Markets Organization and Corporate Strategy
George Norman
Cummings Professor of Entrepreneurship and Business
Economics
Some Introductory Comments
Textbook: The Economics of StrategyGrading:
Two sets of essays: 20% and 25% respectively Research paper: 30% Industry analysis and presentation: 25%
Syllabus: not a legally binding descriptionWeb-site
http://www.tufts.edu/~gnorman/cmba344.html
Objectives
Focus on strategic decision-making Application of economic reasoning to develop
insights necessary for a firm to deal effectively with its operating environment
The central role of strategic decision-making in determining a firm’s success
Strategy and Economics
The definition of strategy no single definition different from tactics - essentially short-term
Strategy Definition
The determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. (Chandler, 1962)
Strategy Definition
The pattern of objectives, purposes or goals, and the major policies and plans for achieving these goals, stated in such a way as to define what business the company is in or should be in and the kind of company it is or should be. (Andrews, 1971)
Strategy Definition
What determines the framework of a firm’s business activities and provides guidelines for coordinating activities so that the firm can cope with and influence the changing environment. Strategy articulates the firm’s preferred environment and the type of organization it is striving to become. (Itami, 1987)
Why an Economic Perspective?
Other approaches are possible game theory psychology
how motivation and behavior of individuals shape organizations
sociology social structures, peer networks, routines and their
effects on organizational decisions and decision-making
Economics
Requires that we be explicit about the elements that generate strategies decision-makers goals choice of strategic variables relationships between choices and outcomes
Provides a clear linkage between conclusions and assumptions
Cost: lose some detail
The Need for Principles
What makes a profitable, successful business? Can general lessons be drawn from the behavior of
successful organizations? Reasons for success often unclear and complex No list of characteristics that guarantee success Partial data Success stories bias interpretation
No automatic or general recipe for success Trek: outsourcing and brand-management (Raleigh) Usiminas: excellence in manufacturing (Bethlehem) Wal-Mart: initiative of local managers; inventory management
(Kmart)
Principles (cont.)
Successful firms adopt strategies that exploit potential profit opportunities.
Adapt to changing environments Need to analyze decision making using
consistent principles of market economics and strategic action
A Framework for Strategy
The big issues: boundaries of the firm markets and competitive analysis position and dynamics internal organization
The boundaries of the firm
These extend in three directions horizontal: how much of the product market the
firm serves vertical: the set of activities that the firm
performs itself and those it purchases from other firms
corporate: the set of distinct businesses in which the firm operates
Markets and competitive analysis
Understand the markets in which the firm operates
Industry-specific effects constrain profitability and must be understood: high-tech e.g. pharmaceuticals or low-tech e.g.
airline travel determinants of entry mistakes can be made e.g. major
pharmaceutical companies’ attempts to move into production of generics
Position and dynamics
How and on what a company competes cost advertising product positioning R&D
Dynamics how the firm accumulates resources how the firm adjusts to changing circumstances
Internal organization
How should a firm organize itself to give effect to its strategies?
Organizational structure determines information flows and alignment of individuals with the objectives of the firm decentralized versus centralized incentives versus culture
An Economics Primer
Some Introductory Ideas
Objectives need well-defined strategies that are under the control of the decision-maker
Success is determined by the economic environment within which the firm operates
Strategies must be consistent with the environment law of demand size and profitability of price-matching
is it reasonable to match a small competitor’s price cut? Price and cost: can additional volume be sold at a profit?
Costs
How do costs change as output changes?
This is the total cost function - TC(Q)
Describes the efficient relationship between output and total cost
Total cost increases with output
Tot
al C
ost
Output
TC(Q)
Fixed and variable costs
Variable costs increase with output labor costs materials costs
Fixed costs are independent of output general administration costs property taxes
The distinction is fuzzy some costs have fixed and variable components costs may be fixed over one range and vary over
another
Fixed and variable costs (cont.)
Fixed costs are invariant with output but are affected by other decisions
Whether costs are fixed or variable depends upon the time period
Average and marginal costs
Average cost is total cost divided by output: AC(Q)=TC(Q)/Q.
Marginal cost is the additional cost of producing one more unit of output: MC(Q)=dTC(Q)/dQ.
They are related as follows:
Cos
t
Output
AC(Q)
MC(Q)
The importance of time
Distinguish between short-run and long-run costs
In the long-run choose plant size that is adjusted to anticipated output
In the short run may have to live with “wrong” plant
SACS(Q)SACM(Q)
SACL(Q)
Q1 Q2 Q3
Ave
rage
Cos
t
Output
If expected output is Q1 install the small scale plant
If expected output is Q2 install the medium scale plant
If expected output is Q3 install the large scale plant
Q4
If expected outputis Q1 but actual
output is Q4 thenshort-run costs
will be on SACS(Q)
The long-run cost curveis the lower envelope ofthe short-run cost curves
Sunk costs
When assessing the costs of a decision consider only those costs the decision affects
Distinguish between sunk costs and avoidable costs inventory already existing is a sunk cost additions to inventory are avoidable costs
Sunk costs are not the same as fixed costs some fixed inputs can be redeployed from their existing
use if conditions change
Sunk costs (cont.)
Sunk costs affect strategy - particularly on entry and exit change of technology with existing production versus
adoption of new technology with greenfield site existing firms generally more reluctant to adopt new
technologies
The existence of sunk costs makes it difficult to eliminate a competitor
The existence of sunk costs is a barrier to entry
Demand and Revenues
The demand function describes the relationship between quantity demanded and variables that affect demand income tastes advertising price
The relationship between quantity and price is generally negative
Price
Quantity
P1
P2
Q1 Q2
At price P1 thequantity demanded
is Q1
At price P2 thequantity demanded
is Q2
Demand and Revenues (cont.)
There are exceptions to this “law of demand” prestige goods: price confers prestige goods where quality is not directly observable: price is
taken as a signal of quality
Where this is true then a cut in price may damage sales by damaging the good’s image
Price elasticity of demand
An increase in price generally reduces the quantity sold has an ambiguous effect on sales revenue
The relationship between a price change and sales revenue is determined by the elasticity of demand (or the sensitivity of demand to price)
definition:
= % change in quantity
% change in price
Price elasticity of demand (cont.)
If price elasticity of demand is greater than unity then an increase in price reduces sales revenue
If price elasticity of demand is less than unity then an increase in price increases sales revenue
Pri
ce
Quantity
Pri
ce
Quantity
Reduction in salesrevenue from increased
price
Increase in salesrevenue from increased
price
Reduction in salesrevenue from increased
price
Increase in salesrevenue from increased
price
Elastic demand Inelastic demand
Price elasticity of demand (cont.)
Demand is elastic if: close substitutes buyers’ expenditures
are a large proportion of total expenditure
product is an input to another product with elastic demand
Demand is inelastic if: comparison is difficult
complex product little experience
buyers’ pay only a small proportion of total cost
insurance coverage switching costs exist complementary with
other products
Pricing Decisions
If firm aims to maximize profit then the pricing and output rule is simple: choose output such that marginal revenue
equals marginal cost get price from the demand function: the price
that clears the marketUse the standard pricing formula:
P(1 - 1/) = MC
Game Theory
Firms not in competitive markets must make strategic decisions
When there are “few” firms these decisions are interdependent
game theory is a particularly useful tool for analyzing such interdependence and strategic choice assumes rationality
Matrix form and Nash equilibrium
Simple example of capacity choice by two firms
Alpha
Do Not Expand
Expand
Beta
Do Not Expand Expand
$18, $18
$20, $15 $16, $16
$15, $20
Dominantstrategyfor Beta
Dominantstrategy
for Alpha
$16, $16$16, $16
NashEquilibrium
Nash equilibrium
Need not be attractive generally does not maximize joint profits Prisoners’ dilemma
But it is compelling neither firm would choose to change strategy if its rival
does not
Timing is important: simultaneous (or non-observable) sequential (or observable)
Game trees and equilibrium
Consider a modified and expanded example
$18, $18
Alpha
Do Not Expand
Large
Beta
Do Not Expand LargeSmall
Small
$15, $20
$8, $12
$8, $12 $0, $0
$9, $18
$20, $15
$18, $9
$16, $16$16, $16$16, $16
Sequential choice
If choices are sequential the first mover can anticipate rival’s choice manipulate rival’s choice
With sequential choice use game tree
A game tree
Do not Expand
Do not Expand
Do not Expand
Do not Expand
Small
Small
Small
SmallLarge
Large
Large
Large
Alpha
Beta
Beta
Beta
($18, $18)
($15, $20)
($9, $18)
($20, $15)
($16, $16)
($8, $12)
($18, $9)
($12, $8)
($0, $0)
Small
Small
Do not Expand
Large