effect,

make

Wahaha’s

dis

trib

uti

on

inlo

calsuperm

ark

ets

and

mom

and

pop

sto

res

much

easie

rth

an

ifth

ey

go

inM

exic

oby

them

selv

es.

Wit

hD

anone

ow

nin

g5

1%

ofW

ahaha

inC

hin

a,th

ecom

panie

s’clo

se

rela

tionship

would

pro

vid

eW

ahaha

an

easie

rand

more

effecti

ve

entr

ystr

ate

gy.It

allow

sth

em

tobe

com

peti

tive

wit

hlo

cal

bra

nds

that

are

com

peti

ng

inth

elo

w-cost,

hig

h-volu

me

soft

dri

nk

pro

duct.

How

Wahaha

Should

Ente

rM

exic

o


MOR-492: Projects

Quality

Extr

a

Pro

fits

Advert

isin

gIm

pro

ve

bra

nd

aw

are

ness

and

use

pull

mark

eting

to

incre

ase

WTP In

cre

ased

Marg

in

Low

Unit

Cost

Econom

ies

Of

scale

sR&

DIn

novation

and

cre

ativity

for

new

taste

sand

pro

ducts

Volu

me

Num

ber

of

vis

its

And

repeating

vis

its

Price

The

exhib

itbelo

wis

adepic

tion

of

Wahaha’s

busin

ess

model.

The

main

focus

of

Wahaha

isin

cre

asin

gsale

svolu

me

incre

ative

and

eff

ective

ways.

Success

inth

eir

modelis

driven

by

quality

,R

&D

,advert

isin

g,

and

econom

ies

of

scale

.

Wahaha’s

busin

ess

modelis

transfe

rable

but

sm

all

adapta

tions

are

necessary

.In

Chin

a,

Wahaha

targ

ets

the

lower

tiers

inru

ralare

as.

However,

inM

exic

o,

the

rura

lare

as

are

not

as

popula

ted

and

the

popula

tion

inth

ese

are

as

isdeclinin

g.

For

this

reason,

they

must

alter

their

str

ate

gy

tore

ach

the

lower

tiers

inurb

an

and

suburb

an

are

as

as

well.

Wahaha’s

Busin

ess

Model


MOR-492: Projects

Bra

nd

Image

Many

carb

onate

d

dri

nks

taste

sim

ilar.

Bra

nd

image

willdri

ve

incre

ased

sale

s

and

mark

et

share

inth

elo

ng

run.

Dis

trib

ution

Wahaha’s

targ

et

mark

et

inclu

des

people

livin

gin

tiers

3

&4,

and

these

custo

mers

oft

en

buy

soda

from

am

ong

the

many

mom

and

pop

sto

res

inM

exic

o.

Itis

impera

tive

that

Wahaha

finds

aw

ay

todis

trib

ute

eff

ectively

toth

ese

scatt

ere

d

locations.

Sale

sV

olu

me

There

are

many

dete

rmin

ants

for

the

success

ofa

com

pany.In

the

case

ofW

ahaha,th

em

ost

import

ant

facto

ris

sale

svolu

me

whic

his

essential

togenera

ting

incom

e.W

ith

volu

me

bein

gth

efo

cus,

there

are

oth

er

facto

rsth

at

are

supple

menta

ry.

Advert

isin

gcan

incre

ase

bra

nd

equity

and

consum

ers

’w

illingness-t

o-p

ay.G

ood

advert

isin

g

builds

astr

ong

bra

nd

image,w

hic

hdrives

volu

me.

The

channels

for

dis

trib

ution

are

als

oextr

em

ely

import

ant—

part

icula

rly

inM

exic

ow

here

itis

a

challenge

tore

ach

custo

mers

with

so

many

sm

all

Advert

isin

gW

hen

ente

ring

a

new

mark

et,

advert

isin

gis

essentialto

buildin

g

consum

er

aw

are

ness

about

the

pro

duct.

Incre

ased

aw

are

ness

can

als

o

lead

toan

incre

ased

willingness-t

o-p

ay

and

hig

her

pro

fit

marg

ins.

CriticalS

uccess

Facto

rs


MOR-492: Projects

Industr

yand

Countr

yAnaly

sis


MOR-492: Projects

•More

than

90%

oftr

ade

under

free

trade

agre

em

ents

•Mem

ber

ofW

TO

,th

ere

fore

subje

ctto

regula

tions

Eco

no

mie

so

f

Scale

Nati

on

al

Dif

fere

nces

No

n-M

ark

et

Str

ate

gy

Fle

xib

ilit

yL

earn

ing

Econom

ies

ofscale

are

cru

cia

lfo

rW

ahaha

as

costsavin

gs

from

scale

effectis

cri

ticalto

sta

ycom

petitive

inth

esoft

dri

nk

industr

y.B

ycom

peting

with

hig

hvolu

me

&lo

wm

arg

inpro

ducts

,W

ahaha

has

tohave

low

cost

ofpro

duction

tosupport

the

low

pri

ces

thatth

ey

charg

e

Inord

er

tobe

successfu

lin

Mexic

o,it

isim

pera

tive

thatW

ahaha

take

full

advanta

ge

ofeconom

ies

ofscale

.

We

recom

mend

that

Wahaha

lim

its

their

pro

duct

line

when

ente

ring

Mexic

o.

This

isbecause

one

ofth

ecri

ticalsuccess

facto

rsfo

rth

ein

dustr

yis

scale

advanta

ge

and

notscope.

There

fore

,once

they

have

esta

blished

the

scale

they

needed,th

en

they

should

sta

rtconsid

eri

ng

expansio

nto

cre

ate

scope.

Eco

no

mie

so

f

Rep

licati

on

•Location

Advanta

ges:H

igh

volu

me

oflo

w-m

iddle

incom

econsum

ers

who

are

very

pri

ce

sensitiv

e

•Language

barr

ier

thatm

ight

affectth

ebra

nd

nam

e

•Diffe

rentconsum

er

taste

and

pre

fere

nce

mig

htaffectsale

s.

•Very

little

flexib

ility

as

ente

ring

anew

mark

etin

this

industr

yre

quir

es

very

hig

hcapitalcosts

.

•Ris

ks

may

be

reduced

ifbottling

or

oth

er

opera

tions

can

be

outs

ourc

ed

toa

local

part

ner.

Wahaha’s

pro

ductta

kes

advanta

ge

ofeconom

ies

ofre

plication

as

soft

dri

nks

are

sta

ndard

ized

and

are

manufa

ctu

red

thro

ugh

afixed

pro

duction

pro

cess.

There

fore

,th

ey

requir

elittle

modific

ation

and

are

sim

ple

topro

duce.

Eco

no

mie

so

f

Sco

pe

•Learn

scru

cia

lin

form

ation

aboutth

eM

exic

an

mark

et

(consum

er

pre

fere

nce,

cultura

ldiffe

rences,

dis

trib

ution

channel

effectiveness,etc

.)

•Str

ate

gic

allia

nce

with

Danone

would

pro

vid

eth

em

with

abetter

unders

tandin

gof

their

mark

et

This

dia

gra

mof

Volu

me

and

Location

drivers

allows

for

an

in-depth

analy

sis

of

Wahaha’s

opera

tions

and

the

advanta

ges

/dis

advanta

ges

of

movin

gin

toanoth

er

location.

This

willle

ad

toa

bett

er

unders

tandin

gof

the

com

pany’s

com

para

tive

advanta

ge.

Com

petitive

Advanta

ge

&Location

Drivers


MOR-492: Projects

Mexic

o is t

he w

orld’s

2nd

larg

est

soft

drink m

ark

et

CompoundAnnualGrowthRate

GlobalSoftDrinkSales(InbillionsUS$)

•C

arb

onate

sale

spro

ved

tobe

the

most

lucra

tive

inM

exic

o,

genera

ting

revenues

of

US$9.7

billion,

or

60.6

%of

the

soft

drink

mark

et

•Bott

led

wate

rgenera

tes

anoth

er

27.4

%of

sale

sof

soft

drinks

inM

exic

o

•PepsiC

oand

Coca-C

ola

are

both

purs

uin

gaggre

ssiv

ecam

paig

ns

togain

mark

et

share

inM

exic

o,

recogniz

ing

the

hig

hvalu

eof

the

mark

et

•By

2010,

the

Mexic

an

soft

drink

mark

et

isexpecte

dto

be

valu

ed

at

$20.3

billion,

an

incre

ase

of

27%

sin

ce

2005

•In

this

sam

etim

eperiod,

sale

svolu

me

isexpecte

dto

incre

ase

by

28.6

%to

49.6

billion

lite

rs

•In

2002,

the

Mexic

an

govern

ment

appro

ved

a20

perc

ent

tax

on

soft

drink

manufa

ctu

rers

who

use

fructo

se

sweete

ners

,in

ord

er

tohelp

stim

ula

teth

edom

estic

sugar

industr

y

Why

Go

To

Mexic

o?


MOR-492: Projects

FirmStrategy,

Structure,Rivalry

•R

ivalry

from

localcola

s

(Big

Cola

)and

leadin

g

cola

bra

nds

(C

oke,

Pepsi)

.•Low

-cost,

Hig

hVolu

me

str

ate

gy.

•Targ

ets

mid

dle

-lo

w

incom

egro

ups

FactorConditions

•W

ahaha

has

the

experience

of

doin

g

busin

ess

ina

develo

pin

gcountr

y.

•M

exic

ois

suited

for

their

busin

ess

modelbecause

of

sim

ilar

mark

et.

DemandConditions

•G

row

ing

mark

et

for

soft

drink

industr

yin

Mexic

o

•D

em

and

for

low

cost

soft

drink

ishig

hdue

tolo

wer

purc

hasin

gpow

er

of

consum

er

Relatedand

SupportingIndustry

•D

anon

could

pro

vid

e

dis

trib

ution

channels

for

Wahaha

•Larg

esuperm

ark

et

chain

saro

und

the

com

pany

toact

as

pote

ntialdis

trib

uto

r

(C

alim

ax)

Go

vern

men

t

Ch

an

ce

Port

er’s

dia

mond

analy

sis

of

com

petitive

facto

rsallows

us

toanaly

ze

Wahaha’s

com

petitive

advanta

ges

when

the

com

pany

makes

the

move.

With

good

dem

and

conditio

ns

and

support

ing

industr

ies,

we

can

conclu

de

that

there

are

sig

nific

ant

facto

rsth

at

can

pote

ntially

allow

them

tosucceed

inM

exic

o.

The

Key

toS

uccessfu

lM

ark

etE

ntr

ance


MOR-492: Projects

ThreatofEntry-Low

•M

ostly

am

ark

eting-based

industr

y,

whic

hre

quires

heavy

use

of

capitalto

gain

asig

nific

ant

mark

et

share

•O

nly

inth

eenerg

ydrink

cate

gory

do

we

see

fragm

enta

tion

•Fairly

sim

ple

toente

ras

there

are

many

bott

lers

tocontr

act

with,

but

difficult

togain

mark

et

share

without

advert

isin

gcapital

BuyerPower-Low

•The

buyers

are

bott

ling

com

panie

sand/or

reta

ilers

•Thre

at

of

forw

ard

inte

gra

tion:

many

larg

ecom

panie

sare

buyin

gth

ebott

lers

they

used

tosell

to•Bott

lers

are

undiffe

rentiate

d,

can

easily

be

substitu

ted

with

anoth

er

bott

ler

inth

eare

a

Substitutes-High

•M

any

substitu

tes

for

soft

drinks:

Wate

r,ju

ices,

alc

ohol,

and

energ

ydrinks

•Private

labels

show

thre

at

within

the

soft

drink

mark

et

(i.e.

sto

re-bra

nd

labels

or

‘spin

-off

s’)

Supplier

Power–

Medium/Low

•Suppliers

for

sugar

and

oth

er

raw

mate

rials

are

mostly

undiffe

rentiate

dand

have

litt

lepower

•Em

plo

yee

are

backed

by

unio

ns

Rivalry-Medium-

High

•Advert

isin

gis

heavy

from

the

majo

rcom

petito

rs,

rivalry

for

mark

et

share

isvery

hig

hThe

mark

et

has

been

recogniz

ed

by

majo

rpla

yers

as

agro

win

gm

ark

et,

spurn

ing

heavy

investm

ent

tocaptu

regro

wth

•Pepsi,

Coke,

Big

Cola

Heavy

rivalry

and

ahig

hth

reat

of

substitu

tes

off

sets

the

low

ratings

for

the

oth

er

facto

rsfo

rnew

entr

ants

.Low

supplier

and

buyer

power

make

the

industr

yatt

ractive

for

esta

blished

com

petito

rsand

those

with

larg

ecapitalsourc

es.

How

Attra

ctive

isth

eIn

dustr

y?


MOR-492: Projects

So

ftD

rin

ks

Ma

rke

tS

ha

re

•There

are

about

43

soft

drink

com

panie

sin

Mexic

o,

though

70%

of

sale

scam

efr

om

the

top

8com

panie

s

•Pepsiand

Coke

his

torically

split

up

Mexic

oin

tore

gio

ns,

where

each

would

dom

inate

the

mark

et;

this

has

changed

inre

cent

years

,in

cre

asin

gcom

petition

•In

2004,

Coca-C

ola

em

plo

yed

86,0

00

people

inM

exic

o

•PepsiC

oconsid

ers

Mexic

oits

second

most

import

ant

mark

et

outs

ide

of

the

US;

inearly

2002,

PepsiC

oannounced

its

goalto

invest

more

than

US$1.2

billion

inM

exic

oby

2006

•Bott

lers

inM

exic

ohave

been

consolidating

opera

tions,

leadin

gto

apossib

lestr

ength

enin

gof

buyer

power

•In

the

past,

Coke

and

Pepsitr

ied

topre

vent

sm

aller

com

panie

sfr

om

ente

ring

the

mark

et,

but

this

behavio

ris

no

longer

bein

gto

lera

ted.

in2005,

the

Mexic

an

govern

ment

fined

15

Coke

bott

lers

and

dis

trib

uto

rs$15

million

for

anti-com

petitive

pra

ctices.

The

deale

rs“u

nfa

irly

pre

ssure

dm

om

-and-pop

reta

ilers

not

tocarr

yBig

Cola

by

thre

ate

nin

gto

sto

pC

oke

deliveries

and

yank

from

their

tiny

sto

res

While

Coke

and

Pepsidom

inate

the

mark

et,

Wahaha

willnot

be

directly

com

peting

with

them

.In

ste

ad,W

ahaha

willfo

cus

on

gra

bbin

gsom

eofth

em

ark

et

that

the

sm

aller

bra

nds

reach.

There

fore

,W

ahaha

willbe

priced

low

er

than

Coke

and

Pepsi.

Com

petition

inM

exic

o


MOR-492: Projects

BackgroundFacts

–Bott

led

and

mark

ete

dby

Aje

max,

asubsid

iary

of

Peru

via

nfirm

Kola

Real

–Ente

red

Mexic

an

mark

et

in2002

–Pre

sently

accounts

for

5%

of

the

Mexic

an

dri

nk

mark

et

–In

vestm

ent

sta

nds

at

$40

million

in2004

TargetMarket

–3

rd&

4th

tier

of

the

pyra

mid

,sim

ilar

toW

ahaha

–“T

aste

sgood

as

long

as

itis

cold

,”accord

ing

toa

consum

er

–Sold

for

$1.1

3,

som

etim

es

as

low

as

87

cents

–Forc

ed

PepsiC

oto

low

er

pri

ces

Distribution

–Consid

ere

da

“counte

r-bra

nd”

–O

nly

28

dis

trib

ution

cente

rsand

sells

tosm

all

gro

cery

sto

res

–Busin

ess

modelbased

on

econom

ics

alo

ng

valu

echain

–Savin

gs

passed

alo

ng

toconsum

ers

–U

ses

freela

nce

vendors

who

open

up

new

mark

ets

for

Big

Cola

Main

Com

petito

r:

Wa

ha

ha

wil

lb

ed

ire

ctl

yc

om

pe

tin

gw

ith

Big

Co

la,

aP

eru

via

ne

ntr

an

tin

toM

exic

o.

Bo

thsh

are

the

sam

eta

rge

tm

ark

et

an

dw

ill

be

co

mp

eti

ng

fie

rce

lyto

co

me

ou

tw

ith

the

low

est

pri

ce

sin

ord

er

toa

ttra

ct

the

pri

ce

-se

nsi

tive

co

nsu

me

rs


MOR-492: Projects

CountryFactorEndowments

•U

nsta

ble

political

envir

onm

ent

Soft

Infrastructure

•Logis

tical

inte

rmedia

ries

–

dis

trib

ution

channels

are

lim

ited

inru

ral

are

as

•Legalsyste

m

HardInfrastructure

•Poor

sanitation

•In

adequate

waste

dis

posalfa

cilitie

s

•Conta

min

ate

dw

ate

r

•55%

of

Mexic

an

household

sw

ith

access

topip

ed

wate

rre

ceiv

ed

serv

ices

on

an

inte

rmitte

nt

basis

Th

em

ost

imp

ort

an

tc

ha

lle

ng

es

for

Wa

ha

ha

wil

lb

ed

eve

lop

ing

ao

n-s

ite

wa

ter

pu

rifi

ca

tio

nsy

ste

ma

nd

wo

rkin

gw

ith

the

loc

al

go

ve

rnm

en

tto

en

sure

are

gu

lar

wa

ter

sup

ply

at

the

irb

ott

lin

gp

lan

t.M

ore

ove

r,W

ah

ah

aw

ill

ne

ed

tore

lyo

na

ne

sta

bli

she

dp

art

ne

rfo

ra

de

qu

ate

dis

trib

uti

on

.B

uil

din

gth

eir

ow

nd

istr

ibu

tio

nc

ha

nn

el

wil

lb

eto

oc

ost

lya

nd

tim

ec

on

sum

ing

.

Institu

tionalV

oid

sA

naly

sis


MOR-492: Projects

P.E

.S.T

.A

na

lys

is

PoliticalEnvironment

•Federa

lRepublic

•C

om

merc

ialand

financia

ldependence

on

the

US

•Part

ofW

TO

,subje

ct

tore

gula

tions

•Ranked

as

num

ber

63

for

index

ofeconom

ic

freedom

•M

ixtu

reofU

Sconstitu

tionalth

eory

and

civ

il

law

syste

m

•Blu

ecollar

work

forc

eis

up

toa

6-d

ay,48-

hour

work

week

•M

exic

an

Federa

lLabor

Law

pre

vents

unsafe

work

ing

conditio

ns

•Fore

igners

are

not

allow

ed

toow

nla

nd

inth

e

restr

icte

dzone

EconomicEnvironment

•Tourism

inM

exic

ois

ala

rge

industr

y,

ranked

third

inim

port

ance

•Fre

em

ark

et

econom

y

•13th

larg

est

econom

yin

the

world

•Esta

blished

as

an

upper

mid

dle

-incom

e

countr

y

•G

DP

-per

capita:

$10,6

00

•U

nem

plo

ym

ent

rate

:3.2

%•U

ndere

mplo

ym

ent

ofabout

25%

•Fore

ign

Debt:

$178.3

billion

•Low

labor

wages

•Sta

ble

inflation

rate

5.4

%

•G

row

thra

te1.1

6%

SocialEnvironment

•M

ain

lyspeak

Spanis

h,and

som

eEnglish

dependin

gon

are

a

•Litera

cy

rate

was

at

92.2

%

•N

ooffic

ialre

ligio

n

•D

ress

and

gro

om

ing

are

sta

tus

sym

bols

TechnologicalEnvironment

•U

se

modern

technolo

gy

•W

eak

infr

astr

uctu

rein

cert

ain

are

as

•Avera

ge

wate

rtr

ansport

ation

The

econom

icconditio

ns

inM

exic

om

ake

this

an

att

ractive

mark

et

for

Wahaha

toente

r.

Although

there

are

negative

politicaland

econom

icaspects

inth

eM

exic

an

mark

et,

Wahaha

can

mitig

ate

these

facto

rsby

imple

menting

an

appro

priate

entr

ystr

ate

gy

and,

ultim

ate

ly,lo

wer

the

politicalrisk

and

benefit

from

the

gro

win

geconom

y.

Mexic

o’s

Macro

Environm

ent


MOR-492: Projects

Cultural

�D

onot

favor

Asia

npro

ducts

�M

ark

et

dom

inate

d

pro

ducts

:Coke

and

Pepsi

�M

ajo

rity

of

sto

res

are

sm

all

scale

(Mom

&Pop)

�D

iffe

rent

language

�D

iffe

rent

taste

s

&pre

fere

nces

Administrative

�H

igh

corr

uption

and

politicalrisk

�W

eak

law

enfo

rcem

ent

Geographic

�W

ate

r

conta

min

ation

�D

istr

ibution

mobility

islim

ited

inru

ralare

as

Economic

�Ranked

9th

most

impoveri

shed

out

of

102

develo

pin

g

countr

ies

�17.6

%of

the

popula

tion

isin

extr

em

epovert

y

�Severe

undere

mplo

ym

ent

for

much

of

the

popula

tion

�Consum

ers

are

price

sensitiv

e

Based

on

this

analy

sis

,W

ahaha

should

main

lyfo

cus

on

how

they

willget

their

pro

ducts

tobe

as

clo

se

as

possib

leto

the

lower

tiers

because

of

the

lim

ited

mobility.

Their

pro

duct

isalready

priced

low

toappealto

the

lower

mark

et,

so

the

financia

lsituation

inM

exic

oshould

not

be

am

ajo

rhurd

leto

overc

om

e.

Wahaha

should

be

able

tooverc

om

eth

em

obility

pro

ble

mbecause

they

face

the

sam

esituation

inC

hin

awhen

dis

trib

uting

toth

elo

wer

tiers

of

the

mark

et.

Als

o,

apart

ners

hip

with

acom

pany

that

has

been

inM

exic

ofo

ra

while

can

help

Wahaha

learn

and

respond

as

necessary

toth

ediffe

rences

inth

eM

exic

an

mark

et.

Wahaha’s

Dis

tance

Barr

iers


MOR-492: Projects

BENEFITS

•C

arb

onate

sale

slu

cra

tive

inM

exic

o,

genera

ting

revenues

of

US$9.7

billion

•PepsiC

oand

Coca-

Cola

purs

uin

gaggre

ssiv

ecam

paig

ns

togain

mark

et

share

,re

cogniz

ing

the

hig

hvalu

eof

the

mark

et

•By

2010,

Mexic

an

soft

drink

mark

et

tobe

valu

ed

at

$20.3

billion,

an

incre

ase

of

27%

sin

ce

2005

•By

2010,

sale

svolu

me

isto

incre

ase

by

28.6

%to

49.6

billion

lite

rs

COSTS

•H

ighly

fragm

ente

dcom

mand

and

com

munic

ation

str

uctu

re

•M

obility

lim

ited

inru

ral

are

as

•Lim

ited

purc

hasin

gpower

of

40%

Mexic

an

household

s

RISKS

•M

exic

an

drinkers

may

not

want

topurc

hase

anew

drink

from

aC

hin

ese

corp

ora

tion

•M

ay

not

be

able

topenetr

ate

mark

et

dom

inate

dby

Coca-

Cola

and

Pepsi

ATTRACTIVENESS

Although

there

are

obvio

us

costs

and

risks

(both

mark

et

and

non-m

ark

et

forc

es)

involv

ed

inente

ring

into

Mexic

o’s

soft

drink

mark

et,

the

lucra

tive

mark

et

offers

trem

endous

benefits

for

acom

pany

tocapitalize

on,as

agro

win

gdom

estic

dem

and

makes

itm

ore

wort

hw

hile

for

new

entr

ants

into

the

industr

y.

Benefits

Outw

eig

hC

osts

&R

isks


MOR-492: Projects

Entr

yStr

ate

gy


MOR-492: Projects

�H

ot

weath

er

inN

ort

hern

Mexic

o

incre

ases

import

ance

of

Sin

gle

Serv

efo

rmat

and

Coole

rs,

�Sta

ble

Pri

cin

gEnvir

onm

ent

�Pri

ces

do

not

fluctu

ate

�H

igh

Dem

and

per

Capita

GoalsforDistribution

�M

ust

esta

blish

am

eth

od

tore

ach

the

mom

and

pop

sto

res

�Exis

ting

transport

ation

infr

astr

uctu

recan

pose

challenges

tooverc

om

e

�Access

tobott

ling

facilitie

sw

hic

hare

geogra

phic

ally

dis

burs

ed

�Access

tow

ate

r

Whic

hever

dis

trib

ution

meth

od

Wahaha

chooses,it

must

be

able

toeffectively

reach

the

channels

show

nin

the

chart

belo

w.

Dis

trib

ution

Channels

inM

exic

o


MOR-492: Projects

�Low-cost

�U

tilize

exis

ting

expert

ise

�R

ela

tionship

swith

sto

res

already

esta

blished

�D

istr

ibution

infr

astr

uctu

rewill

already

be

inpla

ce

�Access

towate

rrights

isre

sponsib

ility

of

part

ner

�Easy

exit

str

ate

gy

�Less

financia

lrisk

�Because

have

part

ialowners

hip

of

Wahaha,

they

are

more

aligned

with

their

core

valu

es

�H

ave

apre

vio

usly

built

rela

tionship

with

dis

trib

uto

rs

�Share

shelf

space

insto

res

�G

ain

contr

olover

dis

trib

ution

�C

an

focus

on

Wahaha

bra

nd

inste

ad

of

com

peting

with

oth

ers

�D

istr

ibution

Infr

astr

uctu

rewill

already

be

inpla

ce

�C

an

levera

ge

exis

ting

rela

tionship

swith

sto

res

�C

an

levera

ge

exis

ting

rela

tionship

swith

consum

ers

�C

om

ple

tecontr

ol

over

entire

dis

trib

ution

pro

cess

�C

an

concentr

ate

on

Wahaha

bra

nd

only

�Ability

toset

up

new

channels

with

rura

llo

cations

�Lack

of

contr

olover

dis

trib

ution

�Part

ner

may

not

prioritize

bra

nd

�M

ust

share

shelf-

space

with

the

big

bra

nds.

�Their

pla

nts

are

only

inth

eNort

hern

regio

nof

Mexic

o

�M

ay

not

want

tohave

aJV

with

Wahaha

�Less

contr

olover

dis

trib

ution

�Lim

ited

dis

trib

ution

toth

eru

ralare

as

�H

igh

initia

lentr

ycost

�M

ust

main

tain

infr

astr

uctu

re

�M

ore

difficult

exit

str

ate

gy

�M

ore

financia

lrisk

ifacquire

adis

trib

uto

r

�Extr

em

ely

hig

hentr

ycost

�M

ust

secure

access

towate

rand

oth

er

resourc

es

�M

ust

main

tain

entire

infr

astr

uctu

re

�Very

difficult

exit

str

ate

gy

�W

illhave

towork

toesta

blish

new

rela

tionship

swith

sto

res

Co

ntr

ac

tw

ith

an

Ex

isti

ng

Dis

trib

uto

r-

AR

CA

Ac

qu

ire

an

Ex

isti

ng

Dis

trib

uto

r

Bu

ild

Ow

nD

istr

ibu

tio

n

Ne

two

rk

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JV

Pa

rtn

ers

hip

wit

h

Da

no

ne

Based

on

the

pro

sand

cons

inth

isanaly

sis

,it

com

es

down

todecid

ing

betw

een

contr

acting

with

AR

CA

or

aJV

with

Danone.

There

fore

,a

clo

ser

look

at

these

two

choic

es

isneeded

tom

ake

afinaldecis

ion

on

whic

hstr

ate

gy

touse.

Possib

leW

ays

toD

istr

ibute


MOR-492: Projects

•The

Com

pany

dis

trib

ute

sits

pro

ducts

innort

hern

Mexic

o,m

ain

lyin

the

sta

tes

ofN

uevo

Leon,C

oahuila,

Sonora

,Sin

alo

a,Baja

Califo

rnia

,Baja

Califo

rnia

Sur,

and

Tam

aulipas.

�C

urr

ently,ARC

Ahas

14

bott

ling

pla

nts

and

61

dis

trib

ution

cente

rs.

•Seekin

gopport

unitie

sto

div

ers

ify

port

folio

•Recent

new

pro

duct

launches:

•C

iel

Aquarius,

Min

ute

Maid

,Purified

Wate

r.

•Expansio

nto

West

Coast

•In

cre

ase

Advert

isin

g

•Reta

iler

Loyalty

Pro

gra

ms

Second-L

arg

est

bott

ler

inLatin

Am

erica

serv

ing

16

million

consum

ers

and

over

214,0

00

poin

ts-o

f-sale

.

•Resultin

gfr

om

the

merg

er

ofth

ree

ofth

eold

est

bott

lers

inM

exic

o–

Arg

os,

Arm

aand

Pro

cor-

Em

bote

lladora

sArc

a,

itw

as

cre

ate

din

2001.

AR

CA

Dis

trib

ution

Part

ners

hip


MOR-492: Projects

HistoryofCooperation

�W

ahaha

form

ed

aJoin

tVentu

rein

Chin

awith

Gro

upe

Danone

SA

in1996

�Investe

din

advanced

pro

duction

lines

and

impro

ved

eff

icie

ncy

�Pro

duction

double

din

just

one

year

�D

anone

curr

ently

owns

51%

of

Wahaha

30YearsofPresenceinMexico

�Entr

ance

in1976

“1st

Danone

Com

pany

outs

ide

Euro

pe

”

�Pio

neer

inC

orp

ora

teSocia

lR

esponsib

ility

�M

ark

et

share

leader

inth

eir

industr

y(41.3

%in

2006)

ExcellenceinExecution

�Shelf

space

leader

�33.5

%share

of

shelf

spaces

inle

adin

gsuperm

ark

et

chain

s

(in

clu

din

gC

alim

ax)

�10,0

00

PO

Sto

cate

rto

rura

lare

as

by

12/2007

As

there

isalready

ahis

tory

of

successfu

lcoopera

tion

betw

een

Wahaha

and

Danone

inC

hin

a,

Wahaha

can

appro

ach

Danone

inM

exic

oand

try

tore

plicate

their

join

tventu

repro

ject.

Havin

gspent

30

years

opera

ting

inM

exic

o,

Danone

willbe

able

topro

vid

eW

ahaha

with

asolid

footh

old

inth

em

ark

et

as

they

already

have

awid

edis

trib

ution

and

manufa

ctu

ring

netw

ork

.In

this

way,

Wahaha

willbe

able

toente

rth

enew

mark

et

of

Mexic

oknowin

gth

at

they

have

are

puta

ble

and

trustw

ort

hy

part

ner

toback

them

up.

Da

no

ne

’sM

ark

et

Sh

are

Gro

wth

:U

sin

gA

nE

xis

ting

Rela

tionship


MOR-492: Projects

Export

ing

Wahaha

willalter

their

entr

ystr

ate

gy

into

Mexic

oby

ship

pin

gth

esoda

concentr

ate

toD

anone.

Danone

willbott

leand

dis

trib

ute

the

pro

duct.

Wahaha

willavoid

ship

pin

gbott

led

soda

because

of

the

low

valu

e-to

-weig

ht

ratio

whic

hm

akes

itim

pra

ctical.

There

are

hig

hpoliticaland

financia

lrisks

toente

ring

the

mark

et

as

awholly-owned

subsid

iary

.There

fore

,to

mitig

ate

these

risks,

Wahaha

willJ.V

.with

Danone.

Glo

ba

l

Inte

rna

tio

na

l

LocalR

esponsiv

eness

GlobalCoordination

L oL o

L oH i

H iW

ah

ah

a&

Da

no

ne

JV

Polit

icalR

isk

Econ.Opportunity

L oL o

L oH i

H i

Aft

er

successfu

lly

movin

gin

toM

exic

oto

com

pete

inth

ecarb

onate

ddrinks

mark

et,

Wahaha

can

late

rin

troduce

their

oth

er

drinks

inclu

din

gju

ices,

tea,

and

sport

drinks.

Adapta

tion

&P

olit

icalR

isks

Dic

tate

Entr

y


MOR-492: Projects

Wahaha

willta

rget

tiers

3&

4w

hic

h

inclu

des

65.7

million

people

Tie

r5

Tie

r4

Tie

r3

Tie

r1

&2

Me

xic

an

Po

pu

lati

on

(in

mil

lio

ns

)

Rath

er

than

com

peting

head-t

o-h

ead

with

Coca-C

ola

and

Pepsi,

Wahaha

willaim

for

the

low

er

tiers

ofth

em

ark

et

with

more

price

sensitiv

econsum

ers

.This

repre

sents

a

very

larg

eperc

enta

ge

ofth

eovera

llM

exic

an

mark

et.

How

ever,

our

targ

et

mark

et

als

o

care

sabout

image,w

hic

his

why

Wahaha

willuse

lim

ited

advert

isin

gto

build

abra

nd

and

diffe

rentiate

from

our

key

com

petito

r,Big

Cola

.

Our

Targ

etM

ark

et


MOR-492: Projects

SuccessfulMarketingStrategyinChina

-C

entr

alized

mark

eting

cam

paig

n

-H

igh

cash

investm

ent

(USD

$60.5

Million)

-TV:

Bra

nd

aw

are

ness

&re

cognitio

n

-Print

Ads:

Pro

duct

functionality

&pro

motions

-1

stC

hin

ese

com

pany

touse

cele

brities’endors

em

ents

TargetMarket

-U

rban,Suburb

an,and

Rura

lare

as

-M

ass

mark

et

pote

ntial

-Priced

low

er

than

know

ncom

para

ble

pro

ducts

-Sim

ilar

toC

hin

ese

mark

et

-G

DP

per

capita

hig

her

and

media

nage

low

er

Mark

eting

Str

ate

gy

Replic

ation

As

Mexic

opossess

asim

ilar

dem

ogra

phic

toC

hin

a,

asim

ilar

mark

eting

cam

paig

ncan

be

instilled

inth

enew

mark

et.

The

budget

willbe

sm

aller,

adju

ste

dto

the

diffe

rence

inpopula

tion

betw

een

the

two

countr

ies.

The

mark

eting

cam

paig

ncan

“kic

k-o

ff”

duri

ng

the

Copa

Am

eri

cas,

whic

his

the

most

watc

hed

tele

vis

ion

event

inM

exic

o,

sim

ilar

toth

ero

llout

of

Wahaha’s

TV

advert

isem

ents

duri

ng

the

Worl

dC

up

of

2006.


MOR-492: Projects

Ma

nu

fac

ture

Co

nc

en

tra

te

Wa

ha

ha

Da

no

ne

Da

no

ne

Wa

ha

ha

Va

rio

us

Wahaha

willm

anufa

ctu

reth

esyru

pconcentr

ate

at

the

facto

ries

inC

hin

aand

export

it

toD

anone’s

bott

ling

pla

nt.

Danone

willth

en

bott

leand

dis

trib

ute

the

soda

usin

gth

eir

pre

-exis

ting

dis

trib

ution

netw

ork

.W

ahaha

willm

anage

mark

eting

effort

sw

ith

input

from

Danone’s

localm

anagem

ent.

Acom

bin

ation

push

and

pull

mark

eting

willbe

used

togain

shelf

space

at

reta

illo

cations.D

anone

willuse

its

clo

ut

and

levera

ge

to

negotiate

with

reta

ilers

and

Wahaha’s

cre

ative

advert

isin

gw

illcre

ate

adra

win

dem

and

by

custo

mers

.

Wahaha’s

Valu

eC

hain

Bo

ttlin

gD

istr

ibu

tio

nM

ark

eti

ng

Re

tail


MOR-492: Projects

2008E

2009E

2010E

Volu

me

(in

millions

of

lite

rs)

440.6

935.0

1488.0

Revenue

149.8 1

317.8

9505.9

2

CO

GS

77.9

0165.3

0263.0

8

Gro

ss

Marg

in71.9

1152.5

9242.8

4D

epre

cia

tion

(Bott

ling

Pla

nt)

20.0

020.0

020.0

0SG

&A

(in

clu

din

gm

ark

eting)

65.0

020.0

020.0

0

Opera

ting

Incom

e(EBIT)

- 1 3 . 0 9112.5

9202.8

4

Taxes

0.0

033.7

860.8

5

Net

Incom

e

- 1 3 . 0 978.8

1141.9

9Tota

l NPV

NPV

(8%

dis

count

rate

)

- 1 2 . 1 267.5

7112.7

2168.1

6

NPV

(10%

dis

count

rate

)

- 1 1 . 9 065.1

3106.6

8159.9

1

NPV

(12%

dis

count

rate

)

- 1 1 . 6 962.8

3101.0

7152.2

0

Exp

ecte

dB

rea

ke

ve

nin

2N

DY

ea

r!

As

su

mp

tio

ns

:•R

eta

ilprice:

$0.3

4/liter

•Mark

et

share

:1%

in2008,

2%

in2009,

3%

in2010

•Mark

et

gro

wth

(in

volu

me):

6.1

%C

AG

R•T

ax

rate

:30%

(sam

eas

Coca-C

ola

FE

MS

A)

•Depre

cia

tion:

$60M

bott

ling

pla

nt

str

aig

ht-

line

depr.

ov

er

3y

rs•N

oin

tere

st

expense

(all-

equity

firm

)

Reta

ilPrice

Per

Liter

Com

parison

(U

SD

)

Coca-cola

$0.5

3

Pepsi

$0.3

8

Big

Cola

$0.3

4

Wahaha

$0.34

Pro

Fo

rma

Inc

om

eS

tate

me

nt

(millio

ns

of

US

D)

Fin

ancia

lA

naly

sis


MOR-492: Projects

�Sell

off

the

bott

ling

pla

nt

toCoca

Cola

,Pepsi,

Big

Cola

,ARCA,

or

anoth

er

com

pany

�D

iscount

rem

ain

ing

invento

ryuntilall

issold

off

�W

ors

tcase

scenario,

liquid

ate

all

rem

ain

ing

assets

inM

exic

o

Possib

leE

xit

Str

ate

gie

s


MOR-492: Projects

�C

IA

–The

World

Factb

ook

–M

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MOR-492: Projects

1

Mexican Expansion

Presented by

Mark Davenport, C.K. Hsu, Gary Lilardi, Kerry MacDonald,Keith Parker, Whitney Stambler, Nan Wang

The Wahaha Group

AGENDA COMPANYINFORMATION

ANALYSIS FINANCIALANALYSIS

CONCLUSIONENTRYSTRATEGY

• Company Information

• Country & Industry Analysis

• Entry Strategy

• Financial Analysis

• Conclusion




Company Information




Who is Wahaha?• Private-owned company and biggest beverage producer (15.6% of totalproduction) in China

• Found by Mr. Zong Qinghou in 1989

• “Wahaha” in Chinese is the sound happy kids make when they arelaughing

• Non-alcoholic beverages and non-beverage goods

• $600M USD in total assets

• JV ownership with Danone

• Looking for growth opportunities




Wahaha’s Business Model

Quality

Extra

Profits

AdvertisingImprove brand

awareness and use

pull marketing to

increase WTP

IncreasedMargin

Low UnitCost

Economies

Of scalesR&D

Innovation and

creativity for new

tastes and products

VolumeNumber of visits

And repeating

visits

Price

Advertising Brand ImageSales

VolumeDistribution

Critical Success Factors




Country & Industry Analysis


MOR-492: Projects

2




Why, or Why Not, Go to Mexico?• Why?

– Market Size

– Market Value– Market Growth

• Why Not?

– Aggressive Competitor Campaigns– Government Imposed Tax

• Competitors– Market Concentration

– Pepsi and Coca Cola– Recent Anti-competitive practices– Wahaha will compete more directly with more fragmented, smallercompetitors

Market Growth




How Attractive is the Industry?

Threat of Entry: Low

Buyer

Power:

Low

Substitutes: High

Supplier

Power:

Medium/

Low

Rivalry:

Medium/

High




Wahaha’s Target Market

Wahaha willtarget tiers 3 & 4

which includes

65.7 million people

Tier 5

Tier 4

Tier 3

Tiers 1 & 2




Main Competitor: Big ColaWahaha will be directly competing with Big Cola in the same target market

•Background Facts–Bottled and marketed by Ajemax, a subsidiary of Peruvian firm Kola Real

–Entered Mexican market in 2002

–Presently accounts for 5% of the Mexican drink market

•Target Market–3rd & 4th tier of the pyramid, similar to Wahaha

–Sold for $1.13, sometimes as low as 87 cents

–Forced PepsiCo to lower prices

•Distribution–Considered a “counter-brand”

–Business model based on economics along value chain

–Uses freelance vendors who open up new markets for Big Cola




Wahaha’s Distance Barriers

Economic

•Ranked 9th mostimpoverished out of102 developingcountries

•17.6% of thepopulation is inextreme poverty

•Severeunderemployment formuch of the population

•Consumers are pricesensitive

Geographic

•Water contamination

•Distribution mobility islimited in rural areas

Administrative

•High corruption andpolitical risk

•Weak law enforcement

Cultural

•Do not favor Asianproducts

•Market dominatedproducts: Coke andPepsi

•Majority of stores aresmall scale (Mom &Pop)

•Different language

•Different tastes &preferences

Partnership with a company that has been in Mexico for a while can help Wahaha learnand respond as necessary to the differences in the Mexican market.




Entry Strategy


MOR-492: Projects

3




Entering Mexico – How?

Mexico

Joint Venture with

Existing firms in Mexico

(Danone)

Partnership with local

bottler/distribution

(ARCA)

Acquisition of a local

Brand

Direct investment

Without any

Strategic alliances




Distribution Channels in Mexico

Goals for Distribution• Must establish a method to reach the Mom and Pop stores• Existing transportation infrastructure can pose challenges to overcome• Access to bottling facilities which are geographically disbursed

• Access to water




Distribution Options

•Low-cost

•Utilize existing expertise

•Relationships with stores already established

•Distribution infrastructure will already be inplace

•Access to water rights is responsibility ofpartner

•Easy exit strategy

• Less financial risk

•Because have partial ownership ofWahaha, they are more aligned with theircore values

•Have a previously built relationship withdistributors

•Share shelf space in stores

•Lack of control over distribution

•Partner may not prioritize brand

•Must share shelf-space with the big brands.

•Their plants are only in the Northern regionof Mexico

•May not want to have a JV with Wahaha

•Less control over distribution

•Limited distribution to the rural areas

Ad

van

tag

es

Dis

ad

van

tag

es

Contracting with ARCA JV Partnership with Danone




: Utilizing an Existing Relationship

• History of Cooperation– Wahaha formed a Joint Venture in China with Groupe Danone SA in 1996

– Invested in advanced production lines and improved efficiency

– Production doubled in just one year

• 30 Years of Presence in Mexico– Market share leader in their industry (41.3% in 2006)

• Excellence in Execution– 33.5% share of shelf space in leading supermarket chains

– 10,000 POS to cater to rural areas by 12/2007

Danone’s Market Share Growth




Adaptation & Political Risks Dictate Entry

Global

International


Glo

bal

Coord

inatio

n

LoLo

Lo H

i

Hi Wahaha &

Danone JV

Political Risk

Eco

n.

Opport

unity

LoLo

Lo H

i

Hi

Manufacture

ConcentrateBottling Distribution Marketing Retail

Wahaha Danone Danone Wahaha Various

E




Financial Analysis


MOR-492: Projects

4




Financial Analysis

Expected Breakeven in 2ND Year!

$0.34Wahaha

$0.34Big Cola

$0.38Pepsi

$0.53Coca-cola

Retail Price Per LiterComparison (USD)

Capital Investments: $60M bottling plant, $60.5M advertising




Exit Strategies & Conclusion




Possible Exit Strategies

Sell off the bottling plant to Coca Cola, Pepsi,Big Cola, ARCA, or another company

Discount remaining inventory until all is sold off

Worst case scenario, liquidate all remainingassets in Mexico

Insure it, burn it, and move to New Zealand!




Conclusion

•Enter Mexico

•JV with Danone

•Target tiers 3 & 4

•Start with carbonated products and

later add teas, juices, etc.

Thank you!Xie Xie

Questions?




Financial Analysis

152.20101.0762.83-11.69NPV (12% discount rate)



Total NPV

141.9978.81-13.09Net Income

60.8533.780.00Taxes

202.84112.59-13.09Operating Income (EBIT)

20.0020.0065.00SG&A (including marketing)

20.0020.0020.00Depreciation (Bottling Plant)

242.84152.5971.91Gross Margin

263.08165.3077.90COGS

505.92317.89149.81Revenue

1488.0935.0440.6Volume (in millions of liters)

2010E2009E2008E

Expected Breakeven in 2ND Year!

Assumptions:•Retail price: $0.34/l i ter•Market share: 1% in 2008, 2% in 2009, 3% in 2010

•Market growth (in volume): 6.1% CAGR

•Tax rate: 30% (same as Coca-Cola FEMSA)•Deprec iation: $60M bottl ing plant straight-l ine

deprec iation over 3 years

•No interest expense (all-equity firm)

$0.34Wahaha

$0.34Big Cola

$0.38Pepsi

$0.53Coca-cola

Retail Price Per Liter Comparison (USD)

Pro Forma Income Statement (millions of USD)


MOR-492: Projects

Plantronics, Inc. (NYSE: PLT)

Headquarters

Address: 345 Encinal St.Santa Cruz, CA 95060 USA

Tel: 831-426-5858Toll Free: 800-544-4660Fax: 831-426-6098Web: http://www.plantronics.com

Mexico (dba Plamex, S.A. de C.V.)

Address: Avenida Produccion, #12Parque Industrial Internacional TijuanaMesa de OtayTijuana, Baja California 22390, Mexico

Tel: +52 664-682-2798Fax: +52 66-822796

Overview

Plantronics, Inc. engages in the design, manufacture, and marketing of lightweightcommunications headsets, telephone headset systems, and accessories for the business andconsumer markets under the Plantronics brand worldwide. It also manufactures and marketscomputer and home entertainment sound systems, portable audio products, and a line ofheadsets, headphones, and microphones for personal digital media under Altec Lansing brand.In addition, the company offers specialty telephone products, such as telephones for thehearing impaired, and other related products for people with special communication needsunder Clarity brand. Further, Plantronics provides audio enhancement solutions to consumers,audio professionals, and businesses under Volume Logic brand. It distributes its productsthrough a network of distributors, original equipment manufacturers, wireless carriers, retailers,and telephony service providers. (Yahoo Finance, 2007)

Finances (2006)

Sales: $750.4M1 yr sales growth: 34%Net Income: $81.2M

Miscellaneous

Founded: 1961Top competitors: GN Netcom, Logitech, MotorolaTotal employees: 7,300

PeopleChairman: Marvin TseuPresident, CEO, & Director: S. Kenneth KannappanSVP, Finance & Administration, CFO: Barbara SchererSVP, Chief Marketing Officer: Mark BreierSVP, Operations: Terry Walters

Operations in Mexico

Plantronics opened Plamex in Tijuana, Mexico, 35 years ago and since then the facility hasbeen recognized worldwide for its commitment to quality and progressive employeeprograms. Plamex has won nine international manufacturing awards over the past two years,and was recognized twice by Mexico president Vicente Fox Quesada for its technology andquality leadership. Plamex is also the only manufacturing facility in the world to win both theIbero American Quality Award and Asia-Pacific Quality Award for large manufacturingorganizations. PLAMEX's 3,600 associates contribute to Plantronics' worldwide success bymanufacturing more than 8,000 different models of headset products.


MOR-492: Projects

1

COMPETITIVESTRATEGY

A Primer

Overarching Goal

• Above Normal Returns

• Strategic Competitiveness

• Sustainable/Renewable

Sustainable/RenewableAbove Normal Returns &Strategic Competitiveness

Profits = Q (R-C) X Time

• Aggressive Competition (all 5 forces)• Uncertain turbulent future

Margin

Willingness to Buy

Q Quantity

•Fast food – Size of the ticket•Discount Stores – volume purchasing•Staples are at the back of the store• Impulse buys

•ADVERTISING!!!/POINT OF PURCHASE

Willingness to Pay

R Price/Revenue

•Premium prices•Branding•Monopoly situations – broken arm•Lifecycle costs of a product

•Customer loyalty – Harley Davidson tattoos

Cost Minimization

• Scales

• Scope

• Location

• Experience

• Design

• Productivity

• Capacity Utilization

• HR Productivity

C Costs


MOR-492: Powerpoints

2

Sustainability

TIME•Competitive imitation•Substitution

•Technological Obsolescence•Organizational Slack

Business Models: TheCore of a Strategy

• A firm’s choice of relationshipamong these variables is itsbusiness model

• Focus and tradeoffs amongvariables

• Two generic business models:• Cost-based

• Differentiation-based

Illustration of tradeoffs inQ*Margin

Volume

Margin

Hi

Hi

Lo

Lo

Made in Heaven

Market Share (Quantity)Low High

Prof

itabi

lity

Low

High

Differentiation-based Strategies

Low CostLeadershipStrategies

Stuck-in-the-Middle

Market Share-Profitability Relationship:“Porter’s Bucket”

Business Models

Volume

Economiesof Scale

Low UnitCost

IncreasedMargins

R&D Advertising

Price

ExtraProfits

Quality

Business Models

LoyalConsumers

PremiumPrices

IncreasedMargins

R&D BrandMktg

ReputationExtra

Profits

Quality

InvestmentsUniqueness



3

Strategic AdvantageUniqueness Perceived

by the CustomerLow Cost Position

Industrywide

Stra

tegi

c Ta

rget

DIFFERENTIATIONOVERALL

COSTLEADERSHIP

FOCUSParticular Segment Only

Porter's Generic Strategies

Source: Porter (1980)

Firm A:

Firm B:

Firm C:

Firm B:

Price

Price

Price

Price

Total cost to buyer

Firm A has acost advantage

Firm C has adifferentiationadvantage

Producer’s cost Producer’s margin Buyer’s cost

Value Chains for Cost Advantageand Differentiation Advantage

Sourcesof AboveNormalReturn

GreatStrategies

GreatIndustries

0

10

20

30

40

50

60

70

80

90

100

2% 4% 6% 8% 10%

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

32%

Numberof

Industries

First QuartileAverage

22.2%

Fourth QuartileAverage

9.3%

Note: Return on Equity = Net Income / Year EndShareholders’ Equity; Analysis based on sample of 593industries

Average = 14.7%Median = 13.8%

11.7%

13.8%

16.5%

Return on Equity (Percent)

Average Return on Equity in US Industries, 1982-1993

Distribution of Industry Returns

Source: Jan W. Rivkin’s Analysis Based on Dun and Bradstreet Data

Source: Jan W. Rivkinbased on Compustat

Computer system design

Operating Income / Assets, 1988-95 (%)

0 5 10 15 20 25

Scheduled airlines

Motor vehicles

Cable TV service

Engineering services

Trucking except local

Race track operations

Petroleum / natural gas

Drug stores

Eating places

Dental equipment

Women's clothing stores

Semiconductors

Prepackaged software

Pharmaceuticals

Profitability Differences AcrossSelected Industries

WHY?

Superior Profitability

DELLCOMMODOREWANG

GATEWAYHP

LENOVO???



4

Determinants of SuperiorPerformance

• Profits earned are determined by:• Willingness-to-Pay: the value of the product/service to

customers• Intensity of Competition• the relative Bargaining Power at different levels in the

production chain• Sources of profits above competitive level are

determined by:• Industry attractiveness• Strategic group attractiveness• Competitive position attractiveness

Threat of New Entry

Rivalry AmongExisting Competitors

Bargaining Powerof Customers


Bargaining Powerof Suppliers

• Economies of scale• Proprietary product

differences• Brand identity• Switching costs

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

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

• Industry growth• Fixed costs / value

added• Overcapacity• Product differences• Brand identity

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

• 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

Porter’s Five Forces Analysis

Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

SUPPLIER POWERLOW

THREAT OF ENTRYLOW

•economies of scale•capital requirements

for R&D and clinicaltrials

•product differentiation•control of distribution

channels•patent protection

INDUSTRYCOMPETITIVENESSLOW

•high concentration•product differentiation•patent protection•steady demand growth•no cyclical fluctuations of demand

THREAT OFSUBSTITUTES

LOW

No substitutes.(Changing as managed care

encourages generics.)

BUYER POWER LOW

Physician as buyer: Not price sensitive No bargaining power.(Changing with managed care.)

DRUG INDUSTRY(ROE=28%)

30

SUPPLIER POWERHIGH

•strong labor unions•concentrated aircraft makers

THREAT OF ENTRYHIGH

•entrants have cost advantages

•low capital requirements•little product differentiation•deregulation of governmental barriers

INDUSTRYCOMPETITIVENESSHIGH•many companies•little product differentiation•excess capacity•high fixed/variable costs•cyclical fluctuations of demand

THREAT OFSUBSTITUTESMEDIUM

•autos for short distancetravel

BUYER POWERMEDIUM/HIGH

Buyers extremely price sensitiveGood access to informationLow switching costs

Airline Industry(ROE=-1%)

31

Neutralizing the Five CompetitiveForces

Force Entry

Rivalry

Substitutes

Buyers

Suppliers

Method for Neutralizing Force Erecting barriers (isolating

mechanisms) create exploit economies of scale,aggressive deterrence, design in switching costs, etc

Compete on nonprice dimensions:cost leadership, differentiation, cooperation, etc

Improve attractiveness compared tosubstitutes: better service, more features, etc

Reduce buyer uniqueness: forwardintegrate, differentiate product, new customers, etc

Reduce supplier uniqueness: backwardintegrate, obtain minority position, second source, etc

Issues with the Five-ForcesFramework

• Industry definition• Completeness (e.g., import competition)• Consistency (e.g., import strategic variety)• Duplication (e.g., switching costs)• Symmetry (e.g., buyer substitution vs. supplier

substitution, complements)• The role of informational conditions• The need for macroenvironmental analysis• Long-run focus vs. change

• shocks• cycles• trends

• Product rather than resource focus



5

Customers

Firm

Suppliers

Competitors Complementors

A player is your complementorwith respect to customers ifcustomers value your product morewhen they have the other player’sproduct as well

A player is your competitor withrespect to customers if customersvalue your product less whenthey have the other player’sproduct as well

A player is your complementorwith respect to suppliers if it ismore attractive for a supplier toprovide resources to you when itis also supplying the other player

A player is your competitor withrespect to suppliers if it is lessattractive for a supplier toprovide resources to you when itis also supplying the other player

Coopetition and the Value

Net

Source: Adam Brandenburger and Barry Nalebuff, Co-operation (New York: Currency Doubleday, 1996)

Continually ChangingIndustry Conditions• Exogenous Changes

• Shocks and Trends

• TINAs

• Endogenous Changes• New innovations

• New business models

• New Supply chains

• Etc.

Shocks and Trends

Uncertainty &Market Ignorance

ConsumerTastes

TechnologyLaws,Tax Policy,Regulations

Relative Pricesof InputsGlobal Supply &

DemandConditions

Inventions &Discoveries

External “Triggers”

• “Triggering” shifts, shocks and trends, even in adjacentmarkets, may create uncertainties that allow/force firms tochange their strategies

• Shocks and Trends• changes in consumer tastes• changes in technology• changes in relative prices of inputs• changes in laws, regulations, and tax policy• inventions and discoveries• changes in global supply and demand conditions

• Uncertainty and market ignorance create/produce theopportunity for firms to reformulate their strategies

Examples of Intelligentand Threatening

Competitors

Aggregating Demand in NewWays



6

New Product Concept &New Business Model

New Types of Arbritage

Narayana Hrudayalaya Heart Hospital, India

Closing the “GlobalDistance”

New Customer Segments

New Strategic GroupsComplementaryProducts/Services



7

Strategic Group

AnalysisCompanies may take differentapproaches to competing in

the same industry

Strategic Map of the United States Airline Industry

International

National

Regional

NoFrills

Full ServiceQuality of Service

The Late 1970s

Braniff

TWA

EasternUnited

American

Delta

Western Republic Ozark

USAir Piedmont

Frontier AirCal

PSA

South-west

Texas Int’l

Continental

PanAm

Northwest

Laker

World

Geo

grap

hic

Scop

e

Strategic Map of the United States Airline IndustryThe Early 1980s

TWA

United

Eastern

American

Delta

Western Republic Ozark

USAir Piedmont

Frontier AirCal

PSA

South-west

Continental

PanAm

Northwest

NewEntrants

XX

International

National

Regional

Geo

grap

hic

Scop

e

Quality of ServiceNoFrills

Full Service

Strategic Map of the United States Airline IndustryThe Mid 1980s

Republic

Ozark

USAir Piedmont

Frontier

AirCal

PSA

South-west

Continental

TWA

Eastern

UnitedAmerican

Delta

Northwest

NewEntrants

International

National

Regional

Geo

grap

hic

Scop

e


Full Service

Strategic Map of the United States Airline IndustryThe Late 1980s

South-west

United

TWA

American

Delta

USAir

Continental

Northwest

AmericaWest

MGMGrand

International

National

Regional

Geo

grap

hic

Scop

e


Full Service

Strategic Map of the United States Airline IndustryThe Early 1990s

South-west

United

TWA

American

Delta

USAir

Continental

Northwest

AmericaWest

XReno

Kiwi

Others

International

National

Regional

Geo

grap

hic

Scop

e


FullService

Mobility Barriers



8

Finding New ProfitPools within Industries

Profits earned in different partsof the industry production chain

can change over time0% 100%

Share of Industry Revenue

Ope

ratin

g M

argi

n

The U.S. Auto Industry’s Profit Pool

Source: Gadiesh & Gilbert, 1998

Competitive Advantages

GreatStrategies

ValuableResources&Capabilities

ProtectedCompetitivePositions

A Three-Dimensional BusinessLandscape: Great Positions!!!

CompetitiveAdvantages

(Sources of Rates of Profit inExcess of the Competitive Level)

AvoidCompetitors

(Position)

Be Better ThanCompetition(Capability)

Sources of Competitive Advantage

Better,Faster,Cheaper

Get in first,Keep others out

Attractive Industryprotected by Entry Barriers

Attractive Strategic Groups(within Industry) protectedby Mobility Barriers

Attractive CompetitivePositions (within Strategic Group)protected by IsolatingMechanisms

AND/OR

AND/OR

Sustainability of Superior Performance Based on Impediments to Imitation



9

Isolating Mechanisms

• Information Impactedness• Response Lags• Economies of Scale and Scope• Producer Learning• Buyer Switching Costs• Reputation• Buyer Evaluation Costs• Advertising and Channel Crowding

Source: Richard Rumelt, 1987

COMPETENCIES & CAPABILITIES:

Outperforming Competitors

Building and RenewingDistinctive Competencies &Organizational Capabilities

Building Cost and DifferentiationStrategies

• Cheaper• Better• Faster

Differentiation

Cost Reduction

Total Quality Management

Just-In-Time

Time Management

Geographic Location

Business Re-engineering

Mass Customization

etc.

etc.

Cost Drivers

• Economies ofscale

• Economies ofscope

• Learning

• Pattern ofcapacity utilization

• Linkages

• Interrelationships

• Integration

• Timing

• Policies

• Location

• Institutionalfactors

Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

TANGIBLEDIFFERENTIATION

Observable product characteristics:• size, color, materials, etc.• performance• packaging• complementary services

INTANGIBLEDIFFERENTIATIONUnobservable and subjectivecharacteristics relating toimage status, exclusively,identity.

TOTAL CUSTOMER RESPONSIVENESS: Differentiation not justabout the product, it embraces the whole relationship between thesupplier and the customer.

The Nature of Differentiation

“Differentiation means providing something unique that is valuableto the buyer beyond simply offering a low price.” (M. Porter) THE KEY IS CREATING VALUE FOR THE CUSTOMER

The Sources ofDifferentiation Advantage

• Observable Goods:– Buyer Learning– Buyer Switching Costs– Advertising Economies

• Experience Goods:– Reputation– Credibility

• Communication Goods:– Relative Base



10

TECHNOLOGY PRODUCT DESIGN MANUFACTURING MARKETING DISTRIBUTION SERVICE

The McKinsey Business System

The Value Chain as a Frameworkfor Creating CompetitiveAdvantages

Inbound Logistics Operations Outbound

Logistics Service

Marketing Management Adv ertising

Sales Force

Administration

Sales Force

OperationsTechnical Literature Promotion

Source: Michael E. Porter, Competitive Advantage, 1985.

Firm Infrastructure

Human Resource Management

Procurement

Technology Development

The Porter Value Chain

Marketing& Sales

• Identify activities

• Assign costs, assets • Identify cost drivers • Competitive scope

• Cost position of competitors • Control drivers

Cost Advantage

• Change chain

Source: Susan Polk, 1991

Cost Analysis

ValueChain

Using The Value Chain ToAnalyze Costs

Stages In Value ChainAnalysis

• Disaggregate firm into separate activities• Establish relative importance of activities• Identify cost drivers• Identify linkages• Examine scope for reducing costs

Be Better Than Competitors

(2) In coordinating elements of value chain

(1) In individual elements of value chain

(3) In selecting elements of value chain (make vs. buy)

X XSource: Michael E. Porter “What is Strategy” Harvard Business Review, Nov-Dec 1966

Limitedpassengeramenities

Short-haul,point-to-pointroutes betweenmidsize cities

and secondaryairports

Highaircraft

utilization

Frequent,reliable

departures

Lean, highlyproductiveground andgate crews

Very lowticket prices

No meals

No seatassignments

No baggagetransfers

No connectionswith other

airlines

15-minutegate

turnarounds

Limited useof travelagents

Automaticticketingmachines

Standardizedfleet of 737

aircraft

Flexibleunion

contracts

High levelof employee

stockownership

“Southwest,the low-fare

airline”

Highcompensationof employees

Southwest Airlines’ ActivitySystem



11

0

10

20

30

40

1 2 3 4 5 6 7 8 9 10

Year

RO

I%

Source: Pankaj Ghemawat, Commitment (New York: The Free Press, 1991)

Reversion to the Mean

AddedValue

AppropriatedValue

Imitation Substitution

Slack Holdup

Four Threats to Sustainability

AddedValue

AppropriatedValue

Responding to the Threats toSustainability

Responses toImitationBuilding Barriers• Economies of scale andscope• Learning/privateinformation• Contracts and relationships• Network externalities• Threats of retaliation• Time lags• Strategic complexity• Upgrading

Responses to Slack• Gathering information• Monitoring behavior• Offering performanceincentives• Shaping norms• Bonding resources• Changing governance• Mobilizing for change

Responses toSubstitution• Not responding• Fighting• Switching• Recombining• Straddling• Harvesting

Responses toHoldup• Contracting• Integrating• Building bargainingpower• Bargaining hard• Reducing asset-specificity• Building relationships• Developing trust

Strategic Renewal

The Strategic Task

HIGH

EXTENT OFADVANTAGE

LOW

TIMESource: Marvin Lieberman, 1997

The Strategic TaskKeep developing new sources of competitive advantage!

HIGH

EXTENT OFADVANTAGE

LOW

TIMESource: Marvin Lieberman, 1997



12

Customer/ Market

Product/ Service

Assets /Resources

Business System/ Value Chain

Scale/Scope

The Hexagon of Competitive Advantage:Potential Sources for Creating Advantages

Competitor/ Partner

Interaction

Source: George Yip,1997

CompetitiveAdvantage



Marshall School of BusinessDepartment of Management and Organization

Voigt, Spring 2007

GSBA 582: GLOBE 1

GSBA 582: GLOBE

Country AnalysisAnalyzing the Attractiveness of

Regions, Economies, Industrial Sectors,and Markets for Global Business

MOR 492: Global Strategy

Country Analysis Framework

2

Session Agenda Analyzing the “Meet” Dimension Country Analysis Institutional Differences & “Voids”

Analysis Getting to Know the Data Workshop



3

Analyzing the Global Market:What will the firm meet?

Regional Analysis

Country Analysis

Industry Analysis

Industrial Sector Competitiveness Analysis

Market Potential Analysis

Competitor Analysis

FeasibilityAnalysis

ProfitabilityAnalysis

Meet Question?



4

Country Analysis Global Economics of Region

ASEAN, NAFTA, APEC, etc. Macroeconomic Policies

Political Agenda Fiscal & Monetary Policies Policies toward foreign investments & control

Political Risk Analysis Institutional Voids Analysis

Meet question?



5

Firm Strategy, Structure, and

Rivalry

Factor Conditions

Demand Conditions

Related and Supporting Industries


Government

Chance

Diamond of Global CompetitivenessMeet Question?



6

Examining Relevant “Distances” CAGE Framework (Ghemawat)

Cultural Distance Administrative Distance Geographic Distance Economic Distance

• Global strategy must exploit/mitigate relative“distance” between the firm and the global market

• CAGE can be applied at the Country level, industrialsector, industry, and firm level

Meet Question?




Voigt, Spring 2007

GSBA 582: GLOBE 2



7

Business “Context”

Land Political &Social Systems

CapitalMarketsLaborCountry Factor

Endowments

“Hard”Infrastructure

Roads, Rail& Ports

FunctioningIndependentLegal System

Banks & FinancialInstitutions, Regulators

Physical &Property

Rights Security

“Soft”Infrastructure

LogisticsIntermediaries

Spec ial izedConsultantsAccountants

& Legal System

Debt & EquityMarkets,

Venture Capital

Professions,CredentialingSearch Firms

Schools,Universities,

Training

Business Strategy& Operations



8

Country AnalysisFramework

Comparing and ContrastingOpportunities and Differences



9

Why Country Analysis? Countries continue to achieve remarkably

different rates of economic growth Countries differ in size, geographic location,

resource endowments, historical experiences,cultures and income levels, and thesedifference are important for global strategydecisions

The profit performance of similar industriesdiffers widely from one country to another

“Country effects” matter



10

Country Effects Matter Nation States make the “rules” by which businesses

must abide Country “Institutions” (courts, laws, capital

markets, law & order enforcement, unions,governments, etc) create the context for businessand markets

Countries “do” compete with each other forresources

Countries do have “strategies” too Governments do play an active role Country borders (degree of openness) do matter



11

Country Borders Matter Within countries, economic forces

work efficiently to bring convergence Across countries, global economic

forces are impeded by barriers totrade, capital flows and immigrationand convergence is mitigated



12

Foreign Direct Investment Distribution

Theory suggests that capital should flow towhere the arbitrage opportunities aregreatest However, low wages may be offset by institutional

voids which raise overall costs In reality, most FDI is between “rich”

countries, and a select group of emergingeconomies (e.g. China, Brazil, Mexico,Singapore, Indonesia, Malaysia, SaudiArabia, Argentina)




Voigt, Spring 2007

GSBA 582: GLOBE 3



13

Institutional Voids Institutional voids are the absence of intermediaries

between buyers and sellers Examples:

FinanceVenture Capital FirmsPrivate Equity ProvidersMutual FundsBanksAuditors

ManagementTalent

Business SchoolsCertification AgenciesHeadhunting FirmsRelocation Services

Products Certification AgenciesConsumer ReportsRegulatory AuthoritiesExtra-judicial dispute resolution



14

Country Analysis Framework Identification

Strategy Context Performance

Evaluation Prediction

Context Strategy Performance



15

Performance Formal economy, grey market, black market Economic Performance Measures

Output Prices Employment Savings Investment Productivity Wages increases Unit labor costs Utilization of capital Distribution of income

Net inflows vs outflows of capital, labor, etc.MOR 492: Global Strategy


16

Strategy Vision – guiding motivating values

Community solidarity vs. individual achievement Goals Policies – policy mix Foreign/Defense Policies Fiscal Policy

Spending priorities, types of taxes, balanced/ deficit/surplus budgets



17

Strategy (continued)

Monetary Policy Income Policies

Redistribution of incomes Foreign Trade and Investment Policies

Import vs. Export Orientation Industrial Policy Social Policies

Education, Population, Health Care, Religion



18

Context International Context

Trading Blocs Historical ties

Domestic Context Political – strong or weak governments, ability to

bring about reform Institutional Context – Government, legal, financial,

agricultural, transportation, energy, infrastructure.Other institutions like union, religions




Voigt, Spring 2007

GSBA 582: GLOBE 4



19

Context (Continued)

Ideological Context Rights vs. Obligations Individual vs. Group (minority rights

protection) International Context

GATT, WTO, IMF



20

Resources – The equipment andrecruiting system Human capital, physical capital, natural

resource wealth, and technological skills The Players in the Game

Firms, government actors, and non-government organizations

Context (Continued)



21

The Rules of the Game Written and unwritten rules of conduct Formal

Laws, property-rights Informal

Business practices which come for culture heritage Rules define what is possible and what is not

International Dimension Role of multinational corporations International organizations like IMF, World Bank, WTO

Context (Continued)



22

Treaties on Trade and Inv estment, InternationalMonetary Sy stem

Tarif f s, quotasInternational Organizations

Exchange ratesLocation

Balance of pay mentsInternational

International

- conventions, culture, religious beliefs, ideology

Political stability , political f reedom, etc.Inf ormal rules

Politicaleconomic (e.g. property rights, contract law), political ( e.g.federal system, separation of powers), treaties

Formal rules

Fertility , mortality , literacy , etc.Rules of the GameConstitutional ref orm

Income distributionIndustrial policies

Social Unions, employer associations, religious groups, politicalparties, etc.Sectoral policies

Non-state organizations:Trade and inv estment policies

Unemploy mentGov ernment actorsExchange rate policies

Inf lationFirmsFiscal & monetary policies

PricesPlayers in the GamesPolicies

National income accounts

GNPLabor, capital, natural resources, technology ,geography

Higher per-capita income lev el and growth,equality of income, stability , autonomy ,def ense, etc.

EconomicNational ResourcesGoals

PerformanceContextStrategyFRAMEWORK FOR COUNTRY ANALYSIS

GSBA 582: GLOBE

Examining the InstitutionalContext for Business in New

and Emerging Markets

Institutional Voids Analysis



24

Framework for Analyzing the“Fitness” of Emerging Markets

The creation or replication of a global businessstrategy in a new market presupposes theexistence of supporting “infrastructure” andcomplementary “institutions” Physical infrastructure, specialized intermediaries, legal

support, contract-enforcing mechanisms, disputemediation, regulatory systems, etc.

Firms have three choices: Adapt to local “institutional voids” and market conditions Change the local markets and “fix” the institutional voids Stay out of the market altogether




Voigt, Spring 2007

GSBA 582: GLOBE 5



25

Business “Context”

Land Political &Social Systems

CapitalMarketsLaborCountry Factor

Endowments

“Hard”Infrastructure

Roads, Rail& Ports

FunctioningIndependentLegal System

Banks & FinancialInstitutions, Regulators

Physical &Property

Rights Security

“Soft”Infrastructure

LogisticsIntermediaries

Spec ial izedConsultantsAccountants

& Legal System

Debt & EquityMarkets,

Venture Capital

Professions,CredentialingSearch Firms

Schools,Universities,

Training

Business Strategy& Operations



26

Spotting Institutional Voids:Hard Infrastructure

Political and Social System Role of government in supporting/controlling business/market

activities Transparency in regulatory environment

Physical Infrastructure Quality of ports, roads, rail Energy, water, housing stock, etc.

Personal and Property Protection Personal safety – atmosphere of security, law & order Health care Legal protection of personal property, intellectual property, etc.



27

Openness Role of media, non-government institutions, churches, social

groups, etc. Restrictions on foreign investment, repatriation of profits, etc. Restrictions on foreign intermediaries (e.g. auditing firms, ad

agencies, consulting firms, banks, insurance, etc. Free trade agreements (WTO compliant, FTAs, RTAs) Freedoms on business activities – restrictions on where and in

what sectors foreign businesses are allowed to invest Freedom of foreigners and locals to travel within, and into and

out of country

Spotting Institutional Voids:Hard Infrastructure



28

Spotting Institutional Voids:“Soft” Infrastructure

Product Markets Existence of reliable data on consumer behavior Access to quality raw materials, local manufacturing of

components Quality of retail sector Consumer credit (credit cards, cheques, etc.) Regulation of quality standards, product content, etc. Environment and safety standards

Supply Chain Intermediaries Logistics and transportation specialists Distribution channels, wholesale markets, warehousing



29


Labor Markets Quality of basic and specialized education

Technical and professional training Accreditation of education

Prevalence of “English” (Int’l language of Business) Free movement of employees Compensation practices (merit pay, seniority based, stock options) Enforcement of labor contracts Workers’ rights, Unions Regulations on layoffs, etc.



30


Capital Markets Prevalence and effectiveness of banks, insurance companies,

savings & loan institutions Access to banking for consumers, businesses Transparency in Banking practices Debt & equity raising, venture capital Standards of financial reporting, protection for stockholders,

bankruptcy laws/protections Market for acquisitions/takeovers



Marshall School of BusinessDepartment of Management and Organization Mayer & Voigt, Term IV, 2001

GSBA 515 GLOBAL STRATEGY 1

MOR 492 Global Strategy

Geographic Scope

1

Geographic Scopeof Competition and

Strategy


Geographic Scope

2

Geographic Scope of Competition Effective geographic

scope of competition Local Regional National International global

Geographic Scopeis influenced by: Economics Politics Corporate Strategy


Geographic Scope

3

Geographic Scope of Competition Geographic scope of competition

tends to expand with: Increases in economies of scale, scope, and

learning Reductions in logistical constraints Reductions in the distinctiveness of local

markets – differences in consumers tastes Reductions in barriers to competition


Geographic Scope

4

Drivers of Change in Scope Exogeneous drivers

Changes in government policies Reductions in trade barriers

Endogeneous drivers: New technologies Adoption of strategies requiring large fixed

investments Decisions to enter new markets


Geographic Scope

5

Geographic Scope of Strategy Firms choose:

Overall geographic scope of firm’s strategy The markets to compete in The location of important activities The organization and coordination of these

activities


Geographic Scope

6

Geographic Scope Choices Geographically-

focused Serving local markets Distinct products/services Localized marketing Satisfying local

regulatory requirements Local distribution

Advantage Strong local responsiveness Strong differentiated market

position Dangers

Scale, scope and learningadvantages of globalcompetitors may overtakelocal advantages



Marshall School of BusinessDepartment of Management and Organization Mayer & Voigt, Term IV, 2001

GSBA 515 GLOBAL STRATEGY 2


Geographic Scope

7

Geographic Scope Choices Global Strategy

Serving universal needsacross borders

Same product everywhere Global customers Global product varieties –

slightly modified for localmarkets requirements

Global marketing approach

Advantage Exploit scale, scope, and

learning economies Capture global low-cost

leadership position

Dangers Inability to compete with

locally responsivedifferentiated firms


Geographic Scope

8

Configuration and Coordinationof Firm Activities

Location of firm activities are influenced by: Market conditions Regulatory barriers Tax regimes Wages rates Locations of specific pockets of expertise

Firms can choose to locate activities insingle or disperse locations


Geographic Scope

9

Configuration and Coordinationof Firm Activities

Two extremes Tight coordination

Important decisions centrally managed from homenation

Loose coordination Important decisions decentralized to many nations

The appropriate form of coordination willdepend on the relative importance ofpressures for global coordination andpressures for local responsiveness


Geographic Scope

10

Competitive Interactionand Multi-market Competition

The scope of competition may expandglobally as firms match/mirror themoves of rivals

Firms feel compelled to match therivals to avoid cross-subsidization




Voigt, Fall, 2000

MOR 492 GLOBAL STRATEGY 1


Strategic Alliances

1

THE COLLABORATIVE CHALLENGE:JOINT VENTURES AND STRATEGIC ALLIANCES

“Companies are just beginning to learn whatnations have always known -- in a complex,uncertain world filled with dangerousopponents, it is best not to go it alone.”

Kenichi Ohmae, McKinsey - Japan


Strategic Alliances

2

STRATEGIC ALLIANCESSTRATEGIC CHALLENGEPre 1980s

Protect profits from erosion throughcompetition/bargaining

1980s and 1990sPursue multiple sources of competitive advantageSimultaneous reliance on competition and

collaboration [Coopetition]


Strategic Alliances

3

STRATEGIC ALLIANCESQUESTIONSWhat types of arrangements are most

appropriate?

What can we learn from the experience ofothers?

How do we successfully manage thesealliances?


Strategic Alliances

4

TYPES OF STRATEGIC ALLIANCES

JOINT VENTURESNew entity jointly owned by two or more firms

Shared or 50-50 venturesDominant ventures

INFORMALCooperation without any formal contractual

obligations


Strategic Alliances

5

STRATEGIC ALLIANCES

TraditionalJoint Venture

Exchange of access

Alliances offeringaccess to marketsin return for technology

Joint developmentKnow how

Access tobusiness system

Know -how:Technology; concept

Access to business system:Customers; distribution; manufacturing

Local company offers

Foreign company offers


Strategic Alliances

6

TYPES OF STRATEGIC ALLIANCES

MINORITY INVESTMENTSFirm buys stock in anotherOften access to resources for capitalStronger mutual commitment

TWO-WAY INVESTMENTSReciprocal equity stakes/cross-ownershipLess concern about dominance




Voigt, Fall, 2000



Strategic Alliances

7

WHY STRATEGIC ALLIANCES?TRADITIONAL REASONSSharing of resources and risksHost government requirementsOvercoming strong nationalistic sentimentsQuicker entryBenefit from partner’s local knowledge


Strategic Alliances

8

EMERGING REASONS Learning from one another Attain global scale economies

Raw material/ Component supply Marketing and distribution

Rising R&D costs and technological interdependence Short product life cycles

Industry convergence

WHY STRATEGIC ALLIANCES?


Strategic Alliances

9

Industry Globalization and Global CompetitionImproved market access

Stronger product line

Superior timing

Shaping competitive rivalry

Keeping key competitors at bay

Reduced transaction and other costs



Strategic Alliances

10

STRATEGIC ALLIANCES –POTENTIAL RISKS

Partner opportunism and loss of competitiveedge

Strategic and organizational complexity

Conflict of interest problems

Decreasing partner commitment


Strategic Alliances

11

MAKING STRATEGIC ALLIANCES WORK

ASSESSING NEED Do you need a partner? How big is the payoff? How likely is success?PARTNER SELECTION Does the partner share your goals and objectives? Does strategic synergy exist? Is the partner compatible?


Strategic Alliances

12


DEFINING GOALS AND OBJECTIVES Clarify and resolve separate interests Develop mutual trust and understandingDESIGNING AN ALLIANCE Define role of each partner Define venture boundaries Identifying champion(s) Trust versus legal considerations Allow for termination




Voigt, Fall, 2000



Strategic Alliances

13


MANAGING THE ALLIANCE

Achieving operating momentum

Recognize alliance needs Policies

Resources (inc. human resources)

Overcoming reluctance to give up autonomy


Strategic Alliances

14



Managing cultural differences

Flexibility

Assuring continued commitments

Increasing willingness to learn

Avoiding bottleneck dependence


Strategic Alliances

15

STRUCTURING ALLIANCES TO REDUCEOPPORTUNISM

Probability ofOpportunism by Alliance PartnerReduced By

Walling off Critical technology

Establishingcontractualsafeguards

Agreeing to swap valuable skills andtechnologies

Seeking crediblecommitments




Voigt, Fall, 2000



Generic Global Strategies

1


Multidomestic strategy Global strategy Choice -- Global versus Multidomestic Transition -- Multidomestic to Global Transnational strategy



2

FOUR BASIC STRATEGIES

Benefits from nationalresponsiveness

Efficiencybenefitsfrom globalintegration

GLOBAL

INTERNA-TIONAL

TRANS-NATIONAL

MULTI-DOMESTIC



3

Location and Coordination IssuesLOCATION COORDINATION

Production facilities Product line, market

selection Location of service

organization Number and location

of R&D centers Location of

purchasing function

Networking ofinternational plants

Commonality of brandname, similarity ofchannels etc.

Similarity of servicestandards

Coordination of pricing Coordination of

suppliers



4

PRESSURES: NATIONALRESPONSIVENESS

Differences in consumer preferences

Infra-structural differences Government demands New manufacturing technology Organizational limitations Managerial resistance



5

MULTIDOMESTIC STRATEGY

Customized product

Countries -- selected on their stand-alone potential

Units independent

Low coordination; high dispersion

Few inter-subsidiary transfersMOR 492 Global Strategy


6

MULTIDOMESTIC STRATEGY

Unit 3

Unit 1

Unit 2

HQ




Voigt, Fall, 2000




7

MULTIDOMESTIC STRATEGYCompetitive advantage from Local responsiveness Goodwill -- local government,

customers Lower costs -- avoiding shipping costs

and tariffs Quick response to local market

situations MOR 492 Global Strategy


8

INDUSTRY GLOBALIZATION POTENTIAL

COST DRIVERS

MARKET DRIVERS

GOVERNMENT DRIVERS

COMPETITIVE DRIVERSIndustry

GlobalizationPotential



9

PRESSURES: GLOBAL INTEGRATION COST DRIVERS

Economies of scale Economies of scope Decreased transportation costs Learning and experience Lower communication costs

GOVERNMENT DRIVERS Reduced tariffs, quotas Compatible technical standards



10

MARKET DRIVERS Homogenization of product needs Global customers Improved product quality Reduced adaptation costs

COMPETITIVE DRIVERS Global competitors Increased formation of global alliances

PRESSURES: GLOBAL INTEGRATION



11

GLOBAL STRATEGY Central control over country operations Central surveillance of resource allocation

and performance Standardized products Extensive transshipments Cross-subsidization Activities located in country(ies) providing

comparative advantageMOR 492 Global Strategy


12

GLOBAL STRATEGY

Unit 3

Unit 1

Unit 2

HQ




Voigt, Fall, 2000




13

GLOBAL STRATEGYCompetitive advantage from Lower cost structure

Economies of scale Less duplication of activities Lower inventories

Improved quality Increased competitive leverage Greater bargaining power Quick response -- R&D concentration



14

TRANSITION: MULTIDOMESTIC TO GLOBAL

Determine where the benefits ofglobalization lie

Establish mandate for each subsidiary

Reduce strategic autonomy of subsidiaries Rotate country managers to help them

develop a global vision

Change reward and evaluation system to fitthe mandate



15

MULTIDOMESTIC AND GLOBALSTRATEGIES

Strategic Arena

Business Strategy

Product-line strategy

Production Strategy

Sources of supply

Marketing

Organization

Most countries whichconstitute critical markets

Same basic strategyworldwide

Standardized products

Plants located on thebasis of competitiveadvantage

Attractive suppliers fromanywhere

Worldwide coordination;minor adaptation

Central control

Selected TargetCountries

Custom strategies;little coordination

Adapted to localneeds

Plants scatteredacross many hostcountries

Suppliers in hostcountry preferred

Adapted to localpractices and culture

Autonomy

MULTIDOMESTIC GLOBAL



16

CONSUMER ELECTRONICS


GlobalIntegration

Matsushita

Philips

General Electric



17

“You want to be able to optimize abusiness globally -- to specializein the production of components,to drive economies of scale asfar as you can ....But you alsowant to have deep local rootseverywhere you operate ... If youbuild such an organization, youcreate a business advantagethat’s damn difficult to copy.”

Percy Barnevik, CEO, ABBMOR 492 Global Strategy


18

CONSUMER ELECTRONICS:TRANSITION TO TRANSNATIONALITY


GlobalIntegration

Matsushita

Philips




Voigt, Fall, 2000




19

TRANSNATIONAL STRATEGY Greater emphasis on differentiated products than in

“pure” global industries

Greater demand for global efficiency and lowercosts than in “pure” multidomestic industries

Greater sensitivity to governmental demands

Units coordinate activities with HQ and with oneanother

Units may adapt to special circumstances only theyface



20

TRANSNATIONAL STRATEGY

Unit 3

Unit 1

Unit 2

HQ



21

TRANSNATIONAL CORPORATION Each national unit is a source of ideas and

competencies that can be harnessed for thebenefit of the corporation

National units achieve global scale by makingthem the company’s world source for particularproduct, component or activity

New, highly-complex managing roles whichcoordinates relationships between units in aflexible way



22

FOUR BASIC STRATEGIES

Benefits from nationalresponsiveness

Efficiencybenefitsfrom globalintegration

GLOBAL

INTERNA-TIONAL

TRANS-NATIONAL

MULTI-DOMESTIC



Marshall School of BusinessDepartment of Management and Organization Voigt, Fall, 2003



Global Competitive Advantage

1

Creating GlobalCompetitive Advantage

Building Multinational Competencies



2

Creating Competitive Advantage

Most markets have local, regional, andglobal aspects

ExampleGlobal IndustryCharacteristics

• Interdependent markets

• Extra-national scale

• Cross-market competition

National IndustryCharacteristics

• Differentiated markets

• National scale economies

• Local competition



3

Strategies for Globalization

Adaptation

Arbitrage

Aggregation

LocalCustomization

GlobalStandardization

Loca

lizat

ion

Glo

baliz

atio

n

Exploit differencesacross countries

Exploit similaritiesacross countries



4

Logic of Global Advantages Arbitrage Adaptation/Replication Aggregation Transformation(“ARAT” Model)

From Ghemawat, “ Global Advantage…”



5

Arbitrage Taking advantage of supply and demand

mismatches Taking advantage of national differences

Factor endowments Industry clusters, etc. Unique consumer demand

Consolidated and coordinated globaloperations



6

Three Kinds of Arbitrage

Classic Trading Arbitrage Relocation Arbitrage Production Integration Arbitrage







7

Classic Trading Arbitrage

Taking advantage of supply and demandmismatches through trading

Taking advantage of national differences insupply and demand prices and qualities Factor endowments: Raw materials, Labor Unique consumer demand: US Surfboards in Japan, Unique production capability: Japanese textiles,

French and Belgian goldsmithing



8

Relocation Arbitrage

Taking advantage of differences in endowmentsthrough activity relocation

Activity location depends on countrydifferences: Cost and quality of inputs and processes Porter’s Diamond Factors Risks and Uncertainties Transport costs Tariffs



9

Production Integration asArbitrage

Economies of scale or scope acrosscountries/regions/globe

Where integrating and trading outperformsreplication

TENSION between scale/scope economies onthe one hand and commitment, tariffs, andtransport costs on the other



10

Integration and the Value Chain

REMEMBER:Integration can take place at anypoint in the value chain:

Local selling, global sourcingGlobal selling, local sourcingGlobal selling, global sourcing



11

Integration and ExtensibilityDeciding Tradeoffs in Activity Integration

National

Activity 3

Activity 2

Activity 1

GlobalRegionalLocal



12

Other Forms of Arbitrage Cultural arbitrage

Examples: French Culture, US Culture, Brazilianlifestyle

Administrative arbitrage Examples: tax differentials, smuggling

Geographic arbitrage Examples: international flower markets

Economic arbitrage Examples: lower cost labor, cheaper capital







13

Replication (with Adaptation) Applying a successful model in multiple national

environments; “transfering DNA” Taking advantage of similarities among nations

Product Segment similarity Value Chain similarity Customization/Standardization tension

Replication will almost always require someadaptation to local market conditions

Multi-divisional organization in order to focus onnational organizations



14

Adaptation “Think Global, act local (and adjust)” Strategic action on both the global and

local levels



15

Forms of Adaptation Decentralization – moving decision-making from HQ to

the field Partitioning – separating choice elements Modularization – separating and designing standard

interfaces Recombination – melding elements of the parent

business model with new possibilities Innovation – deliberate local-for-local innovations Transformation of context – reduce the need for

adaptation by changing tastes Scope selection – reduce need for adaptation by

focusing on a narrow geographic area similar todomestic market



16

Transformation Trying to simultaneously take advantage

of differences and similarities amongnations Utilize arbitrage strategies where nations have

different and strategically significantcharacteristics (e.g., differences in productioncosts or natural resources)

Utilize replication strategies to capitalize onwhat has worked in other settings



17

Economic Implications ofArbitrage and Replication

Strategies

From Ghemawat, “ Global Advantage…”

Arbitrage ReplicationCost

Drivers

BenefitDrivers

Key Metrics

Risk Mgmt

International differences in absolute costs

Country-of-origineffects

International economiesof scale and/or scope

Nature, amount, & effectsof standardization

Spread/Margin Volume/Market Share

Hedging (e.g., Enron)Spreading risks across markets



18

Aggregation Finding scale and scope opportunities in

new markets/nations Aggregation mechanisms that operate at

levels intermediate to one country and thewhole world.

Like a transnational mentality Deals with the integration-responsiveness

trade-off







19

Bases for Creating Global Advantage

NationalDifferences

Economiesof Scale

EconomiesofReplication

Economiesof Scope

GlobalLearning

GlobalFlexibility

Non-MarketStrategies

© Voigt, Mayer & Liebeskind, 2006



20

NationalDifferences

Location Drivers


GlobalLearning

GlobalFlexibility




21

Cost and Volume Drivers


Economiesof Scale

Economies ofReplication

Economiesof Scope



22© Voigt, Mayer & Liebeskind, 2006

NationalDifferences

Economiesof Scale


Economiesof Scope

GlobalLearning

GlobalFlexibility




23

National Differences Comparative advantage

Natural factor endowments and Societal endowments Scarce or abundant resources Cost differences in factors of production

Lower labor costs, lower cost of capital, tax advantages,availability of land, etc.

Differences in consumer demand “Relatively “ high willingness-to-pay

Location advantages Lower transportation costs, etc.



24

Economies of Scale Economies of scale

Expand output in order to achieve lower production costs Lowering costs by expanding in one area

Experience or learning effects Higher volume helps firms exploit benefits of accumulated

learning

Value-added Chain Selecting components of chain to specialize in, and exploiting

coordination benefits across activities







25

Economies of ScopeEconomies of scope

Expand into different activities in order to maximizeutilization of resources and lower total costs

Lowering costs by expanding into different areasSharing investments and costs across the same or

different value chainsSources

Shared physical activitiesShared external relationsShared learning



26

Examples of Scope Economies

From Bartlett and Ghoshal, “ T ransnational Management”

Multi-ProductScope Advantages

Shared PhysicalAssets

SharedExternal

Relations

SharedLearning

A factory that can produceseveral different products or

product variations (e.g., Ford)

Using common distributionchannels for multiple products

(e.g., Matsushita)

Global brand name (Coca-Cola)

Servicing multinationalcustomers worldwide

(e.g., Citibank)

Shared R&D across multipleproducts (e.g., NEC computer

& communications LOBs)

Pooling knowledge developed in different

markets (e.g., P&G)

Multi-MarketScope Advantages



27

Economies of Replication Duplicating successful profit-making

activities in new locations May also involve learning advantages

– costing of replicating a business mayfall with cumulative experience



28

Global Learning & Innovation Transfer of learning & innovations across markets

From the center to the subsidiaries From the periphery to the center Throughout the network of locations

Organizational challenges Putting the right incentives and processes in place

Decentralize collection of knowledge Centralize processes for sharing knowledge across markets

and divisions Local loyalties, turf protections, NIH (not-invented here)

Intelligence gathering Identification of market opportunities



29

Creating Worldwide Innovations Capture external diversity

Worldwide stimuli as potential source ofcompetitive information advantage

Need to convert “delivery pipelines” into“sensory feelers”

Leverage internal variety Worldwide human resources and capabilities as

potential sources of competitive advantage Opportunity to leverage central and local innovations Create true global innovations by linking sensing,

response and implementation capabilitiesMOR 492 Global Strategy


30

Global Flexibility and Adaptiveness Managing diversity and volatility across

markets – manage the risk/exploit the opportunities Portfolio of national and product markets Minimize impact of adverse conditions (political or

economic) in a single market Competitive actions

Cross-parrying, multi-market retaliation, etc. Cross-market subsidization (e.g. cross-market cash-flows)

Internal markets for resources Labor, capital, etc.







31

Global Flexibility Macroeconomic Risks

Shocks and major trends in macro-environment Political Risks

Actions of national governments Competitive Risks

Uncertainties of competitors actions & reactions Resource Risks

Scarcity of strategic resources



32

Non-Market Strategies Taking advantage of government

protection, subsidies, tax holidays,interest-free loans, etc.

Taking advantage of government rule-making that creates barriers for newcompetitors



33

GlobalHighGlobalCoordination,Integration International

Low

Low NationalDifferentiation,

Responsiveness

Multi-Domestic

High

Trans-National

Global Strategy Perspectives



34

The Four Strategies and ART

MULTIDOMESTICProduct And Value ChainArbitrage through RDI

INTERNATIONALArbitrage throughexporting

TRANSNATIONALTransformation:Products and ValueChain

GLOBALProduct Replication;Value Chain Arbitragethrough integration



35

The Four Strategies:Replicating Versus Responding

Multidomestic StrategyInternational Strategy

Transnational StrategyGlobal Strategy

RESPONDREPLICATE



Marshall School of BusinessDepartment of Management and Organization Voigt



Global Context

1

Globalizationin Context


Global Context

2

Overview Analyzing the Global External

Environment Globalization and “Distance” National Competitiveness: Competitive

and Comparative Advantage of Nations Non-Market Strategy Political Risk


Global Context

3

Country’s Overall Attractiveness

BENEFITS•Size of market•Growth rate•EconomicSystem

COSTS•Political factors•Economicunderdevelopment

•Legal system

RISKS•Political•Economic•Legal

ATTRACTIVENESS

GSBA 492 Global Strategy

Macro-environmentalAnalysis

Analyzing Similarities andDifferences


Global Context

5

Global External EnvironmentFirst Cut Analysis

Macro-environmental (PEST) Analysis Political Environment Economic Environment Social Environment Technological Environment

Competitive and Competitor Analysis Similarities, Differences, and Rate/Velocity

of Change Shocks and Trends


Global Context

6

Political Environment Type of Government

Stability Political goals/agenda Succession and transfer of power

Political Alliances Legal Infrastructure

Contract enforcement Nature and extent of Regulation






Global Context

7

Political Environment Business-government relationships

Role of business in political agenda Role of Public Sector

Privatization Influence Activities

Lobbying Bribery/corruption


Global Context

8

Legal Environment Property Rights Intellectual Property Rights - Patent,

trademark, copyright laws Contract Law – common law and civil law Tariffs, quotas and trade barriers Restrictive trade practices legislation Taxation Product liability, civil and criminal laws Labor laws Laws governing business practices


Global Context

9

Political Systems

Political System – the system of government in a nation

Collectivism Individualism

• Socialism• Communism• Social Democracy

• Individual Freedom &Self-Expression

• Economic Self-interest (invisiblehand)


Global Context

10

Political EnvironmentPOLITICAL SYSTEMS Democracy – representative democracy Totalitarianism

Communist Theocratic Tribal Right-wing

Others (e.g., Oligarchy)


Global Context

11

Economic Environment Economic growth; stage of economic development GDP per capita (income) Financial Institutions – stock exchanges, banks, etc. Monitoring Institutions

SEC, Auditors, GAAP Money supply and monetary stability Balance of payments; foreign debt “Hard” currency reserves Exchange rate fluctuations Fiscal policies, interest rates, taxation Unemployment levels


Global Context

12

Economic Systems Market Economy

Free interplay of demand and supply No restrictions on supply

Central Command Government moderates the activities of different economic systems –

quantity produced and prices charged set by government

Mixed Combination of market and command economies – both private

ownership and free markets and government planning

State-Directed Economy State plays a significant role in directing the investment activities of

private enterprise through “industrial policy” and other wise regulatingbusiness activity in accordance with national goals






Global Context

13

Social/Cultural Environment

CULTURE

Norms, ValueSystems, Attitudes

and Beliefs Education

Work PlaceValues

Religion

Language

Social structure


Global Context

14

Culture : Silent Language Time

Meaning of delays, deadlines, schedules

Space Size, conversation distance

Things Material possessions, language of money

Friendships Meanings of “friends”, expectations

Agreements “Verbal” versus “written” agreements


Global Context

15

Demographic Environment

Population growth

Education and literacy

Age distribution and changes

Population shifts


CAGE FrameworkPankaj Ghemawat,

“Globalization and Distance”


Global Context

17

Country Level Influences on Bilateral Trade Flows

Economic Size: GDP (1% increase) Income Level: GDP per capita Distance: 1% increase Geographic size Landlockedness Common Land Border Common Language Common Regional Trading Bloc Colony/Colonizer Common Colonizer Common Polity Common Currency

+0.8%+0.7%-1.1%-0.2%-50%+80%+200%+330%+900%+190%+300%+340%


Global Context

18

CAGE Framework for Thinking aboutDistance(Closeness) at Country Level

Cultural Distance Cultural attributes of society that are sustained by general social

interaction Administrative Distance

Administrative attributes encompass laws, policies andinstitutions that emerge from the political process

Geographic Distance Geographic attributes include natural constraints and physical

differences Economic Distance

Economic Factors






Global Context

19

Cultural Distance Common (Different) Languages

Example: Spanish companies invest more in South Americawhich is geographically further away than Asia

Common (Different) Ethnicity Lack of connective ethnic or social networks Immigrant populations can substitute for language-related links

Common (Different) Religions Common (Different) Values, Norms, and Dispositions

Examples: values (Confucian vs Western), norms (insiders vsoutsiders), average disposition (materialism, individualism, orrisk-taking)

Other: Insularity, traditionalism


Global Context

20

Administrative Distance Common (Lack) Colonial Ties Shared Regional Trading Agreements

NAFTA, Mercosur, ASEAN, European Union Common Currencies Political Climate (hostility)

Examples: Pakistan vs. India, Pariah States Others:

restrictions on foreign trade & investment, discrimination against foreign companies, limits on currency convertibility/remittance, poor institutional quality – bribery/corruption poor contract enforcement


Global Context

21

Geographic Distance Physical Distance Land Borders Differences in Climates/Disease Environments Others:

landlockness lack of internal navigability geographic size absolute remoteness


Global Context

22

Economic Distance Rich/Poor Differences

80% of the trade/FDI of high-income countries isdirected at other high-income countries

Rich-Rich is “replication”, Rich-Poor is “arbitrage” Others:

factor endowments infrastructure advanced factors


NationalCompetitiveness

Comparative andCompetitive Advantages


Global Context

24

Comparative Advantages:Factor Endowments

Natural Resources Land, climate, mineral resources, water,

demographics, location, etc. National Infrastructure

Ports, transportation system, energy,telecommunications, banking system, etc.

Labor Productivity Education levels, skill levels, labor costs, etc.

Advanced Factors Research facilities, technical know-how, court system

etc.






Global Context

25

Competitive Advantage of Nations What explains:

Japan Inc., Taiwan Dragon, “The German Machine”etc.

Why Competitive Clusters? Silicon Valley, French Wines, Italian Ceramics, UK

Formula I Racing, etc. Why do some nations have such negative

inertia? India, Mexico, Russia, China, etc.


Global Context

26


Rivalry

Factor Conditions

Demand Conditions


Source: Porter (1990) Government

Chance

Determinants of National CompetitiveAdvantage of Nations: Porter’s Complete System


Non-MarketStrategy

Non-market Influences onGlobal Economic Activities


Global Context

28

BUYERS

Threat ofnew entrants MARKET

COMPETITORS

Bargaining powerof customers

SUPPLIERS

SUBSTITUTES

Rivalry amongexisting firms

Bargaining powerof suppliers

Threat of substituteproducts or services


Porter’s Five Forces Framework

POTENTIALENTRANTS

Governmentas Supplier

Governmentas Buyer


Global Context

29

BUYERS

Threat ofnew entrants MARKET

COMPETITORS

Bargaining powerof customers

SUPPLIERS

SUBSTITUTES

Rivalry amongexisting firms

Bargaining powerof suppliers

Threat of substituteproducts or services


Government as a Sixth Force

POTENTIALENTRANTS

Government:Player and/or

Rulemaker


Global Context

30

Disaggregating Non-Market Influences

Government Roles Transactor (Government entities) vs. Rulemaker

National vs. Regional vs. Local Government Politicians vs. Bureaucrats Stakeholders

Regulators, partners, competitors, unions, media,consumers, communities, interest groups/activists






Global Context

31

Government as a Rulemaker Taxes and subsidies Price/profit restrictions Disclosure requirements and other financial

regulations Product/process regulation Local content requirements Trade/industrial policy Governmental ownership by statute


Global Context

32

Local ownership/partnership requirements Competition policy Restrictions on entry/expansion Patent law Intellectual property right recognition and

enforcement Technology transfer policies

Government as a Rulemaker


Global Context

33

Non-market Strategy Responses Lobbying Political Contributions, bribery Advocacy advertising Public exposure Constituency influence Collegial persuasion Litigation Collective organizing Official testimony


Political RiskAnalysis


Global Context

35

US Intelligence Sources (1985)estimated that 80 percent of

foreign contracts for large scalecapital projects were won by

firms paying bribes.


Global Context

36

Political Risk Political Risk arises from the vagaries of

governmental action: Policy changes Leadership changes Nationalization of private property Expropriation of foreign holdings Civil strife Currency inconvertibility War Etc.






Global Context

37

Political Risks -- Macro

Competingpoliticalphilosophies

Armed conflictsand rebellion

Social unrest anddisorders

New internationalalliances

Confiscation,nationalexpropriation

Damage toproperty, persons

Loss of transferfreedoms

Causes Form


Global Context

38

Political Risks -- Micro

Changing socialvalues

Unstable economicconditions

Vested interests Quasi-political Local business

Latent hostilitytowards foreigners

High inflation,currency instability

Breach/revision ofcontracts

Discrimination

Operatingrestrictions

Causes Form


Global Context

39

Political Risk -- Vulnerability

“Critical” industries Entirely foreign or entirely local

management Control over foreign firm’s access to

market, raw materials etc.

Globally, integrated firm High technology firm

HIGHER

LOWER


Global Context

40

Political Risk -- Defensive Strategies Stay ahead -- technical and managerial

capabilities Multiple sourcing of products Raise political costs of intervention JVs with politically connected local

companies Maximize debt investment from local sources Significant exports “Good citizen” -- public services


Global Context

41

Political Risk Forecasting Internal stability

Prospects of domestic violence Demonstrations, riots, strikes Terrorisms, assassinations

External political relations Prospects of border warfare Regional political alliances Trade disputes and economic warfare


Global Context

42

Political Risk Rating Agencies

Business Environment Risk Intelligence:BERI Index

Bank of America World InformationServices: Country Risk Monitor Rankings

Economist Intelligence Unit (EIU): CountryRisk Ratings

Euromoney: Country Risk Ratings Institutional Investor: Country Credit Ratings






Global Context

43

Example: The Economist Rankings Politics (50 points)

Being near a superpower or troublemaker Authoritarianism Longevity of regime Illegitimacy General in power War/armed insurrection

Economics (33 points) Falling GDP per capita High inflation Capital flight High and rising foreign debt as a proportion

of GDP Decline in food production per capita Raw material as a high percent of exports

Society (17 points) Pace of urbanization Islamic fundamentalism Corruption Ethnic tension


Global Context

44

Example: Business Environment Risk Intelligence(BERI) Political Risk Index

Internal Causes of Political Risk Political fractionalization Ethnic fractionalization Coercive measures required for retaining power Mentality, including xenophobia, nationalism, corruption, nepotism Social conditions, including population density and wealth distribution Radical left

External Causes of Political Risk Importance of hostile major power Negative regional influences

Symptoms of Political Risk Societal conflict involving demonstrating, strikes, and street violence Instability as perceived by non-constitutional changes, assassinations, and

guerilla wars


Global Context

45

Country’s Overall Attractiveness

BENEFITS•Size of market•Growth rate•EconomicSystem

COSTS•Political factors•Economicunderdevelopment

•Legal system

RISKS•Political•Economic•Legal

ATTRACTIVENESS



1

COMPETITIVEADVANTAGE OF NATIONS

This is presentation is based onMichael E. Porter’s book:

The Competitive Advantage of Nations, Free Press, 1990

Source: The presentation slides were prepared by George Yip,UCLA

MOR 492 Porter on Global Strategy 2Voigt, 2002

Porter’sCompetitive Advantage of Nations

Extends and modifies traditional theory ofcomparative advantage to take into account thefollowing factors:

Competitive advantage is about companies -- theimportance of the national environment is providing ahome base for the company

Sustained competitive advantage depends upon dynamicfactors -- innovation and upgrading of firm’s resourcesand capabilities

The critical role of the national environment is itsinfluence upon the dynamics of innovation and upgrading



2



Rivalry

Factor Conditions

Demand Conditions



The Determinants ofNational Advantage


Factor Conditions



3


Demand Conditions


Leather Footwear

Leather Working

Machinery

Design Services

Processed Leather


Parts of Footwear




4


Internationally CompetitiveRelated Industries


Firm Strategy, Structure and Rivalry



5


Estimated Number of Japanese Rivalsin Selected Industries, 1987



Rivalry

Factor Conditions

Demand Conditions



Government

Chance

The Complete System



6


Company Strategy


1. Competitive advantage grows fundamentally out of improvement, innovation, and change. 2. Competitive advantage involves the entire value system. 3. Competitive advantage is sustained only through relentless improvement. 4. Sustaining advantage demands that its sources be upgraded. 5. Sustaining advantage ultimately requires a global approach to strategy.

Competitive Advantage inInternational Competition



7


Pressures For Innovation


Perceiving Industry Change



8


Predicting the Behavior of Foreign Rivals FirmStrategy, Structure and Rivalry


FACTOR CONDITIONS What is the direction of industry-related researchin the nation and the types of training received bynew employees?

How will pressures from selective factordisadvantages modify strategies?

Predicting the Behavior ofForeign Rivals, cont.



9


DEMAND CONDITIONS Which industry segments are likely to beemphasized because of their importancedomestically?

What trends in domestic buyer needs willshape competitor perceptions of new productdirections?

Predicting the Behavior of ForeignRivals, cont.


RELATED AND SUPPORTING INDUSTRIES How will developments in local supplier industriesskew the direction of technical development? How will entry from related industries redefine the natureof domestic rivalry or pressure firms to change?

Predicting the Behavior ofForeign Rivals, cont.



10


Choosing Industries and Segments For Whichthe Nation is a Favorable Home Base


Choosing Industries and Segments For Whichthe Nation is a Favorable Home Base, cont.



11








Voigt, Fall, 2005



Introduction: What is Globalization?

1

What is Globalization andthe Global Marketplace,

really?



2

Outline What is Globalization? Drivers of Globalization The Changing Demographics of the

Global Economy The Globalization Debate: Prosperity

or Improverishment? Managing in the Global Marketplace



3

Definition of Globalization Globalization is the trend toward a

more integrated global economicsystem

Examples: telecommunications,automobiles, computers, credit cards,fast food, etc.



4

What is Globalization?The Globalization of Markets

The merging of historically distinct andseparate national markets into one huge globalmarket place

Convergence of consumer tastes andpreferences Citicorp credit cards, Coca-Cola, Levis, Sony Walkman,

Nintendo, McDonalds, etc.



5

Globalization of Markets (Continued)

The most global of markets are for industrialgoods and materials Markets for Commodities

aluminum, oil, wheat Markets for Industrial Products

microprocessors, DRAMs, commercial jet aircraft Markets for Financial Assets

T-bills, Eurobonds, futures

Same multinationals compete with each otherin multiple national markets



6

Globalization of Production The tendency of firms to source goods and

services from different locations around theglobe to take advantage of nationaldifferences in the cost and quality factors orproduction (such as labor, energy, land, andcapital)

Global web of suppliers Almost irrelevant to speak about American

products, Chinese products, Japaneseproducts, Italian products




Voigt, Fall, 2005




7

Semi-Globalization

Globalization vs Semi-Globalization Semi-Globalization is a state between

completely integrated markets andcompletely independent localizedmarkets

Regionalization – NAFTA, EU, Mercosur



8

Drivers of GlobalizationDeclining Trade (tariffs) and

Investment Barriers General Agreement on Tariffs and Trade (GATT) World Trade Organization (WTO)

The lowering of trade and investment barriershas allowed firms to locate productionoptimally almost anywhere in the world

“Home” markets are now under attack fromforeign competitors



9

The Role of Technological Change Microprocessors and Telecommunications

As costs of telecommunications fall, so do thecosts of coordinating and controlling globalorganizations

Internet and the World Wide Web Information backbone of the global economy Greatly increased across-border transaction Location, scale and time no longer become

major competitive advantages



10

The Role of Technological Change(continued)

Transportation Technology Development of commercial aircraft and

superfreighters Containerization (simplifying transshipments) Commercial jet travel (reducing time to travel)



11 MOR 492 Global Strategy


12

Implications for the Globalization ofProduction Containerization

Development of commercial aircraft andsuperfreighters

Containerization (simplifying transshipments) Commercial jet travel (reducing time to travel)

Information Technology Real costs of info processing and

communication have fallen dramatically Ability to manage globally dispersed production

systems




Voigt, Fall, 2005




13

Implications for the Globalization ofMarkets Containerization and Low-cost Transportation

Economical to ship products around world Low-cost Global Communication

eCommerce Low-cost Jet Travel

mass movement of people between countries reduced cultural distance between countries creating a worldwide culture

Emergence of global markets for consumerproducts



14

Changing Demographics of theGlobal Economy

In the 1960s world stylized factscharacterized the demographics of theglobal economy:1. US dominance of the world economy and world trade2. US dominance of world foreign direct investment3. Dominance of international business by large US

multinational corporations4. Approximately half of the world was under the control

of centrally-planned communist economies which wereoff-limits to US businesses



15

Changing World Output and WorldTrade Patterns

Decline of US of world output (and othertraditionally dominant economies) relative toemerging economies such as Asia

Decline of US as leading exporter relative toJapan, Germany, South Korea, China, etc.

Emerging regions and economies such asthose of South America, Eastern Europe, andAsian Pacific have further eroded US position



16

The Changing Pattern of World Output and TradeCountry Share of World

Output, 1963Share of WorldOutput, 1997+

Share of WorldExports, 1998

United States 40.3% 20.8% 12.7%

Japan 5.5 8.3 7.26

Germany* 9.7 4.8 10

France 6.3 3.5 5.7

United Kingdom 6.5 3.2 5.1

Italy 3.4 3.2 4.5

Canada 3 1.7 4.0

China++ NA 11.3 3.4

South Korea NA 1.7 2.45*1963 figure for Germany refers to the former West Germany.+ Output is measured by gross national product. The 1997 estimates are based on purchasing power parity (PPP) statistics that adjust GNP for differences in prices (the cost ofliving) between countries.++ The Chinese figures are somewhat suspect. When calculated using unadjusted GNP data, China's share of world output shrinks to 3.1 percent. Thus, China's high share ofworld output on a PPP basis is partly due to the relatively low cost of living in China.Source: Export data from World Trade Organization, Annual Report, 1999 and Statistics, 1996 (Geneva: WTO, 1996). World output data from CIA factbook, 1999.



17

Changing Foreign Direct InvestmentPicture Relative decline to US foreign direct

investment Emergence of non-US firms investing across-

borders



18

Changing Nature of the MultinationalEnterprise Definition: A multinational corporation (MNC)

is any business that has productive activitiesin two or more countries

Two important trends: Emergence of non-US MNCs

Japanese and European MNCs Growth of mini-MNCs

Medium and small businesses with as few as 25employees




Voigt, Fall, 2005




19

The National Composition of theLargest Multinationals

Source: The 1973 figures from Hood and Young, The Economics of the Multinational Enterprise (NewYork: Longman, 1979). The 1997 figures from "The Global 500," Fortune, August 4, 1997, pp. 130-31.

Of the Top 260 in 1973 Of the Top 500 in 1997

United States 126 (48.5%) 162 (32.4%)

Japan 9 (3.5) 126 (25.2)

Britain 49 (18.8) 34 (6.8)

France 19 (7.3) 42 (8.4)

Germany 21 (8.1) 41 (8.2)



20

Changing World Order

Between 1989-1991 a series of democraticrevolutions swept the communist world Collapse of the Soviet Union Numerous European and Asian countries with

a commitment to free-markets createsinternational business opportunities

Quieter revolutions in China and LatinAmerica



21

The Global Economy of the 21st Century Barriers to the free flow of goods, services, and

capital have come down The volume of cross-border trade and

investment grew more than global output indicates national economies are becoming more

closely integrated into a single, interdependent,global economic system

More nations have joined the ranks of thedeveloped world e.g. Korea, Taiwan



22

The Global Economy of the 21stCentury (Continued)

Widespread adoption of liberal economicpolicies privatization of state-owned businesses deregulation removal tariffs and other barriers

New countries are expected to build powerfulmarket economies Czech Republic, Poland, Brazil, China, South

Africa



23

The Global Economy of the 21stCentury (Continued)

Russia appears to be backing away from amarket economy

Financial crises such as the Asian crisis of1998 spread very quickly across borders,driving economies to recession

Some South American countries seem to bereversing course



24

The Globalization Debate:Prosperity or Impoverishment

Pros: Lower prices for goods or services Economic growth resulting in increased

household incomes Job creation from international trade Countries that conduct a lot of trade together

usually don’t go to “war” with each other Promotes cross-cultural understanding




Voigt, Fall, 2005




25

The Globalization Debate:Prosperity or Impoverishment (Continued)

Cons: Destroys manufacturing jobs in developed

countries Wages rates of unskilled workers in

developed countries have declined Growing inequality between skilled and

unskilled workers wages



26

The Globalization Debate:Prosperity or Impoverishment (Continued)

Cons: Movement of manufacturing facilities of

advanced nations to developing countries exploitation of labor and environmental abuse

in developing countries “fleeing” to avoid perceived burdensome

regulations Economic power and sovereignty is being

challenged by supranational organizations WTO, EU, UN



27

Managing in the Global Marketplace International Business and MNCs

Definition of international business Any firm that engages in international trade or

investment Managerial Challenges

Profound and enduring differences incultures, political systems, economicsystems, legal systems,and levels ofeconomic development International business must vary practices

country by country MOR 492 Global Strategy


28

Managing in the Global Marketplace Strategic Questions

Where in the world to produce to minimizecost and maximize added-value?

How to best coordinate and control theglobally dispersed production activities?

Which foreign to enter and which to avoid? What mode of entry?

Export? License? Joint Venture? Wholly-owned subsidiary?



29

Managing in the Global Marketplace Across-border financial transaction

challenges Government restrictions on international

trade and investment Foreign exchange rate movements Restrictions on the repatriation of profits



30

Managing in the Global Marketplace Differences between international

business and domestic business1. Countries are different2. The range of problems confronted by a manager in an

international business is wider and the problems aremore complex

3. An international business must find ways to work withinthe limits imposed by government intervention in theinternational trade and investment system

4. International transactions involve converting moneyinto different currencies




Voigt, Fall, 2005




31

Who is us?AND

Who is them?






Modes ofGlobal Market

Entry


Global Entry Mode

2

OVERVIEW: ENTRY STRATEGIES EXPORT ENTRY

Direct and indirect exporting

CONTRACTUAL ENTRY Licensing/franchising, technical agreements Contract manufacturing, turnkey projects

STRATEGIC ALLIANCES

INVESTMENT ENTRY Wholly owned subsidiaries


Global Entry Mode

3

Choice of International Entry ModeDIRECT INVESTMENTTRANSACTIONS

EXPORTING:Spot

Transactions

EXPORTING:with

Long-termcontracts

EXPORTING:with

foreigndistributor/ag

ent

LICENSINGTECHN-OLOGY

and

TRDAE-MARKS

FRANCH-ISING

JOINT VENTURE FULLY OWNEDSUBSIDIARY

Market-ing &Dist’nonly

Fullyinte-

grated


Fullyinte-grated

Key Issues:Is the firm’s competitive advantages based upon firm-specific or country-specificresources and capabilitiesIs the product tradable and what are the barriers to/costs of trade?Does the firm possess the full range of resources and capabilities needed toserve the overseas market?


EXPORTSTRATEGIES


Global Entry Mode

5

EXPORT - APPROACHESDIRECT Firm handles entire export operations itselfINDIRECT Exports using

Manufacturers' export agents

Export commission agents

Export merchants


Global Entry Mode

6

EXPORT - ADVANTAGES

Lower per unit cost Economies of scale Better capacity utilization

Overcome domestic market size limitations

Offset market cyclicality Low asset exposure to political risk

Flexibility of switching the geographicaldirection of products






Global Entry Mode

7

EXPORT -- DISADVANTAGES Costs associated with trade barriers Lower control over market Local government objections Transportation costs Costs associated with locating and

maintaining relationships with importer(s) Conflicts-- exporters’ and importers’ goals


Global Entry Mode

8

EXPORT -- QUESTIONS

Will there be sustainable competitiveadvantage in export markets? Why?

What exports markets and segments willvalue our products sufficiently?

Standard product with standard marketingmix or tailored products?

What trade barriers impede export? What are the appropriate channels for

distribution?


LICENSING


Global Entry Mode

10

LICENSING: ADVANTAGES

Extends product life cycle Allows penetration of small markets Helps build goodwill for MNC’s products Limited exposure to political risks Reduces loss due to “piracy” Requires limited resources Quick entry


Global Entry Mode

11

LICENSING: DISADVANTAGES Lost control over technology

Difficulty in maintaining quality standards

Government restrictions/ high taxes on royalties

Development of potential competitors

Opportunity costs

Post-agreement costs Protecting industrial property Backup services


Global Entry Mode

12

LICENSING PROCESS

Building aworkingpartnershipwithlicensee

Assessingpotentialin targetmarket

Findingsuitablelicensingcandidates

Negotiatinga licensingagreement






Global Entry Mode

13

WHEN IS LICENSING EMPLOYED?

Firm lacks capital, managerial resources orknowledge of foreign markets

Testing and developing a market that can belater exploited by direct investment

Technology involved is not central to thelicensor’s core business

Prospects of “technology feedback” are high Host-country government restricts imports or FDI Licensee unlikely to become a future competitor Pace of technological change is rapid Beamish (1994)


CONTRACTMANUFACTURING


Global Entry Mode

15

CONTRACT MANUFACTURINGADVANTAGES Limited commitment

of resources Quick entry Avoids ownership

problems Cost reduction Access to technology

DISADVANTAGES Time and effort required

to develop manufacturer Adverse sentiment

domestically Potential loss in

flexibility and control Expense -- negotiating,

maintaining andenforcing contracts

Creation of futurecompetitor


Global Entry Mode

16

GLOBAL SOURCING STRATEGY

OUTSOURCING

DOMESTICDomestic purchasing agreement

FOREIGNOffshore outsourcing


STRATEGICALLIANCES


Global Entry Mode

18

STRATEGIC ALLIANCES• Enable firms to shares risks and resources to expand

into international ventures• Most joint ventures (JVs) involve a foreign company

with a new product or technology and a hostcompany with access to distribution or knowledgeof local customs, norms or politics

• May experience difficulties in merging disparatecultures

• May not understand the strategic intent of partnersor experience divergent goals






Global Entry Mode

19


TRADITIONAL REASONS Sharing of resources and risks Host government requirements Overcoming strong nationalistic sentiments Quicker entry Benefit from partner’s local knowledge


Global Entry Mode

20

WHY STRATEGIC ALLIANCES?EMERGING REASONS Learning from one another Attain global scale economies

Raw material/ Component supply Marketing and distribution

Rising R&D costs and technological interdependence Short product life cycles

Industry convergence


Global Entry Mode

21


Industry Globalization and Global Competition Improved market access

Stronger product line

Superior timing

Shaping competitive rivalry

Keeping key competitors at bay

Reduced transaction and other costs


Global Entry Mode

22

RISKS OF STRATEGIC ALLIANCES

Partner opportunism and loss ofcompetitive edge

Strategic and organizational complexity

Conflict of interest problems

Decreasing partner commitment


Global Entry Mode

23


ASSESSING NEED Do you need a partner? How big is the payoff? How likely is success?PARTNER SELECTION Does the partner share your goals and

objectives? Does strategic synergy exist? Is the partner compatible?


Global Entry Mode

24

MAKING STRATEGIC ALLIANCES WORKDEFINING GOALS AND OBJECTIVES Clarify and resolve separate interests Develop mutual trust and understanding

DESIGNING AN ALLIANCE Define role of each partner Define venture boundaries Identifying champion(s) Trust versus legal considerations Allow for termination






Global Entry Mode

25



Achieving operating momentum

Recognize alliance needs Policies

Resources (inc. human resources)

Overcoming reluctance to give up autonomy


Global Entry Mode

26

MAKING ALLIANCES WORKMANAGING THE ALLIANCE

Managing cultural differences

Flexibility

Assuring continued commitments

Increasing willingness to learn

Avoiding bottleneck dependence


Global Entry Mode

27

STRUCTURING ALLIANCES TOREDUCE OPPORTUNISM

Probability ofOpportunism by Alliance PartnerReduced By

Walling off Critical technology

Establishingcontractualsafeguards

Agreeing to swap valuable skills andtechnologies

Seeking crediblecommitments


DIRECTINVESTMENTSTRATEGIES


Global Entry Mode

29

FULLY-OWNED SUBSIDIARIES:GREENFIELD INVESTMENTS

ADVANTAGES Total control Lack of partner

commitment not aconcern

Greater learning aboutforeign markets

No loss of technology

DISADVANTAGES Host government objections Large investment required Labor union objections Vulnerability to political risk Time required to establish

competitive advantage


Global Entry Mode

30

FULLY-OWNED SUBSIDIARIES:ACQUISITIONS

ADVANTAGES Total control Quick entry

DISADVANTAGES Acquisitions difficult to

evaluate Post-acquisition assimilation

problems Vulnerability to political risk Can be considered as “anti-

social”






GLOBAL MARKETENTRY CHOICES


Global Entry Mode

32

ENTRY STRATEGIES

EXPORTING

LICENSING

STRATEGIC ALLIANCES

WHOLLY OWNED SUBSIDIARY

Ownership and control of foreign operations

Limited Medium High

Limited

Medium

High

Level ofInvestmentRisk


Global Entry Mode

33

ENTRY STRATEGY: CHOICEEXTERNAL FACTORS Target country environment

Government policies/regulations Economy Socio-cultural factors Institutional voids Political risk

Market factors Size/attractiveness of markets Competitive structure Marketing infrastructure


Global Entry Mode

34

RESPONSE TOGOVERNMENTAL BARRIERS

TRADE BARRIERS Tariffs and quotas Domestic content

restrictions Government

procurementrestrictions

BUSINESS RESPONSE Establish manufacturing

operations in country Acquire local firm Subcontract or purchase

locally Develop products jointly Shift to higher-priced

exports (for quotas)


Global Entry Mode

35

RESPONSE TOGOVERNMENTAL BARRIERS

INVESTMENT BARRIERS Limits on foreign

ownership Restrictions on

repatriation of earning Fear of expropriation Tax barriers

BUSINESS RESPONSE Enter into a JV Franchising/ licensing

agreements Set up affiliate

relationships with localfirms

Shift high value-addedactivities to low-taxnations


Global Entry Mode

36

ENTRY STRATEGY: CHOICEINTERNAL FACTORS Technology and product characteristics

Product factors Pre and post purchase services Technological intensity Minimum efficient scale

Resource and commitment factors Resource availability Willingness to take risks Corporate goals






Global Entry Mode

37

CHOICE OFENTRY

STRATEGY

Firm CapabilityFirm Size; Multinational Experience

Industry Factors Industry growth; Global industry

concentration; Technical intensity;Advertising intensity

Location-specific Factors Country risk; Cultural distance;

Market potential; Market Knowledge

Venture-specific Factors Contractual risk; Venture size; Tacit

nature of know-how

Strategic Factors Global strategic motivation; Global

synergy

ENTRY MODESAND DEGREEOF CONTROL


Global Entry Mode

38

ENTRY STRATEGY SELECTION• Joint Venture• Contract manufacturing• Exporting

• Joint Venture• Wholly owned subsidiaries

• Licensing• Contract manufacturing• Exporting

• Licensing• Exporting

POLITICAL RISK

Low High

ECONOMICOPPORTUNITY

Low

High


Global Entry Mode

39

ENTRY STRATEGY SELECTION

POLITICAL RISK

HighLow

RISK OF HOLD-UPBY TRADINGPARTNER

Low

High Wholly OwnedSubsidiary

MarketTransaction

ExportDelay EntryGet Creative

Joint Venture/Strategic Alliance




Voigt, Fall, 2004


MOR 492 Global Strategy 1

The Global Organization andManagement Challenge:

Organizational Design,Coordination, and Control


OVERVIEW

Control: Essence of Implementation

Global Managers

Organization Design

Organization Systems

Organization Culture


Global Managers The Business Manager (Global scale & competitiveness)

Strategist+Architect+Coordinator The Country Manager (Local responsiveness & flexibility)

Sensor+Builder+Contributor The Functional Manager (Linking functions worldwide)

Scanner+Cross-Pollinator+Champion The Corporate Manager (Transnational mission)

Leader+Talent Scout+Developer


Four Basic Global Strategies

Importance of Local Responsiveness

Efficiency,Global Scale,Low Cost,GlobalIntegration

GLOBAL

INTERNA-TIONAL

TRANS-NATIONAL

MULTI-DOMESTIC

High

High

LowLowEXPORT

-ING


Four Basic Global Organizational Designs



CENTRALIZEDGLOBAL

BUSINESSUNITS

INTERNA-TIONAL

FUNCTIONAL

GLOBALNETWORKS

DECENTRAL-IZED

AREA-FOCUSED

High

High

LowLowEXPORT

-INGMOR 492 Global Strategy 6

Aligning Managers Responsibility and Decision-makingDiscretion with Organizational Arrangements



GBU ManagerDominant

InternationalFunctionalManagerDominant

NetworkedTeam

Country ManagerDominant

High

High

LowLowEXPORT

-ING




Voigt, Fall, 2004



Successful Multinational Execution Important but not sufficient – Formal Control

Mechanisms Incentives, compensation, monitoring systems, rewards &

punishments Due Process in Global Strategic Decision-making

Head office is familiar with subsidiaries local situation Two-way communication exists in the global strategy-making

process Head office is relatively consistent in making decisions across

subsidiaries Subsidiary units can legitimately challenge HQ views and

decisions Subsidiary units receive an explanation for final strategic

decisionsMOR 492 Global Strategy 8

Global Strategy Prescriptions Locate each value-added activity in the country that has

the least cost for the factor that activity uses mostintensely

Dexterously shift capital and resources across nationalmarkets, cross-subsidizing global units

Institutionalize fully standardized product offerings,marketing approaches, and commonly used distributionsystems worldwide to allow maximum global efficiencies

Consciously consolidate worldwide knowledge,technology, marketing and production skills to buildreservoirs of distinctive core competencies that can actas engines for continuous new business development,innovation and enhanced customer value


How do you execute them? Increasing sacrifice of subsystem for system

priorities and considerations Swift actions in a globally coordinated manner Effective and efficient exchange relations

among the nodes of the multinational’s globalnetwork

Multinational enterprises need subsidiarymanagers with a sense of commitment, trustand social harmony

- compulsory vs. voluntary executionMOR 492 Global Strategy 10

CONTROLIMPEDIMENTS Historical evolution of headquarters-

subsidiary relationship HQ managers may lack understanding

of skills and limitations involved inoperating in dissimilar environments

Presence of JV partners Host governments like to influence

strategy at subsidiary level


ORGANIZATION STRUCTURE

International

Worldwide Area

Global Product Division

Matrix

Network

NameTitle

NameTitle

NameTitle

NameTitle

NameTitle

NameTitle


EXPORT ORGANIZATIONDisadvantages

Export manager may have insufficient clout

Export orders may receive low priority

Domestically oriented organization notsupportive of foreign market requirements




Voigt, Fall, 2004



TRADITIONAL SOLUTION:STRUCTURAL MERRY-GO-ROUND

InternationalDivision

AreaDivision

WorldwideProductDivision

FOREIGN PRODUCTDIVERSITY

FOREIGN SALES ASPERCENTAGE OF TOTAL SALES

GlobalMatrix


INTERNATIONAL DIVISIONCEO/

PRESIDENT

DOMESTICDIVISION

B

DOMESTICDIVISION

A

DOMESTICDIVISION

C

INTERNATIONALDIVISION

Germany Japan Brazil


INTERNATIONAL DIVISION

· Focus oninternationalopportunities· Greater “weight”

in hierarchy· Establishment of

formal controlprocedures

· International-domestic split· Domestic

divisions exertgreater power· Manager needs to

understandproduct marketstrategies of alldivisions

ADVANTAGES DISADVANTAGES


WORLDWIDE AREACEO/

PRESIDENT

EuropeNorth

AmericaSouth

America Asia

CountryManager: U.S.

Canada

Germany

Spain

Brazil

Argentina

India

Japan


WORLDWIDE AREA

· Local sensitivity· More efficient

use of resourceswithin country· Motivated

countrymanagers

· Countryconsiderationsdominate over global· Country managers

may not haveadequate knowledgeof all products· Duplication at HQ



WORLDWIDE PRODUCT DIVISIONCEO/

PRESIDENT

Product Division B

Product Division A

Product Division C

Product Division D

Area ProductManager: U.S.

Area ProductManager: Japan










Voigt, Fall, 2004



WORLDWIDE PRODUCT DIVISION

· Bettercoordinationwithin productgroups· Global view of

competition· Facilitates

technologytransfer acrosscountry border

· Duplication atcountry level· Coordination across

product groups· Less subsidiary

initiative



PORTFOLIO- WORDWIDEBUSINESS MANAGER

WorldwideBusinessManager

Country 1

Country 2 Country

3

Country 4

Country 5


PORTFOLIO- COUNTRYMANAGER

CountryManager

Business 1

Business 2 Business

3

Business4

Business 5


GLOBAL MATRIXCEO/

PRESIDENT

Product Division A

ProductDivision B

Product Division C

Subs. Mgr.Japan

Subs. Mgr.Germany

Manager A Manager B Manager C


GLOBAL MATRIX

· Combinespositives ofproduct andarea structures· May be

suitable fortransnationalstrategies

· Dual reporting cancause confusion· Slow decision

making· Requires high

horizontal andverticalcoordination



ORGANIZATIONAL IMPLICATIONS:THE INTEGRATED NETWORK

DECENTRALIZEDFEDERATION

THE INTEGRATED NETWORK

COORDINATED FEDERATION

CENTRALIZEDHUB




Voigt, Fall, 2004



NETWORKBusinessmanager

Businessmanager

Businessmanager

CorporateManagement

Businessmanager

Businessmanager

Businessmanager


TRANSNATIONAL MANAGEMENT

BUILDING AND MANAGING THETRANSNATIONAL


STRATEGIC CAPABILITY OF THE TRANSNATIONAL:The New Multi-layered Game

Sensitivity, flexibility, and responsivenessto local needs

Global scale efficiency and competitiveresponse capability

Worldwide innovation skills and learningcapabilities


Developing Transnational Organization

Building an organization - More than Installing a Structure

Requires an integrated approach - Building the Transnational Anatomy - Shaping the Transnational Physiology - Moulding the Transnational Psychology


BUILDING AND MANAGING THE TRANSNATIONAL:A Biological Metaphor

A new structural anatomy* Redistributing assets and responsibilities

A new process physiology* Redefining information flows and relationships

A new cultural psychology* Readjusting mentalities and beliefs


Building and Managing the Transnational

- Don’t manage like the United Nations: Differentiate roles and responsibilities

- Don’t let a single perspective dominate: Legitimize business, area and functional

management

- Don’t search for a standard coordination process: Develop and apply different tools to different tasks

- Focus beyond structure and systems: Build a matrix in managers’ minds




Voigt, Fall, 2004



The New Organizational Roles andResponsibilities

ConsumerElectronics

Production

Phillips

Matsushita

GE

Medical

Telecom

Lighting

ResearchPurchasing

Development

Marketing

SalesService

TaiwanSingapore

UK

France

Australia

Brazil

India

Company Business Function Geography


Building and Maintaining Multiple Strategic CapabilitiesRequire Protecting the Legitimacy of Multiple Management Tasks

BUSINESS MANAGEMENT

AREAMANAGEMENT

FUNCTIONAL MANAGEMENT NATIONAL

RESPONSIVENESS

WORLDWIDEINNOVATION AND

LEARNIING

GLOBALEFFICIENCY


Building and Balancing MultipleOrganizational Perspectives

- Build legitimacy and credibility of nondominant groups: Coopt specific individuals Provided required mandate- Provide access to information channels Modify existing channels Create new channels- Create influence in decision processes Use micro-structural tools Use both visible and invisible hands- Maintain balance over time Manage ambiguity and flux Develop fit and flexibility


Transnational CoordinateMechanisms

- Intense cross-border flows - Goods: Materials, components, products - Resources: Financial, human - Knowledge: Technology, expertise, Intelligence

- Administrative heritage influences coordination - Centralization in Japanese centralized hubs - Formalization in American coordinated federations - Socialization in European decentralized federations


Transnational Coordination MechanismsPortfolio of tools, selectively applied - Goods flows: Formalized coordination - Resource flows: Centralized coordination - Knowledge flows: Socialized coordination

With flexibility to match roles and tasks

- Leaders and black holes: Socialization dominates - Contributors: Centralization dominates - Implementers: Formalization dominates


Traditional Solution: Structural Merry-Go-Round

Structure and systems- Blunt instrument of change

- Deny, oversimplify or compartmentalize complexity

- Reinforce parochial, hierarchical, adversarial mentality




Voigt, Fall, 2004



CHANGING ATTITUDES AND BEHAVIORS:The Foundation Stone of Change

Developing shared values and purpose * Clarity, Continuity, Consistency

Building multi-dimensional perspectives, capabilities * Expand career paths, assignments, education

Helping the organization embrace, not deny,complexity

* “Create a matrix in managers’ minds”


INSTALLING THE TRANSNATIONALSTRUCTURE LIMITS OF TRADITIONAL

CHANGE MODELS

•Classic change process driven by structural reconfiguration

Assumptions of change model:

Change in formal structure/responsibilitiesreshapes

redefines

Organizational processes/relationships

Individuals attitude/mentalities


BUILDING THE TRANSNATIONAL ORGANIZATION:The Alternative Approach

• Recognizes structures as a blunt instrument of change

* Simultaneous changes organization's anatomy, Physiology, psychology

Modify individual attitudes/mentalities (Psychology)

Develop new processes/relationships (Physiology)

Confirm with redefined structures/responsibilities (Anatomy)




Voigt, Term Iv, 2006

GSBA 519b Corporate & Global Strategy 1


WBMH FrameworkAn Overview Framework for

Global Strategy Analysis


WBMH Framework

2

The “Radio” Model Framework

W Why go global? What is the motivation,goals, intended end outcomes?

B What does the firm bring (and what will“travel”) to the global market opportunity?

H How should the firm enter the globalmarket? How should it organize itself?

M What will/should/can the firm expect tomeet when it goes global?

Source: WBMH is bui l t on idea from Porter


WBMH Framework

3

Motivations/Imperativesfor “Becoming” Global

Growth Imperative: pursuing new sources ofvolume by finding “Q” in new global markets “Replication” of existing business model in new

locationEfficiency Imperative:

pursuing low cost raw materials, labor, etc. “Arbitrage” is using involved in some way

economies of scale and scope Minimum efficient scale may be bigger than any single

market reducing distribution costs, inventory costs, etc

Why?


WBMH Framework

4

Motivations/Imperatives (Continued)

Knowledge Imperative: continuous learning markets change, consumer’s tastes and needs change, competitors innovate and adapt, technology “jumps”

Globalization of Customers: when customersstart to go global, firms must keep pace with themor lose overseas and domestic business to newrivals

Globalization of Competitors: Rivals may capture global first mover advantages Rival may be able to use multi-market presence to

cross-subsidize an attack on a firm’s home market

Why?


WBMH Framework

5

Transferring Competitive Advantages, CoreCompetencies and Capabilities across Borders

What “travels” from a firm’s strategy(business model) to the new global market?

What can the firm “take” with it? What can the firm replicate in the local market? What can the firm adapt to the local market? What resources and skills will not travel?Asking and answering the “Taco Stand” question iscritical to determining what the firm can “bring” global

Bring?


WBMH Framework

6

Global “Generic” Strategies Source of Global Strategies are in two

areas: Arbitrage Replication Transformation (third area which combines first two)

Bring?







WBMH Framework

7

Bases for Global Advantage

NationalDifferences

Economiesof Scale


Economiesof Scope

GlobalLearning

GlobalFlexibility



Bring?


WBMH Framework

8

Analyzing the Global Market:What will the firm meet?

Regional Analysis

Country Analysis

Industry Analysis

Industrial Sector Competitiveness Analysis

Market Potential Analysis

Competitor Analysis

FeasibilityAnalysis

ProfitabilityAnalysis

Meet?


WBMH Framework

9

Country Analysis Global Economics of Region Macroeconomic Policies

Political Agenda Fiscal & Monetary Policies Policies toward foreign investments & control

Political Risk Analysis Institutional Voids Analysis

Meet?


WBMH Framework

10

Global Competitiveness Relative competitiveness of “Country” Relative competitiveness of “Industries” Use Porter’s Diamond of Global Competitive

Advantage

Also important to examine sources leading to“un”competitiveness of country or industry

Meet?


WBMH Framework

11


Rivalry

Factor Conditions

Demand Conditions



Government

Chance

Diamond of Global CompetitivenessMeet?


WBMH Framework

12

Examining Relevant “Distances”

CAGE Framework (Ghemawat) Cultural Distance Administrative Distance Geographic Distance Economic Distance

Global strategy must exploit/mitigate relative“distance” between the firm and the global market

Meet?







WBMH Framework

13

“How” to Become Global? Choice of Global Strategy Choice of Entry Mode Choice of Organizational Structure

How?


WBMH Framework

14

Four Basic Global Strategies



GLOBAL

INTERNA-TIONAL

TRANS-NATIONAL

MULTI-DOMESTIC

High

High

LowLowEXPORT

-ING

How?


WBMH Framework

15

Choice of International Entry ModeDIRECT INVESTMENTTRANSACTIONS

EXPORTING:Spot

Transactions

EXPORTING:with

Long-termcontracts

EXPORTING:with

foreigndistributor/ag

ent

LICENSINGTECHN-OLOGY

and

TRDAE-MARKS

FRANCH-ISING

JOINT VENTURE FULLY OWNEDSUBSIDIARY


Fullyinte-

grated


Fullyinte-grated

Key Issues:Is the firm’s competitive advantages based upon firm-specific or country-specificresources and capabilitiesIs the product tradable and what are the barriers to/costs of trade?Does the firm possess the full range of resources and capabilities needed toserve the overseas market?

How?


WBMH Framework

16

Traditional Solution:Structural “Merry-go-round”

InternationalDivision

AreaDivision

WorldwideProductDivision

FOREIGN PRODUCTDIVERSITY

FOREIGN SALES ASPERCENTAGE OF TOTAL SALES

GlobalMatrix

How?


WBMH Framework

17

International DivisionCEO/

PRESIDENT

DOMESTICDIVISION

B

DOMESTICDIVISION

A

DOMESTICDIVISION

C

INTERNATIONALDIVISION

Germany Japan Brazil

How?


WBMH Framework

18

Worldwide AreaCEO/

PRESIDENT

EuropeNorth

AmericaSouth

America Asia

CountryManager: U.S.

Canada

Germany

Spain

Brazil

Argentina

India

Japan

How?







WBMH Framework

19

Worldwide Product DivisionCEO/

PRESIDENT

Product Division B

Product Division A

Product Division C

Product Division D









How?


WBMH Framework

20

Global MatrixCEO/

PRESIDENT

Product Division A

ProductDivision B

Product Division C

Subs. Mgr.Japan

Subs. Mgr.Germany

Manager A Manager B Manager C

How?


WBMH Framework

21

NetworkBusinessmanager

Businessmanager

Businessmanager

CorporateManagement

Businessmanager

Businessmanager

Businessmanager

How?


WBMH Framework

22

Organizational Implications:The Integrated Network

DECENTRALIZEDFEDERATION

THE INTEGRATED NETWORK

COORDINATED FEDERATION

CENTRALIZEDHUB

How?



University Notes - Senior Year, 2nd Semester

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