STRATEGY & ECONOMICS

The objective of the course is to come to understand ho the CEO is res!onsib"e for ensurin# the "on# term surviva" of the or#ani$ation ithin its environment% This is accom!"ished throu#h the strate#ic mana#ement !rocess% Successfu" strate#ies resu"t from the a!!"ication of consistent !rinci!"es to constant"& chan#in# business conditions% Strate#ies are the ada!tive' but !rinci!"ed' res!onses of firms to their surroundin#s% This course is about !rinci!"es' not reci!es( A strate#& is se"ected after addressin# the fo""o in# four areas) Boundaries Of The Firm: *hat shou"d the firm be doin# +Chand"er,s "o#ic of the mana#eria" enter!rise "ecture-% The boundaries define hat the firm is' and hat the firm does% .ertica" boundaries) the set of activities that the firm !erforms% The ori#ina" ma/e or bu& decision% Net or/ or#ani$ation .irtua" cor!oration 0ori$onta" boundaries) ho much of the !roduct mar/et the firm serves +de#ree and t&!e of !roduct diversification-% 1earnin# curve Mar/et #ro th rate Cor!orate boundaries) hat business or industr& shou"d e be in +de#ree and t&!e of diversification-2 3CG Matri4 5ortfo"io Mana#ement Industry and Competitive Analysis: The nature of the industr&+ies- in hich the firm com!etes% 5orter Business Strategy: 0o i"" e com!ete in this industr&2 5orter,s #eneric strate#ies) "o 6cost' differentiation' and focus Internal Organization: Structure 1eadershi! 5rocesses 666666666666666666666666 Basic Economic rinciples: *e /no from economics that com!etition ithin industries or/s to reduce returns to the !oint here mar#ina" costs e7ua"s mar#ina" revenue% One major objective of strate#& is to find a&s to avoid com!etitive !ressures so as to receive above norma" returns%

Economies of sca"e) Economies of Sca"e and Minimum Efficient Sca"e AC+8-

Cos t

8,

Out!ut

89

Economies of sca"e e4ist at out!ut "eve"s u! to 8,% It then e4hibits constant returns to sca"e u! to 89% 3e&ond 89 there are diseconomies of sca"e% 3ecause economies are e4hausted at 8, this !oint is ca""ed minimum efficient sca"e% :emand and Revenues) The demand function describes the re"ationshi! bet een the 7uantit& and !rice% E"asticit& of demand% If bu&ers are not !rice sensitive' e can raise !rices and sti"" se"" the same 7uantit&% That is' demand is !rice ine"astic% Note that there is a difference bet een brand6"eve" and industr&6"eve" e"asticit&% ;or e4am!"e' in the auto industr&' demand at the industr& "eve" is ine"astic% That is' tota" sa"es i"" not chan#e much if !rices are raised% 0o ever' if one manufacturer raises !rices +brand "eve"- hi"e others do not' the manufacturer i"" e4!erience a dec"ine in sa"es% That is' at the brand "eve" !rices are e"astic%

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!ertical Boundaries " The Original #a$e or Buy %ecision

Mar/et firms +Ni/e- vs% .ertica""& inte#rated firms +Internationa" 5a!er5rinci!"e) A !roduction techno"o#& that invo"ves a "ar#e u!6front investment in faci"ities and e7ui!ment i"" have a cost advanta#e over a techno"o#& that invo"ves a sma"" u!6front investment on"& if the firm can achieve a sufficient"& "ar#e "eve" of throu#h!ut% Sim!"& stated) i"" the firm be ab"e to achieve economies of sca"e' or #reater efficienc&' for the s!ecific activit& in 7uestion2 A /e& e"ement to assist is the conce!t of the va"ue chain hich #oes from u!stream su!!"iers' throu#h the firm' do nstream to the u"timate consumer% 3enefits of bein# a mar/et firm) Economies of sca"e +GM ith its bra/e unitMust be efficient and innovative to survive 6 subject to disci!"ine of mar/ets A#enc& costs<) the costs associated ith s"ac/ effort and the costs of administrative contro"s Inf"uence costs) the cost of interna" "obb&in# for resources Costs of bein# a mar/et firm) Coordination of activities a"on# va"ue chain Each e"ement on the va"ue chain must ma/e a !rofit .ertica""& inte#rated firms ca!ture that !rofit 5rivate information ma& be "ea/ed to other firms Transaction costs) re"ated to the cost of contracts 6 o!!ortunistic behavior 6666666666666666666666666666666666

Technical vs& Agency Efficiency

Given the above' e sti"" need more theor& as to h& some firms are vertica""& inte#rated as o!!osed to bein# mar/et firms% Technica" efficienc& indicates hether the firm is usin# the "east6cost !roduction !rocess% +!roductionA#enc& efficienc& refers to the e4tent to hich the e4chan#es are minimi$in# costs% +e4chan#eThere is a" a&s a trade off% Economizing is findin# the ba"ance hich minimi$es tota" costs% The fo""o in# fi#ure sho s this trade off% *e assume a fi4ed cost for a !articu"ar #ood% The vertica" a4is measures cost differences bet een ma/in# and bu&in#% 5ositive va"ues indicate it is chea!er to bu&% The hori$onta" a4is measures asset s!ecificit& +/-%
<

See the :&namism "ecture on the eb !a#e for a discussion of A#enc& Theor& and Transaction Cost Economics% There is a"so some materia" in the te4t on these subjects%

The curve =T sho s the differences in technica" efficienc& hen !roduced vs% !urchased% The curve is a" a&s !ositive sho in# it is chea!er to bu& than ma/e% *h&2 ;irms that s!ecia"i$e i"" a" a&s be more efficient% The curve dec"ines as s!ecificit& increases because fe er firms are "i/e"& to need the !roducts bein# made +banana bo"ts for ;<<< en#ines-% The curve =A sho s the difference in e4chan#e costs' a#enc& efficienc&' hen item is made vs% bou#ht% The curve is !ositive for "o 6s!ecificit& items +bric/s-' but ne#ative as s!ecificit& increases% At /> the costs become so "ar#e that ma/in# is more efficient than bu&in#% Curve =C is the sum of the other t o curves' and sho s the trade6off bet een technica" and a#enc& efficienc&% If the curve is !ositive' then bu&% If ne#ative' ma/e%

Genera" observations derived from the fi#ure) *hen the curve =C is !ositive' bu&% *hen ne#ative' ma/e% Sca"e and sco!e) A firm #ains "ess from vertica" inte#ration the #reater the abi"it& of an outside firm to ta/e advanta#e of economies of sca"e and sco!e% .ertica" inte#ration becomes increasin#"& attractive as the economies of sca"e in !roduction become "ess !ronounced% +The hei#ht of =T ref"ects the abi"it& of inde!endent !roducer to achieve economies of sca"e% Asset s!ecificit&) .ertica" inte#ration is !referred hen asset s!ecificit& is #reater than />>% 5roduct mar/et sca"e and #ro th) A firm #ains more from vertica" inte#ration the "ar#er the sca"e of its !roduct mar/et activities% As the sca"e of the transaction +vo"ume- increases' vertica" inte#ration is !referred +not sho n-% This is because the firm can e4!"oit economies of sca"e better than su!!"iers% Other factors hich indicate that vertica" inte#ration ma& be desirab"e refer to Mar/et Im!erfections% These inc"ude) The effects of im!erfect com!etition +bre er& industr&-

Achieve !rice discrimination +contro" of in!uts ? a"uminum;orec"ose entr& of ne firms +meat !ac/in# industr&Ac7uire information +com!uters and soft are industr&-

Other means of achievin# si$e' and hence economies' inde!endent of vertica" inte#ration) A""iances and joint ventures @eiretsu

'orizontal Boundaries: Economies of Scale ( Scope

The hori$onta" boundaries of the firm are the 7uantities and varieties of !roducts and services that the firm !roduces% These boundaries de!end on the effects of economies of sca"e and sco!e% These are !resent henever "ar#e6sca"e !roduction' distribution' or retai" !rocesses have a cost advanta#e over sma"" !rocesses% Economies of Sca"e) The avera#e cost !er unit dec"ines as the 7uantit& of #oodsAservices !roduced increases% ;or avera#e costs to dec"ine as out!ut increases the mar#ina" cost must be "ess than the overa"" avera#e cost% Economies of Sco!e) e4ist if the firm achieves savin#s as it increases the variet& of activities it !erforms% Bsua""& defined in terms of the re"ative tota" cost of !roducin# a variet& of #oods to#ether in one firm versus se!arate"& in other firms% In strate#ic mana#ement this is ca""ed C"evera#in# core com!etencies%9 Sources of Economies) <% Indivisibi"it& and the S!readin# of ;i4ed Costs) Indivisib"e means that an in!ut cannot be sca"ed do n be"o a certain minimum si$e% Economies of Sca"e) ca!acit& uti"i$ation #iven the indivisibi"it& of !roduction e7ui!ment% Auto !roduction' too" & d&e' etc% Economies of Sco!e) in!uts are shared to !roduct severa" !roductsAservices% GE) mu"ti!"e t&!es of e"ectric motors from one assemb"& "ine Retai"ers' air"ine industr& hub & s!o/e s&stems D% Increased 5roductivit& of .ariab"e In!uts) Economies of sca"e from increasin# the !roductivit& of variab"e in!uts) s!ecia"i$ation of "aborE efficiencies in ener#& usa#e% F% Inventories) Inventor& costs drive u! the avera#e costs of #ood so"d% G% The Cube6S7uare Ru"e) for#et it( This shou"d have been covered in !roduction mana#ement% H% Mar/et Economies) S!readin# advertisin# costs over "ar#er mar/etsE re!utation effects% An e4am!"e ou"d be Mc:ona"ds' EMI' 3an# and O"afson% I% Research & :eve"o!ment) invo"ves si#nificant indivisibi"ities' thus here R&: is critica" e4!ect to see "ar#er firms% E4am!"e) !harmaceutica" firms% J% 5urchasin# Economies) The #reater the fi4ed costs associated ith a #iven sa"e' the #reater the !robabi"it& of firms offerin# vo"ume discounts% E4am!"es) *a"Mart' the food industr&% Other conce!ts re"ated to hori$onta" boundaries)

The 1earnin# Curve) It is im!ortant to distin#uish economies due to the "earnin# curve from economies of sca"e% Economies of sca"e refer to the abi"it& to !erform activities at a "o er unit cost hen those activities are !erformed on a "ar#e sca"e% 1earnin# economies refer to reductions in unit costs due to accumu"atin# e4!erience% The& are distinct conce!ts%

666666666666666666666666666666666666666666666666 Source) 3esan/o' :ranove & Shan"e& +<KKI- Economics of Strategy' Ne Yor/) Lohn *i"e&%

Economies of sca"e) Economies of Sca"e and Minimum Efficient Sca"e

AC+8-

Cos t

8,

Out!ut

89

Economies of sca"e e4ist at out!ut "eve"s u! to 8,% It then e4hibits constant returns to sca"e u! to 89% 3e&ond 89 there are diseconomies of sca"e% 3ecause economies are e4hausted at 8, this !oint is ca""ed minimum efficient sca"e% *hat &ou are concerned ith is the sha!e of the curve% If re"ative"& f"at' economies of sca"e do not e4ist' but efficiencies can e4ist% If re"ative"& stee!' economies do e4ist% This is a jud#ement ca"" and re7uires &our justification of &our !osition( You i"" need t o indicators to !rove that economies of sca"e e4ist%