Economics of Strategy

Introduction: Strategy and Economics 1 Why Study Strategy? 1 Why Economics? 2 The Need for Principles 2 So What’s the Problem? 3 A Framework for Strategy 5 Boundaries of the Firm 6 Market and Competitive Analysis 6 Positioning and Dynamics 6 Internal Organization 6 The Book 7 Endnotes 7 Economics Primer: Basic Principles 8 Costs 9 Cost Functions 9 Total Cost Functions 9 Fixed and Variable Costs 11 Average and Marginal Cost Functions 11 The Importance of the Time Period: Long-Run versus Short-Run Cost Functions 14 Sunk versus Avoidable Costs 16 Economic Costs and Profitability 17 Economic versus Accounting Costs 17 Economic Profit versus Accounting Profit 18 Demand and Revenues 18 Demand Curve 18 The Price Elasticity of Demand 19 Brand-Level versus Industry-Level Elasticities 22 Total Revenue and Marginal Revenue Functions 22 Theory of the Firm: Pricing and Output Decisions 23 Perfect Competition 25 Game Theory 29 Games in Matrix Form and the Concept of Nash Equilibrium 30 Game Trees and Subgame Perfection 31 Chapter Summary 33 Questions 33 Endnotes 34 Part One Firm Boundaries 35 1 The Power of Principles: An Historical Perspective 37 Doing Business in 1840 37 Business Conditions in 1840: Life without a Modern Infrastructure 39 Transportation 39 Communications 40 Finance 41 Production Technology 42 Government 42 Doing Business in 1910 44 Business Conditions in 1910: A “Modern” Infrastructure 45 Production Technology 45 Transportation 45 Communications 46 Finance 46 Government 46 Doing Business Today 48 Modern Infrastructure 49 Transportation 49 Communications 49 Finance 50 Production Technology 50 Government 50 Infrastructure in Emerging Markets 51 Three Different Worlds: Consistent Principles, Changing Conditions, and Adaptive Strategies 52 Chapter Summary 52 Questions 53 Endnotes 54 2 The Horizontal Boundaries of The Firm 55 Definitions 55 Definition of Economies of Scale 55 Definition of Economies of Scope 57 Scale Economies, Indivisibilities, and the Spreading of Fixed Costs 57 Economies of Scale Due to Spreading of Product-Specific Fixed Costs 58 Economies of Scale Due to Trade-offs among Alternative Technologies 58 Indivisibilities Are More Likely When Production is Capital Intensive 60  “The Division of Labor is Limited by the Extent of the Market” 62 Special Sources of Economies of Scale and Scope 64 Density 64 Purchasing 65 Advertising 65 Costs of Sending Messages per Potential Consumer 65 Advertising Reach and Umbrella Branding 66 Research and Development 66 Physical Properties of Production 67 Inventories 67 Complementarities and Strategic Fit 68 Sources of Diseconomies of Scale 68 Labor Costs and Firm Size 69 Spreading Specialized Resources Too Thin 69 Bureaucracy 69 Economies of Scale: A Summary 70 The Learning Curve 70 The Concept of the Learning Curve 70 Expanding Output to Obtain a Cost Advantage 71 Learning and Organization 73 The Learning Curve versus Economies of Scale 74 Diversification 75 Why Do Firms Diversify? 76 Efficiency-Based Reasons for Diversification 76 Scope Economies 76 Internal Capital Markets 77 Problematic Justifications for Diversification 78 Diversifying Shareholders’ Portfolios 78 Identifying Undervalued Firms 78 Reasons Not to Diversify 79 Managerial Reasons for Diversification 79 Benefits to Managers from Acquisitions 79 Problems of Corporate Governance 80 The Market for Corporate Control and Recent Changes in Corporate Governance 81 Performance of Diversified Firms 83 Chapter Summary 85 Questions 86 Endnotes 88 3 The Vertical Boundaries of The Firm 90 Make versus Buy 90 Upstream, Downstream 92 Defining Boundaries 94 Some Make-or-Buy Fallacies 94 Avoiding Peak Prices 95 Tying Up Channels: Vertical Foreclosure 96 Reasons to “Buy” 98 Exploiting Scale and Learning Economies 98 Bureaucracy Effects: Avoiding Agency and Influence Costs 101 Agency Costs 101 Influence Costs 102 Organizational Design 104 Reasons to “Make” 104 The Economic Foundations of Contracts 104 Complete versus Incomplete Contracting 105 Bounded Rationality 105 Difficulties Specifying or Measuring Performance 106 Asymmetric Information 106 The Role of Contract Law 106 Coordination of Production Flows through the Vertical Chain 107 Leakage of Private Information 109 Transaction Costs 110 Relationship-Specific Assets 111 Forms of Asset Specificity 111 The Fundamental Transformation 112 Rents and Quasi-Rents 112 The Holdup Problem 113 Holdup and Ex Post Cooperation 115 The Holdup Problem and Transaction Costs 115 Contract Negotiation and Renegotiation 115 Investments to Improve Ex Post Bargaining Positions 116 Distrust 116 Reduced Investment 117 Recap: From Relationship-Specific Assets to Transaction Costs 117 Summarizing Make-or-Buy Decisions: The Make-or-Buy Decision Tree 118 Chapter Summary 119 Questions 119 Endnotes 122 4 Integration and Its Alternatives 124 What Does It Mean to Be “Integrated”? 124 The Property Rights Theory of the Firm 124 Alternative Forms of Organizing Transactions 125 Governance 127 Delegation 128 Recapping PRT 128 Path Dependence 129 Making the Integration Decision 129 Technical Efficiency versus Agency Efficiency 130 The Technical Efficiency/Agency Efficiency Trade-off 130 Real-World Evidence 134 Double Marginalization: A Final Integration Consideration 136 Alternatives to Vertical Integration 138 Tapered Integration: Make and Buy 138 Franchising 138 Strategic Alliances and Joint Ventures 140 Implicit Contracts and Long-Term Relationships 143 Business Groups 145 Keiretsu 145 Chaebol 147 Business Groups in Emerging Markets 148 Chapter Summary 149 Questions 150 Endnotes 151 Part Two Market and Competitive Analysis 153 5 Competitors and Competition 155 Competitor Identification and Market Definition 156 The Basics of Market Definition and Competitor Identification 156 Putting Competitor Identification into Practice 157 Empirical Approaches to Competitor Identification 158 Geographic Competitor Identification 160 Measuring Market Structure 162 Market Structure and Competition 163 Perfect Competition 163 Many Sellers 164 Homogeneous Products 164 Excess Capacity 165 Monopoly 166 Monopolistic Competition 168 Demand for Differentiated Goods 168 Entry into Monopolistically Competitive Markets 169 Oligopoly 170 Cournot Quantity Competition 171 The Revenue Destruction Effect 174 Cournot’s Model in Practice 175 Bertrand Price Competition 175 Why Are Cournot and Bertrand Different? 177 Bertrand Price Competition When Products Are Horizontally Differentiated 179 Evidence on Market Structure and Performance 181 Price and Concentration 181 Chapter Summary 182 Questions 182 Endnotes 184 6 Entry and Exit 186 Some Facts about Entry and Exit 187 Entry and Exit Decisions: Basic Concepts 188 Barriers to Entry 188 Bain’s Typology of Entry Conditions 189 Analyzing Entry Conditions: The Asymmetry Requirement 189 Structural Entry Barriers 191 Control of Essential Resources 191 Economies of Scale and Scope 192 Marketing Advantages of Incumbency 194 Barriers to Exit 195 Entry-Deterring Strategies 196 Limit Pricing 196 Is Strategic Limit Pricing Rational? 198 Predatory Pricing 200 The Chain-Store Paradox 200 Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation 202 Wars of Attrition 203 Predation and Capacity Expansion 204 Strategic Bundling 205 “Judo Economics” 206 Evidence on Entry-Deterring Behavior 207 Contestable Markets 208 An Entry Deterrence Checklist 208 Entering a New Market 208 Preemptive Entry and Rent-Seeking Behavior 210 Chapter Summary 211 Questions 212 Endnotes 213 7 Dynamics: Competing Across Time 214 Microdynamics 215 The Strategic Benefits of Commitment 215 Strategic Substitutes and Strategic Complements 216 The Strategic Effect of Commitments 217 Tough and Soft Commitments 219 A Taxonomy of Commitment Strategies 219 The Informational Benefits of Flexibility 220 Real Options 222 A Framework for Analyzing Commitments 223 Competitive Discipline 224 Dynamic Pricing Rivalry and Tit-for-Tat Pricing 225 Why is Tit-for-Tat So Compelling? 227 Coordinating on the Right Price 227 Impediments to Coordination 229 The Misread Problem 229 Lumpiness of Orders 230 Information about the Sales Transaction 231 Volatility of Demand Conditions 231 Asymmetries among Firms and the Sustainability of Cooperative Prices 232 Price Sensitivity of Buyers and the Sustainability of Cooperative Pricing 233 Market Structure and the Sustainability of Cooperative Pricing: Summary 233 Facilitating Practices 234 Price Leadership 234 Advance Announcement of Price Changes 234 Most Favored Customer Clauses 234 Uniform Delivered Prices 236 Where Does Market Structure Come From? 237 Sutton’s Endogenous Sunk Costs 238 Innovation and Market Evolution 240 Learning and Industry Dynamics 241 Chapter Summary 241 Questions 242 Endnotes 244 8 Industry Analysis 247 Performing a Five-Forces Analysis 248 Internal Rivalry 249 Entry 250 Substitutes and Complements 251 Supplier Power and Buyer Power 251 Strategies for Coping with the Five Forces 252 Coopetition and the Value Net 253 Applying the Five Forces: Some Industry Analyses 255 Chicago Hospital Markets Then and Now 255 Market Definition 255 Internal Rivalry 255 Entry 256 Substitutes and Complements 257 Supplier Power 257 Buyer Power 258 Commercial Airframe Manufacturing 259 Market Definition 259 Internal Rivalry 259 Barriers to Entry 260 Substitutes and Complements 261 Supplier Power 261 Buyer Power 262 Professional Sports 262 Market Definition 262 Internal Rivalry 262 Entry 264 Substitutes and Complements 266 Supplier Power 267 Buyer Power 267 Conclusion 267 Professional Search Firms 268 Market Definition 268 Internal Rivalry 268 Entry 269 Substitutes and Complements 269 Supplier Power 270 Buyer Power 270 Conclusion 270 Chapter Summary 271 Questions 271 Endnotes 275 Part Three Strategic Position and Dynamics 277 9 Strategic Positioning For Competitive Advantage 279 Competitive Advantage and Value Creation: Conceptual Foundations 280 Competitive Advantage Defined 280 Maximum Willingness-to-Pay and Consumer Surplus 281 From Maximum Willingness-to-Pay to Consumer Surplus 282 Value-Created 284 Value Creation and “Win–Win” Business Opportunities 287 Value Creation and Competitive Advantage 288 Analyzing Value Creation 288 Value Creation and the Value Chain 292 Value Creation, Resources, and Capabilities 292 Strategic Positioning: Cost Advantage and Benefit Advantage 296 Generic Strategies 296 The Strategic Logic of Cost Leadership 296 The Strategic Logic of Benefit Leadership 298 Extracting Profits from Cost and Benefit Advantage 301 Comparing Cost and Benefit Advantages 302 “Stuck in the Middle” 304 Diagnosing Cost and Benefit Drivers 306 Cost Drivers 306 Cost Drivers Related to Firm Size, Scope, and Cumulative Experience 307 Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience 307 Cost Drivers Related to Organization of the Transactions 308 Benefit Drivers 308 Methods for Estimating and Characterizing Costs and Perceived Benefits 309 Estimating Costs 309 Estimating Benefits 310 Strategic Positioning: Broad Coverage versus Focus Strategies 310 Segmenting an Industry 310 Broad Coverage Strategies 311 Focus Strategies 312 Chapter Summary 314 Questions 315 Endnotes 318 10 Information and Value Creation 320 The “Shopping Problem” 321 Unraveling 322 Alternatives to Disclosure 323 Nonprofit Firms 327 Report Cards 327 Multitasking: Teaching to the Test 328 What to Measure 331 Risk Adjustment 335 Presenting Report Card Results 336 Gaming Report Cards 337 The Certifier Market 339 Certification Bias 340 Matchmaking 342 When Sellers Search for Buyers 343 Chapter Summary 345 Questions 346 Endnotes 347 11 Sustaining Competitive Advantage 349 Market Structure and Threats to Sustainability 349 Threats to Sustainability in Competitive and Monopolistically Competitive Markets 350 Threats to Sustainability under All Market Structures 351 Evidence: The Persistence of Profitability 351 The Resource-Based Theory of the Firm 353 Imperfect Mobility and Cospecialization 353 Isolating Mechanisms 355 Impediments to Imitation 358 Legal Restrictions 358 Superior Access to Inputs or Customers 359 The Winner’s Curse 361 Market Size and Scale Economies 361 Intangible Barriers to Imitation 362 Causal Ambiguity 363 Dependence on Historical Circumstances 363 Social Complexity 363 Early-Mover Advantages 364 Learning Curve 364 Reputation and Buyer Uncertainty 364 Buyer Switching Costs 364 Network Effects 365 Networks and Standards 365 Competing “For the Market” versus “In the Market” 366 Knocking Off a Dominant Standard 367 Early-Mover Disadvantages 367 Imperfect Imitability and Industry Equilibrium 368 Creating Advantage and Creative Destruction 370 Disruptive Technologies 370 The Productivity Effect 371 The Sunk Cost Effect 371 The Replacement Effect 372 The Efficiency Effect 372 Disruption versus the Resource-Based Theory of the Firm 373 Innovation and the Market for Ideas 373 Evolutionary Economics and Dynamic Capabilities 375 The Environment 376 Factor Conditions 376 Demand Conditions 376 Related Supplier or Support Industries 376 Strategy, Structure, and Rivalry 378 Chapter Summary 378 Questions 379 Endnotes 381 Part Four Internal Organization 383 12 Performance Measurement and Incentives 385 The Principal–Agent Relationship 386 Combating Agency Problems 386 Performance-Based Incentives 388 Problems with Performance-Based Incentives 393 Preferences over Risky Outcomes 393 Risk Sharing 394 Risk and Incentives 396 Performance Measures That Fail to Reflect All Desired Actions 399 Selecting Performance Measures: Managing Trade-offs between Costs 401 Do Pay-for-Performance Incentives Work? 404 Implicit Incentive Contracts 405 Subjective Performance Evaluation 405 Promotion Tournaments 406 Efficiency Wages and the Threat of Termination 409 Incentives in Teams 410 Chapter Summary 413 Questions 414 Endnotes 416 13 Strategy and Structure 419 An Introduction to Structure 421 Individuals, Teams, and Hierarchies 421 Complex Hierarchy 424 Departmentalization 424 Coordination and Control 426 Approaches to Coordination 428 Types of Organizational Structures 431 Functional Structure (U-form) 431 Multidivisional Structure (M-form) 433 Matrix Structure 434 Matrix or Division? A Model of Optimal Structure 435 Network Structure 436 Why Are There So Few Structural Types? 438 Strategy-Environment Coherence 439 Technology and Task Interdependence 440 Information Processing 442 Structure Follows Strategy 443 Strategy, Structure, and the Multinational Firm 445 Hybrid Organizations 449 Chapter Summary 451 Questions 452 Endnotes 453 14 Environment, Power, and Culture 456 The Social Context of Firm Behavior 456 Internal Context 458 Power 459 The Sources of Power 460 Structural Views of Power 463 Do Successful Organizations Need Powerful Managers? 464 The Decision to Allocate Formal Power to Individuals 466 Culture 468 Culture Complements Formal Controls 470 Culture Facilitates Cooperation and Reduces Bargaining Costs 471 Culture, Inertia, and Performance 472 A Word of Caution about Culture 473 External Context, Institutions, and Strategies 474 Institutions and Regulation 477 Interfirm Resource Dependence Relationships 478 Industry Logics: Beliefs, Values, and Behavioral Norms 481 Chapter Summary 483 Questions 484 Endnotes 485 Glossary 488 Name Index ••• Subject Index •••